Management's discussion and analysis of financial condition and results of operations of First SunAmerica Life Insurance Company (the "Company") for the three years ended December 31, 1999, September 30, 1998 and 1997 follows. Effective December 31, 1998, the Company changed its fiscal year end from September 30 to December 31. Accordingly, the three-month period ended December 31, 1998 was a transition period.
PRETAX INCOME totaled $14.3 million in 1999, $28.6 million in 1998 and $13.9 million in 1997 and primarily reflects the effect of the Acquisitions and changes in net realized investment gains and losses. The decrease in 1999 resulted primarily from a decrease in net realized investment gains, increased general and administrative expenses and increased amortization of deferred acquisition costs which were partially offset by increased net investment income and variable annuity and universal life insurance fees. The improvement in 1998 over 1997 resulted primarily from increased net investment income and fee income, partially offset by increased amortization of deferred acquisition costs.
NET INVESTMENT INCOME, which is the spread between the income earned on invested assets and the interest paid on fixed annuities, universal life insurance contracts and other interest-bearing liabilities, increased to $44.7 million in 1999 from $36.8 million in 1998 and $19.2 million in 1997. These amounts equal 2.53% on average invested assets (computed on a daily basis) of $1.77 billion in 1999, 2.37% on average invested assets of $1.55 billion in 1998 and 2.16% on average invested assets of $887.4 million in 1997. On a pro forma basis, assuming the Acquisitions had been consummated on October 1, 1996, net investment income on related average invested assets would have been 1.87% in 1999, 1.71% in 1998 and 1.51% in 1997 on average invested assets of $2.59 billion, $2.37 billion and $2.41 billion, respectively. The improvement in 1999 net investment yields over these pro forma amounts reflects a redeployment of assets received in the MBL Life acquisition into higher yielding investment categories.
GROWTH IN AVERAGE INVESTED ASSETS largely resulted from the impact of the Acquisitions. The Company acquired $1.40 billion of invested assets associated with the JANY merger on March 31, 1997 and $678.3 million of invested assets associated with the MBL Life acquisition at July 1, 1999. Changes in average invested assets also reflect sales of fixed annuities and the fixed account options of the Company's variable annuity products ("Fixed Annuity Premiums"), and renewal premiums on its universal life product ("UL Premiums") acquired in the MBL Life acquisition, partially offset by net exchanges from fixed accounts into the separate accounts of variable annuity contracts. Fixed Annuity Premiums and UL Premiums totaled $41.0 million in 1999 compared with $130.9 million in 1998 and $131.7 million in 1997 and are largely premiums for the fixed accounts of variable annuities. Such premiums have decreased in 1999 principally as a result of regulatory changes in the State of New York relating to non-taxable policy exchange requirements partially offset by greater inflows into the one-year and six-month fixed accounts of these products, which are principally used for dollar-cost averaging into the variable accounts. Accordingly, the Company anticipates that it will see a large portion of these premiums transferred into the variable funds. These premiums represent 6%, 8% and 9%, respectively, of the related reserve balances at the beginning of the respective periods. These premiums include premiums for the fixed accounts of variable annuities totaling $61.0 million, $77.3 million and $68.9 million in 1999, 1998 and 1997, respectively.
The Company sold or redeemed invested assets, principally bonds and notes, aggregating $478.7 million, $985.1 million and $634.8 million in 1999, 1998 and 1997, respectively. Sales of investments result from the active management of the Company's investment portfolio, including assets received as part of the Acquisitions. Because redemptions of investments are generally involuntary and sales of investments are made in both rising and falling interest rate environments, net gains and losses from sales and redemptions of investments fluctuate from period to period, and represent 0.20%, 0.33% and 0.57% of average invested assets for 1999, 1998 and 1997, respectively. Active portfolio management involves the ongoing evaluation of asset sectors, individual securities within the investment portfolio and the reallocation of investments from sectors that are perceived to be relatively overvalued to sectors that are perceived to be relatively undervalued. The intent of the Company's active portfolio management is to maximize total returns on the investment portfolio, taking into account credit, option, liquidity and interest-rate risk.
The Company has encountered increased competition in the variable annuity marketplace during recent years and anticipates that the market will remain highly competitive for the foreseeable future. Also, from time to time, Federal initiatives are proposed which could affect the taxation of variable annuities and annuities generally (See "Regulation").
