Effective July 1, 2003, we adopted Statement No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” Statement No. 150 required the classification of preferred dividends as interest expense on a prospective basis from the date of adoption. Net income for 2003 would have been $2.2 million lower if Statement No. 150 had been effective January 1, 2003. Net income applicable to common stock was not impacted by Statement No. 150.
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses and the disclosure of contingent assets and liabilities. It is reasonably possible that actual experience could differ from the estimates and assumptions utilized which could have a material impact on the consolidated financial statements. A summary of our significant accounting estimates and the hypothetical effects of changes in the material assumptions used to develop each estimate, are included in the following table. We have discussed the identification, selection and disclosure of these critical accounting estimates with the Audit Committee of the Board of Directors.
Excluding U.S. government treasury securities, very few of our fixed maturity securities trade on the balance sheet date. For those securities without a trade on the balance sheet date, market values are determined using valuation processes that require judgment.
We are required to exercise judgment to determine when a decline in the value of a security is other than temporary. When the value of a security declines and the decline is determined to be other than temporary, the carrying value of the investment is reduced to its fair value and a realized loss is recorded to the extent of the decline.
At December 31, 2007, we had 864 fixed maturity and equity securities with gross unrealized losses totaling $287.1 million. Included in the gross unrealized losses are losses attributable to both movements in market interest rates as well as temporary credit issues. Details regarding these securities are included in the “Financial Condition - Investments” section that follows. Net income would have been reduced by approximately $160.2 million if all these securities were deemed to be other-than-temporarily impaired on December 31, 2007.
Net income applicable to common stock decreased 4.2% in 2007 to $86.2 million and increased 23.8% in 2006 to $90.0 million. As discussed in detail below, net income applicable to common stock decreased in 2007 due to the impact of changes in unrealized gains and losses on derivatives and a decrease in realized gains on investments, partially offset by the impact of growth in the volume of business in force and decreases in death benefits. Net income applicable to common stock increased in 2006 due to the growth in the volume of business in force and an increase in realized gains on investments, partially offset by increases in death benefits.
The increase in volume of business in force is quantified in the detailed discussion that follows by summarizing the face amount of insurance in force for life products or account values of contracts in force for interest sensitive products. The face amount of life insurance in force represents the gross death benefit payable to policyholders and account value represents the value of the contract to the contract holder before application of surrender charges or reduction for any policy loans outstanding.
As noted in the “Segment Information” section that follows, we use both net income and operating income to measure our operating results. Operating income for the years covered by this report equals net income, excluding the impact of: (1) realized gains and losses on investments, (2) the change in net unrealized gains and losses on derivatives, (3) the cumulative effect of change in accounting principles and (4) a lawsuit settlement. The rationale for excluding these items from operating income is explained in the “Segment Information” section that follows and Note 14 to the consolidated financial statements. The impact of these adjustments on net income is as follows:
Effective January 1, 2007, we adopted Financial Accounting Standards Board Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” which requires a more-likely-than-not recognition threshold for evaluating our tax positions. The impact of adopting Interpretation No. 48 was not material to our consolidated financial statements; therefore the cumulative effective of change in this accounting principle, totaling $0.3 million, was reflected as an increase to income tax expense in our 2007 consolidated income statement. Net income for the full year 2007 was $0.3 million lower ($0.01 per basic and diluted common share) as a result of adopting this Interpretation.
Effective January 1, 2006, we adopted Statement No. 123(R), “Share-Based Payment,” using the modified-prospective-transition method. Statement No. 123(R) is a revision of Statement No. 123, “Accounting for Stock-Based Compensation.” As a result of adopting Statement No. 123(R), net income for the full year 2006 was $0.2 million lower (less than $0.01 per basic and diluted common share), than if we had continued to account for share-based compensation under Statement No. 123.
Premiums and product charges increased 6.5% in 2007 to $259.2 million and 5.4% in 2006 to $243.4 million. The increases in interest sensitive and index product charges in 2007 and 2006 are driven principally by surrender charges on annuity and universal life products, mortality and expense fees on variable products and cost of insurance charges on variable universal life and universal life products.
Surrender charges totaled $23.4 million in 2007, $18.3 million in 2006 and $13.5 million in 2005. Surrender charges increased primarily due to an increase in surrenders relating to growth in the volume and aging of business in force. The average aggregate account value for annuity and universal life insurance in force, which increased due to increases in premiums collected as summarized in the “Other data” table above, totaled $8,428.8 million for 2007, $6,861.7 million for 2006 and $5,523.8 million for 2005. We believe aging of the business in force is driving a portion of the increase in surrender charges relating to the annuity business assumed under coinsurance agreements and business written directly through the EquiTrust Life independent agents as the surrender charge rate decreases with the passage of time (at a rate generally equal to 1.0% per year). This makes a surrender later in the contract period more economical for the contract holder, which results in higher lapse rates as the business ages. We started assuming business under coinsurance agreements in 2001 and started selling annuities directly through EquiTrust Life independent agents in the fourth quarter of 2003. In total, surrender charges on this coinsurance and direct business totaled $20.5 million for 2007, $15.6 million for 2006 and $10.9 million for 2005.
Mortality and expense fees totaled $10.0 million in 2007, $8.1 million in 2006 and $6.9 million in 2005. Mortality and expense fees increased due to increases in the separate account balances on which fees are based. The average separate account balance increased to $823.2 million for 2007, from $697.6 million for 2006 and $588.0 million for 2005 due to the impact of new sales and favorable investment results. Transfers of premiums to the separate accounts totaled $138.6 million for 2007, $93.6 million for 2006 and $118.2 million for 2005. Net investment income and net realized and unrealized gains on separate account assets totaled $60.6 million for 2007, $39.8 million for 2006 and $37.7 million for 2005.
Net investment income, which excludes investment income on separate account assets relating to variable products, increased 17.2% in 2007 to $628.0 million and increased 12.7% in 2006 to $535.8 million. These increases are primarily due to an increase in average invested assets. Average invested assets increased 18.2% to $10,430.4 million (based on securities at amortized cost) in 2007 and 15.4% to $8,822.7 million (based on securities at amortized cost) in 2006. Average invested assets totaled $7,645.4 million in 2005. The increase in average invested assets in 2007 and 2006 is principally due to net premium inflows from the Life Companies and, for 2007, proceeds totaling $98.5 million from issuance of our Senior Notes in March 2007 (2017 Senior Notes). The annualized yield earned on average invested assets decreased to 6.02% in 2007 from 6.07% in 2006 and 6.22% in 2005. Market conditions in 2007, 2006 and 2005 impacted our investment portfolio yield as market investment rates were, in general, lower than our portfolio yield or yield on investments maturing or being paid down. The average yields on fixed maturity securities purchased were 6.11% for 2007, 6.04% for 2006 and 5.44% for 2005. The average yields on fixed maturity securities maturing or being paid down were 6.59% for 2007, 6.62% for 2006 and 6.10% for 2005. For 2007, the impact of these market conditions on our portfolio yield was partially offset by increased fee income. Fee income from bond calls, tender offers and mortgage loan prepayments totaled $10.1 million in 2007, $8.9 million in 2006 and $8.4 million in 2005. Net investment income also includes ($1.3) million in 2007, $0.1 million in 2006 and ($0.6) million in 2005 representing the acceleration (reversal) of net discount accretion on mortgage and asset-backed securities resulting from changing prepayment speed assumptions at the end of each respective period. See “Financial Condition - Investments” section that follows for a description of how changes in prepayment speeds impact net investment income.
Interest sensitive and index product benefits increased 6.7% in 2007 to $436.6 million and 41.6% in 2006 to $409.1 million. The increase in interest sensitive and index product benefits for 2007 is primarily due to an increase in volume of annuity business in force, partially offset by market depreciation on the indices backing the index annuities and a decrease in interest sensitive death benefits. In 2006, the increase in interest sensitive and index product benefits was primarily due to an increase in volume of annuity business in force, an increase in interest sensitive death benefits and an increase in market appreciation on the indices backing the index annuities. Interest sensitive and index product benefits tend to fluctuate from period to period primarily as a result of changes in mortality experience and the impact of changes in the equity markets on index credits, the value of the embedded derivatives in our index annuities and amortization of deferred sales inducements.
