RGA Reinsurance houses its employees and the majority of RGA's officers in approximately 161,500 square feet of office space at 1370 Timberlake Manor Parkway, Chesterfield, Missouri. These premises are leased through December 31, 2014, at annual rents ranging from approximately $2,000,000 to $2,900,000. RGA Reinsurance also conducts business from a total of approximately 1,400 square feet of office space in Norwalk, Connecticut and North Palm Beach, Florida. These premises are leased through December 2006, at an annual rent of approximately $39,000. GA Argentina, part of the
RGA Canada conducts business from approximately 27,000 square feet of office space in Montreal and Toronto, Canada. These premises are leased through November 2016, at annual rents ranging from approximately $670,000 to $735,000. These rents are net of expected sublease income ranging from approximately $336,000 to $354,000 annually through 2010.
This report contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 including, among others, statements relating to projections of the strategies, earnings, revenues, income or loss, ratios, future financial performance, and growth potential of the Company. The words "intend," "expect," "project," "estimate," "predict," "anticipate," "should," "believe," and other similar expressions also are intended to identify forward-looking statements. Forward-looking statements are inherently subject to risks and uncertainties, some of which cannot be predicted or quantified. Future events and actual results, performance, and achievements could differ materially from those set forth in, contemplated by, or underlying the forward-looking statements.
Forward-looking statements should be evaluated together with the many risks and uncertainties that affect the Company's business, including those mentioned in this document and the cautionary statements described in the periodic reports the Company files with the SEC. These forward-looking statements speak only as of the date on which they are made. The Company does not undertake any obligations to update these forward-looking statements, even though the Company's situation may change in the future. The Company qualifies all of its forward-looking statements by these cautionary statements. For a discussion of these risks and uncertainties that could cause actual results to differ materially from those contained in the forward-looking statements, you are advised to see Item 1A Risk Factors.
RGA is an insurance holding company that was formed on December 31, 1992. As of December 31, 2005, General American, a Missouri life insurance company, directly owned approximately 52.8% of the outstanding shares of common stock of RGA. General American is a wholly-owned subsidiary of MetLife, Inc., a New York-based insurance and financial services holding company.
The Company is primarily engaged in traditional individual life, asset-intensive, critical illness and financial reinsurance. RGA and its predecessor, the Reinsurance Division of General American, have been engaged in the business of life reinsurance since 1973. Approximately 71.8% of the Company's 2005 net premiums were from its more established operations in North America, which include its U.S. and Canada segments.
In 1994, the Company began using its North American underwriting expertise and industry knowledge to expand into international markets and now has subsidiaries, branches or offices in Australia, Barbados, Bermuda, China, Hong Kong, India, Ireland, Japan, Mexico, South Africa, South Korea, Spain, Taiwan and the United Kingdom. These operations are included in either the Company's Asia Pacific segment or its Europe & South Africa segment. The Company generally starts new operations from the ground up in these markets as opposed to acquiring existing operations, and it often enters these markets to support its North American clients as they expand internationally. Based on Standard & Poor's Global Reinsurance Highlights, 2005 Edition, the Company believes it is the third largest life reinsurer in the world based on 2004 gross life reinsurance premiums. While the Company believes information published by Standard & Poor's is generally reliable, the Company has not independently verified the data. Standard & Poor's does not guarantee the accuracy and completeness of the information. The Company conducts business with the majority of the largest U.S. and international life insurance companies. The Company has also developed its capacity and expertise in the reinsurance of asset-intensive products (primarily annuities and corporate-owned life insurance) and financial reinsurance.
The Company believes that the following trends in the life insurance industry will continue to create demand for life reinsurance.
Outsourcing of Mortality. The SOA survey indicates that U.S. life reinsurance in force has more than doubled from $3.2 trillion in 1999 to $6.6 trillion at year-end 2004. The Company believes this trend reflects increased utilization by life insurance companies of reinsurance to manage capital and mortality risk and to develop competitive products. Reinsurers are able to efficiently aggregate a significant volume of life insurance in force, creating economies of scale and greater diversification of risk. As a result of having larger amounts of data at their disposal compared to primary life insurance companies, reinsurers tend to have better insights into mortality trends, creating more efficient pricing for mortality risk.
Consolidation and Reorganization Within the Life Reinsurance and Life Insurance Industry. As a result of consolidations in recent years within the life reinsurance industry, there are fewer competitors. According to the SOA survey, as of December 31, 2004, the top five companies held approximately 79% of the market share in North America based on life reinsurance in force, whereas in 1999, the top five companies held approximately 57% of the market share. As a consequence, the Company believes the life reinsurance pricing environment will remain attractive for the remaining life reinsurers, particularly those with a significant market presence and strong ratings.
Changing Demographics of Insured Populations. The aging of the population in North America is increasing demand for financial products among "baby boomers" who are concerned about protecting their peak income stream and are considering retirement and estate planning. The Company believes that this trend is likely to result in continuing demand for annuity products and life insurance policies, larger face amounts of life insurance policies and higher mortality risk taken by life insurers, all of which should fuel the need for insurers to seek reinsurance coverage.
Continue Growth of Core North American Business. The Company's strategy includes continuing to grow each of the following components of its North American operations:
- Facultative Reinsurance. Based on discussions with the Company's clients and informal knowledge about the industry, the Company believes it is a leader in facultative underwriting in North America. The Company intends to maintain that status by emphasizing its underwriting standards, prompt response on quotes, competitive pricing, capacity and flexibility in meeting customer needs. The Company believes its facultative business has allowed it to develop close, long-standing client relationships and generate additional business opportunities with its facultative clients.
- Asset-intensive and Other Products. The Company intends to continue leveraging its existing client relationships and reinsurance expertise to create customized reinsurance products and solutions. Industry trends, particularly the increased pace of consolidation and reorganization among life insurance companies and changes in products and product distribution, are expected to enhance existing opportunities for asset-intensive and other products. To date, most of the Company's asset-intensive business has been written in the U.S.; however, the Company believes opportunities outside of the U.S. may further develop in the near future.
- Achieving annual earnings per share growth of 11% to 13%; and
Additionally, the Company has financial growth expectations for various operating segments for the intermediate period (next three to five years). In its U.S. and Canada operations, the Company expects growth rates for premium and income before income taxes of 8% to 10% and 10% to 15%, respectively. The Company's newer international operations, which include Europe & South Africa, and Asia Pacific, are subject to more volatility. For these newer international operations, the Company anticipates growth in premium and income before income taxes of approximately 15% over the intermediate term (next three to five years).
These goals and expectations are aspirational and you should not rely on them. The Company can give no assurance that it will be able to approach or meet any of these goals, and it may fall short of any or all of them. See "Forward-Looking and Cautionary Statements" and "Risk Factors."
The Company's primary business is life reinsurance, which involves reinsuring life insurance policies that are often in force for the remaining lifetime of the underlying individuals insured, with premiums earned typically over a period of 10 to 30 years. Each year, however, a portion of the business under existing treaties terminates due to, among other things, lapses or voluntary surrenders of underlying policies, deaths of policyholders, and the exercise of recapture options by ceding companies.
During December 2003, the Company completed a large coinsurance agreement with Allianz Life. Under this agreement, RGA Reinsurance assumed the traditional life reinsurance business of Allianz Life, including yearly renewable term reinsurance and coinsurance of term policies. The business did not include any accident and health risk, annuities or related guaranteed minimum death benefits or guaranteed minimum income benefits. This transaction added additional scale to the Company's U.S. traditional business, but did not significantly add to its client base because most of the underlying ceding companies were already its clients. Substantially all of the underlying ceding companies novated their treaties from Allianz Life to RGA Reinsurance during 2004. Novation results in the underlying client companies reinsuring the business directly to RGA Reinsurance versus passing through Allianz Life.
The Company's profitability primarily depends on the volume and amount of death claims incurred and the ability to adequately price the risks it assumes. While death claims are reasonably predictable over a period of many years, claims become less predictable over shorter periods and are subject to significant fluctuation from quarter to quarter and year to year. Effective July 1, 2003, the Company increased the maximum amount of coverage that it retains per life from $4 million to $6 million. This increase does not affect business written prior to July 1, 2003. Claims in excess of this retention amount are retroceded to retrocessionaires; however, the Company remains fully liable to the ceding company for the entire amount of risk it assumes. The increase in the Company's retention limit from $4 million to $6 million reduces the amount of premiums it pays to retrocessionaires, but increases the maximum effect a single death claim can have on its results and therefore may result in additional volatility to its results.
