Allstate Life of New York occupies office space in Farmingville, New York and Northbrook, Illinois.
The following discussion highlights significant factors influencing results of operations and financial position of the Company. It should be read in conjunction with the financial statements and related notes. To conform to the 2002 presentation, certain prior year amounts have been reclassified.
In addition to information presented in the financial statements, the Company uses information other than that determined using accounting principles generally accepted in the United States of America ("GAAP") to analyze and report its financial position and results of operations. Management believes that these non-GAAP and operating measures, when used in conjunction with the financial statements, can improve the understandability of the financial statements and allow readers to evaluate the information used by management to analyze company performance.
OPERATING INCOME is a non-GAAP measure used by the Company's management to supplement its evaluation of Net income. Operating income is "Income before cumulative effect of change in accounting principle, after-tax" excluding the effects of Realized capital gains and losses, after-tax. In this computation, Realized capital gains and losses, after-tax is presented net of the effects of deferred policy acquisition costs amortization and additional future policy benefits, to the extent that such effects resulted from the recognition of realized capital gains and losses.
Management believes that the supplemental Operating income information presented below allows for a more complete analysis of results of operations. The net effect of Realized capital gains and losses have been excluded due to their volatility between periods and because such data is often excluded when evaluating the overall financial performance of insurers. Operating income should not be considered as a substitute for any GAAP measure of performance. This method of calculating Operating income may be different from the method used by other companies and therefore comparability may be limited. A reconciliation of Operating income to Net income for the years ended December 31, is presented in the following table:
The Company, a wholly owned subsidiary of ALIC, which is a wholly owned subsidiary of AIC, a wholly owned subsidiary of the Corporation, markets a diversified group of products to meet customers' lifetime needs in the areas of financial protection and retirement solutions in the State of New York through exclusive Allstate agencies, financial services firms, direct marketing and specialized brokers. The Company's products include term life insurance; whole life and universal life insurance; annuities such as fixed annuities, market value adjusted annuities and treasury-linked annuities; variable annuities; immediate annuities; and other protection products such as accidental death and hospital indemnity.
The Company has identified four of its accounting policies that, due to their nature, have required management to make assumptions and estimates that are significant to the financial statements at December 31, 2002. It is reasonably likely that changes in these assumptions and estimates could occur from period to period, and have a material impact on the Company's financial statements.
A brief summary of each of these critical accounting policies follows. For a more complete discussion of the judgments and other factors affecting the measurement of these policies, see the referenced sections of Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A"). There is also a complete summary of the Company's significant accounting policies in Note 2 of the financial statements.
INVESTMENTS- Fixed income securities include bonds and mortgage-backed and asset-backed securities. All fixed income securities are carried at fair value and are classified as available for sale. The fair value of publicly traded fixed income securities is based on independent market quotations. The fair value of non-publicly traded securities, primarily privately placed corporate obligations, is based on either widely accepted pricing valuation models which utilize internally developed ratings and independent third party data (e.g., term structures and current publicly traded bond prices) as inputs or independent third party pricing sources. The valuation models use indicative information such as ratings, industry, coupon, and maturity along with related third party data and publicly traded bond prices to determine security specific spreads. These spreads are then adjusted for illiquidity based on historical analysis and broker surveys. Periodic changes in fair values are reported as a component of Accumulated other comprehensive income on the Statements of Financial Position and are reclassified to Net income only when supported by the consummation of a transaction with an unrelated third party, or when declines in fair values are deemed other than temporary.
These risks and uncertainties could result in a charge to earnings in future periods to the extent that losses are realized. The charge to earnings, while potentially significant to Net income, would not have a significant impact on Shareholder's equity since the majority of the portfolio is held at fair value and as a result, the related unrealized gain (loss), net of tax, would already be reflected as Accumulated other comprehensive income in Shareholder's equity. For a further discussion of these policies, and quantification of the impact of these estimates and assumptions, see the Investments, Market risk and Forward-looking statements and risk factors sections of the MD&A.
The fair value of the Company's exchange traded derivative contracts is based on independent market quotations. The fair value of non-exchange traded derivative contracts is based on valuation models which utilize independent third party data as inputs. Periodic changes in the fair values are reported as a component of Net income or liabilities depending on the nature of the derivative and the program to which it relates. For further discussion of these policies, and quantification of the impact of these estimates and assumptions, see the Investments, Market risk and Forward-looking statements and risk factors sections of the MD&A.
