Management's discussion and analysis of financial condition and results of operations of SunAmerica Inc. (the "Company") for the three years in the period ended September 30, 1998 follows. In connection with the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995, the Company cautions readers regarding certain forward-looking statements contained in this report and in any other statements made by, or on behalf of, the Company, whether or not in future filings with the Securities and Exchange Commission (the "SEC"). Forward-looking statements are statements not based on historical information and which relate to future operations, strategies, financial results, or other developments. Statements using verbs such as "expect," "anticipate," "believe" or words of similar import generally involve forward-looking statements. Without limiting the foregoing, forward-looking statements include statements which represent the Company's beliefs concerning future levels of sales and redemptions of the Company's products, investment spreads and yields, or the earnings and profitability of the Company's activities.
The Company has historically sought to enhance investment yield through total return bond swap agreements (the "Total Return Agreements"). However, because of recent significant market declines in the non-investment-grade bond sector, the Company recorded losses of $33.7 million on Total Return Agreements in 1998. The Company recorded income of $35.4 million in 1997 and $32.5 million in 1996 on Total Return Agreements. (See "Asset-Liability Matching" for additional discussion of Total Return Agreements.)
Average invested assets also increased as a result of sales of the Company's fixed-rate products, consisting of both fixed annuity premiums (including those for the fixed accounts of variable annuity products) and GIC premiums. Fixed annuity premiums totaled $1.80 billion in 1998, compared with $1.49 billion in 1997 and $993.4 million in 1996. These amounts represent 12%, 15% and 20% of the fixed annuity reserve balance at the beginning of the respective periods. The decreases in percentages in 1998 and 1997 reflect the impact of the Acquisitions, which increased fixed annuity reserve balances at the beginning of the respective periods. Fixed annuity premiums include premiums for the fixed accounts of variable annuities totaling $1.59 billion, $1.17 billion and $782.6 million, in 1998, 1997 and 1996, respectively. Increases in premiums for the fixed accounts of variable annuity products principally reflect higher variable annuity product sales and the use of the fixed accounts for dollar cost averaging into the variable accounts.
NET REALIZED INVESTMENT LOSSES totaled $41.7 million in 1998, compared with $29.2 million in 1997 and $30.3 million in 1996. Net realized investment losses include impairment writedowns of $109.8 million in 1998, $65.3 million in 1997 and $34.9 million in 1996. Thus, net gains from sales and redemptions of investments totaled $68.1 million in 1998, $36.1 million in 1997 and $4.6 million in 1996.
investments result from the active management of the Company's investment portfolio. Because redemptions of investments are generally involuntary and sales of investments are made in both rising and falling interest rate environments, net gains from sales and redemptions of investments fluctuate from period to period, and represent 0.27%, 0.17%, and 0.03% of average invested assets for 1998, 1997 and 1996, respectively. Active portfolio management involves the ongoing evaluation of asset sectors, individual securities within the investment portfolio and the reallocation of investments from sectors that are perceived to be relatively overvalued to sectors that are perceived to be relatively undervalued. The intent of the Company's active portfolio management is to maximize total returns on the investment portfolio, taking into account credit, option, liquidity and interest-rate risk.
Historically, impairment writedowns primarily have been applied to defaulted bonds. However, in 1998, as a result of equity market declines in the later part of the fiscal year, impairment writedowns were also applied to various cost-method partnerships. Impairment writedowns represent 0.44%, 0.31% and 0.24% of average invested assets for 1998, 1997 and 1996, respectively. For the five years ended September 30, 1998, impairment writedowns as a percentage of average invested assets have ranged from 0.24% to 0.63% and have averaged 0.41%. Such writedowns are based upon estimates of the net realizable value of the applicable assets. Actual realization will be dependent upon future events.
representative and generally favorable market conditions. The greater number of registered representatives was primarily due to acquisitions, including the April 2, 1998 acquisition of Sentra Securities Corporation and Spelman & Co. Inc. ("Sentra-Spelman"), the October 1, 1997 acquisition of Financial Service Corporation and the January 22, 1997 acquisition of The Financial Group, Inc. At their respective dates of acquisition, these acquired companies licensed through their subsidiaries approximately 500, 1,500 and 400 independent registered representatives, respectively. Increases in net retained commissions may not be proportionate to increases in sales primarily due to differences in sales mix.