The Company has five main operational segments, each of which is a distinct reportable segment: U.S., Canada, Europe & South Africa, Asia Pacific and Corporate and Other. The U.S. operations provide traditional life, asset-intensive, and financial reinsurance primarily to domestic clients. The Canada operations provide insurers with reinsurance of traditional life products as well as reinsurance of critical illness products. Europe & South Africa operations include traditional life reinsurance and critical illness business from Europe & South Africa, in addition to other markets the Company is developing. Asia Pacific operations provide primarily traditional life reinsurance, critical illness and, to a lesser extent, financial reinsurance. The Company's discontinued accident and health business is excluded from continuing operations. The Company measures segment performance based on profit or loss from operations before income taxes.
The consolidated provision for income taxes from continuing operations represents approximately 33.9%, 33.6%, and 34.3% of pre-tax income for 2005, 2004, and 2003, respectively. Absent unusual items, the Company expects the consolidated effective tax rate to be between 34% and 35%. The effective tax rate for 2005 includes an increase in tax liability of $3.2 million related to various tax audit exposures, whereas the 2004 effective tax rate includes the effect of a $1.9 million reduction in tax resulting from the favorable resolution of a tax position and the settlements of Internal Revenue Service audit matters. The Company calculated tax benefits related to its discontinued operations of $6.2 million for 2005, $12.4 million for 2004, and $3.1 million for 2003. The effective tax rate on discontinued operations is approximately 35% for each of the three years.
The Company periodically reviews actual historical experience and relative anticipated experience compared to the assumptions used to establish policy reserves. Further, the Company determines whether actual and anticipated experience indicates that existing policy reserves together with the present value of future gross premiums are sufficient to cover the present value of future benefits, settlement and maintenance costs and to recover unamortized acquisition costs. This loss
recognition testing is performed at the segment level and, if necessary, net liabilities are increased along with a charge to income. Because of the many assumptions and estimates used in establishing reserves and the long-term nature of reinsurance contracts, the reserving process, while based on actuarial science, is inherently uncertain.
Differences in actual experience compared with the assumptions and estimates utilized in the justification of the recoverability of DAC, in establishing reserves for future policy benefits and claim liabilities, or in the determination of other-than-temporary impairments to investment securities can have a material effect on the Company's results of operations and financial condition.
Further discussion and analysis of the results for 2005 compared to 2004 and 2003 are presented by segment. Certain prior-year amounts have been reclassified to conform to the current year presentation. References to income before income taxes exclude the effects of discontinued operations and the cumulative effect of changes in accounting principles.
U.S. operations consist of two major sub-segments: Traditional and Non-Traditional. The Traditional sub-segment primarily specializes in mortality-risk reinsurance. The Non-Traditional category consists of Asset-Intensive and Financial Reinsurance.
The U.S. traditional sub-segment provides life reinsurance to domestic clients for a variety of life products through yearly renewable term agreements, coinsurance and modified coinsurance agreements. These reinsurance arrangements may be either facultative or automatic agreements. During 2005, production totaled $186.8 billion of face amount of new business, compared to $168.8 billion in 2004 and $423.4 billion in 2003. Production for 2003 included $287.2 billion related to the Allianz Life transaction. Management believes industry consolidation and the trend toward reinsuring mortality risks should continue to provide opportunities for growth.
Income before income taxes for U.S. traditional reinsurance decreased 11.2% in 2005 primarily due to poor mortality experience. At year-end 2004, income increased 45.8% over prior year in large part due to the Allianz Life business, which generated a full year of premium and income in 2004. Mortality experience was also favorable in 2004.
Net premiums for U.S. traditional reinsurance increased $221.7 million in 2005, or 10.0% and $410.3 million in 2004, or 22.8%. Premium levels are driven by the growth of total U.S. business in force, which increased to $1.1 trillion in 2005, an increase of 8.7% over prior year. Total in force at year-end 2003 was $896.8 billion. This included $278.0 billion of in force from the Allianz Life acquisition. In addition to the growth in business, the large increase in 2004 reflects the full integration of the Allianz Life business into the U.S. traditional sub-segment. Large transactions and reporting practices of ceding companies can influence premium levels and therefore cause fluctuations from period to period.
The amount of policy acquisition costs and other insurance expenses, as a percentage of net premiums, was 14.0%, 14.9%, and 13.5% in 2005, 2004 and 2003, respectively. Overall, these percentages will fluctuate due to varying allowance levels within coinsurance-type arrangements, the timing of amounts due to and from ceding companies, as well as the amortization pattern of previously capitalized amounts, which are based on the form of the reinsurance agreement and the underlying insurance policies. Additionally, the mix of first year coinsurance versus yearly renewable term can cause the percentage to fluctuate from period to period.
Other operating expenses, as a percentage of net premiums, were 1.7%, 2.0% and 2.3% in 2005, 2004 and 2003, respectively. The slightly higher ratios in 2004 and 2003 can be attributed to Allianz, including expenses associated with transferring the Allianz business to the Company in 2004. The 2004 and 2003 amounts include $3.1 million and $2.7 million, respectively, of expenses associated with the Allianz Life transaction.
During 2003, the Company adopted the provisions of Statement of Financial Accounting Standards ("SFAS") No. 133 Implementation Issue No. B36, "Embedded Derivatives: Modified Coinsurance Arrangements and Debt Instruments
Total revenues, which are comprised primarily of investment income, decreased 3.6% from 2004 to 2005. This can be attributed to the change in fair value of embedded derivatives which contributed $26.1 million to revenue in 2004 compared to $7.4 million in 2005. This is slightly offset by smaller realized investment losses and higher investment income due to the growth in the asset base in 2005. Total revenues in 2004 increased 15.0% over 2003. This increase in 2004 is primarily attributed to continued growth in the asset base for this segment coupled with the $11.7 million increase in investment income due to the aforementioned converted annuity treaty. The average invested asset balance was $3.9 billion, $3.3 billion and $2.7 billion for 2005, 2004 and 2003, respectively. Invested assets outstanding as of December 31, 2005 and 2004 were $4.0 billion and $3.7 billion, of which $2.4 billion and $1.9 billion were funds withheld at interest, respectively. Of the $2.4 billion total funds withheld balance as of December 31, 2005, 86.9% of the balance is associated with one client.
Total expenses, which are comprised primarily of interest credited, policy benefits, and acquisition costs decreased 6.4% in 2005 primarily due to the deferred acquisition costs associated with the change in fair value of embedded derivatives which totaled $22.9 million in 2004 compared to $7.0 million in 2005. Expenses increased 21.2% from 2003 to 2004 mainly due to the policy acquisition costs, which increased $13.7 million due to the conversion of the funds withheld treaty previously discussed and interest credited, which increased $26.9 million, or 22.5%, primarily due to the increase in the average invested asset base.
The U.S. financial reinsurance sub-segment income consists primarily of net fees earned on financial reinsurance transactions. Included in the results is net income from RGA Financial Group L.L.C. ("RGA Financial Group"), a wholly-owned subsidiary. The majority of the financial reinsurance transactions assumed by the Company are retroceded to other insurance companies. The fees earned from the assumption of the financial reinsurance contracts are reflected in other revenues, and the fees paid to retrocessionaires are reflected in policy acquisition costs and other insurance expenses. RGA Financial Group earns fees from brokered business that is placed with third parties and does not participate in the assumption of the financial reinsurance. This income is reflected in other revenues.
Income before income taxes increased 17.5% and 1.8% in 2005 and 2004, respectively. The increase in income for 2005 relates to several new financial reinsurance transactions in 2005. Income in 2004 remained somewhat flat as the growth in capital provided was mostly offset by reduced spreads earned on the business.
RGA Canada's reinsurance in force totaled approximately $127.4 billion and $105.2 billion at December 31, 2005 and 2004, respectively.
Net premiums increased 35.2% to $343.1 million in 2005, and increased 18.2%, to $253.9 million in 2004, primarily due to new business from new and existing treaties. Approximately $29.4 million, or 11.6%, of the 2005 premium increase represents the effect of two in force creditor treaties that were executed in 2005. Additionally, a stronger Canadian dollar contributed $22.6 million, or 8.9%, and $17.6 million, or 8.2%, to net premiums reported in 2005 and in 2004, respectively. Premium levels are significantly influenced by large transactions, mix of business and reporting practices of ceding companies, and therefore can fluctuate from period to period.
