U.S. Dollar-denominated ordinary whole life insurance and endowment policies predominantly to high net worth, high income foreign residents, located principally in Latin America and the Pacific Rim, through approximately 2,100 independent marketing consultants;
ordinary whole life insurance policies to middle income households in the midwest and the southern United States through approximately 340 independent marketing consultants; and
Life Insurance. Over the past 30 years, CICA and its predecessors have accepted policy applications from foreign nationals for U.S. Dollar-denominated ordinary whole life insurance and endowment policies. Traditionally, this market has been concentrated in the top 3-5% of the population of a country in terms of income and net worth. In recent years, however, there has been a shift to encompass a broader spectrum of the population, as upper middle classes develop in Latin America and the Pacific Rim. We make our insurance products available using third-party marketing organizations and independent marketing consultants. The number of our producing independent consultants has expanded over the years in this segment to approximately 2,100, and we received applications from residents of more than 30 countries outside of the U.S. in 2009. Historically, the majority of our international business has come from Latin America; however, the Pacific Rim has represented a meaningful source of new business for several years.
Through the domestic market of our Life Insurance segment, we provide ordinary whole life, credit life insurance, and final expense policies to middle income families and individuals in certain markets in the midwest and southern U.S. The majority of our revenues are the result of acquisitions of domestic life insurance company acquisitions since 1987.
Home Service Insurance. We provide final expense ordinary life insurance to middle and lower income individuals in Louisiana, Mississippi and Arkansas. Our policies in this segment are sold and serviced through a home service marketing distribution system utilizing employee-agents who work on a route system to collect premiums and service policyholders and through networks of funeral homes who collect premium and provide personal policyholder service.
The current worldwide recession and contraction of credit availability has resulted in adverse effects for the life insurance industry, including increased surrender of life insurance policies in force, decreased new life insurance policy sales and increased competition for new life insurance policy sales. Our operations in 2009 reflected these adverse developments, and are discusssed further below.
Many of the events and trends affecting the life insurance industry have had an impact on the life reinsurance industry. These events have led to a decline in the availability of reinsurance. While we currently cede a limited amount of our primary insurance business to reinsurers, we may find it difficult to obtain reinsurance in the future, forcing us to seek reinsurers who are more expensive to us. If we cannot obtain affordable reinsurance coverage, either our net exposures will increase or we will have to reduce our underwriting commitments.
Premium Income. Premium income during 2009 increased 4.2% to $147.3 million from $141.3 million in 2008. The increase resulted primarily from renewal premiums, which totaled $123.2 million, $116.6 million and $111.2 million in 2009, 2008 and 2007, respectively. The Company believes that new business sales were negatively impacted due to the global recession and policyholder concerns. Endowment sales represented an increased portion of new business sales internationally, as these products have gained in popularity over the past several years. In addition, most of our life insurance policies contain a policy loan provision, which allows the policyholder to use cash value of a policy to pay premiums. The Company believes this feature is routinely used by policyholders to keep a policy active, as evidenced by the increase in the policy loan asset balance year over year.
Net Investment Income. Net investment income decreased during 2009 to $29.6 million, compared to $30.5 million during 2008 and $30.7 million in 2007. The decrease resulted from lower investment rates available in 2009 on new money investments compared to the prior two years, as well as the significant call activity the Company experienced on its overall investment portfolio in the current year, resulting in lower rates on reinvested funds. We continue to invest in bonds of U.S. Government-sponsored enterprises, such as Federal National Mortgage Association (“FNMA”) and Federal Home Loan Mortgage Association (“FHLMC”), due to our conservative investment strategy of investing in high quality issuers. Over 85% of total investment income is attributable to the Company holdings of fixed maturity securities. Policy loan income increased in the current year due to the growth in the asset balance, as policyholders utilized the policy loan feature to pay premiums and keep policies in force.
Claims and Surrenders. As noted in the table below, claims and surrenders increased 6.6% from $56.3 million in 2008 to $60.0 million in 2009. The 2009 increase primarily related to an increase in surrender expense, as well as an increase in endowments.
Endowment benefits increased 1.9% from $13.8 million in 2008 to $14.1 million in 2009. Endowments totaled $12.8 million in 2007. We have a series of international policies that carry an immediate endowment benefit of an amount elected by the policy owner. These benefits have been popular in the Pacific Rim and Latin America, where the Company has experienced increased interest in our guaranteed products in recent years. Like policy dividends, endowments are factored into the premium and, as such, the increase has no impact on profitability. The Company expects these benefits to continue to increase as this block of business increases.
