The following analysis of our consolidated financial condition and results of operations should be read in conjunction with Item 6. Selected Financial Data and the consolidated financial statements and accompanying notes included elsewhere in this report.
A purported shareholder class action lawsuit has been filed against us and certain of our present and former officers and directors alleging violations of United States securities laws. In addition, Transamerica has asserted that we are in breach of our reinsurance agreement with them and has demanded arbitration. We cannot assure you that we will be successful in the defense of any of our current or future litigation or arbitration proceedings. If the outcome in any such proceeding is adverse to us, our results of operations and financial condition would be adversely impacted.
On April 8, 2003, we received notice from the New York Stock Exchange that we did not satisfy its continued listing standards as of that date because the average closing price of our common shares had been below $1.00 for a 30 consecutive trading day period. The notice indicated that if we could not achieve (i) a $1.00 average share price for the 30 consecutive trading days prior to October 7, 2003, the expiration of the six month period following the date of the receipt of the notification, and (ii) a $1.00 share price on October 7, 2003, then the NYSE would commence suspension and delisting procedures with respect to our common shares. In addition, the NYSE informed us that it was considering whether we continued to meet certain of the NYSE’s qualitative continued listing standards due to concerns over our financial condition. On October 14, 2003, the NYSE informed us that we had satisfied the NYSE’s continued listing standards, and as a result would not be delisted from the Exchange. There can be no assurance, however, that we will be able to continue to meet the NYSE’s qualitative or quantitative listing standards.
We are exposed to the risk that the level of death claims we receive will exceed that which we assumed in pricing our reinsurance contracts. In 2001, 2002 and 2003, we had substantial unexpected adverse mortality experience compared to our original pricing assumptions under many of our life reinsurance contracts. Mortality experience that is less favorable than we assumed in pricing a reinsurance agreement will negatively affect our net income. Furthermore, even if the total benefits paid over the life of a contract do not exceed the expected amount, unexpected increases in the incidence of deaths or the size of individual claims can cause us to pay more benefits in a given accounting period than expected, adversely impacting the earnings of our business in any particular quarter or year.
As of the date of this report, approximately $667.8 million of the assets supporting the policies we reinsure were held and managed by our ceding companies or their investment managers under modified coinsurance and coinsurance funds withheld arrangements. A significant portion of our total investments is therefore dependent upon the investment decisions of third parties over whom we have limited, if any, control.
Pursuant to FAS 133 - Accounting for Derivative Instruments and Hedging Activities, one of our annuity reinsurance contracts is deemed to host an embedded derivative that must be bifurcated and accounted for separately. The change in the fair value of the embedded derivative is primarily driven by credit risk related changes in the market value of assets underlying the contract, changes in expected future cash flows under the annuity reinsurance agreement and changes in interest rates. The change in fair value is reported as a component of our results of operations, thereby increasing the volatility of our reported net income (loss). If prevailing market conditions or other factors adversely impact the value of the embedded derivative, it could have a substantial effect on our results of operations.
The loss of any member of our management team, particularly John F. Burke, our current Chief Executive Officer, or John W. Lockwood, our recently appointed Chief Financial Officer, could adversely affect our business.
sole source of funds to pay expenses and dividends, and any limitations imposed on our subsidiaries to make such payments to us, especially our Bermuda operating subsidiary, may cause us to have insufficient funds to operate our business and satisfy our obligations.
There can be no assurance that we will be able to improve our operations and liquidity. If we are unable to reposition our investment portfolio to achieve a substantially higher yield within our investment guidelines, successfully defend against the pending purported shareholder class action suit, improve the performance of our reinsurance agreement with Transamerica and restructure our reinsurance agreement with CIGNA, we may not be able to meet our obligations in 2004. Our failure to achieve any one of the foregoing items could have a material adverse effect on our financial condition and results of operations. For a more detailed discussion of certain factors that could materially and adversely affect our financial condition and results of operations, please see - Forward-Looking Statements.
