The following table summarizes the properties we lease and own at December 31, 2004:
The following table sets forth certain financial and operating data of the Company.
Financial data for 2001 includes the results for ILICO, subsequent to the acquisition date of May 18, 2001.
For purposes of computing the ratio of earnings to fixed charges, “earnings” consist of income from operations before income taxes and fixed charges. “Fixed charges” consist of interest credited on annuity and universal life contracts and interest expense on debt and amortization of debt expense.
The following analysis of the consolidated financial condition and results of operation of AmerUs Group Co. should be read in conjunction with the Selected Financial Data and Consolidated Financial Statements and related notes. We are incorporating by reference “Item 1. Business” information into Management’s Discussion and Analysis of Financial Condition and Results of Operations section.
Non-segment expense, net consists primarily of open block realized/unrealized gains and losses, derivative related market value adjustments, reinsurance adjustments, non-insurance operations, restructuring costs, interest expense, income taxes, discontinued operations and cumulative effect of change in accounting.
Operating segment income increased for the protection products segment in 2004 compared to 2003 primarily as a result of increased open block margins and lower operating expenses. Operating segment income decreased for the protection products segment in 2003 compared to 2002 primarily as a result of lower net investment income and the continued decrease in closed block operating income. The continued shift in our business from traditional fixed annuities to higher margin equity indexed annuities and more assets under management increased accumulation products segment earnings in 2004 and 2003 compared to the respective years. The increased operating segment income in 2004 for the protection products and accumulation products segments was partially reduced by higher other operations’ losses resulting primarily from additional holding company expenses.
Total assets increased $1.6 billion in 2004 primarily as a result of net cash received from collected premiums and deposits, positive cash flows from operating activities and the utilization of securities lending and borrowing arrangements. Liabilities increased primarily due to policy reserves and policyowner funds which increased due to the higher volume of insurance in force and additional securities lending and borrowing arrangements. Stockholders’ equity increased $213.7 million during 2004 primarily as a result of 2004 net income of $192.6 million, stock issued under incentive plans amounting to $15.8 million and additional unrealized gains on available-for-sale investments of $34.0 million. The unrealized gains included in accumulated other comprehensive income are presented after related adjustments to DAC, VOBA,
capitalized bonus interest, closed block policyowner dividend obligation, unearned revenue reserves and deferred income taxes. The additions to equity were reduced by treasury stock purchases which decreased equity $9.2 million and dividends declared in the fourth quarter of 2004 which decreased equity $15.7 million.
Market value changes and amortization of assets and liabilities associated with the accounting for derivatives, such as:
Unrealized gains and losses on open block options and securities held for trading.
Pre-tax operating income from our protection products increased 9% in 2004 and decreased 1% in 2003 compared to the respective prior years. The increase in 2004 was primarily due to higher open block product margins and lower operating expenses. Higher product margins increased open block operating income in 2003 compared to 2002; however, the declining closed block glide path (see Dividends to Policyowners for additional information) offset the open block operating income. The key drivers of our protection products business include sales, persistency, net investment income, mortality and expenses.
Sales, Premiums and Product Charges. Sales are a key driver of our business as they are a leading indicator of future revenue trends to emerge in segment operating income. As shown in the Sales Activity by Product table presented in “Item 1 Business - Protection Products Segment,” direct first year annualized premiums increased 5% in 2004 compared to 2003 and decreased 9% in 2003 compared to 2002. The increase in 2004 resulted from higher equity indexed life product sales as we continue to focus our marketing efforts on this product. The equity indexed life product allows the policyowner to elect an earnings strategy for a portion of the account value whereby earnings are credited based primarily on increases in the S&P 500 Index, excluding dividends. The earnings credit is subject to a participation rate and an annual cap. Sales of equity indexed life products were $74.6 million in 2004 as compared to $51.6 million in 2003 and $45.8 million in 2002. We are the leading writer of equity indexed life products in the United States. The increase in 2004 was partially offset by decreased traditional and universal life insurance product sales due to our continued shift in sales focus to equity indexed products and uncertainty in government tax policy and regulation. The decrease in 2003 resulted from lower traditional and universal life insurance product sales as we re-priced our products and discontinued our par whole life product. The lower traditional and universal sales were partially offset by increased equity indexed life sales.
