The Company leases its principal executive office at 1105 North Market Street, Suite 1230, Wilmington, Delaware under an operating lease expiring in October 2009. RSLIC leases its administrative office at 2001 Market Street, Suite 1500, Philadelphia, Pennsylvania, under an operating lease expiring in December 2015. SNCC owns its home office building at 2043 Woodland Parkway, Suite 200, St. Louis, Missouri, which consists of approximately 58,000 square feet. SNCC also owns land located at 1832 Schuetz Road, St. Louis, Missouri. This location, which is currently under construction and expected to be completed in 2008, will serve as SNCC’s new home office consisting of approximately 140,000 square feet. SNCC leases additional office space at 2029 Woodland Parkway, St. Louis, Missouri, under an operating lease expiring in September 2008. DCM and FRSLIC lease office space at 590 Madison Avenue, New York, New York under an operating lease expiring in November 2010. A substantial portion of the office space that DCM and FRSLIC formerly occupied at 153 East 53rd Street, 49th Floor, New York, New York under an operating lease expiring in July 2008 has been sublet to third parties. Matrix leases its principal office at 5225 Hellyer Avenue, Suite 210, San Jose, California under an operating lease expiring in December 2010. The Company also maintains sales and administrative offices throughout the country to provide nationwide sales support and service existing business. The Company believes that its properties and facilitates are suitable and adequate for current operations.
The Company also operates an asset accumulation business that focuses primarily on offering fixed annuities to individuals. In addition, during the first quarter of 2006, the Company issued $100 million in aggregate principal amount of fixed and floating rate funding agreements with maturities of three to five years in connection with the issuance by an unconsolidated special purpose vehicle of funding agreement-backed notes in a corresponding principal amount. The Company believes that the funding agreement program enhances the Company’s asset accumulation business by providing an alternative source of distribution for this business. The Company’s liabilities for the funding agreements are recorded in policyholder account balances. Deposits from the Company’s asset accumulation business are recorded as liabilities rather than as premiums. Revenues from the Company’s asset accumulation business are primarily comprised of investment income earned on the funds under management. The profitability of asset accumulation products is primarily dependent on the spread achieved between the return on investments and the interest credited to holders of these products. The Company sets the crediting rates offered on its asset accumulation products in an effort to achieve its targeted interest rate spreads on these products, and is willing to accept lower levels of sales on these products when market conditions make these targeted spreads more difficult to achieve.
As noted above and elsewhere in this document, the management of the Company’s investment portfolio is an important component of its profitability. Over the second half of 2007 and continuing into 2008, due to the subprime mortgage crisis and other market developments, the investment markets have been the subject of substantially increased volatility, while at the same time the overall level of risk-free interest rates has declined substantially. If these market conditions continue to persist, the Company’s ability to achieve attractive yields with respect to its fixed maturity security investments may be adversely affected, and the carrying values of certain portions of its investment portfolio may be subject to an unusually high degree of variability. In the cases of those investments whose changes in value, positive or negative, are included in the Company’s net investment income, such as the investment funds organized as limited partnerships and limited liability companies, this variability may result in significant fluctuations in net investment income, and as a result, in the Company’s results of operations.
Summary of Results. Net income was $164.5 million, or $3.19 per diluted share, in 2007 as compared to $142.1 million, or $2.79 per diluted share, in 2006. Net income in 2007 and 2006 included net realized investment losses, net of the related income tax benefit, of $1.2 million, or $0.02 per diluted share, and $0.6 million, or $0.01 per diluted share, respectively. Net income in 2007 benefited from growth in income from the Company’s core group employee benefit products, increased investment spreads on the Company’s asset accumulation products and an increase in net investment income, and was adversely impacted by an increase in interest expense and by a loss on the redemption of junior subordinated deferrable interest debentures. Core group employee benefit products include disability, group life, excess workers’ compensation, travel accident and dental insurance. See “Group Employee Benefit Products” in Part I, Item 1 - Business. Premiums from these core group employee benefit products increased 14% in 2007 and the combined ratio (loss ratio plus expense ratio) for group employee benefit products decreased to 92.4% in 2007 from 93.2% in 2006. Net investment income in 2007, which increased 6% from 2006, primarily reflects a 13% increase in average invested assets. The increase in interest expense was primarily due to interest payments on the 2007 Junior Debentures, which the Company issued in the second quarter of 2007.
