Kansas City Life Insurance Company (the Company) is a financial services company that is predominantly focused on sales and administration of life and annuity insurance products. The Company primarily consists of three life insurance companies. Kansas City Life Insurance Company (Kansas City Life) is the parent company. Sunset Life Insurance Company of America (Sunset Life) and Old American Insurance Company (Old American) are wholly-owned subsidiaries.
The Company earns revenues primarily from premiums received from the sale of life, annuity and accident and health policies, from earnings on its investment portfolio and from the sale of investment assets. Revenues from the sale of traditional life insurance and annuity products and supplemental contracts with life contingencies are reported as premium income for financial statement purposes. Considerations for supplemental contracts with life contingencies are reported as part of other revenues. However, deposits received from the sale of interest sensitive products, namely universal life insurance products, deferred annuities, and annuities and supplemental contracts without life contingencies are not reported as premium revenues, but are instead reported as additions to the policyholders’ account balances and are reflected as deposits in the Statements of Cash Flows. Accordingly, revenues on these products are recognized over time in the form of contract charges assessed against policyholder account balances, charges assessed on the early surrender of policyholder account balances and other charges deducted from policyholders’ balances.
The ability to maximize investment returns and minimize risks such as interest rate risk, credit risk and equity risk;
Strong sales competition, highly competitive products and a very challenging economic environment present significant challenges to the Company from a new sales perspective. The Company’s primary emphasis is on expanding sales of individual life products. The Company’s continued focus is on delivering competitive products for a reasonable cost, superior customer service, excellent financial strength and superior sales and marketing support to the field force.
The Company generates cash largely through premiums and deposits collected through the sale of insurance products, through the sale of universal life-type and deposit-type products and through investment activity. The principal uses of cash are for the insurance operations, including the purchase of investments, payment of insurance benefits and other withdrawals from policyholder accounts, operating expenses, premium taxes, and costs related to acquiring new business. In addition, cash is used to pay income taxes and stockholder dividends as well as to fund potential acquisition opportunities.
The Company’s principal investments are in fixed maturity securities, mortgage loans and real estate; all of which are exposed to three primary sources of investment risk: credit, interest rate and liquidity. Over the past year, the Company and its policyholders have been exposed to higher degrees of credit risk, interest rate risk and liquidity risk, as evidenced by the general and overall decline in the financial markets. The highly publicized failures of many investment brokerage firms, banks and other companies across a broad spectrum of industries not experienced in many decades is evidence of the effects of this general change in the economic environment.
Interest rate risk arises from the price sensitivity of investments to changes in interest rates. Coupon and dividend income represent the greatest portion of an investment’s total return for most fixed income instruments in stable interest rate environments. The changes in the fair market price of such investments are inversely related to changes in market interest rates. As interest rates fall, the coupon and dividend streams of existing fixed rate investments become more valuable and market values rise. As interest rates rise, the opposite effect occurs.
In addition, the Company is exposed to liquidity risk. Liquidity risk refers to the risk that investments cannot be converted into cash when needed or that the terms for conversion have a negative effect on the Company. This risk has increased in the recent economic downturn.
The length of time the fair value has been below cost;
The risk that the economic outlook will be worse or longer than expected or have more of an impact on the issuer than anticipated;
The risk that new information obtained by the Company or changes in other facts and circumstances may lead the Company to change its intent to hold the security to maturity or until it recovers in value;
The risk that inaccurate or misleading information could be provided to the Company’s investment professionals who determine the fair value estimates.
Deferred income taxes are recorded on the differences between the tax bases of assets and liabilities and the amounts at which they are reported in the consolidated financial statements. Recorded amounts are adjusted to reflect changes in income tax rates and other tax law provisions as they become enacted. Deferred income tax assets are subject to ongoing evaluation of whether such assets will be realized. The ultimate realization of deferred income tax assets generally depends on the reversal of deferred tax liabilities and the generation of future taxable income and realized gains during the periods in which temporary differences become deductible. A valuation allowance against deferred income tax assets may be required if future taxable income of the correct character is not expected.
The Company adopted the provisions of FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes”, on January 1, 2007. The Company did not change the liability for unrecognized tax benefits as of January 1, 2007 as a result of implementation of Interpretation No. 48. The total amount of unrecognized tax benefits, if recognized, that would reduce the effective tax rate were $0.7 million and $0.8 million as of December 31, 2008 and 2007, respectively.
Consolidated total premiums increased $5.3 million or 3% in 2008 versus 2007 as total new premiums increased $6.5 million or 20% and total renewal premiums decreased $1.2 million or 1%. The largest contributor to the increase in new premiums was a $4.5 million or 55% increase in immediate annuity premiums. This increase largely reflects changes in consumer preferences. New group life insurance premiums increased $0.6 million or 37% and new group accident and health premiums increased $0.9 million or 9%, reflecting an increase in dental premiums. The improvements in both new group life and new group accident and health premiums reflect an increase in the number of sales representatives and the realignment of sales territories. In addition, enhanced product features within the dental product line contributed to the increase in new group accident and health premiums. The Company exited the stop loss market during 2006 but continued to process existing business until the stop loss contracts expired in 2007. Excluding this product line from 2007, the result would be a 4% increase in total premiums, a 26% increase in total new premiums and a 27% increase in new group accident and health premiums in 2008. New individual life premiums increased $0.6 million or 5%, which includes an 11% increase in new premiums in the Old American segment. The increase in new premiums at the Old American segment reflects a combination of enhancements to products, compensation and distribution expansion. The slight decline in total renewal premiums was largely the result of a 1% decline in total individual life renewal premiums.
Consolidated total premiums were relatively flat in 2007 compared with 2006 as total new premiums increased $0.3 million or 1% and total renewal premiums decreased $0.8 million or 1%. In 2007, a $1.0 million or 13% increase in new immediate annuity premiums and a $0.5 million or 49% increase in new group life insurance premiums was mostly offset by a $1.3 million or 11% decrease in new group accident and health insurance premiums. The termination of the stop loss product line resulted in a $1.5 million reduction in new group accident and health premiums in 2007. Excluding the premiums for this product line from 2007 and 2006, the result would be a 1% increase in total premiums, a 6% increase in total new premiums and a 3% increase in new group accident and health premiums.
Insurance revenues consist of premiums from traditional insurance products and contract charges on interest sensitive products less reinsurance ceded. Insurance revenues increased $4.3 million or 2% to $236.2 million in 2008, compared to a $3.4 million or 1% decrease in 2007. The increase in 2008 was largely due to a $5.3 million or 3% increase in premiums and a $1.4 million or 2% decrease in reinsurance ceded. These were partially offset by a $2.4 million or 2% decrease in contract charges. Total annuity premiums increased $4.5 million or 55% and accident and health premiums increased $0.8 million or 2% in 2008 compared to a year earlier. The decline in 2007 was primarily the result of a $3.1 million decrease in contract charges. A $1.0 million increase in immediate annuity premiums in 2007 was offset by a $0.9 million decrease in individual life premiums and a $0.6 million decrease in accident and health premiums.
Investments in mortgage loans decreased $4.8 million in 2008 and investment income from mortgage loans decreased $1.6 million or 5% for the year. The declines in 2008 were due to reduced mortgage loan balances as a result of fewer new mortgage loans, lower rates earned on new loans and lower fee income earned. Investments in mortgage loans decreased $21.9 million during 2007, primarily due to scheduled amortization. The sale of Generations Bank resulted in a decrease in mortgage loans of $18.3 million in 2007. Consequently, investment income from mortgage loans decreased $0.5 million or 2% for the year.
Real estate investments were $99.6 million at December 31, 2008 and $96.0 million at December 31, 2007. Real estate investments consist principally of office buildings and industrial warehouses that are both in use and under development, and investments in multi-family and single-family residential properties, including affordable housing. The Company also invests in unimproved land for future development. Properties have been acquired through individual purchases, build-to-suit and speculative development. The Company generally maintains its ownership interest in these properties on a direct and joint venture basis with the long-term intention of earning positive cash flow and income by leasing the properties, along with the expectation of realizing capital appreciation upon sale. The Company periodically sells certain real estate assets when management believes that the market and timing are perceived to be advantageous. Investment income on real estate decreased 4% in 2008. While higher rental income resulted from an increase in occupancy in certain real estate properties, investment income on real estate joint ventures declined. Real estate investments decreased $13.5 million in 2007 compared with 2006 due to property sales during the year. Accordingly, investment income on real estate decreased 21% in 2007. Real estate investments comprised 3% of the investment portfolio at both December 31, 2008 and 2007.
