In December 2001, we signed a promissory note and mortgage due December 31, 2011, with a current outstanding principal amount of $6.8 million at December 31, 2002, used to finance our home office building consisting of 58,000 square feet and located at 10689 North Pennsylvania Street, Indianapolis, Indiana. Approximately 46,000 square feet of the building is leased to Standard Life pursuant to a lease agreement entered into on January 1, 2002.
U.S. Health Services leases approximately 15,000 square feet in an office building located at 6210 N. Technology Center Drive, Indianapolis, Indiana. The lease expires April 16, 2007.
The following historical financial data was derived from our audited Consolidated Financial Statements. This historical financial data should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our Consolidated Financial Statements and related Notes.
Comparison of consolidated financial information is significantly affected by the acquisitions of Savers Life on March 12, 1998 and Midwestern Life on October 30, 1998.
General economic conditions and other factors, including prevailing interest rate levels, and stock market performance, which may affect our ability to sell products, the market value of our investments and the lapse rate and profitability of our policies.
Declining interest rates generally have little immediate effect on our investment earnings rates. Over time, as we invest positive cash flows at lower rates, our earned rates decline. In such an environment, we attempt to adjust credited interest rates accordingly, subject to competitive pressures. In most situations, this action allows us to maintain our margins. However, the sustained period of low interest rates may impact future interest spreads, results of operations and financial condition.
Life insurance policyholders sometimes do not pay premiums, thus causing their policies to lapse. For the years 2002, 2001 and 2000 Standard Life experienced total policy lapses, excluding surrenders, of 3.4%, 3.7% and 5.7% of total policies in force at December 31 of each year, respectively. Ongoing premiums are not required for annuity policies, so annuities do not experience policy lapses.
After purchase, amortization of the asset occurs in proportion to profits emerging from the purchased policies. The asset is amortized over the expected life of the block of business. The percentages of expected net amortization of the beginning balance of the total PVFP asset as of December 31, 2002 are expected to be between 10% and 15% in each of the years 2003 through 2007.
Amortization of DAC related to operations was $19.0 million, $10.7 million and $8.7 million for the years ended December 31, 2002, 2001 and 2000, respectively. The increase in current year amortization expense resulted primarily from the emergence of gross profits from business sold in recent years and the acceleration of DAC amortization due to DAC unlocking. Future expected amortization of DAC, assuming no new business after December 31, 2002 and current assumptions, is as follows (in thousands):
Costs related to the acquisition of new business, primarily commissions paid to agents, which vary with and are directly related to the production of new business, are deferred to the extent that such costs are recoverable from future profit margins. At the time of issuance, the acquisition expenses are capitalized as DAC. In accordance with SFAS No. 60, DAC with interest is amortized over the lives of the policies in a constant relationship to policy premiums.
The carrying value of our investment portfolio was $1.4 billion at December 31, 2002. The accounting risks associated with these assets relate to the recognition of income, our determination of other-than-temporary impairments and our estimation of fair values.
We periodically evaluate whether the declines in fair value of our investments are other-than-temporary. Our evaluation consists of a review of qualitative and quantitative factors. For investments with publicly quoted market prices, we generally consider a decline to be an other-than-temporary impairment if the quoted market price is less than its accounting basis for three quarters, absent evidence to the contrary. We also consider additional factors to determine whether the declines in fair value are other-than-temporary, such as downgrades of the security by a rating agency, deterioration in the financial condition of the issuer, and other publicly available issuer-specific news or general market conditions. For investments in companies with no quoted market price, we consider similar qualitative and quantitative factors and also take into account the cost of the investment, the type of investment, subsequent purchases of the same or similar investments, the current financial position and operating results of the company invested in, and such other factors as may be relevant. Declines in fair values of securities deemed to be other-than-temporary are recognized as a reduction of net income.
Equity indexed call options are derivative instruments linked to the major stock indices (S&P 500 Index and DJIA) which are used to hedge the equity benefits of our equity indexed annuity products. We purchase call options whose payoff characteristics mirror the equity benefits of our products. These securities are carried at fair value and the change in fair value is included in net investment income.
