The following table sets forth a consolidated summary of selected financial data for the company and its subsidiaries (all significant intercompany accounts have been eliminated) for each of the last ten years. In this table the year ended December 31, 1987 has been restated to reflect the implementation of SFAS No. 97 in 1988. In addition, the years ended December 31, 1987 through 1991 have been restated to reflect the sale of Younkers, Inc. in 1992 and treatment of that entity as a discontinued operation. This summary should be read in conjunction with the related consolidated financial statements and notes thereto.
SELECTED FINANCIAL DATA - CONTINUED (Dollars in thousands, except per share data)
The acquisition was accounted for as a purchase and, accordingly, 1996 results of operations include the operations of BT Variable and its subsidiaries, Golden American and DSI, from the date of acquisition. Prior periods do not include the operations of BT Variable. Certain additional information has been provided in this discussion on a pro forma combined basis, as if the operations of BT Variable had been included in prior periods, to assist the reader in assessing the operations and prospects of the company as it is currently comprised. The following table includes premiums of Golden American since its acquisition on August 13, 1996.
Total annuity and life insurance premiums increased 13.6% to $1,811,521,000 in 1996 compared to a decrease of 8.0% to $1,594,771,000 in 1995 from $1,733,304,000 in 1994. Fixed annuity premiums decreased 10.0% in 1996 compared to a decrease of 13.6% in 1995 from 1994 due to continued contraction in the fixed annuity marketplace. Variable annuity premiums continue to reflect strong growth, with a 521.1% increase in 1996 compared to 2,305.4% increase in 1995 from 1994. This increase is due, in part, to the August 13, 1996 acquisition of Golden American, recent strong market returns, and the company's marketing efforts. Golden American reported variable annuity premiums of $169,259,000 and variable life premiums of $3,619,000 from August 14 to December 31, 1996. Equitable Life introduced its variable annuity product in the fourth quarter of 1994. Variable annuities have grown as a percentage of the company's total premiums due to market conditions which have made products with variable returns relatively more attractive than products with fixed returns, expansion of variable product offerings and growth and diversification of distribution channels. As a result, variable annuity premiums have grown to 23.5% of total premiums in 1996, compared to 0.2% in 1994. During the same period, fixed annuity premiums have declined to 69.4% of total premiums in 1996, compared to 93.3% in 1994, while life insurance premiums have remained at approximately 7% of total premiums.
Based on preliminary estimates from Life Insurance Marketing and Research Association ("LIMRA") data, fixed annuity premiums for the industry appear to have fallen an average of 27% for the year ended December 31, 1996, while the company's fixed annuity premiums were off 10% for the same period. The decrease in fixed annuity premiums during 1996 reflects the impact of a relatively low interest rate environment, flat yield curve and strong stock market returns. In such an environment, the returns provided by variable annuities and mutual funds are relatively more attractive than fixed annuity returns, placing pressure on fixed annuity sales. The acquisition of Golden American has complemented and significantly enhanced the company's existing variable annuity business. As a result of the acquisition, the company has expanded the distribution of its variable products, and plans to continue this expansion as well as market fixed products through Golden American's distribution system. While fixed annuity sales are lower than in previous periods, the company believes that the product diversification achieved with the acquisition of Golden American, expansion and diversification of distribution channels, its commitment to customer service, the quality of its investment portfolio, competitive pricing and its overall financial strength will continue to attract consumers to its annuity products as consumers seek a secure return on their retirement savings. The diversity of products and distribution channels the company now offers is intended to improve the stability of sales under a variety of market conditions. Insurance agents and broker/dealers are attracted to sell the company's products by several factors, including the company's diversified product portfolio, competitive commissions, rapid policy issuance and weekly commission payments.
Total revenues increased 13.6% to $868,675,000 in 1996 compared to an increase of 17.4% to $764,862,000 in 1995 from $651,660,000 in 1994. Annuity and interest sensitive life insurance product charges increased 38.7% in 1996 compared to an increase of 17.6% in 1995. Excluding Golden American, annuity and interest sensitive life product charges increased 21.7% in 1996. These product charges consist primarily of cost of insurance charges, policy administrative charges and surrender charges that increase as the company's policyholder liabilities, including variable separate account liabilities, grow. In addition, withdrawals and surrenders of the company's annuity products which contain a "market value adjustment" feature generate greater surrender charge income as interest rates increase and lower surrender charge income as interest rates decrease. Surrender charge income allows the company to recover a portion of the expenses incurred to generate policy sales and partially offsets the amortization of deferred policy acquisition costs related to surrendered policies. Premiums from traditional life insurance products, which are included in revenue, decreased 8.9% in 1996 compared to a decrease of 6.1% in 1995 as a result of the company's continued emphasis on the more popular universal life and fixed premium, current interest life insurance products (for which premiums are not included in revenues).
Total insurance benefits and expenses increased 4.0% to $638,210,000 in 1996 compared to an increase of 27.3% to $613,905,000 in 1995 from $482,499,000 in 1994. Interest credited to fixed annuity and interest sensitive life account balances increased 13.7% to $443,443,000 in 1996 compared to an increase of 21.8% to $390,039,000 in 1995 from $320,312,000 in 1994 as a result of higher account balances associated with those products. Excluding Golden American, interest credited to fixed annuity and interest sensitive life account balances increased 12.2% in 1996. The amortization of financial instruments purchased for the company's hedging program during the second quarter increased interest credited to account balances by $3,081,000 during 1996. See further discussion of the hedging program in the Financial Instruments - Risk Management section below.
The company's policy is to change rates credited to policy accounts as the company's investment portfolio yield changes. Most of the company's interest sensitive products, including fixed annuities, interest sensitive life policies and participating policies, allow for interest rate adjustments at least annually. The company also sells deferred annuities with multi-year interest rate guarantees. The design of these products makes them more competitive with savings alternatives such as certificates of deposit. As a result, sales of these products have grown as sales through banks and financial institutions have grown. The 1996 sales of these products totaled approximately $260,000,000 and policy reserves were $361,994,000, or 5%, of fixed annuity reserves, at December 31, 1996. The following table summarizes the effective annual yield on assets invested to support policy accounts for interest-sensitive products, the average interest rate credited to those products and the interest spread for the years ended December 31, 1996, 1995 and 1994. Yield on assets and cost of funds are estimated by calculating the weighted average of the twelve month end values for those items. Golden American is included in the tables below for periods since its acquisition by the company.
Death benefits on traditional life products and benefit claims incurred in excess of account balances decreased 13.1% to $32,209,000 in 1996 compared to an increase of 12.3% to $37,073,000 in 1995 from $33,020,000 in 1994. After adjustment for charges for mortality risk, reserves released on death claims and taxes, the overall impact of mortality on net income was more favorable in 1996 compared to 1995 by approximately $4,405,000 and less favorable in 1995 compared to 1994 by $1,409,000. Other benefits decreased 49.0% to $21,261,000 in 1996 compared to an increase of 27.1% to $41,661,000 in 1995 from $32,780,000 in 1994. The decrease in other benefits in 1996 is primarily attributable to the coinsurance of a small block of disability income business in 1995 which affected only the 1995 amount. The 1995 increase in other benefits caused by the coinsurance was offset by a corresponding reduction in future policy benefits and, therefore, had only a minor impact on net income in 1995.
Commissions decreased 4.4% to $139,705,000 in 1996 compared to a decrease of 7.0% to $146,069,000 in 1995 from $157,028,000 in 1994. Excluding Golden American, commissions decreased 11.1% in 1996. Insurance taxes decreased 82.3% to $8,063,000 in 1996 compared to an increase of 356.5% to $45,472,000 in 1995 from $9,961,000 in 1994. Increases and decreases in commissions and insurance taxes are generally related to changes in the level of annuity sales. Insurance taxes reported in 1995 included a special reserve accrual for future guaranty fund assessments totaling $36,000,0000. Excluding this amount, insurance taxes decreased 14.9% from 1995 to 1996. Most costs incurred as the result of new sales have been deferred, thus having very little impact on current earnings.