The weighted average interest crediting rate/index cost for universal life and individual traditional annuity products, excluding the impact of the amortization of deferred sales inducements, was 3.67% for 2007, 3.57% for 2006 and 3.68% for 2005. See the “Segment Information” section that follows for additional details on our spreads.
The change in the amount of index credits is impacted by growth in the volume of index annuities in force and the amount of appreciation/depreciation in the underlying equity market indices on which our options are based as discussed above under “Derivative income (loss).” The change in the value of the embedded derivative is impacted by the change in expected index credits on the next policy anniversary dates, which is related to the change in the fair value of the options acquired to fund these index credits as discussed above under “Derivative income (loss).” The value of the embedded derivative is also impacted by the timing of the posting of index credits and changes in reserve discount rates and assumptions used in estimating future call option costs. In addition, during 2006, we reduced our reserves for the embedded derivative in our coinsured index annuities $7.1 million. This adjustment, which is the correction of an overstatement that started in 2001, increased net income $2.6 million ($0.09 per basic and diluted common share) after offsets for taxes and the amortization of deferred policy acquisition costs and deferred sales inducements. This adjustment does not impact our segment results as the segment results are based on operating income which, as explained in the “Segment Information” section, excludes the impact of changes in the valuation of derivatives.
The decrease in amortization of deferred sales inducements in 2007 is primarily due to the impact of changes in unrealized gains and losses on derivatives, partially offset by the impact of capitalization of costs incurred with new sales and profitability on the underlying business. Deferred sales inducements on interest sensitive and index products totaled $319.2 million at December 31, 2007, $225.1 million at December 31, 2006 and $147.0 million at December 31, 2005. The impact of realized/unrealized gains and losses on investments and the change in unrealized gains/losses on derivatives is detailed and in the “Net income applicable to common stock” section above.
Underwriting, acquisition and insurance expenses decreased 1.7% in 2007 to $161.8 million and increased 7.9% in 2006 to $164.5 million. Amortization of deferred policy acquisition costs decreased in 2007 primarily due to the impact of the change in unrealized gains/losses on derivatives, partially offset by the impact of an increase in profitability and volume of business in force resulting from direct sales from our EquiTrust Life distribution channel. Amortization of deferred policy acquisition costs on this business, excluding the impact of changes in unrealized gains/losses on derivatives, totaled $24.1 million in 2007, $14.9 million in 2006 and $6.5 million in 2005. The impact of realized/unrealized gains and losses on investments and the change in unrealized gains/losses on derivatives is detailed and in the “Net income applicable to common stock” section above. In addition, amortization of deferred policy acquisition costs in 2005 included $0.9 million in connection with the recapture by a former variable alliance partner of a previously coinsured block of variable annuity contracts. Amortization of value of insurance in force acquired increased in 2007 primarily due to the impact of unlocking and more favorable mortality experience.
Interest expense totaled $16.7 million in 2007 compared to $11.7 million in 2006 and $13.6 million in 2005. The increase in 2007 is due to an increase in our long-term debt due to issuance of the 2017 Senior Notes in March 2007. Our average debt outstanding was $296.6 million in 2007 compared to $218.4 million in 2006 and $254.6 million in 2005. Interest expense in 2006 decreased $2.3 million due to dividends on the Series C redeemable preferred stock, which was redeemed in December 2005, partially offset by an increase in the effective interest rate on our $46.0 million line of credit to 5.50% in 2007 and 2006 from 4.55% in 2005.
In its Revenue Ruling 2007-61, issued on September 25, 2007, the Internal Revenue Service (IRS) announced its intention to issue regulations which would limit our ability to receive a dividends-received deduction (DRD) on separate account assets held in connection with variable annuity and variable universal life insurance contracts. Revenue Ruling 2007-61 suspended Revenue Ruling 2007-54 issued in August 2007 that purported to change accepted industry and IRS interpretations of the statutes governing these computation questions. Any regulations that the IRS ultimately proposes for issuance in this area will be subject to public notice and comment, at which time insurance companies and other members of the public will have the opportunity to raise legal and practical questions about the content, scope and application of such regulations. As a result, the ultimate timing, substance, and effective date of any such regulations are unknown, but they could result in the elimination of some or all of the separate account DRD tax benefit we receive. We recorded separate account DRD tax benefits totaling $2.4 million in 2007, $1.6 million in 2006 and $1.2 million in 2005.
Equity income, net of related income taxes, totaled $1.5 million in 2007, $1.1 million in 2006 and $1.2 million in 2005. Equity income includes our proportionate share of gains and losses attributable to our ownership interest in partnerships, joint ventures and certain companies where we exhibit some control but have a minority ownership interest. Given the timing of availability of financial information from our equity investees, we will consistently use information that is as much as three months in arrears for certain of these entities. Several of these entities are investment companies whose operating results are derived primarily from unrealized and realized gains and losses generated by their investment portfolios. As is normal with these types of entities, the level of these gains and losses is subject to fluctuation from period to period depending on the prevailing economic environment, changes in prices of equity securities held by the investment partnerships, timing and success of initial public offerings and other exit strategies, and the timing of the sale of investments held by the partnerships and joint ventures.
We analyze our segment results based on pre-tax operating income (loss). Accordingly, income taxes are not allocated to the segments. In addition, operating results are generally reported net of any transactions between the segments. Operating income (loss) represents net income excluding, as applicable, the after tax impact of:
A reconciliation of net income to pre-tax operating income and a summary of pre-tax operating income (loss) by segment follows:
See “Net income applicable to common stock” above for additional details on operating income adjustments.
In addition to the impact of unlocking on deferred policy acquisition costs described above, benefits and expenses were also impacted by unlocking value of insurance in force acquired, which increased amortization less than $0.1 million in 2007 and reduced amortization $0.2 million in 2006 and $0.7 million in 2005. In addition, other underwriting expenses decreased 8.4% in 2006 to $8.9 million primarily due to expense savings initiatives. Other underwriting expenses totaled $8.7 million in 2007.
Premiums collected decreased 9.6% to $126.8 million in 2007 and 20.9% to $140.3 million in 2006. The amount of traditional annuity premiums collected is highly dependent upon the relationship between the current crediting rates on our products and the crediting rates available on competing products, including bank-offered certificates of deposit. We believe the decreases in annuity premiums in 2007 and 2006 are due to a rise in short-term market interest rates, making certificates of deposit and other short-term investments more attractive in relation to traditional annuities. We also believe the competitive environment resulted in increased surrenders, therefore increasing the withdrawal rate in 2007 and 2006. For the company in total, the decrease in annuity premiums in 2007 is offset by increases in variable annuity premiums as discussed in the “Variable Segment” section that follows.
The changes in derivative income (loss) are primarily due to increases in proceeds from call option settlements, partially offset by increases in the cost of money for call options as discussed under “Derivative income (loss)” above. Call option settlements increased to $155.3 million in 2007, from $68.5 million in 2006 and $41.9 million in 2005. The cost of money for call options totaled $108.0 million in 2007, $72.8 million in 2006 and $44.3 million in 2005.
Benefits and expenses increased in 2007 and 2006 due to growth in the volume of business in force. The timing of policy anniversary dates and the amount of appreciation in the underlying indices also contributed to increases in index credits totaling $154.0 million in 2007, compared to $71.2 million in 2006 and $44.5 million in 2005. In addition, operating expenses include $6.8 million in 2007, $5.9 million in 2006 and $4.1 million in 2005 relating to the expansion of our EquiTrust Life distribution. These increases were partially offset by the impact of unlocking adjustments, which decreased amortization of deferred policy acquisition costs and deferred sales inducements $1.9 million in 2007, less than $0.1 million in 2006 and $0.5 million in 2005.
