Protective’s Home Office is located at 2801 Highway 280 South, Birmingham, Alabama. This campus includes the original 142,000 square-foot building which was completed in 1976, a second contiguous 220,000 square-foot building which was completed in 1985, and a third contiguous 315,000 square-foot building that was completed in January 2003. In addition, parking is provided for approximately 2,760 vehicles. In 2000, Protective entered into an arrangement, with an unrelated party, for the construction of the third building. The unrelated party owns the building and leases it to Protective. The lease is accounted for as an operating lease under SFAS No. 13 “Accounting For Leases”. Lease payments are based on current LIBOR interest rates and the cost of the building. At the end of the lease term, February 1, 2007, Protective may purchase the building for the original building cost of approximately $75 million. Based upon current interest rates, annual lease payments are estimated to be $1.5 million. Were Protective not to purchase the building, a payment of approximately $66 million would be due at the end of the lease term.
Protective leases administrative and marketing office space in approximately 24 cities including approximately 24,173 square feet in Birmingham (excluding the home office building), with most leases being for periods of three to ten years. The aggregate annualized rent is approximately $8.0 million.
Year Ended December 31 ------------------------------------------------------------------------------- 2003 2002 2001 2000 1999 -------------------------------------------------------------------------------------------------------------------------- (dollars in thousands) INCOME STATEMENT DATA(3) Premiums and policy fees................ $1,653,609 $1,548,201 $1,389,819 $1,175,943 $ 861,021 Reinsurance ceded....................... (917,935) (738,158) (771,151) (686,108) (462,297) -------------------------------------------------------------------------------------------------------------------------- Net of reinsurance ceded................ 735,674 810,043 618,668 489,835 398,724 Net investment income................... 980,743 971,808 835,203 692,081 617,829 Realized investment gains (losses): Derivative financial instruments..... 8,249 (4,708) 2,182 2,157 3,425 All other investments................ 66,764 12,314 (6,123) (16,756) 1,335 Other income............................ 46,825 41,483 38,578 35,194 22,599 -------------------------------------------------------------------------------------------------------------------------- Total revenues.......................... 1,838,255 1,830,940 1,488,508 1,202,511 1,043,912 Benefits and expenses................... 1,488,283 1,589,317 1,274,550 1,027,889 857,299 Income tax expense...................... 117,932 84,229 70,457 61,478 67,991 Income (loss) from discontinued operations(1)........................... 0 0 (27,610) 16,299 22,027 Change in accounting principle(2)....... 0 0 (8,341) 0 0 -------------------------------------------------------------------------------------------------------------------------- Net Income.............................. $ 232,040 $ 157,394 $ 107,550 $ 129,443 $ 140,649 ==========================================================================================================================
Income from discontinued operations in 2001 includes loss on sale of discontinued operations and loss from discontinued operations, net of income tax.
This report reviews Protective’s financial condition and results of operations including its liquidity and capital resources. Historical information is presented and discussed. Where appropriate, factors that may affect future financial performance are also identified and discussed. Certain statements made in this report include “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements include any statement that may predict, forecast, indicate or imply future results, performance or achievements instead of historical facts and may contain words like “believe,” “expect,” “estimate,” “project,” “budget,” “forecast,” “anticipate,” “plan,” “will,” “shall,” “may,” and other words, phrases, or expressions with similar meaning. Forward-looking statements involve risks and uncertainties which may cause actual results to differ materially from the results contained in the forward-looking statements, and Protective cannot give assurances that such statements will prove to be correct. Given these risks and uncertainties, investors should not place undue reliance on forward-looking statements as a prediction of actual results. Please refer to “Known Trends and Uncertainties” herein for more information about factors which could affect future results.
In 2003, Protective’s net income increased 47.4% to $232.0 million compared to $157.4 million in 2002. Included in 2003 net income were net realized investment gains of $75.0 million compared to gains of $7.6 million in 2002.
The Acquisitions segment’s pretax operating income was $96.7 million in 2003, up slightly from the $96.4 million reported in 2002. Increased earnings from recently completed transactions were offset by the expected declining earnings from older acquired blocks of business.
Stable Value Products pretax operating income was $38.9 million in 2003, compared to $42.3 million in 2002. Average operating spreads decreased to 96 basis points in 2003, compared to 107 basis points in 2002.
The Asset Protection segment had pretax operating income of $10.6 million in 2003, compared to a loss of $15.2 million in 2002. This increase in pretax operating income was primarily due to improvements in service contract lines and charges recorded in 2002 due to negative trends in service contract and residual value product lines.
Protective also establishes liabilities for guaranteed minimum death benefits (GMDB) on its variable annuity products. The methods used to estimate the liabilities employ assumptions about mortality and the performance of equity markets. Protective assumes mortality of 60% of the National Association of Insurance Commissioners 1994 Variable Annuity GMDB Mortality Table to reflect improvements in mortality since the table was derived and other factors. Future declines in the equity market would increase Protective’s GMDB liability. Differences between the actual experience and the assumptions used result in variances in profit and could result in losses. Protective’s GMDB at December 31, 2003, are subject to a dollar-for-dollar reduction upon withdrawal of related annuity deposits on contracts issued prior to January 1, 2003.
Determining whether a decline in the current fair value of invested assets is an other-than-temporary decline in value can involve a variety of assumptions and estimates, particularly for investments that are not actively traded in established markets. For example, assessing the value of certain investments requires Protective to perform an analysis of expected future cash flows or rates of prepayments. Other investments, such as collateralized mortgage or bond obligations, represent selected tranches of a structured transaction, supported overall by underlying investments in a wide variety of issuers. Protective’s specific accounting policies related to its invested assets are discussed in the Notes to the Consolidated Financial Statements.
Protective utilizes derivative transactions primarily in order to reduce its exposure to interest rate risk as well as currency exchange risk. Assessing the effectiveness of these hedging programs and evaluating the carrying values of the related derivatives often involve a variety of assumptions and estimates. Protective employs a variety of methods for determining the fair value of its derivative instruments. The fair values of interest rate swaps, interest rate swaptions, total return swaps and put or call options are based upon industry standard models which present-value the projected cash flows of the derivatives using current and implied future market conditions.
Determining Protective’s obligations to employees under its defined benefit pension plan and stock-based compensation plans requires the use of estimates. The calculation of the liability related to Protective’s defined benefit pension plan requires assumptions regarding the appropriate weighted average discount rate, estimated rate of increase in the compensation of its employees and the expected long-term rate of return on the plan’s assets. Accounting for other stock-based compensation plans may require the use of option pricing models to estimate PLC’s obligations. Assumptions used in such models relate to equity market volatility, the risk-free interest rate at the date of grant, as well as the expected exercise date.
Percentage Year Ended Increase December 31 Amount (Decrease) ----------------------------------------------------------------------------- (in thousands) 2001 $618,668 26.3% 2002 810,043 30.9 2003 735,674 (9.2) -----------------------------------------------------------------------------
Premiums and policy fees were $810.0 million in 2002, an increase of $191.4 million or 30.9% from the $618.7 million reported for 2001. During 2002, Protective discovered that it had overpaid the reinsurance premiums due on certain life insurance policies over a period of 10 years. Protective recorded cash and receivables totaling $69.7 million, and a corresponding increase in premiums and policy fees, which reflected its then current estimate of amounts to be recovered. Excluding this increase, premiums and policy fees in the Life Marketing segment increased $29.5 million due to an increase in sales. Premiums and policy fees in the Acquisitions segment are expected to decline with time (due to the lapsing of policies resulting from deaths of insureds or terminations of coverage) unless new acquisitions are made. In June 2002, Protective coinsured a block of insurance policies from Conseco Variable Insurance Company (Conseco). This transaction resulted in an increase in premiums and policy fees of $18.8 million. The acquisition of Inter-State and First Variable resulted in a $27.0 million increase in premiums and policy fees. Premiums and policy fees from older acquired blocks decreased $3.7 million. Premiums and policy fees from the Annuities segment declined $2.3 million due to a decline in variable annuity management fees caused by the general decline in the equity markets. Premiums and policy fees related to the Asset Protection segment increased $53.4 million due to continued higher sales in its service contracts and residual value lines. Lower sales in other Asset Protection lines during 2002 were more than offset by a decline in the amount of reinsurance ceded. The decline in reinsurance ceded was primarily due to a change in the form of a credit reinsurance agreement in 2002. Premiums and policy fees relating to various health insurance lines in the Corporate and Other segment decreased $1.0 million.
Premiums and policy fees were $735.7 million in 2003, a decrease of $74.4 million or 9.2% from 2002 premiums and policy fees. In 2003, Protective substantially completed its recovery of all of the previously mentioned reinsurance overpayments. As a result, $18.4 million of premiums and policy fees were recorded in 2003 related to the collection of the reinsurance overpayment. Overall, premiums and policy fees in the Life Marketing segment declined $21.5 million from 2002, reflecting an increase in the use of reinsurance. Premiums and policy fees from the Conseco transaction resulted in an increase of $7.2 million. Premiums and policy fees from older acquired blocks decreased $17.8 million as a result of normal lapsing of policies resulting from deaths of insureds or terminations of coverage. Premiums and policy fees in the Annuities segment increased by $0.4 million in 2003. Premiums and policy fees in the Asset Protection segment decreased by $40.9 million due to reduced credit earned premiums attributable to lower sales and the termination of non-core lines of business. Premiums and policy fees in the Corporate and Other segment decreased by $1.8 million.