The company currently has fixed annuity products available for sale through stockbrokers. Prior to the second quarter of 1995, the company had not actively solicited fixed annuity sales through stockbrokers since 1989. The variable products sold through Golden American are primarily sold by stockbrokers. The company plans to continue to expand its distribution channels to include stockbrokers, banks and other financial institutions in addition to its current independent and career agency distribution channels.
The amortization of deferred policy acquisition costs increased 9.7% to $79,550,000 in 1996 compared to an increase of 42.5% to $72,537,000 in 1995 from $50,921,000 in 1994. Increases in amortization of deferred acquisition costs related to operating earnings are the result of increases in the deferred policy acquisition cost asset (before adjustment to reflect the impact of SFAS No. 115) as costs of generating sales of the company's products are deferred and amortized in later periods. Also, higher withdrawals and surrenders of the company's products have accelerated the amortization of deferred acquisition costs related to those products although surrender charges assessed on certain withdrawals offset some of the earnings impact of this accelerated amortization. Amortization related to realized gains continues to decline as a result of the decrease in realized and prepayment gains from assets backing fixed annuity and interest sensitive life insurance liabilities.
As a part of the acquisition of Golden American, $85,796,000 of the cost was allocated to the right to receive future cash flows from the insurance contracts existing with Golden American at the date of acquisition. This allocated cost represents the present value of in force acquired ("PVIF") which reflects the value of those purchased policies calculated by discounting the actuarially determined expected future cash flows at the discounted rate determined by the company. Amortization of PVIF totaled $2,745,000 in 1996. Based on current conditions and assumptions as to the impact of future events on acquired policies in force, amortization of PVIF is expected to be approximately $9,700,000 in 1997, $10,100,000 in 1998, $9,200,000 in 1999, $7,900,000 in 2000 and $6,800,000 in 2001.
The acquisition of Golden American was accounted for as a purchase resulting in a new basis of accounting, reflecting estimated fair values for assets and liabilities at the acquisition date. Goodwill of $39,254,000 has been established for the excess of the acquisition cost over the fair value of net assets acquired. The acquisition cost is preliminary with respect to the final settlement of taxes with Bankers Trust and estimated expenses and, as a result, goodwill may change. Amortization of goodwill during the period from the acquisition date to December 31, 1996 totaled $589,000. Amortization of goodwill attributed to licenses acquired in conjunction with the purchase of USG totaled $74,000 in 1996 and 1995. Goodwill resulting from the acquisition of Golden American is being amortized on a straight-line basis over 25 years and is expected to total $1,570,000 annually.
Operating income (income excluding realized gains and losses, commercial mortgage and mortgage-backed securities prepayment gains, related amortization of deferred policy acquisition costs ("DPAC") and the 1995 special reserve accrual for future guaranty fund assessments, net of related income taxes) increased 14.0% in 1996 compared to an increase of 14.2% in 1995. Net income increased 45.1% in 1996 compared to a decrease of 13.6% in 1995. A breakdown of income is as follows:
The financial statement carrying value of the company's total investments grew 10.9% (7.3% excluding Golden American) in 1996. The amortized cost basis of the company's total investment portfolio grew 14.8% (11.0% excluding Golden American) during the same period. Effective December 1, 1995, all of the company's investments, other than mortgage loans and real estate, are carried at fair value in the company's financial statements. As such, growth in the carrying value of the company's investment portfolio included changes in unrealized appreciation and depreciation of fixed maturity and equity securities as well as growth in the cost basis of these securities. Growth in the cost basis of the company's investment portfolio resulted from the investment of premiums from the sale of the company's fixed annuity and insurance products and the acquisition of Golden American. The company manages the growth of its insurance operations in order to maintain adequate capital ratios.
Fixed Maturity Securities: At December 31, 1996, the ratings assigned by Standard & Poor's Corporation ("Standard & Poor's") to the individual securities in the company's fixed maturities portfolio are summarized as follows:
On November 15, 1995, the Financial Accounting Standards Board ("FASB") issued a special report "A Guide to Implementation of Statement 115 on Accounting for Certain Investments in Debt and Equity Securities". This report allowed companies a one-time opportunity to reassess the classification of their securities holdings pursuant to Statement of Financial Accounting Standards ("SFAS") No. 115. SFAS No. 115 requires companies to classify their securities as "available for sale", "held to maturity", or "trading". SFAS No. 115 significantly restricts a company's ability to sell securities in the held to maturity category without raising questions about the appropriateness of its accounting policy for such securities. Classification of securities as held to maturity, therefore, limits a company's ability to manage its investment portfolio in many circumstances. For example, a company would be prohibited from accepting a tender offer or responding to an anticipated decline in the credit quality of assets in a particular industry when the security is categorized as held to maturity. Additionally, a company is unable to adjust its portfolio to take advantage of tax planning opportunities or economic changes that would assist in asset liability management. Thus a company's ability to maintain the appropriate flexibility to make optimal investment decisions is significantly restricted if it classifies securities as held to maturity.
On December 31, 1996, fixed income securities with an amortized cost of $7,557,735,000 and an estimated fair value of $7,731,964,000 were designated as available for sale. Unrealized holding gains on these securities, net of adjustments to deferred policy acquisition costs and deferred income taxes, increased stockholders' equity by $76,387,000, or $2.38 per share at December 31, 1996.
Net unrealized appreciation of fixed maturity securities of $174,229,000 was comprised of gross appreciation of $270,742,000 and gross depreciation of $96,513,000.
The company analyzes its investment portfolio, including below investment grade securities, at least quarterly in order to determine if its ability to realize its carrying value on any investment has been impaired. For debt and equity securities, if impairment in value is determined to be other than temporary (i.e. if it is probable that the company will be unable to collect all amounts due according to the contractual terms of the security), the cost basis of the impaired security is written down to fair value, which becomes the security's new cost basis. The amount of the writedown is included in earnings as a realized loss. Future events may occur, or additional or updated information may be received, which may necessitate future write-downs of securities in the company's portfolio. Significant write-downs in the carrying value of investments could materially adversely affect the company's net income in future periods.
At December 31, 1996, no fixed maturity securities were deemed to have impairments in value that are other than temporary.
Hedging Program: During the second quarter of 1996, the company implemented a hedging program under which certain derivative financial instruments, interest rate caps and cash settled put swaptions ("instruments"), were purchased to reduce the negative effects of potential increases in withdrawal activity related to the company's annuity liabilities which may result from extreme increases in interest rates. The company purchased instruments, all during the second quarter, with notional amounts totaling approximately $600,000,000 in interest rate caps and $1,300,000,000 in cash settled put swaptions, all of which were outstanding at December 31, 1996. The company paid approximately $21,100,000 in premiums for these instruments. The cost of this program has been incorporated into the company's product pricing. The instruments do not require any additional payments by the company.
The agreements for these instruments entitle the company to receive payments from the instruments' counterparties on future reset dates if interest rates, as specified in the agreements, rise above a specified fixed rate (9.0% and 9.5%). The amount of such payments to be received by the company for the interest rate caps, if any, will be calculated by taking the excess of the current applicable rate over the specified fixed rate, and multiplying this excess by the notional amount of the caps. Payments on cash settled put swaptions are also calculated based upon the excess of the current applicable rate over the specified fixed rate multiplied by the notional amount. The product of this rate differential times the notional amount is assumed to continue for a series of defined future semi-annual payment dates and the resulting hypothetical payments are discounted to the current payment date using the discount rate defined in the agreement. Any payments received from the counterparties will be recorded as an adjustment to interest credited.