In 2007, the weighted average yield on cash and invested assets increased primarily due to an increase in market investment rates and the acquisition of investments at yields greater than the existing portfolio yield, partially offset by a decrease in fee income discussed above. In 2006, market investment rates were generally lower than our portfolio yield. The weighted average crediting rate increased in 2007 due to increasing crediting rates and option costs. The decreases in spread are primarily due to a shift in business to our multi-year guaranteed annuity which has a lower spread target than other products in our portfolio. Spreads earned in 2005 were primarily a result of spreads on index annuities assumed under a coinsurance agreement, which is driven by option costs, the extent to which the business was over hedged and fluctuations in the minimum guarantees credited to the contracts.
expenses decreased 4.3% to $29.7 million in 2007 primarily due to lower employee benefit expenses. In 2006, other underwriting expenses decreased 12.4% to $31.1 million due to a reduction in software costs and expense saving initiatives, primarily relating to the closure of a life insurance processing unit during 2005. Other underwriting expenses in 2005 include approximately $0.8 million of severance benefits as a result of closing the life processing unit and other unrelated terminations.
The changes in the weighted average yield on cash and invested assets are attributable to the items affecting net investment income noted above. The decrease in weighted average interest crediting rate is due to a decrease in credited rates on both direct and assumed business.
Pre-tax operating loss totaled $2.0 million in 2007 compared to $3.9 million in 2006 and $2.7 million in 2005. Net investment income increased in 2007 due to an increase in invested assets, primarily from the proceeds of our 2017 Senior Notes offering as discussed in the “Net investment income” section above. Net investment income decreased in 2006 primarily due to a decrease in investments resulting from the redemption of the Series C preferred stock in December 2005 and an increase in investments allocated to the product segments. Net investment income also includes fee income from bond calls, mortgage loan prepayments and the reversal of net discount accretion on mortgage and asset-backed securities totaling $0.1 million in 2007, $0.5 million in 2006 and $1.2 million in 2005. In addition, we recorded $0.9 million in net investment income during 2005, representing past due interest that had not been accrued, relating to the redemption of a fixed maturity security that had been impaired in a prior period.
Staff Position FIN 39-1, which amends certain aspects of FASB Interpretation No. 39, “Offsetting of Amounts Related to Certain Contracts - an interpretation of APB Opinion No. 10 and FASB Statement No. 105, “ allows a reporting entity to offset fair value amounts recognized for the right to reclaim or obligation to return cash collateral against fair value amounts recognized for derivative instruments executed with the same counterparty under the same master netting arrangement. At December 31, 2007, we had master netting agreements with counterparties covering cash collateral payable totaling $73.2 million and cash collateral receivable totaling $7.5 million. These amounts are included in collateral payable for securities lending and other transactions and collateral held for securities lending and other transactions lines on our consolidated balance sheet at December 31, 2007, but will be netted against the fair value of the call options included in derivative instruments and swaps included in other liabilities in 2008.
Statement No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106 and 132(R),” which requires measurement of a plan’s assets and benefit obligations as of the end of the employer’s fiscal year. The impact of this adoption will result in a decrease to the beginning balance of retained earnings totaling $0.7 million.
In addition, in 2009 we plan to adopt Statement No. 160, “Accounting and Reporting of Noncontrolling Interest in Consolidated Financial Statements, an amendment of ARB No. 51,” which establishes accounting and reporting standards for the minority interest in a subsidiary. The impact of this adoption on our consolidated financial statements is expected to be immaterial and will primarily result in a reclassification of minority interest. We will also adopt Statement No. 141(R), “Business Combinations,” relating to acquisitions or consolidations occurring after December 31, 2008. The impact of this new statement will depend on the size and nature of any business combinations we do in the future.
The Securities Valuation Office of the NAIC generally rates private placement securities. Comparisons between NAIC designations and S&P ratings are published by the NAIC. S&P has not rated some of the fixed maturity securities in our portfolio.
A summary of the gross unrealized gains and gross unrealized losses on our available-for-sale fixed maturity securities, by internal industry classification, as of December 31, 2007 and 2006, is as follows:
The following tables set forth the number of issuers, amortized cost, unrealized losses and market value of available-for-sale fixed maturity securities in an unrealized loss position listed by the length of time the securities have been in an unrealized loss position:
Corporate securities: The unrealized losses on corporate securities, which include redeemable preferred stocks, totaled $151.6 million, or 52.8% of our total unrealized losses. The largest losses were in the financial services sector ($1,106.7 million carrying value and $91.7 million unrealized loss) and in the manufacturing sector ($507.8 million carrying value and $31.7 million unrealized loss). The largest unrealized losses in the financial services sector were in the depository institutions sector ($345.3 million carrying value and $32.9 million unrealized loss) and the holding and other investment offices sector ($480.7 million carrying value and $30.8 million unrealized loss). The unrealized losses in the depository institutions sector are primarily due to a decrease in market liquidity and concerns regarding the underlying credit quality of subprime and other assets these institutions hold. The majority of securities in the holding and other investment offices sector are real estate investment trust bonds. The unrealized losses in this sector are primarily due to an increase in credit spreads due to the sector’s exposure to
commercial real estate and market concerns about the ability to access the capital markets. The largest unrealized losses in the manufacturing sector were in the paper and allied products sector ($90.7 million carrying value and $10.0 million unrealized loss) and the printing and publishing sector ($31.9 million carrying value and $4.1 million unrealized loss). The unrealized losses in the paper and allied products sector and the printing and publishing sector are due to spread widening that is the result of weaker operating results. The unrealized losses in the remaining corporate sectors are also primarily attributable to spread widening due to a decrease in market liquidity, an increase in market volatility and concerns about the general health of the economy. Because we have the ability and intent to hold these investments until a recovery of fair value, which may be maturity, we do not consider these investments to be other-than-temporarily impaired at December 31, 2007.
State, municipal and other governments: The unrealized losses on state, municipal and other governments totaled $15.1 million, or 5.2% of our total unrealized losses, and were primarily caused by general spread widening. We purchased most of these investments at a discount to their face amount and the contractual cash flows of these investments are based on the taxing authority of a municipality or the revenues of a municipal project. Additional details regarding the composition of our municipal bond portfolio are provided later in this section. Because the decline in market value is primarily attributable to increased spreads and not credit quality, and because we have the ability and intent to hold these investments until a recovery of fair value, which may be maturity, we do not consider these investments to be other-than-temporarily impaired at December 31, 2007.
Public utilities: The unrealized losses on public utilities totaled $13.2 million, or 4.65% of our total unrealized losses, and were caused primarily by spread widening. Because the decline in market value is attributable to changes in market interest rates and not credit quality, and because we have the ability and intent to hold these investments until recovery of fair value, which may be maturity, we do not consider these investments to be other-than-temporarily impaired at December 31, 2007.
At December 31, 2007, we had one security with an unrealized loss of $8.5 million. This security, which is included in the financial services sector of the corporate securities industry above, has subprime collateral exposure and been impacted by the loss of market liquidity and spread widening. At December 31, 2007, this security is rated investment grade by two major rating agencies, remains adequately collateralized and is expected to continue its principal and interest payments. We believe the decline in market value is temporary, and we have the ability and intent to hold the security until recovery of fair value. Excluding mortgage and asset-backed securities and this one security, no securities from the same issuer had an aggregate unrealized loss in excess of $4.5 million at December 31, 2007. With respect to mortgage and asset-backed securities not backed by the United States Government, no securities from the same issuer had an aggregate unrealized loss in excess of $17.9 million at December 31, 2007. The $17.9 million unrealized loss from one issuer relates to fourteen different securities that are backed by different pools of residential mortgage loans. All fourteen securities are rated investment grade and the largest unrealized loss on any one security totaled $5.9 million at December 31, 2007.
Mortgage and other asset-backed securities comprised 28.2% at December 31, 2007 and 28.0% at December 31, 2006 of our total available-for-sale fixed maturity securities. These securities are purchased when we believe these types of investments provide superior risk-adjusted returns compared to returns of more conventional investments such as corporate bonds and mortgage loans. These securities are diversified as to collateral types, cash flow characteristics and maturity.
security with an amortized cost of $12.0 million and an estimated market value of $8.9 million, that had a “BBB+” rating at December 31, 2007.
