Selected consolidated financial data for the Corporation are presented below for each of the five years in the period ended December 31, 2005. 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 Operations and Financial Condition.
Profitability in the Insurance Company’s individual annuities, individual life insurance and group accident and health depends largely on the size of its inforce block, the adequacy of product pricing and underwriting discipline, and the efficiency of its claim and expense management.
The Corporation’s earnings per share were $3.12 for 2005, as compared to $2.25 in 2004 and $1.31 in 2003. Results in 2005 reflected a continuation of year-to-year increases in investment income and net realized investment gains from the prior years. Our total revenues in 2005 were $459 million, compared to $396 million in 2004 and $355 million in 2003. The Corporation’s increases in earning and revenues in 2005 resulted primarily from the improved performance of the investment portfolio, particularly the investments in limited partnerships and capital gains. The improvement of global capital and equity markets in 2004 and 2005 also contributed to our financial performance.
Legal and Regulatory Risk: As an insurance company, we are subject to substantial regulatory control. Any material change in the framework in which we operate could have a material impact on the business. For further discussion on how we deal with the regulatory requirements, see “Business - Insurance Regulation.”
The assumed rate of return on invested cash and desired spreads during the period that insurance policies or annuity contracts are in force also affects pricing of products and currently includes an assumption by the Insurance Company of a specified rate of return and/or spread on its investments for each year that such insurance or annuity product is in force.
The Insurance Company's investment philosophy generally focuses on purchasing investment grade securities with the intention of holding such securities to maturity. However, as market opportunities, liquidity, or regulatory considerations may dictate, securities may be sold prior to maturity. The Insurance Company has categorized all fixed maturity securities as available for sale and carries such investments at market value.
As of December 31, 2005, approximately 7.0% 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 $88.6 million of additional capital to certain of these limited partnerships. $14.9 million in commitments will expire in 2006, $20.3 million in 2007, $18.2 in 2008, $16.2 in 2009 and $19.0 in 2010. 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 annual 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.
The following table presents the amortized cost and gross unrealized losses for fixed maturities and common stock where the estimated fair value had declined and remained below amortized cost at December 31, 2005:
The following table presents the total gross unrealized losses for fixed maturities where the estimated fair value had declined and remained below amortized cost by December 31, 2005.
Corporate Bonds: The predominant investment category for the Company’s investments is the Corporate Bond category, which totaled approximately $ 3.2 billion at December 31, 2005. Most of the $ 37.25 million of unrealized short-term losses in these investments represent increases in interest rates and widening of corporate credit spreads against Treasuries in the 5-10 year maturity spectrum of the yield curve. Two holdings, in Ford Motor Credit and Knight-Ridder, represent losses of approximately $2.9 million and $1.0 million, respectively and each exceed 10% of book value. Ford Motor Credit’s parent, Ford Motor Co., has been affected by a decline in the domestic U.S. automobile and truck industry. Ford Motor Credit is in a more secure position than its parent, as the Credit Company has a liquid portfolio of high-quality receivables with the possibility of attracting a high-quality financial company as a potential equity investor, as is being contemplated by General Motors Acceptance Corp. Knight-Ridder has been rumored to be a leveraged buy-out candidate, which has coincided with a decline in the market value of its bonds. The Company is closely monitoring the financial situation of each credit but believes that these investments are not other than temporarily impaired as of December 31, 2005. The Company believes that it has the ability and intent to hold each of these positions to maturity.
Between 1997 and 1999, the Insurance Company made a series of investments in instruments known as principal protected notes. These Notes, marketed by investment companies, consist of an investment in a trust unit or corporate note. The trusts contain two assets, a variable rate income note issued by a collateralized debt obligation structure and a AAA rated zero coupon security, primarily U.S. Treasury Strips, with maturity dates no later than the variable rate income note and a face value equal to the principal amount of the investment in the principal protected note. The U.S. Treasury Strip is designed to defease the principal amount of the investment, while the variable rate income note provides periodic distributions of cash flow when sufficient cash flow is generated by the collateralized debt obligation structure. In accordance with applicable accounting rules, the Company has consolidated the issuers of these notes. As a result, the assets underlying the notes (the variable rate income note and the AAA-rated zero coupon securities) are accounted for separately within the Insurance Company’s investment portfolio. Substantially all of the variable rate income notes were sold in 2005. The zero coupon securities are recorded at cost and annual accretions are recorded as investment income.