Our remaining annuity products are reinsurance of general account fixed deferred annuities and certain ancillary risks arising from variable annuities. Profitability of the annuity reinsurance line is primarily dependent on earning a spread between the interest rate earned on the assets under management and the interest rate credited to the policyholder. This product line is market and interest rate sensitive. Fluctuations in the general level of interest rates, fixed income markets, and equity markets from period to period may cause fluctuations in the results of our operations. The combined effects of poor market performance and excessive surrender rates can adversely impact this product line, such as occurred in 2001 and 2002. At December 31, 2003 and 2002, our liability for annuity reinsurance agreements amounted to approximately $671 million and $1.4 billion, respectively.
Annuity and Life Re (Holdings), Ltd. is a Bermuda holding company with operating subsidiaries in Bermuda and the United States. We consolidate the operations of all of our subsidiaries in accordance with accounting principles generally accepted in the United States. The preparation of financial statements in
conformity with generally accepted accounting principles requires the use of estimates and assumptions developed by our management. Any adjustments to the reported amounts of assets or liabilities resulting from changes in estimates are reflected in earnings in the period the estimates are revised. Certain management estimates are based, in part, on information provided by ceding companies. Our ceding companies periodically update, refine and revise the reinsurance information they provide to us. This revised data is reflected in earnings as changes in estimates.
For traditional life and annuity policies with life contingencies, deferred policy acquisition costs are charged to expense using assumptions consistent with those used in computing policy reserves. Assumptions as to anticipated premiums are estimated at the date of the policy issuance, or the effective date of the most recent premium rate increase, and are consistently applied during the life of the contracts. Deviations from estimated experience are reflected in earnings in the period such deviations occur. For these contracts, the amortization periods are generally the estimated life of the policies. As discussed elsewhere in this report, we terminated or recaptured several of our reinsurance agreements during 2003. These terminations and recaptures have caused us to incur significant deferred acquisition cost write-downs. While we believe that there will be minimal, if any, termination or recapture activity in the future, we will consider transactions in connection with the resolution of outstanding disputes with certain of our ceding companies, or that are otherwise economically beneficial to us, which may require further write downs of deferred acquisition costs.
In preparing our financial statements, we make assumptions about our proportionate share of future investment income that will be earned from the investment of premiums received from underlying policyholders by our ceding companies and about future rates of lapse of policies underlying our annuity reinsurance contracts when estimating gross profits arising from such contracts. These assumptions have a direct impact on the amount of expected future minimum interest guarantee payments and our estimated expected gross profits on these annuity reinsurance contracts and, therefore, on the recoverability of the deferred acquisition costs carried on our balance sheet for these contracts. While these estimates are based upon historical results and information provided to us by our ceding companies, actual results could differ (and, in the past, have differed) materially from our estimates for a variety of reasons, including the failure of our ceding companies to report timely information regarding material developments under our reinsurance agreements. Such differences could be material to our future results. If our assumptions for investment returns prove to be inaccurate, or if lapse rates exceed our assumptions, we may be required to make additional minimum interest guarantee payments and record additional charges, which would adversely impact our earnings.
Embedded Derivatives. We have concluded that there is an embedded derivative within the Funds withheld at interest receivable related to one of our annuity reinsurance contracts written on a modified coinsurance basis that requires bifurcation and separate accounting under Statement of Financial Accounting Standards No. 133 - Accounting for Derivative Instruments and Hedging Activities. This embedded derivative is similar to a total return swap arrangement on the underlying assets held by our ceding company under the agreement. The fair value of the embedded derivative is classified as part of our Funds withheld asset on our balance sheet. We have developed a cash flow model with the assistance of outside advisors to arrive at an estimate of the fair value of this total return swap that uses various assumptions regarding future cash flows under the affected annuity reinsurance agreement. The fair value of the embedded derivative is influenced by changes in credit risk, changes in expected future cash flows under the annuity reinsurance agreement and interest rates. The change in fair value of the embedded derivative is recorded in our statement of operations as Net change in fair value of embedded derivatives, which is a non-cash item. The change in fair value of the embedded derivative also impacts the emergence
Recognition of Revenues and Expenses. Reinsurance premium revenues from life products with mortality risk are recognized when due from the policyholders. Premiums from universal life and investment-type contracts are recorded on our balance sheet as interest sensitive contracts liability. Revenues from these investment-type contracts consist of income earned on the assets and amounts assessed during the period against policyholders’ account balances for mortality charges, policy administration charges and surrender charges. Items that are charged to expense represent interest credited to policyholder accounts and other benefits in excess of related policyholders’ account balances, including minimum interest guarantee payments (“LMIG”). Such LMIG payments are recognized as an expense when paid upon the surrender of the underlying policy and are not charged to the policyholder’s account balances. We make estimates at the end of each reporting period regarding premiums and benefits for ceding companies who do not report such information in a timely manner. These estimates can have a significant effect on the amounts we report in our financial statements.
