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 171,000 square feet of a 400,000 square foot office building in West Des Moines, Iowa. Operations related to our EquiTrust Life expansion are conducted from 16,000 square feet of another office building in West Des Moines, Iowa. This space is leased under two operating leases which expire in 2006. We expect to renew these leases when they come due. 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 and 2001. 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.
See Note 1 to the consolidated financial statements for an explanation of the impact of accounting changes on net income, long-term debt, company-obligated mandatorily redeemable preferred stock of subsidiary trust and Series C redeemable preferred stock beginning in 2003.
In accordance with U.S. generally accepted accounting principles (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 and deferred sales inducements, are capitalized and amortized into expense. We also record an asset, value of insurance in force acquired, for the cost assigned to insurance contracts when an insurance company is acquired. 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 and deferred sales inducements 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 July 1, 2003, our company-obligated mandatorily redeemable preferred stock of subsidiary trust and Series C preferred stock are classified as debt and related dividend payments are classified as interest expense.
We believe that reasonable changes in the credit spreads, ranging from 15 basis points to 151 basis points, depending upon credit quality, would produce a total value ranging from $324.6 million to $310.3 million, as compared to the recorded amount of $312.7 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 or loss.
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.
The determination of net periodic pension expense and related accrued/prepaid pension cost requires the use of estimates as to the expected return on plan assets, discount rate on plan liabilities and other actuarial assumptions. Pension expense for 2005 totaled $7.8 million.
A 100 basis point decrease in the expected return on assets would result in a $0.5 million increase in pension expense. A 100 basis point decrease in the assumed discount rate would result in a $0.5 million increase in pension expense. A 100 basis point increase in these rates would result in a decrease to expense in approximately the same amount noted above.
Results of Operations for the Three Years Ended December 31, 2005
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 2005 and 2004 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 10,162 at December 31, 2005, from 4,778 at December 31, 2004 and 177 at December 31, 2003. Reinsurance assumed and other premiums collected decreased during 2005 and 2004 due to the suspension of our coinsurance agreement (the coinsurance agreement) with 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 will remain as part of our in force business.
Net income applicable to common stock increased 10.3% in 2005 to $72.7 million and 3.6% in 2004 to $65.9 million. As discussed in detail below, net income applicable to common stock in 2005 was positively impacted by growth in the volume of business in force, increased spreads earned on our universal life and individual traditional annuity products and a reduction in other underwriting, acquisition and insurance expenses. These items are 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. Net income applicable to common stock in 2004 was positively impacted by growth in the volume of business in force, an increase in realized gains on investments and a decrease in our effective tax rate, partially offset by decreases in equity income and spreads earned on our individual annuity products and increases in operating expenses.
products. The face amount of life insurance in force represents the gross death benefit payable to policyholders and account value represents the value of the contract to the contract holder before application of surrender charges or reduction for any policy loans outstanding.
Surrender charges totaled $13.5 million in 2005, $9.9 million in 2004 and $7.5 million in 2003. Surrender charges increased due primarily to increases in surrenders relating to growth in the volume and aging of business in force. The average 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 $5,523.8 million for 2005, $4,638.7
Cost of insurance charges totaled $61.9 million in 2005, $59.8 million in 2004 and $58.1 million in 2003. 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 44.6 years in 2005, 44.0 years in 2004 and 43.4 years in 2003.
Traditional premiums increased in 2005 and 2004 due to an increase in the volume of business in force. The increase in the business in force is attributable primarily to sales of traditional life products by our Farm Bureau Life agency force exceeding the loss of in force amounts through deaths, lapses and surrenders. Our average traditional life insurance in force, net of reinsurance ceded, totaled $17,344 million for 2005, $16,246 million for 2004 and $15,116 million for 2003.
The increases in gains received at expiration or termination are attributable to growth in the volume of index annuities in force and appreciation in the market indices on which our options are based. The average account value of index annuities in force, which has increased due to new sales, totaled $2,299.1 million for 2005, $1,593.6 million for 2004 and $1,105.7 million for 2003. The changes in the difference between the fair value of the call options and the remaining option costs for 2005 and 2004 are caused primarily by the general change in the S&P 500 Index (upon which the majority of our options are based). For 2005, the S&P 500 Index increased on a point-to-point basis by 3.0%, compared to a point-to-point increase of 9.0% for 2004 and a point-to-point increase of 26.4% for 2003. While the difference between the fair value of the call options and the remaining option costs generally corresponds to the point-to-point change in the S&P 500 Index, the change in fair value is also impacted by options based on daily or monthly S&P 500 Index averages and options which are based on other underlying indices. Furthermore, the timing of option settlements also impacts the change in fair value. The cost of money for call options increased due primarily to the impact of 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.
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 2005, 2004 and 2003, including the circumstances requiring the write downs, are summarized in the following table:
In March, we noted disappointing fiscal second quarter 2004 results and a 9% decrease in sales.
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 changes in the amount of index credits are impacted by growth in the volume of index annuities in force and the level of appreciation 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 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).” The value of the
Traditional life insurance and accident and health policy benefits increased 1.8% in 2005 to $144.8 million and 4.5% in 2004 to $142.2 million. These increases are partially attributable to higher traditional life insurance death benefits, which increased 7.9% to $51.5 million in 2005 and 11.9% to $47.7 million in 2004. Traditional life insurance and accident and health future policy benefits for 2003 includes a reduction of $1.8 million in reserves relating to a change in valuation methodology for certain traditional life business. Distributions to participating policyholders decreased in 2005 and 2004 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.
