Adjusted net operating income reflects net income adjusted to eliminate certain items (net of applicable income taxes and minority interest) which our management believes are not indicative of overall operating trends, including net realized gains or losses on investments. Different items are likely to occur in each period presented and others may have different opinions as to which items may warrant adjustment. The adjusted net operating income shown does not constitute net income computed in accordance with GAAP. See additional description of Adjusted Net Operating Income included in
The following analysis of the consolidated financial condition and results of operations of AmerUs Group Co. should be read in conjunction with the Selected Financial Data and Consolidated Financial Statements and related notes.
Total assets increased $2.0 billion during 2002 primarily as a result of the placement of funding agreements totaling $875 million, growth in annuity sales, net of surrenders, and increased investment market values. Total assets increased $6.8 billion during 2001 primarily due to the acquisition of ILICO.
Stockholders’ equity, excluding accumulated other comprehensive income (AOCI), declined $51.4 million in 2002 as a result of treasury stock purchases of $112.1 million and dividends of $15.5 million. The stock
repurchases and dividends were partially offset by an increase in equity for 2002 net income of $62.9 million. Stockholders’ equity, excluding AOCI, increased $380.7 million in 2001, primarily due to the issuance of $232.4 million worth of stock in connection with the acquisition of ILICO, the issuance of $127.5 million of stock in connection with the conversion of capital securities, and net income. Treasury stock purchases in 2001 were $45.0 million.
The following table reflects net income adjusted to eliminate certain items which management believes do not necessarily indicate overall operating trends. Adjusted net operating income is the basis we use to assess our overall performance. Adjusted net operating income as described by us may not be comparable to similarly titled measures reported by other companies, including insurance companies. The adjusted net operating income shown below does not constitute net income computed in accordance with GAAP. The adjustments are presented net of income taxes. In addition, the adjustments for 2000 and prior years are also presented after minority interest.
Represents amortization of DAC and value of business acquired (VOBA) on the non-core realized gains or losses that are included in our product margins.
Represents costs directly related to our demutualizations. The costs consist primarily of legal, actuarial and consulting expenses.
Represents the net income from our residential financing and property operations which is not part of our insurance operations.
Represents the cumulative effect of change in accounting for derivatives, as of January 1, 2001, resulting from our adoption of SFAS 133.
The increase in adjusted net operating income in 2002 compared to 2001 was primarily attributable to the acquisition of ILICO which operations have been included in our consolidated financial statements since May 18, 2001 and the growth in our protection products and accumulation products segments as explained in the next two sections. The increase in adjusted net operating income in 2001 compared to 2000 was primarily due to the acquisition of ILICO and the reduction in income applicable to the minority interests.
We use the same accounting policies and procedures to measure operating segment income as we use to measure consolidated income from operations with the exception of the elimination of certain items which management believes are not necessarily indicative of overall operating trends. These items are shown between adjusted pre-tax operating income and income from continuing operations on the following operating segment tables and are as follows:
2) Market value changes and amortization of assets and liabilities associated with the application of SFAS 133, such as:
Our protection products segment consists of whole life, interest-sensitive whole life, term life, universal life and equity-indexed life insurance policies. These products are marketed on a national basis primarily through a Preferred Producer agency system, PPGA distribution system and IMOs. Included in protection products is the closed block of ALIC and the closed block of ILIC established when the companies reorganized from mutual forms to stock forms of ownership. When protection products are sold, we invest the premiums we receive in our investment portfolio and establish a liability representing our commitment to the policyholder. We manage investment spread by seeking to maximize the return on these invested assets, consistent with our asset/ liability and credit quality needs. Protection products in force totaled $80.0 billion at December 31, 2002, $70.5 billion at December 31, 2001 and $36.2 billion at December 31, 2000. A summary of our protection products segment operations follows:
sensitive whole life and equity-indexed life products were $76.5 million in 2002 as compared to $33.6 million in 2001 and $7.1 million in 2000. We are a leading writer of equity-indexed life products in the United States.
Mortality and Benefit Expense. For 2002 and 2001, we experienced favorable mortality but, due to the acquisition of ILICO, total benefit expense is higher than in the respective prior years. Total policyowner benefits for ILICO were $186.9 million for the full year of 2002 and $127.4 million for the portion of the year after its acquisition in May 2001. In addition, we had increased reinsurance recoveries in 2002 and 2001, which decrease benefit expense, as a result of the additional reinsurance arrangements entered into in 2002, 2001 and 2000.
