THE FOLLOWING DISCUSSION HIGHLIGHTS SIGNIFICANT FACTORS INFLUENCING RESULTS OF OPERATIONS AND CHANGES IN FINANCIAL POSITION OF ALLSTATE LIFE INSURANCE COMPANY OF NEW YORK (THE "COMPANY"). IT SHOULD BE READ IN CONJUNCTION WITH THE FINANCIAL STATEMENTS AND RELATED NOTES. TO CONFORM WITH THE 2001 PRESENTATION, CERTAIN PRIOR YEAR AMOUNTS HAVE BEEN RECLASSIFIED.
- INVESTMENTS AND DERIVATIVE INSTRUMENTS -All fixed income securities are carried at fair value and may be sold prior to their contractual maturity ("available for sale"). The difference between the amortized cost of fixed income securities and fair value, net of deferred income taxes, certain life and annuity deferred policy acquisition costs, and certain reserves for life-contingent contract benefits, is reflected as a component of Shareholder's equity. Mortgage loans are carried at outstanding principal balance, net of unamortized premium or discount and valuation allowances.
The Company closely monitors its fixed income and mortgage loan portfolios for declines in value that are other than temporary. Securities are placed on non-accrual status when they are in default or when timing or receipt of principal or interest payments are in doubt. Provisions for losses are recognized for declines in the value of fixed income securities and mortgage loans that are deemed to be other than temporary. Such write-downs are included in Realized capital gains and losses.
For traditional life insurance and structured settlement annuities with life contingencies, these costs are amortized in proportion to the estimated future revenues on such business.
Contractholder funds arise from the issuance of policies and contracts that include an investment component, including fixed annuities, interest-sensitive life policies and other investment contracts. Deposits received are recorded as interest-bearing liabilities. Contractholder funds are equal to deposits received and interest credited to the benefit of the contractholder less surrenders, withdrawals, mortality charges and administrative expenses. For further discussion of these policies, see the Market Risk and Forward-looking Statements and Risk Factors section of MD&A.
The Company also discloses its significant accounting policies in Note 2 to the financial statements.
The Company earns revenue primarily from: (a) premiums on insurance products with significant mortality or morbidity risk; (b) contract charges and fees from investment contracts; (c) net investment income earned on its investments, excluding those in Separate Accounts; and (d) realized capital gains and losses recognized on its investments, excluding those in the Separate Accounts. The Company's primary costs and expenses consist of contract benefits, interest credited to contractholders' funds, amortization of DAC and operating costs and expenses.
The process of developing product pricing involves analyzing several key dynamic factors, including market conditions, competitive environment, mortality assumptions, investment returns, surrender and withdrawal assumptions and operating costs and expenses of the business. The Company's profitability depends on the adequacy of investment margins (the spread between interest credited to contractholder's account balances and the interest earned on the investments, excluding those in Separate Accounts), the management of market and credit risks associated with investments, the Company's ability to maintain premiums and contract charges at a level to cover mortality benefits, the adequacy of contract charges from variable annuity contracts to cover the costs of various product features, the persistency of policies to ensure recovery of acquisition expenses, and the management of operating costs and expenses within anticipated pricing allowances. Legislation and regulation of the insurance marketplace and products could also affect the Company's profitability.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Cont.)
The Company utilizes an alternative method of presenting its operating results in the following discussion that differs from the presentation of the financial information in the financial statements. This presentation allows for a more complete analysis of results of operations. The net effects of realized capital gains and losses, after-tax have been excluded from operating income due to the volatility between periods and because such data is often excluded when evaluating the overall financial performance of insurers. Realized capital gains and losses, after-tax is presented net of the effects of DAC to the extent that such effects resulted from the recognition of realized capital gains and losses. Operating income should not be considered a substitute for any measure of performance under accounting principles generally accepted in the United States of America ("GAAP"). The Company's method of calculating operating income may be different from the method used by other companies and therefore comparability may be limited.
(1) For a complete definition of operating income, see the operating income discussion beginning on page 7.
