Selected consolidated financial data for the Corporation are presented below for each of the five years in the period ended December 31, 2006. This data should be read in conjunction with the Corporation’s Consolidated Financial Statements and notes thereto and Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations.
In 2002, the general economic recession caused a severe deterioration in many investment grade companies. While some actually went bankrupt, many others lost their investment grade debt ratings with resulting market declines. The Insurance Company’s investment portfolio realized losses from sales and from recognition of other than temporary impairment charges, with the result that net losses were encountered in 2002. A corollary impact of these was that capital ratios were adversely affected in that year. In 2003 and 2004, recoveries in the market values were experienced, which resulted in the Corporation achieving record high levels of capital and improved capital ratios. In 2005 and 2006, the Company rebalanced a portion of its fixed income portfolio (See, Item 7, Management’s Discussion and Analysis, Liquidity and Capital Resources, “Asset/Liability Management.”) The portfolio rebalancing resulted in a decreased yield on investments, as longer-term assets were sold with the proceeds being reinvested in shorter-term assets with a lower yield. The sale of the long-term investments also resulted in approximately $75 million of realized capital gains in 2005. In 2006, the lower yields from portfolio rebalancing contributed to decreased income from investments. This, along with a loss on the payor swaptions, (reflected in realized capital gains) and decreased investment income from the partnerships resulted in lower revenues and a lower investment return on assets in 2006.
In this discussion, we have included statements that may constitute “forward-looking statements” within the meaning of the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. These forward-looking statements are not historical facts but instead represent only our beliefs regarding future events, many of which, by their nature, are inherently uncertain and beyond our control. These statements may relate to our future plans and objectives. By identifying these statements for you in this manner, we are alerting you to the possibility that our actual results may differ, possibly materially, from results indicated in these forward-looking statements. Important factors, among others, that could cause our results to differ from those indicated in the forward-looking statements are discussed below and under “Certain Factors That May Affect Our Business.”
The reduction in the net investment income ratios from 2002 to 2003 was attributable to the low interest rate environment and overall economic conditions, which led to defaults or write-downs within the Company’s investment portfolio. A general improvement in market conditions and an increase in net investment income were the primary factors in the 2003 to 2004 increase, while the rebalancing of the portfolio into lower yield, short-term investments and the need for cash to fund annuity surrenders, caused a decrease in the net investment income ratio in 2005 and 2006. (See, Item 7, Management’s Discussion and Analysis, Liquidity and Capital Resources, “Asset /Liability Management.”) The sale of long-term investments to support the portfolio rebalancing also resulted in approximately $75 million of realized capital gains in 2005. In 2006, a loss of $14.1 million on the payor swaptions (reflected in the realized capital gains/(losses)), and the absence of the capital gains from portfolio rebalancing realized in 2005, resulted in a difference between a net realized investment gain of $75 million in 2005 and a net realized investment loss of $3.6 million in 2006.
The Insurance Company's investment philosophy generally focuses on purchasing investment grade securities with the intention of holding such securities to maturity. However, as market opportunities liquidity, or regulatory considerations may dictate, securities may be sold prior to maturity. The Insurance Company has categorized all fixed maturity securities as available for sale and carries such investments at market value.
The Insurance Company seeks to manage its investment portfolio in part to reduce its exposure to interest rate fluctuations. In general, the market value of our fixed maturity portfolio increases or decreases in an inverse relationship with fluctuations in interest rates, and our net investment income increases or decreases in direct relationship with interest rate changes. For example, if interest rates decline, the Insurance Company's fixed maturity investments generally will increase in market value, while net investment income will decrease as fixed income investments mature or are sold and proceeds are reinvested at the declining rates, and vice versa. Management is aware that prevailing market interest rates frequently shift and,
As of December 31, 2006, 18.9% of the Company’s invested assets (approximately $839.5 million) consisted of investment grade short-term commercial paper. These investments typically had credit ratings of A1/P1 or higher (but in no event lower than A2/P2) and durations of 30 days or less (but in no event longer than 60 days). The Company accumulated this volume of short term paper largely by investing the proceeds from the sale during the fourth quarter of 2006 of approximately $460 million of long term duration assets in furtherance of the Company’s continuing asset/liability matching efforts (See Liquidity and Capital Resources, Asset/Liability Management below), as well as approximately $90 million in proceeds from redemptions of the Company’s trust preferred securities during the same period. Subsequent to December 31, 2006, the Company has reinvested a substantial portion of this short-term commercial paper into investment grade corporate bonds with a weighted average maturity of approximately 2.5 years.
