Erie Family Life Insurance Company (the Company) is a Pennsylvania life insurance company operating as one reportable segment, offering a range of products and services. These products include nonparticipating individual and group life insurance policies, including fixed universal life. The Company also sells fixed individual and group annuities and disability income policies. The Company markets its products through independent agents throughout 10 states and the District of Columbia. The Company is owned 21.6% by Erie Indemnity Company (EIC), 53.5% by Erie Insurance Exchange (Exchange) and the remaining 24.9% by public shareholders. The Company, EIC and the Exchange and its subsidiaries and affiliates operate collectively under the name “Erie Insurance Group.”
The Company earns premiums principally from the sale of individual life, group life and disability income insurance products. The Company also generates a significant amount of investment income from investing deposits received on fixed annuity contracts. Operating expenses principally consist of insurance benefits provided, interest credited on annuity and universal life deposits, general business expenses, premium taxes and commissions and other costs of selling and servicing the Company’s various products.
• Pricing insurance products at a competitive level while enabling the Company to earn a margin over the cost of providing benefits;
• Mortality and morbidity experience on individual and group life insurance, annuity and disability income products;
• Persistency experience, which affects the recovery of the costs of acquiring new business over the lives of the contracts;
In addition, external factors such as regulation, competition, interest rates, taxes, securities market conditions and general economic conditions affect profitability.
Employees performing services for the Company participate in the pension and other employee benefit plans sponsored by EIC. Pension benefits are based on years of service and salary. Pension costs are funded by EIC in amounts sufficient to at least meet ERISA minimum funding requirements. The Company reimburses EIC on a monthly basis for its share of pension costs. The Company, through EIC, also participates in certain deferred compensation and supplemental pension plans for certain executive and senior officers. The amounts recorded by the Company for the deferred compensation and supplemental pension plan are reimbursed to EIC as costs are incurred under these plans. Amounts allocated to the Company from EIC for these pension and other employee benefit plans, and included in the total reimbursements noted above, totaled $1.7 million, $1.3 million and $0.7 million for 2004, 2003 and 2002, respectively.
The Erie Insurance Group 401(k) plan for employees includes an investment option in a Company group annuity. Annuity deposit balances outstanding relating to 401(k) contributions from employees are $30.2 million and $28.0 million at December 31, 2004 and 2003, respectively.
The DAC related to traditional life insurance products is amortized in proportion to premiums over the premium-paying period of related policies using assumptions consistent with those used in computing policy liability reserves. Assumptions used for a specific issue year are “locked-in;” therefore, amortization in subsequent years is not adjusted for changing assumptions.
The Company periodically reviews the DAC asset to determine if it continues to be recoverable from future premiums or profits. If less than the full amount of DAC is determined to be recoverable, a portion of such costs are expensed at the time of determination. The amount of DAC considered recoverable may be reduced in the near term if the estimate of future gross premiums or profits were to be reduced. The amount of DAC amortization may be revised if any of the estimates discussed above are revised.
Significant assumptions underlying estimates of reserves for policy liabilities include a variety of factors such as anticipated mortality, morbidity, withdrawals, lapses and investment yields. Liabilities for life insurance and income-paying annuity future policy benefits are computed primarily by the net level premium method. Disability income reserves are calculated as two-year preliminary term mid-terminal reserves plus unearned premium reserves plus claim reserves. Deferred annuity future policy benefit liabilities are established at accumulated values without reduction for surrender charges. Reserves for universal life plans are based on the contract account balance.
Net income decreased 8.8% to $29.6 million, or $3.14 per share, in 2004, from $32.5 million, or $3.44 per share, in 2003. Although amortization expense decreased to $0.8 million from $7.5 million in 2003 as a result of unlocking of projected profit assumptions on interest sensitive products in the amount of $7.2 million, the Company also took a charge of $2.0 million to write-off an asset related to the PEGLI pool. In addition, income from realized gains on investments was lower in 2004.
Universal life products generated premium, net of reinsurance, of $14.2 million, $13.4 million and $12.2 million in 2004, 2003 and 2002, respectively. Reinsurance premiums ceded on universal life policies totaled $1.3 million, $1.2 million and $1.1 million in 2004, 2003 and 2002, respectively. Reinsurance arrangements for universal life products did not change in 2003 or 2004.
