Our principal operations are conducted from property leased from a subsidiary of the Iowa Farm Bureau Federation under a 15 year operating lease that expires in 2013. The property leased currently consists primarily of approximately 166,000 square feet of a 400,000 square foot office building in West Des Moines, Iowa. Operations related to our EquiTrust Life independent distribution are conducted from approximately 26,000 square feet of another office building in West Des Moines, Iowa. We consider the current facilities to be adequate for the foreseeable future.
Amounts are impacted by equity income from an equity investee totaling $4.4 million in 2003 and $1.4 million in 2002. Beginning in 2004, we discontinued applying the equity method of accounting for this investment as our share of percentage ownership decreased due to the equity investee’s initial public offering of common stock in December 2003.
We sell individual life insurance and annuity products through an exclusive distribution channel and individual annuity products through independent agents and brokers. Our exclusive agency force consists of 2,011 Farm Bureau agents and managers operating in the Midwestern and Western sections of the United States. Our fast growing independent channel, which we began in 2003, consists of 18,849 agents and brokers operating throughout the United States. In addition to writing direct insurance, we assume business through various coinsurance agreements. Several subsidiaries support various functional areas of the Life Companies and other affiliates, by providing investment advisory, marketing and distribution, and leasing services. In addition, we manage three Farm Bureau affiliated property-casualty companies.
The volume of our life insurance and annuity business in force, which is driven by the level of our sales, the volume of business assumed through coinsurance agreements and the persistency of the business written.
The amount of spread (excess of net investment income earned over interest credited/option costs) we earn on contract holders’ general account balances.
For variable universal life and variable annuities, premiums received are not reported as revenues. Similar to universal life and traditional annuities, revenues reported consist of fee income and product charges collected from the policyholders. Expenses related to these products include benefit claims incurred in excess of policyholder account balances.
As described in more detail in Note 1 to our consolidated financial statements, during the first quarter of 2006, we changed our method of computing share-based compensation expense, and changed our presentation of the related excess tax deductions in the consolidated statement of cash flows. In addition, effective January 1, 2004, we changed our method of computing reserves for guaranteed minimum death benefits and incremental death benefits associated with our variable annuities.
Fair values are principally estimated using a matrix calculation assuming a spread over U.S. Treasury bonds. The spread is based on current interest rates, risk assessment of the bonds and the current market environment.
We believe that reasonable changes in the credit spreads, ranging from 17 basis points to 151 basis points, depending upon credit quality, would produce a total value ranging from $312.4 million to $298.1 million, as compared to the recorded amount of $301.4 million. Unrealized gains and losses on these securities are recorded directly in stockholders’ equity, net of offsets, as a component of accumulated other comprehensive income.
Amortization of deferred policy acquisition costs and deferred sales inducements for participating life insurance and interest sensitive and index products is expected to total $96.5 million for 2007, excluding the impact of new production in 2007. A 10% increase in estimated gross profits for 2007 would result in $7.8 million of additional amortization expense. Correspondingly, a 10% decrease in estimated gross profits would result in an $8.0 million reduction of amortization expense.
We have assumed the expected long-term rate of return on plan assets will be 7.00%. In estimating the discount rate, we use the Citigroup Pension Discount Liability Index yield curve (5.50% for 2006), as it represents a group of high quality fixed income bonds that could be used to settle the pension obligations.
Premiums collected is a non-GAAP financial measure for which there is no comparable GAAP financial measure. We use premiums collected to measure the productivity of our exclusive and independent agents. Direct Traditional Annuity - Independent Distribution premiums collected increased significantly during 2006 and 2005 due to the successful expansion of our EquiTrust Life independent distribution channel. This is driven largely by an increase in the number of licensed independent agents to 18,849 at December 31, 2006 from 10,162 at December 31, 2005 and 4,778 at December 31, 2004. Reinsurance assumed and other premiums collected in 2006 and 2005 decreased from 2004 due to the suspension of a coinsurance agreement (the coinsurance agreement) with American Equity Investment Life Insurance Company (American Equity) effective August 1, 2004. As a result of this suspension, no transfers of new business will occur unless we and American Equity agree to resume the coinsurance of new business. The business assumed by us prior to the suspension remains as part of our in force business.
Net income applicable to common stock increased 23.8% in 2006 to $90.0 million and 10.3% in 2005 to $72.7 million. As discussed in detail below, net income applicable to common stock in 2006 was positively impacted by growth in the volume of business in force and an increase in realized gains on investments, partially offset by increases in death benefits and expenses resulting from a lawsuit settlement in 2006 totaling $4.9 million ($0.11 per basic and diluted common share, after taxes). Net income applicable to common stock in 2005 was positively impacted by growth in the volume of business in force, an increase in spreads earned and a reduction in other underwriting, acquisition and insurance expenses, partially offset by a decrease in realized gains on investments and a net increase in the value of embedded derivatives relating to our index annuities.
The increase in volume of business in force is quantified in the detailed discussion that follows by summarizing the face amount of insurance in force for life products or account values of contracts in force for interest sensitive products. The face amount of life insurance in force represents the gross death benefit payable to policyholders and
The weighted average yield on cash and invested assets represents the yield on cash and investments backing the universal life and individual traditional annuity products, net of investment expenses. With respect to our index annuities, index costs represent the expenses we incur to fund the annual income credits through the purchase of options and minimum guaranteed interest credited on the index business. The weighted average crediting rate/index cost and spread are computed excluding the impact of the amortization of deferred sales inducements. See the “Segment Information” section that follows for a discussion of our spreads.
We periodically revise the key assumptions used in the calculation of the amortization of deferred policy acquisition costs, deferred sales inducements, value of insurance in force acquired and unearned revenues for participating life insurance, variable and interest sensitive and index products, as applicable, through an unlocking process. Revisions are made based on historical results and our best estimate of future experience. The impact of unlocking on our results is as follows:
The amounts of the unlocking adjustments and whether they increase or decrease income depend upon the nature of the underlying assumption changes made in the underlying amortization models. See the “Segment Information” section that follows for additional discussion of our unlocking adjustments.
Surrender charges totaled $18.3 million in 2006, $13.5 million in 2005 and $9.9 million in 2004. Surrender charges increased due primarily to an increase in surrenders relating to growth in the volume and aging of business in force. The average aggregate account value for annuity and universal life insurance in force, which increased due to increases in premiums collected as summarized in the “Other data” table above, totaled $6,861.7 million for 2006, $5,523.8 million for 2005 and $4,638.7 million for 2004. We believe aging of the business in force is driving a portion of the increase in surrender charges relating to the annuity business assumed under the coinsurance agreement and business written directly through the EquiTrust Life independent agents as the surrender charge rate decreases with the passage of time (at a rate generally equal to 1.0% per year). This makes a surrender later in the contract period more economical for the contract holder. We started assuming business under the coinsurance agreement in 2001 and started selling annuities directly through EquiTrust Life independent agents in the fourth quarter of 2003. In total, surrender charges on this coinsurance and direct business totaled $15.6 million for 2006, $10.9 million for 2005 and $7.6 million for 2004.
Cost of insurance charges totaled $63.8 million in 2006, $61.9 million in 2005 and $59.8 million in 2004. Cost of insurance charges increased due primarily to aging of the business in force as the cost of insurance charge rate per each $1,000 in force increases with the age of the insured. The average age of our universal life and variable universal life policyholders was 45.0 years in 2006, 44.6 years in 2005 and 44.0 years in 2004.
Net investment income, which excludes investment income on separate account assets relating to variable products, increased 12.7% in 2006 to $535.8 million and increased 14.3% in 2005 to $475.4 million. These increases are primarily due to an increase in average invested assets. Average invested assets increased 15.4% to $8,822.7 million (based on securities at amortized cost) in 2006 and 13.5% to $7,645.4 million in 2005. Average invested assets totaled $6,734.7 million in 2004. The increases in average invested assets in 2006 and 2005 are due principally to net premium inflows from the Life Companies. The annualized yield earned on average invested assets decreased to 6.07% in 2006 from 6.22% in 2005 and 6.18% in 2004. Market conditions in 2006, 2005 and 2004 impacted our investment portfolio yield as market investment rates were, in general, lower than our portfolio yield or yield on
If we determine that an unrealized loss is other than temporary, the security is written down to its fair value with the difference between amortized cost and fair value recognized as a realized loss. Details regarding our significant investment impairments for 2006, 2005 and 2004, including the circumstances requiring the write downs, are summarized in the following table:
Other income and other expenses include revenues and expenses, respectively, relating primarily to our non- insurance operations. These operations include management, advisory, marketing and distribution services and leasing activities. Fluctuations in these financial statement line items are generally attributable to fluctuations in the level of these services provided during the years.
