(1) Amounts for 2001, 2002 and 2003 are impacted by the acquisition of Kansas Farm Bureau Life Insurance Company, Inc. effective January 1, 2001 and the assumption of business through two coinsurance transactions during 2001.
(2) See Note 1 to the consolidated financial statements for an explanation of the impact of accounting changes on long-term debt, company-obligated mandatorily redeemable preferred stock of subsidiary trust and Series C redeemable preferred stock as of December 31, 2003.
(5) Net statutory premiums include premiums collected from annuities and universal life-type products. These premiums are not reported as revenues in accordance with accounting principles generally accepted in the United States. Amounts include premiums assumed from two insurance companies totaling $653.1 million in 2003, $842.7 million in 2002 and $281.8 million in 2001. Amounts also include internal rollover premiums to variable universal life or variable annuity contracts totaling $2.9 million in 2003, $7.0 million in 2002, $10.2 million in 2001, $25.0 million in 2000 and $17.1 million in 1999.
The following is a brief summary of our significant accounting policies and a review of our most critical accounting estimates. For a complete description of our significant accounting polices, see Note 1 to our consolidated financial statements.
In accordance with accounting principles generally accepted in the United States (GAAP), premiums and considerations received for interest sensitive and index products such as ordinary annuities and universal life insurance are reflected as increases in liabilities for policyholder account balances and not as revenues. Revenues reported for these products consist of policy charges for the cost of insurance, administration charges, amortization of policy initiation fees and surrender charges assessed against policyholder account balances. Surrender benefits paid relating to these products are reflected as decreases in liabilities for policyholder account balances and not as expenses. The Life Companies receive investment income earned from the funds deposited into account balances, a portion of which is passed through to the policyholders in the form of interest credited. For index annuities, proceeds from call options are earned from a portion of the funds deposited, which are passed through to the contract holders in the form of index credits. Index credits and interest credited to policyholder account balances and benefit claims in excess of policyholder account balances are reported as expenses in the consolidated financial statements.
The costs related to acquiring new business, including certain costs of issuing policies and other variable selling expenses (principally commissions), defined as deferred policy acquisition costs, are capitalized and amortized into expense. 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 and are generally “locked in” at the date the policies are issued. For participating traditional life insurance, interest sensitive and index products, these costs are amortized generally in proportion to expected gross profits from surrender charges and investment, mortality and expense margins. This amortization is adjusted when the Life Companies revise their estimate of current or future gross profits or margins. For example, deferred policy acquisition costs are amortized earlier than originally estimated when policy terminations are higher than originally estimated or when investments backing the related policyholder liabilities are sold at a gain prior to their anticipated maturity.
• Beginning October 1, 2003, embedded derivatives in our modified coinsurance contracts are identified and accounted for at fair value.*
• Effective January 1, 2001, derivatives are recorded at fair value and the recording of the change in fair value is dependent on the use of the derivative and whether it qualifies for hedge accounting.
* We do not believe the impact on our consolidated financial statements of adopting this standard was material.
We evaluate the operating results of the underlying issuer, near-term prospects of the issuer, general market conditions, causes for the decline in value, the length of time there has been a decline in value and other key economic measures. We also evaluate our ability and intent to hold the security.
Amortization of deferred policy acquisition costs for participating life insurance and interest sensitive and index products is dependent upon estimates of current and future gross profits or margins on this business. Key assumptions used include the following:
• amount of death and surrender benefits and the length of time the policies will stay in force.
A 50 basis point decrease in the expected return on assets would result in a $0.3 million increase in pension expense. A 50 basis point decrease in the assumed discount rate would result in a $0.3 million increase in pension expense. A 50 basis point increase in these rates would result in a decrease to expense in approximately the same amount noted above.
Effective May 1, 2001, we entered into a coinsurance agreement with EMC National Life Company (NTL), formerly known as National Travelers Life Company, whereby we assumed 90% of NTL’s traditional life, universal life and annuity business in force. In addition, we agreed to assume 50% of NTL’s traditional life, universal life and annuity business issued on an ongoing basis. Assets acquired on May 1, 2001 in connection with this transaction totaled $337.2 million. Effective October 1, 2003, our coinsurance agreement with NTL was amended so that we now assume 90% of NTL’s traditional life, universal life and annuity business inforce as of December 31, 2002, with no assumption of new business on an ongoing basis. Collected premiums assumed as a result of this agreement totaled $18.7 million for 2003, $20.8 million for 2002 and $13.3 million for 2001.
The American Equity and NTL coinsurance agreements are collectively referred to as “the coinsurance agreements.”
Net income applicable to common stock increased 37.4% in 2003 to $63.6 million and increased 26.8% in 2002 to $46.3 million. The increases in net income are primarily due to decreases in realized losses on investments and an increase in our volume of annuity business and life insurance in force. The increase in the amount of business in force is driven by strong sales from our core distribution agency force and premiums assumed from American Equity. The increases in 2002 are also attributable to the inclusion of a full year of business from the coinsurance agreements. Net income in 2003 also increased due to increases in equity income and fee income from bond calls and mortgage loan prepayments. Furthermore, results in 2002 benefited from an acceleration of net discount accretion on mortgage and asset-backed securities resulting from increasing prepayment speed assumptions.