Net investment income increased $1.9 million, or 2.4%, in 2004 and $11.3 million, or 16.7%, in 2003. The rate at which investment income grew was lower in 2004 due to lower yields in 2004 and a decline in annuity deposits.
The Company’s equity in earnings of limited partnerships increased to $2.1 million in 2004, from $1.3 million in 2003. The Company recognized no impairment charges on limited partnerships in 2004 and $2.0 million and $1.0 million relating to mezzanine debt partnerships in 2003 and 2002, respectively.
Net death benefits on life insurance policies increased $2.4 million, or 15.5%, to $17.6 million in 2004, compared to $15.2 million in 2003 and $15.5 million in 2002. These benefits are net of reinsurance recoveries of $6.2 million, $4.7 million and $2.9 million in 2004, 2003 and 2002, respectively. As noted previously in the “Analysis of Policy Revenue” section, the Company’s primary term products are substantially reinsured. As the Company’s life insurance in force continues to grow, death benefits can be expected to increase. Net life insurance in force has grown from $17.3 billion at December 31, 2003 to $17.6 billion at December 31, 2004. Random fluctuations in death benefits incurred can be expected when mortality results are measured over a short time period due to the small number of claims involved. These
short-term fluctuations can influence quarterly or annual results without impacting long-term profitability. Management believes that its underwriting philosophy and practices are sound.
Surrender and other benefits increased by $2.0 million to $3.3 million in 2004 and decreased by $0.5 million to $1.3 million in 2003. Surrender and other benefits include life surrender benefits, matured endowments, disability benefits and interest on death benefits. The increase in surrender and other benefits in 2004 resulted from charges related to the Pennsylvania Employees Group Life Insurance (PEGLI) pool. PEGLI is a voluntary reinsurance pool that provides reinsurance coverage to primary insurers who insure Commonwealth of Pennsylvania employees upon their retirement. The Company was a participant in this pool for a number of years. Beginning July 1, 2001, the Company stopped receiving new business from the PEGLI pool. The Company continued carrying a balance on the Statements of Financial Position for its share of the assets and liabilities of the PEGLI pool. However, the Company’s inability to obtain reliable information for the appropriate balance of these assets and liabilities raised the concern of the recoverability of the net asset. During the fourth quarter of 2004, it was determined that it was unlikely the net asset would be recovered. The Company made the decision to write-off the net asset, which totaled $2.0 million.
The amortization of deferred policy acquisition costs decreased to $0.8 million in 2004 compared to $7.5 million in 2003 and $7.3 million in 2002. For traditional life products, the amortization of DAC was $4.9 million for 2004, $3.8 million for 2003 and $3.3 million for 2002. The decrease in total amortization from 2003 to 2004 is principally attributable to changes in the amortization related to the Company’s universal life products. The DAC on these products is amortized in relation to estimated gross profits in accordance with Statement of Financial Accounting Standard No. 97, Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments (FAS 97). The Company regularly evaluates the appropriateness of certain assumptions related to the interest sensitive products as provided under FAS 97 and modifies (“unlocks”) assumptions as appropriate. As a result of unlocking assumptions, the amortization of DAC decreased by $7.2 million in 2004. Approximately $4.8 million of this amount resulted from updating universal life mortality assumptions to best estimates in light of substantially more favorable claims expectations than originally reflected in the DAC amortization models. Another $1.9 million resulted from increasing the interest spread assumption on universal life policies to reflect anticipated investment earnings rates and actual crediting practices in recent years.
Direct commissions to independent agents include new and renewal commissions, production bonuses and promotional incentives to agents. These direct commission expenses are reported on the Statements of Operations net of commissions received from reinsurers. The reported expense is also affected by the amount of commission expenses capitalized as DAC. Commissions, which vary with and are related
primarily to the production of new business, are deferrable as DAC. Most first-year and incentive commissions and some renewal commissions qualify for deferral as DAC. Commission expense, net of DAC, decreased $1.5 million or 54.4% to $1.2 million in 2004, and decreased 29.6% to $2.7 million in 2003. These decreases are partially attributable to the decline in annuity sales and a decrease in the annuity commission rates in 2004. Commissions and bonuses on annuity premiums, net of DAC, were $0.7 million, $2.4 million and $3.0 million for 2004, 2003 and 2002, respectively. In addition, the 2004 commission expense was reduced by a $0.7 million adjustment to the reinsurance expense allowance reimbursements due to reinsurance administration system corrections, as discussed previously in the “Analysis of policy revenue” section.
