Allstate Life of New York occupies office space in Hauppauge, New York and Northbrook, Illinois that is owned or leased by AIC. Expenses associated with these facilities are allocated to us on both a direct and indirect basis, depending on the nature and use. We believe that these facilities are suitable and adequate for our operations.
Our goal is to reinvent protection and retirement for the consumers. To achieve this goal, we are focused on the following operating priorities: consumer focus, operational excellence, enterprise risk and return, and capital management.
- For operations: premiums and deposits, benefit and investment spread, amortization of deferred policy acquisition costs, expenses, operating income, net income, and invested assets, product returns and profitably growing distribution partner relationships;
- For investments: credit quality/experience, stability of long-term returns, total returns, cash flows and asset and liability duration; and
INVESTMENT FAIR VALUE AND IMPAIRMENT The fair value of our investments in fixed income securities is based on observable market quotations, other market observable data, or is derived from such quotations and market observable data. We utilize third party pricing servicers, brokers and internal valuation models to determine fair value. We gain assurance of the overall reasonableness and consistent application of the assumptions and methodologies and compliance with accounting standards for fair value determination through our ongoing monitoring of the fair values received or derived internally. Our exposure to changes in market conditions is discussed more fully in the Market Risk section of the MD&A.
Our models are based on discounted cash flow methodology and calculate a single best estimate of fair value for each security. Our internally developed pricing models use credit ratings and liquidity risk associated with privately-placed securities, which are difficult to independently observe and verify. Inputs used in these fair value estimates include specific attributes of the security being valued including; coupon rate, weighted average life, an internal credit rating assigned by us (which is consistent with any external ratings and those we use to report our holdings by credit rating), sector of the issuer, and call provisions. Our assumptions incorporate market information as of the measurement date that represents what we believe independent third parties would use to determine fair value, which include: interest rate yield curves, quoted market prices of comparable securities, credit spreads, estimated liquidity premiums and other applicable market data. Our assumption for liquidity risk associated with privately-placed securities reduces the value of these securities to reflect their reduced liquidity as compared to similar securities that are publicly traded. Additionally, no assumption is included in the valuation of privately placed securities for an increase to the value to reflect the generally enhanced structural features of the securities, such as covenants or change of control protection. However, judgment is required in developing these estimates and, as a result, the estimated fair value of these securities may differ from amounts that would be realized upon an orderly sale of the securities at the measurement date. The use of different assumptions may have a material effect on the estimated fair values.
For a more detailed discussion of the risks relating to changes in investment values and levels of investment impairment as well as the potential causes of such changes, see Note 6 of the financial statements and the Investments, Market Risk, and Forward-looking Statements and Risk Factors sections of this document.
DEFERRED POLICY ACQUISITION COST AMORTIZATION We incur significant costs in connection with acquiring business. In accordance with GAAP, costs that vary with and are primarily related to acquiring business are deferred and recorded as an asset on the Statements of Financial Position.
AGP and EGP consist of the following components: benefit margins primarily from cost of insurance contract charges less mortality, investment margins including realized capital gains and losses; and expense margins including surrender and other contract charges, less maintenance expenses. The amount of EGP is principally dependent on assumptions for investment returns, including capital gains and losses on assets supporting contract liabilities, interest crediting rates to policyholders, the effect of any hedges, persistency, mortality and expenses. Of these factors, we anticipate that investment returns, credited interest, persistency, mortality, and expenses are reasonably likely to have the greatest impact on the amount of DAC amortization. Changes in these assumptions can be offsetting and the Company is unable to predict their future movements or offsetting impacts over time.
For quantification of the impact of these estimates and assumptions, see the Operations, and Forward-looking Statements and Risk Factors sections of this document and Note 2 and 10 of the financial statements.
RESERVE FOR LIFE-CONTINGENT CONTRACT BENEFITS ESTIMATION Benefits for these contracts are payable over many years; accordingly, the reserves are calculated as the present value of future expected benefits to be paid, reduced by the present value of future expected net premiums. Long-term actuarial assumptions of future investment yields, mortality, morbidity, policy terminations and expenses are used when establishing the reserve for life-contingent contract benefits payable under insurance policies including traditional life insurance, life-contingent annuities and voluntary health products. These assumptions, which for life-contingent annuities and traditional life insurance are applied using the net level premium method, include provisions for adverse deviation and generally vary by such characteristics as type of annuity benefit or coverage, year of issue and policy duration. Future investment yield assumptions are determined based upon prevailing investment yields as well as estimated reinvestment yields. Mortality, morbidity and policy termination assumptions are based on our experience and industry experience. Expense assumptions include the estimated effects of inflation and expenses to be incurred beyond the premium-paying period. These assumptions are established at the time the policy is issued, are consistent with assumptions for determining DAC amortization for these contracts, and are generally not changed during the policy coverage period. However, if actual experience emerges in a manner that is significantly adverse relative to the original assumptions, adjustments to DAC or reserves may be required resulting in a charge to earnings which could have a material adverse effect on our operating results and financial condition. We periodically review the adequacy of these reserves and recoverability of DAC for these contracts on an aggregate basis using actual experience. In the event that actual experience is significantly adverse compared to the original assumptions any remaining unamortized DAC balance must be expensed to the extent not recoverable and the establishment of a premium deficiency reserve may be required. The effects of changes in reserve estimates are reported in the results of operations in the period in which the changes are determined. The company has not recognized a charge of this nature in the three years ended December 31, 2007. We anticipate that mortality, investment and reinvestment yields, and policy terminations are the factors that would be most likely to require adjustment to these reserves or related DAC.
Effective June 1, 2006, we disposed of our variable annuity business through reinsurance with Prudential Financial Inc. ("Prudential"). The following table presents the results of operations attributable to our variable annuity business for the period of 2006 prior to the disposition and 2005.
(IN THOUSANDS) 2006 2005 -------- ------- Contract charges $ 8,127 $16,728 Net investment income 8,789 23,781 Realized capital gains and losses (4,079) (231) -------- ------- Total revenues 12,837 40,278 Contract benefits 2,281 10,401 Interest credited to contractholder funds 6,408 18,744 Amortization of deferred policy acquisition costs (7,277) 6,746 Operating costs and expenses 4,233 7,789 -------- ------- Total costs and expenses 5,645 43,680 Loss on disposition of operations (10,694) -- -------- ------- Income from operations before income tax expense(1) $ (3,502) $(3,402) ======== =======
- ---------- (1) For 2006 and 2005, income from operations before income tax expense attributable to the variable annuity business reinsured to Prudential included an investment spread of $2.4 million and $5.0 million, respectively, and benefit spread of $(1.3) million and $(9.0) million, respectively.
(IN THOUSANDS) 2007 2006 2005 ---------- ---------- ---------- REVENUES Premiums $ 69,124 $ 84,313 68,538 Contract charges 59,530 63,426 66,280 Net investment income 386,738 373,064 356,162 Realized capital gains and losses (831) (22,085) (5,192) ---------- ---------- ---------- Total revenues 514,561 498,718 485,788 COSTS AND EXPENSES Contract benefits (181,803) (190,506) (183,227) Interest credited to contractholder funds (177,407) (167,171) (161,936) Amortization of DAC (53,445) (31,672) (41,663) Operating costs and expenses (37,624) (46,578) (43,497) ---------- ---------- ---------- Total costs and expenses (450,279) (435,927) (430,323) Gain (loss) on disposition of operations 429 (10,694) 1 Income tax expense (22,802) (17,755) (20,945) ---------- ---------- ---------- Net income $ 41,909 $ 34,342 $ 34,521 ========== ========== ========== Investments at December 31 $7,057,629 $6,779,874 $6,726,547 ========== ========== ==========
NET INCOME in 2007 increased 22.0% compared to 2006 as higher revenues more than offset higher total costs and expenses, and 2006 included losses relating to the disposition of our variable annuity business. Net income in 2006 was comparable to 2005 as higher revenues and lower income tax expense were offset by the losses related to the disposition of our variable annuity business in 2006 and higher total costs and expenses.
CONTRACT CHARGES are revenues generated from interest-sensitive and variable life insurance, fixed annuities and variable annuities for which deposits are classified as contractholder funds or separate accounts liabilities. Contract charges are assessed against the contractholder account values for maintenance, administration, cost of insurance and surrender prior to the contractually specified dates. As a result, changes in contractholder funds are considered in the evaluation of growth and as indicators of future levels of revenues. Subsequent to the close of our reinsurance transaction with Prudential on June 1, 2006, variable annuity contract charges on the business subject to the transaction are fully reinsured to Prudential and presented net of reinsurance on the Statements of Operations and Comprehensive Income (see Note 3 to the financial statements).