Policyholder Dividends. Policyholder dividends decreased 2.7% during 2009 to $6.7 million from $6.9 million in 2008 and $6.4 million in 2007, due to the decline in inforce of our ordinary whole life products. All of our international policies are participating. Policyholder dividends are factored into the premiums and have no impact on profitability.
Deferred Policy Acquisition Costs. Capitalized deferred policy acquisition costs (“DAC”) decreased 1.9% from $24.1 million in 2008 to $23.7 million in 2009. These costs were $26.2 million in 2007. The decrease resulted from the decline in new business and, therefore, the decline in the associated new business costs that were capitalized. Significantly lower amounts are capitalized related to renewal business. Amortization amounts increased in 2009 to $17.2 million compared to $15.6 million in 2008 and $12.5 million in 2007. The increase in 2009 and 2008 was significantly impacted by the amount of policy surrenders that the Company experienced in the latter part of 2008 and throughout 2009. We believe this trend is driven primarily by the negative economy and resulting policyholder uncertainty.
Federal Income Tax. The Federal income tax expense was $3.3 million, $3.1 million and $6.9 million in 2009, 2008 and 2007, respectively, resulting in effective tax rates of 15.8%, 24.7% and 29.5%, respectively. The Company established a tax valuation allowance related to OTTI losses on its mutual funds of $6.9 million in 2008. The establishment of the valuation allowance had the effect of increasing tax expense. In 2009, $2.8 million of this allowance was released as a reduction of tax expense primarily due to the sale of approximately 42% of the mutual fund portfolio in 2009. In addition, the fair market value change related to outstanding warrants of $3.2 million reported as an increase in revenues in 2009 compared to a decrease in income of $2.7 million and increase of $0.8 million in 2008 and 2007, respectively, which was not taxable and also impacted the corporate tax rate.
Our Life Insurance segment consists of issuing primarily ordinary whole life insurance in U.S. Dollar-denominated amounts to foreign residents in 30 countries, and domestically through independent marketing firms and consultants throughout the United States.
Surrender benefits increased 28.3% to $17.7 million in 2009 compared to $13.8 million and $12.3 million in 2008 and 2007. The majority of this increase in policy surrenders was attributable to our international business and related to policies that have been in force over fifteen years, and no longer have a surrender charge. The Company believes a significant portion of the increase was a result of the global recession and policyholder uncertainty. In addition, the Company recorded surrenders resulting from poor persistency related to one Brazilian agent. The Company has canceled the contract with this agent.
Commissions. Commissions are a principal operating expense that is paid in relation to sales production. The decline in commission expense in 2009 is a reflection of the decrease in first year business, which pays a higher commission rate than the renewal business that is the source of a significant portion of current year premium revenues. Renewal premiums represented 85% of total premium revenue in 2009 compared to 82% in 2008.
Deferred Policy Acquisition Costs (“DAC”). Capitalized DAC was lower in 2009, with $17.9 million compared to $19.2 million and $20.7 million in 2008 and 2007, respectively, due to decreased sales of new products. The Company believes a significant portion of this decrease resulted from the global recession and policyholder uncertainty. Amortization of DAC increased to $14.8 million compared to lower levels in 2008 and 2007, primarily due to an increase in lapses on this segment of business as previously noted.
Amortization of Cost of Customer Relationships Acquired (“COIA”). Amortization expense increased to $1.5 million in 2009 compared to $1.0 million and $1.2 million in 2008 and 2007, due to increased lapses relating to the purchased blocks. The Company generally reports higher amortization in the first year of an acquisition because lapses are typically higher, and then a leveling off and more consistent amortization in the following years. Amortization related to ICIC acquired business in early 2009 totaled $0.6 million at year end 2009.
Our Home Service Insurance segment provides preneed and final expense ordinary life insurance and annuities to middle and lower income individuals primarily in Louisiana, Mississippi and Arkansas. Our policies in this segment are sold and serviced through funeral homes and a home service marketing distribution system utilizing employee and independent agents. Ozark National Life Insurance Company (“ONLIC”) was acquired in late 2008.