General expenses include wages and salaries, employee benefits, data processing expenses, occupancy expenses and other office and general administrative expenses of the Company. General expenses related to the acquisition and underwriting of new policies are deferrable as DAC. These expenses include medical inspection and exam fees related to new business production and wages, salaries and employee benefits of underwriting and new policy processing personnel. General expenses, net of DAC additions, increased $1.4 million to $16.3 million in 2004, compared to $14.9 million in 2003 and $11.0 million in 2002. Part of this increase can be attributed to: (1) the costs of professional fees associated with refining the processes used to determine the recorded amount of DAC and related DAC amortization and subsequent restatement of prior period financial statements, (2) costs associated with the upgrading of the Company’s policy administration systems for new products and (3) costs for implementing a new life valuation system.
At December 31, 2004, the Company’s investment in fixed maturities totaled $1.4 billion, or 93.2%, of total investments. These resources provide the liquidity the Company requires to meet known and unforeseen demands on its funds. Nonredeemable preferred stock, limited partnerships, real estate, policy loans and real estate mortgage loans comprised the remaining 6.8% of total investments.
The Company’s performance of its fixed maturities and equity securities compared to market indices is presented below.
The Company’s fixed maturity investments include 97.4%, or $1.3 billion, of high-quality, marketable bonds and redeemable preferred stock, all of which were rated at investment-grade levels (above Ba1/BB+) at December 31, 2004. The below-investment-grade category consists of $29.4 million of bonds rated Ba1/BB+ and $6.8 million of bonds rated below Ba1/BB+. Generally, the fixed-maturity securities in the Company’s portfolio are rated by external rating agencies. If not externally rated, they are rated by the Company on a basis consistent with the basis used by the rating agencies.
Management believes that having all fixed maturities classified as available-for-sale securities will allow the Company to meet its liquidity needs and provide greater flexibility for its investment managers to respond to changes in market conditions or strategic direction. Securities classified as available-for-sale are carried at market value with unrealized gains and losses included in shareholders’ equity net of deferred taxes and offsetting adjustments to DAC. At December 31, 2004 and 2003, net unrealized gains on fixed maturities available-for-sale amounted to $44.8 million and $49.9 million, respectively, net of deferred taxes.
Equity securities at December 31, 2004, consist of nonredeemable preferred stock carried on the Statements of Financial Position at market value. At December 31, 2004 and 2003, nonredeemable preferred stock held by the Company had net unrealized gains of $4.5 million and $4.1 million, respectively, net of deferred taxes. As with the fixed maturities portfolio, the Company’s nonredeemable preferred stock portfolio provides a source of highly predictable current income. These securities are diversified within each market sector and support the investment return provided to policyholders. The nonredeemable preferred stock consist entirely of high quality positions rated investment-grade level (above Ba1/BB+) at December 31, 2004.
Cash flow sources from investing activities includes proceeds from the sales, calls and maturities of fixed maturity positions. These proceeds totaled $223.5 million, $340.0 million and $267.6 million in 2004, 2003 and 2002, respectively. Market interest rates declined in 2003 and 2002 causing greater levels of calls. Also, record numbers of credit quality downgrades and defaults occurred in the bond markets in 2002. The Company sold many of these issues in order to improve the overall credit quality of the fixed income portfolio.
Annuity and universal life deposits, which do not appear as revenue on the financial statements, are a source of funds from financing activities. Net cash provided by annuity and universal life deposits in 2004 were $52.4 million and $13.1 million, respectively. These deposits do not involve a mortality or morbidity risk and are accounted for using methods applicable to comparable interest-bearing obligations of other types of financial institutions.
Cash outflow requirements are primarily for policy death benefits, policy surrenders and withdrawals, commissions, general operating expenses, federal income taxes, dividends to shareholders and purchases of investments.
The following table sets forth withdrawal characteristics of annuity reserves and deposit liabilities as of December 31:
The following table presents the Company’s contractual cash flow commitments on surplus notes, limited partnerships and policyholder obligations.