Statutory premiums and deposits increased $19.0 million or 2.8% in 2001 as compared to 2000. In 2001, fixed investment products increased 11.1% from increased sales in the financial services firms channel and increased focus on investment products sold within the Allstate agencies channel. Traditional life and other life products increased 37.3% and 14.8%, respectively, due to strong sales stemming from a pricing change implemented late in 2000. In 2001, interest-sensitive life products and variable Separate Accounts decreased 6.0% and 1.1%, respectively, due to market conditions.
In 2001, total premiums were comparable to 2000. Increased premiums from traditional life and other products were more than offset by a decrease in premiums from immediate annuities with life contingencies. The sales mix of immediate annuities with life contingencies and those without life contingencies can cause fluctuations in premiums and contract charges from year to year. The increase in sales of traditional products resulted, in part, due to an increase in retention limits associated with third party reinsurance instituted during the year.
In 2001, contract charges remained fairly constant with 2000 as decreased contract charges from interest-sensitive life products were partially offset by increased contract charges from variable annuities and investment contracts. Contract charges on variable Separate Accounts products are generally calculated as a percentage of account value and therefore are impacted by market volatility. Contract charges on immediate annuities without life contingencies, included in investment contract charges, increased due to an increase in premium deposits.
OPERATING INCOME Operating income is a measure used by management to evaluate profitability. Operating income is defined as income before the cumulative effect of changes in accounting principle, after-tax, excluding the after-tax effects of realized capital gains and losses. In this management measure, the effects of realized capital gains and losses have been excluded due to the volatility between periods and because such data is often excluded when evaluating the overall financial performance and profitability of other insurers. These operating results should not be considered as a substitute for any GAAP measure of performance. A reconciliation of operating income to net income is provided in the table on page 5. The Company's method of calculating operating income may be different from the method used by other companies and therefore comparability may be limited.
Investment margin, which represents the excess of investment income earned over interest credited to policyholders and contractholders, increased 19.0% in 2001 compared to 2000. The increase was primarily due to a larger asset base from additional sales of fixed annuities partially offset by an increase in interest credited. Investment margin increased 15.4% in 2000 compared to 1999. The increase was primarily due to a larger asset base coupled with slightly higher yielding assets and lower investment expenses.
Mortality margin, which represents premiums and cost of insurance charges in excess of related policy benefits, decreased 25.4% in 2001 compared to 2000. The decrease in mortality margin was due to a higher number of incurred death claims, including $6.6 million from the tragedy of the September 11 attack on the World Trade Center in New York City and the Pentagon in Washington D.C., and the plane crash in Pennsylvania. The 2001 mortality margin also includes an increase in death benefits on variable annuity contracts over 2000. See the Market Risk section for a detailed description of the equity risk related to these death benefits. Mortality and morbidity loss experience can cause benefit payments to fluctuate from period to period while underwriting and pricing guidelines utilize a long-term view of the trends in mortality and morbidity when determining premium rates and cost of insurance charges. Mortality margin increased 44.1% in 2000 compared to 1999. The increase was due to positive mortality results on immediate annuities with life contingencies.
COMPANY OUTLOOK - - Consistent with the marketplace, the Company's sales continue to move towards lower profit margin products, such as term life and variable annuities. These lower profit margin products require a higher volume of sales to increase the Company's operating results. The Company achieved this increased volume in 2000 and expects product growth in 2002, as the economy improves and additional products are offered and updated.
- - The Company's ability to manage its investment margin is dependent upon the level of interest rates and the quality of its investment portfolio. Changes in interest rates and the level of defaults may affect investment income. The Company also has the ability to impact the investment margin by changing the crediting rates on flexible rate contracts, but these changes could be limited by market conditions and minimum rate guarantees on certain contracts.
- - The Company's contract charge revenue is dependent upon the value of the accounts supporting its variable annuity products. Most account values for these products are invested, at the discretion of the contractholder, in equity mutual funds. Therefore, returns on these products are significantly influenced by market performance, thus impacting contract charge revenue.
NET INVESTMENT INCOME Net investment income increased 15.8% and 19.0% in 2001 and 2000, respectively. Increases in both years were due to higher investment balances due to positive cash flows from operations. Net investment income increased 19.0% in 2000 compared to 1999 due to higher yields. Investments, excluding Separate Accounts assets and unrealized gains on fixed income securities, grew 17.7% and 21.7% in 2001 and 2000, respectively.