Premium and Fee Income. Premium and fee income in 2007 was $1,304.2 million as compared to $1,156.6 million in 2006, an increase of 13%. Premiums from core group employee benefit products increased 14% to $1,227.9 million in 2007 from $1,081.7 million in 2006. This increase reflects normal growth in employment and salary levels for the Company’s existing customer base, price increases, new business production and improved persistency. Premiums from excess workers’ compensation insurance for self-insured employers increased 6% to $276.2 million in 2007 from $260.0 million in 2006. This increase was primarily due to the continuing substantial level of demand for this product. Excess workers’ compensation premiums in 2007 included $3.5 million of 2006 policy year premiums from Canadian policies assumed by SNCC in the first quarter of 2007 under the renewal rights agreement entered into by SNCC in 2005 (the “Renewal Rights Agreement”), pursuant to Canadian regulatory approval received in the first quarter. Under the agreement, SNCC acquired, among other things, the right to offer renewal quotes to expiring excess workers’ compensation policies of a former competitor. Excess workers’ compensation new business production, which represents the amount of new annualized premium sold, was $30.1 million in 2007, including $3.4 million from the Renewal Rights Agreement, compared to $57.2 million in 2006, including $25.8 million from such agreement. SNCC’s rates declined modestly on its 2008 renewals and SIRs on average are up modestly in 2008 new and renewal policies, excluding the
Premiums from the Company’s other core group employee benefit products increased 16% to $951.7 million in 2007 from $821.6 million in 2006, primarily attributable to a 15% increase in premiums from the Company’s group disability products, new business production, improved retention of existing customers and a decrease in premiums ceded by the Company to reinsurers for these products. During 2007, premiums from the Company’s group disability products increased to $527.5 million from $458.1 million in 2006, primarily reflecting new business production. Premiums from the Company’s turnkey disability business were $53.6 million and $54.3 million in 2007 and 2006, respectively. New business production for the Company’s other core group employee benefit products increased 18% to $262.7 million in 2007 from $222.9 million in 2006 reflecting growth in the Company’s integrated employee benefits program and its suite of voluntary group insurance products, which includes, among others, its group limited benefit health insurance product. New business production includes only directly written business, and does not include premiums from the Company’s turnkey disability business. The level of production achieved from these other core group employee products also reflects the Company’s focus on the small case niche (insured groups of 10 to 500 individuals). The Company continues to implement price increases for certain existing group disability and group life insurance customers.
Net Realized Investment Losses. Net realized investment losses were $1.9 million in 2007 as compared to $0.9 million in 2006. The Company’s investment strategy results in periodic sales of securities and, therefore, the recognition of realized investment gains and losses. During 2007 and 2006, the Company recognized $2.2 million and $3.3 million, respectively, of net gains on the sales of securities. The Company monitors its investments on an ongoing basis. When the market value of a security declines below its cost, and management judges the decline to be other than temporary, the security is written down to fair value, and the decline is reported as a realized investment loss. In 2007 and 2006, the Company recognized $4.1 million and 4.2 million, respectively, of losses due to the other than temporary declines in the market values of various fixed maturity and other securities.
Loss on Redemption of Junior Subordinated Deferrable Interest Debentures. During 2007, the Company recognized a pre-tax loss of $2.2 million from the redemption of the 9.31% junior subordinated deferrable interest debentures (“Junior Debentures”) underlying the 9.31% Capital Securities, Series A (“Capital Securities”) of Delphi Funding L.L.C. On March 27, 2007, Delphi Funding L.L.C. redeemed the remaining $36.0 million liquidation amount of Capital Securities
Benefits and Expenses. Policyholder benefits and expenses were $1,310.6 million in 2007 as compared to $1,178.2 million in 2006, an increase of 11%. This increase primarily reflects the increase in premiums from the Company’s group employee benefit products discussed above, and also reflects additions to reserves for prior years’ claims and claim expenses in the amount of $11.6 million due to adverse loss experience, primarily arising from the Company’s excess workers’ compensation line, due principally to moderately increased claim frequency, relative to prior periods, relating to policies written during the period from 2000 to 2002. If this experience trend were to continue in the future, absent favorable loss experience in other policy years, the Company’s results of operations could be materially adversely affected. The combined ratio (loss ratio plus expense ratio) for the Company’s group employee benefits products decreased to 92.4% in 2007 from 93.2% in 2006. The weighted average annual crediting rate on the Company’s asset accumulation products, which reflects the effects of the first year bonus crediting rate on certain newly issued products, was 4.3% and 4.5% in 2007 and 2006, respectively.
