In an effort to meet or reduce the collateral requirements of our ceding companies, we have negotiated the termination, recapture or novation of several of our annuity and life reinsurance contracts, including certain of our historically profitable contracts. We also have ceased to write new reinsurance agreements and have notified our existing clients that we will not be accepting any new business under existing treaties on their current terms. Further, we do not anticipate resuming to write new reinsurance agreements in the foreseeable future. As a result, our cash flow and results of operations in the near future will be based solely upon the performance of our remaining book of business and the returns generated from our invested assets. Of our remaining book of business, we have a few large reinsurance contracts that represent a material concentration of our net premiums, funds withheld at interest asset,
deferred policy acquisition costs and interest sensitive contract liabilities. We have experienced substantial losses on certain of these remaining contracts in the past, including our annuity reinsurance contract with Transamerica and our largest guaranteed minimum death benefit contract. Unless our remaining contracts perform substantially better than they have in past periods, the losses from these contracts will have an increasingly significant adverse impact on our results of operations.
The financial strength ratings of both our operating subsidiaries have been downgraded to a level that effectively precludes them from writing new business. We cannot assure you that we will be able to increase those financial strength ratings or our cash and liquidity positions to a level where we can resume writing new business. If we are able to position ourselves to write new business in the future, we cannot assure you that we will be able to attract and retain customers.
A purported shareholder class action lawsuit has been filed against us and certain of our present and former officers and directors alleging violations of United States securities laws. In addition, several of our ceding companies have asserted that we are in breach of our reinsurance agreements, and we may need to enter into arbitration or litigation to resolve these matters. We cannot assure you that we will be successful in the defense of any of our current or future litigation or arbitration proceedings. If the outcome in any such proceeding is adverse to us, our results of operations and financial condition would be adversely impacted.
In preparing our financial statements, we use estimates and assumptions based upon the best information available and management’s best judgment at the time our financial statements are prepared. The most significant estimates relate to policyholder benefit reserves for both the life and annuity business, the recoverability of deferred acquisition costs and the fair value of the embedded derivatives related to certain of our annuity reinsurance contracts. These estimates require us to make assumptions about, among other things, future mortality, persistency, lapses, expenses and investment performance based upon historical results and information provided to us by our cedents. While we believe these estimates to be reasonable, we cannot assure you that they will be accurate. If these estimates prove to be inaccurate, they could have a significant adverse impact on our financial condition and results of operations. For example, we have had to increase our reserves in the recent past regarding several of our largest contracts, including our largest guaranteed minimum death benefit contract. We also had to record substantial write downs of deferred acquisition costs related to our annuity reinsurance contract with Transamerica in 2002, after having written down such costs in 2001 to what we then believed to be an appropriate level.
Our continued operations are dependent on our ability, and the ability of our ceding companies, to manage investment risks. Unexpected volatility or illiquidity in the markets in which we directly or indirectly hold positions could adversely affect our business. Our investments and the assets held and managed by our ceding companies include a limited amount of investments in below investment grade fixed income securities. While any investment carries some risk, the risks associated with lower-rated securities generally are greater than the risks associated with investment grade securities. We also may be exposed to equity related investment risk associated with certain of our products. If we fail to match the equity related asset risk accurately with the equity related liabilities, we could be exposed to the volatility of the equity markets. This could result in losses, such as those experienced under our Transamerica contract, which in turn would further adversely affect our business.
As of the date of this report, approximately $1.0 billion of the assets supporting the policies we reinsure were held and managed by our ceding companies or their investment managers under our modified coinsurance and coinsurance funds withheld arrangements. A significant portion of our total investments is therefore dependent upon the investment decisions of third parties over whom we have limited, if any, control.
Our ability to satisfy our obligations under our reinsurance contracts is significantly affected by the performance of our investments and the invested assets held and managed by our ceding companies. For example, if the invested assets held and managed by our ceding companies or their investment managers in connection with our remaining annuity reinsurance contracts do not accumulate at rates sufficient to allow us to meet our obligations to make certain guaranteed payments, we could be forced to fund any shortfalls in these policy benefits, as we had to do in recent years with respect to our annuity reinsurance contract with Transamerica and our largest guaranteed minimum death benefit contract. If we are required to fund similar shortfalls in the future, it would adversely affect our business.
