Selected consolidated financial data for the Corporation are presented below for each of the five years in the period ended December 31, 2007. This data should be read in conjunction with the Corporation’s Consolidated Financial Statements and notes thereto and Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations.
Unless specifically stated otherwise, all references to 2007, 2006 and 2005 refer to our fiscal years ended, or the dates, as the context requires, December 31, 2007, December 31, 2006 and December 31, 2005, respectively.
In this discussion, we have included statements that may constitute “forward-looking statements” within the meaning of the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. These forward-looking statements are not historical facts but instead represent only our beliefs regarding future events, many of which, by their nature, are inherently uncertain and beyond our control. These statements may relate to our future plans and objectives. By identifying these statements for you in this manner, we are alerting you to the possibility that our actual results may differ, possibly materially, from results indicated in these forward-looking statements. Important factors, among others, that could cause our results to differ from those indicated in the forward-looking statements are discussed below under “Certain Factors That May Affect Our Business” and under “Risk Factors” (See item 1A).
The Corporation’s earnings per share were $2.16 for 2007, as compared to $1.69 in 2006 and $3.12 in 2005. Results in 2006 and 2007 reflect decreases in both investment income and net realized investment gains from 2005. Our total revenues in 2007 were $364 million, compared to $359 million in 2006 and $459 million in 2005. The Corporation’s decreases in earning and revenues in 2006 and 2007 resulted primarily from decreases in net investment income and realized capital gains. Lower yields from the portfolio rebalancing (See, Item 7, Management’s Discussion and Analysis, Liquidity and Capital Resources, “Asset/Liability Management.”), a loss on the payor swaptions (reflected in the realized capital gains), and decreased investment income from the Corporation’s partnership investments all contributed to lower revenues in 2006 and 2007.
Interest Rate Risk: The Insurance Company’s principal products are deferred annuities, which are interest rate sensitive instruments. In an interest rate environment of falling or stable rates the Insurance Company’s annuity holders are less likely to seek to surrender their annuities prior to maturity to seek alternative, higher-yielding investments. However, in an environment of moderately or significantly increasing rates, such surrenders should be expected to increase. As of December 31, 2007, the existence of surrender fees on approximately 43.2% of the Insurance Company’s outstanding deferred annuities acts as a deterrent against surrenders. However, if interest rates climb sufficiently, such fees may not have a significant deterrent effect. Moreover, the surrender fees are only in effect for up to the first 7 years of each annuity policy and, therefore, disappear over time (see table below). In the event of a substantial increase in surrenders during a short period of time, the Insurance Company may have to sell off longer-term assets to pay current surrender liabilities. The Insurance Company continually develops strategies to address the match between the timing of its assets and liabilities. To that end, in 2006 and 2007, a significant number of policies came off surrender charge and a significant portion of this business did surrender. This can be seen in the surrender ratio in the table on page 3. The company anticipated this and increased liquidity, maintaining significant levels of cash equivalents to fund surrenders. Due to the relatively flat or inverted yield curve during much of this time, this increased level of liquidity resulted in a relatively small reduction of income. The Company believes that the heavy surrender activity is now largely behind us and, along with expected new sales, there should be a turn around in the inforce this year. Additionally, management has increased the incentive for agents to retain this business with the Company by paying full first year compensation on internal rollovers. Beginning in 2008, a significantly smaller amount of business will be coming off surrender charge - as shown in the table below and consequently we expect a significant reduction in the surrender ratio. During 2005 and 2006, especially in light of the substantial number of policies coming off surrender charges in those years and in 2007, the Insurance Company reduced the amount of assets invested in longer-term investments by approximately $1,239 million and reinvested in short and intermediate return investments at reduced yields. These reduced yields were partially offset by the gains recognized by the Insurance Company from the sale of the longer-term assets. To protect against a substantial sudden increase in rates (300 basis points), the Company has entered into a series of payor swaption investments. Under these investments, the Company obtained the right to enter into interest rate swap agreements with counterparties under which the Company’s interest rate obligations are fixed and the counterparties’ obligations are variable, thus protecting the Company from sudden rate increases. (See, Item 7, Management’s Discussion and Analysis, Liquidity and Capital Resources, “Asset /Liability Management.”)