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
Interest expense totaled $13.6 million in 2005 compared to $11.4 million in 2004 and $5.1 million in 2003. The increases in 2005 and 2004 are 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 2005 and $3.1 million for 2004. The increase in 2005 is also attributable to an increase in the variable interest rate on our $46.0 million line of credit to an average of 4.55% in 2005 from 2.70% in 2004. The increase in 2004 is also due to the adoption of Statement No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity,” and Financial Accounting Standards Board (FASB) Interpretation No. 46, “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51,” resulting in $7.0 million in 2004 and $4.6 million in 2003 being classified as interest expense. Interest expense includes $2.3 million in 2005 of dividends paid on the Series C redeemable preferred stock that will no longer be incurred in future periods due to the redemption of the remaining shares in December 2005.
Income taxes increased 32.7% in 2005 to $36.8 million and decreased 11.8% in 2004 to $27.7 million. The effective tax rate was 33.9% for 2005, 30.0% for 2004 and 33.4% for 2003. Our effective tax rates for 2005 and 2004 are impacted by tax accrual reversals. During 2005 and 2004, based on events and analysis performed, we determined that these tax accruals were no longer necessary and related benefits totaling $0.5 million in 2005 and $4.5 million in 2004 were recorded. The effective rates, excluding the impact of the accrual reversals, were 34.4% in 2005 and 34.8% in 2004. The increase in the effective rate for 2004, excluding the impact of the accrual reversals, is primarily due to the adoption of Statement No. 150 and FASB Interpretation No. 46 noted above. The effective tax rates were lower than the federal statutory rate of 35% due primarily to tax-exempt interest, tax-exempt dividend income and, for 2003 the tax benefit associated with the payment of dividends on mandatorily redeemable preferred stock of subsidiary trust.
Given the timing of availability of financial information from our equity investees, 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.
Dividends on company-obligated mandatorily redeemable preferred stock of subsidiary trust and dividends on Series B and C preferred stock decreased in 2004 due to the impact of accounting changes as discussed in “Interest expense” above.
We use operating income, in addition to net income, to measure our performance since realized and unrealized gains and losses on investments and the change in net unrealized gains and losses on derivatives can fluctuate greatly from period to period. These fluctuations make it difficult to analyze core operating trends. In addition, for derivatives not designated as hedges, there is a mismatch between the valuation of the asset and liability when deriving net income. For example, call options relating to our index business are generally one or two-year assets while the embedded derivative in the index contracts represents the rights of the contract holder to receive index credits over the entire period the index annuities are expected to be in force. For our other embedded derivatives in the product segments, the embedded derivatives are marked to market, but the associated insurance liabilities are not marked to market. A view of our operating performance without the impact of these mismatches enhances the analysis of our results. We use operating income for goal setting, determining company-wide bonuses and evaluating performance on a basis comparable to that used by many in the investment community.
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 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.
Also beginning in 2005, we changed the method in which indirect expenses (those expenses for which we do not have a reliable basis such as time studies for allocating the costs) are allocated among the segments from a pro rata method based on allocated capital to a pro rata method based on direct expenses. The change in allocating indirect expenses was made in conjunction with our change in allocating capital to better reflect the effort and resources required to operate the separate segments. The exact impact of this change is not determinable as it was not practicable to calculate required capital under both the new and old capital allocation methodologies during 2005. The most significant impact of this change was to shift approximately $4.0 million in 2005 of other underwriting expenses from the Corporate and Other segment to the Traditional and Universal Life Insurance and Variable segments. The impact on the Exclusive Annuity and Independent Annuity segments is not believed to be significant with slight reductions in other underwriting expenses resulting from this change.
A reconciliation of net income to pre-tax operating income (loss) and a summary of pre-tax operating income (loss) by segment follows:
business in force in 2004. Revenues, benefits and expenses increased in 2005 and 2004 due to growth in volume of business in force. The average account value for annuity contracts in force in the Exclusive Annuity segment totaled $1,428.8 million for 2005, $1,308.5 million for 2004 and $1,161.1 million for 2003. Net investment income was positively impacted in 2005 by an increase in investments due to the change in allocation of capital discussed above and impacted during 2005 and 2004 by a decrease in our cash position and increased investment in corporate bonds. In addition, net investment income includes $4.2 million in 2005, $0.7 million in 2004 and $4.9 million in 2003 in fee income from bond calls, tender offers and mortgage loan prepayments and the acceleration (reversal) of net discount accretion on mortgage and asset-backed securities as noted in the investment income discussion above. These factors are partially offset by the impact of a decline in market interest rates during 2005 and 2004.
Premiums collected decreased 23.3% to $177.4 million in 2005 and increased 1.6% to $231.2 million in 2004. 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 decrease in annuity premiums in 2005 is due to a rise in short-term market interest rates during 2005, making certificates of deposit and other short-term investments more attractive in relation to these traditional annuities.
Pre-tax operating income for the Independent Annuity segment increased 61.8% in 2005 to $22.2 million and decreased 23.7% in 2004 to $13.7 million. The increase in 2005 is due principally to growth in the volume of business in force and spreads earned on individual deferred annuities. The decrease in 2004 is due principally to decreases in spreads earned and increased operating expenses, partially offset by growth in the volume of business in force. Revenues, benefits, expenses and the volume of business in force increased in 2005 and 2004 primarily due to the expansion of our EquiTrust Life distribution channel and business assumed under the coinsurance agreement prior to its suspension on August 1, 2004. The average account value for annuity contracts in force in the Independent segment totaled $3,114.7 million for 2005, $2,359.8 million for 2004 and $1,717.2 million for 2003.
Benefits and expenses increased in 2005 and 2004 due to growth in the volume of business in force. Operating expenses include $4.1 million in 2005 and $4.0 million in 2004 relating to the expansion of our EquiTrust Life distribution.