REALIZED CAPITAL GAINS AND LOSSES After-tax realized capital gains were $105 thousand in 2001 compared to after-tax realized capital losses of $3.4 million and $1.3 million in 2000 and 1999, respectively. After-tax realized capital gains and losses are presented net of the effects of DAC amortization, to the extent that such effects resulted from the recognition of realized capital gains and losses. The following table describes the factors impacting the realized capital gains and losses results:
Realized capital gains and losses from the valuation of certain derivative instruments in 2001 reflected the impact of new accounting policies adopted during the year related to Statements of Financial Accounting Standards ("SFAS") Nos. 133 and 138.
- - The Company expects to experience lower investment yields due, in part, to the reinvestment of proceeds from prepayments, calls and maturities, and the investment of cash flows from operations, in securities yielding less than the average portfolio rate.
The composition of the investment portfolio is presented in the table below (see Notes 2 and 4 to the financial statements for investment accounting policies and additional information):
(1) Fixed income securities are carried at fair value. Amortized cost for these securities was $2.68 billion and $2.26 billion at December 31, 2001 and 2000, respectively.
As of December 31, 2001, the fixed income securities portfolio contained $879.7 million of privately-placed corporate obligations compared to $712.0 million at December 31, 2000. The benefits of privately-placed securities as compared to public securities are generally higher yields, improved cash flow predictability through pro-rata sinking funds on many bonds, and a combination of covenant and call protection features designed to better protect the holder against losses resulting from credit deterioration, reinvestment risk and fluctuations in interest rates. A relative disadvantage of privately-placed securities as compared to public securities is relatively reduced liquidity. At December 31, 2001, 96.2% of the privately-placed securities were rated as investment grade by either the NAIC or the Company's internal ratings. The Company determines the fair value of privately-placed fixed income securities based on discounted cash flows using current interest rates for similar securities.
The fixed income securities portfolio contained $55.0 million and $39.4 million of asset-backed securities ("ABS") at December 31, 2001 and 2000, respectively. The ABS portfolio is subject to credit and interest rate risk. Credit risk is mitigated by monitoring the performance of the collateral. Approximately 29.2% of the ABS portfolio is rated in the highest rating category by one or more credit rating agencies. The ABS portfolio is subject to interest rate risk since the price volatility and ultimate realized yield are affected by the rate of repayment of the underlying assets. Approximately 25.3% of the Company's ABS portfolio is invested in securitized credit card receivables. The remainder of the portfolio is backed primarily by securitized home equity, manufactured housing, and auto loans.
The Company closely monitors its commercial mortgage loan portfolio on a loan-by-loan basis. Loans with an estimated collateral value less than the loan balance, as well as loans with other characteristics indicative of higher than normal credit risk, are reviewed by financial and investment management at least quarterly for purposes of establishing valuation allowances and placing
loans on non-accrual status. The underlying collateral values are based upon discounted property cash flow projections, which are updated as conditions change, or at least annually.
In light of recent economic events, commercial mortgages might be adversely affected due to the inability to obtain insurance coverage to restore the related real estate or other property, thereby creating the potential for increased default risk. As interest rates on mortgage loans continue to decrease, the Company also faces the risk of prepayments and refinancing of existing mortgage loans. As these mortgages are prepaid and new ones issued at lower rates, the Company's investment income can also be adversely impacted.
SHORT-TERM INVESTMENTS The Company's short-term investment portfolio was $57.5 million and $58.2 million at December 31, 2001 and 2000, respectively. The Company invests available cash balances primarily in taxable short-term securities having a final maturity date or redemption date of one year or less.
To the extent unrealized gains or losses on fixed income securities carried at fair value would result in an adjustment of estimated gross profits had those gains or losses actually been realized, the related unamortized deferred policy acquisition costs are recorded net of tax as a reduction of the unrealized capital gains or losses included in Shareholder's equity.
SEPARATE ACCOUNTS Separate Accounts assets and liabilities increased 7.6% to $602.7 million at December 31, 2001 from December 31, 2000. The increases were primarily attributable to additional deposits and transfers from the fixed account fund to variable Separate Accounts funds partially offset by declines in account values due to equity market conditions.