CONTRACT BENEFITS decreased 4.6% or $8.7 million in 2007 compared to 2006 due to lower sales of immediate annuities with life contingencies and the absence in 2007 of contract benefits on the reinsured variable annuity business, partially offset by an increase in the implied interest on immediate annuities with life contingencies. This implied interest totaled $107.5 million and $103.9 million in 2007 and 2006, respectively.
We analyze our mortality and morbidity results using the difference between premiums, contract charges earned for the cost of insurance and contract benefits excluding the portion related to the implied interest on immediate annuities with life-contingencies ("benefit spread"). The benefit spread by product group is disclosed in the following table.
INTEREST CREDITED TO CONTRACTHOLDER FUNDS increased 6.1% or $10.2 million in 2007 compared to 2006 and 3.2% or $5.2 million in 2006 compared to 2005. Both increases were due primarily to growth in average contractholder funds, partially offset by the impact of the reinsured variable annuity business. The increase in 2007 compared to 2006 was also influenced by higher weighted average interest crediting rates on deferred fixed annuities, which are detailed in the table on the next page. Excluding the impact of the reinsured variable annuity business, interest credited to contractholder funds increased 10.4% in 2007 compared to 2006 and 12.3% in 2006 compared to 2005.
In order to analyze the impact of net investment income and interest credited to policyholders on net income, we review the difference between net investment income and the sum of interest credited to contractholder funds and the implied interest on life-contingent immediate annuities which is included as a component of contract benefits on the Statements of Operations and Comprehensive Income ("investment spread"). The investment spread by product group is shown in the following table.
AMORTIZATION OF DAC increased 68.7% or $21.8 million in 2007 compared to 2006 and decreased 24.0% or $10.0 million in 2006 compared to 2005. The components of amortization of DAC are shown in the following table.
(IN THOUSANDS) 2007 2006 2005 -------- -------- -------- Amortization of DAC before amortization relating to realized capital gains and losses and changes in assumptions (1) $(47,431) $(45,957) $(45,520) Amortization relating to realized capital gains and losses (2) (196) 14,139 (3,670) Amortization (acceleration) deceleration for changes in assumptions ("DAC unlocking") (3) (5,818) 146 7,527 -------- -------- -------- Total amortization of DAC $(53,445) $(31,672) $(41,663) ======== ======== ========
(3) Amortization (acceleration) deceleration for changes in assumptions ("DAC unlocking") for 2005 includes $4.3 million relating to the reinsured variable annuity business. There was no DAC unlocking related to variable annuities in 2006.
GAIN (LOSS) ON DISPOSITION OF OPERATIONS reflected a gain of $429 thousand in 2007 compared to a loss of $10.7 million in 2006 and a gain of $1 thousand in 2005. The loss in 2006 was attributable to our reinsured variable annuity business.
The Company's effective tax rate is impacted by tax favored investment income such as dividends qualifying for the dividends received deduction ("DRD"). In 2007, the Internal Revenue Service ("IRS") announced its intention to issue regulations dealing with certain computational aspects of the DRD related to separate account assets ("separate accounts DRD"). The ultimate timing and substance of any such regulations are unknown at this time, but may result in the elimination of some or all of the separate accounts DRD tax benefit reflected as a component of the Company's income tax expense. The Company recognized a tax benefit from the separate accounts DRD of $3.1 million, $3.7 million and $2.7 million in 2007, 2006 and 2005, respectively.
As of December 31, 2007 and 2006, for certain term life insurance policies, we ceded up to 90% of the mortality risk depending on the length of the term. Further, we ceded the mortality risk associated with coverage in excess of $250 thousand per life to ALIC. As of December 31, 2007 and 2006, 39.8% and 39.4%, respectively, of our face amount of life insurance in force is reinsured to non-affiliates and ALIC. We cede all of the risk associated with variable annuity contracts to Prudential (see Note 3 to the financial statements).
- - We plan to increase sales of our financial products by Allstate exclusive agencies by developing and bringing to market new innovative, consumer-driven financial products and features targeted to middle market customers.
- - The transition of our investment objective from primarily income generation to increased focus on increasing total returns may result in increased volatility in net investment income and realized capital gains and losses from period to period.
In conjunction with our priority of optimizing the returns we realize for the risks we accept, we will be undertaking selected new investment strategies. As a result of these strategies and enterprise asset allocation, there may be a different mix in the reporting of returns between investment income, realized capital gains and losses, unrealized capital gains and losses and higher investment expenses. Additionally, these strategies may result in increased leverage from investing activities.
As a result of tactical decisions, we may sell fixed income securities during the period in which fair value has declined below amortized cost. Portfolio monitoring, which includes identifying securities that are other-than-temporarily impaired and recognizing other-than-temporary impairments on securities in an unrealized loss position for which we do not have the intent and ability to hold until recovery, are conducted regularly. For more information, see the Portfolio Monitoring section of the MD&A.
PORTFOLIO COMPOSITION The composition of the investment portfolio at December 31, 2007 is presented in the table below. Also see Notes 2 and 6 to the financial statements for investment accounting policies and additional information.
PERCENT (IN THOUSANDS) INVESTMENTS OF TOTAL ----------- -------- Fixed income securities (1) $6,271,128 88.9% Mortgage loans 725,301 10.3 Short-term 22,688 0.3 Policy loans 38,509 0.5 Other 3 -- ---------- ----- Total $7,057,629 100.0% ========== =====
Total investments at amortized cost related to collateral received in connection with securities lending business activities decreased to $198.1 million at December 31, 2007 from $199.5 million at December 31, 2006. As of December 31, 2007 and 2006, these investments were carried at fair value and classified in fixed income securities totaling $183 million and $115 million, respectively, and short-term investments totaling $13 million and $87 million, respectively.
Securities lending activities are primarily used as an investment yield enhancement, and are conducted with third parties such as brokerage firms. We obtain collateral, typically in the form of cash, in an amount generally equal to 102% of the securities and monitor the market value of the securities loaned on a daily basis with additional collateral obtained as necessary. The cash we receive is invested in short-term and fixed income investments, and an offsetting liability to return the collateral is recorded in other liabilities and accrued expenses.
FIXED INCOME SECURITIES See Note 6 of the financial statements for a table showing the amortized cost, unrealized gains, unrealized losses and fair value for each type of fixed income security for the years ended December 31, 2007 and 2006.
FAIR VALUE ----------------------- (IN THOUSANDS) 2007 2006 ---------- ---------- U.S. government and agencies $ 797,191 $ 729,111 Municipal 433,307 323,003 Corporate 3,378,811 3,304,762 Foreign government 333,540 304,947 Mortgage-backed securities 419,617 433,196 Commercial mortgage-backed securities 791,941 673,179 Asset-backed securities 106,877 109,022 Redeemable preferred stock 9,844 9,919 ---------- ---------- Total fixed income securities $6,271,128 $5,887,139 ========== ==========
MUNICIPAL BONDS, including tax-exempt and taxable securities, totaled $433.3 million, all of which were rated investment grade at December 31, 2007.
As of December 31, 2007, approximately $246.9 million or 57.0% of our municipal bond portfolio is insured by five bond insurers and 96.9% have a Moody's equivalent rating of Aaa. Our practices for acquiring and monitoring municipal bonds primarily take into consideration the quality of the underlying security. As of December 31, 2007, we believe that the valuations already reflect a significant decline in the value of the insurance, and further such declines, if any, are not expected to be material. While the valuation of these holdings may be temporarily impacted by negative market developments, we continue to have the intent and ability to hold the bonds and expect to receive all of the contractual cash flows. As of December 31, 2007, 49.4% of our insured municipal bond portfolio was insured by MBIA, 20.7% by AMBAC, 9.8% by FSA and 14.6% by FGIC. In total, we hold $273.0 million of fixed income securities that are insured by bond insurers, including $19.2 million of our ABS RMBS.