The decreases in the weighted average yield on cash and invested assets are primarily the result of the impact of the decline in market interest rates during 2005, 2004 and 2003. The decrease in 2004 is also partially attributable to decreases in fee income from bond calls and mortgage loan prepayments and discount accretion on mortgage and asset-backed securities as noted above. Our spreads earned for 2005, 2004 and 2003 were primarily impacted by changes in spreads on index annuities assumed under the coinsurance agreement, which is driven by option costs, the extent to which the business was over hedged and fluctuations in the minimum guarantees credited to the contracts.
Benefits and expenses for 2005 and 2004 increased due primarily to increases in death benefits. Death benefits totaled $75.4 million in 2005, $69.9 million in 2004 and $69.4 million in 2003. Underwriting expenses in 2005 includes approximately $0.8 million of severance benefits as a result of closing of our life insurance processing unit and other unrelated terminations as described in the “Underwriting, acquisition and insurance expenses” section above. Also, as noted in the discussion of traditional life insurance and accident and health 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. Amortization of deferred policy acquisition costs was reduced by $3.2 million in 2005, $1.4 million in 2004 and $0.4 million in 2003 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 estimate of projected investment income on traditional participating life business.
The changes in the weighted average yield on cash and invested assets are primarily due to the changes in fee income and cash position noted above and the impact of the decline in market interest rates. We reduced the dividend and interest crediting rates on many of our life products in response to this decline in yield. For example, we decreased crediting rates on our primary universal life insurance product 20 basis points in 2004 and 75 basis points in 2003. The changes in our spread earned are due primarily to changes in investment yield and the timing of the crediting rate changes made on our products.
Pre-tax operating income for the Variable segment totaled $2.6 million in 2005, $2.2 million in 2004 and $0.6 million in 2003. The increases in 2005 and 2004 are due to the impact of an increase in the volume of business in force, partially offset by an increase in death benefits and, for 2005, a loss on the recapture by a former variable alliance partner of a previously coinsured block of variable annuity contracts. Mortality and expense fee income increased 19.4% to $6.9 million in 2005 and 31.9% to $5.8 million in 2004 due to growth in separate account assets. Death benefits in excess of related account values on variable universal life policies increased 21.1% to $12.4 million in 2005 and 4.2% to $10.3 million in 2004. Amortization of deferred policy acquisitions costs decreased $0.6 million in 2005, increased $0.8 million in 2004 and decreased $0.5 million in 2003 due to changes in assumptions used to calculate deferred policy acquisition costs.
Pre-tax operating income (loss) totaled ($2.7) million in 2005 compared to ($8.4) million in 2004 and $3.7 million in 2003. The increase 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. The decrease for 2004 is attributable to a decrease in equity income and an increase in interest expense. Net investment income was positively impacted during 2005 due to the change in allocation of capital discussed above and an increase in invested assets from our Senior Note offering in April 2004. Income from the Senior Note offering is estimated to be approximately $1.9 million in 2005 and $1.7 million in 2004. Net investment income also includes fee income from bond calls and mortgage loan prepayments and the acceleration (reversal) of net discount accretion on mortgage and asset-backed securities totaling $1.2 million in 2005, $0.2 million in 2004 and $2.1 million in 2003. 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. Other income includes revenues relating primarily to our non-insurance operations. These operations include management, advisory, marketing and distribution services and leasing activities. Fluctuations in other income are generally attributable to fluctuations in the level of these services provided during the years.
As of December 31, 2005, 95.0% (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, 2005, the investment in non-investment grade debt was 5.0% of available-for-sale fixed maturity securities. At that time, no single non-investment grade holding exceeded 0.2% of total investments.
The following table sets forth the credit quality, by NAIC designation and Standard & Poor’s (S&P) rating equivalents, of available-for-sale fixed maturity securities:
A summary of the gross unrealized gains and gross unrealized losses on our available-for-sale fixed maturity securities, by internal industry classification, as of December 31, 2005 and 2004, is as follows:
The following tables set forth the composition by credit quality of the available-for-sale fixed maturity securities with gross unrealized losses:
The scheduled maturity dates for available-for-sale fixed maturity securities in an unrealized loss position, are as follows:
United States Government and agencies: The unrealized losses on U.S. governments and agencies were caused by increases in market interest rates. We purchased 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, 2005.
Excluding mortgage and asset-backed securities, no securities from the same issuer had an aggregate unrealized loss in excess of $1.6 million at December 31, 2005. With respect to mortgage and asset-backed securities not backed by the United States government, no securities from the same issuer had an aggregate unrealized loss in excess of $2.6 million at December 31, 2005. The $2.6 million unrealized loss from one issuer relates to six different securities that are backed by different pools of residential mortgage loans. All six securities are rated investment grade and the largest unrealized loss on any one security totaled $1.2 million at December 31, 2005.
Deferred policy acquisition costs increased 18.3% to $695.1 million and deferred sales inducements increased 87.4% to $147.0 million at December 31, 2005 due to the capitalization of costs incurred with new sales. Assets held in separate accounts increased 15.9% to $640.0 million at December 31, 2005 due primarily to the transfer of net premiums to the separate accounts.
December 31, 2005 and $4.91 at December 31, 2004 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 $58.9 million during 2005, after related adjustments to deferred policy acquisition costs, deferred sales inducements, value of insurance in force acquired, unearned revenue reserve and deferred income taxes.
For a substantial portion of our direct business in force, we have the ability to adjust interest or dividend crediting rates in reaction to changes in portfolio yield. We had the ability to adjust rates on 95% of our policyholder liabilities at December 31, 2005 and 92% at December 31, 2004. However, the ability to adjust these rates is limited by competitive factors. Surrender rates could increase and new sales could be negatively impacted if the crediting rates are not competitive with the rates on similar products offered by other insurance companies and financial services institutions. In addition, if market rates were to decrease substantially and stay at a low level for an extended period of time, our spread could be lowered due to interest rate guarantees on many of our interest sensitive products. At December 31, 2005, interest rate guarantees on our direct interest sensitive products ranged from 1.50% to 5.50%, with a weighted average guarantee of 2.83%. The following table sets forth account values of direct individual deferred annuities (excluding index annuities) and interest sensitive life products, including the general account portion of variable contracts, broken out by the excess of current interest crediting rates over guaranteed rates at December 31, 2005.