The balance of our goodwill was $6.4 million at December 31, 2002. The recovery of this asset is dependent on the fair value of the business to which it relates. Prior to January 1, 2002, these assets were generally amortized over a 20-40 year period. Effective in 2002, pursuant to SFAS No. 142, “Goodwill and Other Intangible Assets”, (“SFAS No. 142”), goodwill is no longer amortized but is subject to annual impairment tests based on the estimated fair value of the business units that comprise our domestic segment. There are numerous assumptions and estimates underlying the determination of the estimated fair value of these businesses. Different valuation methods and assumptions can produce significantly different results that could affect the amount of any potential impairment charge that might be required to be recognized. A charge of $1.2 million resulting from the impairment of goodwill from the adoption of SFAS No. 142 was recorded in 2002.
Our income tax expense includes deferred income taxes arising from temporary differences between the financial reporting and tax basis of assets and liabilities and capital loss carryforwards. We have gross deferred income tax assets of $48.4 million at December 31, 2002. In assessing the realization of our deferred income tax assets, we consider whether it is more likely than not that the deferred income tax assets will be realized. The ultimate realization of our deferred income tax assets depends upon generating future taxable income during the periods in which our temporary differences become deductible and capital gains before our capital loss carryforwards expire. We evaluate the recoverability of our deferred income tax assets by assessing the need for a valuation allowance on a quarterly basis. If we determine that it is more likely than not that our deferred income tax assets will not be recovered, a valuation allowance will be established against some or all of our deferred income tax assets. This could have a significant effect on our future results of operations and financial position.
The total balance of our liabilities for insurance products was $1.57 billion at December 31, 2002. These liabilities are often payable over an extended period of time and the profitability of the related products is dependent on the pricing of the products and other factors. Differences between pricing assumptions and actual experience will impact future financial results.
We calculate and maintain reserves for the estimated future payment of claims to our policyholders based on actuarial assumptions. These assumptions are generally best estimates, with moderate provision for adverse deviation. Many factors can affect the adequacy of these reserves and liabilities, such as economic and social conditions, inflation, changes in doctrines of legal liability and extra contractual damage awards. Therefore, the reserves and liabilities we establish are necessarily based on extensive estimates, assumptions and historical experience. Establishing reserves is an uncertain
Premium income for 2001 remained constant at $9.4 million. Effective August 2001, we suspended the active marketing of life products indefinitely, however we continue to manage our in force life business.
Call option losses relate to equity-indexed products that are hedged with call options to limit risk against unusually high crediting rates from favorable returns in the equity market. The market value of these options fluctuate from period to period and are substantially offset by amounts credited to policyholder account balances.
Call option losses for the 2002 and 2001 periods were due to the impact from changes in the market value of our call options as a result of changes in the S&P 500 Index and the purchase of additional options to support increased equity-indexed liabilities.
See also “Interest credited to interest sensitive annuities and other financial products” for information regarding the impact of our equity-indexed products.
Benefits and claims in 2002 decreased by $3.1 million or 24%, to $9.9 million. This decrease includes the impact from single premium immediate annuity reserves of approximately $1.7 million, which is offset by a comparable increase in interest credited. In addition, we experienced favorable mortality of $.5 million compared to the 2001 period.
Benefits and claims in 2001 decreased by $.8 million or 6%, to $13.0 million, as a result of favorable mortality of $.9 million compared to the 2000 period.
Interest credited to interest sensitive annuities and other financial products represents interest credited to insurance liabilities of deferred annuities, equity-indexed annuities, single premium immediate annuities and other financial products. This expense fluctuates with changes in 1) the average interest-sensitive insurance liabilities, 2) the average credited rate on those liabilities, and 3) the market value fluctuations of call options.
In 2001, interest credited increased $8.9 million or 42%, to $30.2 million due to increased average interest sensitive liabilities of $159.2 million or 25% compared to the 2000 period. In addition, interest credited increased $3.7 million as a result of market value changes of call options supporting our equity-indexed products.
Amortization includes 1) amortization related to the present value of polices purchased from acquired insurance business, 2) amortization of deferred policy acquisition costs related to capitalized costs of insurance business sold, and 3) amortization of goodwill for the 2001 period.
Amortization in 2002 increased by $11.6 million or 129%, to $20.5 million. This increase relates primarily to a $7.8 million acceleration of DAC amortization due to DAC unlocking and the emergence of gross profits from business sold in recent years.