The Company offers policy loans as a benefit to its policyholders, and loans are secured by the cash value of the policy. Investment income from policy loans was flat in 2008 and declined by $0.5 million or 7% in 2007. In 2008, the decline in the balance of policy loans was offset by an increase in yields. The decline in 2007 was directly related to reduced balances of loans outstanding.
Investment expenses decreased $0.7 million or 6% in 2008 compared to 2007. This decrease was primarily due to a decrease in real estate investment expenses and interest expense. The largest factor contributing to the decrease was reduced tenant improvement costs on buildings held for investments. The Company maintains access to liquidity thorough borrowing from the Federal Home Loan Bank. The Company periodically borrows and subsequently reinvests these proceeds in higher-yielding investments. The Company had increased its borrowings at year-end 2007 and subsequently reduced these borrowings in 2008. Investment expenses increased $0.6 million or 5% in 2007 versus 2006. This increase largely resulted from reduced real estate accruals in the prior year.
The Company realized investment gains and losses from several sources, including write-downs of investment securities, sales of investment securities and real estate. Many securities purchased by the Company contain call provisions, which allow the issuer to redeem the securities at a particular price. Depending upon the terms of the call provision and price at which the security was purchased, a gain or loss may be realized.
The Company reviews and analyzes its securities on an ongoing basis to determine whether impairments exist that are other-than-temporary. Based upon these analyses, specific security values are written down to fair value through earnings as a realized investment loss if the security is considered to be other-than-temporarily impaired.
Following is a description of the securities that were written down during the fourth quarter of 2008. 1) Two of the securities were preferred stocks of government-sponsored agencies that were written down by a total of $0.4 million. These entities buy and hold mortgages and issue and sell guaranteed mortgage-backed securities to facilitate housing ownership. They are now operated in conservatorship by the U.S. government and their existing common and preferred stock securities are severely diluted. Dividend payments have been suspended, driving the fair value of these securities down. 2) Two securities were written down by $3.1 million, primarily as a result of declines in price and rating agency downgrades on debt issues from issuers that completed leveraged buyout transactions during 2008. One of these securities was subsequently sold during the fourth quarter of 2008. 3) Three securities were collateralized debt obligations (CDOs) that were written down by a total of $5.3 million. These securities have been impacted by the rapid rise in delinquencies and foreclosures in the sub-prime and Alt-A mortgage markets, along with a decline in the fair value of securities issued by financial institutions. Ongoing CDO liquidations and investor selling have caused extreme declines in market valuations, regardless of individual security performance. 4) Two securities were written down by $1.9 million due to a decline in price that had persisted for a period longer than the Company considered temporary. One of these securities was subsequently sold during the fourth quarter of 2008. 5) One security is an originator of residential prime, Alt-A and subprime mortgages that was written down $4.2 million. The significant decline in the subprime and non-conforming mortgage markets resulted in a reduction in value for this security. 6) One security is from an issuer that designs, manufactures and services cars and trucks and provides vehicle-related financing, leasing and insurance was written down $1.2 million, largely resulting from the decline in the U.S. automotive industry. 7) One security that is a financial services company involved in automotive and real estate financing and mortgage lending was written down by $0.6 million and subsequently sold during the fourth quarter of 2008. 8) Four securities (two issuers) were perpetual preferred securities that were written down $3.3 million. These securities have been negatively impacted by the housing and mortgage credit crisis and have received TARP (Troubled Assets Relief Program) funds.
Following is a description of the securities that were written down during the third quarter of 2008. 1) Two of the securities were preferred stocks of government-sponsored agencies that were written down by a total of $6.5 million. These entities buy and hold mortgages and issue and sell guaranteed mortgage-backed securities to facilitate housing ownership. They are now operated in conservatorship by the U.S. government and their existing common and preferred stock securities are severely diluted. Dividend payments have been suspended, driving the fair value of these securities down. 2) Two securities from the same issuer were from an investment banking firm that filed for bankruptcy during the third quarter of 2008 and was written down by a total of $9.2 million. This firm was part of the financial industry that was hit hard by the mortgage credit crisis. After a severe decline in equity valuations, the inability to obtain short-term funding and the failure to find an acquirer forced this firm to file for Chapter 11 bankruptcy. 3) Two securities were collateralized debt obligations (CDOs) that were written down by a total of $5.1 million. These securities had been impacted by the rapid rise in delinquencies and foreclosures in the sub-prime and Alt-A mortgage markets, along with a decline in the fair value of securities issued by financial institutions. Ongoing CDO liquidations and investor selling had caused extreme declines in market valuations, regardless of individual security performance. 4) Two securities, one issuer a parent organization of the other, are financial guarantee insurance companies that provide credit enhancement for bond issuers as well as investment management services and were written down by a total of $4.9 million. These issuers had also experienced declines in value related to the mortgage credit crisis and had recently been downgraded to a negative outlook. 5) One security was from the auto industry and is a supplier of auto parts for light trucks and sport-utility vehicles. The deteriorating truck and sport-utility vehicle markets of the auto industry combined with the sharp decline in value and recent ratings declines resulted in a $2.1 million write-down. 6) One security was written down $1.1 million as continued price deterioration occurred on this security that was previously written down. This issuer is primarily in the radio and advertising business. 7) One security provides custom-tailored financing to private and corporate owners of real estate nationwide. This security had a recent rating decline to below investment grade status combined with continued price deterioration and was written down $2.8 million. 8) One security was a bank holding company that recently filed for bankruptcy. This holding company was the parent of a large nationwide bank that was recently taken over by the Office of Thrift Supervision who appointed the Federal Deposit Insurance Corporation (FDIC) as its receiver. As a result of the bankruptcy filing, this security was written down $0.8 million.
Following is a description of the securities that were written down during the second quarter of 2008: 1) Three of the securities were written down by a total of $3.3 million, primarily as a result of declines in price and rating agency downgrades on debt issues from issuers that had recently completed leveraged buyout (LBO) transactions. These LBO transactions greatly increased the debt level of each issuer. One of these securities had been written down previously. 2) Two securities were collateralized debt obligations (CDOs) and were written down by $2.8 million, primarily due to price declines that had persisted for periods longer than the Company considered temporary. 3) One security was written down by $3.3 million due to combination of a decline in price that had persisted for a period longer than the Company considered temporary, rating agency downgrades and a debt restructuring during the quarter. 4) The final security was written down $0.8 million due to a combination of a decline in price that had persisted for a period longer than the Company considered temporary and a further deterioration in fair value during the second quarter of 2008.
The Company had no securities that it identified as other-than-temporary impaired in the first quarter of 2008.
The Company’s ability to manage these risks is essential to the success of the organization. In particular, the Company devotes considerable resources to the credit analysis of each new investment and the ongoing credit positions. The majority of the Company’s investments are exposed to varying degrees of credit risk. Credit risk is the risk that the value of the investment may decline due to deterioration in the financial strength of the issuer and that the timely or ultimate payment of principal or interest might not occur. A default by an issuer usually involves some loss of principal to the investor. Losses can be mitigated by timely sales of affected securities or by active involvement in a restructuring process. However, there can be no assurance that the efforts of an investor will lead to favorable outcomes in a bankruptcy or restructuring. Credit risk is managed primarily through industry, issuer, structure and asset diversification. In addition, the Company’s Investment Committee is appointed by the Board of Directors and is responsible for establishing investment policies and approving or authorizing all investments.
The following table provides information regarding fixed maturity securities by sector as of December 31, 2008.
The following table provides information regarding fixed maturity securities by sector as of December 31, 2007.