The following table summarizes the contractual maturities of notional amounts by type of instrument at December 31, 1996:
Intangible assets increased $43,087,000 during 1996. Goodwill totaling $39,254,000, representing the excess of the acquisition cost over the fair value of net assets acquired in conjunction with the purchase of Golden American, was established in 1996. In addition, the costs of issuing the company's Trust Originated Preferred Securities totaling $4,695,000 were capitalized in 1996. Amortization of intangible assets totaled $896,000 during 1996, including $233,000 reported in interest expense.
Other assets increased $34,332,000 during 1996. Included in this increase is the unamortized cost of interest rate caps and cash settled put swaptions purchased to hedge the company's annuity liabilities totaling $18,041,000. Also included in this increase are various assets of Golden American and DSI totaling $2,568,000, an increase in prepaid pension costs of $2,640,000 and increases in capitalized guaranty fund assessments of $5,064,000.
In conjunction with the volume of annuity and insurance sales, the acquisition of Golden American and the resulting increase in business in force, the company's liability for policy liabilities and accruals increased $1,173,503,000, or 14.2%, during 1996 and totaled $9,415,413,000 at December 31, 1996.
Reserves for the company's annuity contracts and life insurance policies, including separate account reserves for variable contracts, as of December 31, 1996 and 1995 are as follows:
The company incorporates a number of features in its annuity products designed to reduce the early withdrawal or surrender of the policies and to partially compensate the company for its costs if policies are withdrawn early. Current surrender charge periods on fixed annuity policies typically range from 5 years to the term of the policy. During 1996, 85% of such policies issued by Equitable Life and USG had a surrender charge period of seven years or more. The initial surrender charge on Equitable Life and USG fixed annuity policies ranges from 5% to 20% of the premium and decreases over the surrender charge period.
The following table summarizes the company's non-par deferred fixed annuity liabilities and sales at and for the year ended December 31, 1996 by surrender charge range category. Notwithstanding policy features, the withdrawal rates of policyholder funds may be affected by changes in interest rates.
Deferred income taxes decreased $69,234,000 during 1996 and totaled $45,681,000 at December 31, 1996, including $43,678,000 ($113,503,000 at December 31, 1995) of deferred taxes recorded as a result of unrealized gains of $174,229,000 on fixed maturity securities designated as available for sale. Total consolidated debt increased $46,500,000 during 1996 as the company issued additional commercial paper. Commercial paper, issued to offset short-term timing differences in investment related cash receipts and disbursements (investment smoothing) and to provide for short-term operating needs, amounted to $104,600,000 at December 31, 1996. At December 31, 1996, none of the commercial paper was issued for investment smoothing purposes. Other liabilities increased $33,201,000 from year-end 1995 levels primarily due to an increase in draft accounts payable, mortgage trust funds and transfer and suspense accounts.
On July 23, 1996, the Trust, a consolidated, wholly-owned subsidiary of the company, issued $125,000,000 of 8.70% Trust Originated Preferred Securities (see Liquidity and Capital Resources section below). The net proceeds of this offering were used to fund, in part, the acquisition of BT Variable, Inc.
The effects of inflation and changing prices on the company are not material since insurance assets and liabilities are both primarily monetary and remain in balance. An effect of inflation, which has been low in recent years, is a decline in purchasing power when monetary assets exceed monetary liabilities.
The liquidity requirements of the company's subsidiaries are met by cash flow from annuity and insurance premiums, investment income and maturities of fixed maturity investments and mortgage loans. The company primarily uses funds for the payment of annuity and insurance benefits, operating expenses and commissions and the purchase of new investments.
The company's home office operations are currently housed in four leased locations in downtown Des Moines, Iowa, a leased location in Wilmington, Delaware and a leased location in New York, New York. The company has entered into agreements with a developer to develop and lease a 200,000 square foot office building in downtown Des Moines, Iowa to house the company's Des Moines based home office operations. The company anticipates an additional $3,000,000 to $4,000,000 for fixed assets will be spent in 1997 for the new location. In total, the company intends to increase its commitment to improve product development, customer service and operating efficiencies by spending approximately $8,000,000 to $11,000,000 per year over the next three years on capital needs, primarily for information technology, as compared to the approximately $5,400,000 spent in 1996 ($3,400,000 spent in 1995). No other material capital expenditures are planned.
The company issues short-term debt, including commercial paper notes, for working capital needs, investment smoothing and to provide short term liquidity. At December 31, 1996, the company had $104,600,000 in commercial paper notes outstanding, an increase of $46,500,000 from December 31, 1995. The company's commercial paper is rated A-1 by Standard and Poor's, D-1 by Duff & Phelps Credit Rating Co. and P-2 by Moody's.
The NAIC's risk-based capital requirements require insurance companies to calculate and report information under a risk-based capital formula. These requirements are intended to allow insurance regulators to identify inadequately capitalized insurance companies based upon the type and mixture of risks inherent in the company's operations. The formula includes components for asset risk, liability risk, interest rate exposure and other factors. The company's insurance subsidiaries have complied with the NAIC's risk-based capital reporting requirements. Amounts reported indicate that the company's insurance subsidiaries have total adjusted capital (as defined in the requirements) which is well above all required capital levels.
The company intends to continue growing its insurance operations, either internally or through acquisition, and has established a goal of achieving average annual asset growth excluding SFAS No. 115, as measured over the preceding three years, of at least 20%. See "Cautionary Statement Regarding Forward-Looking Statements" below. Future growth in the company's insurance operations may require additional capital. As discussed above, the company has available an effective universal shelf registration on Form S-3 which will enable the company to issue up to $175,000,000 of securities to support such growth. Sources of additional capital include the retention of earnings and the additional issuance of securities.
Currently, the company's insurance subsidiaries are subject to regulation and supervision by the states in which they are admitted to transact business. State insurance laws generally establish supervisory agencies with broad administrative and supervisory powers related to granting and revoking licenses to transact business, establishing guaranty fund associations, licensing agents, market conduct, approving policy forms, regulating premium rates for some lines of business, establishing reserve requirements, prescribing the form and content of required financial statements and reports, determining the reasonableness and adequacy of statutory capital and surplus and regulating the type and amount of investments permitted.
There has been increased scrutiny by insurance regulators and the insurance industry itself of insurance sales and marketing activities. New rules for life insurance illustrations have been adopted as a model regulation by the NAIC. Many states have adopted the regulation effective January 1, 1997, and an NAIC committee has begun to work on the issue of annuity marketing. The company conducts an ongoing thorough review of its sales and marketing process and continues to emphasize its compliance efforts.
Guaranty Fund Assessments: On December 5, 1996, the American Institute of CPAs ("AICPA") issued an exposure draft of its Proposed Statement of Position on "Accounting for Guaranty-Fund Assessments". This proposed standard provides: (1) guidance for determining when an insurance enterprise should recognize a liability for guaranty fund and other assessments; (2) guidance on how to measure the liability and allows discounting the liability, if the amount and timing of the cash payments are fixed and reliably determinable; (3) criteria for when an asset may be recognized for a portion or all of the assessment liability or paid assessment that can be recovered through premium tax offsets or policy surcharges; and (4) requirements for disclosure of certain information. The company's liability established for guaranty fund assessments and related premiums tax offset at December 31, 1996 is undiscounted and adequately reserves for guaranty fund assessments based upon the Proposal as currently written.
Comprehensive Income: On June 20, 1996, the FASB issued an exposure draft of its Proposed Statement of Financial Accounting Standards "Reporting Comprehensive Income". Comprehensive income is defined as "the change in equity of a business enterprise during a period from transactions and other events and circumstances from nonowner sources. It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners". Comprehensive income would be reported in either one or two statements of financial performance and an enterprise would be required to report an amount representing total comprehensive income as well as a per share amount for that total. In addition to items currently reported in net income, comprehensive income would include in other comprehensive income such items as changes in fair value of fixed maturity securities designated as available for sale, changes in fair value of derivatives designated as cash flow or foreign currency hedges and unrecognized assets or liabilities of pension plans pursuant to SFAS No. 87. This proposed standard is not expected to change the company's reported net income but would increase the prominence of changes in the items listed above to be perceived as equivalent to net income. This proposal is expected to cause increased volatility in stockholders' equity primarily due to fluctuations in the fair value of derivatives not currently reflected in equity. In January 1997, FASB decided not to require the presentation of comprehensive income in a separate statement that would treat comprehensive income as a measure of performance similar to the income statement. Instead, FASB is considering placing comprehensive income in the existing statement of stockholders' equity. The requirement to present comprehensive income per share has also been dropped.