Premiums and product charges increased 6.3% in 2003 to $213.7 million and 6.6% in 2002 to $201.0 million. Revenues from the coinsurance agreements included interest sensitive and index product charges totaling $15.9 million in 2003, $11.9 million in 2002 and $6.9 million in 2001 and traditional life insurance premiums totaling $5.0 million in 2003, $5.1 million in 2002 and $3.8 million in 2001. Cost of insurance charges, which are included in interest sensitive and index product charges, increased in 2003 and 2002 primarily as a result of an increase in the volume and age of business in force. Accident and health premiums decreased in 2001 as a result of a 100% coinsurance agreement to reinsure our individual long-term disability income business effective September 1, 2001.
Net investment income, which excludes investment income on separate account assets relating to variable products, increased 13.6% in 2003 to $395.9 million and increased 22.2% in 2002 to $348.4 million. These increases are due to an increase in average invested assets of 20.3% to $5,828.5 million (based on securities at amortized cost) in 2003 compared to $4,845.3 million in 2002 and $3,850.2 million in 2001. The increases in average invested assets in 2003 and 2002 are due principally to net premium inflows from our American Equity coinsurance agreement and core distribution agency force. The annualized yield earned on average invested assets was 6.79% in 2003, 7.19% in 2002 and 7.40% in 2001. Market conditions in 2003, 2002 and 2001 decreased our investment portfolio yield as market investment rates were, in general, lower than our portfolio yield or yield on investments maturing or being paid down. However, in 2003, an increase in fee income from bond calls and mortgage loan prepayments partially offset the impact of these market conditions. Fee income from mortgage loan prepayments and bond calls totaled $9.6 million in 2003, $1.8 million in 2002 and $4.8 million in 2001. Net investment income includes $3.3 million in 2003, $4.0 million in 2002 and $0.6 million in 2001 representing an acceleration of net discount accretion on mortgage and asset-backed securities resulting from increasing prepayment speed assumptions during the respective periods. The amount of bond call and prepayment fee income we earn typically increases with a decrease in market interest rates as more bonds and mortgage loans are prepaid before their contractual maturity. See “Financial Condition - Investments” section that follows for a description of how changes in prepayment speeds impact net investment income.
The increases in gains received at expiration or termination and in the difference between the fair value of the call options and the remaining option costs for 2003 are caused by the general increase in the underlying equity market indices on which our options are based. For 2003, the S&P 500 Index (upon which the majority of our options are based) increased by 26.4%, compared to a decrease of 23.4% for 2002. The increase in the cost of money for call options is due to growth in the volume of index annuities in force. Other derivative income (loss) is comprised of changes in the value of (i) the conversion feature embedded in convertible fixed maturity securities, (ii) the embedded derivative included in our modified coinsurance contracts and (iii) the forward commitments for the purchase of certain when-issued securities. Derivative income (loss) will fluctuate based on market conditions.
Realized losses on investments decreased 86.5% in 2003 to $2.0 million and decreased 6.3% in 2002 to $14.9 million. Writedowns for other-than-temporary impairments are the result of the issuers of the securities having deteriorating operating trends, alleged corporate fraud, decreases in debt ratings, defaults on loan payments, unsuccessful efforts to raise capital and various other operational or economic factors that became evident in the respective years. Approximately $8.5 million of the realized losses in 2002 were from securities issued by or affiliated with WorldCom Inc., including $1.9 million of losses assumed from an investment in WorldCom, Inc. bonds made by a variable alliance partner. Our 2002 losses also include approximately $7.8 million from securities issued by United Air Lines. Approximately $8.4 million of the realized losses in 2001 were from four securities issued by or affiliated with Enron Corporation. The level of realized gains (losses) is subject to fluctuation from year to year depending on the prevailing interest rate and economic environment and the timing of the sale of investments. See “Financial Condition - Investments” for details regarding our unrealized losses at December 31, 2003.
For accounting purposes, the rights of the index annuity contract holders to participate in the performance of the underlying indices is treated as a “series of embedded derivatives” over the lives of the applicable contracts. We are required to estimate the fair value of the embedded derivatives by valuing the “host” (or guaranteed) component of the liabilities and projecting (i) the expected index credits on the next policy anniversary dates and (ii) the net cost of the annual options we will purchase in the future to fund index credits. The change in the value of the embedded derivative primarily results from the change in expected index credits on the next policy anniversary dates, which are related to the change in the fair value of the options acquired to fund these index credits as discussed above under “Derivative income (loss).” Changes in the value of the embedded derivatives included in the index annuity contracts, which are recorded as a component of interest sensitive and index product benefits, totaled $14.2 million in 2003, $1.0 million in 2002 and $1.2 million in the fourth quarter of 2001. Index credits, which are also recorded as a component of interest sensitive and index product benefits, totaled $20.2 million in 2003 and $4.2 million in 2002. No index credits were recorded in 2001.
Expenses relating to the expansion of our EquiTrust distribution through independent agents and brokers, which are included in other underwriting, acquisition and insurance expenses, are expected to increase to approximately $5.8 million for 2004 compared to $0.6 million for 2003. These expenses are for items such as product development, personnel, systems and other infrastructure necessary to develop, market and administer a new portfolio of products.
