The results of operations for 2002 are affected by the profit sharing agreement with AIG SunAmerica Asset Management Corp. (See Note 10 of the accompanying financial statements).
The Company has one business segment, annuity operations, which consists of the sale and administration of deposit-type insurance contracts, such as fixed and variable annuities and universal life insurance contracts. The Company focuses primarily on the marketing of fixed and variable annuity products. The variable annuity products offer investors a broad spectrum of fund alternatives, with a choice of investment managers, as well as guaranteed fixed-rate account options. The Company earns fee income on investments in the variable account options and net investment income on the fixed-rate account options.
The Company considers among its most critical accounting policies those policies with respect to valuation of certain financial instruments and amortization of deferred acquisition costs. In the implementation of each of the aforementioned policies, management is required to exercise its judgment on both a quantitative and qualitative basis. Further explanation of how management exercises that judgment follows:
AMORTIZATION OF DEFERRED ACQUISITION COSTS: We amortize our deferred acquisition costs (“DAC”) based on a percentage of expected gross profits (“EGPs”) over the life of the underlying policies. EGPs are computed based on assumptions related to the underlying policies written, including their anticipated duration, the growth rate of the separate account assets (with respect to variable annuities) or general account assets (with respect to fixed annuities) supporting the annuity obligations, the anticipated value of guaranteed minimum death benefits to be paid, and the level of expenses necessary to maintain the policies. The Company adjusts DAC amortization (a “DAC unlocking”) when estimates of current or future gross profits to be realized from its annuity policies are revised. Approximately 60% of the Company’s DAC balance at December 31, 2002 related to fixed annuity products and 40% related to variable annuity products.
On December 9, 2002, the Company entered into a profit sharing agreement with AIG SunAmerica Asset Management Corp. (“SAAMCO”), whereby SAAMCO will pay its profits earned through servicing the Company’s variable annuity contracts to the Company (“SAAMCO Agreement”). SAAMCO is the investment adviser or business manager for certain trusts that hold deposits from the Company’s variable annuity products. Pursuant to the SAAMCO Agreement, SAAMCO will pay to the Company variable annuity fee income earned from acting as the investment adviser or business manager for certain trusts that hold deposits from the Company’s variable annuity products. The SAAMCO Agreement is retroactive to January 1, 2002. Amounts paid or accrued to the Company under this agreement totaled $1.8 million in 2002.
NET INCOME totaled $6.8 million in 2002, compared with $8.2 million in 2001 and $7.3 million in 2000. The operating results for 2002 include $1.8 million of fees earned by the Company pursuant to the SAAMCO Agreement.
CUMULATIVE EFFECT OF ACCOUNTING CHANGE, NET OF TAX reflected the adoption of EITF 99-20 in 2001. The Company recorded a loss of $520,000, net of tax, which is recognized in the statement of income and comprehensive income as a cumulative effect of accounting change for the year ended December 31, 2001 (see Note 2 of Notes to Financial Statements).
PRETAX INCOME BEFORE CUMULATIVE EFFECT OF ACCOUNTING CHANGE totaled $15.8 million in 2002, compared with $14.9 million in 2001 and $11.6 million in 2000. The improvement in 2002 over 2001 primarily resulted from decreased net realized investment losses, increased variable annuity fees and increased net investment income partially offset by increased amortization of deferred acquisition costs, increased general and administrative expenses and increased guaranteed minimum death benefits on variable annuities. The improvement in 2001 over 2000 primarily resulted from decreased amortization of deferred acquisition costs, partially offset by lower net investment income and fee income.
NET REALIZED INVESTMENT LOSSES totaled $10.0 million in 2002, compared with $19.3 million in 2001 and $20.8 million in 2000 and include impairment writedowns of $9.5 million, $17.3 million and $20.8 million, respectively. Thus, net realized losses from sales and redemptions of investments totaled $0.5 million in 2002, compared with $2.0 million of losses in 2001 and $0.03 million of gains in 2000.