Loss ratios for this segment were 89.7% in 2005, 98.7% in 2004 and 104.0% in 2003. Excluding creditor business, the loss ratios for this segment were 97.0% in 2005, 101.0% in 2004 and 105.6% in 2003. The lower loss ratio for the current period is primarily due to better mortality experience compared to the prior year. Historically, an increase in percentages is primarily the result of several large permanent level premium in force blocks assumed in 1998 and 1997. These blocks are mature blocks of permanent level premium business in which mortality as a percentage of premiums is expected to be higher than the historical ratios. The nature of level premium permanent policies requires the Company to set up actuarial liabilities and invest the amounts received in excess of early-year mortality costs to fund claims in the later years when premiums, by design, continue to be level as compared to expected increasing mortality or claim costs. Claims and other policy benefits, as a percentage of net premiums and investment income, were 66.4% during 2005 compared to 70.8% in 2004 and 74.0% in
support the segment business volumes. Investment performance varies with the composition of investments and the relative allocation of capital to the operating segments.
Net premiums grew 34.0% during 2005 and 54.1% during 2004. The growth in 2005 was primarily the result of organic growth in certain markets, along with favorable exchange rates in multiple countries. In terms of growth of premium dollars during 2005, the Australia and Korea markets were the primary contributors, adding approximately $40.7 million and $46.3 million, respectively, in premium volume compared to 2004. Growth in Australia for both 2005 and 2004 was driven primarily by continued success in the group market. Given the maturing nature of the Australian market, and increased competition for group business, it is unlikely that future growth rates will continue at the levels of 2003, 2004 and 2005 in this market, but some level of additional growth is anticipated. In Korea, 2005 premium growth was driven by the growth of $42.2 million for four primary clients. Premium levels are significantly influenced by large transactions and reporting practices of ceding companies and therefore can fluctuate from period to period.
Other revenue during 2005 primarily represented profit and fees associated with financial reinsurance in Japan of approximately $3.7 million. Other revenue during 2004 primarily represented profit and fees associated with financial reinsurance in Japan, Taiwan and South Korea of approximately $2.1 million, and fees associated with the recapture provisions for two client treaties of approximately $0.9 million. In 2003, other revenue primarily represented profit and fees associated with financial reinsurance in Taiwan and South Korea.
65.8% in 2003 to 87.7% in 2004, primarily due to recording of additional reserves on disability income business of approximately $22.8 million, and a reserve of approximately $2.7 million related to the tsunami in December 2004. New Zealand's loss experience is primarily due to the unfavorable performance of four significant treaties. These four treaties combined reflect an increase of approximately $17.7 million in claims and other policy benefits over 2003.
Policy acquisition costs and other insurance expenses as a percentage of net premiums increased by 1.7% to 14.8% during 2005 and decreased by 5.2% to 13.1% during 2004. The ratio of policy acquisition costs and other insurance expenses as a percentage of net premiums will fluctuate periodically due to timing of client company reporting and variations in the mixture of business being reinsured. During 2005, the percentage of policy acquisition costs and other insurance expenses as a percentage of net premiums was consistent with 2004 results. During 2004, the percentage declined, in part, due to the addition of a significant block of yearly renewable term business with no allowance included within the treaty terms. Policy acquisition costs are capitalized and charged to expense in proportion to premium revenue recognized.
Other operating expenses decreased to 5.1% of net premiums in 2005, from 6.1% in 2004 and 6.5% in 2003. The Company believes that sustained growth in premiums should lessen the burden of start-up expenses and expansion costs over time. The timing of the entrance into and development of new markets in the growing Asia Pacific segment may cause other operating expenses as a percentage of premiums to be somewhat volatile over periods of time.
Loss before income taxes increased $38.0 million, or 98.8% during 2005 compared to 2004, primarily due to an increase in claims and other policy benefits of $25.9 million and a reduction in investment income of $9.6 million. The increase in claims and other policy benefits is due to an increase in the policy liabilities associated with the commutation of treaties covering the reinsurance of Argentine pension accounts. The decrease in investment income was the result of an allocation to other segments based upon average assets and related capital levels deemed appropriate to support their business volumes.
Loss before income taxes decreased $5.1 million, or 11.6%, during 2004 compared to 2003, primarily due to an increase in unallocated investment related gains and investment income of $13.6 million and $5.4 million, respectively. These increases in revenues were partially offset by an increase in Argentine pension account reserves of $10.0 million during the fourth quarter of 2004 and a $2.4 million increase in unallocated general corporate expenses.
Since 2001, the Company has attempted to negotiate settlements of its obligations and has pursued other courses of action, including withholding payment of claims and filing a request for arbitration. The Company's actions have resulted in one AFJP ceding company demanding arbitration and could result in litigation or arbitrations in the future. However, as of January 2006, the Company had commuted about 95% of its obligations associated with the AFJP business and is in discussions with the remaining clients regarding settlement of all obligations under the remaining treaties. Therefore, the risk of litigation or arbitrations in the future has significantly declined. During 2005, the Company reported in excess of $33.0 million in additional liabilities to satisfy its obligations as a result of the negotiated settlements and expected settlements for the remaining treaties. While it is not feasible to predict or determine the ultimate outcome of litigation or arbitrations that may occur in Argentina in the future, it is the opinion of management, after consultation with counsel, that their outcomes, after consideration of the provisions made in the Company's consolidated financial statements, would not have a material adverse effect on its consolidated financial position. However, it is possible that an adverse outcome could, from time to time, have a material adverse effect on the Company's consolidated net income or cash flows in particular quarterly or annual periods.
The reinsurance markets for several accident and health risks, most notably involving workers' compensation carve-out and personal accident business, have been quite volatile over the past several years. Certain programs are alleged to have been inappropriately underwritten by third party managers, and some of the reinsurers and retrocessionaires involved have alleged material misrepresentation and non-disclosures by the underwriting managers. In particular, over the past several years a number of disputes have arisen in the accident and health reinsurance markets with respect to London market personal accident excess of loss ("LMX") reinsurance programs that involved alleged "manufactured" claims spirals designed to transfer claims losses to higher-level reinsurance layers. The Company is currently a party to three arbitrations that involve some of these LMX reinsurance programs. Additionally, while the Company did not underwrite workers' compensation carve-out business directly, it did offer certain indirect high-level common account coverages to other reinsurers and retrocessionaires, which could result in exposure to workers' compensation carve-out risks. The Company and other
The Company is currently a party to three arbitrations that involve personal accident business as mentioned above. As of January 31, 2006, the companies involved in these litigation actions have raised claims, or established reserves that may result in claims, that are $23.5 million in excess of the amounts held in reserve by the Company. The Company generally has little information regarding any reserves established by ceding companies, and must rely on management estimates to establish policy claim liabilities. It is possible that any such reserves could be increased in the future. The Company believes it has substantial defenses upon which to contest these claims, including but not limited to misrepresentation and breach of contract by direct and indirect ceding companies. While it is not feasible to predict or determine the ultimate outcome of the pending arbitrations or provide reasonable ranges of potential losses, it is the opinion of management, after consultation with counsel, that their outcomes, after consideration of the provisions made in the Company's consolidated financial statements, would not have a material adverse effect on its consolidated financial position. However, it is possible that an adverse outcome could, from time to time, have a material adverse effect on the Company's consolidated net income or cash flows in particular quarterly or annual periods.
DAC related to interest-sensitive life and investment-type contracts are amortized over the lives of the contracts, in relation to the present value of estimated gross profits ("EGP") from mortality, investment income, and expense margins. The EGP for asset-intensive products include the following components: (1) estimates of fees charged to policyholders to cover mortality, surrenders and maintenance costs; (2) expected interest rate spreads between income earned and amounts credited to policyholder accounts; and (3) estimated costs of administration. EGP is also reduced by the Company's estimate of future losses due to defaults in fixed maturity securities. DAC is sensitive to changes in assumptions regarding these EGP components, and any change in such an assumption could have an effect on the Company's profitability.
The DAC associated with the Company's non-asset-intensive business is less sensitive to changes in estimates for investment yields, mortality and lapses. In accordance with Statement of Financial Accounting Standards No. 60, "Accounting and Reporting by Insurance Enterprises," the estimates include provisions for the risk of adverse deviation and are not adjusted unless experience significantly deteriorates to the point where a premium deficiency exists.
As of December 31, 2005, the Company estimates that approximately 51.0% of its DAC balance is collateralized by surrender fees due to the Company and the reduction of policy liabilities, in excess of termination values, upon surrender or lapse of a policy.
