We own and occupy four buildings in League City, Texas, consisting of a total of approximately 298,000 square feet. Approximately one-third of such space is leased to third parties. Our use of these facilities is related primarily to our Life, Health, and Corporate and Other segments.
Set forth on the following pages is management’s discussion and analysis (“MD&A”) of our financial condition. This narrative analysis should be read in conjunction with the forward-looking statement information below, the audited consolidated financial statements and related notes included in Item 8 and Risk Factors included in Item 1A.
We manage our business through five business segments, which are comprised of four insurance segments: Life, Annuity, Health and Property and Casualty, and our Corporate and Other segment. The life, annuity, and health insurance segments are primarily operated through five domestic insurance companies. The property and casualty insurance segment is operated through eight domestic property and casualty insurance companies.
The insurance segments have revenues, which consist primarily of the following:
The insurance segments have liabilities for all of the insurance products sold through the segment. Each insurance segment also has an amount of surplus allocated to it sufficient to support the segment’s business activities. The insurance segments do not directly own any assets, but assets are allocated to the segments to support the liabilities and surplus of each segment. The mix of assets allocated to each of the insurance segments is modified as necessary to provide the right match of cash flows and earnings to properly support the characteristics of the insurance liabilities. We have utilized this methodology consistently over all periods presented.
The Corporate and Other segment directly owns all of the invested assets of the Company. As noted above, assets and surplus from the Corporate and Other segment are allocated to the insurance segments as necessary to support the liabilities of those segments. The investment income from the invested assets is also allocated to the insurance segments from the Corporate and Other segment in accordance with the amount of assets allocated to each segment. Earnings of the Corporate and Other segment are derived from our non-insurance businesses as well as earnings from those invested assets that do not support the insurance segments. All realized investment gains and losses are recorded in this segment.
In recent years, our business has been and likely will continue to be, influenced by a number of industry-wide and segment or product specific trends and conditions. In our discussion below, we first outline the broad macro-economic or industry trends (General Trends) that we expect will have an impact on our overall business. Second, we discuss certain segment specific trends that we believe may impact either individual segments of our business or specific products within these segments.
Low Interest Rates: Low interest rate environments are typically challenging for life and annuity companies as the spreads on deposit-type funds and contracts narrow and policies approach their minimum crediting rates. Low market interest rates may reduce the spreads between the amounts we credit to fixed annuity and individual life policyholders and the yield we earn on the investments that support these obligations. We have an established Asset/Liability Management Committee that actively manages the profitability of our in force block of insurance policies. In response to the unusually low interest rates in recent years, we have reduced the guaranteed minimum crediting rates on newly issued fixed annuity contracts and reduced crediting rates on in-force contracts, where permitted to do so. These actions have helped mitigate the adverse impact of low interest rates on our spreads and on the profitability of these products, although sales volume and persistency could diminish as a result. Additionally, the committee maintains assets with various maturities to support product liabilities and ensure liquidity. A gradual increase in longer-term interest rates relative to short-term rates generally will have a favorable effect on the profitability of these products. Although rapidly rising interest rates could result in reduced persistency in our spread-based retail products, as contract holders shift assets into higher yielding investments, we believe that our ability to react quickly to the changing marketplace will allow us to manage this risk.
Focus on Operating Efficiencies: The challenging economic environment and the recent investment related losses across the industry have created a renewed focus on operating cost reductions and efficiencies. We continue to aggressively manage our cost base while maintaining our commitment to provide superior customer service to agents and policyholders. Investments in technology are aligned with activities and are coordinated through a disciplined project management process. In 2009, we consolidated our data centers and Information Technology (“IT”) operations to realize some of the synergies with our subsidiaries. We also anticipate using technology to enhance our web experience for policyholders and agents.
Changing Regulatory Environment: The insurance industry is regulated at the state level with some life and annuity products and services also subject to federal regulation. The debate over the federal regulatory role in the insurance industry continues to be a divisive issue within the industry. We proactively monitor this debate to determine its impact on our business. The SEC is attempting to enact new registration requirements for equity-indexed products. American National is prepared to support these products, even with additional registration requirements and regulation.
While the annuity segment had insignificant sales volume historically, this segment now represents a major and growing contributor to our operations. Although we experienced a slowdown in variable annuity sales in 2009, our fixed annuity sales continued to increase as investors sought less volatile investment vehicles. In light of the current market, we are committed to maintaining our fixed annuity product lines. We have a conservation program to retain policyholders through proactive communication and education when a policyholder is considering surrendering his or her policy. This has resulted in our retaining approximately 10% of policyholders that have submitted surrender requests.
Demographics: We believe that a key driver shaping the actions of the life insurance industry is the rising income protection, wealth accumulation, and insurance needs of the retiring Baby Boomers (those born between 1946 and 1964). According to the U.S. Census published in 2008, about 19.6 percent of the total population will be over 65 by 2030, compared to about 12.4 percent now. Also, the most rapidly growing age group is expected to be the 85 and older population. As a result of increasing longevity and uncertainty regarding the Social Security system, retirees will need to accumulate sufficient savings to support retirement income requirements.
We are well positioned to address the Baby Boomers’ rapidly increasing need for savings tools and income protection. We believe that our overall financial strength and broad distribution channels will position us to respond with a variety of products needed by Baby Boomers for retirement planning and income requirements. We are ready to respond to individuals approaching retirement age who seek information to plan for and manage their retirement needs. Our products that offer guaranteed income flows for life, including single premium immediate annuities, are well positioned to serve this market.
Established in 2009, we have a project under way to establish a New York life insurance subsidiary. We anticipate that sales will begin through this new company in the first half of 2010. A variety of annuity products will be available for sale once the subsidiary is established, followed in subsequent years by our life products. Initial sales are anticipated through independent and multiple-line agents. Based on competitors’ market experience, we expect annuity deposits from this subsidiary to represent five to ten percent of total deposits received once the market is established.
We have repositioned the competitiveness of life products sold through our Independent Marketing Group, particularly at older ages. While this repositioning resulted in a slowing of sales in the last quarter of 2008 and 2009, it has and will help improve the future profitability of these products.
Since 2007, the property and casualty insurance industry has been experiencing a soft market, characterized by declining premium growth for three consecutive years. “U.S. Property/Casualty - Review and Preview” published by A.M. Best on February 8, 2010 noted that the expected decrease in Net Premiums Written in 2009 has resulted in the first three consecutive year decline in A.M. Best’s recorded history. Following the industry’s historical decreases the last three years to Net Written Premiums, industry-wide operating results are expected to have improved in 2009. This improvement was due to the decline in catastrophe activity from an estimated $23 billion industry-wide in 2008 to an estimated $14 billion in 2009, offset by the prolonged period of competitive market conditions, excess capacity, leakage of premium to non-U.S. companies, alternative forms of risk transfer and the weak economy. A.M. Best expects this competitive pressure will continue in 2010, with an average forecast decline in industry net premiums written of 1.6%. We expect to experience continued pressure on pricing early in 2010, but easing from the levels experienced since 2007, and increasing by the end of 2010. To compete in this tough pricing environment, our long-term plans include developing tiered pricing for our agricultural and commercial lines. Tiered pricing will create a broader range of premiums and is designed to continue to improve our competitive position in the marketplace and our profitability.
With less consumer credit being offered in the market, we anticipate that fewer credit-related insurance products will be purchased. The tightening of credit is more heavily impacting the products written through the auto dealer market. However, the collateral protection production tends to increase in this type of economic environment. We continue to update credit insurance product offerings and pricing to meet these changing market needs, as well as adding new agents to expand our exposure to the credit-related insurance market. We are reviewing and implementing improved procedures to enhance customer service and, at the same time, looking for efficiencies to reduce administrative costs.
Competition: Property and casualty insurers are facing a continued competitive pricing environment. The condition of the economy in 2009 prevented the rate hardening most industry leaders were expecting following the declines in previous years. The competitive environment is expected to continue into 2010 as forecasts for an active hurricane season, the low interest rate environment, and an anticipated sluggish economic recovery all undermine any significant improvement in the market.
The consolidated financial statements have been prepared in conformity with GAAP. The preparation of financial statements requires us to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and their accompanying notes. Actual results could differ from results reported using those estimates.
Our accounting estimates inherently require the use of judgments relating to a variety of assumptions, in particular, expectations of current and future mortality, morbidity, persistency, losses and loss adjustment expenses, recoverability of receivables, investment returns and interest rates. In developing these estimates, we make subjective and complex judgments that are inherently uncertain and subject to material changes as facts and circumstances develop. Although variability is inherent in these estimates, we believe that the amounts provided are appropriate, based upon the facts available upon compilation of the consolidated financial statements.
For traditional life insurance and payout annuities, deferred costs consist of certain underwriting fees, commissions (in excess of ultimate renewal commissions) and certain agent fringe benefit costs, other policy set-up costs, and the cost of insurance in-force gained through acquisitions. The DAC on traditional life and annuity products is amortized with interest over the anticipated premium-paying period of the related policies, in proportion to annual premium revenue to be received over the life of the policies. The present value of expected premium revenue is estimated by using the same mortality, morbidity, persistency and withdrawal assumptions (with provisions for adverse deviation) used in computing liabilities for future policy benefits. These assumptions are not revised after policy issuance or acquisition (i.e., they are “locked in”) unless the DAC balance is deemed to be unrecoverable. We periodically perform loss recognition analysis utilizing best estimate assumptions to determine whether or not the DAC balance is recoverable. See the discussion of Life and Annuity Reserves below for additional details.
DAC on health products is amortized with interest over the anticipated premium-paying period of the related policies. Expected premium revenue is estimated using the same actuarial assumptions used in computing reserves for future policy benefits. Health insurance products that require DAC consideration are those with contractual obligations, which includes all of our products.
Future policy benefits for group life policies have been calculated using a level interest rate ranging from 3.0% to 5.5%. Mortality and withdrawal assumptions are based on our experience.
Fixed payout annuities included in future policy benefits are calculated using a level interest rate of 5.0%. Mortality assumptions are based on standard industry mortality tables. Liabilities for payout annuities classified as investment contracts (payout annuities without life contingencies) are determined as the present value of future benefits at the “breakeven” interest rate determined at inception.
Life Reserving Methodology - We establish liabilities for amounts payable under life insurance policies, including participating and non-participating traditional life insurance and interest sensitive and variable universal life insurance. In general, amounts are payable over an extended period of time and related liabilities are calculated as the present value of future expected benefits to be paid, reduced by the present value of future expected premiums (for traditional life insurance), or as the account value established for the policyholder (for universal and variable universal life insurance). Such liabilities are established based on methods and underlying assumptions in accordance with GAAP and applicable actuarial standards. Principal assumptions used in the establishment of liabilities for future policy benefits are mortality, policy lapse, investment return, inflation, expenses and other contingent events as appropriate to the respective product type.
Future policy benefits for interest sensitive and variable universal life insurance policies are calculated consistent with ASC 944-40 (formerly “FAS 97”), Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments, for universal life type products and are equal to the current account value established for the policyholder. Some of our universal life policies contain secondary guarantees, for which an additional liability is established consistent with ASC 944-40 (formerly (“SOP 03-01”), Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and Separate Accounts. Liabilities for universal life secondary guarantees and paid-up guarantees are determined by estimating the expected value of death benefits payable when the account balance is projected to be zero and recognizing those benefits over the accumulation period based on total expected assessments.
We regularly evaluate estimates used and adjust the additional liability balances, with a related charge or credit to benefit expense, if actual experience or other evidence suggests that earlier assumptions should be revised. The assumptions used in estimating the secondary and paid-up guarantee liabilities are consistent with those used for amortizing DAC and are thus subject to the same variability and risk. The benefits used in calculating the liabilities are based on the average benefits payable over a range of scenarios.