Acquisition costs for deferred annuity contracts and equity indexed annuity contracts are required to be amortized over the lives of the contracts in relation to the incidence of estimated gross profits. Estimated gross profits on fixed and equity indexed annuity contracts include investment spread, surrender income, expense margins, and realized investment gains and losses. Gross profit estimates are evaluated regularly, with historical gross profit estimates adjusted to actual results and projected gross profit estimates updated to reflect current expectations. DAC amortization is adjusted both retrospectively and prospectively (unlocked) in accordance with the revised profit stream, and retrospective adjustments are reported in the current reporting period. DAC unlocking in the current period created a charge to earnings of $7.8 million.
During 2002, commission expenses decreased $2.7 million to $1.2 million primarily due to the termination of a marketing and administration contract in 2002.
During 2001, commission expenses increased $2.0 million to $3.9 million primarily due to $1.1 million of additional commissions paid by Savers Marketing due to increased sales.
In 2002, operating expenses increased $4.3 million or 40%, to $15.0 million. This increase is primarily due to $1.7 million related to the development of our new U.S. Health Services subsidiary, $1.3 million related to write off and legal costs related to the recovery of agency receivable balances, and $.5 million of severance costs.
In 2002, interest expense and financing costs increased by $.9 million or 25%, to $4.4 million. Average borrowings for the period increased $4.4 million and included the impact from our Trust Preferred Offering and our mortgage payable.
Net realized investment losses for 2002, net of DAC amortization of $9.9 million, were $10.0 million. The majority of the loss was attributable to the write-downs on the value of collateralized debt obligations due to increased default rates and securities in the energy and telecommunications sectors.
During 2002, net deposits decreased $42.0 million or 56%, to $32.4 million. The decrease in deposits is primarily due to the volatile global equity environment and the sale of the International operations in the second and third quarter of 2002.
Net investment income represents income earned on our corporate assets such as cash, short-term investments and fixed maturity securities. Standard Management International is required to hold a certain level of cash and short-term investments in order to comply with local insurance laws.
Net investment income was $.1 million in 2002 and $.5 million in 2001, respectively. Corporate assets averaged $5.3 million for 2002 and $12.1 million for 2001, respectively.
During 2002, fees from separate accounts decreased $5.3 million or 60%, to $3.6 million. The decrease is primarily due to the sale of the International operations in the second and third quarter of 2002.
Operating expenses decreased $1.2 million or 40% in 2002, to $1.9 million primarily as a result of the sale of International Operations in the second and third quarter of 2002.
There were no net realized investment losses for 2002. Net realized investment losses, for 2001 were $.8 million due to the sale of a security reflecting changes in market conditions.
Gain on sale of discontinued operations, net of related costs results from the sale of our International Operations in 2002.
Surplus Debenture Interest. We loaned $27.0 million to Standard Life pursuant to unsecured surplus debenture agreements (“surplus debentures”) which requires Standard Life to make quarterly interest payments at a variable corporate base rate plus 2% per annum, and annual principal payments of $1.0 million per year beginning in 2007 and concluding in 2033. The interest and principal payments are subject to quarterly approval by the Indiana Department of Insurance, depending upon satisfaction of certain financial tests relating to levels of Standard Life’s capital and surplus and general approval of the Commissioner of the Indiana Department of Insurance. We currently anticipate these quarterly approvals will be granted. Assuming the approvals are granted and the December 31, 2002 interest rate of 6.25% continues, we expect to receive interest income of $1.8 million from the surplus debentures in 2003.
Dividends paid from Standard Life are limited by laws applicable to insurance companies. As an Indiana domiciled insurance company, Standard Life may pay a dividend or distribution from its surplus profits, without the prior approval of the Commissioner of the Indiana Department of Insurance, if the dividend or distribution, together with all other dividends and distributions paid within the preceding twelve months, does not exceed the greater of 1) net gain from operations or 2) 10% of surplus, in each case as shown in its preceding annual statutory financial statements. In 2002, there were no dividends received from our subsidiaries. In 2001, we received dividends of $1.6 million and $.5 million from Standard Life and Savers Marketing, respectively. In 2003, we could receive dividends of approximately $5.6 million from Standard Life, without regulatory approval; however, the payment of dividends will require approval from SCOR Life U.S. Insurance Company, a reinsurer of Standard Life.
