The Company owns, and leases to the Insurance Company, it’s sole occupant, two adjacent office buildings located at 69 Lydecker Street and 10 North Broadway in Nyack, New York. These buildings contain an aggregate of approximately 45,000 square feet of useable floor space.
Selected consolidated financial data for the Company are presented below for each of the five years in the period ended December 31, 2003. This data should be read in conjunction with the Company's Consolidated Financial Statements and notes thereto and Item 7, Management's Discussion and Analysis of Results of Operations and Financial Condition.
In 2001 and 2002 the general economic recession caused a severe deterioration in many investment grade companies such as Owens Corning, MCI Worldcom, Pacific Gas and Electric, Southern California Edison, US Airways and Sunbeam. While some actually went bankrupt, many others lost their investment grade debt ratings with resulting market declines. The Company’s investment portfolio realized losses or required substantial write-downs with the result that net net losses were encountered in 2001 and 2002. In 2001, these losses were $65.1 million with an increase to a loss of $146.7 million in 2002. A corollary impact of these was that capital ratios were adversely affected in both years.
Earnings have been and may expected to be affected by the decline in interest rates, as described herein under “Market Risk”. This is shown above in the impact of the decline on the “net investment return on assets”.
The Company is engaged in the sale of insurance products with two primary lines of business: individual annuities and individual life insurance. Our revenues are derived primarily from premiums received from the sale of annuity contracts and universal life insurance policies, from premiums received for whole life and term life insurance products and gains (or losses) from our investment portfolio.
For financial statement purposes, our revenues from the sale of whole life and term life insurance products and annuity contracts with life contingencies are treated differently from our revenues from the sale of annuity contracts without life contingencies, deferred annuities and universal life insurance products. Premiums from the sale of whole or term life insurance products and life contingency annuities are reported as premium income on our financial statements. Premiums from the sale of deferred annuities, universal life insurance products and annuities without life contingencies are not reported as premium revenues, but rather are reported as additions to policyholders’ account balances. From these products, revenues are recognized over time in the form of policy fee income, surrender charges and mortality and other charges deducted from policyholders’ account balances.
Unless specifically stated otherwise, all references to 2003, 2002 and 2001 refer to our fiscal years ended, or the dates, as the contacts requires, December 31, 2003, December 31, 2002 and December 31, 2001, respectively.
When we use the term “We,” “Us” and “Our” we mean Presidential Life Corporation, a Delaware Corporation, and its consolidated subsidiaries.
Our earnings per share were $1.07 for 2003, as compared to losses of ($2.36) per share in 2002 and ($.26) per share in 2001. Our results in 2003 reflected a continuing of our year-to-year increase in investment income and a reversal in net realized investment losses from the prior years to a net realized gain in 2003. Our total revenues in 2003 were $344 Million, as compared to $205 million in 2002 and $284 million in 2001.
Market Conditions: We, like all companies, are affected by the general state of financial markets and economic conditions in the U.S. and elsewhere. Despite certain recent improvements in business conditions, the business environment in recent years has been difficult. In this difficult environment, our ability to obtain desired returns on investment portfolio without exposing the Company to excess risk has been very challenging. This, in turn, has had an impact on our willingness to expand the sale of our single premium deferred annuity and universal life products. Since we rely substantially on the availability of reinsurance for portions of our life insurance and accident and health insurance, any material change in the reinsurance market could also have an impact on our business.
Operational Risk: Our business is dependent on our ability to process on a daily basis our payment obligations under our outstanding policies and the condition of our investment portfolio. Any failures in our internal processes, people or systems could lead to adverse consequences to the Company. In addition, despite the contingency plans we have in place, our ability to conduct business may be adversely impacted by the disruption in the infrastructure that supports our business and the community in which we are located.
Persistency is the rate at which insurance policies remain in force, expressed as a percentage of the number of policies remaining in force over the previous year. Policyholders sometimes do not pay premiums, thus, causing their policies to lapse.
The assumed rate of return on invested cash and desired spreads during the period that insurance policies or annuity contracts are in force also affects pricing of products and currently includes an assumption by the Company of a specified rate of return and/or spread on its investments for each year that such insurance or annuity product is in force.
<F2> Net investment income is net of investment expenses and excludes capital gains and losses and provision for income taxes.
Another major factor affecting profitability is the level of expenses. Management believes that one of the Company's strengths is its concentration on minimizing expenses through periodic review and adjustment of general and administrative costs.
The Company derives a substantial portion of its total revenues from investment income. The Company manages most of its investments internally. All investments made on behalf of the Company are governed by the general requirements and guidelines established and approved by the Company's investment committee (the “Investment Committee”) and by qualitative and quantitative limits prescribed by applicable insurance laws and regulations. The Investment Committee meets regularly to set and review investment policy and to approve current investment plans. The actions of the Investment Committee are subject to review and approval by the Board of Directors of the Insurance Company. The Company's investment policy must comply with NYSID regulations and the regulations of other applicable regulatory bodies.