As of December 31, 2008 and December 31, 2007, 96% and 94%, respectively, of all fixed maturity securities were investment grade, reflecting the high quality of securities maintained. Significant changes in the mix of investment grade securities for the comparative year-end dates include a decline of 2% in AAA-rated securities and a 4% increase in A-rated securities.
This process also involves monitoring several factors including late payments, downgrades by rating agencies, asset quality, key financial ratios, financial statements, revenue forecasts and cash flow projections, as indicators of credit issues.
All securities are reviewed to determine whether impairments should be recorded. This process includes an assessment of the credit quality of each investment in the entire securities portfolio. Additional reporting and review procedures are conducted for those securities where fair value is less than 90% of amortized cost. Further, detailed analysis is performed for each issue or issues having experienced a formal restructuring or where the security has experienced material deterioration in fair value or where the fair value is less than 80% of amortized cost.
The Company considers relevant facts and circumstances in evaluating whether the impairment of a security is other-than-temporary. Relevant facts and circumstances considered include but are not limited to: (1) the current fair value of the security as compared to cost; (2) the extent and the length of time the fair value has been below cost; (3) the financial position of the issuer, including the current and future impact of any specific events, material declines in the issuer’s revenues, margins, cash positions, liquidity issues, debt levels and income results; (4) significant management or organizational changes; (5) significant uncertainty regarding the issuer’s industry; (6) violation of financial covenants; (7) consideration of information or evidence that supports timely recovery; and (8) other business factors related to the issuer’s industry.
Risk that the Company’s assessment of an issuer’s ability to meet all of its contractual obligations will change based on changes in the credit characteristics of that issuer;
While the Company has both the ability and intent to hold its investments to maturity, the Company may also selectively determine, as part of its individual investment assessment process in relation to specific investments, that it no longer intends to hold a specific issue to its maturity. If the Company makes this determination, an analysis of the fair value of the investment is performed and the investment is written down to the fair value and an other-than-temporary impairment is recorded on this particular position. Subsequently, the Company seeks to obtain the best possible outcome available for this specific issue and records an investment gain or loss at the disposal date.
The following table provides information regarding investment securities with unrealized losses on fixed maturity and equity security investments available for sale, as of December 31, 2007.
At December 31, 2008, $103.7 million or 45% of the gross unrealized losses on fixed maturity and equity security investments was attributable to securities having gross unrealized losses of less than 12 months. This compares to $14.6 million or 31% at December 31, 2007. The corporate obligations category of securities accounted for most of the increase for the two comparative year-end dates. Corporate obligations also represented the largest category of securities with unrealized losses of twelve months or longer.
65 security issues representing 13% of the issues with unrealized losses, including 88% being rated as investment grade, were below cost for one year or more and less than three years; and,
Total unrealized losses on fixed maturity securities at December 31, 2008 were $230.1 million. The Company segments these unrealized losses into three primary categories. The first category includes unrealized losses of 10% or less of amortized cost, which totaled $43.8 million or 19% of the total unrealized losses on fixed maturity securities. The second category reflects unrealized losses of 20% or less and greater than 10%. This category totaled $58.5 million or 25% of the total unrealized losses. The third category includes unrealized losses greater than 20%. This category totaled $127.8 million or 56% of the total.
In addition, securities having unrealized losses greater than 20% are further evaluated based upon the length of time that they have been above the 20% unrealized loss threshold. Securities in this classification are divided into three different categories, including less than six months, six months or more and less than twelve months, and twelve months or greater. The Company had investment grade securities with unrealized losses of greater than 20% that totaled $90.9 million for less than six months at December 31, 2008. This represented 71% of total unrealized losses greater than 20%. Investment grade securities with unrealized losses for six months or more and less than twelve-months totaled $17.1 million. The Company also had below investment grade securities with unrealized losses of greater than 20% that totaled $17.3 million for less than six months and $2.4 million for six months or more and less than twelve-month periods. The Company had no securities with unrealized losses of greater than 20% for twelve months or greater at December 31, 2008.
Total unrealized losses on fixed maturity securities at December 31, 2007 were $45.2 million. Unrealized losses of 10% or less of amortized cost totaled $30.5 million or 67% of the total unrealized losses on fixed maturity securities. Unrealized losses of 20% or less and greater than 10% totaled $9.3 million or 21% of the total unrealized losses. Unrealized losses greater than 20% totaled $5.4 million or 12% of the total. Investment grade securities with unrealized losses greater than 20% had $2.3 million in unrealized losses, while securities rated below investment grade had $3.0 million in unrealized losses at December 31, 2007. The Company had no investment grade or below investment grade securities with unrealized losses of greater than 20% for six months or more and less than twelve months or twelve months or greater.
The following table provides information on fixed maturity securities with gross unrealized losses by rating as of December 31, 2008.
Other revenues consist primarily of supplemental contract considerations, policyholder dividends left with the Company to accumulate and income received from the sale of state low income housing tax credits (“LIHTC credits”). Other revenues increased $1.5 million or 13% in 2008 compared to 2007. This increase was largely due to additional sales of LIHTC credits. Other revenues increased $0.2 million or 1% in 2007 compared to 2006, also primarily a result of increased sales of LIHTC investments.
Policyholder benefits for the group accident and health product line increased $3.0 million or 13% in 2008 and $0.9 million or 4% in 2007. These increases were largely the result of increases in group dental benefits, which increased $3.5 million or 17% and $0.5 million or 2% in 2008 and 2007, respectively.
VOBA is amortized in concert with each purchased block of business. The amortization of VOBA was $7.1 million in 2008, $9.2 million in 2007 and $7.4 million in 2006. Generally, as policies run off, the amortization will decline over time. In addition, VOBA is evaluated each period for unlocking adjustments. The unlocking adjustment totaled $0.2 million in 2008 and was related to a change in the policy surrender assumptions. The unlocking adjustment totaled $1.1 million in 2007 and was primarily related to a reduction in the mortality assumptions.
Premiums are reported on a gross basis, with separate reporting for premiums ceded under reinsurance agreements. Policyholder benefits and expenses are reported net of reinsurance ceded and equaled $68.1 million, $61.1 million, and $57.2 million for the years ended December 31, 2008, 2007, and 2006, respectively.
Future policy benefits and other related assets and liabilities are not reduced for reinsurance in the balance sheet. A reinsurance receivable is established for such balance sheet items. Reinsurance related to policy and claim reserves ceded of $154.1 million and $149.5 million were included in the reinsurance receivables as of December 31, 2008 and 2007, respectively. Ceded benefits recoverable from reinsurers were $14.4 million and $12.8 million as of December 31, 2008 and 2007, respectively.
The Company’s overall reinsurance strategy has not changed during the periods addressed in this report. However, the Company has implemented changes to its reinsurance on certain new products by reducing the amount of coverage that is reinsured. These changes have been made primarily due to the increased cost of reinsurance currently available in the market.
The Company recorded an income tax benefit of $9.2 million or 35% of income before tax in 2008, compared to an income tax expense of $17.3 million or 33% of income before tax in 2007. The decrease in tax expense in 2008 versus 2007 was due to lower income before tax and a decrease in the provision to tax return adjustments, offset by a decrease in low income housing tax credits earned. In 2006, the Company recorded an income tax expense of $13.7 million or 27% of income before tax. The increase in the tax expense in 2007 versus 2006 was primarily the result of higher income before tax, a decrease in low income housing tax credits earned, and the provision to tax return adjustments. Income taxes will fluctuate depending upon items such as net income, realized investment gains and losses, and affordable housing tax credits.
The income tax rate in 2007 and 2006 was reduced by tax credits generated from the Company’s investments in affordable housing. The effect of the affordable housing credits on the effective tax rate was a tax benefit of $2.0 million or 4% in 2007 and $2.9 million or 6% in 2006. The Company’s investments in affordable housing did not create a tax benefit in 2008.
The Company establishes contingent tax assets or liabilities, when appropriate, to provide for potential challenges by taxing jurisdictions. In 2008, the Company’s income tax expense was increased $0.1 million, due to a net increase in contingent tax liabilities relating to the 2005 through 2008 tax years. In 2007 and 2006, the Company’s income tax expense was reduced $0.1 million and $0.7 million, respectively, due to a net decrease in contingent tax liabilities.
