In accordance with General Instruction I(2)(a), the Company includes the following analysis with the reduced disclosure format.
The Company’s accounting policies inherently require the use of judgments relating to a variety of assumptions and estimates, in particular expectations of current and future mortality, morbidity, persistency, expenses, and interest rates. Because of the inherent uncertainty when using the assumptions and estimates, the effect of certain accounting policies under different conditions or assumptions could be materially different from those reported in the financial statements. A discussion of the various critical accounting policies is presented below.
Determining whether a decline in the current fair value of invested assets is an other-than-temporary decline in value can involve a variety of assumptions and estimates, particularly for investments that are not actively traded in established markets. For example, assessing the value of some investments requires the Company to perform an analysis of expected future cash flows or rates of prepayments. Other investments, such as collateralized mortgage or bond obligations, represent selected tranches of a structured transaction, supported overall by underlying investments in a wide variety of issuers. The Company’s specific accounting policies related to its invested assets are discussed in Notes 1 and 3 to the Financial Statements. At December 31, 2004, the Company held $625.1 million of available-for-sale investments, including $63.7 million in investments with a gross unrealized loss of $2.8 million.
The sales of investments that have occurred generally result from portfolio management decisions to maintain proper matching of assets and liabilities. During 2004, the Company recorded other-than-temporary impairments in its investments of $0.2 million, as compared to $0.3 million in 2003. Additional details on the Company’s investment performance and evaluation is provided in the section entitled “Investments” included herein.
The Company became involved with PLC’s Life Marketing segment during 2002. Segment operating income in 2004 was relatively unchanged as the $0.2 million increase in net premiums was substantially offset by higher benefits expense and amortization of DAC. Income from the Acquisitions segment decreased $0.8 million in 2004 as compared to 2003, as no new acquisitions were made in 2004 or 2003. Earnings from the Acquisitions segment are normally expected to decline over time (due to the lapsing of policies resulting from deaths of insureds or terminations of coverage) unless new acquisitions are made. The Annuities segment 2004 operating income improved by $0.2 million primarily due to an increase in net investment income and a reduction in benefits expense. The Asset Protection segment’s 2004 income remained relatively unchanged as compared to 2003.
The Corporate and Other segment consists of net investment income and expenses not identified with the preceding business segments. Operating income in 2004 decreased $1.0 million as compared to 2003, primarily due to decreased net investment income on unallocated capital.
The Company’s investment portfolio consists primarily of fixed maturity securities. The Company generally purchases its investments with the intent to hold to maturity by purchasing investments that match future cash flow needs. However, the Company may sell any of its investments to maintain proper matching of assets and liabilities. Accordingly, the Company has classified its fixed maturities and certain other securities as “available for sale.”
At December 31, 2003, the Company’s fixed maturity investments had a market value of $636.5 million, which was 6.3% above amortized cost of $598.9 million. The Company estimated the market value of its mortgage loans to be $1.4 million at December 31, 2003.
There are certain risks and uncertainties associated with determining whether declines in market values are other-than-temporary. These include significant changes in general economic conditions and business markets, trends in certain industry segments, interest rate fluctuations, rating agency actions, changes in significant accounting estimates and assumptions, commission of fraud and legislative actions. The Company continuously monitors these factors as they relate to the investment portfolio in determining the status of each investment. Provided below are additional facts concerning the potential effect upon the Company’s earnings should circumstances lead management to conclude that some of the current declines in market value are other than temporary.
The information presented below relates to investments at a certain point in time and is not necessarily indicative of the status of the portfolio at any time after December 31, 2004, the balance sheet date. Information about unrealized gains and losses is subject to rapidly changing conditions, including volatility of financial markets and changes in interest rates. As indicated above, the Company’s management considers a number of factors in determining if an unrealized loss is other-than-temporary, including its ability and intent to hold the security until recovery. Furthermore, since the timing of recognizing realized gains and losses is largely based on management’s decisions as to the timing and selection of investments to be sold, the tables and information provided below should be considered within the context of the overall unrealized gain (loss) position of the portfolio. At December 31, 2004, the Company had an overall pretax net unrealized gain of $46.3 million.
The range of maturity dates for securities in an unrealized loss position at December 31, 2004 varies, with 26.8% maturing in less than 5 years, 22.5% maturing between 5 and 10 years, and 50.7% maturing after 10 years. The following table shows the credit rating of securities in an unrealized loss position at December 31, 2004.