Net investment income in 2002 increased $136.6 million or 16.4% over 2001, and in 2003 increased $8.9 million or 0.9% over 2002, primarily due to increases in the average amount of invested assets. Invested assets have increased primarily due to acquisitions, receiving stable value and annuity deposits, and the asset growth that results from the sale of various insurance products. The Standard coinsurance transaction and the acquisition of Inter-State and First Variable resulted in an increase in investment income of $57.5 million in 2002. The Conseco coinsurance transaction resulted in an increase in investment income of $13.3 million in 2003. This increase was more than offset by $19.3 million decline in investment income from older acquisitions.
Realized investment gains and losses related to derivative financial instruments primarily represent changes in the fair values of certain derivative financial instruments. Realized investment gains and losses related to derivatives include periodic settlements related to interest rate swaps intended to mitigate the risks associated with certain investments, but do not qualify as hedges under SFAS No. 133.
Income before income tax excluding realized investment gains and losses and related amortization of deferred policy acquisition costs
The Life Marketing segment’s 2003 pretax operating income was $160.0 million, an increase of $34.5 million over 2002. During 2003, Protective received payment from substantially all of the affected reinsurance companies. As a result Protective increased premiums and policy fees by $18.4 million and amortization of deferred policy acquisition costs by $6.1 million, resulting in an increase in the Life Marketing segment’s pretax operating income of $12.3 million. The remaining increase is attributable to growth of business-in-force due to strong sales in 2002 and 2003 and favorable expense variances as compared to pricing allowances.
In 2002, the segment’s pretax operating income was $96.4 million, $27.2 million above 2001. The Conseco and Standard coinsurance transactions and the acquisition of Inter-State and First Variable resulted in a $24.7 million increase in earnings in 2002. Earnings on older acquired blocks of policies increased $2.4 million. In 2003, the segment’s pretax operating income was $96.7 million, $0.3 million above 2002. The Conseco transaction contributed a $9.1 million increase in earnings over 2002, and earnings from older acquired blocks of business decreased by $8.8 million.
Protective offers a guaranteed minimum death benefit feature (GMDB) on its variable annuity products. Protective’s accounting policy has been to calculate its total exposure to GMDB, and then apply a mortality factor to determine the amount of claims that could be expected to occur in the coming twelve months. Protective then accrues to that amount over four quarters. At December 31, 2003, the total GMDB reserve was $5.1 million. The total guaranteed amount payable under the GMDB feature based on variable annuity account balances at December 31, 2003, was $287.0 million, a decrease of $252.0 million from December 31, 2002, caused by an improvement in the equity markets.
Although positive performance in the equity markets in 2003 allowed Protective to decrease its GMDB related policy liabilities, the Annuities segment’s future results may be negatively affected by a slow economy. Volatile equity markets could negatively affect sales of variable annuities and the fees the segment assesses on variable annuity contracts. Lower interest rates have negatively affected sales of fixed annuities. In this segment, equity market volatility may create uncertainty regarding the level of future profitability in the variable annuity business and the related rate of amortization of deferred policy acquisition costs.
Protective has registered a program with the Securities and Exchange Commission in which up to $3 billion of secured medium-term notes may be issued to the institutional market and InterNotes® may be issued to the retail market on a delayed (or shelf) basis. Each series of notes will be issued by a separate trust and will be secured by one or more funding agreements issued by Protective. Notes issued under the program will be accounted for in a manner consistent with Protective’s other stable value products (i.e., included in “stable value product account balances” in Protective’s balance sheet). Protective issued $450 million of notes under this program in the fourth quarter of 2003 to institutional investors.
The Asset Protection segment’s core lines of business are vehicle and marine service contracts and credit insurance. The results of the Asset Protection segment have been significantly affected by general economic conditions and trends in used vehicle prices. The segment’s claims and corresponding loss ratios have increased in the current economic environment. In addition, the segment has been exiting certain ancillary lines of business, which are not core to either the service contract or credit insurance businesses.
In 2002, as a result of the negative trends the Asset Protection segment was experiencing, Protective performed claims experience studies and other analyses and determined that it should increase its estimates of policy liabilities and accruals and write off certain deferred policy acquisition costs and receivables which resulted in a pretax charge of $30.9 million. Examples of the negative trends affecting the segment are lower used vehicle prices resulting from new vehicle sales incentives and an increase in residual value claims on automobiles. Claims experience studies are necessarily complex and involve analyzing and interpreting large quantities of data to deduce whether the trends appear to be temporary and likely to reverse, or not. Any adverse development in the trends of used vehicle prices or in service contract claims could have a material adverse effect on Protective.
The Asset Protection segment had a pretax operating loss of $15.2 million in 2002, $50.9 million lower than the pretax operating income of $35.7 in 2001. The decrease included the $30.9 million charge discussed above. The segment also experienced lower service contract administration fees of $2.8 million and lower earned credit premiums that reduced income $5.8 million. Higher loss ratios in the vehicle service contract line lowered earnings $2.8 million. Also, higher loss ratios in the segment’s ancillary lines led to higher losses of $6.1 million in 2002. Included in the segment’s pretax loss for 2002 was $2.7 million of income related to the sale of the inactive charter of a small subsidiary compared to $2.0 million for a charter sale in 2001. In addition, 2001 operating income included a change in estimate of $6.7 million related to reserves in certain credit lines. All other items increased 2002 operating income by $3.5 million.
On January 1, 2001, Protective adopted Statement of Financial Accounting Standards (SFAS) No. 133, “Accounting for Derivative Instruments and Hedging Activities.” The adoption of SFAS No. 133 resulted in a cumulative $8.3 million charge to net income, net of $4.0 million income tax.
The operating results of companies in the insurance industry have historically been subject to significant fluctuations. The factors which could affect Protective’s future results include, but are not limited to, general economic conditions and the known trends and uncertainties which are discussed more fully below.
While Protective has obtained insurance, implemented risk management and contingency plans, and taken preventive measures and other precautions, no predictions of specific scenarios can be made nor can assurance be given that there are not scenarios that could have an adverse effect on Protective. A natural disaster or an outbreak of an easily communicable disease could adversely affect the mortality or morbidity experience of Protective or its reinsurers.
Rating organizations periodically review the financial performance and condition of insurers, including Protective’s subsidiaries. In recent years, downgrades of insurance companies have occurred with increasing frequency. A downgrade in the rating of Protective’s subsidiaries could adversely affect Protective’s ability to sell its products, retain existing business, and compete for attractive acquisition opportunities. Specifically, a ratings downgrade would materially harm Protective’s ability to sell certain products, including guaranteed investment products and funding agreements.
Protective’s results may be negatively affected should actual experience differ from management’s assumptions and estimates.
In the conduct of business, Protective makes certain assumptions regarding the mortality, persistency, expenses and interest rates, or other factors appropriate to the type of business it expects to experience in future periods. These assumptions are also used to estimate the amounts of deferred policy acquisition costs, policy liabilities and accruals, future earnings, and various components of Protective’s balance sheet. Protective’s actual experience, as well as changes in estimates, are used to prepare Protective’s statements of income.
The calculations Protective uses to estimate various components of its balance sheet and statements of income are necessarily complex and involve analyzing and interpreting large quantities of data. Protective currently employs various techniques for such calculations and it from time to time will develop and implement more sophisticated administrative systems and procedures capable of facilitating the calculation of more precise estimates.
Assumptions and estimates involve judgment, and by their nature are imprecise and subject to changes and revision over time. Accordingly, Protective’s results may be affected, positively or negatively, from time to time, by actual results differing from assumptions, by changes in estimates, and by changes resulting from implementing more sophisticated administrative systems and procedures that facilitate the calculation of more precise estimates.
The use of reinsurance introduces variability in Protective’s statements of income.
Protective could be forced to sell investments at a loss to cover policyholder withdrawals.
Many of the products offered by Protective and its insurance subsidiaries allow policyholders and contract holders to withdraw their funds under defined circumstances. Protective and its insurance subsidiaries manage their liabilities and configure their investment portfolios so as to provide and maintain sufficient liquidity to support anticipated withdrawal demands and contract benefits and maturities. While Protective and its life insurance subsidiaries own a significant amount of liquid assets, a certain portion of their assets are relatively illiquid. If Protective or its subsidiaries experience unanticipated withdrawal or surrender activity, Protective or its subsidiaries could exhaust their liquid assets and be forced to liquidate other assets, perhaps on unfavorable terms. If Protective or its subsidiaries are forced to dispose of assets on unfavorable terms, it could have an adverse effect on Protective’s financial condition.
Changes in interest rates may also impact its business in other ways. Lower interest rates may result in lower sales of certain of Protective’s insurance and investment products. In addition, certain of Protective’s insurance and investment products guarantee a minimum credited interest rate, and Protective could become unable to earn its spread income should interest rates decrease significantly.
