CRITICAL ACCOUNTING POLICIES In response to the Securities and Exchange Commission's ("SEC") release "Cautionary Advice Regarding Disclosure about Critical Accounting Policies", the Company identified critical accounting policies by considering policies that involve the most complex or subjective judgments or assessments. The Company has identified three policies as critical accounting policies because they involve a higher degree of judgment and complexity. A brief summary of each critical accounting policy follows. For a more complete discussion of the judgments and other factors affecting the measurement of these items see the referenced sections of Management's Discussion and Analysis ("MD&A").
Derivative instruments include futures. Derivatives are accounted for on a fair value basis and reported as Other assets. Beginning in January 2001, hedge accounting is not applied to those strategies that utilize financial futures contracts for interest rate risk management purposes. Therefore, the gains and losses pertaining to the change in the fair value of the financial futures contracts are recognized in Realized capital gains and losses during the period on a current basis.
- DEFERRED POLICY ACQUISITION COSTS ("DAC")- The Company establishes a deferred asset for costs that vary with and are primarily related to acquiring life and investment business, principally agents' remuneration, certain underwriting costs and direct mail solicitation expenses, which are deferred and amortized to income.
For interest-sensitive life and investment contracts, the costs are amortized in relation to the present value of estimated gross profits on such business over the estimated terms of the contract periods. Gross profits are determined at the date of contract issue and comprise estimated future investment margins, mortality margins, surrender charges and expenses. Assumptions underlying the gross profits are periodically updated to reflect actual experience, and changes in the amount or timing of estimated gross profits will result in adjustments in the cumulative amortization of these costs. To the extent that unrealized capital gains or losses on fixed income securities carried at fair value would result in an adjustment of estimated gross profits had those gains or losses actually been realized, the related unamortized DAC is recorded net of tax as a reduction of the Unrealized capital gains or losses included in Shareholder's equity. For further discussion of these policies, see the Market Risk and Forward-looking Statements and Risk Factors section of MD&A.
- LIFE INSURANCE RESERVES AND CONTRACTHOLDER FUNDS - Reserves for life-contingent contract benefits, which relate to traditional life insurance and immediate annuities with life contingencies are computed on the basis of long-term actuarial assumptions as to future investment yields, mortality, morbidity, terminations and expenses. These assumptions, which for 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 coverage, year of issue and policy duration. To the extent that unrealized capital gains on fixed income securities would result in a premium deficiency had those gains actually been realized, the related increase in reserve is recorded net of tax as a reduction of the Unrealized capital gains included in Shareholder's equity.
Statutory premiums and deposits increased $364.4 million or 119.7% in 2000 as compared to 1999, due to increases in all product categories. In 2000, variable Separate Accounts, immediate annuity and fixed annuity increased 330.1%, 88.8% and 81.2%, respectively. Increased variable investment product sales were primarily driven by $185.4 million of sales from the Putnam Allstate Advisor variable annuity product that was launched in January 2000 pursuant to an alliance between the Company, ALIC and Putnam Investments, Inc. The large increase in fixed investment products resulted from new distribution outlets in the financial services channel. Structured settlement annuities, a type of immediate annuity, increased due to strong sales activity.
In 2000, total premiums increased 63.6% over 1999, due in large part to a 97.1% increase in sales of immediate annuities with life contingencies. This increase resulted from a more competitive pricing strategy introduced in late 1999, as well as, enhanced wholesaling efforts.
In 2000, contract charges increased 8.4% compared to 1999 levels as a result of increases in all products types. Variable Separate Accounts increased due to new sales and favorable market performance, partially offset by benefit payments and increased contract charges. For 2000, contract charges on interest-sensitive life products increased primarily as a result of increased mortality charges as policyholders aged during 2000.
Operating income increased 3.3% in 2001 compared to 2000 primarily due to increases in the investment margin partially offset by decreases in mortality margin. Operating income increased 23.0% in 2000 compared to 1999 primarily due to increases in the investment and mortality margin partially offset by higher operating costs and expenses.