REINSURANCE RECOVERABLE Reinsurance recoverable decreased $123 thousand, or 9.7%, to $1.1 million at December 31, 2001 from $1.3 million at December 31, 2000. Reinsurance recoverable decreased due to benefits paid partially offset by an increase in traditional life insurance product sales. The Company purchases reinsurance to limit aggregate and single losses on large risks. The Company continues to have
primary liability as a direct insurer for risks reinsured. Estimating amounts of reinsurance recoverable is impacted by the uncertainties involved in the establishment of loss reserves. Failure of reinsurers to honor their obligations could result in losses to the Company.
The Company reinsures certain of its risks to other reinsurers under yearly renewable term and coinsurance agreements. Yearly renewable term and coinsurance agreements result in the passing of a portion of the risk to the reinsurer. Generally, the reinsurer receives a proportionate amount of the premiums less commissions and is liable for a corresponding proportionate amount of all benefit payments. As of December 31, 2001, $2.19 billion or 12.5% of life insurance in force was ceded to other companies.
RESERVE FOR LIFE CONTINGENT CONTRACT BENEFITS The Company establishes and carries as liabilities, actuarially determined reserves that are calculated to meet its future obligations for life-contingent contract benefits. The calculation of reserves for life-contingent contract benefits includes assumptions for mortality, future investment yields, terminations and expenses at the time the policy is issued. These assumptions include provisions for adverse deviation and generally vary by such characteristics as type of coverage, year of issue and policy duration. The assumptions for mortality generally utilized in calculating reserves include the United States population with projected calendar year improvements and age setbacks for impaired lives for structured settlement annuities, the 1983 group annuity mortality table for other immediate annuities, and actual experience plus loading for traditional life insurance. Interest rate assumptions vary from 5.5% to 9.5% for structured settlement annuities; 3.0% to 11.5% for immediate annuities with life contingencies and 4.0% to 8.0% for traditional life insurance. Other estimation techniques used in the calculation of these reserves include the present value of contractually fixed future benefits for structured settlement annuities, the present value of expected future benefits based on historical experience for other immediate annuities and the net level premium reserve method using withdrawal experience rates for traditional life insurance. Premium deficiency reserves are established, if necessary, and have been recorded for certain immediate annuities with life contingencies, to the extent the unrealized gains on fixed income securities would result in a premium deficiency had those gains actually been realized.
The active management of market risk is integral to the Company's results of operations. The Company may use the following approaches to manage its exposure to market risk within defined tolerance ranges: 1) rebalance its existing asset or liability portfolios, 2) change the character of investments purchased in the future or 3) use derivative instruments to modify the market risk characteristics of
existing assets and liabilities or assets expected to be purchased. For a more detailed discussion of these derivative financial instruments, see Note 5 to the financial statements.
The Company administers and oversees its investment risk management processes primarily through its Board of Directors, Investment Committee and the Credit and Risk Management Committee ("CRMC"). The Board of Directors and Investment Committees provide executive oversight of investment activities and set investment strategies, guidelines and policy that delineates the investment limits and strategies that are appropriate given the Company's liquidity, capital, product portfolios and regulatory requirements. The CRMC is a senior investment management committee consisting of the Chief Investment Officer, the Investment Risk Manager, and other investment officers who are responsible for the day-to-day management of investment risk. The CRMC meets at least monthly to provide detailed oversight of investment risk, including market risk.
INTEREST RATE RISK Interest rate risk is the risk that the Company will incur economic losses due to adverse changes in interest rates. This risk arises from the Company's primary activities, as the Company invests substantial funds in interest-sensitive assets and also carries certain interest-sensitive liabilities.
The Company manages the interest rate risk inherent in its assets relative to the interest rate risk inherent in its liabilities. One of the measures the Company uses to quantify this exposure is duration. Duration measures the sensitivity of the fair value of assets and liabilities to changes in interest rates. For example, if interest rates increase by 1%, the fair value of an asset with a duration of 5 is expected to decrease in value by approximately 5%. At December 31, 2001, the difference between the Company's liability and asset duration was approximately 1.1 versus a 1.5 gap at December 31, 2000. This duration gap indicates that the fair value of the Company's liabilities is more sensitive to interest rate movements than the fair value of its assets.
