The following selected financial data of the Company should be read in conjunction with the financial statements and notes thereto and Management’s Discussion and Analysis of Financial Condition and Results of Operations, both of which are included elsewhere herein.
In 2001, the Company adopted EITF 99-20, the effect of which was recorded as a cumulative effect of accounting change (See Note 2 of the accompanying financial statements).
The results of operations for 2003 and 2002 are affected by the profit sharing agreement with AIG SunAmerica Asset Management Corp. (See Notes 2 and 9 of the accompanying financial statements).
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, 2003 (“2003”), 2002 (“2002”) and 2001 (“2001”) follows. Certain prior period amounts have been reclassified to conform to the current period’s presentation.
In connection with the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995, the Company cautions readers regarding certain forward-looking statements contained in this report and in any other statements made by, or on behalf of, the Company, whether or not in future filings with the Securities and Exchange Commission (the “SEC”). Forward-looking statements are statements not based on historical information and which relate to future operations, strategies, financial results, or other developments. Statements using verbs such as “expect,” “anticipate,” “believe” or words of similar import generally involve forward-looking statements. Without limiting the foregoing, forward-looking statements include statements which represent the Company’s beliefs concerning future levels of sales and redemptions of the Company’s products, investment spreads and yields, or the earnings or profitability of the Company’s activities.
VALUATION OF CERTAIN FINANCIAL INSTRUMENTS: Gross unrealized losses on the debt and equity securities available for sale amounted to $24.0 million at December 31, 2003. In determining if and when a decline in fair value below amortized cost is other-than-temporary, the Company evaluates at each reporting period the market conditions, offering prices, trends of earnings, price multiples, and other key measures for our investments in debt and marketable equity securities. In particular, for debt securities, the Company assesses the probability that all amounts due are collectible according to the contractual terms of the obligation. When such a decline in value is deemed to be other-than-temporary, the Company recognizes an impairment loss in the current period operating results to the extent of the decline (See also discussion within “Capital Resources and Liquidity” herein).
Securities in the Company’s portfolio with a carrying value of approximately $558.0 million at December 31, 2003 do not have readily determinable market prices. For these securities, the Company estimates the fair value with internally prepared valuations (including those based on estimates of future profitability). Otherwise, the Company uses its most recent purchases and sales of similar unquoted securities, independent broker quotes or comparison to similar securities with quoted prices when possible to estimate the fair value of those securities. All such securities are classified as available for sale. The Company’s ability to liquidate its positions in these securities will be impacted to a significant degree by the lack of an actively traded market, and may not be able to dispose of these investments in a timely manner. Although the Company believes its estimates reasonably reflect the fair value of those securities, the key assumptions about the risk-free interest rates, risk premiums, performance of underlying collateral, if any, and other factors may not reflect those of an active market.
On December 9, 2002, the Company entered into a profit sharing agreement with AIG SunAmerica Asset Management Corp. (“SAAMCO”), whereby SAAMCO will pay its profits earned through servicing the Company’s variable annuity contracts to the Company (“SAAMCO Agreement”). SAAMCO is the investment adviser or business manager for certain trusts that hold deposits from the Company’s variable annuity products. Pursuant to the SAAMCO Agreement, SAAMCO will pay to the Company variable annuity fee income earned from acting as the investment adviser or business manager for certain trusts that hold deposits from the Company’s variable annuity products. The SAAMCO Agreement was retroactive to January 1, 2002. Amounts paid or accrued to the Company under this agreement totaled $1.6 million in 2003 and $1.8 million in 2002.
NET INCOME totaled $16.9 million in 2003, compared with $6.8 million in 2002 and $8.2 million in 2001.
CUMULATIVE EFFECT OF ACCOUNTING CHANGE, NET OF TAX reflected the adoption of EITF 99-20 in 2001. The Company recorded a loss of $0.5 million, net of tax, which is recognized in the statement of income and comprehensive income as a cumulative effect of accounting change for the year ended December 31, 2001 (see Note 2 of Notes to Financial Statements).