For interest-sensitive life insurance, variable annuities and investment contracts, DAC is amortized in relation to the present value of estimated gross profits ("EGP") on such business over the estimated lives of the contracts. Generally, the amortization period ranges from 15-30 years, however an assumed surrender rate is also used which results in the majority of deferred costs being amortized over the surrender charge period. The rate of amortization during this term is matched to the pattern of EGP. EGP consists of the following components: margins from mortality, including guaranteed minimum death and income benefits, investment margin, including realized capital gains and losses, contract administration, surrender and other contract charges, less maintenance expenses. The estimation of EGP requires judgment, including the forecasting of highly uncertain events such as the level of surrenders at the end of a surrender charge period and, in some cases, future equity market performance. In estimating the impact of highly uncertain events, the Company considers historical experience as well as current trends.
FINANCIAL HIGHLIGHTS Summarized financial data and key operating measures for the years ended and as of December 31, are presented in the following table.
(1)Under GAAP accounting requirements, only those immediate annuities with life contingencies are recognized in premiums. Those without life contingencies, called period certain, are recorded directly as liabilities and generate contract charges and investment margin.
Contract charges increased 21.4% in 2002 compared to 2001 due primarily to increased contract charges on interest-sensitive life insurance resulting from increased customer account values. Variable annuity contract charges increased 11.6% due to fees received on new deposits more than offsetting the impact of declines in account values resulting from poor equity market performance. Contract charges on variable annuities are generally calculated as a percentage of account value. Variable annuities are typically invested in equity mutual funds and therefore contract charges assessed as a percentage of account value are impacted by equity market volatility. Contract charges on other investment contracts decreased 14.7% compared to prior year.
Premiums and deposits increased $259.4 million or 37.7% in 2002 as compared to 2001. In 2002, fixed annuities increased 70.3% from increased sales in the financial services firms channel and increased focus on investment products sold within the Allstate agencies channel. Variable annuity sales increased 49.6% in 2002 compared to 2001. Attractive crediting rates on the variable annuity products' fixed funds drove additional sales in most distribution channels, while an increase in the number of Allstate agents licensed to sell variable annuity products increased their variable annuity sales to new record levels. Interest-sensitive life insurance and other life products increased 15.3% and 3.0%, respectively, compared to 2001, as consumer preference for interest-sensitive life insurance continues to replace traditional whole life insurance contributing to the 17.1% decrease in traditional life products premiums.
INVESTMENT MARGIN, which represents the excess of investment income earned over interest credited to policyholders and contractholders, increased 14.0% during 2002 compared to 2001. The increased investment margin is a result of growth in portfolio balances of 24.3% as of December 31, 2002 compared to December 31, 2001. This portfolio growth is a result of new sales of fixed and immediate annuities. The impact of greater portfolio balances was partly offset by a decline in portfolio yields from lower market interest rates affecting the yield on the investment of cash flows from operations and investments. Another development affecting investment margin was a shift to sales of investment products with lower investment margins such as market value adjusted annuities. Management actions taken in 2002 and 2001 to reduce crediting rates, where contractually allowed, have partially offset the impact on investment margin from the decline in portfolio yields.
MORTALITY MARGIN, which represents premiums and cost of insurance charges less related policy benefits, increased 48.5% in 2002 compared to last year. The mortality margins in 2001 reflect the impact of the September 11, 2001 attack on the World Trade Center in New York City. Premiums and cost of insurance contract charges on new business have improved the mortality margin compared to prior year. Mortality and morbidity loss experience can cause benefit payments to fluctuate from period to period while underwriting and pricing guidelines are based on a long-term view of the trends in mortality and morbidity.
AMORTIZATION OF DAC, included in the Operating income table on page 9, increased 373.0% during 2002 compared to 2001 due to the acceleration of amortization in 2002, as discussed below, and the ongoing growth of the business inforce. DAC amortization decreased 61.8% during 2001 compared to 2000 as amortization on interest-sensitive life insurance was decelerated in part due to the death benefits related to the events of September 11, 2001.
The factors causing a change in DAC asset balances for the year ended December 31 are summarized in the following table.
the timing or magnitude of changes in asset yields. The level of defaults may also affect investment income. The Company will continually monitor its risk limits related to credit quality and duration as well as monitor and adjust its crediting rates.
