The selected financial data presented for, and as of the end of, each of the years in the five-year period ended December 31, 2006, have been prepared in accordance with accounting principles generally accepted in the United States of America. All amounts shown are in millions, except per share and operating data. The following data should be read in conjunction with the Consolidated Financial Statements and the Notes to Consolidated Financial Statements appearing in Part II Item 8 and Management’s Discussion and Analysis of Financial Condition and Results of Operations appearing in Part II
In 1994, the Company began using its North American underwriting expertise and industry knowledge to expand into international markets and now has subsidiaries, branches or representative offices in Australia, Barbados, Bermuda, China, Hong Kong, India, Ireland, Japan, Mexico, Poland, South Africa, South Korea, Spain, Taiwan and the United Kingdom. These operations are included in either the Company’s Asia Pacific segment or its Europe & South Africa segment. The Company generally starts new operations from the ground up in these markets as opposed to acquiring existing operations, and it often enters these markets to support its North American clients as they expand internationally. Based on Standard & Poor’s Global Reinsurance Highlights, 2006 Edition, the Company believes it is the third largest life reinsurer in the world based on 2005 gross life reinsurance premiums. While the Company believes information published by Standard & Poor’s is generally reliable, the Company has not independently verified the data. Standard & Poor’s does not guarantee the accuracy and completeness of the information. The Company conducts business with the majority of the largest U.S. and international life insurance companies. The Company has also developed its capacity and expertise in the reinsurance of asset-intensive products (primarily annuities and corporate-owned life insurance) and financial reinsurance.
remain attractive for the remaining life reinsurers, particularly those with a significant market presence and strong ratings.
Facultative Reinsurance. Based on discussions with the Company’s clients, an industry survey and informal knowledge about the industry, the Company believes it is a leader in facultative underwriting in North America. The Company intends to maintain that status by emphasizing its underwriting standards, prompt response on quotes, competitive pricing, capacity and flexibility in meeting customer needs. The Company believes its facultative business has allowed it to develop close, long-standing client relationships and generate additional business opportunities with its facultative clients.
In Force Block Reinsurance. The Company anticipates additional opportunities to grow its business by reinsuring “in force block” insurance, as insurers and reinsurers seek to exit various non-core businesses and increase financial flexibility in order to, among other things, redeploy capital and pursue merger and acquisition activity. The Company took advantage of one such opportunity in 2003 when it assumed the traditional life reinsurance business of Allianz Life.
Continue Expansion Into Selected Markets and Products. The Company’s strategy includes building upon the expertise and relationships developed in its core North American business platform to continue its expansion into selected markets and products, including:
Since December 31, 1998, the Company has formally reported its accident and health division as a discontinued operation. The accident and health business was placed into run-off, and all treaties were terminated at the earliest possible date. Notice was given to all cedants and retrocessionaires that all treaties were being cancelled at the expiration of their terms. The nature of the underlying risks is such that the claims may take several years to reach the reinsurers involved. Thus, the Company expects to pay claims over a number of years as the level of business diminishes. The Company will report a loss to the extent claims and related expenses exceed established reserves. During 2004, the accident and health division reported a net loss of $23.0 million, due to claim payments in excess of established reserves, an arbitration settlement and legal fees. See Note 20 - “Discontinued Operations” in the Notes to Consolidated Financial Statements.
The Company has five main operational segments, each of which is a distinct reportable segment: U.S., Canada, Europe & South Africa, Asia Pacific and Corporate and Other. The U.S. operations provide traditional life, asset-intensive, and financial reinsurance primarily to domestic clients. The Canada operations provide insurers with reinsurance of traditional life products as well as creditor reinsurance, group life and health reinsurance and non-guaranteed critical illness products. Europe & South Africa operations include traditional life reinsurance and critical illness business from Europe & South Africa, in addition to other markets the Company is developing. Asia Pacific operations provide primarily traditional life reinsurance, critical illness and, to a lesser extent, financial reinsurance. The Corporate and Other segment results include the corporate investment activity, general corporate expenses, interest expense of RGA, operations of RGA Technology Partners, Inc., a wholly-owned subsidiary that develops and markets technology solutions, Argentine business in run-off, and the investment income and expense associated with the Company’s collateral finance facility. The Company’s discontinued accident and health business is excluded from continuing operations. The Company measures segment performance based on profit or loss from operations before income taxes.
Consolidated income from continuing operations increased 24.5% in 2006 to $293.3 million and decreased 4.0% in 2005 to $235.6 million. Diluted earnings per share from continuing operations were $4.65 for 2006 compared to $3.70 for 2005 and $3.90 for 2004. A majority of the Company’s earnings during these years were attributed primarily to traditional reinsurance results in the U.S.
Costs of acquiring new business, which vary with and are primarily related to the production of new business, have been deferred to the extent that such costs are deemed recoverable from future premiums or gross profits. DAC amounts reflect the Company’s expectations about the future experience of the business in force and include commissions and allowances as well as certain costs of policy issuance and underwriting. Some of the factors that can affect the carrying value of DAC include mortality assumptions, interest spreads and policy lapse rates. For traditional life and related coverages, the Company performs periodic tests to determine whether DAC remains recoverable, and if experience significantly deteriorates to the point where a premium deficiency exists, a cumulative charge to current operations will be recorded. No such adjustments were made during 2006, 2005 or 2004. For its asset intensive business, the Company updates the estimated gross profits with actual gross profits each reporting period, resulting in an increase or decrease to DAC to reflect the difference in the actual gross profits versus the previously estimated gross profits. As of December 31, 2006, the Company estimates that approximately 78.9% of its DAC balance is collateralized by surrender fees due to the Company and the reduction of policy liabilities, in excess of termination values, upon surrender or lapse of a policy.
Liabilities for future policy benefits under long-term life insurance policies (policy reserves) are computed based upon expected investment yields, mortality and withdrawal (lapse) rates, and other assumptions, including a provision for adverse deviation from expected claim levels. The Company primarily relies on its own valuation and administration systems to establish policy reserves. The policy reserves established by the Company may differ from those established by its ceding companies (clients) due to the use of different mortality and other assumptions. However, the Company relies on its clients to provide accurate data, including policy-level information, premiums and claims, which is the primary information used to establish reserves. The Company’s administration departments work directly with clients to help ensure information is submitted by them in accordance with the reinsurance contracts. Additionally, the Company performs periodic audits of the information provided by ceding companies. The Company establishes reserves for processing backlogs with a goal of clearing all backlogs within a ninety-day period. The backlogs are usually due to data errors the Company discovers or computer file compatibility issues, since much of the data reported to the Company is in electronic format and is uploaded to its computer systems.
The Company periodically reviews actual historical experience and relative anticipated experience compared to the assumptions used to establish policy reserves. Further, the Company determines whether actual and anticipated experience indicates that existing policy reserves together with the present value of future gross premiums are sufficient to cover the present value of future benefits, settlement and maintenance costs and to recover unamortized acquisition costs. This loss recognition testing is performed at the segment level and, if necessary, net liabilities are increased along with a charge to income. Because of the many assumptions and estimates used in establishing reserves and the long-term nature of reinsurance contracts, the reserving process, while based on actuarial science, is inherently uncertain.
The Company primarily invests in fixed maturity securities. The Company monitors its fixed maturity securities to determine potential impairments in value. The Company evaluates factors such as the financial condition of the issuer, payment performance, the extent to which the market value has been below amortized cost, compliance with covenants,
The Company is currently a party to various litigation and arbitrations. While it is not feasible to predict or determine the ultimate outcome of the pending litigation or arbitrations or even provide reasonable ranges of potential losses, it is the opinion of management, after consultation with counsel, that the outcomes of such litigation and arbitrations, after consideration of the provisions made in the Company’s consolidated financial statements, would not have a material adverse effect on its consolidated financial position. However, it is possible that an adverse outcome could, from time to time, have a material adverse effect on the Company’s consolidated net income or cash flows in particular quarterly or annual periods. See Note 13 - “Commitments and Contingent Liabilities” and Note 20 - “Discontinued Operations” in the Notes to Consolidated Financial Statements.
The U.S. traditional sub-segment provides life reinsurance to domestic clients for a variety of life products through yearly renewable term agreements, coinsurance and modified coinsurance agreements. These reinsurance arrangements may
Net investment income increased $36.7 million, or 13.7%, and $31.3 million, or 13.2%, in 2006 and 2005, respectively. The increase in both years is primarily due to growth in the invested asset base, due to increased operating cash flows on traditional reinsurance. Investment income and investment related gains and losses are allocated to the various operating segments based on average assets and related capital levels deemed appropriate to support the segment business volumes. Investment performance varies with the composition of investments and the relative allocation of capital to the operating segments.
Claims and other policy benefits, as a percentage of net premiums (loss ratios), were 82.1%, 82.7%, and 79.8% in 2006, 2005, and 2004, respectively. Mortality experience in 2006 improved to be generally in line with expectations while 2005 was higher than expected and 2004 was favorable. The first six months of 2005 showed an increase in the severity of claims, which was the primary contributor to the higher loss ratio in 2005. Death claims are reasonably predictable over a period of many years, but are less predictable over shorter periods and are subject to significant fluctuation.