Costs and expenses decreased 3.0% during 2001 compared to 2000 due to higher marketing, technology and distribution expenses incurred on new growth initiatives more than offset by lower DAC amortization. In 2000, operating costs and expenses increased 29.0% compared to 1999 due to higher marketing, distribution and technology expenses.
- - The Company is encouraging exclusive Allstate agents to become Personal Financial Representatives ("PFRs"). PFRs are licensed to sell products such as variable annuities. As additional agents become licensed, the mix of products sold through this channel could change.
- - In order to compete with major insurance company competitors, as well as non-traditional competitors, such as banks, financial services firms and securities firms, the Company will have to distribute its products within its pricing parameters while increasing the amount of business inforce to improve its economies of scale.
Period to period fluctuations in realized capital gains and losses are the result of timing of sales decisions reflecting management's decision on positioning the portfolio, as well as assessments of individual securities and overall market conditions.
An important ingredient of the Company's financial results is the return on invested assets. The investment portfolios are managed based upon the nature of the business and its corresponding liability structure.
The investment strategy for the Company is based upon a strategic asset allocation framework that takes into account the need to manage on a risk adjusted spread basis for the underwriting liability product portfolio and to maximize return on retained capital. Generally, a combination of recognized market modeling, analytical models and proprietary models is used to achieve a desired optimal asset mix in the management of the portfolio. The strategic asset allocation model portfolio is the primary basis for setting annual asset allocation targets with respect to interest sensitive, illiquid and credit asset limitations with respect to overall below investment grade exposure and diversification requirements. On a tactical basis, decisions are made on an option adjusted relative value basis staying within the constraints of the strategic asset allocation framework. The Company believes it maximizes asset spread by selecting assets that perform on a long-term basis and by using trading to minimize the effect of downgrades and defaults. Total return measurement is used on a selective basis where the asset risks are significant (i.e., high yield fixed income securities). The Company expects that employing this strategy in a declining interest rate market will slow the rate of decline in investment income. This strategy is also expected provide sustainable investment-related operating income over time.
Total investments were $3.23 billion at December 31, 2001 compared to $2.77 billion at December 31, 2000. The increase was due to positive cash flows generated from operations.
The fair value of the Company's exchange traded marketable investment securities is based on independent market quotations. The fair value of non-exchange traded marketable investment securities is based on either independent third party pricing sources or widely accepted pricing valuation models which utilize internally developed ratings and independent third party data as inputs. Periodic changes in the fair values are reported as a component of other comprehensive income and are reclassified to net income only when supported by the consummation of a transaction with an unrelated third party.
The following table shows the Company's investment portfolio, and the sources of its fair value, at December 31, 2001.
FIXED INCOME SECURITIES The Company's fixed income securities portfolio consists of privately-placed securities, publicly traded corporate bonds, U.S. government bonds, asset and mortgage-backed securities and municipal bonds. The Company generally holds its fixed income securities to maturity, but has classified all of these securities as available for sale to allow maximum flexibility in portfolio management. At December 31, 2001, unrealized net capital gains on the fixed income securities portfolio were comparable to unrealized net capital gains at December 31, 2000. As of December 31, 2001, all of the fixed income securities portfolio was invested in taxable securities.
The Securities Valuation Office of the National Association of Insurance Commissioners ("NAIC") evaluates the fixed income securities investments of insurers for regulatory reporting purposes and assigns securities to one of six investment categories called "NAIC designations." The NAIC designations parallel the credit ratings of the Nationally Recognized Statistical Rating Organizations for marketable securities. NAIC designations 1 and 2 include securities considered investment grade (rated "Baa3" or higher by Moody's, or rate "BBB-" or higher by Standard & Poor's ("S&P")) by such rating organizations. NAIC designations 3 through 6 include securities considered below investment grade (rated "Ba1" or lower by Moody's, or rated "BB+" or lower by S&P).
