Selected consolidated financial data for the Corporation are presented below for each of the five years in the period ended December 31, 2009. This data should be read in conjunction with the Corporation’s Consolidated Financial Statements and notes thereto and Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations.
As described under “Ratings” and “Regulation,” the Corporation’s business is substantially affected by capital ratios and their impact on its ratings. Sales are being made with a greater selectivity based on increased profit level requirements for new business. The Insurance Company has determined that the level of competition in the sale of traditional and universal life insurance products has made it very difficult for smaller insurance companies, such as the Insurance Company, to participate in this business in a profitable way. Accordingly, the Insurance Company has determined that, under the current market conditions, it will not participate in the sale of traditional and universal life policies.
The Corporation’s earnings per share were $0.08 for 2009, as compared to $0.63 in 2008 and $2.16 in 2007. Results in 2009 primarily reflect a decrease in investment income. Our total revenues in 2009 were $242 million, compared to $266 million in 2008 and $364 million in 2007. Net income in 2009 was $2.2 million as compared to $18.6 million in 2008 and $63.7 million in 2007. Benefits and expenses in 2009 were $245 million, compared to $249 million in 2008 and $267 million in 2007. The Corporation’s decreases in earnings and revenues in 2009 resulted primarily from decreases in net investment income. Decreased investment income from the Corporation’s short-term investments and fixed maturities as well as investment losses from the limited partnerships all contributed to lower revenues in 2009.
As shown in the table below, due to the global economic recession that took hold in 2008, the Company’s net income began to decrease each quarter following the first quarter of 2008. In fact, the Company reported a net loss in the fourth quarter of 2008 and continued to report losses through the second quarter of 2009. As the economic climate began to improve in the second half of 2009, the Company was able to post net income of $63 thousand and $12.2 million in the third and fourth quarters of 2009, respectively. If the economy continues to strengthen in 2010, the Company’s earnings should continue to improve although there can be no assurance that this trend will continue.
The Company experienced a decline in net investment income of $77.5 million from $261.7 million in 2008 to $184.3 million in 2009. A significant part of this decline was due to income from the limited partnerships. Due to schedule K1 adjustments caused by the extraordinary decline in the financial markets in 2008, which were realized in net investment income in 2009, income from the limited partnerships had a decline of $59.4 million in 2009. Limited partnership income declined from a gain of $49.1 million in 2008 to a loss of $10.3 million in 2009. The Insurance Company experienced a decline of $8.3 million of investment income from short-term investments caused by the abnormally low commercial paper rates throughout 2009. Income from bonds also declined $5.8 million from $193.0 million in 2008 to $187.2 million in 2009, due to a decline in both invested assets and invested yields compared to 2008.
The Insurance Company¢s principal investments are in fixed maturities, all of which are exposed to at least one of three primary sources of investment risk: credit, interest rate and market valuation. The financial statement risks are those associated with the recognition of impairments and income, as well as the determination of fair values. When assessing our intent to sell a fixed maturity security or if it is more likely that we will be required to sell a fixed maturity security before recovery of its cost basis, we evaluate facts and circumstances such as, but not limited to, decisions to reposition our security portfolio and sale of securities to meet cash flow needs. In order to determine the amount of the credit loss for a fixed maturity security, we calculate the recovery value by performing a discounted cash flow analysis based on the current cash flows and future cash flows we expect to recover. The discount rate is the effective interest rate implicit in the underlying fixed maturity security. The effective interest rate is the original yield or the coupon if the fixed maturity security was previously impaired. If an Other than Temporary Impairment (“OTTI”) exists and we have the intent to sell the security, we conclude that the entire OTTI is credit-related and the amortized cost for the security is written down to current fair value with a corresponding charge to realized loss on our Consolidated Statements of Income. If we do not intend to sell a fixed maturity security or it is not more likely than not we will be required to sell a fixed maturity security before recovery of its amortized cost basis but the present value of the cash flows expected to be collected is less than the amortized cost of the fixed maturity security (referred to as the credit loss), we conclude that an OTTI has occurred and the amortized cost is written down to the estimated recovery value with a corresponding charge to realized loss on our Consolidated Statements of Income, as this is also deemed the credit portion of the OTTI. The remainder of the decline to fair value is recorded to other comprehensive income (“OCI”), as an unrealized OTTI loss on our Consolidated Balance Sheets, as this is considered a noncredit (i.e., recoverable) impairment.