We reinsure certain minimum guarantees associated with variable annuity agreements. These have historically included GMDB, GMIB and enhanced earnings benefits contracts, although, as of December 31, 2003, our combined GMDB/GMIB agreement with CIGNA was the only reinsurance agreement we had covering minimum guarantees associated with variable annuity agreements. Our accounting policy is designed to establish reserves for expected claim payments based upon the view of expected losses over the life of the underlying policies, based upon the original pricing assumptions. Our reserving policy allows us to increase reserves if reported claim amounts or claims volume exceed what was anticipated in pricing.
Our obligations arising from our fixed annuity reinsurance agreements are reflected on our balance sheet as “Interest sensitive contracts liability” and are reported at the accumulated policyholder balances of these accounts.
If actual events differ significantly from the underlying estimates and assumptions used by us in the application of these accounting policies, there could be a material adverse effect on our results of operations and financial condition.
We have a combined GMDB/GMIB contract with CIGNA and an annuity reinsurance agreement with Transamerica that will be affected by the adoption of this new SOP. The SOP provides guidance for reserving for contracts with guaranteed minimum death and guaranteed minimum income benefits. The methodology is based on projection of a wide number of future scenarios regarding the present value of premiums earned and claims incurred. Based on this future projection and actual past experience of premiums and claims, a Benefit Ratio percentage is determined. The reserve is then determined by applying the Benefit Ratio percentage to actual premiums received less actual claims, both with interest. Management does not expect the amount of reserves carried for our GMDB/GMIB reinsurance agreement to change significantly as a result of the adoption of the SOP. The SOP also provides guidance for reserving for annuity agreements with more than one potential account balance. Such reserves should be based upon the highest contractually determinable balance, without consideration of surrender fees. Upon adoption of the SOP, there is a one-time transition adjustment to the amount of carried deferred acquisition costs. Management is currently analyzing the impact of the adoption of the SOP on our accounting for the Transamerica annuity reinsurance agreement.
For further information about the market risk sensitivity of minimum guarantee associated with variable annuity products, see
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company and its subsidiaries as of December 31, 2003 and 2002 and the results of their operations and cash flows for the years ended December 31, 2003, 2002 and 2001 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.
The accompanying consolidated financial statements and financial statement schedule have been prepared assuming that the Company will continue as a going concern. As discussed in Note 2 to the consolidated financial statements, the Company has suffered significant losses from operations and experienced liquidity demands that raise substantial doubt about its ability to continue as a going concern. Management’s plans with regard to these matters are also described in Note 2. The consolidated financial statements and financial statement schedule do not include any adjustments that might result from the outcome of this uncertainty.
As discussed in Note 3(k) to the consolidated financial statements, as of January 1, 2001, the Company changed its method of accounting for derivative financial instruments and hedging activities.
Deposit accounting procedures are applied to considerations received or paid relating to reinsurance contracts that do not qualify for reinsurance accounting, with any revenue or expense associated with such deposits reflected in net investment income and other insurance expenses, respectively.
For traditional life and annuity policies with life contingencies, deferred policy acquisition costs are charged to expense using assumptions consistent with those used in computing policy reserves. Assumptions as to anticipated premiums are estimated at the date of the policy issuance, or the effective date of the most recent premium rate increase, and are consistently applied during the life of the contracts. Deviations from estimated experience are reflected in earnings in the period such deviations occur. For these contracts, the amortization periods are generally the estimated life of the policies.
The Company has classified as insurance licenses the cost in excess of fair value of net assets acquired in a purchase transaction. Prior to January 1, 2002, the Company had been amortizing these insurance licenses on a straight-line basis over 20 years. In June 2001, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards Number 142 - Goodwill and Other Intangible Assets. Under FAS 142 the insurance licenses are no longer amortized, but are subjected to an initial impairment test on adoption of FAS 142 and an annual impairment test in subsequent years. The Company adopted FAS 142 on January 1, 2002. In 2003, the Company determined that an impairment charge was necessary and the entire amount was written off. The amount carried at December 31, 2002 was $2,128,000.