Summary of Results. Net income was $142.1 million, or $2.79 per diluted share, in 2006 as compared to $113.3 million, or $2.25 per diluted share, in 2005. Net income in 2006 and 2005 included realized investment (losses) gains (net of the related income tax (benefit) expense) of $(0.6) million, or $(0.01) per diluted share, and $5.9 million, or $0.12 per diluted share, respectively. Net income in 2006 benefited from growth in income from the Company’s core group employee benefit products, increased investment spreads on the Company’s asset accumulation products and an increase in net investment income, and was adversely impacted by an increase in interest expense. Core group employee benefit products include disability, group life, excess workers’ compensation, travel accident and dental insurance. See “Group Employee Benefit Products” in Part I, Item 1 - Business. Premiums from these core group employee benefit products increased 16% in 2006 and the combined ratio (loss ratio plus expense ratio) for these products decreased to 93.2% in 2006 from 94.1% in 2005. Net investment income in 2006, which increased 14% from 2005, reflects a 12% increase in average invested assets. The increase in interest expense was primarily due to increases in the Company’s weighted average borrowings under the Company’s revolving credit facility, as well as in the weighted average borrowing rate due to the increases in the levels of the short-term interest indices referenced under such facility during 2006 as compared to 2005. During 2006 and 2005, the Company had losses from discontinued operations (net of the related income tax benefit) of $2.9 million, or $0.06 per diluted share, and $13.4 million, or $0.27 per diluted share, respectively, attributable to its non-core property catastrophe reinsurance business which it decided to exit during the fourth quarter of 2005.
Premium and Fee Income. Premium and fee income in 2006 was $1,156.6 million as compared to $990.2 million in 2005, an increase of 17%. Premiums from core group employee benefit products increased 16% to $1,081.7 million in 2006 from $936.2 million in 2005. This increase reflects normal growth in employment and salary levels for the Company’s existing customer base, price increases, new business production and improved persistency. Premiums from excess workers’ compensation insurance for self-insured employers increased 18% to $260.0 million in 2006 from $220.3 million in 2005. This increase was primarily due to the demand for this product as a result of high primary workers’ compensation rates. In its renewals of insurance coverage during 2006, SNCC continued to obtain higher SIR levels, which were up 6%, while maintaining its pricing. Excess workers’ compensation new business production, which represents the amount of new annualized premium sold, increased 24% to $57.2 million in 2006 from $46.0 million in 2005 and the retention of existing customers in 2006 remained strong. New business production for 2005 and 2006 benefited from the aforementioned Renewal Rights Agreement.
Deposits from the Company’s asset accumulation products were $190.7 million in 2006 as compared to $95.0 million in 2005. These deposits consist of new annuity sales and funding agreements, which are recorded as liabilities rather than as premiums. The increase in deposits reflects the issuance of $100.0 million in aggregate principal amount of fixed and floating rate funding agreements during the first quarter of 2006 under the Company’s new program under which funding agreement-backed notes are issued to institutional investors by an unconsolidated special purpose vehicle which uses the proceeds to purchase from the Company funding agreements having terms substantially similar to those of the notes.
Net Investment Income. Net investment income in 2006 was $255.9 million as compared to $223.6 million in 2005, an increase of 14%. The level of net investment income in the 2006 period reflects a 12% increase in average invested assets to $4,038.7 million in 2006 from $3,621.6 million in 2005. The tax equivalent weighted average annual yield on invested assets was 6.6% and 6.4% in 2006 and 2005, respectively.