Income taxes increased 31.6% in 2003 to $31.4 million and 28.5% in 2002 to $23.9 million. The effective tax rate was 33.4% for 2003, 30.1% for 2002 and 29.2% for 2001. The increase in the effective rate for 2003 is primarily due to the increase in pre-tax operating income and the adoption of Statement No. 150 noted above. The effective tax rates were lower than the federal statutory rate of 35% due primarily to the tax benefit associated with the payment of dividends on mandatorily redeemable preferred stock of subsidiary trust, tax-exempt interest and tax-exempt dividend income.
Given the timing of when financial information from our equity investees is available, we will consistently use information that is as much as three months in arrears for certain of these entities. Several of these entities are investment companies whose operating results are derived primarily from unrealized and realized gains and losses generated by their investment portfolios. As is normal with these types of entities, the level of these gains and losses is subject to fluctuation from period to period depending on the prevailing economic environment, changes in prices of equity securities held by the investment partnerships, timing and success of initial public offerings and other exit strategies, and the timing of the sale of investments held by the partnerships and joint ventures. See the “Other Assets” section following for additional information regarding the composition of our equity investees.
In June 2003, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants issued Statement of Position (SOP) 03-1, “Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts.” The SOP provides guidance on separate account presentation and valuation, the accounting for sales inducements (including bonus interest) and the classification and valuation of long-duration contract liabilities. We expect to adopt this SOP when it becomes effective in the first quarter of 2004. While we currently comply with most of the guidance presented in this SOP, we will need to change our method of computing reserves for guaranteed minimum death benefits (GMDB) associated with our variable annuities and change our presentation of deferred expenses relating to sales inducements. We have not quantified the impact of adoption on our financial statements; however, the impact is not expected to be material due to our limited exposure to GMDBs. Our exposure to GMDBs (GMDB exceeds account value), net of reinsurance ceded, totaled $14.2 million at December 31, 2003. Our recorded reserves for this benefit, which take into account the probability of death before the account value increases to an amount equal to or greater than the GMDB, totaled $0.3 million at December 31, 2003. We currently include bonus interest as a component of deferred policy acquisition costs and the related amortization expense. The amount of bonus interest included as a component of deferred policy acquisition costs totaled $40.8 million at December 31, 2003 and $25.1 million at December 31, 2002.
Pre-tax operating income for the traditional and universal life insurance segment decreased 10.8% in 2003 to $54.5 million and increased 21.0% in 2002 to $61.0 million. The decrease in 2003 and increase in 2002 is due primarily to the impact of changes in the assumptions used to calculate deferred policy acquisition costs as discussed under “Significant Accounting Policies and Estimates.” The decrease in 2003 is also attributable to an increase in death benefits. Amortization of deferred policy acquisition costs was decreased $0.4 million in 2003 and $4.2 million in 2002 and increased $1.4 million in 2001 due to changes in the assumptions used to calculate deferred policy acquisition costs. On a consolidated basis, the impact of these assumption changes was largely offset by the impact of assumption changes made in the amortization of deferred policy acquisition costs in the other product segments. Revenues, benefits and expenses for 2003 and 2002 increased due to increases in the volume of business in force and for 2002, the inclusion of a full year of NTL business. Net investment income includes $2.9 million in 2003, $2.0 million in 2002 and $3.1 million in 2001 in fee income from bond calls and mortgage loan prepayments and the acceleration of net discount accretion on mortgage and asset-backed securities as noted in the investment income discussion above. Death benefits totaled $69.4 million in 2003, $65.2 million in 2002 and $62.9 million in 2001. As noted in the discussion of policy benefits above, pre-tax operating income in 2003 benefited from a $1.8 million reduction in reserves relating to a change in the valuation methodology for certain traditional life business. In addition, pre-tax operating income for 2002 benefited from a $1.3 million reserve reduction relating to the discontinuation of certain group life business.
Pre-tax operating income (loss) for the variable segment totaled $1.0 million in 2003, compared to ($0.8) million in 2002 and $5.5 million in 2001. Revenues increased 6.7% to $49.7 million in 2003 due to an increase in the volume of business in force. The 2002 pre-tax operating loss is primarily attributable to increases in death benefits and amortization of deferred policy acquisition costs. Death benefits in excess of related account values on variable universal life policies increased 1.1% to $9.9 million in 2003 and increased 62.5% to $9.7 million in 2002. Amortization of deferred policy acquisition costs was decreased $0.5 million in 2003, increased $3.7 million in 2002 and decreased $1.5 million in 2001 due to changes in the assumptions used to calculate deferred policy acquisition costs. As noted above, on a consolidated basis the impact of these assumption changes for 2002 and 2001 were largely offset by the impact of assumption changes made in the amortization of deferred policy acquisition costs in the traditional and universal life insurance segment. Expenses were reduced by $1.0 million in 2001 as a result of the recovery of certain royalty fees as discussed above.
Pre-tax operating income (loss) for the corporate and other segment totaled $4.2 million in 2003, compared to ($2.2) million in 2002 and ($3.5) million in 2001. The increase in pre-tax operating income in 2003 is primarily due to mortgage prepayment fee income totaling $2.0 million earned in 2003 and fluctuations in equity income as described above. The increase in benefits and expenses and decrease in minority interest in 2003 are due primarily to the reclassification of certain dividends to interest expense in connection with the adoption of Statement No. 150.
See “Interest expense” for additional details regarding this reclassification. The decrease in accident and health insurance premiums and benefits and expenses from 2001 is due to the sale of our long-term disability income business in 2001. This sale decreased the level of operations reflected in the corporate and other segment.
