The Company incurs significant costs in connection with acquiring new insurance business. These costs, which vary with and are primarily related to the production of new business and coinsurance of blocks of policies, are deferred. The recovery of such costs is dependent on the future profitability of the related policies. The amount of future profit is dependent principally on investment returns, mortality, morbidity, persistency, and expenses to administer the business and certain economic variables, such as inflation. These factors enter into management’s estimates of future profits which generally are used to amortize certain of such costs. Revisions to estimates result in changes to the amounts expensed in the reporting period in which the revisions are made and could result in the impairment of the asset and a charge to income if estimated future profits are less than the unamortized deferred amounts. At December 31, 2004, the Company had a deferred acquisition cost asset of $93.1 million.
The Company has a deferred policy acquisition costs asset of approximately $0.7 million related to its variable annuity product lines with an account balance of $14.1 million at December 31, 2004. The Company monitors the rate of amortization of the deferred policy acquisition costs associated with its variable annuity product line. The Company’s monitoring methodologies employ varying assumptions about how much and how quickly the stock markets will appreciate. The primary assumptions used to project future profits as part of the recoverability analysis include: a long-term equity market growth rate of 9%, reversion to the mean methodology with a reversion to the mean cap rate of 14%, reversion to the mean period of 5 years, and an amortization period of 20 years. A recovery in equity markets, or the use of methodologies and assumptions that anticipate a recovery, result in lower amounts of amortization, and a worsening of equity markets results in higher amounts of amortization.
Establishing an adequate liability for the Company’s obligations to its policyholders requires the use of assumptions. Estimating liabilities for future policy benefits on life and health insurance products requires the use of assumptions relative to future investment yields, mortality, morbidity, persistency and other assumptions based on the Company’s historical experience, modified as necessary to reflect anticipated trends and to include provisions for possible adverse deviation. At December 31, 2004, the Company had total policy liabilities and accruals of $494.5 million.
Premiums and policy fees, net of reinsurance (“premiums and policy fees”) decreased $0.8 million or 3.2% in 2004 as compared to 2003. Premiums and policy fees in the Life Marketing segment increased $0.2 million in 2004 as compared to 2003 due to growth of business in-force. Premiums and policy fees in the Acquisitions segment are expected to decline with time unless new acquisitions are made. There were no new acquisitions made in 2004 or 2003, resulting in a decrease in premiums of $0.9 million.
Net investment income for 2004 was $40.4 million, 2.2% lower than for the preceding year primarily due to lower amounts of invested assets for the year 2004 as compared to 2003. The percentage earned on average cash and investments was 6.0% in 2004 and 5.9% in 2003.
Realized investment gains in 2004 were approximately $0.5 million as compared to $3.3 million in 2003. The Company generally purchases its investments with the intent to hold to maturity by purchasing investments that match future cash flow needs. However, the Company may sell any of its investments to maintain proper matching of assets and liabilities. Accordingly, the Company has classified its fixed maturities and certain other securities as "available for sale."
The following table sets forth segment operating income (loss) and income (loss) before income tax by business segment for the periods shown:
(1) Income before income tax excluding realized investment gains and related amortization of deferred policy acquisition costs.
Management's current estimate of the effective income tax rate for 2005 is 34.9%.
Net income for 2004 decreased compared to 2003, reflecting lower realized investment gains and lower operating earnings in Acquisitions, Asset Protection, and Corporate and Other, partially offset by improved operating earnings in the Life Marketing and Annuities segments.
The Company’s investments in debt securities are reported at market value, and investments in mortgage loans are reported at amortized cost. At December 31, 2004, the Company’s fixed maturity investments (bonds) had a market value of $625.1 million, which is 8.0% above amortized cost of $578.8 million. The Company had $1.2 million in mortgage loans at December 31, 2004. While the Company’s mortgage loans do not have quoted market values, at December 31, 2004, the Company estimates the market value of its mortgage loans to also be $1.2 million (using discounted cash flows from the next call date).
Market values for private, non-traded securities are determined as follows: 1) the Company obtains estimates from independent pricing services or 2) the Company estimates market value based upon a comparison to quoted issues of the same issuer or issues of other issuers with similar terms and risk characteristics. The market value of private, non-traded securities was $80.5 million at December 31, 2004, representing 11.8% of the Company’s total invested assets.