A deferred annuity is an annuity contract that has not reached the starting date of its periodic benefit payout. The Company establishes liabilities for deferred annuities based on methods and underlying assumptions in accordance with ASC 944-40 for investment contracts. Under ASC 944-40 for investment contracts, reserves for Policyholder Account Balances are established as the account value held on behalf of the policyholder. The possible need for additional reserves for guaranteed minimum death benefits are determined per guidance under SOP 03-01. Currently, no additional reserves are recorded for guaranteed minimum death benefits due to the immaterial amount of this reserve. Our exposure to this risk is minimal. The profit recognition on deferred annuity contracts is gradual over the expected life of the contract. No immediate profit is recognized on the sale of the contract.
Reserving Methodology - Several methods are employed to establish claim reserves and liabilities for Health lines of business.
Completion Factor Approach: The claim reserves for most health care coverage can be suitably calculated using a Completion Factor Method. This method assumes that the historical lag pattern will be an accurate representation for the payment of claims that have been incurred but not yet completely paid. An estimate of the unpaid claim reserves is calculated by subtracting period-to-date paid claims from an estimate of the ultimate aggregate payment for all incurred claims in the time period. The method is based on the pattern of claims incurred within a given month and paid out in future months until such a point that no more payments are expected. Completion factors are calculated which “complete” the current period-to-date payment totals for each incurred month to estimate the ultimate expected payout. The method is best used when the incurred date and subsequent paid date is known for each claim and if fairly consistent patterns can be determined from the progression date of incurral until the date paid in full. The completion factor approach is also best used when the time between date of incurral and final payment is short (i.e., less than 24 month) in duration.
For the individual and association medical block (including Medicare Supplement), we use a completion factor approach to generate claim liability and reserves. Group and managing general underwriter claim reserves are also calculated by these methods. Outstanding claim inventories are monitored by management monthly to determine if any adjustment to the completion factor approach is needed.
Some of the larger managing general underwriters that we use engage external actuarial firms to provide an estimate of the claim reserves for their respective blocks. We independently evaluate the external claim reserve estimates provided for reasonableness as well as for consistency with other completion-factor based reserves. These estimates are incorporated into our reserve analysis to determine the booked reserves for the segment.
Tabular Reserves: Disability Income and Long Term Care blocks of business utilize a tabular calculation to generate the Present Value of Expected Future Payments. These reserves are called tabular because they rely on the published valuation tables for disability termination as maintained by the Society of Actuaries and validated by the National Association of Insurance Commissions (“NAIC”). Tabular reserves are determined by applying termination assumptions related to mortality or recovery, or for Long Term Care, shifts in the mode of care, to the stream of contractual benefit payments. The present value of these expected benefit payments at the required rate of return establishes the tabular reserve.
Credit Health claim reserves and liabilities are also based on a tabular calculation, using actuarial tables published by the Society of Actuaries and accepted by the NAIC. The reserve for this business is calculated as a function of open claims using the same actuarial tables discussed above. Periodically we test the total claim reserve using a completion factor calculation.
Case Reserves: Case reserves are also required for certain lines of business. Case reserves reflect known claims where an estimate of the exposure is readily available and quantifiable based on historical experience or other similar basis. We establish Long Term Care and Nursing Home reserves, on a case-by-case basis, by reviewing the open claims and estimating the remaining liability and applying probabilities derived from continuance tables based on company and industry experience.
Premium Deficiency Reserves - Deficiency reserves are established when the expected benefit payments for a classification of policies having homogenous characteristics are in excess of the expected premiums for these policies. The determination of a deficiency reserve takes into consideration the likelihood of premium rate increases, the timing of these increases, and the expected benefit utilization patterns. We have a premium deficiency reserve for the Major Medical block of business. This line of business is in run-off and continues to under-perform relative to the original pricing. The assumptions and methods used to determine the deficiency reserves are reviewed periodically for reasonableness and the reserve amount is monitored against emerging losses.
Reserves for Loss and Loss Adjustment Expense (“LAE”) - Property and casualty reserves are established to provide for the estimated costs of paying claims under insurance policies written. These reserves include estimates for both:
These reserves include an estimate of the expense associated with settling claims, including legal and other fees, and the general expenses of administering the claims adjustment process. The two major categories of loss adjustment expense are defense and cost containment expense and adjusting and other expense. Net loss and LAE reserves for case reserves and IBNR as of December 31, 2009 and 2008 are shown in the following table (in thousands):
Case Reserves: Reserves for reported losses are established on either a judgment or formula basis, depending on the type of the loss. Formula reserves are used for losses such as credit property, automobile, property damage liability and automobile physical damage. They are based on historical paid loss data for similar claims with provisions for trend changes, such as those caused by inflation. The formula reserve is a fixed amount for each claim of a given type.
Judgment reserve amounts are set on a per case basis based on facts and circumstances of each case, the type of claim and the expectation of damages. We regularly monitor the adequacy of judgment reserves and formula reserves on a case-by-case basis and change the amount of such reserves as necessary.
Our actuaries reflect the potential uncertainty generated by volatility in our loss development profiles when selecting loss development factor patterns for each line of insurance. Therefore, net and gross reserve calculations have shown redundancies for the last several year-ends as a result of losses emerging favorably compared to what is implied by the selected loss development patterns. See Results of Operations and Related Information by Segment - Property and Casualty, Prior Period Reserve Development discussion for additional information.
Reserving Methodology - The following actuarial methods are utilized in our reserving process during both annual and interim reporting periods:
Calendar Year Paid Adjusting and Other Expense to Paid Loss: This method uses the ratio of prior calendar years’ paid expense to paid loss to project ultimate loss adjustment expenses for adjusting and other expense. The key to this method is the selection of the paid expense to paid loss ratio based on prior calendar years’ activity. A percentage of the selected ratio is applied to the case reserves (depending on the line of insurance) and 100% to the indicated IBNR reserves. These ratios assume a percentage of the expense is incurred when a claim is opened and the remaining percentage is paid throughout the claim’s life.
The basis of our selected single point best estimate on a particular line of business is often a blend of results from two or more methods (e.g. weighted averages). Our estimate is highly dependent on actuarial and management judgment as to which method(s) is most appropriate for a particular accident year and class of business. Our liability for unpaid claims and claim adjustment expense does not materially differ from the amount determined by our independent actuaries. Our methodology changes over time, as new information emerges regarding underlying loss activity and other factors.
Implicit in the actuarial methodologies utilized above are the following critical reserving assumptions:
The loss ratio selections and loss development profiles are primarily developed using our own historical claims and loss experience. These assumptions have not been modified from the preceding periods and are consistent with historical loss reserve development patterns.
Management believes that our loss reserves at December 31, 2009 are adequate. However, new information, legislation, events or circumstances, unknown at the original valuation date, may result in future development to our ultimate losses significantly greater or less than the reserves provided for at December 31, 2009. As noted in our “Key Assumptions” above, there are many factors that may impact our reserves, specifically those related to loss ratios for the credit insurance lines of business and those related to a consistent claims handling process for all other lines of business.
The table below for the lines of business indicated quantifies the estimated impact on our gross loss reserves of possible scenarios of the speeding-up or slowing-down of claims being processed at December 31, 2009. The results of our analysis below show the cumulative increase (decrease) in gross loss reserves of the lines of business indicated across all accident years combined (in thousands):
It is not appropriate to add together the total impact shown in the table above, as our lines of business are not directly correlated. It is important to note that the variations set forth in the table above are not meant to be a “best-case” or “worst-case” scenario, and therefore, it is possible that future variations may be more or less than the amounts set forth above. While we believe these are possible scenarios based on the information available to us at this time, we do not believe the reader should consider the above sensitivity analysis an actual reserve range.
Short-tail business - Lines of business for which loss data emerge more quickly are referred to as short-tail lines of business. For these lines, emergence of paid losses and case reserves is credible and likely indicative of ultimate losses; therefore, more reliance is placed on the Loss or Expense Development methods.
Large catastrophe and weather events are analyzed separately using information from our claims staff and loss development profiles from similar events and from our own historical experience.
Reinsurance recoverable balances include amounts owed to us in respect of paid and unpaid ceded losses and loss expenses and are presented net of a reserve for non-recoverability. At December 31, 2009 and 2008, reinsurance recoverable balances were $371.7 million and $482.8 million, respectively.
Our reinsurance contracts contain clauses that allow us to terminate the participation with reinsurers who are downgraded. Our risk assessment is comprised of industry ratings, recent news and reports, and a limited review of financials, for any new reinsurer under consideration. We also may require letters of credit, trust agreements, or cash advances from unauthorized reinsurers (reinsurers not licensed in our state of domicile) to fund their share of outstanding losses and LAE. Final assessment is based on the judgment of senior management.
As described in Note 2 to the Consolidated Financial Statements, effective December 31, 2006, the Company adopted ASC 715-30 (formerly “FAS 158”), Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plan. In accordance with ASC 715-30, we recognize the funded status of defined benefit pension and other postretirement plans, on our consolidated balance sheet.
For additional information regarding our pension plan obligations, see Note 15 to the Consolidated Financial Statements.
Realized gains are attributable to the sale of our invested assets, while realized losses are due to both the sale of investment assets and the write-down of investments from other-than-temporary impairments. In 2009, the consolidated pretax net realized loss on invested assets was $75.7 million, with pre-tax realized loss of $379.7 million and pre-tax realized gain of $41.0 million reported for 2008 and 2007, respectively. Included in these amounts are other-than-temporary impairment write-downs of $98.9 million, $367.0 million and $7.2 million for the years ended 2009, 2008 and 2007, respectively.
Based on information currently available, we believe that amounts ultimately paid, if any, arising from existing and currently potential litigation would not have a material effect on our results of operations and financial position. However, it should be noted that the frequency of large damage awards, which bear little or no relation to the economic damages incurred by plaintiffs continue to create the potential for an unpredictable judgment in any given lawsuit. It is possible that, if the defenses in these lawsuits are not successful, and the judgments are greater than we anticipate, the resulting liability could have a material impact on the consolidated financial results.
The application of U.S. GAAP requires us to evaluate the recoverability of our deferred tax assets and establish a valuation allowance if necessary to reduce our deferred tax asset to an amount that is more likely than not to be realized. Considerable judgment is required in determining whether a valuation allowance is necessary, and if so, the amount of such valuation allowance. In evaluating the need for a valuation allowance we consider many factors, including: (1) the nature of the deferred tax assets and liabilities; (2) whether they are ordinary or capital; (3) taxable income in prior carryback years as well as projected taxable earnings exclusive of reversing temporary differences and carryforwards; (4) the length of time that carryovers can be utilized; (5) any unique tax rules that would impact the utilization of the deferred tax assets; and (6) any tax planning strategies that we would employ to avoid a tax benefit from expiring unused. Although realization is not assured, management believes it is more likely than not that, the deferred tax assets, net of valuation allowances, will be realized.
Our accounting represents management’s best estimate of future events that can be appropriately reflected in the accounting estimates. Certain changes or future events, such as changes in tax legislation, geographic mix of earnings and completion of tax audits could have an impact on our estimates and effective tax rate. For example, the dividends received deduction or DRD, reduces the amount of dividend income subject to tax and is a significant component of the difference between our actual tax expense and the expected amount determined using the federal statutory tax rate of 35%. The U.S. Treasury Department and the Internal Revenue Service, or IRS, intend to address through regulations the methodology to be followed in determining the DRD related to variable life insurance and annuity contracts. A change in the DRD, including the possible retroactive or prospective elimination of this deduction through regulations or legislation, could increase our actual tax expense and reduce our consolidated net income.