At December 31, 2004, securities in an unrealized loss position that were rated as below investment grade represented 9.4% of the total market value and 37.6% of the total unrealized loss. Unrealized losses related to below investment grade securities that had been in an unrealized loss position for more than twelve months were $1.0 million. The Company generally purchases its investments with the intent to hold to maturity. The Company does not consider these unrealized losses as other-than-temporary impairments.
As discussed earlier, the Company’s management considers several factors when determining other-than-temporary impairments. Although the Company generally intends to hold securities until maturity, the Company may change its position as a result of a change in circumstances. Any such decision is consistent with the Company’s classification of its investment portfolio as available for sale. During the year ended December 31, 2004, the Company sold securities in an unrealized loss position with a market value of $5.7 million resulting in a realized loss of less than $0.1 million. For such securities, the proceeds, realized loss and total time period that the security had been in an unrealized loss position are presented in the table below.
The Company’s financial position and earnings are subject to various market risks including changes in interest rates, changes in the yield curve, changes in spreads between risk-adjusted and risk-free interest rates, and equity price risks. The Company analyzes and manages the risks arising from market exposures of financial instruments, as well as other risks, through an integrated asset/liability management process. The Company’s asset/liability management programs and procedures involve the monitoring of asset and liability durations for various product lines; cash flow testing under various interest rate scenarios; and the continuous rebalancing of assets and liabilities with respect to yield, risk, and cash flow characteristics.
The Company’s annuity products tend to be more sensitive to market risks than the Company’s other products. As such, many of these products contain surrender charges and other features that reward persistency and penalize the early withdrawal of funds. Certain annuity contracts have market-value adjustments that protect the Company against investment losses if interest rates are higher at the time of surrender than at the time of issue.
At December 31, 2004, the Company had $60.0 million of annuity account balances with an estimated fair value of $64.3 million (using surrender values). At December 31, 2003, the Company had $57.9 million of annuity account balances with an estimated fair value of $62.2 million.
The following table sets forth the estimated fair values of the Company’s annuity account balances resulting from a hypothetical immediate 1 percentage point decrease in interest rates from levels prevailing at December 31, and the percent change in fair value the following estimated fair values would represent.
Approximately 10% of the Company’s liabilities relate to products (primary whole life insurance) the profitability of which could be affected by changes in interest rates. The effect of such changes in any one year is not expected to be material.
Statements of Income for the years ended December 31, 2004, 2003, and 2002
Fixed maturities, at market (amortized cost: 2004 - $578,812,588; 2003 - $598,941,913)
There was no cash paid during any of the periods presented related to interest on indebtedness or income taxes.
The accompanying financial statements of Protective Life and Annuity Insurance Company (“the Company”) are prepared on the basis of accounting principles generally accepted in the United States of America (“GAAP”). Such accounting principles differ from statutory reporting practices used by insurance companies in reporting to state regulatory authorities (see also Note 2).
The Company, since it is licensed in the State of New York, is the entity through which PLC markets, distributes, and services insurance and annuity products in New York. The operating results of companies in the insurance industry have historically been subject to significant fluctuations due to changing competition, economic conditions, interest rates, investment performance, insurance ratings, and other factors.
In July 2003, the American Institute of Certified Public Accountants issued Statement of Position (SOP) 03-1, “Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts.” SOP 03-1 was effective for fiscal years beginning after December 15, 2003. SOP 03-1 provides guidance related to the reporting and disclosure of certain insurance contracts and separate accounts, including the calculation of guaranteed minimum death benefits (GMDB). SOP 03-1 also addresses the capitalization and amortization of sales inducements to contract holders. The adoption of SOP 03-1 did not have a material impact on the Company’s financial condition or results of operations.
The market values of fixed maturities increase or decrease as interest rates fall or rise. As prescribed by GAAP investments deemed as “available for sale” are recorded at their market values with the resulting unrealized gains and losses reduced by a related adjustment to deferred policy acquisition costs, net of income tax, reported as a component of share-owners’ equity.
Investment securities are regularly reviewed for impairment. Unrealized losses that are deemed to be other-than-temporary are recognized in realized gains (losses). See Note 3 for further discussion of the Company’s policies regarding identification of other-than-temporary impairments. Realized gains and losses on sales of investments are recognized in net income using the specific identification basis.
The cost to acquire blocks of insurance representing the present value of future profits from such blocks of insurance is also included in deferred policy acquisition costs. The Company amortizes the present value of future profits over the premium payment period, including accrued interest of up to approximately 8%. The unamortized present value of future profits was approximately $95.0 million and $100.1 million at December 31, 2004 and 2003, respectively. During 2004, $5.1 million of present value of future profits was amortized. During 2003, $6.4 million of present value of future profits was amortized. No amounts were capitalized during 2004 or 2003.