Underwriting, Acquisition and Other Expenses. Expenses increased in 2002 and 2001 compared to the respective prior years, primarily due to the acquisition of ILICO. The addition of expenses associated with ILICO of $30.1 million and $19.5 million for 2002 and 2001, respectively, were partially offset by increased reimbursement from reinsurers for commission and expense allowances. Commission and expense allowances increased as more policies were subject to reinsurance. In addition, expenses decreased due to expense structure changes resulting from the integration with ILICO.
continue to realize operating efficiencies created by the restructuring and centralization of our administrative functions as discussed later in “Non-recurring Expenses.”
Adjusted pre-tax operating income from our accumulation products operations increased 26% in 2002 and 9% in 2001 compared to the respective prior years. The increases in 2002 and 2001 were primarily due to the acquisition of ILICO in 2001 and increased IMO operating income. In addition, the increase in 2002 was also due to the discontinuation of goodwill amortization. The drivers of profitability in our accumulation products business are sales, persistency, investment spread, expenses and IMO operations.
return for the duration of the contract. Total funding agreements as of December 31, 2002 amounted to $1.125 billion compared to $250 million at December 31, 2001 and 2000.
The deposits we receive on accumulation products are not recorded as revenue but instead as a policyholder liability. Surrender charges are recorded as revenue as an annuity product charge. Annuity product charges increased in 2002 and 2001 as compared to each prior year due to the growth in business and the acquisition of ILICO.
Investment Spread. Investment results and interest crediting rates were as follows for deferred fixed annuities:
Outlook. We anticipate increased product sales from our IMOs but decreased product sales from other distribution as we manage our sales in this current low interest rate environment. We also expect to continue the shift of our product mix to higher return products, in particular the equity-indexed annuity products. In addition, we will continue to manage our spreads as we strive for our desired profitability in this economic environment.
The other segment primarily consists of holding company revenues and expenses and operations of our real estate management subsidiary. The adjusted pre-tax operating loss in 2002 as compared to the adjusted pre-tax operating income in 2001 is primarily due to real estate investment and management fee income which continue to decline as we reduce these investment holdings and a decline in investment fee income for asset management services provided to ILICO prior to the acquisition amounting to $2.8 million in 2001 and $2.6 million in 2000. After the acquisition of ILICO, such fees are eliminated with expenses in consolidation. Also, other segment income declined in 2001 compared to 2000 from the reduction in holding company cash equivalents of approximately $340 million generated primarily from the sale of discontinued operations in 1998 and distributed to our members in connection with our demutualization in October 2000.
A reconciliation of our adjusted pre-tax operating income by segment to net income as shown in our consolidated statements of income follows:
The fair value change in options embedded within our equity-indexed products and the fair value changes on our total return strategy fixed annuity contracts are being recorded in accordance with SFAS No. 133, which we adopted January 1, 2001. As previously discussed, these fair value changes are offset by similar adjustments to unrealized gains (losses) on investments related to the fair value changes on the options that hedge the equity-indexed products and on the trading securities that back the total return strategy products. The reduction in such contract expense is less than the decline in investment income primarily due to the inability to lower crediting rates below minimum guaranteed interest rates.
Non-recurring Expenses. The 2000 demutualization costs consist primarily of legal, actuarial and consulting expenses associated with our demutualization that was completed in the third quarter of 2000. The 2001 demutualization costs are associated with the demutualization of ILIC, which was completed when we acquired ILICO in May 2001. As a requirement of ILIC’s demutualization, we undertook a commission-free program under which shareholders with less than one hundred shares could redeem those shares for cash or purchase additional shares, commission-free, to reach a holding of at least one hundred shares. The 2002 costs are primarily for commissions, postage and printing under this program. Since these costs are not ongoing, they have been excluded from our operating segment amounts.
Minority Interest. Minority interest represents the minority stockholders’ ownership percentage share of net income of ALHI prior to our acquisition of this minority interest. The minority shareholder ownership percentage was 42% through September 20, 2000, the date at which the minority interest was acquired. As a result of our acquisition of the minority interest, there is no net income applicable to the minority interest after 2000.