Other operating expenses, as a percentage of net premiums, were 1.6%, 1.7% and 2.0% in 2006, 2005 and 2004, respectively. The expense ratio is expected to fluctuate slightly from period to period, however, the size and maturity of the U.S. operations segment indicates it should remain relatively constant over the long term. The slightly higher ratio in 2004 can be attributed to expenses associated with the 2003 coinsurance agreement with Allianz Life.
spreads on the underlying treaties. Therefore, Company management believes it is helpful to distinguish between the effects of Issue B36 and the primary factors that drive profitability of the underlying treaties, namely investment income, fee income, and interest credited. Additionally, over the expected life of the underlying treaties, management expects the cumulative effect of Issue B36 to be immaterial.
Total revenues, which are comprised primarily of investment income, increased 24.1% from 2005 to 2006. This increase can be primarily attributed to an increase in investment income as a result of a growing asset base and an increase in other revenues resulting from mortality and expense charges earned on a new variable annuity contract. Offsetting this increase is a $7.6 million increase in investment related losses. These losses were mainly the result of an increased rate environment which allowed the Company to sell bonds at low book yields and reinvest in higher book yielding securities. Total revenues in 2005 increased $1.7 million over 2004, excluding the impact of investment related losses and Issue B36. This can be attributed primarily higher investment income due to a larger asset base.
The U.S. Financial Reinsurance sub-segment income consists primarily of net fees earned on financial reinsurance transactions. The majority of the financial reinsurance risks are assumed by the Company and retroceded to other insurance companies or brokered business in which the company does not participate in the assumption of risk. The fees earned from the assumption of the financial reinsurance contracts are reflected in other revenues, and the fees paid to retrocessionaires are reflected in policy acquisition costs and other insurance expenses. Fees earned on brokered business are reflected in other revenues.
Income before income taxes decreased 8.8% and increased 27.8% in 2006 and 2005, respectively. The decrease in 2006 was primarily the result of unfavorable mortality experience in the current year as compared to more favorable experience in the prior year, offset by an increase in investment related gains of $2.0 million. Additionally, the Canadian dollar strengthened against the U.S. dollar during 2006, and contributed $3.5 million to income before income taxes. The increase in 2005 was primarily the result of more favorable mortality experience, offset by a decrease in investment related gains of $4.6 million. Additionally, the Canadian dollar strengthened against the U.S. dollar during 2005 and contributed $3.4 million to income before income taxes in 2005.
Net premiums increased 25.2% to $429.4 million in 2006, and increased 35.2% to $343.1 million in 2005. An increase in premium from creditor treaties contributed $39.2 million and $38.7 million of the 2006 and 2005 premium increase respectively. Creditor insurance covers the outstanding balance on personal, mortgage or commercial loans in the event of death, disability or critical illness and is generally shorter in duration than traditional life insurance. Creditor and group life and health premiums represented 20.6% of net premiums in 2006 and 14.4% in 2005. Additionally, a stronger Canadian dollar contributed $25.2 million and $22.6 million to net premiums reported in 2006 and 2005, respectively. Premium levels are significantly influenced by large transactions, mix of business and reporting practices of ceding companies, and therefore can fluctuate from period to period.
Loss ratios for this segment were 89.9% in 2006, 89.7% in 2005, and 98.7% in 2004. During 2006 and 2005, the Company entered into three significant creditor reinsurance treaties. The loss ratios on this type of business are normally lower than traditional reinsurance, however allowances are normally higher as a percentage of premiums. Excluding creditor business, the loss ratios for this segment were 102.2% in 2006, 97.7% in 2005, and 101.0% in 2004. The higher loss ratio for 2006 is primarily due to unfavorable mortality experience compared to the prior year. Historically, the loss ratio has been influenced by several large permanent level premium in force blocks assumed in 1998 and 1997. These represent mature blocks of permanent level premium business in which mortality as a percentage of premiums is expected to be higher than the historical ratios. The nature of level premium permanent policies requires the Company to set up actuarial liabilities and invest the amounts received in excess of early-year mortality costs to fund claims in the later years when premiums, by
The Europe & South Africa segment has operations in India, Mexico, Poland, Spain, South Africa and the UK. The segment provides life reinsurance for a variety of products through yearly renewable term and coinsurance agreements, and reinsurance of critical illness coverage. Reinsurance agreements may be either facultative or automatic agreements covering primarily individual risks and in some markets, group risks.
Income before income taxes increased 64.0% and 19.9% in 2006 and 2005, respectively. The increase in 2006 was primarily the result of favorable mortality and morbidity experience in the UK in 2006 versus adverse experience in 2005. Also, investment income increased $4.8 million. Both of these were partially offset by an increase in other operating expenses of $13.0 million. The increase in 2005 was primarily the result of additional business volume and an increase in net premiums of $74.1 million. Additionally, investment income increased $5.0 million and was offset by a decrease in investment related gains of $2.7 million and an increase in other operating expenses of $6.3 million.
Europe & South Africa net premiums grew 6.4% during 2006 and 15.5% in 2005. The growth was primarily the result of new business from both existing treaties and new treaties. The rate of growth in net premiums is below historical levels due to increased competition in the UK and a slowing of growth in insurance product sales associated with the UK retail mortgage market. Also, there was a favorable effect from currency exchange rates in 2006 of $2.6 million and an unfavorable effect from currency exchange rates in 2005 of $2.3 million. In 2006, several foreign currencies, particularly the British pound and the euro, strengthened against the U.S. dollar, while the South African rand weakened against the U.S. dollar. Also, a significant portion of the growth of premiums was due to reinsurance of critical illness coverage, primarily in the UK. This coverage provides a benefit in the event of a death from or the diagnosis of a pre-defined critical illness coverage. Premiums earned from this coverage totaled $208.8 million, $199.3 million and $177.4 million in 2006, 2005 and 2004, respectively. Premium levels are significantly influenced by large transactions and reporting practices of ceding
Investment income increased $4.8 million and $5.0 million in 2006 and 2005, respectively. These increases were primarily due to growth in the 2006 and 2005 invested assets in the UK. The segment has also experienced growth in allocated investment income. Investment income and investment related gains and losses are allocated to the various operating segments based on average assets and related capital levels deemed appropriate to support the segment business volumes. Investment performance varies with the composition of investments and the relative allocation of capital to the operating segments.
Loss ratios were 70.6%, 73.3% and 65.6% for 2006, 2005 and 2004, respectively. Death claims are reasonably predictable over a period of many years, but are less predictable over shorter periods and are subject to significant fluctuation. Policy acquisition costs and other insurance expenses as a percentage of net premiums represented 15.3%, 17.2% and 25.8% for 2006, 2005 and 2004, respectively. These percentages fluctuate due to timing of client company reporting, variations in the mixture of business being reinsured and the relative maturity of the business. In addition, as the segment grows, renewal premiums which have lower allowances than first year premiums, represent a greater percentage of the total premiums. In 2005, the loss ratio increased and the policy acquisition costs and other insurance expenses, as a percentage of net premiums, decreased due to the increase in renewal business in the mixture of business.
The Asia Pacific segment has operations in Australia, Hong Kong, Japan, Malaysia, Singapore, New Zealand, South Korea, Taiwan and mainland China. The principal types of reinsurance for this segment include life, critical illness, disability income, superannuation, and financial reinsurance. Superannuation is the Australian government mandated compulsory retirement savings program. Superannuation funds accumulate retirement funds for employees, and in addition, offer life and disability insurance coverage. Reinsurance agreements may be either facultative or automatic agreements covering primarily individual risks and in some markets, group risks.
Income before income taxes increased 87.4% during 2006 and increased 319.8% during 2005. The increase in income before taxes for 2006 was the result of strong results in the Australia, Japan and Korea operations. Significant net premium growth in the Australia, Japan and Korea offices, along with good mortality experience and reserve reductions associated with Australian disability treaties, allowed these combined operations to contribute an additional $20.6 million of income before income taxes in 2006 compared to 2005. The increase in income before taxes for 2005 was primarily the result of the Australian operations. During 2005, favorable mortality along with an overall reduction of reserves for disabled life reserves contributed to an increase in income before income taxes of approximately $25.1 million in Australia.
Net premiums grew 25.8% during 2006 and 34.0% during 2005. During 2006, growth in premium volume was primarily the result of organic growth in certain markets, along with favorable exchange rates in multiple countries. In terms of growth of premium dollars during 2006, the Australia, Japan and Korea markets were the primary contributors, collectively adding approximately $125.8 million in premium volume compared to 2005. Growth in Australia was driven by broad-based success in both the individual and group markets. In Japan and Korea, 2006 premium growth was driven by an increase in volume from existing large clients.
During 2005, the Australia and Korea markets were the primary contributors to the increase in net premiums, adding approximately $40.7 million and $46.3 million, respectively, in premium volume compared to 2004. In Korea, 2005 premium growth was driven by an increase of $42.2 million for four primary clients. Growth in Australia was driven primarily by continued success in the group market. Premium levels are significantly influenced by large transactions and reporting practices of ceding companies and therefore can fluctuate from period to period.