Insurance premium revenue in 2004 and 2003 was lower than the respective prior years primarily due to lower sales of traditional products, additional premiums ceded and a decline in closed block in force business.
Net Investment Income. Net investment income is a key driver of our business as it reflects earnings on our invested assets. Net investment income increased in 2004 and decreased in 2003 compared to the respective prior years. The increase in 2004 was primarily due to growth in average protection products assets which were approximately $318 million higher than 2003. The decrease in net investment income in 2003 was due to low interest rates and increased prepayments of mortgage-backed securities. The earned rate of the investment portfolio was 6.44% in 2004 compared to 6.63% in 2003 and 7.22% in 2002. The decrease in rates in 2004 and 2003 was primarily a result of the continued low interest rate environment.
Our accumulation products segment primary offerings consist of individual fixed annuities and funding agreements. The fixed annuities are marketed on a national basis primarily through IMOs and independent brokers. Similar to our protection products segment, we invest the premiums we receive from accumulation product deposits in our investment portfolio and establish a liability representing our commitment to the policyowner. We manage product spread by seeking to maximize the return on our invested assets consistent with our asset/liability management and credit quality policies. When appropriate, we periodically reset the interest rates credited to our policyowner liability. Accumulation products reserves totaled $12.3 billion at December 31, 2004, $11.7 billion at December 31, 2003 and $11.3 billion at December 31, 2002. A summary of our accumulation products segment operations follows:
Pre-tax operating income from our accumulation products operations increased 25% in 2004 and 8% in 2003 compared to the respective prior years. The 2004 increase was primarily due to higher assets under management and improved product spreads. The 2003 increase was primarily due to higher assets under management which were reduced by decreased product spreads. The increases for both years were partially offset by lower contributions from IMO operations. The drivers of profitability in our accumulation products business are deposits, persistency, product spread, expenses and IMO operations.
We placed fixed rate funding agreements totaling $85 million in 2004 and $875 million in 2002. Funding agreements are insurance contracts for which we receive deposit funds and for which we agree to repay the deposit and a contractual return for the duration of the contract. In December 2003, a $250 million funding agreement originally placed in 1999 was terminated. Total funding agreements outstanding as of December 31, 2004 amounted to $960 million compared to $875 million outstanding at December 31, 2003.
The product spread increased 25 basis points to 223 basis points in 2004 compared to 2003 and decreased 12 basis points to 198 basis points in 2003 compared to 2002. Liability crediting rates on traditional annuities were lowered throughout 2003 and 2004 to correspond with the decline in investment yields caused by lower rates on new and reinvested funds. As described in the Traditional Annuity Products and Equity Indexed Annuities sections presented in “Item 1 Business - Accumulation Products Segment,” the annuity products have various differentials between the credited rate and minimum guarantee rate, including some which have no differential, and as such cannot be lowered. Additionally, some traditional annuities have multi-year interest rate guarantees for which the credited rate cannot be decreased until the end of the multi-year period. Due to these limitations on the ability to lower interest crediting rates and the potential for credit defaults and lower reinvestment rates on investments, we could experience spread compression in future periods.
We also earn a spread on our funding agreements. Funding agreement income less associated interest expense totaled $6.8 million in 2004, $11.1 million in 2003, and $6.1 million in 2002. The 2004 decrease was due to the termination of a $250 million funding agreement during the fourth quarter of 2003. The 2003 increase was due to the $875 million of funding agreements placed throughout 2002.
Underwriting, Acquisition and Other Expenses. Underwriting, acquisition and other expenses are a key driver of our business as they represent costs of our operations. Expenses in 2004 and 2003 decreased compared to the respective prior years due primarily to continued process improvements to enhance operating efficiencies and lower fees associated with a declining block of annuity business processed by a third party administrator.