Contractual obligations on other long-term liabilities represent estimated benefit payments from insurance policies and annuity contracts less amounts the Company expects to recover under reinsurance agreements. Actual obligations in any single year will vary based on actual mortality, morbidity, lapse, and withdrawal experience. The sum of these obligations exceeds the liability on the balance sheet of $1,246,810 (net of the Reserve Credit for Reinsurance Ceded) due to expected future premiums and investment income that, along with invested assets backing the liabilities, will be used to fund these obligations.
The Company’s annuity and universal life contracts contain provisions that guarantee interest rates will not decrease below certain levels. If the interest rates on fixed income securities decline further, the interest earned on the Company’s investment portfolio may be insufficient to produce target profit margins or, in extreme situations, could produce negative profit margins on annuity and universal life deposits.
Effective July 10, 2003, the Company revised its current deferred annuity products to lower interest rate guarantees on newly issued policies to 1.5% in all policy years. This change has been approved in all states in which the Company operates.
During 2004, the average rates credited on flexible premium deferred annuity and universal life account values were 4.2% and 4.6%, respectively. The current coupon yield on fixed maturities matched against universal life and annuity products at December 31, 2004, is 5.9%.
The Company’s deposit-type products compete with a wide variety of investment options. Among other
factors affecting the investment decisions of policyholders and potential policyholders are general investment market conditions, particularly the market interest rate environment and the performance of the equity markets. Changes in interest rates affect pricing and the relative attractiveness of interest-sensitive investment options, which bears directly on the ability of the Company to attract new policyholders and retain existing holders of annuity, universal life and certain permanent life insurance products.
The Company put in place a new ceding arrangement for new issues under certain of its Target Term plans as of January 1, 2005. Allowances under this new arrangement are not as favorable as those under the arrangement in place through 2004. While increased reinsurance costs (reduced expense allowances) on this product will reduce the profitability of the Company’s traditional life line of business, this line of business is expected to remain profitable. Changes in the price or features of new Target Term policies may be necessary in 2005 in order to return the profitability of this product to desired levels.
The combination of Company growth and declines in investment returns exposes the Company to reduced statutory surplus levels. Surplus levels are an important element of the rating process used by such agencies as A.M. Best and Standard & Poor’s, which are industry-accepted measures of an insurance company’s financial health and ability to meet ongoing obligations to policyholders. These ratings are a factor in establishing the competitive position of insurance companies.
If the Company were to incur reductions in statutory surplus for an extended period of time, the ratings of the Company may be downgraded. Future downgrades in these or other ratings would reduce the competitive position of the Company by making it more difficult to attract business in the highly competitive life insurance industry. In such circumstances, the Company may need to take measures to increase surplus levels in order to maintain adequate ratings. The Company may increase surplus through a variety of means, including the issuance of additional surplus notes.
In 2004, the Company implemented a new valuation system for its statutory and tax reserves on traditional products. As a result, adjustments were made to conform reserve estimates of the old system to the estimates from the new system. The Company expects to implement the new valuation system for GAAP reserving on traditional products in the first half of 2005. In implementing the new valuation system for GAAP, the Company will consider numerous variables concerning reserves and may revise some of the assumptions as accommodated by the new system. The impact of the revised reserving assumptions on the recorded reserves cannot be estimated until such considerations are evaluated and modeled as part of the implementation in 2005.
In 2001, the Erie Insurance Group began a comprehensive program of eCommerce initiatives in support of the Erie Insurance Group’s agency force and back office policy underwriting, issuance and administration. The eCommerce program is intended to improve service and efficiency, as well as result in increased sales.
The program will produce an enduring benefit to the Company as the system avails the Erie Insurance Group of infrastructure and processing capability that is progressive, expandable and capable of supporting the Group’s strategic direction.
The first major component of the eCommerce program (network and desktop hardware deployment) was completed during 2002. Also in 2002, the Erie Insurance Group completed a pilot of the new Web interface to a limited number of agents and employees. In August 2002, the Erie Insurance Group began working with a well-known provider of information technology services and solutions to be the chief integrator and co-manager of the eCommerce program and to co-develop software applications that meet the Group’s needs.