Lower sales of our single premium immediate annuity products, caused by the drop in interest rates, which made the product less desirable; and
Increased interest credited to policy account balances due to an 18.2% increase in average account balances; and
These increases were partially offset by the decrease in other operating costs due to non-recurring litigation costs and costs for preparing for compliance with SEC and Sarbanes-Oxley requirements in 2008.
The Life segment markets traditional life insurance products such as whole life and term life, and interest sensitive life insurance products such as universal life, variable universal life and as well as indexed universal life. These products are marketed on a nationwide basis through employee agents, multiple line agents, independent agents and brokers and direct marketing channels.
For the year ended December 31, 2009, earnings increased compared to 2008. The overall increase we experienced in 2009 can be primarily attributed to the cost of two lawsuit settlements in 2008 and the corresponding impact on other operating costs and expenses. In addition, costs related to our initial SEC registration and expenses related to the implementation of Sarbanes-Oxley compliance decreased compared to 2008. Our benefit to revenue ratio was 52.9% for 2009 compared to 52.3% in 2008. These results are discussed in further detail below.
During the second quarter of 2009, we paid premium refunds as the result of a class action settlement made by us in May 2007. The refunds on the credit life product resulted in issuing $12.9 million in settlement payments in 2009 comprised of credit life premium refunds and other related damages and fees, to certain previously insured persons. The Life segment was fully reserved for this settlement and did not incur any related impact to its gain from operations for the year ended December 31, 2009. However, during the second quarter of 2009, several categories of the statement of income were impacted by the recording of the settlement as follows: premiums were decreased by $4.5 million, other income was decreased by $0.8 million, commissions were decreased by $0.9 million, and other operating costs and expenses were decreased by $4.5 million. For additional information on this settlement, refer to the discussion of the Perkins litigation in Note 16 to the Consolidated Financial Statements in our amended Form 10 Registration Statement, filed with the SEC on July 1, 2009.
Revenues from traditional life insurance products include scheduled premium payments from policyholders on whole life and term life products. These premiums are in exchange for financial protection for the policyholder from a specific insurable event, such as death or disability. The change in these premiums is impacted by new sales during the period and the persistency of in-force policies.
Other policy revenues include mortality charges, earned policy service fees, and surrender charges on interest sensitive life insurance policies. These charges increased for the year ended December 31, 2009 compared to 2008. Other policy revenues had also increased in 2008 compared to 2007. The increases were primarily due to higher mortality charges and fees, which are a result of the large volume of sales of lifetime secondary guarantee universal life products in 2007 and 2008.
Net investment income in the Life segment decreased slightly for the year ended December 31, 2008 compared to 2007. This decrease was due to a small decline in the investment yield earned on the block of invested assets supporting the Life segment. We continuously manage the crediting rates on interest sensitive products to reflect the lower yields and maintain a suitable interest spread.
Non-interest sensitive life products, such as whole life and term life policies cannot be adjusted to reflect a change in earned investment rates. In a low interest rate environment, the effect of this lower yield earned directly impacts earnings.
Benefits increased slightly for the year ended December 31, 2009 compared to 2008. The increase was primarily the result of higher claim dollar values. Benefits increased for the 2008 compared to 2007. This increase was due to the claims and reserve costs associated with the $24.2 million increase in other policy revenues that occurred from the sales of universal life lifetime secondary guarantee policies, including an $11.0 million increase in reserve accrual expense.
Commissions decreased for the year ended December 31, 2009 compared to 2008. Related to the previously noted settlement payments, we recorded a reversal of $0.9 million. Excluding the effect of the settlement payments, commissions decreased $33.9 million for the year ended December 31, 2009. The decrease was primarily attributable to lower first year universal life premiums. Partially offsetting the decrease in commissions was the increase in renewal commissions at a lower rate on a large volume of business sold in 2008. In addition, credit life business experienced a decrease in sales for 2009 as a result of the downturn in the economy and the constraints of the credit markets. Commissions also decreased in 2008 compared to 2007. During 2008, we implemented a re-pricing of lifetime guarantee universal life plans to include increases in premiums at higher issue. As a result, we experienced a decrease in sales of interest sensitive products from the level of sales established in 2007.
We regularly review the underlying DAC assumptions, including future mortality, expenses, lapses, premium persistency, investment yields and interest spreads. Relatively minor adjustments to these assumptions can significantly impact changes in DAC. We monitor the amortization of DAC as a percentage of gross profits before DAC amortization, as a deterioration of this ratio could indicate an emergence of adverse experience affecting the future profitability of a particular block of business and, in turn, affect the recoverability of DAC from such future profits.
Acquisition costs capitalized decreased for the year ended December 31, 2009 compared to 2008. We also experienced a decrease in 2008 compared to 2007. These decreases resulted from the decline in production related compensation in first year commissions in our Independent Marketing Group. The amortization of DAC as a percentage of gross profits for the years ended December 31, 2009, 2008 and 2007 was 43.3%, 44.5 % and 41.1%, respectively. The change in the ratio for 2009 was primarily attributable to the premium refund lawsuit as previously discussed. The deterioration of the ratio in 2008 was a result of reduced gross profits from overall reduced profitability of the life business. Profitability was down due to decreased investment yields, increased surrenders and higher expenses due to our initial SEC registration and implementation costs related to Sarbanes-Oxley compliance.
We periodically adjust our reinsurance program and retention limits as market conditions warrant, consistent with our corporate risk management strategy. While we have, in the past, reinsured up to 90% of new business, we are currently reinsuring newly developed permanent products on a modified excess retention basis, in which we reinsure mortality risk on a yearly renewable term basis, ceding a 75% quota share of policies with a face value of at least $500,000 up to our retention and then a 100% quota share in excess of retention. Term products are coinsured between 90% and 100% on a first-dollar quota share basis. The current term portfolio is also coinsured with a 90% quota share up to our retention and then a 100% quota share in excess of retention.
Our individual life reinsurance is primarily placed with highly rated companies, and we monitor the financial condition of those companies on a routine basis. For 2009, the companies where we have placed material amounts of reinsurance for the Life segment are shown in the table below (in thousands, except percentages):
The following tables summarize changes in the Life segments in-force amounts and policy counts (in thousands, except percentages):
The decreasing trend in our policy count is attributable to new business activity being comprised of fewer, but larger face-value policies. However, we experienced higher levels of traditional life in-force, due to the larger face values on those policies. The changes in the Life segment are relatively normal to our business.
Income from continuing operations decreased for the year ended December 31, 2009 compared to 2008 and during 2008 compared to 2007. A number of factors contributed to pressure on earnings, including compressed earned investment spreads, decreased annuity surrender charge revenue and certain non-recurring expenses. The expense increases are primarily due to consultant fees related to our initial SEC registration and implementation costs associated with Sarbanes-Oxley compliance. In addition, 2008 expenses increased due to lawsuit settlements. Interest spreads in 2009 were decreased from 2008 levels as a result of yields decreasing on a relatively large cash position, which slightly increased from 2008. We experienced similar events with our interest spread during 2008 compared to 2007, as our cash position had built up, as a result of the very large inflow of funds into fixed deferred annuities just as rates on short-term invested assets were starting to fall. The decreases in cash yield continues a trend first observed in 2008, but the decrease in 2009 was much more substantial than in 2008.
Variable annuity products are a relatively small portion of our annuity portfolio. Variable deferred annuity premiums and deposits decreased for the year ended December 31, 2009 compared to 2008 and during 2008 compared to 2007. These decreases are primarily attributable to our decision to not offer income guarantees on our variable annuity business.
Realized and unrealized gains or losses on the derivative hedge portfolio are recognized in earnings as investment income. Equity-indexed annuities include a fixed host annuity contract and an embedded equity derivative. The gain or loss on the embedded option is recognized in earnings as interest credited to policyholders.
For a number of years, earnings in the Annuity segment have been pressured by a long-term trend of lower average yield rates on the bonds and mortgage loans supporting the reserves. Offsetting the effect of lower yield rates, crediting rates on interest sensitive products have been decreased accordingly where permitted by policy terms. Since approximately 90% of the Annuity segment is interest sensitive, offsetting credited rate adjustments are usually possible subject to minimum interest rate guarantees that may apply. All contracts also have minimum floor interest rate guarantees, and we have reconfigured the product portfolio to lower those guarantees in response to the current low interest rate environment.
We evaluate the performance of our Annuity segment primarily based on interest spreads earned compared to the required spreads in our pricing. Interest spread is the difference between investment income on assets supporting the product lines less benefits credited to policyholders, including interest credited to deferred annuities and reserve change on immediate annuities. In determining interest spread, deferred sales inducements, such as first-year interest bonuses, are excluded from the interest-credited measurement. The variable annuity spread is equal to the mortality and expense charge assessed against policyholder funds. The table below shows the interest spreads for the annuity products (in thousands, except percentages):
The profits on fixed deferred annuity contracts and single premium immediate annuities are driven by the difference of interest spreads earned versus the required spread in our pricing and, to a lesser extent, other policy fees. When determining crediting rates for fixed deferred annuities, we consider current investment yields in setting new money crediting rates and look at average portfolio yields when setting renewal rates. Similarly, in pricing immediate annuity premium rates, we also evaluate expected long-term investment yields. In setting rates, we take into account target spreads established by pricing models while also factoring in price levels needed to maintain a competitive position. Target interest spreads vary by product depending on attributes such as interest bonus, interest guarantee term, and length of surrender charge period.
Interest spread on fixed deferred annuities decreased 2008 to 2009 primarily as a result of a decreasing yield on our cash position, a decreasing yield on our bond positions, and our cash position being above target in proportion to the total asset portfolio. We will continue to hold our cash position until long-term investment opportunities arise.
The gross margin on single premium immediate annuities, which includes the effect of mortality, were 0.71%, 0.43% and 0.87% for 2009, 2008 and 2007, respectively.
We are subject to equity market volatility related to these guaranteed minimum death benefits. We use reinsurance to mitigate the mortality exposure associated with such benefits. Our maximum guaranteed minimum death benefit exposure, before reinsurance, which represents the total exposure in the event that all annuitants die, was $6.6 million, $17.9 million, and $1.4 million as of December 31, 2009, December 31, 2008, and December 31, 2007 respectively.
Variable Deferred Annuity: Variable deferred annuity account values increased for the year ended December 31, 2009 compared to 2008. The increase in account value was primarily due to market appreciation. Variable deferred annuity account values decreased during 2008 compared to 2007. The decrease was attributable to market decline, offset by net inflows.
Single Premium Immediate Annuity: Single premium immediate annuity reserves increased for the years ended December 31, 2009 compared to 2008 and during 2008 compared to 2007. The increases were primarily due to reserves established on inflows from new sales and accretion of reserves on existing policies due to interest and survivorship. Premium inflows from new sales were greater than payment outflows on existing business.
Benefits consist of annuity payments and reserve increases on single premium immediate annuity contracts. Benefits increased for the year ended December 31, 2009 compared to the year ended December 31, 2008. The increase was due to higher single premium immediate annuity in-force volume resulting from increased single premium immediate annuity sales. These benefits decreased for the year ended December 31, 2008 compared to 2007. This decrease was primarily due to lower sales resulting in less reserve increase.
Interested credited increased in 2008 compared to 2007. This increase was primarily the result of the increased volume of in-force fixed deferred annuity account values due to issued business. The increase in interest credited resulting from in-force growth was offset by decreases in embedded derivative gain/ (loss).