RGA is an insurance holding company whose primary uses of liquidity include, but are not limited to, the immediate capital needs of its operating companies associated with the Company's primary businesses, dividends paid to its shareholders, interest payments on its indebtedness (See Note 15, "Debt and Trust Preferred Securities" of the Notes to Consolidated Financial Statements), and repurchases of RGA common stock under a board of director approved plan. The primary sources of RGA's liquidity include proceeds from its capital raising efforts, interest income on undeployed corporate investments, interest income received on surplus notes with RGA Reinsurance and RCM, and dividends from operating subsidiaries. As the Company continues its expansion efforts, RGA will continue to be dependent upon these sources of liquidity.
RGA has repurchased shares in the open market in the past primarily to satisfy obligations under its stock option program. In 2001, the Board of Directors approved a repurchase program authorizing RGA to purchase up to $50 million of its shares of stock, as conditions warrant. During 2002, RGA purchased approximately 0.2 million shares of treasury stock under the program at an aggregate cost of $6.6 million. In December 2005, the board of directors authorized RGA to enter
RCM and RGA Reinsurance are subject to statutory provisions that restrict the payment of dividends. They may not pay dividends in any 12-month period in excess of the greater of the prior year's statutory operating income or 10% of capital and surplus at the preceding year-end, without regulatory approval. The applicable statutory provisions only permit an insurer to pay a shareholder dividend from unassigned surplus. Any dividends paid by RGA Reinsurance would be paid to RCM, its parent company, which in turn has restrictions related to its ability to pay dividends to RGA. The assets of RCM consist primarily of its investment in RGA Reinsurance. As of January 1, 2006, RCM and RGA Reinsurance could pay maximum dividends, without prior approval, of approximately $41.4 million and $97.5 million, respectively. Dividend payments from other subsidiaries are subject to regulations in the jurisdiction of domicile.
Certain of the Company's debt agreements contain financial covenant restrictions related to, among others, liens, the issuance and disposition of stock of restricted subsidiaries, minimum requirements of net worth, maximum ratios of debt to capitalization, change in control provisions, and minimum rating requirements. A material ongoing covenant default could require immediate payment of the amount due, including principal, under the various agreements. Additionally, the Company's debt agreements contain cross-default covenants, which would make outstanding borrowings immediately payable in the event of a material covenant default under any of the agreements which remains uncured, including, but not limited to, non-payment of indebtedness when due for amounts greater than $10.0 million or $25.0 million depending on the agreement, bankruptcy proceedings, and any event which results in the acceleration of the maturity of indebtedness. The facility fee and interest rate for the Company's credit facilities is based on its senior long-term debt ratings. A decrease in those ratings could result in an increase in costs for the credit facilities. As of December 31, 2005, the Company had $800.0 million in outstanding borrowings under its short- and long-term debt agreements and was in compliance with all covenants
under those agreements. The ability of the Company to make debt principal and interest payments depends primarily on the earnings and surplus of subsidiaries, investment earnings on undeployed capital proceeds, and the Company's ability to raise additional funds.
In December 2005, RGA issued Junior Subordinated Debentures with a face amount of $400 million. Interest is payable semi-annually and is fixed at 6.75% per year until December 15, 2015. From December 15, 2015 until December 15, 2065, interest on the debentures will accrue at an annual rate of 3-month LIBOR plus a margin equal to 266.5 basis points, payable quarterly. The Company has the option to defer interest payments, subject to certain limitations. In addition, interest payments are mandatorily deferred if the Company does not meet specified capital adequacy, net income and shareholders' equity levels. Upon an optional or mandatory deferral, the Company is not permitted to pay common-stock dividends or make payments of interest or principal on securities which rank equal or junior to the subordinated debentures, until the accrued and unpaid interest on the subordinated debentures is paid. The subordinated debentures are redeemable at the Company's option. Approximately $75.9 million of the net proceeds were used to purchase the Company's common stock under an ASR agreement with a financial counterparty. RGA intends to use a portion of the net proceeds from the sale of these debentures to repay approximately $100.0 million of its 7.25% senior notes when they mature on April 1, 2006. As of December 31, 2005, the average interest rate on long-term and short-term debt outstanding, excluding the Preferred Income Redeemable Securities Units, was 6.62% compared to 6.10% at the end of 2004.
Based on the historic cash flows and the current financial results of the Company, subject to any dividend limitations which may be imposed by various insurance regulations, management believes RGA's cash flows from operating activities, together with undeployed proceeds from its capital raising efforts, including interest and investment income on those proceeds, interest income received on surplus notes with RGA Reinsurance and RCM, and its ability to raise funds in the capital markets, will be sufficient to enable RGA to make dividend payments to its shareholders, make interest payments on its senior indebtedness, trust preferred securities and junior subordinated notes, repurchase RGA common stock under the board of director approved plan, and meet its other obligations.
A general economic downturn or a downturn in the equity and other capital markets could adversely affect the market for many annuity and life insurance products and RGA's ability to raise new capital. Because the Company obtains substantially all of its revenues through reinsurance arrangements that cover a portfolio of life insurance products, as well as annuities, its business would be harmed if the market for annuities or life insurance was adversely affected.
subsidiary or make payments under the treaty. These conditions include change in control of the subsidiary, insolvency, nonperformance under a treaty, or loss of reinsurance license of such subsidiary. If RGA was ever required to perform under these obligations, the risk to the consolidated company under the reinsurance treaties would not change; however, additional capital may be required due to the change in jurisdiction of the subsidiary reinsuring the business and may create a strain on liquidity.
RGA has issued guarantees to third parties on behalf of its subsidiaries' performance for the payment of amounts due under certain credit facilities, reinsurance treaties and an office lease obligation, whereby if a subsidiary fails to meet an obligation, RGA or one of its other subsidiaries will make a payment to fulfill the obligation. In limited circumstances, treaty guarantees are granted to ceding companies in order to provide them additional security, particularly in cases where RGA's subsidiary is relatively new, unrated, or not of a significant size, relative to the ceding company. Liabilities supported by the treaty guarantees, before consideration for any legally offsetting amounts due from the guaranteed party, totaled $256.2 million and $285.4 million as of December 31, 2005 and 2004, respectively, and are reflected on the Company's consolidated balance sheets in future policy benefits. Potential guaranteed amounts of future payments will vary depending on production levels and underwriting results. Guarantees related to trust preferred securities and credit facilities provide additional security to third parties should a subsidiary fail to make principal and/or interest payments when due. As of December 31, 2005, RGA's exposure related to these guarantees was $184.2 million. RGA has issued a guarantee on behalf of a subsidiary in the event the subsidiary fails to make payment under its office lease obligation, the exposure of which was insignificant as of December 31, 2005.
The Company's principal cash outflows primarily relate to the payment of claims liabilities, interest credited, operating expenses, income taxes, and principal and interest under debt obligations. The Company seeks to limit its exposure to loss on any single insured and to recover a portion of benefits paid by ceding reinsurance to other insurance enterprises or reinsurers under excess coverage and coinsurance contracts (See Note 2, "Summary of Significant Accounting Policies" of the Notes to Consolidated Financial Statements). The Company also retrocedes most of its financial reinsurance business to other insurance companies to alleviate regulatory capital requirements created by this business. The Company performs annual financial reviews of its retrocessionaires to evaluate financial stability and performance. The Company has never experienced a material default in connection with retrocession arrangements, nor has it experienced any difficulty in collecting claims recoverable from retrocessionaires; however, no assurance can be given as to the future performance of such retrocessionaires or as to the recoverability of any such claims. The Company's management believes its current sources of liquidity are adequate to meet its cash requirements for the next 12 months.
Net cash used in investing activities was $893.1 million, $768.0 million and $1,288.3 million in 2005, 2004 and 2003, respectively. Changes in cash used in investing activities primarily relate to the management of the Company's investment portfolios and the investment of excess cash generated by operating and financing activities. Net cash invested in 2005 includes the investment of approximately $318.8 million of proceeds from the Company's subordinated debenture offering in December 2005. Net cash used in investing activities was relatively high in 2003 as a result of the investment of approximately $426.7 million related to the Company's stock offering.
The following table displays the Company's contractual obligations, other than certain obligations arising from its reinsurance business (in millions):
Life claims payable include benefit and claim liabilities for which the Company believes the amount and timing of the payment is essentially fixed and determinable. Such amounts generally relate to incurred and reported death and critical illness claims. As of December 31, 2005, liabilities for future policy benefits of approximately $4,693.5 million related primarily to reinsurance of traditional life insurance and related policies and approximately $5,503.5 million of interest sensitive contract liabilities, primarily deferred annuities, have been excluded from this table. Amounts excluded from the table are generally comprised of policies or contracts where (i) the Company is not currently making payments and will not make payments in the future until the occurrence of an insurable event, such as death or disability or (ii) the occurrence of a payment triggering event, such as a surrender of a policy or contract, is outside of the control of the Company. The timing of payment on these liabilities is not reasonably fixed and determinable since the insurable event or payment triggering event has not yet occurred, and the Company has no control over the timing of such occurrence. In addition to timing of payments, significant uncertainties relating to these liabilities include mortality, morbidity and persistency. On a consolidated basis, the Company has historically generated positive cash flows from operations; however, it must factor these uncertainties regarding its insurance obligations into its asset/liability management program. See "Asset / Liability Management" for additional discussion.
