We conduct our operations from leased office space located at Cumberland House, 1 Victoria Street, Hamilton, HM 11, Bermuda. Annuity and Life Re America conducts its operations from leased space located at 280 Trumbull Street, Hartford, Connecticut, USA. We believe our space is adequate to meet our current and future needs.
Factors that could materially and adversely affect our operations and financial condition and/or cause our actual results of operations or financial condition to differ from those expressed or implied in our forward-looking statements include, but are not necessarily limited to, the following:
• While we believe we have sufficient operating liquidity to sustain our operations through at least the next twelve months, we continue to explore strategic alternatives to attempt to maximize shareholder value. These alternatives include, but are not limited to, a merger, sale, joint venture, sale of assets, including our remaining reinsurance agreements, or other comparable transaction. We do not know the terms upon which these transactions might be available, if at all.
• As a Bermuda reinsurer, we are required to post collateral for the statutory reserves ceded to us by U.S. based insurers and reinsurers. Although our liquidity position has improved following the novation and recapture transactions we completed with Transamerica Occidental Life Insurance Company (“Transamerica”), a large portion of our cash and investments is held by our U.S. operating subsidiary or is posted as collateral under our remaining life reinsurance agreements and is unavailable to fund our operations or those of our Bermuda operating subsidiary.
• We have ceased to write new reinsurance agreements and are not accepting new business on existing agreements. We do not anticipate resuming writing new reinsurance agreements in the foreseeable future, unless we are able to increase our cash and liquidity positions. As a result, our cash flow and results of operations in the near future will be based solely upon the performance of our remaining book of business and the returns generated from our invested assets. Of our remaining book of business, we have a few large reinsurance contracts that represent a material concentration of our net premiums and deferred policy acquisition costs. Our remaining annuity reinsurance agreement represents the vast majority of our funds withheld at interest asset and the entirety of our interest sensitive contract liabilities.
• Prior to requesting their withdrawal, the financial strength ratings of both our operating subsidiaries had been downgraded to a level that effectively precluded them from writing new business. We cannot assure you that we will be able to obtain sufficient financial strength ratings or increase our cash and liquidity positions to a level where we can resume writing new business. If we are able to position ourselves to write new business in the future, we cannot assure you that we will be able to attract or retain customers.
• The New York Stock Exchange suspended trading in our common shares prior to the market opening on Friday July 30, 2004. The NYSE’s action was taken because we had again fallen below the NYSE’s continued listing standards, as the average closing price of our common shares had been less than $1.00 over a consecutive 30-trading-day period. On August 17, 2004, our common shares began trading on the OTC Bulletin Board under the ticker symbol ANNRF.OB. We cannot assure you that we will be able to list our common shares for trading on any other national exchange or automated quotation system, which will adversely affect the public market for and liquidity of our common shares, and may adversely affect any capital raising or other strategic transactions we may choose to pursue in the future.
• We are exposed to the risk that the level of death claims we receive will exceed that which we assumed in pricing our reinsurance contracts. In 2001, 2002 and 2003, we had substantial unexpected adverse mortality experience compared to our original pricing assumptions under many of our life reinsurance contracts. Mortality experience that is less favorable than we assumed in pricing a reinsurance agreement will negatively affect our results of operations. Furthermore, even if the total benefits paid over the life of a contract do not exceed the expected amount, unexpected increases in the incidence of deaths or the size of individual claims can cause us to pay more benefits in a given accounting period than expected, adversely impacting the results of operations in any particular quarter or year.
• Our continued operations are dependent on our ability, and the ability of our ceding companies, to manage investment risks. Unexpected volatility or illiquidity in the markets in which we directly or indirectly hold positions could adversely affect our business. Our investments and the assets held and managed by our ceding companies may include a limited amount of investments in below investment grade fixed income securities. While any investment carries some risk, the risks associated with lower-rated securities generally are greater than the risks associated with investment grade securities.
• Significant changes in interest rates expose us to the risk of reduced investment income when interest rates are falling and to greater realized losses from the sale of securities when interest rates are rising. In addition, changes in interest rates can negatively affect the income we derive from the spreads between the interest rates earned on investments and the credited interest rates paid on the policies that we reinsure. If interest rates decline below current levels, our investment yields may be insufficient to cover the credited interest rates paid under the policies we reinsure, which would adversely affect our business.
• Pursuant to SFAS No. 133 - Accounting for Derivative Instruments and Hedging Activities, our annuity reinsurance agreement with Lafayette is deemed to host an embedded derivative that must be bifurcated and accounted for separately. The change in the fair value of the embedded derivative is primarily driven by credit risk related changes in the market value of assets underlying the contract, changes in expected future cash flows under the annuity reinsurance agreement and changes in interest rates. The change in fair value is reported on our statements of operations, thereby increasing the volatility of our reported results of operations. If prevailing market conditions or other factors adversely impact the value of the embedded derivative, it could have a substantial effect on our results of operations.
• The loss of any member of our management team, particularly John F. Burke, our Chief Executive Officer, John W. Lockwood, our Chief Financial Officer, or William H. Mawdsley, our Chief Actuary, could adversely affect our business.
• We, along with Annuity and Life Reassurance, are Bermuda corporations that we believe are not subject to United States income tax because neither engages in business in the United States. However, because there is no definitive guidance as to what constitutes being engaged in trade or business in the United States, there can be no assurance that in the future the Internal Revenue Service may not contend that we are engaged in trade or business in the United States. The Internal Revenue Service is currently conducting an audit of our United States subsidiaries and has requested certain information and documents from us and our Bermuda operating subsidiary. While our United States subsidiaries have complied with the IRS’ requests for information, both we and our Bermuda operating subsidiary declined to supply the IRS with certain information in response to its initial requests for information on May 7, 2002 and July 1, 2002. We did provide the IRS with certain publicly available information regarding us and our Bermuda operating subsidiary in addition to minutes of the Board of Directors meetings and committee meetings held from 1999 through to 2001. We have not received any additional requests for information since July 1, 2002. If we were considered to be engaged in business in the United States, we could be subject to United States tax at regular corporate rates on our taxable income that is effectively connected with their United States business plus an additional 30% “branch profits” tax on such income remaining after the regular tax. Such taxes would have a material adverse effect on our results of operations and financial condition.
per share. The warrant expires on September 30, 2014. We recorded a charge of approximately $2.4 million in the third quarter of 2004 as a result of the settlement with CIGNA.
Pursuant to our letter of intent with Transamerica, on January 31, 2005, we executed definitive documents and novated our life reinsurance agreements with Scottish Re and F&G to Transamerica as of December 31, 2004. In consideration of these novations, we paid Transamerica $18.5 million, representing a transfer of reserves related to the life reinsurance agreements that were novated. Also, on January 31, 2005, we completed an amendment to our annuity reinsurance agreement with Transamerica, pursuant to which our agreement with Transamerica was terminated, and Transamerica recaptured all business ceded under the agreement effective as of December 1, 2004. In consideration of the recapture, we paid Transamerica all amounts owed under the annuity reinsurance agreement through November 30, 2004, which was approximately $7.1 million, along with a termination premium of $14.0 million.
Our remaining life reinsurance agreements are the reinsurance of ordinary life insurance, primarily for mortality risk. Profitability of our life reinsurance line depends in large part on the volume and amount of death claims incurred. While death claims are reasonably predictable over a long time horizon, they are less predictable over shorter periods and are subject to fluctuation from quarter to quarter and year to year, particularly given the relatively small size of our in force business as a result of recaptures and terminations in previous periods. Significant fluctuations from period to period could adversely affect the results of our operations. Similarly, claims experience that exceeds what we anticipated at the time we entered into reinsurance agreements can also adversely affect the results of our operations, as occurred in 2003 and 2002. At December 31, 2004 and December 31, 2003, the total face amount of our life insurance in force was approximately $2.3 billion and $17.5 billion, respectively.
Our remaining annuity reinsurance agreement reinsures general account fixed deferred annuities. Profitability of this agreement is primarily dependent on earning a spread between the interest rate earned on the assets under management and the interest rate credited to the policyholder. This agreement is market and interest rate sensitive. Fluctuations in the general level of interest rates and fixed income markets from period to period may cause fluctuations in the profitability of this agreement. At December 31, 2004 and
Because our financial results are heavily dependent on three life reinsurance agreements and one remaining annuity reinsurance agreement which contains an embedded derivative, large fluctuations in any one of these contracts could cause volatility in our overall financial results.