The Company’s liability for contracts providing reinsurance for life insurance policies is recorded in the balance sheet as reserves for future policy benefits. The reserve is estimated using a net level premium method utilizing actuarial assumptions for mortality, persistency, interest and expenses established when
the contract is underwritten. These assumptions are based on anticipated experience with a margin for adverse deviation. If the reserves for future policy benefits plus the present value of expected future gross premiums are insufficient to provide for expected future benefits and expenses, deferred policy acquisition costs are written down and, if required, a premium deficiency reserve is established, by a charge to income. Benefit liabilities for traditional annuities that contain mortality risk are recorded at the present value of expected future benefit payments. Reserves are also established to cover death claims that may have been incurred and reported to the ceding company, but not yet reported to the Company due to timing delays.
The Company reinsures certain minimum guarantees associated with variable annuity contracts. The Company’s accounting policy is designed to establish reserves for expected claim payments based upon the view of expected losses over the life of the underlying policies, based upon the original pricing assumptions. The Company’s reserving policy allows the Company to increase reserves if claim amounts or claims volume exceed what was anticipated in pricing.
In December 2002, the FASB issued Statement Number 148 - Accounting for Stock-Based Compensation - Transition and Disclosure, an amendment of FASB Statement Number 123. This statement provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. On January 1, 2003, the Company voluntarily adopted the fair value based method of accounting for stock-based employee compensation under the prospective method described in FASB Statement Number 148. Under this method, the Company applies fair value accounting to all grants of employee stock options subsequent to December 31, 2002. Previously, the Company had applied the intrinsic value method when accounting for its stock-based compensation and continues to apply the intrinsic value method to stock-based compensation issued prior to January 1, 2003. FASB Statement Number 148 also amends the disclosure requirements of FASB Statement Number 123 to require more prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The following table provides the required disclosure for grants made prior to the Company’s adoption of the prospective method described in FASB Statement Number 148.
Funds withheld at interest represents a receivable balance equivalent to the Company’s proportionate share of its ceding companies’ statutory reserves related to policies reinsured by the Company under annuity reinsurance agreements written on a modified coinsurance or coinsurance funds withheld basis. The premiums received by a ceding company on the policies underlying these types of reinsurance agreements are used to purchase investment securities that are managed by that ceding company or investment managers appointed by it. Net investment income includes the Company’s proportionate share of the investment income and realized capital gains and losses on the sale of investments purchased with those premiums, as well as distributions from the embedded derivatives contained in certain of these agreements.
The Company has reviewed the Standards and Interpretations recently issued by the American Institute of Certified Public Accountants and the Financial Accounting Standards Board and has concluded that, with the exception of Statement of Position No. 03-1, the adoption of those Standards and Interpretations will not have a significant impact in the Company’s financial reporting.
In July 2003, the Accounting Standards Executive Committee of the AICPA issued Statement of Position (SOP) 03-1, Accounting and Reporting by Insurance Enterprises for Certain Non-Traditional Long-Duration Contracts and for Separate Accounts. The SOP provides guidance on accounting and reporting by insurance enterprises for certain nontraditional long-duration contracts and for separate accounts. The SOP will change the manner in which life insurance companies account for certain types of insurance and reinsurance contracts including those that cover risks such as guaranteed minimum death benefits and guaranteed minimum income benefits. Additionally, the SOP provides accounting guidance for sales inducements paid to contract holders and provides guidance for establishing liabilities for contracts with features that may result in more than one potential account balance. The SOP is effective for financial statements for fiscal years beginning after December 15, 2003. The SOP may not be applied
The amortized cost and fair values of investments in fixed income securities classified as available for sale at December 31, 2003 and 2002 are as follows:
A deferred tax liability of $377,000 and $765,000 has been provided against unrealized gains on fixed income securities as of December 31, 2003 and December 31, 2002, respectively.