Total premiums for this segment increased $4.7 million or 9% in 2008 compared to a $1.6 million or 3% increase in 2007. Total new premiums increased $4.3 million or 31% in 2008 versus 2007, reflecting a $4.5 million or 55% increase in new immediate annuity premiums. The increase in annuity premiums primarily reflects changes in consumer preferences. Total renewal premiums increased $0.4 million or 1% compared to one year ago, reflecting a $0.6 million or 2% increase in individual life insurance premiums. Total new premiums increased $0.8 million or 6% in 2007 versus 2006. This increase was largely due to a $1.0 million or 13% increase in immediate annuity premiums. Renewal premiums increased $0.8 million or 2% in 2007, due to a $1.0 million or 3% increase in individual life insurance premiums.
The Company’s analysis of securities for the quarter ended December 31, 2008 resulted in the determination that 16 securities (14 issuers) had other-than-temporary impairments affecting the Individual Insurance segment. These securities were written down by a combined $19.5 million and the fair value of the investments after the write-downs was $11.2 million.
Following is a description of the securities that were written down during the fourth quarter of 2008. 1) Two of the securities were preferred stocks of government-sponsored agencies that were written down by a total of $0.4 million. These entities buy and hold mortgages and issue and sell guaranteed mortgage-backed securities to facilitate housing ownership. They are now operated in conservatorship by the U.S. government and their existing common and preferred stock securities are severely diluted. Dividend payments have been suspended, driving the fair value of these securities down. 2) Two securities were written down by $2.8 million, primarily as a result of declines in price and rating agency downgrades on debt issues from issuers that completed leveraged buyout transactions during 2008. One of these securities was subsequently sold during the fourth quarter of 2008. 3) Three securities were collateralized debt obligations (CDOs) that were written down by a total of $5.1 million. These securities have been impacted by the rapid rise in delinquencies and foreclosures in the sub-prime and Alt-A mortgage markets, along with a decline in the fair value of securities issued by financial institutions. Ongoing CDO liquidations and investor selling have caused extreme declines in market valuations, regardless of individual security performance. 4) Two securities were written down by $1.9 million due to a decline in price that had persisted for a period longer than the Company considered temporary. One of these securities was subsequently sold during the fourth quarter of 2008. 5) One security is an originator of residential prime, Alt-A and subprime mortgages that was written down $4.2 million. The significant decline in the subprime and non-conforming mortgage markets resulted in a reduction in value for this security. 6) One security is from an issuer that designs, manufactures and services cars and trucks and provides vehicle-related financing, leasing and insurance was written down $1.2 million, largely resulting from the decline in the U.S. automotive industry. 7) One security that is a financial services company involved in automotive and real estate financing and mortgage lending was written down by $0.6 million and subsequently sold during the fourth quarter of 2008. 8) Four securities (two issuers) were perpetual preferred securities that were written down $3.3 million. These securities have been negatively impacted by the housing and mortgage credit crisis and have received TARP (Troubled Assets Relief Program) funds.
The Company’s analysis of securities for the quarter ended June 30, 2008 resulted in the determination that seven fixed-maturity securities had other-than-temporary impairments affecting the Individual Insurance segment. These securities were written down by a combined $9.7 million in the second quarter. The total fair value of the affected securities after the write-downs was $15.2 million.
The Company offers several insurance products in the Group Insurance segment: dental, group life, and short and long-term disability. The Group Insurance segment markets its group products primarily to small and mid-size organizations. Products are sold through group representatives targeting a nationwide network of independent general agents and group brokers, along with the Company’s career general agents. This sales network is this segment’s core distribution system. Additionally, the Company enters into selective third-party marketing arrangements to market group products. This segment generated 21% of the Company’s consolidated insurance revenues in 2008, an increase from 20% in 2007.
The group market is highly competitive. Accordingly, group policies are periodically reviewed to ensure they conform to target claims, expenses and profit objectives. Group products are generally contracted for on a yearly renewal basis. Renewal terms that meet target pricing objectives are communicated to the group policyholder for renewal consideration.
This segment exited the stop loss market, but continued to process existing business until the stop loss contracts expired in 2007. The stop loss product line was being offered through an independent managing general underwriter, which also provided third-party administration. During the fourth quarter of 2006, the independent managing general underwriter was acquired by another organization, which then terminated the agreement. The Company has continued to focus on its core products and services, but may re-enter the stop loss market at a later date.
Total group premiums increased $2.1 million or 4% in 2008 and were flat in 2007. Excluding the terminated stop loss product line, total group premiums increased 7% in 2008 and 3% in 2007. New premiums increased 13% in 2008 over 2007, following a 6% decrease in 2007. The growth in premiums in 2008 was the result of a $2.2 million or 32% increase in new group dental premiums and a $0.6 million or 37% increase in new group life premiums. These improvements reflect the expansion of the group distribution system begun in 2007. Excluding the terminated stop loss block, new premiums increased 29% compared to one year ago. In 2007, new group life premiums increased 49%, while total new group accident and health premiums declined 11%. However, excluding the terminated stop loss block, new group accident and health premiums increased 3% compared with 2006. This increase reflected a 4% increase in dental premiums.
Improvement efforts for this segment continue to be focused in three primary areas. First, emphasis is being placed on the growth of the in-force business. Increased productivity from existing group representatives and the continued expansion of the group distribution system are priorities for growth. Sales improvements in 2008 reflect the success of this emphasis. This segment is also seeking additional third-party arrangements to advance its sales objectives. Second, improvement in administrative efficiency is targeted through the increased use of technology, which should ultimately reduce expenses. Finally, this segment added a new voluntary disability product to the portfolio in 2008 and will introduce a new voluntary life product in 2009. Voluntary products are sponsored by employers, but are elected by the employee and are entirely paid for by the employee. This coverage is portable as the employees can continue this coverage if they change employers. Voluntary products tend to be more profitable and are expected to become a larger share of the group marketplace.
The Company’s analysis of securities for the quarter ended December 31, 2008 resulted in the determination that two securities had other-than-temporary impairments affecting the Old American segment. These securities were written down by a combined $0.5 million in the fourth quarter. Following is a description of the securities that were written down during the fourth quarter of 2008. 1) One security was written down by $0.3 million, primarily as a result of a decline in price on a debt security from an issuer that completed a leveraged buyout (LBO) transaction during 2008. This security had been also been written down during the second quarter of 2008. 2) a collateralized debt obligation (CDO) security was written down by $0.2 million, primarily due to a price decline that had persisted for a period longer than the Company considered temporary and the deteriorating performance of the collateral. This security had also been written down during the second quarter of 2008.
The Company’s analysis of securities for the quarter ended September 30, 2008 resulted in the determination that an investment in two issuers of fixed-maturity securities had other-than-temporary impairment affecting this segment. These investments were written down by $1.5 million in the third quarter. The fair value of the investments after the write-downs was $1.5 million.
Following is a description of the securities that were written down during the third quarter of 2008. 1) Two securities, one issuer a parent organization of the other, were financial guarantee insurance companies that provide credit enhancement for bond issuers as well as investment management services and were written down by a total of $1.0 million. These issuers have also experienced declines in value related to the mortgage credit crisis and had recently been downgraded to a negative outlook. 2) One security provides custom-tailored financing to private and corporate owners of real estate nationwide. This security had a recent rating decline to below investment grade status combined with continued price deterioration and was written down $0.5 million.
The Company’s analysis of securities for the quarter ended June 30, 2008 resulted in the determination that three fixed-maturity securities had other-than-temporary impairments affecting this segment. These securities were written down by a combined $0.5 million in the second quarter. The total fair value of the affected securities after the write-downs was $1.6 million.
Following is a description of the securities that were written down during the second quarter of 2008: 1) One security was written down by $0.2 million, primarily as a result of a decline in price on a debt security from an issuer that recently completed a leveraged buyout (LBO) transaction. This security had been written down previously. 2) A collateralized debt obligation (CDO) security was written down by $0.2 million, primarily due to a price decline that had persisted for a period longer than the Company considered temporary. The security was below cost by 20% or more for at least six consecutive months. 3) The final security was written down by $0.1 million due to a combination of a decline in price that had persisted for a period longer than the Company considered temporary and a further deterioration in fair value during the second quarter of 2008.