A general improvement in market conditions and an increase in net investment income were the primary factors in the increase from 2003 to 2004. Portfolio rebalancing and the decline in total assets in 2006 and 2007 resulting from annuity surrenders exceeding net premium written contributed to the decline in net investment income in 2005-2007. Net investment margin (the difference between the return on invested assets and credited rates paid on annuities) improved during 2007 and is expected to favorably impact results in 2008. The sale of long-term bonds to support the portfolio rebalancing in 2005 resulted in $75.0 million in realized capital gains. During 2006, a loss of $14.1 million on the Payor Swaption Portfolio combined with a decline in security sales resulted in a decline to $ (3.6) million in net realized investment gains. The Company had net realized investment gains of $24.8 million in 2007, due primarily to the premiums from optionally called trust preferred securities.
The Insurance Company derives a predominant portion of its total revenues from investment income. The Insurance Company manages most of its investments internally. All investments made on behalf of the Insurance Company are governed by the Statement of Investment Policy established and approved by the Investment Committee, the Finance Committee and the Board of Directors of the Insurance Company and the Corporation and by qualitative and quantitative limits prescribed by applicable insurance laws and regulations. The Investment Committee meets regularly to set and review investment policy and to approve current investment plans. The actions of the Investment Committee are subject to review and approval by the Finance Committee and the Board of Directors of the Insurance Company and Corporation. The Insurance Company's Statement of Investment Policy must comply with NYSID regulations and the regulations of other applicable regulatory bodies.
As of December 31, 2007, 9.1% of the Company’s invested assets (approximately $363.1 million) consisted of short-term commercial paper and corporate bonds and U.S. Agencies with maturities of less than 1-year at the time of purchase. The commercial paper, which totaled approximately $292.0 million at December 31, 2007, consisted of direct obligations of various corporations rated a minimum of A1 by Standard and Poor’s and P1 by Moody’s with maturities of less than 45 days. The fixed income securities with less than 1-year to maturity (approximately $80 million) consisted primarily of investment-grade corporate bonds which, as of December 31, 2007, had quality ratings (except for one) of at least A2 by Moody’s and A by Standard and Poor’s. As part of its Asset-Liability management strategy, the Insurance Company has kept elevated levels of cash or cash equivalent investments since 2005, anticipating the potential surrender of annuity policies with expiring surrender charges. This cash has been available to meet actual surrenders and any other cash needs. By having the liquidity afforded by these cash investments during 2007, the Company has been able to satisfy all cash needs without portfolio sales from the fixed income portfolio.
As of December 31, 2007, approximately 8% of the Insurance Company's total invested assets were invested in limited partnerships and equity securities. Investments in limited partnerships are included in the Corporation's consolidated balance sheet under the heading “Other long-term investments.” See “Note 2 to the Notes to Consolidated Financial Statements.” The Insurance Company is committed, if called upon during a specified period, to contribute an aggregate of approximately $140.7 million of additional capital to certain of these limited partnerships. Commitments of $13.2 million will expire in 2008, $2.8 million in 2009, $8.8 in 2010, $47.7 in 2011 and $68.0 in 2012. The Insurance Company may make selective investments in additional limited partnerships as opportunities arise. In general, risks associated with such limited partnerships include those related to their underlying investments (i.e., equity securities, debt securities and real estate), plus a level of illiquidity, which is mitigated by the ability of the Insurance Company to take quarterly distributions of partnership earnings. There can be no assurance that the Insurance Company will continue to achieve the same level of returns on its investments in limited partnerships as it has historically. Further, there can be no assurance that the Insurance Company will receive a return of all or any portion of its current or future capital investments in limited partnerships. The failure of the Insurance Company to receive the return of a material portion of its capital investments in limited partnerships, or to achieve historic levels of return on such investments, could have a material adverse effect on the Corporation's financial condition and results of operations.
Notwithstanding an overall decrease in the number of securities in an unrealized loss position at the end of 2007 from 398 to 360, there was an 11% increase in the amount of the unrealized losses for 12 months or more. The number of securities with unrealized losses greater than 12 months decreased to 214 from 266 while the number of securities with unrealized losses less than 12 months increased from 76 to 135. Approximately 82% of the securities with unrealized losses greater than 12 months are corporate bonds. The average unrealized loss at December 31, 2007 has increased to 4.59% of book value from 4.30% for the prior year.
Unrealized losses in bank and financial issues increased due to concerns about the sub-prime mortgage market and widening corporate spreads. Spreads on 10-year A-rated financials increased from +96 at year-end 2006 to +225 at year-end 2007. Losses were further increased for bank trust preferreds and preferreds by year-end 2007 tax loss selling. This situation improved subsequent to December 31, 2007, as many of the trust preferreds and preferred issues saw an increase in market value by more than 10% over year-end 2007 levels. The Company addresses other than temporary impairment issues consistent with its policy as described on page 26.