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
For index annuities, call options are purchased to fund the index credits owed to contract holders who elect to participate in one or more market indices. Except for certain contracts for which minimum guaranteed interest rates apply, the options are purchased to fund the full amount of the annual index credits. For contracts for which minimum guaranteed interest rates apply, the options are generally purchased to fund the amount of the annual index credits in excess of minimum guaranteed interest accrued on the contracts. In 2005, proceeds from the maturity of call options totaled $41.6 million while related index amounts credited to contract holders’ account balances totaled $44.5 million. The difference between index credits and option proceeds is primarily attributable to call options being purchased out-of-the-money by the amount of minimum guarantees applicable to certain coinsured contracts.
A major component of our asset-liability management program is structuring the investment portfolio with cash flow characteristics consistent with the cash flow characteristics of our insurance liabilities. We use computer models to perform simulations of the cash flows generated from existing insurance policies under various interest rate scenarios. Information from these models is used in the determination of interest crediting rates and investment strategies. Effective duration is a common measure for price sensitivity to changes in interest rates. It measures the 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 maturity and mortgage loan portfolios was 5.8 at December 31, 2005 and December 31, 2004. The effective duration of the interest sensitive products was approximately 6.5 at December 31, 2005 and 5.5 at December 31, 2004.
fee income based on the value of our separate accounts. On an annualized basis, the investment management fee rates range from 0.20% to 0.45% for 2005, 2004 and 2003. The mortality and expense fee rates range from 0.90% to 1.40% for 2005, 2004 and 2003. As a result, revenues from these sources do fluctuate with changes in the market value of the equity, fixed maturity and other securities held by the separate accounts. In addition, we have equity price risk to the extent we may owe amounts under the guaranteed minimum death benefit and incremental death benefit provisions of our variable annuity contracts. See Note 1 to the consolidated financial statements for additional discussion of these provisions.
In December 2005, we redeemed the remaining 1,724,000 shares, or $46.3 million, of the Series C preferred stock. See Note 7 to the consolidated financial statements for further discussion of this debt and redemption.
On April 12, 2004, we issued $75.0 million of 5.85% 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. We received net proceeds of approximately $75.5 million from the issuance of the Senior Notes after underwriting fees, offering expenses, original issue discount and the impact of a rate lock agreement.
We paid cash dividends on our common and preferred stock totaling $12.3 million in 2005, $11.6 million in 2004 and $12.0 million in 2003. Interest payments on our debt totaled $11.8 million in 2005, $8.6 million in 2004 and $3.6 million in 2003. It is anticipated that cash dividend requirements for 2006 will be $0.115 per quarter per common share and $0.0075 per quarter per Series B redeemable preferred share, or approximately $13.7 million. In addition, interest payments on our debt are estimated to be $11.9 million for 2006.
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 2006, the maximum amount legally available for distribution to FBL Financial Group, Inc., without further regulatory approval, from Farm Bureau Life is $44.9 million and from EquiTrust Life is $21.6 million. With respect to the amount available from Farm Bureau Life, $39.2 million is not available until December 2006 due to the timing and amount of dividend payments made during 2005.
FBL Financial Group, Inc. expects to rely on available cash resources and dividends from the Life Companies to make any dividend payments to its stockholders and interest payments on its debt. In addition, it is anticipated that a combination of available cash and investments and dividends from the Life Companies will be used to fund dividends on our common and preferred stock and interest expense payments on our debt.
The Life Companies’ cash inflows consist primarily of premium income, deposits to policyholder account balances, income from investments, sales, maturities and calls of investments, repayments of investment principal and proceeds from call option exercises. The Life Companies’ cash outflows are primarily related to withdrawals of policyholder account balances, investment purchases, payment of policy acquisition costs, policyholder benefits, income taxes, dividends and current operating expenses. Life insurance companies generally produce a positive cash flow which may be measured by the degree to which cash inflows are adequate to meet benefit obligations to policyholders and normal operating expenses as they are incurred. The remaining cash flow is generally used to increase the asset base to provide funds to meet the need for future policy benefit payments and for writing new business. The Life Companies’ liquidity positions continued to be favorable in 2005, with cash inflows at levels sufficient to provide the funds necessary to meet their obligations.
We have audited the accompanying consolidated balance sheets of FBL Financial Group, Inc. as of December 31, 2005 and 2004, 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, 2005. 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, 2005 and 2004, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2005, 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, 2005, 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 3, 2006 expressed an unqualified opinion thereon.
Our consolidated financial statements include the financial statements of FBL Financial Group, Inc. and its direct and indirect subsidiaries. All significant intercompany transactions have been eliminated.
In June 2005, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (Statement) No. 154, “Accounting Changes and Error Corrections”, which is a replacement of Accounting Principals Board Opinion No. 20, “Accounting Changes” and FASB Statement No. 3, “Reporting Accounting Changes in Interim Financial Statements.” Statement No. 154 requires retrospective application to prior periods’ financial statements for all voluntary changes in accounting principle, unless impracticable. Statement No. 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 31, 2005. Statement No. 154 will have no immediate impact on our consolidated financial statements, though it will impact our presentation of future voluntary accounting changes, if any such changes occur.
Incurred benefits for GMDBs and IDBs totaled $0.6 million for 2005, ($0.1) million for 2004, excluding the impact of the adoption of SOP 03-1 and $0.3 million for 2003. Paid benefits for GMDBs and IDBs totaled $0.1 million for 2005, 2004 and 2003. The adoption of SOP 03-1 provisions relating to GMDBs and IDBs resulted in an increase to net income for 2004 totaling less than $0.1 million (less than $0.01 per common share - basic and diluted).