Equipment Rental Fees. In 2002, we received $1.1 million from Standard Life for the use of our equipment and we expect to receive the same amount in 2003.
Lease Income. Effective January 1, 2002, we entered into a lease agreement with Standard Life whereby Standard Life will lease approximately 46,000 square feet of our office space located at 10689 North Pennsylvania Street. During 2002, we received approximately $.8 million in lease income from Standard Life and we expect to receive the same amount in 2003.
Marketing paid $.4 million and Standard Management International recovered $.1 million in accordance with this agreement. Standard Management International terminated its participation in this agreement with the sale of our International Operations.
The following are the characteristics of our mortgage payable, promissory note, notes payable and trust preferred securities, including estimated required payments in 2003.
principal and interest payments: $56 thousand per month through December, 2011;
note may be prepaid on or before January, 2005 at 105% and declining to 101% after December, 2008.
The following are characteristics of our promissory note at December 31, 2002:
interest payments required in 2003 based on current balances will be $30 thousand.
interest payments required in 2003 based on current balances will be $18 thousand.
interest rate is greater of 1) 10% per annum or 2) six month London Inter-Bank Offered Rate (“LIBOR”) plus 1.5%;
Trust Preferred Securities: These securities represent an undivided beneficial interest in the assets of SMAN Capital Trust I, a Delaware business trust organized to purchase our junior subordinated debentures and issue preferred securities. The assets of the Trust consist solely of the debentures which were purchased by the Trust with the proceeds of the offering. On August 9, 2001, the Trust completed a public offering of $20.7 million of its 10.25% preferred securities. The Trust used
the proceeds of this offering to purchase our 10.25% junior subordinated debentures. Net proceeds from the sale of the debentures of approximately $19.3 million were used to redeem our Series A preferred stock of $6.5 million and repay $7.3 million of our notes payable. The remaining proceeds were used for general corporate purposes.
The following are characteristics of our trust preferred securities at December 31, 2002:
General: On a consolidated basis we reported net cash provided by operations of $18.4 million and $8.0 million for 2002 and 2001, respectively. Although deposits received on our interest-sensitive annuities and other financial products are not included in cash flow from operations under GAAP, these funds are available. Cash provided by operations plus net deposits received, less net account balances returned to policyholders on interest sensitive annuities and other financial products, resulted in positive cash flow of $469.0 million and $222.0 million for 2002 and 2001, respectively. Cash generated on a consolidated basis is available only to the extent that it is generated at the holding company level or is available through interest, dividends, management fees or other payments from our subsidiaries.
U.S. Insurance Operations. The principal liquidity requirements of Standard Life are its 1) contractual obligations to policyholders, 2) surplus debenture interest, dividends, management fees and rental fees to Standard Management and 3) operating expenses. The primary source of funding for these obligations has been cash flow from premium income, net investment income, investment sales and maturities and sales of annuity products. These sources of liquidity for Standard Life significantly exceed scheduled uses. Liquidity is also affected by unscheduled benefit payments including death benefits, policy withdrawals and surrenders. The amount of withdrawals and surrenders is affected by a variety of factors such as renewal interest crediting rates, interest rates for competing products, general economic conditions, Standard Life’s A.M. Best rating and events in the industry that affect policyholders’ confidence. In August 2002, Standard Life received a rating from A.M. Best of (“B+”), or “very good” category, a one-category reduction from its previous rating of (“B++”) (Very Good). A.M. Best cited “rapid growth in the annuity business, modest risk-adjusted capitalization and high exposure to below investment grade bonds as a percentage of capital and surplus,” as the primary reasons for the rating change.
Statutory surplus is computed according to rules prescribed by the NAIC as modified by the Indiana Department of Insurance, or the state in which our insurance subsidiaries do business. Statutory accounting rules are different from GAAP and are intended to reflect a more conservative perspective. With respect to new business, statutory accounting practices require that: 1) acquisition costs (primarily commissions and policy issue costs) and 2) reserves for future guaranteed principal payments and interest in excess of statutory rates, be expensed in the year the new business is written. These items cause a reduction in statutory surplus or surplus strain in the year written for many insurance products. We design our products to minimize such first-year losses, but certain products continue to cause a statutory loss in the year written. Our long-term growth goals contemplate continued growth in our insurance businesses. To achieve these growth goals, our U.S. insurance subsidiaries will need to increase statutory surplus. Additional statutory surplus may be secured through various sources such as internally generated statutory earnings, infusions with funds generated through our debt or equity offerings, or mergers with other life insurance companies. If additional capital is not available from one or more of these sources, we believe that we could reduce surplus strain through the use of reinsurance or through reduced writing of new business.
