The Company owns real property for investment purposes as provided in Schedule I “Summary of Investments Other Than Investments in Related Parties.” This investment property, located in Bethlehem, Pennsylvania, is leased to EIC and a nonaffiliated business. Total rental income on this property for 2005 was $0.4 million. The executive and administrative offices of the Company are located in the headquarters office of Erie Insurance Group in Erie, Pennsylvania. The Company pays other members of the Erie Insurance Group an amount determined by an agreement for office space and for the use of facilities, equipment and services.
Net income decreased to $16.5 million, or $1.75 per share, in 2005, from $29.6 million, or $3.14 per share, in 2004. Contributing to the decline in earnings for the year 2005 was (1) a decrease in realized capital gains of more than $9 million, (2) a charge of $2.5 million relating to the implementation of the Company’s new FAS 60 and FAS 97 valuation systems, (3) an increase in amortization of deferred policy acquisition costs and (4) an increase in general expenses, partly offset by increases in policy revenues and investment earnings.
These adjustments are described more fully in the Results of Operations section below and did not require restatement of prior year amounts.
Persistency experience to enable the recovery of the costs of acquiring new business over the lives of the contracts;
In addition, external factors such as regulation, competition, interest rates, technology, taxes, market conditions and general economic conditions affect the Company’s profitability.
Management makes estimates concerning the valuation of all investments. Fixed maturity and preferred stock investments are recorded at fair value under generally accepted accounting principles. Fair values are estimated using quoted market prices where available. For securities not actively traded, fair values are obtained from independent pricing services, from broker dealers, or from models that take into consideration such factors, among others, as the credit rating of the issuer, duration of the security, yields on comparably rated publicly-traded securities and risk-free yield curves. At December 31, 2005, the Company’s internally-valued securities amounted to 1.4% of its total invested assets. The Company holds no common stock securities. Changes in fair values of the fixed maturity and preferred stock investments are recorded in other comprehensive income as unrealized gains or losses. See also Notes 3 and 4 to the Company’s financial statements where unrealized gains and losses and information on impairments are discussed more fully.
Long term actuarial assumptions are required in order to estimate reserves for policy liabilities and deferred acquisition costs (DAC) in the financial statements of the Company. These actuarial assumptions for mortality rates, lapse rates, administrative expenses and investment returns must be made for many years into the future and vary by product type and policy duration as well as the age, sex and underwriting class of the insured or annuitant. Management makes these assumptions after studying past results and trends along with applying judgments about future events.
During 2005, the Company completed a series of comprehensive studies related to factors used in developing its insurance liabilities. These studies included (1) a mortality study, (2) a lapse study and (3) an expense study. The mortality study covered 1998-2004 for its traditional life insurance products accounted for under Financial Accounting Standard 60, Accounting and Reporting by Insurance Enterprises (FAS 60 products). Actual claims from mortality were approximately 14% below expected values in the aggregate. Results were comparable between standard and select underwriting classes, which were approximately 15% and 11% below expected, respectively. Prior to 2005, the Company completed simplified reviews of mortality for its universal life insurance products accounted for under Financial Accounting Standard 97, Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments (FAS 97 products). These reviews, while based on a small number of claims, indicated that mortality experience was within an acceptable range of expected levels. In 2006, the Company plans to include universal life policies in a more comprehensive mortality study, similar to that completed for traditional life policies in 2005.
The lapse study covered all of the major product groupings. Lapse rates were lower than expected for large face term, other than annual renewable term (ART), and decreasing term plans, but were higher than expected for ART and permanent plans. Results varied by duration of the contract and by calendar year within the 1998-2004 period studied. For universal life and annuity products, results have been favorable, with actual rates less than expected for most product types and policy durations.
and/or increase reserves and flow through the Statements of Operations. Shadow loss recognition adjustments also decrease DAC and/or increase reserves but are included in “Accumulated Other Comprehensive Income” in Shareholders’ Equity.