Corporate Bonds: The predominant investment category for the Company’s investments is the Corporate Bond Category (including Public Utilities), which totaled $2.374 billion at December 31, 2007. The $55.0 million of unrealized losses at December 31, 2007, an increase from $48.76 million at December 31, 2006, reflected the general widening of corporate spreads in 2007. The 5 largest unrealized loss positions consisted of the following holdings: GMAC 8% due November 1, 2031; Countrywide Capital III, 8.05% due June 15, 2027; Knight-Ridder (assumed by McClatchy Company), 4 5/8% due November 1, 2014; Limited Brands, 5 ¼% due November 1, 2014; and Ford Motor Credit, 5.70% due January 15, 2010. The GMAC unrealized loss reflected concerns about sub-prime mortgages at its Residential Capital LLC subsidiary. The unrealized loss in Countrywide Capital represented the significant deterioration of the residential mortgage market and its effect on Countrywide; the takeover bid that Countrywide subsequently received from Bank of America has narrowed this unrealized loss. Knight-Ridder suffered from the widening in corporate spreads combined with the McClatchy rating downgrades (in 2007) below investment-grade by S&P and Fitch. The Limited Brands holding reflects a significant book value position ($14 million) that experienced a widening in credit spreads combined with cyclical concerns about the retailing sector. The Ford Motor Credit position is a significant book value position ($14.95 million) that has been hurt by cyclical concerns about automobile and truck sales.
In February 2007, A.M. Best Company reaffirmed the Insurance Company’s rating at “B+” (Good). At the time of the B+ rating, publications of A.M. Best indicated that the “B+” rating was assigned to those companies that, in A.M. Best's opinion, have achieved a very good overall performance when compared to the norms of the insurance industry and that generally have demonstrated a good ability to meet their respective policyholder and other contractual obligations over a long period of time. The B+ rating is within A.M Best’s “Secure” classification, along with A++, A+, A, A-, and B++ ratings. In 2007, A.M. Best Company changed the Financial Strength Rating Descriptor for B+ and B++ ratings on insurance companies from “Very Good” to “Good”. The change was made to make the Rating Descriptor consistent with the existing Rating definition and did not, in any way, represent a change in A.M. Best’s opinion of the Company.
In evaluating a company's statutory financial and operating performance, A.M. Best reviews the company's profitability, leverage and liquidity, as well as the company's book of business, the adequacy and soundness of its reinsurance, the quality and estimated market value of its assets, the adequacy of its reserves and the experience and competency of its management.
In May 2007, Moody's Investor Services (“Moody's”) reaffirmed the Insurance Company's insurance financial strength at Ba2 (“Questionable financial security”) with a stable outlook, and its rating on the Corporation’s Senior Notes at B2 (“Poor financial security”), with a stable outlook.
In March 2007, Standard & Poor's Corporation (“Standard & Poor's”) raised the Insurance Company's insurance financial strength rating from a BB- which is defined as “a vulnerability to the broad array of risks that are embedded in its investment and operational profile” to a BB, which is defined as “marginal financial security with positive attributes, but adverse business conditions could lead to insufficient ability to meet financial commitments.” In March 2007, Standard & Poors raised the credit rating of the Senior Notes from a B- (weak financial security, adverse business conditions will likely impair its ability to meet financial commitments) to a B (weak financial security, adverse business conditions will likely impair its ability to meet financial commitments) with a stable outlook.
Total annuity considerations and life insurance premiums decreased to approximately $40.4 million in 2007 from approximately $41.4 million in 2006, a decrease of approximately 2.4% and increased from approximately $39.1 million in 2005 to $41.4 million in 2006, an increase of approximately 5.9%. Life insurance premiums were $15.6 million, $13.8 million and $11.8 million in 2007, 2006 and 2005 respectively. Annuity considerations decreased to approximately $24.8 million in 2007 from approximately $27.6 million in 2006, a decrease of approximately $2.8 million, and increased from approximately $27.4 million in 2005 to $27.6 million in 2006, an increase of approximately $0.2 million. These amounts do not include consideration from the sales of deferred annuities or immediate annuities without life contingencies. Under GAAP, such sales are reported as additions to policyholder account balances. Consideration from such sales was approximately $136.5 million, $163.6 million and $139.7 million in 2007, 2006 and 2005, respectively. Several factors attributed to the decrease of annuity premium considerations. The continued repressive interest environment beginning in 2002 has been persistent causing annuity carriers to credit relatively lower and unattractive rates of interest versus the banking savings market which enjoyed a favorable yield curve advantage throughout 2007. Liquidity is at a premium, as the economy appears to continue slipping towards recession creating an unfavorable environment for the purchase of annuity contracts. The Company’s diminished A.M. Best, Standard and Poors, and Moody’s ratings from the 2001 levels remain a significant contributory factor to the annuity premium slowdown.