Other revenue during 2006 and 2005 represented primarily profit and fees associated with financial reinsurance in Japan of approximately $4.7 million and $3.7 million, respectively. Other revenue during 2004 primarily represented profit and fees associated with financial reinsurance in Japan, Taiwan and South Korea of approximately $2.1 million, and fees associated with the recapture provisions for two client treaties of approximately $0.9 million.
Loss ratios for this segment were 76.2%, 78.5% and 82.7% for 2006, 2005 and 2004, respectively. This percentage will fluctuate due to timing of client company reporting, variations in the mixture of business being reinsured and the relative maturity of the business. Death claims are reasonably predictable over a period of many years, but are less predictable over shorter periods and are subject to significant fluctuation. While loss ratios were relatively stable between 2005 and 2006, the overall segment loss ratio was 4.2% higher in 2004 than in 2005. The higher 2004 loss ratio was attributable primarily to loss experience in Australia and New Zealand. Australia’s loss ratio in 2004 was affected by the recording of additional reserves on disability income business of approximately $22.8 million, and a reserve of approximately $2.7 million related to the tsunami in December 2004. New Zealand’s loss experience in 2004 was affected by the unfavorable performance of four significant treaties.
Other operating expenses increased to 6.3% of net premiums in 2006, from 5.1% in 2005 and 6.1% in 2004. The Company believes that sustained growth in premiums should lessen the burden of start-up expenses and expansion costs over time. However, the timing of the entrance into and development of new markets in the growing Asia Pacific segment may cause other operating expenses as a percentage of premiums to be somewhat volatile over periods of time.
Corporate and Other revenues include investment income from invested assets not allocated to support segment operations and undeployed proceeds from the Company’s capital raising efforts, in addition to unallocated investment related gains and losses. Corporate expenses consist of the offset to capital charges allocated to the operating segments within the policy acquisition costs and other insurance expenses line item, unallocated overhead and executive costs, and interest expense related to debt and the $225.0 million of 5.75% Company-obligated mandatorily redeemable trust preferred securities. Additionally, the Corporate and Other Operations includes results from RGA Technology Partners, Inc., a wholly-owned subsidiary that develops and markets technology solutions for the insurance industry, the Company’s Argentine privatized pension business, which is currently in run-off, an insignificant amount of direct insurance operations in Argentina and the investment income and expense associated with the Company’s collateral finance facility.
Loss before income taxes increased $23.1 million during 2005 compared to 2004, primarily due to an increase in claims and other policy benefits of $29.0 million and a reduction in investment income of $4.0 million, offset by an increase in investment related gains of $12.6 million. The increase in claims and other policy benefits is due to an increase in the policy liabilities associated with the commutation of treaties covering the reinsurance of Argentine pension accounts. The decrease in investment income was the result of an allocation to other segments based upon average assets and related capital
levels deemed appropriate to support their business volumes. Investment related gains are related to a number of different market factors and such gains are subject to fluctuation from period to period.
The Company has maintained its ownership of the direct insurance operations in Argentina but has reached an agreement as of December 31, 2006 to transfer the majority of the underlying insurance policies to an unrelated third party. Total future policy benefits and other liabilities associated with this business totaled approximately $6.9 million as of December 31, 2006. The transfer received regulatory approval on February 13, 2007 and will be reflected in the Company’s consolidated financial statements for the quarter ended March 31, 2007. The Company does not expect a significant gain or loss upon transfer of this business to the third party.
At the time it was accepting accident and health risks, the Company directly underwrote certain business provided by brokers using its own staff of underwriters. Additionally, it participated in pools of risks underwritten by outside managing general underwriters, and offered high level common account and catastrophic protection coverages to other reinsurers and retrocessionaires. Types of risks covered included a variety of medical, disability, workers’ compensation carve-out, personal accident, and similar coverages.
The reinsurance markets for several accident and health risks, most notably involving workers’ compensation carve-out and personal accident business, have been quite volatile over the past several years. Certain programs are alleged to have been inappropriately underwritten by third party managers, and some of the reinsurers and retrocessionaires involved have alleged material misrepresentation and non-disclosures by the underwriting managers. In particular, over the past several years a number of disputes have arisen in the accident and health reinsurance markets with respect to London market personal accident excess of loss (“LMX”) reinsurance programs that involved alleged “manufactured” claims spirals designed to transfer claims losses to higher-level reinsurance layers. The Company is currently a party to three arbitrations that involve some of these LMX reinsurance programs. Additionally, while the Company did not underwrite workers’ compensation carve-out business directly, it did offer certain indirect high-level common account coverages to other reinsurers and retrocessionaires, which could result in exposure to workers’ compensation carve-out risks. The Company and other reinsurers and retrocessionaires involved have raised substantial defenses upon which to contest claims arising from these coverages, including defenses based upon the failure of the ceding company to disclose the existence of manufactured claims spirals, inappropriate or unauthorized underwriting procedures and other defenses. As a result, there have been a significant number of claims for rescission, arbitration, and litigation among a number of the parties involved in these various coverages. This has had the effect of significantly slowing the reporting of claims between parties, as the various outcomes of a series of arbitrations and similar actions affect the extent to which higher level reinsurers and retrocessionaires may ultimately have exposure to claims.
pretax, negotiated settlement of all disputed claims associated with the Company’s largest identified accident and health exposure during 2004.
DAC related to interest-sensitive life and investment-type contracts are amortized over the lives of the contracts, in relation to the present value of estimated gross profits (“EGP”) from mortality, investment income, and expense margins. The EGP for asset-intensive products include the following components: (1) estimates of fees charged to policyholders to cover mortality, surrenders and maintenance costs; (2) expected interest rate spreads between income earned and amounts credited to policyholder accounts; and (3) estimated costs of administration. EGP is also reduced by the Company’s estimate of future losses due to defaults in fixed maturity securities. DAC is sensitive to changes in assumptions regarding these EGP components, and any change in such an assumption could have an effect on the Company’s profitability.
The DAC associated with the Company’s non-asset-intensive business is less sensitive to changes in estimates for investment yields, mortality and lapses. In accordance with Statement of Financial Accounting Standards No. 60, “Accounting and Reporting by Insurance Enterprises,” the estimates include provisions for the risk of adverse deviation and are not adjusted unless experience significantly deteriorates to the point where a premium deficiency exists.
RGA is an insurance holding company whose primary uses of liquidity include, but are not limited to, the immediate capital needs of its operating companies associated with the Company’s primary businesses, dividends paid to its shareholders, interest payments on its indebtedness (See Note 14 - “Debt and Trust Preferred Securities” in the Notes to Consolidated Financial Statements), and repurchases of RGA common stock under a board of directors approved plan. The primary sources of RGA’s liquidity include proceeds from its capital raising efforts, interest income on undeployed corporate investments, interest income received on surplus notes with RGA Reinsurance and RCM, and dividends from operating subsidiaries. As the Company continues its expansion efforts, RGA will continue to be dependent upon these sources of liquidity.
RCM and RGA Reinsurance are subject to statutory provisions that restrict the payment of dividends. They may not pay dividends in any 12-month period in excess of the greater of the prior year’s statutory operating income or 10% of capital and surplus at the preceding year-end, without regulatory approval. The applicable statutory provisions only permit an insurer to pay a shareholder dividend from unassigned surplus. Any dividends paid by RGA Reinsurance would be paid to RCM, its parent company, which in turn has restrictions related to its ability to pay dividends to RGA. The assets of RCM consist primarily of its investment in RGA Reinsurance. As of January 1, 2007, RCM and RGA Reinsurance could pay maximum dividends, without prior approval, of approximately $55.7 million and $105.1 million, respectively. However, on December 19, 2006, RCM received approval from the Missouri Department of Insurance that allows RCM to pay a dividend to RGA to the extent RCM received the dividend from RGA Re, without limitation related to the level of unassigned surplus. Thus, RCM’s allowable dividend is $104.6 million to the extent that amount has been received from RGA Re. Dividend payments from other subsidiaries are subject to regulations in the jurisdiction of domicile.
Historically, RGA has paid quarterly dividends ranging from $0.027 per share in 1993 to $0.09 per share in 2006. All future payments of dividends are at the discretion of the Company’s board of directors and will depend on the Company’s earnings, capital requirements, insurance regulatory conditions, operating conditions, and such other factors as the board of directors may deem relevant. The amount of dividends that the Company can pay will depend in part on the operations of its reinsurance subsidiaries. Under certain circumstances, RGA may be contractually prohibited from paying dividends on common stock, see discussion below in “Debt and Trust Preferred Securities”.
In December 2005, RGA issued Junior Subordinated Debentures with a face amount of $400.0 million. Interest is payable semi-annually and is fixed at 6.75% per year until December 15, 2015. From December 15, 2015 until December 15, 2065, interest on the debentures will accrue at an annual rate of 3-month LIBOR plus a margin equal to 266.5 basis points, payable quarterly. RGA has the option to defer interest payments, subject to certain limitations. In addition, interest payments are mandatorily deferred if the Company does not meet specified capital adequacy, net income and shareholders’ equity levels. Upon an optional or mandatory deferral of interest payments, RGA is generally not permitted to pay common-stock dividends or make payments of interest or principal on securities which rank equal or junior to the subordinated debentures, until the accrued and unpaid interest on the subordinated debentures is paid. The subordinated debentures are redeemable at RGA’s option. Approximately $76.1 million of the net proceeds were used to purchase RGA’s common stock
under an ASR agreement with a financial counterparty. Additionally, RGA used a portion of the net proceeds from the sale of these debentures to repay approximately $100.0 million of its 7.25% senior notes when they matured in April 2006. As of December 31, 2006, the average interest rate on long-term and short-term debt outstanding, excluding the Preferred Income Redeemable Securities Units, was 6.63% compared to 6.62% at the end of 2005.