The average aggregate account value of annuity contracts in force, which increased due to increases in premiums collected as summarized in the “Other data” table above, totaled $5,970.0 million for 2006, $4,637.6 million for 2005 and $3,762.0 million for 2004. These account values include values relating to index contracts totaling $3,200.1 million for 2006, $2,299.1 million for 2005 and $1,593.6 million for 2004.
The weighted average interest crediting rate/index cost for universal life and individual traditional annuity products, excluding the impact of the amortization of deferred sales inducements, was 3.57% for 2006, 3.68% for 2005 and 3.97% for 2004. In 2005 and 2004, decreases in interest crediting rates were made in response to declining yields as noted in the “Net investment income” section above.
The changes in the amount of index credits are impacted by growth in the volume of index annuities in force and the amount of appreciation/depreciation in the underlying equity market indices on which our options are based as discussed above under “Derivative income (loss).” The change in the value of the embedded derivative is impacted by the change in expected index credits on the next policy anniversary dates, which is related to the change in the fair value of the options acquired to fund these index credits as discussed above under “Derivative income (loss).” The value of the embedded derivative is also impacted by the timing of the posting of index credits and changes in reserve discount rates and assumptions used in estimating future call option costs. In addition, during 2006, we reduced our reserves for the embedded derivative in our coinsured index annuities $7.1 million. This adjustment, which is the correction of an overstatement that started in 2001, increased net income $2.6 million ($0.09 per basic and diluted common share) after offsets for taxes and the amortization of deferred policy acquisition costs and deferred sales inducements. This adjustment does not impact our segment results as the segment results are based on operating income which, as explained in the section entitled “Segment Information,” excludes the impact of changes in the valuation of derivatives.
Traditional life insurance and accident and health policy benefits increased 1.6% in 2006 to $147.2 million and 1.8% in 2005 to $144.8 million. These increases are attributable to increases in traditional life insurance death and surrender benefits and an increase in the volume of traditional life business in force. Traditional life insurance death benefits increased 4.5% to $53.8 million in 2006 and 7.9% to $51.5 million in 2005. Surrender benefits increased 9.8% to $32.9 million in 2006 and less than 0.1% to $30.0 million in 2005. The increases in death and surrender benefits also contributed to lower increases in traditional life future policy benefits in 2006. The change in traditional life and accident and health future policy benefits may not be proportional to the change in traditional premiums and benefits as reserves on term policies are generally less than reserves on whole life policies. Distributions to participating policyholders decreased in 2006 and 2005 due to reductions in our dividend crediting rates in response to the impact of declining market interest rates on our investment portfolio yield as discussed in the “Net investment income” section above. Traditional life insurance and accident and health policy benefits can fluctuate from period to period primarily as a result of changes in mortality experience.
Underwriting, acquisition and insurance expenses increased 7.8% in 2006 to $164.6 million and 1.7% in 2005 to $152.6 million. Commission expense decreased in 2006 and 2005 primarily due to the impact of agent contract changes, partially offset by the impact of an increase in premiums. An increase in commission allowances on reinsurance ceded also contributed to the 2005 decrease in commission expense. Amortization of deferred policy acquisition costs increased due primarily to an increase in profitability and volume of business in force resulting from direct sales from our EquiTrust Life distribution channel. Amortization of deferred policy acquisition costs on this business totaled $16.4 million in 2006, $6.2 million in 2005 and $0.7 million in 2004. The impact of realized/unrealized gains and losses on investments and the change in unrealized gains/losses on derivatives also increased (decreased) amortization of deferred policy acquisition costs $1.6 million in 2006, ($1.5) million in 2005 and $1.4 million in 2004. In addition, amortization of deferred policy acquisition costs during 2005 increased $0.9 million in connection with the recapture by a former variable alliance partner of a previously coinsured block of variable annuity contracts. Amortization of value of insurance in force acquired increased in 2006 and 2005 primarily due to the impact of unlocking described above, partially offset in 2006 by the impact of increased death benefits on the underlying business.
Other underwriting, acquisition and insurance expenses increased in 2006 primarily due to a $4.9 million lawsuit settlement and a $0.9 million increase in stock-based compensation expense. These increases were partially offset by expense savings initiatives, mostly relating to the closure of a life processing unit in Manhattan, Kansas during the third quarter of 2005. See Note 1 of our notes to the consolidated financial statements for further details regarding the lawsuit settlement and a related unrecorded gain contingency. Other underwriting, acquisition and insurance expenses decreased in 2005 due primarily to a $2.1 million decrease in information technology expenses, a $1.5 million decrease in expenses relating to the imaging of policy files and a $0.6 million decrease in the loss on the sale of fixed assets. The information technology and imaging decreases are the result of completing projects and a reduction in allocated resources. These items were partially offset by a $2.3 million charge for severance, early retirement benefits and other costs relating to the closure of the life processing unit and other unrelated terminations during 2005.
Interest expense totaled $11.7 million in 2006 compared to $13.6 million in 2005 and $11.4 million in 2004. The decrease in 2006 is primarily a result of the redemption of our Series C preferred stock in December 2005. Interest expense included $2.3 million in 2005 and $2.2 million in 2004 of dividends on the Series C redeemable preferred stock. The increase in 2005 is partially attributable to the issuance of $75.0 million of 5.85% Senior Notes (Senior Notes) in April 2004. Interest on the Senior Notes totaled $4.3 million for 2006 and 2005 and $3.1 million for 2004. In addition, interest expense increased in 2006 and 2005 due to increases in the effective interest rate on our $46.0 million line of credit to an average of 5.50% in 2006, from 4.55% in 2005 and 2.70% in 2004.
Beginning in 2005, we changed the allocation of capital among our segments to be consistent with a change in how we manage capital at the segment level. This change, coupled with a refinement in the allocation of accrued investment income and certain other assets and liabilities among the segments, resulted in an increase (decrease) in investments in our segments as of January 1, 2005 as follows: Exclusive Annuity - $41.9 million; Independent Annuity - $19.8 million; Traditional and Universal Life Insurance - ($69.4) million; Variable - ($12.5) million and Corporate and Other - $20.2 million. Accordingly, operating revenues and pre-tax operating income (loss) by segment in 2005 is impacted by the income on the investments transferred. An estimate of the impact of this asset transfer on operating revenues and pre-tax operating income (loss) for 2005 is as follows: Exclusive Annuity - $2.7 million; Independent Annuity - $1.3 million; Traditional and Universal Life Insurance - ($4.5) million; Variable - ($0.8) million and Corporate and Other - $1.3 million.
Net investment income includes $3.5 million in 2006, $4.2 million in 2005 and $0.7 million in 2004 in fee income from bond calls, tender offers and mortgage loan prepayments and the reversal of net discount accretion on mortgage and asset-backed securities as noted in the “Net investment income” section above. Net investment income was also positively impacted in 2005 by an increase in investments due to the change in allocation of capital discussed above. These factors were partially offset by the impact of market investment rates being lower than our portfolio yield or yield on investments maturing or being paid down.
Benefits and expenses were impacted by changes in the assumptions used to calculate deferred policy acquisition costs as discussed under “Significant Accounting Policies and Estimates.” Amortization of deferred policy acquisition costs decreased $1.7 million in 2006, increased $2.4 million in 2005 and decreased $0.3 million in 2004 due to changes in the assumptions used to calculate deferred policy acquisition costs. The 2005 unlocking adjustment is primarily due to a change in the premium persistency assumption on our flexible premium deferred annuity business. Amortization of value of insurance in force acquired was reduced $0.2 million in 2006 and $0.7 million in 2005 and 2004 as a result of changes in the assumptions used in the underlying calculation. Other underwriting expenses decreased 8.4% in 2006 to $8.9 million and 8.6% in 2005 to $9.7 million primarily due to expense savings initiatives.