Net investment income totaled $294.9 million in 2007, as compared to $316.4 million in 2006 and $339.7 million in 2005. This represents a 6.8% decrease comparing 2007 to 2006 and a 6.9% decrease comparing 2006 to 2005. Invested assets, at amortized cost, for 2007, 2006 and 2005 totaled $4.0 billion, $4.2 billion and $4.5 billion, respectively. This decrease in invested assets was primarily caused by an increase in policy surrenders in the Insurance Company’s annuity business which exceeded the level of new annuity sales for the respective periods. Reduced income resulted from a decrease in invested assets, as well as, the income reduction attributable to portfolio rebalancing activities in 2006 and 2005, which involved the sale of higher yielding long-term assets and the reinvestment into lower yielding short-term investments. The Insurance Company's ratios of net investment income to average cash and invested assets, at amortized cost, for the years ended December 31, 2007, 2006 and 2005 were approximately 7.44%, 7.43% and 7.97%, respectively. Income from limited partnership investments amounted to approximately $52.9 million, $47.0 million and $63.5 million in 2007, 2006 and 2005, respectively. The changes in the amounts are largely reflective of the inherent volatility of income in the Company’s limited partnership portfolio. (See Item 7, Management’s Discussion and Analysis, Asset/Liability Management). Without taking into account the Corporation’s returns on its limited partnership investments in those years, the respective ratios would have been 6.43%, 6.64% and 6.85% for the years ended December 31, 2007, 2006 and 2005. For additional information, please refer to “Note 2 of the Notes to Consolidated Financial Statements.”
Net realized investment gains/(losses) (pre-tax) amounted to $24.8 million in fiscal 2007, as compared to $(3.6 million) in fiscal 2006 and $75.0 million in fiscal 2005. The increase in 2007 was primarily attributable to gains on fixed maturities. The decrease in 2006 was primarily attributable to recorded losses on the Insurance Company’s investment in Payor Swaptions. Due to accounting rules governing these investments, fluctuations in market value are realized in the income statement, even if the investments continued to be held by the Company. The values of the payor swaptions were $7.0, $9.8 million and $19.0 million for the years ended 2007, 2006 and 2005, respectively. The decrease in investment gains from 2005 to 2006 was largely attributable to gains from the portfolio rebalancing activities in 2005. Net realized investment gains for years ended December 31, 2007, 2006 and 2005 include realized investment losses of approximately $52 thousand, $4.5 million, and $10.3 million, respectively, attributable to writedowns of certain securities contained in the Insurance Company's investment portfolio that were deemed by management to be other than temporarily impaired. For a discussion of the procedure by which such determinations were made, see “Investments” above. Realized investment gains (losses) also resulted from sales of certain equities and convertible securities and calls and sales of fixed maturity investments in the Company’s investment portfolio.
Interest credited and benefits paid to policyholders amounted to $217.7 million in fiscal 2007 as compared to $242.2 million in fiscal 2006 and $255.7 million in fiscal 2005. These represent a decrease of 10.1% comparing fiscal 2007 to fiscal 2006 and a 5.3% decrease comparing fiscal 2006 to fiscal 2005. These amounts are consistent with the Company’s historic expense levels.
The interest expense on the Corporation's notes payable amounted to approximately $9.1 million in 2007, approximately $10.4 million in 2006 and approximately $9.6 million in 2005.
Under applicable accounting rules (FASB 97), DAC related to deferred annuities is amortized in proportion to the estimated gross profits over the estimated lives of the contracts. Essentially, as estimated profits of the Insurance Company related to these assets increase, the amount and timing of amortization is accelerated. The increase in 2007 relates to an increase in realized gains in 2007. The decrease from 2005 to 2006 was primarily due to a substantial decrease in the realized gains; a direct result of the Company’s portfolio rebalancing program in 2005. (See also the discussion of Deferred Policy Acquisition Costs under Critical Accounting Policies below.)