Target delivery dates established in 2002 have generally not been met as management has devoted increased effort to quality assurance efforts to ensure that the rollout creates only minimal business disruption. In February 2005, the Group reached a contractual milestone relative to contractual acceptance of the base ERIEConnection® system with the co-developer and chief integrator of the software. The timeline and costs for further deployment of ERIEConnection ® are currently under development.
North Carolina - In November 2004, the Company, Exchange, and Erie Insurance Company received a Demand to Produce Information (Demand) from the North Carolina Department of Insurance. The Demand requested any and all documents and other information related to “bid rigging” of any person, insurer, or insurance producer concerning any North Carolina insured or any North Carolina business. The Company, Exchange and Erie Insurance Company filed a response certifying that they do not have any information related to or knowledge of bid rigging, as defined in the Demand since the companies have not engaged in such practices.
The Company’s system of internal control is designed to safeguard Company assets from unauthorized use or disposition and to provide for proper authorization, execution and recording of Company transactions. Company personnel design, maintain and monitor internal control on an ongoing basis. The Company’s report on its evaluation of internal controls is provided in Item 9A of this Annual Report on Form 10-K. In addition, the Company’s internal auditors review and report on the functioning of various aspects of internal control.
We have audited the accompanying Statements of Financial Position of Erie Family Life Insurance Company as of December 31, 2004 and 2003, and the related Statements of Operations, Shareholders’ Equity, and Cash Flows for each of the two years in the period ended December 31, 2004. Our audits also included the 2004 and 2003 financial statement schedules listed in the Index at Item 15(a). These financial statements and schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. The financial statements and schedules of Erie Family Life Insurance Company for the year ended December 31, 2002 were audited by other auditors, whose report dated February 7, 2003 (except for Note 2 as to which the date is August 12, 2004) expressed an unqualified opinion on those statements.
We have audited the Statements of Operations, Shareholders’ Equity and Cash Flows for Erie Family Life Insurance Company (Company) for the year ended December 31, 2002. In connection with our audit of the financial statements, we also have audited the 2002 financial statement schedules. These financial statements and financial statement schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audit.
We conducted our audit in accordance with standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements and financial statement schedules are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the results of operations and cash flows of Erie Family Life Insurance Company for the year ended December 31, 2002 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the related 2002 financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.
February 7, 2003, except for Note 2 as to which the date is August 12, 2004
The Company is owned 21.6% by the Erie Indemnity Company (EIC), 53.5% by the Erie Insurance Exchange (Exchange) and the remaining 24.9% by public shareholders. EIC is a Pennsylvania business corporation formed in 1925 to be the attorney-in-fact for policyholders of Erie Insurance Exchange, a Pennsylvania-domiciled reciprocal insurance exchange. As attorney-in-fact for the Exchange, EIC has a fiduciary duty to protect the policyholders of the Exchange in addition to its fiduciary duty to protect the interests of its shareholders. EIC operates predominantly as a provider of certain management services to the Exchange. EIC also is engaged in the property/casualty insurance business through its wholly-owned subsidiaries, Erie Insurance Company, Erie Insurance Property and Casualty Company, and Erie Insurance Company of New York and through a subsidiary of the Exchange, Flagship City Insurance Company. The Company, EIC, the Exchange and their subsidiaries and affiliates operate collectively under the name Erie Insurance Group.
During the second quarter of 2004, the Company completed a comprehensive analysis of its deferred acquisition costs asset. In completing the analysis, the Company determined that amounts previously reported for deferred acquisition costs and related amortization were incorrectly determined due to errors in the underlying computations. In order to correct these errors, prior to the filing of the Company’s second quarter 2004 Form 10-Q, the Company restated the first quarter Form 10-Q and the 2003 Form 10-K. The impact of the restatement to net income and net income per share for the years ended December 31, 2003 and 2002, and deferred policy acquisition costs and shareholders’ equity as of December 31, 2003 and 2002 follows:
Limited partnerships include U.S. and foreign real estate and mezzanine debt investments. These partnerships are recorded using the equity method, which is the Company’s share of the carrying value of the partnership. Unrealized gains and losses on limited partnerships are reflected in shareholders’ equity in accumulated other comprehensive income, net of deferred taxes. The Company has not guaranteed any of the partnership liabilities.