The Company maintains three revolving credit facilities. The largest is a syndicated credit facility with an overall capacity of $600.0 million that expires in September 2010. The overall capacity available for issuance of letters of credit is reduced by any cash borrowings made by the Company against this credit facility. The Company may borrow up to $300.0 million of cash under the facility. As of December 31, 2006 the Company’s outstanding cash borrowing was $50.0 million under this credit facility, with an average interest rate of 5.76%. The Company’s other credit facilities consist of a £15.0 million credit facility that expires in May 2007 and an AUD$50.0 million Australian credit facility that expires in June 2011. The Company’s foreign denominated credit facilities had a combined outstanding balance of $57.0 million as of December 31, 2006.
Some treaties give ceding companies the right to request that the Company place assets in trust for the benefit of the cedant to support reserve credits in the event of a downgrade of the Company’s ratings to specified levels. As of December 31, 2006, these treaties had approximately $686.0 million in reserves. Assets placed in trust continue to be owned by the Company, but their use is restricted based on the terms of the trust agreement. Securities with an amortized cost of $756.1 million were held in trust for the benefit of certain subsidiaries of the Company to satisfy collateral requirements for reinsurance business at December 31, 2006. Additionally, securities with an amortized cost of $1,364.4 million as of December 31, 2006 were held in trust to satisfy collateral requirements under certain third-party reinsurance treaties. Under certain conditions, RGA may be obligated to move reinsurance from one RGA subsidiary company to another RGA subsidiary or make payments under the treaty. These conditions include change in control of the subsidiary, insolvency, nonperformance under a treaty, or loss of reinsurance license of such subsidiary. If RGA was ever required to perform under these obligations, the risk to the consolidated company under the reinsurance treaties would not change; however, additional capital may be required due to the change in jurisdiction of the subsidiary reinsuring the business and may create a strain on liquidity.
In order to reduce the level of statutory reserves, primarily in the U.S. and Canada, which may be significantly in excess of reserves required under GAAP, the Company has entered into various reinsurance agreements with affiliates and third parties. In order for the Company to receive statutory reserve credit, the affiliate or third party must provide collateral for the benefit of the Company, usually in the form of assets in trust or letters of credit.
The Company’s net cash flows provided by operating activities for the years ended December 31, 2006, 2005 and 2004, were $846.2 million, $599.4 million and $710.8 million, respectively. Cash flows from operating activities are affected by the timing of premiums received, claims paid and working capital changes. Operating cash increased $246.8 million during 2006 due to increased cash from premiums and investment income of $412.2 million and $139.8 million, respectively, largely offset by higher operating cash outlays of $305.2 million. During 2005, operating cash decreased $111.5 million due to higher operating cash outlays of $613.3 million largely offset by increased cash from premiums and investment income of $438.2 million and $63.6 million, respectively. The Company believes the short-term cash requirements of its business operations will be sufficiently met by the positive cash flows generated. Additionally, the Company believes it maintains a high-quality fixed maturity portfolio with positive liquidity characteristics. These securities are available for sale and could be sold if necessary to meet the Company’s short- and long-term obligations, subject to market conditions.
Net cash provided by financing activities was $817.9 million, $274.3 million and $120.9 million in 2006, 2005 and 2004, respectively. Changes in cash provided by financing activities primarily relate to the issuance of equity or debt securities, borrowings or payments under the Company’s existing credit agreements, collateral finance facility activity, treasury stock activity and excess deposits (payments) under investment-type contracts.
1Future policyholder benefits include liabilities related primarily to the Company’s reinsurance of life and health insurance products. Amounts presented in the table above represent the estimated obligations as they become due both to and from ceding companies for benefits under such contracts including future premiums, allowances and other amounts due as the result of assumptions related to mortality, morbidity, policy lapse and surrender as appropriate to the respective product. In certain periods, expected premiums exceed expected policy benefit payments and allowances, resulting in a negative obligation. The sum of the obligations shown for all years in the table of $22.6 billion exceeds the liability amount of $5.3 billion included on the consolidated balance sheet principally due to the fact that amounts presented above are on an undiscounted basis.
2Interest sensitive contract liabilities include amounts related to the Company’s reinsurance of asset intensive products, primarily deferred annuities and corporate-owned life insurance. Amounts presented in the table above represent the estimated obligations as they become due both to and from ceding companies relating to activity of the underlying policyholders. Amounts presented in the table above represent the estimated obligations under such contracts undiscounted as to interest, including assumptions related surrenders, withdrawals, premium persistency, partial withdrawals, surrender charges, annuitizations, mortality, future interest credited rates and policy loan utilization. The sum of the obligations shown for all years in the table of $7.1 billion exceeds the liability amount of $6.2 billion included on the consolidated balance sheet principally due to the lack of discounting.
3Assumes that all securities will be held until the stated maturity date of March 18, 2051. For additional information on these securities, see “Company-Obligated Mandatorily Redeemable Preferred Securities of Subsidiary Trust Holding Solely Junior Subordinated Debentures of the Company” in Note 2 - “Summary of Significant Accounting Policies” in the Notes to Consolidated Financial Statements.
See Note 8 - “Income Tax” and Note 9 - “Employee Benefit Plans” in the Notes to Consolidated Financial Statements for information related to the Company’s obligations for taxes and funding requirements for retirement and other post-employment benefits.
Based on the growth of the Company’s business and the pattern of reserve levels under Regulation XXX associated with term life business, the amount of ceded reserve credits is expected to grow. This growth will require the Company to obtain additional letters of credit, put additional assets in trust, or utilize other mechanisms to support the reserve credits. If the Company is unable to support the reserve credits, the regulatory capital levels of several of its subsidiaries may be significantly reduced. The reduction in regulatory capital would not directly affect the Company’s consolidated shareholders’ equity under GAAP; however, it could affect the Company’s ability to write new business and retain existing business.
In 2006, the Company entered into a reinsurance agreement that requires it to post collateral for a portion of the business being reinsured. As part of the collateral requirements, a third party financial institution has issued a letter of credit for the benefit of the ceding company (the “beneficiary”), which may draw on the letter of credit to be reimbursed for valid claim payments not made by RGA pursuant to the reinsurance treaty. RGA is not a direct obligor under the letter of credit. To the extent the letter of credit is drawn by the beneficiary, reimbursement to the third party financial institution will be through reduction in amounts owed to RGA by the third party financial institution under a secured structured loan. RGA’s liability under the reinsurance agreement will be reduced by any amount drawn by the ceding company under the letter of credit. As of December 31, 2006, the structured loan totaled $5.1 million and the amount of the letter of credit totaled $5.1 million. The structured loan is recorded in “other invested assets” on RGA’s consolidated balance sheet.
The Company has established target asset portfolios for each major insurance product, which represent the investment strategies intended to profitably fund its liabilities within acceptable risk parameters. These strategies include objectives for effective duration, yield curve sensitivity and convexity, liquidity, asset sector concentration and credit quality.
The Company’s liquidity position (cash and cash equivalents and short-term investments) was $300.7 million and $255.0 million at December 31, 2006 and December 31, 2005, respectively. Liquidity needs are determined from valuation analyses conducted by operational units and are driven by product portfolios. Annual evaluations of demand liabilities and short-term liquid assets are designed to adjust specific portfolios, as well as their durations and maturities, in response to anticipated liquidity needs.
The Company’s asset-intensive products are primarily supported by investments in fixed maturity securities. Investment guidelines are established to structure the investment portfolio based upon the type, duration and behavior of products in the liability portfolio so as to achieve targeted levels of profitability. The Company manages the asset-intensive business to provide a targeted spread between the interest rate earned on investments and the interest rate credited to the underlying interest-sensitive contract liabilities. The Company periodically reviews models projecting different interest rate scenarios and their effect on profitability. Certain of these asset-intensive agreements, primarily in the U.S. operating segment, are generally funded by fixed maturity securities that are withheld by the ceding company.
The Company’s fixed maturity securities are invested primarily in commercial and industrial bonds, mortgage- and asset-backed securities, finance, public utilities, and Canadian government securities. As of December 31, 2006, approximately 97.1% of the Company’s consolidated investment portfolio of fixed maturity securities was investment-grade. Important factors in the selection of investments include diversification, quality, yield, total rate of return potential and call protection. The relative importance of these factors is determined by market conditions and the underlying product or portfolio characteristics. Cash equivalents are invested in high-grade money market instruments. The largest asset class in which fixed maturities were invested was in corporate securities, which represented approximately 54.2% of total fixed maturities at December 31, 2006, compared to 58.0% at December 31, 2005. Corporate securities are diversified by sector, with the majority in finance, commercial and industrial bonds. The average Standard and Poor’s (“S&P”) rating of corporate securities was A- at December 31, 2006.