Other operating costs and expenses increased during 2009 compared to 2008. These expenses also increased for the year ended December 31, 2008 compared to 2007. These were primarily the result of increases to our defined benefit pension costs and fees due to our initial SEC registration and expenses associated with Sarbanes-Oxley compliance. Also, there were expense increases that were attributable to agent production bonus payments resulting from the increased level of new business written.
DAC on deferred annuities is amortized in proportion to gross profits. The change in DAC represents acquisition costs capitalized, net of changes in the amortization of existing DAC. The following table presents the components of change in DAC for the years ended December 31, 2009, 2008 and 2007 (in thousands, except percentages):
Acquisition costs capitalized increased in 2009 compared to 2008 and during 2008 compared to 2007. The increases were primarily attributable to higher sales of fixed deferred annuities, which resulted in increases to commissions and other operating costs and expenses.
We employ reinsurance for guaranteed minimum death benefit risks on certain variable annuity contracts. Our maximum guaranteed minimum death benefit exposure, before reinsurance, which represents the total exposure in the event that all annuity policyholders die, was $6.6 million, $17.9 million and $1.4 million as of December 31, 2009, 2008, and 2007, respectively. After reinsurance, the net amounts at risk were $3.3 million, $9.9 million and $0.4 million respectively. All such guaranteed minimum death benefit reinsurance is with reinsurers rated “A” or higher by A.M. Best.
The Health segment has been primarily focused on supplemental and limited benefit coverage products including Medicare Supplement insurance for the aged population as well as hospital surgical and cancer policies for the general population. In 2009, premium volume for health insurance-related products was concentrated in our Medicare Supplement (39.7%) and hospital surgical (16.5%) lines. Our other health products include major medical insurance, credit accident and health policies, employer-based stop loss, and dental coverage. We distribute our health insurance products through our network of independent agents and managing general underwriters (“MGU’s”). Segment results for the periods indicated were as follows (in thousands, except percentages):
During the second quarter of 2009, we paid premium refunds as a result of a class action settlement made by us in May, 2007. The refunds on the credit accident and health product resulted in issuing $12.4 million of settlement payments comprised of credit accident and health premium refunds and other related damages and fees, to certain previously insured persons. The Health segment was fully reserved for this settlement and did not incur any related impact to its loss from operations during the year ended December 31, 2009. However, during the second quarter of 2009, several categories of the consolidated statements of income were impacted by the recording of the settlement as follows: premiums decreased by $4.3 million, other income decreased by $0.8 million, commissions decreased by $0.9 million, and other operating costs and expenses decreased by $4.3 million. For additional information on this settlement, refer to the discussion of the Perkins litigation within Note 16 to the Consolidated Financial Statements in our amended Form 10 Registration Statement, filed with the SEC on July 1, 2009.
During 2009, as a matter of standard practice, our Health segment’s management requested an outside firm to review the records of one of our MGU’s. This review resulted in the following adjustments, which were recorded in the year ended December 31, 2009 (the “review adjustments”): $23.6 million increase in premiums, $12.9 million increase in policy benefits and $10.7 million increase in commissions. These review adjustments had no material net impact to the Consolidated Statements of operations for 2009.
The increase in earned premium for the year ended December 31, 2008 as compared to the same period in 2007 was driven in large part by new business generated from our Medicare Supplement and hospital surgical products, which was partially offset by the decline in new policies being written on our major medical product.
Net investment income remained relatively consistent for 2009, 2008 and 2007. Refer to the Investments discussion below for further analysis.
As of December 31, 2009, the Health claim reserve had increased $3.1 million to $115.9 million from $112.8 million as of December 31, 2008. The increase was primarily due to an increase in the benefit ratio in 2009.
Commissions increased approximately 9.9% in 2008 when compared to 2007. This increase was primarily generated by an increase in earned premiums and the resulting higher first year commissions. Initial year policies pay at higher commission rates than renewal policies.
For the year ended December 31, 2009, other operating costs and expenses decreased 11.2% when compared to the same period in 2008. We recorded a reversal of $4.3 million related to the settlement payments noted above. Excluding the effect of the settlement payments, other operating costs and expenses decreased 5.0% in 2009 when compared to 2008. The decrease was primarily attributed to the absence of a $10.9 million legal reserve for the previously noted settlement payments, which was established in September 2008. The foregoing decrease was partially offset by increases in an excise tax on reinsured foreign premiums, employee benefits, information technology consulting fees and a one-time marketing expense of $2.8 million for the write-off for agents’ balances as part of reconciliations performed during 2009.
Other operating costs and expenses increased 20.7% for the year ended December 31, 2008 as compared to the same period in 2007. The biggest driver for this increase was the establishment of a $10.9 million legal reserve for the previously noted settlement payments during 2008. Expenses unrelated to this litigation increased by $1.0 million over the prior year or 1.7%, consistent with increases in premiums.
The change in DAC expense remained flat in 2009 and had minimally decreased in 2008 from 2007.
From 2008 to 2009, the change in DAC was primarily driven by a reversal of acquisition costs previously capitalized and related amortization expense associated with the previously noted settlement payments.
The decrease in DAC from 2007 to 2008 was primarily attributed to an increase in acquisition costs capitalized which resulted from increased sales of our Medicare Supplement product. This was offset by an increase in amortization of DAC, which was mainly attributed to the aforementioned increase in acquisition costs capitalized.
At December 31, 2009, the companies where we have placed material amounts of reinsurance for the Health segment are shown in the table below (in thousands, except percentages):
Property and Casualty business is written through our multiple line agents and Credit Insurance Division agents. Evaluation of our property and casualty insurance operations is based on the total underwriting results (net premiums earned less incurred losses and loss expenses, policy acquisition costs and other underwriting expenses) and the following ratios:
Loss and loss adjustment expense ratio (“loss ratio”), which is calculated by dividing policy benefits by net premiums earned;
Underwriting expense ratio (“expense ratio”), which is calculated by dividing all expenses related to the issuance of new and renewal policies by net premiums earned; and
Net premiums written is a measure of the premiums charged for policies issued during a fiscal period. Property and casualty premiums are recognized as earned premiums proportionately over the contract period. The majority of our automobile policies have terms of six months to one year while our credit related property policies have terms of six months to five years, depending on the related loan period. All other policies, such as homeowners’ policies and the agribusiness product policies, have terms of twelve months. The portion of the premiums written applicable to the unexpired terms of the policies are recorded as unearned premiums on our consolidated balance sheet.
Net premiums earned increased in 2008 compared to 2007 as a result of a 2007 reduction of $11.2 million relating to the increase in our estimate of retrospective premium adjustments payable on auto and homeowner policies with no reported losses for three years. Excluding the effect of this adjustment, earned premium decreased $6.4 million, primarily due to decreases in personal and commercial auto net premiums written for the year ended December 31, 2008 and a $5.6 million reinsurance reinstatement premium due to catastrophe activity in 2008.
The loss ratio for 2009 remained relatively unchanged from 2008, due to increases in claims in personal auto, workers’ compensation and credit insurance products, offset by the decrease in net catastrophe experience. These are discussed in further detail in the “Products” discussion below. The increase in loss ratio for 2008 as compared to 2007 was due to the significant level of net catastrophe losses during 2008, particularly compared to the low level of losses in 2007. 2008 was a busy year for natural catastrophes in the United States compared to 2007, which was relatively mild.
For the year ended December 31, 2009, gross catastrophe losses decreased to $80.9 million, compared to $191.6 million and $32.4 million for the years ended December 31, 2008 and 2007, respectively. Estimated reinsurance recoveries on all catastrophe losses were ($9.4) million for the year-end December 31, 2009 and $60.8 million for the year ended December 31, 2008. There were no material reinsurance recoveries on catastrophe losses for the year ended December 31, 2007.
The negative amount of estimated reinsurance recoverables for 2009 arise mainly from a decrease in the ultimate gross loss estimates for Hurricanes Ike and Gustav at December 31, 2009 compared to December 31, 2008. These 2008 hurricanes produced losses, which are recoverable under our reinsurance program, and a decrease in the ultimate gross loss estimates resulted in a decrease in estimated reinsurance recoverables as well.
Over the last five years, we have suffered our worst three catastrophe years in our history. These years include hurricanes Katrina and Rita in 2005, Ike and Gustav in 2008 along with record Midwest storms in 2008 and an abnormally high number of Midwest storms in 2009 particularly impacting Colorado and Oklahoma, which are some of our larger states. A number of actions have been taken to reduce our exposure to catastrophic losses such as reducing coastal exposure, increased spread of risk and lower reinsurance retentions for our 2010 program. Implementation of these actions are expected to result in substantially improved results even if the high catastrophe losses of 2005, 2008, or 2009 were to repeat.
Commissions decreased in 2009 compared to 2008 as the result of a $9.6 million decrease in credit related insurance commissions due to a shift in our credit insurance products towards those with lower commission structures. Commissions on personal and commercial auto policies also decreased compared to the same period in 2008 due to reductions in net premiums earned in these lines as well as an overall decrease in bonuses.
The decrease in deferred policy acquisition costs was less in 2009 compared to 2008 due to the decrease in commissions noted above during the period, and was larger in 2008 compared to 2007 due to the increase in commissions during 2008. A positive change in DAC represents a reduction to DAC and a decrease in expenses being deferred for the period, while a negative change represents an increase to DAC as a result of an increase in expenses for the period.
Other operating costs and expenses decreased for the year ended December 31, 2009 compared to the same period in 2008. The decrease was due to the Farm Bureau lawsuit resulting in a one-time accrual of $7.4 million in expenses during the third quarter of 2008. For additional information on this lawsuit, refer to our Commitments and Contingencies footnote within the Notes to the Consolidated Financial Statements in Item 8 “Financial Statements and Supplementary Data.”
Our Property and Casualty segment consists of three product lines: (i) Personal Lines products, which we market primarily to individuals representing 54.6% of net premiums written, (ii) Commercial Lines products, which focus primarily on businesses engaged in agricultural and other targeted markets representing 24.2% of net premiums written, and (iii) Credit related property insurance products which are marketed to financial institutions and retailers and representing 21.2% of net premiums written. Segment results by product for the periods indicated (in thousands, except percentages) were as follows:
A portion of the decrease in net premiums earned during 2009 was due to an internal review of our methodology for establishing reserves for our “Cashback” program, which refunds a portion of premiums paid on homeowners and auto policies within certain product lines and certain states. This resulted in a $4.6 million decrease during the second quarter of 2009.
The loss ratio has steadily increased since 2007 primarily due to an increase in the severity of claims each year coupled with the continued decline of net premiums earned. In recent years, we have experienced a decrease in loss frequency offset by a significant increase in loss severity. The increase in loss severity is due to increased bodily injury claims, increased litigation costs and increased property damage liabilities.
The combined ratios for 2009 (projected), 2008 and 2007 are comparable to the industry average for the same periods of 99.3%, 100.3%, and 98.3%, respectively, per A.M. Best’s is “U.S. Property/Casualty-Review and Preview”. Our 2009-combined ratio was slightly above average due to our decline in net premiums earned outpacing the industry average.
Homeowners: Net premiums earned have continued to increase slightly since 2007 due to rate increases across the entirety of this product line, as well as increases in policyholder-insured values as replacement and repair costs continue to increase even amidst declining home values. During the same period, this increase in premiums was offset by policy count decreasing by approximately 2.0% each year.
The significant increase in policy benefits and the loss ratio for 2008 compared to 2007 was due to the record level of catastrophe losses. Gross catastrophe losses for 2008 were $191.6 million, of which $132.9 million was attributable to homeowners’ claims from 2008 catastrophe occurrences, compared to $63.4 million for 2009 and $22.5 million for 2007. Estimated reinsurance recoveries on all catastrophe losses were $60.8 million for 2008, with no material recoveries for 2009 or 2007.