The Company's investment philosophy generally focuses on purchasing investment grade securities with the intention of holding such securities to maturity. The Company's investment philosophy is focused on the intermediate to longer-term horizon and is not oriented towards trading. However, as market opportunities, liquidity, or regulatory considerations may dictate, securities may be sold prior to maturity. The Company has categorized all fixed maturity securities as available for sale and carries such investments at market value.
The Company manages its investment portfolio to meet the diversification, yield and liquidity requirements of its insurance policy and annuity contract obligations. The Company's liquidity requirements are monitored regularly so that cash flow needs are sufficiently satisfied. Adjustments periodically are made to the Company's investment policies to reflect changes in the Company's short-and long-term cash needs, as well as changing business and economic conditions.
The Company seeks to manage its investment portfolio in part to reduce its exposure to interest rate fluctuations. In general, the market value of the Company's fixed maturity portfolio increases or decreases in an inverse relationship with fluctuations in interest rates, and the Company's net investment income increases or decreases in direct relationship with interest rate changes. For example, if interest rates decline, the Company's fixed maturity investments generally will increase in market value, while net investment income will decrease as fixed income investments mature or are sold and proceeds are reinvested at the declining rates, and vice versa. Management is aware that prevailing market interest rates frequently shift and, accordingly, the Company has adopted strategies that are designed to address either an increase or decrease in prevailing rates.
The primary market risk in the Company’s investment portfolio is interest rate risk and to a lesser degree, equity price risk. The Company's exposure to foreign exchange risk is not significant. The Company has no direct commodity risk. Changes in interest rates can potentially impact the Company’s profitability. In certain scenarios where interest rates are volatile, the Company could be exposed to disentermediation risk and reduction in net interest rate spread or profit margin.
Under the NAIC's risk-based capital formula, insurance companies must calculate and report information under a risk-based capital formula. The standards require the computation of a risk-based capital amount, which then is compared to a company's actual total adjusted capital. The computation involves applying factors to various financial data to address four primary risks: asset default, adverse insurance experience, disintermediation and external events. This information is intended to permit insurance regulators to identify and require remedial action for inadequately capitalized insurance companies, but is not designed to rank adequately capitalized companies. The NAIC formula provides for four levels of potential involvement by state regulators for inadequately capitalized insurance companies, ranging from a requirement for the Insurance Company to submit a plan to improve its capital (Company Action Level) to regulatory control of the insurance company (Mandatory Control Level). At December 31, 2003, the Insurance Company’s Company Action Level was $117.3 million and the Mandatory Control Level was $41.0 million. The Insurance Company’s adjusted capital at December 31, 2003 was $260.2 million which exceeds all four action levels.
During 2002, the Insurance Company's rating was lowered to “B+” (Very Good) from an “A-” (Excellent) by A.M. Best Company ("A.M. Best"). Publications of A.M. Best indicate that the “B+” rating is assigned to those companies that, in A.M. Best's opinion, have achieved a very good overall performance when compared to the norms of the insurance industry and that generally have demonstrated a good ability to meet their respective policyholder and other contractual obligations over a long period of time. In 2003, the “B+” rating was affirmed by A.M. Best.
For 2003, the impact of the downgrades did not have a material impact on the financial statements of the Company. The reduction in sales was primarily attributable to management’s intention to preserve and build the Insurance Company’s capital and surplus ratios. Surrenders of the Company’s annuity products continue to remain below 5% of the surrenderable annuities and have not had a material impact on the Company’s consolidated financial sttements.
Universal life and investment type policy fee income was approximately $1.0 million in fiscal 2003, as compared to approximately $.7 million in fiscal 2002 and approximately $.8 million in fiscal 2001. The increase in 2003 is attributed to an increased number of life policies surrendered during 2003 that were within the surrender charge period. Policy fee income consists principally of amounts assessed during the period against policyholders' account balances for mortality charges and surrender charges.
Net investment income totaled approximately $288.4 million in fiscal 2003, as compared to approximately $267.6 million in fiscal 2002 and approximately $234.1 million in fiscal 2001. This represents approximately a 7.8% increase comparing fiscal 2003 to fiscal 2002 and approximately 14.3% increase comparing fiscal 2002 to fiscal 2001. The full impact of the increase in sales for 2002 was reflected in the increase in fixed maturity income for 2003. Income from fixed maturities totaled $259.6 million in 2003 compared to $234.3 million in 2002 and $177.5 in 2001. Investment income from ”other invested assets” totaled approximately $30.2 million in fiscal 2003, $21.9 million in fiscal 2002 and $40.3 million in fiscal 2001. The Company's ratio of net investment income to average cash and invested assets less net investment income for the years ended December 31, 2003, 2002 and 2001 was approximately 7.11%, 7.56% and 8.19%, respectively. For additional information, please refer to “Note 2 of the Notes to Consolidated Financial Statements.”