While we believe we have sufficient operating liquidity to sustain our operations through at least the next twelve months, we continue to explore strategic alternatives to attempt to maximize shareholder value. These alternatives include, but are not limited to, a merger, sale, joint venture, sale of assets, including our remaining reinsurance agreements, or other comparable transaction. We do not know the terms upon which these transactions might be available, if at all. For a more detailed discussion of certain factors that could materially and adversely affect our financial condition and results of operations, please see - Forward-Looking Statements.
Annuity and Life Re (Holdings), Ltd. is a Bermuda holding company with operating subsidiaries in Bermuda and the United States. We consolidate the operations of all of our subsidiaries in accordance with accounting principles generally accepted in the United States. The preparation of financial statements in conformity with generally accepted accounting principles requires the use of estimates and assumptions developed by our management. Any adjustments to the reported amounts of assets or liabilities resulting from changes in estimates are reflected in our results of operations in the period the estimates are revised. Certain management estimates are based, in part, on information provided by ceding companies. Our ceding companies periodically update, refine and revise the reinsurance information they provide to us. This revised data is reflected in our results of operations as changes in estimates.
Deferred Policy Acquisition Costs. The costs of acquiring new business, principally allowances, which vary with and are primarily related to the production of new business, are deferred. For traditional life and annuity policies with life contingencies, deferred policy acquisition costs are charged to expense using assumptions consistent with those used in computing policy reserves. Assumptions as to anticipated premiums are estimated at the date of the policy issuance, or the effective date of the most recent premium rate increase, and are consistently applied during the life of the contracts. Deviations from estimated experience are reflected in results of operations in the period such deviations occur. For these contracts, the amortization periods are generally the estimated life of the policies. We terminated or recaptured several of our reinsurance agreements during 2003 and 2004, which caused us to incur significant deferred acquisition cost write-downs. For example, we completed the termination and recapture of our annuity reinsurance agreement with Transamerica effective as of December 1, 2004, which resulted in a write off of deferred acquisition costs of approximately $63,100,000. We will consider other transactions that are economically beneficial to us, which may require write downs of deferred acquisition costs.
In preparing our financial statements, we make assumptions about our proportionate share of future investment income that will be earned from the investment of premiums received from underlying policyholders by our ceding companies and about future rates of lapse of policies underlying our annuity reinsurance contracts. These assumptions have a direct impact on our estimated expected gross profits on our annuity reinsurance contracts and, therefore, on the recoverability of the deferred acquisition costs carried on our balance sheet for these contracts. While these estimates are based upon historical results and information provided to us by our ceding companies, actual results could differ (and, in the past, have differed) materially from our estimates for a variety of reasons, including the failure of our ceding companies to report timely information regarding material developments under our reinsurance agreements. Such differences could be material to our future results. If our assumptions for investment returns prove to
Embedded Derivatives. We have concluded that there is an embedded derivative within the Funds withheld at interest receivable related to our annuity reinsurance agreement with Lafayette that requires bifurcation and separate accounting under Statement of Financial Accounting Standards No. 133 - Accounting for Derivative Instruments and Hedging Activities. This embedded derivative is similar to a total return swap arrangement on the underlying assets held by Lafayette. The fair value of the embedded derivative is classified as part of our Funds withheld asset on our balance sheet. We have developed a cash flow model with the assistance of outside advisors to arrive at an estimate of the fair value of this total return swap that uses various assumptions regarding future cash flows under the agreement. The fair value of the embedded derivative is influenced by changes in credit risk, changes in expected future cash flows under the agreement and interest rates. The change in fair value of the embedded derivative is recorded in our statement of operations as Net change in fair value of embedded derivatives, which is a non-cash item.
Reserves for Policy Benefits, Including Claims Incurred but not Reported (IBNR) and Interest Sensitive Contracts Liabilities. The development of reserves for policy benefits and for claims incurred but not reported for our life reinsurance agreements requires us to make estimates and assumptions regarding mortality, lapse, persistency, expense and investment experience. Such estimates are primarily based on historical experience and information provided by ceding companies. Actual results could differ, and in the past have differed, materially from those estimates. We monitor actual experience, and where circumstances warrant, will revise our assumptions and the related reserve estimates.
On January 1, 2004, we had a combined GMDB/GMIB agreement with CIGNA and an annuity reinsurance agreement with Transamerica, both of which were affected by the adoption of this new SOP. The agreement with CIGNA and the Transamerica agreement have both since been recaptured. The SOP provides guidance for reserving for contracts with guaranteed minimum death and guaranteed minimum income benefits. The SOP requires projections of a wide number of future economic scenarios that impact the present value of premiums earned and claims paid. Based on these projections and historical experience, a Benefit Ratio is determined. The reserve is then determined by applying the Benefit Ratio to premiums received and then deducting claims paid, both with interest. The SOP also provides guidance for reserving for annuity agreements with more than one potential account balance. These types of exposures are reserved for based upon the highest contractually determinable balance for each policyholder, without consideration of surrender fees. Upon adoption of the SOP on January 1, 2004, we recorded a one-time transition adjustment to our carried reserves for interest sensitive contracts liability and deferred acquisition costs asset for the Transamerica annuity reinsurance agreement, and future policy benefits for the CIGNA contract. The impact of our adoption of the SOP is discussed below in “Operating Results.”
Stock-Based Compensation. On December 16, 2004, the FASB issued SFAS No. 123 (revised 2004), Share-Based Payment (“SFAS No. 123R”). SFAS No. 123R replaces SFAS No. 123 “Accounting for Stock-Based Compensation” and supersedes APB opinion No. 25 “Accounting for Stock Issued to Employees”. The statement requires all entities to recognize compensation expense in an amount equal to the fair value of share-based payments granted to employees and is effective as of the beginning of the first interim or annual reporting period that begins after June 15, 2005. We already record compensation expense for awards of stock options and restricted stock to employees based on the fair value of the awards, consequently this statement will not have a material impact on our results of operations or financial condition.
Net Loss. For the year ended December 31, 2004, we had a net loss, after the cumulative effect of a change in accounting principle, of $(68,326,455), or $(2.64) per basic and fully diluted common share, as compared to net loss of $(132,155,584), or $(5.11) per basic and fully diluted common share, for the year ended December 31, 2003. Our loss for the year ended December 31, 2004 was primarily the result of the novation and recapture transactions with Transamerica which produced a loss of approximately
$60,627,000. Also contributing to our net loss was a $5,000,000 accrual for the settlement of the shareholder lawsuit and a charge in the third quarter of 2004 of approximately $2,421,000 associated with the recapture of our GMDB/ GMIB agreement with CIGNA.
On October 26, 2004, CIGNA agreed to recapture its GMDB/GMIB agreement with us. We agreed with CIGNA to a mutual release of all past, present and future claims under the agreement, including all obligations for claims and premiums that had accrued under the agreement since July 1, 2004. We also agreed with CIGNA to a mutual release of all claims under the letter of credit that we had posted as collateral under the agreement, and that CIGNA would retain the $11,000,000 it previously drew under the letter of credit. In addition, on October 26, 2004, we issued CIGNA a warrant dated as of September 30, 2004 to acquire one million of our common shares at an exercise price of $1.00 per share. The warrant expires on September 30, 2014. The impact of the recapture, net of reserves released for GMDB and GMIB risks, was a charge of approximately $2,421,000. Following the recapture of our agreement with CIGNA, we no longer have any exposure to GMDB or GMIB.
For the year ended December 31, 2004, our loss before cumulative effect of a change in accounting principle was $(67,960,495). The cumulative effect of a change in accounting principle due to the adoption of Statement of Position (SOP) 03-1 was a net loss of $(365,960) for the year ended December 31, 2004. Upon the adoption of the SOP on January 1, 2004, the amount of Reserves for future policy benefits relating to our GMDB/GMIB agreement with CIGNA was reduced by $1,878,760, favorably impacting our reported results of operations during the year ended December 31, 2004. The impact of the adoption of the SOP on our accounting for the Transamerica annuity reinsurance agreement was a net charge of $2,244,720 as a result of an increase in interest sensitive contracts liability of $38,398,730, partially offset by an increase in deferred policy acquisition costs of $36,154,010.