The business of insurance necessarily involves the collection and dissemination of large amounts of data using systems operated by Protective. Examples of data collected and analyzed include policy information, policy rates, expenses, mortality and morbidity experience. To the extent that data input errors, systems errors, or systems failures are not identified and corrected by Protective’s internal controls, the information generated by the systems and used by Protective and/or supplied to business partners, policyholders, and others may be incorrect and may result in an overpayment or underpayment of amounts owed to or by Protective and/or Protective using incorrect assumptions in its business decisions or financial reporting.
Protective and its subsidiaries are subject to government regulation in each of the states in which they conduct business. Such regulation is vested in state agencies having broad administrative power dealing with many aspects of Protective’s business, which may include premium rates, marketing practices, advertising, privacy, policy forms, and capital adequacy, and is concerned primarily with the protection of policyholders and other customers rather than share owners. At any given time, a number of financial and/or market conduct examinations of Protective’s subsidiaries is ongoing. Protective is required to obtain state regulatory approval for rate increases for certain health insurance products, and Protective’s profits may be adversely affected if the requested rate increases are not approved in full by regulators in a timely fashion. From time to time, regulators raise issues during examinations or audits of Protective’s subsidiaries that could, if determined adversely, have a material impact on Protective. Protective cannot predict whether or when regulatory actions may be taken that could adversely affect Protective or its operations. In addition, the interpretations of regulations by regulators may change and statutes may be enacted with retroactive impact, particularly in areas such as health insurance.
Certain policies, contracts, and annuities offered by Protective and its subsidiaries are subject to regulation under the federal securities laws administered by the Securities and Exchange Commission. The federal securities laws contain regulatory restrictions and criminal, administrative, and private remedial provisions.
Group health coverage issued through associations has received some negative coverage in the media as well as increased regulatory consideration and review. Protective has a small closed block of group health insurance coverage that was issued to members of an association; a lawsuit is currently pending against Protective in connection with this business.
Protective’s ability to maintain low unit costs is dependent upon the level of new sales and persistency of existing business.
Protective’s invested assets and derivative financial instruments are subject to customary risks of credit defaults and changes in market values. The value of Protective’s commercial mortgage loan portfolio depends in part on the financial condition of the tenants occupying the properties which Protective has financed. Factors that may affect the overall default rate on, and market value of, Protective’s invested assets, derivative financial instruments, and mortgage loans include interest rate levels, financial market performance, and general economic conditions as well as particular circumstances affecting the businesses of individual borrowers and tenants.
Protective’s acquisitions have increased its earnings in part by allowing Protective to enter new markets and to position itself to realize certain operating efficiencies. There can be no assurance, however, that suitable acquisitions, presenting opportunities for continued growth and operating efficiencies, or capital to fund acquisitions will continue to be available to Protective, or that Protective will realize the anticipated financial results from its acquisitions.
Additionally, in connection with its acquisitions, Protective assumes or otherwise becomes responsible for the obligations of policies and other liabilities of other insurers. Any regulatory, legal, financial, or other adverse development affecting the other insurer could also have an adverse effect on Protective.
Certain of these other parties may act on behalf of Protective or represent Protective in various capacities. Consequently, Protective may be held responsible for obligations that arise from the acts or omissions of these other parties.
Protective and its insurance subsidiaries cede material amounts of insurance and transfer related assets to other insurance companies through reinsurance. Protective may enter into third-party reinsurance arrangements under which Protective will rely on the third party to collect premiums, pay claims, and/or perform customer service functions. However, notwithstanding the transfer of related assets or other issues, Protective remains liable with respect to ceded insurance should any reinsurer fail to meet the obligations assumed by it.
A computer virus could affect the data processing systems of Protective or its business partners, destroying valuable data or making it difficult to conduct business. In addition, despite our implementation of network security measures, our servers could be subject to physical and electronic break-ins, and similar disruptions from unauthorized tampering with our computer systems.
Protective’s ability to grow depends in large part upon the continued availability of capital.
Protective has recently deployed significant amounts of capital to support its sales and acquisitions efforts. Capital has also been consumed as Protective increased its reserves on the residual value product. Although positive performance in the equity markets has recently allowed Protective to decrease its GMDB related policy liabilities and accruals, deterioration in these markets could lead to further capital consumption. Although Protective believes it has sufficient capital to fund its immediate growth and capital needs, the amount of capital available can vary significantly from period to period due to a variety of circumstances, some of which are neither predictable nor foreseeable, nor within Protective’s control. A lack of sufficient capital could impair Protective’s ability to grow.
New accounting rules or changes to existing accounting rules could negatively impact Protective’s reported financial results.
In July 2003, the American Institute of Certified Public Accountants issued Statement of Position (SOP) 03-1, “Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts.” SOP 03-1 is effective for fiscal years beginning after December 15, 2003. SOP 03-1 provides guidance related to the reporting and disclosure of certain insurance contracts and separate accounts, including the calculation of guaranteed minimum death benefits (GMDB). SOP 03-1 also addresses the capitalization and amortization of sales inducements to contract holders. Had the provision been effective at December 31, 2003, Protective would have reported a GMDB accrual $0.3 million higher than currently reported. Although the original intent of SOP 03-1 was to address the accounting for contract provisions not addressed by SFAS No. 97, such as guaranteed minimum death benefits within a variable annuity contract, it appears that SOP 03-1 contains language that may impact the accounting for universal life products in a material way. The life insurance industry and some insurance companies have filed letters with the American Institute of Certified Public Accountants seeking clarification, guidance, delay and/or revision to more appropriately reflect the underlying economic issues of universal life insurance products. Protective is currently evaluating the impact of SOP 03-1 on the accounting for its universal life products.
Protective’s operations usually produce a positive cash flow. This cash flow is used to fund an investment portfolio to finance future benefit payments. Since future benefit payments largely represent medium- and long-term obligations reserved using certain assumed interest rates, Protective’s investments are predominantly in medium- and long-term, fixed-rate investments such as bonds and mortgage loans.
At December 31, 2002, Protective’s fixed maturity investments had a market value of $11.7 billion, which was 3.9% above amortized cost of $11.2 billion. Protective estimated the market value of its mortgage loans to be $2.8 billion at December 31, 2002, which was 12.2% above amortized cost of $2.5 billion.
Estimated market values were derived from the durations of Protective’s fixed maturities and mortgage loans. Duration measures the relationship between changes in market value to changes in interest rates. While these estimated market values generally provide an indication of how sensitive the market values of Protective’s fixed maturities and mortgage loans are to changes in interest rates, they do not represent management’s view of future market changes, and actual market results may differ from these estimates.
Limiting bond exposure to any creditor group is another way Protective manages credit risk. The following table summarizes Protective’s ten largest fixed maturity exposures to an individual creditor group as of December 31, 2003.
Once management has determined that a particular investment has suffered an other-than-temporary impairment, the asset is written down to its estimated fair value. Protective generally considers a number of factors in determining whether the impairment is other-than-temporary. These include, but are not limited to: 1) actions taken by rating agencies, 2) default by the issuer, 3) the significance of the decline, 4) the intent and ability of Protective to hold the investment until recovery, 5) the time period during which the decline has occurred, 6) an economic analysis of the issuer’s industry, and 7) the financial strength, liquidity, and recoverability of the issuer. Management performs a security by security review each quarter in evaluating the need for any other-than-temporary impairments. Although no set formula is used in this process, the investment performance and continued viability of the issuer are significant measures.
Market values for private, non-traded securities are determined as follows: 1) Protective obtains estimates from independent pricing services or 2) Protective estimates market value based upon a comparison to quoted issues of the same issuer or issues of other issuers with similar terms and risk characteristics. The market value of private, non-traded securities was $1,956.7 million at December 31, 2003, representing 11.5% of Protective’s total invested assets.
The majority of unrealized losses in Protective’s investment portfolio can be attributed to interest rate fluctuations and have been deemed temporary. As indicated above, when Protective’s investment management deems an investment’s market value decline as other than temporary, it is written down to estimated market value. In all cases, management will continue to carefully review and monitor each security.
Estimated % Market Amortized % Amortized Unrealized % Unrealized Market Value Value Cost Cost Loss Loss ------------------------------------------------------------------------------------------------------------------------ (in thousands) = 90 days $953,867 44.9% $964,963 43.6% $(11,096) 13.4% 90 days but = 180 days 721,961 34.0 744,905 33.8 (22,944) 27.9 180 days but = 270 days 219,312 10.3 231,500 10.5 (12,188) 14.8 270 days but = 1 year 23,483 1.1 25,410 1.2 (1,927) 2.3 1 year but = 2 years 92,724 4.4 97,917 4.4 (5,193) 6.3 2 years but = 3 years 37,099 1.7 41,176 1.9 (4,077) 5.0 3 years but = 4 years 2,560 0.1 2,857 0.1 (297) 0.4 4 years but = 5 years 31,559 1.5 36,814 1.7 (5,255) 6.4 5 years 41,476 2.0 60,789 2.8 (19,313) 23.5 ------------------------------------------------------------------------------------------------------------------------ Total $2,124,041 100.0% $2,206,331 100.0% $(82,290) 100.0% ------------------------------------------------------------------------------------------------------------------------
Protective has no material concentrations of issuers or guarantors of fixed maturity securities. The industry segment composition of all securities in an unrealized loss position held by Protective at December 31, 2003, is presented in the following table.