Included in our municipal bond portfolio at December 31, 2007 are $133.7 million of auction rate securities ("ARS") that have long-term stated maturities, with the interest rate reset based on auctions every 7, 28 or 35 days depending on the specific security. At the auction date, if the quantity of sell orders exceeds the quantity of purchase orders, the auction "fails" and the issuers are forced to pay a "maximum rate" as defined for each issue. The maximum rate is designed so that its prolonged use is an incentive to the issuer to call and refinance the long-term bonds. When auctions are successfully completed, the interest rate reset normally corresponds with the short-term rate associated with the reset period. Our holdings primarily have a Moody's or equivalent rating of Aaa and fair value was estimated at the corresponding par value at December 31, 2007. We make our investment decisions based on the underlying credit of each security, which for approximately 93% of our holdings are pools of student loans for which at least 85% of the collateral is insured by the U.S. Department of Education. In 2008 through March 13, dealers were no longer supporting auctions with their own bids as they had in the past and we experienced failed auctions for all
CORPORATE BONDS totaled $3.38 billion and 94.1% were rated investment grade at December 31, 2007. As of December 31, 2007, $1.52 billion or 45.1% of the portfolio consisted of privately placed securities compared to $1.50 billion or 45.4% at December 31, 2006. Privately placed securities primarily consist of corporate issued senior debt securities that are in unregistered form and are directly negotiated with the borrower. All privately placed corporate securities are rated by The National Association of Insurance Commissioners ("NAIC") based on information provided to them and are also internally rated. Additionally, approximately 34.3% of the privately placed corporate securities in our portfolio are rated by an independent rating agency. The following table summarizes the privately placed corporate securities portfolio by credit quality as of December 31, 2007.
Hybrid securities are carried at fair value and total $224.5 million and $184.0 million at December 31, 2007 and 2006, respectively. For further discussion on hybrid securities, see Note 2 to the financial statements.
MORTGAGE-BACKED SECURITIES ("MBS") totaled $419.6 million, all of which were rated investment grade at December 31, 2007. The credit risk associated with MBS is mitigated due to the fact that 81.4% of the portfolio consists of securities that were issued by, or have underlying collateral that is guaranteed by U.S. government agencies or U.S. government sponsored entities ("U.S. Agency"). The MBS portfolio is subject to interest rate risk since price volatility and the ultimate realized yield are affected by the rate of prepayment of the underlying mortgages.
All of our Alt-A mortgage-backed securities are at fixed rates and include certain securities that are collateralized by residential mortgage loans issued to borrowers with stronger credit profiles than sub-prime borrowers, but do not qualify for prime financing terms due to high loan-to-value ratios or limited supporting documentation. Fair value represents 97.4% of the amortized cost of these securities. At December 31, 2007, the Alt-A portfolio had net unrealized losses of $767 thousand, which were comprised of $100 thousand of gross unrealized gains and $867 thousand of gross unrealized losses.
COMMERCIAL MORTGAGE-BACKED SECURITIES ("CMBS") totaled $791.9 million and all were rated investment grade at December 31, 2007. Approximately 93.2% of the CMBS investments are pools of commercial mortgages, broadly diversified across property types and geographical area. The CMBS portfolio is subject to credit risk, but unlike other structured products, is generally not subject to prepayment risk due to protections within the underlying commercial mortgages, whereby borrowers are effectively restricted from prepaying their mortgages due to changes in interest rates. Credit defaults can result in credit directed prepayments.
% TO TOTAL (IN THOUSANDS) FAIR VALUE INVESTMENTS AAA AA A BAA ----------- ----------- ---- ---- ---- --- CMBS $758,874 10.8% 74.2% 18.3% 7.0% 0.5% CRE CDO 33,067 0.4 24.4 45.2 24.3 6.1 -------- ---- Total CMBS $791,941 11.2% ======== ====
(2) The credit ratings of the first lien ABS RMBS were 99.0% Aaa, and 1.0% Aa at December 31, 2007.
During 2007, one second lien ABS RMBS with a value of $1.7 million was downgraded within the investment grade ratings. Two second lien securities with a fair value of $1.6 million were downgraded from investment grade to below investment grade ratings.
The following table summarizes the credit quality of the fixed income securities portfolio at December 31, 2007.
NAIC FAIR PERCENT RATING MOODY'S EQUIVALENT VALUE OF TOTAL - ------ ---------------------- ---------- -------- 1 Aaa/Aa/A $4,580,229 73.0% 2 Baa 1,492,290 23.8 ---------- ----- Investment grade (1) 6,072,519 96.8 3 Ba 169,117 2.7 4 B 28,194 0.5 5 Caa or lower 1,298 -- ---------- ----- Below investment grade 198,609 3.2 ---------- ----- Total $6,271,128 100.0% ========== =====
MORTGAGE LOANS Our mortgage loan portfolio was $725.3 million at December 31, 2007 and $708.4 million at December 31, 2006, and was comprised primarily of loans secured by first mortgages on developed commercial real estate. Geographical and property type diversification are key considerations used to manage our exposure.
The table above includes 10 securities with a fair value totaling $48.6 million and an unrealized loss of $1.8 million that have not yet received an NAIC rating, for which we have assigned a comparable internal rating. Due to lags between the funding of an investment, execution of final legal documents, filing with the Securities Valuation Office ("SVO") of the NAIC, and rating by the SVO, we generally have a small number of securities that have a pending rating.
Unrealized losses on investment grade securities principally relate to changes in interest rates or changes in credit spreads, which reflect liquidity conditions of the related markets, since the securities were acquired. Of the unrealized losses on below investment grade securities, there were no significant loss positions (greater than or equal to 20% of amortized cost) for six or more consecutive months prior to December 31, 2007. Included among the securities rated below investment grade are high-yield bonds and securities that were investment grade when originally acquired. We mitigate the credit risk of investing in below investment grade fixed income securities by limiting the percentage of our fixed income portfolio invested in such securities, through diversification of the portfolio, active credit monitoring and portfolio management.
PORTFOLIO MONITORING We have a comprehensive portfolio monitoring process to identify and evaluate, on a case-by-case basis, fixed income securities whose carrying value may be other-than-temporarily impaired. The process includes a quarterly review of all securities using a screening process to identify situations where the fair value compared to amortized cost, is below established thresholds for certain time periods, or which are identified through other monitoring criteria such as ratings downgrades or payment defaults. The securities identified, in addition to other securities for which we may have a concern, are evaluated based on facts and circumstances for inclusion on our watch-list. We also conduct a portfolio review to recognize impairment on investments in an unrealized loss position for which we do not have the intent and ability to hold until recovery as a result of approved programs involving the disposition of investments for reasons such as changes in duration, revisions to strategic asset allocations and liquidity actions, as well as certain dispositions anticipated by portfolio managers. All investments in an unrealized loss position at December 31, 2007 were included in our portfolio monitoring process for determining whether declines in value were other-than-temporary.
The largest individual unrealized loss was $1.7 million for category (i) as of December 31, 2007 and $2.5 million for category (ii) as of December 31, 2007.
The following table contains the individual securities with the largest unrealized losses as of December 31, 2007. No other fixed income security had an unrealized loss of or greater than $1.2 million or 1.3% of the total unrealized loss on fixed income securities.
We monitor the quality of our fixed income portfolio by categorizing certain investments as "problem", "restructured" or "potential problem." Problem fixed income securities are securities in default with respect to principal or interest and/or securities issued by companies that have gone into bankruptcy subsequent to our acquisition or loan. Restructured fixed income securities have rates and terms that are not consistent with market rates or terms prevailing 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, we have concerns regarding the borrower's ability to pay future principal and interest, which causes us to believe these securities may be classified as problem or restructured in the future.
We had no problem, restructured or potential problem fixed income securities as of December 31, 2007. The fixed income securities categorized as problem and potential problem as of December 31, 2006, were disposed of in 2007.
Dispositions in 2007 included net realized gains on sales and other transactions such as calls and prepayments of $10.3 million and losses recorded in connection with anticipated dispositions of $6.8 million. The net realized gains on sales and other transactions were comprised of gross gains of $17.6 million and gross losses of $7.3 million.
Net realized capital losses related to the valuation of derivative instruments increased 50.4% in 2007 compared to 2006 due primarily to lower valuations of interest rate cap agreements resulting from decreased market interest rates.
During our comprehensive portfolio reviews, we determine whether there are any approved programs involving the expected disposition of investments such as changes in duration, revision to strategic asset allocation and liquidity actions, as well as any dispositions anticipated by the portfolio managers resulting from their on-going comprehensive reviews of the portfolios. Upon approval of such programs, we identify a population of suitable investments, typically larger than needed to accomplish the objective, from which specific securities are selected to sell. Due to our change in intent to hold until recovery, we recognize impairments on investments within the population that are in an unrealized loss position. When the objectives of the programs are accomplished, any remaining securities are redesignated as intent to hold until recovery.