A reconciliation of the Insurance Company’s net income (loss) as filed with regulatory authorities to net income reported in the accompanying financial statements for the years ended December 31, 2005, 2004 and 2003, follows:
The downgrades did not have a material impact on the financial statements of the Corporation for 2005.
Net investment income totaled $339.7 million in fiscal 2005, as compared to $339.4 million in fiscal 2004 and $299 million in fiscal 2003. This represents a 0.08% increase comparing fiscal 2005 to fiscal 2004 and a 17.7% increase comparing fiscal 2004 to fiscal 2003. The increase from 2003 to 2004 was largely attributable to an increase in investment income from the Insurance Company’s limited partnership investments. In 2005, income from these investments amounted to $63.5 million. Income from these investments amounted to $57.5 million in fiscal 2004 as compared to $30.2 million in fiscal 2003. In 2005, increases in income from limited partnerships and short-term investments was largely offset by a decrease in income from bonds from $272.7 million in 2004 to $263.8 million in 2005 after an increase from $255.7 million in 2003. The decrease in income from fixed maturities was largely the result of the portfolio rebalancing activities in 2005, which resulted in the sale of higher yielding long-term investments and the reinvestment into lower yielding short-term investments. (See Item 7, Management’s Discussion and Analysis, Asset/Liability Management). In addition, the Company increased the portion of its portfolio invested in short-term assets to enhance liquidity. The Insurance Company's ratios of net investment income to average cash and invested assets less net investment income for the years ended December 31, 2005, 2004 and 2003 were approximately 7.45%, 7.78% and 7.38%, respectively. Without taking into account the Corporation’s returns on its limited
partnership investments in those years, the respective ratios would have been 6.43%, 6.92% and 7.12% for the years ended December 31, 2005, 2004 and 2003. For additional information, please refer to “Note 2 of the Notes to Consolidated Financial Statements.”
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. During 2005, the Corporation’s Board of Directors maintained the quarterly dividend rate of $.10 per share. During 2005 and 2004, the Corporation did not repurchase any of its common stock, although at December 31, 2005, 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 surplus as of the immediately preceding calendar year or (ii) its 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 no dividends to the Corporation in fiscal 2005, 2004 or 2003. 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.
Notwithstanding the above, the Corporation was able to meet all its liquidity needs in 2005, including the payment of dividends, and anticipates being able to meet those needs in 2006 and the foreseeable future.
Given the Insurance Company’s historical cash flow and current financial results, management believes that, for the next twelve months and for the reasonably foreseeable future, the Insurance Company’s cash flow from operating activities will provide sufficient liquidity for the operations of the Insurance Company.
Net cash provided by the Insurance Company's operating activities was approximately $45.4 million, $41.8 million and $15.7 million in fiscal 2005, 2004 and 2003, respectively. The increase from 2003 to 2004 and 2005 is largely attributable to the increase in net investment income. Net cash (used in)/provided by in the Insurance Company's investing activities (principally reflecting investments purchased less investments called, redeemed or sold) was approximately $(60.8) million, $(183.2) million and $76.9 million in fiscal 2005, 2004 and 2003, respectively.
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 provided by /(used in) by the Insurance Company's financing activities amounted to approximately $15.7 million, $134.8 million and $(92.8) million in fiscal 2005, 2004 and 2003, respectively. These fluctuations primarily are attributable to changes in policyholder account balances as a result of sales and interest earned by the policyholders.
The indenture governing the Senior Notes contains covenants relating to limitations on liens and sale or issuance of capital stock of the Corporation. In the event the Corporation violates such covenants as defined in the indenture, we may be obligated to offer to repurchase the entire outstanding principal amount of such notes. As of December 31, 2005, we believe that we are in compliance with all of the covenants.
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, 2005, 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 $253.5 million.
The Insurance Company, in consultation with its actuarial consultant, Milliman, Inc., is continually assessing its overall Swaption portfolio to determine if sufficient protection is provided to cover projected realized losses in the event of a liquidation of assets to satisfy annuity surrenders under the aforementioned 300 basis points increase in interest rates. As part of this process, Presidential may consider extending the maturity of its Swaption portfolio by selling the Swaptions maturing in July 2006 and purchasing a July 2009 Swaption to cover future portfolio needs. Future consideration of this transaction or other asset/liability management strategies is dependent upon periodic testing based on updated asset and liability data.