Outlook. We anticipate increased product sales from our IMOs but decreased product sales from other distribution channels as we manage our sales in this current low interest rate environment. We also expect to continue the shift of our product mix to higher return products, in particular the equity indexed annuity products. We will continue to manage our spreads as we strive for our desired profitability in this economic environment.
Interest Expense. Interest expense increased in 2004 and 2003 as compared to the respective prior years. The increases were primarily due to interest associated with the PRIDES securities of $143.8 million issued in the second quarter of 2003.
Discontinued Operations. In November 2003, we entered into an agreement to sell our residential financing operations. The results of the residential financing operations have been classified as discontinued operations. The sale was completed in January 2004, resulting in an after-tax gain of $3.9 million.
The payment of dividends by our insurance subsidiaries is regulated under various state laws. Generally, under the various state statutes, our insurance subsidiaries’ dividends may be paid only from the earned surplus arising from their respective businesses and must receive the prior approval of the respective state regulator to pay any dividend that would exceed certain statutory limitations. The current statutes generally limit any dividend, together with dividends paid out within the preceding 12 months, to the greater of (i) 10% of the respective company’s policyowners’ statutory surplus as of the preceding year end or (ii) the statutory net gain from operations for the previous calendar year. Generally, the various state laws give the state regulators discretion to approve or disapprove requests for dividends in excess of these limits. Based on these limitations and 2003 results, our life insurance subsidiaries could have paid us an estimated $77 million in dividends in 2004 without obtaining regulatory approval. Our subsidiaries paid us approximately $15 million in 2004. Based on 2004 results, our subsidiaries can pay an estimated $186 million in dividends without obtaining regulatory approval during 2005. We also consider risk-based capital levels, capital and liquidity operating needs, and other factors prior to paying dividends from the insurance subsidiaries.
On May 28, 2003, we issued $125 million of PRIDES securities and on December 15, 2004 we exchanged $185 million of aggregate original principal amount of OCEANs as previously discussed in “Item 5 - Market for Registrant’s Common Equity, Related Stockholder Matters, and Issuer Purchases of Equity Securities,” which portions are incorporated herein by reference.
The Company has several options for deploying excess capital, including supporting higher sales growth, reducing debt levels, pursuing acquisitions and buying back common stock. Our Board of Directors approved a stock purchase program effective August 9, 2002, under which we may purchase up to three million shares of our common stock at such times and under such conditions, as we deem advisable. The purchases may be made in the open market or by such other means as we determine to be appropriate, including privately negotiated purchases. The purchase program supercedes all prior purchase programs. We plan to fund the purchase program from a combination of our internal sources, dividends from insurance subsidiaries and the Revolving Credit Agreement. Approximately 2.0 million shares remain available for repurchase under this program. There were 244,400 shares purchased in 2004 for $9.2 million. Holding company cash was utilized to purchase the shares.
The insurance subsidiaries may also obtain liquidity through sales of investments. The investment portfolio as of December 31, 2004, had a carrying value of $19.2 billion, including closed block investments.
We may also enter into securities borrowing arrangements from time to time whereby we borrow securities from other institutions and pay a fee. Securities borrowed amounted to $138.2 million and none at
December 31, 2004, and 2003, respectively, and are also included in accrued expenses and other liabilities in the consolidated balance sheet.
Represents future payments for annuities and other non-life insurance obligations. Such obligations are included in the determination of reserves and are included in policy reserves and policyowner funds on the consolidated balance sheet.
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of
We hold derivative financial instruments to hedge growth in policyowner liabilities for certain protection and accumulation products and to hedge market risk for fixed income investments. These derivatives qualify for hedge accounting or are considered economic hedges as discussed in detail in note 4 to our consolidated financial statements.
To hedge equity market risk, we primarily use S&P 500 Index call options to hedge the growth in interest credited to the customer as provided by our equity indexed products. We may also use interest rate swaps or options to manage our fixed products’ risk profile. Generally, credit default swaps are coupled with a bond to synthetically create an instrument cheaper than an equivalent investment traded in the cash market.