Significant changes in interest rates expose us to the risk of reduced investment income when interest rates are falling and to greater realized losses from the sale of securities when interest rates are rising. In addition, changes in interest rates can negatively affect the income we derive from the spreads between the interest rates earned on investments and the credited interest rates paid on the policies that we reinsure. If interest rates remain at their current low levels, our investment yields likely will be insufficient to cover the credited interest rates paid under the policies we reinsure, which would adversely affect our business.
The American Institute of Certified Public Accountants has issued a proposed Statement of Position that, if adopted, could require us to establish additional reserves for our reinsurance contracts covering guaranteed minimum benefits related to variable annuity contracts, which could result in losses. We anticipate that this new standard, if adopted, will increase the volatility of our reserves, which will affect our reported results of operations.
The loss of any member of our management team, particularly John F. Burke, our current Chief Executive Officer and Chief Financial Officer, could adversely affect our business.
When we purchase reinsurance from another reinsurance company, known as a retrocessionaire, to cover certain risks that we have ourselves reinsured, we are subject to the risk that the retrocessionaire will be unable to pay amounts due to us because of its own financial troubles. The failure of a retrocessionaire to pay amounts due to us will not absolve us of our responsibility to pay our customers for risks that we have insured. Failure of our retrocessionaires to pay us could have a material adverse effect on our business, results of operations and financial condition.
Our company encountered significant difficulties during the year ended December 31, 2002. In addition to reporting a significant operating loss for the year, we did not have sufficient available cash and investments at December 31, 2002 to post collateral to satisfy all of our obligations under certain of our reinsurance treaties. Since that date, certain of our cedents have asserted that we must satisfy additional substantial collateral requirements, bringing the total asserted collateral requirements to approximately $140 million in excess of amounts we currently have posted. We are currently analyzing these asserted collateral requirements and have not concluded that such amounts are in fact required to be posted as collateral under the relevant reinsurance contracts. In addition, we are also attempting to address a request from a letter of credit provider to collateralize or return approximately $45 million of outstanding letters of credit issued on our behalf. In an effort to meet or reduce our collateral requirements and improve our liquidity, we have novated, terminated or negotiated the recapture of several of our annuity and life reinsurance contracts, including our annuity reinsurance contract with Ohio National, which was our second largest annuity reinsurance contract, and certain of our more profitable life reinsurance contracts.
Our primary annuity products are reinsurance of general account fixed deferred annuities, general account payout annuity obligations and certain ancillary risks arising from variable annuities. Profitability of the annuity reinsurance line is primarily dependent on earning a spread between the interest rate earned on the assets under management and the interest rate credited to the policyholder. This product line is market and interest rate sensitive. Fluctuations in the general level of interest rates, fixed income markets, and equity markets from period to period may cause fluctuations in the results of our operations. The combined effects of poor market performance and excessive surrender rates can adversely impact this product line, such as occurred in 2002 and 2001. At December 31, 2002 and 2001, our liability for annuity reinsurance contracts amounted to approximately $1.4 billion and $1.5 billion, respectively. At March 31, 2003, our liability for annuity reinsurance contracts amounted to approximately $1.0 billion, reflecting terminations and recaptures that have occurred since December 31, 2002, including the termination of our annuity reinsurance contract with Ohio National in February 2003.
Annuity and Life Re (Holdings), Ltd. is a Bermuda holding company with operating subsidiaries in Bermuda and the United States. We consolidate the operations of all of our subsidiaries in accordance with accounting principles generally accepted in the United States. The preparation of financial statements in conformity with generally accepted accounting principles requires the use of estimates and assumptions developed by our management. Any adjustments to the reported amounts of assets or liabilities resulting from changes in estimates are reflected in earnings in the period the estimates are revised. Certain management estimates are based, in part, on information provided by ceding companies. Our ceding companies periodically update, refine and revise the reinsurance information they provide to us. This revised data is reflected in earnings as changes in estimates.
Deferred Policy Acquisition Costs. The costs of acquiring new business, principally allowances, which vary with and are primarily related to the production of new business, are deferred.