The short-term notes payable relates to a line of credit issued by The Bank of New York in the amount of $50,000,000. The line of credit provides for interest on borrowings based on the 30, 60 and 90-day LIBOR rate depending on the duration of the Corporation’s periodic renewals. At December 31, 2005, the Corporation had the full $50,000,000 outstanding. The line of credit renews annually and is up for renewal on April 22, 2006. If the bank chooses not to renew the line of credit, the Corporation would be forced to pay-down the $50,000,000 in April 2006 or seek alternative financing options. The Corporation does not believe that there would be a material adverse impact on its liquidity or cash flow position if the line of credit were to be called in April 2006.
In a declining interest rate environment, the Insurance Company's cost of funds would be expected to decrease over time, reflecting lower interest crediting rates on its fixed annuities. Should increased liquidity be required for withdrawals in such an interest rate environment, management believes that the portion of the Insurance Company's investments that are designated as available for sale in the Corporation's consolidated balance sheet could be sold without materially adverse consequences in light of the general strengthening in market prices that would be expected in the fixed maturity security market.
Interest rate changes also may have temporary effects on the sale and profitability of our annuity products. For example, if interest rates rise, competing investments (such as annuity or life insurance products offered by the Insurance Company's competitors, certificates of deposit, mutual funds and similar instruments) may become more attractive to potential
The Insurance Company¢s principal investments are in fixed maturities, all of which are exposed to at least one of three primary sources of investment risk: credit, interest rate and market valuation. The financial statement risks are those associated with the recognition of other than temporary impairments and income, as well as the determination of fair values. Recognition of income ceases when a bond goes into default and management evaluates whether temporary or other than temporary impairments have occurred on a case-by-case basis. Management considers a wide range of factors about the security issuer and uses its best judgment in evaluating the cause and decline in the estimated fair value of the security and in assessing the prospects for near-term recovery. Inherent in management’s evaluation of the security are assumptions and estimates about the operations of the issuer and its future earnings potential. Considerations used by the Company in the other than temporary impairment evaluation process include, but are not limited to: (i) the length of time and the extent to which the market value has been below amortized cost; (ii) whether the issuer is experiencing significant financial difficulties; (iii) financial difficulties being experienced by an entire industry sector or sub-sector; (iv) economically depressed geographic locations; (v) situations where the issuer, series of issuers or industry has a catastrophic type of loss or has exhausted natural resources; (vi) in situations where it is determined that an impairment is attributable to changes in market interest rates, the Corporation’s ability and intent to hold impaired securities until recovery of fair value at or above cost; and (vii) other subjective factors, including concentrations and information obtained from regulators and rating agencies. In addition, the earnings on certain investments are dependent upon market conditions, which could result in prepayments and changes in amounts to be earned due to changing interest rates or equity markets. The determination of fair values in the absence of quoted market values is based on valuation methodologies, securities the Company deems to be comparable and assumptions deemed appropriate given the circumstances. The use of different methodologies and assumptions may have a material effect of the estimated fair value amounts.
The Insurance Company incurs significant costs in connection with acquiring new business. Under applicable accounting rules, these costs, which vary, are deferred. The recovery of such costs is dependent upon the future profitability of the related product, which in turn is dependent mainly on investment returns in excess of interest credited, as well as persistency and expenses. These factors enter into Management¢s estimate of future gross profits, which generally are used to amortize such costs. Changes in these estimates result in changes to the amounts expensed in the reporting period in which the revisions are made and could result in the impairment of the deferred acquisition cost asset and a charge to income if estimated future gross profits are less than amounts deferred.
The reserves reflected in the Corporation's consolidated financial statements are based upon the Corporation's best estimates of mortality, persistency, expenses and investment income, with appropriate provisions for adverse statistical deviation and the use of the net level premium method for all non-interest-sensitive products. For all interest-sensitive products, the policy account value is equal to the accumulation of gross premiums plus interest credited less mortality and expense charges and withdrawals. In determining reserves for its insurance and annuity products, the Insurance Company performs periodic studies to compare current experience for mortality, interest and lapse rates with expected experience in the reserve assumptions. Differences are reflected currently in earnings for each period. The Insurance Company historically has not experienced significant adverse deviations from its assumptions.