Premiums collected decreased 20.9% to $140.3 million in 2006 and 23.3% to $177.4 million in 2005. The amount of traditional annuity premiums collected is highly dependent upon the relationship between the current crediting rates on our products and the crediting rates available on competing products, including bank-offered certificates of deposit. We believe the decreases in annuity premiums in 2006 and 2005 are due to a rise in short-term market interest rates during these years, making certificates of deposit and other short-term investments more attractive in relation to traditional annuities. During 2006, we also believe the competitive environment resulted in increased surrenders, therefore increasing the withdrawal rate. To enhance our competitive position in the current interest rate environment, we introduced a new deferred annuity contract effective July 1, 2006 that has an interest crediting rate based on the current market investment rates.
Benefits and expenses increased in 2006 and 2005 due to growth in the volume of business in force. Index credits increased $26.6 million in 2006 however decreased $5.1 million in 2005 due to timing of policy anniversary dates and the amount of appreciation in the underlying indices. Operating expenses include $5.9 million in 2006, $4.1 million in 2005 and $4.0 million in 2004 relating to the expansion of our EquiTrust Life distribution.
Pre-tax operating income for the Traditional and Universal Life Insurance segment increased 7.1% in 2006 to $58.7 million and 5.3% in 2005 to $54.8 million. The increase in 2006 is primarily due to an increase in the volume of business in force and a decrease in other underwriting expenses, partially offset by an increase in death benefits and lower spreads on our interest sensitive life business. The increase for 2005 is driven by an increase in the volume of business in force, increased spreads and the impact of unlocking on deferred policy acquisition costs.
The changes in the weighted average yield on cash and invested assets are attributable to the items affecting net investment income noted above. The changes in our spread earned are due primarily to changes in investment yield.
Interest sensitive product charges increased in 2006 and 2005 due to increases in mortality and expense fee income and cost of insurance charges. Mortality and expense fee income increased 18.2% to $8.1 million in 2006 and 19.4% to $6.9 million in 2005 due to growth in separate account assets. Cost of insurance charges increased 5.3% to $26.7 million in 2006 and 6.0% to $25.4 million in 2005 due primarily to aging of business in force. Death benefits in excess of related account values on variable universal life policies increased 18.3% to $14.7 million in 2006 and 21.1% to $12.4 million in 2005. Amortization of deferred policy acquisitions costs increased $1.8 million in 2006, decreased $0.6 million in 2005 and increased $0.8 million in 2004 due to changes in assumptions used to calculate deferred policy acquisition costs.
Pre-tax operating loss totaled $3.9 million in 2006 compared to $2.7 million in 2005 and $8.4 million in 2004. The increase in losses in 2006 is primarily due to a decrease in net investment income, partially offset by a decrease in interest expense. The decrease in losses for 2005 is primarily due to an increase in net investment income and reduction in operating expenses, partially offset by an increase in interest expense.
Net investment income declined in 2006 primarily due to a decrease in investments resulting from the redemption of the Series C preferred stock in December 2005 and an increase in investments allocated to the product segments. Net investment income in 2005 was positively impacted by the change in allocation of capital discussed above and an increase in invested assets from our Senior Note offering in April 2004. Net investment income includes fee income from bond calls, mortgage loan prepayments and the reversal of net discount accretion on mortgage and asset-backed securities totaling $0.5 million in 2006, $1.2 million in 2005 and $0.2 million in 2004. In addition, we recorded $0.9 million in net investment income during 2005, representing past due interest that had not been accrued, relating to the redemption of a fixed maturity security that had been impaired in a prior period.
Interest expense decreased in 2006 due to the redemption of our Series C preferred stock but increased in 2005 due to our Senior Notes offering. Interest expense also increased during 2006 and 2005 due to an increase in the effective interest rate on our line of credit as discussed in the “Interest Expense” section above. The decrease in benefits and expenses in 2005 is attributable to an estimated $4.0 million reduction in insurance-related expenses due to the change in the method of allocating indirect expenses among the segments as discussed above.
Statement 133 Implementation Issue No. G26, “Cash Flow Hedges: Hedging Interest Cash Flows on Variable-Rate Assets and Liabilities That Are Not Based on a Benchmark Interest Rate,” (DIG G26), which clarifies the accounting for a cash flow hedge of a variable-rate asset or liability. Upon adoption, we will undesignate the hedging relationship for the interest rate swaps related to our flexible premium deferred annuity contracts and begin recording changes in unrealized gains or losses on these swaps in derivative income, rather than accumulated other comprehensive income. The impact of this adoption will vary based on changes in market conditions. Net unrealized gains on these swaps included in accumulated other comprehensive income totaled $4.4 million at December 31, 2006, $5.5 million at December 31, 2005 and $3.2 million at December 31, 2004.
As of December 31, 2006, 95.8% (based on carrying value) of the available-for-sale fixed maturity securities were investment grade debt securities, defined as being in the highest two National Association of Insurance Commissioners (NAIC) designations. Non-investment grade debt securities generally provide higher yields and involve greater risks than investment grade debt securities because their issuers typically are more highly leveraged and more vulnerable to adverse economic conditions than investment grade issuers. In addition, the trading market for these securities is usually more limited than for investment grade debt securities. We regularly review the percentage of our portfolio that is invested in non-investment grade debt securities (NAIC designations 3 through 6). As of December 31, 2006, the investment in non-investment grade debt was 4.2% of available-for-sale fixed
Equity securities totaled $50.3 million at December 31, 2006 and $82.5 million at December 31, 2005. Gross unrealized gains totaled $14.9 million and gross unrealized losses totaled $0.2 million at December 31, 2006. At December 31, 2005, gross unrealized gains totaled $28.1 million and gross unrealized losses totaled $0.2 million on these securities. Included in equity securities is our investment in AEL which totaled $39.4 million at December 31, 2006 and $72.0 million at December 31, 2005. During 2006 we sold 2,500,000 shares of AEL and realized a pre-tax gain of $13.5 million.
Mortgage loans totaled $979.9 million at December 31, 2006 and $840.5 million at December 31, 2005. These mortgage loans are diversified as to property type, location and loan size, and are collateralized by the related properties. Mortgages more than 60 days delinquent accounted for less than 0.1% of the carrying value of the mortgage portfolio at December 31, 2006 and less than 0.3% at December 31, 2005. Our mortgage lending policies establish limits on the amount that can be loaned to one borrower and require diversification by geographic location and collateral type. Information regarding the collateral type and related geographic location within the United States follows:
Derivative instruments consist primarily of call options totaling $121.9 million at December 31, 2006 and $38.2 million at December 31, 2005, supporting our index annuity business.
Policy liabilities and accruals and other policyholders’ funds increased 22.5% to $10,037.4 million at December 31, 2006 primarily due to increases in the volume of business in force. The deferred income tax liability decreased 29.2% to $62.4 million at December 31, 2006 due to a $29.0 million decrease resulting from the impact of the change in unrealized appreciation/depreciation on fixed maturity securities. Other liabilities increased 14.9% to $174.5 million at December 31, 2006, due to a $70.8 million increase in collateral owed to counterparties for call options. This increase was partially offset by a decrease in negative cash, primarily attributable to a $46.3 million outstanding check at December 31, 2005 relating to our Series C preferred stock redemption.
At December 31, 2006, common stockholders’ equity was $877.7 million, or $29.59 per share, compared to $841.2 million, or $28.88 per share at December 31, 2005. Included in stockholders’ equity per common share is $0.95 at December 31, 2006 and $2.83 at December 31, 2005 primarily attributable to net unrealized investment gains resulting from marking to market value our fixed maturity and equity securities classified as available for sale and interest rate swaps. The change in net unrealized appreciation of these securities and derivatives decreased stockholders’ equity $53.9 million during 2006, after related adjustments to deferred policy acquisition costs, deferred sales inducements, value of insurance in force acquired, unearned revenue reserve and deferred income taxes.
A majority of our insurance liabilities are backed by fixed maturity securities and mortgage loans. The weighted average life of the fixed maturity and mortgage loan portfolio, based on market values and excluding convertible bonds, was approximately 9.6 years at December 31, 2006 and 8.9 years at December 31, 2005. Accordingly, the earned rate on the portfolio lags behind changes in market yields. The extent that the portfolio yield lags behind changes in market yields generally depends upon the following factors:
For a majority of our traditional products, profitability is significantly affected by the spreads between interest yields on investments and interest crediting rates/call option costs relating to our insurance liabilities. For variable annuities and variable universal life policies, profitability on the portion of the policyholder’s account balance invested in the fixed general account option, if any, is also affected by the spreads earned. For the variable products, the policyholder assumes essentially all the investment earnings risk for the portion of the account balance invested in the separate accounts.