Excluding the effects of the Acquisitions, withdrawal payments represented 8.7% in 1998, 10.4% in 1997 and 11.6% in 1996 of related average fixed and variable annuity reserves. These lower surrender rates in the current periods reflect the continued decreases in the percentage of non-acquisition-related annuity contracts that are free of surrender charges.
ASSET MANAGEMENT FEES, which include investment advisory fees and 12b-1 distribution fees, are based on the market value of assets managed in mutual funds by SunAmerica Asset Management Corp. Such fees totaled $29.6 million on average assets managed of $2.89 billion in 1998, $25.8 million on average assets managed of $2.34 billion in 1997 and $25.4 million on average assets managed of $2.14 billion in 1996. Asset management fees are not proportionate to average assets managed, principally due to changes in product mix. Sales of mutual funds, excluding sales of money market accounts, aggregated $853.6 million in 1998, compared with $454.8 million in 1997 and $223.4 million in 1996. The significant increases in sales principally resulted from sales of the Company's "Style Select Series" product (which was introduced in November 1996) and the introduction in June 1998 of the "Dogs" of Wall Street. The "Style Select Series" is a group of mutual funds which are each managed by three industry recognized fund managers. The "Dogs" of Wall Street fund contains 30 large capitalization value stocks which are selected by strict criteria. Sales of these products totaled $611.1 million in 1998, compared with $267.8 million in 1997, reflecting the addition of five new Style Select funds, which more than doubled the number of Style Select funds to nine, and generally favorable market conditions. Redemptions of mutual funds, excluding redemptions of money market accounts, amounted to $402.5 million in 1998, $412.8 million in 1997 and $379.9 million in 1996, which represent 17.5%, 22.0% and 21.4%, respectively, of average mutual fund assets.
LOAN SERVICING FEES are earned by Imperial Premium Finance, Inc. ("Imperial"). Imperial provides short-term installment loans for borrowers to fund their property and casualty insurance premiums. These loans are secured by the unearned premium associated with the underlying insurance policies. Currently, Imperial sells most of the loans it originates and earns fee income by servicing the sold loans. Such fee income totaled $23.4 million on average loans serviced of $483.0 million in 1998, compared with $24.3 million on average loans serviced of $490.5 million in 1997 and $23.8 million on average loans serviced of $457.8 million in 1996.
TRUST FEES are earned by Resources Trust Company for providing administrative and custodial services primarily for individual retirement accounts, as well as for other qualified retirement plans. Trust fees increased to $18.1 million in 1998 (on an average of 208,000 trust accounts) from $17.9 million in 1997 (on an average of 204,000 trust accounts) and $16.7 million in 1996 (on an average of 202,000 trust accounts).
AMORTIZATION OF DEFERRED ACQUISITION COSTS totaled $241.2 million in 1998, compared with $165.1 million in 1997 and $108.2 million in 1996. The increases in amortization primarily reflect the amortization of the deferred acquisition costs attributable to the Acquisitions, which aggregated $133.0 million in 1998, $65.2 million in 1997 and $16.8 million in 1996. Amortization has also increased due to additional fixed and variable annuity and mutual fund sales and the subsequent amortization of related deferred commissions and other direct selling costs.
INCOME TAX EXPENSE totaled $191.0 million in 1998, compared with $158.0 million in 1997 and $117.6 million in 1996, representing effective tax rates of 27% in 1998, 29% in 1997 and 30% in 1996. These tax rates reflect the favorable impact of tax credits associated with tax-advantaged investments in affordable housing partnerships owned by the Company.
On September 22, 1998, the Company announced that it would redeem all of its Series E Preferred Stock. The redemption was completed on October 30, 1998 and resulted in the issuance of approximately 11.3 million shares of common stock. For the year ending September 30, 1998, the Series E Preferred Stock was included in the computation of diluted earnings per share as 12.2 million of common stock equivalents.