The range of maturity dates for securities in an unrealized loss position at December 31, 2003 varies, with 11.5% maturing in less than 5 years, 23.2% maturing between 5 and 10 years, and 65.3% maturing after 10 years. The following table shows the credit rating of securities in an unrealized loss position at December 31, 2003.
S&P or Equivalent Estimated % Market Amortized % Amortized Unrealized % Unrealized Designation Market Value Value Cost Cost Loss Loss ------------------------------------------------------------------------------------------------------------------------- (in thousands) AAA/AA/A $1,417,473 66.7% $1,449,428 65.7% $(31,955) 38.9% BBB 458,807 21.6 476,849 21.6 (18,042) 21.9 ------------------------------------------------------------------------------------------------------------------------- Investment grade 1,876,280 88.3 1,926,277 87.3 (49,997) 60.8 ------------------------------------------------------------------------------------------------------------------------- BB 131,833 6.2 142,421 6.5 (10,588) 12.9 B 101,665 4.8 108,791 4.9 (7,126) 8.6 CCC or lower 13,143 0.6 27,491 1.2 (14,348) 17.4 In or near default 1,120 0.1 1,351 0.1 (231) 0.3 ------------------------------------------------------------------------------------------------------------------------- Below investment grade 247,761 11.7 280,054 12.7 (32,293) 39.2 ------------------------------------------------------------------------------------------------------------------------- Total 2,124,041 100.0% $2,206,331 100.0% $(82,290) 100.0% -------------------------------------------------------------------------------------------------------------------------
At December 31, 2003, securities in an unrealized loss position that were rated as below investment grade represented 11.7% of the total market value and 39.2% of the total unrealized loss. Unrealized losses related to below investment grade securities that had been in an unrealized loss position for more than twelve months were $28.9 million. Bonds in an unrealized loss position rated less than investment grade were 1.5% of invested assets. Protective does not expect these investments to adversely affect its liquidity or ability to maintain proper matching of assets and liabilities.
At December 31, 2003, $21.1 million of below investment grade securities in an unrealized loss position were securities issued in Protective-sponsored commercial mortgage loan securitizations, including $18.1 million in an unrealized loss position greater than five years. Protective does not consider these unrealized positions to be other-than-temporary, because the underlying mortgage loans continue to perform consistently with Protective’s original expectations.
At December 31, 2003, Protective had outstanding mortgage loan commitments of $578.5 million with an estimated fair value of $595.7 million (using discounted cash flows from the first call date). At December 31, 2002, Protective had outstanding commitments of $455.7 million with an estimated fair value of $494.1 million. The following table sets forth the estimated fair value of Protective’s mortgage loan commitments resulting from a hypothetical immediate 1 percentage point increase in interest rate levels prevailing at December 31, and the percent change in fair value the following estimated fair values would represent.
At December 31 Amount Percent Change ------------------------------------------------------------- (in millions) 2002 $468.4 (5.2)% 2003 566.1 (5.0) -------------------------------------------------------------
The estimated fair values were derived from the durations of Protective’s outstanding mortgage loan commitments. While these estimated fair values generally provide an indication of how sensitive the fair value of Protective’s outstanding commitments are to changes in interest rates, they do not represent management’s view of future market changes, and actual market results may differ from these estimates.
At December 31, 2003, Protective had policy liabilities and accruals of $9.7 billion. Protective’s life insurance products have a weighted average minimum credited interest rate of approximately 4.6%.
At December 31, 2003, Protective had $4.7 billion of stable value product account balances with an estimated fair value of $4.7 billion (using discounted cash flows), and $3.5 billion of annuity account balances with an estimated fair value of $3.5 billion (using surrender values).
The following table sets forth the estimated fair values of Protective’s stable value product and annuity account balances resulting from a hypothetical immediate 1 percentage point decrease in interest rates from levels prevailing at December 31, and the percent change in fair value the following estimated fair values would represent.
Estimated fair values were derived from the durations of Protective’s stable value product and annuity account balances. While these estimated fair values generally provide an indication of how sensitive the fair values of Protective’s stable value and annuity account balances are to changes in interest rates, they do not represent management’s view of future market changes, and actual market results may differ from these estimates.
Protective monitors its use of derivatives in connection with its overall asset/liability management programs and procedures. Protective’s asset/liability committee is responsible for implementing various strategies to mitigate or eliminate certain financial and market risks. These strategies are developed through the committee’s analysis of data from financial simulation models and other internal and industry sources and are then incorporated into Protective’s overall interest rate and currency exchange risk management strategies.
Estimated gains and losses were derived using pricing models specific to derivative financial instruments. While these estimated gains and losses generally provide an indication of how sensitive Protective’s derivative financial instruments are to changes in interest rates and foreign currency exchange rates, they do not represent management’s view of future market changes, and actual market results may differ from these estimates.
Protective believes its asset/liability management programs and procedures and certain product features provide protection for Protective against the effects of changes in interest rates under various scenarios. Additionally, Protective believes its asset/liability management programs and procedures provide sufficient liquidity to enable it to fulfill its obligation to pay benefits under its various insurance and deposit contracts. However, Protective’s asset/liability management programs and procedures incorporate assumptions about the relationship between short-term and long-term interest rates (i.e., the slope of the yield curve), relationships between risk-adjusted and risk-free interest rates, market liquidity and other factors, and the effectiveness of Protective’s asset/liability management programs and procedures may be negatively affected whenever actual results differ from those assumptions.
At December 31, 2003, Protective Life Corporation had $25.0 million outstanding under its $200 million revolving lines of credit due October 1, 2005, at an interest rate of 1.64%.
As disclosed in the Notes to the Consolidated Financial Statements, at December 31, 2003, approximately $1,386.9 million of consolidated share-owner’s equity, excluding net unrealized investment gains and losses, represented net assets of Protective that cannot be transferred to PLC. In addition, the states in which Protective and its insurance subsidiaries are domiciled impose certain restrictions on their ability to pay dividends to PLC. In general, dividends up to specified levels are considered ordinary and may be paid thirty days after written notice to the insurance commissioner of the state of domicile unless such commissioner objects to the dividend prior to the expiration of such period. Dividends in larger amounts are considered extraordinary and are subject to affirmative prior approval by such commissioner. The maximum amount that would qualify as ordinary dividends to PLC by Protective in 2004 is estimated to be $293.8 million.
Inflation increases the need for life insurance. Many policyholders who once had adequate insurance programs may increase their life insurance coverage to provide the same relative financial benefit and protection. Higher interest rates may result in higher sales of certain of Protective’s investment products.
In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Protective Life Insurance Company and its subsidiaries at December 31, 2003 and 2002, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2003 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedules listed in the accompanying index present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedules are the responsibility of the Company’s management; our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States of America, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
December 31 ------------------------------------ 2003 2002 ---------------------------------------------------------------------------------------------------------------------- (dollars in thousands) Assets Investments: Fixed maturities, at market (amortized cost: 2003 - $12,314,822; 2002 - $11,212,765) $12,927,520 $11,655,465 Equity securities, at market (cost: 2003 - $29,169; 2002 - $51,095) 30,521 48,799 Mortgage loans 2,733,722 2,518,151 Investment real estate, net of accumulated depreciation (2003 - $1,314; 2002 - $1,099) 13,152 15,499 Policy loans 502,748 543,161 Other long-term investments 244,913 210,381 Short-term investments 510,635 447,155 ---------------------------------------------------------------------------------------------------------------------- Total investments 16,963,211 15,438,611 Cash 111,059 85,850 Accrued investment income 184,439 180,950 Accounts and premiums receivable, net of allowance for uncollectible amounts (2003 - $2,617; 2002 - $2,825) 43,095 50,544 Reinsurance receivables 2,308,153 2,333,800 Deferred policy acquisition costs 1,863,568 1,709,254 Goodwill 35,143 35,143 Property and equipment 43,156 38,878 Other assets 198,581 262,127 Assets related to separate accounts Variable annuity 2,045,038 1,513,824 Variable universal life 171,408 114,364 Other 4,361 4,330 ---------------------------------------------------------------------------------------------------------------------- $23,971,212 $21,767,675 ======================================================================================================================
On May 1, 2001, PLC transferred its ownership of five companies (that marketed prepaid dental products) to Protective. Protective has recorded these transactions on a pooling of interests basis whereby Protective’s financial statements reflect the consolidation of the contributed entities as if they had been wholly owned by Protective for all periods in which common control existed.
Protective provides financial services through the production, distribution, and administration of insurance and investment products. Protective markets individual life insurance, credit life and disability insurance, guaranteed investment contracts, guaranteed funding agreements, fixed and variable annuities, and extended service contracts throughout the United States. Protective also maintains a separate division devoted to the acquisition of insurance policies from other companies.
On October 1, 2003, Protective adopted Derivatives Implementation Group Issue No. B36, “Embedded Derivatives: Modified Coinsurance Arrangements and Debt Instruments That Incorporate Credit Risk Exposures That Are Unrelated or Only Partially Related to the Creditworthiness of the Obligor under Those Instruments” (DIG B36). DIG B36 requires the bifurcation of embedded derivatives within certain modified coinsurance and funds withheld coinsurance arrangements that expose the creditor to credit risk of a company other than the debtor, even if the debtor owns as investment assets the third-party securities to which the creditor is exposed. The adoption did not have a material impact on its financial condition or results of operations.
