The following analysis of our consolidated financial condition and results of operations should be read in conjunction with “Selected Financial Data” and the consolidated financial statements and accompanying notes included elsewhere in this report.
Global Preferred provides reinsurance solutions for the life insurance and annuity industry. Our principal business objective is to align the long-term interests between independent marketing organizations and life insurance companies. Through these collaborative relationships, we believe both the IMOs and insurers benefit from mutually rewarding relationships based on parallel interests, a dedication to quality business, and a focus on managing insurance and distribution risk for long-term economic rewards.
policies. These revenues represent the policy mortality and expense charges, asset-based allowances and deferred sales charges that have been assessed against the reinsured policy account balances.
Net Income. Our profitability, in part, depends on the volume of policies reinsured and experience of the reinsured policies. Factors that affect the experience of the business include reinsured policy persistency, death claims, and investment performance of the separate account balances. While death claims are reasonably predictable over a period of years, claims become less predictable over shorter periods, and are subject to fluctuation from quarter to quarter and year to year. Similarly, separate account investment returns, upon which a significant portion of our revenues depend, may have relatively stable returns over a period of years but can be volatile over shorter periods. A considerable amount of separate account balances is invested in equities; therefore, prolonged deterioration in the equity markets will result in a decrease in our current and future income.
Under the coinsurance and modified coinsurance agreements, the amortization of the deferred acquisition costs is in proportion to the ratio of gross profits recognized during the then current period to total anticipated future gross profits. During each accounting period, assumptions used in calculating the amortization of the deferred acquisition expense reflect actual experience for the then current accounting period. We also review, on a periodic basis, our evolving experience with regard to our assumptions concerning future experience as to mortality, persistency, investment yields, and expenses in determining our estimate of anticipated future gross profits. This periodic review is commonly referred to as “unlocking.” Our normal period of observation is from October 1 of the previous calendar year through September 30 of the current calendar year. If we believe variances from expected assumptions are permanent, we will change the assumptions we use with regard to future experience. Upon adoption of any
A material component of variable life and annuity product revenues is derived from the asset-based fees that have been assessed against the policy account balances, of which a considerable portion is invested in the equity markets. The volatility of equity market returns over the short-term can be significant without materially impacting long-term equity market returns. Historical equity market performance shows equity market volatility is much higher over short term horizons as compared to long-term horizons. The short-term volatility of the policy fund value would result in a proportional adjustment to all future expected gross profits if no other adjustments were made to account for the differences between long-term and short-term volatility. We utilize a “credibility approach” to account for the differences between long-term and short-term volatility. Under this approach, the estimates of future expected gross profits are revised to recognize the effects short-term volatility and market yields have upon long-term yield expectations. We review our approach annually to determine if additional adjustments to amortization are necessary as a result of prolonged and/or severe negative or positive equity market performance. In such instances, the equity market performance must be sufficiently high or low to justify a belief that the effect of current market conditions on future expected gross profits should be more permanently reflected.
In addition, certain variable annuity policies we reinsure include a death benefit typically equal to a return of premium or the highest level the fund values had accumulated over certain prescribed periods under the annuity policy. Upon the death of an annuity policyholder, we will incur a claims expense equal to the excess, if any, of the amount guaranteed under this provision over the then current policy fund value. This expense increases when equity markets decline and decreases as equity markets increase. We utilize an implicit approach to account for the expense associated with these guaranteed minimum death benefits. Under this approach, future expected gross profits are decreased to account for future expected claims expenses. The short-term volatility of the policy fund value will result in significant volatility in the expected claims expense if no recognition is made to acknowledge differences between long-term yields and short-term volatility. Our implicit approach recognizes the effect of long-term versus short-term volatility when accounting for guaranteed minimum death benefits. In conjunction with the implementation of Statement of Position (“SOP”) 03-1, (refer to Note 2 to the Consolidated Financial Statements), we will be converting from an implicit approach to an explicit approach in first quarter 2004. We do not expect these changes to have a material impact on our financial statements.
Liabilities for future policy benefits under the renewable term agreements include provisions for claims in the course of settlement, claims incurred but not reported, and expected future claims. The liability is estimated using assumptions such as estimates of expected investment yields, mortality, persistency and expenses applicable at the time the reinsurance contracts are executed.