At December 31, 2001, 97.5% of the Company's fixed income securities portfolio was rated investment grade, which is defined by the Company as a security having a NAIC rating of 1 or 2, a Moody's rating of Aaa, Aa, A or Baa, or a comparable Company internal rating. The quality mix of the Company's fixed income securities portfolio at December 31, 2001 is presented in the following table:
At December 31, 2001 and 2000, $442.1 million and $381.0 million, respectively, of the fixed income securities portfolio was invested in mortgage-backed securities ("MBS"). The MBS portfolio consists primarily of securities that were issued by, or have underlying collateral that is guaranteed by, U.S. government agencies or sponsored entities. Therefore, the MBS portfolio has relatively low credit risk.
DEFERRED POLICY ACQUISITION COSTS Deferred policy acquisition costs increased $32.0 million or 25.7% to $156.6 million at December 31, 2001 from $124.6 million at December 31, 2000. In 2001, $51.2 million of costs were deferred and $7.2 million was amortized into income. Costs that vary with and are primarily related to acquiring business, principally agents' remuneration, certain underwriting costs and direct mail solicitation expenses, are deferred and amortized into income over a period of time, usually seven or ten years, that varies based upon the particular product sold. Deferred policy acquisition costs are periodically reviewed as to recoverability and written down where necessary. For additional information, see Note 2 and Note 7 to the financial statements.
The present value of future profits inherent in acquired blocks of insurance is classified as a component of deferred policy acquisition costs. The present value of future profits is amortized over the life of the block of insurance using current crediting rates.
The assets and liabilities related to variable annuity contracts are legally segregated and reflected as Separate Accounts. The assets of the Separate Accounts are carried at fair value. Separate Accounts liabilities represent the contractholders' claims to the related assets and are carried at the fair value of the 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. Revenues to the Company from the Separate Accounts consist of contract maintenance and administration fees and mortality, surrender and expense charges.
Contractholder funds are equal to deposits received and interest credited to the benefit of the contractholder less surrenders and withdrawals, mortality charges and administrative expenses. Interest rates credited range from 5.3% to 6.3% for interest-sensitive life contracts; 3.2% to 9.8% for immediate annuities; 4.2% to 7.7% for deferred annuities; and 2.0% to 5.7% for other investment contracts. Withdrawal and surrender charge protection includes i) for interest-sensitive life, either a percentage of account balance or dollar amount grading off generally over 20 years; and, ii) for deferred annuities not subject to a market value adjustment, either a declining or a level percentage charge generally over nine years or less. Approximately 1.2% of deferred annuities are subject to a market value adjustment.
CORPORATE OVERSIGHT The Company's primary business operations provide substantial investable funds. In formulating and implementing policies for investing funds, the Company seeks to earn returns that enhance its ability to offer competitive rates and prices to customers while contributing to attractive and stable profits and long-term capital growth for the Company. Accordingly, the Company's investment decisions and objectives are a function of its underlying risks and product profiles.
The 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 inherent by the investment policy. The Company has implemented a comprehensive daily measurement process, administered by the Investment Risk Manager, for monitoring compliance to limits established by the investment policy.
In a falling interest rate environment, the risk of pre-payment of some fixed income securities increases, causing funds to be reinvested at lower yields. The Company limits this risk by weighting the investments in the fixed income portfolio on non-callable securities. The Company seeks to invest in mortgage-backed securities that are structured to minimize cash volatility and by securities that provide for make-whole type pre-payment fees. Falling interest rates can also negatively impact demand for the Company's products while increasing demand for products offered by other institutions. For example, bank certificates of deposits that do not impose surrender charges, and equity investments which may have higher average returns could become more attractive than the Company's existing products to new and existing customers. Conversely, in a rising interest rate environment, maintaining an acceptable investment interest rate spread on inforce interest-sensitive liabilities may prompt withdrawal by contractholders. The Company manages this risk by adjusting crediting rates, at least on an annual basis, with due regard to the yield of its investment portfolio and pricing assumptions and by prudently managing interest rate risk of assets and liabilities
The Company seeks to invest premiums and deposits to create future cash flows that will fund future claims, benefits and expenses, and that will earn stable margins across a wide variety of interest rate and economic scenarios. In order to achieve this objective and limit its exposure to interest rate risk, the Company adheres to a philosophy of managing the duration of assets and related liabilities. The Company uses financial futures to hedge the interest rate risk related to anticipatory purchases and sales of investments and product sales to customers.