Generally at the time of purchase, the contractholders of a variable annuity contract receive a minimum death benefit guarantee and, for certain contracts, may elect to purchase an enhanced minimum death benefit guarantee. The Company charges a fee for these guarantees that is generally calculated as a percentage of the account value. This guarantee subjects the Company to additional equity risk as the beneficiary or contractholder may receive a benefit for an amount greater than the fund balance under contractually defined circumstances and terms.
Growth in variable annuity contracts in the future, stemming from both new sales as well as market value appreciation, will increase the Company's amount of overall exposure to equity price risk embedded in these contracts. An increase in the equity markets above December 31, 2001 levels will increase the contractholder returns on these products, thereby decreasing the risk from utilizing these guarantees on the inforce business. A decrease in the equity markets that causes a decrease in the variable annuity contracts' fund balances will increase the equity risk profile of the inforce business.
The Company also is exposed to equity risk in its DAC. DAC represents costs that are primarily related to acquiring
CAPITAL RESOURCES The Company's capital resources consist of shareholder's equity. The following table summarizes the capital resources at December 31:
The Company had no outstanding debt at December 31, 2001 and 2000, respectively. The Company has entered into an inter-company loan agreement with the Corporation. The amount of inter-company loans available to the Company is at the discretion of the Corporation. The maximum amount of loans the Corporation will have outstanding to all its eligible subsidiaries at any given point in time is limited to $1.00 billion. No amounts were outstanding for the Company under the inter-company loan agreement at December 31, 2001 and 2000, respectively. The Corporation uses commercial paper borrowings and bank lines of credit to fund inter-company borrowings.
FINANCIAL RATINGS AND STRENGTHS Financial strength ratings have become an increasingly important factor in establishing the competitive position of insurance companies and, generally, may be expected to have an effect on an insurance company's sales. On an ongoing basis, rating agencies review the financial performance and condition of insurers. A downgrade, while not expected, could have a material adverse effect on the Company's business, financial condition and results of operations. The Company's current financial strength ratings are listed below:
In February 2002, Standard & Poor's affirmed its December 31, 2001 ratings. Standard & Poor's revised its outlook for ALIC and its rated subsidiaries and affiliates to "negative" from "stable". This revision is part of an ongoing life insurance industry review recently initiated by Standard & Poor's. Moody's and A.M. Best reaffirmed its ratings and outlook for the Company.
The maturity structure of the Company's fixed income securities, which represent 89.7% of the Company's total investments, is managed to meet the anticipated cash flow requirements of the underlying liabilities.
A portion of the Company's diversified product portfolio, primarily fixed deferred annuity and interest-sensitive life is subject to discretionary surrender and withdrawal by contractholders. As the Company's interest-sensitive life policies and annuity contracts in force grow and age, the dollar amount of surrenders and withdrawals could increase, as experienced in 2001 and 2000. While the overall amount of surrenders may increase in the future, a significant increase in the level of surrenders relative to total contractholder account balances is not anticipated. Management believes the assets are sufficiently liquid to meet future obligations to the Company's contractholders under various interest rate scenarios.
REGULATIONS AND LEGAL PROCEEDINGS The Company's business is subject to the effects of a changing social, economic and regulatory environment. State and federal regulatory initiatives have varied and have included employee benefit regulations, removal of barriers preventing banks from engaging in the securities and insurance businesses, tax law changes affecting the taxation of insurance companies, the tax treatment of insurance products and its impact on the relative desirability of various personal investment vehicles, and the overall expansion of regulation. The ultimate changes and eventual effects, if any, of these initiatives are uncertain.
STATE INSURANCE REGULATION State insurance authorities have broad administrative powers with respect to all aspects of the life insurance business including: - Licensing to transact business - Licensing agents - Admittance of assets to support statutory surplus - Approving policy forms - Regulating unfair trade and claims practices - Establishing reserve requirements and solvency standards - Regulating the type, amounts and valuations of investments permitted and other matters
MARKET CONDUCT REGULATION State insurance laws and regulations include numerous provisions governing the marketplace activities of insurers, including provisions governing the form and content of disclosure to consumers, illustrations, advertising, sales practices and complaint handling. State regulatory authorities generally enforce these provisions through periodic market conduct examinations.