On October 7, 1998, subsequent to the Company's fiscal year end, the Company announced that it will redeem all of its 8 1/2% Premium Equity Redemption Cumulative Security Units ("PERCS Units") on December 6, 1998. In connection with this redemption, the Company will issue approximately 10.1 million shares of its common stock and will receive $431.3 million in cash proceeds. For the year ending September 30, 1998, the PERCS Units were included in the computation of diluted earnings per share as 4.3 million of common stock equivalents.
BOOK VALUE PER SHARE amounted to $14.45 at September 30, 1998, up from $12.40 at September 30, 1997. Excluding net unrealized gains on debt and equity securities available for sale, book value per share amounted to $13.50 at September 30, 1998 and $11.39 at September 30, 1997. On a pro forma basis, assuming that the PERCS Units were converted to Common Stock, book value per share would have been $16.02 at September 30, 1998, compared with $13.40 at September 30, 1997 and, excluding net unrealized gains on debt and equity securities available for sale, would have been $15.10 at September 30, 1998 and $12.47 at September 30, 1997.
The following table summarizes the Company's rated bonds by rating classification as of September 30, 1998 (dollars in thousands):
(2) Bonds and short-term promissory instruments are divided into six quality categories for NAIC rating purposes, ranging from 1 (highest) to 5 (lowest) for nondefaulted bonds plus one category, 6, for bonds in or near default. These six categories correspond with the S&P/Moody's/DCR/Fitch rating groups listed above, with categories 1 and 2 considered investment grade. The NAIC categories include $1.30 billion of assets that were rated by the Company pursuant to applicable NAIC rating guidelines.
MORTGAGE LOANS aggregated $3.41 billion at September 30, 1998 and consisted of 1,538 commercial first mortgage loans with an average loan balance of approximately $2.2 million, collateralized by properties located in 47 states. Approximately 27% of this portfolio was multifamily residential, 23% was retail, 17% was office, 11% was manufactured housing, 7% was industrial and 15% was other types. At September 30, 1998, approximately 19%, 12% and 10% of this portfolio was secured by properties located in California, New York and Texas, respectively, and no more than 7% of this portfolio was secured by properties located in any other single state. At September 30, 1998, there were 59 mortgage loans with outstanding balances of $10 million or more, which loans collectively aggregated approximately 30% of this portfolio. At September 30, 1998, approximately 31% of the mortgage loan portfolio consisted of loans with balloon payments due before October 1, 2001. During 1998, 1997 and 1996 loans delinquent by more than 90 days, foreclosed loans and restructured loans have not been significant in relation to the total mortgage loan portfolio.
At September 30, 1998, approximately 40% of the mortgage loans were seasoned loans underwritten to the Company's standards and purchased at or near par from other financial institutions. Such loans generally have higher average interest rates than loans that could be originated today. The balance of the mortgage loan portfolio has been originated by the Company under strict underwriting standards. Commercial mortgage loans on properties such as offices, hotels and shopping centers generally represent a higher level of risk than do mortgage loans secured by multifamily residences. This greater risk is due to several factors, including the larger size of such loans and the more immediate effects of general economic conditions on these commercial property types. However, due to the seasoned nature of the Company's mortgage loan portfolio, its emphasis on multifamily loans and its strict underwriting standards, the Company believes that it has prudently managed the risk attributable to its mortgage loan portfolio while maintaining attractive yields.
PARTNERSHIP investments totaled $1.65 billion at September 30, 1998, constituting investments in approximately 661 separate partnerships with an average size of approximately $2.5 million. This portfolio includes: (i) $867.7 million of partnerships managed by independent money managers that invest in a broad selection of equity and fixed-income securities, currently including approximately 4,700 separate issuers; (ii) $640.7 million of partnerships that make tax-advantaged investments in affordable housing properties, currently involving approximately 540 multifamily projects in 41 states; and (iii) $136.7 million of partnerships that invest in mortgage loans and income-producing real estate. The risks generally associated with partnerships include those related to their underlying investments (i.e. equity securities, debt securities and real estate), plus a level of illiquidity, which is mitigated, to some extent, a) for the affordable housing partnerships, by the marketability of the tax credits they generate, and b) in the case of many of the other partnerships, by the existence of contractual termination provisions.