- - A portion of the Company's contract charge revenue is dependent upon the value of the accounts supporting its variable annuity products. Most account values for these products are invested, at the discretion of the contractholder, in Separate Accounts invested primarily in equity securities. Therefore, future equity market performance has a significant impact on contract charge revenue and benefit guarantees which are key drivers of the returns on these products.
- - The Company expects to experience lower investment yields as positive cash flows from operations and investment activities are invested at market yields that are less than the average portfolio rate, and as the lower rate environment impacts securities with variable yields.
An important component of the Company's financial results is the return on portfolio balances. The investment portfolios are managed based upon the nature of the business and its corresponding liability structure.
(1) Fixed income securities are carried at fair value. Amortized cost basis for these securities was $3.28 billion and $2.68 billion at December 31, 2002 and 2001, respectively.
The fair value of the Company's publicly traded marketable investment securities is based on independent market quotations. The fair value of non-publicly traded securities, primarily privately placed corporate obligations, is based on either widely accepted pricing valuation models which utilize internally developed ratings and independent third party data (e.g., term structures and current publicly traded bond prices) as inputs or independent third party pricing sources. The valuation models use indicative information such as ratings, industry, coupon, and maturity along with related third party data and publicly traded bond prices to determine
As of December 31, 2002, the key assumptions used to estimate the fair value of privately placed corporate obligations included the following: - Risk free interest rates are based on the current yield curve for U.S. Treasuries with 10 term points ranging from 1 year to 30 years. - Current public corporate spreads for 22 sectors in 16 quality categories are based on the Bloomberg fair market industrial yield curve and the median Lehman sector spreads over the Bloomberg industrial curve. - The 22 sectors include airlines, banking, basic industry, brokerage, capital goods, chemicals, communications, consumer cyclical - auto, consumer cyclical - services, consumer cyclical - others, consumer non-cyclical, electric, energy, finance companies, insurance, natural gas, other industrial, REITS, technology, telecommunications, transportation, and water. Since the water sector has no public market counterpart, sector spread for this sector is based on selected broker quotes and analyst estimates. - The 16 quality categories range from AAA to B3. - An additional 25 basis points are added to public corporate spreads to compensate for illiquidity. - Watch-list securities are conservatively priced at the lower of analyst price or an adjusted model price for a rating that is one category lower and are capped at 100.
The following table shows the Company's investment portfolio, and the sources of its fair value, at December 31, 2002.
The fair value of the Company's exchange traded derivative contracts is based on independent market quotations. The fair value of non-exchange traded derivative contracts is based on valuation models which utilize independent third party data as inputs. Periodic changes in the fair values are reported as a component of either Net income, Other comprehensive income, assets or liabilities depending on the nature of the derivative and the program to which it relates.
Fixed income securities issued by U.S. government and agencies of the U.S. government totaled $608.1 million at December 31, 2002 compared to $515.2 million at December 31, 2001. All of these securities are rated investment grade at December 31, 2002.
Public corporate obligations totaled $1.07 billion at December 31, 2002, and 93.1% of these obligations were rated investment grade. As of December 31, 2002, the fixed income securities portfolio contained $1.01 billion of privately placed corporate obligations compared to $879.7 million at December 31, 2001. The benefits of privately placed securities as compared to public securities are generally higher yields, improved cash flow predictability through pro-rata sinking funds on many bonds, and a combination of covenant and call protection features designed to better protect the holder against losses resulting from credit deterioration, reinvestment risk and fluctuations in interest rates. A relative disadvantage of privately placed securities as compared to public securities is reduced liquidity. At December 31, 2002, 90.2% of the privately placed securities were rated as
investment grade by either the National Association of Insurance Commissioners ("NAIC") or the Company's internal ratings. The Company determines the fair value of privately placed fixed income securities based on discounted cash flows using current interest rates for similar securities.
The MBS portfolio is subject to interest rate risk since the price volatility and ultimate realized yield are affected by the rate of repayment of the underlying mortgages. The Company attempts to limit interest rate risk on these securities by investing a portion of the portfolio in securities that provide prepayment protection. At December 31, 2002, approximately 50.6% of the MBS portfolio was invested in planned amortization class bonds or the equivalent.