For a substantial portion of business assumed through our coinsurance agreements with American Equity and EMC National Life Company (EMCNL), the ceding companies have the ability to adjust interest and dividend crediting rates in reaction to portfolio yield. Most of the traditional annuity and universal life insurance contracts assumed through the coinsurance agreements have guaranteed minimum crediting rates. For contracts assumed from American Equity, these rates range from 2.25% to 4.00%, with a weighted average guaranteed crediting rate of approximately 3.02% at December 31, 2006. For contracts assumed from EMCNL, these rates range from 2.50% to 4.00% with a weighted average guaranteed crediting rate of approximately 3.66% at December 31, 2006. The following table sets forth account values broken out by the excess of current interest crediting rates over guaranteed rates for fixed rate annuities and universal life business assumed through the coinsurance agreements at December 31, 2006.
Profitability on the portion of the index annuities tied to market indices is significantly impacted by the spread on interest earned on investments and the sum of (1) cost of underlying call options purchased to fund the credits owed to contract holders and (2) minimum interest guarantees owed to the contract holder, if any. The cost of the call options is managed through the terms of the index annuities, which permit adjustments to annual participation rates, asset fees, and/or caps, subject to guaranteed minimums. The minimum guaranteed contract values for the majority of index annuities sold by our EquiTrust Life distribution are equal to 87.5% of the premium collected plus interest credited at 3.00%. A few state variations exist where the minimum guaranteed contract value was based on 100% of premium accumulated at 1.50%. The minimum guaranteed contract values for index annuities assumed under the coinsurance agreement with American Equity are equal to 80% to 100% of the premium collected plus interest credited at rates ranging between 2.25% to 3.50%. Profitability on the index annuities in any given year is also impacted by changes in the fair value of the embedded option which provides the contract holder the right to participate in market index returns after the next index reset date of the contract. This impacts profitability because only one or two-year call options are purchased to fund the index credits owed to the contract holders at the inception of each reset period. This practice matches well with the contract holders’ rights to switch to different indices on each reset date. The value of the forward starting options embedded in the index annuities can fluctuate with changes in assumptions as to the expected cost of the options, which is driven by expectations as to the future
volatility of the market indices, risk free interest rates, market returns, contractual features such as participation rates, asset fees, and/or caps and the lives of the contracts.
As of December 31, 2006, we have entered into six interest rate swaps to manage interest rate risk associated with a portion of our flexible premium deferred annuity contracts. Under the interest rate swaps, we pay a fixed rate of interest and receive a floating rate of interest on a notional amount totaling $300.0 million. These interest rate swaps effectively fix the interest crediting rate on a portion of our flexible premium deferred annuity contract liabilities thereby hedging our exposure to increases in market interest rates. We also have one interest rate swap to hedge the variable component of the interest rate on our line of credit borrowings. The terms of this swap provide that we pay a fixed rate of interest and receive a floating rate of interest on a notional amount of $46.0 million. Any gain or loss on the interest rate swap settlements offset any increase or decrease in the interest paid on the line of credit, effectively fixing our interest expense related to the outstanding debt on this line of credit. As discussed in Note 1 to the consolidated financial statements, we will discontinue the use of hedge accounting during 2007 for the interest rate swaps backing our annuity liabilities in connection with the adoption of a pending accounting change. This change will not impact the economic benefit the swaps provide the company. For additional discussion of these interest rate swaps, also see Note 3 to the consolidated financial statements.
If interest rates were to increase 10% from levels at December 31, 2006 and 2005, the market value of our fixed maturity securities and short-term investments would decrease approximately $260.8 million at December 31, 2006 and $192.8 million at December 31, 2005, while the value of our interest rate swaps would increase approximately $6.4 million at December 31, 2006 and $3.5 million at December 31, 2005. These hypothetical changes in value do
not take into account any offsetting change in the value of insurance liabilities for investment contracts since we estimate such value to be the cash surrender value for a majority of the underlying contracts. If interest rates were to decrease 10% from levels at December 31, 2006 and 2005, the fair value of our debt would increase $4.9 million at December 31, 2006 and $4.8 million at December 31, 2005, while the value of our interest rate swap on our line of credit would decrease $0.4 million at December 31, 2006.
In connection with our use of interest rate swaps and call options, we are exposed to counterparty credit risk (the risk that a counterparty fails to perform under the terms of the derivative contract). We do not anticipate nonperformance by any of our counterparties. We purchase our derivative instruments from multiple counterparties and evaluate the creditworthiness of all counterparties prior to purchase of the contracts. Purchasing such agreements from financial institutions with superior performance reduces the credit risk associated with these agreements. Our policy allows us to purchase derivative instruments from nationally recognized investment banking institutions with an S&P rating of BBB+ or higher. As of December 31, 2006, all derivative instruments have been purchased from counterparties with an S&P rating of A or higher. Collateral support documents are negotiated to further reduce the exposure when deemed necessary. See Note 2 to the consolidated financial statements for details regarding collateral we held as of December 31, 2006. Counterparty credit ratings are monitored on a regular basis (at least quarterly). Credit exposure is monitored monthly and reviewed quarterly by our credit and investment committees. Our credit exposure is the fair value of derivative instruments with a positive value, which totaled $127.5 million at December 31, 2006.
We have a $60.0 million revolving line of credit agreement with LaSalle Bank National Association and Bankers Trust Company, N.A. due October 2010. Debt outstanding on this line of credit totaled $46.0 million at December
31, 2006 and December 31, 2005. Interest on any borrowings accrues at a variable rate (6.12% at December 31, 2006 and 5.13% at December 31, 2005). In 2006, we entered into an interest rate swap to fix the interest expense we incur on the $46.0 million at rate of 5.51%. Under this agreement, we are required to meet certain financial covenants. In addition, we are prohibited from incurring additional indebtedness in excess of $25.0 million while this line of credit is in effect. In January 2006, we entered into a $46.0 million interest rate swap to hedge the variable component of the interest rate on the line of credit borrowings. See “Market Risks of Financial Instruments” and Note 3 to the consolidated financial statements for additional details on this interest rate swap.
The ability of the Life Companies to pay dividends to FBL Financial Group, Inc. is limited by law to earned profits (statutory unassigned surplus) as of the date the dividend is paid, as determined in accordance with accounting practices prescribed by insurance regulatory authorities of the State of Iowa. In addition, under the Iowa Insurance Holding Company Act, the Life Companies may not pay an “extraordinary” dividend without prior notice to and approval by the Iowa Insurance Commissioner. An “extraordinary” dividend is defined under the Iowa Insurance Holding Company Act as any dividend or distribution of cash or other property whose fair market value, together with that of other dividends or distributions made within the preceding 12 months, exceeds the greater of (i) 10% of policyholders’ surplus (total statutory capital stock and statutory surplus) as of December 31 of the preceding year, or (ii) the statutory net gain from operations of the insurer for the 12-month period ending December 31 of the preceding year. During 2007, the maximum amount legally available for distribution to FBL Financial Group, Inc., without further regulatory approval, from Farm Bureau Life is $38.3 million and from EquiTrust Life is $32.8 million. However, distributions from Farm Bureau Life are not available until December 2007, due to the timing and amount of dividend payments made during 2006.
In the normal course of business, we enter into insurance contracts, financing transactions, lease agreements or other commitments which are necessary or beneficial to our operations. These commitments may obligate us to certain cash flows during future periods. The following table summarizes such obligations as of December 31, 2006:
reserves for products such as annuities and universal life products are generally based on the account values of the contracts without taking into account surrender charges, while the contractual obligations table includes projected cash payments. The following are the reconciling items between these balances (dollars in thousands):
In addition, contractual obligations totaling $352.6 million relating to dividend accumulations and other policy claims are included in the “Other policy claims and benefits” and “Advance premiums and other deposits” lines on the consolidated balance sheets.
Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rules 13a - 15(f). Under the supervision and the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on our evaluation under the framework in Internal Control - Integrated Framework, our management concluded that our internal control over financial reporting was effective as of December 31, 2006.
Our management’s assessment of the effectiveness of our internal control over financial reporting as of December 31, 2006 has been attested to by Ernst & Young LLP, an independent registered public accounting firm, as stated in their report that follows.
We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control Over Financial Reporting, that FBL Financial Group, Inc. maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). FBL Financial Group, Inc.’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the company’s internal control over financial reporting based on our audit.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the accompanying consolidated balance sheets as of December 31, 2006 and 2005, and the related statements of income, changes in stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2006 of FBL Financial Group, Inc. and our report dated February 13, 2007 expressed an unqualified opinion thereon.
We have audited the accompanying consolidated balance sheets of FBL Financial Group, Inc. as of December 31, 2006 and 2005, and the related consolidated statements of income, changes in stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2006. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of FBL Financial Group, Inc. at December 31, 2006 and 2005, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2006, in conformity with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of FBL Financial Group, Inc.’s internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 13, 2007 expressed an unqualified opinion thereon.
In January 2007, the Financial Accounting Standards Board (FASB) issued Statement 133 Implementation Issue No. G26, “Cash Flow Hedges: Hedging Interest Cash Flows on Variable-Rate Assets and Liabilities That Are Not Based on a Benchmark Interest Rate,” (DIG G26) which clarifies the accounting for a cash flow hedge of a variable-rate asset or liability, specifically addressing when an entity is permitted to hedge benchmark interest rate risk. DIG G26 indicates that the risk being hedged in a cash flow hedge of a variable-rate financial asset or liability cannot be designated as interest rate risk unless the cash flows of the hedged transaction are explicitly based on that same benchmark interest rate. In addition, DIG G26 clarifies that the only permitted benchmarks are the risk-free rate and rates based on the LIBOR swap curve. Hedging relationships that no longer qualify for cash flow hedge accounting based on this guidance must be undesignated prospectively. Future changes in fair value of derivatives not subsequently re-designated to a new qualifying hedging relationship must be recorded in earnings. Gains or losses previously included in accumulated other comprehensive income will remain in accumulated other comprehensive income and be amortized to net income over the remaining term of the swaps as the hedged anticipated cash flows occur. If it becomes probable that the anticipated cash flows will not occur, the deferred gains or losses will be reclassified into earnings immediately. We intend to adopt this Issue when required in the second quarter of 2007 and undesignate the hedging relationship for the interest rate swaps related to our flexible premium deferred annuity contracts as they are not explicitly based on one of the two permitted benchmarks. The impact of this adoption will vary based on changes in market conditions. Net unrealized gains on these swaps included in accumulated other comprehensive income totaled $4.4 million at December 31, 2006 and $5.5 million at December 31, 2005. This guidance does not impact the interest rate swap on our line of credit, as both the derivative instrument and hedged item are based on the three-month LIBOR rate. See Note 3, “Derivative Instruments,” for additional details on these interest rate swaps.
In June 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes.” Interpretation No. 48 creates a single model to address uncertainty in tax positions and clarifies the accounting for income taxes by prescribing the minimum recognition threshold a tax position is required to meet before being recognized in the financial statements. Under the Interpretation, a tax position can be recognized in the financial statements if it is more likely than not that the position will be sustained upon examination by taxing authorities who have full knowledge of all relevant information. A tax position that meets the more-likely-than-not recognition threshold is measured at the largest amount of benefit that is greater than 50 percent likely of being realized upon settlement. Interpretation No. 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. We intend to adopt Interpretation No. 48 beginning in 2007 and expect to record a tax liability for tax positions totaling less than $0.5 million.
Effective January 1, 2006, we adopted Statement No. 123(R), “Share-Based Payment,” using the modified-prospective-transition method. Statement No. 123(R) is a revision of Statement No. 123, “Accounting for Stock-Based Compensation.” Details regarding the impact of changes in accounting for stock-based compensation and our application of the modified-prospective-transition method of adoption are outlined in the “Stock-Based Compensation” section of this Note.
In September 2005, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants (AcSEC) issued Statement of Position (SOP) 05-1, “Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchanges of Insurance Contracts.” The SOP provides guidance on the accounting for internal replacements of one insurance contract for another insurance contract. Under the SOP, an internal replacement that is determined to result in a replacement contract that is substantially changed from the replaced contract is accounted for as an extinguishment of the replaced contract. As an extinguishment, the unamortized deferred policy acquisition costs, deferred sales inducements, value of insurance in force acquired and unearned revenue reserves from the replaced contract are written off at the time of the extinguishment. An internal replacement that is determined to result in a replacement contract that is substantially unchanged from the replaced contract is accounted for as a continuation of the replaced contract. The SOP is effective for internal replacements occurring in fiscal years beginning after December 15, 2006. We do not expect to record a cumulative effect of accounting change adjustment upon adoption of this SOP in 2007 as adoption is expected to have an insignificant impact on lapse assumptions included in our deferred policy acquisition cost and related models. In addition, net income is not expected to be impacted materially going forward as our current accounting policy for internal replacements substantially conforms to current interpretations of the guidance in the SOP.
other comprehensive income. Unrealized gains and losses relating to the conversion feature embedded in convertible fixed maturity securities are recorded as a component of derivative income (loss) in the consolidated statements of income. The unrealized gains and losses are reduced by a provision for deferred income taxes and adjustments to deferred policy acquisition costs, deferred sales inducements, value of insurance in force acquired and unearned revenue reserve that would have been required as a charge or credit to income had such amounts been realized. Fixed maturity securities that are purchased with the intent to sell within a short period of time are classified as “trading.” These securities are carried at fair value and unrealized gains and losses are reflected in the consolidated statements of income as a component of realized/unrealized gains on investments. Premiums and discounts are amortized/accrued using methods which result in a constant yield over the securities’ expected lives. Amortization/accrual of premiums and discounts on mortgage and asset-backed securities incorporates prepayment assumptions to estimate the securities’ expected lives.
Our interest rate swaps are accounted for as cash flow hedges. The swaps are carried on the consolidated balance sheet as either a derivative instrument or other liability. The effective portion of any unrealized gain or loss is recorded in accumulated other comprehensive income. If a portion of the hedges become ineffective, the ineffective portion of any unrealized gain or loss on the swap will be recorded in earnings as a component of derivative income (loss) as it occurs. The net periodic interest settlement between the interest paid and the interest received under these swaps is recorded as a component of interest sensitive and index product benefits.
For derivatives not designated as a hedging instrument, the change in fair value is recognized in earnings in the period of change. See “Accounting Changes” above, Note 3, “Derivative Instruments,” and Note 7, “Credit Arrangements,” for more information regarding our derivative instruments and embedded derivatives.
Realized gains and losses on sales of investments are determined on the basis of specific identification. This line item also includes the change in unrealized gains and losses on trading securities. The carrying values of all our investments are reviewed on an ongoing basis for credit deterioration. If this review indicates a decline in market value that is other than temporary, the carrying value of the investment is reduced to its fair value and a specific write down is taken. Such reductions in carrying value are recognized as realized losses on investments. For fixed maturity securities and equity securities, the fair value becomes the new cost basis for the security and the cost basis is not adjusted for subsequent recoveries in fair value. However, for fixed maturity securities for which we can reasonably estimate future cash flows after a write down, the discount or reduced premium recorded, based on the new cost basis, will be amortized over the remaining life of the security. Amortization in this instance is computed using the prospective method and the current estimate of the amount and timing of future cash flows. It is difficult to estimate cash flows on securities that have been written down for an other-than-temporary impairment due to the inherent variability of cash flows associated with distressed securities. No such amortization was recorded in 2006, 2005 or 2004.
Market values of fixed maturity securities are reported based on quoted market prices, where available. Market values of fixed maturity securities not actively traded in a liquid market are estimated using a matrix calculation assuming a spread (based on interest rates and a risk assessment of the bonds) over U. S. Treasury bond yields. Market values of the conversion features embedded in convertible fixed maturity securities are estimated using an option-pricing model. Market values of redeemable preferred stocks, equity securities, call options and interest rate swaps are based on the latest quoted market prices, or for those stocks not readily marketable, generally at values which are representative of the market values of comparable issues. Market values for the embedded derivatives in our modified coinsurance contracts and relating to our when-issued securities are based on the difference between the fair value and the cost basis of the underlying investments. Market values for the embedded derivatives in our reinsurance recoverable relating to call options are based on quoted market prices.