On December 31, 2003, Protective adopted SFAS No. 132, “Employers’ Disclosures about Pensions and Other Postretirement Benefits,” as revised by the FASB in December 2003. The FASB revised disclosure requirements for pension plans and other postretirement benefit plans to require more information. The revision of SFAS No. 132 did not have a material effect on Protective’s financial position or results of operations.
Fixed maturities (bonds and redeemable preferred stocks) - at current market value. Where market values are unavailable, Protective obtains estimates from independent pricing services or estimates market value based upon a comparison to quoted issues of the same issuer or issues of other issuers with similar terms and risk characteristics.
Mortgage loans - at unpaid balances, adjusted for loan origination costs, net of fees, and amortization of premium or discount.
The market values of fixed maturities increase or decrease as interest rates fall or rise. As prescribed by generally accepted accounting principles, investments deemed as “available for sale” are recorded at their market values with the resulting unrealized gains and losses reduced by a related adjustment to deferred policy acquisition costs, net of income tax, reported as a component of share-owner’s equity.
Combinations of interest rate swap contracts, futures contracts, and option contracts are sometimes used to mitigate or eliminate certain financial and market risks, including those related to changes in interest rates for certain investments, primarily outstanding mortgage loan commitments and mortgage-backed securities. Interest rate swap contracts generally involve the exchange of fixed and variable rate interest payments between two parties, based on a common notional principal amount and maturity date. Interest rate futures generally involve exchange traded contracts to buy or sell treasury bonds and notes in the future at specified prices. Interest rate options allow the holder of the option to receive cash or purchase, sell or enter into a financial instrument at a specified price within a specified period of time. Protective uses interest rate swap contracts, swaptions (options to enter into interest rate swap contracts), caps, and floors to modify the interest characteristics of certain investments and liabilities. Swap contracts are also used to alter the effective durations of assets and liabilities. Protective uses foreign currency swaps to reduce its exposure to currency exchange risk on certain stable value contracts denominated in foreign currencies, primarily the European euro and the British pound.
Cash-Flow Hedges. Protective has entered into a foreign currency swap to hedge the risk of changes in the value of interest and principal payments to be made on certain of its foreign-currency-based stable value contracts. Under the terms of the swap, Protective pays a fixed U.S.-dollar-denominated rate and receives a fixed foreign-currency-denominated rate. Effective July 1, 2002, Protective designated this swap as a cash flow hedge and therefore recorded the change in the fair value of the swap during the period in accumulated other comprehensive income. In 2003 and 2002, a pretax loss of $66.0 million and $19.8 million, respectively, representing the change in fair value of the hedged contracts, and a gain of like amount representing the application of hedge accounting to this transaction, were recorded in “Realized Investment Gains (Losses) - Derivative Financial Instruments” in Protective’s consolidated condensed statements of income. For the years ended December 31, 2003 and 2002, the amount of the hedge’s ineffectiveness reported in income was a $0.3 million gain and an immaterial loss, respectively. Additionally, as of December 31, 2003 and 2002, Protective reported an increase to accumulated other comprehensive income of $2.7 million (net of income tax of $1.4 million) and a reduction to accumulated other comprehensive income of $2.1 million (net of income tax of $1.1 million), respectively, related to its derivative designated as a cash flow hedge. During 2004, Protective expects to reclassify out of accumulated other comprehensive income and into earnings, as a reduction of interest expense, approximately $3.4 million.
Other Derivatives. Protective uses certain interest rate swaps, caps, floors, swaptions, options and futures contracts to mitigate or eliminate exposure to changes in value or cash flows of outstanding mortgage loan commitments and certain owned investments. In 2003, 2002, and 2001, Protective recognized net pre-tax gains of $4.2 million, $5.3 million, and $2.7 million, respectively, representing the change in fair value of these derivative instruments as well as a realized gain or loss on contracts closed during the period.
On its foreign currency swaps, Protective recognized a $2.6 million pre-tax gain in 2003 while recognizing a $1.9 million foreign exchange pre-tax loss on the related foreign-currency-denominated stable value contracts. In 2002, Protective recognized a $70.8 million pre-tax gain on its foreign currency swaps; while recognizing a $74.9 million foreign exchange pre-tax loss on the related foreign-currency-denominated stable value contracts. In 2001, Protective recognized an $8.2 million pre-tax loss on its foreign currency swaps while recognizing an $11.2 million foreign exchange pre-tax gain on the related foreign-currency-denominated stable value contracts. The net gain, net loss and net gain in 2003, 2002 and 2001, respectively, primarily results from the difference in the forward and spot exchange rates used to revalue the currency swaps and the stable value contracts, respectively. The net gains and losses are reflected in “Realized Investment Gains (Losses) - Derivative Financial Instruments” in Protective’s consolidated statements of income.
At December 31, 2003, contracts with a notional amount of $2.2 billion were in a $169.0 million net gain position. At December 31, 2002, contracts with a notional amount of $6.0 billion were in an $83.9 million net gain position.
Commissions and other costs of acquiring traditional life and health insurance, credit insurance, universal life insurance, and investment products that vary with and are primarily related to the production of new business, have been deferred. Traditional life and health insurance acquisition costs are amortized over the premium-payment period of the related policies in proportion to the ratio of annual premium income to the present value of the total anticipated premium income. Credit insurance acquisition costs are being amortized in proportion to earned premium. Acquisition costs for universal life and investment products are amortized over the lives of the policies in relation to the present value of estimated gross profits before amortization. Under SFAS No. 97, “Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments,” Protective makes certain assumptions regarding the mortality, persistency, expenses, and interest rates (equal to the rate used to compute liabilities for future policy benefits; currently 2.6% to 9.4%) it expects to experience in future periods. These assumptions are to be best estimates and are to be periodically updated whenever actual experience and/or expectations for the future change from that assumed. Additionally, relating to SFAS No. 115, these costs have been adjusted by an amount equal to the amortization that would have been recorded if unrealized gains or losses on investments associated with Protective’s universal life and investment products had been realized.
Property and equipment are reported at cost less accumulated depreciation. Protective primarily uses the straight-line method of depreciation based upon the estimated useful lives of the assets. Protective’s Home Office building is depreciated over a thirty-nine year useful life, furniture is depreciated over a ten year useful life, office equipment and machines are depreciated over a five year useful life, and software and computers are depreciated over a three year useful life. Major repairs or improvements are capitalized and depreciated over the estimated useful lives of the assets. Other repairs are expensed as incurred. The cost and related accumulated depreciation of property and equipment sold or retired are removed from the accounts, and resulting gains or losses are included in income.
Traditional life insurance products consist principally of those products with fixed and guaranteed premiums and benefits, and they include whole life insurance policies, term and term-like life insurance policies, limited-payment life insurance policies, and certain annuities with life contingencies. Life insurance and immediate annuity premiums are recognized as revenue when due. Health and credit insurance premiums are recognized as revenue over the terms of the policies. Benefits and expenses are associated with earned premiums so that profits are recognized over the life of the contracts. This is accomplished by means of the provision for liabilities for future policy benefits and the amortization of deferred policy acquisition costs. Gross premiums in excess of net premiums related to immediate annuities are deferred and recognized over the life of the policy.
Protective uses the asset and liability method of accounting for income taxes. Income tax provisions are generally based on income reported for financial statement purposes. Deferred federal income taxes arise from the recognition of temporary differences between the basis of assets and liabilities determined for financial reporting purposes and the basis of assets and liabilities determined for financial reporting purposes and the basis for income tax purposes. Such temporary differences are principally related to the deferral of policy acquisition costs and the provision for future policy benefits and expenses.
On December 31, 2001, Protective completed the sale to Fortis, Inc. of substantially all of its Dental Benefits Division (Dental Division) and discontinued other remaining Dental Division related operations, primarily other health insurance lines.
2003 2002 2001 -------------------------------------------------------------------------------------------------------------------------- Cash paid during the year: Interest on debt $ 1,582 $ 987 $ 1,390 Income taxes 66,082 125,039 27,395 -------------------------------------------------------------------------------------------------------------------------- Noncash investing and financing activities: Reduction of principal on note from ESOP $ 412 $ 661 $ 342 Common dividend $(1,809) $ 0 $ 0 -------------------------------------------------------------------------------------------------------------------------- Acquisitions, related reinsurance transactions and subsidiary transfer: Assets acquired $ 0 $ 358,897 $ 2,549,484 Liabilities assumed 0 (489,412) (2,430,927) -------------------------------------------------------------------------------------------------------------------------- Net $ 0 $ (130,515) $ 118,557 --------------------------------------------------------------------------------------------------------------------------
Financial statements prepared in conformity with accounting principles generally accepted in the United States of America differ in some respects from the statutory accounting practices prescribed or permitted by insurance regulatory authorities. The most significant differences are as follows: (a) acquisition costs of obtaining new business are deferred and amortized over the approximate life of the policies rather than charged to operations as incurred; (b) benefit liabilities are computed using a net level method and are based on realistic estimates of expected mortality, interest, and withdrawals as adjusted to provide for possible unfavorable deviation from such assumptions; (c) deferred income taxes are not subject to statutory limitations as to amounts recognized and are recognized through earnings as opposed to being charged to share-owners’ equity; (d) the Asset Valuation Reserve and Interest Maintenance Reserve are restored to share-owners’ equity; (e) furniture and equipment, agents’ debit balances, and prepaid expenses are reported as assets rather than being charged directly to surplus (referred to as nonadmitted assets); (f) certain items of interest income, such as mortgage and bond discounts, are amortized differently; and (g) bonds are recorded at their market values instead of amortized cost. The National Association of Insurance Commissioners (NAIC) has adopted the Codification of Statutory Accounting Principles (Codification). Codification changed statutory accounting rules in several areas and was effective January 1, 2001. The adoption of Codification did not have a material effect on Protective’s statutory capital.