VARIABLE ANNUITY FEES are based on the market value of assets in separate accounts supporting variable annuity contracts. Such fees totaled $9.0 million in 2002, $8.0 million in 2001 and $9.1 million in 2000. The 2002 amount includes $1.8 million of fees relating to the SAAMCO Agreement. Excluding the impact of the SAAMCO Agreement, the decreased fees in 2002 as compared to 2001 and 2000 reflect the unfavorable equity market conditions
in 2002, and the resulting unfavorable impact on market values of assets in the separate accounts and additionally from net exchanges from the separate accounts to the fixed accounts of variable annuity contracts. The decline in fees during 2001 is partially offset by net exchanges to the separate accounts from the fixed accounts of variable annuity contracts. Variable annuity fees represent 1.9% of average variable annuity assets in 2002 and 1.5% of average variable annuity assets in 2001 and 2000. The increase in fees as a percentage of average variable assets is due primarily to the $1.8 million in fees related to the SAAMCO Agreement. Excluding the impact of the SAAMCO Agreement, variable annuity fees would have represented 1.6% of average variable annuity assets in 2002. Variable annuity assets averaged $462.3 million, $517.1 million and $591.9 million during the respective periods. Variable annuity deposits, which exclude deposits allocated to the fixed accounts of variable annuity products, totaled $65.0 million in 2002, $34.6 million in 2001 and $39.6 million in 2000. These amounts represent 13%, 6% and 7% of variable annuity reserves at the beginning of the respective periods. The increase in variable annuity deposits in 2002 reflected increased demand for a new product, FSA Advisor, initially marketed in January 2001. The decrease in variable annuity deposits in 2001 reflected lower demand for the variable account options of the Company’s variable annuity products due to the unfavorable equity market conditions discussed above. Transfers from the fixed accounts of the Company’s variable annuity products to the separate accounts (see “Change in Average Invested Assets”) are not classified as variable annuity deposits. Accordingly, changes in variable annuity deposits are not necessarily indicative of the ultimate allocation by customers among fixed and variable account options of the Company’s variable annuity products.
Sales of variable annuity products (which include deposits allocated to the fixed accounts) (“Variable Annuity Product Sales”) amounted to $101.3 million, $90.5 million, $72.0 million in 2002, 2001 and 2000, respectively. Such sales primarily reflect those of FSA Advisor as well as the Company’s flagship variable annuity line, Polaris. FSA Advisor is a multimanager variable annuity that offers investors a choice of 27 variable funds and a guaranteed fixed-rate fund. Polaris is a multimanager variable annuity that offers investors a choice of 31 variable funds and a number of guaranteed fixed-rate funds. Variable Annuity Product Sales have increased in 2002 and 2001, primarily due to increased demand for the new product, FSA Advisor, which was initially marketed in January 2001. FSA Advisor product sales were approximately $51.3 million in 2002 as compared to $15.9 million in 2001 and zero in 2000. Annuity Product Sales have increased in 2001, primarily due to both new and enhanced relationships with New York based investment firms as well as the addition of four new funds offered by Polaris in December 2000.
SURRENDER CHARGES on fixed annuity, variable annuity and universal life contracts totaled $1.9 million in 2002, $2.1 million in 2001 and $3.8 million in 2000. Surrender charges generally are assessed on withdrawals at
AMORTIZATION OF DEFERRED ACQUISITION COSTS totaled $16.4 million in 2002, compared with $11.6 million in 2001 and $19.4 million in 2000. The increase in amortization in 2002 was primarily related to the impact of decreased net investment losses while the decrease in amortization in 2001 is principally due to the impact of increased amortization during 2000 of certain closed blocks of fixed annuities.
ANNUAL COMMISSIONS totaled $0.8 million in 2002, compared with $0.7 million in 2001 and $0.6 million in 2000. Annual commissions represent renewal commissions paid quarterly in arrears to maintain the persistency of certain of the Company’s variable annuity contracts. Substantially all of the Company’s currently available variable annuity products allow for an annual commission payment option in return for a lower immediate commission. The Company estimates that approximately 8% of the average balances of its variable annuity products is currently subject to such annual commissions. Based on current sales, this percentage is expected to increase in future periods.
GUARANTEED MINIMUM DEATH BENEFITS totaled $1.7 million in 2002, compared with $0.5 million in 2001 and $4,000 in 2000. The increase in guaranteed minimum death benefits related to the Company’s variable annuity contracts reflects the downturn in the equity markets since 2000. Further downturns in the equity markets could increase these expenses.
INCOME TAX EXPENSE totaled $9.0 million in 2002, $6.2 million in 2001 and $4.3 million in 2000, representing effective tax rates of 57%, 41% and 37%, respectively. The higher rate in 2002 was principally due to the impact of a deferred tax liability adjustment. The lower rate in 2000 was principally due to the impact of lower state income taxes. See Note 9 of the accompanying financial statements for a reconciliation of income tax expense to the federal statutory rate.