Deferred Policy Acquisition Costs, Deferred Sales Inducements and Value of Insurance In Force Acquired
Deferred policy acquisition costs include certain costs of acquiring new insurance business, principally commissions and other expenses related to the production of new business, to the extent recoverable from future policy revenues and gross profits. Deferred sales inducements include premium bonuses and bonus interest credited to contracts during the first contract year only. The value of insurance in force acquired represents the cost assigned to insurance contracts when an insurance company is acquired. The initial value is determined by an actuarial study using expected future gross profits as a measurement of the net present value of the insurance acquired. Interest accrued on the unamortized balance at a weighted average rate of 4.95% in 2006, 4.88% in 2005 and 5.02% in 2004.
For participating traditional life insurance, interest sensitive and index products, these costs are being amortized generally in proportion to expected gross profits (after dividends to policyholders, if applicable) from surrender charges and investment, mortality, and expense margins. That amortization is adjusted retrospectively through an unlocking process when estimates of current or future gross profits/margins (including the impact of investment gains and losses) to be realized from a group of products are revised. For nonparticipating traditional life products, these costs are amortized over the premium paying period of the related policies, in proportion to the ratio of annual premium revenues to total anticipated premium revenues. Such anticipated premium revenues are estimated using the same assumptions used for computing liabilities for future policy benefits.
Goodwill represents the excess of the amount paid to acquire a company over the fair value of its net assets acquired. Goodwill is not amortized but is subject to annual impairment testing. We have performed impairment testing using cash flow analyses and determined none of our goodwill was impaired as of December 31, 2006 or December 31, 2005.
2005 and 2004. It is anticipated that estimated future guaranty fund assessments on known insolvencies will be paid during 2007 and substantially all the related future premium tax offsets will be realized during the five-year period ending December 31, 2011. We believe the reserve for guaranty fund assessments is sufficient to provide for future assessments based upon known insolvencies and projected premium levels.
We reduced our reserves for the embedded derivative in our coinsured index annuities $7.1 million in 2006. This adjustment, which is the correction of an overstatement that started in 2001, increased 2006 net income $2.6 million ($0.09 per basic and diluted common share) after offsets for taxes and the amortization of deferred policy acquisition costs and deferred sales inducements. The impact to the financial statement line items and prior period financial statements affected by this overstatement is not material. This adjustment does not impact our segment results as the segment results are based on operating income which, as explained in Note 14, excludes the impact of changes in the valuation of derivatives.
Underwriting, acquisition and insurance expenses include a pre-tax charge of $4.9 million ($0.11 per basic and diluted common share) for the year ended December 31, 2006 relating to the settlement of a lawsuit with a husband and wife who had applied for life insurance policies. The settlement ends litigation regarding the process we followed in denying insurance coverage for medical reasons. The settlement was entered into after adverse judicial rulings were made against us in June 2006. Prior to the issuance of the adverse judicial rulings, a material loss, net of insurance recoveries, was not deemed to be reasonably possible.
Insurance claims have been filed under our professional liability and general liability insurance policies for reimbursement of the settlement amount, but coverage has been denied, and we have filed a claim against an insurance broker for breach of contractual duties. We believe these claims have merit and have filed lawsuits against the insurer and the insurance broker to recover damages. Recoveries from third parties are required to be accounted for as gain contingencies and not recorded in our financial statements until the lawsuits are resolved. Accordingly, our financial statements for the year ended December 31, 2006 include the $4.9 million settlement expense, but any recoveries will be recorded in net income in the period the recovery is received.
Other income and other expenses consist primarily of revenue and expenses generated by our various non-insurance subsidiaries for investment advisory, marketing and distribution, and leasing services. They also include revenues and expenses generated by our parent company for management services. Certain of these activities are performed on behalf of affiliates of the Company. In addition, certain revenues generated by our insurance subsidiaries are classified as other income. Revenues of the insurance subsidiaries included as other income totaled $1.3 million in 2006, $0.7 million in 2005 and $1.2 million in 2004. Lease income from leases with affiliates totaled $12.0 million in 2006, $11.0 million in 2005 and $8.2 million in 2004. Investment advisory fee income from affiliates totaled $1.5 million in 2006, $2.5 million in 2005 and $2.3 million in 2004.
Unrealized gains and losses on our available-for-sale securities and interest rate swaps are included in accumulated other comprehensive income in stockholders’ equity. Other comprehensive income excludes net investment gains included in net income which represent transfers from unrealized to realized gains and losses. These amounts totaled $7.9 million in 2006, $1.9 million in 2005 and $1.4 million in 2004. These amounts, which have been measured through the date of sale, are net of income taxes and adjustments to deferred policy acquisition costs, deferred sales inducements, value of insurance in force acquired and unearned revenue reserve totaling ($4.0) million in 2006, ($1.5) million in 2005 and ($1.7) million in 2004. Beginning in 2006, accumulated other comprehensive income also includes $0.2 million to recognize the underfunded status of our single employer health and medical postretirement benefit plans.
The following tables contain amortized cost and estimated market value information on fixed maturities and equity securities classified as available for sale:
The carrying value and estimated market value of our portfolio of available-for-sale fixed maturity securities at December 31, 2006, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
The changes in net unrealized investment gains and losses are recorded net of deferred income taxes and other adjustments for assumed changes in the amortization pattern of deferred policy acquisition costs, deferred sales inducements, value of insurance in force acquired and unearned revenue reserve totaling ($48.1) million in 2006, ($66.4) million in 2005 and $24.4 million in 2004.
Included in the above table are 780 securities from 513 issuers at December 31, 2006 and 515 securities from 328 issuers at December 31, 2005. These increases are primarily due to the impact of increases in market interest rates. The following summarizes the details describing the more significant unrealized losses by investment category as of December 31, 2006.
United States Government and agencies: The unrealized losses on U.S. Governments and agencies totaled $13.4 million, or 11.0% of our total unrealized losses, and were caused by increases in market interest rates. We purchased most of these investments at a discount to their face amount and the contractual cash flows of these investments are based on direct guarantees from the U.S. Government and by agencies of the U.S. Government. Because the decline in market value is attributable to changes in market interest rates and not credit quality, and because we have the ability and intent to hold these investments until a recovery of fair value, which may be maturity, we do not consider these investments to be other-than-temporarily impaired at December 31, 2006.
We also have $0.2 million of gross unrealized losses on equity securities with an estimated market value of $0.7 million at December 31, 2006 and $0.2 million of gross unrealized losses on equity securities with an estimated market value of $0.6 million at December 31, 2005. These equity securities have been in an unrealized loss position for more than one year.
We establish an allowance, consisting of specific reserves, for possible losses against our mortgage loan portfolio. There were no impaired loans (those loans in which we do not believe we will collect all amounts due according to
the contractual terms of the respective loan agreements) requiring a valuation allowance at December 31, 2006 and 2005. An analysis of the allowance provided in 2005 and 2004 is as follows:
The entire realized/unrealized loss on fixed maturity securities classified as trading relates to securities held as of December 31, 2006 and December 31, 2005.
Realized losses on fixed maturities totaling $2.3 million in 2006, $2.2 million in 2005 and $6.3 million in 2004 were incurred as a result of writedowns for other-than-temporary impairment of fixed maturity securities.
Income taxes include a provision of $4.9 million in 2006, $1.0 million in 2005 and $2.9 million in 2004 for the tax effect of realized gains and losses.
We have a common stock investment in American Equity’s parent, American Equity Investment Life Holding Company (AEL), valued at $39.4 million at December 31, 2006 and $72.0 million at December 31, 2005. American Equity underwrites and markets life insurance and annuity products throughout the United States. During 2006, we sold 2,500,000 shares of AEL and realized a gain of $13.5 million.
At December 31, 2006, we had committed to provide additional funding for mortgage loans on real estate aggregating $63.2 million. These commitments arose in the normal course of business at terms that are comparable to similar investments.