Considering the above factors in aggregate, the Company is satisfied that no primary loss recognition position exists as of the balance sheet date. As a result of the shadow loss recognition testing discussed above, the Company made a $3.0 million adjustment to increase its annuity liabilities at December 31, 2005. The amount charged to “Accumulated Other Comprehensive Income” was $2.0 million, net of $1.0 million of deferred federal income tax.
The components of net policy revenue are reflected below for the years ended December 31:
Total individual policies in force increased slightly to 308,520 at December 31, 2005, from 302,115 at December 31, 2004. Policies in force on traditional life products increased 3.0% to 218,457 in 2005, from 212,102 in 2004.
As noted above, direct renewal premiums account for a vast majority of the increase in direct premiums on traditional products in 2005. In an effort to improve profitability from new product sales, the Company, effective July 1, 2005, discontinued writing new business under its Target Term plans. In August 2005, the Company began offering ERIE Flagship Term Plus. This new product offers fully
Included in the Company’s net realized gains on investments are impairments of $2.9 million on fixed maturity investments in 2005 and $3.4 million in 2003. There were no impairments in 2004.
The components of DAC amortization for the year ended December 31 are:
The Company regularly evaluates the appropriateness of certain assumptions related to the interest sensitive products as provided under FAS 97 and modifies (“unlocks”) assumptions as appropriate. As a result of unlocking assumptions, the amortization of DAC decreased by $7.2 million in 2004. Approximately $4.8 million of this amount resulted from updating universal life mortality assumptions to best estimates in light of substantially more favorable claims expectations than originally reflected in the DAC amortization models. Another $1.9 million resulted from increasing the interest spread assumption on universal life policies to reflect anticipated investment earnings rates and actual crediting practices in recent years.
The components of the increase in future life policy benefits for the years ended December 31, were:
General expenses include wages and salaries, employee benefits, data processing expenses, occupancy expenses and other office and general administrative expenses of the Company. General expenses related to the acquisition and underwriting of new policies are deferrable as DAC. These expenses include medical inspection and exam fees related to new business production and wages, salaries and employee benefits of underwriting and new policy processing personnel. General expenses, net of DAC additions, increased 29.1%, or $4.7 million, to $21.0 million in 2005, compared to $16.3 million in 2004 and $14.9 million in 2003. The increase in general expenses includes increases in information technology costs, including professional costs related to the Company’s efforts to improve its actuarial systems and processes and the development of new products. Contract labor costs related to these activities increased by $1.8 million in 2005 versus 2004. Expenses allocated to the Company for salaries and benefits of various members of executive management of the Erie Insurance Group also increased due to an increased amount of effort dedicated to Company issues.
The Company’s effective tax rate for 2005, based on information reported in its Statement of Operations, was 32%. During the third quarter of 2005, the Company adjusted its federal income tax liability to reflect the difference in the December 31, 2004 federal income tax expense provision and the Company’s 2004 federal income tax return filed in September 2005. This adjustment decreased the federal income tax expense for the period by $0.7 million. The Company’s effective tax rate for 2005, excluding this adjustment, would have been 34.9%, compared to effective tax rates of 34.6% and 31.3% in 2004 and 2003, respectively. The Company recorded an adjustment to deferred income taxes in 2003. Deferred tax liabilities established in previous years to reflect potential income tax exposures were determined to be unnecessary and the amounts provided were reversed during the year. The one-time non-cash reduction in deferred taxes of $1.3 million increased earnings by $0.14 per share in 2003.
The Company’s fixed maturities at December 31, 2005, consist of investments in bonds, redeemable preferred stock and notes. It is the Company’s objective that the fixed maturity portfolio be of very high quality and well-diversified within each market sector. The Company only purchases investment-grade securities. Non-investment grade issues held by the Company are the result of downgrades of securities previously rated investment grade. The portfolio is managed with the goal of achieving reasonable returns while limiting exposure to risk.