All of the securities with a NAIC rating of 5 or 6 and 38% of securities with an NAIC rating of 4 are reflected in securities defined as problem or potential problem as described on page 18. These securities represent 0.7% of the fixed income securities portfolio at December 31, 2002.
earnings potential. Some of the factors considered in evaluating whether a decline in fair value is other than temporary are: - The Company's ability and intent to retain the investment for a period of time sufficient to allow for an anticipated recovery in value; - The recoverability of principal and interest; - The duration and extent to which the fair value has been less than amortized cost for fixed income securities; - The financial condition, near-term and long-term prospects of the issuer, including relevant industry conditions and trends, and implications of rating agency actions and offering prices; and - The specific reasons that a security is in a significant unrealized loss position, including market conditions which could affect liquidity.
There are a number of risks and uncertainties inherent in the process of monitoring impairments and determining if an impairment is other than temporary. These risks and uncertainties include the risks that: - The economic outlook is worse than anticipated and has a greater adverse impact on a particular issuer than anticipated; - The Company's assessment of a particular issuer's ability to meet all of its contractual obligations changes based on changes in the facts and circumstances related to that issuer; and - New information is obtained or facts and circumstances change that cause a change in the Company's ability or intent to hold a security to maturity or until it recovers in value.
The Company has an extensive monitoring process to identify fixed income securities whose carrying value may be other than temporarily impaired. This process includes a quarterly review of all securities using a screening process to identify those securities whose fair value compared to amortized cost for fixed income securities is below established thresholds and time periods, or which are identified through other monitoring criteria such as ratings downgrades or payment defaults. Securities with an unrealized loss of greater than 20% of their amortized cost for fixed income securities for a period of six months or more, are identified through this process. The securities identified, in addition to other securities for which the Company may have concern, are evaluated based on facts and circumstances for inclusion on a watch list. Securities on the watch list are reviewed in detail to determine whether any other than temporary impairment exists.
The Company monitors the quality of its fixed income portfolio, in part, by categorizing certain investments as problem, restructured or potential problem. Problem fixed income securities are securities in default with respect to principal and/or interest and/or securities issued by companies that have gone into bankruptcy subsequent to the Company's acquisition of the security. Restructured fixed income securities have modified terms and conditions that were not at current market rates or terms at the time of the restructuring. Potential problem fixed income securities are current with respect to contractual principal and/or interest, but because of other facts and circumstances, management has serious concerns regarding the borrower's ability to pay future principal and interest, which causes management to believe these securities may be classified as problem or restructured in the future.
The following table summarizes problem and potential problem fixed income securities at December 31.
The Company has experienced an increase in its balance of fixed income securities categorized as problem or potential problem as of December 31, 2002 compared to December 31, 2001. The Company had no fixed income securities categorized as restructured at December 31, 2002 or 2001. The increases in problem and potential problem assets primarily resulted from poor operating fundamentals as well as liquidity constraints in the utilities, transportation and energy sectors of the market in 2002. The Company expects eventual recovery in these sectors but evaluated each fixed income security in these sectors through its watch list process at December 31, 2002 and recorded write-downs when appropriate. Approximately $2.3 million of gross unrealized losses at December 31, 2002 are related to securities that the Company has included in the problem or potential problem categories. These securities represent 0.7% of the fixed income portfolio. The Company concluded, through its watch list monitoring process that these unrealized losses were temporary in nature. While it is possible for these balances to increase in the future if economic conditions continue to be unfavorable, the total amount of securities in these categories is expected to remain a relatively low percentage of the total fixed income securities portfolio.
Fixed income write-downs of $15.8 million during 2002 represent 0.4% of the average total investments during the year.
The $7.8 million in losses from sales of fixed income securities primarily related to a decision to reduce exposure to certain holdings due to severely constrained liquidity conditions in the market and routine reductions of exposure to deteriorating credits.
The following list details the five largest realized losses from write-downs by issuer, the related circumstances giving rise to the loss and a discussion of how those circumstances may have impacted other material investments held.
The Company's $323.1 million investment in mortgage loans at December 31, 2002 and $242.7 million at December 31, 2001 is comprised primarily of loans secured by first mortgages on developed commercial real estate. Geographical and property type diversification are key considerations used to manage the Company's mortgage loan risk.
The Company closely monitors its commercial mortgage loan portfolio on a loan-by-loan basis. Loans with an estimated collateral value less than the loan balance, as well as loans with other characteristics indicative of higher than normal credit risk, are reviewed by financial and investment management at least quarterly for purposes of establishing valuation allowances and placing loans on non-accrual status. The underlying collateral values are based upon discounted property cash flow projections. The Company had no realized capital gains related to prepayments and write-downs on mortgage loans at December 31, 2002. At December 31, 2001 and 2000, the Company had realized capital gains related to prepayments and write-downs on mortgage loans of $119 thousand and $697 thousand, respectively.