The Company’s analysis of fixed maturity securities for this segment at year-end 2007 resulted in the determination that one security had an other-than-temporary decline which was written down by $0.4 million. This security was below cost by 20% or more for more than six consecutive months and was the subject of a recent leveraged buyout. The transaction was finalized during the fourth quarter of 2007, which greatly increased the debt level of the company. No securities were identified as other-than-temporarily impaired for this segment in the first, second and third quarters of 2007,or for the year ended December 31, 2006.
Amortization of deferred acquisition costs and value of business acquired increased $0.4 million or 3% in 2008, following a $1.0 million or 9% increase in 2007 compared to 2006. Beginning in mid 2007, Old American increased the commissions paid on the sale of certain new individual life policies. This change increased capitalization and the DAC asset, but this also results in a higher amount of amortization. The increase in 2007 was largely due to a reduction in amortization of DAC by $1.2 million in 2006. This adjustment, which was a correction of an understatement of the capitalization of DAC in prior periods, was not material to 2006 or any prior period financial statements.
Operating expenses include commissions and production allowances, net of the capitalization of certain commission and production allowances, and expenses from operations. Operating expenses decreased 6% in 2008, primarily due to decreases in salaries, lead production expenses and taxes. Operating expenses decreased 2% in 2007, largely due to reduced salaries and benefits and a reduction in agent costs.
The Company meets liquidity requirements primarily through positive cash flows from operations. Management believes that the Company has sufficient sources of liquidity to satisfy operational requirements and to finance expansion and planned initiatives. Primary sources of cash flow are premiums, other insurance considerations and deposits, receipts for policyholder accounts, investment sales and maturities, investment income and access to credit from other financial institutions. In addition, the Company has credit facilities that are available for additional working capital needs or investment opportunities. The principal uses of cash are for the insurance operations, including the payment of insurance benefits, purchase of investments, operating expenses, dividends, income taxes, withdrawals from policyholder accounts and costs related to acquiring new business.
Cash provided from operations in each of the three years ended 2008, 2007 and 2006 was $12.3 million, $32.9 million, and $23.9 million, respectively. Cash provided from operating activities decreased $20.6 million in 2008 compared with an increase in cash provided from operating activities of $9.0 million in 2007. The decrease in 2008 compared with 2007 was largely the result of a $15.3 million decline in net investment income and a $4.4 million increase in cash benefit payments. These were partially offset by a $6.5 million increase in premium receipts. Cash is also affected by increases and decreases in the Company’s net receivables and net payables. Income taxes payable decreased $33.1 million during 2008 largely due to the net loss incurred. Suspense items on ongoing operations also decreased $1.3 million. These decreases were partially offset by a $3.7 million increase in accrued investment income, a $1.9 million increase in reinsurance receivables established at the time claims are paid, and a $23.1 million increase in accrued employee and agent benefits. Accrued employee and agent benefits were higher because of the lower return on plan assets in the cash balance pension plan due to the current market conditions. The increase in 2007 compared with 2006, was largely the result of a $7.2 million reduction in claims paid to policyholders. Partially offsetting this, premium receipts decreased $1.6 million and commissions paid to agents from premium and deposit activity increased $1.4 million. Also at year-end 2007 compared with 2006, receivables increased $5.8 million while payables and suspense items on ongoing operations increased $2.1 million.
Net cash used in financing activities was $63.7 million in 2008, $108.8 million in 2007 and $100.2 million in 2006. The net repayments of short-term notes payable were $7.5 million in 2008, $4.3 million in 2007 and $12.6 million in 2006. Deposits on policyholder account balances equaled $200.5 million in 2008, $205.8 million in 2007 and $203.0 million in 2006. Withdrawals on policyholder account balances were $240.5 million in 2008, $294.8 million in 2007 and $273.8 million in 2006. The decrease in withdrawals can be attributed to the volatility in the equity markets and is consistent with falling interest rates. The net acquisition of treasury stock totaled $16.8 million in 2008 compared to $4.5 million in 2007 and $3.3 million in 2006. The net acquisition of treasury stock in 2008 reflects purchases from employee benefit plans of $8.5 million and the stock repurchase program of $8.3 million. Finally, the Company’s stockholder dividends were $12.5 million in 2008, $36.4 million in 2007 and $12.8 million in 2006. During 2007, the Company paid a special, one-time dividend of $2.00 per share in addition to its quarterly dividends.
The ratio of equity to assets less separate accounts declined 3% in 2008. Stockholders’ equity decreased $157.3 million from year-end 2007. The decrease was largely due to increases in unrealized investment losses, payments of stockholder dividends, an increase in the minimum pension liability and an increase in treasury stock. Stockholders’ equity per share, or book value, equaled $46.11 for year-end 2008, a 21% decrease for the year.
The Company’s statutory equity exceeds the minimum capital deemed necessary to support its insurance business, as determined by the risk-based capital calculations and guidelines established by the National Association of Insurance Commissioners. The maximum stockholder dividends that can be paid out of stockholders’ equity in 2009 without prior approval of the Missouri Director of Insurance are $30.6 million - 10 % of statutory stockholders’ equity at the end of 2008.
The stock repurchase program was extended by the Board of Directors through January 25, 2010 to permit the purchase up to one million shares of the Company’s common stock on the open market, which would represent approximately 9% of the shares outstanding. This authorization is consistent with the parameters provided by the Board of Directors in prior years, including 2007 and 2006. In 2008, as disclosed in Item 5 herein, the Company purchased 181,661 shares of its common stock at a total cost of $8.2 million with an average price per share of $45.38. In 2007, the Company purchased 90,341 shares at a total cost of $4.1 million with an average price per share of $45.59, and in 2006, the Company purchased 4,976 shares at a total cost of $0.2 million with an average price per share of $46.14.
On January 26, 2009, the Board of Directors declared a quarterly dividend of $0.27 per share that was paid February 10, 2009 to stockholders of record as of February 5, 2009. On January 28, 2008, the Board of Directors declared a quarterly dividend of $0.27 per share that was paid February 12, 2008 to stockholders of record as of February 7, 2008.
The following table summarizes (in millions) the Company’s contractual obligations by due date and expiration date as of December 31, 2008. Contractual obligations of the Company are those obligations fixed by agreement as to dollar amount and date of payment.
The Company leases its mainframe computer and certain related support equipment. The Company is also a lessee of an office building with a 20-year lease that began in 1989 with two five-year renewal options. In 1998, the Company assigned the interest in the lease to a third-party for the remainder of the lease period.
(4) The Company’s mortgage loan commitments provide funding to originate commercial mortgage loans. Mortgage loan commitments generally do not extend beyond 90 days. Other investments are primarily commitments for real estate investments.
Annuity certain contracts are those insurance liabilities (included in future policy benefits and policyholder account balances on the balance sheet) which do not have life contingencies and have scheduled payments. Annuity certain contracts without life contingencies consist of single premium immediate annuities, supplementary contracts and structured settlements.
Tax contingencies represent the liabilities for unrecognized tax benefits calculated in accordance with FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes”. A high degree of uncertainty exists with respect to the expected timing of certain cash payments associated with unrecognized tax benefits. In addition to the tax contingencies in the table, $6.0 million of liabilities related to unrecognized tax benefits is excluded from the table due to this high degree of uncertainty.
The preparation of the consolidated financial statements requires management of the Company to make estimates and assumptions relating to the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the consolidated financial statements, and the reported amounts of revenue and expenses during the period. These estimates are inherently subject to change and actual results could differ from these estimates. Included among the material (or potentially material) reported amounts and disclosures that require extensive use of estimates are the fair value of certain invested assets, deferred acquisition costs, value of business acquired, future policy benefits, policy and contract claim liabilities and the valuation allowance on deferred income tax assets.