The Company’s fixed maturity investments include 96.4%, or $1.3 billion, of high-quality, marketable bonds and redeemable preferred stock, all of which were rated at investment-grade levels (above Ba1/BB+) at December 31, 2005. The below-investment-grade category consists of $42.2 million of bonds rated Ba1/BB+ and $6.9 million of bonds rated below Ba1/BB+. Generally, the fixed-maturity securities in the
Liquidity is a measure of the Company’s ability to secure enough cash to meet its contractual obligations and operating needs. Generally, insurance premiums are collected prior to claims and benefit disbursements and these funds are invested to provide necessary cash flows in future years. The Company’s major sources of cash from operations are life insurance premiums and investment income.
Major cash outflows from operations are for benefits to policyholders, commissions to agents and salaries, wages and operating expenses. The net positive cash flow from operations is used to fund Company commitments and to build the investment portfolio, thereby increasing future investment returns. Net cash provided by operating activities in 2005 was $33.1 million compared to $22.2 million in 2004 and $19.4 million in 2003.
The Company uses surrender charges to mitigate the extent, timing and profitability impact of withdrawals of funds from annuity contracts and universal life policies.
The Company’s liquidity position remains strong as investments and cash and cash equivalents increased by $27.7 million during 2005 to $1.5 billion at December 31, 2005. As an added measure of liquidity, the Company has arranged for a $10 million line of credit with a commercial bank. The Company may use extensions of credit from the bank to fund working capital needs of the Company and for other general corporate purposes. There were no borrowings under this credit line in 2005, 2004 or 2003. Management believes its cash flow from operations and its liquid assets and marketable securities will enable the Company to meet foreseeable cash requirements. The continued adequacy of the liquidity depends upon factors including future securities’ market conditions, changes in interest rate levels and policyholder perceptions of the Company’s strength, which could lead to reduced cash inflows or increased cash outflows.
The following table presents the Company’s gross contractual cash flow commitments on surplus notes, limited partnerships and policyholder obligations.
The Commonwealth of Pennsylvania follows the statutory accounting practices related to minimum Risk-Based Capital (RBC) requirements for domestic insurance companies that were developed by the NAIC. The NAIC standard set for measuring RBC is a method of calculating the minimum amount of capital appropriate for an insurance company to support its overall business operations in consideration of its size
and risk profile. The RBC formula is used by the state insurance regulators as an early warning tool to identify, for the purpose of initiating regulatory action, insurance companies that potentially are inadequately capitalized. In addition, the formula defines minimum capital standards that will supplement the current system of low fixed minimum capital and surplus requirements on a state-by-state basis. At December 31, 2005, the Company substantially exceeded the minimum RBC levels that require regulatory action.
The Company, EIC and the Exchange share common facilities and services. The costs of such common services are allocated to the Company based upon the Company’s usage. Additionally, EIC is the common paymaster for administrative expenses of the Erie Insurance Group. The Company reimburses EIC for these expenses, including salary and benefit costs. Operating expenses of the Company paid by EIC are reimbursed on a monthly basis. The amount of these reimbursements totaled $30.7 million, $26.1 million and $23.6 million for 2005, 2004 and 2003, respectively. No interest is charged or received on these intercompany balances due to the timely settlement terms and nature of the items.
Employees performing services for the Company participate in the pension and other employee benefit plans sponsored by EIC. Pension benefits are based on years of service and salary. Pension costs are funded by EIC in amounts sufficient to at least meet ERISA minimum funding requirements. The Company reimburses EIC on a monthly basis for its share of pension costs. The Company, through EIC, also participates in certain deferred compensation and supplemental pension plans for certain executive and senior officers. The amounts recorded by the Company for the deferred compensation and supplemental pension plan are reimbursed to EIC as costs are incurred under these plans. Amounts allocated to the Company from EIC for these pension and other employee benefit plans, and included in the total reimbursements noted above, totaled $2.0 million, $1.7 million and $1.3 million for 2005, 2004 and 2003, respectively.
The Erie Insurance Group affiliated property/casualty insurance companies periodically purchase annuities from the Company in connection with the structured settlement of claims. The reserves held for structured settlement annuities sold to the affiliated property/casualty insurance companies totaled $216.1 million and $213.7 million at December 31, 2005 and 2004, respectively.