PRETAX INCOME BEFORE CUMULATIVE EFFECT OF ACCOUNTING CHANGE totaled $29.0 million in 2003, compared with $15.8 million in 2002 and $14.9 million in 2001. The increase in 2003 compared to 2002 was primarily due to growth in average invested assets from the sales of annuity products, effective management of interest credited rates in response to the lower investment yields available in a declining interest rate environment, increased net realized investment gains, decreased general and administrative expenses, and decreased guaranteed minimum death benefits on variable annuities, partially offset by increased amortization of deferred acquisition costs and decreased fees on variable annuity and universal life contracts. The improvement in 2002 over 2001 primarily resulted from decreased net realized investment losses, increased variable annuity fees and increased net investment income partially offset by increased amortization of deferred acquisition costs, increased general and administrative expenses and increased guaranteed minimum death benefits on variable annuities.
NET INVESTMENT SPREAD, a non-GAAP measure which represents investment income earned on invested assets less interest credited to fixed annuity contracts, is a key measurement used by the Company in evaluating the profitability of its fixed annuity business. Accordingly, the Company presents an analysis of net investment spread because the Company has determined this measure to be useful and meaningful.
In evaluating its investment yield and net investment spread, the Company calculates average invested assets using the amortized cost of bonds, notes and redeemable preferred stocks. This basis does not include unrealized gains and losses, which are reflected in the carrying value (i.e., fair value) of those investment pursuant to Statement of Financial Accounting Standards No. 115, Accounting for Certain Investments in Debt and Equity
Securities. In the calculation of average invested assets, the Company excludes cash collateral received from the securities lending program, which is offset by a securities lending payable in the same amount. As discussed in Notes 2 and 9 of Notes to Financial Statements, the Company participates in a securities lending program with an affiliated agent, pursuant to which it lends its securities and primarily takes cash as collateral with respect to the securities lent. Participation in securities lending agreements provides additional net investment income for the Company, resulting from investment income earned on the collateral, less interest paid on the securities lending agreements and the related management fees paid to administer the program.
An analysis of net investment spread and a reconciliation to net income is presented in the following table:
The Company sold or redeemed invested assets, principally bonds and notes, aggregating $715.0 million in 2003, $370.9 million in 2002 and $427.5 million in 2001. Sales of investments result from the active management of the Company’s investment portfolio. 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 0.26%, 0.04% and 0.14% of average invested assets for 2003, 2002 and 2001, 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.
Impairment writedowns include $3.1 million, $9.5 million and $17.3 million of provisions applied to bonds in 2003, 2002 and 2001, respectively. Impairment writedowns represent 0.15%, 0.66% and 1.21% of average invested assets for 2003, 2002 and 2001, respectively. For the five years ended December 31, 2003, impairment writedowns as a percentage of average invested assets have ranged from 0.15% to 1.23% and have averaged 0.74%. Such writedowns are based upon estimates of the fair value of invested assets and recorded when declines in the value of such assets are considered to be other than temporary. Actual realization will be dependent upon future events. The Company recorded $0.8 million ($0.5 million, net of tax) of additional impairments in 2001 pursuant to the implementation of EITF 99-20. This adjustment was recorded as a cumulative effect of accounting change in the accompanying statement of income and comprehensive income for 2001.