The Company participates in securities lending programs, primarily as an investment yield enhancement with third parties, such as large brokerage firms. The Company obtains collateral in an amount that approximates 102% of the fair value of loaned securities and monitors the market value of the securities loaned on a daily basis with additional collateral obtained as necessary. At December 31, 2002, fixed income securities with a carrying value of $160.0 million have been loaned under these agreements. This compares to $140.3 million at December 31, 2001. In return for these securities, the Company receives cash that is subsequently invested in either Fixed income securities or Short-term investments with an offsetting liability recorded in other liabilities.
The assets and liabilities related to variable annuity contracts are legally segregated and reflected as Separate Accounts. The assets of the Separate Accounts are carried at fair value. Separate Accounts liabilities represent the contractholders' claims to the related assets and are carried at the fair value of the assets. Investment income and realized capital gains and losses of the Separate Accounts accrue directly to the contractholders and therefore, are not included in the Company's Statements of Operations and Comprehensive Income. Revenues to the Company from the Separate Accounts consist of contract maintenance and administration fees and mortality, early surrender and expense charges.
Absent any contract provision wherein the Company guarantees either a minimum return or account value upon death or annuitization, variable annuity contractholders bear the investment risk that the underlying mutual funds of the Separate Accounts may not meet their stated investment objectives.
Beginning in 2002, the Company cedes 80% of the mortality risk on certain term life policies to a pool of eight reinsurers. Mortality risk on policies in excess of $250 thousand per life are ceded to ALIC.
a financial strength rating above investment grade level, as measured by at least one of the major rating agencies. In certain cases, these ratings refer to the financial strength of the affiliated group or parent company of the reinsurer.
Market risk is the risk that the Company will incur losses due to adverse changes in equity prices or interest rates. The Company's primary market risk exposures are to changes in interest rates, although the Company also has certain exposures to changes in equity prices.
The Company administers and oversees its investment risk management processes primarily through its Board of Directors, Investment Committee and the Credit and Risk Management Committee ("CRMC"). The Board of Directors and Investment Committee provide executive oversight of investment activities and set investment strategies, guidelines and policy that delineates the investment limits and strategies that are appropriate given the Company's liquidity, capital, product portfolios and regulatory requirements. The CRMC is a senior investment management committee consisting of the Chief Investment Officer, the Investment Risk Manager, and other investment officers who are responsible for the day-to-day management of investment risk. The CRMC meets at least monthly to provide detailed oversight of investment risk, including market risk.
The Company manages its exposure to market risk through the use of asset allocation limits and duration limits. It also uses stress tests when appropriate. Asset allocation limits place restrictions on the aggregate fair value that may be invested within an asset class. The Company sets duration limits on its investment portfolios, and, in certain circumstances, on individual components of these portfolios. These duration limits place a restriction on the level of interest rate risk which is acceptable in the investment portfolios. Stress tests measure downside risk to fair value and earnings over longer time intervals and/or for adverse market scenarios.
The day-to-day management of market risk within defined tolerance ranges occurs as portfolio managers buy and sell within their respective markets based upon the acceptable boundaries established by the investment policy. The Company has implemented a comprehensive daily measurement process, administered by the Investment Risk Manager, for monitoring compliance to limits established by the investment policy.
The Company seeks to invest Premiums and deposits to generate future cash flows that will fund future claims, benefits and expenses, and that will earn stable margins across a wide variety of interest rate and economic scenarios. In order to achieve this objective and limit its exposure to interest rate risk, the Company adheres to a philosophy of managing the duration of assets and related liabilities. The Company uses financial futures and a reinsurance treaty with ALIC (see Note 3) to hedge the interest rate risk related to anticipatory purchases and sales of investments and product sales to customers.
