Management's discussion and analysis of financial condition and results of operations of First SunAmerica Life Insurance Company (the "Company") for the three years ended December 31, 2001 ("2001"), 2000 ("2000") and 1999 ("1999") follows. Certain prior period amounts have been reclassified to conform to the current period's presentation.
In connection with the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995, the Company cautions readers regarding certain forward-looking statements contained in this report and in any other statements made by, or on behalf of, the Company, whether or not in future filings with the Securities and Exchange Commission (the "SEC"). Forward-looking statements are statements not based on historical information and which relate to future operations, strategies, financial results, or other developments. Statements using verbs such as "expect," "anticipate," "believe" or words of similar import generally involve forward-looking statements. Without limiting the foregoing, forward-looking statements include statements which represent the Company's beliefs concerning future levels of sales and redemptions of the Company's products, investment spreads and yields, or the earnings or profitability of the Company's activities.
Securities in our portfolio with a carrying value of approximately $183.2 million at December 31, 2001 do not have readily determinable market prices. For these securities, we estimate their fair value with internally prepared valuations (including those based on estimates of future profitability). Otherwise, we use our most recent purchases and sales of similar unquoted securities, independent broker quotes or comparison to similar securities with quoted prices when possible to estimate the fair value of those securities. All such securities are classified as available for sale. Our ability to liquidate our positions in these securities will be impacted to a significant degree by the lack of an actively traded market, and we may not be able to dispose of these investments in a timely manner. Although we believe our estimates reasonably reflect the fair value of those securities, our key assumptions about the risk-free interest rates, risk premiums, performance of underlying collateral (if any), and other factors may not reflect those of an active market.
Because the EGPs are only an estimate of the profits we expect to recognize from these policies, the EGPs are adjusted at each balance sheet date to take into consideration the actual gross profits to date and any changes in the remaining expected future gross profits. When EGPs are adjusted, we also adjust the DAC amount on the balance sheet, with a corresponding charge or credit to current period operating results, to reflect our revised estimate of DAC amortization.
Interest expense totaled $63.1 million in 2001, $77.5 million in 2000 and $82.6 million in 1999. The average rate paid on all interest-bearing liabilities was 4.70% in 2001, compared with 4.81% in 2000 and 4.92% in 1999. Interest-bearing liabilities averaged $1.34 billion during 2001, $1.61 billion during 2000 and $1.68 billion during 1999. The decline in average interest rates paid in 2001 resulted primarily from the impact of a declining interest rate environment during 2001 and the continued reduction of crediting rates on certain closed blocks of business. On a pro forma basis, assuming the Acquisition had been consummated on January 1, 1999, the average rate paid on all interest-bearing liabilities would have been 4.96% in 1999 and interest-bearing liabilities would have averaged $2.10 billion during 1999.
CHANGE IN AVERAGE INVESTED ASSETS largely resulted from the surrenders of certain closed blocks of fixed annuity policies. Changes in average invested assets also reflect net exchanges from fixed accounts into the separate accounts of variable annuity contracts partially offset by sales of fixed annuities and the fixed account options of the Company's variable annuity products ("Fixed Annuity Deposits"), and renewal deposits on its universal life product ("UL Deposits"). Fixed Annuity Deposits and UL Deposits totaled $80.8 million in 2001, $63.9 million in 2000 and $89.2 million in 1999, and are largely deposits for the fixed accounts of variable annuities. These deposits represent 6%, 5% and 6%, respectively, of the related reserve balances at the beginning of the respective periods. The increased deposits in 2001 largely reflect the increased demand for the fixed account options of the Company's variable annuity product lines. Such deposits decreased in 2000, in part, as a result of regulatory changes in the state of New York relating to non-taxable policy exchange requirements.
NET REALIZED INVESTMENT LOSSES totaled $19.3 million in 2001, compared with $20.8 million in 2000 and $11.2 million in 1999 and include impairment writedowns of $17.3 million in 2001, $20.8 million in 2000 and $7.7 million in 1999, respectively. Thus, net realized losses from sales and redemptions of investments totaled $2.0 million in 2001, compared with $0.03 million of gains in 2000 and $3.5 million of losses in 1999.