Prudent actions to generate profitable premium growth and reduce earnings volatility will continue. Evaluation and managing our risk with targeted rate activity will continue along with purchasing additional reinsurance coverage where we believe it is cost efficient to do so. We will continue to replace lost in-force policies with new business and increase insured values for our in-force book as necessary. However, we also expect the continued low level of new home sales and the economic recession to negatively impact premium growth, as consumers increase deductibles and reduce coverages to lower insurance costs.
Other Personal: The other personal product line is comprised primarily of watercraft, rental-owner and umbrella coverages for individuals seeking to protect their personal property. While historically this was not a significant piece of our personal insurance business, we continue to see promising growth in premium counts and operating results as our agents continue to increase our business with our current customers.
The combined ratio fell in 2009 due to the increase in premiums and decrease in catastrophe experience from 2008. The increase in 2008 compared to 2007 was also due to the significant catastrophe experience in 2008. Segment results by product for the periods indicated (in thousands, except percentages) were as follows:
Agribusiness Product: Our agribusiness product allows policyholders to customize and combine their coverage for residential and household contents, buildings and building contents, farm personal property and liability. Net premiums earned remained flat in 2009 compared to 2008, while 2008 increased over 2007. The increase in 2008 was primarily the result of rate increases initiated during 2007 that were fully earned in 2008 and remained in effect in 2009.
The loss ratio has been steadily increasing since 2007, as a result of storm and weather related losses. We expect variability in this line, which is sensitive to the frequency and severity of storm and weather related losses, and expect the loss ratio to normalize in 2010.
The combined ratio has been steadily increasing as premiums in this product have not decreased as it has in some of the other products and it is becoming a larger portion of our business, which results in more costs being allocated to it.
The decrease in the loss ratio during 2009 reflects our disciplined underwriting and focus on appropriate risks at a fair price, offset by the decrease in net premiums earned. The minimal increase in 2008 was the result of a slight increase in storm and weather related claims in 2008, compared to the relatively low number in 2007.
The increase in the loss ratio in 2009 is attributable to an increase in frequency and severity of GAP claims during 2009 as compared to the same period in 2008 from 39.3% to 41.1%, due to policy benefits in this line increasing 61.7% to $14.0 million. Slowing auto sales have driven down the replacement values of most vehicles, thus creating a larger difference between a vehicle’s value and its indebtedness.
We reinsure a portion of the risks that we underwrite to manage our loss exposure and protect capital resources. In return for a premium, reinsurers assume a portion of the losses and loss adjustment expense incurred. Amounts not reinsured are known as retention. We primarily use three types of reinsurance to manage our loss exposures:
Treaty reinsurance, in which certain types of policies are automatically reinsured without the need for approval by the reinsurer of the individual risks;
Facultative reinsurance, in which individual insurance policy or a specific risk is reinsured with the prior approval of the reinsurer. Facultative reinsurance is purchased for risks which fall outside the treaty reinsurance; and
Excess of loss treaty reinsurance, where the reinsurer indemnifies us against all, or a specified portion, of losses and loss adjustment expense incurred in excess of a specified retention or attachment point, and up to the contract limit.
In addition to treaty and facultative reinsurance, we are partially protected by the Terrorism Risk Insurance Act of 2002, which was modified and extended through December 31, 2014 via the Terrorism Risk Insurance Program Reauthorization Act of 2007.
Our surplus has allowed us to increase retentions in recent years. Our retention for each loss increased to $1.0 million in 2006 where it remained to 2009. Our catastrophe reinsurance retention has also increased, from $25.0 million in 2006 and 2007 to $40.0 million in 2008 and 2009. However, in order to manage our risk exposure, we purchased additional catastrophe reinsurance coverage for Louisiana, Texas, and the Northeast, effectively lowering our retention in these states.
The property catastrophe reinsurance limit has increased substantially, to $500.0 million in 2008 where it remained for 2009. The most significant increases in catastrophe reinsurance limit occurred after Hurricane Katrina.
The top line shows our original reserves, net of reinsurance recoverable, for each of the indicated years. The table then shows the cumulative net paid loss and loss adjustment expense as of successive years. The table also shows the re-estimated amount of previously recorded reserves based on experience as of the end of each succeeding year. The cumulative deficiency or redundancy represents the aggregate change in the estimates over all prior years. Conditions and trends that affected development of liabilities in the past may not necessarily occur in the future. Accordingly, it may be inappropriate to anticipate future redundancies or deficiencies based on historical experience.
For 2009, the net favorable prior year loss and loss adjustment expense development was $49.2 million, compared to approximately $42.6 million of net favorable prior year loss and loss adjustment expense development for 2008, as a result of better than expected paid and incurred loss emergence across several lines of business.
The current year loss ratio is a blend of the current accident year loss ratio and the impact of favorable or adverse development on prior accident years during the current calendar year. Excluding the 4.2% impact of favorable prior year loss development for accident years 2008 and prior, the 2009 loss ratio would have been 83.8%. Excluding the 3.6% impact of favorable prior year loss development for accident years 2007 and prior, the 2008 loss ratio would have been 83.1%.
Net favorable reserve development in each of the last two years was primarily generated from the personal auto, commercial auto and commercial multi-peril lines. The favorable development reflects the recognition of better than expected loss emergence rather than explicit changes to our actuarial assumptions. The homeowners’ line experienced moderate reserve deterioration related to the continuing settlement of Hurricane Katrina claims.
For additional information regarding losses and loss expenses, refer to Item 8, Note 8 to the Annual Consolidated Financial Statements and Financial Condition and Results of Operations section.
Corporate and Other primarily includes the capital not allocated to support our insurance business segments. Our excess capital and surplus is invested and managed by internal investment staff. Investments include publicly traded equities, real estate, mortgage loans, high-yield bonds, venture capital partnerships, mineral interests and tax-advantaged instruments. See the Investments section of the MD&A for a more detailed discussion of our investments.
In accordance with our segment allocation process, all realized gains and losses, except those on derivatives, are allocated to the Corporate and Other segment. The Corporate and Other segment is compensated for the risk it assumes for realized losses through a monthly charge to the insurance segments that reduces the amount of investment income allocated to those segments. Since other-than-temporary impairments are recorded as realized losses, they are accordingly, allocated to the Corporate and Other segment.
Our cash and short-term investment position at December 31, 2009 was $798.3 million, an increase from $361.3 million for 2008. The $437.0 million increase in cash and short-term investments relates primarily to increases in commercial paper and other short-term investments in the current interest rate environment to ensure liquidity. This was partially offset by the increase in claim payments in 2009 compared to 2008.
We were committed at December 31, 2009 to purchase, expand or improve real estate, to fund mortgage loans and to purchase other invested assets in the amount of $240.4 million, compared to $203.7 million for 2008. The expansion of real estate investments and mortgage loans in 2009 has been robust compared to 2008 due to improvement in available yields and growing opportunities.
In the normal course of business, we guarantee bank loans for customers of a third-party marketing operation. The customers, through the use of a trust, use the bank loans to fund premium payments of life insurance policies. These bank loans enable individuals with substantial illiquid wealth to finance their life insurance premiums using the cash value of the policies as security for the loans. In the case of a default on the bank loan, we would be obligated to pay off the loan. The total amounts of guarantees outstanding for 2009 and 2008 was approximately $206.5 million, while the total cash values of the related life insurance policies were $211.8 million for 2009 and $212.0 million for 2008.
Our capital resources at December 31, 2009, 2008 and 2007 consisted of American National stockholders’ equity summarized as follows (in thousands):
Total stockholders’ equity in 2009 increased $326.6 million primarily due to the $383.1 million change in net unrealized gains on marketable securities as a result of improving financial markets, combined with $15.6 million in net income, offset by $82.5 million in dividends paid to stockholders. The decrease in stockholders’ equity from 2007 to 2008 is comprised of the total net loss of $154.0 million, $331.8 million in net unrealized losses related to marketable securities and $82.7 million in dividends paid to stockholders.
Statutory surplus represents the capital of our insurance companies reported in accordance with accounting practices prescribed or permitted by the applicable state insurance departments. State laws specify regulatory actions if an insurer’s risk-based capital (“RBC”), a measure of an insurer’s solvency, falls below certain levels. The NAIC has a standard formula for annually assessing RBC. The formulas identify companies that are undercapitalized.
RBC is calculated for property and casualty companies after adjusting capital for certain underwriting, asset, credit and off-balance sheet risks. The achievement of long-term growth will require growth in the statutory capital of our insurance subsidiaries to roll up into the consolidated entity. Our subsidiaries may secure additional statutory capital through various sources, such as retained statutory earnings or equity contributions from us. As of December 31, 2009, the levels of our and our insurance subsidiaries’ surplus and risk-based capital exceeded the NAIC’s minimum RBC requirements.
Expected future gross loss and loss adjustment expense payments from property and casualty policies. This includes case reserves for reported claims and reserves for claims IBNR. Timing of future payments is estimated based on the Company’s historical payment patterns. The timing of these payments may vary significantly from the amounts shown above. The ultimate losses may vary materially from the recorded amounts, which are our best estimates.
Accident and health insurance obligations reflect estimated future claim payment amounts net of reinsurance for claims incurred prior to January 1, 2009. The estimate does not include claim payments for claims incurred after December 31, 2008. Estimated claim payment amounts are based on mortality and morbidity assumptions that are consistent with historical experience and are not discounted with interest so will exceed the liabilities recorded in reserves for future claim payments. Due to the significance of the assumptions used, actual results could vary greatly from the estimates shown here.
Represents estimated obligations due to contracts and agreements entered into within the ordinary course of business for items classified by ASC 840-20 (formerly “FAS 13”), Accounting for Operating Leases. The Company rents office space, which qualifies as operating leases under ASC 840-20 (formerly “FAS 13”).
Our only off-balance sheet transactions relate to third-party marketing operation bank loans, which were discussed previously under the Liquidity section of the MD&A. In 2010, the third-party marketing operation plans to renegotiate the bank loans. If these renegotiations are unsuccessful, we would have to pay the bank loans using the cash value of the underlying insurance contracts. As of December 31, 2009, the cash value of the policies totaled $211.8 million. With regard to the impact on our results of operations, the payment of the cash value of the policies would require a write-off of deferred acquisition costs through the income statement, which totaled $9.4 million at December 31, 2009.
We manage our investment portfolio to optimize the rate of return that is commensurate with sound and prudent underwriting practices and maintain a well-diversified portfolio. Our investment operations are governed by various regulatory authorities, including but not limited to, the Texas Department of Insurance. Investment activity, including the setting of investment policies and defining acceptable risk levels, is subject to review and approval of our Finance Committee, a committee made up of two members of the Board of Directors and senior investment professionals.
Pursuant to our Corporate Bylaws, the Finance Committee is also charged with the duty of supervising all of the Company’s investments and loans. The Finance Committee meets weekly to review and approve investment activity. The committee operates pursuant to an established, formal Investment Plan and Guidelines adopted by our Board of Directors. Collectively, these documents provide issuer and geographic concentration limits, investment size limits and other applicable parameters such as loan to value guidelines. No material changes were made to these documents during 2009.
The following summarizes the carrying values of our invested assets by asset class as of December 31, 2009 and December 31, 2008 (other than investments in unconsolidated affiliates), (in thousands, except percentages):
The increase in our total invested assets was a combined result of net sales and value recovery attributable to stock market gains and spread narrowing in fixed income securities.
The increase in our short-term investments was the result of an increase in fixed deferred annuity account values and mortgage loan commitments pending at year-end. We also held in cash the proceeds of sales of common stock during the fourth quarter.