VARIABLE ANNUITY POLICY FEES are based on the market value of assets in separate accounts supporting variable annuity contracts. Such fees totaled $8.1 million in 2003, $9.0 million in 2002, and $8.0 million in 2001 and include fees related to the SAAMCO Agreement of $1.6 million and $1.8 million in 2003 and 2002, respectively. The decreased fees in 2003 as compared to 2002 and 2001 primarily reflects the unfavorable equity market conditions in 2002 and the early part of 2003, and the resulting unfavorable impact on market values of assets in the separate accounts. Excluding the impact of the SAAMCO Agreement, the decreased fees in 2002 reflected the unfavorable equity market conditions in 2002. Variable annuity fees represent 2.0%, 1.9%, and 1.6% of average variable annuity assets in 2003, 2002 and 2001, respectively. The increase in fees as a percentage of average variable assets in 2003 and 2002 is due primarily to the fees related to the SAAMCO Agreement. Excluding the impact of the SAAMCO Agreement, variable annuity fees would have represented 1.6% of average variable annuity assets in all periods. Variable annuity assets averaged $410.1 million, $462.3 million and $517.1 million during the respective periods. Variable annuity deposits, which exclude deposits allocated to the fixed accounts of variable annuity products, totaled $25.5 million in 2003, $65.0 million in 2002 and $34.6 million in 2001. These amounts represent 6%, 13% and 6% of variable annuity reserves at the beginning of the respective periods. The increase in variable annuity deposits in 2002 reflected increased demand for a new product, FSA Advisor, initially marketed in January 2001. Transfers from the fixed accounts of the Company’s variable annuity products to the separate accounts (see “Change in Average Invested Assets”) are not classified as variable annuity deposits. Accordingly, changes in variable annuity deposits are not necessarily indicative of the ultimate allocation by customers among fixed and variable account options of the Company’s variable annuity products.
the fixed accounts) (“Variable Annuity Product Sales”) amounted to $142.6 million, $101.3 million and $90.5 million in 2003, 2002 and 2001, respectively. The increase in Variable Annuity Product Sales during 2003 reflect the sales of the Company’s new products, WM Diversfied Strategies III and Polaris II. Introduced at the beginning of 2003, WM Diversified Strategies III, product sales totaled $56.5 million in 2003. Polaris II product sales totaled $63.2 million 2003 with no sales occurring in 2002. The increase in Variable Annuity Product Sales during 2002 primarily reflects those of FSA Advisor, originally marketed in 2001. FSA Advisor product sales were approximately $51.3 million in 2002 as compared to $15.9 million in 2001.
UNIVERSAL LIFE INSURANCE FEES, NET OF REINSURANCE amounted to $5.3 million in 2003, $6.3 million in 2002 and $5.8 million in 2001 and are net of reinsurance premiums of $7.1 million, $6.1 million and $6.3 million, respectively . Universal life insurance fees consist of mortality charges, up-front fees earned on deposits received and administrative fees, net of reinsurance premiums. The administrative fees are assessed based on the number of policies in force as of the end of each month. The Company acquired its universal life contracts as part of the acquisition of business from MBL Life Assurance Corporation on July 1, 1999 and does not actively market such contracts. Such fees represent 2.26%, 2.59% and 2.32% of average reserves for universal life insurance contracts in the respective periods. The decrease in fees in 2003 resulted primarily from increased reinsurance premiums ceded.
GENERAL AND ADMINISTRATIVE EXPENSES totaled $6.0 million in 2003, $8.1 million in 2002 and $4.3 million in 2001. General and administrative costs were unusually low in 2001 due to certain guaranty fund credits, which reduced overall expenses. Excluding the impact of this item, general and administrative expenses increased approximately 20% in 2002, representing the additional costs of selling and servicing a growing fixed annuity block of business. 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.
CLAIMS ON UNIVERSAL LIFE INSURANCE CONTRACTS, NET OF REINSURANCE RECOVERIES totaled $3.1 million in 2003, compared to $3.0 million in 2002 and $2.4 million in 2001 (net of reinsurance recoveries of $3.6 million in 2003, $4.2 million in 2002 and $3.9 million in 2001).
INCOME TAX EXPENSE totaled $12.1 million in 2003, $9.0 million in 2002 and $6.2 million in 2001, representing effective tax rates of 42%, 57%, and 41%, respectively. The higher rate in 2002 was principally due to the impact of a deferred tax liability adjustment. See Note 8 of the accompanying financial statements for a reconciliation of income tax expense to the federal statutory rate.