Net Premiums. Net premium revenue for the year ended December 31, 2004 was $48,297,706, a decrease of 71% from net premium revenue of $166,972,840 for the year ended December 31, 2003. Substantially all premium revenue in both years was derived from traditional ordinary life reinsurance agreements. The decline in premium revenue reflects the significant reduction of business in force resulting from the recapture and termination of life reinsurance agreements during 2003. At December 31, 2003, the total face amount of life insurance in force was approximately $17.5 billion, as compared with approximately $117.5 billion at December 31, 2002. At December 31, 2004, the total face amount of life insurance in force had decreased to approximately $2.3 billion reflecting the novation of our life reinsurance agreements with Scottish Re and F&G to Transamerica effective as of December 31, 2004. Our now largest life reinsurance agreement represented approximately $0.3 billion of life insurance in force at December 31, 2004 and approximately $11.3 million of premium revenue for the year ended December 31, 2004. We have stopped writing new reinsurance agreements and are not accepting any new business under existing treaties. The novations and terminations of life reinsurance agreements on December 31, 2004 will further reduce net premiums in future periods. Approximately $30.3 million of net premium revenue for 2004 was generated from reinsurance agreements that have been novated and terminated.
Net Realized Investment Gains. Net realized investment gains for the year ended December 31, 2004 were $439,536, as compared with net realized investment gains of $6,406,587 for the year ended December 31, 2003. The relatively high level of net realized investment gains for the year ended December 31, 2003 reflected the significant sales from our investment portfolio in 2003 in connection with the termination and recapture of a number of our reinsurance agreements and to meet the collateral requirements of certain of our ceding companies. Although we have begun to move a greater portion of our invested assets into longer duration investments, we plan to continue to hold a relatively large portion of our assets in short duration investments until interest rates rise or we conclude they are not going to rise in the foreseeable future. However, we will adjust our investment strategy based on developments in the markets and our business and those adjustments may result in realized gains or losses being recognized. We make decisions concerning the sales of invested assets based on a variety of market, business and other factors.
Net Change in the Fair Value of Embedded Derivatives. Under SFAS No. 133, we have been required to bifurcate and separately account for the embedded derivatives contained in certain of our annuity reinsurance agreements, and unrealized changes in the fair value of those embedded derivatives are reflected in our results of operations. Since the end of the third quarter of 2003, only our annuity reinsurance agreement with Lafayette contained embedded derivatives that we were required to bifurcate and separately account for. For the year ended December 31, 2004, the net change in fair value of our embedded derivatives was an unrealized gain of $2,181,070, as compared to an unrealized gain of $16,692,688 for the year ended December 31, 2003. The primary reason for the net change in fair value of our embedded derivatives for the year ended December 31, 2003 was the termination of certain of our annuity reinsurance agreements, including the termination of an annuity reinsurance agreement with an affiliate of XL Life as part of our comprehensive settlement with XL Life, and the termination of our agreement with Ohio National. Widening credit spreads and bond defaults in the portfolio of assets supporting these agreements had caused unrealized losses in our embedded derivatives in prior periods, which were reversed upon termination of the reinsurance agreements.
Claims and Policy Benefits. Claims and policy benefits include both life and variable annuity benefits, including GMDB, GMIB and, during the first half of 2003, enhanced earnings benefits (“EEB”). Claims and policy benefits for the year ended December 31, 2004 were $14,101,129 or 29% of net premiums, as compared with $198,002,905, or 119% of net premiums for the year ended December 31, 2003. The decrease in Claims and policy benefits is partially due to the release of approximately $36,855,000 of life reinsurance reserves related to the agreements with Scottish Re and F&G that were terminated and novated to Transamerica in excess of the $18,500,000 we agreed to pay for the transfer of reserves related to the those agreements, and the $11,000,000 release of reserves due to the recapture of our GMDB/GMIB agreement with CIGNA in 2004. The absolute decline in claims and policy benefits in 2004 was also the result of the significant reduction of life insurance in force from approximately $117.5 billion at December 31, 2002 to approximately $2.3 billion at December 31, 2004. This included the termination of our GMDB agreement with Hartford Life in 2003 and the recapture and termination of other life and annuity
reinsurance agreements in 2003, including the comprehensive settlement with XL Life, as well as the novation of our life reinsurance agreements with Scottish Re and F&G to Transamerica as of December 31, 2004. While the recaptures of life reinsurance agreements have reduced claims and policy benefits in 2004, they may increase volatility in the level of claims and policy benefits as a percentage of premiums in the future.
Interest Credited to Interest Sensitive Products. Interest credited to interest sensitive products, which are liabilities we assume under certain annuity reinsurance agreements, was $5,399,460 for the year ended December 31, 2004, as compared with $13,980,723 for the year ended December 31, 2003. Included in Interest credited to interest sensitive products for the year ended December 31, 2004 are lifetime minimum interest guarantee (“LMIG”) payments of approximately $9,990,000, as compared to LMIG payments of approximately $16,120,000 for the year ended December 31, 2003. The reduction in LMIG payments in 2004 was primarily due to improving lapse experience and total returns on our annuity reinsurance agreement with Transamerica during 2003 and the first quarter of 2004. The decrease in Interest credited to interest sensitive products is also due to the release of reserves for interest sensitive contract liabilities in excess of the write-off of funds withheld at interest and the termination premium related to our Transamerica agreement, which was terminated effective as of December 1, 2004.
Policy Acquisition Costs and Other Insurance Expenses. Policy acquisition costs and other insurance expenses, consisting primarily of allowances and amortization and write downs of deferred policy acquisition costs, for the year ended December 31, 2004 were $110,922,948, as compared with $128,549,288 for the year ended December 31, 2003. The expense for the year ended December 31, 2004 was primarily comprised of approximately $88,000,000 for the write-downs of deferred acquisition costs associated with the recaptures and terminations of life and annuity reinsurance agreements during 2004. Of these write-downs, approximately $63,100,000 related to the recapture of our annuity reinsurance agreement with Transamerica and approximately $24,900,000 related to our life reinsurance agreements with Scottish Re and F&G that were novated to Transamerica as of December 31, 2004. Policy acquisition costs and other insurance expenses for the year December 31, 2003 included the net write down of deferred acquisition costs associated with the recapture and termination of life and annuity reinsurance agreements of approximately $85,931,000.
During the year ended December 31, 2003, we negotiated the recapture and termination of most of our life and annuity reinsurance agreements. As a result, we incurred charges from the write down of deferred acquisition costs and cash payments made to ceding companies in excess of reserve releases associated with the recaptured agreements aggregating to approximately $90,830,000. These charges include costs of
In addition to the costs associated with the recapture and termination of those agreements, we experienced losses during 2003 amounting to approximately $24,843,000 on the agreements that were recaptured or terminated during the year. This includes a loss of approximately $6,379,000 for our contract with MetLife and a net loss of approximately $5,866,000 for our reinsurance agreements with XL Life. We also recorded a net loss related to the recaptured Hartford Life treaty amounting to $6,537,000 in 2003. The remaining business recaptured in 2003 generated approximately $6,062,000 in losses.
Net Premiums. Net premium revenue for the year ended December 31, 2003 was $166,972,840, a decrease of 51% from net premium revenue of $344,097,441 for the year ended December 31, 2002. The majority of premium revenue in both years was derived from traditional ordinary life reinsurance. The decline in premium revenue reflects the decision to cease writing new business in 2003 and the significant reduction of business in force resulting from the recapture and termination of reinsurance agreements in the fourth quarter of 2002 and during the year 2003. Net premiums for 2003 related to agreements that were recaptured or terminated in 2003 were approximately $103,876,000. At December 31, 2003, the total face amount of life insurance in force was approximately $17.5 billion, as compared with approximately $117.5 billion at December 31, 2002. Our now largest life reinsurance agreement represented approximately $7.9 billion of life insurance in force at December 31, 2003. We have stopped writing new reinsurance agreements and are not accepting any new business under existing treaties. The recaptures and terminations of reinsurance agreements during 2003 will further reduce net premiums in future periods.