Our total investment portfolio increased 17.7% to $6,341.7 million at December 31, 2003 compared to $5,387.4 million at December 31, 2002. This increase is primarily the result of net cash received from interest sensitive and index products and positive cash flow provided by operating activities. In addition, net unrealized appreciation on fixed maturity and equity securities classified as available for sale increased $20.0 million during 2003 to $223.1 million at December 31, 2003 due principally to appreciation of common stock investments and the impact of a decline in market interest rates.
(1) The Securities Valuation Office of the NAIC generally rates private placement securities. Comparisons between NAIC designations and S & P ratings are published by the NAIC. S & P has not rated some of the fixed maturity securities in our portfolio.
The following table sets forth the composition by credit quality of the fixed maturity securities with gross unrealized losses as of December 31, 2003.
The following table sets forth the number of issuers, amortized cost, unrealized losses and market value of fixed maturity securities in an unrealized loss position as of December 31, 2003, listed by the length of time the securities have been in an unrealized loss position.
Included in the above table are 136 securities from 80 issuers. Approximately 86.2% of the unrealized losses on fixed maturity securities are on securities that are rated investment grade. Investment grade securities are defined as those securities rated a “1” or “2” by the Securities Valuation Office of the National Association of Insurance Commissioners. Unrealized losses on investment grade securities principally relate to changes in market interest rates or changes in credit spreads since the securities were acquired. Approximately 13.8% of the unrealized losses on fixed maturity securities are on securities that are rated below investment grade. We monitor the financial condition and operations of the issuers of securities rated below investment grade and of the issuers of certain investment grade securities on which we have concerns regarding credit quality. In determining whether or not an unrealized loss is other than temporary, we review factors such as:
• length of time the security has been in an unrealized loss position; and
At December 31, 2003, we held $66.7 million or 1.1% of invested assets in equity securities. At December 31, 2003, gross unrealized gains totaled $11.5 million and gross unrealized losses totaled $0.1 million on these securities.
At December 31, 2003, we held $632.9 million or 9.9% of invested assets in mortgage loans. These mortgage loans are diversified as to property type, location and loan size, and are collateralized by the related properties. At December 31, 2003, mortgages more than 60 days delinquent accounted for less than 0.2% of the carrying value of the mortgage portfolio. 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. Regions with the largest concentration of our mortgage loan portfolio at December 31, 2003 include: Pacific (23.5%), which includes California and Hawaii; and East North Central (18.0%), which includes Illinois, Indiana, Michigan, Ohio and Wisconsin. Mortgage loans on real estate are also diversified by collateral type with office buildings (40.8%), retail facilities (31.3%) and industrial facilities (26.6%) representing the largest holdings at December 31, 2003.
Securities and indebtedness of related parties decreased 54.8% to $21.8 million due principally to the classification of our investment in AEHC as of December 31, 2003 to the equity securities line on the consolidated balance sheet. This change in classification is the result of AEHC’s initial public offering as discussed in “Equity income” above. This decrease is partially offset by additional investments in real estate investment partnerships during 2003.
Policy liabilities and accruals and other policyholders’ funds increased 18.5% to $6,302.1 million at December 31, 2003 primarily due to the increase in the volume of business in force. Other liabilities decreased 8.0% to $135.7 million at December 31, 2003, due primarily to a decrease in payables for security purchases. At December 31, 2003, we had total liabilities of $7,201.1 million, a 20.9% increase from total liabilities at December 31, 2002.
During the third quarter of 2003, our company-obligated mandatorily redeemable preferred stock of subsidiary trust and Series C preferred stock were reclassified to debt ($140.2 million long-term debt and $45.3 million short-term debt) in connection with the adoption of Statement No. 150. Our $40.0 million in short-term debt at December 31, 2002 was restructured during 2003 into a $40.0 million funding agreement, which is included in the policy liabilities and accruals - interest sensitive and index products line on the consolidated balance sheet.
At December 31, 2003, common stockholders’ equity was $744.8 million, or $26.42 per share, compared to $658.4 million, or $23.71 per share at December 31, 2002. Included in stockholders’ equity per common share is $4.31 at December 31, 2003 and $3.43 at December 31, 2002 attributable to net unrealized investment gains resulting from marking our fixed maturity and equity securities classified as available for sale and interest rate swaps to market value. The change in unrealized appreciation of these securities increased stockholders’ equity $26.4 million during 2003, after related adjustments to deferred policy acquisition costs, value of insurance in force acquired, unearned revenue reserve and deferred income taxes.
• The amount by which bond calls, mortgage loan prepayments and paydowns on mortgage and asset-backed securities accelerate during periods of declining interest rates.
We design our products and manage our investment portfolio in a manner to encourage persistency and to help ensure targeted spreads are earned. In addition to the ability to change interest crediting rates on our direct products, certain interest sensitive and index contracts have surrender and withdrawal penalty provisions. The following is a summary of the surrender and discretionary withdrawal characteristics of our interest sensitive and index products and supplementary contracts without life contingencies:
approximate percentage change in the market value of a portfolio when interest rates change by 100 basis points. This measure includes the impact of estimated changes in portfolio cash flows from features such as bond calls and prepayments. When the estimated durations of assets and liabilities are similar, exposure to interest rate risk is reduced because a change in the value of assets should be largely offset by a change in the value of liabilities. The effective duration of our fixed income portfolio was approximately 5.3 at December 31, 2003 and 4.1 at December 31, 2002. The effective duration of the interest sensitive products was approximately 4.6 at December 31, 2003 and 4.4 at December 31, 2002.