The following table presents the amortized cost and gross unrealized losses for fixed maturities and common stock where the estimated fair value had declined and remained below amortized cost at December 31, 2006:
The following table presents the total gross unrealized losses for fixed maturities where the estimated fair value had declined and remained below amortized cost by December 31, 2006.
At December 31, 2006, the Company owned 398 securities with a net realized loss position.
Corporate Bonds: The predominant investment category for the Company’s investments is the Corporate Bond category, which totaled approximately $2.02 billion at December 31, 2006. The $48.76 million of total unrealized losses in this category reflect the combination of a general rise in interest rates subsequent to the purchase of these bonds and a widening of credit spreads in specific credits. The 2005 10-K discussed credit losses in Ford Motor Credit and Knight-Ridder, Inc. Both credits experienced a subsequent improvement in value in 2006, with the Ford Motor Credit loss declining from $2.9 million at December 31, 2005 to a loss of $549,000 at December 31, 2006. With respect to Knight-Ridder, which was purchased by McClatchy Company, an investment-grade credit, the Company experienced a decline in its unrealized loss from $1.0 million at December 31, 2005 to $615,000 in 2006.
During 2006, three additional credits experienced declines in total market value where the aggregate unrealized losses exceeded both 10% of book value and $500,000. The Insurance Company holds $5,242,707 book value of Pioneer Natural Resources Senior Notes, which had an unrealized loss of $877,186. Due to a lagging stock price, Pioneer Natural executed a stock buy-back that triggered a downgrade in its credit ratings to Ba1 by Moody’s, BB+ by Standard and Poors, and BB+ by Fitch. The Insurance Company has a book value of $5,031,077 in Clear Channel Communications Senior Notes, which had an unrealized loss of $813,676 at December 31, 2006. Clear Channel became the target of a leveraged buy-out transaction, which is expected to close in the first half of 2007. The Insurance Company owns $3,759,965 book value of Masco Corporate Notes, which had an unrealized loss of $609,375 at December 31, 2006. The Masco Notes experienced a decline in market value due to an overall decline in the housing and home improvement markets. Masco continues to carry investment-grade ratings (Baa1, BBB+ and BBB+) at all 3 rating agencies. The Company is closely monitoring the financial situation of each credit but believes that these investments are not other than temporarily impaired as of December 31, 2006. The Company believes that it has the ability and intent to hold each of these positions to maturity.
A reconciliation of the Insurance Company’s net income (loss) as filed with regulatory authorities to net income reported in the accompanying financial statements for the years ended December 31, 2006, 2005 and 2004, is set forth in the following table:
In February 2006, A.M. Best Company reaffirmed the Insurance Company’s rating at “B+” (Very Good) with a stable outlook. In 2007, A.M. Best Company changed the Financial Strength Rating Descriptor for B+ and B++ ratings on insurance companies from “Very Good” to “Good”. The change was made to make the Rating Descriptor consistent with the existing Rating definition and did not, in any way, represent a change in A.M. Best’s opinion of the Company.
Interest credited and benefits paid to policyholders amounted to $242.2 million in fiscal 2006 as compared to $255.7 million in fiscal 2005 and $254.0 million in fiscal 2004. These represent a decrease of 5.3% comparing fiscal 2006 to fiscal 2005 and a 0.7% increase comparing fiscal 2005 to fiscal 2004. These amounts are consistent with the Company’s historic expense levels.