Net Change in Fair Value of Embedded Derivatives. Under SFAS No. 133, we are required to bifurcate and separately account for the embedded derivatives contained in certain of our annuity reinsurance contracts, and unrealized changes in the fair value of those embedded derivatives are reflected in our results of operations. The net change in fair value of embedded derivatives for the year ended December 31, 2003 was an unrealized gain of $16,692,688, as compared to an unrealized loss of $(25,846,110) for the year ended December 31, 2002. The unrealized gain during 2003 includes the reversal of previously reported losses of $12,323,000 upon the termination of our agreement with Ohio National in February 2003 and the termination of other annuity reinsurance agreements in 2003, including the termination of our annuity reinsurance agreements with an affiliate of XL Life as part of our comprehensive settlement with XL Life. Widening credit spreads and bond defaults in the portfolio of assets supporting these agreements had caused unrealized losses in our embedded derivatives in prior years. As of December 31, 2003, we have one remaining embedded derivative related to an annuity reinsurance agreement that we must bifurcate and separately account for, and that embedded derivative had an unrealized loss of approximately $7,790,000 at December 31, 2003.
Throughout 2003, we updated our analysis of carried reserves for incurred but not reported (“IBNR”) claims. In determining the amount of IBNR required at December 31, 2003, we considered the full trending of claims reported through December 31, 2003. As a result of our review and reflecting the decrease in life reinsurance in force, our reserve for IBNR at December 31, 2003 was $4,500,000, as compared to $9,000,000 at December 31, 2002. We will continue to examine these IBNR reserve levels in relation to past experience each quarter.
Interest Credited to Interest Sensitive Products. Interest credited to interest sensitive products, which represents liabilities to policyholders we assume under certain annuity reinsurance agreements, was $13,980,723 for the year ended December 31, 2003, as compared with $71,370,616 for the year ended December 31, 2002. The decline in Interest credited to interest sensitive contracts liabilities for the year ended December 31, 2003 was primarily the result of the termination and recapture of several annuity reinsurance agreements, particularly our agreements with Ohio National and an affiliate of XL Life during 2003. We terminated our annuity reinsurance agreement with Ohio National on February 14, 2003, another large annuity reinsurance agreement on April 1, 2003 and two annuity reinsurance agreements with an affiliate of XL Life effective as of July 1, 2003. In 2003, we recorded $6,595,000 of interest credited to interest sensitive products related to agreements that were recaptured or terminated. Interest credited to interest sensitive products in 2003 includes approximately $16,120,000 in minimum interest guarantee payments, which was partially offset by a $10,000,000 deemed recovery of minimum interest guarantee payments in connection with the comprehensive settlement with XL Life. We incurred approximately $26,760,000 of minimum interest guarantee payments in 2002. The minimum interest guarantee payments in both years resulted from prior poor investment performance of the invested premiums managed by the primary insurance company under our annuity reinsurance contract with Transamerica. The reduction in minimum interest guarantee payments in 2003 was primarily due to improving lapse and total returns on our annuity reinsurance contract with Transamerica during 2003.
Policy Acquisition Costs and Other Insurance Expenses. Policy acquisition costs and other insurance expenses, consisting primarily of allowances and amortization or write downs of deferred policy acquisition costs, were $128,549,288 for the year ended December 31, 2003, as compared with $125,877,980 for the year ended December 31, 2002. The expense is primarily comprised of the write-downs of deferred acquisition costs associated with the recaptures and terminations of life and annuity reinsurance agreements during 2003 of approximately $85,931,000. In addition to those write downs, we also amortized $17,400,000 of deferred acquisition costs associated with our Transamerica annuity reinsurance agreement, of which $10,000,000 was a result of our deemed recovery of minimum interest guarantee payments in connection with the comprehensive settlement with XL Life. In 2002, we wrote down deferred acquisition costs on our Transamerica contract by approximately $27,474,000. This write down was the result of higher than expected surrender rates on the policies underlying our reinsurance agreement with Transamerica, and our reduced estimate of expected gross profits under the contract in future periods due to minimum interest guarantee payments. The change in amortization of the deferred acquisition cost as a result of the change in the fair value of our embedded derivatives was an increase of approximately $6,954,000 in 2003, as compared to a reduction in amortization of approximately $8,274,000 in 2002.
Life Segment. Our life segment is our largest segment as measured by revenues. Life segment loss for the year ended December 31, 2004 was $(118,095), as compared to segment loss of $(90,436,276) for the year ended December 31, 2003. Our life segment loss for the year ended December 31, 2004 includes the write-down of deferred acquisition costs in excess of the release of life reinsurance reserves related to the life reinsurance agreements that were novated to Transamerica as of December 31, 2004. We recorded a gain of approximately $3,995,000 in connection with the novation of our life reinsurance agreement with Scottish Re, and incurred a charge of approximately $10,570,000 in connection with the novation of our life reinsurance agreement with F&G. The net charge from these novations was partially offset by operating income of approximately $5,824,000 on our life reinsurance agreement with Scottish Re and an operating loss of $1,397,000 was incurred under our life reinsurance agreement with F&G during 2004. Our life segment loss for the year ended December 31, 2003 reflects charges for recaptures of life reinsurance agreements of approximately $60,510,000. These charges reflect net costs of approximately $11,680,000 due to the recapture of our 50% quota share reinsurance agreement with XL Life, the recapture cost of our MetLife agreement of approximately $3,540,000 and the cost of recapture transactions completed with 22 additional ceding companies totaling approximately $45,290,000 in the aggregate.
Life segment revenues declined 70% to $50,153,025 for the year ended December 31, 2004, as compared with $166,333,033 for the year ended December 31, 2003. These declines reflect our reduced levels of life reinsurance in force as a result of recaptures of life reinsurance agreements during 2003. In addition, net investment income attributable to the life segment for 2004 decreased approximately $2,800,000, as compared with 2003, primarily reflecting a reduction in invested assets allocated to the life segment as a result of the terminations and recaptures in 2003.
benefits for 2003 related to agreements that were recaptured in 2003 were $103,586,000. The balance of the decline in 2004 is attributable to the significant reduction in life insurance in force compared to the comparable periods during 2003, as well as reported claims under our life reinsurance agreements that had exceeded our expectations during 2003. While the recaptures and novations of life reinsurance agreements during 2003 and 2004 will reduce claims and policy benefits in absolute terms in future periods, they may increase volatility in the level of claims and policy benefits as a percentage of premiums in the future.
Annuity Segment. Our annuity reinsurance segment has historically consisted of the reinsurance of general account fixed deferred annuities and certain minimum guarantees arising from variable annuities. We currently have only one remaining annuity reinsurance agreement, which covers individual general account single premium deferred annuity policies, which involve the tax-deferred accumulation of interest on a single premium paid by the policyholder (accumulation phase policies). Accumulation phase policies are subject primarily to investment risk and persistency (lapse) risk. Historically, we have also reinsured certain guarantees associated with variable annuity agreements, including GMDB and GMIB. As of December 31, 2004, we no longer reinsured any GMDB or GMIB due to the recapture of our reinsurance agreement with CIGNA.
Our annuity segment has historically contained the majority of our assets and exposed us to significant volatility in our results from operations from three sources. First, under SFAS No. 133 - Accounting for Derivative Instruments and Hedging Activities, we must currently bifurcate and separately account for the embedded derivative associated with our annuity reinsurance agreement with Lafayette, and we have had to do so for other annuity reinsurance agreements in the past. This unrealized change in the value of the derivative is reported in our statement of operations each quarter. The change in the value of the derivative can be large, and is driven by financial market conditions, most notably credit risk related changes. Second, as a result of our adoption of AICPA Statement of Position (SOP) 03-1, changes in our reserve levels for our Transamerica annuity reinsurance agreement resulting from underlying asset value changes were not offset with corresponding changes in our Funds withheld asset values, which caused volatility in our results of operations. To the extent that the minimum guarantee payable under the policies underlying the Transamerica agreement exceeded the payment that would be required as a result of the market value adjustment in those policies, the reserves required under the SOP would be based upon the minimum guarantee and the mismatch between liabilities and assets was less significant. Third, our Transamerica annuity reinsurance agreement exhibited volatility in the past due to write downs of our deferred acquisition cost balance which were based upon management’s estimates of future investment performance and lapse experience. On December 31, 2004, we entered into a binding letter of intent with Transamerica that provided that Transamerica would terminate its annuity reinsurance agreement with us and recapture all business ceded under the agreement effective as of December 1, 2004. Pursuant to our letter of intent with Transamerica, on January 31, 2005, we executed definitive documents and completed the termination and recapture of our annuity reinsurance agreement with Transamerica. As a result, as of December 31, 2004, our only remaining annuity reinsurance agreement was with Lafayette, significantly reducing the assets contained in our annuity segment.