For traditional life and annuity policies with life contingencies, deferred policy acquisition costs are charged to expense using assumptions consistent with those used in computing policy reserves. Assumptions as to anticipated premiums are estimated at the date of the policy issuance, or the effective date of the most recent premium rate increase, and are consistently applied during the life of the contracts. Deviations from estimated experience are reflected in earnings in the period such deviations occur. For these contracts, the amortization periods are generally the estimated life of the policies. As discussed elsewhere in this report, we are attempting to improve our liquidity by novating and recapturing certain of our reinsurance agreements. If we cannot novate or recapture these reinsurance agreements on favorable terms, we will incur additional deferred acquisition cost write downs.
Embedded Derivatives. We have concluded that there are embedded derivatives within the Funds withheld at interest receivable related to certain of our annuity reinsurance contracts written on a modified coinsurance or coinsurance funds withheld basis that require bifurcation and separate accounting under Statement of Financial Accounting Standards No. 133 - Accounting for Derivative Instruments and Hedging Activities. These embedded derivatives are similar to a total return swap arrangement on the underlying assets held by our ceding companies. The net fair value of these embedded derivatives is classified as part of our Funds withheld asset on our balance sheet. We have developed a cash flow model with the assistance of outside advisors to arrive at an estimate of the fair value of this total return swap that uses various assumptions regarding future cash flows under the affected annuity reinsurance contracts. The fair value of the embedded derivative is influenced by changes in credit risk, changes in expected future cash flows under the annuity contracts and interest rates. The change in fair value of these embedded derivatives is recorded in our statement of operations as Net change in fair value of embedded derivatives, which is a non-cash item. The change in fair value of these embedded derivatives also impacts the emergence of expected gross profits for purposes of amortizing deferred acquisition costs associated with these contracts. The application of this accounting policy has increased the volatility of our reported earnings. While we have made an estimate of the fair value of these embedded derivatives using a model that we believe to be appropriate and based upon reasonable assumptions, the assumptions used are subjective and may require adjustment in the future. In addition, as industry standards for estimating the fair value of embedded derivatives develop, it is possible that we may modify our methodology. Changes in our assumptions and industry standards could have a significant impact on the fair value of the embedded derivatives and our reported earnings. We do not bifurcate and separately account for the embedded derivatives contained in certain of our contracts, including our Transamerica annuity reinsurance agreement and our guaranteed minimum income benefit reinsurance agreement, because we acquired those agreements prior to the transition date elected by us under FAS 133, as amended by FAS 137. Because of the nature of the assets underlying our Transamerica contract, which were roughly 65% convertible bonds at December 31, 2002, the bifurcation and separate accounting for the embedded derivatives contained in that contract would add significant volatility to our reported results. If we bifurcated and separately accounted for the embedded derivative contained in our guaranteed minimum income benefit reinsurance agreement, it also would add volatility to our reported results.
Recognition of Revenues and Expenses. Reinsurance premium revenues from life products with mortality risk are recognized when due from the policyholders. For those policies with premium paying periods that are significantly shorter than the total period over which benefits are expected to be provided, profits are deferred and recognized as income in a constant relationship to the insurance in force or, for annuities, in relation to the amount of expected future benefit payments. Premiums from universal life and investment-type contracts are recorded on our balance sheet as interest sensitive contracts liability. Revenues from these investment-type contracts consist of income earned on the assets and amounts assessed during the period against policyholders’ account balances for mortality charges, policy administration charges and surrender charges. Items that are charged to expense represent interest credited to policyholder accounts and other benefits in excess of related policyholders’ account balances, including minimum interest guarantee payments. We make estimates at the end of each reporting period regarding premiums and benefits for cedents who do not report such information in a timely manner. These estimates can have a significant effect on the amounts we report in our financial statements.
Reserves for Policy Benefits, Including Claims Incurred but not Reported (IBNR) and Interest Sensitive Contract Liabilities. The development of reserves for policy benefits and for claims incurred but not reported for our life reinsurance contracts requires us to make estimates and assumptions regarding mortality, lapse, persistency, expense and investment experience. Such estimates are primarily based on historical experience and information provided by ceding companies. As occurred in the fourth quarter of 2002, actual results could differ materially from those estimates. We monitor actual experience, and where circumstances warrant, will revise our assumptions and the related reserve estimates.