The Company generally considers a number of factors relating to the issuer in determining the financial strength, liquidity, and recoverability of an issuer. These include but are not limited to: available collateral, tangible and intangible assets that might be available to repay debt, operating cash flows, financial ratios, access to capital markets, quality of management, market position, exposure to litigation or product warranties, and the effect of general economic conditions on the issuer. Once management has determined that a particular investment has suffered an other-than-temporary impairment, the asset is written down to its estimated fair value.
For traded and private fixed maturity securities held by the Company that are in an unrealized loss position at December 31, 2004, the estimated market value, amortized cost, unrealized loss and total time period that the security has been in an unrealized loss position are presented in the table below.
Statements of Share-Owners’ Equity for the years ended December 31, 2004, 2003, and 2002
Statements of Cash Flows for the years ended December 31, 2004, 2003, and 2002
All other schedules to the financial statements required by Article 7 of Regulation S-X are not required under the related instructions or are inapplicable and therefore have been omitted.
In our opinion, the financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Protective Life and Annuity Insurance Company at December 31, 2004 and 2003, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2004 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedules listed in the accompanying index present fairly, in all material respects, the information set forth therein when read in conjunction with the related financial statements. These financial statements and financial statement schedules are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
Benefits and settlement expenses (net of reinsurance ceded: 2004 - $28,535,116; 2003 - $30,371,296; 2002 - $18,296,707)
Change in policy liabilities and other policyholders’ funds of traditional life and
On October 1, 2003, the Company adopted Derivatives Implementation Group Issue No. B36, “Embedded Derivatives: Modified Coinsurance Arrangements and Debt Instruments That Incorporate Credit Risk Exposures That Are Unrelated or Only Partially Related to the Creditworthiness of the Obligor under Those Instruments” (DIG B36). DIG B36 requires the bifurcation of embedded derivatives within certain modified coinsurance and funds withheld coinsurance arrangements that expose the creditor to credit risk of a company other than the debtor, even if the debtor owns as invested assets the third-party securities to which the creditor is exposed. The adoption did not have a material impact on its financial condition or results of operations.
The Company has classified all of its investments in fixed maturities and short-term investments as "available for sale."
Certain reclassifications have been made in the previously reported financial statements and accompanying notes to make the prior year amounts comparable to those of the current year. Such reclassifications had no effect on previously reported net income, total assets, or share-owners’ equity.
Financial statements prepared in conformity with GAAP differ in some respects from the statutory accounting practices prescribed or permitted by insurance regulatory authorities. The most significant differences are as follows: (a) acquisition costs of obtaining new business are deferred and amortized over the approximate life of the policies rather than charged to operations as incurred; (b) benefit liabilities are computed using a net level method and are based on realistic estimates of expected mortality, interest, and withdrawals as adjusted to provide for possible unfavorable deviation from such assumptions; (c) deferred income taxes are not subject to statutory limitations as to amounts recognized and are recognized through earnings as opposed to being charged to share-
owners’ equity; (d) the Asset Valuation Reserve and Interest Maintenance Reserve are restored to share-owners’ equity; (e) agents' debit balances and prepaid expenses are reported as assets rather than being charged directly to surplus (referred to as nonadmitted items); (f) certain items of interest income, such as mortgage and bond discounts, are amortized differently; and (g) bonds are recorded at their market values instead of amortized cost.
The other corporate bonds and public utilities categories had gross unrealized losses in an unrealized loss position for greater than 12 months of $1.1 million and $1.1 million, respectively, at December 31, 2004. The aggregate decline in market value of these securities was deemed temporary due to positive factors supporting the recoverability of the respective investments. Positive factors considered included credit ratings, the financial health of the investee, the continued access of the investee to capital markets, and other pertinent information, including the Company’s ability and intent to hold these securities to recovery.
At December 31, 2004 and 2003, the Company had no problem mortgage loans (over sixty days past due) or foreclosed properties. Since the Company’s mortgage loans are collateralized by real estate, any assessment of impairment is based upon the estimated fair value of the real estate. Based on the Company’s evaluation of its mortgage loan portfolio, the Company does not expect any material losses on its mortgage loans.
The Company's income tax returns are included in the consolidated income tax returns of PLC. The allocation of income tax liabilities among affiliates is based upon separate income tax return calculations. At December 31, 2004, $529,937 was due from PLC for income tax liabilities. At December 31, 2003, $702,883 was payable to PLC for income tax liabilities.