To calculate duration, the Company projects asset and liability cash flows, and discounts them to a net present value using a risk-free market rate adjusted for credit quality, sector attributes, liquidity and other specific risks. Duration is calculated by revaluing these cash flows at an alternative level of interest rates, and determining the percentage change in fair value from the base case. The cash flows used in the model reflect the expected maturity and repricing characteristics of the Company's derivative financial instruments, all other financial instruments (as depicted in Note 5 to the financial statements), and certain non-financial instruments including interest-sensitive life insurance contract liabilities. The projections include assumptions (based upon historical market experience and Company specific experience) reflecting the impact of changing interest rates on the prepayment, lapse, leverage and/or option features of instruments, where applicable. Assumptions utilized relate primarily to assets such as mortgage-backed securities, collateralized mortgage obligations, callable corporate and municipal obligations, and liabilities including fixed rate single and flexible premium deferred annuities.
Based upon the information and assumptions the Company uses in its duration calculation and interest rates in effect at December 31, 2001, management estimates that a 100 basis point immediate, parallel increase in interest rates ("rate shock") would increase the net fair value of its assets and liabilities identified above by approximately $6.0 million, versus a decrease of $25.2 million at December 31, 2000. The selection of a 100 basis point immediate parallel increase in interest rates should not be construed as a prediction by the Company's management of future market events, but only as an illustration of the potential impact of such an event.
To the extent that actual results differ from the assumptions utilized, the Company's duration and rate shock measures could be significantly impacted. Additionally, the Company's calculation assumes that the current relationship between short-term and long-term interest rates (referred to as the term structure of interest rates) will remain constant over time. As a result, these calculations may not fully capture the impact of non-parallel changes in the term structure of interest rates and/or large changes in interest rates.
EQUITY PRICE RISK Equity price risk is the risk that the Company will incur economic losses due to adverse changes in a particular stock, stock fund or stock index.
At December 31, 2001, the Company had Separate Accounts assets with account values totaling $602.7 million. This is an increase over the $560.1 million of Separate Accounts assets at December 31, 2000. The Company earns mortality and expense fees as a percentage of account values in the Separate Accounts. In the event of an immediate decline of 10% in the account values due to equity market declines, the Company would earn approximately $916 thousand less in annualized fee income. This is an increase over the $700 thousand amount determined at December 31, 2000.
Substantially all of the Company's variable annuity contracts in force contain some type of death benefit guarantee. In general, the types of guarantees offered include a return of premium, the highest anniversary value or a guaranteed compound earnings rate on the initial deposit over the contract period. At December 31, 2001, the guaranteed value in excess of the account value, payable if all contractholders were to die, is estimated to be $118.8 million. However, the estimated present value of expected future payments for guaranteed death benefits, net of estimated fee revenue, is approximately $950 thousand at December 31, 2001. In the event of an immediate decline of 10% in contractholders' account values at December 31, 2001 due to equity market declines, payments for guaranteed death benefits may increase by $1.1 million during the next year, based on expected mortality rates. The selection of a 10% immediate decrease should not be construed as a prediction by management of future market events, but only as an example to illustrate the potential impact to earnings and cash flow of equity market declines as a result of this guarantee. Also, the actual mortality rates experienced by the Company in the future may not be consistent with the rates expected by the Company.
business. These costs are expensed as premiums on the related business are earned, or are expensed based on the estimated gross profits of the related business. Projected fee income and guaranteed benefits payable are components of the estimated gross profits for these contracts sold through Separate Accounts. For a more detailed discussion of DAC, see Note 2 to the financial statements.