Litigation: As previously reported, the company and certain of its subsidiaries are defendants in class action lawsuits filed in the United States District Court for the Middle District of Florida, Tampa Division, in February, 1996 and in the Court of Common Pleas of Allegheny County, Pennsylvania in June 1996. The suits claim unspecified damages as a result of alleged improper life insurance sales practices. The company believes the allegations are without merit. The suits are in the discovery and procedural stages and have not yet been certified as class actions. The company intends to defend the suits vigorously. The amount of any liability which may arise as a result of these suits, if any, cannot be reasonably estimated and no provision for loss has been made in the company's financial statements. The company had also been a party to a similar previously reported class action lawsuit filed in Iowa which has now been dismissed.
CONSOLIDATED BALANCE SHEETS - CONTINUED (Dollars in thousands, except per share data)
CONSOLIDATED STATEMENTS OF INCOME - CONTINUED (Dollars in thousands, except per share data)
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (Dollars in thousands, except per share data)
Consolidation The consolidated financial statements include the company and its subsidiaries. The principal subsidiaries are Equitable Life Insurance Company of Iowa ("Equitable Life"), Golden American Life Insurance Company ("Golden American") and USG Annuity & Life Company ("USG"). At December 31, 1996 and 1995, all subsidiaries are wholly owned (see Note 7 regarding purchase of Golden American). All significant intercompany accounts and transactions have been eliminated.
Equity securities: Equity securities (common and non-redeemable preferred stocks) are reported at estimated fair value if readily marketable or conversion value, if applicable, or at cost if not readily marketable. The change in unrealized appreciation and depreciation of marketable equity securities (net of related deferred income taxes, if any) is included directly in stockholders' equity. Equity securities that are determined to have a decline in value that is other than temporary are written down to estimated fair value which becomes the security's new cost basis by a charge to realized losses in the company's Statement of Income.
Mortgage loans: Mortgage loans on real estate are reported at cost adjusted for amortization of premiums and accrual of discounts. If the value of any mortgage loan is determined to be impaired (i.e., when it is probable that the company will be unable to collect all amounts due according to the contractual terms of the loan agreement), the carrying value of the mortgage loan is reduced to the present value of expected future cash flows from the loan, discounted at the loan's effective interest rate, or to the loan's observable market price, or the fair value of the underlying collateral. The carrying value of impaired loans is reduced by the establishment of a valuation allowance which is adjusted at each reporting date for significant changes in the calculated value of the loan. Changes in this valuation allowance are charged or credited to income.
Real estate: Real estate, which includes real estate acquired through foreclosure, is reported at cost less allowances for depreciation. Real estate acquired through foreclosure, or in-substance foreclosure, is recorded at the lower of cost (which includes the balance of the mortgage loan, any accrued interest and any costs incurred to obtain title to the property) or fair value at or before the foreclosure date. The carrying value of these assets is subject to review when events or circumstances indicate an impairment might exist. If the estimated undiscounted cash flows is less than the carrying amount of the assets, an impairment in value is deemed to exist and an impairment loss is recognized. The carrying value of the asset is written down to an amount representing the sum of the estimated undiscounted cash flows which becomes the asset's new cost basis.
Fair values: Estimated fair values, as reported herein, of publicly traded fixed maturity securities are as reported by an independent pricing service. Fair values of conventional mortgage-backed securities not actively traded in a liquid market are estimated using a third party pricing system. This pricing system uses a matrix calculation assuming a spread over U.S. Treasury bonds based upon the expected average lives of the securities. Fair values of private placement bonds are estimated using a matrix that assumes a spread (based on interest rates and a risk assessment of the bonds) over U.S. Treasury bonds. Estimated fair values of redeemable preferred stocks are as reported by the National Association of Insurance Commissioners ("NAIC"). Estimated fair values of equity securities are based on the latest quoted market prices or conversion value, if applicable. Estimated fair values of the company's investment in its registered separate accounts are based upon the quoted fair value of the securities comprising the individual portfolios underlying the separate accounts. Fair values of equity securities which are not readily marketable, are estimated based upon values which are representative of the fair values of issues of comparable yield and quality. Realized gains and losses are determined on the basis of specific identification and average cost methods for manager initiated and issuer initiated disposals, respectively.
Financial Instruments Interest rate caps and cash settled put swaptions ("instruments") are reported at amortized cost and included in other assets. These instruments were purchased to reduce the negative effects of potential increases in withdrawal activity related to the company's annuity liabilities which may result from extreme increases in interest rates. All outstanding instruments are designated as hedges and, therefore, are not reported at fair value. Premiums paid to purchase these instruments are deferred and amortized over the term of the instruments on a straight-line basis. The instruments do not require any additional payments by the company. Any payments received in accordance with the terms of the instruments are recorded as an adjustment to interest credited. Unrealized gains and losses on these instruments and related assets or liabilities will not be recorded in income until realized.
Deferred Policy Acquisition Costs Certain costs of acquiring new insurance business, principally commissions and other expenses related to the production of new business, have been deferred. For annuity and interest sensitive life products, such costs are amortized generally in proportion to the present value (using the assumed crediting rate) of expected gross profits. This amortization is adjusted retrospectively, or "unlocked", when the company revises its estimate of current or future gross profits to be realized from a group of products. For traditional life insurance products, such costs are amortized over the premium-paying period of the related policies in proportion to premium revenues recognized, using principally the same assumptions for interest, mortality and withdrawals that are used for computing liabilities for future policy benefits subject to traditional "lock-in" concepts. Deferred policy acquisition costs are adjusted to reflect the pro-forma impact of unrealized gains and losses on fixed maturity securities the company has designated as "available for sale" under SFAS No. 115.
Present Value of In Force Acquired A portion of the cost for the Golden American acquisition was allocated to the right to receive future cash flows from the insurance contracts existing with Golden American at the date of acquisition. This allocated cost represents the present value of in force acquired ("PVIF") which reflects the value of those purchased policies calculated by discounting the expected future cash flows at the discount rate determined by the company. The expected future cash flows used to determine the PVIF are based on actuarially determined projected net cash flows from the policies in force acquired from Golden American. Interest is imputed on the unamortized balance of PVIF at rates of 7.70% to 7.80%. Amortization of PVIF is charged to expense in proportion to expected gross profits. This amortization is adjusted retrospectively, or "unlocked", when the company revises its estimate of current or future gross profits to be realized from the insurance contracts acquired. PVIF is adjusted to reflect the pro forma impact of unrealized gains (losses) on available for sale fixed maturity securities.
Intangible Assets Intangible assets include goodwill established with the purchase of Golden American, the value of various licenses acquired with the purchase of USG and capitalized costs related to the company's mandatorily-redeemable preferred securities, lines of credit and long-term debt. Goodwill, related to the purchase of Golden American, is being amortized over twenty-five years. Intangible assets related to insurance licenses are being amortized over forty years. Capitalized line of credit costs are being amortized over the term of the underlying line of credit agreement. Debt issuance costs and issue costs associated with the company-obligated, mandatorily-redeemable preferred securities are being amortized over the term of the instruments, ten years and thirty years, respectively. All intangible assets are being amortized on a straight-line basis.