We intend to rely primarily on dividends and interest income from our insurance subsidiaries in order to make dividend payments to our shareholders. The payment of dividends by our insurance subsidiaries is regulated under various state laws. Generally, under the various state statutes, our insurance subsidiaries’ dividends may be paid only from the earned surplus arising from their respective businesses and must receive the prior approval of the respective state regulator to pay any dividend that would exceed certain statutory limitations. The current statutes generally limit any dividend, together with dividends paid out within the preceding 12 months, to the greater of (i) 10% of the respective company’s policyowners’ statutory surplus as of the preceding year end or (ii) the statutory net gain from operations for the previous calendar year. Generally, the various state laws give the state regulators discretion to approve or disapprove requests for dividends in excess of these limits. Based on these limitations and 2001 results, our life insurance subsidiaries
could have paid us an estimated $80.5 million in dividends in 2002 without obtaining regulatory approval. Our subsidiaries paid us $20.6 million in 2002. Based on 2002 results, our subsidiaries can pay an estimated $82.3 million in dividends without obtaining regulatory approval during 2003. We also consider risk-based capital levels, capital and liquidity operating needs, and other factors prior to paying dividends from the insurance subsidiaries.
We generated cash flows from operating activities of $920.1 million, $97.1 million and $373.3 million for the years ended December 31, 2002, 2001, and 2000, respectively. Operating cash flows were primarily used to increase our investment portfolio.
We have a $175 million revolving credit facility with a syndicate of lenders (which we refer to as the Revolving Credit Agreement). As of December 31, 2002, there was a $113 million outstanding loan balance under the facility. The Revolving Credit Agreement provides for typical events of default and covenants with respect to the conduct of business and requires the maintenance of various financial levels and ratios. Among other covenants, we (a) cannot have a leverage ratio greater than 0.35:1.0, (b) cannot have an interest coverage ratio less than 2.50:1.0, (c) are prohibited from paying cash dividends on common stock in excess of an amount equal to 3% of consolidated net worth as of the last day of the preceding fiscal year, and (d) must cause our insurance subsidiaries to maintain certain levels of risk-based capital. We closely monitor all of these covenants to ensure continued compliance.
On March 6, 2002, we issued and sold in a private placement $185 million aggregate original principal amount of OCEANs. The OCEANs are senior subordinated debt and were issued and sold in an original principal amount of $1,000 per OCEAN, with a principal amount at maturity of $1,270 per OCEAN. The maturity date of the OCEANs is March 6, 2032. The OCEANs will have aggregate principal amount at maturity of $235 million. The notes are convertible into shares of AmerUs Group Co.’s common stock at an initial conversion price (subject to adjustment) of $37.60 per share only if the sale price of the common stock exceeds $47.85 per share for at least 20 trading days in a 30-day trading period or in certain other limited circumstances. The OCEANs were registered on Form S-3 filed with the Securities and Exchange Commission on September 20, 2002.
In addition, we use reinsurance agreements, where cost-effective, to generate capital in the insurance subsidiaries. We also focus on optimizing the consolidated capital structure to properly balance the levels and sources of borrowing and the issuance of equity securities. We are currently exploring additional alternatives for increasing liquidity.
Includes $1,126 million of statutory liabilities with a contractual surrender charge of less than five percent of the account balance.
In addition to the interest-sensitive products, an insurance subsidiary is party to a $250 million fixed rate funding agreement. Under the transaction, a five-year floating rate insurance contract was issued to a commercial paper conduit and the liability was swapped to a fixed-rate. During 2002, our insurance subsidiaries placed additional funding agreements totaling $875 million primarily in six to ten year fixed rate insurance contracts. The assets backing the funding agreements are legally segregated and are not subject to claims that arise out of any other business of the insurance subsidiaries. The funding agreements are further backed by the general account assets of the insurance subsidiaries. The segregated assets and liabilities are included with general account assets in the financial statements. The funding agreements may not be cancelled unless there is a default under the agreement, but the insurance subsidiaries may terminate the agreement at any time.
In addition, there are variable separate account assets and liabilities representing funds that are separately administered, principally for variable annuity contracts, and for which the contractholder bears the investment risk. Separate account assets and liabilities are reported at fair value and amounted to $235.9 million at December 31, 2002. Separate account contractholders have no claim against the assets of the general account. The operations of the separate accounts are not included in the accompanying consolidated financial statements.
Through their respective memberships in the Federal Home Loan Banks (FHLB) of Des Moines and Topeka, ALIC and American Investors Life Insurance Company, Inc. are eligible to borrow under variable-rate short term fed funds arrangements to provide additional liquidity. These borrowings are secured and interest is payable at the current rate at the time of each advance. There were no borrowings under these arrangements outstanding at December 31, 2002. In addition, ALIC has long-term fixed rate advances from the FHLB outstanding of $13.9 million at December 31, 2002.
The level of capital in the insurance companies is also regulated by risk-based capital formulas and is monitored by rating agencies. In order to maintain appropriate capital levels, it may be necessary from time to time for AmerUs Group Co. to provide additional capital to the insurance companies.