Net income and share-owner’s equity prepared in conformity with statutory reporting practices to that reported in the accompanying consolidated financial statements are as follows:
As of December 31, 2003, Protective had on deposit with regulatory authorities, fixed maturity and short-term investments with a market value of approximately $74.8 million.
Fixed maturities $ 738,503 $ 673,393 $ 609,578 Equity securities 2,321 3,500 2,247 Mortgage loans 208,983 218,165 208,830 Investment real estate 2,854 881 2,094 Policy loans 42,092 37,463 31,763 Other. 46,561 95,575 32,795 ----------------------------------------------------------------------------- 1,041,314 1,028,977 887,307 Investment expenses 60,571 57,169 52,104 ----------------------------------------------------------------------------- $ 980,743 $ 971,808 $ 835,203 -----------------------------------------------------------------------------
Fixed maturities $66,101 $ 12,606 $ (4,693) Equity securities (1,372) 65 2,462 Mortgage loans and other investments 2,035 (357) (3,892) ------------------------------------------------------------------------------------------ $66,764 $ 12,314 $ (6,123) ------------------------------------------------------------------------------------------
In 2003, gross gains on the sale of investments available for sale (fixed maturities, equity securities, and short-term investments) were $90.3 million, and gross losses were $25.6 million. In 2002, gross gains were $73.0 million, and gross losses were $60.3 million. In 2001, gross gains were $27.5 million, and gross losses were $29.7 million.
Each quarter Protective reviews investments with material unrealized losses and tests for other-than-temporary impairments. Protective analyzes various factors to determine if any specific other-than-temporary asset impairments exist. Once a determination has been made that a specific other-than-temporary impairment exists, a realized loss is incurred and the cost basis of the impaired asset is adjusted to its fair value. During 2003, 2002 and 2001, respectively, Protective recorded other-than-temporary impairments in its investments of $13.6 million, $17.8 million and $12.6 million, respectively.
Gross Gross Estimated Amortized Unrealized Unrealized Market Cost Gains Losses Values ------------------------------------------------------------------------------------------------------------------- Fixed maturities: Bonds: Mortgage-backed securities $ 4,491,392 $132,984 $(36,112) $ 4,588,264 United States Government and authorities 83,834 6,538 (119) 90,253 States, municipalities, and political subdivision 25,349 1,738 (1) 27,086 Public utilities 1,389,389 96,926 (10,776) 1,475,539 Convertibles and bonds with warrants 43,384 743 (277) 43,850 All other corporate bonds 6,278,517 455,323 (34,476) 6,699,364 Redeemable preferred stocks 2,957 207 0 3,164 ------------------------------------------------------------------------------------------------------------------- 12,314,822 694,459 (81,761) 12,927,520 Equity securities 29,169 1,881 (529) 30,521 Short-term investments 510,635 0 0 510,635 ------------------------------------------------------------------------------------------------------------------- $12,854,626 $696,340 $(82,290) $13,468,676 ------------------------------------------------------------------------------------------------------------------- Fixed maturities: Bonds: Mortgage-backed securities $4,168,026 $199,316 $(28,311) $4,339,031 United States Government and authorities 90,647 5,752 0 96,399 States, municipalities, and political subdivisions 27,005 2,349 0 29,354 Public utilities 1,153,710 61,831 (42,139) 1,173,402 Convertibles and bonds with warrants 115,728 2,656 (5,872) 112,512 All other corporate bonds 5,655,949 348,809 (101,818) 5,902,940 Redeemable preferred stocks 1,700 127 0 1,827 ------------------------------------------------------------------------------------------------------------------- 11,212,765 620,840 (178,140) 11,655,465 Equity securities 51,095 2,409 (4,705) 48,799 Short-term investments 447,155 0 0 447,155 ------------------------------------------------------------------------------------------------------------------- $11,711,015 $623,249 $(182,845) $12,151,419 -------------------------------------------------------------------------------------------------------------------
Estimated Estimated Amortized Market Cost Values ------------------------------------------------------------------------------- Due in one year or less $ 543,623 $ 553,550 Due after one year through five years 2,540,318 2,632,788 Due after five years through ten years 3,566,765 3,771,510 Due after ten years 5,664,116 5,969,672 ------------------------------------------------------------------------------- $12,314,822 $12,927,520 -------------------------------------------------------------------------------
The following table shows our investments’ gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities have been in a continuous loss position at December 31, 2003.
Less Than 12 Months 12 Months or More Total -------------------------- ------------------------ ---------------------------- Market Unrealized Market Unrealized Market Unrealized Value Loss Value Loss Value Loss --------------------------------------------------------------------------------------------------------------------- Mortgage-backed securities $ 653,360 $(12,329) $100,397 $(23,784) $753,757 $(36,113) US Government 15,763 (119) 0 0 15,763 (119) State, municipalities, etc. 488 (1) 0 0 488 (1) Public utilities 286,552 (10,080) 18,165 (696) 304,717 (10,776) Convertible bonds 21,409 (167) 229 (111) 21,638 (278) Other corporate bonds 940,949 (25,414) 83,757 (9,077) 1,024,706 (34,491) Equities 102 (45) 2,870 (467) 2,972 (512) --------------------------------------------------------------------------------------------------------------------- $1,918,623 $(48,155) $205,418 $(34,135) $2,124,041 $(82,290) ---------------------------------------------------------------------------------------------------------------------
The corporate bonds category has gross unrealized losses of $9.1 million at December 31, 2003, composed of $2.8 million of electrical industry securities, $5.0 million of transportation industry securities, and $1.3 million of other industry securities. The aggregate decline in market value of these securities was deemed temporary due to positive factors supporting the recoverability of the respective investments. Positive factors considered included credit ratings, the financial health of the investee, the continued access of the investee to capital markets, and other pertinent information.
Protective participates in securities lending, primarily as an investment yield enhancement, whereby securities that are held as investments are loaned to third parties for short periods of time. Protective requires collateral of 102% of the market value of the loaned securities to be separately maintained. The loaned securities’ market value is monitored, on a daily basis, with additional collateral obtained as necessary. At December 31, 2003, securities with a market value of $324.5 million were loaned under these agreements. As collateral for the loaned securities, Protective receives short-term investments, which are recorded in “short-term investments” with a corresponding liability recorded in “other liabilities” to account for Protective’s obligation to return the collateral.
At December 31, 2003, all of Protective’s mortgage loans were commercial loans of which 75% were retail, 8% were apartments, 8% were office buildings, and 8% were warehouses, and 1% were other. Protective specializes in making mortgage loans on either credit-oriented or credit-anchored commercial properties, most of which are strip shopping centers in smaller towns and cities. No single tenant’s leased space represents more than 2.8% of mortgage loans. Approximately 74% of the mortgage loans are on properties located in the following states listed in decreasing order of significance: Texas, Tennessee, Georgia, North Carolina, South Carolina, Alabama, Florida, Pennsylvania, California, Ohio, Mississippi, and Indiana.
At December 31, 2003, the average mortgage loan was approximately $2.2 million, and the weighted average interest rate was 7.2%. The largest single mortgage loan was $19.6 million.
For several years Protective has offered a type of commercial mortgage loan under which Protective will permit a slightly higher loan-to-value ratio in exchange for a participating interest in the cash flows from the underlying real estate. As of December 31, 2003 and 2002, approximately $382.7 million and $475.5 million, respectively, of Protective’s mortgage loans have this participation feature.
At December 31, 2003 and 2002, Protective’s problem mortgage loans (over ninety days past due) and foreclosed properties totaled $11.8 million and $16.2 million, respectively. Since Protective’s mortgage loans are collateralized by real estate, any assessment of impairment is based upon the estimated fair value of the real estate. Based on Protective’s evaluation of its mortgage loan portfolio, Protective does not expect any material losses on its mortgage loans.
The components of Protective’s net deferred income tax liability as of December 31 were as follows:
2003 2002 -------------------------------------------------------------------------------------- Deferred income tax assets: Policy and policyholder liability reserves $279,016 $320,081 Other 4,292 3,001 -------------------------------------------------------------------------------------- 283,308 323,082 -------------------------------------------------------------------------------------- Deferred income tax liabilities: Deferred policy acquisition costs 485,816 431,069 Unrealized gains (losses) on investments 136,765 98,857 -------------------------------------------------------------------------------------- 622,581 529,926 -------------------------------------------------------------------------------------- Net deferred income tax liability $339,273 $206,844 --------------------------------------------------------------------------------------
Protective has a mortgage note on investment real estate amounting to approximately $2.2 million that matures in 2004.