For an equity security, if we do not have the ability and intent to hold the security for a sufficient period of time to allow for a recovery in value, we conclude that an OTTI has occurred, and the cost of the equity security is written down to the current fair value, with a corresponding change to realized gain (loss) in our Consolidated Statements of Income. We base our review on a number of factors including, but not limited to, the severity and duration of the decline in fair value of the equity security as well as the cause of the decline, the length of time we have held the equity security, any third party research reports or analysis, and the financial condition and near-term prospects of the security’s issuer, taking into consideration the economic prospects of the issuer’s industry and geographical location.
As of December 31, 2009, approximately 5.5% of the Insurance Company's total invested assets were invested in limited partnerships and equity securities. Investments in limited partnerships are included in the Corporation's consolidated balance sheet under the heading “Other long-term investments.” See “Note 2 to the Notes to Consolidated Financial Statements.” The Insurance Company is committed, if called upon during a specified period, to contribute an aggregate of approximately $93.8 million of additional capital to certain of these limited partnerships. Commitments of $12.2 million will expire in 2010, $35.6 million in 2011, $40.4 in 2012, and $5.6 in 2013. The Insurance Company may make selective investments in additional limited partnerships as opportunities arise. In general, risks associated with such limited partnerships include those related to their underlying investments (i.e., equity securities, debt securities and real estate), plus a level of illiquidity, which is mitigated by the ability of the Insurance Company to take quarterly distributions of partnership earnings. There can be no assurance that the Insurance Company will continue to achieve the same level of returns on its investments in limited partnerships as it has historically. Further, there can be no assurance that the Insurance Company will receive a return of all or any portion of its current or future capital investments in limited partnerships. The failure of the Insurance Company to receive the return of a material portion of its capital investments in limited partnerships, or to achieve historic levels of return on such investments, could have a material adverse effect on the Corporation's financial condition and results of operations.
As of December 31, 2009, the Company had 315 securities in a net unrealized loss position. Of this total, 283 are bonds holdings, 31 represent preferred stocks and 1 is an equity position.
Total unrealized losses decreased from $355.9 million at December 31, 2008 to $102.9 million at December 31, 2009. This decrease in the unrealized losses resulted from the significant tightening in corporate bond spreads caused by the improvement in the financial markets in 2009 and the strong recovery in corporate financing, particularly in investment-grade corporate bond financing. According to the Bank of America/Merrill Lynch corporate spread indices, 10-year, BBB-rated industrial spreads tightened by 467 basis points, BBB-rated financial spreads tightened by 804 basis points and BBB-rated utility spreads tightened by 349 basis points during 2009. The Company carefully examines each issue where the market value has fallen below 70% of book value to determine if the bonds are not-other-than-temporarily impaired. Consistent with the Company’s OTTI (Other than Temporarily Impaired) Policy as discussed above, the Company will recognize a write-down of book value to current market value, if warranted.
The unrealized losses on corporate bonds decreased from $311.2 million at December 31, 2008 to $86.7 million at December 31, 2009. The 5 largest loss positions consisted of the following holdings: Western and Southern Financial ($4.0 million), Principal Mutual Life Insurance Company ($3.3 million), First Tennessee Capital Trust ($3.2 million), American General Institutional Capital Trust II ($3.1 million) and Nationwide Mutual Insurance Company ($2.5 million). The Western and Southern, Principal Mutual and Nationwide Life are substantial positions of $16.7 million, $23.4 million and $11.9 million, respectively (cost basis) of bonds maturing beyond 20 years in the insurance sector. BBB-rated spreads in 30-year financials have improved since 2008 but are still in excess of 400 basis points over 30-year Treasuries. The First Tennessee position is a Capital Trust Security in a regional bank (First Horizon Corp.) that has been impacted by the losses in residential and commercial lending. Although recovering from depressed 2008 levels, the American General position is a trust preferred of a subsidiary of AIG, which is attempting to unwind from its rescue by the U.S. Government.
Results of Operations - Comparison of Fiscal Year 2009 to Fiscal Year 2008 and Fiscal Year 2008 to Fiscal Year 2007.
In 2009, annuity sales grew by over $50 million as a direct result of several factors. Fixed interest rates were fairly attractive most of the year, following a difficult year in the market for most investors. In February, the Company paid off its’ outstanding long term bond debt. The independent agent marketplace interpreted this as a strong showing of the financial strength of the Company. The Company took advantage of the situation at hand and hired new sales staff to recruit distribution in relatively untapped states. All of the sales team focused on new General Agent distribution and a major focus was placed on our immediate annuity product line.
Universal life and investment type policy fee income totaled $2.2 million, $2.7 million and $2.6 million in fiscal years 2009, 2008 and 2007, respectively. Policy fee income consists principally of amounts assessed during the period against policyholders' account balances for mortality charges and surrender charges.