In the current economic environment, including the decline in the interest rates and in the bond and equity markets, insurance regulators are closely monitoring the capital and liquidity position of insurance companies in their periodic financial examinations. One of our insurance subsidiaries which is no longer writing new business is now under its periodic financial examination and is involved in discussions with state examiners concerning its capital position. The Company believes that these discussions will be concluded without any material effect upon the Company’s consolidated financial position or results of operation, but that some contribution of capital to that subsidiary may be appropriate.
We have an agreement with Bank One, N.A. whereby we guarantee the payment of loans made to certain managers and executives for the purpose of purchasing common stock and ACES pursuant to the stock purchase program. Our liability in respect of the principal amount of loans is limited to $20.1 million. We have also guaranteed interest and all other fees and obligations owing on the loans. Each participant in the program has agreed to repay any amounts paid by us under the guarantee in accordance with a reimbursement agreement with the participant. This agreement was entered into in 1999, prior to the restrictions imposed by the Sarbanes-Oxley Act regarding loans with executive officers.
We have obligations to make future capital contributions to various partnerships of up to $3.1 million and to loan funds up to $6.9 million to partnerships. In addition, at December 31, 2002, we had loan guarantees which totaled $6.1 million.
Our investment philosophy is to employ an integrated asset/liability management approach with separate investment portfolios for specific product lines, such as traditional life, universal life, equity-indexed life, deferred fixed annuities, equity-indexed annuities, variable annuities and funding agreements to generate attractive risk-adjusted returns on capital. Essential to this philosophy is coordinating investments in the investment portfolio with product strategies, focusing on risk-adjusted returns and identifying and evaluating associated business risks.
The fixed maturity securities portfolio consists primarily of investment grade corporate fixed maturity securities, high-quality mortgage-backed securities (or MBS) and United States government and agency obligations. As of December 31, 2002, fixed maturity securities were $15,172.8 million, or 89.6% of the carrying value of invested assets with public and private fixed maturity securities constituting $13,573.6 million, or 89.5%, and $1,599.2 million, or 10.5%, respectively, of total fixed maturity securities, respectively.
The following table summarizes the composition of the fixed maturity securities by category as of December 31, 2002 and 2001:
The portfolio of investment grade fixed maturity securities is diversified by number and type of issuer. As of December 31, 2002, investment grade fixed maturity securities included the securities of 903 issuers, with 2,761 different issues of securities. No non-government/agency issuer represents more than 1% of investment grade fixed maturity securities.
As of December 31, 2002, 82.8% of total invested assets were investment grade fixed maturity securities. The following table sets forth the credit quality, by NAIC designation and Standard & Poor’s rating equivalents, of fixed maturity securities as of December 31, 2002:
MBS investments are mortgage-related securities including collateralized mortgage obligations (or CMOs) and pass-through mortgage securities. Asset-backed securities are both residential and non-residential including exposure to home equity loans, home improvement loans, manufactured housing loans as well as securities backed by loans on automobiles, credit cards, and other collateral or collateral bond obligations. As of December 31, 2002, asset-backed residential mortgages total $496.9 million or 2.9% of total invested assets. As of December 31, 2002, residential mortgage pass-through and CMOs total $2,391.3 million or 14.1% of total invested assets. As of December 31, 2002, $2,118.9 million or 88.6% of MBS were from government sponsored enterprises. Other MBS were $272.4 million or 11.4% of MBS as of December 31, 2002. Management believes that the quality of assets in the MBS portfolio is generally high, with 99.7% of such assets representing agency backed or “AAA” rated securities. Collateralized mortgage backed securities (or CMBS) total $682.3 million or 4.0% of total invested assets as of December 31, 2002.
We held $496.8 million of policy loans on individual insurance products as of December 31, 2002. Policy loans are permitted to the extent of a policy’s contractual limits and are fully collateralized by policy cash values. As of December 31, 2002, we held equity securities of $63.3 million of which the largest holding was Federal Home Loan Bank common stock totaling $50.3 million.
We held $283.8 million of other invested assets (including short-term investments and real estate) on December 31, 2002. Other invested assets consist primarily of our Ameritas Joint Venture investment, various other joint ventures and limited partnership investments and derivatives.
Interest rate changes may have temporary effects on the sale and profitability of the protection products and accumulation products offered. For example, if interest rates rise, competing investments (such as annuities or life insurance products offered by competitors, certificates of deposit, mutual funds, and similar instruments) may become more attractive to potential purchasers of our products until we increase the interest rate credited to owners of our protection products and accumulation products. In contrast, as interest rates fall, we attempt to adjust credited rates to compensate for the corresponding decline in reinvestment rates. We monitor interest rates and sell annuities and life insurance policies that permit flexibility to make interest rate changes as part of management of interest spreads. However, the profitability of our products is based upon persistency, mortality and expenses, as well as interest rate spreads.