Liabilities for future policy benefits under coinsurance and modified coinsurance agreements equal reinsured policy account balances on the underlying life insurance and annuity policies. With regard to the separate account benefits reinsured on a modified coinsurance basis, we record the liabilities as an offset to related assets as our intentions and rights under the agreements with the ceding life companies meet the appropriate conditions governing rights of setoff. The nature of separate account benefits under variable life insurance or variable annuity policies do not permit us to reinsure those benefits on a coinsurance basis. We currently reinsure the fixed account portion of life insurance and annuity policies only on a coinsurance basis and, accordingly, the liabilities for that portion of the reinsurance are recorded as future policy benefits.
Liabilities for future policy benefits reflected in the consolidated financial statements are based on information provided to us by the ceding life companies. Reserves established by us with respect to
individual risks or classes of business may not be the same as those established by ceding life companies due to differing risks and assumptions regarding mortality, persistency, investment, and expenses.
Investments. We classify all fixed maturity securities and equity securities, with readily determinable fair values, as “available for sale.” Such securities are reported at fair value. Fixed maturity securities available for sale are so classified based upon the possibility that such securities could be sold prior to maturity if that action enables us to execute our investment philosophy and appropriately match investment results to operating and liquidity needs. Equity securities are classified as available for sale because we do not intend to actively trade such securities. Unrealized gains and losses on marketable equity securities and fixed maturity securities available for sale, less applicable deferred income taxes, are reported as a separate component of “accumulated other comprehensive income” within stockholders’ equity.
Other Financial Assets and Liabilities. The carrying value of cash and cash equivalents, reinsurance receivables and payables, short-term debt, accrued expenses and accounts payable approximate their fair values due to the short-term nature of these accounts. The carrying value of future policy benefits approximates its fair value as credited interest approximates current market rates.
$9.9 million of fixed maturity securities in 2002, with $8.5 million of such amount being sold in December 2002. The proceeds from these sales were predominantly held in cash and cash equivalents during 2003. The purchases and sales activities by quarter are shown in the table below:
Reinsurance Expense Allowances, Net. Net reinsurance expense allowances decreased $382,000, or 4%, from $8.5 million for the year ended December 31, 2002 to $8.1 million for the same period in 2003. These amounts reflect the decrease in business in force due to policy lapse and surrender activity. The decrease was also due to lower average account balances in 2003 as compared to the same periods in 2002 because of equity market performance.
Operating Expenses. Operating expenses increased $267,000, or 9%, from $3.1 million for the year ended December 31, 2002 to $3.4 million for the same period in 2003. These expenses include salaries and benefits, professional fees for legal, actuarial and accounting fees and other operating expenses. The majority of the increase was attributable to an increase of $572,000 resulting from directors’ and officers’ insurance premiums, office operating expenses, professional fees, marketing expenses, taxes and licenses, and shareholder communications. These increases were partially offset by a $301,000 decrease in salaries, bonuses and recruiting expenses due to the reductions in staffing and employee bonuses.
Reinsured Policy Revenues. Reinsured policy revenues increased $2.7 million, or 24%, from $11.2 million for the year ended December 31, 2001 to $13.9 million for the same period in 2002. This increase was due to: (1) the conversion of certain Financial Freedom Builder variable universal life policies and riders, as described above; (2) the reinsurance, at a quota share rate of 20%, of the Western Reserve Freedom Elite Builder variable universal life policies sold by the agents associated with World Financial Group and issued from July 1, 2001 through December 31, 2001; (3) the increase in our reinsurance on a coinsurance and modified coinsurance basis, from a 10% quota share rate to a 14% quota share rate, of all Western Reserve variable annuity policies sold by those agents and issued from January 1, 1999 through December 31, 2001; and (4) an increase in revenues from surrender charges in
2002 compared to 2001. These increases were partially offset by a decrease in mortality and expense charges and asset-based allowances resulting from the decline in variable annuity separate account balances.
Operating Expenses. Operating expenses increased $1.1 million, or 60%, from $2.0 million for the year ended December 31, 2001 to $3.1 million for the same period in 2002. These expenses include salaries and benefits, professional fees for legal, actuarial and accounting expenses and other operating
expenses. The majority of the increase for the year ended December 31, 2002 was attributable to a $752,000 increase in salaries, bonuses, benefits and recruiting expenses due to the employment of additional staff, a $221,000 increase in our directors’ and officers’ insurance premiums, and a $128,000 increase in legal fees.