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. On December 31, 2003, Farm Bureau Life transferred the stock of EquiTrust to FBL Financial Group, Inc. through an “extraordinary” dividend, which was approved by the Iowa Insurance Commissioner. As a result, Farm Bureau Life will not be able to distribute dividends to FBL Financial Group, Inc. during 2004 without further regulatory approval. During 2004, the maximum amount legally available for distribution to FBL Financial Group, Inc. from EquiTrust without further regulatory approval is $13.4 million.
For the life insurance operations, cash outflow requirements for operations are typically met from normal premium and deposit cash inflows. This has been the case for all reported periods as the Life Companies’ continuing operations and financing activities relating to interest sensitive and index products provided funds totaling $711.2 million in 2003, $1,068.0 million in 2002 and $536.0 million in 2001. The decrease in net cash flows in 2003 is primarily due to a decrease in premiums assumed through the coinsurance agreements. The significant increase in net cash flows in 2002 is due principally to the impact of entering into the coinsurance agreements during 2001. Positive cash flow from operations is generally used to increase the Life Companies’ fixed maturity securities and other investment portfolios. In developing their investment strategy, the Life Companies establish a level of cash
We anticipate that funds to meet our short-term and long-term capital expenditures, cash dividends to stockholders and operating cash needs will come from our line of credit, existing capital and internally generated funds. We believe that the current level of cash and available-for-sale and short-term securities, combined with expected net cash inflows from operations, maturities of fixed maturity investments, principal payments on mortgage and asset-backed securities, mortgage loans and our insurance products, are adequate to meet our anticipated cash obligations for the foreseeable future. Our investment portfolio at December 31, 2003, included $35.3 million of short-term investments, $233.9 million of cash (consisting primarily of securities purchased with a maturity of three months or less) and $1,027.4 million in carrying value of U.S. Government and U.S. Government agency backed securities that could be readily converted to cash at or near carrying value.
In the normal course of business, we enter into 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, 2003:
We are also a party to other operating leases with total payments of approximately $1.7 million per year. Generally, these leases are renewable annually with similar terms. Although our current intention is to renew these leases, we are not obligated to do so.
• The degree to which customers and agents (including the agents of our alliance partners) accept our products will influence our future growth rate.
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, 2003 and 2002, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2003, in conformity with accounting principles generally accepted in the United States.
As discussed in Note 1 to the consolidated financial statements, in 2003 the Company changed its method of accounting for its Series C redeemable preferred stock, the subsidiary trust that issued the company-obligated mandatorily redeemable preferred stock and stock options, in 2002 the Company changed its method of accounting for goodwill and in 2001 the Company changed its method of accounting for derivative instruments.
As discussed in the “Stock-Based Compensation” section that follows, effective January 1, 2003, we changed our method of accounting for stock options.
Effective July 1, 2003, we adopted Statement of Financial Accounting Standards (Statement) No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities.” Statement No. 149 codifies several Derivatives Implementation Group (DIG) issues, including DIG Issue C18, “Scope Exceptions: Shortest Period Criterion for Applying the Regular-Way Security Trades Exception to When-Issued Securities or Other Securities That Do Not Yet Exist.” DIG Issue C18 clarifies the applicability of Statement No. 133 to when-issued securities by holding that the regular-way security trade exception may not be applied to securities which are not settled within the shortest period possible for that security. If settlement does not occur within the shortest period possible, there is deemed to be a forward contract for the purchase of that security which is subject to fair value accounting under Statement No. 133. 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 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 (loss). The adoption of Statement No. 149 resulted in a $0.4 million decrease to net income for 2003.
Effective October 1, 2003, we adopted the DIG’s Statement 133 Implementation Issue No. B36, “Embedded Derivatives: Bifurcation of a Debt Instrument that Incorporates Both Interest Rate Risk and Credit Rate Risk Exposures that are Unrelated or Only Partially Related to the Creditworthiness of the Issuer of that Instrument” (DIG B36). DIG B36 addresses whether Statement No. 133 requires bifurcation of a debt instrument into a debt host contract and an embedded derivative if the debt instrument incorporates both interest rate risk and credit risk exposures that are unrelated or only partially related to the creditworthiness of the issuer of that instrument. Under DIG B36, a modified coinsurance agreement where interest on funds withheld is determined by reference to a pool of fixed maturity assets is an example of an arrangement containing embedded derivatives requiring bifurcation. Embedded derivatives in these contracts are to be recorded at fair value at each balance sheet date and changes in the fair values of the derivatives are recorded as income or expense. This guidance applies to general account investments supporting our variable alliance business. At December 31, 2003, the fair value of the embedded derivatives pertaining to funds withheld on variable business assumed by us totaled $0.5 million, and the fair value of the embedded derivatives pertaining to funds withheld on variable business ceded by us was less than $0.1 million. Net income for 2003 was increased by $0.2 million as a result of adopting DIG B36.
As discussed in the “Goodwill” section that follows, effective January 1, 2002, we changed our method of accounting for goodwill.
