Corporate and Other operations, conducts business from approximately 3,900 square feet of office space in Buenos Aires. These premises are leased through July 2008, at annual rents of approximately $34,000.
RGA Reinsurance also conducts business from a total of approximately 7,500 square feet of office space in Madrid, Mexico City and Mumbai. These premises are leased through November 2007, at total annual rents of approximately $169,000. RGA International, which also provides support functions for the Asia Pacific operations, conducts business from approximately 9,800 square feet of office space in Toronto. These premises are leased through August 2007, at annual rents of approximately $493,000. RGA UK conducts business from approximately 6,400 square feet of office space in London. These premises are leased through April 2010, at annual rents of approximately $577,000. RGA South Africa conducts business from approximately 12,800 square feet of office space in Cape Town and Johannesburg. These premises are leased through June 2009, at annual rents of approximately $90,000.
RGA Reinsurance also conducts business from a total of approximately 25,500 square feet of office space in Hong Kong, Tokyo, Taipei, Seoul and Beijing. These premises are leased through May 2008, at annual rents of approximately $1,272,000. RGA Australia conducts business from approximately 11,100 square feet of office space in Sydney. These premises are leased through January 2010, at annual rents of approximately $402,000.
The selected financial data presented for, and as of the end of, each of the years in the five-year period ended December 31, 2005, have been prepared in accordance with accounting principles generally accepted in the United States of America. All amounts shown are in millions, except per share and operating data. The following data should be read in conjunction with the Consolidated Financial Statements and the Notes to Consolidated Financial Statements appearing in Part II Item 8 and Management's Discussion and Analysis of Financial Condition and Results of Operations appearing in Part II
Numerous important factors could cause actual results and events to differ materially from those expressed or implied by forward-looking statements including, without limitation, (1) adverse changes in mortality, morbidity or claims experience, (2) changes in the Company's financial strength and credit ratings or those of MetLife, Inc. ("MetLife"), the beneficial owner of a majority of the Company's common shares, or its subsidiaries, and the effect of such changes on the Company's future results of operations and financial condition, (3) inadequate risk analysis and underwriting, (4) general economic conditions or a prolonged economic downturn affecting the demand for insurance and reinsurance in the Company's current and planned markets, (5) the availability and cost of collateral necessary for regulatory reserves and capital, (6) market or economic conditions that adversely affect the Company's ability to make timely sales of investment securities, (7) risks inherent in the Company's risk management and investment strategy, including changes in investment portfolio yields due to interest rate or credit quality changes, (8) fluctuations in U.S. or foreign currency exchange rates, interest rates, or securities and real estate markets, (9) adverse litigation or arbitration results, (10) the adequacy of reserves, resources and accurate information relating to settlements, awards and terminated and discontinued lines of business, (11) the stability of and actions by governments and economies in the markets in which the Company operates, (12) competitive factors and competitors' responses to the Company's initiatives, (13) the success of the Company's clients, (14) successful execution of the Company's entry into new markets, (15) successful development and introduction of new products and distribution opportunities, (16) the Company's ability to successfully integrate and operate reinsurance business that the Company acquires, (17) regulatory action that may be taken by state Departments of Insurance with respect to the Company, MetLife, or its subsidiaries, (18) the Company's dependence on third parties, including those insurance companies and reinsurers to which the Company cedes some reinsurance, third-party investment managers and others, (19) the threat of natural disasters, catastrophes, terrorist attacks, epidemics or pandemics anywhere in the world where the Company or its clients do business, (20) changes in laws, regulations, and accounting standards applicable to the Company, its subsidiaries, or its business, (21) the effect of the Company's status as an insurance holding company and regulatory restrictions on its ability to pay principal of and interest on its debt obligations, and (22) other risks and uncertainties described in this document and in the Company's other filings with the Securities and Exchange Commission ("SEC").
The Company believes it is one of the leading life reinsurers in North America based on premiums and the amount of life insurance in force. The Company believes, based on an industry survey prepared by Munich American at the request of the Society of Actuaries Reinsurance Section ("SOA survey"), that it has the second largest market share in North America as measured by life insurance in force. The Company's approach to the North American market has been to:
- manage risk-based capital by shifting mortality and other risks to reinsurers, thereby reducing amounts of reserves and capital they need to maintain;
- Automatic Reinsurance. The Company intends to expand its presence in the North American automatic reinsurance market by using its mortality expertise and breadth of products and services to gain additional market share.
- In Force Block Reinsurance. The Company anticipates additional opportunities to grow its business by reinsuring "in force block" insurance, as insurers and reinsurers seek to exit various non-core businesses and increase financial flexibility in order to, among other things, redeploy capital and pursue merger and acquisition activity. The Company took advantage of one such opportunity in 2003 when it assumed the traditional life reinsurance business of Allianz Life.
Continue Expansion Into Selected Markets. The Company's strategy includes building upon the expertise and relationships developed in its core North American business platform to continue its expansion into selected products and markets, including:
- International Markets. Management believes that international markets offer opportunities for growth, and the Company intends to capitalize on these opportunities by establishing a presence in selected markets. Since 1994, the Company has entered new markets internationally, including, in the mid-to-late 1990's, Australia, Hong Kong, Japan, Malaysia, New Zealand, South Africa, Spain, Taiwan and the UK, and beginning in 2002, China, India and South Korea. The Company's most recent expansion took place in January 2005, when the Company received regulatory approval to open a representative office in China. Before entering new markets, the Company evaluates several factors including:
- Maintaining a debt to capital ratio of less than 25%.