We amortize the VOBA based on the incidence of the EGMs from insurance contracts using the interest rate credited to the underlying policies. The EGMs are based on actuarially determined projections of future premium receipts, mortality, surrenders, operating expenses, changes in insurance liabilities, investment yields on the assets retained to support the policy liabilities and other factors. These projections take into account all factors known or expected by management. The actual gross margins may vary from expected levels due to differences in renewal premium, investment spread, investment gains or losses, mortality and morbidity costs and other factors.
Our investment philosophy is to employ an integrated asset/liability management approach with separate investment portfolios for specific product lines, such as traditional life, universal life, equity indexed life, traditional annuities, equity indexed annuities, variable annuities and funding agreements to generate attractive risk-adjusted returns on capital. Essential to this philosophy is coordinating investments in the investment portfolio with product strategies, focusing on risk-adjusted returns and identifying and evaluating associated business risks.
The following table summarizes fixed maturity securities by remaining maturity as of December 31, 2004:
Below-investment grade fixed maturity securities as of December 31, 2004, included the securities of 322 issuers representing 7.0% of total invested assets, with the largest being a $29.9 million investment.
MBS investments are mortgage-related securities including collateralized mortgage obligations (CMOs) and pass-through mortgage securities. Asset-backed securities are both residential and non-residential including exposure to home equity loans, home improvement loans, manufactured housing loans as well as securities backed by loans on automobiles, credit cards, and other collateral or collateral bond obligations. As of December 31, 2004, asset-backed residential mortgages totaled $259.9 million or 1.4% of total invested assets. As of December 31, 2004, residential mortgage pass-through and CMOs totaled $2,020.6 million or 10.5% of total invested assets. As of December 31, 2004, $1,824.1 million or 90.3% of MBS were from government sponsored enterprises. Other MBS were $196.5 million or 9.7% of MBS as of December 31, 2004. Management believes that the quality of assets in the MBS portfolio is generally high, with 99.5% of such assets representing agency backed or “AAA” rated securities. Collateralized mortgage backed securities (or CMBS) totaled $1,119.2 million or 5.8% of total invested assets as of December 31, 2004.
As of December 31, 2004, mortgage loans in the investment portfolio were $865.7 million, or 4.5% of the aggregate carrying value of invested assets. As of December 31, 2004, commercial mortgage loans and residential mortgage loans comprised 99.9% and 0.1%, respectively, of total mortgage loans. Commercial mortgage loans consist primarily of fixed-rate mortgage loans. As of December 31, 2004, we held 713 individual commercial mortgage loans with an average balance of $1.2 million.
As of December 31, 2004, there were no loans in the loan portfolio classified as delinquent or in foreclosure. As of the same date, there were no loans classified as restructured. During 2004, we had three foreclosures.
We hold investments in indexed debt instruments (IDIs) in which the principal is initially partially defeased by an obligation of a third party financial institution (institution) collateralized by U.S. Treasuries which will accrete to 50% of the original principal amount of the IDIs at maturity. The balance of the principal amount due at maturity is subject to a dynamic defeasance mechanism, which should provide a return of the initial investment. The instruments issued by the institutions are linked to the performance of a hedge fund or fund of funds. The annual income on these investments will be equal to the quarterly distribution of the hedge fund or fund of funds plus the change in the present value of anticipated distributions to be received at maturity and will be included in net investment income. Over the life of the IDIs, the income will be a
function of the cumulative performance of the linked hedge fund or fund of funds and the return on any defeased portion of the investment. The quarterly distribution paid, if any, reduces the amount of future participation in the performance of the linked hedge fund or fund of funds. At maturity, the Company will take delivery of the referenced hedge fund interests and cash or U.S. Treasuries equal to the portion of the instruments that have been defeased, the total of which should equal or exceed the instruments’ principal amount. The investment purpose of these instruments is to enable the Company to obtain the return as if they had invested in hedge funds or fund of funds with dynamic principal protection. The instruments as of December 31, 2004 carried an A rating or better by Fitch. The carrying value of IDIs was $564.7 million and $396.1 million at December 31, 2004 and 2003, respectively.