For the mortgage-backed bond portion of the fixed maturity securities portfolio, the Company recognizes income using a constant effective yield method based on anticipated prepayments and the estimated economic life of the securities. If actual prepayments differ significantly from anticipated prepayments, the effective yield is recalculated to reflect actual payments to date and anticipated future payments. The net investment in the security is adjusted to the amount that would have existed had the new effective yield been applied since the acquisition of the security, with the corresponding adjustment included as part of investment income.
All investments are evaluated monthly for other-than-temporary impairment loss. Some factors considered in evaluating whether or not a decline in fair value is other-than-temporary include: 1) the extent and duration to which fair value is less than cost, 2) historical operating performance and financial condition of the issuer, 3) near term prospects of the issuer and its industry, 4) specific events that occurred affecting the issuer, including a ratings downgrade, and 5) the Company’s ability and intent to retain the investment for a period of time sufficient to allow for a recovery in value. An investment which is deemed impaired is written down to its estimated net realizable value. For all investments except limited partnerships, the impairment charge is included as a realized loss in the Statements of Operations. For limited partnerships, the impairment charge is included as a component of equity in earnings of limited partnerships in the Statements of Operations.
Cash equivalents are comprised of investments in bank money market funds and short-term bonds, which mature in 90 days or less at the date of acquisition, and approximate fair value.
The Company incurs significant costs in connection with acquiring new business, principally commissions and policy issue and underwriting expenses. Acquisition costs, which vary with and are primarily related to the production of new business, are deferred as an asset and amortized over the estimated lives of the policies. At each balance sheet date, the Company evaluates the value of this asset in light of historical and expected future gross premiums and profits on its insurance and annuity products.
In accordance with Financial Accounting Standard (FAS) 60, Accounting and Reporting by Insurance Enterprises, the DAC related to traditional life insurance products is amortized in proportion to premium revenues over the premium-paying period of related policies using assumptions consistent with those used in computing policy liability reserves. Assumptions used for a specific issue year are “locked-in;” therefore, amortization in subsequent years is not adjusted for changing assumptions.
The Company periodically reviews the DAC asset to determine if it continues to be recoverable from future premiums or profits. If less than the full amount of DAC is determined to be recoverable, a portion of such costs are expensed at the time of determination. The amount of DAC considered recoverable would be reduced in the near term if the estimate of future gross premiums or profits were to be reduced. The amount of DAC amortization may be revised if any of the estimates discussed above are revised.
In accordance with FAS 97, DAC is adjusted for the impact of unrealized gains or losses on investments as if these gains or losses had been realized, with corresponding credits or charges included in accumulated other comprehensive income.
benefits are estimated in a manner consistent with the assumptions used for the underlying policy benefits and are recorded as an asset under “Reserve Credit for Reinsurance Ceded” on the Statements of Financial Position. Amounts recoverable for incurred claims and expense reimbursements are included as an asset under “Reinsurance Recoverable” in the Statements of Financial Position.
Provisions for income taxes include deferred taxes resulting from changes in cumulative temporary differences between the tax bases and financial statement bases of assets and liabilities. Deferred taxes are provided on a liability method whereby deferred tax assets are recognized for deductible temporary differences and deferred tax liabilities are recognized for taxable temporary differences. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment.
The following tables summarize the cost and market value of available-for-sale securities at December 31, 2004 and 2003:
Components of net investment income follow for the years ended December 31:
Components of realized gains and losses on investments reflected in operations for the years ended December 31 are included below. There were no impairment charges in 2004. Included in 2003 gross
realized losses of fixed maturities are impairment charges totaling $3.4 million. These charges related primarily to investments in the communications, energy and finance sectors. Included in 2002 gross realized losses of fixed maturities and equity securities are impairment charges totaling $25.8 million. These charges related primarily to investments in the communications, energy and finance sectors.
Investments at carrying value in limited partnerships consisted of the following at December 31:
The components of equity in earnings of limited partnerships reported for the years ended December are reflected below. Impairment charges on mezzanine debt partnerships of $2.0 million and $1.0 million in 2003 and 2002, respectively, are included in equity in earnings of limited partnerships in the Statements of Operations. There were no impairment charges in 2004.