Income (Loss) from limited partnerships amounted to approximately $(10.3 million), $49.1 million and $52.9 million in 2009, 2008 and 2007, respectively. The decrease in investment income from the limited partnerships in 2009 is largely reflective of the global economic recession and the inherent volatility in this portfolio. (See Item 7, Management’s Discussion and Analysis, Asset/Liability Management). Income from short-term investments amounted to approximately $.8 million, $9.1 million and $26.3 million in 2009, 2008 and 2007, respectively. The decrease in income from short-term investments was due to lower short-term interest rates in 2009 as compared to previous years.
The Insurance Company’s ratios of net investment income to average cash and invested assets, at amortized cost, for the years ended December 31, 2009, 2008 and 2007 were approximately 5.15%, 7.14% and 7.44% respectively. Without taking into account the returns on its limited partnership investments in those years, the respective ratios would have been 5.85%, 6.17% and 6.43%. For additional information, please refer to “Note 2 of the Notes to the Consolidated Financial Statements.”
Net realized investment (losses)/gains, pre-tax, amounted to $(3.0 million) in 2009, $(47.9 million) in 2008 and $24.8 million in 2007. With improving market conditions in 2009, the Company experienced a reduction in impairment charges associated to the fixed maturity portfolio when compared to 2008. Other than temporary impairments charges amounted to $9.9 million, $43.6 million and $52 thousand in 2009, 2008 and 2007, respectively. When impairments are determined to be other than temporary, the Company adjusts the book value to reflect the fair value, as appropriate, on a quarterly basis and the amount of the impairments are recorded as realized investment losses in the income statement. Realized investment gains (losses) also result from the sale of certain equity and convertible securities and calls and sales of fixed maturity investments in the Company’s investment portfolio. Also, the change in the fair value of the derivative instruments, even if the investments continue to be held by the Company, is reflected in the income statement as a realized gain or loss.
Interest credited and benefits paid to policyholders amounted to $214.6 million in fiscal 2009 as compared to $208.7 million in fiscal 2008 and $217.7 million in fiscal 2007. These represent an increase of 2.8% comparing fiscal 2009 to fiscal 2008 and a 4.1% decrease comparing fiscal 2008 to fiscal 2007.
In 2009, the Insurance Company’s average credited rate for reserves and account balances was greater than the Company’s ratio of net investment income to mean assets (based on book value) for the same period as noted above under “Net Investment Income”. In 2008 and 2007, the average credited rate was less than the Company’s ratio of net investment income to mean assets (based on book value). There can be no assurance that the Company's ratio of net investment income to book value mean assets (the "Spread") will not decline in future periods or that such decline will not have a material adverse effect on the Company's financial condition and results of operations. Depending, in part, upon competitive factors affecting the industry in general, and the Company, in particular, the Company may, from time to time, change the average credited rates on certain of its products. There can be no assurance that the Company will be able to reduce such rates or that any such reductions will broaden the Spread. The Company has performed an updated loss recognition test to re-confirm the recoverability of DAC, with best estimate actuarial assumptions. The actual Spread, excluding capital gains, for the 12 months ended December 31, 2009, 2008 and 2007 was (0.04%), 1.89% and 2.13%, respectively. In comparing year-end 2009 to year-end 2008 and 2008 to year-end 2007, the decrease was primarily due to the decrease in net investment income, as discussed above.
General expenses, taxes, commissions to agents and costs related to consent revocation solicitation totaled $30.5 million in 2009 as compared to $26.8 million in 2008 and $28.3 million in 2007. This represents an increase of 13.8% comparing 2009 to 2008 and a decrease of 5.4% comparing fiscal 2008 to fiscal 2007. The increase in 2009 was primarily due to increased corporate and legal expenses in connection with Herbert Kurz’s commencement of a consent solicitation of approximately $2.5 million. See Note 16 to the accompanying financial statements. The decrease in 2008 was primarily due to lower first year commissions and lower commissions paid on internal rollovers in an effort to keep policies in-force.
The change in the net DAC for 2009 resulted in a benefit of approximately $0.4 million, as compared to a charge of approximately $6.1 million and a charge of approximately $12.3 million for 2008 and 2007, respectively. Changes in DAC consist of three elements: deferred costs associated with product sales, amortization of the DAC on deferred annuity business and amortization of the DAC on the remainder of the Company’s business. Deferred costs consisted of credits of $10.0 million, $8.3 million and $11.3 million for 2009, 2008 and 2007 respectively. Amortization of the DAC on deferred annuity business consisted of charges of $4.7 million, $9.0 million and $17.9 million in 2009, 2008 and 2007 respectively. Amortization of the DAC on the remainder of the Company’s business consisted of charges of $4.8 million in 2009, $5.4 million in 2008 and $5.8 million in 2007.