The Insurance Company’s average credited rate for reserves and account balances for the years ended December 31, 2006, 2005 and 2004 was less than the Company’s ratio of net investment income to mean assets (based on book value) for the same period as noted above under “Net Investment Income”. Although management does not currently expect material declines in the spread between the Company's average credited rate for reserves and account balances and the Company's ratio of net investment income to book value mean assets (the "Spread"), there can be no assurance that the Spread will not decline in future periods or that such decline will not have a material adverse effect on the Company's financial condition and results of operations. Depending, in part, upon competitive factors affecting the industry in general and the Company, in particular, the Company may, from time to time, change the average credited rates on certain of its products. There can be no assurance that the Company will be able to reduce such rates or that any such reductions will broaden the Spread. The actual spread, excluding capital gains, for the for the 12 months ended December 31, 2006, 2005 and 2004 was 2.01%, 2.33% and 2.49%, respectively. The decrease was primarily due to a reduction in the earned rate, partially offset by a decrease in the crediting rate.
The interest expense on the Corporation's notes payable amounted to approximately $10.4 million in 2006, approximately $9.6 million in 2005 and approximately $9.8 million in 2004.
General expenses, taxes and commissions to agents totaled $27.0 million in 2006 as compared to $25.0 million in 2005 and $28.0 million in 2004. This represents an increase of 8.2% comparing 2006 to 2005 and a decrease of 8.9% comparing fiscal 2005 to fiscal 2004. The increase in 2006 was primarily due to increased conservation expenses relating to fees paid to agents in an effort to keep policies in-force. The decreases in both 2005 and 2004 were principally attributable to lower costs associated with lower commissions and selling expenses incurred associated with the lower level of sales of single premium annuities.
The change in the net DAC for 2006 resulted in a charge of approximately $9.0 million, as compared to a charge of approximately $20.0 million and a charge of approximately $4.5 million for 2005 and 2004, respectively. Changes in DAC consist of three elements: deferred costs associated with product sales, amortization of the DAC on deferred annuity business and amortization of the DAC on the remainder of the Company’s business. Deferred costs consisted of credits of $12.1 million, $8.4 million and $11.4 million for 2006, 2005 and 2004 respectively. Amortization of the DAC on deferred annuity business consisted of charges of $15.9 million, $23.2 million and $11.0 million in 2006, 2005 and 2004 respectively. Amortization of the DAC on the remainder of the Company’s business consisted of charges of $5.2 million in both 2006 and 2005 and $4.9 million in 2004.
Income tax expense was approximately $20.5 million in 2006, as compared to an expense of approximately $56.6 million in 2005 and approximately $34.1 million in 2004. The decrease in income taxes in fiscal 2006 was primarily attributable to a net realized investment loss in 2006. The increase from 2004 to 2005 was primarily attributable to a substantial increase in net investment gains in 2005.
The Corporation is an insurance holding company and its primary uses of cash are debt service obligations, operating expenses and dividend payments. The Corporation’s principal sources of cash are sales of and interest on the Corporation’s investments and rent from its real estate. During 2006, the Corporation’s Board of Directors maintained the quarterly dividend rate of $.10 per share. The quarterly dividend was increased to $.125 per share in 2007. During 2006 and 2005, the Corporation did not repurchase any of its common stock, although at December 31, 2006, the Corporation was authorized to purchase approximately 385,000 shares of common stock.
The Insurance Company is subject to various regulatory restrictions on the maximum amount of payments, including loans or cash advances that it may make to the Corporation without obtaining prior regulatory approval. Under the New York Insurance Law, the Insurance Company is permitted without prior insurance regulatory clearance to pay a stockholder dividend to the Corporation as long as the aggregate amount of all such dividends in any calendar year does not exceed the lesser of (i) 10% of its statutory surplus as of the immediately preceding calendar year or (ii) its statutory net gain from operations for the immediately preceding calendar year (excluding realized capital gains and losses). The Insurance Company will only be permitted to pay a stockholder dividend to the Corporation in excess of that amount if it files notice of its intention to declare
such a dividend and the amount thereof with the Superintendent and the Superintendent does not disapprove the distribution. The Insurance Company paid no dividends to the Corporation in fiscal 2005 or 2004. In 2006, the Insurance Company paid a $20 million dividend to the Corporation. On a going forward basis, there can be no assurance that the Insurance Company will have statutory earnings to support payment of dividends to the Corporation in an amount sufficient to fund its cash requirements and pay cash dividends or that the Superintendent will not disapprove any dividends that the Insurance Company must submit for the Superintendent’s consideration.