On January 23, 2006 the Company entered into a definitive agreement to sell its bank subsidiary, Generations Bank, for $10.1 million in cash. On January 8, 2007, the Company completed the sale of Generations Bank after receiving regulatory approval from the Office of Thrift Supervision. The gain on the sale was $1.9 million and is included in realized investment gains. The bank subsidiary and the results of operations were not material to the financial statements of the Company and are not disclosed separately.
The Company’s fair value of fixed maturity and equity securities are determined by management, utilizing external pricing sources, brokers, and internal matrices. At December 31, 2008 approximately 90% of these investments were from external pricing services while 10% were derived from brokers, internal matrices and calculations. The Company reviews and analyzes its securities on an ongoing basis to determine whether impairments exist that are other-than-temporary. Based upon these analyses, specific security values are written down to fair value through earnings as a realized investment loss if the security's value is considered to be an other-than-temporary impairment. Premiums and discounts on fixed maturity securities are amortized over the life of the related security as an adjustment to yield using the effective interest method. See Note 3 - Investments for further details.
adjustable rate mortgage-backed securities where the prospective method is used. Under the retrospective method the amortized cost of the security is adjusted to the amount that would have existed had the revised assumptions been in place at the time of purchase. Under the prospective method, future cash flows are estimated and interest income is recognized going forward using the new internal rate of return. The adjustments to amortized cost under both methods are recorded as a charge or credit to net investment income.
Deferred acquisition costs (DAC), principally agent commissions and other selling, selection and issue costs, which vary with and are directly related to the production of new business, are capitalized as incurred. These deferred costs are then amortized in proportion to future premium revenues or the expected future profits of the business, depending upon the type of product. Profit expectations are based upon assumptions of future interest spreads, mortality margins, expense margins and policy and premium persistency experience. These assumptions involve judgment and are compared to actual experience on an ongoing basis. If it is determined that the assumptions related to the profit expectations for interest sensitive and variable insurance products should be revised, the impact of the change is reported in the current period’s income as an unlocking adjustment. The DAC unlocking adjustment was $3.0 million for the year ended 2008 (2007 - $3.4 million; 2006 - $0.7 million) which reduced the amortization of DAC. During the fourth quarter of 2006, the Old American segment reduced its amortization of DAC by $1.2 million. This adjustment, which is a correction of an understatement of the capitalization of DAC in prior periods, was not material to 2006 or any prior period financial statements.
Separate account assets and liabilities arise from the sale of variable life insurance and annuity products. The separate account represents funds segregated for the benefit of certain policyholders who bear the investment risk. The assets are legally segregated and are not subject to claims which may arise from any other business of the Company. The separate account assets and liabilities, which are equal, are recorded at fair value. Policyholder account deposits and withdrawals, investment income and realized investment gains and losses are excluded from the amounts reported in the Consolidated Statements of Income. Revenues to the Company from separate accounts consist principally of contract charges, which include maintenance charges, administrative fees and mortality and risk charges.
As of December 31, 2008, separate account balances for variable annuity contracts were $182.3 million. The total reserve held for variable annuity guaranteed minimum death benefits was $0.5 million. Additional information related to the guaranteed minimum death benefits and related separate account balances and net amount at risk (the amount by which the guaranteed minimum death benefit exceeds the account balance) as of December 31, 2008 is provided below:
Crediting rates for universal life insurance and fixed deferred annuity products ranged from 3.00% to 5.50% (2007 - 3.00% to 5.50%; 2006 - 3.00% to 5.75%).
Deferred income taxes are recorded on the differences between the tax bases of assets and liabilities and the amounts at which they are reported in the consolidated financial statements. Recorded amounts are adjusted to reflect changes in income tax rates and other tax law provisions as they become enacted.
Comprehensive income (loss) is comprised of net income (loss) and other comprehensive income (loss). Other comprehensive income (loss) includes the change in unrealized investment gains or losses on securities available for sale (net of reclassification adjustments for realized investment gains or losses) net of adjustments to DAC, VOBA, taxes and policyholder account balances. In addition, other comprehensive income (loss) includes the change in the additional minimum pension liability, and the adjustment to adopt SFAS No. 158 - described below under New Accounting Pronouncements. The adjustment to adopt SFAS No. 158 consisted of pension and postretirement net losses and prior service costs. Other comprehensive income (loss) also includes deferred income taxes on these items.
In October 2008, the FASB issued FASB Staff Position (FSP) No. 157-3, “Determining the Fair Value of a Financial Asset When the Market for That Asset is Not Active” (FSP FAS 157-3). FSP FAS 157-3 clarifies the application of FASB Statement No. 157, “Fair Value Measurements”, in a market that is not active and provides an example to illustrate key considerations in determining the fair value of a financial asset when the market for that financial asset is not active. The Company adopted FSP FAS 157-3 on issuance, with no material impact to the consolidated financial statements.
In May 2008, the FASB issued SFAS No. 163, “Accounting for Financial Guarantee Insurance Contracts” (SFAS 163). SFAS 163 clarifies how FASB Statement No. 60, “Accounting and Reporting by Insurance Enterprises”, applies to financial guarantee insurance contracts, including the recognition and measurement of premium revenue and claim liabilities. This statement also requires expanded disclosures about financial guarantee insurance contracts. This statement became effective for financial statements issued for fiscal years beginning after December 15, 2008. The Company adopted SFAS 163 on January 1, 2009 with no material impact to the consolidated financial statements as it does not sell financial guarantee insurance contracts.
In May 2008, the FASB issued SFAS No. 162, “The Hierarchy of Generally Accepted Accounting Principles” (SFAS 162). SFAS 162 identifies the sources of accounting principles and the framework for selecting the principles used in the preparation of financial statements. This statement shall be effective 60 days following the SEC’s approval of the Public Company Accounting Oversight Board (PCAOB) amendments to AU Section 411, “The Meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles”. The Company adopted SFAS 162 on issuance, with no material impact on the consolidated financial statements.
In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (SFAS 157). SFAS 157 provides a single definition of fair value, together with a framework for measuring it, and requires additional disclosure about the use of fair value to measure assets and liabilities. SFAS 157 also emphasizes that fair value is a market-based measurement, not an entity-specific measurement, and established a fair value hierarchy with the highest priority being the quoted price in active markets. SFAS 157 amended SFAS 107, “Disclosure about Fair Value of Financial Instruments.” This statement became effective for years beginning after November 15, 2007. The Company adopted SFAS 157 on January 1, 2008 with no material impact to the consolidated financial statements. Please see Note 2 Fair Value of Financial Instruments for disclosures pertaining to SFAS 157.
In August 2006, the Securities and Exchange Commission (SEC) adopted SEC Release No. 33-8732A, “Executive Compensation and Related Person Disclosure” which amends the disclosure requirements for executive and director compensation, related person transactions, director independence and other corporate governance matters and security ownership of officers and directors. The release expanded the required tabular disclosures and added a narrative Compensation Discussion & Analysis (CD&A) which must describe the Company’s compensation policies and decisions. The amendments in the release apply to disclosures included in Proxy and information statements, periodic and current reports, as well as other filings under the Securities Exchange Act of 1934 and to registration statements under the Exchange Act and the Securities Act of 1933. For financial statement purposes, this release was effective for years ending on or after December 15, 2006. The Company has adopted this release and includes the required disclosures in the appropriate filings.
In June 2006, the FASB issued Interpretation 48 “Accounting for Uncertainty in Income Taxes” (FIN 48). FIN 48 applies to all uncertain tax positions accounted for under SFAS No. 109 “Accounting for Income Taxes”. FIN 48 addresses whether tax positions taken or to be taken on tax returns should be reflected in the financial statements before they are resolved with the appropriate taxing authority. Previous statements provided no specific guidance related to such positions. FIN 48 was adopted on January 1, 2007, with no material impact to the consolidated financial statements.
All other Standards and Interpretations of those Standards issued during 2008 did not relate to accounting policies and procedures pertinent to the Company at this time.
Level 1 - Valuations are based upon quoted prices for identical instruments traded in active markets. Level 1 assets include U.S. Treasury Notes and Bonds, other U.S. Government securities and certain common and preferred stocks that are traded by dealers or brokers in active markets.