Within the fixed maturity security portfolio, the Company holds approximately $2.0 billion in mortgage-backed securities at December 31, 2006, which include agency-issued pass-through securities, collateralized mortgage obligations guaranteed or otherwise supported by the Federal Home Loan Mortgage Corporation, Federal National Mortgage Association, or the Government National Mortgage Association, and commercial mortgage-backed securities. As of December 31, 2006, 99.9% of these securities were investment-grade. The principal risks inherent in holding residential mortgage-backed securities are prepayment and extension risks, which will affect the timing of when cash will be received and are dependent on the level of mortgage interest rates. Prepayment risk is the unexpected increase in principal payments, primarily as a result of homeowner refinancing. Extension risk relates to the unexpected slowdown in principal payments. The Company monitors its residential mortgage-backed securities to mitigate exposure to the cash flow uncertainties associated with these risks.
Within the fixed maturity security portfolio, the Company holds approximately $469.9 million in asset-backed securities at December 31, 2006, which include credit card and automobile receivables, home equity loans and collateralized bond obligations. The Company’s asset-backed securities are diversified by issuer and contain both floating and fixed-rate securities. The Company owns floating rate securities that represent approximately 12.6% of the total fixed maturity securities at December 31, 2006. These investments have a higher degree of income variability than the other fixed income holdings in the portfolio due to the floating rate nature of the interest payments. The majority of floating rate securities collateralize the notes issued by the Company’s collateral finance facility. See Note 15 - “Collateral Finance Facility” in the Notes to Consolidated Financial Statements for additional information. In addition to the risks associated with floating rate securities, principal risks in holding asset-backed securities are structural, credit and capital market risks. Structural risks include the securities’ priority in the issuer’s capital structure, the adequacy of and ability to realize proceeds from collateral, and the potential for prepayments. Credit risks include consumer or corporate credits such as credit card holders, equipment lessees, and corporate obligors. Capital market risks include general level of interest rates and the liquidity for these securities in the marketplace.
The following table presents the total gross unrealized losses for 982 fixed maturity securities and equity securities as of December 31, 2006, where the estimated fair value had declined and remained below amortized cost by the indicated amount (in thousands):
The Company believes that the analysis of each security whose price has been below market for greater than twelve months indicated that the financial strength, liquidity, leverage, future outlook and/or recent management actions support the view that the security was not other-than-temporarily impaired as of December 31, 2006. The unrealized losses on fixed maturity securities did not exceed 14.3% on an individual security basis and are primarily a result of rising interest rates, changes in credit spreads and the long-dated maturities of the securities.
Mortgage loans represented approximately 5.0% and 5.3% of the Company’s investments as of December 31, 2006 and 2005, respectively. As of December 31, 2006, all mortgages were U.S. based. The Company invests primarily in mortgages on commercial offices, industrial properties and retail locations. The Company’s mortgage loans generally range in size up to $11.0 million, with the average mortgage loan investment as of December 31, 2006 totaling approximately $4.2 million. The mortgage loan portfolio was diversified by geographic region and property type as discussed further in Note 4 - “Investments” in the Notes to Consolidated Financial Statements. Substantially all mortgage loans are performing and no valuation allowance has been established as of December 31, 2006 or 2005.
agreements written on a coinsurance basis, assets equal to the net statutory reserves are withheld and legally owned and managed by the ceding company, and are reflected as funds withheld at interest on the Company’s consolidated balance sheets. In the event of a ceding company’s insolvency, the Company would need to assert a claim on the assets supporting its reserve liabilities. However, the risk of loss to the Company is mitigated by its ability to offset amounts it owes the ceding company for claims or allowances with amounts owed by the ceding company. Interest accrues to these assets at rates defined by the treaty terms and the Company estimates the yield was approximately 7.08% for the year ended December 31, 2006. The Company is subject to the investment performance on the withheld assets, although it does not directly control them. These assets are primarily fixed maturity investment securities and pose risks similar to the fixed maturity securities the Company owns. To mitigate this risk, the Company helps set the investment guidelines followed by the ceding company and monitors compliance. Ceding companies with funds withheld at interest had an average A.M. Best rating of “A+”. Certain ceding companies maintain segregated portfolios for the benefit of the Company.
Based on data provided by the ceding companies as of December 31, 2006, the maturity distribution of the segregated portfolio portion of funds withheld at interest was approximately (in thousands):
The Company maintains a catastrophe insurance program (“Program”) that renews on August 13th of each year. The current Program began August 13, 2006, and covers events involving 10 or more insured deaths from a single occurrence. The Company retains the first $25 million in claims, the Program covers the next $50 million in claims, and the Company retains all claims in excess of $75 million. The Program covers only losses under North American guaranteed issue (corporate owned life insurance, bank owned life insurance, etc.) reinsurance programs and includes losses due to acts of terrorism, but excludes terrorism losses due to nuclear, chemical and/or biological events. The Program is insured by several insurance companies and Lloyd’s Syndicates, with no single entity providing more than $10 million of coverage.
given as additional security in favor of RGA Reinsurance. In addition, the Company performs annual financial and in force reviews of its retrocessionaires to evaluate financial stability and performance.
This risk arises from many of the Company’s primary activities, as the Company invests substantial funds in interest-sensitive assets and also has certain interest-sensitive contract liabilities. The Company manages interest rate risk and credit risk to maximize the return on the Company’s capital effectively and to preserve the value created by its business operations. As such, certain management monitoring processes are designed to minimize the effect of sudden and sustained changes in interest rates on fair value, cash flows, and net interest income. The Company manages its exposure to interest rates principally by matching floating rate liabilities with corresponding floating rate assets and by matching fixed rate liabilities with corresponding fixed rate assets. On a limited basis, the Company uses equity options to minimize its exposure to movements in equity markets that have a direct correlation with certain of its reinsurance products.
Interest rate sensitivity analysis is used to measure the Company’s interest rate price risk by computing estimated changes in fair value of fixed rate assets and liabilities in the event of a hypothetical 10% change in market interest rates. The Company does not have fixed rate instruments classified as trading securities. The Company’s projected loss in fair value of financial instruments in the event of a 10% unfavorable change in market interest rates at its fiscal years ended December 31, 2006 and 2005 was $415.4 million and $262.6 million, respectively.
Interest rate sensitivity analysis is also used to measure the Company’s interest rate cash flow risk by computing estimated changes in the cash flows expected in the near term attributable to floating rate assets and liabilities in the event of a range of assumed changes in market interest rates. This analysis assesses the risk of loss in cash flows in the near term in market risk sensitive floating rate instruments in the event of a hypothetical 10% change (increase or decrease) in market interest rates. The Company does not have variable rate instruments classified as trading securities. The Company’s projected decrease in cash flows in the near term associated with floating rate instruments in the event of a 10% unfavorable change in market interest rates at its fiscal years ended December 31, 2006 and 2005 was $0.5 million and $0.4 million, respectively.
Computations of prospective effects of hypothetical interest rate changes are based on numerous assumptions, including relative levels of market interest rates, and mortgage prepayments, and should not be relied on as indicative of future results. Further, the computations do not contemplate any actions management could undertake in response to changes in interest rates.
In September 2006, the FASB ratified the Emerging Issues Task Force (“EITF”) consensus on Issue 06-5. This issue titled “Accounting for the Purchases of Life Insurance - Determining the Amount That Could Be Realized in Accordance with FASB Technical Bulletin No. 85-4”, clarified that the amount of the DAC receivable beyond one year generally must be discounted to present value under Accounting Principles Board Opinion 21. The ratification is effective for reporting periods after December 15, 2006. The Company is currently evaluating the impact of EITF Issue 06-05 and does not expect that the pronouncement will have a material impact on the Company’s consolidated financial statements.
In September 2006, the SEC issued Staff Accounting Bulletin (“SAB”) No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements” (“SAB 108”). SAB 108 provides guidance on how prior year misstatements should be considered when quantifying misstatements in current year financial statements for purposes of assessing materiality. SAB 108 requires that a registrant assess the materiality of a current period misstatement by determining how the current period’s balance sheet would be affected in correcting a misstatement without considering the year(s) in which the misstatement originated and how the current period’s income statement is misstated, including the reversing effect of prior year misstatements. SAB 108 is effective for fiscal years ending after November 15, 2006. The cumulative effect of applying SAB 108 may be recorded by adjusting current year beginning balances of the affected assets and liabilities with a corresponding adjustment to the current year opening balance in retained earnings if certain criteria are met. The adoption of SAB 108 did not have a material impact on the Company’s consolidated financial statements.
In September 2006, the FASB issued SFAS 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans - an amendment of FASB Statements No. 87, 88, 106, and 132(r)” (“SFAS 158”). The pronouncement revises financial reporting standards for defined benefit pension and other postretirement plans by requiring the (i) recognition in the statement of financial position of the funded status of defined benefit plans measured as the difference
In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS 157”). SFAS 157 defines fair value, establishes a framework for measuring fair value in GAAP and requires enhanced disclosures about fair value measurements. SFAS 157 does not require any new fair value measurements. The pronouncement is effective for fiscal years beginning after November 15, 2006. The guidance in SFAS 157 will be applied prospectively with the exception of: (i) block discounts of financial instruments; (ii) certain financial and hybrid instruments measured at initial recognition under SFAS 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”); both of which are to be applied retrospectively as of the beginning of initial adoption (a limited form of retrospective application). The Company is currently evaluating the impact of SFAS 157 and does not expect that the pronouncement will have a material impact on the Company’s consolidated financial statements.