Based on the growth of the Company's business and the pattern of reserve levels under Regulation XXX associated with term life business, the amount of ceded reserve credits is expected to grow. This growth will require the Company to obtain additional letters of credit, put additional assets in trust, or utilize other mechanisms to support the reserve credits. If the Company is unable to support the reserve credits, the regulatory capital levels of several of its subsidiaries may be significantly reduced. The reduction in regulatory capital would not directly affect the Company's consolidated shareholders' equity under GAAP; however, it could effect the Company's ability to write new business and retain existing business.
During the third quarter of 2005, the Company entered into a five-year, syndicated credit facility with an overall capacity of $600.0 million. The amount of the overall capacity available for issuance of letters of credit is reduced by any cash borrowings, up to $300.0 million, made by the Company against this credit facility. At December 31, 2005, there were $320.0 million letters of credit outstanding against this credit facility, which is included in the total above. Applicable letter of credit fees and fees payable for the credit facility depend upon the Company's senior unsecured long-term debt rating. Fees associated with the Company's other letters of credit are not fixed for periods in excess of one year and are based on the Company's ratings and the general availability of these instruments in the marketplace.
The Company's fixed maturity securities are invested primarily in commercial and industrial bonds, mortgage- and asset-backed securities, public utilities, and Canadian government securities. As of December 31, 2005, approximately 97.3% of the Company's consolidated investment portfolio of fixed maturity securities was investment-grade. Important factors in the selection of investments include diversification, quality, yield, total rate of return potential and call protection. The relative importance of these factors is determined by market conditions and the underlying product or portfolio characteristics. Cash equivalents are invested in high-grade money market instruments. The largest asset class in which fixed maturities were invested was commercial and industrial bonds, which represented approximately 26.9% of fixed maturity securities as of December 31, 2005, down from 28.2% as of December 31, 2004. A majority of these securities were classified as corporate securities, with an average Standard and Poor's ("S&P") rating of A at December 31, 2005.
Within the fixed maturity security portfolio, the Company holds approximately $1.5 billion in mortgage-backed securities at December 31, 2005, which include agency-issued pass-through securities, collateralized mortgage obligations guaranteed or otherwise supported by the Federal Home Loan Mortgage Corporation, Federal National Mortgage Association, or the Government National Mortgage Association, and commercial mortgage-backed securities. All of these securities were investment-grade. The principal risks inherent in holding residential mortgage-backed securities are prepayment and extension risks, which will affect the timing of when cash will be received and are dependent on the level of mortgage interest rates. Prepayment risk is the unexpected increase in principal payments, primarily as a result of homeowner refinancing. Extension risk relates to the unexpected slowdown in principal payments. The Company monitors its residential mortgage-backed securities to mitigate exposure to the cash flow uncertainties associated with these risks.
The following table presents the total gross unrealized losses for 679 fixed maturity securities and equity securities as of December 31, 2005, where the estimated fair value had declined and remained below amortized cost by the indicated amount (in thousands):
The following tables present the estimated fair values and gross unrealized losses for the 679 fixed maturity securities and equity securities that have estimated fair values below amortized cost as of December 31, 2005. These investments are presented by class and grade of security. The length of time the related market value has remained below amortized cost is provided for fixed maturity securities as of December 31, 2005.
Mortgage loans represented approximately 5.3% and 5.8% of the Company's investments as of December 31, 2005 and 2004, respectively. As of December 31, 2005, all mortgages were U.S.-based. The Company invests primarily in mortgages on commercial offices, industrial properties and retail locations. The Company's mortgage loans generally range in size from $0.5 million to $11.0 million, with the average mortgage loan investment as of December 31, 2005 totaling approximately $4.6 million. The mortgage loan portfolio was diversified by geographic region and property type as discussed further in Note 5 of the Notes to Consolidated Financial Statements. Substantially all mortgage loans are performing and no valuation allowance has been established as of December 31, 2005 or 2004.
Under Issue B36, the Company's funds withheld receivable under certain reinsurance arrangements incorporate credit risk exposures that are unrelated or only partially related to the creditworthiness of the obligor and include an embedded derivative feature that is not clearly and closely related to the host contract. Therefore, the embedded derivative feature must be measured at fair value on the consolidated balance sheets and changes in fair value reported in income.
Interest rate sensitivity analysis is also used to measure the Company's interest rate cash flow risk by computing estimated changes in the cash flows expected in the near term attributable to floating rate assets and liabilities in the event of a range of assumed changes in market interest rates. This analysis assesses the risk of loss in cash flows in the near term in market risk sensitive floating rate instruments in the event of a hypothetical 10% change (increase or decrease) in market interest rates. The Company does not have variable-rate instruments classified as trading securities. The Company's projected decrease in cash flows in the near term associated with floating-rate instruments in the event of a 10% unfavorable change in market interest rates at its fiscal years ended December 31, 2005 and 2004 was $0.4 million and $0.3 million, respectively.
The cash flows from coupon payments move in the same direction as interest rates for the Company's floating rate instruments. The volatility in mortgage prepayments partially offsets the cash flows from interest. At December 31, 2005, the Company's estimated changes in cash flows were within the targets outlined in the Company's investment policy.
In June 2005, the Financial Accounting Standards Board ("FASB") completed its review of Emerging Issues Task Force ("EITF") Issue No. 03-1, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments" ("EITF 03-1"). EITF 03-1 provides accounting guidance regarding the determination of when an impairment of debt and marketable equity securities and investments accounted for under the cost method should be considered other-than-temporary and recognized in income. EITF 03-1 also requires certain quantitative and qualitative disclosures for debt and
annuity contracts. The fair value of the total return swap is affected by changes, both actual and expected, in the cash flows of the underlying annuity contracts, changes in credit risk associated with the assets held by the ceding company and changes in interest rates. The change in fair value, which is a non-cash item, also affects the amortization of deferred acquisition costs since the Company is required to include it in its expectation of gross profits. At December 31, 2005 and 2004, the fair value of the embedded derivative totaled $50.3 million and $42.8 million, respectively, and is included in the funds withheld at interest line item on the consolidated balance sheets. Subsequent to the initial adoption of Issue B36, the change in the market value of the underlying is recorded in the consolidated statement of income as change in value of embedded derivatives. Industry standards and practices continue to evolve related to valuing these types of embedded derivative features.
Reinsurance Group of America, Incorporated ("RGA") is an insurance holding company that was formed on December 31, 1992. As of December 31, 2005, General American Life Insurance Company ("General American"), a Missouri life insurance company, directly owned approximately 52.8% of the outstanding shares of common stock of RGA. General American is a wholly-owned subsidiary of MetLife, Inc., a New York-based insurance and financial services holding company.
The accompanying consolidated financial statements include the accounts of RGA and its subsidiaries, both direct and indirect, subject to an ownership position greater than fifty percent, and any variable interest entities where the Company is the primary beneficiary. Entities in which the Company has an ownership position greater than twenty percent, but less than or equal to fifty percent are reported under the equity method of accounting. The Company evaluates variable interest entities in accordance with Financial Accounting Standards Board ("FASB") Interpretation No. 46(r) "Consolidation of Variable Interest Entities - An Interpretation of ARB No. 51". All significant intercompany balances and transactions have been eliminated.
Investments. Fixed maturity securities available-for-sale are reported at fair value and are so classified based upon the possibility that such securities could be sold prior to maturity if that action enables the Company to execute its investment philosophy and appropriately match investment results to operating and liquidity needs.
Impairments in the value of securities held by the Company, considered to be other than temporary, are recorded as a reduction of the book value of the security, and a corresponding realized investment loss is recognized in the consolidated statements of income. The Company's policy is to recognize such impairment when the projected cash flows of these
Short-term investments represent investments with original maturities of greater than three months but less than twelve months and are stated at amortized cost, which approximates fair value.
Cash and Cash Equivalents. The Company considers all investments purchased with an original maturity of three months or less to be cash equivalents.