At December 31, 2003 and 2002, letters of credit totaling $54,000,000 and $174,000,000, respectively, issued in the ordinary course of the Company’s business had been issued by its bankers in favor of certain ceding insurance companies to provide security and meet regulatory requirements. At December 31, 2003 and 2002, cash and investments of approximately $56,000,000 and $115,000,000, respectively, were pledged as collateral for letters of credit.
At December 31, 2003 and 2002, cash and investments of $96,000,000 and $125,000,000, respectively, were held in trust for the benefit of certain ceding insurance companies to provide security and to meet regulatory requirements. Substantially all remaining cash and investments held at December 31, 2003 were held by the Company’s U.S. operating subsidiary and are required by the subsidiary to maintain its statutory capital and surplus.
Investment income earned during the years ended December 31, 2003, 2002 and 2001 was as follows:
During the years ended December 31, 2002, the Company recognized a charge of $900,000 for securities that were impaired on an other than temporary basis.
The Company is authorized to issue 100,000,000 common shares of par value $1.00 each. The common shareholders have no pre-emptive, redemption, conversion or sinking fund rights. Subject to certain voting restrictions, which limit the voting power of United States persons to less than 10%, and non-United States persons to less than 17%, of the combined voting power of the issued voting shares of the Company, each holder is entitled to one vote per share.
In the event of a liquidation, dissolution or winding up of the Company, the holders of the common shares are able to share equally in the assets of the Company, if any remain after payment of all liabilities and the liquidation preference of any outstanding preferred shares. Certain restrictions exist with respect to the transfer of shares, should such a transfer cause the number of shares held by one United States person to be 10% or more, or a non-United States person to be 17% or more, of the Company’s outstanding common shares.
the Class B Warrants was $15.00 per share, which was equal to the price of the common shares in the initial public offering. Due to the effect of anti-dilution adjustment provisions in the Class B Warrants, the number of shares issuable upon exercise of the Class B Warrants has increased to 409,885 common shares and the exercise price of the Class B Warrants has been adjusted to $14.55 as the result of our issuance of warrants to Hartford Life, discussed below. The Class B Warrants are all currently exercisable and expire on April 15, 2008. No Class B Warrants have been exercised at December 31, 2003.
On June 30, 2003, the Company issued warrants to purchase an aggregate 1,000,000 common shares of the Company at an exercise price of $1.25 per share to Hartford Life, the ceding company under the Company’s then largest guaranteed minimum death benefit reinsurance agreement. The warrants were issued in connection with the recapture of that agreement. The warrants are currently exercisable and expire on June 30, 2013. At June 30, 2003, the fair value of warrants, using a Black-Scholes pricing model, was estimated at $1,250,000, which was included in the charge associated with the recapture. The expense of issuing these warrants is reflected as a component of Claim and policy benefits expense in the Company’s Consolidated Statements of Operations and as Stock warrants in the Company’s Consolidated Balance Sheet.
As of December 31, 2003, 2002, and 2001 the Company had 955,869, 1,144,535, and 1,860,536 options outstanding, respectively. There were Class A and Class B warrants outstanding representing the right to acquire 3,565,216 shares as of December 31, 2003, and 3,457,490 shares at both December 31, 2002 and 2001. Warrants issued to Hartford Life to acquire 1,000,000 shares were outstanding at December 31, 2003. Inclusion of the incremental shares from assumed exercise of options and warrants is considered anti-dilutive in 2003, 2002 and 2001. Consequently they are not included in diluted (loss) per share in these years.
The Prudential Investment Corporation serves as the Company’s investment managers. The Company has agreed to pay a fee for investment management services to The Prudential Investment Corporation based upon the amount of funds managed. The fee is based upon a sliding scale and has been determined on an arms-length basis. The Company also had entered into several life reinsurance agreements with the Prudential Insurance Company of America, all of which were recaptured during 2003. These contracts had been negotiated under normal commercial terms. One of the Company’s former directors was an executive officer of Prudential Financial, Inc. an affiliate of both The Prudential Investment Corporation and Prudential Insurance Company of America.