Separate Accounts Assets and liabilities of the separate accounts reported in the accompanying balance sheets represent funds that are separately administered principally for variable annuity and variable life contracts, as well as, the company's defined pension benefit plan assets and liabilities. Contractholders, rather than the company, bear the investment risk for variable products. At the direction of the contractholders, the separate accounts invest the premiums from the sale of variable annuity and variable life products in shares of specified mutual funds. The assets and liabilities of the separate accounts are clearly identified and segregated from other assets and liabilities of the company. The portion of the separate account assets applicable to variable annuity and variable life contracts cannot be charged with liabilities arising out of any other business the company may conduct. Variable separate account assets carried at fair value of the underlying investments generally represent contractholder investment values maintained in the accounts. Variable separate account liabilities represent account balances for the variable annuity and variable life contracts invested in the separate accounts. The company's separate account assets and liabilities for its pension plan represent the estimated fair values of the pension plan assets and associated liabilities. Net investment income and realized and unrealized capital gains and losses related to separate account assets are not reflected in the accompanying Statement of Income. Product charges recorded by the company from variable annuity and variable life products consist of charges applicable to each contract for mortality and expense risk, cost of insurance, contract administration and surrender charges. In addition, some variable annuity and all variable life contracts provide for a distribution fee collected for a limited number of years after each premium deposit. Revenue recognition of collected distribution fees is amortized over the life of the contract in proportion to its expected gross profits. The balance of unrecognized revenue related to the distribution fees is reported as an unearned revenue reserve. The company also receives investment advisory and investment management fees from the mutual funds underlying its variable products which is recorded in other income.
Recognition of Premium Revenues and Costs Revenues for fixed annuity and interest sensitive life products consist of policy charges for the cost of insurance, policy administration charges, amortization of policy initiation fees and surrender charges assessed against policyholder account balances during the period. Expenses related to these products include interest credited to policyholder account balances and benefit claims incurred in excess of policyholder account balances. Traditional life insurance premiums are recognized as revenues over the premium-paying period. Future policy benefits and policy acquisition costs are associated with the premiums as earned by means of the provision for future policy benefits and amortization of deferred policy acquisition costs.
Deferred Income Taxes Deferred tax assets or liabilities are computed based on the difference between the financial statement and income tax bases of assets and liabilities using the enacted marginal tax rate. Deferred tax assets or liabilities are adjusted to reflect the pro forma impact of unrealized gains and losses on equity securities and fixed maturity securities the company has designated as available for sale under SFAS No. 115. Changes in deferred tax assets or liabilities resulting from this SFAS No. 115 adjustment are charged or credited directly to stockholders' equity. Deferred income tax expenses or credits reflected in the company's Statements of Income are based on the changes in the deferred tax asset or liability from period to period (excluding the SFAS No. 115 adjustment).
The financial statements of the life insurance subsidiaries differ from related statutory financial statements principally as follows: (1) acquisition costs of acquiring new business are deferred and amortized over the life of the policies rather than charged to operations as incurred, (2) an asset representing the present value of future cash flows from insurance contracts acquired was established as a result of an acquisition and is being amortized and charged to expense, (3) future policy benefit reserves for annuity and interest sensitive life products are based on full account values, rather than the greater of cash surrender value or amounts derived from discounting methodologies utilizing statutory interest rates, (4) future policy benefit reserves on traditional life insurance products are based on reasonable assumptions of expected mortality, interest and withdrawals which include a provision for possible unfavorable deviation from such assumptions, which may differ from reserves based upon statutory mortality rates and interest, (5) reserves are reported before reduction for reserve credits related to reinsurance ceded and a receivable is established, net of an allowance for uncollectible amounts, for these credits rather than presented net of these credits, (6) fixed maturity investments are designated as "available for sale" and valued at fair value with unrealized appreciation/depreciation, net of adjustments to deferred income taxes (if applicable), deferred policy acquisition costs, and present value of in force acquired, credited/charged directly to stockholders' equity rather than valued at amortized cost, (7) the carrying value of fixed maturity securities is reduced to fair value by a charge to realized losses in the statements of income when declines in carrying value are judged to be other than temporary, rather than through the establishment of a formula-determined statutory investment reserve (carried as a liability), changes in which are charged directly to surplus, (8) deferred income taxes are provided for the difference between the financial statement and income tax bases of assets and liabilities, (9) net realized gains or losses attributed to changes in the level of interest rates in the market are recognized when the sale is completed rather than deferred and amortized over the remaining life of the fixed maturity security or mortgage loan, (10) gains arising from sale lease-back transactions are deferred and amortized over the life of the lease rather than recognized in the period of sale, (11) a liability is established for anticipated guaranty fund assessments, net of related anticipated premium tax credits, rather than capitalized when assessed and amortized in accordance with procedures permitted by insurance regulatory authorities, (12) a prepaid pension cost asset established in accordance with SFAS No. 87, "Employers' Accounting for Pensions", agents' balances and certain other assets designated as "non-admitted assets" for statutory purposes are reported as assets rather than being charged to surplus, (13) revenues for annuity and interest sensitive life products consist of policy charges for the cost of insurance, policy administration charges, amortization of policy initiation fees and surrender charges assessed rather than premiums received, (14) expenses for postretirement benefits other than pensions are recognized for all qualified employees rather than for only vested and fully- eligible employees, and the accumulated postretirement benefit obligation for years prior to adoption of SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions" was recognized as a cumulative effect of change in accounting method rather than deferred and amortized over twenty years, (15) assets and liabilities are restated to fair values when a change in ownership occurs, with provisions for goodwill and other intangible assets, rather than continuing to be presented at historical cost, and (16) amortization of the cost of financial instruments purchased in conjunction with the company's hedging program are recorded in interest credited rather than as a deduction from net investment income. Net income for Equitable Life, USG and Equitable American Insurance Company as determined in accordance with statutory accounting practices was $96,841,000 in 1996, $87,179,000 in 1995 and $61,421,000 in 1994. Net income (loss) for Golden American as determined in accordance with statutory accounting practices was $(9,188,000) in 1996, $(4,117,000) in 1995 and $(11,260,000) in 1994. Total combined statutory capital and surplus, including Golden American in 1996 and 1995, was $647,746,000 at December 31, 1996 and $599,175,000 at December 31, 1995.
Investment Results Major categories of net investment income are summarized below:
At December 31, 1996 and 1995, the amortized cost, gross unrealized gains and losses and estimated fair value of the company's fixed maturity securities, all of which are designated as available for sale, are as follows:
An analysis of sales, maturities and principal repayments of the company's fixed maturities portfolio for the years ended December 31, 1996, 1995 and 1994 is as follows:
Investment Diversifications: The company's investment policies related to its investment portfolio require diversification by asset type, company and industry and set limits on the amount which can be invested in an individual issuer. Such policies are at least as restrictive as those set forth by regulatory authorities. Fixed maturity investments included investments in various non-governmental mortgage-backed securities (30% in 1996, 33% in 1995), public utilities (17% in 1996, 19% in 1995), basic industrials (23% in 1996, 21% in 1995) and consumer products (12% in 1996 and 1995). Mortgage loans on real estate have been analyzed by geographical location and there are no concentrations of mortgage loans in any state exceeding ten percent in 1996 and 1995. Mortgage loans on real estate have also been analyzed by collateral type with significant concentrations identified in retail facilities (28% in 1996, 32% in 1995), industrial buildings (29% in 1996, 26% in 1995), multi- family residential buildings (20% in 1996, 24% in 1995) and office buildings (22% in 1996, 17% in 1995). Equity securities (which represents 0.8% of the company's investments) consist primarily of investments in the company's registered separate accounts and an investment of $61,339,000 in a real estate investment trust. Real estate and investments accounted for by the equity method are not significant to the company's overall investment portfolio. No investment in any person or its affiliates (other than bonds issued by agencies of the United States government) exceeded ten percent of stockholders' equity at December 31, 1996.