We received cash collateral for derivative transactions totaling $70.5 million at December 31, 2006 and $6.4 million at December 31, 2005 that was invested and included in the consolidated balance sheet with a corresponding amount recorded in other liabilities. We also have securities we hold as off-balance sheet collateral for derivative transactions with a market value totaling $10.5 million that at December 31, 2006 and $4.7 million at December 31, 2005.
We have entered into six interest rate swaps to manage interest rate risk associated with a portion of our flexible premium deferred annuity contracts. Under the interest rate swaps, we pay a fixed rate of interest and receive a floating rate of interest on a notional amount totaling $300.0 million. These interest rate swaps effectively fix the interest crediting rate on a portion of our flexible premium deferred annuity contract liabilities thereby hedging our exposure to increases in market interest rates. Interest sensitive product benefits decreased $3.7 million in 2006, decreased $1.0 million in 2005 and increased $1.6 million in 2004 as a result of the net interest settlements on the interest rate swaps.
We formally document hedging relationships, including identification of the interest rate swaps as the hedging instruments and interest credited to the related flexible premium deferred annuity contract liabilities or interest expense on the line of credit as the hedged transactions. We also document our risk management objectives and strategies for undertaking these transactions. There was no ineffectiveness recorded in the consolidated statements of income during 2006, 2005 or 2004. See Note 1, “Significant Accounting Policies - Accounting Changes,” for changes in accounting for the swaps hedging our annuity contracts when we are required to undesignated those hedging relationships in 2007.
We assume index annuity business under the coinsurance agreement and began writing index annuities directly during 2004. Index annuities guarantee the return of principal to the contract holder and credit amounts based on a percentage of the gain in a specified market index. Most of the premium received is invested in investment grade fixed income securities and a portion of the premium received from the contract holder is used to purchase derivatives consisting of one-year or two-year call options on the applicable market indices to fund the index credits due to the index annuity contract holders. On the respective anniversary dates of the index annuity contracts, the market index used to compute the index credits is reset and new call options are purchased to fund the next index credit. Although the call options are designed to be effective hedges from an economic standpoint, they do not meet the requirements for hedge accounting treatment under Statement No. 133, “Accounting for Derivative Instruments and Hedging Activities.” Therefore, the change in fair value of the options is recognized in earnings in the period of change. The cost of the options can be managed through the terms of the index annuities, which permit changes to participation rates, asset fees and/or caps, subject to guaranteed minimums.
We held call options relating to our direct business with a fair value of $121.9 million at December 31, 2006 and $38.2 million at December 31, 2005. Our share of call options assumed under the coinsurance agreement, which is recorded as embedded derivatives in reinsurance recoverable, totaled $42.5 million at December 31, 2006 and $27.7 million at December 31, 2005. Derivative income (loss) includes $70.5 million for 2006, ($2.3) million for 2005 and $15.2 million for 2004 relating to call option proceeds and changes in fair value.
The reserve for index annuity contracts includes a series of embedded derivatives that represent the contract holder’s right to participate in index returns over the expected lives of the applicable contracts. The reserve includes the value of the embedded forward options despite the fact that call options are not purchased for a period longer than the period of time to the next index reset date. The change in the value of this embedded derivative is included in interest sensitive and index product benefits in the consolidated statements of income and totaled $70.3 million for 2006, $4.9 million for 2005 and $2.4 million for 2004.
We have modified coinsurance agreements where interest on funds withheld is determined by reference to a pool of fixed maturity securities. These arrangements contain embedded derivatives requiring bifurcation. Embedded derivatives in these contracts are recorded at fair value at each balance sheet date and changes in the fair values of the derivatives are recorded as derivative income or loss. The fair value of the embedded derivatives pertaining to funds withheld on variable business assumed by us totaled $0.1 million at December 31, 2006 and 2005, and the fair value of the embedded derivatives pertaining to funds withheld on business ceded by us was less than $0.1 million at December 31, 2006 and 2005. Derivative income (loss) from our modified coinsurance contracts totaled less than $0.1 million in 2006, ($0.4) million in 2005 and $0.1 million in 2004.
We occasionally purchase asset-backed securities and agree to settle at a future date, even though the same security or an essentially similar security could be settled at an earlier date. For these “when issued” securities, any changes in the market value of the security from the trade date through the settlement date are recorded as derivative income (loss) rather than as a component of accumulated other comprehensive income. We did not purchase any when issued securities in 2006 or 2005. Derivative income from when issued securities totaled less than $0.1 million in 2004.
our modified coinsurance contracts under which we assume business. Market values for these embedded derivatives are based on the difference between the fair value and the cost basis of the underlying fixed maturity securities. We are not required to estimate fair value for the remainder of the reinsurance recoverable balance.
Other assets and other liabilities: Fair values for interest rate swaps are based on quoted market prices. Other assets or other liabilities also include the embedded derivatives in our modified coinsurance contracts under which we cede business. Market values for these embedded derivatives are based on the difference between the fair value and the cost basis of the underlying investments. We are not required to estimate fair value for the remainder of the other assets or other liabilities balances.
We participate in a reinsurance pool with various unaffiliated life insurance companies to mitigate the impact of a catastrophic event on our financial position and results of operations. Members of the pool share in the eligible catastrophic losses based on their size and contribution to the pool. Under the pool arrangement, we will be able to cede approximately 60% of catastrophic losses after other reinsurance and a deductible of $0.8 million. Pool losses are capped at $11.7 million per event and the maximum loss we could incur as a result of losses assumed from other pool members is $4.2 million per event.
We assume certain traditional life, universal life and annuity business issued through October 1, 2003 from EMC National Life Company (EMCNL). In addition, we also assume variable annuity and variable life business from alliance partners through modified coinsurance arrangements.
Certain variable annuity and variable universal life contracts in our separate accounts have minimum interest guarantees on funds deposited in our general account and guaranteed minimum death benefits (GMDBs) on our variable annuities. In addition, we have certain variable annuity contracts that have an incremental death benefit (IDB) rider that pays a percentage of the gain on the contract upon death of the contract holder. Information regarding our GMDBs and IDBs by type of guarantee and related separate account balance and net amount at risk (amount by which GMDB or IDB exceeds account value) is as follows:
We have a $60.0 million revolving line of credit agreement with LaSalle Bank National Association and Bankers Trust Company, N.A. This agreement is effective through October 31, 2010 and interest on any borrowings accrues at a variable rate (6.12% at December 31, 2006 and 5.13% at December 31, 2005). Under this agreement, we are required to meet certain financial covenants. In addition, we are prohibited from incurring additional indebtedness in excess of $25.0 million without prior approval from the banks while this line of credit is in effect. Debt outstanding on this line of credit totaled $46.0 million at December 31, 2006 and 2005.
In April 2004, we issued $75.0 million of 5.85% Senior Notes (Senior Notes) due April 15, 2014. Interest on the Senior Notes is payable semi-annually on April 15 and October 15 each year. The Senior Notes are redeemable in whole or in part at any time at our option at a “make-whole” redemption price equal to the greater of 100% of their principal amount or the sum of the present values of the remaining scheduled payments of principal and interest on the Senior Notes, discounted to the redemption date on a semiannual basis at the treasury rate plus 25 basis points.
In connection with the 2001 acquisition of Kansas Farm Bureau Life Insurance Company, we issued 3,411,000 shares of Series C cumulative voting mandatorily redeemable preferred stock with an estimated fair value of $80.0 million to the Kansas Farm Bureau. Each share of Series C preferred stock had a par value of $26.8404 and voting rights identical to that of Class A common stock. Dividends on the Series C preferred stock were payable quarterly at a rate equal to the regular cash dividends per share of common stock, as defined, then payable. We redeemed 1,687,000 shares, or $45.3 million, of the Series C preferred stock in January 2004 and 1,724,000 shares, or $46.3
Long-term debt includes $97.0 million of our subordinated debt obligation to FBL Financial Group Capital Trust (the Trust). FBL Financial Group, Inc. (parent company) issued 5% Subordinated Deferrable Interest Notes, due June 30, 2047 (the Notes) with a principal amount of $100.0 million to support $97.0 million of 5% Preferred Securities issued by the Trust. FBL Financial Group, Inc. also has a $3.0 million equity investment in the Trust, which is netted against the Notes on the consolidated balance sheets due to a contractual right of setoff. The sole assets of the Trust are and will be the Notes and any interest accrued thereon. The interest payment dates on the Notes correspond to the distribution dates on the 5% Preferred Securities. The 5% Preferred Securities, which have a liquidation value of $1,000.00 per share plus accrued and unpaid distributions, mature simultaneously with the Notes and are owned by AEL. As of December 31, 2006 and 2005, 97,000 shares of 5% Preferred Securities were outstanding, all of which we unconditionally guarantee.