The mortgage and asset-backed portfolios also include securities wrapped by bond insurers providing additional credit enhancement for the investment. At December 31, 2007, our insured asset-backed holdings totaled $209.3 million, or 7.8% of our mortgage and asset-backed portfolios and 2.2% of our total fixed income portfolio. We believe these securities were underwritten at investment grade levels excluding any credit enhancing protection. The insolvency of one or more of the insurance providers could have a short-term liquidity impact and expose these securities to a higher probability of experiencing a cash flow shortfall, but would not dramatically increase our investment portfolio’s risk profile.
We do not directly own any fixed income or equity investments in bond insurers. A summary of the primary insurers of the municipal bonds we hold follows:
Includes 98.1% in AAA rated insurers and 1.9% non-rated insurers at December 31, 2007.
Equity securities totaled $23.6 million at December 31, 2007 and $50.3 million at December 31, 2006. Gross unrealized gains totaled $1.3 million and gross unrealized losses totaled $0.1 million at December 31, 2007. At December 31, 2006, gross unrealized gains totaled $14.9 million and gross unrealized losses totaled $0.2 million on these securities. Included in equity securities is our investment in AEL which totaled $12.6 million at December 31, 2007 and $39.4 million at December 31, 2006.
Mortgage loans totaled $1,221.6 million at December 31, 2007 and $979.9 million at December 31, 2006. These mortgage loans are diversified as to property type, location and loan size, and are collateralized by the related properties. There were no mortgages more than 60 days delinquent at December 31, 2007. At December 31, 2006, mortgages more than 60 days delinquent accounted for less than 0.1% of the carrying value of the mortgage portfolio. Our mortgage lending policies establish limits on the amount that can be loaned to one borrower and require diversification by geographic location and collateral type. Information regarding the collateral type and related geographic location within the United States follows:
Derivative instruments consist primarily of call options totaling $114.8 million at December 31, 2007 and $121.9 million at December 31, 2006, supporting our index annuity business. See “Market Risks of Financial Instruments” for details regarding how we manage counterparty credit risk.
In 2007, we began participating in a securities lending program administered by a lending agent, whereby certain fixed maturity securities from our investment portfolio are loaned to other institutions for a short period of time. We require collateral equal to or greater than 100 percent of the market value of the loaned securities. The collateral is invested by the lending agent, in accordance with our guidelines, generating fee income that is recognized as net investment income over the period the security is on loan. Securities recorded on our consolidated balance sheet with a market value of $179.5 million were on loan under the program and we were liable for cash collateral under our control totaling $185.3 million at December 31, 2007.
Policy liabilities and accruals and other policyholders’ funds increased 15.1% to $10,900.7 million at December 31, 2007 primarily due to increases in the volume of business in force. Long-term debt increased 45.1% to $316.9 million due to the issuance of $100.0 million of 2017 Senior Notes as described in Note 7, “Credit Arrangements,” to the consolidated financial statements. The deferred income tax liability decreased 54.8% to $28.2 million at December 31, 2007 primarily due to the impact of the change in net unrealized investment gains/losses.
Stockholders’ equity increased 2.5% to $902.9 million at December 31, 2007, compared to $880.7 million at December 31, 2006. This increase is attributable to net income for the year and proceeds from stock option exercises, partially offset by the change in unrealized appreciation/depreciation on investments and dividends paid.
At December 31, 2007, common stockholders’ equity was $899.9 million, or $29.98 per share, compared to $877.7 million, or $29.59 per share at December 31, 2006. Included in stockholders’ equity per common share is ($1.21) at December 31, 2007 and $0.95 at December 31, 2006 attributable to accumulated other comprehensive income (loss).
A majority of our insurance liabilities are backed by fixed maturity securities and mortgage loans. The weighted average life of the fixed maturity and mortgage loan portfolio, based on market values and excluding convertible
For index annuities, call options are purchased to fund the index credits owed to contract holders who elect to participate in one or more market indices. Except for certain contracts for which minimum guaranteed interest rates apply, the options are purchased to fund the full amount of the annual index credits. For contracts for which minimum guaranteed interest rates apply, the options are generally purchased to fund the amount of the annual index credits in excess of minimum guaranteed interest accrued on the contracts. In 2007, proceeds from the maturity of call options totaled $156.4 million while related index amounts credited to contract holders’ account balances totaled $154.4 million. The difference between index credits and option proceeds is primarily attributable to call options being purchased for contracts that had a full or partial surrender during the year.
Profitability on the index annuities in any given year is also impacted by changes in the fair value of the embedded option which provides the contract holder the right to participate in market index returns after the next index reset date of the contract. This impacts profitability because only one or two-year call options are purchased to fund the index credits owed to the contract holders at the inception of each reset period. This practice matches well with the contract holders’ rights to switch to different indices on each reset date. The value of the forward starting options embedded in the index annuities can fluctuate with changes in assumptions as to the expected cost of the options, which is driven by expectations as to the future volatility of the market indices, risk free interest rates, market returns, contractual features such as participation rates, asset fees, and/or caps and the lives of the contracts.
We design our products and manage our investment portfolio in a manner to encourage persistency and to help ensure targeted spreads are earned. In addition to the ability to change interest crediting rates on our direct products, certain interest sensitive and index contracts have surrender and withdrawal penalty provisions. The following is a summary of the surrender and discretionary withdrawal characteristics of our interest sensitive and index products and supplementary contracts without life contingencies at December 31, 2007.
interest and receive a floating rate of interest on a notional amount totaling $300.0 million. These interest rate swaps effectively fix the interest crediting rate on a portion of our flexible premium deferred annuity contract liabilities thereby hedging our exposure to increases in market interest rates. We also have one interest rate swap to hedge the variable component of the interest rate on our line of credit borrowings. The terms of this swap provide that we pay a fixed rate of interest and receive a floating rate of interest on a notional amount of $46.0 million. Any gain or loss on the interest rate swap settlements offset any increase or decrease in the interest paid on the line of credit, effectively fixing our interest expense related to the outstanding debt on this line of credit. As discussed in Note 1 to the consolidated financial statements, we discontinued the use of hedge accounting during 2007 for the interest rate swaps backing our annuity liabilities in connection with the adoption of new accounting pronouncement DIG G26. This change does not impact the economic benefit the swaps provide to us. See Note 3 to the consolidated financial statements for additional discussion of these interest rate swaps.
If interest rates were to increase 10% from levels at December 31, 2007 and 2006, the market value of our fixed maturity securities and short-term investments would decrease approximately $254.2 million at December 31, 2007 and $260.8 million at December 31, 2006, while the value of our interest rate swaps would increase approximately $4.9 million at December 31, 2007 and $6.4 million at December 31, 2006. These hypothetical changes in value do not take into account any offsetting change in the value of insurance liabilities for investment contracts since we estimate such value to be the cash surrender value for a majority of the underlying contracts. If interest rates were to decrease 10% from levels at December 31, 2007 and 2006, the fair value of our debt would increase $6.5 million at December 31, 2007 and $4.9 million at December 31, 2006, while the value of our interest rate swap on our line of credit would decrease $0.5 million at December 31, 2007 and $0.4 million at December 31, 2006.
Equity price risk is not material to us due to the relatively small equity portfolio held at December 31, 2007. However, we do earn investment management fees (on those investments managed by us) and mortality and expense fee income based on the value of our separate accounts. On an annualized basis, the investment management fee rates range from 0.20% to 0.45% for 2007, 2006 and 2005. The mortality and expense fee rates range from 0.90% to 1.40% for 2007, 2006 and 2005. As a result, revenues from these sources do fluctuate with changes in the market value of the equity, fixed maturity and other securities held by the separate accounts. In addition, we have equity price risk to the extent we may owe amounts under the guaranteed minimum death benefit and incremental death benefit provisions of our variable annuity contracts. See Note 5 to the consolidated financial statements for additional discussion of these provisions. Furthermore, as discussed above, our profitability would be impacted if there were little or no gains in the entire series of options purchased over the expected life of an index annuity contract.