At December 31, 2002, we had reserves for minimum guarantees associated with variable annuity contracts of $18,500,000. The American Institute of Certified Public Accountants has issued a proposed Statement of Position that could set new standards for accounting for Certain Nontraditional Long-Duration Contracts and for Separate Accounts. We anticipate that this new standard will, if adopted as currently written, increase the volatility of our reserves, which will affect our reported results of operations. Had we followed this proposed standard, at December 31, 2001, and March 31, and June 30, 2002, we estimate that no such reserves would have been required, while at September 30, and December 31, 2002, we estimate that approximately $22 million and $23 million, respectively, of such reserves would have been required. For further information about the market risk sensitivity of minimum guarantee associated with variable annuity products, see
Our independent auditors, KPMG, have audited the Company’s consolidated financial statements. Our independent auditors had unrestricted access to each member of management in conducting their audit. Management has made available to our auditors all of the Company’s financial records and related data, as well as the minutes of shareholders’ and directors’ meetings. Management believes that all representations made to our auditors during their audits were valid and appropriate.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company and its subsidiaries as of December 31, 2002 and 2001 and the results of their operations and cash flows for the years ended December 31, 2002, 2001 and 2000 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.
The Company engaged a financial advisor in September 2002 to assist it in seeking to raise capital, but the Company has not been able to successfully raise new capital to date. The Company has ceased to write new reinsurance agreements and has notified its existing clients that it will not be accepting any new business under existing treaties on their current terms. The Company does not anticipate resuming to write new
There can be no assurance that the Company’s plans will be successful in improving its operations and liquidity. If the Company is not successful in implementing its plans, management believes that the Company will not be able to satisfy its obligations in 2003. The accompanying consolidated financial statements do not include any adjustments that might be necessary should the Company be unable to continue as a going concern.
The costs of acquiring new business, principally allowances, which vary with and are primarily related to the production of new business, are deferred. Where a ceding company pays a bonus interest amount in the first year of a policy to induce a policyholder to acquire the product, and this bonus interest amount is distinct from and incremental to the expected ongoing interest crediting amount, the bonus interest is capitalized and amortized to income in a manner similar to deferred acquisition costs. Deferred policy acquisition costs are subject to recoverability testing at the time of policy issuance and loss recognition testing at the end of each accounting period.
In June 2001, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards Number 142 - Goodwill and Other Intangible Assets. Under FAS 142 the insurance licenses are no longer amortized, but are subjected to an initial impairment test on adoption of FAS 142 and an annual impairment test in subsequent years. The Company adopted FAS 142 on January 1, 2002. The Company completed the impairment test and determined that no impairment charge was necessary. Because the amount of amortization in 2001 and 2000 was not significant, the pro forma impact on reported net income and earnings per share arising from the adoption of FAS 142 is not presented.
The Company reinsures certain minimum guarantees associated with variable annuity contracts. These include guaranteed minimum death benefits, guaranteed minimum income benefits, and enhanced earnings benefits. The Company’s accounting policy is designed to establish reserves for expected claim payments based upon the long-term view of expected losses over the life of the underlying policies, based upon the original pricing assumptions. The Company’s reserving policy allows the Company to increase reserves if claim amounts or claims volume exceed what was anticipated in pricing.
The Company’s net (loss) per common share would have been increased and its net income per common share would have been reduced to the pro forma amounts indicated below, had compensation cost been determined based on the fair value of the options at the grant date, consistent with the method of SFAS No. 123, “Accounting for Stock-Based Compensation.”
The fair value of the options is estimated on the date of grant using the Black-Scholes option-pricing model. The following table details the assumptions and fair values for options issued in 2000, 2001 and 2002.
A portion of the Company’s funds withheld at interest receivable asset contains embedded derivatives, which require bifurcation and separate accounting under FAS 133 - Accounting for Derivative Instruments and Hedging Activities, which the Company adopted as of January 1, 2001. The net fair value of these embedded derivatives is classified as part of the Company’s funds withheld asset on its balance sheet. The change in the fair value of these embedded derivatives is recorded in the Company’s statement of operations as Net change in fair value of embedded derivatives, which is a non-cash item. The Company, with the
The fair value of the embedded derivatives at the date of adoption of FAS 133 on January 1, 2001 was a loss of $3,665,735 and this has been accounted for as a cumulative effect of a change in accounting principle. The change in fair value of the Company’s embedded derivatives for the year ended December 31, 2002 and 2001 was a loss of $25,846,110 and a gain of $5,029,027, respectively. Additionally, an adjustment was made of $8,274,088 in the year ended December 31, 2002 to decrease the amortization of deferred acquisition costs to reflect lower profits on the affected annuity reinsurance agreements as a result of the change in fair value of the embedded derivatives. In 2001, an adjustment of $1,320,184 was made to increase the amortization of deferred acquisition costs to reflect higher profits on the affected annuity reinsurance agreements as a result of the change in fair value of the embedded derivatives. As a result, for the year ended December 31, 2002 and 2001, the net impact on reported earnings was a loss of $17,572,022 and a gain of $43,108, respectively.