In June 2006, the FASB issued FIN No. 48, “Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income tax recognized in a company’s financial statements. FIN 48 requires companies to determine whether it is “more likely than not” that a tax position will be sustained upon examination by the appropriate taxing authorities before any part of the benefit can be recorded in the financial statements. It also provides guidance on the recognition, measurement and classification of income tax uncertainties, along with any related interest and penalties. Previously recorded income tax benefits that no longer meet this standard are required to be charged to earnings in the period that such determination is made. FIN 48 will also require significant additional disclosures. FIN 48 is effective for fiscal years beginning after December 15, 2006. The Company will adopt FIN 48 as of January 1, 2007, as required. Based upon the Company’s evaluation work completed to date, the Company expects to recognize an increase of approximately $25.2 million in the liability for unrecognized tax benefits, which will be accounted for as a reduction to the January 1, 2007 balance of retained earnings.
The Company is primarily engaged in life reinsurance. Reinsurance is an arrangement under which an insurance company, the reinsurer, agrees to indemnify another insurance company, the ceding company, for all or a portion of the insurance risks underwritten by the ceding company. Reinsurance is designed to (i) reduce the net liability on individual risks, thereby enabling the ceding company to increase the volume of business it can underwrite, as well as increase the maximum risk it can underwrite on a single life or risk; (ii) stabilize operating results by leveling fluctuations in the ceding company’s loss experience; (iii) assist the ceding company to meet applicable regulatory requirements; and (iv) enhance the ceding company’s financial strength and surplus position.
Consolidation and Basis of Presentation. The consolidated financial statements of the Company have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the reported amounts of revenues and expenses during the reporting period. The most significant estimates include those used in determining deferred policy acquisition costs, premiums receivable, future policy benefits, other policy claims and benefits, including incurred but not reported claims, provision for adverse litigation, and valuation of investment impairments. Actual results could differ materially from the estimates and assumptions used by management.
Impairments in the value of securities held by the Company, considered to be other than temporary, are recorded as a reduction of the book value of the security, and a corresponding realized investment loss is recognized in the consolidated statements of income. The Company’s policy is to recognize such impairment when the projected cash flows of these
Unrealized gains and losses on marketable equity securities and fixed maturity securities classified as available for sale, less applicable deferred income taxes as well as related adjustments to deferred acquisition costs, if applicable, are reflected as a direct charge or credit to accumulated other comprehensive income in stockholders’ equity on the consolidated balance sheets.
Change in value of embedded derivatives reflects the change in the market value of specific financial instruments as required upon the adoption of Statement of Financial Accounting Standards (“SFAS”) No. 133 Implementation 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” (“Issue B36”).
Substantially all of the Company’s funds withheld at interest balance is associated with its reinsurance of annuity contracts. The funds withheld at interest balance totaled $4.1 billion and $3.5 billion at December 31, 2006 and 2005, respectively, of which $2.9 billion and $2.3 billion, respectively, were subject to the provisions of Issue B36. Management believes the embedded derivative feature in each of these reinsurance treaties is similar to a total return swap on the assets held by the ceding companies. The change in fair value, which is a non-cash item, also affects the amortization of deferred acquisition costs since the Company is required to include it in its expectation of gross profits. At December 31, 2006 and 2005, the fair value of the embedded derivative totaled $56.8 million and $50.3 million, respectively, and is included in the funds withheld at interest line item on the consolidated balance sheets. Subsequent to the initial adoption of Issue B36, the change in the market value of the underlying is recorded in the consolidated statements of income as change in value of embedded derivatives.
Premiums Receivable. Premiums are accrued when due and in accordance with information received from the ceding company. When a ceding company fails to report information on a timely basis, the Company records accruals based on the terms of the reinsurance treaty as well as historical experience. Other management estimates include adjustments for lapsed premiums given historical experience, the financial health of specific ceding companies, collateral value and the legal right of offset on related amounts (i.e. allowances and claims) owed to the ceding company. Under the legal right of offset provisions in its reinsurance treaties, the Company can withhold payments for allowances and claims for unpaid premiums. Based on its review of these factors and historical experience, the Company did not believe a provision for doubtful accounts was necessary as of December 31, 2006 or 2005.
Deferred Policy Acquisition Costs. Costs of acquiring new business, which vary with and are primarily related to the production of new business, have been deferred to the extent that such costs are deemed recoverable from future premiums or gross profits. Such costs include commissions and allowances as well as certain costs of policy issuance and underwriting. The Company performs periodic tests to establish that DAC remains recoverable, and if financial performance significantly deteriorates to the point where a premium deficiency exists, a cumulative charge to current operations will be recorded. No such adjustments were made during 2006, 2005 or 2004. Deferred costs related to traditional life insurance contracts, substantially all of which relate to long-duration contracts, are amortized over the premium-paying period of the related policies in proportion to the ratio of individual period premium revenues to total anticipated premium revenues over the life of the policy. Such anticipated premium revenues are estimated using the same assumptions used for computing liabilities for future policy benefits.
Other Reinsurance Balances. The Company assumes and retrocedes financial reinsurance contracts that represent low mortality risk reinsurance treaties. These contracts are reported as deposits and are included in other reinsurance assets/liabilities. The amount of revenue reported in other revenues on these contracts represents fees and the cost of insurance under the terms of the reinsurance agreement. Balances resulting from the assumption and/or subsequent transfer
Other Assets. In addition to the goodwill and value of business acquired previously discussed, other assets primarily includes separate accounts, unamortized debt issuance costs, capitalized software, and other capitalized assets. Capitalized software is stated at cost, less accumulated amortization. Purchased software costs, as well as internal and external costs incurred to develop internal-use computer software during the application development stage, are capitalized. As of December 31, 2006 and 2005, the Company had unamortized computer software costs of approximately $19.2 million and $18.9 million, respectively. During 2006, 2005 and 2004, the Company amortized computer software costs of $3.0 million, $5.7 million, and $2.2 million, respectively. Amortization of software costs is recorded on a straight-line basis over periods ranging from three to ten years. Carrying values are reviewed periodically for indicators of impairment in value. The amortization in 2005 includes an asset impairment charge of $2.7 million.
The Company reinsures asset-intensive products, including annuities and corporate-owned life insurance. The investment portfolios for these products are segregated for management purposes within the general account of RGA Reinsurance. The liabilities under asset-intensive reinsurance contracts are included in interest-sensitive contract liabilities on the consolidated balance sheets.
Other Policy Claims and Benefits. Claims payable for incurred but not reported losses are determined using case basis estimates and lag studies of past experience. The time lag from the date of the claim or death to when the ceding company reports the claim to the Company can vary significantly by ceding company and business segment, but generally averages around 2.8 months on a consolidated basis. The Company updates its analysis of incurred but not reported, including lag studies, on a quarterly basis and adjusts its claim liabilities accordingly.
Company-Obligated Mandatorily Redeemable Preferred Securities of Subsidiary Trust Holding Solely Junior Subordinated Debentures of the Company. During December 2001, RGA Capital Trust I (the “Trust”), a wholly-owned subsidiary of RGA, sold Preferred Income Equity Redeemable Securities (“PIERS”) Units. Each unit consists of a preferred security (“Preferred Securities”) issued by the Trust with a detachable warrant to purchase 1.2508 shares of RGA common stock. The Trust sold 4.5 million PIERS units. The market value of the Preferred Securities on the date issued ($158.1 million) was recorded in liabilities on the consolidated balance sheets under the caption “Company-obligated mandatorily redeemable preferred securities of subsidiary trust holding solely junior subordinated debentures”. The coupon rate of the Preferred Securities is 5.75% on a face amount of $225.0 million.
Warrants. The market value of the detachable warrants on the date the PIERS units were issued is recorded in stockholders’ equity on the consolidated balance sheets under the caption “Warrants”. In the aggregate as of December 31, 2006, 4.5 million warrants to purchase approximately 5.6 million shares of Company common stock at a price per share of $39.98 were outstanding. If on any date after December 18, 2004, the closing price of RGA common stock exceeds and has exceeded a price per share equal to $47.97 for at least 20 trading days within the immediately preceding 30 consecutive trading days, the Company may redeem the warrants in whole for cash, RGA common stock, or a combination of cash and RGA common stock.
Recognition of Revenues and Related Expenses. Life and health premiums are recognized as revenue when due from the insured, and are reported net of amounts retroceded. Benefits and expenses are reported net of amounts retroceded and are associated with earned premiums so that profits are recognized over the life of the related contract. This association is accomplished through the provision for future policy benefits and the amortization of deferred policy acquisition costs. Other revenue includes items such as treaty recapture fees, and fees associated with financial reinsurance. Any fees that are collected in advance of the period benefited are deferred and recognized over the period benefited. Initial reserve changes are netted against premiums when an in force block of business is reinsured.