The ability of the Life Companies to pay dividends to FBL Financial Group, Inc. is limited by law to earned profits (statutory unassigned surplus) as of the date the dividend is paid, as determined in accordance with accounting practices prescribed by insurance regulatory authorities of the State of Iowa. The annual dividend limitation is defined under the Iowa Insurance Holding Company Act as any dividend or distribution of cash or other property whose fair market value, together with that of other dividends or distributions made within the preceding 12 months, exceeds the greater of (i) 10% of policyholders’ surplus (total statutory capital stock and statutory surplus) as of December 31 of the preceding year, or (ii) the statutory net gain from operations of the insurer for the 12-month period ending December 31 of the preceding year. During 2008, the maximum amount legally available for distribution to FBL Financial Group, Inc., without further regulatory approval, from Farm Bureau Life is $51.7 million and from EquiTrust Life is $39.2 million.
We may from time to time review potential acquisition opportunities. It is anticipated that funding for any such acquisition would be provided from available cash resources, debt or equity financing. As of December 31, 2007, we had no material commitments for capital expenditures. The parent company had available cash and investments totaling $51.7 million at December 31, 2007.
The Life Companies’ cash inflows consist primarily of premium income, deposits to policyholder account balances, income from investments, sales, maturities and calls of investments, repayments of investment principal and proceeds from call option exercises. In addition, EquiTrust Life receives capital contributions from FBL Financial Group to help fund its growth. The Life Companies’ cash outflows are primarily related to withdrawals of policyholder account balances, investment purchases, payment of policy acquisition costs, policyholder benefits, income taxes, dividends and current operating expenses. Life insurance companies generally produce a positive cash flow which may be measured by the degree to which cash inflows are adequate to meet benefit obligations to policyholders and normal operating expenses as they are incurred. The remaining cash flow is generally used to increase the asset base to provide funds to meet the need for future policy benefit payments and for writing new business. The Life Companies’ liquidity positions continued to be favorable in 2007, with cash inflows at levels sufficient to provide the funds necessary to meet their obligations.
For the life insurance operations, cash outflow requirements for operations are typically met from normal premium and deposit cash inflows. This has been the case for all reported periods as the Life Companies’ continuing operations and financing activities relating to interest sensitive and index products provided funds totaling $1,418.4 million in 2007, $1,599.1 million in 2006 and $892.2 million in 2005. Positive cash flow from operations is generally used to increase the Life Companies’ fixed maturity securities and other investment portfolios. In developing their investment strategy, the Life Companies establish a level of cash and securities which, combined with expected net cash inflows from operations, maturities of fixed maturity investments and principal payments on mortgage and asset-backed securities and mortgage loans, are believed adequate to meet anticipated short-term and long-term benefit and expense payment obligations.
We anticipate that funds to meet our short-term and long-term capital expenditures, cash dividends to stockholders and operating cash needs will come from existing capital and internally generated funds. We believe that current levels of cash, available-for-sale and short-term securities, combined with expected net cash inflows from operations, maturities of fixed maturity investments, principal payments on mortgage and asset-backed securities and mortgage loans and premiums and deposits on our insurance products, will be adequate to meet our anticipated cash obligations for the foreseeable future. Our investment portfolio at December 31, 2007, included $72.0 million of short-term investments, $84.0 million of cash and $1,194.2 million in carrying value of U.S. Government and U.S. Government agency backed securities that could be readily converted to cash at or near carrying value.
We do not have any off-balance sheet arrangements as of December 31, 2007 or 2006, except for collateral held at December 31, 2006 for derivative transactions as discussed in Note 2 of our notes to the consolidated financial statements.
We do not believe that inflation has had a material effect on our consolidated results of operations.
Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rules 13a - 15(f). Under the supervision and the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on our evaluation under the framework in Internal Control - Integrated Framework, our management concluded that our internal control over financial reporting was effective as of December 31, 2007.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of FBL Financial Group, Inc. at December 31, 2007 and 2006, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2007, in conformity with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), FBL Financial Group, Inc.’s internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 14, 2008 expressed an unqualified opinion thereon.
Effective April 1, 2007, we adopted Statement of Financial Accounting Standards (Statement) 133 Implementation Issue No. G26, “Cash Flow Hedges: Hedging Interest Cash Flows on Variable-Rate Assets and Liabilities That Are Not Based on a Benchmark Interest Rate,” (DIG G26) which clarifies the accounting for a cash flow hedge of a variable-rate asset or liability, specifically addressing when an entity is permitted to hedge benchmark interest rate risk. DIG G26 indicates that the risk being hedged in a cash flow hedge of a variable-rate financial asset or liability cannot be designated as interest rate risk unless the cash flows of the hedged transaction are explicitly based on that same benchmark interest rate. In addition, DIG G26 clarifies that the only permitted benchmarks are the risk-free rate and rates based on the LIBOR swap curve. Hedging relationships that no longer qualify for cash flow hedge accounting based on this guidance must be undesignated prospectively. Changes in fair value of derivatives not subsequently re-designated to a new qualifying hedging relationship are recorded in earnings. Gains or losses previously included in accumulated other comprehensive income (loss) remain in accumulated other comprehensive income (loss) and are amortized to net income over the remaining term of the swaps as the hedged anticipated cash flows occur. If it becomes probable that the anticipated cash flows will not occur, the deferred gains or losses will be reclassified into earnings immediately. As a result of adopting DIG G26, we undesignated the hedging relationship for the interest rate swaps related to our flexible premium deferred annuity contracts as they are not explicitly based on one of the two permitted benchmarks. Net unrealized gains on these swaps included in accumulated other comprehensive income (loss) totaled $2.8 million at March 31, 2007 and are being amortized into income over the life of the individual swaps. The adoption of DIG G26 decreased net income $2.2 million ($0.07 per basic and diluted common share) during 2007. This guidance does not impact the interest rate swap on our line of credit, as both the derivative instrument and hedged item are based on the three-month LIBOR rate.
Effective January 1, 2007, we adopted Statement of Position (SOP) 05-1, “Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchanges of Insurance Contracts” issued by the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants. The SOP provides guidance on the accounting for internal replacements of one insurance contract for another insurance contract. Under the SOP, an internal replacement that is determined to result in a replacement contract that is substantially changed from the replaced contract is accounted for as an extinguishment of the replaced contract. As an extinguishment, the unamortized deferred policy acquisition costs, deferred sales inducements, value of insurance in force acquired and unearned revenue reserve from the replaced contract are written off at the time of the extinguishment. An internal replacement that is determined to result in a replacement contract that is substantially unchanged from the replaced contract is accounted for as a continuation of the replaced contract. The impact of adopting SOP 05-1 was not material to our consolidated financial statements for 2007 (estimated to be a $0.1 million decrease to net income - less than $0.01 per basic and diluted common share) as our previous accounting policy for internal replacements substantially conformed to current interpretations of the guidance in the SOP.
In September 2006, the FASB issued Statement No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106 and 132(R).” This Statement requires the recognition of an asset or liability in the consolidated balance sheet based on the funded status of a defined benefit postretirement plan and changes in the funded status of the plan are recorded as a component of comprehensive income in the year in which the changes occur. These requirements were effective for fiscal years ending after December 15, 2006. The impact of adopting Statement No. 158 at December 31, 2006 was minimal on our consolidated financial statements as we participate with several affiliates and an unaffiliated organization in various multiemployer defined benefit and other postretirement plans, which are exempt from this Statement. However, we did adopt Statement No. 158 for two small single employer health and medical postretirement plans. The impact of this adoption in 2006 was to increase other liabilities $0.3 million for the underfunded status of these plans, reduce accumulated other comprehensive income (loss) $0.2 million and record a deferred tax asset of $0.1 million. This adoption had no impact on our consolidated statements of income. Statement No. 158 also requires measurement of a plan’s assets and benefit obligations as of the end of the employer’s fiscal year, beginning with fiscal years ending after December 15, 2008. We plan to adopt the measurement date portion of this Statement in 2008, using the single measurement date method, which will result in a decrease to the beginning balance of retained earnings totaling $0.7 million.