For the year ended December 31, 2004, segment loss before the cumulative effect of a change in accounting principle was $(59,658,730), as compared to a loss of $(44,370,938) for the year ended December 31, 2003. The loss for the year ended December 31, 2004 reflects a loss of approximately $57,730,000 (excluding the cumulative charge of approximately $2,244,000 upon the adoption of the SOP) incurred on our annuity agreement with Transamerica, a loss of approximately $1,539,000 incurred on our GMDB/GMIB agreement with CIGNA (including a $2,421,000 charge in connection with the recapture of our GMDB/GMIB reinsurance agreement with CIGNA), and a loss of $732,000 from our annuity reinsurance agreement with Lafayette. The loss from our Transamerica agreement reflects a charge of approximately $54,100,000 for the termination of our annuity reinsurance agreement in 2004. The charge includes the write-off of deferred policy acquisition costs of approximately $63,100,000 along with a termination premium of $14,000,000, partially offset by the release of reserves for interest sensitive contract liabilities in excess of the write-down of funds withheld at interest assets of approximately $23,000,000.
The 2003 loss includes Hartford Life’s recapture of its GMDB reinsurance agreement, which generated a $20,400,000 loss, a net charge of $5,020,000 related to the termination of our annuity reinsurance agreement with Ohio National, a net cost of $4,900,000 from the recapture of three smaller annuity agreements, losses of $4,687,000 on annuity reinsurance agreements terminated or recaptured during 2003, a $1,934,000 loss under our GMDB/GMIB agreement with CIGNA, as well as a loss of $3,067,000 on our annuity reinsurance agreement with Transamerica. The net unrealized gain on our embedded derivatives during the year ended December 31, 2003 was approximately $16,693,000 and largely reflects the reversal of previously reported losses caused by the termination of our annuity reinsurance agreement with Ohio National and certain of other annuity reinsurance agreements during the year, including our annuity reinsurance agreements with an affiliate of XL Life. This gain was partially offset by a related increase in the amortization of deferred acquisition costs of approximately $6,954,000.
For the year ended December 31, 2004, segment loss was $(8,183,670) compared to segment income of $2,651,630 for the year ended December 31, 2003 The loss primarily reflects the $5,000,000 accrual for the anticipated settlement of the purported shareholder class action lawsuit, as well as increased consulting fees in connection with our efforts to pursue strategic alternatives in 2004. Costs associated with capital raising efforts were approximately $914,000 for the year ended December 31, 2004. Also, the decline in
At December 31, 2004 and December 31, 2003, a large portion of our invested assets, including cash and cash equivalents, were posted as collateral to secure our obligations under reinsurance agreements and letter of credit facilities or were required to maintain the statutory capital and surplus requirements of our U.S. operating subsidiary. At December 31, 2004, our invested assets, including cash and cash equivalents, had an aggregate fair value of $138,428,894, as compared with an aggregate fair value of $197,880,755 at December 31, 2003. The decline in our invested assets during 2004 was due to approximately $23,300,000 of payments we made in connection with the settlement of the recapture of our life reinsurance agreement with Metropolitan Life Insurance Companies, payments of approximately $23,900,000 to Transamerica under our annuity reinsurance agreement, and an $11,000,000 payment made in connection with the recapture of our combined GMDB/GMIB reinsurance agreement with CIGNA. At December 31, 2004, gross unrealized gains totaled $1,266,517, as compared to gross unrealized gains of $2,218,246 at December 31, 2003. At December 31, 2004 and December 31, 2003, the weighted average duration of the fixed income securities included in our invested assets was 2.9 and 3.9 years, respectively, and the weighted average investment quality rating was “AA” at the end of each period.
Our investments are governed by investment guidelines established and approved by our Board of Directors. Our investment objectives are to achieve above average risk-adjusted total returns, maintain a high quality portfolio, maximize current income, maintain an adequate level of liquidity in our portfolio and match the cash flows of our investments to our related insurance liabilities. Our investment guidelines require our overall fixed income portfolio to maintain a minimum weighted average credit quality of “A” and limit investment in fixed income securities that are non-rated or below investment grade at the time of purchase to an aggregate of $3,000,000. In 2004, we invested approximately $900,000 in securities that were non-rated at the time of their purchase. While any investment carries some risk, the risks associated with non-rated or lower-rated securities generally are greater than the risks associated with investment grade securities. A fixed income security rated “A” by Standard & Poor’s is considered to be somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions than higher rated issuers; however, the issuer’s capacity to meet its financial commitment on the security is still considered to be strong. We currently do not invest in any fixed income securities in emerging markets.
Prudential Investment Corporation serves as our advisor for our general account investment portfolio. Our management agreement with Prudential may be terminated by either party with 45 days notice. Our Board of Directors periodically reviews the performance of Prudential and the fees associated with this arrangement.
We do not engage in trading activities to generate realized investment gains and, thus, do not have a trading portfolio. However, we evaluate the desirability of continuing to hold a security when market conditions, creditworthiness or other measurement factors change. These changes may relate to a change in the credit risk of an issuer and a decision to sell may be made to avoid further declines in realizable value. Securities also may be sold prior to maturity to provide liquidity, as was the case in 2003 and 2004. As a result, our securities are classified as “available for sale” and are carried at fair value on our balance sheet.
At December 31, 2004, mortgage-backed securities represented approximately 7% of our invested assets, including cash and cash equivalents, as compared with approximately 11% at December 31, 2003. Investors in these securities are compensated primarily for reinvestment risk rather than credit quality risk. Investments in mortgage-backed securities include collateralized mortgage obligations (“CMO’s”) and mortgage backed pass-through securities. Mortgage backed securities generally are collateralized by mortgages issued by the Government National Mortgage Association (“GNMA”), the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation. Of these, only GNMA mortgages are backed by the full faith and credit of the U.S. government. Credit risk generally is not a consideration when investing in agency mortgage backed securities. Our mortgage backed securities portfolio had a weighted average investment quality rating of “AAA” at both December 31, 2004 and 2003.
The following table summarizes the investment results of our general account portfolio for the periods indicated:
According to information provided by Lafayette, at December 31, 2004 the credit ratings of the assets (excluding accrued investment income) funding the policyholder obligations under our annuity reinsurance agreement were approximately as follows:
Book values are those statutory book values reported to us by the ceding company for the underlying investments and represent the value of our Funds withheld at interest receivable. We present statutory book values in the above table because that is the basis upon which we settle with the ceding company under the contract. We believe this presents a better understanding of potential future returns and cash flows under the contract.
to pay UBS a minimum transaction fee of $1,000,000. If we close a sale transaction during the term of the Engagement Letter, we are obligated to pay UBS a minimum fee either $1,500,000 or $2,000,000, depending on whether the other party to that transaction is one identified in the Engagement Letter. In any case, the transaction fee payable to UBS may increase as the transaction value increases. Any transaction fee payable to UBS under the Engagement Letter will be offset by certain fees paid by us to UBS prior to the closing of the equity investment or sale transaction. At December 31, 2004, such fees totaled $240,000. We are also obligated to pay a transaction fee to UBS if, during the one year period following the expiration or termination of the Engagement Letter, we either consummate or enter into an agreement that results in an equity investment or sale transaction with any party identified to us by UBS as part of their engagement or with which we had discussions during the term of the Engagement Letter. The table above does not include any amounts that may be payable pursuant to the Engagement Letter.
Our liquidity and capital resources are a measure of our overall financial strength and our ability to generate cash flows from our operations to meet our operating and growth needs. Our principal sources of funds are premiums received, net investment income, proceeds from investments called, redeemed or sold and cash and short-term investments. Our principal obligations and uses of the funds are to post collateral for the statutory reserves ceded to us by U.S. based insurers and reinsurers, the payment of policy benefits, acquisition and operating expenses and the purchase of investments.