Revenues for interest-sensitive and investment-type products consist of investment income, policy charges for the cost of insurance, policy administration, and surrenders that have been assessed against policy account balances during the period. Interest-sensitive contract liabilities for these products represent policy account balances before applicable surrender charges. Deferred policy acquisition costs are recognized as expenses over the term of the policies. Policy benefits and claims that are charged to expenses include claims incurred in the period in excess of related policy account balances and interest credited to policy account balances. The weighted average interest-crediting rates for interest-sensitive products were 4.3%, 4.1% and 4.5%, during 2006, 2005 and 2004, respectively. The weighted average interest-crediting rates for U.S. dollar-denominated investment-type contracts ranged from 2.5% to 4.8% during 2006, 3.2% to 5.8% during 2005 and 2.8% to 5.9% during 2004.
New Accounting Pronouncements. In September 2006, the FASB ratified the Emerging Issues Task Force (“EITF”) consensus on Issue 06-5. This issue titled “Accounting for the Purchases of Life Insurance - Determining the Amount That Could Be Realized in Accordance with FASB Technical Bulletin No. 85-4”, clarified that the amount of the DAC receivable beyond one year generally must be discounted to present value under Accounting Principles Board Opinion 21. The ratification is effective for reporting periods after December 15, 2006. The Company is currently evaluating the impact of EITF Issue 06-05 and does not expect that the pronouncement will have a material impact on the Company’s consolidated financial statements.
In February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid Instruments” (“SFAS 155”). SFAS 155 amends SFAS No. 133 and SFAS 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities”. SFAS 155 allows financial instruments that have embedded derivatives to be accounted for as a whole, eliminating the need to bifurcate the derivative from its host, if the holder elects to account for the whole instrument on a fair value basis. In addition, among other changes, SFAS 155 (i) clarifies which interest-only strips and principal-only strips are not subject to the requirements of SFAS 133; (ii) establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation; (iii) clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives; and (iv) eliminates the prohibition on a qualifying special-purpose entity (“QSPE”) from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial interest. The Company
Reclassification. The Company has reclassified the presentation of certain prior period information to conform to the 2006 presentation.
On December 12, 2005, RGA entered into an accelerated share repurchase (“ASR”) agreement with a financial counterparty. Under the ASR agreement, RGA purchased 1,600,000 shares of its outstanding common stock at an initial price of $47.43 per share and at an aggregate price of approximately $75.9 million. The counterparty completed its purchases during the first quarter of 2006 and as a result, the Company was required to pay $194 thousand to the counterparty for the final settlement which resulted in a final price of $47.55 per share on the repurchased common stock. The common shares repurchased have been placed into treasury to be used for general corporate purposes. The repurchase of shares pursuant to the ASR agreement is in addition to the Company’s previously announced stock repurchase authorization.
As of December 31, 2006, the Company held securities with a market value of $582.2 million issued by the Federal Home Loan Mortgage Corporation, $450.0 million issued by the Federal National Mortgage Corporation, $545.0 million that were issued by a Canadian province, and $481.7 million in one entity that were guaranteed by a Canadian province, all of which exceeded 10% of consolidated stockholders’ equity. As of December 31, 2005, the Company held securities with a market value of $586.1 million issued by the Federal Home Loan Mortgage Corporation, $407.4 million issued by the Federal National Mortgage Corporation, $485.7 million in one entity were guaranteed by a Canadian province, and $454.0 million in one entity that was guaranteed by a Canadian province, all of which exceeded 10% of consolidated stockholders’ equity.
The amortized cost and estimated fair value of fixed maturity securities available-for-sale at December 31, 2006 are shown by contractual maturity for all securities except certain U.S. government agencies securities, which are distributed to maturity year based on the Company’s estimate of the rate of future prepayments of principal over the remaining lives of the securities. These estimates are developed using prepayment rates provided in broker consensus data. Such estimates are derived from prepayment rates experienced at the interest rate levels projected for the applicable underlying collateral and can be expected to vary from actual experience. Actual maturities can differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
The following table presents the total gross unrealized losses for 982 and 679 fixed maturity securities and equity securities as of December 31, 2006 and 2005, respectively, where the estimated fair value had declined and remained below amortized cost by the indicated amount (in thousands):
The following tables present the estimated fair values and gross unrealized losses for the 982 and 679 fixed maturity securities and equity securities that have estimated fair values below amortized cost as of December 31, 2006 and 2005, respectively. These investments are presented by class and grade of security, as well as the length of time the related market value has remained below amortized cost.
The Company believes that the analysis of each security whose price has been below market for greater than twelve months indicated that the financial strength, liquidity, leverage, future outlook, and the Company’s ability and intent to hold the security until recovery support the view that the security was not other-than-temporarily impaired as of December 31, 2006. The unrealized losses on fixed maturity securities did not exceed 14.3% on an individual security basis and are primarily a result of rising interest rates, changes in credit spreads and the long-dated maturities of the securities.
All of the Company’s mortgage loans are amortizing loans. As of December 31, 2006 and 2005, the Company’s mortgage loans were distributed as follows (in thousands):
All mortgage loans are performing and no valuation allowance had been established as of December 31, 2006 and 2005.
Funds withheld at interest comprised approximately 28.3% and 28.1% of the Company’s investments as of December 31, 2006 and 2005, respectively. Of the $4.1 billion funds withheld at interest balance as of December 31, 2006, $2.8 billion of the balance is associated with one client. For agreements written on a modified coinsurance basis and certain agreements written on a coinsurance funds withheld basis, assets equal to the net statutory reserves are withheld and legally owned and managed by the ceding company and are reflected as funds withheld at interest on the Company’s consolidated balance sheets. In the event of a ceding company’s insolvency, the Company would need to assert a claim on the assets supporting its reserve liabilities. However, the risk of loss to the Company is mitigated by its ability to offset amounts it owes the ceding company for claims or allowances with amounts owed to the Company from the ceding company. Interest accrues to these assets at rates defined by the treaty terms and the Company estimates the yield was approximately 7.08%, 6.63% and 7.51% for the years ended December 31, 2006, 2005 and 2004, respectively. In most cases, the Company is subject to the investment performance on the funds withheld assets, although it does not control them. To mitigate this risk, the Company helps set the investment guidelines followed by the ceding company and monitors compliance.
Publicly traded fixed maturity securities are valued based upon quoted market prices. Private placement securities are valued based on the credit quality and duration of marketable securities deemed comparable by the Company’s investment advisor, which may be of another issuer. The fair value of mortgage loans on real estate is estimated using discounted cash flows. Policy loans typically carry an interest rate that is tied to the crediting rate applied to the related policy and contract reserves. The carrying value of funds withheld at interest approximates fair value except where the funds withheld are specifically identified in the agreement. The carrying value of short-term investments at December 31, 2006 and 2005 approximates fair
Retrocession reinsurance treaties do not relieve the Company from its obligations to direct writing companies. Failure of retrocessionaires to honor their obligations could result in losses to the Company. Consequently, allowances would be established for amounts deemed uncollectible. At December 31, 2006 and 2005, no allowances were deemed necessary. The Company regularly evaluates the financial condition of its reinsurers and retrocessionaires.
The effect of reinsurance on net premiums is as follows (in thousands):
At December 31, 2006 and 2005, there were no reinsurance ceded receivables associated with a single reinsurer with a carrying value in excess of 5% of total assets.
At December 31, 2006, the Company has provided approximately $1.8 billion of statutory financial reinsurance, as measured by pre-tax statutory surplus, to other insurance companies under financial reinsurance transactions to assist ceding companies in meeting applicable regulatory requirements. Generally, such financial reinsurance is provided by the Company committing cash or assuming insurance liabilities, which are collateralized by future profits on the reinsured business. The Company retrocedes the majority of the assumed financial reinsurance. The Company earns a fee based on the amount of net outstanding financial reinsurance.
During 2006, 2005, and 2004, the Company received federal income tax refunds and foreign tax credit reimbursements of approximately $46.3 million, $32.3 million and $1.4 million, respectively. The Company made cash income tax payments of approximately $12.9 million, $79.3 million and $29.9 million in 2006, 2005 and 2004, respectively. At December 31, 2006 and 2005, the Company recognized gross deferred tax assets associated with net operating losses of approximately $2.2 billion and $1.6 billion, respectively, that will expire between 2019 and 2026. However, these net operating losses are expected to be utilized in the normal course of business during the period allowed for carryforwards and in any event, are not expected to be lost due to the application of tax planning strategies that management would utilize.
The following table presents additional year-end information for pension plans based on the excess or shortfall of plan assets as compared to the accumulated benefit obligation (“ABO”) as of December 31, 2006 and 2005 (in thousands):
The components of net periodic benefit cost were as follows (in thousands):
The Company expects to contribute to the plans $8.3 million in pension benefits and $0.2 million in other benefits during 2007.
The estimated net loss and prior service cost for the defined benefit pension plans that will be amortized from accumulated other comprehensive income into net periodic benefit cost over the next fiscal year are $0.7 and $0.1 million, respectively.