Financial conditions and trends including strength of balance sheet and financial liquidity
Length of time the fair value was below 80% of amortized cost
There are risks and uncertainties inherent in the process of monitoring impairments and determining if an impairment is OTTI. Risks may include 1) the credit characteristics change affecting the creditor’s ability to meet all of its contractual obligations; 2) the economic outlook may be worse than expected or impact the credit more than anticipated; 3) accuracy of information provided by issuers could affect valuations; and 4) new information may change our intent to hold the security to maturity. Any of these items could result in a charge to net income in the future.
Alleged credit specific fraud and default issues with no impact on other material investments
Specific collateral and structure issues with no impact on other material investments
The following tables present unrealized losses for fixed maturity securities at December 31, 2004 and 2003 by investment category and industry sector:
be realized. These unrealized gains or losses are subject to fluctuation, reflective of such things as volatile financial markets, interest rate movements, credit spread changes and sale decisions.
In force reserves and the assets allocated to each segment are modeled on a regular basis to analyze projected cash flows under a variety of economic scenarios. The result of this modeling is used to modify asset allocation, investment portfolio duration and renewal crediting strategies. We invest in derivatives to hedge against the effects of interest rate fluctuations or to hedge growth in policyowner liabilities for certain life and annuity products and funding agreements. For a further discussion and disclosure of the nature and extent of the use of derivatives, see note 4 to the consolidated financial statements.
In addition, the adoption of SOP 03-1 established guidance for the accounting and presentation of costs related to sales inducements. There was no change to the Company’s method of accounting for sales inducements; however, the capitalized costs are now separately disclosed in the consolidated balance sheet and the related amortization expense is included in policyowner benefits in the consolidated statement of income. Prior to 2004, the capitalized costs were included in DAC and the amortization expense was included in the amortization of DAC. The 2003 amounts have been reclassified to conform with the 2004 presentation.
In March 2004, the Emerging Issues Task Force of the Financial Accounting Standards Board (FASB) reached a final consensus on Issue 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments,” (EITF 03-1). EITF 03-1 established impairment models for determining whether to record impairment losses associated with investments in certain equity and debt securities. It also required income to be accrued on a level-yield basis following an impairment of debt securities, where reasonable estimates of the timing and amount of future cash flows can be made. EITF 03-1 indicated that, although not presumptive, a pattern of selling investments prior to the forecasted recovery may call into question an investor’s intent to hold the security until its value recovers. EITF 03-1 was to be effective for reporting periods beginning after June 15, 2004; however, in September 2004, the effective date of these provisions was delayed until the finalization of a FASB Staff Position (FSP) to provide further guidance on this topic.
In June 2004, the FASB issued Financial Staff Position FAS 97-1, “Situations in Which Paragraphs of FASB Statement No. 97 Permit or Require Accrual of an Unearned Revenue Liability,” (FSP 97-1). FSP 97-1 clarifies that SOP 03-1 did not restrict the recording of a liability for unearned revenue as defined in accordance with paragraphs 17(b) and 20 of SFAS 97, “Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments,” to only those situations where profits are followed by expected losses. FSP 97-1 was effective for periods beginning after June 18, 2004. The adoption of FSP 97-1 did not have an effect on our consolidated financial position or results of operations in 2004.
In May 2004, the FASB issued Financial Staff Position FAS 106-2, “Accounting and Disclosure Requirements Related to the Medicare Prescription Drug Improvement and Modernization Act of 2003,” (FSP 106-2). FSP 106-2 requires sponsors of a post-retirement health care plan that provides retiree prescription drug benefit to reflect the provisions of the Medicare Prescription Drug Improvement and Modernization Act of 2003 (the Medicare Act) in determining post-retirement benefit cost for the first annual or interim period beginning after June 15, 2004. We have determined that the drug benefits provided under our post-retirement benefits program for Medicare eligible retirees are not actuarially equivalent to the benefit established by the Medicare Act, and therefore we will not be eligible to receive the federal subsidy. As a result, there was no effect on our consolidated financial position or results of operations in 2004.