SHAREHOLDER'S EQUITY Shareholder's equity increased for 2001 and 2000 due to Net income and increased Unrealized net capital gains.
The principal sources of funds for the Company are statutory premiums and deposits; receipts of principal and interest from the investments; capital contributions from ALIC; and intercompany loans from the Corporation. The primary uses of these funds are purchases of investments and the payment of policyholder claims, contract maturities, benefits, surrenders and withdrawals, operating costs, income taxes, dividends to ALIC and the repayment of intercompany loans to the Corporation. Management believes that cash flows from operating and investing activities of the Company are adequate to satisfy liquidity requirements of these operations based on the current liability structure and considering a variety of reasonably foreseeable stress scenarios.
The Company is also exposed to interest rate risk on certain insurance liabilities. Decreases in interest rates can cause contractholders to surrender their contracts
The ability of the Company to pay dividends is dependent on business conditions, income, cash requirements of the Company and other relevant factors. The payment of shareholder dividends by the Company without prior approval of the state insurance regulator in any calendar year is limited to formula amounts based on statutory surplus and statutory net gain from operations, for the immediately preceding calendar year. The maximum amount of dividends that the Company can distribute during 2002 without prior approval of the New York State Insurance Department is $8.7 million. In the twelve-month period beginning January 1, 2001, the Company did not pay any dividends.
GUARANTY FUNDS Under state insurance guaranty fund laws, insurers doing business in a state can be assessed, up to prescribed limits, for certain obligations of insolvent insurance companies to policyholders and claimants. Amounts assessed to each company are typically related to its proportion of business written in a particular state. The Company's expenses related to these funds have been immaterial.
Accounting changes adopted to conform to the provisions of Codification are reported as changes in accounting principles. The cumulative effect of changes in accounting principles is reported as an adjustment to unassigned funds (surplus) in the period of the change in accounting principle. The cumulative effect is the difference between the amount of capital and surplus at the beginning of the year and the amount of capital and surplus that would have been reported at that date if the new accounting principles had been applied retroactively for all prior periods. The Company reported an increase to surplus of $1.9 million effective January 1, 2001.
In December 2001, the Accounting Standards Executive Committee ("AcSEC") issued Statement of Position ("SOP") 01-6, "Accounting by Certain Entities (Including Entities With Trade Receivables) That Lend to or Finance the Activities of Others", which is effective for interim and annual financial statements issued for the fiscal year beginning after December 15, 2001. The SOP conforms accounting and financial reporting practices for certain lending and financing activities, eliminating various specialized accounting practices that developed from the issuance of AICPA finance company, bank, and credit union audit guides. The SOP also explicitly incorporates lending and financing activities of insurance companies within its scope. The Company's adoption of SOP 01-6 is not expected to have a material effect on the results of operations or financial position.
Forward-looking statements do not relate strictly to historical or current facts and may be identified by their use of words like "plans," "expects," "will," "anticipates," "estimates," "intends," "believes," "likely," and other words with similar meanings. These statements may address, among other things, the Company's strategy for growth, product development, regulatory approvals, market position, expenses, financial results and reserves. Forward-looking statements are based on management's current expectations of future events. The Company cannot guarantee that any forward-looking statement will be accurate. However, management believes that our forward-looking statements are based on reasonable, current expectations and assumptions. We assume no obligation to update any forward-looking statements as a result of new information or future events or developments.
If the expectations or assumptions underlying our forward-looking statements prove inaccurate or if risks or uncertainties arise, actual results could differ materially from those communicated in these forward-looking statements. In addition to the normal risks of business, the Company is subject to significant risk factors, including those listed below which apply to it as an insurance business and provider of other financial services.