The assets and liabilities related to separate accounts in which the Company does not bear the investment risk are valued at market and reported separately as assets and liabilities related to separate accounts in the accompanying financial statements. Amounts assessed against policy account balances for the costs of insurance, policy administration, and other services are included in premiums and policy fees in the accompanying statements of income.
Traditional life insurance products consist principally of those products with fixed and guaranteed premiums and benefits and include whole life insurance policies, term and term-like life insurance policies, limited-payment life insurance policies, and certain annuities with life contingencies. Life insurance premiums are recognized as revenue when due. Health and credit insurance premiums are recognized as revenue over the terms of the policies. Benefits and expenses are associated with earned premiums so that profits are recognized over the life of the contracts. This is accomplished by means of the provision for liabilities for future policy benefits and the amortization of deferred policy acquisition costs. Gross premiums in excess of net premiums related to immediate annuities are deferred and recognized over the life of the policy.
Universal life and investment products include universal life insurance, deferred annuities, and annuities without life contingencies. Premiums and policy fees for universal life and investment products consist of policy fees that have been assessed against policy account balances for the costs of insurance, policy administration, and surrenders. Such fees are recognized when assessed and earned. Benefit reserves for universal life and investment products represent policy account balances before applicable surrender charges plus certain deferred policy initiation fees that are recognized in income over the term of the policies. Policy benefits and claims that are charged to expense include benefit claims incurred in the period in excess of related policy account balances and interest credited to policy account balances. Interest credit rates for universal life ranged from 4.6% to 6.0% and investment products ranged from 2.6% to 7.8% in 2004.
The net income and share-owners’ equity prepared in conformity with statutory reporting practices as compared to that reported in the accompanying financial statements are as follows:
In 2004, gross gains on the sale of investments available for sale (fixed maturities and short-term investments) were $0.7 million and gross losses were $0.2 million. In 2003, gross gains were $3.6 million and gross losses were $0.3 million. In 2002, gross gains were $2.1 million and gross losses were $2.8 million.
Each quarter the Company reviews investments with unrealized losses and tests for other-than-temporary impairments. The Company analyzes various factors to determine if any specific other than temporary asset impairments exist. These include, but are not limited to: 1) actions taken by rating agencies, 2) default by the issuer, 3) the significance of the decline, 4) the intent and ability of the Company to hold the investment until recovery, 5) the time period during which the decline has occurred, 6) an economic analysis of the issuer’s industry, and 7) the financial strength, liquidity, and recoverability of the issuer. Management performs a security by security review each quarter in evaluating the need for any other-than-temporary impairments. Although no set formula is used in this process, the investment performance and continued viability of the issuer are significant measures considered. Once a determination has been made that a specific other-than-temporary impairment exists, a realized loss is incurred and the cost basis of the impaired asset is adjusted to its fair value. During 2004, 2003, and 2002, the Company recorded other-than-temporary impairments in its investments of $0.2 million, $0.3 million, and $4.3 million, respectively.
The following table shows the Company’s investments’ gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities have been in a continuous loss position at December 31, 2004.
The Company’s preferred stock pays, when and if declared, noncumulative participating dividends to the extent the Company’s statutory earnings for the immediately preceding year exceeded $1.0 million. No preferred dividends were paid in 2004 or 2003. In 2002, the Company paid $50,000 of preferred dividends.
Receivables from and payables to related parties consisted of receivables from and payables to affiliates under control of PLC in the amount of a $3.3 million payable at December 31, 2004 and a $7.5 million payable at December 31, 2003. The Company routinely receives from or pays to affiliates under the control of PLC reimbursements for expenses incurred on one another’s behalf. Receivables and payables among affiliates are generally settled monthly.
The Asset Protection segment markets extended service contracts and credit life and disability insurance to protect consumers’ investments in automobile and watercraft.
The Company continues to monitor the consolidation of reinsurers and the concentration of credit risk the Company has with any reinsurer. At December 31, 2004, the Company had reinsured approximately 83.0% of the face value of its life insurance in force. Approximately 34% and 28% of the reinsurance receivable balances at December 31, 2004 and 2003, respectively, relate to one unaffiliated insurance company rated “A+” (Superior) by the A. M. Best Company, an independent rating organization. Another $16.0 million or 37% and $34.7 million or 57% of the reinsurance receivable balances at December 31, 2004 and 2003, respectively relates to Protective.
The Company believes it is not practicable to determine the fair value of its policy loans since there is no stated maturity, and policy loans are often repaid by reductions to policy benefits.
(2) Adjustments represent the inclusion of assets related to discontinued operations.