The Company performs an analysis on the prices received from third party security pricing services and independent brokers to ensure that the prices represent a reasonable estimate of the fair value. The Company corroborates and validates the primary pricing sources through a variety of procedures that include but are not limited to comparison to additional independent third-party pricing services or brokers, where possible, a review of third party pricing service methodologies, back testing and comparison of prices to actual trades for specific securities where observable data exists. In addition, in accordance with SFAS No. 157, the Company analyzed the third-party pricing services’ methodologies and related inputs and has also evaluated the various types of securities in its investment portfolio to determine an appropriate SFAS No. 157 fair value hierarchy.
Fair value measurements for assets and liabilities where there exists limited or no observable market data, are often calculated using the Company’s own estimates, based on current interest rates, credit spreads, liquidity premium or discount, the economic and competitive environment, unique characteristics of the asset or liability and other pertinent factors. Therefore, the results cannot be determined with precision and may not be realized in an actual sale or immediate settlement of the asset or liability. Additionally, there may be inherent weaknesses in any calculation technique. Further, changes in the underlying assumptions used, including discount rates and estimates of future cash flows, could significantly affect the results of current or future values.
The Company introduced a GMWB rider in 2007 that can be added to new or existing variable annuity contracts. The rider provides a minimum guarantee that the owner can make annual withdrawals equal to 5% of the initial annuity deposit for twenty years, or for life if withdrawals were started at age 65 or later, regardless of market returns. The value of variable annuity separate accounts with the GMWB rider was $31.1 million and the liability was $0.8 million at December 31, 2008. The value of the GMWB rider is recorded at fair value. Fair values for GMWB rider contracts result in a Level 3 valuation as it is based on models developed for this purpose which utilize significant unobservable inputs. These models require actuarial and financial market assumptions, which reflect the assumptions market participants would use in pricing the contract, including adjustments for risk and issuer non-performance. The change in this liability is included in policyholder benefits in the Consolidated Statements of Income.
The roll forward of Level 3 liabilities begins with the prior period balance and adjusts for the realized gains or losses that occurred during the current period. These realized gains or losses are reflected as policyholder benefits in the Consolidated Statements of Income. Issuances, or new sales, are then added. The ending balance represents the current fair value of liabilities which are designated as Level 3.
The table below is a summary of fair value estimates as of December 31, 2008 and December 31, 2007 for financial instruments, as defined by SFAS No. 107. In accordance with SFAS No. 107, the Company has not included assets and liabilities that are not financial instruments in this disclosure. The total of the fair value calculations presented do not represent, and should not be construed to represent, the underlying value of the Company.
The following tables provide investment revenues by major category for the years ended December 31. Realized gains and losses on the sale of investments are determined on the basis of specific security identification.
The following table provides unrealized gains (losses) on the Company’s investments in securities available for sale, at December 31.
The Company reviews all security investments, particularly including those having unrealized losses. Further, the Company specifically assesses all investments with greater than 10% declines in fair value and, in general, monitors all security investments as to ongoing risk. These risks are fundamentally evaluated through both a qualitative and quantitative analysis of the issuer. The Company prepares a formal review document no less often than quarterly of all investments with greater than 20% declines in fair value for six months or more, investments that have previously been written down and that remain in an unrealized loss position, and selected investments that have changed significantly from a previous period and that have a decline in fair value greater than 10% of amortized cost.
The Company’s analysis of securities for the quarter ended December 31, 2008 resulted in the determination that 16 securities (14 issuers) had other-than-temporary impairments and were written down by a combined $20.0 million in the fourth quarter. The fair value of the investments after the write-downs was $11.3 million.
Following is a description of the securities that were written down during the fourth quarter of 2008. 1) Two of the securities were preferred stocks of government-sponsored agencies that were written down by a total of $0.4 million. These entities buy and hold mortgages and issue and sell guaranteed mortgage-backed securities to facilitate housing ownership. They are now operated in conservatorship by the U.S. government and their existing common and preferred stock securities are severely diluted. Dividend payments have been suspended, driving the fair value of these securities down. 2) Two securities were written down by $3.1 million, primarily as a result of declines in price and rating agency downgrades on debt issues from issuers that completed leveraged buyout transactions during 2008. One of these securities was subsequently sold during the fourth quarter of 2008. 3) Three securities were collateralized debt obligations (CDOs) that were written down by a total of $5.3 million. These securities have been impacted by the rapid rise in delinquencies and foreclosures in the sub-prime and Alt-A mortgage markets, along with a decline in the fair value of securities issued by financial institutions. Ongoing CDO liquidations and investor selling have caused extreme declines in market valuations, regardless of individual security performance. 4) Two securities were written down by $1.9 million due to a combination of a decline in price that had persisted for a period longer than the Company considered temporary. One of these securities was subsequently sold during the fourth quarter of 2008. 5) One security is an originator of residential prime, Alt-A and subprime mortgages that was written down $4.2 million. The significant decline in the subprime and non-conforming mortgage markets resulted in a reduction in value for this security. 6) One security is from an issuer that designs, manufactures and services cars and trucks and provides vehicle-related financing, leasing and insurance was written down $1.2 million, largely resulting from the decline in the U.S. automotive industry. 7) One security that is a financial services company involved in automotive and real estate financing and mortgage lending was written down by $0.6 million and subsequently sold during the fourth quarter of 2008. 8) Four securities (two issuers) were perpetual preferred securities that were written down $3.3 million. These securities have been negatively impacted by the housing and mortgage credit crisis and have received TARP (Troubled Assets Relief Program) funds.
The Company’s analysis of securities for the quarter ended September 30, 2008 resulted in the determination that ten fixed-maturity issuers (twelve specific securities) had other-than-temporary impairments and were written down by a combined $32.5 million in the third quarter. The total fair value of the affected securities after the write-downs was $17.9 million
Following is a description of the securities that were written down during the second quarter of 2008: 1) Three of the securities were written down by a total of $3.3 million, primarily as a result of declines in price and rating agency downgrades on debt issues from issuers that had recently completed leveraged buyout (LBO) transactions. These LBO transactions greatly increased the debt level of each issuer. One of these securities had been written down previously. 2) Two securities were collateralized debt obligations (CDOs) and were written down by $2.8 million, primarily due to price declines that had persisted for periods longer than the Company considered temporary. 3) One security was written down by $3.3 million due to combination of a decline in price that had persisted for a period longer than the Company considered temporary, rating agency downgrades and a debt restructuring during the quarter. 4) The final security was written down by $0.8 million due to a combination of a decline in price that had persisted for a period longer than the Company considered temporary and a further deterioration in fair value during the second quarter of 2008.
As of December 31, 2008, the Company had gross unrealized losses of $231.9 million on investment securities, including fixed maturity and equity securities that had a fair value of $1.5 billion. As of December 31, 2007, the Company had gross unrealized losses of $47.0 million on investment securities, including fixed maturity and equity securities that had a fair value of $1.3 billion. The increase in unrealized losses was primarily attributable to increased credit and liquidity risk discounts in the pricing of financial assets during the twelve months ended December 31, 2008. Although these changes affected the broad financial markets, specific sectors, security issuers and security issues were affected differently.
The following table provides information regarding unrealized losses on investments available for sale, as of December 31, 2007.
Total unrealized losses on investments available for sale increased from $47.0 million at December 31, 2007 to $231.9 million at December 31, 2008. At December 31, 2008, approximately 45% of the gross unrealized losses was attributable to securities having gross unrealized losses of less than 12 months. This compares to approximately 31% at December 31, 2007. At December 31, 2008, unrealized losses on investments available for sale totaled $231.9 million, primarily due to $138.0 million in unrealized losses on corporate securities. The unrealized losses on corporate securities were primarily due to increased credit spreads from weaker operating results in the industrial and consumer sectors, along with concerns about the earnings, liquidity and capital strength of financial institutions. In addition, the unrealized losses on mortgage-backed securities totaled $52.8 million, primarily due to an increase in credit spreads and decrease in market liquidity resulting from concern about mortgage defaults. Based, in part, by the Company’s assessment of expected credit losses of the securities given the performance of the underlying collateral compared to the credit enhancement, the Company concluded that these securities were not other-than-temporarily impaired at December 31, 2008.