Target allocations of assets are determined with the objective of maximizing returns and minimizing volatility of net assets through adequate asset diversification and partial liability immunization. Adjustments are made to target allocations based on the Company’s assessment of the effect of economic factors and market conditions.
General American and MetLife have historically provided certain administrative services to RGA and RGA Reinsurance. Such services include risk management and corporate travel. The cost of these services for the years ended December 31, 2006, 2005 and 2004 was approximately $2.4 million, $1.7 million and $1.0 million, respectively.
The Company also has arms-length direct policies and reinsurance agreements with MetLife and certain of its subsidiaries. As of December 31, 2006, the Company had reinsurance related assets, excluding investments allocated to support the business, and liabilities from these agreements totaling $114.6 million and $306.7 million, respectively. Prior-year comparable assets and liabilities were $121.9 million and $277.8 million, respectively. Additionally, the Company reflected net premiums of approximately $227.8 million, $226.7 million and $164.4 million in 2006, 2005 and 2004, respectively. The premiums reflect the net of business assumed from and ceded to MetLife and its subsidiaries. The pre-tax income (loss), excluding investment income allocated to support the business, was approximately $10.9 million, ($11.3) million and $22.4 million in 2006, 2005 and 2004, respectively.
The Company leases office space and furniture and equipment under non-cancelable operating lease agreements, which expire at various dates. Future minimum office space annual rentals under non-cancelable operating leases at December 31, 2006 are as follows:
Note 12 FINANCIAL CONDITION AND NET INCOME ON A STATUTORY BASIS - SIGNIFICANT SUBSIDIARIES
The following table presents selected statutory financial information for the Company’s primary life reinsurance legal entities, as of or for the years ended December 31, 2006 , 2005, and 2004 (in thousands):
The total capital and surplus positions of RCM, RGA Reinsurance and RGA Canada exceed the risk-based capital requirements of the applicable regulatory bodies. RCM and RGA Reinsurance are subject to Missouri statutory provisions that restrict the payment of dividends. They may not pay dividends in any 12-month period in excess of the greater of the prior year’s statutory operating income or 10% of capital and surplus at the preceding year-end, without regulatory approval. The applicable statutory provisions only permit an insurer to pay a shareholder dividend from unassigned surplus. Any dividends paid by RGA Reinsurance would be paid to RCM, its parent company, which in turn has restrictions related to its ability to pay dividends to RGA. The assets of RCM consist primarily of its investment in RGA Reinsurance. As of January 1, 2007, RCM and RGA Reinsurance could pay maximum dividends, without prior approval, of approximately $55.7 million and $105.1 million, respectively. However, on December 19, 2006, RCM received approval from the Missouri Department of Insurance that allows RCM to pay a dividend to RGA to the extent RCM received the dividend from RGA Re, without limitation related to the level of unassigned surplus. Thus, RCM’s allowable dividend is $104.6 million to the extent that amount has been received from RGA Re. Dividend payments by other subsidiaries are subject to regulations in the jurisdiction of domicile.
The Company has commitments to fund investments in mortgage loans and limited partnerships in the amount of $19.9 million and $32.7 million, respectively, at December 31, 2006. The Company anticipates that the majority of these amounts will be invested over the next five years, however, contractually these commitments could become due at the request of the counterparties. Investments in mortgage loans and limited partnerships are carried at cost and included in total investments in the consolidated balance sheets.
The Company is currently a party to three arbitrations that involve its discontinued accident and health business, including personal accident business (including London market excess of loss business) and workers’ compensation carve-out business. The Company is also a party to a threatened arbitration related to its life reinsurance business. As of January 31, 2007, the parties involved in these actions have raised claims, or established reserves that may result in claims, in the amount of $27.3 million, which is $26.6 million in excess of the amounts held in reserve by the Company. The Company generally has little information regarding any reserves established by the ceding companies, and must rely on management estimates to establish policy claim liabilities. It is possible that any such reserves could be increased in the future. The Company believes it has substantial defenses upon which to contest these claims, including but not limited to misrepresentation and breach of contract by direct and indirect ceding companies. See Note 20, “Discontinued Operations” for more information. Additionally, from time to time, the Company is subject to litigation related to employment-related matters in the normal course of its business. The Company cannot predict or determine the ultimate outcome of the pending litigation or arbitrations or provide useful ranges of potential losses, it is the opinion of management, after consultation with counsel, that their outcomes, after consideration of the provisions made in the Company’s consolidated financial statements, would not have a material adverse effect on its consolidated financial position. However, it is possible that an adverse outcome could, from time to time, have a material adverse effect on the Company’s consolidated net income in particular quarterly or annual periods.
In December 2005, RGA issued Junior Subordinated Debentures with a face amount of $400.0 million. Interest is payable semi-annually and is fixed at 6.75% per year until December 15, 2015. From December 15, 2015 until December 15, 2065, interest on the debentures will accrue at an annual rate of 3-month LIBOR plus a margin equal to 266.5 basis points, payable quarterly. RGA has the option to defer interest payments, subject to certain limitations. In addition, interest payments are
Certain of the Company’s debt agreements contain financial covenant restrictions related to, among others, liens, the issuance and disposition of stock of restricted subsidiaries, minimum requirements of consolidated net worth, maximum ratios of debt to capitalization, change of control provisions, and minimum rating requirements. A material ongoing covenant default could require immediate payment of the amount due, including principal, under the various agreements. Additionally, the Company’s debt agreements contain cross-default covenants, which would make outstanding borrowings immediately payable in the event of a material uncured covenant default under any of the agreements, including, but not limited to, non-payment of indebtedness when due for amounts greater than $25 million or $50 million depending on the agreement, bankruptcy proceedings, and any other event which results in the acceleration of the maturity of indebtedness. As of December 31, 2006, the Company had $705.5 million in outstanding borrowings under its debt agreements and was in compliance with all covenants under those agreements. The ability of the Company to make debt principal and interest payments depends on the earnings and surplus of subsidiaries, investment earnings on undeployed capital proceeds, and the Company’s ability to raise additional funds.
The Company adopted the RGA Flexible Stock Plan (the “Plan”) in February 1993, as amended, and the Flexible Stock Plan for Directors (the “Directors Plan”) in January 1997, as amended, (collectively, the “Stock Plans”). The Stock Plans provide for the award of benefits (collectively “Benefits”) of various types, including stock options, stock appreciation rights (“SARs”), restricted stock, performance shares, cash awards, and other stock-based awards, to key employees, officers, directors and others performing significant services for the benefit of the Company or its subsidiaries. As of December 31, 2006, shares authorized for the granting of Benefits under the Plan and the Directors Plan totaled 6,260,077 and 212,500, respectively.
In general, options granted under the Plan become exercisable over vesting periods ranging from one to eight years while options granted under the Directors Plan become exercisable after one year. Options are generally granted with an exercise
price equal to the stock’s fair value at the date of grant and expire 10 years after the date of grant. Information with respect to option grants under the Stock Plans follows.
The intrinsic value of options exercised was $9.6 million, $4.7 million, and $6.3 million for 2006, 2005, and 2004, respectively.
The Black-Scholes model was used to determine the fair value of stock options granted and recognized in the financial statements. The Company used daily historical volatility when calculating stock option values. The risk-free rate is based on observed interest rates for instruments with maturities similar to the expected term of the stock options. Dividend yield is determined based on historical dividend distributions compared to the price of the underlying common stock as of the valuation date and held constant over the life of the stock options. The Company estimated expected life using the historical average years to exercise or cancellation. The per share weighted-average fair value of stock options granted during 2006, 2005 and 2004 was $16.06, $17.35 and $12.81 on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions: 2006-expected dividend yield of 0.76%, risk-free interest rate of 4.35%, expected life of 6.0 years, and an expected rate of volatility of the stock of 28.4% over the expected life of the options; 2005-expected dividend yield of 0.76%, risk-free interest rate of 3.86%, expected life of 6.0 years, and an expected rate of volatility of the stock of 33.47% over the expected life of the options; and 2004-expected dividend yield of 0.61%, risk-free interest rate of 3.30%, expected life of 6.0 years, and an expected rate of volatility of the stock of 28.7% over the expected life of the options.
During 2006, 2005 and 2004 the Company also issued 144,097, 126,305 and 128,693 performance contingent units (“PCUs”) to key employees at a weighted average fair value per unit of $47.47, $47.45 and $39.61, respectively. As of December 31, 2006, 144,097, 124,397 and 123,686 PCUs were outstanding from the 2006, 2005 and 2004 grants, respectively. Each PCU represents the right to receive up to two shares of Company common stock, depending on the results of certain performance measures over a three-year period. The compensation expense related to the PCUs is recognized ratably over the requisite performance period. In February 2007, the board of directors approved a 2.0 share payout for each PCU granted in 2004, resulting in the issuance of 242,613 shares of common stock from treasury.
As of December 31, 2006, there was $17.0 million of unrecognized compensation costs related to equity-based grants or awards. It is estimated that these costs will vest over a weighted average period of 2.2 years.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Reinsurance Group of America, Incorporated and subsidiaries as of December 31, 2006 and 2005, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2006, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects the information set forth therein.
Reinsurance Group of America, Incorporated common stock is traded on the New York Stock Exchange (NYSE) under the symbol “RGA”.