The Erie Insurance Group Retirement Plan for employees purchases from the Company individual annuities for some terminated vested employees or beneficiaries receiving benefits. These are nonparticipating annuity contracts under which the Company has unconditionally contracted to provide specified benefits to beneficiaries in return for a fixed premium from the plan. Annuity deposit balances outstanding relating to pension annuities sold to the Erie Insurance Group Retirement Plan are $41.2 million and $43.0 million at December 31, 2005 and 2004, respectively.
The Erie Insurance Group 401(k) plan for employees includes an investment option in a Company group annuity. Annuity deposit balances outstanding relating to 401(k) annuities sold to employees are $32.6 million and $30.2 million at December 31, 2005 and 2004, respectively.
paid semi-annually. The surplus note is payable on demand on or after December 31, 2018. Both principal and interest payments were approved by the Pennsylvania Insurance Commissioner. Interest paid on this note totaled $1.7 million in 2005 and 2004 and $0.6 million in 2003.
The guaranteed interest rates and approximate deposit liabilities for deferred annuity products with credited interest rates subject to change by the Company are as follows:
The Company has some ability to restrict new deposits on its universal life and annuity contracts. New deposits can be limited to planned premium amounts under the terms of the Company’s universal life contracts. Deposits are limited also by IRS guidelines. Flexible premium deferred annuity (FPDA) contracts allow the Company to limit deposits to a maximum of $25,000 per year.
As mentioned previously, the Company introduced a new portfolio of deferred annuity products during the third quarter of 2005. The new portfolio includes a number of features that are expected to add flexibility in dealing with interest rate changes, including higher interest rates on larger deposits and a “new money” interest crediting method that allows the Company to quickly change credited interest rates in response to market conditions. The portfolio has longer and higher surrender charges, which will reduce the Company’s vulnerability to disintermediation risk.
If the Company were to incur reductions in statutory surplus for an extended period of time, the ratings of the Company may be downgraded. Future downgrades in these or other ratings would reduce the competitive position of the Company by making it more difficult to attract business in the highly competitive life insurance industry. In such circumstances, the Company may need to take measures to increase surplus levels in order to maintain adequate ratings. The Company may increase surplus through a variety of means, including the issuance of additional surplus notes. In addition, management of the Erie Insurance Group could elect to use the Exchange for capital needs as the Exchange has over $3 billion in surplus at December 31, 2005.
ERIEConnection, the central policy administration and agent interface application under development in the eCommerce program, has not progressed as originally expected. Development costs have substantially exceeded estimates made in 2002. Target delivery dates established in 2002 have generally not been met. While functional as a personal lines rating and policy administration system, the agency interface component of ERIEConnection has generally not met the Company's or agents' expectations for ease of use. The Group has postponed further deployment of the system until such usability issues are resolved. Estimates of the costs for alternative approaches to improve the agency interface for ease of use needed to facilitate future deployment and the timetable for deployment continue to be analyzed and developed. Through December 31, 2005, the total costs incurred by the Group for the development of the ERIEConnection application amounted to approximately $100 million. This amount includes approximately $10 million related to the development of an alternative agent interface approach which has been abandoned.
Since the substantial majority of the costs for program development are borne by other members of the Group, the Company’s operating results are not expected to be materially impacted in the near term by ERIEConnection development decisions. However, the financial terms and conditions of the Company's eventual use of the ERIEConnection system have not, as yet, been determined, and could have an impact on the Companys future earnings. In addition, the Company's ability to attract new policyholders is directly influenced by the Company's independent agent decisions to place business with the Company. To the extent that technological capabilities of alternative carriers represented by the Company's agents are greater than those of the Company, the Company’s sales could be adversely affected.