• the rights of an index annuity contract holder to participate in the index returns available under the contract are considered embedded derivatives, and
These derivatives are described more fully in this note under the captions “Investments - Fixed Maturities and Equity Securities,” “Investments - Other Investments,” “Reinsurance Recoverable” and “Future Policy Benefits.” Additional details regarding our interest rate swaps are included in Note 3, “Interest Rate Swaps.”
The cumulative effect of adopting these Statements on net income was $0.3 million in 2001. This amount represents the difference in accumulated net unrealized capital gains (losses) on the date of adoption, net of tax, resulting from the change in accounting for the conversion features embedded in our convertible fixed maturity securities. Upon the adoption of Statement No. 133, we transferred our fixed maturity securities classified as held for investment, formerly recorded at amortized cost, to the available-for-sale category. In connection with this transfer, the securities were marked to market and the corresponding increase in carrying value totaling $2.8 million, net of offsetting adjustments to deferred policy acquisition costs, value of insurance in force acquired, unearned revenue reserve and income taxes, was credited to stockholders’ equity.
Other long-term investments include investment deposits and other miscellaneous investments which are reported at amortized cost and securities held by subsidiaries engaged in the broker/dealer industry. In accordance with accounting practices for the broker/dealer industry, marketable securities held by subsidiaries in this industry are valued at market value. The resulting difference between cost and market is included in the consolidated statements of income as net investment income. Realized gains and losses are also reported as a component of net investment income.
We assume, under a coinsurance agreement, certain index annuity contracts issued by American Equity. The call options used to fund the index credits on the index annuities are purchased by and maintained on the books of American Equity. We record our proportionate share of the option value supporting the business we reinsure as reinsurance recoverable on the consolidated balance sheets. This component of the reinsurance contract is an embedded derivative and we record our share of the call options at market value. Our share of the call options totaled $30.6 million at December 31, 2003 and $17.2 million at December 31, 2002. Changes in market value of the call options, as well as option proceeds, are included as a component of derivative income (loss) on our consolidated statements of income. See Note 5, “Reinsurance, Acquisition and Policy Provisions,” for additional information regarding this reinsurance agreement.
Deferred Policy Acquisition Costs and Value of Insurance In Force Acquired
Property and equipment, comprised primarily of furniture, equipment and capitalized software costs, are reported at cost less allowances for depreciation and amortization. Depreciation and amortization expense is computed primarily using the straight-line method over the estimated useful lives of the assets. Furniture and equipment had a carrying value of $29.7 million at December 31, 2003 and $28.3 million at December 31, 2002, and estimated useful lives that range from two to ten years. Capitalized software costs had a carrying value of $7.0 million at December 31, 2003 and $6.8 million at December 31, 2002, and estimated useful lives that range from two to five years. Depreciation expense was $7.4 million in 2003, $7.1 million in 2002 and $7.4 million in 2001. Amortization expense was $4.7 million in 2003, $4.0 million in 2002 and $6.0 million in 2001.
Goodwill represents the excess of the fair value of assets exchanged over the net assets acquired. Effective January 1, 2002, we adopted Statement No. 141, “Business Combinations,” and Statement No. 142, “Goodwill and Other Intangible Assets.” Under these Statements, goodwill is not amortized but is subject to annual impairment tests in accordance with the Statements. In addition, Statement No. 142 requires the identification and amortization of certain intangible assets that had previously been included as a component of goodwill. We have performed impairment testing and determined none of our goodwill was impaired as of December 31, 2003 or December 31, 2002. In addition, we have no intangible assets included as a component of goodwill that require separate accounting.
We had undiscounted reserves of $0.1 million at December 31, 2003 and December 31, 2002 to cover estimated future assessments on known insolvencies. We had assets totaling $0.4 million at December 31, 2003 and $0.7 million at December 31, 2002 representing estimated premium tax offsets on paid and future assessments. Expenses (credits) incurred for guaranty fund assessments, net of related premium tax offsets, totaled less than $0.1 million in 2003, ($0.1) million in 2002 and $0.2 million in 2001. It is anticipated that estimated future guaranty fund assessments on known insolvencies will be paid during 2004 and substantially all the related future premium tax offsets will be realized during the five year period ending December 31, 2008. We believe the reserve for guaranty fund assessments is sufficient to provide for future assessments based upon known insolvencies and projected premium levels.
Revenues for interest sensitive, index and variable products consist of policy charges for the cost of insurance, administration charges, amortization of policy initiation fees and surrender charges assessed against policyholder account balances. Expenses related to these products include interest or index amounts credited to policyholder account balances, changes in the reserves for the embedded derivatives in the index annuities, benefit claims incurred in excess of policyholder account balances and amortization of deferred policy acquisition costs.
Traditional life insurance premiums are recognized as revenues over the premium-paying period. Future policy benefits and policy acquisition costs are recognized as expenses over the life of the policy by means of the provision for future policy benefits and amortization of deferred policy acquisition costs.
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 $1.2 million in 2003 and 2002 and $0.8 million in 2001. Lease income from leases with affiliates totaled $6.9 million in 2003, $5.8 million in 2002 and $5.2 million in 2001. Investment advisory fee income from affiliates totaled $2.0 million in 2003, $1.5 million in 2002 and $1.4 million in 2001.