Premiums. The increase in 2009 was due to a full year of ONLIC premiums, which were reflected in 2009 for this segment compared to only one quarter of premium in 2008. In addition, in 2009 there was an increase in premiums related to SPFIC fire business sales and a premium rate increase for SPFIC that was effective in the last quarter of 2009.
Realized Gains (Losses), Net. Gains reported in 2009 totaled $6.6 million compared to losses of $9.9 million in 2008. The net gains in 2009 related primarily to sales of equity mutual funds previously impaired in 2008 under other-than-temporary impairment guidance. The impairments in 2008 totaled $9.9 million relative to the Home Service segment. Additional impairments of $0.3 million were recorded in 2009 due to further declines in market values relating to credit issues and are reducing the net gains as reported.
Increase in Future Policy Benefit Reserves. The increase in 2009 included $0.4 million resulting from a correction related to ONLIC reserves caused by data issues discovered in the current year.
Commissions. Commission expense in 2009 included a full year of ONLIC commissions that were not completely included in the prior year, due to the acquisition date of October 2008. Higher commissions were recorded in 2008 for Security Plan due to the use of a manual computation, which resulted in a higher commission expense. This process was partially automated in 2009 and is resulting in a more refined computation in the current year.
The administration of our investment portfolios is handled by our management, pursuant to board-approved investment guidelines, with all trading activity approved by a committee of the respective boards of directors of our insurance company subsidiaries. The guidelines used require that bonds, both government and corporate, are of high quality and comprise a majority of the investment portfolio. State insurance statutes prescribe the quality and percentage of the various types of investments that may be made by insurance companies and generally permit investment in qualified state, municipal, federal and foreign government obligations, high quality corporate bonds, preferred and common stock, real estate, mortgage loans and real estate within certain specified percentages. The assets selected are intended to mature in accordance with the average maturity of the insurance products and to provide the cash flow for our insurance company subsidiaries to meet their respective policyholder obligations.
Liquidity refers to a company’s ability to generate sufficient cash flows to meet the needs of its operations. Liquidity is managed on insurance operations to ensure stable and reliable sources of cash flows to meet obligations and is provided by a variety of sources.
The liquidity requirements of our Company are met primarily by funds provided from operations. Premium deposits and revenues, investment income and investment maturities are the primary sources of funds, while investment purchases, policy benefits, and operating expenses are the primary uses of funds. We historically have not had to liquidate investments to provide cash flow, but in 2008 SPFIC sold $237,000 of bonds because of liquidity needs as a result of Hurricanes Gustav and Ike. There were no liquidity issues in 2009. Our investments consist primarily of marketable debt securities that could be readily converted to cash for liquidity needs. See Note 8 of the “Notes to Consolidated Financial Statements” for a table disclosing our contractual obligations.
Policy loans comprised 4.8% of invested assets at December 31, 2009 compared to 5.1% at December 31, 2008. These loans, which are secured by the underlying policy values, have yields ranging from 5% to 12% and maturities that are related to the maturity or termination of the applicable policies. Management believes we maintain adequate liquidity despite the uncertain maturities of these loans.
The NAIC has established minimum capital requirements in the form of Risk-Based Capital (“RBC”). Risk-based capital factors the type of business written by an insurance company, the quality of its assets, and various other aspects of an insurance company’s business to develop a minimum level of capital called “Authorized Control Level Risk-based Capital” and compares this level to an adjusted statutory capital that includes capital and surplus as reported under statutory accounting principles, plus certain investment reserves. Should the ratio of adjusted statutory capital to control level risk-based capital fall below 200%, a series of actions by the affected company would begin. At December 31, 2009, all of our insurance subsidiaries were above the required minimum levels.
We continue to use the original assumptions (including a provision for the risk of adverse deviation) in subsequent periods to determine the changes in the liability for future policy benefits (the “lock-in concept”) unless a premium deficiency exists. Management monitors these assumptions and has determined that a premium deficiency did not exist as of December 31, 2009. Management believes that our policy liabilities and increase in future policy benefit reserves as of the years ended December 31, 2009, 2008 and 2007 are based upon assumptions, including a provision for the risk of adverse deviation, that do not warrant revision. The relative stability of these assumptions and management’s analysis is discussed below.
See “Item 8. Financial Statements and Supplementary Data, Notes to Consolidated Financial Statements, Note 1. Accounting Pronouncements.”