Effective July 1, 2003, we adopted Statement No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” This Statement establishes standards for classifying and measuring as liabilities certain financial instruments that embody obligations of the issuer and have characteristics of both liabilities and equity. Upon adoption of this Statement, our company-obligated mandatorily redeemable preferred stock of subsidiary trust and Series C redeemable preferred stock were reclassified to debt on our consolidated balance sheet. There were no adjustments to the carrying values of these instruments upon reclassification. Also, in accordance with Statement No. 150, amounts previously classified as dividends on these financial instruments ($2.3 million for 2005, $2.2 million for 2004 and $4.6 million for the six months ended December 31, 2003) are recorded as interest expense. All changes in classifications made due to the adoption of Statement No. 150 were made on a prospective basis only as reclassification of prior period amounts was not permitted. The adoption of Statement No. 150 resulted in a $2.2 million decrease to net income for 2003. The adoption of Statement No. 150 did not impact net income applicable to common stock or earnings per common share. As discussed below, our company-obligated mandatorily redeemable preferred stock of subsidiary trust was removed from our consolidated financial statements in connection with the deconsolidation of the trust effective December 31, 2003.
rewards of the entity. In addition, the Interpretation requires that investments made by related parties be analyzed together in applying the variable interests model. The disclosure provisions of this Interpretation were effective for financial statements issued after January 31, 2003. The consolidation provisions are effective for new transactions entered into after January 31, 2003 and for pre-existing entities as of December 31, 2003.
Upon adoption of Interpretation No. 46, effective December 31, 2003, the subsidiary trust that issued the company-obligated mandatorily redeemable preferred stock was deconsolidated. The effect of this deconsolidation is to replace the obligations of the trust to the preferred security holders with our subordinated debt obligation to the trust and our equity investment in the trust. In addition, the dividends on the company-obligated mandatorily redeemable preferred stock of the trust are replaced in our consolidated statements of income with the interest expense on our subordinated debt obligation to the trust and the dividends we receive on our equity investment in the trust. We record our subordinated debt obligation to the trust and our equity investment in the trust, along with the related interest expense and dividend income, on a net basis due to the contractual right of setoff. The adoption of the Interpretation with respect to the subsidiary trust has no impact on net income or earnings per common share.
Fixed maturity securities, comprised of bonds and redeemable preferred stocks, which may be sold, are designated as “available for sale.” Available-for-sale securities are reported at market value and unrealized gains and losses on these securities, with the exception of unrealized gains and losses relating to the conversion feature embedded in convertible fixed maturity securities, are included directly in stockholders’ equity as a component of accumulated 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 (losses) 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.
Derivative instruments include interest rate swaps used to reduce our exposure to increases in market interest rates on a portion of our annuity product portfolio and call options used to fund index credits on index annuities. In addition, during 2004 we had a treasury rate lock agreement (“rate lock”) in effect in connection with a debt offering. Furthermore, we have embedded derivatives associated with our index annuity business, certain modified coinsurance contracts and when-issued investment trading activity. All derivatives are recognized as either assets or liabilities in the consolidated balance sheets and measured at fair value.
Other long-term investments include an investment deposit which is 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.
Securities and indebtedness of related parties include investments in corporations and partnerships over which we may exercise significant influence. These corporations and partnerships operate predominately in the insurance, broker/dealer, investment company and real estate industries. Such investments are generally accounted for using the equity method. In applying the equity method, we record our share of income or loss reported by the equity investees. For partnerships operating in the investment company industry, this income or loss includes changes in unrealized gains and losses in the partnerships’ investment portfolios. Changes in the value of our investment in equity investees attributable to capital transactions of the investee, such as an additional offering of stock, are recorded directly to stockholders’ equity.
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 and the volatility of market values with changes in market interest rates. Due to these difficulties, amortization of amounts previously recorded as realized losses is expected to be rare. No such amortization was recorded in 2005, 2004 or 2003.
We assume, under a coinsurance agreement, certain fixed and index annuity contracts issued by American Equity (the coinsurance agreement). 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. See Note 3, “Derivative Instruments,” for more information regarding these call options and see Note 5, “Reinsurance and Policy Provisions,” for additional information regarding this reinsurance agreement.
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 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, 2005 or December 31, 2004.
We had undiscounted reserves of $0.1 million at December 31, 2005 and December 31, 2004 to cover estimated future assessments on known insolvencies. We had assets totaling $0.4 million at December 31, 2005 and $0.3 million at December 31, 2004 representing estimated premium tax offsets on paid and future assessments. Expenses incurred for guaranty fund assessments, net of related premium tax offsets, totaled less than $0.1 million in 2005, 2004 and 2003. It is anticipated that estimated future guaranty fund assessments on known insolvencies will be paid during 2006 and substantially all the related future premium tax offsets will be realized during the five year period ending December 31, 2010. We believe the reserve for guaranty fund assessments is sufficient to provide for future assessments based upon known insolvencies and projected premium levels.
All insurance-related revenues, benefits and expenses are reported net of reinsurance ceded. The cost of reinsurance ceded is generally amortized over the contract periods of the reinsurance agreements. Policies and contracts assumed are accounted for in a manner similar to that followed for direct business.