Included in indebtedness to related parties at December 31, 2002,was a surplus debenture issued by Protective to PLC. The balance of the surplus debenture was $2 million. The surplus debenture was due and paid in 2003.
Protective leases administrative and marketing office space in approximately 24 cities including Birmingham, with most leases being for periods of three to ten years. The aggregate annualized rent is approximately $8.0 million.
In 2000, Protective entered into an arrangement with an unrelated party related to the construction of a building contiguous to its existing home office complex. The unrelated party owns the building and leases it to Protective. The lease is accounted for as an operating lease under SFAS No. 13 “Accounting For Leases”. Lease payments commenced upon completion, which occurred January 31, 2003, and is based on then current LIBOR interest rates and the cost of the building. At the end of the lease term, February 1, 2007, Protective may purchase the building for the original building cost of approximately $75 million. Based upon current interest rates, annual lease payments are estimated to be $1.5 million. Were Protective not to purchase the building, a payment of approximately $66 million would be due at the end of the lease term.
Under insurance guaranty fund laws, in most states insurance companies doing business therein can be assessed up to prescribed limits for policyholder losses incurred by insolvent companies. Protective does not believe such assessments will be materially different from amounts already provided for in the financial statements. Most of these laws do provide, however, that an assessment may be excused or deferred if it would threaten an insurer’s own financial strength.
At December 31, 2003, approximately $1,386.9 million of consolidated share-owner’s equity, excluding net unrealized gains on investments, represented net assets of Protective and its subsidiaries that cannot be transferred to PLC in the form of dividends, loans, or advances. In addition, Protective and its subsidiaries are subject to various state statutory and regulatory restrictions on their ability to pay dividends to PLC. In general, dividends up to specified levels are considered ordinary and may be paid thirty days after written notice to the insurance commissioner of the state of domicile unless such commissioner objects to the dividend prior to the expiration of such period. Dividends in larger amounts are considered extraordinary and are subject to affirmative prior approval by such commissioner. The maximum amount that would qualify as ordinary dividends to PLC by Protective in 2004 is estimated to be $293.8 million.
PLC owns all of the 2,000 shares of preferred stock issued by Protective’s subsidiary, Protective Life and Annuity Insurance Company (PL&A). The stock pays, when and if declared, noncumulative participating dividends to the extent PL&A’s statutory earnings for the immediately preceding fiscal year exceeded $1.0 million. In 2003, PL&A paid no dividend to PLC. In 2002, PL&A paid a $50.0 thousand preferred dividend to PLC, and PL&A paid a $1.0 million preferred dividend to PLC in 2001.
On August 6, 1990, PLC announced that its Board of Directors approved the formation of an Employee Stock Ownership Plan (ESOP). On December 1, 1990, Protective transferred to the ESOP 520,000 shares of PLC’s common stock held by it in exchange for a note. The outstanding balance of the note, $3.4 million at December 31, 2003, is accounted for as a reduction to share-owner’s equity. The stock will be used to match employee contributions to PLC’s existing 401(k) Plan. The ESOP shares are dividend paying. Dividends on the shares are used to pay the ESOP’s note to Protective.
Protective operates several business segments, each having a strategic focus. An operating segment is generally distinguished by products and/or channels of distribution. A brief description of each segment follows.
Protective has an additional segment herein referred to as Corporate and Other. The Corporate and Other segment primarily consists of net investment income and expenses not attributable to the segments above (including net investment income on unallocated capital and interest on substantially all debt). This segment also includes earning from several lines of business which Protective is not actively marketing (mostly cancer insurance and group annuities), and various investment-related transactions.
Operating Segment Income for the Year Ended December 31, 2001 ----------------------------------------------------------------------------------------------------------------------------------- Life Stable Value Marketing Acquisitions Annuities Products ----------------------------------------------------------------------------------------------------------------------------------- Premiums and policy fees $ 542,407 $243,914 $ 28,145 Reinsurance ceded (421,411) (61,482) ----------------------------------------------------------------------------------------------------------------------------------- Net of reinsurance ceded 120,996 182,432 28,145 Net investment income 178,866 187,535 167,809 $261,079 Realized investment gains (losses) 1,139 7,218 Other income 1,134 345 3,441 ----------------------------------------------------------------------------------------------------------------------------------- Total revenues 300,996 370,312 200,534 268,297 ----------------------------------------------------------------------------------------------------------------------------------- Benefits and settlement expenses 190,538 238,877 137,204 222,306 Amortization of deferred policy acquisition costs and goodwill 41,399 20,500 24,021 1,662 Other operating expenses (22,957) 41,684 24,073 3,961 ----------------------------------------------------------------------------------------------------------------------------------- Total benefits and expenses 208,980 301,061 185,298 227,929 ----------------------------------------------------------------------------------------------------------------------------------- Income from continuing operations before income tax 92,016 69,251 15,236 40,368 Less: realized investment gains (losses) 1,139 7,218 Add back: related amortization of deferred policy acquisition cost 996 ----------------------------------------------------------------------------------------------------------------------------------- Operating income 92,016 69,251 15,093 33,150
----------------------------------------------------------------------------------------------------------------------------------- Corporate Asset and Total Protection Other Adjustments Consolidated ----------------------------------------------------------------------------------------------------------------------------------- Premiums and policy fees $ 524,281 $ 51,072 $1,389,819 Reinsurance ceded (274,220) (14,038) (771,151) ----------------------------------------------------------------------------------------------------------------------------------- Net of reinsurance ceded 250,061 37,034 618,668 Net investment income 48,617 (8,703) 835,203 Realized investment gains (losses) (12,298) (3,941) Other income 31,907 1,751 38,578 ----------------------------------------------------------------------------------------------------------------------------------- Total revenues 330,585 17,784 1,488,508 ----------------------------------------------------------------------------------------------------------------------------------- Benefits and settlement expenses 154,893 28,806 972,624 Amortization of deferred policy acquisition costs and goodwill 60,508 1,795 149,885 Other operating expenses 79,453 25,827 152,041 ----------------------------------------------------------------------------------------------------------------------------------- Total benefits and expenses 294,854 56,428 1,274,550 ----------------------------------------------------------------------------------------------------------------------------------- Income (loss) from continuing operations before income tax 35,731 (38,644) 213,958 Less: realized investment gains (losses) (12,298) Add back: derivative gains related to investments 3,900 ----------------------------------------------------------------------------------------------------------------------------------- Operating income (loss) 35,731 (22,446) Income tax expense $ 70,457 70,457 Discontinued operations, net of income tax (27,610) (27,610) Change in accounting principle, net of income tax (8,341) (8,341) ----------------------------------------------------------------------------------------------------------------------------------- Net income $ 107,550 ===================================================================================================================================
Operating Segment Assets December 31, 2002 ----------------------------------------------------------------------------------------------------------------------------------- Life Stable Value Marketing Acquisitions Annuities Products ----------------------------------------------------------------------------------------------------------------------------------- Investments and other assets $4,193,729 $4,553,958 $4,821,398 $3,930,669 Deferred policy acquisition costs 973,631 435,592 93,140 4,908 Goodwill ----------------------------------------------------------------------------------------------------------------------------------- Total assets $5,167,360 $4,989,550 $4,914,538 $3,935,577 -----------------------------------------------------------------------------------------------------------------------------------
----------------------------------------------------------------------------------------------------------------------------------- Corporate Asset and Total Protection Other Adjustments Consolidated ----------------------------------------------------------------------------------------------------------------------------------- Investments and other assets $1,043,933 $1,400,527 $ 79,064 $20,023,278 Deferred policy acquisition costs 194,281 7,702 1,709,254 Goodwill 35,143 35,143 ----------------------------------------------------------------------------------------------------------------------------------- Total assets $1,273,357 $1,408,229 $ 79,064 $21,767,675 -----------------------------------------------------------------------------------------------------------------------------------
2003 2002 ----------------------------------------------------------------------------------- Weighted average discount rate 6.25% 6.75% Rates of increase in compensation level 4.00 4.50 Expected long-term rate of return on assets 8.50 8.50 -----------------------------------------------------------------------------------
Prior to July 1999, upon an employee’s retirement, a distribution from pension plan assets was used to purchase a single premium annuity from Protective in the retiree’s name. Therefore, amounts shown above as plan assets exclude assets relating to such retirees. Since July 1999, retiree obligations have been fulfilled from pension plan assets. The defined benefit pension plan has a target asset allocation of 60% domestic equities, 38% fixed income, and 2% cash and cash equivalents. When calculating asset allocation, PLC includes reserves for pre-July 1999 retirees. Based on historical data of the domestic equity markets and PLC’s group annuity investments, the plan’s target asset allocation would be expected to earn annualized returns in excess of 9% per year. In arriving at the plan’s 8.5% expected rate of return, PLC has adjusted this historical data to reflect lower expectations for equity returns. The plan’s equity assets are invested in a domestic equity index collective trust managed by Northern Trust Corporation. The plan’s cash equivalents are invested in a collective trust managed by Northern Trust Corporation. The plan’s fixed income assets are invested in a group annuity contract with Protective.