Under applicable accounting rules, DAC related to deferred annuities is amortized in proportion to the estimated gross profits over the estimated lives of the contracts. Essentially, as estimated profits of the Insurance Company related to these assets increase, the amount and timing of amortization is accelerated. The lower levels of amortization in 2008 and 2009 relates primarily to the occurrence of net capital losses in 2008 and 2009 compared to net capital gains in 2007. (See also the discussion of Deferred Policy Acquisition Costs under Critical Accounting Policies below.)
Income tax benefits of approximately $5.3 million and $1.7 million were generated in 2009 and 2008, respectively, as compared to an expense of approximately $33 million in 2007. The benefit in 2009 was due to a net loss attributable to lower net income. The benefit in 2008 was primarily attributable to a lower net income and a deferred tax benefit realized on other than temporary impairments incurred on the Corporation’s investment portfolio. Higher income in 2007 generated higher income taxes.
The Corporation is an insurance holding company and its primary uses of cash are operating expenses and dividend payments. The Corporation’s principal sources of cash are sales of and interest on the Corporation’s investments, rent from its real estate and dividends from the Insurance Company. In 2007, the Corporation’s Board of Directors increased the quarterly dividend rate to $.125 per share from $.10 per share in 2006. In 2008, the Board of Directors reduced the quarterly dividend by 50% to $.0625 per share as a prudent measure to preserve capital. During 2009 and 2008, the Corporation did not repurchase any of its common stock, although at December 31, 2009, the Corporation was authorized to purchase approximately 385,000 shares of common stock.
The Insurance Company’s inability to upstream a dividend could have an adverse material impact on the Corporation. With no debt on the balance sheet, currently the Corporation biggest cash outlay is to the shareholders in the form of cash dividends, which at the current level of $.25 per share annually, would total approximately $7.4 million per year. The Insurance Company’s current capital and surplus level does not trigger an urgent need for capital raising at the Corporation. However, there are reasons to explore capital raising options including, but not limited to, the following:
A persistent focus of the Insurance Company’s management is maintaining the appropriate balance between the duration of its invested assets and the duration of its contractual liabilities to its annuity holders and credit suppliers. Towards this end, at least quarterly, the investment department of the Company determines the duration of the Company’s invested assets in coordination with the Company’s actuaries, who are responsible for calculating the liability duration. In the event it is determined that the duration gap between its assets and liabilities exceeds target levels, the Company may re-position its assets through the sale of invested assets or the purchase of new investments.
Another element of the asset liability management strategy is to hedge against the risks posed by a rapid and sustained rise in interest rates by entering into a form of derivative transaction known as a Payor Swaption. The effect of this transaction would be to lessen the negative impact on the Insurance Company of a significant increase in interest rates. With Payor Swaptions, the Company should be able to maintain more competitive crediting rates to policyholders when interest rates rise.
The following presents a summary of the Company’s significant contractual obligations as of December 31, 2009.
In a declining interest rate environment, the Insurance Company's cost of funds would be expected to decrease over time, reflecting lower interest crediting rates on its fixed annuities. Conversely, in an increasing interest rate environment, the cost of funds would be expected to increase, reflecting higher interest crediting rates. Should increased liquidity be required for withdrawals in such an interest rate environment, management believes that the portion of the Insurance Company's investments that are designated as available for sale in the Corporation's consolidated balance sheet could be sold without materially adverse consequences in light of the general strengthening in market prices that would be expected in the fixed maturity security market.