As discussed above, we will adopt Statement 123(R) on January 1, 2006, using the modified-prospective-transition method. Under the modified-prospective-transition method, we will recognize compensation expense in financial statements issued subsequent to the adoption for all share-based payments granted, modified or settled after the date of adoption, as well as for any awards that were granted prior to the adoption date for which the requisite service has not been provided as of the adoption date. We are not able to estimate the impact of adopting Statement No. 123(R) for the future as it is dependent on unknown factors such as the amount of future stock option grants and forfeitures and the timing of employee stock option exercises. However, we estimate that if Statement No. 123(R) would have been adopted as of January 1, 2005, net income would have been decreased by $0.7 million ($0.02 per basic and diluted share) for the year ended December 31, 2005. This includes a cumulative effect adjustment of $0.1 million (less than $0.01 per basic and diluted share) relating to the change in accounting for forfeitures. The impact of adopting Statement No. 123(R) on operating and financing cash flows is not expected to be material since the cash flow from excess tax deductions totaled $1.4 million for 2005 and $1.8 million for 2004.
While the paragraph above explains the impact of adopting Statement No. 123(R), the following table illustrates the effect on net income and earnings per share if the fair value based method under Statement No. 123 had been applied to all outstanding and unvested awards in each period.
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 $1.9 million in 2005, $1.4 million in 2004 and $1.0 million in 2003. 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 ($1.5) million in 2005, ($1.7) million in 2004 and ($0.4) million in 2003.
Certain amounts in the 2004 and 2003 consolidated statements of cash flows have been reclassified to conform to the 2005 financial statement presentation.
The preparation of financial statements in conformity with U.S. generally accepted accounting principles (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 and deferred sales inducements, 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.
Corporate securities: The unrealized losses on corporate securities totaled $39.0 million, or 55.0% of our total unrealized losses. The largest losses were in the manufacturing sector ($335.4 million carrying value and $17.4 million unrealized loss) and in the financial services sector ($604.2 million carrying value and $11.1 million unrealized loss). The largest unrealized losses in the manufacturing sector were in the transportation manufacturing sector ($47.9 million carrying value and $5.7 million unrealized loss) and the paper and allied products sector ($58.7 million carrying value and $4.8 million unrealized loss). The unrealized loss in the transportation manufacturing industry is mainly due to credit spread widening on issues involved in automobile manufacturing and automobile parts manufacturing. These sectors have been hurt by poor operating results and weak competitive positions due to high operating cost structures. The unrealized loss in the paper and allied products sector is mainly due to spread widening that is the result of weaker operating results. In addition, we believe there are concerns that the sector may see increased equity enhancing activity by management, such as common stock buybacks, which could be detrimental to credit quality. The unrealized loss in the financial sector and the remaining corporate sectors was caused primarily by a rise in market interest rates. 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, 2005.
Public utilities: Unrealized losses on public utilities totaled $4.2 million at December 31, 2005. The largest portion of this loss ($1.1 million) is attributable to four issues with a total carrying value of $21.9 million. The unrealized loss on these issues was due to an increase in market interest rates and a modest widening in the credit spreads. The credit spreads widened because one of the utilities operates in the Gulf Coast region and the other utilities’ parent company had operations in the Gulf Coast region. The markets appear to be factoring in concern as to whether the issuers will be able to recover all of the infrastructure repair costs that will be incurred as a result of hurricane damage. These issues are still rated investment grade and given that they are first mortgage bonds, it is probable that all payments on the issues will be made. Because we have the ability and intent to hold these investments until recovery of fair value, which may be maturity, we do not consider the investment in these four issues to be other-than-temporarily impaired at December 31, 2005. The remaining $3.1 million of unrealized losses on public utility investments are from 30 issues with a total fair value of $127.5 million. These unrealized losses were caused primarily by an increase in market interest rates. We have the ability and intent to hold these investments until recovery of fair value, which may be maturity and we do not consider these investments to be other-than-temporarily impaired at December 31, 2005.
We also have $0.2 million of gross unrealized losses on equity securities with an estimated market value of $0.6 million at December 31, 2005 and $0.1 million of gross unrealized losses on equity securities with an estimated market value of $0.7 million at December 31, 2004. These equity securities have been in an unrealized loss position for more than one year.
We have provided an allowance for possible losses against our mortgage loan portfolio. An analysis of this allowance, which consists of specific reserves, is as follows:
Income taxes (credits) include a provision of $1.0 million in 2005, $2.9 million in 2004 and ($0.7) million in 2003 for the tax effect of realized gains and losses.
We have investments in several variable interest entities for which we are not considered the primary beneficiary. These investments consist of common and preferred stock investments in a company that operates in the broker/ dealer industry and certain mezzanine commercial real estate loans on real estate properties. The broker/dealer had revenues totaling $49.7 million for 2005, $43.9 million for 2004 and $30.3 million for 2003. There were three real estate projects in 2005 and four real estate projects in 2004 and 2003. Each real estate project has assets totaling less than $17.0 million at December 31, 2005 and December 31, 2004 and less than $16.0 million at December 31, 2003. Our investments in these entities were made during the period from 2002 to 2005. Our maximum exposure to loss is the carrying value of our investments which totaled $5.0 million at December 31, 2005 and $4.6 million at December 31, 2004 for the broker/dealer and $4.3 million at December 31, 2005 and $6.2 million at December 31, 2004 for the mezzanine commercial real estate loans.
During 2004, we sold certain investment real estate properties to Farm Bureau Mutual Insurance Company (Farm Bureau Mutual), an affiliate, at their fair market value of $20.0 million. A realized gain of $5.3 million was recognized related to these transactions.
We received cash collateral for derivative transactions totaling $6.4 million at December 31, 2005 and $1.9 million at December 31, 2004 that was invested and included in the consolidated balance sheet with a corresponding amount recorded in other liabilities. We also have securities with a market value of $4.7 million that we hold as off-balance sheet collateral for derivative transactions at December 31, 2005.
The carrying value of investments which have been non-income producing for the twelve months preceding December 31, 2005 include real estate, equity securities and other long-term investments totaling $2.7 million.