Net Realized Investment (Losses) Gains. Net realized investment losses were $0.9 million in 2006 as compared to net realized investment gains of $9.0 million in 2005. The Company’s investment strategy results in periodic sales of securities and, therefore, the recognition of realized investment gains and losses. During 2006 and 2005, the Company recognized $3.3 million and $13.2 million, respectively, of net gains on the sales of securities. The Company monitors its investments on an ongoing basis. When the market value of a security declines below its cost, and management judges the decline to be other than temporary, the security is written down to fair value, and the decline is reported as a realized investment loss. In each of 2006 and 2005, the Company recognized $4.2 million of losses due to the other than temporary declines in the market values of various fixed maturity and other securities.
During the first quarter of 2007, the Company recognized a pre-tax loss of $2.2 million from the redemption of the Junior Debentures underlying the Capital Securities of Delphi Funding L.L.C. On March 27, 2007, Delphi Funding L.L.C. redeemed the remaining $36.0 million liquidation amount of Capital Securities concurrently with the redemption by the Company of the underlying Junior Debentures held by Delphi Funding L.L.C. The redemption price was $1,046.55 per Capital Security plus accrued dividends. As a result, the $103.1 million principal amount of the Junior Debentures ceased to be outstanding and dividends on the Junior Debentures ceased to accrue. The Company utilized borrowings under its Amended Credit Agreement and cash on hand to fund such redemption.
The following table summarizes the Company’s significant contractual obligations at December 31, 2007 and the future periods in which such obligations are expected to be settled in cash. The 2033 Senior Notes, 2007 Junior Debentures and the junior subordinated deferrable interest debentures underlying company-obligated mandatorily redeemable capital securities issued by unconsolidated subsidiaries are assumed to be repaid on their respective maturity dates. Additional details regarding these obligations are provided in the notes to the consolidated financial statements, as referenced in the table:
Other long-term liabilities consist of future policy benefits and unpaid claims and claim expenses relating to the Company’s insurance products, as well as policyholder account balances. Substantially all of the amounts reflected in this table with respect to such liabilities consist of estimates by the Company’s management based on various actuarial and other assumptions relating to the Company’s insurance products and, as to policyholder account balances, the periods for which the related annuity and other contracts will remain in force and the crediting rates to be applied thereto in the future. In accordance with GAAP, a substantial portion of such liabilities, as they relate to the Company’s insurance products, are carried on a discounted basis on its consolidated balance sheet; however, the amounts contained in this table are presented on an undiscounted basis. The actual payments relating to these liabilities will differ, both in amount and timing, from those indicated in this table and such differences are likely to be significant. See “Critical Accounting Policies and Estimates - Future Policy Benefits and Unpaid Claims and Claim Expenses”.
Interest on the 2007 Junior Debentures is fixed at 7.376% until May 15, 2017.
The principal liquidity requirements of the Company’s insurance subsidiaries are their contractual obligations to policyholders and other financing sources. The primary sources of funding for these obligations, in addition to operating earnings, are the marketable investments included in the investment portfolios of these subsidiaries. The Company actively manages its investment portfolio to match its invested assets and related liabilities. The Company regularly analyzes the results of its asset/liability matching through cash flow analysis and duration matching under multiple interest rate scenarios. See “Asset/Liability Management and Market Risk.” Therefore, the Company believes that these sources of funding will be adequate for its insurance subsidiaries to satisfy on both a short-term and long-term basis these contractual obligations throughout their estimated or stated period. However, if such contractual obligations were to arise more rapidly or in greater amounts than anticipated in the Company’s asset/liability matching analysis, the Company could be required to sell securities earlier than anticipated, potentially resulting in the realization of capital losses (particularly, as regards fixed income securities, in a rising interest rate environment), or to borrow funds from available credit sources, in order to fund the payment of such obligations. In any of such events, the Company’s results of operations, liquidity and financial condition could be materially adversely affected.
At December 31, 2007, approximately 30% of the Company’s total invested assets were comprised of corporate fixed maturity securities. Eighty-two percent of the Company’s corporate fixed maturity portfolio, based on fair values, has been rated investment grade by nationally recognized statistical rating organizations. Investment grade corporate fixed maturity securities are distributed among the various rating categories as follows: AAA - 4%, AA - 19%, A - 21%, and BBB - 38%. Corporate fixed maturity securities subject the Company to credit risk and, to a lesser extent, interest rate risk. To reduce its exposure to corporate credit risk, the Company diversifies its investments across economic sectors, industry classes and issuers.