SURRENDER CHARGES on fixed and variable annuity and universal life contracts totaled $3.3 million (including $0.04 million attributable to the MBL Life acquisition and $2.5 million attributable to the JANY merger) in 1999, $4.4 million (including $3.9 million attributable to the JANY merger) in 1998 and $1.8 million (including $1.5 million attributable to the JANY merger) in 1997. Surrender charges generally are assessed on annuity withdrawals at declining rates during the first seven years of a contract. Withdrawal payments, which include surrenders and lump-sum annuity benefits, totaled $392.4 million (including $187.2 million attributable to the MBL Life acquisition and $167.2 million attributable to the JANY merger) in 1999, compared with $234.4 million (including $198.3 million attributable to the JANY merger) in 1998 and $93.5 million (including $72.9 million attributable to the JANY merger) in 1997. These payments, when expressed as
a percentage of averaged fixed and variable annuity and universal life reserves, represent 19.0% (9.1% attributable to the MBL Life acquisition and 8.1% attributable to the JANY merger), 14.0% (11.9% attributable to the JANY merger) and 9.9%, respectively. Excluding the effects of the MBL Life acquisition, withdrawal payments represent 11.3% of related average fixed and variable annuity reserves in 1999. Withdrawals include variable annuity payments from the separate accounts totaling $28.6 million (6.9% of average variable annuity reserves), $12.8 million (5.5% of average variable annuity reserves) and $5.3 million (4.8% of average variable annuity reserves) in 1999, 1998 and 1997, respectively. Consistent with the assumptions used in connection with the Acquisitions, management anticipates that the level of withdrawal payments will reflect higher relative withdrawal rates in the near future because of higher surrenders on the acquired businesses.
GENERAL AND ADMINISTRATIVE EXPENSES totaled $7.9 million in 1999 compared with $3.3 million in 1998 and $3.2 million in 1997. The increases in 1999 over 1998 principally reflect $1.5 million of reinsurance premiums paid and other increased costs related to the business acquired in the MBL Life acquisition, and expenses related to servicing the Company's growing block of variable annuity policies. In addition, expenses in 1998 include a credit of approximately $1.2 million relating to expense allowances on ceded reinsurance. General and administrative expenses remain closely controlled through a company-wide cost containment program and continue to represent less than 1% of average total assets.
AMORTIZATION OF DEFERRED ACQUISITION COSTS totaled $22.7 million in 1999 (including $0.6 million attributable to the MBL Life acquisition and $14.9 million attributable to the JANY merger) compared with $17.1 million in 1998 (including $15.7 million attributable to the JANY merger) and $10.4 million (including $9.2 million attributable to the JANY merger) in 1997. The increase in amortization during 1999 was also due to additional Variable Annuity Product Sales and the subsequent amortization of related deferred commissions and other direct selling costs.
ANNUAL COMMISSIONS represent renewal commissions, including those paid quarterly in arrears to maintain the persistency of certain of the Company's fixed and variable annuity contracts. Annual commissions totaled $450,000 in 1999, $348,000 in 1998 and $195,000 in 1997. These increases are primarily attributable to the fixed annuity contracts acquired in the Acquisitions. Based on current sales, the Company estimates that such annual commissions will increase in future periods.
INCOME TAX EXPENSE totaled $6.6 million in 1999, compared with $12.1 million in 1998 and $5.1 million in 1997, representing effective tax rates of 46% in 1999, 42% in 1998 and 37% in 1997. The increase in the tax rates for 1999 and 1998 is due to an increase in state income taxes.
SHAREHOLDER'S EQUITY decreased 12.7% to $161.2 million at December 31, 1999 from $184.7 million at December 31, 1998, primarily due to a $31.1 million increase in accumulated other comprehensive loss partially offset by $7.7 million of net income recorded in 1999.
At December 31, 1999, the Bond Portfolio included $1.48 billion of bonds rated by Standard & Poor's Corporation ("S&P"), Moody's Investors Service ("Moody's"), Duff & Phelps Credit Rating Co. ("DCR"), Fitch Investors Service, L.P. ("Fitch") or the National Association of Insurance Commissioners ("NAIC"), and $41.8 million of bonds rated by the Company pursuant to statutory ratings guidelines established by the NAIC. At December 31, 1999, approximately $1.40 billion of the Bond Portfolio was investment grade, including $575.6 million of U.S. government/agency securities and mortgage-backed securities ("MBSs").
At December 31, 1999, the Bond Portfolio included $123.8 million of bonds that were not investment grade. These non-investment-grade bonds accounted for 4.8% of the Company's total assets and 6.9% of its invested assets.
The table on the following page summarizes the Company's rated bonds by rating classification as of December 31, 1999.
(1) S&P and Fitch rate debt securities in rating categories ranging from AAA (the highest) to D (in payment default). A plus (+) or minus (-) indicates the debt's relative standing within the rating category. A security rated BBB- or higher is considered investment grade. Moody's rates debt securities in rating categories ranging from Aaa (the highest) to C (extremely poor prospects of ever attaining any real investment standing). The number 1, 2 or 3 (with 1 the highest and 3 the lowest) indicates the debt's relative standing within the rating category. A security rated Baa3 or higher is considered investment grade. DCR rates debt securities in rating categories ranging from AAA (the highest) to DD (in payment default). A plus (+) or minus (-) indicates the debt's relative standing within the rating category. A security rated BBB- or higher is considered investment grade. Issues are categorized based on the highest of the S&P, Moody's, DCR and Fitch ratings if rated by multiple agencies.