The amortized cost and estimated fair value of fixed maturities at December 31, 2004 by remaining contractual term to maturity are shown below. Mortgage-backed securities are allocated based on their stated maturity dates. Actual cash flows may differ from those stated as a result of calls, prepayments or defaults.
Changes in net unrealized gains include the following for the years ended December 31:
The Company participates in a securities lending program whereby certain securities from its portfolio are loaned to other institutions for short periods of time. A fee is paid to the Company by the borrower in return. Company policy requires collateral equal to 102% of the fair value of the loaned securities. The Company maintains full ownership rights to the securities loaned and continues to earn interest on them. In addition, the Company has the ability to sell the securities while they are on loan. The Company has an indemnification agreement with the lending agent in the event a borrower becomes insolvent or fails to return securities. Securities lending collateral is recorded by the Company as a liability. The proceeds from the collateral are invested in cash and short-term investments and are reported on the Statements of Financial Position as cash and cash equivalents. The Company shares a portion of the interest received on these short-term investments with the lending agent. Revenue received for the years ended December 31, 2004 and 2003, related to this program, totaled $0.1 million for each year. The Company had no loaned securities at December 31, 2004 and loaned securities with a market value of $64.1 million and secured collateral of $65.5 million at December 31, 2003. The Company has incurred no losses on the loan program since the program’s inception.
During 2004, the Company unlocked certain assumptions used to determine DAC for its universal life and fixed annuity products. As a result of unlocking these assumptions in 2004, the DAC asset was increased and the amortization of DAC was decreased by $7.2 million. Approximately $4.8 million of this amount resulted from updating universal life mortality assumptions to best estimates in light of substantially more favorable claims expectations than originally reflected in the DAC amortization models. Another $1.9 million resulted from increasing the interest spread assumption on universal life policies to reflect anticipated investment earnings rates and actual crediting practices in recent years.
Estimated fair value for financial instruments were determined from market information and if necessary from quotations provided by broker-dealers. Certain financial instruments, including insurance contracts other than financial guarantees and investment contracts, are exempt from fair value disclosure requirements. The following methods were used in estimating fair value.
Annuity payouts: Included in this category are annuity contracts that the policyholder cannot surrender at any time and for which the policyholder is locked into a benefit payment schedule for the duration of the contract. These contracts provide benefits that are either guaranteed or contingent upon the survival of the annuitant. Fair values of these contracts were estimated using discounted project cash flows based upon U.S. Treasury spot rates. At December 31, 2004 and 2003, the carrying value of these contracts totaled $296.4 million and $283.7 million, respectively, while the estimated fair value of these contracts totaled $334.5 million and $328.3 million, respectively.
The components of other changes to comprehensive income for the years ended December 31 are as follows:
The “Accumulated Other Comprehensive Income” balances of $39.3 million and $44.6 million as of December 31, 2004 and 2003, respectively, in the Statements of Financial Position relate entirely to the unrealized appreciation of investments, net of tax and deferred acquisition costs.
Allocations from EIC for operating expenses paid on behalf of the Company are made on a monthly basis. The Company reimburses EIC when the expenses are paid. The amount of these cash settlements for the Company totaled $28.9 million, $26.1 million and $23.8 million in 2004, 2003 and 2002, respectively.
The second note was issued in 2003 for an additional $25 million. This surplus note bears an annual interest rate of 6.70% and is scheduled to be paid semi-annually. The surplus note is payable on demand on or after December 31, 2018. Both principal and interest payments are subject to prior approval by the Pennsylvania Insurance Commissioner. Interest paid on this note totaled $1.7 million and $0.6 million in 2004 and 2003, respectively.
EIC purchased certain software and equipment for use by the Company. Depreciation and applicable interest are charged to the Company throughout the estimated useful life of the asset and is included in general expenses. Depreciation and interest charged the Company in 2004, 2003 and 2002 amounted to $0.7 million in each of the three years.
The Erie Insurance Group affiliated property/casualty insurance companies periodically purchase annuities from the Company in connection with the structured settlement of claims. Considerations recorded in annuity deposits in the Statements of Financial Position from structured settlement annuities sold to affiliated property/casualty companies of the Erie Insurance Group totaled $20.5 million, $20.9 million and $18.6 million in 2004, 2003 and 2002, respectively. The reserves held for structured settlement annuities sold to the affiliated property/casualty insurance companies equal $213.7 million and $201.9 million at December 31, 2004 and 2003, respectively.