Net cash provided by the Corporation’s operating activities was approximately $77.4 million, $45.4 million and $41.8 million in 2006, 2005 and 2004, respectively. Net cash provided by/(used in) in the Corporation's investing activities (principally reflecting investments purchased, called, redeemed or sold) was approximately $236.6 million, $(60.8) million and $(183.2) million in 2006, 2005 and 2004, respectively.
For purposes of the Corporation's consolidated statements of cash flows, financing activities relate primarily to sales and surrenders of the Insurance Company's annuity and universal life insurance products. The payment of dividends by the Corporation to its stockholders is also considered to be a financing activity. Net cash (used in)/provided by the Insurance Company's financing activities amounted to approximately $(300.8) million, $15.8 million and $134.8 million in 2006, 2005 and 2004, respectively. These fluctuations primarily are attributable to changes in policyholder account balances as a result of surrenders, sales and interest earned by the policyholders.
The indenture governing the Senior Notes contains covenants relating to limitations on liens and sale or issuance of capital stock of the Corporation. In the event the Corporation violates such covenants, we may be obligated to offer to repurchase the entire outstanding principal amount of such notes. As of December 31, 2006, we believe that we are in compliance with all of the covenants.
In order to maintain consistency in our portfolio, our deferred annuity products incorporate surrender charges to discourage surrenders or withdrawals. Annuitants may not terminate or withdraw funds from their annuity contracts for a significant initial period (generally seven years) without incurring penalties in the form of surrender charges. These surrender charges generally range from 1% to 7% of the investment. Approximately 46.9%, 33.5% and 25.4% of the Insurance Company's deferred annuity contracts in force (measured by reserves) as of December 31, 2006, 2005, and 2004 were surrenderable without charge.
The market value of our fixed maturity portfolio changes as interest rates change. In general, rate decreases cause asset prices to rise, while rate increases cause asset prices to fall. Based on market values and prevailing interest rates as of December 31, 2006, a hypothetical instantaneous increase in interest rates of 100 basis points would produce a loss in fair value of our fixed maturity assets of approximately $192.7 million.
A persistent concern of the Insurance Company’s management is maintaining the appropriate balance between the duration of its invested assets and the duration of its contractual liabilities to its annuity holders and credit suppliers. In the past, the Insurance Company had permitted the duration gap between its assets and liabilities to rise during a period in which it expected relatively stable interest rates and, most importantly, in which its liabilities were largely protected by significant
As the second element of the asset liability management strategy, the Company hedged against the risks posed by a rapid and sustained rise in interest rates by entering into a form of derivative transaction known as payor swaptions. Swaptions are options to enter into an interest rate swap arrangement with a counter party at a specified future date. At expiration, the counter party would be required to pay the Insurance Company the amount of the present value of the difference between the fixed rate of interest on the swap agreement and a specified strike rate in the agreement multiplied by the notional amount of the swap agreement. The effect of these transactions would be to lessen the negative impact on the Insurance Company of a significant and prolonged increase in interest rates. With the Swaptions, the Company should be able to maintain more competitive crediting rates to policyholders when interest rates rise.
In July 2005, Presidential Life entered into a series of Payor Swaption investments designed to protect the Company against an instantaneous rise in interest rates of 300 basis points, as required by the New York State Insurance Department (Regulation 126). Six contracts against the 10-year swap rate were executed with one dealer and three banks at a total cost of $19,430,625. During the 3rd quarter of 2006 (July 11, 2006), Presidential sold the expiring 2006 Payor Swaption for $5,930,000, realizing a capital gain of $3,186,000. The proceeds were reinvested into a new Payor Swaption with a notional value of $325,000,000 (increased from the $200,000,000 notional value for the expiring Payor Swaption) that expires on July 13, 2009, for a total cash consideration of $6,170,000.