The Company, through its insurance subsidiaries, maintains a program in which investments are financed using advances from various Federal Home Loan Banks. The Company has utilized this program to manage the duration of its liabilities and to earn spread income, which is the difference between the financing cost and the earnings from the investments purchased with those funds. At December 31, 2007, the Company had an outstanding advance of $55.0 million. The advance was obtained at a fixed rate and has a term to maturity of 12.5 years. In addition, the Company has from time to time utilized reverse repurchase agreements, futures and option contracts and interest rate and credit default swaps in connection with its investment strategy. These transactions may require the Company to maintain securities or cash on deposit with the applicable counterparty as collateral. As the market value of the collateral or contracts changes, the Company may be required to deposit additional collateral or be entitled to have a portion of the collateral returned to it.
Asset/Liability Management and Market Risk. Because the Company’s primary assets and liabilities are financial in nature, the Company’s consolidated financial position and earnings are subject to risks resulting from changes in interest rates. The Company seeks to manage this risk by active portfolio management focusing on minimizing its exposure to fluctuations in interest rates by matching its invested assets and related liabilities and by periodically adjusting the crediting rates on its annuity products and the discount rate used to calculate reserves on the Company’s other products. In its asset/liability matching process, the Company determines and monitors on a quarterly basis the duration of its insurance liabilities in the aggregate and the duration of the investment portfolio supporting such liabilities in order to ensure that the difference between such durations, or the “duration gap,” remains below an internally specified maximum, and similarly determines and monitors the duration gap as between its interest-sensitive liabilities, substantially all of which relate to its asset accumulation products, and the components of its investment portfolio supporting such liabilities in relation to a separate internally specified maximum. As of December 31, 2007, the Company maintained these duration gaps within the aforementioned maximums. In addition, the Company, at times, has utilized futures and option contracts and interest rate or credit default swap agreements primarily to reduce the risk associated with changes in the value of its fixed maturity portfolio. At December 31, 2007, the Company had no material outstanding futures or option contracts or interest rate or credit default swap agreements. The Company, at times, may also invest in foreign currency denominated fixed maturity securities that expose it to fluctuations in foreign currency rates, and therefore, may hedge such exposure by using currency forward contracts. The Company’s investment in foreign currency denominated fixed maturity securities during 2007 was less than 0.6% of total invested assets.
The preparation of financial statements in conformity with GAAP requires the Company’s management, in some instances, to make judgments about the application of these principles. The amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period could differ materially from the amounts reported if different conditions existed or different judgments were utilized. Management’s judgment is most critical in the estimation of its liabilities for future policy benefits and unpaid claims and claim expenses and its assets for cost of business acquired and in the valuation of its investments. A discussion of how management applies these critical accounting policies follows.
Future Policy Benefits and Unpaid Claims and Claim Expenses. The Company establishes reserves that are intended to be sufficient to fund the future policy benefits and unpaid claims and claim expenses relating to its insurance products. These reserves, which totaled $2,353.4 million at December 31, 2007, represent management’s best estimate of future policy benefits and unpaid claims and claim expenses. The reserves are calculated using various generally recognized actuarial methodologies and are based upon assumptions and estimates that management believes are appropriate and which vary by type of product. Annually, external actuarial experts also review the Company’s property and casualty reserve methodologies, assumptions and the resulting reserves. The Company’s projected ultimate insurance liabilities and associated reserves are estimates, which are subject to variability. This variability arises because the factors and events affecting the ultimate liability for claims have not all taken place, and thus cannot be evaluated with certainty. As a result, actual future ultimate losses will not develop exactly as projected and may vary significantly from the projections. The estimation process is complex and involves information obtained from company-specific and industry-wide data, as well as general economic information. The Company’s insurance reserves are based upon management’s informed estimates and judgments using currently available data. As additional experience emerges and other data become available, these estimates and judgments are reviewed and may be revised. The methods and assumptions used to establish the Company’s insurance reserves are continually reviewed and updated based on current circumstances, and any
The most significant assumptions made in the estimation process for future policy benefits and unpaid claims and claim expenses for the Company’s disability and accident products relate to mortality, morbidity, claim termination and discount rates. Mortality and morbidity assumptions are based on various actuarial tables that are generally utilized in the industry, modified as believed to be necessary for possible variations. The claim termination rate represents the probability that a disability claim will close or change due to maximum benefits being paid under the policy, the recovery or death of the claimant, or a change in status in any given period. Establishing claim termination rates is complex and involves many factors, including the cause of disability, the claimant’s age and the type of contractual benefits provided. The Company uses its extensive claim experience database to develop its claim termination rate assumptions, which are applied as an average to its large population of active claims. A one percent increase or decrease in the group long-term disability claim termination rate established by the Company, which the Company believes is a reasonable range of variance in this regard, would have decreased or increased, respectively, the reserves established for claims incurred in 2007 by approximately $0.8 million, which would in turn have increased or decreased, respectively, its 2007 net income by $0.5 million. Disability reserves are discounted using interest rate assumptions based upon projected portfolio yield rates for the assets supporting the liabilities. The Company’s discount rate assumptions are discussed in further detail below.