In December 2007, the FASB issued Statement No. 160, “Accounting and Reporting of Noncontrolling Interest in Consolidated Financial Statements, an amendment of ARB No. 51.” This Statement establishes accounting and reporting standards for the noncontrolling (minority) interest in a subsidiary, which requires that the minority interest be reported in equity and the related net income and comprehensive income be included in the respective lines of the consolidated financial statements. This Statement is effective for the first annual reporting period beginning on or after December 15, 2008 and early adoption is prohibited. The impact of this adoption on our consolidated financial statements is expected to be immaterial and will primarily result in a reclassification of minority interest as noted above.
In April 2007, the FASB issued Staff Position FIN 39-1 (FSP FIN 39-1), which amends certain aspects of FASB Interpretation No. 39, “Offsetting of Amounts Related to Certain Contracts - an interpretation of APB Opinion No. 10 and FASB Statement No. 105.” This FSP allows a reporting entity to offset fair value amounts recognized for the right to reclaim cash collateral (a receivable) or the obligation to return cash collateral (a payable) against fair value amounts recognized for derivative instruments executed with the same counterparty under the same master netting arrangement. The guidance in this FSP is effective for fiscal years beginning after November 15, 2007, with
Equity securities, comprised of common and non-redeemable preferred stocks are designated as “available for sale” and are reported at market value. The change in unrealized appreciation and depreciation of equity securities is included directly in stockholders’ equity, net of any related deferred income taxes, as a component of accumulated other comprehensive income (loss).
Derivative instruments include interest rate swaps used to reduce our exposure to increases in market interest rates and call options used to fund index credits on index annuities. In addition, we have embedded derivatives associated with our index annuity business and certain modified coinsurance contracts. All derivatives are recognized as either assets or liabilities in the consolidated balance sheets and measured at fair value.
Policy loans are reported at unpaid principal balance. Short-term investments are reported at cost adjusted for amortization of premiums and accrual of discounts. Other long-term investments include an investment deposit which is reported at amortized cost.
the bonds) over U.S. Treasury bond yields. Regardless of the pricing source, we take full responsibility for the reasonableness of all market value estimates.
We assume, under coinsurance agreements, certain fixed rate and index annuity contracts. Call options used to fund index credits on the assumed index annuities are purchased by and maintained on the books of the ceding company. We record our proportionate share of the option value supporting the business we reinsure as reinsurance recoverable on the consolidated balance sheets. See Note 3, “Derivative Instruments,” for more information regarding these call options and see Note 5, “Reinsurance and Policy Provisions,” for additional information regarding these reinsurance agreements.
Property and equipment, comprised primarily of furniture, equipment and capitalized software costs, are reported at cost less allowances for depreciation and amortization. Depreciation and amortization expense is computed primarily using the straight-line method over the estimated useful lives of the assets. Furniture and equipment had a carrying value of $33.4 million at December 31, 2007 and $35.2 million at December 31, 2006, and estimated useful lives that generally range from two to twenty years. Capitalized software costs had a carrying value of $15.8 million at December 31, 2007 and $10.8 million at December 31, 2006, and estimated useful lives that range from two to five years. Depreciation expense for furniture and equipment was $9.0 million in 2007, $9.4 million in 2006 and $8.7 million in 2005. Amortization expense for capitalized software was $5.3 million in 2007, $4.9 million in 2006 and $4.8 million in 2005.
Goodwill includes $9.9 million related to the excess of the amounts paid to acquire companies over the fair value of its net assets acquired. Goodwill also includes $1.2 million of identifiable intangible assets relating to insurance licenses obtained with the acquisition of EquiTrust Life Insurance Company. Goodwill and identifiable intangible assets with indefinite lives are not amortized but are subject to annual impairment testing. We have performed impairment testing using cash flow and other analyses and determined none of our goodwill was impaired as of December 31, 2007 or December 31, 2006.
For our direct business, interest crediting rates for interest sensitive products ranged from 2.30% to 5.50% in 2007 and 2006 and from 2.40% to 5.50% in 2005. These ranges exclude certain contracts with an account value totaling $2.5 million with guarantees ranging up to 9.70%. For interest sensitive products assumed through coinsurance agreements, interest crediting rates ranged from 3.00% to 6.00% in 2007 and 2006 and 3.00% to 11.50% in 2005. A portion of the interest credited on our direct business ($9.6 million in 2007, $3.9 million in 2006 and $1.2 million in 2005) represents an additional interest credit on first-year premiums, payable at policy issue or until the first contract anniversary date (first-year bonus interest). These amounts are included as deferred sales inducements.
The liability for future policy benefits for direct participating traditional life insurance is based on net level premium reserves, including assumptions as to interest, mortality and other factors underlying the guaranteed policy cash values. Reserve interest assumptions are level and range from 2.00% to 6.00%. The average rate of assumed investment yields used in estimating gross margins was 6.32% in 2007, 6.33% in 2006 and 6.28% in 2005. Accrued dividends for participating business are established for anticipated amounts earned to date that have not been paid. The declaration of future dividends for participating business is at the discretion of the Board of Directors of Farm Bureau Life. Participating business accounted for 42% of direct receipts from policyholders during 2007 (2006 - 42% and 2005 - 43%), and represented 13% of life insurance in force at December 31, 2007 (2006 and 2005 - 14%). The liability for future policy benefits for non-participating traditional life insurance is computed using a net level method, including assumptions as to mortality, persistency and interest and includes provisions for possible unfavorable deviations.
We had undiscounted reserves of $0.1 million at December 31, 2007 and December 31, 2006 to cover estimated future assessments on known insolvencies. We had assets totaling $0.5 million at December 31, 2007 and $0.3 million at December 31, 2006 representing estimated premium tax offsets on paid and future assessments. Expenses incurred for guaranty fund assessments, net of related premium tax offsets, totaled less than $0.1 million in 2007, 2006 and 2005. It is anticipated that estimated future guaranty fund assessments on known insolvencies will be paid during 2008 and substantially all the related future premium tax offsets will be realized during the five-year period ending December 31, 2012. We believe the reserve for guaranty fund assessments is sufficient to provide for future assessments based upon known insolvencies and projected premium levels.
The separate account assets and liabilities reported in our accompanying consolidated balance sheets represent funds that are separately administered for the benefit of certain policyholders that bear the underlying investment risk. The separate account assets and liabilities are carried at fair value. Revenues and expenses related to the separate account assets and liabilities, to the extent of benefits paid or provided to the separate account policyholders, are excluded from the amounts reported in the accompanying consolidated statements of income.
Insurance claims have been filed under our professional liability and general liability insurance policies for reimbursement of the settlement amount, but coverage has been denied, and we have made a claim against an insurance broker for breach of contractual duties. We have filed lawsuits against the insurer and the insurance broker to recover those damages. While we have received an adverse ruling in the case against the insurer at the district court level, the adverse ruling has been appealed and we continue to believe both claims are valid. Recoveries from third parties are required to be accounted for as gain contingencies and not recorded in our financial statements until the lawsuits are resolved. Accordingly, our financial statements for 2006 include the $4.9 million settlement expense, but any recoveries will be recorded in net income in the period the recovery is received.
We have two share-based payment arrangements under our Class A Common Stock Compensation Plan, which are described in more detail in Note 9, “Retirement and Compensation Plans - Stock Compensation Plans.” Effective January 1, 2006, we adopted Statement No. 123(R), “Share-Based Payment,” using the modified-prospective-transition method. Beginning in 2006, compensation expense includes expense for awards that were granted prior to the adoption date for which the requisite service had not been provided as of the adoption date. In addition, we recognize compensation expense for all share-based payments granted, modified or settled after the date of adoption. The stock option expense is recognized over the shorter of our five-year vesting schedule or the period ending when the employee becomes eligible for retirement using the straight-line method. The impact of forfeitures is estimated and compensation expense is recognized only for those options expected to vest. Beginning in 2006, we report stock option-related tax deductions in excess of recognized compensation expense as a financing cash flow, as required under Statement No. 123(R).