Additional Information Regarding Statements of Cash Flows. Cash and cash equivalents include cash on deposit and highly liquid debt instruments purchased with an original maturity of three months or less. The consolidated statements of cash flows includes the results of discontinued operations in net cash from operations for all years presented, as the effect of the discontinued operations on cash flows is not considered material.
Premiums Receivable. Premiums are accrued when due and in accordance with information received from the ceding company. When a ceding company fails to report information on a timely basis, the Company records accruals based on the terms of the reinsurance treaty as well as historical experience. Other management estimates include adjustments for lapsed premiums given historical experience, the financial health of specific ceding companies, collateral value and the legal right of offset on related amounts (i.e. allowances and claims) owed to the ceding company. Under the legal right of offset provisions in its reinsurance treaties, the Company can withhold payments for allowances and claims for unpaid premiums. Based on its review of these factors and historical experience, the Company did not believe a provision for doubtful accounts was necessary as of December 31, 2005 or 2004.
Deferred Policy Acquisition Costs. Costs of acquiring new business, which vary with and are primarily related to the production of new business, have been deferred to the extent that such costs are deemed recoverable from future premiums or gross profits. Such costs include commissions and allowances as well as certain costs of policy issuance and underwriting. The Company performs periodic tests to establish that DAC remains recoverable, and if financial performance significantly deteriorates to the point where a premium deficiency exists, a cumulative charge to current operations will be recorded. No such adjustments were made during 2005, 2004 or 2003. Deferred costs related to traditional life insurance contracts, substantially all of which relate to long-duration contracts, are amortized over the premium-paying period of the related policies in proportion to the ratio of individual period premium revenues to total anticipated premium revenues over the life of the policy. Such anticipated premium revenues are estimated using the same assumptions used for computing liabilities for future policy benefits.
Deferred costs related to interest-sensitive life and investment-type policies are amortized over the lives of the policies, in relation to the present value of estimated gross profits from mortality, investment income less interest credited, and expense margins.
Other Assets. In addition to the goodwill and value of business acquired previously discussed, other assets primarily includes separate accounts, unamortized debt issuance costs, capitalized software, and other capitalized assets. Capitalized software is stated at cost, less accumulated amortization. Purchased software costs, as well as internal and external costs incurred to develop internal-use computer software during the application development stage, are capitalized. As of December 31, 2005 and 2004, the Company had unamortized computer software costs of approximately $18.9 million and $20.3 million, respectively. During 2005, 2004 and 2003, the Company amortized computer software costs of $5.7 million, $2.2 million, and $0.5 million, respectively. Amortization of software costs is recorded on a straight-line basis over periods ranging from
three to ten years. Carrying values are reviewed periodically for indicators of impairment in value. The amortization in 2005 includes an asset impairment charge of $2.7 million.
Future Policy Benefits and Interest-Sensitive Contract Liabilities. Liabilities for future benefits on life policies are established in an amount adequate to meet the estimated future obligations on policies in force. Liabilities for future policy benefits under long-term life insurance policies have been computed based upon expected investment yields, mortality and withdrawal (lapse) rates, and other assumptions. These assumptions include a margin for adverse deviation and vary with the characteristics of the plan of insurance, year of issue, age of insured, and other appropriate factors. Interest rates range from 4.0% to 6.0%. The mortality and withdrawal assumptions are based on the Company's experience as well as industry experience and standards. Liabilities for future benefits on interest-sensitive life and investment-type contract liabilities are carried at the accumulated contract holder values without reduction for potential surrender or withdrawal charges.
Income Taxes. RGA and its eligible U.S. subsidiaries file a consolidated federal income tax return. The U.S. consolidated tax return includes RGA, RGA Americas Reinsurance Company, Ltd., RGA Reinsurance, RGA Barbados, RGA Technology Partners, Inc., Reinsurance Company of Missouri, Incorporated, and Fairfield Management Group, Inc. Due to rules that affect the ability of an entity to join in a consolidated tax return, RGA Sigma Reinsurance SPC, and RGA Worldwide Reinsurance Company, Ltd. ("RGA Worldwide"), formerly Triad Re, Ltd., file separate tax returns, even though they are considered to be U.S. taxpayers. The Company's Argentine, Australian, Canadian, South African, Indian, Irish and United Kingdom subsidiaries are taxed under applicable local statutes. The Company's branch operations are taxable under U.S. tax law and applicable local statutes.
Company-Obligated Mandatorily Redeemable Preferred Securities of Subsidiary Trust Holding Solely Junior Subordinated Debentures of the Company. During December 2001, RGA Capital Trust I (the "Trust"), a wholly-owned subsidiary of RGA, sold Preferred Income Equity Redeemable Securities ("PIERS") Units. Each unit consists of a preferred security
Warrants. The market value of the detachable warrants on the date the PIERS units were issued is recorded in stockholders' equity on the consolidated balance sheets under the caption "Warrants." In the aggregate as of December 31, 2005, 4.5 million warrants to purchase approximately 5.6 million shares of Company common stock at a price per share of $39.98 were outstanding. If on any date after December 18, 2004, the closing price of RGA common stock exceeds and has exceeded a price per share equal to $47.97 for at least 20 trading days within the immediately preceding 30 consecutive trading days, the Company may redeem the warrants in whole for cash, RGA common stock, or a combination of cash and RGA common stock.
Foreign Currency Translation. The translation of the foreign currency into U.S. dollars is performed for balance sheet accounts using current exchange rates in effect at the balance sheet date and for revenue and expense accounts using a weighted average exchange rate during each year. Gains or losses, net of applicable deferred income taxes, resulting from such translation are included in accumulated currency translation adjustments, in accumulated other comprehensive income on the consolidated balance sheets. The Company's material functional currencies are the Australian dollar, the British pound, the Canadian dollar, the Japanese yen, the Korean won and the South African rand.
For certain reinsurance transactions involving in force blocks of business, the ceding company pays a premium equal to the initial required reserve (future policy benefit). In such transactions, for income statement presentation, the Company nets the expense associated with the establishment of the reserve on the consolidated balance sheet against the premiums from the transaction.
New Accounting Pronouncements. In June 2005, the FASB completed its review of Emerging Issues Task Force ("EITF") Issue No. 03-1, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments" ("EITF 03-1"). EITF 03-1 provides accounting guidance regarding the determination of when an impairment of debt and marketable equity securities and investments accounted for under the cost method should be considered other-than-temporary and recognized in income. EITF 03-1 also requires certain quantitative and qualitative disclosures for debt and marketable equity securities classified as available-for-sale or held-to-maturity under SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities" ("SFAS 115"), that are impaired at the balance sheet date but for which an other-than-temporary impairment has not been recognized. The FASB decided not to provide additional guidance on the meaning of other-than-temporary impairment but has issued FASB Staff Position ("FSP") 115-1, "The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments" ("FSP 115-1"), which nullifies the accounting guidance on the determination of whether an investment is other-than-temporarily impaired as set forth in EITF 03-1. As required by FSP 115-1, the Company adopted this guidance on a prospective basis, which had no material effect on the Company's consolidated financial statements. The Company has complied with the disclosure requirements of EITF 03-1, which was effective December 31, 2003 and remained in effect until the adoption of FSP 115-1.
Substantially all of the Company's funds withheld receivable balance is associated with its reinsurance of annuity contracts. The funds withheld receivable balance totaled $3.5 billion and $2.7 billion at December 31, 2005 and 2004, respectively, are subject to the provisions of Issue B36. Management believes the embedded derivative feature in each of these reinsurance treaties is similar to a total return swap on the assets held by the ceding companies. The Company has developed cash flow models as the basis for estimating the value of the total return swap. The cash flow models are based on the Company's expectations of the future cash flows under the reinsurance treaties that in turn are driven by the underlying annuity contracts. The fair value of the total return swap is affected by changes, both actual and expected, in the cash flows of the underlying annuity contracts, changes in credit risk associated with the assets held by the ceding company and changes in interest rates. The change in fair value, which is a non-cash item, also affects the amortization of deferred acquisition costs since the Company is required to include it in its expectation of gross profits. At December 31, 2005 and 2004, the fair value of the embedded derivative totaled $50.3 million and $42.8 million, respectively, and is included in the funds withheld at interest line item on the consolidated balance sheets. Subsequent to the initial adoption of Issue B36, the change in the market value of the underlying is recorded in the consolidated statements of income as change in value of embedded derivatives. Industry standards and practices continue to evolve related to valuing these types of embedded derivative features.
Reclassification. The Company has reclassified the presentation of certain prior period information to conform to the 2005 presentation.