A changing interest rate environment will drive changes in our portfolio duration targets at a tactical level. A duration target and range is established with an economic view of liabilities relative to a long-term portfolio view. Tactical duration management is accomplished through both cash market transactions including new purchases and derivative activities that generate realized gains and losses. As a component of our approach to managing portfolio duration, realized gains and losses on certain derivative instruments are most appropriately considered in conjunction with the unrealized gains and losses on the fixed income portfolio. This approach mitigates the impacts of general interest rate changes to the overall financial condition of the Company as shown in the Market Risk section of the MD&A.
We manage our exposure to market risk through the use of asset allocation, duration and value-at-risk limits, simulation and, as appropriate, through the use of stress tests. We have asset allocation limits that place restrictions on the total funds that may be invested within an asset class. We have duration limits on our investment portfolio, and, as appropriate, on individual components of the portfolio. These duration limits place restrictions on the amount of interest rate risk that may be taken. Our value-at-risk limits are intended to restrict the potential loss in fair value that could arise from adverse movements in the fixed income, equity, and currency markets based on historical volatilities and correlations among market risk factors. Comprehensive 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 policies. This day-to-day management is integrated with and informed by the activities of the ALM organization. This integration results in a prudent, methodical and effective adjudication of market risk and return, conditioned by the unique demands and dynamics of our product liabilities and supported by the continuous application of advanced risk technology and analytics.
INTEREST RATE RISK is the risk that we will incur loss due to adverse changes in interest rates relative to the interest rate characteristics of interest bearing assets and liabilities. This risk arises from many of our primary activities, as we invest substantial funds in interest-sensitive assets and issue interest-sensitive liabilities. Interest rate risk includes risks related to changes in U.S. Treasury yields and other key benchmarks as well as changes in interest rates resulting from the widening credit spreads and credit exposure to collateralized securities.
We manage the interest rate risk in our assets relative to the interest rate risk inherent in our liabilities. One of the measures used to quantify this exposure is duration. Duration measures the price sensitivity of the assets and liabilities to changes in interest rates. For example, if interest rates increase by 100 basis points, the fair value of an asset with a duration of 5 is expected to decrease in value by approximately 5%. At December 31, 2007, the difference between our asset and liability duration was approximately 0.62, compared to a (0.45) gap at December 31, 2006. A positive duration gap indicates that the fair value of our assets is more sensitive to interest rate movements than the fair value of our liabilities. A negative duration gap indicates that the fair value of our liabilities is more sensitive to interest rate movements than the fair value of our assets.
We seek to invest premiums, contract charges and deposits to generate future cash flows that will fund future claims, benefits and expenses, and that will earn stable spreads across a wide variety of interest rate and economic scenarios. To achieve this objective and limit interest rate risk, we adhere to a philosophy of managing the duration of assets and related liabilities within predetermined tolerance levels. This philosophy may include using futures to reduce the interest rate risk resulting from mismatches between existing assets and liabilities, and financial futures to hedge the interest rate risk of anticipated purchases and sales of investments and product sales to customers.
Based upon the information and assumptions we use in this duration calculation, and interest rates in effect at December 31, 2007, we estimate that a 100 basis point immediate, parallel increase in interest rates ("rate shock") would decrease the net fair value of the assets and liabilities by approximately $97.2 million, compared to $23.1 million at December 31, 2006. The selection of a 100 basis point immediate parallel change in interest rates should not be construed as our prediction of future market events, but only as an illustration of the potential effect of such an event. There were $458.1 million of assets supporting life insurance products such as traditional and interest-sensitive life, which are not considered financial instruments. These assets and the associated liabilities have not been included in the above estimate. The $458.1 million of assets excluded from the calculation has increased from $393.2 million reported at December 31, 2006 due to an increase in the in-force account value of interest-sensitive life products. Based on assumptions described above, in the event of a 100 basis point immediate increase in interest rates, the assets
supporting life insurance products would decrease in value by $32.8 million, compared to a decrease of $29.3 million at December 31, 2006.
(IN THOUSANDS) 2007 2006 2005 -------- -------- -------- Common stock, additional capital paid-in and retained income $615,684 $574,958 $538,465 Accumulated other comprehensive income 65,188 78,038 128,968 -------- -------- -------- Total shareholder's equity $680,872 $652,996 $667,433 ======== ======== ========
SHAREHOLDER'S EQUITY increased in 2007 due primarily to net income, partially offset by lower unrealized net capital gains on fixed income securities. Shareholder's equity decreased in 2006 due to lower unrealized net capital gains on fixed income securities, partially offset by net income and a gain recorded to retained income related to the recapture of a reinsurance treaty with ALIC.
LIQUIDITY SOURCES AND USES Our potential sources of funds principally include the following activities:
As reflected in our Statements of Cash Flows, lower operating cash flows in 2007, compared to 2006, primarily related to a settlement of an intercompany obligation in 2007, lower premiums received and lower contract charges on the reinsured variable annuity business, partially offset by higher net investment income. Higher operating cash flows in 2006, compared to 2005, primarily related to higher interest received on investments and premiums received, partially offset by higher contract benefits and expenses paid.
Certain remote events and circumstances could constrain our or The Allstate Corporation's liquidity. Those events and circumstances include, for example, a catastrophe resulting in extraordinary losses, a downgrade in The Allstate Corporation's long-term debt rating of A1, A+ and a (from Moody's, Standard & Poor's and A.M. Best, respectively) to non-investment grade status of below Baa3/BBB-/bb, a downgrade in AIC's financial strength rating from Aa2, AA and A+ (from Moody's, Standard & Poor's and A.M. Best, respectively) to below Baa/BBB/A-, or a downgrade in our financial strength ratings from Aa2, AA and A+ (from Moody's, Standard & Poor's and A.M. Best, respectively) to below Aa3/AA-/A-. The rating agencies also consider the interdependence of the The Allstate Corporation's individually rated entities, therefore, a rating change in one entity could potentially affect the ratings of other related entities.
- ---------- (1) Liabilities for securities lending are typically fully secured with cash. We manage our short-term liquidity position to ensure the availability of a sufficient amount of liquid assets to extinguish short-term liabilities as they come due in the normal course of business, including utilizing potential sources of liquidity as disclosed previously.
(2) Contractholder funds represent interest-bearing liabilities arising from the sale of products such as interest-sensitive life, fixed annuities, including immediate annuities without life contingencies. The reserve for life-contingent contract benefits relates primarily to traditional life and immediate annuities with life contingencies. These amounts reflect the present value of estimated cash payments to be made to contractholders and policyholders. Certain of these contracts, such as immediate annuities without life contingencies, involve payment obligations where the amount and timing of the payment is essentially fixed and determinable. These amounts relate to (i) policies or contracts where we are currently making payments and will continue to do so and (ii) contracts where the timing of a portion or all of the payments has been determined by the contract. Other contracts, such as interest-sensitive life, fixed deferred annuities, traditional life and immediate annuities with life contingencies, involve payment obligations where a portion or all of the amount and timing of future payments is uncertain. For these contracts, the Company is not currently making payments and will not make payments until (i) the occurrence of an insurable event, such as death, or illness or (ii) the occurrence of a payment triggering event such as the surrender of or partial withdrawal on a policy or deposit contract, which is outside of the control of the Company. We have estimated the timing of payments related to these contracts based on historical experience and our expectation of future payment patterns. Uncertainties relating to these liabilities include mortality, morbidity, expenses, customer lapse and withdrawal activity, estimated additional deposits for interest-sensitive life contracts, and renewal premium for life policies, which may significantly impact both the timing and amount of future payments. Such cash outflows reflect adjustments for the estimated timing of mortality, retirement, and other appropriate factors, but are undiscounted with respect to interest. As a result, the sum of the cash outflows shown for all years in the table exceeds the corresponding liabilities of $4.85 billion for contractholder funds and $2.02 billion for reserve for life-contingent contract benefits as included in the Statements of Financial Position as of December 31, 2007. The liability amount in the Statements of Financial Position reflects the discounting for interest as well as adjustments for the timing of other factors as described above.
(4) Balance sheet liabilities not included in the table above include unearned and advanced premiums of $573 thousand and deferred tax liabilities netted in the net deferred tax asset of $40 million. These items were excluded as they do not meet the definition of a contractual liability as we are not contractually obligated to pay these amounts to third parties. Rather, they represent an accounting mechanism that allows us to present our financial statements on an accrual basis. In addition, other liabilities of $15 million were not included in the table above because they did not represent a contractual obligation or the amount and timing of their eventual payment was sufficiently uncertain.
At December 31, 2007, we had $16 million in contractual conditional commitments to invest in private placements and mortgage loans that were due in less than one year.