We have agreed that we will not declare or pay dividends on any class or series of stock except for regular cash dividends as long as any Series C redeemable preferred stock is outstanding. Regular cash dividends are defined as regular, fixed, quarterly or other periodic cash dividends as declared by our Board of Directors as part of the stated cash dividend policy and do not include any other dividends or distributions, such as extraordinary, special or otherwise non-recurring dividends. Additionally, we have agreed that we will not pay dividends on the Class A or Class B Common Stock, nor on the Series B or Series C Preferred Stock, if we are in default of our line of credit agreement with LaSalle Bank National Association, or in default of the Subordinated Deferrable Interest Note Agreement Dated May 30, 1997 with FBL Financial Group Capital Trust. See Note 7, “ Credit Arrangements,” for additional information regarding these agreements.
The preparation of financial statements in conformity with accounting principles generally accepted in the United States (GAAP) requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses and the disclosure of contingent assets and liabilities. For example, significant estimates and assumptions are utilized in the valuation of investments, determination of other-than-temporary impairments of investments, amortization of deferred policy acquisition costs, calculation of policyholder liabilities
and accruals and determination of pension expense. It is reasonably possible that actual experience could differ from the estimates and assumptions utilized which could have a material impact on the consolidated financial statements.
The carrying value of 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) was $4.9 million at December 31, 2003 and less than $0.1 million at December 31, 2002.
Other investment income in 2001 includes $2.5 million earned in connection with the American Equity coinsurance agreement on investment income due but not yet received under the terms of the reinsurance agreement.
Realized losses on fixed maturities totaling $9.2 million in 2003, $26.9 million in 2002 and $14.5 million in 2001 were incurred as a result of writedowns for other than temporary impairment of fixed maturity securities.
We have a common stock investment in American Equity’s parent, American Equity Investment Life Holding Company (AEHC), valued at $52.3 million at December 31, 2003 and $26.9 million at December 31, 2002. American Equity underwrites and markets life insurance and annuity products throughout the United States. In December 2003, AEHC completed an initial public offering (IPO). Prior to the IPO, we accounted for AEHC using the equity method and included the investment in the securities and indebtedness of related parties line item on the consolidated balance sheets. Due to the timing of the availability of financial information, we recorded our share of AEHC’s results one quarter in arrears. As a result of the IPO, our percentage ownership interest in AEHC decreased and we discontinued applying the equity method of accounting. At December 31, 2003, our investment was carried at market value and was included in the equity securities line item on the consolidated balance sheet.
At December 31, 2003, we had committed to provide additional funding for mortgage loans on real estate aggregating $47.4 million. These commitments arose in the normal course of business at terms that are comparable to similar investments.
The carrying value of investments which have been non-income producing for the twelve months preceding December 31, 2003 include real estate, fixed maturities, equity securities and other long-term investments totaling $10.3 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 formally document this hedging relationship, including identification of the interest rate swaps as the hedging instruments and interest credited to the related flexible premium deferred annuity contract liabilities as the hedged transactions. We also document our risk management objectives and strategies for undertaking these transactions. The interest rate swap agreements are accounted for as cash flow hedges.
Mortgage loans on real estate and policy loans: Fair values are estimated by discounting expected cash flows using interest rates currently being offered for similar loans.
Future policy benefits and other policyholders’ funds: Fair values of our liabilities under contracts not involving significant mortality or morbidity risks (principally deferred annuities, deposit administration funds, funding agreements and supplementary contracts) are estimated at cash surrender value, the cost we would incur to extinguish the liability. We are not required to estimate the fair value of our liabilities under other insurance contracts.
Other liabilities: Fair values for interest rate swaps are based on quoted market prices. 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 liabilities balance.
During 2001, we entered into a coinsurance agreement with American Equity whereby we assumed 70% of certain fixed and index annuity business written from August 1, 2001 to December 31, 2001 and 40% of certain annuity business written during 2002 and 2003. The reinsurance of the business written prior to October 1, 2001 was accounted for as the acquisition of an in force block of business on October 1, 2001. With the reinsurance of the in force block, we recorded cash and reinsurance recoverable totaling $120.4 million, deferred acquisition costs of $18.3 million and policy liabilities of $138.7 million. Premiums collected on this assumed business, not included in revenues in the consolidated statements of income, totaled $649.5 million in 2003, $837.9 million in 2002 and $280.0 million in the fourth quarter of 2001.
Our initial coinsurance agreement with American Equity expired effective December 31, 2003. Effective January 1, 2004, we reached an agreement to continue our coinsurance relationship under which we will assume 20% of selected fixed and index annuities with a limit, or cap, on annual premiums assumed. The cap will become effective at the end of any month in which the annual premiums assumed for the year exceed $500.0 million. The agreement will renew automatically every two years unless terminated by either party.
The index annuities assumed guarantee the return of principal to the contract holder and credit amounts based on a percentage of the gain in a specified market index. A portion of the premium assumed is invested in investment grade fixed income securities to cover our share of the minimum guaranteed value due to the contract holder at the end of the contract term. A portion of the premium received from the contract holder is used to purchase derivatives consisting of call options on the applicable market indices to fund the index credits due to the index annuity contract holders. As described in Note 1, “Significant Accounting Policies - Reinsurance Recoverable,” the call options are purchased by and maintained on the books of American Equity and we record our proportionate share of the option value supporting the business we reinsure as reinsurance recoverable. Changes in market value of the call options, as well as option proceeds and gain on early termination of options, are included as a component of derivative income (loss).