Certain private placement debt securities are priced via independent broker quotes and internal valuation methodologies. The quotations received from the broker may use inputs that are difficult to corroborate with observable market data. Additionally, we only obtain non-binding quotations from the independent brokers. Internal pricing methodologies include inputs such as externally provided credit spreads and internally determined credit ratings. Due to the significant non-observable inputs, these prices determined by the use of independent broker pricing and internal valuation methodologies are classified as Level 3.
The discount rate for the fair value of mortgage loans is determined by the weighted average adjustment of the “spread factor” against U.S. treasury rates. The spread factor includes an adjustment for quality rating, property type, geographic distribution and payment status (current, delinquent, in process of foreclosure) of each loan. Management performs periodic reviews and weighs each adjustment to calculate the spread factor based on the current economic environment and lending practices.
Debt securities accounted for under ASC 320-10 (formerly, “EITF” No. 99-20), “Investments Debt and Equity” may experience other-than-temporary impairment in future periods in the event an adverse change in cash flows is anticipated or probable. Other debt securities may experience other-than-temporary impairment in the future based on the probability that the issuer may not be able to make all contractual payments when due. Equity securities may experience other-than-temporary impairment in the future based on the prospects for recovery in value in a reasonable period.
In the first quarter of 2009, we recorded $68.1 million in other-than-temporary impairments. With the change in the rules from new accounting guidance, we recorded $6.0 million in the second quarter, $4.2 million in the third quarter and $20.6 million for the three months ended December 31, 2009, making a total of $98.9 million for year ended December 31, 2009. No other-than-temporary impairment was recorded in 2009 as a result of the change in our intent and ability to hold to recovery. The following summarizes our other-than-temporary impairments by investment type (in thousands):
Of the bond and equity impairments, a total of $30.0 million relates to the financial services industry. For the year ended December 31, 2009, we have received the principal and interest in accordance with the contractual terms with the exception of one bond, which represents 6.5% of our total bond impairments and less than 0.77% of our total other-than-temporary impairments.
The real estate impairment for 2009 was primarily taken against five foreclosed properties. The impairments recognized both changes in the real estate market in general and issues specific to those properties impaired.
During the second quarter of 2009, we adopted new accounting guidance, which significantly modified the rules regarding other-than-temporary impairments on bonds (see Note 2 to the Consolidated Financial Statements for further information on our adoption of new accounting guidance).
All bonds below cost were subjected to impairment review, additionally bonds were subjected to further review if any of the following situations were observed: a) fair value was more than 50% below our cost, b) fair value was 35% or more below our cost at the reporting date and had been below cost by some amount continuously for nine months, c) the issue had been downgraded by a national rating agency, or d) the issuer had widely publicized financial problems. Once a bond was determined as needing further review, it was subjected to a three-part test:
We determined if we intend to hold the bond until maturity.
All equity investments below costs were subjected to impairment review, additionally, equity investments were subjected to further review if any of the following situations were observed: a) fair value was more than 50% below our cost, b) fair value was 25% or more below our cost at the reporting date and had been below cost by some amount continuously for six months, or c) the issuer had widely publicized financial problems. Equity investments were evaluated individually to determine the reason for the decline in fair value and whether such decline was other-than-temporary. The individual determination included multiple factors including our ability and intent to hold the security, performance of the security against other securities in its sector historical price/earnings ratios together with forecast earnings, stock re-purchase programs, and other information specific to each issue.
The following tables summarize the portfolio’s contractual maturities, for the periods indicated (in thousands, except percentages):
The following table identifies the total bonds by credit quality as of December 31, 2009 and 2008 (in thousands, except percentages):
Our exposure to below investment grade securities increased during the year ended December 31, 2009 as a result of downgrades including some multiple step downgrades. At 7.4% of our portfolio, the exposure is acceptable to management, particularly since it contains securities purchased below investment grade as part of a high yield portfolio. We have reached our portfolio target allocation for securities rated BBB and plan on maintaining that target allocation. Corporate bonds represent $8.9 billion or 74.5 % of our total bonds at fair value, as of December 31, 2009.
As shown in the table below, mortgage loans at December 31, 2009 and 2008 had diversity across geographic regions and property types:
We increased our investment in mortgage loans on real estate by $352.6 million in 2009 as the combination of yield and collateral made them relatively attractive compared to other fixed income alternatives. The combination of new loans, normal amortization of existing loans, payoffs, and prepayments resulted in minor shifts in distribution of our portfolio by both geography and property type. There was no change in our investment guidelines.
As of December 31, 2009 and 2008, our valuation allowance for mortgage loan credit losses was $23.5 million and $19.4 million, respectively. The valuation allowance has two components. The first component, largely responsible for the year-over-year increase, is a portfolio default risk related to current loans. The second component of the allowance is calculated through analysis of specific loans that are believed to be at a higher risk of becoming impaired in the near future.
We carry our equity portfolio at market value based on quoted market prices obtained from independent pricing services. The cost and estimated market value of the equity portfolio as of December 31, 2009, and December 31, 2008 are (in thousands):
We invest in commercial real estate with positive cash flows or where appreciation in value is expected. Real estate is owned directly by our insurance companies, through non-insurance affiliates, or through joint ventures. The carrying value of real estate is stated at cost, less allowance for depreciation and valuation impairments. Depreciation is provided over the estimated useful lives of the properties. We have recorded valuation impairments on investments in real estate in the year ended December 31, 2009 (see the Other-Than-Temporary Impairments section above). Several real estate investment properties were completed and placed into service in 2009. The partial-year operations of those properties negatively affected the portfolio yield. We expect some of those properties to be affected by the national real estate market, primarily by the length of time necessary to achieve pro-forma objectives.
Policy loans may be repaid at any time by the policyholder and have priority to any claims on the policy. If the policyholder fails to repay the policy loan, funds are withdrawn from the policy’s death benefits.
Short-term investments are composed primarily of Commercial Paper rated A2/P2 or better by Standard & Poor’s and Moody’s, respectively. The amount fluctuates depending on our liquidity needs, including investment-funding commitments.
In the ordinary course of operations, we had commitments outstanding at December 31, 2009, to purchase, expand or improve real estate, to fund mortgage loans, and to purchase other invested assets aggregating $240.4 million, of which $218.6 million is expected to be funded during 2010. The remaining balance of $21.8 million will be funded in 2011 and beyond. As of December 31, 2009, all of the mortgage loan commitments have interest rates that are fixed.
Net investment income from those assets used to support our insurance products (bonds and mortgage loans) increased consistently over the period as assets increased as a result of net annuity sales each year. Net investment income in other asset classes (equities and real estate) fluctuated in response to investment decisions based on market movement. Real estate property sales due to favorable market conditions in 2007 led to decreased real estate investment income in 2008. In 2008 and 2009, the proceeds of those sales were reinvested, coming into service during 2009.
All of the realized gains and losses are allocated to the Corporate and Other segment. The risk of realized losses from fixed income securities used to support our products is charged to the insurance segments through a monthly default charge with the income from the charge allocated to the Corporate and Other segment to compensate it for any potential realized losses that would be recorded. The default charge rate is set as a percentage of the asset base that supports each of the insurance segments, with the rate set depending on the risk level of the asset involved.
Consolidated Statements of Operations for the years ended December 31, 2009, 2008 and 2007
We have audited the accompanying consolidated statements of financial position of American National Insurance Company and subsidiaries (“the Company”) as of December 31, 2009 and 2008, and the related consolidated statements of operations, changes in equity, comprehensive income (loss), and cash flows for each of the years in the three-year period ended December 31, 2009. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We have audited American National Insurance Company’s (“the Company”) internal control over financial reporting as of December 31, 2009, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Annual Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated statements of financial position of American National Insurance Company and subsidiaries as of December 31, 2009 and 2008, and the related consolidated statements of operations, changes in equity, comprehensive income (loss), and cash flows for each of the years in the three-year period ended December 31, 2009, and our report dated March 11, 2010 expressed an unqualified opinion on those consolidated financial statements.
The accompanying consolidated financial statements are presented in our reporting currency, the U.S. dollar. All material intercompany transactions with consolidated entities have been eliminated.
the rights of other investors to participate in the decision making process; and
Investments in unconsolidated affiliates are shown at cost plus equity in undistributed earnings since the dates of acquisition.
Accounting estimates inherently require the use of judgments relating to a variety of assumptions; in particular, expectations of current and future mortality, morbidity, persistency, losses and loss adjustment expenses, recoverability of receivables, investment returns and interest rates. In developing these estimates, we make subjective and complex judgments that are inherently uncertain and subject to material changes as facts and circumstances develop. Although variability is inherent in these estimates, management believes that the amounts provided are appropriate, based upon the facts available upon compilation of the financial statements. Due to the inherent uncertainty when using assumptions and estimates, the effect of certain accounting policies under different conditions or assumptions could be different from those reported in the financial statements.
All preferred stocks are classified as available-for-sale and are carried at fair value.
Mortgage loans on real estate are recorded at carrying value, which is comprised of the original cost, net of repayments, amortization of premiums, accretion of discounts, unamortized deferred revenue and valuation allowances. The mortgage loan portfolio is closely monitored through the review of payment history, loan and property information, such as debt service coverage, annual operating statements and property inspection reports. This information is evaluated in light of current economic conditions and other factors, such as geographic location and property type. As a result of this review, impaired loans are identified and valuation allowances are established. The change in valuation allowances is reported in current period income as a realized loss. Impaired loans are those which, based on current information and events, it is probable that American National will be unable to collect all amounts due, according to the contractual terms of the loan agreement.
Investment real estate is carried at cost, less allowance for depreciation. Real estate classified as held-for-sale is stated at the lower of depreciated cost or fair value less expected disposition costs at the time classified as held-for-sale. Real estate is not depreciated while it is classified as held-for-sale.
Depreciation is provided over the estimated useful lives of the properties (15 to 50 years) using straight-line and accelerated methods allowable under GAAP. American National’s real estate portfolio is closely monitored through the review of operating information and periodic inspections. This information is evaluated in light of current economic conditions and other factors, such as geographic location and property type. As a result of this review, if there is any indication of an adverse change in the economic condition of a property, a complete cash flow analysis is performed to determine whether or not the property is impaired. If a possible impairment is indicated, the fair value of the property is estimated using a variety of techniques, including cash flow analysis, appraisals and comparison to the values of similar properties. If the book value is greater than the estimated fair value, an impairment is recorded.
Short-term investments, comprised of commercial paper, are carried at amortized cost, which approximates fair value.
Other invested assets, comprised primarily of derivative contracts (equity-indexed options), construction loans, CAPCO investments and mineral rights, are carried at cost, less allowance for valuation, where applicable. Impairments for other invested assets are considered on an individual basis.
An OTTI has occurred for a debt security in an unrealized loss position when American National either (a) has the intent to sell the debt security or (b) it is more likely than not that it will be required to sell the debt security before its anticipated recovery of its amortized costs basis. If either criterion is met, an OTTI is recognized in earnings in the amount of the amortized cost basis of the debt security in excess of its fair value, as of the impairment measurement date.
After the recognition of an OTTI, the debt security is accounted for as if it had been purchased on the measurement date of the OTTI, with an amortized cost basis equal to its previous amortized cost basis less the related OTTI recognized in earnings. The new amortized cost basis of an impaired security is not adjusted for subsequent increases in estimated fair value. Should there be a significant increase in the estimate of cash flows expected to be collected from a previously impaired debt security, the increase would be accounted for prospectively by accreting it as interest income over the remaining life of the debt security.
American National purchases derivative instruments as hedges of a recognized asset or liability, which are recorded on the consolidated statements of financial position at fair value. The change in fair value of derivative assets is reported as net investment income. The change in fair value of embedded derivative liabilities is reported through policy benefits-annuity. Derivative instruments held at December 31, 2009 and 2008 had an immaterial impact on the consolidated statements of operations and consolidated statements of cash flows.