There are several pending accounting standards that we have not implemented either because the standard had not been finalized or the implementation date has not yet occurred. For a discussion of these pending standards, see Note 2 of the financial statements.
determine prior to implementation. For this reason, we are sometimes unable to estimate the effect of certain pending accounting standards until the relevant authoritative body finalizes these standards or until we implement them.
Investment income consists primarily of interest and is recognized on an accrual basis using the effective yield method. Interest income for mortgage-backed securities, commercial mortgage-backed securities and asset backed-securities is determined considering estimated principal repayments obtained from widely accepted third party data sources and internal estimates. Accrual of income is suspended for fixed income securities and mortgage loans that are in default or when the receipt of interest payments is in doubt.
Realized capital gains and losses include gains and losses on investment dispositions, write-downs in value due to other-than-temporary declines in fair value and periodic changes in the fair value and settlements of certain derivatives including hedge ineffectiveness. Dispositions include sales, losses recognized in anticipation of dispositions and other transactions such as calls and prepayments. Realized capital gains and losses on investment dispositions are determined on a specific identification basis.
instruments based on specified prices or yields. Derivatives that are required to be separated from the host instrument and accounted for as derivative financial instruments ("subject to bifurcation") are embedded in certain variable life and annuity contracts.
TERMINATION OF HEDGE ACCOUNTING If, subsequent to entering into a hedge transaction, the derivative becomes ineffective (including if the hedged item is sold or otherwise extinguished, the occurrence of a hedged or forecasted transaction is no longer probable, or the hedged asset becomes other than temporarily impaired), the Company may terminate the derivative position. The Company may also terminate derivative instruments or redesignate them as non-hedge as a result of other events or circumstances. If the derivative financial instrument is not terminated when a fair value hedge is no longer effective, the future gains and losses recognized on the derivative are reported in realized capital gains and losses. When a fair value hedge is no longer effective, is redesignated as a non-hedge, or when the derivative has been terminated, the fair value gain or loss on the hedged asset, liability or portion thereof which has already been recognized in income while the hedge was in place and used to adjust the amortized cost for fixed income securities, the carrying value for mortgage loans or the carrying amount for the liability, is amortized over the remaining life of the hedged asset, liability or portion thereof, and reflected in net investment income or interest credited to contractholder funds beginning in the period that hedge accounting is no longer applied. If the hedged item in a fair value hedge is an asset, which has become other-than-temporarily impaired, or is a liability which an increase has been recognized for the obligation, the adjustment made to the amortized cost for fixed income securities, the carrying value for mortgage loans or the
carrying amount for the liability is subject to the accounting policies applied to other-than-temporarily impaired assets.
The Company's business activities include securities lending transactions, which are used primarily to generate net investment income. These transactions are short-term in nature, usually 30 days or less.
Traditional life insurance products consist principally of products with fixed and guaranteed premiums and benefits, primarily term and whole life insurance products. Premiums from these products are recognized as revenue when due from policyholders. Benefits are reflected in contract benefits and recognized in relation to premiums so that profits are recognized over the life of the policy.
Immediate annuities with life contingencies, including certain structured settlement annuities, provide insurance protection over a period that extends beyond the period during which premiums are collected. Premiums from these products are recognized as revenue when received at the inception of the contract. Benefits and expenses are recognized in relation to premiums so that profits are recognized over the life of the policy.
For traditional life insurance, DAC is amortized over the premium paying period of the related policies in proportion to the estimated revenues on such business. Assumptions used in amortization of DAC and reserve calculations are established at the time the policy is issued and are generally not revised during the life of the policy. Any deviations from projected business in force resulting from actual policy terminations differing from expected levels and any estimated premium deficiencies may result in a change to the rate of amortization in the period such events occur. Generally, the amortization period for these contracts approximates the estimated lives of the policies.
AGP and EGP consists primarily of the following components: the excess of contract charges for the cost of insurance over mortality and other benefits; investment income and realized capital gains and losses over interest credited; and surrender and other contract charges over maintenance expenses. The principal assumptions for determining the amount of EGP are investment returns, including capital gains and losses on assets supporting contract liabilities, interest crediting rates to policyholders, the effect of any hedges used, persistency, mortality and expenses.
The Company performs quarterly reviews of DAC and DSI recoverability for interest-sensitive life, annuities and other investment contracts in the aggregate using current assumptions. If a change in the amount of EGP is significant, it could result in the unamortized DAC and DSI not being recoverable, resulting in a charge which is
Customers of the Company may exchange one insurance policy or investment contract for another offered by the Company, or make modifications to an existing investment or life contract issued by the Company. These transactions are identified as internal replacements for accounting purposes. Internal replacement transactions that are determined to result in replacement contracts that are substantially unchanged from the replaced contract are accounted for as continuations of the replaced contracts. Unamortized DAC and DSI related to the replaced contract continue to be deferred and amortized in connection with the replacement contract. For interest-sensitive life insurance and investment contracts, the EGP of the replacement contract is treated as revisions to the EGP of the replaced contract in the determination of amortization of DAC and DSI. For traditional life policies, any changes to unamortized DAC and benefit reserves that result from the replacement contract are treated as prospective revisions. Any costs associated with the issuance of the replacement contract are characterized as maintenance costs and expensed as incurred.
In the normal course of business, the Company seeks to limit aggregate and single exposure to losses on large risks by purchasing reinsurance (see Note 9). The Company has also used reinsurance to effect the disposition of its variable annuity business (see Note 3). The amounts reported in the Statements of Financial Position as reinsurance recoverables include amounts billed to reinsurers on losses paid as well as estimates of amounts expected to be recovered from reinsurers on insurance liabilities and contractholder funds that have not yet been paid. Reinsurance recoverables on unpaid losses are estimated based upon assumptions consistent with those used in establishing the liabilities related to the underlying reinsured contracts. Insurance liabilities are reported gross of reinsurance recoverables. Reinsurance premiums are generally reflected in income in a manner consistent with the recognition of premiums on the reinsured contracts. Reinsurance does not extinguish the Company's primary liability under the policies written. Therefore, the Company regularly evaluates the financial condition of its reinsurers and establishes allowances for uncollectible reinsurance recoverables as appropriate.
Prior to the Company's disposition of the variable annuity business through reinsurance with Prudential effective June 1, 2006 (see Note 3), the Company had a reinsurance treaty through which it ceded contract benefits on its guaranteed minimum accumulation benefits ("GMABs"), guaranteed minimum withdrawal benefits ("GMWBs") and certain guaranteed minimum death benefits ("GMDBs") to ALIC. The terms of the treaty met the accounting definition of a derivative under Statement of Financial Accounting Standards ("SFAS") No. 133 "Accounting for Derivative Instruments and Hedging Activities". Accordingly, the treaty was recorded in the Statement of Financial Position at fair value. Changes in the fair value of the treaty were recognized in contract benefits. The reinsurance treaty was recaptured in 2006 (see Note 5).
The reserve for life-contingent contract benefits payable under insurance policies including traditional life insurance, life-contingent fixed annuities and voluntary health products, is computed on the basis of long-term actuarial assumptions as to future investment yields, mortality, morbidity, policy terminations and expenses (see Note 8). These assumptions, which for traditional life insurance, life-contingent fixed annuities and voluntary health products are applied using the net level premium method, include provisions for adverse deviation and generally vary by such characteristics as type of coverage, year of issue and policy duration. To the extent that unrealized gains on fixed income securities would result in a premium deficiency had those gains actually been realized, the related increase in reserves for certain immediate annuities with life contingencies is recorded net of tax as a reduction of the unrealized net capital gains included in accumulated other comprehensive income.
Separate accounts assets are carried at fair value. Separate accounts liabilities are carried at the account values, which are equal to the carrying value of the corresponding assets. The assets of the separate accounts are legally segregated and available only to settle separate account contract obligations. Separate accounts liabilities represent the contractholders' claims to the related 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. Deposits to, and surrenders and withdrawals from, the separate accounts are reflected in separate accounts liabilities and are not included in cash flows.
In October 2005, the American Institute of Certified Public Accountants ("AICPA") issued SOP 05-1. SOP 05-1 provides accounting guidance for DAC associated with internal replacements of insurance and investment contracts other than those already described in Statement of Financial Accounting Standard ("SFAS") No. 97, "Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments". SOP 05-1 defines an internal replacement as a modification in product benefits, features, rights or coverages that occurs through the exchange of an existing contract for a new contract, or by amendment, endorsement or rider to an existing contract, or by the election of a feature or coverage within an existing contract. The Company adopted the provisions of SOP 05-1 on January 1, 2007 for internal replacements occurring in fiscal years beginning after December 15, 2006. The adoption resulted in a $1.2 million after-tax reduction to retained income to reflect the impact on EGP from the changes in accounting for certain costs associated with contract continuations that no longer qualify for deferral under SOP 05-1 and a reduction of DAC and DSI balances of $1.8 million pre-tax as of January 1, 2007.