We manage our investment portfolio in part to reduce exposure to interest rate fluctuations. In general, the market value of our fixed maturity portfolio increases or decreases in an inverse relationship with fluctuations in interest rates, and net investment income increases or decreases in a direct relationship with interest rate changes.
rate risk through active management of the investment portfolio. Financial, actuarial, investment, product development and product marketing professionals work together throughout the product development, introduction and management phases to jointly develop and implement product features, initial and renewal crediting strategies, and investment strategies based on extensive modeling of a variety of factors under a number of interest rate scenarios.
AmerUs Group and our non-life subsidiaries file a consolidated federal income tax return. The life insurance subsidiaries file separate federal income tax returns, except for ILIC, Bankers Life and IL Annuity which together file a consolidated tax return beginning in 2002. The separate return method is used to compute the provision for allocating federal income taxes. Deferred income tax assets and liabilities are determined based on differences among the financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws.
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities. The following are considered our critical accounting policies due to their subjective nature and significance to the financial statements.
Hedge accounting results when we designate and document the hedging relationships involving derivative instruments. Economic hedging instruments are those instruments whose change in fair value acts as a natural hedge against the change in fair value of hedged assets or liabilities with both changes wholly or partially being offset in earnings.
To hedge equity market risk, we primarily use S&P 500 Index call options to hedge the growth in interest credited to the customer as provided by our equity-indexed life and annuity products. We also use interest rate swaps to effectively provide for fixed interest payments of a floating rate funding agreement liability and hedge market risk from fixed income investments. Credit default swaps are coupled with a bond to synthetically create an instrument cheaper than an equivalent investment traded in the cash market.
We amortize the VOBA based on the incidence of the expected cash flows from insurance contracts using the interest rate credited to the underlying policies. The expected future cash flows are based on actuarially determined projections of future premium receipts, mortality, surrenders, operating expenses, changes in insurance liabilities, investment yields on the assets retained to support the policy liabilities and other factors. These projections take into account all factors known or expected by management. The actual cash flows may vary from expected levels due to differences in renewal premium, investment spread, investment gains or losses, mortality and morbidity costs and other factors.
The excess of the purchase price over the fair value of the net assets acquired for ILICO was recorded as goodwill amounting to $36 million.
SFAS 142 requires goodwill and intangible assets with indefinite useful lives to no longer be amortized but instead tested for impairment at least annually. The evaluation of the impairment analysis for goodwill and other intangible assets, principally VOBA, was completed in 2002 with no impairment indicated as of January 1, 2002. In addition, a reassessment was performed as of October 1, 2002 in conjunction with our annual evaluation which resulted in no indication of impairment of goodwill or other intangible assets. See note 17 to the consolidated financial statements for additional information regarding the adoption of SFAS 142.
In January 2003, the Financial Accounting Standards Board issued FASB Interpretation No. 46, “Consolidation of Variable Interest Entities,” an Interpretation of ARB 51, or FIN 46. FIN 46 provides guidance to identify variable interest entities, or VIEs, and their consolidation by a primary beneficiary. A VIE is defined as an entity in which either 1) the equity investors, if any, do not have a controlling financial interest, or 2) the equity investment at risk is insufficient to finance that entity’s activities without receiving additional subordinated financial support from other parties. An enterprise whose investment in a VIE absorbs the majority of the VIE’s expected losses or receives a majority of its expected residual returns is considered a primary beneficiary, although not all VIEs will have a primary beneficiary. FIN 46 requires primary beneficiaries to consolidate VIEs in their financial statements and also requires additional disclosures for enterprises which are not primary beneficiaries but which have a significant variable interest in a VIE. The provisions of FIN 46 are effective immediately for VIEs created after January 31, 2003 and is to be applied in the first interim period beginning after June 15, 2003 for interests in VIEs acquired before February 1, 2003. The additional disclosure is required for financial statements issued after January 31, 2003. At December 31, 2002, we held interests in structured securities arrangements which meet the definition of VIEs. We would be considered the primary beneficiary for several of those structured securities, which if consolidated at December 31, 2002, would result in an increase in total assets of $167 million, an increase in total liabilities of $154 million and an increase in total stockholders’ equity of $13 million. See note 3 to the consolidated financial statements for disclosures and additional information related to our VIE interests.