2003 2002 2001 ---------------------------------------------------------------------------------------------- Service cost $ 485 $ 455 $ 686 Interest cost 1,182 1,178 1,121 Amortization of prior service cost 16 16 19 Amortization of transition asset 37 Recognized net actuarial loss 118 71 233 Cost of divestiture and special termination benefits 81 1,807 ---------------------------------------------------------------------------------------------- Net pension cost $1,882 $1,720 $3,903 ----------------------------------------------------------------------------------------------
The criteria for payment of performance awards is based primarily upon a comparison of PLC’s average return on average equity and total rate of return over a four-year award period (earlier upon the death, disability, or retirement of the executive, or in certain circumstances, of a change in control of PLC) to that of a comparison group of publicly held life and multiline insurance companies. If PLC’s results are below the median of the comparison group, no portion of the award is earned. If PLC’s results are at or above the 90th percentile, the award maximum is earned. Awards are paid in shares of PLC Common Stock.
Performance shares and performance-based stock appreciation rights (P-SARs) awarded in 2003, 2002, 2001, and 2000, and the estimated fair value of the awards at grant date are as follows:
Estimated Year Awarded Performance Shares P-SARs Fair Value ----------------------------------------------------------------------------------- 2003 148,730 $3,900 2002 192,360 5,700 2001 153,490 40,000 4,900 2000 3,330 513,618 3,700 -----------------------------------------------------------------------------------
Performance shares are equivalent in value to one share of PLC Common Stock times the award earned percentage payout. P-SARs convert to the equivalent of one stock appreciation right (SAR) if earned times the award earned percentage payout. Of the 2000 P-SARs awarded, 87,778 have been canceled and 135,104 have been converted to 145,910 SARs. The remaining 290,076 P-SARs will convert to SARs in 2004 if earned. The 40,000 P-SARs awarded in 2001 were not earned and have been canceled. The P-SARs, if earned and converted to SARs, expire 10 years after the grant date. At December 31, 2003, the total outstanding performance shares and P-SARs related to these performance-based plans measured at maximum payouts were 660,610 and 456,286, respectively.
Between 1996 and 2002 SARs were granted (in addition to the P-SARs discussed above) to certain officers of PLC to provide long-term incentive compensation based solely on the performance of PLC’s Common Stock. The SARs are exercisable after five years (earlier upon the death, disability, or retirement of the officer, or in certain circumstances, of a change in control of PLC) and expire after ten years or upon termination of employment. The SARs activity as well as weighted average base price for 2001, 2002, and 2003 is as follows:
Wtd. Avg.Base Price No. of SARs --------------------------------------------------------------------------------------------- Balance at December 31, 2000 $18.64 875,000 SARs granted 26.34 138,751 P-SARs converted 22.31 100,072 --------------------------------------------------------------------------------------------- Balance at December 31, 2001 $19.92 1,113,823 SARs granted 32.00 480,000 SARs exercised 32.60 (80,000) SARs canceled 22.31 (15,000) --------------------------------------------------------------------------------------------- Balance at December 31, 2002 $23.90 1,498,823 SARs granted 26.49 95,000 SARs converted 22.31 45,838 SARs canceled 30.77 (22,500) --------------------------------------------------------------------------------------------- Balance at December 31, 2003 $23.91 1,617,161 ---------------------------------------------------------------------------------------------
The expense recorded by PLC for its stock-based compensation plans was $5.5 million, $5.2 million, and $5.6 million in 2003, 2002, and 2001, respectively. PLC’s obligations of its stock-based compensation plans that are expected to be settled in shares of PLC’s Common Stock are reported as a component of PLC’s share-owners’ equity.
Protective reinsures certain of its risks with, and assumes risks from other insurers under yearly renewable term, coinsurance, and modified coinsurance agreements. Under yearly renewable term agreements, Protective generally pays specific premiums to the reinsurer and receives specific amounts from the reinsurer as reimbursement for certain expenses. Coinsurance agreements are accounted for by passing a portion of the risk to the reinsurer. Generally, the reinsurer receives a proportionate part of the premiums less commissions and is liable for a corresponding part of all benefit payments. Modified coinsurance is accounted for similarly to coinsurance except that the liability for future policy benefits is held by the original company, and settlements are made on a net basis between the companies. A substantial portion of Protective’s new life insurance and credit insurance sales is being reinsured. Protective reviews the financial condition of its reinsurers.
In 2002, Protective discovered that it had overpaid reinsurance premiums to several reinsurance companies of approximately $94.5 million. At December 31, 2002, Protective had recorded cash and receivables totaling $69.7 million, which reflected the amounts received and Protective’s then current estimate of amounts to be recovered in the future, based upon the information available. The corresponding increase in premiums and policy fees resulted in $62.5 million of additional amortization of deferred policy acquisition costs in 2002. The amortization of deferred policy acquisition costs takes into account the amortization relating to the increase in premiums and policy fees as well as the additional amortization required should the remainder of the overpayment not be collected. In 2003, Protective substantially completed its recovery of the reinsurance overpayment. As a result, Protective increased premiums and policy fees by $18.4 million in 2003. The increase in premiums and policy fees resulted in $6.1 million of additional amortization of deferred policy acquisitions costs. As a result of the recoveries, income before income tax increased $12.3 million and $7.2 million in 2003 and 2002, respectively.
The carrying amount and estimated fair values of Protective’s financial instruments at December 31 are as follows:
2003 2002 ---------------------------------------------------------------------------------------------------------------------- Carrying Carrying Amount Fair Values Amount Fair Values ---------------------------------------------------------------------------------------------------------------------- Assets (see Notes A and C): Investments: Fixed maturities $12,927,520 $12,927,520 $11,655,465 $11,655,465 Equity securities 30,521 30,521 48,799 48,799 Mortgage loans on real estate 2,733,722 2,958,052 2,518,151 2,826,133 Short-term investments 510,635 510,635 447,155 447,155
Liabilities (see Notes A and E): Stable value product account balances 4,676,531 4,736,681 4,018,552 4,124,192 Annuity account balances 3,480,577 3,475,167 3,697,495 3,751,223 Notes payable 2,234 2,234 2,264 2,264 Other (see Note A): Derivative financial instruments 169,798 169,798 86,766 86,766 ----------------------------------------------------------------------------------------------------------------------
Protective estimates the fair value of its guaranteed investment contracts and annuities using discounted cash flows and surrender values, respectively.
SCHEDULE IV-- REINSURANCE PROTECTIVE LIFE INSURANCE COMPANY AND SUBSIDIARIES (dollars in thousands)
COL. A COL. B COL. C COL. D COL. E COL. F Percentage of Ceded to Other Assumed from Amount Assumed Gross Amount Companies Other Companies Net Amount to Net ------------------------------------------------------------------------------------------------------------------------ Year Ended December 31, 2003: Life insurance in force $324,318,517 $292,740,795 $22,176,303 $53,754,025 41.3% ------------------------------------------------------------------------------------------------------------------------ Premiums and policy fees: Life insurance $ 1,011,553 $ 765,276 $ 247,592 $ 493,869 50.1% Accident/health insurance 99,023 61,644 59,633 97,012 61.5% Property and liability insurance 170,322 91,015 65,688 144,995 45.3% ------------------------------------------------------------------------------------------------------------------------ Total $ 1,280,898 $ 917,935 $ 372,913 $ 735,876 ------------------------------------------------------------------------------------------------------------------------ Year Ended December 31, 2002: Life insurance in force $248,994,479 $219,025,215 $21,523,110 $51,492,374 41.8% ------------------------------------------------------------------------------------------------------------------------ Premiums and policy fees: Life insurance $ 831,129 $ 532,738 $ 235,198 $ 533,589 44.1% Accident/health insurance 103,858 61,512 44,337 86,683 51.1% Property and liability insurance 194,601 143,908 110,543 161,236 68.6% ------------------------------------------------------------------------------------------------------------------------ Total $ 1,129,588 $ 738,158 $ 390,078 $ 781,508 ------------------------------------------------------------------------------------------------------------------------ Year Ended December 31, 2001: Life insurance in force $191,105,512 $171,449,182 $23,152,614 $42,808,944 54.1% ------------------------------------------------------------------------------------------------------------------------ Premiums and policy fees: Life insurance $ 774,294 $ 565,130 $ 198,832 $ 407,996 48.7% Accident/health insurance 181,509 122,747 58,762 0.0% Property and liability insurance 158,890 83,274 76,295 151,911 50.2% ------------------------------------------------------------------------------------------------------------------------ Total $ 1,114,693 $ 771,151 $ 275,127 $ 618,669 ------------------------------------------------------------------------------------------------------------------------
COL. A COL. B COL. C COL. D COL. E Additions (1) Balance at Charged to (2) beginning of costs and Charges to Balance at end Description period expenses other accounts Deductions of period ------------------------------------------------------------------------------------------------------------------------ Allowance for Uncollected $24,833 $0 $ 0 $18,371 $ 6,462 Reinsurance Receivable ------------------------------------------------------------------------------------------------------------------------ Allowance for Uncollected $ 0 $0 $24,833 $ 0 $24,833 Reinsurance Receivable ------------------------------------------------------------------------------------------------------------------------