SHAREHOLDER’S EQUITY increased to $349.5 million at December 31, 2003 from $213.0 million at December 31, 2002. The increase reflected a capital contribution of $115.0 million, net income of $16.9 million and other comprehensive income of $4.6 million.
The Company’s general investment philosophy is to hold fixed-rate assets for long-term investment. Thus, it does not have a trading portfolio. However, the Company has determined that all of the Bond Portfolio is available to be sold in response to changes in market interest rates, changes in relative value of asset sectors and individual securities, changes in prepayment risk, changes in the credit quality outlook for certain securities, the Company’s need for liquidity and other similar factors.
At December 31, 2003, the Bond Portfolio included $153.2 million of bonds that were not investment grade. These non-investment-grade bonds accounted for approximately 4.0% of the Company’s total assets and approximately 4.8% of its invested assets. Non-investment-grade securities generally provide higher yields and involve greater risks than investment-grade securities because their issuers typically are more highly leveraged and more vulnerable to adverse economic conditions than investment-grade issuers. In addition, the trading market for these securities is usually more limited than for investment-grade securities. An economic downturn could produce higher than average issuer defaults on the non-investment-grade securities, which could cause the Company’s investment returns and net income
to decline. At December 31, 2003, the Company’s non-investment-grade portfolio consisted of 57 issues with no single issuer representing more than 10% of the total non-investment grade bond portfolio. These non-investment-grade securities are comprised of bonds spanning 11 industries with 20% of these assets concentrated in telecommunications, 20% concentrated in cyclical consumer products and 14% concentrated in noncyclical consumer products. No other industry concentration constituted more than 10% of these assets.
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. Issues are categorized based on the highest of the S&P, Moody’s, and Fitch ratings if rated by multiple agencies.
Bonds and short-term promissory instruments are divided into six quality categories for NAIC rating purposes, ranging from 1 (highest) to 5 (lowest) for non-defaulted bonds plus one category, 6, for bonds in or near default. These six categories correspond with the S&P/Moody’s/Fitch rating groups listed above, with categories 1 and 2 considered investment grade. The NAIC categories include $261.5 million of assets that were rated by the Company pursuant to applicable NAIC rating guidelines.
Another aspect of valuation pertains to impairment. As a matter of policy, the determination that a security has incurred an other-than-temporary decline in value and the amount of any loss recognition requires the judgment of the Company’s management and a continual review of its investments.
The occurrence of a discrete credit event resulting in; (i) the issuer defaulting on a material outstanding obligation; or (ii) the issuer seeking protection from creditors under the bankruptcy laws or similar laws intended for the court supervised reorganization of insolvent enterprises; or (iii) the issuer proposing a voluntary reorganization pursuant to which creditors are asked to exchange their claims for cash or securities having a fair value substantially lower than the par value of their claims; or
In the opinion of the Company’s management, it is unlikely the Company will realize a full recovery on its investment, irrespective of the occurrence of one of the foregoing events.
The Company has the ability to hold any security to its stated maturity. Therefore, the decision to sell reflects the judgment of the Company’s management that the security sold is unlikely to provide, on a relative value basis, as attractive a return in the future as alternative securities entailing comparable risks. With respect to distressed securities, the sale decision reflects management’s judgment that the risk-discounted anticipated ultimate recovery is less than the value achieved on
At December 31, 2003, approximately $834.0 million, at amortized cost, of the Bond Portfolio had a fair value of $810.0 million resulting in an aggregate unrealized loss of $24.0 million. The gross unrealized losses in the bond portfolio included the following concentrations:
The amortized cost of the Bond Portfolio in an unrealized loss position at December 31, 2003, by contractual maturity, is shown below.