American National does not apply hedge accounting treatment to its hedging activities.
The deferred policy acquisition costs on traditional life and health products are amortized with interest over the anticipated premium-paying period of the related policies, in proportion to the ratio of annual premium revenue to be received over the life of the policies. Expected premium revenue is estimated by using the same mortality and withdrawal assumptions used in computing liabilities for future policy benefits. The amount of deferred policy acquisition costs is reduced by a provision for possible inflation of maintenance and settlement expenses in the determination of such amounts by means of grading interest rates.
For traditional products, liabilities for future policy benefits have been provided on a net level premium method based on estimated investment yields, withdrawals, mortality, and other assumptions that were appropriate at the time that the policies were issued. Estimates used are based on the Company’s experience, as adjusted to provide for possible adverse deviation. These estimates are periodically reviewed and compared with actual experience. When it is determined, that future expected experience differs significantly from existing assumptions; the estimates are revised for current and future issues.
Revenues from annuity contracts represent amounts assessed against contract holders. Such assessments are principally surrender charges and, in the case of variable annuities, administrative fees. Policy account balances for annuities represent the deposits received plus accumulated interest less applicable accumulated administrative fees.
A portion of the life insurance portfolio is written on a participating basis. Participating business comprised approximately 9.0% of the life insurance in force at December 31, 2009 and 13.2% of life premiums in 2009. Of the total participating business, 74.6% was written by Farm Family Life Insurance Company (Farm Family Life). For the participating business excluding Farm Family Life, the allocation of dividends to participating policyowners is based upon a comparison of experienced rates of mortality, interest and expenses, as determined periodically for representative plans of insurance, issue ages and policy durations, with the corresponding rates assumed in the calculation of premiums.
American National and its eligible subsidiaries will file a consolidated life/non-life federal income tax return for 2009. Certain subsidiaries that are consolidated for financial reporting are not eligible to be included in the consolidated federal income tax return. Separate provisions for income taxes have been determined for these entities.
Interest expense and penalties, if applicable, are classified as “Other operating costs and expenses” in the consolidated statements of operations.
Separate account assets and liabilities represent funds maintained to meet the investment objectives of contract holders who bear the investment risk. Investment income and investment gains and losses from these separate funds accrue directly to the contract holders of the policies supported by the separate accounts. Separate accounts are established in conformity with insurance laws and are not chargeable with liabilities that arise from any other business of American National. American National reports separately, as assets and liabilities, investments held in separate accounts and liabilities of the separate accounts if (i) such separate accounts are legally recognized; (ii) assets supporting the contract liabilities are legally insulated from American National’s general account liabilities; (iii) investments are directed by the contract holder; and (iv) all investment performance, net of contract fees and assessments, is passed through to the contract holder. The assets of these accounts are carried at fair value. Deposits, net investment income and realized investment gains and losses for these accounts are excluded from revenues, and related liability increases are excluded from benefits and expenses in the consolidated financial statements.
On January 1, 2009, American National adopted accounting guidance contained within ASC 810, “Consolidation-Noncontrolling Interests” (formerly Statement of Financial Accounting Standards (“SFAS”) No. 160, “Noncontrolling Interests in Consolidated Financial Statements-an amendment of ARB No. 51”), (“ASC 810”). This guidance within ASC 810 was issued by the Financial Accounting Standards Board (“FASB”) in December 2007. This guidance required changes to the reporting of noncontrolling interests in financial statements. It was effective for fiscal years beginning on or after December 15, 2008. The adoption of this guidance did not have a material effect on American National’s financial statements.
On April 1, 2009, American National adopted accounting guidance contained within ASC 825, “Financial Instruments” (formerly FSP FAS No.107-1 and Accounting Principles Board Opinion No. 28-1, “Interim Disclosures about Fair Value of Financial Instruments”), and (“ASC 825”). ASC 825 was issued by the FASB in April 2009. This guidance required disclosures about fair value of financial instruments. ASC 825 was effective for interim and annual periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009. The adoption of this guidance did not have a material effect on American National’s consolidated financial statements.
On September 30, 2009, American National adopted accounting guidance contained within ASC 105, “GAAP” (formerly FAS No.168, “The FASB ASC and the Hierarchy of GAAP - a replacement of FASB Statement No. 162”), (“ASC 105”). This guidance within ASC 105 established the FASB ASC as the source of authoritative accounting principles recognized by the FASB to be applied by non-governmental entities in the preparation of financial statements in conformity with GAAP in the United States, superseding existing FASB, American Institute of Certified Public Accountants, EITF, and related accounting literature. This guidance was effective for financial statements issued for interim and annual periods ending after September 15, 2009. Adoption of this guidance did not have an impact on American National’s consolidated financial statements, other than changes in references from former accounting standards to ASC references.
The amortized costs and estimated fair value, by contractual maturity, of debt securities at December 31, 2009, are shown below (in thousands). Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
In 2008, securities with amortized costs of $91,418,000 were transferred from held-to-maturity to available-for-sale due to evidence of a significant deterioration in the issuers’ creditworthiness. An unrealized loss of $67,383,000 was established at the time of the transfer.
In 2007, securities with amortized costs of $27,239,000 were transferred from held-to-maturity to available-for-sale due to evidence of a significant deterioration in the issuers’ creditworthiness. An unrealized loss of $98,000 was established at the time of the transfer.
All gains and losses were determined using specific identification of the securities sold.
The change in the net unrealized gains (losses) on investments for the years ended December 31, are summarized as follows (in thousands):
American National evaluates all bonds that have unrealized losses on a quarterly basis to determine if the creditworthiness of any of the bonds have deteriorated to a point that would prevent American National from realizing the full amount at maturity. For those bonds where management believes that the full amount will not be realized, an other-than-temporary impairment is recorded. At December 31, the unrealized losses on securities that were not impaired were the result of credit spread widening and significant liquidity discounts in an illiquid market. There were no delinquent coupon payments attributed to the bond portfolio at December 31, 2009. American National has the ability and intent to hold these bonds until a market price recovery or maturity and, therefore, these bonds are not considered to be other-than-temporarily impaired. However, it is possible that the investee’s ability to meet future contractual obligations may be different from what American National determined during its analysis, which may lead to a different impairment conclusion in future periods.
Net investment income and realized investments gains (losses), before federal income taxes, for the years ended December 31 are summarized as follows (in thousands):
The following tables summarize other-than-temporary impairments for the periods indicated (in thousands):
As discussed in Note 2, certain OTTI losses on bonds are bifurcated into two components: credit losses and non-credit losses. The net amount recognized in earnings (“credit loss impairments”) represents the difference between the amortized cost of the bond and the net present value of its projected future cash flows discounted at the effective interest rate implicit in the bond prior to impairment. Any remaining difference between the bond’s fair value and amortized cost (“non-credit loss impairments”) is recognized in other comprehensive income.
American National employs a strategy to invest funds at the highest return possible commensurate with sound and prudent underwriting practices to ensure a well-diversified investment portfolio.
American National’s common stock portfolio by market sector distribution at December 31 is summarized as follows:
Mortgage loans and investment real estate by property type distribution at December 31 are summarized as follows:
American National has a diversified portfolio of mortgage loans and real estate properties. Mortgage loans and investment real estate investments by geographic distribution at December 31 are as follows:
Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability. A fair value hierarchy is used to determine fair value based on a hypothetical transaction at the measurement date from the perspective of a market participant. An asset or liability’s classification within the fair value hierarchy is based on the lowest level of significant input to its valuation. The input levels are defined as follows:
Unadjusted quoted prices in active markets for identical assets or liabilities. American National defines active markets based on average trading volume for equity securities. The size of the bid/ask spread is used as an indicator of market activity for fixed maturity securities.
The pricing service evaluates each asset class based on relevant market information, relevant credit information, perceived market movements and sector news. The market inputs utilized in the pricing evaluation, listed in the approximate order of priority, include: benchmark yields, reported trades, broker/dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers, reference data, and economic events. The extent of the use of each market input depends on the asset class and the market conditions. Depending on the security, the priority of the use of inputs may change or some market inputs may not be relevant. For some securities, additional inputs may be necessary.
The transfers into Level 3 were the result of securities no longer being priced by the third-party pricing service. As the securities were priced by a third-party service, inputs were used that are observable or derived from market data, which resulted in classification of these assets as Level 2. In accordance with American National’s pricing methodology, these securities are being valued with similar techniques as the pricing service; however, the Company developed data is used in the process, which results in unobservable inputs, and a corresponding transfer into Level 3. The transfers out of level 3 were comprised of $24.4 million of sales, $13.6 million of maturities, and $11.2 million of transfers into Level 2.
The amounts for the present value of future profits resulting from the acquisition of life insurance portfolios have been accounted for in accordance with ASC 944-20-99-2 and are immaterial in all periods presented.
American National establishes liabilities for amounts payable under insurance policies, including traditional life insurance, traditional annuities and non-medical health insurance. Generally, amounts are payable over an extended period of time and related liabilities are calculated as the present value of future expected benefits to be paid reduced by the present value of future expected premiums. Such liabilities are established based on methods and underlying assumptions in accordance with GAAP and applicable actuarial standards. Principal assumptions used in the establishment of liabilities for future policy benefits are mortality, morbidity, policy lapse, renewal, retirement, disability incidence, disability terminations, investment returns, inflation, expenses and other contingent events as appropriate to the respective product type. Utilizing these assumptions, liabilities are established on a block of business basis.
Future policy benefits for non-participating traditional life insurance policies are equal to the aggregate of the present value of expected future benefit payments and related expenses less the present value of expected future net premiums. Assumptions as to mortality and persistency are based upon American National’s experience when the basis of the liability is established. Interest rates for the aggregate future policy benefit liabilities range from 3% to 8%.
Future policy benefit liabilities for acquired participating traditional life insurance policies are equal to the aggregate of (i) net level premium reserves for death and endowment policy benefits (calculated based upon the non-forfeiture interest rate, ranging from 2.5% to 5.5%) and mortality rates guaranteed in calculating the cash surrender values described in such contracts); and (ii) the liability for terminal dividends. Participating business represented approximately 9% of American National’s life insurance in-force at December 31, 2009.
Future policy benefit liabilities for individual fixed annuities after annuitization are equal to the present value of expected future payments. The interest rate used in establishing such liabilities is 5% for all policies in-force.
Future policy benefit liabilities for non-medical health insurance are calculated using the net level premium method and assumptions as to future morbidity, withdrawals and interest, which provide a margin for adverse deviation. Interest rates used in establishing such liabilities range from 3.5% to 8%.
Future policy benefit liabilities for disabled lives are estimated using the present value of benefits method and experience assumptions as to claim terminations, expenses and interest. Interest rates used in establishing such liabilities range from 3% to 7.5%.
Liabilities for unpaid claims and claim expenses for property and casualty insurance are included in the liability for policy and contract claims and represent the amount estimated for claims that have been reported but not settled and claims incurred but not reported. Liabilities for unpaid claims are estimated based upon American National’s historical experience and other actuarial assumptions that consider the effects of current developments, anticipated trends and risk management programs, reduced for anticipated salvage and subrogation. The effects of changes in such estimated liabilities are included in the results of operations in the period in which the changes occur.
Activity in the liability for accident and health and property and casualty unpaid claims and claim adjustment expenses is summarized as shown below (in thousands):
As is customary in the insurance industry, American National reinsures portions of certain insurance policies written, thereby providing a greater diversification of risk and managing exposure on larger risks. The maximum amount that would be retained by one life insurance company (American National) would be $700,000 individual life, $250,000 individual accidental death, $100,000 group life and $125,000 credit life (total $1,175,000). If individual, group and credit were in force in all companies at the same time, the maximum risk on any one life could be $2,325,000.