A deferred tax liability of $765,000 and $314,000 has been provided against unrealized gains on fixed income securities as of December 31, 2002 and December 31, 2001, respectively.
The following table sets forth certain information regarding the investment ratings of the Company’s fixed income securities portfolio at December 31, 2002 and 2001.
At December 31, 2002 and 2001, cash and investments of $125,000,000 and $272,000,000, respectively, were held in trust for the benefit of certain ceding insurance companies to provide security and to meet regulatory requirements. Substantially all remaining cash and investments held at December 31, 2002 were held by the U.S. operating subsidiary and are required by the subsidiary to maintain its statutory capital and surplus.
(e) Investment income earned during the years ended December 31, 2002, 2001 and 2000 was as follows:
During the years ended December 31, 2002 and 2001, the Company recognized a charge of $900,000 and $600,000, respectively, for securities that were impaired on an other than temporary basis.
In the event of a liquidation, dissolution or winding up of the Company, the holders of the common shares are able to share equally in the assets of the Company, if any remain after payment of all liabilities and the liquidation preference of any outstanding preferred shares. Certain restrictions exist with respect to the
transfer of shares, should such a transfer cause the number of shares held by one United States person to be 10% or more, or a non-United States person to be 17% or more, of the Company’s outstanding common shares.
In connection with the initial capitalization of the Company, the Company issued Class A Warrants that entitle the holders to purchase up to 3,059,990 common shares in the Company. The exercise price of the Warrants, which is subject to adjustment, is $15.00, which was equal to the price of the Company’s common shares in the initial public offering. The Class A Warrants are all currently exercisable and will expire on January 15, 2008. No Class A Warrants have been exercised at December 31, 2002.
During 1998, certain of the Company’s officers purchased 163,121 shares in the Company and the Company made loans to the officers to partially finance such purchases. The loans bear interest at 7% per annum and must be repaid within five years. During 2002, another officer purchased 14,000 shares in the Company and the Company made a loan to the officer to partially finance such purchase. This loan bears interest at 5% per annum and was repaid subsequent to December 31, 2002.
in the Company’s balance sheet as common stock and paid in capital. The fair value of these grants is being amortized on a straight-line basis over the three-year vesting period. The unamortized balance of the grants is reflected in the balance sheet as restricted stock.
Reinsurance has also been placed with affiliates of XL Capital, a related party, as discussed in Note 7. There are no amounts outstanding under these contracts at December 31, 2002. The reinsurance coverage that provides protection against minimum interest guarantee payments has been considered as part of the Company recoverability testing for its deferred acquisition costs carried at December 31, 2002.
It should be noted that retrocession agreements do not relieve the Company from its obligations to its cedents and failure of the Company’s reinsurers to honor their obligations could result in losses to the Company. The Company evaluates the financial condition of its reinsurers and monitors any concentrations of credit risk that may develop to minimize its exposure. The parties to the retrocession agreements described above have current credit rating of A+ or better, as assigned by A.M. Best.
As of December 31, 2002, the Company did not have sufficient available cash and investments to post collateral to satisfy its obligations under certain of its reinsurance treaties. This shortfall was primarily attributable to collateral requirements asserted by the Hartford Life Insurance Company, the cedent under the Company’s largest guaranteed minimum death benefit contract. Since that date, the Company’s cedents have asserted that the Company must satisfy additional substantial collateral requirements, bringing the total asserted collateral requirements to approximately $140,000,000 in excess of amounts the Company currently has posted. Of the collateral requirements asserted by the Company’s cedents, at December 31, 2002, $69,000,000 related to its guaranteed minimum income benefit contract. The Company is working with the cedent to verify the collateral requirements that have been asserted. If the Company is ultimately unable to satisfy its collateral obligations under the contracts, its cedents may elect to pursue the remedies available to them under the contracts, including arbitration against the Company. In an effort to meet or reduce the Company’s collateral requirements and improve its liquidity, the Company has novated, terminated or negotiated the recapture of several of its annuity and life reinsurance contracts, including its second largest annuity reinsurance contract and certain of its more profitable life contracts.