The Company manages the interest rate risk inherent in its assets relative to the interest rate risk inherent in its liabilities. One of the measures the Company uses to quantify this exposure is duration. Duration measures the sensitivity of the fair value of assets and liabilities to changes in interest rates. For example, if interest rates increase by 1%, the fair value of an asset with a duration of 5 is expected to decrease in value by approximately 5%. At December 31, 2002 and 2001, the difference between the Company's liability and asset duration was
The estimated present value of expected future payments for GMDBs, net of estimated fee revenue, is approximately $3.2 million at December 31, 2002 compared to $950 thousand at December 31, 2001. This estimate considers the current guarantees outstanding for all contracts that contain GMDBs and expected fund performance to calculate expected future GMDB payments for the next 40 fiscal quarters. The assumptions and methodology used to determine the present value of the future GMDB payments are consistent with those used for DAC amortization. The increase in this estimate in 2002 is primarily attributable to the decline in account value due to the continued decline in the equity markets during the year. Management also estimates the impact to its expected future GMDB payments in the event of extreme adverse market conditions. For example, in the event of an immediate decline of 10% in contractholders' account values as of December 31, 2002 due to equity market declines, expected payments for guaranteed death benefits would increase by $1.5 million during the next year. The selection of a 10% immediate decrease should not be construed as a prediction by management of future market events, but only as an example to illustrate the potential impact to earnings and cash flow of equity market declines as a result of this guarantee. Also, the Company's actual payment experience in the future may not be consistent with the assumptions used in its model.
The Company's capital resources consist of shareholder's equity. The following table summarizes the Company's capital resources at December 31:
The NAIC has a standard for assessing the solvency of insurance companies, which is referred to as risk-based capital ("RBC"). The standard is based on a formula for determining each insurer's RBC and a model law specifying regulatory actions if an insurer's RBC falls below specified levels. The RBC formula establishes capital requirements relating to insurance, business, asset and interest rate risks. At December 31, 2002, RBC for the Company was significantly above levels that would require regulatory actions.
Premiums and deposits Reinsurance recoveries Receipts of principal, interest and dividends on investments Sales of investments Funds from securities lending Inter-company loans Capital contributions from ALIC
A portion of the Company's diversified product portfolio, primarily fixed annuities and interest-sensitive life insurance products, is subject to discretionary surrenders and withdrawals by contractholders. Total surrenders and withdrawals for 2002 were $162.1 million compared with $106.5 million for last year. The increase was driven primarily from increased surrenders of variable annuities resulting from poor equity market conditions in 2002. As the Company's interest-sensitive life insurance policies and annuity contracts inforce grow and age, the dollar amount of surrenders and withdrawals could increase. While the overall amount of surrenders may increase in the future, a significant increase in the level of surrenders relative to total contractholder account balances is not anticipated.
AIC is defending various lawsuits involving worker classification issues. Examples of these lawsuits include a number of putative class actions challenging the overtime exemption claimed by AIC under the Fair Labor Standards Act or state wage and hour laws. These class actions mirror similar lawsuits filed recently against other insurance carriers in the industry and other employers. Another example involves the worker classification of staff working in agencies. In this putative class action, plaintiffs seek damages under the Employee Retirement Income Security Act ("ERISA") and the Racketeer Influenced and Corrupt Organizations Act alleging that agency secretaries were terminated as employees by AIC and rehired by agencies through outside staffing vendors for the purpose of avoiding the payment of employee benefits. A putative nationwide class action filed by former employee agents also includes a worker classification issue; these agents are challenging certain amendments to the Agents Pension Plan and are seeking to have exclusive agent independent contractors treated as employees for benefit purposes. AIC has been vigorously defending these and various other worker classification lawsuits. The outcome of these disputes is currently uncertain.
Age Discrimination in Employment Act, the Americans with Disabilities Act and Title VII of the Civil Rights Act of 1964. A putative nationwide class action has also been filed by former employee agents alleging various violations of ERISA, breach of contract and age discrimination. AIC has been vigorously defending these lawsuits and other matters related to its agency program reorganization. In addition, AIC is defending certain matters relating to its life agency program reorganization announced in 2000. These matters include an investigation by the EEOC with respect to allegations of age discrimination and retaliation. AIC is cooperating fully with the agency investigation and will continue to vigorously defend these and other claims related to the life agency program reorganization. The outcome of these disputes is currently uncertain.
State insurance laws and regulations include numerous provisions governing the marketplace activities of insurers, including provisions governing the form and content of disclosure to customers, illustrations, advertising, sales practices and complaint handling. State regulatory authorities generally enforce these provisions through periodic market conduct examinations.
The Company's variable annuity products generally are considered securities within the meaning of federal and state securities laws and are registered under the Securities Act of 1933 and are subject to regulation by the SEC, the National Association of Securities Dealers ("NASD") and state securities regulations. The Company's Separate Accounts are registered as unit investment trusts under the Investment Company Act of 1940.
