The Company’s executive offices and its principal office are in leased premises at 733 Third Avenue, 4th Floor, New York, New York 10017. The Company, through an affiliate, also leases office space in Los Angeles and Woodland Hills, California.
On November 1, 2004 the Company entered a contract to reinsure credit life and health insurance policies. The Company receives a share of premium for the reinsured policies and will indemnify the reinsured for a proportionate share of these liabilities while the reinsured retains the assets and corresponding reserve liabilities. The contract is considered modified coinsurance and as such the reinsurance claims payable is offset against reinsurance premiums receivable and included in other assets on the balance sheet. The treaty is for one year with the option to renew annually and may be terminated by either party with 180 days advance notice.
Securities in the Company’s bond portfolio with a carrying value of approximately $464.7 million at December 31, 2004 do not have readily determinable market prices. For these securities, the Company estimates the fair value with internally prepared valuations (including those based on estimates of future profitability). Otherwise, the Company uses its most recent purchases and sales of similar unquoted securities, independent broker quotes or comparison to similar securities with quoted prices when possible to estimate the fair value of those securities. All such securities are classified as available for sale. The Company’s ability to liquidate its positions in these securities will be impacted to a significant degree by the lack of an actively traded market, and the Company may not be able to dispose of these investments in a timely manner. Although the Company believes its estimates reasonably reflect the fair value of those securities, the key assumptions about the risk-free interest rates, risk premiums, performance of underlying collateral, if any, and other factors may not reflect those of an active market.
AMORTIZATION OF DEFERRED ACQUISITION COSTS AND OTHER DEFERRED EXPENSES: Policy acquisition costs include commissions and other costs that vary with, and are primarily related to, the production or acquisition of new business. Such costs are deferred and amortized over the estimated lives of the annuity contracts. The Company amortizes DAC and other deferred expenses based on a percentage of expected gross profits (“EGPs”) over the life of the underlying policies over the estimated lives of the fund deposits on a straight-line basis. EGPs are computed based on assumptions related to the underlying policies written, including their anticipated duration, net spreads earned during the life of the contracts, costs of providing policy guarantees, assumed future growth rates of variable annuity assets and the level of expenses necessary to maintain the policies.
INCOME TAX EXPENSE totaled $7.9 million in 2004, $12.1 million in 2003 and $9.0 million in 2002, representing effective tax rates of 24%, 42% and 57%, respectively. The tax expense in 2004 included the benefit of $6.6 million resulting from the reduction of the prior year tax liability based on additional information becoming available. Excluding this benefit the effective tax rate is 44% in 2004. See Note 11 of the Notes to Financial Statements for a reconciliation of income tax expense to the federal statutory rate.
NET INVESTMENT SPREAD, a non-GAAP measure, represents investment income less interest credited to fixed-rate products, including fixed annuity contracts as well as universal life insurance contracts issued in prior years and Fixed Options (collectively “Fixed-Rate Products”) is a key measurement used by the Company in evaluating the profitability of its annuity business. Accordingly, the Company presents an analysis of net investment spread because the Company has determined this measure to be useful and meaningful.
In evaluating its investment yield and net investment spread, the Company calculates average invested assets using the amortized cost of bonds, notes and redeemable preferred stocks. This basis does not include unrealized gains and losses, which are reflected in the carrying value (i.e., fair value) of those investments pursuant to Statement of Financial Accounting Standards No. 115, “Accounting for Certain Investments in Debt and Equity Securities”. In the calculation of average invested assets, the Company excludes collateral received from a securities lending program, which is offset by a securities lending payable in the same amount. The Company participates in a securities lending program with an affiliated agent, pursuant to which it lends its securities and primarily takes cash as collateral with respect to the securities lent. Participation in securities lending agreements provides additional net investment income for the Company, resulting from investment income earned on the collateral, less interest paid on the securities lending agreements and the related management fees paid to an affiliate to administer the program.
An analysis of net investment spread and reconciliation to pretax income before cumulative effect of accounting change is presented in the following table:
Investment income (and the related yields on average invested assets) totaled $167.4 million (5.33%) in 2004, compared with $119.7 million (5.67%) in 2003 and $97.3 million (6.74%) in 2002. The decrease in the investment yield in 2004 compared to 2003 primarily reflects the reinvestment of maturing investments in the historically low prevailing interest rate environment that has persisted throughout 2003 and 2004. Expenses incurred to manage the investment portfolio amounted to $1.5 million in 2004, $0.7 million in 2003 and $0.6 million in 2002. These expenses are included as a reduction of investment income in the statement of income and comprehensive income.