We have 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. Details regarding the swaps are as follows (dollars in thousands):
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. Interest sensitive product benefits decreased by $1.0 million in 2005, and increased $1.6 million in 2004 and $1.2 million in 2003 as a result of the net interest settlements on the interest rate swaps. There was no ineffectiveness recorded in the consolidated statements of income during 2005, 2004 or 2003.
We held call options relating to our direct business with a fair value of $38.2 million at December 31, 2005 and $12.3 million at December 31, 2004. Our share of call options assumed under the coinsurance agreement, which is recorded as embedded derivatives in reinsurance recoverable, totaled $27.7 million at December 31, 2005 and $35.8 million at December 31, 2004. Derivative income (loss) includes ($2.3) million for 2005, $15.2 million for 2004 and $16.8 million for 2003 relating to call option proceeds and changes in fair value.
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, 2005 and $0.7 million at December 31, 2004, 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, 2005 and December 31, 2004. Derivative income (loss) from our modified coinsurance contracts totaled ($0.4) million in 2005, $0.1 million in 2004 and $0.4 million in 2003.
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. While we didn’t purchase any when issued securities in 2005, derivative income (loss) from when issued securities totaled less than $0.1 million in 2004 and ($0.6) million in 2003.
Fixed maturity securities: Fair values for fixed maturity securities are based on quoted market prices, where available. For fixed maturity securities not actively traded, fair values 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.
Mortgage loans on real estate: Fair values are estimated by discounting expected cash flows using interest rates currently being offered for similar loans.
Securities and indebtedness of related parties: For equity securities that are not actively traded, estimated fair values are based on values of comparable issues. As allowed by Statement No. 107, fair values are not assigned to investments accounted for using the equity method.
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 using one of two methods. For contracts with known maturities, fair value is determined using discounted cash flow analyses based on current interest rates being offered for similar contracts with maturities consistent with those remaining for the contracts being valued. For contracts without known maturities, fair value is 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.
In the normal course of business, we seek to limit our exposure to loss on any single insured and to recover a portion of benefits paid by ceding reinsurance to other insurance enterprises or reinsurers. Our reinsurance coverage for life insurance varies according to the age and risk classification of the insured with retention limits ranging up to $1.1 million of coverage per individual life. New sales of term life products are reinsured on a first dollar quota share basis. We do not use financial or surplus relief reinsurance. Life insurance in force ceded on a consolidated basis totaled $7,068.2 million (19.7% of direct life insurance in force) at December 31, 2005 and $6,419.4 million (18.9% of direct life insurance in force) at December 31, 2004.
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 $0.7 million. Pool losses are capped at $7.6 million per event and the maximum loss we could incur as a result of losses assumed from other pool members is $2.7 million per event.
In total, insurance premiums and product charges have been reduced by $30.4 million in 2005, $29.6 million in 2004 and $27.8 million in 2003 and insurance benefits have been reduced by $15.7 million in 2004, $14.7 million in 2004 and $15.4 million in 2003 as a result of cession agreements.
We assume certain annuity business issued prior to August 1, 2004 through the coinsurance agreement with American Equity. Effective August 1, 2004, we announced the suspension of this agreement and, 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. Premiums collected on this assumed business, not included in revenues in the consolidated statements of income, totaled $4.5 million in 2005, $202.1 million in 2004 and $649.5 million in 2003.
Life insurance in force assumed on a consolidated basis totaled $1,844.5 million (6.0% of total life insurance in force) at December 31, 2005, $1,843.5 million (6.3% of total life insurance in force) at December 31, 2004 and $1,977.1 million (7.0% of total life insurance in force) at December 31, 2003. In total, premiums and product charges assumed totaled $24.8 million in 2005, $23.0 million in 2004 and $18.1 million in 2003. Insurance benefits assumed totaled $10.7 million in 2005, $11.1 million in 2004 and $10.4 million in 2003.
Income tax expenses (credits) are included in the consolidated financial statements as follows:
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 million in December 2005. The Series C preferred stock was initially issued with conversion rights based upon certain contingencies not involving market price triggers. Both parties signed an agreement to waive these rights, so this instrument was not contingently convertible. The Series C preferred stock was issued at an $11.6 million discount to par. This discount accreted to interest expense (preferred stock dividends prior to 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 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, 2005 and 2004, 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. The Class B common stock votes as a separate class on all issues. The holders of the Class A common stock and Series B preferred stock vote for the election of Class A Directors (eight to ten) and only holders of the Class B common stock vote for the election of 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 65.0% of our voting stock as of December 31, 2005, maintaining control of the Company. Holders of Class A common stock and Class B common stock are entitled to share ratably on a share-for-share basis with respect to common stock dividends.
A charge totaling $12.6 million in 2005 and $14.1 million in 2004 for all employers would have been recorded to other comprehensive income due to changes in interest rates and the plan assets earning less than that assumed if the employers followed Statement No. 87, “Employers’ Accounting for Pensions,” as a single employer plan.
Net periodic pension cost recorded in our consolidated income statements totaled $7.8 million in 2005, $6.4 million in 2004 and $5.5 million in 2003. Components of net periodic pension cost for all employers are as follows:
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, to determine the amounts to amortize.
Weighted average assumptions used to determine net periodic pension cost are as follows:
Prior to 2005, all of the plans’ assets were invested in deposit administration fund contracts held by Farm Bureau Life. During 2005, we began executing our long-term strategy of diversifying the assets into equity securities with the long-term target allocation being approximately 60% deposit administration fund contracts and 40% equities. At December 31, 2005, the plan’s assets were invested 89% in deposit administration fund contracts held by Farm Bureau Life and 11% in diversified equity securities. 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 participate with several affiliates in a 401(k) defined contribution plan which covers substantially all employees. We contribute FBL Financial Group, Inc. stock in an amount equal to 100% of an employee’s contributions up to 2% of the annual salary contributed by the employee and an amount equal to 50% of an employee’s contributions between 2% and 4% of the annual salary contributed by the employee. Costs are allocated among the affiliates on a basis of time incurred by the respective employees for each company. Expense related to the plan totaled $0.9 million in 2005 and 2004 and $0.8 million in 2003.