We have no material commitments for capital expenditures as of December 31, 2004. We plan to continue to receive premiums and pay claims under our remaining reinsurance treaties; however, we are not currently underwriting any new treaties or accepting any new business from our existing treaties. While we believe we have sufficient operating liquidity to sustain our operations through at least the next twelve months, we continue to explore strategic alternatives to attempt to maximize shareholder value. These alternatives include, but are not limited to, a merger, sale, joint venture, sale of assets, including our remaining reinsurance agreements, or other comparable transaction. We do not know the terms upon which these transactions might be available, if at all.
Both we and our Bermuda operating subsidiary, Annuity and Life Reassurance, are required to comply with the provisions of the Bermuda Companies Act that regulate the payment of dividends and the making of distributions from contributed surplus. Neither we nor Annuity and Life Reassurance may declare or pay a dividend, or make a distribution out of contributed surplus, if there are reasonable grounds for believing that: (i) the relevant company is, or would be after the payment, unable to pay its liabilities as they become due; or (ii) the realizable value of the relevant company’s assets would thereby be less than the aggregate of its liabilities and its issued share capital and share premium accounts. As of and since December 31, 2002, we have not declared a dividend to shareholders and we do not expect to declare or pay dividends to shareholders in the near future. The declaration and payment of future dividends to holders of our common shares will be at the discretion of our Board of Directors and will depend upon our results of operations and financial condition, capital requirements of our subsidiaries, the ability of our operating subsidiaries to pay dividends to us, regulatory considerations and other factors the Board of Directors deems relevant. For a discussion of other factors affecting our ability to pay dividends, see Item 1. Business - Regulation and Results of Operations - Liquidity and Capital Resources and Note 17 to our consolidated condensed financial statements included elsewhere in this report.
Consolidated Statements of Operations for the years ended December 31, 2004, 2003, and 2002
Consolidated Statements of Comprehensive Loss for the years ended December 31, 2004, 2003, and 2002
Consolidated Statements of Changes in Stockholders’ Equity for the years ended December 31, 2004, 2003 and
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements 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 audits provide a reasonable basis for our opinion.
The Company has encountered significant difficulties during the last four years. In addition to reporting significant operating losses for those years, the Company has reduced its operations significantly through the novation, termination and recapture of many of its life and annuity reinsurance agreements. The Company plans to continue to receive premiums and pay claims under its remaining reinsurance treaties; however, it is not currently underwriting any new treaties or accepting any new business from its existing treaties.
Pursuant to the letter of intent with Transamerica, on January 31, 2005, the Company executed definitive documents and novated its life reinsurance agreements with Scottish Re and F&G to Transamerica as of December 31, 2004. In consideration of these novations, the Company paid Transamerica $18.5 million, representing a transfer of reserves related to the novated life reinsurance agreements. Also, on January 31, 2005, the Company executed an amendment to its annuity reinsurance agreement with Transamerica pursuant to which the annuity reinsurance agreement with Transamerica was terminated, and Transamerica recaptured all business ceded under the agreement effective as of December 1, 2004. In consideration of the recapture, the Company paid Transamerica all amounts owed under the annuity reinsurance agreement through November 30, 2004, which was approximately $7.1 million, along with a termination premium of $14.0 million.
In connection with the novations of the life reinsurance agreements, approximately $28.9 million of collateral held in a trust established with respect to the Company’s life reinsurance agreement with Scottish Re was transferred to Transamerica. In addition, $23.8 million of the letters of credit the Company posted on behalf of its life reinsurance agreement with F&G were cancelled and the collateral securing those letters of credit was released to the Company. Approximately $39.6 million was paid to Transamerica in connection with the novation and recapture transactions from this collateral, including $18.5 million as consideration for the novations, a $14.0 termination premium and approximately $7.1 million for amounts due to Transamerica as of December 1, 2004. Following those payments, approximately $13.1 million of
On and since December 4, 2002, certain of the Company’s stockholders, seeking to act as class representatives, filed lawsuits against the Company and certain of its present and former officers and directors in the United States District Court for the District of Connecticut seeking unspecified monetary damages. The plaintiffs claim that the defendants violated certain provisions of the United States securities laws by making various alleged material misstatements and omissions in public filings and press releases. The plaintiffs filed a single consolidated amended complaint in July 2003, adding as defendants XL Capital Ltd and two additional directors. On October 1, 2003, the Company answered the amended and consolidated complaint and denied liability on the claims the plaintiffs have asserted. In January 2004, the court ordered that a related action that the plaintiffs filed against the KPMG LLP (United States) and KPMG in Bermuda be consolidated with the action against the Company. In February 2004, the court denied certain individual defendants’ motions to dismiss the action. In March 2004, the court denied motions to dismiss filed by certain other individual defendants and XL Capital Ltd. Also in March 2004, KPMG LLP (United States) and KPMG in Bermuda filed motions to dismiss the action. The court has not yet ruled on KPMG LLP’s (United States) and KPMG in Bermuda’s respective motions to dismiss.
In October 2004, the court ordered that notice of the settlement be given to class members, set deadlines for class members to exclude themselves from the class or file objections to the settlement, and scheduled a Settlement Fairness Hearing for January 2005. Following the Settlement Fairness Hearing, the District Court entered an order and final judgment approving the settlement in January 2005. Robert P. Johnson, one of the Company’s current directors, has filed a proof of claim to participate in the settlement based on his transactions in the Company’s stock during the class period and prior to rejoining its board of directors.
Pro Forma Condensed Consolidated Statement of Operation for the Years Ended December 31, 2004
The footnotes to our consolidated financial statements for the year ended December 31, 2003 included the following discussion regarding the going concern basis of accounting that was used as a basis for preparing those consolidated financial statements. See Note 2(b) for the status of the following matters.
The accompanying consolidated financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of
The Company continues to consider its strategic alternatives, including the possibility of raising new capital, but has not been able to successfully raise new capital to date. The Company is currently not writing new reinsurance agreements and is not accepting any new business under existing treaties. In addition, the Company is a defendant in a purported shareholder class action suit. The plaintiffs have not disclosed the damages sought.
The accompanying consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America which require management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements. Actual results could differ from those estimates. The following are the significant accounting policies adopted by the Company:
Reinsurance premiums from traditional life and annuity policies with life contingencies, where premiums collected match the period over which benefits are provided, are recognized as revenue when due from policyholders. Traditional life policies include those contracts with fixed and guaranteed premiums and benefits, and consist principally of whole life and term insurance policies. Benefits and expenses are matched with revenue so as to result in the recognition of profits over the life of the contracts. This is achieved by means of the provision for liabilities for future policy benefits and deferral and subsequent amortization of policy acquisition costs.
Amounts collected on universal life and investment-type contracts are considered deposits and are reported in the balance sheet as interest sensitive contracts liability. Revenues from these investment-type contracts consist of income earned on the assets and amounts assessed during the period against policyholders’ account balances for mortality charges, policy administration charges and surrender charges. Deposit accounting procedures are applied to considerations received or paid relating to reinsurance contracts that do not qualify for reinsurance accounting, with any revenue or expense associated with such deposits reflected in net investment income and other insurance expenses, respectively.
For universal life and investment-type contracts, deferred policy acquisition costs are amortized over the expected average life of the contracts as a constant percentage of the present value of estimated gross profits arising principally from investment results, mortality and expense margins and surrender charges based on historical and anticipated future experience, which is updated at the end of each accounting period. In computing amortization, interest accrues to the unamortized balance of capitalized policy acquisition costs at the rate used to discount expected gross profit. The effect on the amortization of deferred policy acquisition costs of revisions to estimated gross profits are reflected in the results of operations in the period such estimated gross profits are revised.
Changes in deferred policy acquisition costs for the year ended December 31, 2004 is as follows:
Amounts collected on universal life and investment-type contracts and benefit liabilities for traditional annuities (during the accumulation period) are reported in the balance sheet as interest sensitive contracts liability. Universal life and investment-type contracts are recorded at their accumulated policyholder values (without reduction for potential surrender or withdrawal charges). Revenues from these contracts consist of income earned on the assets and amounts assessed during the period against policyholders’ account balances for mortality charges, policy administration charges and surrender charges. Items that are charged to expense represent interest credited to policyholder account and other benefits in excess of related policyholders’ account balances, including minimum interest guarantee payments.