In 2003, the pretax realized losses incurred with respect to the sale of fixed securities in the Bond Portfolio were $3.3 million. The aggregate fair value of securities sold was $140.8 million, which was approximately 98% of amortized cost. The average period of time that securities sold at a loss during 2003 were trading continuously at a price below amortized cost was approximately 10 months.
The valuation for the Company’s Bond Portfolio comes from market exchanges or dealer quotations, with the exception of non-traded securities. The Company considers non-traded securities to mean certain fixed income investments and certain structured securities. The aggregate carrying value of these securities at December 31, 2003 was approximately $509.8 million.
The methodology used to estimate fair value of non-traded fixed income investments is by reference to traded securities with similar attributes and using a matrix pricing methodology. This technique takes into account such factors as the industry, the security’s rating and tenor, its coupon rate, its position in the capital structure of the issuer and other relevant factors. The change in fair value is recognized as a component of other comprehensive income.
For certain structured securities, the carrying value is based on an estimate of the security’s future cash flows pursuant to the requirements of Emerging Issues Task Force Issue No. 99-20 “Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets”. The change in carrying value is recognized in income.
While the trading market for the Company’s privately traded Secured Loans is more limited than for publicly traded issues, participation in these transactions has enabled the Company to improve its investment yield. As a result of restrictive financial covenants, these Secured Loans involve greater risk of technical default than do publicly traded investment-grade securities. However, management believes that the risk of loss upon default for these Secured Loans is mitigated by such financial covenants and the collateral values underlying the Secured Loans. The Company’s Secured Loans are rated by S&P, Moody’s, Fitch, the NAIC or by the Company, pursuant to comparable statutory ratings guidelines established by the NAIC.
At December 31, 2003, approximately 20% of the mortgage loans were seasoned loans underwritten to the Company’s standards and purchased at or near par from other financial institutions. Such loans generally have higher average interest rates than loans that could be originated today. The balance of the mortgage loan portfolio has been originated by the Company under strict underwriting standards. Commercial mortgage loans on properties such as offices, hotels and shopping centers generally represent a higher level of risk than do mortgage loans secured by multifamily residences. This greater risk is due to several factors, including the larger size of such loans and the more immediate effects of general economic conditions on these commercial property types. However, due to the seasoned nature of the Company’s mortgage loan portfolio and its strict underwriting standards, the Company believes that it has prudently managed the risk attributable to its mortgage loan portfolio while maintaining attractive yields.
ASSET-LIABILITY MATCHING is utilized by the Company to minimize the risks of interest rate fluctuations and disintermediation. The Company believes that its fixed-rate liabilities should be backed by a portfolio principally composed of fixed-rate investments that generate predictable rates of return. The Company does not have a specific target rate of return. Instead, its rates of return vary over time depending on the current interest rate environment, the slope of the yield curve, the spread at which fixed-rate investments are priced over the yield curve, default rates, and general economic conditions. Its portfolio strategy is constructed with a view to achieve adequate risk-adjusted returns consistent with its investment objectives of effective asset-liability matching, liquidity and safety. The Company’s fixed-rate products incorporate surrender charges or other restrictions in order to encourage persistency. Approximately 79% of the Company’s fixed annuity and universal life reserves had surrender penalties or other restrictions at December 31, 2003.
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 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 in the Company’s asset-liability modeling include: cash and short-term investments; bonds, notes and redeemable preferred stocks; mortgage loans; and policy loans. At December 31, 2003, these assets had an aggregate fair value of $3.02 billion with an option-adjusted duration of 4.2 years. The Company’s fixed-rate liabilities include fixed annuity, fixed options of variable annuity and universal life insurance contracts. At December 31, 2003, these liabilities had an aggregate fair value (determined by discounting future contractual cash flows by related market rates of interest) of $2.82 billion with an option-adjusted duration of 4.9 years. The Company’s potential exposure due to a relative 10% decrease in prevailing interest rates from their December 31, 2003 levels is a loss of approximately $3.2 million, representing the increase in fair value of its fixed rate liabilities that is not offset by an increase in fair value of its fixed rate assets. Because the Company actively manages its assets and liabilities and has strategies in place to minimize its exposure to loss as interest rate changes occur, it expects that actual losses would be less than the estimated potential loss.