On January 1, 2001, we acquired the assets and liabilities of Kansas Farm Bureau Life Insurance Company, Inc. (Kansas Farm Bureau Life) for $80.7 million. The acquisition was accounted for using purchase accounting. A condensed statement of the assets and liabilities acquired as of January 1, 2001, is as follows (dollars in thousands):
The tax effect of temporary differences giving rise to our deferred income tax assets and liabilities is as follows:
In connection with the acquisition of Kansas Farm Bureau Life, 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 Federation. Each share of Series C preferred stock has a par value of $26.8404 and voting rights identical to that of Class A common stock. Dividends on the Series C preferred stock are payable quarterly at a rate equal to the regular cash dividends per share of common stock, as defined, then payable. The mandatory redemption is structured so that 49.5% of the Series C preferred stock was redeemed at par value, or $45.3 million, on January 2, 2004 with the remaining 50.5% redeemed at par value, or $46.3 million, on January 3, 2006. In the event of a change in the control of the Company, at the option of the holder, each share of Series C preferred stock is convertible into one share of Class A common stock or redeemable for cash at par. As described in Note 1, “Significant Accounting Policies - Accounting Changes,” during 2003, this preferred stock was reclassified to debt ($43.2 million long-term debt and $45.3 million short-term debt at December 31, 2003) in connection with the adoption of Statement No. 150. The Series C preferred stock was issued at an $11.6 million discount to par. This discount accretes to preferred stock dividends (interest expense after the adoption of Statement No. 150) during the life of the securities using the effective interest method.
As described in Note 1, “Significant Accounting Policies - Accounting Changes,” due to the adoption of Interpretation No. 46, long-term debt at December 31, 2003 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 sheet 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. As of December 31, 2003 and 2002, 97,000 shares of 5% Preferred Securities were outstanding, all of which we unconditionally guarantee.
We participate with several affiliates in various multiemployer defined benefit plans covering substantially all of our employees. The benefits of these plans are based primarily on years of service and employees’ compensation. Net periodic pension cost of the plans is allocated between participants generally on a basis of time incurred by the respective employees for each employer. Such allocations are reviewed annually. Pension expense aggregated $5.5 million in 2003, $4.4 million in 2002 and $5.3 million in 2001.
In addition to benefits offered under the aforementioned benefit plans, we and several other affiliates sponsor a plan that provides group term life insurance benefits to retired full-time employees who have worked ten years and attained age 55 while in service. Furthermore, during a portion of 2001 we offered certain retiree health benefits to employees and retirees formerly employed by Kansas Farm Bureau Life. During 2001, we discontinued offering this benefit to active employees and wrote off the related liability. Postretirement benefit expense is allocated in a manner consistent with pension expense discussed above. Postretirement benefit expense (benefit) aggregated less than $0.1 million in 2003 and 2002 and ($0.5) million in 2001.
Information regarding stock options outstanding at December 31, 2003, is as follows:
At December 31, 2003, shares of Class A common stock available for grant as additional awards under the Plan totaled 4,947,948.
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 21,719 at December 31, 2003 and 16,917 at December 31, 2002. At December 31, 2003, shares of Class A common stock available for future issuance under the Director Compensation Plan totaled 28,281.
In the normal course of business, we may be involved in litigation where amounts are alleged that are substantially in excess of contractual policy benefits or certain other agreements. At December 31, 2003, management is not aware of any claims for which a material loss is reasonably possible.
Options to purchase 133,475 shares of common stock in 2001 at $17.13 to $24.25 per share were granted during 1997, 1998, 1999, 2000 and 2001 but were not included in the computation of 2001 diluted earnings per share because the options’ exercise price was greater than the average market price of common shares during 2001. The options, which expire in 2007 through 2011, were still outstanding at December 31, 2001.
Net income (loss) of the Life Companies, as determined in accordance with statutory accounting practices, was $55.1 million in 2003, $24.9 million in 2002 and ($8.8) million in 2001. The net loss for 2001 is primarily attributable to the payment of ceding commissions on the NTL and American Equity coinsurance transactions. Statutory net gain from operations for the Life Companies, which excludes realized gains and losses, totaled $71.4 million in 2003, $48.4 million in 2002 and $5.7 million in 2001. Statutory capital and surplus, after appropriate elimination of intercompany accounts, totaled $465.2 million at December 31, 2003 and $391.8 million at December 31, 2002.
Management analyzes operations by reviewing financial information regarding products that are aggregated into three product segments. The product segments are: (1) traditional annuity, (2) traditional and universal life insurance and (3) variable. We also have various support operations and corporate capital that are aggregated into a corporate and other segment.
• marketing and distribution services for the sale of mutual funds and insurance products not issued by us; and
Depreciation and amortization 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 charges relating to leases with affiliates totaling $5.7 million for 2003, $5.0 million for 2002 and $4.6 million for 2001. In the consolidated statements of income, we record these depreciation amounts net of related lease income from affiliates.
The differences between the derivative income (loss) by quarter primarily corresponds to the performance of the indices upon which our call options are based. As discussed in Note 1 under “Accounting Changes,” amounts previously classified as dividends on our company-obligated mandatorily redeemable preferred stock of subsidiary trust and Series C redeemable preferred stock are recorded as interest expense beginning in the third quarter of 2003 in accordance with Statement No. 150. While the adoption of Statement No. 150 resulted in a $1.1 million decrease to net income for the third and fourth quarters of 2003, the adoption did not impact net income applicable to common stock or earnings per common share.