The Company historically reinsured certain minimum guarantees, including GMDB and GMIB, associated with variable annuity contracts, although as of December 31, 2004, it no longer reinsured these types of contracts. The Company’s accounting policy was designed to establish reserves for expected benefit payments over the life of the underlying policies, based upon the original pricing assumptions. The Company’s reserving policy allows the Company to increase reserves if claim amounts or claims volume exceed what was anticipated in pricing.
The Company’s functional currency is the United States dollar. Premiums written and receivable in foreign currencies and liabilities for future benefits payable in foreign currencies are recorded at exchange rates prevailing at the time such assets and liabilities are first recorded. Exchange gains or losses resulting from the periodic revaluation and settlement of such assets and liabilities are recorded in the Company’s statement of operations. There were no transactions in foreign currencies for the year ended December 31, 2004.
Diluted earnings per common share is calculated by dividing the net income attributable to common stockholders by the weighted average number of common shares outstanding during the period, plus potential dilutive common shares. Options and warrants issued by the Company are considered potential dilutive common shares and are included in the calculation using the treasury stock method, unless their inclusion would be considered anti-dilutive.
For the purposes of the statements of cash flows, the Company considers all time deposits and short-term investments with an original maturity of 90 days or less as equivalent to cash.
The stock-based compensation expense, including restricted common stock issued to employees, for the year ended December 31, 2004 was $295,678.
Funds withheld at interest represents a receivable balance equivalent to the Company’s proportionate share of its ceding companies’ statutory reserves related to policies reinsured by the Company under
reinsurance agreements written on a modified coinsurance or coinsurance funds withheld basis. The premiums received by a ceding company on the policies underlying these types of reinsurance agreements are used to purchase investment securities that are managed by that ceding company or investment managers appointed by it. Net investment income includes the Company’s proportionate share of the investment income and realized capital gains and losses on the sale of investments purchased with those premiums, as well as distributions from the embedded derivatives contained in certain of these agreements.
A portion of the Company’s funds withheld at interest receivable asset contains embedded derivatives, which require bifurcation and separate accounting under SFAS No. 133 - Accounting for Derivative Instruments and Hedging Activities, which the Company adopted as of January 1, 2001. The net fair value of these embedded derivatives is classified as part of the Company’s funds withheld asset on its balance sheet. The change in the fair value of these embedded derivatives is recorded in the Company’s statement of operations as Net change in fair value of embedded derivatives, which is a non-cash item. The Company, with the assistance of outside advisors, has developed a cash flow model to arrive at an estimate of the fair value of these embedded derivatives that uses various assumptions regarding future cash flows under the affected annuity reinsurance contracts. While the Company has made an estimate of the fair value of these embedded derivatives using a model that it believes is appropriate and based upon reasonable assumptions, the assumptions used are subjective and may require adjustment in the future. The Company did not bifurcate and separately account for the embedded derivatives contained in its annuity reinsurance agreement with Transamerica and its guaranteed minimum income benefit reinsurance agreement with CIGNA, because the Company acquired those agreements prior to the transition date it elected under SFAS No. 133, as amended.
The Emerging Issues Task Force (“EITF”) of the FASB issued EITF Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” in late 2003. It contains two aspects that impact the Company. Firstly, it provides details regarding disclosures about unrealized losses on available-for-sale debt and equity securities accounted for under SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities.” These disclosures were effective in annual financial statements for fiscal years ended after December 15, 2003. Secondly, it provides additional guidance for evaluating whether an investment is other-than-temporarily impaired. This guidance was scheduled to be effective for reporting periods beginning after June 30, 2004. However, the FASB has since determined that a delay in the effective date of these provisions was necessary until it can issue additional guidance on the application of EITF Issue No. 03-1. The Company will assess whether this guidance will have a material impact on the Company’s results of operations or financial condition once it is released.
In January 2003, the FASB issued Interpretation No. 46, “Consolidation of Variable Interest Entities” (as amended in December 2003, “FIN 46”), an interpretation of Accounting Research Bulletin No. 51. FIN 46 expands upon and strengthens existing accounting guidance that addresses when a company should include in its financial statements the assets, liabilities and activities of another entity. A variable interest entity is any legal structure used for business purposes that either does not have equity investors with voting rights or has equity investors that do not provide sufficient financial resources for the entity to support its activities. FIN 46 requires a variable interest entity to be consolidated by a company if that company is subject to a majority of the risk of loss from the variable interest entity’s activities or entitled to receive a majority of the entity’s residual returns or both. The consolidation requirements of FIN 46 apply immediately to variable interest entities created after January 31, 2003. The consolidation requirements apply to entities created before January 31, 2003 in the first fiscal year or interim period beginning after March 15, 2004. The effect of the adoption of this new accounting pronouncement did not have any impact on the Company’s consolidated financial statements.
On December 16, 2004, the FASB issued SFAS No. 123 (revised 2004), Share-Based Payment (“SFAS No. 123R”). SFAS No. 123R replaces SFAS No. 123 “Accounting for Stock-Based Compensation” and supersedes APB opinion No. 25 “Accounting for Stock Issued to Employees”. The statement requires all entities to recognize compensation expense in an amount equal to the fair value of share-based payments granted to employees and is effective as of the beginning of the first interim or annual reporting period that begins after June 15, 2005. Since the Company applies fair value accounting to all employee stock options granted or modified subsequent to December 31, 2002, the impact of this statement will be to record compensation expense utilizing fair value accounting for awards vesting on or after July 1, 2005 that were granted on or before December 31, 2002. The Pro forma table in Note 4j illustrates the impact on the Company’s consolidated statement of operations; SFAS No. 123R will have no impact on the Company’s consolidated balance sheet.
(a) The amortized cost and fair values of investments in fixed income securities classified as available for sale at December 31, 2004 and 2003 are as follows:
(b) The following table sets forth certain information regarding the investment ratings of the Company’s fixed income securities portfolio at December 31, 2004 and 2003.
At December 31, 2004, cash and investments of approximately $7,200,000 were held on deposit with various states in which the Company’s U.S. operating subsidiary is licensed to operate in the United States to provide security and meet regulatory requirements.
(1) The Company leases office space in Bermuda and the United States; these leases expire in March 2006 and May 2005, respectively. The Company’s United States operating subsidiary has recently entered into a new lease of office space to replace its existing quarters which came into effect on February 1, 2005 and expires on January 31, 2007.
The Company is authorized to issue 100,000,000 common shares of par value $1.00 each. The common stockholders have no pre-emptive, redemption, conversion or sinking fund rights. Subject to certain voting restrictions, which limit the voting power of United States persons to less than 10%, and non-United States persons to less than 17%, of the combined voting power of the issued voting shares of the Company, each holder is entitled to one vote per share.
In connection with the direct sales of equity securities to certain “Strategic Investors” in connection with the Company’s initial public offering, the Company issued Class B Warrants that initially enabled the holders to purchase an aggregate of 397,500 common shares of the Company. The initial exercise price of the Class B Warrants was $15.00 per share, which was equal to the price of the common shares in the initial public offering. As the result of our issuance of warrants to Hartford Life and CIGNA, discussed below the effect of anti-dilution adjustment provisions in the Class B Warrants has increased the number of shares issuable upon exercise of the Class B Warrants to 424,198 common shares and the exercise price of the Class B Warrants has been adjusted to $14.06. The Class B Warrants are all currently exercisable and expire on April 15, 2008. No Class B Warrants had been exercised at December 31, 2004.
On June 30, 2003, the Company issued warrants to purchase an aggregate one million common shares of the Company at an exercise price of $1.25 per share to Hartford Life, the ceding company under the Company’s then largest guaranteed minimum death benefit reinsurance agreement. The warrants were issued in connection with the recapture of that agreement and expire on June 30, 2013, and are currently exercisable. At June 30, 2003, the fair value of these warrants, using a Black-Scholes pricing model, was estimated at $1,250,000, which was included in a charge associated with the recapture that the Company recorded during the second quarter of 2003 as a component of Claims and policy benefits expense. The expense of issuing these warrants is presented as Stock warrants in the stockholders’ equity section of the Company’s consolidated balance sheet as at December 31, 2004.