INVESTED ASSETS at December 31, 2002 totaled $1.71 billion, compared with $1.37 billion at December 31, 2001. The majority of the Company’s invested assets are managed by an affiliate. The Company’s general investment philosophy is to hold fixed-rate assets for long-term investment. Thus, it does not have a trading portfolio. However, the Company has determined that all of its portfolio of bonds, notes and redeemable preferred stocks (the “Bond Portfolio”) is available to be sold in response to changes in market interest rates, changes in relative value of asset sectors and individual securities, changes in prepayment risk, changes in the credit quality outlook for certain securities, the Company’s need for liquidity and other similar factors.
At December 31, 2002, the Bond Portfolio included $55.7 million of bonds that were not investment grade. These non-investment-grade bonds accounted for approximately 2.5% of the Company’s total assets and approximately 3.3% of its invested assets. Non-investment-grade securities generally provide higher yields and involve greater risks than investment-grade securities because their issuers typically are more highly leveraged and more vulnerable to adverse economic conditions than investment-grade issuers. In addition, the trading market for these securities is usually more limited than for investment-grade securities. These non-investment-grade securities are comprised of bonds spanning 22 industries with 13% of these assets concentrated in telecommunications and 12% of these assets concentrated in energy. No other industry concentration constituted more than 10% of these assets.
At December 31, 2002, approximately $194.1 million of the Bond Portfolio had an aggregate unrealized loss of $27.9 million. The gross unrealized losses in the bond portfolio included the following concentrations:
The amortized cost of the Bond Portfolio in an unrealized loss position at December 31, 2002, by contractual maturity, is shown below.
Senior secured loans (“Secured Loans”) are included in the Bond Portfolio and aggregated $32.3 million at December 31, 2002. Secured Loans are senior to subordinated debt and equity and are secured by assets of the issuer. At December 31, 2002, Secured Loans consisted of $30.9 million of privately traded securities and $1.4 million of publicly traded securities. These Secured Loans are composed of loans to borrowers spanning 6 industries, with 53% of these assets concentrated in energy, 16% concentrated in finance institutions and 11% concentrated in leisure and gaming. No other industry concentration constituted more than 10% of these assets.
of approximately $2.2 million, collateralized by properties located in 29 states. Approximately 41% of this portfolio was office, 16% was retail, 16% was multifamily residential, 14% was industrial, and 13% was other types. At December 31, 2002, approximately 31% of this portfolio was secured by properties located in California, approximately 13% by properties located in Texas, approximately 11% by properties located in Michigan and no more than 10% of this portfolio was secured by properties located in any other single state. At December 31, 2002, 3 mortgage loans have an outstanding balance of $10.0 million or more, which collectively aggregated approximately 25% of this portfolio. At December 31, 2002, approximately 28% of the mortgage loan portfolio consisted of loans with balloon payments due before January 1, 2006. During 2002, 2001 and 2000, loans delinquent by more than 90 days, foreclosed loans and restructured loans have not been significant in relation to the total mortgage loan portfolio.
At December 31, 2002, approximately 32% of the mortgage loans were seasoned loans underwritten to the Company’s standards and purchased at or near par from other financial institutions. Such loans generally have higher average interest rates than loans that could be originated today. The balance of the mortgage loan portfolio has been originated by the Company under strict underwriting standards. Commercial mortgage loans on properties such as offices, hotels and shopping centers generally represent a higher level of risk than do mortgage loans secured by multifamily residences. This greater risk is due to several factors, including the larger size of such loans and the more immediate effects of general economic conditions on these commercial property types. However, due to the seasoned nature of the Company’s mortgage loan portfolio and its strict underwriting standards, the Company believes that it has prudently managed the risk attributable to its mortgage loan portfolio while maintaining attractive yields.
POLICY LOANS totaled $36.1 million at December 31, 2002, compared to $37.3 million at December 31, 2001 and primarily represent loans taken against universal life insurance policies.
OTHER INVESTED ASSETS aggregated $29.6 million at December 31, 2002 and principally included collateral held under a securities lending agreement with an affiliated agent. The Company has entered into such agreement with an affiliated lending agent, which authorizes the agent to lend securities held in the Company’s portfolio to a list of authorized borrowers. The Company receives primarily cash collateral in an amount in excess of the market value of the securities loaned. The Company monitors the daily market value of securities loaned with respect to the collateral value and obtains additional collateral when necessary to ensure that collateral is maintained at a minimum of 102% of the value of the loaned securities. Such collateral is not available for the general use of the Company.