The Insurance Company¢s principal investments are in fixed maturities, all of which are exposed to at least one of three primary sources of investment risk: credit, interest rate and market valuation. The financial statement risks are those associated with the recognition of other than temporary impairments and income, as well as the determination of fair values. Recognition of income ceases when a bond goes into default and management evaluates whether temporary or other than temporary impairments have occurred on a case-by-case basis. When assessing our intent to sell a fixed maturity security or if it is more likely that we will be required to sell a fixed maturity security before recovery of its cost basis, we evaluate facts and circumstances such as, but not limited to, decisions to reposition our security portfolio and sale of securities to meet cash flow needs. In order to determine the amount of the credit loss for a fixed maturity security, we calculate the recovery value by performing a discounted cash flow analysis based on the current cash flows and future cash flows we expect to recover. The discount rate is the effective interest rate implicit in the underlying fixed maturity security. The effective interest rate is the original yield or the coupon if the fixed maturity security was previously impaired. If an OTTI exists and we have the intent to sell the security, we conclude that the entire OTTI is credit-related and the amortized cost for the security is written down to current fair value with a corresponding charge to realized loss on our Consolidated Statements of Income. If we do not intend to sell a fixed maturity security or it is not more likely than not we will be required to sell a fixed maturity security before recovery of its amortized cost basis but the present value of the cash flows expected to be collected is less than the amortized cost of the fixed maturity security (referred to as the credit loss), we conclude that an OTTI has occurred and the amortized cost is written down to the estimated recovery value with a corresponding charge to realized loss on our Consolidated Statements of Income, as this is also deemed the credit portion of the OTTI. The remainder of the decline to fair value is recorded to OCI, as an unrealized OTTI loss on our Consolidated Balance Sheets, as this is considered a noncredit (i.e., recoverable) impairment.
The Company uses the equity method of accounting for investments in limited partnership interests in which it has more than a minor equity interest, or more than a minor influence over the joint ventures and partnership’s operations, but does not have a controlling interest and is not the primary beneficiary. The Company routinely evaluates its limited partnership investments for impairments. The Company considers financial and other information provided by the investee and other known information and inherent risks in the underlying investments in determining whether an impairment has occurred. When an other-than-temporary impairment is deemed to have occurred, the Company records a realized capital loss within net investment income to record the investment at its fair value. Investment income from limited partnerships is recorded based on the Company’s share of earnings reported in the partnership’s most recent audited financial statements and income distributed by the partnerships. Management considers the quarterly financial information received from the limited partnerships to be unreliable or insufficient to record investment income, other than from distributions, on a quarterly basis. Management estimates the classification of cash distributions received between investment income and return of capital based on correspondence from the respective partnerships. The Company adjusts its estimate of investment income recorded during the year to the actual realized gains and other income reported in the limited partnerships’ most recent annual audited financial statements, which are generally received in the second quarter of the subsequent year. As a result, there may be up to a one year reporting lag for recording investment income that is not distributed during the year, which may result in significant adjustments. The Company records its share of net unrealized gains and losses (net of taxes) from the audited financial statements of the limited partnerships. As a result, there may be up to a one year reporting lag for reporting unrealized gains and losses, which may result in significant adjustments to other comprehensive income. Because it is not practicable to obtain an independent valuation for each limited partnership interest, for purposes of disclosure the market value of a limited partnership interest is estimated at book value based on the most recent available audited financial statements. Due to the significant unobservable inputs in these valuations, the Company includes the total fair value estimate for all of these investments in the amount disclosed in level 3. The failure of the Insurance Company to receive the return of a material portion of its capital investments in limited partnerships, or to achieve historic levels of return on such investments, could have a material adverse effect on the Corporation's financial condition and results of operations.
The reserves reflected in the Corporation’s consolidated financial statements included herein are calculated based on GAAP and differ from those specified by the laws of the various states in which the Insurance Company does business and those reflected in the Insurance Company's statutory financial statements. These differences arise from the use of different mortality and morbidity tables and interest rate assumptions, the introduction of lapse assumptions into the reserve calculation and the use of the net level premium reserve method on all insurance business. See “Notes 1G, 1H and 8 to the Notes to the Consolidated Financial Statements.”
For those annuities and supplementary contracts with life contingencies that comprise a portion of future policy benefits ($675 million of reserves), an increase in mortality experience of 1% per year for individual contracts would increase the present value of future benefits by approximately $32 million. Conversely, a decrease in mortality experience of 1% per year would decrease the present value of future benefits by approximately $30 million. We believe that any variation of our mortality estimates is likely to fall within this range.
For traditional life insurance business ($45.8 million of reserves), establishing reserves requires the use of many assumptions. Due to the number of independent variables inherent in the calculation of these reserves, and because this business is not material to the overall Company results, it is not practical to perform a quantitative analysis on the impact of changes in underlying assumptions. However, the Insurance Company historically has not experienced significant adverse deviations from its assumptions and believes that its assumptions are realistic and produce reserves that are fairly stated in accordance with GAAP.
Uncertain Tax Liabilities - We have open tax years in the United States that are currently under examination by the applicable taxing authorities, and certain later tax years that may in the future be subject to examination. We periodically evaluate the adequacy of our uncertain tax liabilities and tax reserves, taking into account our open tax return positions, tax assessments received and tax law changes. The process of evaluating uncertain tax liabilities and tax reserves involves the use of estimates and a high degree of management judgment. The final determination of tax audits could affect our tax reserves.