Effective January 1, 2001, the State of New York required insurance companies domiciled in its state to prepare statutory-basis financial statements in accordance with the NAIC Accounting Practices and Procedures Manual ("Codification") subject to any deviations prescribed or permitted by the State of New York insurance superintendent.
The Company prepares its statutory-basis financial statements in accordance with accounting practices prescribed or permitted by the State of New York. Prescribed statutory accounting practices include a variety of publications of the NAIC, as well as state laws, regulations and general administrative rules. Permitted statutory accounting practices encompass all accounting practices not so prescribed.
Accounting changes adopted to conform to the provisions of Codification are reported as changes in accounting principles. The cumulative effect of changes in accounting principles is reported as an adjustment to unassigned funds (surplus) in the period of the change in accounting principle. The cumulative effect is the difference between the amount of capital and surplus at the beginning of the year and the amount of capital and surplus that would have been reported at that date if the new accounting principles had been applied retroactively for all prior periods. The State of New York has recently adopted Statement of Statutory Accounting Principles ("SSAP") No. 10, Income Taxes, which is effective for statutory-basis financial statements filed as of December 31, 2002 and thereafter. The Company reported an increase to surplus of $11.4 million effective December 31, 2002 to reflect the adoption of SSAP No. 10 by the State of New York as a result of recognizing a net deferred tax asset.
The Financial Accounting Standards Board ("FASB") has exposed guidance that addresses the accounting for certain modified coinsurance agreements. The guidance has been exposed as FASB Interpretation of Statement 133 Implementation Issue No. B36, "Embedded Derivatives: Bifurcation of a Debt Instrument That Incorporates Both Interest Rate Risk and Credit Risk Exposures That Are Unrelated or Only Partially Related to the Creditworthiness of the Issuer of That Instrument." The proposed guidance requires recognizing an embedded derivative in certain reinsurance agreements when certain conditions are met. The initial impact of adopting the proposed guidance would be recorded as a cumulative adjustment to Net income in the first fiscal quarter beginning after June 15, 2003. The Company has no reinsurance arrangements that would be subject to the proposed guidance. Accordingly, the potential impact of recognizing embedded derivatives pursuant to the requirements of the proposed guidance is expected to be immaterial to both the Company's Statements of Financial Position and Statements of Operations and Comprehensive Income.
These forward-looking statements do not relate strictly to historical or current facts and may be identified by their use of words like "plans," "expects," "will," "anticipates," "estimates," "intends," "believes," "likely," and other words with similar meanings. These statements may address, among other things, the Company's strategy for growth, product development, regulatory approvals, market position, expenses, financial results and reserves. Management believes that these statements are based on reasonable estimates, assumptions and plans. However, if the estimates, assumptions or plans underlying the forward-looking statements prove inaccurate or if other risks or uncertainties arise, actual results could differ materially from those communicated in these forward-looking statements. In addition to the normal risks of business, the Company is subject to significant risk and uncertainties, including those listed below which apply to it as an insurance business and a provider of other financial services.
- - A declining market could negatively impact the credit quality of the Company's investment portfolio as adverse equity markets also affect issuers of securities held by the Company. Declines in the quality of the portfolio could cause additional realized losses on securities.
- - Changes in interest rates could also reduce the profitability of the Company's spread-based products, particularly interest-sensitive life insurance and investment products, as the difference between the amount that the Company is required to pay on such products and the rate of return earned on the related investments could be reduced. Changes in market interest rates as compared to rates offered on some of the Company's products could make those products less attractive if competitive investment margins are not maintained, leading to lower sales and/or changes in the level of surrenders and withdrawals for these products. The
Company's products generally have the flexibility to adjust crediting rates to reflect higher or lower investment returns. However, this flexibility is limited by contractual minimum crediting rates. Additionally, unanticipated surrenders could cause acceleration of amortization of DAC or impact the recoverability of DAC and thereby increase expenses and reduce current period profitability. The Company seeks to limit its exposure to this risk by regularly monitoring DAC recoverability as well as offering a diverse group of products, periodically reviewing and revising crediting rates and providing for surrender charges in the event of early withdrawal.