Impairment writedowns include $17.3 million, $20.8 million and $7.7 million of provisions applied to bonds in 2001, 2000 and 1999, respectively. Impairment writedowns represent 1.21%, 1.23% and 0.44% of average invested assets for 2001, 2000 and 1999, respectively. For the five years ended December 31, 2001, impairment writedowns as a percentage of average invested assets have ranged from 0.03% to 1.23% and have averaged 0.56%. Such writedowns are based upon estimates of the net realizable value of invested assets and recorded when declines in the value of such assets are considered to be other than temporary. Actual realization will be dependent upon future events. The Company recorded $0.8 million ($0.5 million, net of tax) of additional impairments in the second quarter of 2001 pursuant to the implementation of EITF 99-20 (see Note 2 of Notes to Financial Statements). This adjustment was recorded as a cumulative effect of change in accounting principle in the accompanying statement of income and comprehensive income for 2001.
Sales of variable annuity products (which include deposits allocated to the fixed accounts) ("Variable Annuity Product Sales") amounted to $90.5 million, $72.0 million, $127.7 million in 2001, 2000 and 1999, respectively. Such sales primarily reflect those of the Company's flagship variable annuity line, Polaris. Polaris is a multimanager variable annuity that offers investors a choice of 31 variable funds and a number of guaranteed fixed-rate funds. Variable Annuity Product Sales have increased in 2001, primarily due to both new and enhanced relationships with New York based investment firms as well as the addition of four new funds offered by Polaris in December 2000. Variable Annuity Product Sales were lower in 2000 primarily due to the continued impact of regulatory changes in the State of New York relating to non-taxable policy exchange requirements, which were introduced in November 1998.
The Company has encountered increased competition in the variable annuity marketplace during recent years and anticipates that the market will remain highly competitive for the foreseeable future. Also, from time to time, Federal initiatives are proposed that could affect the taxation of variable annuities and annuities generally (See "Regulation" in Item 1).
GENERAL AND ADMINISTRATIVE EXPENSES totaled $3.6 million in 2001, $4.8 million in 2000 and $5.2 million in 1999. General and administrative expenses remain closely controlled through a company-wide cost containment program and continue to represent less than 1% of average total assets.
ANNUAL COMMISSIONS totaled $0.7 million in 2001, compared with $0.6 million in 2000 and $0.5 million in 1999. Annual commissions represent renewal commissions paid quarterly in arrears to maintain the persistency of certain of the Company's variable annuity contracts. Substantially all of the Company's currently available variable annuity products allow for an annual commission payment option in return for a lower immediate commission. The Company estimates that approximately 19% of the average balances of its variable annuity products is currently subject to such annual commissions. Based on current sales, this percentage is expected to increase in future periods.
GUARANTEED MINIMUM DEATH BENEFITS totaled $0.5 million in 2001, compared with $4,000 in 2000 and $13,000 in 1999. The increase in guaranteed minimum death benefits reflects the recent downturn in the equity markets. Further downturns in the equity markets could increase these payments.
INCOME TAX EXPENSE totaled $6.2 million in 2001, $4.3 million in 2000 and $6.6 million in 1999, representing effective tax rates of 41%, 37% and 46%, respectively. The lower rate in 2000 was principally due to the impact of lower state income taxes. See Note 9 of the accompanying financial statements for a reconciliation of income tax expense to the federal statutory rate.
INVESTED ASSETS at December 31, 2001 totaled $1.37 billion, compared with $1.49 billion at December 31, 2000. The Company manages most of its invested assets internally. The Company's general investment philosophy is to hold fixed-rate assets for long-term investment. Thus, it does not have a trading portfolio. However, the Company has determined that all of its portfolio of bonds, notes and redeemable preferred stocks (the "Bond Portfolio") is available to be sold in response to changes in market interest rates, changes in relative value of asset sectors and individual securities, changes in prepayment risk, changes in the credit quality outlook for certain securities, the Company's need for liquidity and other similar factors.
THE BOND PORTFOLIO, which constituted 82% of the Company's total investment portfolio at December 31, 2001, had an aggregate fair value that was $5.6 million greater than its amortized cost at December 31, 2001, compared to an amortized cost that was $31.9 million greater than its aggregate fair value at December 31, 2000. The change in net unrealized gains and losses on the Bond Portfolio during 2001 principally reflects the decline in prevailing interest rates and the corresponding effect on the fair value of the Bond Portfolio at December 31, 2001.