Accounting Treatment: Premiums paid to purchase these instruments are deferred and included in other assets. Premiums are amortized and included in interest credited to account balances over the term of the instruments on a straight-line basis. The company has recorded amortization of $3,081,000 for 1996. Unrealized gains and losses on these instruments and related assets or liabilities will not be recorded in income until realized. The Financial Accounting Standards Board ("FASB") and the Securities and Exchange Commission are evaluating the accounting and disclosure requirements for these instruments. The SEC amended its derivative disclosures rules in January of 1997 requiring additional qualitative and quantitative disclosures by December 31, 1997. FASB has issued an exposure draft titled "Accounting for Derivative and Similar Financial Instruments and for Hedging Activities" which, if adopted as a statement of Financial Accounting Standards in its current form, would require the company to change its accounting treatment for these instruments. The requirements of any final standard which may result from this exposure process are not known at this time and, therefore, the impact of such a standard on the company's financial statements cannot be determined at this time.
Exposure to Loss - Counterparty Nonperformance: The company is exposed to the risk of losses in the event of nonperformance by the counterparties of these instruments. Losses recorded in the company's financial statements in the event of nonperformance will be limited to the unamortized premium (remaining amortized cost) paid to purchase the instrument because no additional payments are required by the company on these instruments after the initial premium. Counterparty nonperformance would result in an economic loss if interest rates exceeded the specified fixed rate. Economic losses would be measured by the net replacement cost, or estimated fair value, for such instruments. The estimated fair value is the average of quotes obtained from related and unrelated counterparties. The company limits its exposure to such losses by: diversification among counterparties, limiting exposure to any individual counterparty based upon that counterparty's credit rating, and limiting its exposure by instrument type to only those instruments that do not require future payments. For purposes of determining risk exposure to any individual counterparty, the company evaluates the combined exposure to that counterparty on both a derivative financial instruments' level and on the total investment portfolio credit risk and reports its exposure to senior management at least monthly. The maximum potential economic loss (the cost of replacing an instrument or the net replacement value) due to nonperformance of the counterparties will increase or decrease during the life of the instruments as a function of maturity and market conditions.
SFAS No. 107, "Disclosures about Fair Value of Financial Instruments" requires disclosure of estimated fair value of all financial instruments, including both assets and liabilities recognized and not recognized in a company's balance sheet, unless specifically exempted. SFAS No. 119, "Disclosure about Derivative Financial Instruments and Fair Value of Financial Instruments" requires additional disclosures about derivative financial instruments. Most of the company's investments, insurance liabilities and debt, as well as off-balance-sheet items such as loan guarantees, fall within the standards' definition of a financial instrument. Although the company's life insurance liabilities are specifically exempted from this disclosure requirement, estimated fair value disclosure of these liabilities is also provided in order to make the disclosures more meaningful. Accounting, actuarial and regulatory bodies are continuing to study the methodologies to be used in developing fair value information, particularly as it relates to liabilities for insurance contracts. Accordingly, care should be exercised in deriving conclusions about the company's business or financial condition based on the information presented herein. The company closely monitors the level of its insurance liabilities, the level of interest rates credited to its interest-sensitive products and the assumed interest margin provided for within the pricing structure of its other products. These amounts are taken into consideration in the company's overall management of interest rate risk, which attempts to minimize exposure to changing interest rates through the matching of investment cash flows with amounts expected to be due under insurance contracts. As discussed below, the company has used discount rates in its determination of fair values for its liabilities which are consistent with market yields for related assets. The use of the asset market yield is consistent with management's opinion that the risks inherent in its asset and liability portfolios are similar. This assumption, however, might not result in values that are consistent with those obtained through an actuarial appraisal of the company's business or values that might arise in a negotiated transaction.
Fixed maturities: Estimated fair values of publicly traded securities are as reported by an independent pricing service. Estimated fair values of conventional mortgage-backed securities not actively traded in a liquid market are estimated using a third party pricing system. This pricing system uses a matrix calculation assuming a spread over U.S. Treasury bonds based upon the expected average lives of the securities. Fair values of private placement bonds are estimated using a matrix that assumes a spread (based on interest rates and a risk assessment of the bonds) over U.S. Treasury bonds. Estimated fair values of redeemable preferred stocks are as reported by the NAIC. Equity securities: Estimated fair values are based upon the latest quoted market prices, where available. For equity securities not actively traded, estimated fair values are based upon values of issues of comparable yield and quality or conversion value. Mortgage loans on real estate: Fair values are estimated by discounting expected cash flows, using interest rates currently being offered for similar loans. Short-term investments, cash and cash equivalents, notes and other receivables, commercial paper notes: Carrying values reported in the company's historical cost basis balance sheet approximate estimated fair value for these instruments, due to their short-term nature. Deferred policy acquisition costs, present value of in force acquired and intangible assets: For historical cost purposes, the recovery of policy acquisition costs and present value of in force acquired is based on the realization, among other things, of future interest spreads and gross premiums on in-force business. Because these cash flows are considered in the computation of the future policy benefit cash flows, the balances of deferred policy acquisition cost and present value of in force acquired do not appear on the estimated fair value balance sheet. Intangible assets do not appear in the estimated fair value balance sheet because there are no cash flows related to these assets. Prepaid pension and other postretirement benefits: Estimated fair value of the prepaid pension costs asset and other postretirement benefits obligations represents the fair value of plan assets less accumulated benefit obligations (pension) and accumulated postretirement benefit obligations. Differences in estimated fair value and carrying value are the result of deferral of recognition of: prior service costs, unrecognized gains and losses and the remaining balance of the unrecognized transition asset for pensions. Derivative financial instruments: SFAS No. 119 requires disclosures about derivative financial instruments such as futures, forward, swap or option contracts, or other financial instruments with similar characteristics. During 1996, with the implementation of the company's hedging program, the company purchased interest rate caps and cash settled put swaptions. The estimated fair values are the average of quotes obtained from related and unrelated counterparties. The company was not a party to such instruments at any time during 1995. Estimated fair values for these instruments reflect changes in interest rates and market conditions since time of purchase. Separate account assets: Separate account assets represents the estimated fair values of the underlying securities in the company's historical cost and estimated fair value basis balance sheets. Future policy benefits: Estimated fair values of the company's liabilities for future policy benefits for interest sensitive life products, annuity products and participating insurance and non-participating traditional life insurance products are based upon discounted cash flow calculations. Cash flows of future policy benefits are discounted using the market yield rate of the assets supporting these liabilities. Estimated fair values are presented net of the estimated fair value of corresponding policy loans due to the interdependent nature of the cash flows associated with these items. Long-term debt: Estimated fair value of the company's publicly-traded debt issue was based upon quoted market prices at December 31, 1996. Separate account liabilities: Separate account liabilities are reported at full account value in the company's historical cost balance sheet. Estimated fair values of separate account liabilities are based upon assumptions using an estimated long-term average market rate of return to discount future cash flows. The reduction in fair values for separate account liabilities reflect the present value of future revenue from product charges, distribution fees or surrender charges. Deferred income taxes on fair value adjustments: Deferred income taxes have been reported at the statutory rate for the differences (except for those attributed to permanent differences) between the carrying value and estimated fair value of assets and liabilities set forth herein. Non-financial assets and liabilities: Values are presented at historical cost. Non-financial assets consist primarily of real estate, securities and indebtedness of related parties, property and equipment, current income taxes recoverable and guaranty fund premium tax offset. Non-financial liabilities consist primarily of other policy claims and benefits, accrued dividends, deferred income taxes payable, guaranty fund assessments payable, outstanding checks, suspense accounts, draft accounts payable and mortgage escrow accounts. Company-obligated, mandatorily-redeemable preferred securities: Estimated fair value of the publicly traded preferred securities of the company's subsidiary trust was based upon quoted market prices at December 31, 1996. SFAS No. 107 and SFAS No. 119 require disclosure of estimated fair value information about financial instruments, whether or not recognized in the consolidated balance sheets, for which it is practicable to estimate that value. In cases where quoted market prices are not available, estimated fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. In that regard, the derived fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, could not be realized in immediate settlement of the instrument. The above presentation should not be viewed as an appraisal as there are several factors, such as the fair value associated with customer and agent relationships and other intangible items, which have not been considered. In addition, interest rates and other assumptions might be modified if an actual appraisal were to be performed. Accordingly, the aggregate estimated fair value amounts presented herein are limited by each of these factors and do not purport to represent the underlying value of the company.