On December 31, 2002, the Company entered into a transaction with XL Life Ltd (“XL Life”), a subsidiary of XL Capital, pursuant to which the Company transferred certain blocks of life reinsurance business to XL Life. Under the agreement with XL Life, the Company novated five blocks of life reinsurance business to XL Life, which in turn entered into a 50% quota share reinsurance agreement with the Company with respect to four of those blocks of business. As a result of the transaction, the Company incurred a loss of approximately $26.5 million, primarily as a result of a write down of deferred acquisition costs of $38.7 million (which was partially offset by a net ceding commission to the Company of $18.0 million), a write down of prepaid expenses of $2.4 million and transaction costs of approximately $3.2 million. The agreement also provided that XL Life would receive an additional payment of $5.0 million if, during the 18 months following the agreement, the Company received new capital funding of at least $35.0 million and the Company’s stock traded at a price at or above $5.00 per share for a period of 20 out of 30 consecutive trading days.
As a result of the Company’s discussions with XL Life, the Company and XL Life and its affiliate agreed to mutually discharge their respective rights and obligations under all of the agreements described in the preceding paragraph in a comprehensive settlement effective as of July 1, 2003. Under the terms of the comprehensive settlement, the Company paid $6.0 million to XL Life and was released from any and all obligations to XL Life and its affiliate under all of the agreements among the parties. In addition, as part of the comprehensive settlement, the Company is obligated to pay $2.0 million to XL Life if prior to June 30, 2004 the Company’s stock trades above $2.00 per share for a period of 20 out of any 30 consecutive trading days and the Company raises an aggregate $35.0 million of equity or debt.
During 1998, certain of the Company’s officers purchased 163,121 shares in the Company, and the Company made loans to the officers to partially finance such purchases. The loans accrued interest at 7% per annum and certain unpaid loans became due and payable in April 2003. In connection with the renegotiation or termination of certain officers’ employment agreements, the Company has deemed the outstanding loans of those officers to have been repaid in exchange for the officers agreeing to forego certain bonus, severance or other payments that were or may have become payable to them. During the year ended December 31, 2003, loans of $1,000,000 and accrued interest of $402,812 were deemed repaid in this manner.
In 1998, the Board of Directors adopted a Stock Option Plan (the “Plan”) under which it may grant, subject to certain restrictions, Incentive Stock Options (“ISO’s”) and Non-Qualified Stock Options (“NQSO’s”). The aggregate number of common shares for which options may be granted under the Plan was initially limited to 1,552,500 Common Shares. In 1999, the Plan was amended such that options may be granted in any fiscal year equal to not more than 2% of the adjusted average of the outstanding common shares of the Company, as that number is determined by the Company to calculate diluted earnings per share. Only eligible employees of the Company are entitled to ISO’s, while NQSO’s may be granted to eligible employees, non-employee directors and consultants. The Compensation Committee of the Board of Directors administers the Plan.
Each person who becomes an eligible non-employee director, as defined in the plan, is automatically granted an option to purchase 15,000 common shares on the date he or she becomes an eligible non-employee director. These options have an exercise price equal to the greater of par value per common share or the fair market value of the optioned common shares on the date the options are granted and are exercisable in three equal installments commencing with the first anniversary of the grant date. In addition, subject to certain conditions, each non-employee director is automatically granted an option to purchase 2,500 common shares at each successive annual general meeting. These options have an exercise price equal to the fair market value of the optioned common shares on the date the options are granted and are immediately exercisable if granted after April 8, 1999.
Prior to its acquisition by Annuity and Life Re America, Inc. on June 1, 2000, the in force insurance business of Capitol Bankers Life Insurance Company was 100% reinsured with its former owner, a subsidiary of Swiss Re, who continues to administer the business reinsured. The amounts related to the reinsured business are included on the Company’s balance sheet in assets as Receivable for reinsurance ceded and in liabilities as Reserves for future policy benefits. At December 31, 2003 and 2002, these amounts were $88.2 million and $93.4 million, respectively. Capital Bankers Life Insurance Company was renamed Annuity and Life Reassurance America, Inc. in December 2000.
Retrocession agreements do not relieve the Company from its obligations to its cedents and failure of the Company’s reinsurers to honor their obligations could result in losses to the Company. The Company evaluates the financial condition of its reinsurers and monitors any concentrations of credit risk that may develop to minimize its exposure. The parties to the retrocession agreements described above have current credit rating of A+ or better, as assigned by A.M. Best.