The State of New York chose not to adopt Statement of Statutory Accounting Principles No. 10, Income Taxes. If the State of New York did adopt Statement of Statutory Accounting Principles No. 10, Income Taxes, the Company would have reported an increase to surplus of $3.4 million for the year ended December 31, 2001.
The NAIC is currently in the process of clarifying and interpreting requirements as the insurance industry implements Codification. As the NAIC announces changes and as they are approved by the New York Department of Insurance, the impact of the changes will be recorded.
In June 2001, the Financial Accounting Standards Board ("FASB") issued Statements of Financial Accounting Standards ("SFAS") No. 142, "Goodwill and other Intangible Assets", which eliminates the requirement to amortize goodwill, and requires that goodwill and separately identified intangible assets with indefinite lives be evaluated for impairment on an annual basis (or more frequently if impairment indicators arise) on a fair value as opposed to an undiscounted basis. SFAS No. 142 is effective January 1, 2002. A transitional goodwill impairment test is required to be completed within the first six months of adoption with any resulting impairment charge recognized as the cumulative effect of a change in accounting principle in the statement of operations. As of December 31, 2001, the Company's unamortized goodwill balance was $160 thousand and goodwill amortization expense recognized during 2001 was $6 thousand. Transitional goodwill impairment testing is being conducted and the impact is not expected to be material to the results of operations or financial position of the Company.
FORWARD-LOOKING STATEMENTS AND RISK FACTORS This document contains "forward-looking statements" that anticipate results based on management's plans are subject to uncertainty. These statements are made subject to the safe-harbor provisions of the Private Securities Litigation Reform Act of 1995.
- - The Company amortizes DAC related to contractholder funds in proportion to gross profits over the estimated lives of the contract periods. Periodically, the Company updates its assumptions underlying the gross profits, which include estimated future fees, investment margins and expense margins, in order to reflect actual experience. Updates to these assumptions result in adjustments to the cumulative amortization of DAC. These adjustments may have a material effect on the results of operations.
- - It is possible that the assumptions and projections used by the Company in establishing prices for the guaranteed minimum death benefits on variable annuity contracts, particularly assumptions and projections about investment performance, do not accurately anticipate the level of costs the Company will ultimately incur in providing those benefits.
- - The Company distributes some of its products under agreements with other members of the financial services industry that are not affiliated with the Company. Termination of one or more these agreements due to, for example, changes in control of any of these entities, could have a detrimental effect on the Company's sales. This risk may be exacerbated by the enactment of the Gramm-Leach-Bliley Act of 1999, which eliminated many federal and state law barriers to affiliations among banks, securities firms, insurers and other financial service providers.
- - A portion of the unrealized capital gains and losses included as a component of shareholder's equity relating to non-exchange traded marketable investment securities accounted for at fair value are internally developed using widely accepted valuation models and independent third party data as model inputs. A decrease in these values would negatively impact the Corporation's debt-to-capital ratio.
- - The Gramm-Leach-Bliley Act of 1999 permits mergers that combine commercial banks, insurers and securities firms under one holding company. Until passage of the Gramm-Leach-Bliley Act, the Glass Steagall Act of 1933 had limited the ability of banks to engage in securities-related businesses and the Bank Holding Company Act of 1956 had restricted banks from being affiliated with insurers. With the passage of the Gramm-Leach-Bliley Act, bank holding companies may acquire insurers and insurance holding companies may acquire banks. In addition grand-fathered unitary thrift holding companies, including the Allstate Corporation, may engage in activities that are not financial in nature. The ability of banks to affiliate with insurers may materially adversely affect all of the Company's product lines by substantially increasing the number, size and financial strength of potential competitors.
- - In some states, mutual insurance companies can convert to a hybrid structure known as a mutual holding company. This process converts insurance companies owned by their policyholders to become stock insurance companies owned (through one or more intermediate holding companies) partially by their policyholders and partially by stockholders. Also some states permit the conversion of mutual insurance companies into stock insurance companies (demutualization). The ability of mutual insurance companies to convert to mutual holding companies or to demutualize may materially adversely affect all of our product lines by substantially increasing competition for capital in the financial services industry.