INVESTED ASSETS EVALUATION is routinely conducted by the Company. Management identifies monthly those investments that require additional monitoring and carefully reviews the carrying values of such investments at least quarterly to determine whether specific investments should be placed on a nonaccrual basis and to determine declines in value that may be other than temporary. In making these reviews for bonds, management principally considers the adequacy of any collateral, compliance with contractual covenants, the borrower's recent financial performance, news reports and other externally generated information concerning the creditor's affairs. In the case of publicly traded bonds, management also considers market value quotations, if available. For mortgage loans, management generally considers information concerning the mortgaged property and, among other things, factors impacting the current and expected payment status of the loan and, if available, the current fair value of the underlying collateral. For investments in partnerships, management reviews the financial statements and other information provided by the general partners.
The Parent received dividends from its regulated life insurance subsidiaries totaling $143.0 million in September 1998, $118.7 million in April 1997 and $94.3 million in March 1996. The Parent also received dividends of $12.9 million in fiscal 1998, $17.5 million in fiscal 1997 and $16.0 million in fiscal 1996 from its other directly owned subsidiaries. The ability of the Company's life insurance subsidiaries to pay dividends is limited by statute. For the remainder of calendar year 1998, no amounts are available for dividends to the Parent from its regulated life insurance subsidiaries.
The Company has sold, through three separate coinsurance transactions: (i) the general agency division of SunAmerica Life Insurance Company to Savers Life Insurance Company (in 1989) which subsequently transferred the business to Winterthur Life Re Insurance Company; (ii) the credit life business of Ford Life to Vista Life Insurance Company (in 1996); and (iii) the mortality-based business of CalAmerica Life Insurance Company to Protective Life Insurance Company (in 1996). With respect to these coinsurance transactions, SunAmerica entities could become liable for in-force amounts ceded of $894.7 million, $962.2 million and $1.90 billion, respectively, at September 30, 1998, if the coinsurers were to become unable to meet the obligations assumed under the respective coinsurance agreements. However, the Company considers these contingencies to be remote because the coinsurers are strong credit-worthy institutions and, in the case of the 1989 transaction, assets substantially equal to the policyholder reserves assumed by the coinsurer are held in trust to secure the obligations of the coinsurer. At September 30, 1998, related policyholder reserves carried by the coinsurers were $59.3 million, $10.9 million and $157.3 million, respectively.
Parent has agreed to advance monies to support the operations of the underlying housing projects, if required, and has guaranteed that the transferred partnerships will provide, as of the transfer date and under then current tax laws, a specified level of associated tax credits and deductions to the third- party investors. Based on an evaluation of the underlying housing projects, management does not anticipate any material cash payments with respect to the guarantees.
The Company relies significantly on computer systems and applications in its daily operations. Many of these systems are not presently year 2000 compliant, which means that because they have historically used only two digits to identify the year in a date, they will fail to distinguish dates in the "2000s" from dates in the "1900s." The Company's business, financial condition and results of operations could be materially and adversely affected by the failure of the Company's systems and applications (and those operated by third parties interfacing with the Company's systems and applications) to properly operate or manage these dates.
In addition, the Company has distributed a year 2000 questionnaire to certain of its significant suppliers, distributors, financial institutions, lessors and others with which it does business to evaluate their year 2000 compliance plans and state of readiness and to determine the extent to which the Company's systems and applications may be affected by the failure of others to remediate their own year 2000 issues. To date, however, the Company has received only preliminary feedback from such parties and has not independently confirmed any information received from other parties with respect to the year 2000 issues. Therefore, there can be no assurance that such other parties will complete their year 2000 conversions in a timely fashion or will not suffer a year 2000 business disruption that may adversely affect the Company's financial condition and results of operations.