VARIABLE ANNUITY POLICY FEES are generally based on the market value of assets in the separate accounts supporting variable annuity contracts. Such fees totaled $8.9 million in 2004, $8.1 million in 2003 and $9.0 million in 2002. The increased fees in 2004 compared to 2003 primarily reflect the improved equity market conditions in 2004 and the latter part of 2003, and the resulting favorable impact on market values of assets in the separate accounts. Variable annuity policy fees represent 2.0%, 2.0% and 1.9% of average variable annuity assets in 2004, 2003 and 2002, respectively. Variable annuity assets averaged $449.4 million, $410.1 million and $462.3 million during the respective periods. Variable annuity deposits which include the Fixed Options totaled $97.3 million, $142.6 million and $101.3 million in 2004, 2003 and 2002, respectively. The decrease in 2004 is due to lower sales on certain products with features that have been discontinued.
fees earned on deposits received and administrative fees, net of reinsurance premiums. The administrative fees are assessed based on the number of policies in force as of the end of each month. The Company acquired its universal life insurance contracts as part of the acquisition of business from MBL Life Assurance Corporation on July 1, 1999 and does not actively market such contracts. Such fees represent 2.35%, 2.26% and 2.59% of average reserves for universal life insurance contracts in the respective periods. The decrease in fees in 2003 resulted primarily from increased reinsurance premiums ceded.
GENERAL AND ADMINISTRATIVE EXPENSES totaled $7.7 million in 2004, $6.0 million in 2003 and $8.1 million in 2002. The increase in 2004 results from administrative expenses related to significantly larger blocks of fixed annuity contracts. General and administrative expenses remain closely controlled through a company-wide cost containment program and continue to represent less than 1% of average total assets.
ANNUAL COMMISSIONS totaled $1.6 million in 2004, compared with $1.0 million in 2003 and $0.8 million in 2002. Annual commissions generally represent renewal commissions to maintain the persistency of certain of the Company’s products. Substantially all of the Company’s currently available annuity products allow for an annual commission payment option in return for a lower immediate commission.
COMMISSIONS ON REINSURANCE CONTRACT totaled $3.0 million in 2004, compared to no commissions in 2003 and 2002. The increase in 2004 was due to the Company entering into a reinsurance contract effective November 1, 2004
CLAIMS ON UNIVERSAL LIFE INSURANCE CONTRACTS, NET OF REINSURANCE RECOVERIES totaled $3.9 million in 2004, compared with $3.1 million in 2003 and $3.0 million in 2002 (net of reinsurance recoveries of $8.9 million in 2004, $3.6 million in 2003 and $4.2 million in 2002). The change in such claims resulted principally from changes in mortality experience and the reinsurance recoveries there on.
a liability for GMDB (see Note 2 of Notes to Financial Statements) pursuant to adoption of a new accounting standard, SOP 03-1.
Guaranteed minimum account value (“GMAV”) is a feature the Company began offering on certain variable annuity products in June of 2004. If available and elected by the contract holder at the time of contract issuance, this feature guarantees that the account value under the contract will at least equal the amount of the deposits invested during the first ninety days of the contract, adjusted for subsequent withdrawals, at the end of a ten-year waiting period. The Company bears the risk that protracted under-performance of the financial markets could result in GMAV benefits being higher than the underlying contract holder account balance and that the fees collected under the contract are insufficient to cover the costs of the benefit to be provided. In 2004, variable annuity deposits with the GMAV option were approximately $16.3 million.
The following summarizes the Company’s rated bonds by rating classification as of December 31, 2004.
Bonds and short-term promissory instruments are divided into six quality categories for NAIC rating purposes, ranging from 1 (highest) to 5 (lowest) for non-defaulted bonds plus one category 6, for bonds in or near default. These six categories correspond with the S&P/Moody’s/Fitch rating groups listed above, with categories 1 and 2 considered investment grade. The NAIC categories include $30.7 million of assets that were rated by the Company pursuant to applicable NAIC rating guidelines.
The valuation of invested assets involves obtaining a fair value for each security. The source for the fair value is generally from market exchanges, with the exception of non-traded securities.
• The occurrence of a discrete credit event resulting in: (i) the issuer defaulting on a material outstanding obligation; (ii) the issuer seeking protection from creditors under the bankruptcy laws or similar laws intended for the court supervised reorganization of insolvent enterprises; or (iii) the issuer proposing a voluntary reorganization pursuant to which creditors are asked to exchange their claims for cash or securities having a fair value substantially lower than the par value of their claims; or
• In the opinion of the Company’s management, it is unlikely the Company will realize a full recovery on its investment, irrespective of the occurrence of one of the foregoing events.
As a result of these policies, the Company recorded pretax impairment writedowns of $0.8 million, $3.1 million and $9.5 million in 2004, 2003 and 2002, respectively. No individual impairment loss, net of DAC and taxes, exceeded 10% of the Company’s net income for the year ended December 31, 2004.
At December 31, 2004, the fair value of the Company’s Bond Portfolio aggregated $2.97 billion. Of this aggregate fair value, approximately 0.03% represented securities trading at or below 75% of amortized cost. The impact of unrealized losses on net income will be further mitigated upon realization, because realization will result in current decreases in the amortization of DAC and decreases in income taxes.
The amortized cost of the Bond Portfolio in an unrealized loss position at December 31, 2004, by contractual maturity, is shown below.