SFAS NO. 155, ACCOUNTING FOR CERTAIN HYBRID FINANCIAL INSTRUMENTS - AN AMENDMENT OF FASB STATEMENTS NO. 133 AND 140 ("SFAS NO. 155")
derivative that otherwise would require bifurcation under paragraph 12 or 13 of SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities"("SFAS No.133"); clarifies which interest-only strips and principal-only strips are not subject to the requirements of SFAS No. 133; establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or hybrid financial instruments that contain embedded derivatives requiring bifurcation; and clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives. The Company adopted the provisions of SFAS No. 155 on January 1, 2007, which were effective for all financial instruments acquired, issued or subject to a remeasurement event occurring after the beginning of the first fiscal year beginning after September 15, 2006. The Company elected not to remeasure existing hybrid financial instruments that contained embedded derivatives requiring bifurcation at the date of adoption pursuant to paragraph 12 or 13 of SFAS No. 133. The adoption of SFAS No. 155 did not have a material effect on the results of operations or financial position of the Company.
FASB INTERPRETATION NO. 48, ACCOUNTING FOR UNCERTAINTY IN INCOME TAXES- AN INTERPRETATION OF FASB STATEMENT NO. 109 AND FASB STAFF POSITION NO. FIN 48-1, DEFINITION OF SETTLEMENT IN FASB INTERPRETATION NO. 48 ("FIN 48")
SECURITIES AND EXCHANGE COMMISSION ("SEC") STAFF ACCOUNTING BULLETIN NO. 108, CONSIDERING THE EFFECTS OF PRIOR YEAR MISSTATEMENTS WHEN QUANTIFYING MISSTATEMENTS IN CURRENT YEAR FINANCIAL STATEMENTS ("SAB 108")
In September 2006, the SEC issued SAB 108 to eliminate the diversity of practice in the way misstatements are quantified for purposes of assessing their materiality in the financial statements. SAB 108 was intended to eliminate the potential build up of improper amounts on the balance sheet due to the limitations of certain methods of assessing materiality previously utilized by some reporting entities. SAB 108 establishes a single quantification framework wherein the significance determination is based on the effects of the misstatements on each of the financial statements as well as the related financial statement disclosures. On December 31, 2006, the Company adopted the provisions of SAB 108 which were effective for the first fiscal year ending after November 15, 2006. The adoption of SAB 108 did not have any effect on the results of operations or financial position of the Company.
SFAS NO. 159, THE FAIR VALUE OPTION FOR FINANCIAL ASSETS AND FINANCIAL LIABILITIES-INCLUDING AN AMENDMENT OF FASB STATEMENT NO.115 ("SFAS NO. 159")
SOP 07-1, CLARIFICATION OF THE SCOPE OF THE AUDIT AND ACCOUNTING GUIDE, INVESTMENT COMPANIES ("THE GUIDE") AND ACCOUNTING BY PARENT COMPANIES AND EQUITY METHOD INVESTORS FOR INVESTMENTS IN INVESTMENT COMPANIES ("SOP 07- 1")
In June 2007, the AICPA issued SOP 07-1 which provides guidance for determining whether an entity falls within the scope of the Guide and whether investment company accounting should be retained by a parent company upon consolidation of an investment company subsidiary or by an equity method investor in an investment company. SOP 07-1 was to be effective for fiscal years beginning on or after December 15, 2007, however in February 2008, the FASB issued FASB Staff Position No. SOP 07-1, "Effective Date of AICPA Statement of Position 07-1", which amends SOP 07-1 to (1) delay indefinitely the effective date of the SOP and (2) prohibit adoption of the SOP for an entity that did not early adopt the SOP before December 15, 2007. The Company did not early adopt this standard. Consequently, the standard is expected to have no impact on the Company's results of operations or financial position.
FASB STAFF POSITION NO. 39-1, AMENDMENT OF FASB INTERPRETATION NO. 39 ("FSP FIN 39-1")
determined to be impractical. The adoption of FSP FIN 39-1 is not expected to have a material impact on the Company's results of operations or financial position based on the current level of derivative activity.
The coinsurance provisions of the Reinsurance Agreements were used to transfer the future rights and obligations related to fixed-return fund options and benefit guarantees. $440.0 million of assets supporting general account liabilities have been transferred to Prudential, net of consideration, under the coinsurance reinsurance provisions as of the transaction closing date. General account liabilities of $353.9 million and $415.7 million as of December 31, 2007 and 2006, respectively, however, remain on the Statements of Financial Position with a corresponding reinsurance recoverable.
The terms of the Agreement give Prudential the right to be the exclusive provider of its variable annuity products through the Allstate proprietary agency force for three years and a non-exclusive preferred provider for the following two years. During a transition period, the Company and ALIC will continue to issue new variable annuity contracts, accept additional deposits on existing business from existing contractholders on behalf of Prudential and, for a period of twenty-four months or less from the effective date of the transaction, service the reinsured business while Prudential prepares for the migration of the business onto its servicing platform.
The separate account balances related to the modified coinsurance reinsurance were $944.2 million and $1.01 billion as of December 31, 2007 and 2006, respectively. Separate account balances totaling approximately $4.1 million and $2.7 million at December 31, 2007 and 2006, respectively, related to the variable life business retained by the Company. In the five months of 2006 prior to its disposition, the Company's variable annuity business generated approximately $7.5 million in contract charges, and $16.7 million in 2005.
The Company utilizes services performed by its affiliates, AIC, ALIC and Allstate Investments LLC, and business facilities owned or leased and operated by AIC in conducting its business activities. In addition, the Company shares the services of employees with AIC. The Company reimburses its affiliates for the operating expenses incurred on behalf of the Company. The Company is charged for the cost of these operating expenses based on the level of services provided. Operating expenses, including compensation, retirement and other benefit programs, allocated to the Company were $54.5 million, $53.7 million and $53.8 million in 2007, 2006 and 2005, respectively. A portion of these expenses relate to the acquisition of business, which are deferred and amortized into income as described in Note 2.
Reserves recorded by the Company for annuities issued to ASC and AAC, including annuities to fund structured settlements in matters involving AIC, were $1.93 billion and $1.86 billion at December 31, 2007 and 2006, respectively.
The Company has a service agreement with Allstate Distributors, L.L.C. ("ADLLC"), a broker-dealer company owned by ALIC, whereby ADLLC promotes and markets the fixed and variable annuities sold by the Company to unaffiliated financial services firms. In addition, ADLLC also acts as the underwriter of variable annuities sold by the Company. In return for these services, the Company recorded commission expense of $4.0 million, $6.0 million and $7.1 million for the years ended December 31, 2007, 2006 and 2005, respectively.
The Company received a cash capital contribution from ALIC of $20.0 million in 2005, which was recorded as additional capital paid-in on the Statements of Financial Position.
AMORTIZED FAIR ($ IN THOUSANDS) COST VALUE ---------- ---------- Due in one year or less $ 132,057 $ 132,495 Due after one year through five years 1,052,141 1,074,405 Due after five years through ten years 1,300,761 1,421,624 Due after ten years 2,909,007 3,116,110 ---------- ---------- 5,393,966 5,744,634 Mortgage- and asset-backed securities 534,933 526,494 ---------- ---------- Total $5,928,899 $6,271,128 ========== ==========
($ IN THOUSANDS) 2007 2006 2005 -------- -------- -------- Fixed income securities $358,547 $343,115 $330,567 Mortgage loans 40,916 38,576 33,373 Other 14,487 14,763 6,723 -------- -------- -------- Investment income, before expense 413,950 396,454 370,663 Investment expense 27,212 23,390 14,501 -------- -------- -------- Net investment income $386,738 $373,064 $356,162 ======== ======== ========
($ IN THOUSANDS) 2007 2006 2005 ------- -------- ------- Write-downs $ -- $ (258) $(1,543) Dispositions (1) 3,528 (21,568) (2,053) Valuation of derivative instruments (8,166) (5,429) (4,469) Settlement of derivative instruments 3,807 5,170 2,873 ------- -------- ------- Realized capital gains and losses, pre-tax (831) (22,085) (5,192) Income tax benefit 308 8,216 1,972 ------- -------- ------- Realized capital gains and losses, after-tax $ (523) $(13,869) $(3,220) ======= ======== =======
- ---------- (1) Dispositions include sales, losses recognized in anticipation of dispositions and other transactions such as calls and prepayments. The Company recognized losses of $6.8 million, $16.5 million and $6.8 million in 2007, 2006 and 2005, respectively, due to a change in intent to hold impaired securities.