Option-adjusted duration is a common measure for the price sensitivity of a fixed-maturity portfolio to changes in interest rates. For example, if interest rates increase 1%, the fair value of an asset with a duration of 5.0 is expected to decrease in value by approximately 5%. The Company estimates the option-adjusted duration of its assets and liabilities using a number of different interest rate scenarios, assuming continuation of existing investment and interest crediting strategies, including maintaining an appropriate level of liquidity. Actual company and contract owner behaviors may be different than was assumed in the estimate of option-adjusted duration
The overall interest-credited rate environment has continued to decline in 2003. A significant portion of the Company’s fixed annuity contracts (including the fixed option of variable contracts) has reached or is near the minimum contractual guaranteed rate (generally 3%). Continual declines in interest rates could cause the spread between the yield on the portfolio and the interest rate credited to policyholders to deteriorate. In 2003, the State of New York adopted legislation reducing the minimum contractual rate that can be credited to policyholders on new contracts to 1.5%. As a result, certain contracts issued in 2003 will have a 1.5% minimum contractual guaranteed rate. This will not impact the previously issued contracts.
The Company has had the ability, limited by minimum interest rate guarantees, to respond to the generally declining interest rate environment in the last five years by lowering crediting rates in response to lower investment returns. The trends experienced during the three years ended December 31, 2003 in the Company’s yield on average invested assets and rate of interest credited on average interest-bearing liabilities, compared to the market trend in long-term interest rates as illustrated by the average ten-year U.S. Treasury bond rate, are presented in the following table:
INVESTED ASSETS EVALUATION is routinely conducted by the Company. Management identifies monthly those investments that require additional monitoring and carefully reviews the carrying values of such investments at
least quarterly to determine whether specific investments should be placed on a non-accrual basis and to determine declines in value that may be other than temporary. In conducting these reviews for bonds, management principally considers the adequacy of any collateral, compliance with contractual covenants, the borrower’s recent financial performance, news reports and other externally generated information concerning the creditor’s affairs. In the case of publicly traded bonds, management also considers market value quotations, if available. For mortgage loans, management generally considers information concerning the mortgaged property and, among other things, factors impacting the current and expected payment status of the loan and, if available, the current fair value of the underlying collateral.
If a substantial portion of the Company’s bond portfolio diminished significantly in value and/or defaulted, the Company would need to liquidate other portions of its investment portfolio and/or arrange financing. Such events that may cause such a liquidity strain could be the result of economic collapse or terrorist acts.
Management believes that the Company’s liquid assets and its net cash provided by operations will enable the Company to meet any foreseeable cash requirements for at least the next twelve months.
In January 2001, the Emerging Issues Task Force (“EITF”) issued EITF 99-20, “Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets” (“EITF 99-20”). EITF 99-20 provides guidance on the calculation of interest income and the recognition of impairments related to beneficial interests held in an investment portfolio. The Company’s beneficial interests are investments that represent rights to receive specified cash flows from a pool of underlying assets (i.e., collateralized debt obligations). In accordance with the transition provisions of EITF 99-20, the Company recorded in its statement of income and comprehensive income for 2001 a cumulative effect of an accounting change adjustment loss of $520,000 ($800,000 before tax).
In addition, SOP 03-1 will require the Company to recognize a liability for guaranteed minimum death benefits and modify certain disclosures and financial statement presentations for this product. The Company’s estimate of the liability, including the impact of DAC, will result in a one-time cumulative accounting charge upon adoption of approximately $2 million ($4 million pre-tax) to be recorded in the first quarter of 2004.