In March 2003, Hartford Life Insurance Company, the cedent under the Company’s largest guaranteed minimum death benefit reinsurance contract, served notice seeking to institute arbitration proceedings against the Company alleging that it has failed to satisfy additional collateral requirements under the contract of approximately $59 million. The arbitration is in its preliminary stages.
While the Company plans to continue to receive premiums and pay claims under its remaining reinsurance treaties, the Company has ceased to write new reinsurance agreements and has notified its existing clients that it will not be accepting any new business under existing treaties on their current terms. The Company does not anticipate resuming to write new reinsurance agreements in the foreseeable future. The Company’s plans for the future involve attempting to meet or reduce the additional collateral requirements of its ceding companies by continuing to negotiate the recapture, retrocession, novation or sale of certain of its reinsurance agreements, although there can be no assurance that it will be able to negotiate favorable terms for such transactions. The Company has also instituted substantial premium rate increases on all of its non-guaranteed premium yearly renewable term contracts that remain in force. There can be no assurance that the Company’s plans will be successful in improving its operations and liquidity. If the Company is not successful in implementing its plans, it will not be able to satisfy its obligations in 2003.
As of December 31, 2002, the Company had a $15,000,000 letter of credit outstanding under a letter of credit facility with Manufacturer’s Life Insurance Company that had been posted as security to allow the Company’s United States operating subsidiary to take credit on its statutory financial statements for reinsurance ceded to the Company’s Bermuda operating company. In October 2002, Manulife requested that the Company return or collateralize the letter of credit it had issued on the Company’s behalf. In February 2003, the Company was served with a statutory demand under Bermuda law from Manulife related to its alleged failure to return or collateralize the letter of credit Manulife issued on the Company’s behalf. In February 2003, the Company filed with the Bermuda Supreme Court an application seeking an injunction to prevent Manulife from filing proceedings to wind up the Company’s business on the basis that Manulife is not a creditor of the Company and therefore did not have standing to make the statutory demand. In March 2003, the court held in the Company’s favor and issued an injunction preventing Manulife from commencing winding up proceedings based upon that demand.
In January 2002, the Company served written notice of arbitration in connection with the Company’s annuity reinsurance contract with Transamerica Occidental Life Insurance Company. In the arbitration, the Company was seeking monetary damages and/or equitable relief from Transamerica based on the Company’s claim that certain actions and/or omissions by Transamerica deprived the Company of the benefit of the reinsurance transaction. On November 8, 2002, the Company announced that the arbitration panel assigned to the matter had denied its claim against Transamerica. The arbitration panel upheld Transamerica’s position that the Company’s annuity reinsurance contract was a valid and enforceable contract and that Transamerica had acted in a commercially reasonable manner.