- - In December 2001, the NAIC announced that it reached an agreement regarding the wording of insurance policy exclusions for acts of terrorism for commercial lines. In January 2002, the NAIC issued the following statement, "It is the sense of NAIC membership that terrorism exclusions are generally not necessary in personal lines property and casualty products to maintain a competitive market, and they may violate state law. However we recognize that state laws vary in their authority and discretion. Further, there may be unique company circumstances that need to be considered in individual cases. We expect these cases to be limited." In addition, several states have announced that they will not approve terrorism exclusions for personal and/or commercial lines of property and casualty insurance. Currently, the Corporation is examining the potential exposure in any of its insurance operations from acts of terrorism. The Corporation is also examining how best to address this exposure, if any, considering the interests of policyholders, shareholders, the lending community, regulators and others. The Company does not exclude losses resulting from terrorist events in its life insurance policies. In the event that a terrorist act occurs, the Company may be adversely impacted, depending on the nature of the event. With respect to the Company's investment portfolio, in the event that commercial insurance coverage for terrorism becomes unavailable or very expensive, there could be significant adverse impacts on some portion of the Company's portfolio, particularly in sectors such as airlines and real estate. For example, commercial mortgages or certain debt obligations might be adversely affected
- - In order to meet the anticipated cash flow requirements of its obligations to policyholders, from time to time the Company adjusts the effective duration of investments, liabilities for contractholder funds and reserves for life-contingent contract benefits. Those adjustments may have an impact on the value of the investment portfolio, investment income, interest credited on contractholder funds and the investment margin.
- - Management believes the reserves for life-contingent contract benefits are adequate to cover ultimate policy benefits, despite the underlying risks and uncertainties associated with their determination when payments will not be made until well into the future. Reserves are based on many assumptions and estimates, including estimated premiums received over the assumed life of the policy, the timing of the event covered by the insurance policy, the amount of benefits on claims to be paid and the investment returns on the assets purchased with the premium received. The Company periodically reviews and revises its estimates. If future experience differs from assumptions, it may have a material impact on results of operations.
- - The Corporation's liquidity could be constrained by a catastrophe which results in extraordinary losses, a downgrade of the Corporation's current long-term debt rating of A1 and A+ (from Moody's and Standard & Poor's, respectively) to non-investment grade status of below Baa3/BBB-, 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/B, or a downgrade in ALIC's or the Company's financial strength rating from Aa2, AA+ and A+ (from Moody's Standard & Poor's and A.M. Best, respectively) to below Aa3/AA-/A-. In the event of a downgrade of the Corporations' rating, ALIC and its subsidiaries would also experience a similar downgrade.
- - The events of September 11 and the resulting disruption in the financial markets revealed weaknesses in the physical and operational infrastructure that underlies the U.S. and worldwide financial systems. Those weaknesses did not impair the Company's liquidity in the wake of the September 11. However, if an event of similar or greater magnitude occurs in the future and if the weaknesses in the physical and operational infrastructure of the U.S. and worldwide financial systems are not remedied, the Company could encounter significant difficulties in transferring funds, buying and selling securities and engaging in other financial transactions that support its liquidity.
- - Financial strength ratings have become an increasingly important factor in establishing the competitive position of insurance companies and, generally, may be expected to have an effect on an insurance company's sales. On an ongoing basis, rating agencies review the financial performance and condition of insurers. A downgrade of either the Company or ALIC, while not expected, could have a material adverse effect on the Company's business, including the competitiveness of the Company's product offerings, its ability to market products, and its financial condition and results of operations.
- - Following enactment of the Gramm-Leach-Bliley Act of 1999, federal legislation that allows mergers that combine commercial banks, insurers and securities firms, state insurance regulators have been collectively participating in a reexamination of the regulatory framework that currently governs the U. S. insurance business in an effort to determine the proper role of state insurance regulation in the U. S. financial services industry. We cannot predict whether any state or federal measures will be adopted to change the nature or scope of the regulation of the insurance business or what affect any such measures would have on the Company.