In connection with the recapture of the Company’s GMDB/GMIB reinsurance agreement with CIGNA on October 26, 2004, the Company issued CIGNA a warrant dated as of September 30, 2004 to acquire one million common shares of the Company at an exercise price of $1.00 per share. The warrant expires on September 30, 2014 and is currently exercisable. At September 30, 2004, the fair value of this warrant, using a Black-Scholes pricing model, was estimated at $100,000, which was included in a charge associated with the recapture that the Company recorded during the third quarter of 2004 as a component of Claim and policy benefits expense. The expense of issuing this warrant is presented as Stock warrants in the stockholders’ equity section of the Company’s consolidated balance sheet as at December 31, 2004.
The following table sets forth the computation of basic and diluted loss per common share for the year ended December 31:
As of December 31, 2004, 2003, and 2002 the Company had 719,035, 955,869, and 1,144,535 stock options outstanding, respectively. There were Class A and Class B warrants outstanding representing the right to acquire 3,689,713 shares, 3,565,216 shares and 3,457,490 shares as of December 31, 2004, 2003,
and 2002, respectively. Warrants issued to Hartford Life to acquire 1,000,000 shares were outstanding at December 31, 2003 and 2004. Warrants issued to CIGNA to acquire 1,000,000 shares were outstanding at December 31, 2004.
In accordance with the Company’s Amended and Restated Bye-laws, the Company indemnifies its officers and directors to the fullest extent permissible under Bermuda law. Pursuant to the Bye-laws, the Company will make payments for the expenses incurred in connection with defending any action for which indemnification has properly been sought. In connection with a purported shareholder class action lawsuit (as discussed in Note 3) filed against the Company and certain of its current and former officers and directors, the Company had, as of December 31, 2004, made payments of approximately $140,000 and $53,000 to John F. Burke, its Chief Executive Officer and a director, and Frederick S. Hammer, the non-executive Chairman of its Board of Directors, respectively, for payment of their expenses related to defending this lawsuit. Payments on behalf of Mr. Burke during the year ended December 31, 2004 were approximately $37,000. Payments on behalf of Mr. Hammer during the year ended December 31, 2004 were approximately $4,000.
The Company has a retrocession agreement that generally enables it to limit the amount of life reinsurance it retains to $1,000,000 per single life. The contract is automatic and effective for risks assumed and in force from January 1, 1997. At December 31, 2004 and 2003, the Company had ceded approximately $342 million and $380 million of in force insurance coverage, respectively, to other reinsurers. Total amounts of $102,000 and $465,000 were recoverable from reinsurers at December 31, 2004 and 2003, respectively, and were recorded in other reinsurance receivables on the Company’s balance sheets.
The United States Internal Revenue Service (“IRS”) is currently conducting an audit of the Company’s United States operating subsidiaries. Those companies currently have a significant tax based net operating loss carryforward. In addition, the IRS has requested certain information and documents related to the Company’s Bermuda operations. While the Company’s United States operating subsidiaries have complied with the IRS’ requests for information, both the Company and its Bermuda operating subsidiary have declined to supply the IRS with certain information in response to its initial requests for information on May 7, 2002 and July 1, 2002. The Company did provide the IRS with certain publicly available information in addition to minutes of the Board of Directors meetings and committee meetings held from 1999 through to 2001. The Company has not received any additional requests for information since July 1, 2002. If the IRS were to determine that the Company or its Bermuda operating subsidiary were engaged in business in the United States, those entities could be subject to United States tax at regular corporate rates on their taxable income that is attributable to a permanent establishment, if any, in the United States plus an additional 30% “branch profits” tax on such income remaining after the regular tax. Such taxes would have a material effect on the Company’s results of operation and financial condition.
As discussed in Note 11, 100% of Annuity and Life Reassurance America’s life and annuity policies that were in force prior to the Company’s acquisition of Capitol Bankers Life Insurance Company were reinsured with Reassure. Following the acquisition, the policies continue to be 100% reinsured with Reassure; however, Annuity and Life Reassurance America remains the primary carrier. Reassure is required to indemnify Annuity and Life Reassurance America for any losses associated with these policies. However, Annuity and Life Reassurance America Inc is not discharged from its primary liability as the direct insurer of the risks reinsured should Reassure become default on its obligations. Reserves ceded under its reinsurance agreement amounted to approximately $82.2 million and $88.2 million at December 31, 2004 and December 31, 2003, respectively. As of December 31, 2004, Reassure is rated A+ (g) (superior) by A.M. Best.
Fair values for fixed income securities are based on quoted market prices, where available. For fixed income securities not actively traded, fair values are estimated using values obtained from independent pricing services.
The carrying value of assets classified as cash and cash equivalents approximates fair value.
Fair value disclosures are not required for reinsurance balances recoverable, deferred policy acquisition costs, or liabilities arising from insurance and annuity contracts. As a result, the Company has not
determined such disclosures. Fair values of other assets and liabilities approximate their carrying values due to their short-term nature.
We separately track financial results of our life and annuity operations in segments. Each segment is defined by a dominant risk characteristic inherent in all products in that segment. The life segment consists of all products where the dominant risk characteristic is mortality risk. The annuity segment comprises all products where the dominant risk characteristic is investment risk, including those products which provide minimum guarantees on variable annuity products. In addition, since January 1, 2001, certain of the Company’s modified coinsurance and coinsurance funds withheld annuity reinsurance agreements have features that constitute embedded derivatives that require bifurcation and separate accounting under SFAS No. 133 - Accounting for Derivative Instruments and Hedging Activities. The cumulative effect of the application of SFAS No. 133 through January 1, 2001 and the change in the fair value of these embedded derivatives since that date are included in the annuity segment.
Both the life and annuity segments have specific assets, liabilities, stockholder’s equity, revenue, benefits and expenses that apply only to them. The corporate segment contains all stockholders’ equity not otherwise deployed to the life or annuity segment. In addition, the corporate segment includes all capital gains and losses from sales of securities in our portfolio and investment income on undeployed invested assets. Operating expenses are generally allocated to the segments proportionately based upon the amount of stockholders’ equity deployed to the segment. Costs associated with our efforts to raise capital and pursue other strategic alternatives and the anticipated costs of settling the purported shareholder class action lawsuit have been completely allocated to the corporate segment.
Annuity and Life Re America and Annuity and Life Reassurance America, the Company’s United States operating subsidiaries, are subject to all applicable Federal and State taxes of the United States. U.S. income taxes applicable to the Company’s U.S. operations are not material to the consolidated financial statements and, therefore, no separate item appears on the income statement or balance sheet. At December 31, 2004 and 2003 the Company had recorded a deferred tax liability of $250,000 and $377,000, respectively, related to U.S. income taxes on unrealized gains on investments held by its U.S. operations. These deferred tax amounts have been netted against the unrealized gains in computing other comprehensive loss in the consolidated statements of operations.
reasonable time period. Therefore, the Company has established valuation allowances of $3,672,000 and $3,818,000 at December 31, 2004 and 2003, respectively, against its deferred tax asset.
The Company and Annuity and Life Reassurance are required to comply with the provisions of the Companies Act that regulate the payment of dividends and the making of distributions from contributed surplus. Neither the Company nor Annuity and Life Reassurance may declare or pay a dividend, or make a distribution out of contributed surplus, if there are reasonable grounds for believing that: (i) the relevant company is, or would be after the payment, unable to pay its liabilities as they become due; or (ii) the realizable value of the relevant company’s assets would thereby be less than the aggregate of its liabilities and its issued share capital and share premium accounts. As of and since December 31, 2002, the Company has not declared a dividend. The Company’s ability to pay dividends depends on the ability of its operating subsidiaries to pay dividends to the Company, which may be subject to regulatory constraints that affect their ability to pay dividends to the Company.
Annuity and Life Reassurance America, Inc is subject to statutory regulations of the state of Connecticut of the United States that restrict the payment of dividends. It may not pay dividends in any 12-month period in excess of the greater of the statutory net gain from operations for the immediately proceeding calendar year excluding pro rata distributions of any class of Annuity and Life Reassurance America’s securities or 10% of Annuity and Life Reassurance America’s statutory surplus as regards policyholders as of the immediately preceding December 31 at the end of the preceding year, without regulatory approval. Connecticut regulations also require that dividends be paid from earned surplus unless prior regulatory approval is granted. At December 31, 2004 the statutory capital and surplus of Annuity and Life Reassurance America was $10,766,000.