On December 12, 2005, RGA entered into an accelerated share repurchase ("ASR") agreement with a financial counterparty. Under the ASR agreement, RGA purchased 1,600,000 shares of its outstanding common stock at an initial price of $47.43 per share and at an aggregate price of approximately $75.9 million. In order to deliver the shares to RGA on December 12, 2005, the counterparty borrowed RGA shares from the stock loan market. RGA funded the repurchase from the proceeds of a junior subordinated debenture offering. Under the ASR agreement, the counterparty purchases an equivalent number of shares of common stock in the open market over time in order to pay back the shares it borrowed. At the end of this period, RGA may receive, or may be required to remit, a purchase price adjustment based upon the volume weighted average price of its common shares during the period. The purchase price adjustment can be settled, at the election of RGA, in cash or in shares of its common stock. The counterparty completed its purchases on February 22, 2006 and as a result, the Company was required to pay $130 thousand to the counterparty for the final settlement. The common shares repurchased have been placed into treasury to be used for general corporate purposes. The repurchase of shares pursuant to the ASR agreement is in addition to the Company's previously announced stock repurchase authorization.
On January 23, 2002, the Board of Directors approved a stock repurchase program authorizing the Company to purchase up to $50 million of its shares of stock, as conditions warrant. The Board's action allows management, at its discretion, to purchase shares on the open market. As of December 31, 2005, the Company purchased 225,500 shares under this program at an aggregate cost of $6.6 million. Purchased shares are held as treasury stock. All purchases were made during 2002. The Company generally uses treasury shares to support the future exercise of options granted under its stock option plans.
The amortized cost, gross unrealized gains and losses, and estimated fair values of investments in fixed maturity securities and equity securities at December 31, 2005 and 2004 are as follows (in thousands):
The Company monitors its investment securities to determine impairments in value. The Company evaluates factors such as financial condition of the issuer, payment performance, the length of time and the extent to which the market value has been
The Company believes that the analysis of each security whose price has been below market for greater than twelve months indicated that the financial strength, liquidity, leverage, future outlook, and the Company's ability and intent to hold the security until recovery support the view that the security was not other-than-temporarily impaired as of December 31, 2005. The unrealized losses on fixed maturity securities did not exceed 17.0% on an individual security basis and are primarily a result of rising interest rates, changes in credit spreads and the long-dated maturities of the securities. Additionally, all of the gross unrealized losses are associated with investment grade securities. One equity security had an unrealized loss of approximately 37.6% or $0.5 million at December 31, 2005, as a result of a reduction in the dividend rate.
The Company participates in a securities lending program whereby blocks of securities, which are included in investments, are loaned to third parties, primarily major brokerage firms. The Company requires a minimum of 102% of the fair value of the loaned securities to be separately maintained as collateral for the loans. No securities were loaned to third parties as of December 31, 2005 or 2004. Securities loaned transactions are accounted for as financing arrangements on the Company's consolidated balance sheets and consolidated statements of cash flow and the income and expenses associated with the program are reported in net investment income since such transactions are entered into for income generation purposes, not funding purposes.
The Company makes mortgage loans on income producing properties, such as apartments, retail and office buildings, light warehouses and light industrial facilities. Loan to value ratios at the time of loan approval are 75 percent or less for domestic mortgages. The distribution of mortgage loans by property type is as follows as of December 31, 2005 and 2004 (in thousands):
All of the Company's mortgage loans are amortizing loans. As of December 31, 2005 and 2004, the Company's mortgage loans were distributed as follows (in thousands):
All mortgage loans are performing and no valuation allowance had been established as of December 31, 2005 and 2004.
The maturities of the mortgage loans as of December 31, 2005 and 2004 are as follows (in thousands):
Publicly traded fixed maturity securities are valued based upon quoted market prices. Private placement securities are valued based on the credit quality and duration of marketable securities deemed comparable by the Company's investment advisor, which may be of another issuer. The fair value of mortgage loans on real estate is estimated using discounted cash flows. Policy loans typically carry an interest rate that is tied to the crediting rate applied to the related policy and contract reserves. The carrying value of funds withheld at interest approximates fair value except where the funds withheld are specifically identified in the agreement. The carrying value of short-term investments at December 31, 2005 and 2004 approximates fair value. Common and preferred equity investments and derivative financial instruments included in other invested assets are reflected at fair value on the consolidated balance sheets, while limited partnership interests are carried at cost.
The fair value of the Company's interest-sensitive contract liabilities is based on the cash surrender value of the liabilities, adjusted for recapture fees. The fair value of the Company's long-term debt and the company-obligated mandatorily redeemable preferred securities are estimated based on either quoted market prices or quoted market prices for the debt of corporations with similar credit quality.
The effect of reinsurance on net premiums and amounts earned is as follows (in thousands):
Reinsurance agreements, whether facultative or automatic, may provide for recapture rights on the part of the ceding company. Recapture rights permit the ceding company to reassume all or a portion of the risk formerly ceded to the reinsurer after an agreed-upon period of time, generally 10 years, or in some cases due to changes in the financial condition or ratings of the reinsurer. Recapture of business previously ceded does not affect premiums ceded prior to the recapture of such
business, but would reduce premiums in subsequent periods. Additionally, some treaties give the ceding company the right to request the Company to place assets in trust for their benefit to support their reserve credits, in the event of a downgrade of the Company's ratings to specified levels. As of December 31, 2005, these treaties had approximately $388.0 million in reserves. Assets placed in trust continue to be owned by the Company, but their use is restricted based on the terms of the trust agreement. Securities with an amortized cost of $769.2 million were held in trust to satisfy collateral requirements for reinsurance business for the benefit of certain subsidiaries of the Company at December 31, 2005. Additionally, securities with an amortized cost of $1,454.3 million, as of December 31, 2005, were held in trust to satisfy collateral requirements under certain third-party reinsurance treaties. Additionally, under certain conditions, RGA may be obligated to move reinsurance from one RGA subsidiary company to another or make payments under the treaty. These conditions include change in control of the subsidiary, insolvency, nonperformance under a treaty, or loss of reinsurance license of such subsidiary.
The following reflects the amounts of policy acquisition costs deferred and amortized (in thousands):
During 2005, 2004, and 2003, the Company received federal income tax refunds and foreign tax credit reimbursements of approximately $32.3 million, $1.4 million and $1.6 million, respectively. The Company made cash income tax payments of approximately $79.3 million, $29.9 million and $8.0 million in 2005, 2004 and 2003, respectively. At December 31, 2005 and 2004, the Company recognized gross deferred tax assets associated with net operating losses of approximately $1.6 billion and $458.9 million, respectively, that will expire between 2011 and 2025. However, these net operating losses are expected to be utilized in the normal course of business during the period allowed for carryforwards and in any event, will not be lost due to the application of tax planning strategies that management would utilize.
Most of the Company's U.S. employees participate in a non-contributory qualified defined benefit pension plan sponsored by RGA Reinsurance. The benefits under the pension plan are based on years of service and compensation levels. Certain management individuals participate in several nonqualified defined benefit and defined contribution plans sponsored by RGA Reinsurance. Those plans are unfunded and are deductible for federal income tax purposes when the benefits are paid. The projected obligation was approximately $30.9 million and $22.8 million as of December 31, 2005 and 2004, respectively.
The Company's full time U.S. employees may participate in a defined contribution profit sharing plan. The plan also has a cash or deferred option under Internal Revenue Code section 401(k). The Company's contributions, which are partially tied to RGA's financial results and employee 401(k) contributions, were approximately $2.3 million, $2.2 million, and $1.9 million in 2005, 2004 and 2003, respectively.
The Company also provides certain health care and life insurance benefits for retired employees. The health care benefits are provided through a self-insured welfare benefit plan. Employees become eligible for these benefits if they meet minimum age and service requirements. The retiree's cost for health care benefits varies depending upon the credited years of service. The Company recorded benefits expense of approximately $1.3 million for 2005 and $0.7 million for 2004 and 2003, related to these postretirement plans. The projected obligation was approximately $10.2 million and $8.6 million as of December 31, 2005 and 2004, respectively.
The aggregate projected benefit obligation and aggregate contract value of plan assets for the pension plans were as follows as of December 31, 2005 and 2004 (in thousands):
The Company expects to contribute $3.8 million in pension benefits and $0.1 million in other benefits during 2006.
2006 target range of allocation by asset type of the Pension Plan's total plan fair value on a weighted average basis:
Target allocations of assets are determined with the objective of maximizing returns and minimizing volatility of net assets through adequate asset diversification and partial liability immunization. Adjustments are made to target allocations based on the Company's assessment of the effect of economic factors and market conditions.