To minimize its exposure to significant losses from reinsurer insolvencies, American National evaluates the financial condition of its reinsurers and monitors concentrations of credit risk arising from similar geographic regions, activities, or economic characteristics of the reinsurers. At December 31, 2009, amounts recoverable from reinsurers with a carrying value of $25,119,000 were associated with various auto dealer credit insurance program reinsurers domiciled in the Caribbean islands of Nevis or the Turks and Caicos Islands. American National holds collateral related to these reinsurers totaling $23,319,000. This collateral is in the form of custodial accounts controlled by the Company, which can be drawn on for amounts that remain unpaid for more than 90 days. American National believes that the failure of any single reinsurer to meet its obligations would not have a significant effect on its financial position or results of operations.
American National had amounts receivable from reinsurers totaling $371,654,000 at December 31, 2009. Of this amount, $3,527,000 represents amounts that are the subject of litigation or are in dispute with the reinsurers involved. Management believes that any dispute that may arise would not have a material impact on American National’s consolidated financial position.
Premiums, premium-related reinsurance amounts and reinsurance recoveries for the years ended December 31 are summarized as follows (in thousands):
Life insurance in force and related reinsurance amounts at December 31 are summarized as follows (in thousands):
At December 31, 2009, American National’s real estate holding companies were partners in affiliates that had notes payable to third-party lenders totaling $73,842,000, $34,297,000 of this amount is due in 2010. These notes have interest rates ranging from 5.95% to 8.07% and maturities from 2010 to 2020. Each of these notes are secured by the real estate owned through the respective affiliated entity, and American National’s liability for these notes are limited to the amount of its investment in the respective affiliate, which totaled $33,265,000 at December 31, 2009.
American National recognizes interest expense and penalties related to uncertain tax positions. Interest expense and penalties are included in the “Other operating costs and expenses” line in the Consolidated Statements of Operations. However, no interest expense was incurred as of December 31, 2009 while approximately $268,000 was recognized as of December 31, 2008. Also, no provision for penalties was established for uncertain tax positions.
Management does not believe that there are any tax benefits that could be recognized within the next twelve months that would decrease American National’s effective tax rate.
Federal income taxes netting to approximately $46,818,000 were refunded by the IRS in 2009. Federal income taxes totaling approximately $14,572,000, and $101,333,000 were paid to the Internal Revenue Service in 2008 and 2007, respectively.
The items included in comprehensive income (loss), other than net income (loss), are unrealized gains and losses on available-for-sale securities (net of deferred acquisition costs), foreign exchange adjustments and pension liability adjustments. The details on the unrealized gains and losses included in comprehensive income (loss), and the related tax effects thereon, are as follows (in thousands):
The plan provides for the award of Stock Appreciation Rights (SAR). The SAR’s give the holder the right to compensation based on the difference between the price of a share of stock on the grant date and the price on the exercise date. The SARs vest at a rate of 20% per year for 5 years and expire 5 years after the vesting period. American National uses the average of the high and low price on the last trading day of the period to calculate the fair value and compensation expense for SARs. The fair value of the SARs was $1,613,000 and $16,000 at December 31, 2009 and 2008, respectively. Compensation expense or (income) was recorded totaling $1,997,000, $(1,777,000), and $1,376,000 for the years ended December 31, 2009, 2008, and 2007, respectively.
Due to a loss during 2008, zero incremental shares were included because the effect would be antidilutive.
American National’s payment of dividends to stockholders is restricted by statutory regulations. Generally, the restrictions require life insurance companies to maintain minimum amounts of capital and surplus, and in the absence of special approval, limit the payment of dividends to the greater of statutory net gain from operations on an annual, non-cumulative basis, or 10% of statutory surplus. Additionally, insurance companies are not permitted to distribute the excess of stockholders’ equity, as determined on a GAAP basis over that determined on a statutory basis. At December 31, 2009 and 2008 American National’s statutory capital and surplus was $1,892,467,000 and 1,804,712,000, respectively.
At December 31, 2009, approximately $1,406,599,000 of American National’s consolidated stockholders’ equity represents net assets of its insurance subsidiaries, compared to 1,297,226,000 at December 31, 2008. Any transfer of these net assets to American National would be subject to statutory restrictions and approval.
American National and its subsidiaries are engaged principally in the insurance business. Management organizes the business into five operating segments:
The Life segment markets whole, term, universal and variable life insurance on a national basis primarily through employee and multiple line agents, direct marketing channels and independent third-party marketing organizations.
The Property and Casualty segment writes auto, homeowners, agribusiness and credit related property insurance. These products are primarily sold through multiple line agents and independent agents.
The accounting policies of the segments are the same as those described in the summary of significant accounting policies. Many of the principal factors that drive the profitability of each operating segment are separate and distinct. All income and expense amounts specifically attributable to policy transactions are recorded directly to the appropriate operating segment. Income and expenses not specifically attributable to policy transactions are allocated to each segment as follows:
Net investment income from fixed income assets (bonds and mortgage loans) is allocated based on the funds generated by each line of business at the average yield available from these fixed income assets at the time such funds become available.
Net investment income from all other assets is allocated to the operating segments in accordance with the amount of equity invested in each segment, with the remainder going to Corporate and Other.
Equity in earnings of unconsolidated affiliates are allocated to Corporate and Other.
Segment operating income provides pertinent and advantageous information to investors, as it represents the basis on which American National’s business performance is internally assessed by its chief operating decision makers. During the third quarter of 2008, the chief operating decision makers redefined the segment reporting structure to better align it with their current processes for assessing business performance and allocating resources. In previous financial reporting periods, operating segments were aggregated based on marketing distribution channels. In accordance with the performance measurements used by the chief operating decision makers, the segment reporting has been reorganized into five operating segments according to the type of insurance products sold or services rendered. The segment reporting for prior periods has been restated to reflect the change in business segments.
American National and its subsidiaries have one active, tax-qualified, defined-benefit pension plan and one inactive plan. The active plan has three separate noncontributory programs. One of the programs covers Career Sales & Service Division agents and managers. The other two programs cover salaried and management employees and home office clerical employees subject to a collective bargaining agreement. The program covering salaried and management employees provides pension benefits that are based on years of service and the employee’s compensation during the five years before retirement. The programs covering hourly employees and agents generally provide benefits that are based on the employee’s career average earnings and years of service.
Effective December 31, 2006, American National adopted the recognition and disclosure provisions of ASC 715 (formerly FAS 158). ASC 715 requires companies to recognize the funded status of defined benefit pension and other postretirement plans as a net asset or liability on its consolidated statement of financial position. Effective with the consolidated financial statements for 2008, ASC 715 also requires companies to use a measurement date for their defined benefit plans that is the same as their fiscal year end. As a result of this requirement, American National changed its measurement date from September 30 to December 31, using the alternative method specified in ASC 715, for the one qualified plan that was not already using a December 31 date. The effect of this change was an additional periodic benefit cost of $1,770,000 (net of tax) which was charged directly to retained earnings in 2008.
The following table shows pension benefit payments, which reflect expected future service as appropriate, that are expected to be paid (in thousands) for the years ended December 31:
The Corporate Debt Securities category, in the above table, represents investment grade bonds of U.S and foreign issuers from diverse industries, with a maturity of 1 to 30 years. Foreign bonds acquired by the Company must be Investment Grade, denominated and payable in U.S. Dollars, and in the aggregate shall not exceed 20% of the bond portfolio without approval of the Company’s Finance Committee.
Residential Mortgage Backed Securities represents Asset-Backed Securities with a maturity date 1 to 30 years with a rating of NAIC 1 or 2.
The Commercial Paper category represents investments with a credit rating of A-2 Moody’s or P-2 by Standard and Poor’s with at least BBB rating on company’s outstanding debt, or selected companies with no outstanding debt.
The investment policy for the qualified retirement plan assets is designed to provide the highest return possible commensurate with sound and prudent underwriting practices. The investment diversification goals are to have investments in cash from zero to 15%, debt securities from 40% to 80% and equity securities from 20% to 60% of the total invested plan assets. The amount invested in any particular investment is limited based on credit quality, and no single investment is allowed to be more than 5% of the total invested assets.
American National and its subsidiaries provide certain health and/or dental benefits to retirees. Participation in these plans is limited to current retirees and their dependents who met certain age and length of service requirements. No new participants will be added to these plans in the future.
The primary retiree health benefit plan provides major medical benefits for participants under the age of 65 and Medicare Supplemental benefits for those over 65. Prescription drug benefits are provided to both age groups. The plan is contributory, with the Company’s contribution limited to $80 per month for retirees and spouses under the age of 65 and $40 per month for retirees and spouses over the age of 65. All additional contributions necessary, over the amount to be contributed by American National, are to be contributed by the retirees.
In addition to the defined benefit pension plans, American National sponsors one defined contribution plan for all employees excluding those of the Farm Family companies, and an incentive savings plan for employees of the Farm Family companies. The defined contribution plan (401(k) plan) allows employees to contribute up to the maximum allowable amount as determined by the Internal Revenue Service. American National does not contribute to the defined contribution plan. Company contributions are made under the incentive savings plan for the Farm Family companies, with a discretionary portion based on the profits earned by the Farm Family companies. The expense associated with this plan was $1,400,000 for 2009, $2,800,000 for 2008 and $2,700,000 for 2007.
In the ordinary course of their operations, the companies also had commitments outstanding at December 31, 2009, to purchase, expand or improve real estate, to fund mortgage loans, and to purchase other invested assets aggregating $240,434,000, of which $218,555,000 is expected to be funded in 2010. The remaining balance of $21,879,000 will be funded in 2011 and beyond. As of December 31, 2009, all of the mortgage loan commitments have interest rates that are fixed.
In addition, it should be noted that the frequency of large damage awards, which bear little or no relation to the economic damages incurred by plaintiffs in some jurisdictions, continue to create the potential for an unpredictable judgment in any given lawsuit. It is possible that, if the defenses in these lawsuits are not successful, and the judgments are greater than management can anticipate, the resulting liability could have a material impact on the consolidated financial results.
Assets sold at the closing date included $8,400,000 of invested assets, $700,000 of deferred policy acquisition costs, and $500,000 of other assets. The liabilities sold at the closing date included $5,900,000 of reserves, $400,000 of policy account balances, and $500,000 of other liabilities.
The Mexico operation reported a $3,330,000 in pretax losses for 2008. The sale resulted in a loss on sale of discontinued operations of $1,890,000 before taxes. As part of the sale, a $22,059,000 income tax benefit was reported in 2008 because the tax basis of the investment in American National de Mexico exceeded the financial statement carrying value.
The Unaudited selected quarterly financial data for 2009 and 2008 are summarized in the tables below (in thousands, except per share data):
Effect of accounting change ASC 810 Consolidation-Noncontrolling Interest. Refer to Note 2.
Certain reclassifications have been made to the 2008 and 2007 consolidated financial statements to conform them to the 2009 presentation. Cash flow information has been revised to reclassify the “activities” within the investing sections disclosed in the Form 10 registration statement filed July 2, 2009. The “activities” affected are: Proceeds from the sales of, Proceeds from the maturity of, Principal payments received, and Purchases of investments all within the net cash used in investing activities. Management believes that the changes in the presentation of the consolidated statements of cash flows is immaterial relative to the consolidated financial statements taken as a whole. The result of this reclassification on net cash used in investing activities in the 2008 and 2007 consolidated statements of cash flows is as follows (in thousands):