The Company has established ISDA Credit Support Agreements with the four counterparties. Three of the counterparties have ratings equal to or higher than Aa3/AA- by Moody's and S&P, respectively, and one counterparty carries an A1/A+ rating. These contracts expire in July 2007, July 2008 and July 2009 at varying strike rates based on the 10-year swap rate. The Company has determined that the Payor Swaptions represent a "non-qualified hedge" and has adopted accounting procedures consistent with the provisions of FAS 133. The aggregate market value of the Payor Swaptions as of December 31, 2006 was $9,784,118. These investments are classified on the balance sheet as "Derivative Instruments". Under FAS 133, the value of the Payor Swaptions is recognized at "fair value" (market value), with the resulting change in fair value reflected in the statement of income as a realized loss or gain. The change in market value during the calendar year was a loss of $8,973,980. The Company has determined that the average fair value, based upon weekly market values for the period (December 31, 2005 to December 31, 2006), was $21,446,150.
The short-term notes payable relates to a line of credit issued by The Bank of New York and transferred to JPMorgan Chase Bank in October 2006, in the amount of $50,000,000. The line of credit provides for interest on borrowings based on the 30, 60 and 90-day LIBOR rate depending on the duration of the Corporation’s periodic renewals. At December 31, 2006, the Corporation had the full $50,000,000 outstanding. The line of credit renews annually and is up for renewal on July 31, 2007. If the bank chooses not to renew the line of credit, the Corporation would be forced to pay-down the $50,000,000 in July 2007 or seek alternative financing options. The Corporation does not believe that there would be a material adverse impact on its liquidity or cash flow position if the line of credit were to be called in July 2007.
The Corporation has not entered into any off-balance sheet financing arrangements and has made no financial commitments or guarantees with any unconsolidated subsidiary or special purpose entity. All of the Corporation’s subsidiaries are wholly owned and their results are included in the accompanying consolidated financial statements.
The accompanying Notes to Consolidated Financial Statements contain information regarding payments required under existing long-term borrowing arrangements. The following presents a summary of the Company’s significant contractual obligations as of December 31, 2006.
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America (²GAAP²) requires management to adopt accounting policies and make estimates and assumptions that affect amounts reported in the consolidated financial statements. The critical accounting policies, estimates and related judgments underlying the Corporation¢s consolidated financial statements are summarized below. In applying these accounting policies, management makes subjective and complex judgments that frequently require estimates about matters that are inherently uncertain. Many of these policies, estimates and related judgments are common in the insurance and financial services industries; others are specific to the Insurance Company’s business operations.
The Company uses the equity method of accounting for investments in limited partnership interests in which it has more than a minor equity interest, or more than a minor influence over the joint ventures and partnership’s operations, but does not have a controlling interest and is not the primary beneficiary. The Company routinely evaluates its limited partnership investments for impairments. The Company considers financial and other information provided by the investee and other known information and inherent risks in the underlying investments in determining whether an impairment has occurred. When an other-than-temporary impairment is deemed to have occurred, the Company records a realized capital loss within net investment income to record the investment at its fair value. Investment income from limited partnerships is recorded based on the Company’s share of earnings reported in the partnership’s most recent audited financial statements and income distributed by the partnerships. Management considers the quarterly financial information received from the limited partnerships to be unreliable or insufficient to record investment income, other than from distributions, on a quarterly basis. Management estimates the classification of cash distributions received between investment income and return of capital based on correspondence from the respective partnerships. The Company adjusts its estimate of investment income recorded during the year to the actual realized gains and other income reported in the limited partnerships’ most recent annual audited financial statements, which are generally received in the second quarter of the subsequent year. As a result, there is a six-month reporting lag for recording investment income that is not distributed during the year, which may result in significant adjustments. The Company records its share of net unrealized gains and losses (net of taxes) from the audited financial statements of the limited partnerships. As a result, there is a six-month reporting lag for reporting unrealized gains and losses, which may result in significant adjustments to other comprehensive income in 2007. Because it is not practicable to obtain an independent valuation for each limited partnership interest, for purposes of disclosure the market value of a limited partnership interest is estimated at book value based on the most recent available audited financial statements. The failure of the Insurance Company to receive the return of a material portion of its capital investments in limited partnerships, or to achieve historic levels of return on such investments, could have a material adverse effect on the Corporation's financial condition and results of operations.
For those annuities and supplementary contracts with life contingencies that comprise a portion of future policy benefits ($680 million of reserves), an increase in mortality experience of 1% per year for individual contracts would increase the present value of future benefits by approximately $25 million. We believe that any variation of our mortality estimates is likely to fall within this range.