As of December 31, 2003, the Company did not have sufficient available cash and investments to post as collateral to satisfy the collateral requirements asserted by CIGNA, the ceding company under the Company’s only
remaining guaranteed minimum death benefit and guaranteed minimum income benefit agreement. As of December 31, 2002, CIGNA asserted that the Company was required to post $59.0 million of collateral in addition to the $11.0 million of collateral the Company had previously provided. As of December 31, 2003, CIGNA was seeking $49.0 million of collateral in addition to the $11.0 million of collateral the Company had previously provided. The Company does not agree that the aggregate $60.0 million collateral requirement currently asserted by CIGNA is required to be posted, and has not posted any additional collateral for the agreement. As a result, CIGNA may institute arbitration or litigation proceedings against the Company. If the Company does not prevail in any such arbitration or litigation proceedings, it would have a material adverse effect on the Company’s financial condition and the Company may be required to liquidate its operations.
On November 20, 2002, the State of Connecticut Insurance Department and Annuity and Life Reassurance America entered into a letter agreement that acknowledged that the Department was monitoring the financial condition of Annuity and Life Reassurance America and such letter agreement required that certain financial transactions that Annuity and Life Reassurance America enters into, including disposal of assets, payment of dividends and settlement of inter-company balances with Annuity and Life Reassurance, be pre-approved by the Department. In addition, the Department had requested weekly reports from senior management of Annuity and Life Reassurance America on the Company’s status and any changes in the status of Annuity and Life Reassurance America. The letter agreement was in effect until March 1, 2004 and was not renewed by the Department.
There can be no assurance that the Company will be able to maintain its operations and liquidity. If the Company is unable to reposition its investment portfolio to achieve a substantially higher yield within its investment guidelines, successfully defend against the pending purported shareholder class action suit, improve the performance of its reinsurance agreement with Transamerica and restructure its reinsurance agreement with CIGNA, the Company may not be able to meet its obligations in 2004. The Company’s failure to achieve any one of the foregoing items could have a material adverse effect on its financial condition and results of operations.
The Company has entered into a significant deferred annuity reinsurance agreement with Transamerica. Due to the size of this agreement, there is a material concentration of net investment income, interest credited to interest sensitive products, funds withheld at interest, deferred policy acquisition costs and interest sensitive contract liabilities.
The contract is a modified coinsurance annuity reinsurance agreement whereby the Company reinsures Transamerica. At December 31, 2003 and 2002, approximately $604 million and $734 million, respectively, of the Company’s funds withheld at interest receivable and $602 million and $756 million, respectively, of the Company’s interest sensitive contracts liability related to its reinsurance agreement with Transamerica. The reinsurance agreement is a retrocessional agreement covering policies issued by IL Annuity and Insurance Company. Transamerica’s agreement with IL Annuity is also structured on a modified coinsurance basis, so IL Annuity maintains ownership and control of the assets supporting the Company’s obligations to Transamerica. At December 31, 2003, IL Annuity had financial strength or claims paying ratings of BB+ from Standard & Poor’s. At December 31, 2003, Transamerica had financial strength or claims paying ratings of A+, AA, Aa3 and AA+ (with a negative outlook) from A.M. Best, Standard & Poor’s, Moody’s Ratings and Fitch Ratings, respectively.
As a result of the recapture or termination of many of the Company’s reinsurance agreements, certain of the Company’s remaining agreements, which previously did not represent a significant percentage of the Company’s business, have become more prominent. For the year ended December 31, 2003, the Company recorded losses of approximately $2.1 million, related to its life reinsurance agreement with ERC Life. Premiums associated with this agreement for the year ended December 31, 2003 were approximately $17.1 million. For the year ended December 31, 2003, the Company recorded losses of approximately $2.2 million related to its life reinsurance agreement with National States Life. Premiums associated with this agreement for the year ended December 31, 2003 were approximately $12.2 million. For the year ended
The Company’s United States domiciled operating subsidiary, Annuity and Life Reassurance America, was purchased from a subsidiary of SwissRe on June 1, 2000. Immediately prior to the acquisition, 100% of Annuity and Life Reassurance America’s life and annuity policies were reinsured with Reassure America Life Insurance Company (“Reassure”), a subsidiary of SwissRe, under an indemnity co-insurance agreement. Following the acquisition, the policies continue to be 100% reinsured with Reassure; however, Annuity and Life Reassurance America remains the primary carrier. Reassure is required to indemnify Annuity and Life Reassurance America for any losses associated with these policies. Reserves ceded under its reinsurance agreement amounted to approximately $88.2 million and $93.4 million at December 31, 2003 and December 31, 2002, respectively. Reassure currently is rated A+g (superior) by AM Best.