General American and MetLife have historically provided certain administrative services to RGA and RGA Reinsurance. Such services include risk management and corporate travel. The cost for the years ended December 31, 2005, 2004 and 2003 was approximately $1.7 million, $1.0 million and $1.0 million, respectively.
RGA Reinsurance also has a product license and service agreement with MetLife. Under this agreement, RGA has licensed the use of its electronic underwriting product to MetLife and provides Internet hosting services, installation and modification services for the product. The Company recorded revenue under the agreement for the years ended December 31, 2005, 2004
The Company also has arms-length direct policies and reinsurance agreements with MetLife and certain of its subsidiaries. As of December 31, 2005, the Company had reinsurance related assets and liabilities from these agreements totaling $226.9 million and $281.0 million, respectively. Prior-year comparable assets and liabilities were $143.2 million and $173.3 million, respectively. Additionally, the Company reflected net premiums of approximately $226.7 million, $164.4 million and $157.9 million in 2005, 2004 and 2003, respectively. The premiums reflect the net of business assumed from and ceded to MetLife and its subsidiaries. The pre-tax gain on this business was approximately $14.7 million, $36.5 million and $19.4 million in 2005, 2004 and 2003, respectively.
The amounts above are net of expected sublease income of approximately $0.4 million annually through 2010. Rent expenses amounted to approximately $8.0 million, $8.0 million and $6.8 million for the years ended December 31, 2005, 2004 and 2003, respectively.
The Company has commitments to fund investments in limited partnerships in the amount of $31.1 million at December 31, 2005. The Company anticipates that the majority of these amounts will be invested over the next five years, however, contractually these commitments could become due at the request of the counterparties. Investments in limited partnerships are carried at cost and included in other invested assets in the consolidated balance sheets.
The Company has three revolving credit facilities under which it may borrow up to approximately $351.5 million. As of December 31, 2005, the Company had drawn approximately $101.5 million under these facilities. During 2005, the interest rates on these facilities ranged from 3.47% to 6.58% during the year. The Company may draw up to $300.0 million in cash on its revolving credit facility that expires in September 2010. As of December 31, 2005, the Company had $50.0 million outstanding under this facility. Terminations of revolving credit facilities and maturities of senior notes over the next five years total $125.6 million in 2006, $25.8 million in 2007 and $50.0 million in 2010.
RGA guarantees the payment of amounts outstanding under the credit facility maintained by its subsidiary operation in Australia. The total amount of debt outstanding, subject to the guarantee, as of December 31, 2005 was $25.6 million and is reflected on the Company's consolidated balance sheet under short-term debt.
performance shares, cash awards, and other stock-based awards, to key employees, officers, directors and others performing significant services for the benefit of the Company or its subsidiaries. As of December 31, 2005, shares authorized for the granting of Benefits under the Plan and the Directors Plan totaled 6,260,077 and 212,500, respectively.
The per share weighted-average fair value of stock options granted during 2005, 2004 and 2003 was $17.35, $12.81 and $9.51 on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions: 2005-expected dividend yield of 0.76%, risk-free interest rate of 3.86%, expected life of 6.0 years, and an expected rate of volatility of the stock of 33.4% over the expected life of the options; 2004-expected dividend yield of 0.61%, risk-free interest rate of 3.30%, expected life of 6.0 years, and an expected rate of volatility of the stock of 28.7% over the expected life of the options; and 2003-expected dividend yield of 0.95%, risk-free interest rate of 2.79%, expected life of 6.0 years, and an expected rate of volatility of the stock of 35.0% over the expected life of the options.
In general, restrictions lapse on restricted stock awards at the end of a three- or ten-year vesting period. Restricted stock awarded under the plan generally has no strike price and is included in the Company's shares outstanding. During 2005, the Company awarded 5,450 shares of restricted stock that vest over a three-year holding period.
During 2005 and 2004, the Company also issued 126,305 and 128,693 of performance contingent units ("PCUs") to key employees at a weighted average fair value of $47.45 and $39.61, respectively. As of December 31, 2005, 125,594 PCUs and 124,365 PCUs were outstanding from the 2005 and 2004 grants, respectively. Each PCU represents the right to receive from zero to two shares of Company common stock depending on the results of certain performance measures over a three-year period.
Prior to January 1, 2003, the Company applied APB Opinion No. 25 in accounting for its Stock Plans and, accordingly, no compensation cost was recognized for its stock options in the consolidated financial statements. For grants from 2003 through 2005, the Company determined compensation cost based on the fair value at the grant date for its stock options using the "prospective" approach under FASB Statement No. 123, as amended by SFAS No. 148, "Accounting for Stock-Based Compensation -- Transition and Disclosure, an amendment of FASB Statement No. 123." Beginning January 1, 2006, the Company was required to use the "modified prospective" method for recording compensation expense in accordance with
SFAS 123(r), a revision of SFAS 123. The modified prospective approach will require compensation cost on all unvested options to be recorded in the income statement over its remaining vesting period, regardless of when the options were granted. Had the Company realized compensation expense based on the fair value at the grant date for all stock grants, the Company's net income and earnings per share would have been reduced to the pro forma amounts indicated below. The effects of applying SFAS No. 123(r) will increase compensation cost in 2006 as the Company will expense the unvested portion of options granted in 2002, which were previously not expensed under APB Opinion No. 25.
The calculation of equivalent shares from outstanding stock options does not include the effect of options having a strike price that exceeds the average stock price for the earnings period, as the result would be antidilutive. Approximately 0.3 million outstanding stock options were not included in the calculation of common equivalent shares during 2005. All outstanding options were included in the calculation during 2004, while approximately 0.3 million outstanding stock options
were not included in the calculation of common equivalent shares during 2003. Diluted earnings per share also exclude the antidilutive effect in 2003 of 5.6 million shares that would be issued upon exercise of the outstanding warrants associated with the PIERS units, as the Company could have repurchased more shares than it would have issued with the exercise proceeds.
The reinsurance markets for several accident and health risks, most notably involving workers' compensation carve-out and personal accident business, have been quite volatile over the past several years. Certain programs are alleged to have been inappropriately underwritten by third party managers, and some of the reinsurers and retrocessionaires involved have alleged material misrepresentation and non-disclosures by the underwriting managers. In particular, over the past several years a number of disputes have arisen in the accident and health reinsurance markets with respect to London market personal accident excess of loss ("LMX") reinsurance programs that involved alleged "manufactured" claims spirals designed to transfer claims losses to higher-level reinsurance layers. The Company is currently a party to three arbitrations that involve some of these LMX reinsurance programs. Additionally, while RGA did not underwrite workers' compensation carve-out business directly, it did offer certain indirect high-level common account coverages to other reinsurers and retrocessionaires, which could result in exposure to workers' compensation carve-out risks. The Company and other involved reinsurers and retrocessionaires have raised substantial defenses upon which to contest claims arising from these coverages, including defenses based upon the failure of the ceding company to disclose the existence of manufactured claims spirals, inappropriate or unauthorized underwriting procedures and other defenses. As a result, there have been a significant number of claims for rescission, arbitration, and litigation among a number of the parties involved in these various coverages. This has had the effect of significantly slowing the reporting of claims between parties, as the various outcomes of a series of arbitrations and similar actions affects the extent to which higher level reinsurers and retrocessionaires may ultimately have exposure to claims.
The loss from discontinued accident and health operations, net of income taxes, decreased to $11.4 million in 2005 from $23.0 million in 2004. The decrease in loss in 2005 is due primarily to a $24.0 million, pretax, negotiated settlement of all disputed claims associated with the Company's largest identified accident and health exposure during 2004.
The calculation of the claim reserve liability for the entire portfolio of accident and health business requires management to make estimates and assumptions that affect the reported claim reserve levels. Management must make estimates and assumptions based on historical loss experience, changes in the nature of the business, anticipated outcomes of claim disputes and claims for rescission, anticipated outcomes of arbitrations, and projected future premium run-off, all of which may affect the level of the claim reserve liability. Due to the significant uncertainty associated with the run-off of this business, net income in future periods could be affected positively or negatively. The consolidated statements of income for all periods presented reflect this line of business as a discontinued operation. Revenues associated with discontinued operations, which are not reported on a gross basis in the Company's consolidated statements of income, totaled $2.5 million, $1.4 million, and $4.8 million for 2005, 2004, and 2003, respectively.
Reinsurance Group of America, Incorporated common stock is traded on the New York Stock Exchange (NYSE) under the symbol "RGA". There were 76 stockholders of record of RGA's common stock on January 31, 2006.