The Company has entered into various reinsurance treaties for the purpose of ceding the excess of life insurance over the Company’s established retention limits. Reinsurance contracts do not relieve the Company from its obligations to policyholders. Failure of reinsurers to honor their obligations could result in losses to the Company. The Company considers all of its reinsurance assets to be collectible; therefore, no allowance has been established for uncollectible amounts.
In 2004, the Company evaluated the net asset balance due from the Pennsylvania Employees Group Life Insurance (PEGLI) pool. PEGLI is a voluntary reinsurance pool that provides reinsurance coverage to primary insurers who insure Commonwealth of Pennsylvania employees upon their retirement. The Company was a participant in this pool for a number of years. Beginning July 1, 2001, the Company discontinued accepting new business from the PEGLI pool. The Company continued carrying a balance on the Statement of Financial Position for its share of the assets and liabilities of the PEGLI pool prior to July 1, 2001, however, the Company’s inability to obtain reliable accounting information as to the Company’s share of the pool assets and liabilities during 2004 raised concern over the recoverability of the net asset. During the fourth quarter of 2004, management made the decision to write off the value of the PEGLI net asset and a charge of $2.0 million, or $0.14 per share after taxes, was made to earnings.
Included in the reinsurance treaties are provisions for expense allowances to be provided to the Company by the reinsurer. These allowances are intended to help offset policy acquisition and maintenance costs incurred by the Company. The rate of reimbursement varies from reinsurer to reinsurer. The Company put in place a new ceded arrangement for new issues under certain of its Target Term plans as of January 1, 2005. This change is not expected to have a material impact on the Company’s financial statements in future periods.
The Company’s retention limit is $300,000 per life for individual coverage. For its disability income product, the Company has a 50% coinsurance agreement with its reinsurer. The Company’s most significant reinsurance relationship is with Generali USA Reassurance Company (Generali), which reinsures a portion of the Company’s life and accident and health business. Policy revenue ceded to Generali totaled $10.3 million, $8.2 million and $5.8 million for the years ended December 31, 2004, 2003 and 2002, respectively. At December 31, 2004 and 2003, the amount of in-force life insurance ceded to Generali totaled approximately $6.7 billion and $5.6 billion, respectively.
The Company has outstanding commitments to invest up to $11.6 million in limited partnerships at December 31, 2004. These commitments will be funded as required through the end of the respective investment periods, which typically span 3 to 5 years.
The loss recorded in the Fixed Annuities line for the year ended December 31, 2002, is a direct result of the $24.7 million of impairment charges recognized on fixed maturity investments during 2002.
The decrease in total expenses and benefits in 2004 for the Universal Life line was primarily due to a decrease in amortization of deferred policy acquisition costs. This decrease was the result of the unlocking of certain assumptions under FAS 97 as explained in Notes 3 and 5. The total amount of the unlocking adjustment made in 2004 for universal life products decreased the amortization by $7.7 million.
The increase in Group Life and Other total expenses in 2004 was due to the $2.0 million charge related to the write off of the PEGLI net assets as discussed previously in Note 12.
A reconciliation of net income (loss) as filed with regulatory authorities to net income reported in the accompanying financial statements for the years ended December 31, 2004, 2003 and 2002, follows:
The amount of dividends the Company can pay to its shareholders without the prior approval of the Pennsylvania Insurance Commissioner is limited by statute to the greater of: (a) 10% of its statutory surplus as regards policyholders as shown on its last annual statement on file with the commissioner, or (b) the net income as reported for the period covered by such annual statement, but shall not include pro rata distribution of any class of the insurer’s own securities. Accordingly, the maximum dividend payout which may be made in 2004 without prior Pennsylvania Commissioner approval is $20.5 million. Dividends declared to shareholders totaled $8.3 million and $7.9 million in 2004 and 2003, respectively.
Bonds having a carrying value of $2.1 million at December 31, 2004, were on deposit with various regulatory authorities as required by law. The carrying value of these bonds are not material for separate disclosure on the Company’s Statements of Financial Position and are included with fixed maturities.