Our operating results are affected by many factors, including competition, lapse rates, interest rates, maintenance of insurance ratings, governmental regulation and general business conditions, many of which are outside our control.
We operate in a highly competitive environment and are in direct competition with a large number of insurance companies, many of which offer a greater number of products through a greater number of agents and have greater resources. In addition, we may be subject, from time to time, to new competition resulting from additional insurance carriers introducing products similar to those offered by us. Moreover, as a result of recent federal legislation, commercial banks, insurance companies, and investment banks may now combine, provided certain requirements are satisfied, and we expect to encounter increased competition from these providers of financial services. This competitive environment could result in lower premiums, loss of sales and reduced profitability.
Our management believes that the ability to compete is dependent upon, among other things, the ability to retain and attract independent general agents to market products and the ability to develop competitive products that also are profitable. Although management believes that good relationships with our independent general agents exist, competition for those agents among insurance companies is intense. Our independent general agents typically represent other insurance companies and may sell products that compete with our products. Sales of our annuity products and, therefore, our results of operations and financial condition may be adversely affected if we are unsuccessful in attracting and retaining independent agents and marketing organizations. See “Business of Standard Management-Competition.”
Our success also depends upon the continued contributions of key officers and employees. Should one or more of these individuals leave or otherwise become unavailable for any reason, business and results of operations could be materially adversely affected. See “Business of Standard Management-Employees.”
The NAIC, and state insurance regulators continually reexamine existing laws and regulations and their application to insurance companies. Changes in the NAIC or state regulations, including, for example, changes in the risk-based capital requirements, which are determined by the NAIC and state regulators, could affect the ability of our subsidiaries to pay dividends to us which could affect our ability to make payments to you.
We are able to assume insurance risks beyond the level which our capital and surplus would support by transferring substantial portions of risks to other, larger insurers through reinsurance contracts. Approximately 70% of our life insurance
in force and 6% of our annuity policy liabilities have risks that we have reinsured through reinsurance contracts. However, these reinsurance arrangements leave us exposed to credit risk, which exists because reinsurance does not fully relieve us of our liability to our policyholders for the portion of the risks ceded to reinsurers. This liability may exceed our established reserves, which would have a significant negative affect on our net income. In addition, reinsurance may not continue to be available to us at commercially reasonable rates. If reinsurance is not available to us in the future, the amounts we reserve as liabilities for payment of claims would significantly increase and the amount and value of policies we sell would significantly decrease, which would have a material adverse effect on our business and operating results.
Our earnings are significantly dependent upon the extent to which the actual claims received by our subsidiaries is consistent with the actuarial assumptions we use in establishing reserves for the payment of benefit claims. To the extent that the actual claims experience of our subsidiaries exceeds our established reserves, our operating income would be negatively affected, resulting in an adverse effect on our earnings.
As of December 31, 2002, approximately 84% or $1.1 billion of annuity contracts in force (measured by statutory reserves) were surrenderable. Approximately 8% of those contracts or approximately $109 million of annuity contracts in force (measured by statutory reserves) are surrenderable without charge. Changes in prevailing interest rates, ratings or other factors which result in or lead to significant levels of surrenders of existing annuity contracts could have a material adverse effect on our financial condition and results of operations. Surrenders result in a reduction of invested assets that earn investment income and a reduction of policyholder account balances that credit interest.
The assumptions are based upon, among others, interest rate spread and rates of mortality, surrender and lapse. If, for instance, future mortality rates were higher than expected, projected margins would be lower and deferred policy acquisition cost amortization would increase. The value of these assets reflected in our December 31, 2002 balance sheet totaled $175 million, or 10% of our assets. Although we have established procedures to periodically review the assumptions used to value these assets and determine the need to make adjustments, if our assumptions are incorrect and adjustments need to be made, our financial results could be materially adversely affected.