Company-Obligated, Mandatorily-Redeemable Preferred Securities of Subsidiary Trust: On July 23, 1996, Equitable of Iowa Companies Capital Trust (the "Trust"), a consolidated, wholly-owned subsidiary of Equitable of Iowa Companies ("Equitable"), issued $125,000,000 of its 8.70% Trust Originated Preferred Securities (the "Preferred Securities"). Concurrent with the issuance of the Trust's Preferred Securities, Equitable issued to the Trust $128,866,000 in principal amount, of its 8.70% Subordinated Deferrable Interest Debentures (the "Debt Securities") due July 30, 2026. The sole assets of the Trust are and will remain the Debt Securities and any accrued interest thereon. The interest and other payment dates on the Debt Securities correspond to the distribution and other payment dates on the Preferred Securities. The Debt Securities mature on July 30, 2026, with an option to extend the maturity an additional 19 years, and are redeemable by Equitable, in whole or in part, beginning July 30, 2001. The Preferred Securities will mature or be called simultaneously with the Debt Securities. The Preferred Securities have a liquidation value of $25 per Preferred Security plus accrued and unpaid distributions. As of December 31, 1996, 5,000,000 shares of Preferred Securities were outstanding. Equitable has obligations under the Debt Securities, the Preferred Securities Guarantee Agreement, the Declaration of Trust, as amended, and the Indenture, as amended by the First Supplemental Indenture. These obligations, when considered together, constitute a full and unconditional guarantee by Equitable of the Trust's obligations under the Preferred Securities. Net proceeds of approximately $120,305,000 from the issuance of $125,000,000 of Preferred Securities, were used to fund, in part, the acquisition of BT Variable Inc., which owned all the outstanding capital stock of Golden American and Directed Services, Inc. Refer to Note 7 for further information regarding the acquisition.
Line of Credit: The company maintains a line of credit arrangement with several banks to support its commercial paper notes payable and to provide short-term liquidity. The maximum borrowing allowed under this facility is $300,000,000 (no amounts outstanding at December 31, 1996) expiring on May 10, 2001. The terms of the credit arrangement set limits on debt levels of the company and its insurance subsidiaries, require maintenance of a minimum level of consolidated tangible net worth and insurance subsidiary statutory capital and surplus and risk-based capital, and restricts certain investments.
Transaction: On August 13, 1996, Equitable acquired all of the outstanding capital stock of BT Variable Inc., ("BT Variable"), a New York corporation, from Whitewood Properties Corp. ("Whitewood"), a New York corporation and wholly-owned subsidiary of Bankers Trust Company ("Bankers Trust"), pursuant to the terms of a Purchase Agreement dated as of May 3, 1996 between Equitable and Whitewood. BT Variable, a New York corporation, in turn, owns all the outstanding capital stock of Golden American, a Delaware stock life insurance company, and all of the outstanding capital stock of Directed Services, Inc. ("DSI"), a New York corporation and registered broker/dealer and investment adviser. In exchange for the outstanding capital stock of BT Variable, Equitable paid the sum of $93,000,000 in cash to Whitewood in accordance with the terms of the Purchase Agreement. Equitable also paid the sum of $51,000,000 in cash to Bankers Trust to retire certain debt owed by BT Variable to Bankers Trust pursuant to a revolving credit arrangement. The funds used in completing the acquisition were obtained primarily through a recent offering of securities undertaken by the Trust, an affiliate of Equitable, the proceeds of which were loaned to Equitable in exchange for subordinated debentures issued by Equitable to the Trust. Additional funds were provided by reducing short-term investments of Equitable and its insurance subsidiaries. Funds provided by Equitable's insurance subsidiaries were transferred to Equitable in the form of dividends paid. The acquisition was accounted for using the purchase method, and the results of operations of BT Variable are included in the consolidated statement of income from the date of acquisition. Subsequent to the acquisition, the BT Variable, Inc. name was changed to EIC Variable, Inc.
Accounting Treatment: The acquisition was accounted for as a purchase resulting in a new basis of accounting, reflecting estimated fair values for assets and liabilities at August 13, 1996. The purchase price was allocated to the three companies purchased - BT Variable, DSI, and Golden American. Goodwill relating to the acquisition was established for the excess of the acquisition cost over the fair value of the net assets acquired and pushed down to Golden American. The acquisition cost is preliminary with respect to the final settlement of taxes with Bankers Trust and estimated expenses and, as a result, goodwill may change. The total amount of goodwill and other intangibles deferred relating to the acquisition is comprised of $39,254,000 of estimated goodwill and approximately $4,695,000 of costs of issuance relating to the preferred securities mentioned above. Goodwill and preferred securities issuance costs will be amortized on a straight-line basis over 25 years and 35 years, respectively, and the carrying value will be reviewed periodically for any indication of impairment in value.
Pro Forma Information (Unaudited): The following pro forma information is presented as if the acquisition had occurred on January 1, 1995. This information is intended for informational purposes only and may not be indicative of the company's future results of operations.
Present Value of In Force Acquired: As part of the acquisition, a portion of the cost was allocated to the right to receive future cash flows from the insurance contracts existing with Golden American at the date of acquisition. This allocated cost represents the present value of in force acquired ("PVIF") which reflects the value of those purchased policies calculated by discounting the actuarially determined expected future cash flows at the discount rate determined by the company.
The company's Restated and Amended 1992 Stock Incentive Plan is a successor to the 1982 Stock Incentive Plan. These plans provide for the award of stock options or shares of the company's common stock to key employees through three means: qualified incentive stock options (as defined in the Internal Revenue Code), non-qualified stock options and restricted shares. Shares of common stock may be awarded under the 1982 plan for outstanding stock options granted prior to adoption of the 1992 plan. Under the 1992 plan an initial base of 2,240,000 shares of common stock may be awarded with automatic increases of 7.5% for shares issued after April 30, 1992. At December 31, 1996, the company has reserved 2,564,314 shares (2,803,051 shares at December 31, 1995) of its common stock for future issuances under these plans. The company has elected to follow Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" (APB 25) and related Interpretations in accounting for its employee stock options because, as discussed below, the alternative fair value accounting provided for under SFAS No. 123, "Accounting for Stock-Based Compensation," requires use of option valuation models that were not developed for use in valuing employee stock options. Under APB 25, if the exercise price of the company's employee stock options equals the market price of the underlying stock on the date of grant, no compensation expense is recognized on grant date. Pro forma information regarding net income and earnings per share is required by SFAS 123, and has been determined as if the company had accounted for its employee stock options granted subsequent to December 31, 1994 under the fair value method of that Statement. The fair value for these options was estimated at the date of grant using a Black-Scholes option pricing model with the following weighted-average assumptions for 1996 and 1995, respectively: risk-free interest rates of 6.06% and 5.34% and dividend yields of 1.5%; volatility factors of the expected market price of the company's common stock of .33 and .353; and a weighted-average expected life of the option of 5.35 years. The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility and risk free interest rates. Because the company's employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management's opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options. For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the options' vesting period. Because SFAS No. 123 prohibits retroactive application, pro forma information is not indicative of future amounts. That is, the new rules are applied only to stock options granted in 1995 and 1996 and do not reflect expense on nonvested options granted prior to 1995. The company's pro forma information follows (in thousands except for earnings per share information):
A summary of the company's stock option activity, and related information for the years ended December 31 is as follows:
Information with respect to the company's stock options outstanding at December 31, 1996 is as follows:
Options are granted at fair value on the date of grant. Therefore, the weighted average grant date fair value is equal to the weighted average option price presented above. The company had exercisable options of 246,635, 210,135 and 252,515 at December 31, 1996, 1995 and 1994, respectively.