As a result of adopting Statement No. 123(R), net income for 2006 was $0.2 million lower (less than $0.01 per basic and diluted common share) than if we had continued to account for share-based compensation under Statement No. 123. This included a cumulative effect adjustment of $0.1 million (less than $0.01 per basic and diluted common share) related to the change in accounting for forfeitures which was recorded as a reduction to compensation expense in our 2006 consolidated income statement. Also, for 2006, $1.6 million of excess tax deductions were classified as financing cash inflows instead of operating cash inflows as they would have been under Statement No. 123. Results for prior periods have not been restated.
Unrealized gains and losses on our available-for-sale securities and certain interest rate swaps are included in accumulated other comprehensive income in stockholders’ equity. Other comprehensive income (loss) excludes net
The preparation of financial statements in conformity with U.S. generally accepted accounting principles (GAAP) requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses and the disclosure of contingent assets and liabilities. For example, significant estimates and assumptions are utilized in the valuation of investments, determination of other-than-temporary impairments of investments, amortization of deferred policy acquisition costs and deferred sales inducements, calculation of policyholder liabilities and accruals and determination of pension expense. It is reasonably possible that actual experience could differ from the estimates and assumptions utilized which could have a material impact on the consolidated financial statements.
The carrying value and estimated market value of our portfolio of available-for-sale fixed maturity securities at December 31, 2007, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
Included in the above table are 863 securities from 538 issuers at December 31, 2007 and 780 securities from 513 issuers at December 31, 2006. These increases are primarily due to an increase in spreads between the risk-free and corporate and other bond yields. The following summarizes the details describing the more significant unrealized losses by investment category as of December 31, 2007.
Public utilities: The unrealized losses on public utilities totaled $13.2 million, or 4.6% of our total unrealized losses, and were caused primarily by spread widening. Because the decline in market value is attributable to changes in market interest rates and not credit quality, and because we have the ability and intent to hold these investments until recovery of fair value, which may be maturity, we do not consider these investments to be other-than-temporarily impaired at December 31, 2007.
Regarding our entire portfolio, we monitor the financial condition and operations of the issuers of securities rated below investment grade and of the issuers of certain investment grade securities on which we have concerns regarding credit quality. In determining whether or not an unrealized loss is other than temporary, we review factors such as:
We held one collateralized debt obligation partially backed by subprime mortgages with an amortized cost of $10.0 million at December 31, 2007 and 2006 and an estimated fair value of $1.5 million at December 31, 2007 and $9.9 million at December 31, 2006. We believe the decline in market value on this security is attributable to spread widening from market liquidity and credit quality concerns. This security is rated investment grade by two major rating agencies, remains adequately collateralized and is expected to continue its principal and interest payments. We also have the intent and ability to hold this investment until a recovery of fair value, which may be maturity, therefore we do not consider it to be other-than-temporarily impaired at December 31, 2007.
We also have $0.1 million of gross unrealized losses on equity securities with an estimated market value of $0.7 million at December 31, 2007 and $0.2 million of gross unrealized losses on equity securities with an estimated market value of $0.7 million at December 31, 2006. These equity securities have been in an unrealized loss position for more than one year.
We establish an allowance, consisting of specific reserves, for possible losses against our investment real estate. There were no real estate investments requiring a valuation allowance at December 31, 2007. An analysis of the allowance provided in 2006 and 2005 is as follows:
Realized/unrealized gains (losses), recorded as a component of income, and the change in unrealized appreciation/depreciation on investments and interest rate swaps, recorded as a component of the change in accumulated other comprehensive income (loss), are summarized below:
At December 31, 2007, affidavits of deposits covering investments with a carrying value totaling $10,652.9 million were on deposit with state agencies to meet regulatory requirements. Also, fixed maturity securities with a carrying value of $51.2 million were on deposit with the Federal Home Loan Bank as collateral for a funding agreement.
We held cash collateral for derivative and other transactions totaling $87.9 million at December 31, 2007 and $70.5 million at December 31, 2006 that was invested and included in the consolidated balance sheets with corresponding amounts recorded in collateral payable for securities lending and other transactions. We also had securities we held as off-balance sheet collateral for derivative transactions with a market value totaling $10.5 million at December 31, 2006. No such off-balance sheet collateral was held at December 31, 2007.
The carrying value of investments which have been non-income producing for the twelve months preceding
December 31, 2007 include real estate, fixed income, equity securities and other long-term investments totaling $2.4 million.
the period of time to the next index reset date. The change in the value of this embedded derivative is included in interest sensitive and index product benefits in the consolidated statements of income and totaled $(5.9) million for 2007, $70.3 million for 2006 and $4.9 million for 2005.
We have modified coinsurance agreements where interest on funds withheld is determined by reference to a pool of fixed maturity securities. These arrangements contain embedded derivatives requiring bifurcation. Embedded derivatives in these contracts are recorded at fair value at each balance sheet date and changes in the fair values of the derivatives are recorded as derivative income or loss. The fair value of the embedded derivatives pertaining to funds withheld on variable business assumed by us totaled $0.1 million at December 31, 2007 and 2006, and the fair value of the embedded derivatives pertaining to funds withheld on business ceded by us was $0.2 million at December 31, 2007 and less than $0.1 million at December 31, 2006 and 2005. Derivative income (loss) from our modified coinsurance contracts totaled $0.1 million in 2007, less that $0.1 million in 2006 and ($0.4) million in 2005.
Mortgage loans on real estate: Fair values are estimated by discounting expected cash flows of each loan at an interest rate equal to a spread above the U.S. Treasury bond yield that corresponds to the loan’s expected life. These spreads are based on overall market pricing of commercial mortgage loans at the time of valuation.
Derivative instruments: Fair values for call options and interest rate swaps are based on quoted market prices.
In addition to the cession of risks described above, we also have reinsurance agreements with variable alliance partners to cede a specified percentage of risks associated with variable universal life and variable annuity contracts. Under these agreements, we pay the alliance partners their reinsurance percentage of charges and deductions collected on the reinsured polices. The alliance partners in return pay us their reinsurance percentage of benefits in excess of related account balances. In addition, the alliance partners pay us an expense allowance for certain new business, development and maintenance costs on the reinsured contracts.
In total, insurance premiums and product charges have been reduced by $30.8 million in 2007, $30.7 million in 2006 and $30.4 million in 2005 and insurance benefits have been reduced by $13.7 million in 2007, $21.2 million in 2006 and $15.7 million in 2005 as a result of cession agreements.
The separate account assets are principally comprised of stock and bond mutual funds. The reserve for GMDBs and IDBs, determined using scenario-based modeling techniques and industry mortality assumptions, that is included in future policy benefits, totaled $1.2 million at December 31, 2007 and 2006. The weighted average age of the contract holders with a GMDB or IDB rider was 54 years at December 31, 2007 and 59 years at December 31, 2006.
Incurred benefits for GMDBs and IDBs totaled $0.1 million for 2007, $0.3 million for 2006 and $0.6 million for 2005. Paid benefits for GMDBs and IDBs totaled $0.1 million for 2007, less than $0.1 million for 2006 and $0.1 million for 2005.
On March 12, 2007, we issued $100.0 million of 5.875% Senior Notes due March 15, 2017 (2017 Senior Notes). Interest on the 2017 Senior Notes is payable semi-annually on March 15 and September 15 each year. The 2017 Senior Notes are redeemable in whole or in part at any time at our option at a “make-whole” redemption price equal to the greater of 100% of their principal amount or the sum of the present values of the remaining scheduled payments of principal and interest, discounted to the redemption date on a semiannual basis at the treasury rate plus 20 basis points. We received net proceeds of approximately $98.5 million from the issuance of the 2017 Senior Notes after underwriting fees, offering expenses and original issue discount, which are being amortized over the term of the 2017 Senior Notes, using the effective interest method. The notes offering would have caused us to violate the covenants of our revolving line of credit agreement with LaSalle Bank National Association and Bankers Trust Company, N.A. Therefore, on March 12, 2007, the line of credit agreement was amended to allow for the Senior Notes due 2017 without violating the financial covenants of that agreement.