We have audited the accompanying Statements of Financial Position of Erie Family Life Insurance Company as of December 31, 2005 and 2004, and the related Statements of Operations, Shareholders’ Equity, and Cash Flows for each of the three years in the period ended December 31, 2005. Our audits also included the financial statement schedules listed in the Index at Item 15(2). These financial statements and schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
We conducted our audits in accordance with standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were not engaged to perform an audit of the Company’s internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Erie Family Life Insurance Company at December 31, 2005 and 2004, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2005, in conformity with U.S. generally accepted accounting principles. Also, in our opinion the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.
Erie Family Life Insurance Company (the Company), a Pennsylvania-domiciled life insurer, is engaged in the business of underwriting and selling nonparticipating individual and group life insurance policies and annuities. The Company markets its products through independent agents in 10 states and the District of Columbia and is subject to supervision and regulations of the states in which it operates. A majority of the Company’s business is written in Pennsylvania, Ohio, Maryland and Virginia. See also Note 15.
The Company is owned 21.6% by the Erie Indemnity Company (EIC), 53.5% by the Erie Insurance Exchange (Exchange) and the remaining 24.9% by public shareholders. EIC is a Pennsylvania business corporation formed in 1925 to be the attorney-in-fact for policyholders of Erie Insurance Exchange, a Pennsylvania-domiciled reciprocal insurance exchange. As attorney-in-fact for the Exchange, EIC has a fiduciary duty to protect the policyholders of the Exchange in addition to its fiduciary duty to protect the interests of its shareholders. EIC operates predominantly as a provider of certain management services to the Exchange. EIC also is engaged in the property/casualty insurance business through its wholly-owned subsidiaries, Erie Insurance Company, Erie Insurance Property and Casualty Company, and Erie Insurance Company of New York. The Company, the Exchange and its subsidiary, Flagship City, and EIC and its subsidiaries operate collectively under the name Erie Insurance Group.
In September 2005, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants issued Statement of Position (SOP) 05-1, “Accounting by Insurance Enterprises for Deferred Acquisition Costs (DAC) in Connection with Modifications or Exchanges of Insurance Contracts”, effective for fiscal years beginning after December 15, 2006, with earlier adoption encouraged. This SOP provides guidance on accounting for DAC on internal replacements of insurance and investment contracts. According to this SOP:
An internal replacement that is determined to result in a replacement that is substantially changed from the replaced contract should be accounted for as an extinguishment of the replaced contract. Unamortized DAC from the replaced contract in an internal replacement transaction that results in a substantially changed contract should not be deferred and amortized in connection with the replacement contract. Other balances associated with the replaced contract should be accounted for in a similar manner; that is, accounted for based on an extinguishment of the replaced contract and issuance of a new contract.
Certain amounts previously reported in the 2004 financial statements have been reclassified to conform to the current period’s presentation. Such reclassifications did not impact earnings or total shareholders’ equity.
Also included in fixed maturities are mortgage-backed securities, which are amortized using a constant effective yield method based on anticipated prepayments and the estimated economic life of the securities. If actual prepayments differ significantly from anticipated prepayments, the effective yield is recalculated to reflect actual payments to date and anticipated future payments. The net investment in the security is adjusted to the amount that would have existed had the new effective yield been applied since the acquisition of the security, with the corresponding adjustment included as part of investment income.
Cash equivalents are comprised of investments in bank money market funds and short-term bonds, which mature in 90 days or less from the date of acquisition, and approximate fair value.
All investments are evaluated monthly for other-than-temporary impairment loss. The factors considered in evaluating whether or not a decline in fair value is other-than-temporary include:
the extent and duration to which fair value is less than cost,
An investment that is deemed impaired is written down to its estimated net realizable value. Impairment charges are included as realized losses in the Statements of Operations.