In November 2002, the State of Connecticut Insurance Department and Annuity and Life Reassurance America entered into a letter agreement that acknowledges that the Connecticut Insurance Department is monitoring the financial condition of the Company’s United States operating subsidiary and requested that certain financial transactions entered into by the subsidiary, including disposal of assets, payment of dividends
The Company’s largest annuity reinsurance contract is a retrocessional contract whereby the Company reinsures Transamerica Occidental Life Insurance Company. At December 31, 2002 and 2001, approximately $734 million and $962 million, respectively, of the Company’s funds withheld at interest receivable and $756 million and $991 million, respectively, of the Company’s interest sensitive contracts liability related to its reinsurance contract with Transamerica, which is a retrocessional reinsurance arrangement covering policies issued by IL Annuity and Insurance Company. Transamerica’s agreement with IL Annuity is also structured on a modified coinsurance basis, so IL Annuity maintains ownership and control of the assets supporting the Company’s obligations to Transamerica. At December 31, 2002, IL Annuity had financial strength or claims paying ratings of A from both A.M. Best and Standard & Poor’s. At December 31, 2002, Transamerica had financial strength or claims paying ratings of A+, AA+, Aa3 and AA+ from A.M. Best, Standard & Poor’s, Moody’s Ratings and Fitch Ratings, respectively. At December 31, 2002, the Company’s second largest annuity reinsurance contract was with The Ohio National Life Insurance Company. At December 31, 2002 and 2001, approximately $366 million and $232 million, respectively, of the Company’s funds withheld at interest (net of the fair value of the embedded derivatives associated with that contract, which was an unrealized loss of approximately $10.0 million as of December 31, 2002 and an unrealized gain of approximately $5.3 million as of December 31, 2001) and $376 million and $227 million, respectively, of the Company’s interest sensitive contracts liability related to the Company’s reinsurance contract with Ohio National. At December 31, 2002, Ohio National had financial strength or claims paying ratings of A+, AA, and A1 from A.M. Best, Standard & Poor’s, and Moody’s Ratings, respectively. This contract was terminated in the first quarter of 2003.
During 2002, the Company recorded $54,174,000 of charges and payments related to the Transamerica reinsurance contract, made up of $26,700,000 of payments made under the contract for minimum interest guarantees to policyholders who surrendered their policies and a write-down of deferred acquisition costs of $27,474,000. During 2001, the Company recorded $59,615,000 of charges and payments related to the Transamerica reinsurance contract, made up of $13,500,000 of payments made under the contract for minimum interest guarantees to policyholders who surrendered their policies and a write down of deferred acquisition costs of $46,115,000. These charges are the result of a high level of surrenders by policyholders coupled with poor investment performance on the premiums paid by the holders of policies underlying the reinsurance contract. In writing down the deferred acquisition costs to their estimated recoverable amount, management has estimated the future levels of surrenders of the underlying policies together with the
The following discussion outlines the methodologies and assumptions used to determine the estimated fair value of the Company’s financial instruments. Considerable judgment is required to develop these fair values. Accordingly, the estimates shown are not necessarily indicative of the amounts that would be realized in a one-time, current market exchange of all of the Company’s financial instruments.
Certain of the Company’s modified coinsurance and coinsurance funds withheld annuity reinsurance agreements have features that constitute embedded derivatives which require bifurcation and separate accounting under FAS 133 - Accounting for Derivative Instruments and Hedging Activities. The valuation of these embedded derivatives requires cash flow modeling that uses various assumptions regarding future cash flows under these agreements. The fair value of these derivatives is reported as a component of Funds withheld at interest. At December 31, 2002, the fair value of these embedded derivatives was a loss of approximately $24,483,000. At December 31, 2001, the fair value of these embedded derivatives was a gain of $1,363,000.
nature. Included in other liabilities is $2,570,000 at December 31, 2002 of unrealized loss, representing the fair value of two interest rate swap agreements.
During the first quarter of 2002, the Company began to separately track financial results of the life and annuity operations in segments. Each segment is defined by a dominant risk characteristic inherent in all products in that segment. The life segment consists of all products where the dominant risk characteristic is mortality risk. The annuity segment comprises all products where the dominant risk characteristic is investment risk, including those products which provide minimum guarantees on variable annuity products. In addition, certain of our modified coinsurance and coinsurance funds withheld annuity reinsurance agreements have features that constitute embedded derivatives that require bifurcation and separate accounting under FAS 133 - Accounting for Derivative Instruments and Hedging Activities. The cumulative effect of the application of FAS 133 through January 1, 2001 and the change in the fair value of these embedded derivatives since that date are included in the annuity segment. Both the life and annuity segments have specific assets, liabilities, stockholder’s equity, revenue, benefits and expenses that apply only to them. The corporate segment contains all stockholders’ equity not otherwise deployed to the life or annuity segment. In addition, the corporate segment includes all capital gains and losses from sales of securities in our portfolio and investment income on undeployed invested assets. Operating expenses are allocated to the segments proportionately based upon the amount of stockholder’s equity deployed to the segment, except for capital raising costs that have been completely allocated to the corporate segment in 2002.