Senior secured loans ("Secured Loans") are included in the Bond Portfolio and aggregated $122.1 million at December 31, 1999. Secured Loans are senior to subordinated debt and equity, and are secured by assets of the issuer. At December 31, 1999, Secured Loans consisted of $33.8 million of publicly traded securities and $88.3 million of privately traded securities. These Secured Loans are composed of loans to 50 borrowers spanning 13 industries, with 25% of these assets concentrated in utilities, 11% concentrated in airlines and 8% concentrated in food services. No other industry concentration constituted more than 5% of these assets.
MORTGAGE LOANS aggregated $211.9 million at December 31, 1999 and consisted of 152 commercial first mortgage loans with an average loan balance of approximately $1.4 million, collateralized by properties located in 33 states. Approximately 41% of this portfolio was office, 25% was retail, 12% was industrial, 11% was multifamily residential and 11% was other types. At December 31, 1999, approximately 34% of this portfolio was secured by properties located in California, approximately 11% by properties located in New York and Michigan and no more than 5% of this portfolio was secured by properties located in any other single state. At December 31, 1999, one mortgage loan had an outstanding balance of $10 million or more, which represented approximately 5% of this portfolio, and approximately 36% of the mortgage loan portfolio consisted of loans with balloon payments due before January 1, 2003. During 1999 and 1998, loans delinquent by more than 90 days, foreclosed loans and restructured loans have not been significant in relation to the total mortgage loan portfolio.
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 and notes; and mortgage loans. At December 31, 1999, these assets had an aggregate fair value of $1.77 billion with a duration of 3.7. At December 31, 1999, the Company's fixed annuity liabilities had an aggregate fair value (determined by discounting future contractual cash flows by related market rates of interest) of $1.68 billion with a duration of 3.5. The Company's potential exposure due to a relative 10% increase in interest rates from their December 31, 1999 levels is a loss of $4.6 million in fair value of its fixed-rate assets that is not offset by a decrease in the fair value of its fixed-rate liabilities. 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.
Duration is a common option-adjusted measure for the price sensitivity of a fixed-maturity portfolio to changes in interest rates. It measures the approximate percentage change in the market value of a portfolio if interest rates change by 100 basis points, recognizing the changes in cash flows resulting from embedded options such as policy surrenders, investment prepayments and bond calls. It also incorporates the assumption that the Company will continue to utilize its existing strategies of pricing its fixed annuity products, allocating its available cash flow amongst its various investment portfolio sectors and maintaining sufficient levels of liquidity. Because the calculation of duration involves estimation and incorporates assumptions, potential changes in portfolio value indicated by the portfolio's duration will likely be different from the actual changes experienced under given interest rate scenarios, and the differences may be material.
The Company also seeks to provide liquidity from time to time by using reverse repurchase agreements ("Reverse Repos") and by investing in MBSs. It also seeks to enhance its spread income by using Reverse Repos. Reverse Repos involve a sale of securities and an agreement to repurchase the same securities at a later date at an agreed upon price and are generally over-collateralized. 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.
There are risks associated with some of the techniques the Company uses to provide liquidity, enhance its spread income and match its assets and liabilities. The primary risk associated with the Company's Reverse Repos is counterparty risk. The Company believes, however, that the counterparties to its Reverse Repos are financially responsible and that the counterparty risk associated with those transactions is minimal. It is the
Company's policy that these agreements are entered into with counterparties who have a debt rating of A/A2 or better from both S&P and Moody's. The Company continually monitors its credit exposure with respect to those agreements. The primary risk associated with MBSs is that a changing interest rate environment might cause prepayment of the underlying obligations at speeds slower or faster than anticipated at the time of their purchase. As part of its decision to purchase an MBS, the Company assesses the risk of prepayment by analyzing the security's projected performance over an array of interest-rate scenarios. Once an MBS is purchased, the Company monitors its actual prepayment experience monthly to reassess the relative attractiveness of the security with the intent to maximize total return.
In a declining rate environment, the Company's cost of funds would decrease over time, reflecting lower interest crediting rates on its fixed annuities. Should increased liquidity be required for withdrawals, the Company believes that a significant portion of its investments could be sold without adverse consequences in light of the general strengthening that would be expected in the bond market.
The Company's consolidated financial statements begin on page . Reference is made to the Index to Financial Statements on page herein.