The Company shares a portion of the interest charged on lent securities with the third party custodian and
In accordance with FAS 97, Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments, the DAC related to universal life products and deferred annuities is amortized in relation to the actual and expected gross profits from investment, mortality and expense margins and surrender charges of the policies over a specified period of time. This period is 30 years for universal life and 20 years for deferred annuities. Both historical and anticipated investment returns, including realized gains and losses, are considered in determining the amortization of DAC. Changes in expected future gross profits on the annuity and universal life products cause the DAC amortization rate to be revised retroactively, or “unlocked,” to the date of policy issuance. The cumulative change in DAC related to prior periods is recognized as a component of the current period’s DAC amortization, along with DAC amortization associated with the actual gross profits of the current period. Lower actual gross profits in a period resulting from lower margins on investments, mortality, and/or expenses would typically result in less DAC amortization in that period, whereas higher actual gross profits would result in more amortization in the period. However, if lower gross profits were expected to continue into the future, additional amortization of the existing DAC asset may occur.
Also, in accordance with FAS 97, DAC is adjusted for the impact of unrealized gains or losses on investments as if these gains or losses had been realized, with corresponding credits or charges, net of income taxes, included in accumulated other comprehensive income.
Liabilities for life insurance and income-paying annuity future policy benefits are computed primarily by the net level premium method with assumptions as to anticipated mortality, withdrawals, lapses and investment yields. Deferred annuity future policy benefit liabilities are established at accumulated values without
reduction for surrender charges. Reserves for universal life plans are based on the contract account balance. Interest rate assumptions for non-interest sensitive life insurance range from 3.50% to 7.25%. Mortality and withdrawal assumptions are based on tables typically used in the industry, modified to reflect actual experience where appropriate.
FAS 60 contracts are subject to loss recognition testing. The Company periodically verifies the adequacy of reserves as part of its loss recognition testing. Loss recognition is necessary when the sum of the GAAP reserve and the present value of projected policy cash flows (premiums less benefits and expenses, net of reinsurance) is less than unamortized DAC. There are two types of loss recognition testing: primary (FAS 60) and shadow (FAS 115).
Universal life and annuity deposits are credited with varying interest rates determined at the discretion of the Company subject to certain minimums.
Reinsurance transactions are recorded on a basis consistent with FAS 113, Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts. Reinsurance premiums and commissions and expense reimbursements on reinsurance ceded are accounted for on a basis consistent with those used in accounting for the underlying reinsured policies. Premiums, commissions and expense reimbursements, and benefits to policyholders ceded to other companies have been reported as a reduction of “Net Policy Revenue”, “Death Benefits”, “Increase in Future Life Policy Benefits”, and “Commissions” on the Statements of Operations.
Provisions for income taxes include deferred taxes resulting from changes in cumulative temporary differences between the tax basis and financial statement basis of assets and liabilities. Deferred taxes are provided on a liability method whereby deferred tax assets are recognized for deductible temporary differences and deferred tax liabilities are recognized for taxable temporary differences. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment.
The amortized cost and estimated fair value of fixed maturities at December 31, 2005 by remaining contractual term to maturity are shown below. Mortgage-backed securities are allocated based on their stated maturity dates. Actual cash flows may differ from those stated as a result of calls, prepayments or defaults.
There were no impairment charges recorded in 2004. Impairment charges on mezzanine debt partnerships of $2.0 million in 2003 are included in equity in earnings of limited partnerships in the Statements of Operations.
The Company participates in a program whereby marketable securities from its investment portfolio are lent to independent brokers or dealers based on, among other things, their creditworthiness in exchange for collateral initially equal to 102% of the value of the securities on loan and is thereafter maintained at a minimum of 100% of the market value of the securities loaned. The market value of the securities on loan to each borrower is monitored daily by the third party custodian and the borrower is required to deliver additional collateral if the market value of the collateral falls below 100% of the market value of the securities on loan.
The Company had loaned securities included as part of its invested assets with a market value of $58.0 million at December 31, 2005. The Company had no loaned securities at December 31, 2004. The Company has incurred no losses on the securities lending program since the program’s inception.
Bonds having a fair value of $16.1 million are pledged as collateral on a $10 million line of credit with a bank. There were no borrowings on the line during 2005 and 2004.
Policy loans and real estate mortgage loans: For policy loans and real estate mortgage loans, carrying value is representative of estimated fair value.