The Company’s reserves for unpaid claims and claim expenses are determined on an individual basis for reported claims, for which case reserves are established, and estimates of incurred but not reported (“IBNR”) losses are developed on the basis of past experience. The unpaid claims and claim expense reserves carried for the Company’s casualty insurance products represent the difference between the selected ultimate loss amount and the loss amount paid to date. The unpaid claims and claim expense reserves carried for the Company’s disability and accident insurance products are established by the incurred loss development method (as described below) utilizing various mathematic tools in order to project future loss experience based on the Company’s historical loss experience. The difference between total unpaid claims and claim expense reserves and case unpaid claims and claim expense reserves represent the IBNR reserve. The following table summarizes the composition of the Company’s total reserves for disability, accident and property and casualty claims and claim expenses, split between case and IBNR reserves, as of December 31, 2007 (dollars in millions):
The primary actuarial methods used to establish the Company’s reserves for unpaid claims and claim expenses for its property and casualty insurance products are the incurred loss development method and the Bornhuetter-Ferguson expected loss method. Under the incurred loss development method, various mathematic tools are utilized in order to project future loss experience based on the Company’s historical loss experience. This method is utilized for accident years as to which management believes a sufficient level of historical loss experience exists. For more recent years for which this level of experience does not exist, management utilizes the Bornhuetter-Ferguson expected loss method to establish loss reserves. Under this method, in addition to historical loss experience, the Company also takes into account an expected loss ratio based on information determined during the initial pricing of the business, including, among other factors, rate increases and changes in terms and conditions.
For the Company’s property and casualty insurance products, a review of the nine most recent years’ historical loss development variation reflects an annual range of -3.4% to + 6.6%. The average annual increase reflected in such review was +3.7% and the average decrease was -1.7%. If the Company were to assume subsequent loss development of +3.7% or -1.7%, each of which are within historical variation, the estimated unpaid claims and claims expense reserves, net of reinsurance, established for such products as of December 31, 2007 would be increased by $28.0 million in the first case, which would have decreased its 2007 net income by $18.2 million, or decreased by $12.6 million in the second, which would have increased its 2007 net income by $8.2 million. Management believes that while fluctuations of this magnitude could have a material impact on the Company’s results of operations, they would not be likely to materially affect its financial condition or liquidity. However, it is possible that, using other assumptions or variables that are outside of the range of historical variation, the level of the Company’s unpaid claims and claim expenses could be changed by an amount that could be material to the Company’s results of operations, financial condition and liquidity.
