The following discussion highlights significant factors influencing results of operations and changes in financial position of Allstate Life Insurance Company of New York (the "Company"). It should be read in conjunction with the financial statements and related notes.
Statutory premiums and deposits include premiums and deposits for all products. In 1998, total statutory premiums and deposits increased $58.9 million or 28.3%. The increase was due primarily to increased sales of fixed annuities in the banking distribution channel. Total statutory premiums and deposits decreased $27.5 million, or 11.7%, in 1997 from 1996 as increased sales of variable annuities and life insurance policies were more than offset by a reduction in deposits relating to funding agreements, a type of fixed annuity product. Funding agreements, first sold by the Company in 1996, are entered into based on the Company's assessment of market opportunities.
Pretax net investment income increased 7.6% and 10.7% in 1998 and 1997, respectively. Higher investment balances in each period more than offset lower portfolio yields. Investments, excluding Separate Account assets and unrealized gains on fixed income securities, grew 14.3% and 9.8% in 1998 and 1997, respectively. In the declining interest rate environments of 1998, 1997 and 1996, funds from maturing investments were generally reinvested at lower yields resulting in reduced investment income.
Operating costs and expenses increased $2.4 million, or 8.5% and $5.3 million, or 22.6%, for the years ended December 31, 1998 and 1997, respectively. For the year ended December 31, 1998, the increase in expenses is primarily due to growth in business. For the year ended December 31, 1997 the increase is related to growth in business and the recognition of costs related to the relocation of the policy administration function, offset by a reduction in amortization of deferred acquisition costs due to revised estimates of future gross profits on interest-sensitive life products.
Operating income increased 12.4% in 1998 and 3.1% in 1997. The increase in 1998 resulted from favorable mortality margins and increased contract charges, primarily from variable annuities, partially offset by higher expenses. The increase in 1997 is primarily due to favorable mortality experience and higher investment margins on the structured settlement annuity business.
Realized capital gains and losses increased in 1998 due primarily to higher levels of sales and pre-payments of fixed income securities. In 1997, increased realized capital gains on fixed income securities and reduced losses on other investments were partially offset by increased writedowns on mortgage loans. Year to year fluctuations in realized capital gains are largely the result of the timing of sales decisions reflecting management's view of individual securities and overall market conditions.
The composition of the investment portfolio at December 31, 1998 is presented in the table below (see Notes 2 and 4 to the financial statements for investment accounting policies and additional information). PERCENT ($ in thousands) TO TOTAL --------
Short-term investments increased, in part, at December 31, 1998 by $10.0 million due to a change in accounting treatment for collateral received by the securities lending program and by approximately $34 million in anticipation of an inter-company settlement.
At December 31, 1998, substantially all of the Company's fixed income securities portfolio was rated investment grade, which is defined by the Company as a security having a National Association of Insurance Commissioners ("NAIC") rating of 1 or 2, a Moody's rating of Aaa, Aa, A or Baa, or a comparable Company internal rating. The quality mix of the Company's fixed income securities portfolio at December 31, 1998 is presented below:
NAIC RATINGS MOODY'S EQUIVALENT DESCRIPTION FAIR VALUE PERCENT TO TOTAL ------- ------------------------------ ---------- ----------------
MBS, however, are subject to interest rate risk as the duration and ultimate realized yield are affected by the rate of repayment of the underlying mortgages. The Company attempts to limit interest rate risk by purchasing MBS where cost does not significantly exceed par value, and with repayment protection to provide a more certain cash flow to the Company. At December 31, 1998, the amortized cost of the MBS portfolio was below par value by $6.9 million and over 42% of the MBS portfolio was invested in planned amortization class bonds. This type of MBS is purchased to provide additional protection against declining interest rates.
The Company's short-term investment portfolio was $76.1 million and $9.5 million at December 31, 1998 and 1997, respectively. The Company invests available cash balances primarily in taxable short-term securities having a final maturity date or redemption date of one year or less. The short-term investment portfolio increased, in part, at December 31, 1998 by $10.0 million due to a change in the accounting treatment for collateral received by the securities lending program and by approximately $34 million in anticipation of an inter-company settlement.