Trading assets and trading liabilities: The carrying value of these assets and liabilities arising in the ordinary course of business approximates their fair values.
Annuity deposits: Included in this category are deferred annuity contracts. The Company retains the right to change interest rates subject to a one-year guaranteed interest rate and a minimum interest rate provided in the contract. To the extent that current market rates are below the guaranteed minimum interest rate, the fair value of these contracts may exceed the carrying value. To the extent that surrender charges apply to account balances, the fair value of these contracts may be below the carrying value. The carrying value of these contracts totaled $720.5 million and $688.5 million as of December 31, 2005 and 2004, respectively, while the estimated fair value of these contracts totaled $715.4 million and $698.0 million, respectively.
The Company periodically verifies the adequacy of reserves as part of its loss recognition testing on two bases: primary loss recognition (FAS 60 basis) and “shadow loss recognition” (FAS 115 basis). All reserves were evaluated with no loss recognition required on a primary basis. However, the reserves for payout annuities, including life contingencies, were deemed inadequate on a shadow loss recognition basis as of December 31, 2005. No shadow basis adjustments were recorded on this block of business at December
In 2003, the Company recorded an adjustment to deferred income taxes. Deferred tax liabilities established in previous years to reflect potential income tax exposures were determined to be unnecessary and the amounts provided were reversed during the year. The one-time non-cash reduction in deferred taxes of $1.3 million, increased earnings by $0.14 per share.
Temporary differences that give rise to deferred income tax assets and liabilities for the years ended December 31 are as follows:
Allocations from EIC for operating expenses paid on behalf of the Company are made on a monthly basis. The Company reimburses EIC when the expenses are paid. The amount of these cash settlements for the Company totaled $30.7 million, $26.1 million and $23.6 million in 2005, 2004 and 2003, respectively.
On December 30, 2005, the Company issued a $20 million surplus note to the Exchange. This surplus note bears an annual interest rate of 6.26% and is scheduled to be paid semi-annually. The surplus note is payable on demand on or after December 31, 2025. Both principal and interest payments are subject to prior approval by the Pennsylvania Insurance Commissioner. There was no interest paid on this note in 2005.
EIC purchased certain software and equipment for use by the Company. Depreciation and applicable interest are charged to the Company throughout the estimated useful life of the asset and is included in general expenses. Depreciation and interest charged the Company in 2005, 2004 and 2003 amounted to $0.7 million in each of the three years.
The Erie Insurance Group Retirement Plan for employees purchases from the Company individual annuities for some terminated vested employees or beneficiaries receiving benefits. These are nonparticipating annuity contracts under which the Company has unconditionally contracted to provide specified benefits to beneficiaries in return for a fixed premium from the plan. Due to the low interest rate environment currently, the Erie Insurance Group Retirement Plan for employees did not purchase any annuities from the Company in 2005, 2004 or 2003. Annuity deposit balances outstanding relating to pension annuities sold to the Erie Insurance Group Retirement Plan are $41.2 million and $43.0 million at December 31, 2005 and 2004, respectively.
Annuity deposit balances outstanding relating to 401(k) annuities sold to employees are $32.6 million and $30.2 million at December 31, 2005 and 2004, respectively.
The Erie Insurance Group affiliated property and casualty insurance companies periodically purchase
annuities from the Company in connection with the structured settlement of claims. Considerations recorded as annuity deposits in the Statements of Financial Position from structured settlement annuities sold to affiliated property/casualty companies of the Erie Insurance Group totaled $14.0 million, $20.5 million and $20.9 million in 2005, 2004 and 2003, respectively. The reserves held for structured settlement annuities sold to the affiliated property/casualty insurance companies equal $216.1 million and $213.7 million at December 31, 2005 and 2004, respectively.
The Company has entered into various reinsurance treaties for the purpose of mitigating risk in accordance with Company guidelines. Reinsurance contracts do not relieve the Company from its obligations to policyholders. Failure of reinsurers to honor their obligations could result in losses to the Company. Management believes all of its reinsurance assets are collectible; therefore, no allowance has been established for uncollectible amounts.