The following table presents the amortized cost and gross unrealized losses for fixed maturities where the estimated fair value had declined and remained below amortized cost by less than 20%, or 20% or more for December 31, 2003:
Approximately 93% of the securities with an unrealized loss of 20% or more for a period equal to or greater than twelve months are Principal Protected Notes. This structure utilizes AAA collateral such as U.S Treasury Strips, in conjunction with a variable rate coupon. The AAA rated collateral accretes to par at maturity, defeasing the security and thereby insulating the holder from any negative credit events which might interfere with the repayment of principal.
Interest credited and benefits to policyholders amounted to approximately $258.1 million in fiscal 2003 as compared to approximately $276.8 million in fiscal 2002 and approximately $267.4 million in fiscal 2001. This represents a decrease of approximately 6.8% comparing fiscal 2003 to fiscal 2002 and approximately a 3.5% increase comparing fiscal 2002 to fiscal 2001. This decrease in 2003 and increase in 2002 was principally attributable to varying levels of policyholder account balances as a result of variations in annuity considerations received during the respective years.
The Insurance Company’s average credited rates for reserves and account balances for the 12 months ended December 31, 2003, 2002 and 2001 were less than the Company’s ratio of net investment income to mean assets for the same periods as noted above under “Net Investment Income.” Although management does not currently expect material declines in the spread between the Company’s average credited rate for reserves and account balances and the Company’s ratio of net investment income to mean assets (the “Spread”), there can be no assurance that the spread will not decline in future periods or that such decline will not have a material adverse effect on the Company’s financial condition and results of operations. Depending, in part, upon competitive factors affecting the industry in general, and the Company in particular, the Company may, from time to time, adjust the average credited rates on certain of its products. There can be no assurance that the Company will reduce such rates or that any such reductions will broaden the Spread.
For the reasons discussed above, income (loss) before income taxes amounted to approximately $49.5 million in fiscal 2003, as compared to approximately $(99.2) million in fiscal 2002 and approximately $(18.6) million in fiscal 2001.
Income tax expense was approximately $18.2 million for fiscal 2003, as compared to a benefit of approximately $(30.0) million in fiscal 2002 and a benefit of approximately $(10.9) million in fiscal 2001. The increase in income taxes in fiscal 2003 was primarily attributable to realized capital gains in fiscal 2003 as compared to realized capital losses during fiscal 2002. In 2003, the Company's strategy was to utilize a carryback of its net capital losses reported in the Company's consolidated tax return in 2002.
For the reasons discussed above, the Company had net income of approximately $31.3 million in fiscal 2003, net loss of approximately $(69.3) million in fiscal 2002 and net loss of approximately $(7.7) million in fiscal 2001.
Given the Insurance Company's historic cash flow and current financial results, management believes that, for the next twelve months and for the reasonably foreseeable future, the Insurance Company's cash flow from operating activities will provide sufficient liquidity for the operations of the Insurance Company.
The Company is an insurance holding company and its primary uses of cash are debt service obligations, operating expenses and dividend payments. The Company's principal sources of cash are dividends from the Insurance Company, sales of and interest on the Company's investments and rent from its real estate. During 2003, the Company's Board of Directors maintained the quarterly dividend rate of $.10 per share. During 2003 and 2002, the Company purchased and retired 0 and 0 shares of common stock, respectively. At December 31, 2003, the Company was authorized to purchase approximately 385,000 shares of common stock.
Market risk is the risk of loss arising from adverse changes in market rates and prices, such as interest rates, foreign currency exchange rates, and other relevant market rate or price changes. Market risk is directly influenced by the volatility and liquidity in the markets in which the related underlying assets are traded. The following is a discussion of the Company's primary market risk exposures and how those exposures are currently managed as of December 31, 2003.
We believe that our fixed-rate liabilities should be backed by a portfolio composed principally of fixed-rate investments that generate predictable rates of return. We do not have a specific target rate of return. Instead, our rates of return vary over time depending on the current interest rate environment, the slope of the yield curve, the spread at which fixed-rate investments are priced over the yield curve, and general economic conditions. Our portfolio strategy is designed to achieve adequate risk-adjusted returns consistent with our investment objectives of effective asset-liability matching, liquidity and safety.
In order to maintain consistency in our portfolio, our deferred annuity products incorporate surrender charges to discourage surrenders or withdrawals. An annuitant may not terminate or withdraw funds from their annuity contracts for a significant initial period (generally seven years) without incurring substantial penalties in the form of surrender charges. These surrender charges generally range from 1% to 7% of the investment. Approximately 25.1%, 24.9% and 30.5% of the Company's deferred annuity contracts in force (measured by reserves) as of December 31, 2003, 2002, and 2001 are surrenderable without charge. The decrease since December 31, 2001 is attributable to the increase in deferred annuity contracts inforce as a result of the increase in annuity considerations.