In April 2004, we issued $75.0 million of 5.85% Senior Notes due April 15, 2014 (2014 Senior Notes). Interest on the Senior Notes due 2014 is payable semi-annually on April 15 and October 15 each year. The 2014 Senior Notes are redeemable in whole or in part at any time at our option at a “make-whole” redemption price equal to the greater of 100% of their principal amount or the sum of the present values of the remaining scheduled payments of principal and interest, discounted to the redemption date on a semiannual basis at the treasury rate plus 25 basis points. We received net proceeds of approximately $75.5 million from the issuance of the 2014 Senior Notes after underwriting fees, offering expenses, original issue discount and the impact of a rate lock, which are being amortized over the term of the 2014 Senior Notes, using the effective interest method. We amended our line of credit agreement with LaSalle Bank National Association and Bankers Trust Company, N.A in 2004 to allow for the 2014 Senior Notes without violating the financial covenants of that agreement.
The Iowa Farm Bureau Federation (IFBF), our majority stockholder, owns our Series B preferred stock. Each share of Series B preferred stock has a liquidation preference of $0.60 and voting rights identical to that of Class A common stock with the exception that each Series B share is entitled to two votes while each Class A share is entitled to one vote. The Series B preferred stock pays cumulative annual cash dividends of $0.03 per share, payable quarterly, and is redeemable by us, at our option, at $0.60 per share plus unpaid dividends if the stock ceases to be beneficially owned by a Farm Bureau organization.
Components of net periodic pension cost for all employers are as follows:
The plans’ prior service costs are amortized using a straight-line amortization method over the average remaining service period of the employees. For actuarial gains and losses, we use a corridor, as allowed under Statement No. 87, “Employers Accounting for Pensions,” to determine the amounts to amortize. It is expected that net periodic pension cost for all employers in 2008 will include $3.8 million for amortization of the actuarial loss and $0.8 million of prior service cost amortization.
During 2005, we began executing our long-term investment strategy of diversifying the plans’ assets into equity securities with the long-term target allocation being approximately 60% deposit administration fund contracts and 40% equities. At December 31, 2007, the plans’ assets were invested 67% in deposit administration fund contracts held by Farm Bureau Life and 33% in diversified equities. Our investment strategy is to (1) achieve a long-term return sufficient to satisfy all plan obligations, (2) assume a prudent level of risk and (3) to maintain adequate liquidity. The expected return on plan assets is set at the long-term rate expected to be earned based on the long-term investment strategy of the plans. In estimating the expected rate of return for each asset class, we take into account factors such as historical rates of return, expected future risk free rates of return and anticipated returns expected given the risk profile of each asset class.
We have two share-based payment arrangements under our Class A Common Stock Compensation Plan, which are described below. Compensation expense for these arrangements totaled $4.9 million for 2007, $3.1 million for 2006 and $2.1 million for 2005. The income tax benefit recognized in the income statement for these arrangements totaled $1.8 million for 2007, $1.1 million for 2006 and $0.6 million for 2005.
The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of grant. We use the historical realized volatility of our stock for the expected volatility assumption within the valuation model. For 2007 and 2006, the weighted-average expected term for the majority of our options was presumed to be the mid-point between the vesting date and the end of the contractual term, also known as the “shortcut method.” We assume the contractual term approximates the expected life for the remaining options. For 2005, we used historical data to estimate option exercises and employee terminations to determine the expected term assumption. For 2007 and 2006 we used the shortcut method, as permitted under Statement No. 123(R), due to limited historical share option exercise experience. The change in this assumption in 2006 did not have a material impact on the expected term of the stock options.
Unrecognized compensation expense related to nonvested share-based compensation granted under the stock option arrangement totaled $3.0 million as of December 31, 2007. This expense is expected to be recognized over a weighted-average period of 2.4 years.
Unrecognized compensation expense related to unvested share-based compensation granted under the restricted stock arrangement totaled $1.3 million as of December 31, 2007. This expense is expected to be recognized over a weighted-average period of 1.2 years. The tax benefit realized from restricted stock released to employees was $0.6 million as of December 31, 2007. We have a policy of withholding shares to cover tax payments and expect to withhold approximately 15,000 shares during 2008, based on estimates of restricted shares we expect to vest and be released.
We have a Director Compensation Plan under which non-employee directors on our Board may elect to receive a portion of their compensation in the form of cash, Class A common shares or deferred stock units. Under this plan, we have deferred stock units outstanding totaling 46,846, at December 31, 2007 and 41,272 at December 31, 2006. At December 31, 2007, shares of Class A common stock available for future issuance under the Director Compensation Plan totaled 50,369. We also have an Executive Salary and Bonus Deferred Compensation Plan under which officers of the Company who are required to meet certain stated common stock ownership guidelines are allowed to use their base salary and annual cash bonus to purchase deferred stock units. Under this plan, we have deferred stock units outstanding totaling 19,600 at December 31, 2007 and 11,960 at December 31, 2006. At December 31, 2007, shares of Class A common stock available for future issuance under this plan totaled 230,400.
We have management agreements with Farm Bureau Mutual and other affiliates under which we provide general business, administrative and management services. Fee income for these services totaled $3.1 million in 2007 and $2.6 million in 2006 and 2005. In addition, Farm Bureau Management Corporation, a wholly-owned subsidiary of the IFBF, provides certain management services to us under a separate arrangement. We incurred related expenses totaling $1.0 million in 2007, $1.1 million in 2006 and $1.0 million in 2005.
In the normal course of business, we may be involved in litigation where amounts are alleged that are substantially in excess of contractual policy benefits or certain other agreements. At December 31, 2007, management is not aware of any claims for which a material loss is reasonably possible. See Note 1, “Significant Accounting Policies - Recognition of Premium Revenue and Costs” for disclosure of a gain contingency relating to a lawsuit.
Options to purchase 592,768 shares of common stock in 2007 at $31.43 to $40.85 per share were outstanding during 2007 but were not included in the computation of 2007 diluted earnings per share because the options were antidilutive to the calculation. The options, which expire through 2017, were still outstanding at December 31, 2007.
Options to purchase 747,232 shares of common stock in 2005 at $24.57 to $32.25 per share were outstanding during 2005 but were not included in the computation of 2005 diluted earnings per share because the options were antidilutive to the calculation. The options, which expire through 2015, were still outstanding at December 31, 2005.
Net income of the Life Companies, as determined in accordance with statutory accounting practices, was $77.4 million in 2007, $73.8 million in 2006 and $66.1 million in 2005. Statutory capital and surplus totaled $756.6 million at December 31, 2007 and $663.3 million at December 31, 2006.
We analyze our segment results based on pre-tax operating income (loss). Accordingly, income taxes are not allocated to the segments. In addition, operating results are generally reported net of any transactions between the segments. Operating income (loss) represents net income excluding the impact of:
Depreciation and amortization related to property, plant and equipment are allocated to the product segments while the related property, equipment and capitalized software are generally allocated to the Corporate and Other segment. Depreciation and amortization for the Corporate and Other segment include $7.8 million for 2007, $7.6 million for 2006 and $6.8 million for 2005 relating to leases with affiliates. In the consolidated statements of income, we record these depreciation amounts net of related lease income from affiliates.
Net statutory premiums collected, which include premiums collected from annuities and universal life-type products that are not included in revenues for GAAP reporting, totaled $2,078.4 million in 2007, $2,296.2 million in 2006 and $1,432.7 million in 2005. Premiums are concentrated in the following states:
Net income was decreased $3.2 million in the second quarter of 2006 due to the settlement of a lawsuit. Net income was increased $2.6 million in the third quarter of 2006 due to an adjustment to an embedded derivative. The lawsuit settlement and embedded derivative adjustment are explained in Note 1, “Significant Accounting Policies - Recognition of Premium Revenues and Costs.”