At December 31, 2003, one of the Company’s modified coinsurance annuity reinsurance agreements has a feature that constitutes an embedded derivative which requires bifurcation and separate accounting under FAS 133 - Accounting for Derivative Instruments and Hedging Activities. The valuation of this embedded derivative requires cash flow modeling that uses various assumptions regarding future cash flows under these agreements. The fair value of this derivative is reported as a component of Funds withheld at interest. At December 31, 2003, the fair value of this embedded derivative was a loss of $(7,790,000). At December 31, 2002, the fair value of the Company’s embedded derivatives under its modified coinsurance and coinsurance funds withheld annuity reinsurance agreements was a loss of approximately $(24,483,000).
Fair value disclosures are not required for reinsurance balances recoverable, deferred policy acquisition costs, or liabilities arising from insurance and annuity contracts. As a result, the Company has not determined such disclosures. Fair values of other assets and liabilities approximate their carrying values due to their short-term nature. Included in other liabilities is $2,570,000 at December 31, 2002 of unrealized loss, representing the fair value of two interest rate swap agreements.
mortality risk. The annuity segment comprises all products where the dominant risk characteristic is investment risk, including those products which provide minimum guarantees on variable annuity products. In addition, since January 1, 2001, certain of the Company’s modified coinsurance and coinsurance funds withheld annuity reinsurance agreements have features that constitute embedded derivatives that require bifurcation and separate accounting under FAS 133 - Accounting for Derivative Instruments and Hedging Activities. The cumulative effect of the application of FAS 133 through January 1, 2001 and the change in the fair value of these embedded derivatives since that date are included in the annuity segment.
Both the life and annuity segments have specific assets, liabilities, stockholder’s equity, revenue, benefits and expenses that apply only to them. The corporate segment contains all stockholders’ equity not otherwise deployed to the life or annuity segment. In addition, the corporate segment includes all capital gains and losses from sales of securities in our portfolio and investment income on undeployed invested assets. Operating expenses are allocated to the segments proportionately based upon the amount of stockholder’s equity deployed to the segment, except for capital raising costs that have been completely allocated to the corporate segment.
Annuity and Life Re America and Annuity and Life Reassurance America, the Company’s United States based subsidiaries, are subject to all applicable Federal and State taxes of the United States. U.S. income taxes applicable to the Company’s U.S. operations are not material to the consolidated financial statements and, therefore, no separate item appears on the income statement or balance sheet. At December 31, 2003 and 2002 the Company had recorded a deferred tax liability of $377,000 and $765,000, respectively, related to U.S. income taxes on unrealized gains on investments held by its U.S. operations. No deferred tax asset or liability related to operating income has been recognized. GAAP stand alone net operating results for the Company’s U.S. operations for the year ending 2003, 2002, and 2001 was a loss of $(12,230,000), a loss of $(781,000), and a gain of $891,000, respectively. The tax basis net operating loss carry forward at December 31, 2003 was $12,559,000, which begins expiring in 2019. The Company does not expect that its future taxable net income will be sufficient to offset its deferred tax asset within a reasonable time period. Therefore, the Company has established valuation allowances of $3,818,000 and $200,000 at December 31, 2003 and 2002, respectively, against its deferred tax asset.
Annuity and Life Reassurance America, Inc is subject to statutory regulations of the state of Connecticut of the United States that restrict the payment of dividends. It may not pay dividends in any 12-month period in excess of the greater of the statutory net gain from operations for the immediately proceeding calendar year excluding pro rata distributions of any class of Annuity and Life Reassurance America’s securities or 10% of Annuity and Life Reassurance America’s statutory surplus as regards policyholders as of the immediately preceding December 31 at the end of the preceding year, without regulatory approval. At December 31, 2003 the statutory capital and surplus of Annuity and Life Reassurance America was $13,892,000.