The market value of the Company's fixed maturity portfolio changes as interest rates change. In general, rate decreases cause asset prices to rise, while rate increases cause asset prices to fall.
Based on market values and prevailing interest rates as of December 31, 2003, a hypothetical instantaneous increase in interest rates of 100 basis points would produce a loss in fair value of our fixed maturity assets of approximately $202.4 million. Since the Company is able to hold its fixed maturity securities to maturity, however, we would not in reality expect to realize significant losses under such a hypothetical scenario.
The Company maintains a portfolio, which includes below investment grade securities, which were purchased to achieve a more favorable investment yield, all of which are classified as available for sale and reported at estimated market value. As of December 31, 2003 and 2002, the carrying value of these securities was approximately $328.8 million and $271.3 million, respectively (representing approximately 7.3% and 6.1%, respectively, of the Company's total assets).
All 50 states of the United States, the District of Columbia and Puerto Rico have insurance guaranty fund laws requiring all life insurance companies doing business within the jurisdictions to participate in guaranty associations, which are organized to pay contractual obligations under insurance policies (and certificates issued under group insurance policies) issued by impaired or insolvent life insurance companies. These associations levy assessments (up to prescribed limits) on all member insurers in a particular state on the basis of the proportionate share of the premiums written by member insurers in the lines of business in which the impaired or insolvent insurer is engaged. Some states permit member insurers to recover assessments paid through full or partial premium tax offsets. These assessments may be deferred or forgiven under most guaranty laws if they would threaten an insurer's solvency. The amount of these assessments in current and prior years has not been material, however, the amount and timing of any future assessment on the Insurance Company under these laws cannot be reasonably estimated and are beyond the control of the Company and the Insurance Company. Any failures of substantially larger insurance companies could result in future assessments in material amounts.
See “Item 1 - Business - Insurance Regulation” for a description of certain NAIC initiatives that also may impact the Company's financial condition and results of operations.
In a rising interest rate environment, the Company's average cost of funds would be expected to increase over time as it prices its new and renewing annuities to maintain a generally competitive market rate. In addition, the market value of the Company's fixed maturity portfolio decreases resulting in a decline in shareholders' equity. Concurrently, the Company would attempt to place new funds in investments that were matched in duration to, and higher yielding than, the liabilities associated with such annuities. Management believes that liquidity necessary in such an interest rate environment to fund withdrawals, including surrenders, would be available through income, cash flow, and the Company's cash reserves or from the sale of short-term investments.
Notwithstanding the foregoing, if interest rates continue at current levels or decline, there can be no assurance that this segment of the life insurance industry would not experience increased levels of surrenders and reduced sales and thereby be materially adversely affected. Conversely, if interest rates rise, competing investments (such as annuity or life insurance products offered by the Company’s competitors, certificates of deposit, mutual funds and similar investments) may become more attractive to potential purchasers of the Company’s products until the Company increases its credited rates.
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America (²GAAP²) requires management to adopt accounting policies and make estimates and assumptions that affect amounts reported in the consolidated financial statements. The critical accounting policies, estimates and related judgments underlying the Company¢s consolidated financial statements are summarized below. In applying these accounting policies, management makes subjective and complex judgments that frequently require estimates about matters that are inherently uncertain. Many of these policies, estimates and related judgments are common in the insurance and financial services industries; others are specific to the Company’s business operations.
<F3> Ratings are based primarily upon those assigned by the NAIC.
TheCompany incurs significant costs in connection with acquiring new business. These costs, which vary with and are primarily related to the production of newbusiness, are deferred.The recovery of such costs is dependent upon the future profitability of the related product, which in turn is dependent mainly on investment returns in excess of interest credited, as well as, persistency and expenses. These factors enter into management¢s estimate of future gross profits, which generally are used to amortize such costs. Changes in these estimates result in changes to the amounts expensed in the reporting period in which the revisions are made and could result in the impairment of the deferred acquisition asset and a charge to income if estimated future gross profits are less than amounts deferred.
The reserves reflected in the Company's consolidated financial statements are based upon the Company's best estimates of mortality, persistency, expenses and investment income, with appropriate provisions for adverse statistical deviation and the use of the net level premium method for all non-interest-sensitive products. For all interest-sensitive products the policy account value is equal to the accumulation of gross premiums plus interest credited less mortality and expense charges and withdrawals. In determining reserves for its insurance and annuity products, the
Company performs periodic studies to compare current experience for mortality, interest and lapse rates with expected experience in the reserve assumptions. Differences are reflected currently in earnings for each period. The Company historically has not experienced significant adverse deviations from its assumptions.