Shares of common stock issued under the company's stock incentive plans are set forth in the following table:
Defined Benefit Plans Substantially all full-time employees of the company are covered by a non-contributory self-insured defined benefit pension plan. The benefits are based on years of service and the employee's compensation during the last five years of employment. Further, the company sponsors a supplemental defined benefit plan to provide benefits in excess of amounts allowed pursuant to Internal Revenue Code Section 401(a) (17) and those allowed due to integration rules. The company's funding policy with respect to these plans is consistent with the funding requirements of federal law and regulations. The following table sets forth the plans' funded status and amounts recognized in the company's consolidated balance sheet:
The discount rate and rate of increase in future compensation levels used in determining the actuarial present value of the projected benefit obligation were 7.0% and 5.0%, respectively, at December 31, 1996 and 1995. The average expected long term rate of return on plan assets was 8.0% in 1996, 1995 and 1994.
The weighted-average annual assumed rate of increase in the per capita cost of health care benefits (i.e. health care cost trend rate) used in determining the actuarial present value of the accumulated postretirement benefit obligation was 11.5% at December 31, 1996 and 12.5% at December 31, 1995 for employees under 65 and 8.0% at December 31, 1996 and 8.5% at December 31, 1995 for employees over 65, with the rates for both groups to be graded down to 5.5% for 2005 and thereafter. The health care cost trend rate assumption has a significant effect on the amounts reported. For example, increasing the assumed health care trend rates by one percent would increase the accumulated postretirement benefit obligation as of December 31, 1996 by $861,149 and net periodic postretirement benefit costs for the year ended December 31, 1996 by $165,730. The discount rate used in determining the accumulated postretirement benefit obligation was 7.0% at December 31, 1996 and 1995.
Other Benefit Plans The company also sponsors an unfunded deferred compensation plan providing benefits to certain former employees. The company did not recognize any benefits during 1996. During the years ended December 31, 1995 and 1994, the company recognized benefits of $20,000 and $38,000, respectively, in connection with this plan. The company sponsors pension plans for its employees which are qualified under Internal Revenue Code Section 401(k). Employees may contribute a portion of their annual salary, subject to limitation, to the plans. The company contributes an additional amount, subject to limitation, based on the voluntary contribution of the employee. Company contributions charged to expense with respect to these plans during the years ended December 31, 1996, 1995 and 1994 were $427,000, $328,000 and $333,000, respectively. Equitable Life has non-contributory defined contribution pension plans, tax qualified and non-qualified, for its agents. Combined contributions charged to expense under the career, general and corporate agent pension plans during the years ended December 31, 1996, 1995 and 1994 amounted to $710,000, $729,000 and $507,000, respectively. Certain assets related to the plans discussed above are on deposit with Equitable Life and amounts relating to these plans are included in these consolidated financial statements.
Reinsurance: In the normal course of business, the company seeks to limit its exposure to loss on any single insured and to recover a portion of benefits paid by ceding reinsurance to other insurance enterprises or reinsurers. Reinsurance coverages for life insurance vary according to the age and risk classification of the insured with retention limits ranging up to $500,000 of coverage per individual life. The company does not use financial or surplus relief reinsurance. At December 31, 1996, life insurance in force ceded on a consolidated basis amounted to $1,541,268,000, or approximately 13.3% of total life insurance in force. Reinsurance contracts do not relieve the company of its obligations to its policyholders. To the extent that reinsuring companies are later unable to meet obligations under reinsurance agreements, the company's life insurance subsidiaries would be liable for these obligations, and payment of these obligations could result in losses to the company. To limit the possibility of such losses the company evaluates the financial condition of its reinsurers, monitors concentrations of credit risk arising from factors such as similar geographic regions and limits its exposure to any one reinsurer. At December 31, 1996, the company had reinsurance treaties with 15 reinsurers, all of which are deemed to be long-duration, retroactive contracts, and has established a receivable totaling $14,764,000 for reserve credits ($19,298,000 in 1995), reinsurance claims and other receivables from these reinsurers. No allowance for uncollectible amounts has been established since none of the receivables are deemed to be uncollectible, and because such receivables, either individually or in the aggregate, are not material to the company's operations. The company's liability for future policy benefits and notes and other receivables have been increased by $14,636,000 at December 31, 1996 ($18,103,000 in 1995) for reserve credits on reinsured policies. This "gross-up" of assets and liabilities for reserve credits on reinsurance had no impact on the company's net income. Insurance premiums and product charges have been reduced by $7,725,000, $6,271,000 and $5,916,000 and insurance benefits have been reduced by $6,571,000, $8,281,000 and $5,310,000 in 1996, 1995 and 1994, respectively, as a result of the cession agreements. The amount of reinsurance assumed is not significant.
Guaranty Fund Assessments: Assessments are levied on the company's life insurance subsidiaries by life and health guaranty associations in most states in which these subsidiaries are licensed to cover losses of policyholders of insolvent or rehabilitated insurers. In some states, these assessments can be partially recovered through a reduction in future premium taxes. The company cannot predict whether and to what extent legislative initiatives may affect the right to offset. Based upon information currently available from the National Organization of Life and Health Insurance Guaranty Associations (NOLHGA), the company believes that it is probable these insolvencies will result in future assessments which could be material to the company's financial statements if the company's reserve is not sufficient. The company regularly reviews its reserve for these insolvencies and updates its reserve based upon the company's interpretation of the NOLHGA annual report recently received. The associated cost for a particular insurance company can vary significantly based upon its premium volume by line of business and state premiums levels as well as its potential for premium tax offset. Accordingly, the company accrued and charged to expense an additional $316,000, $36,492,000 and $1,763,000 during 1996, 1995 and 1994, respectively. At December 31, 1996, the company has an undiscounted reserve of $46,718,000 to cover estimated future assessments (net of related anticipated premium tax credits) and has established an asset totaling $16,812,000 for assessments paid which may be recoverable through future premium tax offsets. The company believes this reserve is sufficient to cover expected future insurance guaranty fund assessments, based upon previous premium levels, and known insolvencies at this time.
As previously reported, on December 15, 1995, USG received a Notice of Intention to Arbitrate a dispute with one of its insurance brokerage agencies before the American Arbitration Association regarding the payment of certain commissions. The matter was submitted to arbitration and the determination of the arbitration panel was that the company must pay, over time, commissions in amounts that are not material.
Leases and Other Commitments: The company leases its home office space and certain other equipment under operating leases which expire through 2017. During the years ended December 31, 1996, 1995 and 1994, rent expense totaled $2,953,000, $2,240,000 and $1,998,000, respectively. At December 31, 1996, minimum rental payments due under all non-cancelable operating leases with initial terms of one year or more are: 1997 - $3,734,000; 1998 - $4,285,000; 1999 - $2,908,000; 2000 - $2,638,000 and 2001 - $2,638,000. At December 31, 1996, outstanding commitments to fund mortgage loans on real estate and equity investments totaled $63,300,000 and $10,915,000, respectively.
Insurance revenues and profitability are typically not seasonal in nature. However, the recognition of realized gains and losses on investments may vary from quarter to quarter. During 1996, the company recognized pre-tax realized gains of: first quarter - $5,150,000; second quarter - $6,168,000; third quarter - $4,510,000 and fourth quarter - $427,000. During 1995, the company recognized pre-tax realized gains of: first quarter - $113,000; second quarter - $1,790,000; third quarter - $1,114,000 and fourth quarter - $6,507,000. In the fourth quarter of 1995, the company established an additional accrual for guaranty funds assessments of $23,400,000, net of tax. This reduced net income per share by $0.74. See Note 11 for further discussion.