With Modifications or Exchanges of Insurance Contracts.” SOP 05-1 provides accounting guidance for deferred policy acquisition costs associated with internal replacements of insurance and investment contracts not addressed by previous guidance, including group insurance contracts. It defines an internal replacement as a modification in product benefits, features, rights, or coverages that occurs by the exchange of a contract for a new contract, or by amendment, endorsement or rider to a contract, or by the election of a feature or coverage within a contract. The Company made an after-tax reduction to its retained earnings at January 1, 2007, the date of adoption of SOP 05-1, in the amount of $82.6 million, which represents the net reduction in the deferred policy acquisition cost from internal replacements included in cost of business acquired on the consolidated balance sheet. See Note A to the Consolidated Financial Statements. Deferred acquisition costs related to group life, disability and accident products, which totaled $97.8 million at December 31, 2007, are amortized over the anticipated premium-paying period of the related policies in proportion to the ratio of the present value of annual expected premium income to the present value of the total expected premium income. Deferred acquisition costs related to casualty insurance products, which totaled $13.2 million at December 31, 2007, are amortized over the period in which the related premium is earned. Deferred acquisition costs related to annuity products, which totaled $62.4 million at December 31, 2007, are amortized over the anticipated lives of the policies in relation to the present value of estimated gross profits from such policies’ anticipated surrender charges and mortality, investment and expense margins. The amortization is a constant percentage of estimated gross profits based on the ratio of the present value of amounts deferred as compared to the present value of estimated gross profits. Adjustments are made each year to reflect the actual gross profits to date as compared to assumed experience and any changes in the remaining expected future gross profits. The unamortized balance of deferred policy acquisition costs related to certain asset accumulation products is adjusted for the impact on estimated future gross profits as if net unrealized appreciation and depreciation on available for sale securities had been realized at the balance sheet date. The impact of this adjustment, net of the related income tax expense or benefit, is included in net unrealized appreciation and depreciation as a component of other comprehensive income or loss in shareholders’ equity. Deferred acquisition costs are charged to current earnings to the extent that it is determined that future premiums or estimated gross profits will not be adequate to cover the amounts deferred. The amortization of deferred acquisition costs totaled $80.7 million, $78.7 million and $67.2 million in 2007, 2006 and 2005, respectively. These amounts represented 59%, 33% and 31% of the total amounts of the deferred acquisition cost balances outstanding at the beginnings of the respective periods.
Investments. Investments are primarily carried at fair value with unrealized appreciation and depreciation included as a component of other comprehensive income or loss in shareholders’ equity, net of the related income tax benefit or expense and the related adjustment to cost of business acquired. Ninety-six percent of the Company’s fixed maturity and equity securities portfolio are actively traded in a liquid market or have other liquidity mechanisms. Investments acquired through private placements which are not actively traded in a liquid market and do not have other mechanisms for their liquidation totaled $144.2 million at December 31, 2007. The Company estimates the fair value for these securities primarily by comparison to similar securities with quoted market prices. If quotes are not available on similar securities, the Company estimates fair value based on recent purchases or sales of similar securities or other internally prepared valuations. Key assumptions used in this process include the level of risk-free interest rates, risk premiums, and performance of underlying collateral, if applicable. In certain cases, estimates of the fair value of investments managed by third party investment managers are based on values provided to the Company by such managers. All such investments are classified as available for sale. The Company’s ability to liquidate these investments in a timely manner, if necessary, may be limited by the lack of an actively traded market. Historically, the Company has not realized amounts on dispositions of non-marketable investments that varied materially from the amounts estimated by the Company under this valuation methodology. The Company believes that its estimates reasonably reflect the fair value of these securities; however, had there been an active market for these securities during the applicable reporting period, the market prices may have been materially different than the amounts reported.
Declines in the fair value of investments that are considered in the judgment of management to be other than temporary are reported as realized investment losses. Management evaluates, among other things, the financial position and prospects of the issuer, conditions in the issuer’s industry and geographic area, liquidity of the investment, changes in the amount or timing of expected future cash flows from the investment, and recent changes in credit ratings of the issuer by a
The Company also invests in certain investment funds organized as limited partnerships and limited liability companies which invest in various financial instruments. These investments are reflected in the Company’s financial statements under the equity method; accordingly, positive or negative changes in the value of the investees’ underlying investments are included in net investment income. For this purpose, the Company estimates the values of its investments in these entities based on values provided by their managers. The Company believes that its estimates reasonably reflect the values of its investments in these entities; however, there can be no assurance that such values will ultimately be realized upon liquidation of such investments, which generally can occur only through a redemption or withdrawal from the various entities, since no trading market exists for these investments. Such redemptions and withdrawals are generally available only at specified intervals upon the giving of specified prior notice to the applicable entity.
contingencies can affect actual results and could cause actual results to differ materially from those expressed in any forward-looking statements made by, or on behalf of, the Company. Certain of these uncertainties and contingencies are described in more detail in Part I, Item 1A - Risk Factors. The Company disclaims any obligation to update forward-looking information.
The information required by Item 8 is included in this Form 10-K beginning on page 51 of this Form 10-K.