- - The Company amortizes DAC related to interest-sensitive life insurance and investment contracts in proportion to EGP over the estimated lives of the contracts. Periodically, the Company updates the assumptions underlying the EGP, which include margins from mortality, including guaranteed minimum death and income benefits, investment margin, including realized capital gains and losses, contract administration, surrender and other contract charges, less maintenance expenses, in order to reflect actual and expected experience and its potential impact to the valuation of DAC. Updates to these assumptions could result in adjustment to the cumulative amortization of DAC. For example, reduced EGP resulting from declines in contract charges assessed against declining Separate Accounts' balances resulting from poor equity market performance could result in accelerated amortization of DAC. An adjustment, if any, may have a material effect on the results of operations.
- - The impact of decreasing Separate Accounts balances resulting from volatile equity market conditions, underlying fund performance and the performance of distributors could cause contract charges earned by the Company to decrease and lead to an increase in exposure to pay GMDBs and GMIBs. Poor fund performance could also result in higher partial withdrawals of account value which, for some contracts, do not reduce the GMDB in a proportional amount. In addition, it is possible that the assumptions and projections used by the Company in establishing prices for the GMDBs and GMIBs, particularly assumptions and projections about investment performance, do not accurately anticipate the level of costs the Company will ultimately incur in providing those benefits, resulting in adverse mortality margin trends that may have a material effect on results of operations. These factors may result in accelerated DAC amortization and require increases in statutory reserves which reduce the Company's statutory capital and surplus.
insurance. Such proposals have included legislation relating to the deferral of taxation on the accretion of value within certain annuities and life insurance products. Recent proposals to eliminate the double taxation of dividends and to permit the establishment of tax-free lifetime savings and retirement savings accounts could substantially reduce the tax-advantaged nature of many insurance products. If such proposals were to be adopted, they could have a material adverse effect on the Company's financial position or the Company's ability to sell such products and could result in the surrender of some existing contracts and policies. In addition, recent changes in the federal estate tax laws have negatively affected the demand for the types of life insurance used in estate planning.
- - The Company is affiliated with various entities registered under the federal securities laws as broker-dealers, investment advisers and/or investment companies. These entities are subject to the regulatory jurisdiction of the SEC, NASD and/or, in some cases, state securities administrators. The laws regulating the securities products and activities of the entities are complex, numerous and subject to change. As with any highly regulated industry, there is some degree of risk of regulatory non-compliance; however ALIC has in place various legal and compliance personnel, procedures and systems designed to reasonably assure compliance with these requirements.
- - While positive operating cash flows are expected to continue to meet the Corporation's liquidity requirements, the Corporation's liquidity could be constrained by a catastrophe, or multiple catastrophes, which result in extraordinary losses, a downgrade of the Corporation's long-term debt rating of A1 and A+ (from Moody's and Standard & Poor's, respectively) to non-investment grade status of below Baa3/BBB-, a downgrade of AIC's insurance financial strength rating from Aa2, AA and A+ (from Moody's, Standard & Poor's and A.M. Best, respectively) to below Baa/BBB/B+, or a downgrade in ALIC's or the Company's insurance financial strength rating from Aa2, AA+ and A+ (from Moody's, Standard & Poor's and A.M. Best, respectively) to below Aa3/AA-/A-. In the event of a downgrade of the Corporation's or AIC's rating, ALIC and its subsidiaries including the Company, could also experience a similar downgrade.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONT.)
competitiveness of the Company's product offerings, its ability to market products, and its financial condition and results of operations. Also, the rating agencies have a variety of policies and practices regarding the relationships among ratings of affiliated entities. As such, the ratings of the Company or ALIC could be affected by changes in ratings of AIC and/or the Corporation.
- - State insurance regulatory authorities require insurance companies to maintain specified levels of statutory capital and surplus. In addition, competitive pressures generally require the Company to maintain insurance financial strength ratings. These restrictions affect the Company's ability to pay shareholder dividends to ALIC and to use its capital in other ways.
- - Portions of the non-publicly traded marketable investment securities are accounted for at fair value using internally developed, widely accepted valuation models and independent third party data as model inputs. Changes in the fair value of any security could negatively impact the Corporation's, AIC's, ALIC's and the Company's net income, shareholder's equity, assets, liabilities and debt-to-capital ratio.
- - The design of any system of controls and procedures, including internal controls and disclosure controls and procedures, is based in part upon assumptions about the likelihood of future events. As a result, there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions, regardless of how remote.
- - The impact of The Sarbanes-Oxley Act of 2002 on the business of the Company is being evaluated but cannot be completely determined at this time.