ASSET-LIABILITY MATCHING is utilized by the Company to minimize the risks of interest rate fluctuations and disintermediation. The Company believes that its fixed-rate liabilities should be backed by a portfolio principally composed of fixed-rate investments that generate predictable rates of return. The Company does not have a specific target rate of return. Instead, its rates of return vary over time depending on the current interest rate environment, the slope of the yield curve, the spread at which fixed-rate investments are priced over the yield curve, default rates, and general economic conditions. Its portfolio strategy is constructed with a view to achieve adequate risk-adjusted returns consistent with its investment objectives of effective asset-liability matching, liquidity and safety. The Company’s fixed-rate products incorporate surrender charges or other restrictions in order to encourage persistency. Approximately 65% of the Company’s fixed annuity and universal life reserves had surrender penalties or other restrictions at December 31, 2002.
As part of its asset-liability matching discipline, the Company conducts detailed computer simulations that model its fixed-rate assets and liabilities under commonly used stress-test interest rate scenarios. With the results of these computer simulations, the Company can measure the potential gain or loss in fair value of its interest-rate sensitive instruments and seek to protect its economic value and achieve a predictable spread between what it earns on its invested assets and what it pays on its liabilities by designing its fixed-rate products and conducting its investment operations to closely match the duration of the fixed-rate assets to that of its fixed-rate liabilities. The Company’s fixed-rate assets include: cash and short-term investments; bonds, notes and redeemable preferred stocks; mortgage loans; and policy loans. At December 31, 2002, these assets had an aggregate fair value of $1.73 billion with a duration of 3.9. The Company’s fixed-rate liabilities include fixed annuity and universal life insurance contracts. At December 31, 2002, these liabilities had an aggregate fair value (determined by discounting future contractual cash flows by related market rates of interest) of $1.58 billion with a duration of 4.0. The Company’s potential exposure due to a relative 10% decrease in prevailing interest rates from their December 31, 2002 levels is a loss of approximately $1.2 million, representing the increase in fair value of its fixed rate liabilities that is not offset by an increase in fair value of its fixed rate assets. Because the Company actively manages its assets and liabilities and has strategies in place to minimize its exposure to loss as interest rate changes occur, it expects that actual losses would be less than the estimated potential loss.
The Company also seeks to provide liquidity by investing in MBSs. MBSs are generally investment-grade securities collateralized by large pools of mortgage loans. MBSs generally pay principal and interest monthly. The amount of principal and interest payments may fluctuate as a result of prepayments of the underlying mortgage loans.
covenants, the borrower’s recent financial performance, news reports and other externally generated information concerning the creditor’s affairs. In the case of publicly traded bonds, management also considers market value quotations, if available. For mortgage loans, management generally considers information concerning the mortgaged property and, among other things, factors impacting the current and expected payment status of the loan and, if available, the current fair value of the underlying collateral.
DEFAULTED INVESTMENTS, comprising all investments that are in default as to the payment of principal or interest, totaled $5.7 million of bonds at December 31, 2002, and constituted less than 0.3% of total invested assets. At December 31, 2001, defaulted investments totaled $3.4 million of bonds and constituted less than 0.3% of total invested assets.
Management is aware that prevailing market interest rates may shift significantly and has strategies in place to manage either an increase or decrease in prevailing rates. In a rising interest rate environment, the Company’s average cost of funds would increase over time as it prices its new and renewing annuities to maintain a generally competitive market rate. Management would seek to place new funds in investments that were matched in duration to, and higher yielding than, the liabilities assumed. The Company believes that liquidity to fund withdrawals would be available through incoming cash flow, the sale of short-term or floating-rate instruments or Reverse Repos on the Company’s substantial MBS segment of the Bond Portfolio, thereby avoiding the sale of fixed-rate assets in an unfavorable bond market.
events that may cause such a liquidity strain could be the result of economic collapse or terrorist acts.
GUARANTEES AND OTHER COMMITMENTS: In the ordinary course of business, the Company is obligated to purchase approximately $16.0 million of asset backed securities as of December 31, 2002. The expiration dates of these commitments are as follows: $7.0 million in 2003, $4.0 million in 2004 and $5.0 million in 2006.