At December 31, 2001, the Bond Portfolio included $1.12 billion of bonds rated by Standard & Poor's ("S&P"), Moody's Investors Service ("Moody's"), Fitch ("Fitch") or the Securities Valuation Office of the National Association of Insurance Commissioners ("NAIC"), and $11.0 million of bonds rated by the Company pursuant to statutory ratings guidelines established by the NAIC. At December 31, 2001, approximately $1.07 billion of the Bond Portfolio was investment grade, including $506.0 million of U.S. government/agency securities and mortgage-backed securities ("MBSs").
At December 31, 2001, the Bond Portfolio included $54.5 million of bonds that were not investment grade. These non-investment-grade bonds accounted for approximately 2.7% of the Company's total assets and approximately 4.0% of its invested assets.
Bonds and short-term promissory instruments are divided into six quality categories for NAIC rating purposes, ranging from 1 (highest) to 5 (lowest) for nondefaulted bonds plus one category, 6, for bonds in or near default. These six categories correspond with the S&P/Moody's/Fitch rating groups listed above, with categories 1 and 2 considered investment grade. The NAIC categories include $11.0 million of assets that were rated by the Company pursuant to applicable NAIC rating guidelines.
MORTGAGE LOANS aggregated $172.6 million at December 31, 2001 and consisted of 101 commercial first mortgage loans with an average loan balance of approximately $1.7 million, collateralized by properties located in 32 states. Approximately 26% of this portfolio was office, 24% was retail, 18% was multifamily residential, 15% was industrial, and 17% was other types. At December 31, 2001, approximately 28% of this portfolio was secured by properties located in California, approximately 13% by properties located in Michigan, approximately 7% by properties located in New York and Wisconsin, and no more than 5% of this portfolio was secured by properties located in any other single state. At December 31, 2001, two mortgage loans have an outstanding balance of $10.0 million or more, which represented approximately 13% of this portfolio. At December 31, 2001, approximately 23% of the mortgage loan portfolio consisted of loans with balloon payments due before January 1, 2005. During 2001 and 2000, loans delinquent by more than 90 days, foreclosed loans and restructured loans have not been significant in relation to the total mortgage loan portfolio.
At December 31, 2001, approximately 40% of the mortgage loans were seasoned loans underwritten to the Company's standards and purchased at or near par from other financial institutions. Such loans generally have higher average interest rates than loans that could be originated today. The balance of the mortgage loan portfolio has been originated by the Company under strict underwriting standards. Commercial mortgage loans on properties such as offices, hotels and shopping centers generally represent a higher level of risk than do mortgage loans secured by multifamily residences. This greater risk is due to several factors, including the larger size of such loans and the more immediate effects of general economic conditions on these commercial property types. However, due to the seasoned nature of the Company's mortgage loan portfolio and its strict underwriting standards, the Company believes that it has prudently managed the risk attributable to its mortgage loan portfolio while maintaining attractive yields.
POLICY LOANS are included in other invested assets and totaled $37.3 million at December 31, 2001, compared to $39.9 million at December 31, 2000 and primarily represent loans taken against universal life policies.
Duration is a common option-adjusted measure for the price sensitivity of a fixed-maturity portfolio to changes in interest rates. It measures the approximate percentage change in the market value of a portfolio if interest rates change by 100 basis points (i.e. 1%), recognizing the changes in cash flows resulting from embedded options such as policy surrenders, investment prepayments and bond calls. It also incorporates the assumption that the Company will continue to utilize its existing strategies of pricing its fixed annuity and universal life products, allocating its available cash flow amongst its various investment portfolio sectors and maintaining sufficient levels of liquidity. Because the calculation of duration involves estimation and incorporates assumptions, potential changes in portfolio value indicated by the portfolio's duration will likely be different from the actual changes experienced under given interest rate scenarios, and the differences may be material.
DEFAULTED INVESTMENTS, comprising all investments that are in default as to the payment of principal or interest, totaled $3.4 million of bonds at December 31, 2001, and constituted less than 0.3% of total invested assets. At December 31, 2000, defaulted investments totaled $7.2 million of bonds and constituted less than 0.5% of total invested assets.