For certain structured securities, the carrying value is based on an estimate of the security’s future cash flows pursuant to the requirements of Emerging Issues Task Force Issue No. 99-20 “Recognition of Interest Income
and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets”. The change in carrying value is recognized in income.
While the trading market for the Company’s privately traded Secured Loans is more limited than for publicly traded issues, participation in these transactions has enabled the Company to improve its investment yield. As a result of restrictive financial covenants, these Secured Loans involve greater risk of technical default than do publicly traded investment-grade securities. However, management believes that the risk of loss upon default for these Secured Loans is mitigated by such financial covenants and the collateral values underlying the Secured Loans.
POLICY LOANS totaled $32.9 million at December 31, 2004, compared to $35.3 million at December 31, 2003, and primarily represent loans taken against universal life insurance policies.
SECURITIES LENDING COLLATERAL totaled $517.6 million at December 31, 2004, compared to $154.8 million at December 31, 2003, and consisted of cash collateral invested in highly rated short-term securities received in connection with the Company’s securities lending program. The increase in securities lending collateral in 2004 results from increased demand for securities in the Company’s portfolio. Although the cash collateral is currently invested in highly rated short-term securities, the applicable collateral agreements permit the cash collateral to be invested in highly liquid short and long-term investment portfolios. At least 75% of the portfolio’s short-term investments must have external issue ratings of A-1/P-1, one of the highest ratings for short-term credit quality. Long-term investments include corporate notes with maturities of five years or less and a credit rating by at least two nationally recognized statistical rating organizations (“NRSRO”), with no less than a S&P rating of A or equivalent by any other NRSRO.
A significant portion of the Company’s fixed annuity contracts (including the Fixed Options)
Since the Company’s investing strategy is to hold fixed-rate assets for long-term investment, the Company’s average yield tends to trail movements in the, average U.S treasury yield. For further discussion on average yield on the bond portfolio and the rate paid on average interest-bearing liabilities, see discussion on “Investment Spread” in the Results of Operations section.
INVESTED ASSETS EVALUATION is routinely conducted by the Company. Management identifies monthly those investments that require additional monitoring and carefully reviews the carrying values of such investments at least quarterly to determine whether specific investments should be placed on a nonaccrual basis and to determine declines in value that may be other than temporary. In conducting these reviews for bonds, management principally considers the adequacy of any collateral, compliance with contractual covenants, the borrower’s recent financial performance, news reports and other externally generated information concerning the creditor’s affairs. In the case of publicly traded bonds, management also considers market value quotations, if available. For mortgage loans, management generally considers information concerning the mortgaged property and, among other things, factors impacting the current and expected payment status of the loan and, if available, the current fair value of the underlying collateral.
The carrying values of investments that are determined to have declines in value that are other than temporary are reduced to net realizable value and, in the case of bonds, no further accruals of interest are made. The provisions for impairment on mortgage loans are based on losses expected by management to be realized on transfers of mortgage loans to real estate, on the disposition and settlement of mortgage loans and on mortgage loans that management believes may not be collectible in full. Accrual of interest is suspended when principal and interest payments on mortgage loans are past due more than 90 days. Impairment losses on securitized assets are recognized if the fair value of the security is less than its book value, and the net present value of expected future cash flows is less than the net present value of expected future cash flows at the most recent (prior) estimation date.
DEFAULTED INVESTMENTS, comprising all investments that are in default as to the payment of principal or interest, totaled $1.7 million of bonds at December 31, 2004, and constituted approximately 0.04% of total invested assets. At December 31, 2003, defaulted investments totaled $0.2 million of bonds, which constituted less than 0.01% of total invested assets.
SOURCES OF LIQUIDITY are readily available to the Company in the form of the Company’s existing portfolio of cash and short-term investments, reverse repurchase agreement capacity on invested assets and if required, proceeds from invested asset sales. The Company’s liquidity is primarily derived from operating cash flows from annuity operations. At December 31, 2004, approximately $2.20 billion of the Bond Portfolio had an aggregate unrealized gain of $65.6 million, while approximately $772.8 million of the Bond Portfolio had an aggregate unrealized loss of $13.5 million. In addition, the Company’s investment portfolio currently provides approximately $24.3 million of monthly cash flow from scheduled principal and interest payments. Historically, cash flows from operations and from the sale of the Company’s annuity products have been more than sufficient in amount to satisfy the Company’s liquidity needs.
Management is aware that prevailing market interest rates may shift significantly and has strategies in place to manage either an increase or decrease in prevailing rates. In a rising interest rate environment, the Company’s average cost of funds would increase over time as it prices its new and renewing Fixed-Rate Products to maintain a generally competitive market rate. Management would seek to place new funds in investments that were matched in duration to, and higher yielding than, the liabilities assumed. The Company believes that liquidity to fund
If a substantial portion of the Company’s Bond Portfolio diminished significantly in value and/or defaulted, the Company would need to liquidate other portions of its investment portfolio and/or arrange financing. Such events that may cause such a liquidity strain could be the result of economic collapse or terrorist acts.