Gross gains of $4.0 million, $5.9 million and $5.8 million and gross losses of $7.2 million, $18.8 million and $7.4 million were realized on sales of fixed income securities during 2007, 2006 and 2005, respectively.
A mortgage loan is impaired when it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. Interest income for impaired loans is recognized on an accrual basis if payments are expected to continue to be received; otherwise a cash basis is used. The Company had no impaired loans in 2007, 2006 or 2005.
The Company maintains a diversified portfolio of municipal bonds. The following table shows the principal geographic distribution of municipal bond issuers represented in the Company's portfolio. No other state represented more than 5% of the portfolio at December 31, 2007 and 2006.
The Company's mortgage loans are collateralized by a variety of commercial real estate property types located throughout the United States. Substantially all of the commercial mortgage loans are non-recourse to the borrower. The following table shows the principal geographic distribution of commercial real estate represented in the Company's mortgage portfolio. No other state represented more than 5.0% of the portfolio at December 31, 2007 and 2006.
(% OF COMMERCIAL MORTGAGE PORTFOLIO CARRYING VALUE) 2007 2006 ---- ---- California 21.7% 18.9% Illinois 12.7 14.0 Pennsylvania 8.3 8.6 Texas 7.6 7.2 New York 5.5 5.6 Arizona 5.4 5.6 New Jersey 5.1 4.6 Ohio 5.0 5.2
(% OF COMMERCIAL MORTGAGE PORTFOLIO CARRYING VALUE) 2007 2006 ----- ----- Warehouse 32.6% 30.6% Office buildings 31.4 31.4 Apartment complex 17.1 17.0 Retail 15.3 17.1 Industrial -- 1.0 Other 3.6 2.9 ----- ----- Total 100.0% 100.0% ===== =====
NUMBER OF LOANS CARRYING VALUE PERCENT ------------ -------------- ------- ($ IN THOUSANDS) 2008 1 $ 4,604 0.6% 2009 15 58,625 8.1 2010 19 94,072 13.0 2011 17 83,079 11.5 2012 14 61,768 8.5 Thereafter 85 423,153 58.3 --- -------- ----- Total 151 $725,301 100.0% === ======== =====
The Company's business activities include securities lending programs with third parties, mostly large brokerage firms. At December 31, 2007 and 2006, fixed income securities with a carrying value of $193.8 million and $191.9 million, respectively, were on loan under these agreements. In return, the Company receives cash that it invests and includes in short-term investments and fixed income securities, with an offsetting liability recorded in other liabilities and accrued expenses to account for the Company's obligation to return the collateral. Interest income on collateral, net of fees, was $1.4 million, $455 thousand and $430 thousand, for the years ending December 31, 2007, 2006 and 2005, respectively.
At December 31, 2007, fixed income securities with a carrying value of $2.6 million were on deposit with regulatory authorities as required by law.
At December 31, 2007, there were no fixed income securities or other investments that were non-income producing.
The Company primarily uses derivatives for risk reduction. In addition, the Company has derivatives embedded in financial instruments, which are required to be separated and accounted for as derivative instruments. With the exception of embedded derivatives, all of the Company's derivatives are evaluated for their on-going effectiveness as either accounting or non-hedge derivative financial instruments on at least a quarterly basis (see Note 2). The Company does not use derivatives for trading purposes. Non-hedge accounting is used for "portfolio" level hedging strategies where the terms of the individual hedged items do not meet the strict homogeneity requirements prescribed in SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS 133") to permit the application of SFAS 133's hedge accounting model. The principal benefit of a "portfolio" level strategy is in its cost savings through its ability to use fewer derivatives with larger notional amounts.
Asset-liability management is a risk management strategy that is principally employed to align the respective interest-rate sensitivities of assets and liabilities. Depending upon the attributes of the assets acquired and liabilities issued, derivative instruments such as interest rate caps are acquired to change the interest rate characteristics of existing assets and liabilities to ensure a properly matched relationship is maintained and to reduce exposure to rising or falling interest rates. The Company uses financial futures to hedge anticipated asset and liability purchases.
The notional amounts specified in the contracts are used to calculate the exchange of contractual payments under the agreements and are generally not representative of the potential for gain or loss on these agreements.
Fair value, which is equal to the carrying value, is the estimated amount that the Company would receive (pay) to terminate the derivative contracts at the reporting date. The fair value of exchange traded derivative contracts is based on observable market quotations in active markets, whereas the fair value of non-exchange traded derivative contracts is determined using widely accepted valuation models and other appropriate valuation methods.
- ---------- (1) Carrying value includes the effects of legally enforceable master netting agreements. Fair value and carrying value of the assets and liabilities exclude accrued periodic settlements, which are reported in accrued investment income or other invested assets.
(2) These embedded derivative financial instruments relate to the company's variable annuity business, which was fully reinsured by Prudential effective June 1, 2006 (see Note 3).
The Company manages its exposure to credit risk primarily by establishing risk control limits. The Company uses master netting agreements for over-the-counter derivative transactions, including foreign currency swap and interest rate cap agreements. These agreements permit either party to net payments due for transactions covered by the agreements. Under the provisions of the agreements, collateral is either pledged or obtained when certain predetermined exposure limits are exceeded. The Company has not incurred any losses on derivative financial
- ---------- (1) In 2006, the Company disposed of its variable annuity business through reinsurance agreements with Prudential (see Note 3).
To the extent that unrealized gains on fixed income securities would result in a premium deficiency had those gains actually been realized, a premium deficiency reserve has been recorded for certain immediate annuities with life contingencies. A liability of $261.9 million and $235.7 million is included in the reserve for life-contingent contract benefits with respect to this deficiency as of December 31, 2007 and 2006, respectively. The offset to this liability is recorded as a reduction of the unrealized net capital gains included in accumulated other comprehensive income. At December 31, contractholder funds consists of the following:
2007 2006 ---------- ----------- ($ IN THOUSANDS) Interest-sensitive life $ 530,763 $ 476,729 Investment contracts: Fixed annuities 3,733,197 3,667,459 Immediate annuities and other 584,501 564,240 ---------- ---------- Total contractholder funds $4,848,461 $4,708,428 ========== ==========
($ IN THOUSANDS) 2007 2006 ---------- ---------- BALANCE, BEGINNING OF YEAR $4,708,428 $4,349,395 Deposits 537,755 804,825 Interest credited 179,417 178,493 Benefits (146,828) (137,090) Surrenders and partial withdrawals (316,399) (361,670) Contract charges (49,086) (44,954) Net transfers to separate accounts (2) (18,127) Other adjustments (64,824) (62,444) ---------- ---------- BALANCE, END OF YEAR $4,848,461 $4,708,428 ========== ==========
The Company offers various guarantees to variable annuity contractholders. Liabilities for variable contract guarantees related to death benefits are included in the reserve for life-contingent contract benefits and the liabilities related to the income, withdrawal and accumulation benefits are included in contractholder funds in the Statements of Financial Position. All liabilities for variable contract guarantees are reported on a gross basis on the balance sheet with a corresponding reinsurance recoverable (see Note 3).
Absent any contract provision wherein the Company guarantees either a minimum return or account value upon death, a specified contract anniversary date, partial withdrawal or annuitization, variable annuity and variable life insurance contractholders bear the investment risk that the separate accounts' funds may not meet their stated investment objectives. The account balances of variable annuities contracts' separate accounts with guarantees included $891.5 million and $954.2 million of equity, fixed income and balanced mutual funds and $50.4 million and $51.0 million of money market mutual funds at December 31, 2007 and 2006, respectively.
(3) Included in the total liability balance at December 31, 2007 are reserves for variable annuity death benefits of $2.0 million, variable annuity income benefits of $68 thousand, variable annuity accumulation benefits of $(174) thousand and other guarantees of $34 thousand.
Mortality risk on policies in excess of $250 thousand per life is ceded to ALIC. As of December 31, 2007 and 2006, 39.8% and 39.4%, respectively, of our face amount of life insurance in force was reinsured to non-affiliates and ALIC.