The Company and Annuity and Life Reassurance are required to comply with the provisions of the Companies Act that regulate the payment of dividends and the making of distributions from contributed surplus. Neither the Company nor Annuity and Life Reassurance may declare or pay a dividend, or make a distribution out of contributed surplus, if there are reasonable grounds for believing that: (i) the relevant company is, or would be after the payment, unable to pay its liabilities as they become due; or (ii) the realizable value of the relevant company’s assets would thereby be less than the aggregate of its liabilities and its issued share capital and share premium accounts. As of December 31, 2002, the Company could not reasonably determine that it met these grounds. Further, the Company’s ability to pay dividends depends on the ability of its operating subsidiaries to pay dividends to the Company, which may be subject to regulatory constraints that affect their ability to pay dividends to the Company.
As long-term insurer, Annuity and Life Reassurance must maintain long-term business assets of a value of at least $250,000 greater than its long-term business liabilities. Annuity and Life Reassurance is prohibited from declaring or paying dividends unless the value of its long-term business assets exceed the amount of its long-term business liabilities (as certified by an approved actuary), by the amount of the dividend and by at least $250,000. Additionally, the amounts of any such dividend must not exceed the aggregate of that excess and other funds properly available for the payment of dividends, including funds arising out of its business aside from its long-term business.
Annuity and Life Reassurance America is subject to statutory regulations of the state of Connecticut of the United States that restrict the payment of dividends. It may not pay dividends in any 12-month period in excess of the greater of the statutory net gain from operations for the immediately proceeding calendar year excluding pro rata distributions of any class of Annuity and Life Reassurance America’s securities or 10% of Annuity and Life Reassurance America’s statutory surplus as regards policyholders as of the immediately preceding December 31 at the end of the preceding year, without regulatory approval. At December 31, 2002, the statutory capital and surplus of Annuity and Life Reassurance America was $14,046,000. However, on November 20, 2002, the State of Connecticut Insurance Department and Annuity and Life Reassurance America entered into a letter agreement that acknowledges that the Connecticut Insurance Department is monitoring the financial condition of Annuity and Life Reassurance America and such letter agreement requires that certain financial transactions that it enters into, including disposal of assets, payment of dividends and settlement of inter-company balances with Annuity and Life Reassurance, be pre-approved by the Connecticut Insurance Department. In addition, the Connecticut Insurance Department has requested weekly reports from senior management of Annuity and Life Reassurance America on the Company’s status and any changes in the status of Annuity and Life Reassurance America. The letter agreement continues to be effective until March 1, 2004.
The unaudited quarterly financial data for the following years ended December 31 are as follows:
As of March 31, 2003, the Company has negotiated the novation and recapture of certain of its other reinsurance agreements. The impact on net income in the first quarter of 2003 as a result of these novations and recaptures was a loss of $27,706,963.
At December 31, 2002, the Company had a $15,000,000 letter of credit outstanding under a letter of credit facility with Manufacturer’s Life Insurance Company that had been posted as security to allow the Company’s United States operating subsidiary to take credit on its statutory financial statements for reinsurance ceded to the Company’s Bermuda operating company. In February 2003, the Company was served with a statutory demand under Bermuda law from Manulife related to its alleged failure to return or collateralize the letter of credit Manulife issued on the Company’s behalf. In February 2003, the Company filed with the Bermuda Supreme Court an application seeking an injunction to prevent Manulife from filing winding up proceedings on the basis that Manulife is not a creditor of the Company and therefore did not have standing to make the statutory demand. In March 2003, the court held in the Company’s favor and issued an injunction preventing Manulife from commencing winding up proceedings based upon the statutory demand. Since that time, as a result of recaptures of certain reinsurance agreements by cedents of the Company’s U.S. operating subsidiary, the need for Manulife’s letter of credit facility has been eliminated; and the letter of credit has been terminated.
On April 8, 2003, the Company received notice from the New York Stock Exchange that it did not satisfy the NYSE’s continued listing standards as of that date because the average closing price of the Company’s common shares had been below $1.00 for a 30 consecutive trading day period. If the Company cannot achieve a $1.00 average share price for 30 consecutive trading days within six months of the receipt of this notification, the NYSE will commence suspension and delisting procedures with respect to its common shares. In addition, the NYSE informed the Company that it is considering whether it continues to meet certain of the NYSE’s qualitative continued listing standards due to concerns over the Company’s financial condition.