The Corporation is an insurance holding company and its primary uses of cash are debt service obligations, operating expenses and dividend payments. The Corporation’s principal sources of cash are sales of and interest on the Corporation’s investments and rent from its real estate. In 2007, the Corporation’s Board of Directors increased the quarterly dividend rate to $.125 per share from $.10 per share in 2006 and 2005. During 2007 and 2006, the Corporation did not repurchase any of its common stock, although at December 31, 2007, the Corporation was authorized to purchase approximately 385,000 shares of common stock.
The Insurance Company is subject to various regulatory restrictions on the maximum amount of payments, including loans or cash advances that it may make to the Corporation without obtaining prior regulatory approval. Under the New York Insurance Law, the Insurance Company is permitted without prior insurance regulatory clearance to pay a stockholder dividend to the Corporation as long as the aggregate amount of all such dividends in any calendar year does not exceed the lesser of (i) 10% of its statutory surplus as of the immediately preceding calendar year or (ii) its statutory net gain from operations for the immediately preceding calendar year (excluding realized capital gains and losses). The Insurance Company will only be permitted to pay a stockholder dividend to the Corporation in excess of that amount if it files notice of its intention to declare such a dividend and the amount thereof with the Superintendent and the Superintendent does not disapprove the distribution. The Insurance Company paid $32 million and $20 million in dividends to the Corporation in fiscal 2007 and 2006, respectively. No dividends were paid to the Corporation in 2005. On a going forward basis, there can be no assurance that the Insurance Company will have statutory earnings to support payment of dividends to the Corporation in an amount sufficient to fund its cash requirements and pay cash dividends or that the Superintendent will not disapprove any dividends that the Insurance Company must submit for the Superintendent’s consideration.
The Corporation was able to meet all its liquidity needs in 2007, including the payment of dividends, and anticipates being able to meet those needs in 2008 and the foreseeable future.
For purposes of the Corporation's consolidated statements of cash flows, financing activities relate primarily to sales and surrenders of the Insurance Company's annuity and universal life insurance products. The payment of dividends by the Corporation to its stockholders is also considered to be a financing activity. Net cash (used in)/provided by the Insurance Company's financing activities amounted to approximately $(453.7) million, $(300.8) million and $15.8 million in 2007, 2006 and 2005, respectively. These fluctuations primarily are attributable to changes in policyholder account balances as a result of surrenders, sales and interest earned by the policyholders as well as the repayment of short-term debt.
The market value of our fixed maturity portfolio changes as interest rates change. In general, rate decreases cause asset prices to rise, while rate increases cause asset prices to fall. Based on market values and prevailing interest rates as of December 31, 2007, a hypothetical instantaneous increase in interest rates of 100 basis points would produce a loss in fair value of our fixed maturity assets of approximately $167.3 million.
The short-term note payable relates to a bank line of credit with JPMorgan Chase Bank which had been in the amount of $50,000,000 (“Bank Line”) and provided for interest on borrowings based on market indices. At December 31, 2006 the Company had $50,000,000 outstanding. The Bank Line was up for renewal on July 31, 2007, however, on July 9, 2007, the Company paid down the full $50,000,000 Bank Line with available cash. The proceeds from the Bank Line had previously been used as an arbitrage facility to purchase higher yielding investments. The Company decided to pay off the Bank Line because due to the increased cost of the Bank Line it no longer provided a positive spread to the Company.
Long-term debt obligations consist of $90.2 million, 7 7/8% senior notes due February 15, 2009. See Note 3 in Notes to the Unaudited Condensed Consolidated Financials Statements for additional discussion concerning both long-term and short-term obligations.
See Note 1, Item O, “Notes to the Consolidated Financial Statements” for a full description of the new accounting pronouncements including the respective dates of adoption and the effects on the results of operations and financial condition.
To demonstrate the sensitivity of our net DAC balance ($77.7 million as of December 31, 2007) relative to our future spreads and expenses, the information below indicates how much the net DAC balance would have changed if the future spread assumption decreased by 30% and if the future expense assumption increased by 30%. We believe that any variation in our expense or spread estimate is likely to fall within these ranges.
FIN 48 liabilities and tax reserves - We have open tax years in the United States that are currently under examination by the applicable taxing authorities, and certain later tax years that may in the future be subject to examination. We periodically evaluate the adequacy of our FIN 48 liabilities and tax reserves, taking into account our open tax return positions, tax assessments received and tax law changes. The process of evaluating FIN 48 liabilities and tax reserves involves the use of estimates and a high degree of management judgment. The final determination of tax audits could affect our tax reserves.