In addition, securities having unrealized losses greater than 20% are further evaluated based upon the length of time that they have been above the 20% unrealized loss threshold. Securities in this classification are divided into three different categories, including less than six months, six months or more and less than twelve months, and twelve months or greater. The Company had investment grade securities with unrealized losses of greater than 20% that totaled $90.9 million for less than six months at December 31, 2008. This represented 71% of total unrealized losses greater than 20%. Investment grade securities with unrealized losses for six months or more and less than twelve-months totaled $17.1 million. The Company also had below investment grade securities with unrealized losses of greater than 20% that totaled $17.3 million for less than six months and $2.4 million for less than six months and six months or more and less than twelve-month periods. The Company had no securities with unrealized losses of greater than 20% for twelve months or greater at December 31, 2008.
The following table provides information regarding fixed maturity securities by sector at December 31, 2007.
The table below provides sales of investment securities available for sale, excluding maturities and calls, for the years ended December 31. Realized gains and losses on the sale of investments are determined on the basis of specific security identification.
The Company is exposed to risk that issuers of securities owned by the Company will default or that interest rates or credit spreads will change and cause a decrease in the value of its investments. With mortgage-backed securities, the Company is also exposed to prepayment and extension risks. As interest rates change, the rate at which these securities pay down principal may change. These risks are mitigated by investing in high-grade securities and managing the maturities and cash flows of investments and liabilities.
The following table provides the distribution of maturities for fixed maturity investment securities available for sale as of December 31, 2008. Expected maturities may differ from these contractual maturities since borrowers may have the right to call or prepay obligations.
The table below provides information concerning the Company's real estate investments as of December 31.
1 The incurred benefits related to prior years’ unpaid accident and health claims reflect the (favorable) unfavorable development of these liabilities.
As a member of the FHLB with a capital investment of $5.1 million, the Company has the ability to borrow on a collateralized basis from the FHLB. The Company earned a 4.33% (2007 - 3.33%; 2006 - 3.81%) average rate on the capital investment in the FHLB for 2008.
The table below provides Kansas City Life’s net gain from operations, net income (loss), unassigned surplus (retained earnings) and capital and surplus (stockholders' equity), on the statutory basis used to report to regulatory authorities for the years ended December 31.
Stockholder dividends may not exceed statutory unassigned surplus. Additionally, under Missouri law, the Company must have the prior approval of the Missouri Director of Insurance in order to pay dividends in any consecutive twelve-month period exceeding the greater of statutory net gain from operations for the preceding year or 10% of statutory stockholders' equity at the end of the preceding year. The maximum stockholder dividends payable in 2009 without prior approval is $30.6 million, 10% of 2008 surplus. The Company believes these statutory limitations impose no practical restrictions on its dividend payment plans.
The Company and/or one of its subsidiaries files income tax returns in the U.S. federal jurisdiction, and various state jurisdictions. In general, the Company is no longer subject to U.S. federal, state or local income tax examinations by tax authorities for years prior to 2005. The Company is not currently under examination by the Internal Revenue Service.
The total amount of unrecognized tax benefits, if recognized, that would impact the effective tax rate was $0.7 million and $0.8 million as of December 31, 2008 and 2007, respectively.
The Company recognizes interest and penalties accrued related to unrecognized tax benefits in income tax expense. During the years ended December 31, 2008, 2007, and 2006, the Company recognized expense (benefit) of approximately $0.1 million, $0.3 million, and ($0.6) million in interest and penalties, respectively. The Company had approximately $0.9 million and $0.8 million for the payment of interest and penalties accrued at December 31, 2008 and 2007, respectively.
The Kansas City Life Pension Plan was amended and restated effective January 1, 1998 as the Kansas City Life Cash Balance Pension Plan. Plan benefits are based on a cash balance account consisting of credits to the account based upon an employee’s years of service, compensation and interest credits on account balances calculated using the greater of the average 30-year Treasury bond rate for November of each year or 5.5%. The benefits expected to be paid in each year from 2009 through 2013 are $11,300, $9,000, $11,700, $11,700, and $11,200, respectively. The aggregate benefits expected to be paid in the five years from 2014 through 2018 are $64,900. The expected benefits to be paid are based on the same assumptions used to measure the Company’s benefit obligation at December 31, 2008 and include estimated future employee service. The 2009 contribution for the plan cannot be reasonably estimated at this time. The asset allocation of the fair value of pension plan assets at December 31 was:
This allocation of plan assets approximated the targeted mix by asset class. The strategic goal is to achieve an optimal rate of return at an acceptable level of investment risk in order to provide for the payment of benefits. The Plan does not expect to return any plan assets to the Company during 2009.
Non-contributory defined contribution retirement plans for general agents and eligible sales agents provide supplemental payments based upon earned agency first year individual life and annuity commissions. Contributions to these plans were $113 (2007 - $78; 2006 - $98). Non-contributory deferred compensation plans for eligible agents based upon earned first year commissions are also offered. Contributions to these plans were $400 (2007 - $400; 2006 - $300).
The estimated net loss and prior service cost for the other postretirement plans that will be amortized from accumulated other comprehensive income (loss) into net periodic benefit cost over the next year is $135 and ($222), respectively.
The Company has a long-term incentive plan for senior management that awards participants for the increase in the share price of the Company’s common stock through units (phantom shares) assigned by the Board of Directors. The awards are calculated over three-year intervals on a calendar year basis. At the conclusion of each three-year interval, participants will receive awards based on the increase in the share price during a defined measurement period, times the number of units. The increase in the share price will be determined based on the change in the share price from the beginning to the end of the three-year interval. Dividends are accrued and paid at the end of each three-year interval to the extent that they exceed negative stock price appreciation. Plan payments are contingent on the continued employment of the participant unless termination is due to a qualifying event such as death, disability or retirement.
The Company has three reportable business segments, which are defined based on the nature of the products and services offered: Individual Insurance, Group Insurance and Old American. The Individual Insurance segment consists of individual insurance products for both Kansas City Life and Sunset Life. The Individual Insurance segment is marketed through a nationwide sales force of independent general agents. The Group Insurance segment consists of sales of group life, dental and disability products. This segment is marketed through a nationwide sales force of independent general agents, group brokers and third-party marketing arrangements. Old American consists of individual insurance products designed primarily as final expense products. These products are marketed through a nationwide general agency sales force with exclusive territories, using direct response marketing to supply agents with leads.
Sunset Life entered into a yearly renewable term reinsurance agreement January 1, 2002, whereby it ceded 80% of its retained mortality risk on traditional and universal life policies. As of December 31, 2008, the insurance in force ceded approximated $1.8 billion (2007 - $2.0 billion) and premiums totaled $8.9 million.
Reinsurance receivables were $168.4 million at year end 2008, consisting of reserves ceded of $154.1 million and claims ceded of $14.3 million.
The unaudited quarterly results of operations for the years ended December 31, 2008 and 2007 are summarized in the table below.
Subsequent to December 31, 2008, the credit and liquidity crisis in the United States and throughout the global financial system continued to generate substantial volatility in the financial markets and the banking system. Should this environment and similar events continue, such subsequent events could have a significant impact on the Company’s investment portfolio. The Company has continued to monitor this subsequent event activity and has concluded that the assessment of other-than-temporary impairment as of December 31, 2008 has not changed.
1 Elimination entries to remove intercompany transactions for life and accident and health insurance were as follows: operating expenses from the Individual Insurance segment to arrive at Consolidated Statements of Income.
All other information required by this Schedule is shown in Note 12-Reinsurance in the Notes to Consolidated Financial Statements.
We have audited the accompanying consolidated balance sheets of Kansas City Life Insurance Company and subsidiaries (the Company) as of December 31, 2008 and 2007, and the related consolidated statements of income, stockholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2008. In connection with our audit of the consolidated financial statements, we have also audited financial statement schedules I-V. We also have audited the Company’s internal controls over financial reporting as of December 31, 2008, based on, criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for these consolidated financial statements, for financial statement schedules, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting (included in the accompanying Item 9A). Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules, and an opinion on the Company’s internal control over financial reporting based on our audits.