Sales of ERIE Flagship Term Plus and ERIE Flagship Term2 continue to result in increased ceded reinsurance balances. Total direct life insurance in force on these products, combined with the discontinued ERIE Flagship Term and ERIE Target Term products, was $20.3 billion, $17.4 billion, and $13.9 billion in 2005, 2004, and 2003, respectively. Reinsurance ceded on these products totaled $13.6 billion, $11.6 billion, and $8.9 billion in 2005, 2004, and 2003, respectively.
The effect of ceded reinsurance to the financial statement lines contained in the Statements of Operations is as follows:
The Company has outstanding commitments to invest up to $22.5 million in limited partnerships at December 31, 2005. These commitments will be funded as required through the end of the respective investment periods, which typically span 3 to 5 years.
The decrease in total expenses and benefits in 2004 for the Universal Life line was primarily due to a decrease in amortization of deferred policy acquisition costs. This decrease was the result of the unlocking of certain assumptions under FAS 97 as discussed in Notes 3 and 5. The total amount of the unlocking adjustment made in 2004 for universal life products decreased the DAC amortization by $7.7 million.
A reconciliation of shareholders’ equity as filed with regulatory authorities to shareholders’ equity reported in the accompanying financial statements as of December 31 is as follows:
The minimum statutory capital and surplus requirements under Pennsylvania law for stock life insurance
The amount of dividends the Company can pay to its shareholders without the prior approval of the Pennsylvania Insurance Commissioner is limited by statute to the greater of: (a) 10% of its statutory surplus as regards policyholders as shown on its last annual statement on file with the commissioner, or (b) the net income as reported for the period covered by such annual statement, but shall not include pro rata distribution of any class of the insurer’s own securities. Accordingly, the maximum dividend payout which may be made in 2006 without prior Pennsylvania Commissioner approval is $15.7 million. Dividends declared to shareholders totaled $8.3 million in 2005 and 2004.
Bonds having a carrying value of $2.1 million at December 31, 2005, were on deposit with various regulatory authorities as required by law. The carrying value of these bonds are not material for separate disclosure on the Company’s Statements of Financial Position and are included with fixed maturities.
The following results are unaudited. In the opinion of the Company’s management, all adjustments-consisting only of normal recurring accruals-necessary for a fair presentation of the interim periods presented have been included.
In the first quarter of 2005, the Company recorded a charge to expenses of $0.7 million related to a correction of an error in the determination of reinsurance reserve credits. The prior calculation method overstated the amount of such credits for certain policy types due to an error in determining the inventory of policies qualifying for such credits.
In the second quarter of 2005, the Company made a correction to record unrealized gains and losses on limited partnerships in the equity in earnings of limited partnerships previously recorded in shareholders’ equity in the Statements of Operations. This correction increased pretax income by $1.2 million, or $0.13 per share. Included in the pretax adjustment was $1.0 million related to 2005 and $0.2 million related to 2004 and prior years.
During the third and fourth quarter of 2005, the Company updated the valuation software it uses to estimate insurance liability and DAC balances for its traditional life insurance, universal life and deferred annuity products. This new valuation system uses more refined methods and calculations to estimate these amounts. Differences in liability and DAC estimates between the new and old valuation systems, determined to be changes in accounting estimates, resulted in a $4.5 million pretax charge to the Company, or $0.31 per share after taxes. Differences determined to be a correction of errors resulted in a $2.0 million increase to pretax income, or $0.14 per share after taxes. The adjustments are reflected above as a $3.5 million increase in the third quarter 2005 benefits and expenses and a $1.0 million decrease in the fourth quarter 2005 benefits and expenses.
During the second quarter, the Company unlocked certain assumptions related to the determination of DAC for its universal life and fixed annuities. As a result of unlocking these assumptions, amortization of DAC was decreased by $6.5 million in the second quarter. See Note 12 for a discussion on the charge against income during the fourth quarter of 2004 relating to the PEGLI pool.