($ IN THOUSANDS) 2007 2006 2005 -------- -------- -------- BALANCE, BEGINNING OF YEAR $278,625 $318,551 $238,173 Impact of adoption of SOP 05-1 (1) (1,577) -- -- Disposition of operation (2) -- (79,670) -- Acquisition costs deferred 47,575 62,937 68,205 Amortization charged to income (53,445) (31,672) (41,663) Effect of unrealized gains and losses 7,486 8,479 53,836 -------- -------- -------- BALANCE, END OF YEAR $278,664 $278,625 $318,551 ======== ======== ========
- ---------- (1) The adoption of SOP 05-1 resulted in a $1.6 million adjustment to unamortized DAC related to the impact on future estimated gross profits from the changes in accounting for certain costs associated with contract continuations that no longer qualify for deferral. (see Note 2).
Net amortization charged to income, due to realization of capital (gains) and losses, includes $(196) thousand, $14.1 million and $(3.7) million in 2007, 2006 and 2005, respectively.
As disclosed in Note 3, DAC and DSI balances were reduced during 2006 related to the disposal through reinsurance agreements of all of the variable annuity business. During 2005, DAC and DSI amortization was estimated using stochastic modeling and was significantly impacted by the anticipated return on the underlying funds. The Company's long-term expectation of separate accounts fund performance, net of fees, was approximately 7% in 2005. Whenever actual separate accounts fund performance based on the two most recent years varied from the expectation, the Company projected performance levels over the next five years such that the mean return over a seven-year period equaled the long-term expectation. This approach is commonly referred to as "reversion to the mean" and is commonly used by the life insurance industry as an appropriate method for amortizing variable annuity and life DAC and DSI. In applying the reversion to the mean process, the Company did not allow the future mean rates of return including fees projected over the five-year period to exceed 12.75% or fall below 0%. The Company periodically evaluated the results of utilization of this process to confirm that it was reasonably possible that variable annuity and life fund performance would revert to the expected long-term mean within this time horizon.
(IN THOUSANDS) 2007 2006 2005 ------- ------- ------- BALANCE, BEGINNING OF YEAR $24,731 $18,527 $ 2,955 Impact of adoption of SOP 05-1 (1) (243) -- -- Disposition of operation (2) -- (6,162) -- Sales inducements deferred 8,511 15,740 16,923 Amortization charged to income (6,500) (4,417) (2,373) Effect of unrealized gains and losses 1,492 1,043 1,022 ------- ------- ------- BALANCE, END OF YEAR $27,991 $24,731 $18,527 ======= ======= =======
- ---------- (1) The adoption of SOP 05-1 resulted in a $243 thousand adjustment to unamortized DSI related to the impact on future estimated gross profits from the changes in accounting for certain costs associated with contract continuations that no longer qualify for deferral (see Note 2).
The New York Liquidation Bureau (the "Bureau") has publicly reported that Executive Life Insurance Company of New York ("Executive Life"), currently under its jurisdiction as part of a 1992 court-ordered rehabilitation plan, may only be able to meet future obligations of its annuity contracts for the next fifteen years due to an estimated $600 million shortfall in assets to fund those obligations. If Executive Life were to be declared insolvent in the future, the Company would likely have exposure to guaranty fund assessments or other costs.
Based on currently available information, the outcome of this situation is uncertain at this time. The Bureau may eventually take actions to address this situation that may lead to guaranty fund assessments or other costs to the Company. Under current law, the Company may be allowed to recoup a portion of the amount of any additional guaranty fund assessment in periods subsequent to the recognition of the assessment by offsetting future premium taxes. The Company's market share in New York was approximately 5.5% in 2006 based on industry annuity premium.
The Company and certain affiliates are involved in a number of lawsuits, regulatory inquiries, and other legal proceedings arising out of various aspects of its business. As background to the "Proceedings" subsection below, please note the following:
- The EEOC also filed another lawsuit in 2004 alleging age discrimination with respect to a policy limiting the rehire of agents affected by the agency program reorganization (the "EEOC II" suit). In EEOC II, in 2006, the court granted partial summary judgment to the EEOC. Although the court did not determine that AIC was liable for age discrimination under the ADEA, it determined that the rehire policy resulted in a disparate impact, reserving for trial the determination on whether AIC had reasonable factors other
- A putative nationwide class action has also been filed by former employee agents alleging various violations of ERISA, including a worker classification issue. These plaintiffs are challenging certain amendments to the Agents Pension Plan and are seeking to have exclusive agent independent contractors treated as employees for benefit purposes. This matter was dismissed with prejudice by the trial court, was the subject of further proceedings on appeal, and was reversed and remanded to the trial court in 2005. In June 2007, the court granted AIC's motion to dismiss the case. Following plaintiffs' filing of a notice of appeal, the Third Circuit issued an order in December 2007 stating that the notice of appeal was not taken from a final order within the meaning of the federal law and thus not appealable at this time. Responses to the order were filed in mid- December.
The Internal Revenue Service ("IRS") is currently examining the Company's 2005 and 2006 federal income tax returns. The IRS has completed its examination of the Company's federal income tax returns through 2004 and the statute of limitations has expired on years prior to 2003. Any adjustments that may result from IRS examinations of tax returns are not expected to have a material impact on the results of operations, cash flows or financial position of the Company.
DEFERRED LIABILITIES Deferred policy acquisition costs (56,351) (59,986) Unrealized net capital gains (35,101) (42,020) Difference in tax bases of investments (14,993) (14,127) Other liabilities (1,375) (1,260) --------- ---------
($ IN THOUSANDS) 2007 2006 2005 ------- ------- ------- Current $23,448 $16,949 $24,132 Deferred (646) 806 (3,187) ------- ------- ------- Total income tax expense $22,802 $17,755 $20,945 ======= ======= =======
Statutory accounting practices differ from GAAP primarily since they require charging policy acquisition and certain sales inducement costs to expense as incurred, establishing life insurance reserves based on different actuarial assumptions, and valuing investments and establishing deferred taxes on a different basis.
Statutory net income for 2007, 2006 and 2005 was $38.2 million, $33.4 million and $35.9 million, respectively. Statutory capital and surplus as of December 31, 2007 and 2006 was $462.4 million and $444.6 million, respectively.
Defined pension plans, sponsored by AIC, cover most full-time employees and certain part-time employees. Benefits under the pension plans are based upon the employee's length of service and eligible annual compensation. The Company uses the accrual method for its defined benefit plans in accordance with accepted actuarial methods. AIC's funding policy for the pension plans is to make annual contributions at a minimum level that is at least in accordance with regulations under the Internal Revenue Code and in accordance with generally accepted actuarial principles. The allocated cost to the Company included in net income for the pension plans in 2007, 2006 and 2005 was $2.3 million, $3.8 million and $2.5 million, respectively.
AIC also provides certain health care and life insurance subsidies for employees hired before January 1, 2003 when they retire ("postretirement benefits"). Qualified employees may become eligible for these benefits if they retire in accordance with AIC's established retirement policy and are continuously insured under AIC's group plans or other approved plans in accordance with the plan's participation requirements. AIC shares the cost of the retiree medical benefits with retirees based on years of service, with AIC's share being subject to a 5% limit on annual medical cost inflation after retirement. AIC has the right to modify or terminate these plans. The allocated cost to the Company included in net income was $566 thousand, $551 thousand and $583 thousand for postretirement benefits other than pension plans in 2007, 2006 and 2005, respectively.
Employees of AIC are eligible to become members of The Savings and Profit Sharing Fund of Allstate Employees ("Allstate Plan"). The Corporation's contributions are based on the Corporation's matching obligation and performance. The Company's allocation of profit sharing expense from the Corporation was $1.5 million, $1.5 million and $502 thousand in 2007, 2006 and 2005, respectively.
($ IN THOUSANDS) ------------------------------ After- Pretax Tax tax --------- ------- -------- Unrealized holding gains arising during the period $(46,529) $16,285 $(30,244) Less: reclassification adjustment (6,087) 2,130 (3,957) -------- ------- -------- Unrealized net capital gains and losses (40,442) 14,155 (26,287) -------- ------- -------- Other comprehensive loss $(40,442) $14,155 $(26,287) ======== ======= ========
We have audited the accompanying Statements of Financial Position of Allstate Life Insurance Company of New York (the "Company", an affiliate of The Allstate Corporation) as of December 31, 2007 and 2006 and the related Statements of Operations and Comprehensive Income, Shareholder's Equity, and Cash Flows for each of the three years in the period ended December 31, 2007. Our audits also included the financial statement schedules listed in the Index at Item 15. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on the financial statements and financial statement schedules based on our audits.
/s/ Deloitte & Touche LLP - ------------------------- Chicago, Illinois March 13, 2008