Separate Account assets and liabilities increased 18.7% to $366.2 million at December 31, 1998. The increases were primarily attributable to sales of flexible premium deferred variable annuity contracts and favorable investment performance of the Separate Accounts investment portfolios, partially offset by variable annuity surrenders and withdrawals.
The active management of market risk is integral to the Company's operations. The Company may use the following approaches to manage its exposure to market risk within defined tolerance ranges: 1) rebalance its existing asset or liability portfolios, 2) change the character of future investments purchased or 3) use derivative instruments to modify the market risk characteristics of existing assets and liabilities or assets expected to be purchased. Note 5 to the financial statements provides a more detailed discussion of these instruments.
The Company administers and oversees its investment risk management processes primarily through two oversight bodies: the Board of Directors and the Credit and Risk Management Committee ("CRMC") of the Corporation. The Board of Directors provide executive oversight of investment activities. The Corporation's CRMC is a senior management committee consisting of the Chief Investment Officer, the Investment Risk Manager, and other investment officers who are responsible for the day-to-day management of market risk. The CRMC meets at least monthly to provide detailed oversight of investment risk, including market risk.
The Company manages its exposure to market risk through asset allocation limits, duration limits and, as appropriate, stress tests. Asset allocation limits place restrictions on the aggregate fair value which may be invested within an asset class. The Company has duration limits on investment portfolios, and, as appropriate, on individual components of these portfolios. These duration limits place restrictions on the amount of interest rate risk which may be taken. Stress tests measure downside risk to fair value and earnings over longer time intervals and/or for adverse market scenarios.
The Company manages the interest rate risk inherent in its assets relative to the interest rate risk inherent in its liabilities. One of the measures the Company uses to quantify this exposure is duration. Duration measures the sensitivity of the fair value of assets and liabilities to changes in interest rates. For example, if interest rates increase 1%, the fair value of an asset with a duration of 5 years is expected to decrease in value by approximately 5%. At December 31, 1998, the difference between the Company's liability and asset duration was approximately 3.4 years, which is larger than the 2.8 gap reported for December 31, 1997. This duration gap indicates that the fair value of the Company's liabilities is more sensitive to interest rate movements than the fair value of its assets.
To calculate duration, the Company projects asset and liability cash flows, and discounts them to a net present value basis using a risk-free market rate adjusted for credit quality, sector attributes, liquidity and other specific risks. Duration is calculated by revaluing these cash flows at an alternative level of interest rates, and determining the percentage change in fair value from the base case. The cash flows used in the model reflect the expected maturity and repricing characteristics of the Company's derivative financial instruments, all other financial instruments (as depicted in Note 5 to the financial statements), and certain non-financial instruments including interest-sensitive annuity liabilities. The projections include assumptions (based upon historical market and Company specific experience) reflecting the impact of changing interest rates on the prepayment, lapse, leverage and/or option features of instruments, where applicable. Such assumptions relate primarily to mortgage-backed securities, collateralized mortgage obligations, municipal housing bonds, callable municipal and corporate obligations, and fixed rate single and flexible premium deferred annuities.
The Company's principal sources of funds are collections of principal, interest and dividends from the investment portfolio and the receipt of premiums and deposits. The primary uses of these funds are to purchase investments and pay policyholder claims, benefits, contract maturities, contract surrenders and withdrawals, and operating costs.
At December 31, 1998, the Moody's and Standard and Poor's financial strength ratings for the Company were Aa2 and AA+, respectively.
The Company is dependent upon certain services provided for it by the Corporation including computer-related systems, and systems and equipment not typically thought of as computer-related (referred to as "non-IT"). For this reason, the Company is reliant upon the Corporation for the establishment and maintenance of its computer-related systems and non-IT.
The Corporation is heavily dependent upon complex computer systems for all phases of its operations, including customer service, insurance processing, underwriting, loss reserving, investments and other enterprise systems. Since many of the Corporation's older computer software programs recognize only the last two digits of the year in any date, some software may fail to operate properly in or after the year 1999, if the software is not reprogrammed, remediated, or replaced, ("Year 2000"). Also, non-IT often contains embedded hardware or software that may have a Year 2000 sensitive component. The Corporation believes that many of its counterparties and suppliers also have Year 2000 issues and non-IT issues which could affect the Corporation.