Dividends on common stock are noncumulative and are paid as determined by the Board of Directors. At December 31, 2004, approximately $82.9 million of share-owners’ equity excluding net unrealized gains and losses represented net assets of the Company that cannot be transferred to Protective. In general, dividends up to specified levels are considered ordinary and may be paid thirty days after written notice to the insurance commissioner of the state of domicile unless such commissioner objects to the dividend prior to the expiration of such period. Dividends
in larger amounts are considered extraordinary and are subject to affirmative prior approval by such commissioner. The maximum amount that would qualify as ordinary dividends to Protective by the Company in 2005 is estimated to be $14.7 million.
The Company purchases data processing, legal, investment, and other management services from PLC and other affiliates. The cost of such services was $10.2 million in 2004, $9.6 million in 2003, and $8.4 million in 2002.
Protective and the Company also entered into a guaranty agreement on December 31, 1995, whereby Protective guaranteed that the Company will perform all of the obligations of Protective pursuant to the terms and conditions of an indemnity coinsurance agreement between Protective and an unaffiliated life insurance company. Total liabilities related to this coinsurance agreement were $9.4 million at December 31, 2004 and 2003.
The Company became involved with PLC’s Life Marketing segment beginning in 2002. PLC’s Life Marketing segment markets level premium term and term-like insurance, universal life, variable universal life and “bank owned life insurance” (BOLI) products on a national basis primarily through networks of independent insurance agents and brokers, and in the BOLI market.
The Company has an additional segment herein referred to as Corporate and Other. The Corporate and Other segment primarily consists of net investment income and expenses not attributable to the segments above (including net investment income on unallocated capital and interest on all debt).
The Company uses the same accounting policies and procedures to measure segment operating income and assets as it uses to measure its net income and assets. Segment operating income is generally income before income
tax, adjusted to exclude net realized investment gains and losses. Segment operating income represents the basis on which the performance of the Company’s business is assessed by management. Premiums and policy fees, other income, benefits and settlement expenses, and amortization of deferred policy acquisition costs are attributed directly to each operating segment. Net investment income is allocated based on directly related assets required for transacting the business of that segment. Realized investment gains (losses) and other operating expenses are allocated to the segments in a manner which most appropriately reflects the operations of that segment.
The following table sets forth segment operating income and assets for the periods shown. Asset adjustments represent the inclusion of assets related to discontinued operations.
The Company reinsures certain of its risks with, and assumes risks from, other insurers under yearly renewable term, coinsurance, and modified coinsurance agreements. Under yearly renewable term agreements, the Company generally pays specific premiums to the reinsurer and receives specific amounts from the reinsurer as reimbursement for certain expenses. Coinsurance agreements are accounted for by passing a portion of the risk to the reinsurer. Generally, the reinsurer receives a proportionate part of the premiums less commissions and is liable for a corresponding part of all benefit payments. Modified coinsurance is accounted for similarly to coinsurance except that the liability for future policy benefits is held by the original company, and settlements are made on a net basis between the companies. A substantial portion of the Company’s new life insurance and credit insurance sales is being reinsured. The Company regularly reviews the financial condition of its reinsurers.
The Company has reinsured approximately $7.8 billion, $7.0 billion, and $6.6 billion in face amount of life insurance risks with other insurers representing $30.9 million, $50.1 million, and $23.0 million of premium income for 2004, 2003, and 2002 respectively. The Company has also reinsured accident and health risks representing $6.7 million, $(2.8) million, and $0.8 million of premium income for 2004, 2003, and 2002, respectively. In 2004 and 2003, policy and claim reserves relating to insurance ceded of $43.4 million and $61.2 million respectively are included in reinsurance receivables. Should any of the reinsurers be unable to meet its obligation at the time of the claim, obligation to pay such claim would remain with the Company. At December 31, 2004 and 2003, the Company had paid $2.9 million and $4.1 million, respectively, of ceded benefits which are recoverable from reinsurers.
The Company has assumed approximately $5.4 billion, $6.1 billion, and $7.2 billion in face amount of life insurance risks from other insurers representing $43.6 million, $66.0 million, and $42.2 million of premium income for 2004, 2003, and 2002 respectively. The Company has also assumed accident and health risks representing $6.7 million, $(3.4) million, and $(0.4) million of premium income for 2004, 2003, and 2002, respectively.
(1) Allocations of net investment income and other operating expenses are based on a number of assumptions and estimates and results would change if different methods were applied.