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 retirees who have worked full-time for ten years and attained age 55 while in service. Postretirement benefit expense is allocated in a manner consistent with pension expense discussed above. Postretirement benefit expense aggregated $0.2 million in 2005, $0.1 million in 2004 and less than $0.1 million in 2003.
The weighted average fair value of options granted per common share was $8.86 for 2005, $8.50 for 2004 and $5.49 for 2003. The fair value of our stock options was estimated at the date of grant using the Black-Scholes-Merton option pricing model with the following weighted-average assumptions:
Information regarding stock options outstanding at December 31, 2005, is as follows:
Beginning in 2004, we also grant restricted Class A common shares to certain senior executives. The restricted stock vests by the Company meeting or exceeding operating goals, such as earnings per share and return on equity targets. Depending on performance, the actual amount of shares issued could range from zero to 100% of the granted amount. In 2005, we granted 48,511 restricted shares with a grant-date market value of $1.3 million. In 2004, we granted 38,966 restricted shares with a grant-date market value of $1.0 million. The related expense allocated to the Company totaled $0.3 million for 2005 and $0.1 million for 2004.
We share certain office facilities and services with the IFBF, Kansas Farm Bureau (through December 2005) and their affiliated companies. These expenses are allocated on the basis of cost and time studies that are updated annually and consist primarily of rent, salaries and related expenses, travel and other operating costs.
We lease office space under an annually renewable lease from Farm Bureau Mutual. Related lease expense totaled $0.8 million in 2005 and 2004 and $0.6 million in 2003. This lease was terminated in December 2005.
We have management agreements with Farm Bureau Mutual and other affiliates under which we provide general business, administrative and management services. We also had a management agreement with EMCNL that was terminated effective July 1, 2003. Fee income for these services totaled $2.6 million in 2005, $2.8 million in 2004 and $2.7 million in 2003. In addition, Farm Bureau Management Corporation, a wholly-owned subsidiary of the IFBF, provides certain management services to us under a separate arrangement. We incurred related expenses totaling $1.0 million in 2005, $0.8 million in 2004 and $0.6 million in 2003.
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, 2005, management is not aware of any claims for which a material loss is reasonably possible.
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. We have also not allocated undistributed net income to the unvested Class A restricted stock as those instruments possess certain characteristics, such as vesting, that differ from instruments defined as participating securities under current accounting guidance.
Options to purchase 2,600 shares of common stock in 2005 at $29.60 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.
charged to operations as incurred; (d) future policy benefit reserves for participating traditional life insurance products are based on net level premium methods and guaranteed cash value assumptions which may differ from statutory reserves; (e) future policy benefit reserves on certain interest sensitive products are based on full account values, rather than discounting methodologies utilizing statutory interest rates; (f) net realized gains or losses attributed to changes in the level of market interest rates are recognized as gains or losses in the statements of income when the sale is completed rather than deferred and amortized over the remaining life of the fixed maturity security or mortgage loan; (g) the established formula-determined statutory investment reserve, changes in which are charged directly to surplus, is not recorded as a liability; (h) certain deferred income tax assets, agents’ balances and certain other assets designated as “non-admitted assets” for statutory purposes are reported as assets rather than being charged to surplus; (i) revenues for interest sensitive and variable products consist of policy charges for the cost of insurance, policy administration charges, amortization of policy initiation fees and surrender charges assessed rather than premiums received; (j) pension income or expense is recognized for all employees in accordance with Statement No. 87, “Employers’ Accounting for Pensions” rather than for vested employees only; (k) the financial statements of subsidiaries are consolidated with those of the insurance subsidiary rather than being accounted for under the equity method; and (l) assets and liabilities are restated to fair values when a change in ownership occurs that is accounted for as a purchase, with provisions for goodwill and other intangible assets, rather than continuing to be presented at historical cost.
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 2006, the maximum amount legally available for distribution to FBL Financial Group, Inc. without further regulatory approval is $44.9 million for Farm Bureau Life and $21.6 million for EquiTrust Life. With respect to the amount available from Farm Bureau Life, $39.2 million is not available until December 2006 due to the timing and amount of dividend payments made during 2005.
The Independent Annuity segment consists of fixed rate annuities and supplementary contracts (some of which involve life contingencies) sold through our independent distribution or assumed through our coinsurance agreements with American Equity and EMCNL. The Independent Annuity segment also includes index annuities.
We use operating income, in addition to net income, to measure our performance since realized and unrealized gains and losses on investments and the change in net unrealized gains and losses on derivatives can fluctuate greatly from period to period. These fluctuations make it difficult to analyze core operating trends. In addition, for derivatives not designated as hedges, there is a mismatch between the valuation of the asset and liability when deriving net income. Specifically, call options relating to our index business are one or two-year assets while the embedded derivative in the index contracts represents the rights of the contract holder to receive index credits over the entire period the index annuities are expected to be in force. For our other embedded derivatives in the product segments, the embedded derivatives are marked to market, but the associated insurance liabilities are not marked to market. A view of our operating performance without the impact of these mismatches enhances the analysis of our results. We use operating income for goal setting, determining company-wide bonuses and evaluating performance on a basis comparable to that used by many in the investment community.
Amounts are net of adjustments, as applicable, to amortization of unearned revenue reserves, deferred policy acquisition costs, deferred sales inducements, value of insurance in force acquired and income taxes attributable to gains and losses on investments and derivatives.
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 for 2005 are
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 $6.8 million for 2005, $5.8 million for 2004 and $5.7 million for 2003 relating to leases with affiliates. In the consolidated statements of income, we record these depreciation amounts net of related lease income from affiliates.