Costs of Withdrawn Offering. During October 2002, we withdrew the registration statement for our proposed initial public offering of 9.5 million shares of common stock. Offering costs related to our withdrawn offering were $1.7 million for the year ended December 31, 2002. These costs, which consisted primarily of legal, printing, accounting, and actuarial fees, were expensed during the quarter ended September 30, 2002. We did not incur any similar expenses in 2001.
Income Taxes. Due to lower levels of income before income taxes, income taxes decreased $1.6 million, or 67%, from $2.4 million for the year ended December 31, 2001 to $789,000 for the same period in 2002. Income before income taxes is comprised of income subject to taxes that is recognized and due in the current period and income subject to taxes that is recognized during the current period but is due in future periods. The “small life insurance company deduction” available under Section 806 of the Internal Revenue Code for qualifying life insurance companies can reduce the effective federal income tax rate from 34% to less than 20% depending upon the amount of current taxable income. For the year ended December 31, 2002, we had no current taxable income and, as a result, we were unable to take advantage of any of the small life insurance company deduction. During 2001 our effective tax rate was 30%, as compared to 34% in 2002.
In accordance with SFAS No. 109, Accounting for Income Taxes, we have $8.4 million of net operating loss carryforwards, which begin to expire in 2018. These net operating loss carryforwards at a 34% effective tax rate are included as an offset to the deferred tax liability. It is our belief that it is more likely than not that the deferred tax assets will be realized as an offset against future taxable income, however, if we do not have sufficient taxable income in the future to utilize this asset, a write-off may result thereby reducing our net income.
The following table sets forth, as a percentage of total revenue, certain line items in the consolidated statements of income for the periods indicated:
As of December 31, 2003, we had invested assets totaling $30.6 million with an unrealized gain of $132,331, net of taxes. The table below shows the aggregate amounts of fixed maturity securities, equity securities, cash and cash equivalents, and reinsured policy loans comprising our portfolio of invested assets:
As of December 31, 2003, the fixed maturity portion of our invested asset portfolio had a dollar weighted average Moody’s rating of Aa3, an average duration of 3.3 years and an average yield to maturity of 4.0% before investment expenses.
Our capital structure consists of short-term debt and equity. Our short-term debt is comprised of a $5 million, five-year convertible term note to Money Services, Inc. due on July 29, 2004. Money Services is a subsidiary of AEGON USA, Inc. Proceeds of this note were used to reduce a portion of the outstanding principal balance on a line of credit with Money Services. Interest is payable on the note at 7.5% per annum (except in the event of redemption), on the 29th of each succeeding January and July through and including July 29, 2004. Money Services has the right to convert the outstanding principal balance of this note into common stock at any time. Upon conversion, Money Services would receive 6.255 shares of common stock for each $100 of the outstanding principal amount of the note, for a total of 312,750 shares, which reflects our three-for-two stock split in 2001. We have the option to redeem the note, in whole or in part, before maturity. To redeem the note before maturity, we must pay all principal, plus interest accrued from the date of the note through the redemption date at a higher effective interest rate of 9% per annum. As of December 31, 2002 and 2003, we had an outstanding principal balance on the term note of $5 million and accrued interest of $158,000.
Net cash flows provided by (used in) operating activities were $11.1 million, ($341,000) and $10.8 million for the years ended December 31, 2001, 2002 and 2003, respectively. Cash flows provided by operations in 2003 relating to new policies reinsured under coinsurance and modified coinsurance reflected net payments of $156,000 to Western Reserve to reinsure policies issued in 2003, and cash flows provided
At this time we are exploring financing strategies to fund transactions. The amount, timing, receipt and cost of additional capital may determine the extent we choose to take advantage of the rights we have under our agreements or to enter into new reinsurance transactions.
The following table shows our contractual obligations and commitments including our payments due by period. Refer to Note 10 to the Consolidated Financial Statements for further details.
At December 31, 2003, we had written all of our reinsurance business in U.S. dollars. If, in the future, we write business in currencies other than the U.S. dollar, we intend to invest a portion of the premiums collected on the reinsurance contract in securities denominated in the same foreign currency as the premium received. We also intend to consider and evaluate our foreign currency exchange risk and hedge our exposure.
The amount, timing, receipt, and cost of additional capital to fund our exercise of the rights to increase our reinsurance business with Western Reserve;
Consolidated Statements of Cash Flows for the years ended December 31, 2001, 2002 and 2003
Notes to Consolidated Financial Statements for the years ended December 31, 2001, 2002 and 2003