Holders of the Class A common stock and Series B preferred stock vote together as a group in the election of Class A Directors (eight to ten). The Class B common stock votes as a separate class to elect the Class B Directors (five to seven). Voting for the Directors is noncumulative. In addition, various ownership aspects of our Class B common stock are governed by a Class B Shareholder Agreement which results in the IFBF, which owns 64% of our voting stock as of December 31, 2006, maintaining control of the Company. Holders of Class A common stock and Class B common stock receive equal per-share common stock dividends.
The pension plans’ prior service cost is amortized using a straight-line amortization method over the average remaining service period of the employees. For actuarial gains and losses, we use a corridor, as allowed under Statement No. 87, “Employers Accounting for Pensions,” to determine the amounts to amortize. It is expected that
net periodic pension cost for all employers in 2007 will include $4.5 million for amortization of the actuarial loss and $0.8 million of prior service cost amortization.
During 2005, we began executing our long-term investment strategy of diversifying the plans’ assets into equity securities with the long-term target allocation being approximately 60% deposit administration fund contracts and 40% equities. At December 31, 2006, the plans’ assets were invested 88% in deposit administration fund contracts held by Farm Bureau Life and 12% in diversified equities. Our investment strategy is to (1) achieve a long-term return sufficient to satisfy all plan obligations, (2) assume a prudent level of risk and (3) to maintain adequate liquidity. The expected return on plan assets is set at the long-term rate expected to be earned based on the long-term investment strategy of the plans. In estimating the expected rate of return for each asset class, we take into account factors such as historical rates of return, expected future risk free rates of return and anticipated returns expected given the risk profile of each asset class.
We have two share-based payment arrangements under our Class A Common Stock Compensation Plan, which are described below. Compensation expense for these arrangements totaled $3.1 million for 2006, $2.1 million for 2005 and $1.5 million for 2004. The income tax benefit recognized in the income statement for these arrangements totaled $1.1 million for 2006, $0.6 million for 2005 and $0.4 million for 2004.
We grant stock options for Class A common stock to directors, officers and employees. For officers and employees, the options have a contractual term of 10 years and generally vest over a period up to five years, contingent upon continued employment with us. Options to directors are fully vested upon grant and have a contractual term that varies with the length of time the director remains on the Board, up to ten years. The stock price for all options is equal to the fair market value of the common stock on the grant date. The fair value of each option award is estimated on the date of grant using a Black-Scholes-Merton option valuation model. Assumptions used in our valuation model are as follows:
The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of grant. We use the historical realized volatility of our stock for expected volatilities within the valuation model. For 2006, the weighted-average expected term for the majority of our options is presumed to be the mid-point between the vesting date and the end of the contractual term, also known as the “shortcut method.” We assume the contractual term approximates the expected life for the remaining options. For 2005, we used historical data to estimate option exercises and employee terminations to determine the expected term assumption. We currently use the shortcut method, as permitted under Statement No. 123(R), due to limited historical share option exercise experience. The change in this assumption did not have a material impact on the expected term of the stock options.
The weighted average grant-date fair value of options granted per common share was $8.64 for 2006, $8.86 for 2005 and $8.50 for 2004. The intrinsic value of options exercised during the year totaled $6.9 million for 2006, $5.0 million for 2005 and $7.3 million for 2004.
There has been no restricted stock vested and released to employees as of December 31, 2006. Unrecognized compensation expense related to unvested share-based compensation granted under the restricted stock arrangement totaled $0.8 million as of December 31, 2006. This expense is expected to be recognized over a weighted-average
period of 1.5 years. We have a policy of withholding shares to cover tax payments and expect to withhold approximately 12,000 shares during 2007, based on estimates of restricted shares we expect to vest and be released.
We have a Director Compensation Plan under which non-employee directors on our Board may elect to receive a portion of their compensation in the form of cash, Class A common shares or deferred stock units. Under this plan, we have deferred stock units outstanding totaling 41,272 at December 31, 2006 and 34,559 at December 31, 2005. At December 31, 2006, shares of Class A common stock available for future issuance under the Director Compensation Plan totaled 7,226. Also, beginning in 2005, we have an Executive Salary and Bonus Deferred Compensation Plan under which officers of the company who are required to meet certain stated common stock ownership guidelines are allowed to use their base salary and annual cash bonus to purchase deferred stock units. Under this plan, we have deferred stock units outstanding totaling 11,960 at December 31, 2006 and 2,111 at December 31, 2005. At December 31, 2006, shares of Class A common stock available for future issuance under this plan totaled 238,040.
Also see Note 1, “Significant Accounting Policies - Stock Based Compensation,” for further discussion of the accounting for our stock option plans and certain pro forma financial information due to the adoption of Statement No. 123 and Statement 123(R).
We have marketing agreements with the Farm Bureau property-casualty companies operating within our marketing territory, including Farm Bureau Mutual and another affiliate. Under the marketing agreements, the property-casualty companies are responsible for development and management of our agency force for a fee. We incurred expense totaling $7.2 million in 2006 and $7.3 million in 2005 and 2004 relating to these arrangements.
We are licensed by the IFBF to use the “Farm Bureau” and “FB” designations in Iowa. In connection with this license, we incurred royalty expense totaling $0.4 million in 2006, 2005 and 2004. We have similar arrangements with the Kansas Farm Bureau and other state Farm Bureau organizations in our market territory. Total royalty expense to Farm Bureau organizations other than the IFBF totaled $1.2 million in 2006 and $1.1 million in 2005 and 2004.
Prior to 2006, we had an administrative services agreement with American Equity under which we provided investment accounting and claims processing, accounting, compliance and other administrative services. Fee income from performing these services totaled $0.4 million in 2005 and 2004.
Based upon the provisions of the underlying agreement and the application of the “two class” method to our capital structure, we have not allocated any undistributed net income to the Class C preferred stock since the Class C preferred stockholder’s participation in dividends with the common stockholders was limited to the amount of the annual regular dividend.
Options to purchase 315,225 shares of common stock in 2006 at $30.76 to $39.48 per share were granted during 2006 but were not included in the computation of 2006 diluted earnings per share because the options’ exercise price was greater than the average market price of common shares during 2006. The options, which expire in 2016, were still outstanding at December 31, 2006.
Options to purchase 422,573 shares of common stock in 2005 at $24.57 to $32.25 per share were granted during 2005 but were not included in the computation of 2005 diluted earnings per share because the options’ exercise price was greater than the average market price of common shares during 2005. The options, which expire in 2015, were still outstanding at December 31, 2005.
The ability of the Life Companies to pay dividends to the parent company is restricted because prior approval of the Iowa Insurance Commissioner is required for payment of dividends to the stockholder which exceed an annual limitation. In addition, under the Iowa Insurance Holding Company Act, the Life Companies may not pay an “extraordinary” dividend without prior notice to and approval by the Iowa Insurance Commissioner. An “extraordinary” dividend is defined under the Iowa Insurance Holding Company Act as any dividend or distribution of cash or other property whose fair market value, together with that of other dividends or distributions made within the preceding 12 months, exceeds the greater of (i) 10% of policyholders’ surplus (total statutory capital stock and statutory surplus) as of December 31 of the preceding year, or (ii) the statutory net gain from operations of the insurer for the 12-month period ending December 31 of the preceding year. During 2007, the maximum amount legally available for distribution to FBL Financial Group, Inc. without further regulatory approval is $38.3 million for Farm Bureau Life and $32.8 million for EquiTrust Life. However, distributions from Farm Bureau Life are not available until December 2007 due to the timing and amount of dividend payments made during 2006.
Depreciation and amortization related to property, plant and equipment are allocated to the product segments while the related property, equipment and capitalized software are generally allocated to the Corporate and Other segment. Depreciation and amortization for the Corporate and Other segment include $7.6 million for 2006, $6.8 million for 2005 and $5.8 million for 2004 relating to leases with affiliates. In the consolidated statements of income, we record these depreciation amounts net of related lease income from affiliates.