The transaction was effective retroactive to July 1, 2003. Under the agreement, Allianz Life transferred to RGA Reinsurance $425.7 million in cash and statutory reserves. RGA Reinsurance paid Allianz Life a ceding commission of
The Company maintains a catastrophe insurance program ("Program") that renews on August 13th of each year. The current Program began August 13, 2005, and covers events involving 10 or more insured deaths from a single occurrence. The Company retains the first $25 million in claims, the Program covers the next $50 million in claims, and the Company retains all claims in excess of $75 million. The Program covers only losses under North American guaranteed issue corporate-owned life insurance, bank-owned life insurance and similar reinsurance programs and includes losses due to acts of terrorism, but excludes losses due to nuclear, chemical and/or biological events. The Program is insured by several insurance companies and Lloyd's Syndicates, with no single entity providing more than $10 million of coverage.
Since December 31, 1998, the Company has formally reported its accident and health division as a discontinued operation. The accident and health business was placed into run-off, and all treaties were terminated at the earliest possible date. Notice was given to all cedants and retrocessionaires that all treaties were being cancelled at the expiration of their terms. The nature of the underlying risks is such that the claims may take several years to reach the reinsurers involved. Thus, the Company expects to pay claims over a number of years as the level of business diminishes. The Company will report a loss to the extent claims and related expenses exceed established reserves. During 2004, the accident and health division reported a net loss of $23.0 million due to claim payments in excess of established reserves, an arbitration settlement and legal fees. See Note 20 to the Consolidated Financial Statements. The increase in 2004 is due primarily to a negotiated settlement of all disputed claims associated with the Company's largest identified accident and health exposure.
Consolidated income from continuing operations decreased 4.0% in 2005 to $235.6 million and increased 37.6% in 2004 to $245.3 million. Diluted earnings per share from continuing operations were $3.70 for 2005 compared to $3.90 for 2004 and $3.46 for 2003. A majority of the Company's earnings during these years were attributed primarily to traditional reinsurance results in the U.S.
Consolidated investment income increased 10.1% and 24.7% during 2005 and 2004, respectively. These increases related to a growing invested asset base due to positive cash flows from the Company's mortality operations and deposits from several annuity reinsurance treaties, offset, in part, by declining invested asset yields primarily due to a decline in prevailing interest rates. The cost basis of invested assets increased by $1.6 billion, or 15.9%, in 2005 and increased $1.5 billion, or 17.7%, in 2004. The average yield earned on investments, excluding funds withheld, was 5.89% in 2005, compared with 5.91% in 2004 and 6.39% in 2003. The Company expects the average yield to vary from year to year depending on a number of variables, including the prevailing interest rate environment, and changes in the mix of the
underlying investments. Funds withheld assets are primarily associated with annuity contracts on which the Company earns a spread. Fluctuations in the yield on funds withheld assets are generally offset by a corresponding adjustment to the interest credited on the liabilities. Investment income and realized investment gains and losses are allocated to the operating segments based upon average assets and related capital levels deemed appropriate to support the segment business volumes.
Costs of acquiring new business, which vary with and are primarily related to the production of new business, have been deferred to the extent that such costs are deemed recoverable from future premiums or gross profits. DAC amounts reflect the Company's expectations about the future experience of the business in force and include commissions and allowances as well as certain costs of policy issuance and underwriting. Some of the factors that can affect the carrying value of DAC include mortality assumptions, interest spreads and policy lapse rates. The Company performs periodic tests to establish that DAC remains recoverable, and if experience significantly deteriorates to the point where a premium deficiency exists, a cumulative charge to current operations will be recorded. No such adjustments were made during 2005, 2004 or 2003. As of December 31, 2005, the Company estimates that approximately 51.0% of its DAC balance is collateralized by surrender fees due to the Company and the reduction of policy liabilities, in excess of termination values, upon surrender or lapse of a policy.
Liabilities for future policy benefits under long-term life insurance policies (policy reserves) are computed based upon expected investment yields, mortality and withdrawal (lapse) rates, and other assumptions, including a provision for adverse deviation from expected claim levels. The Company primarily relies on its own valuation and administration systems to establish policy reserves. The policy reserves established by the Company may differ from those established by its ceding companies (clients) due to the use of different mortality and other assumptions. However, the Company relies on its clients to provide accurate data, including policy-level information, premiums and claims, which is the primary information used to establish reserves. The Company's administration departments work directly with clients to help ensure information is submitted by them in accordance with the reinsurance contracts. Additionally, the Company performs periodic audits of the information provided by ceding companies. The Company establishes reserves for processing backlogs with a goal of clearing all backlogs within a ninety-day period. The backlogs are usually due to data errors the Company discovers or computer file compatibility issues, since much of the data reported to the Company is in electronic format and is uploaded to its computer systems.
The Company primarily invests in fixed maturity securities. The Company monitors its fixed maturity securities to determine potential impairments in value. The Company evaluates factors such as the financial condition of the issuer, payment performance, the extent to which the market value has been below amortized cost, compliance with covenants, general market and industry sector conditions, the intent and ability to hold securities, and various other subjective factors. Securities, based on management's judgments, with an other-than-temporary impairment in value are written down to management's estimate of fair value.
The Company is currently a party to various litigation and arbitrations. While it is not feasible to predict or determine the ultimate outcome of the pending litigation or arbitrations or even provide reasonable ranges of potential losses, it is the opinion of management, after consultation with counsel, that the outcomes of such litigation and arbitrations, after consideration of the provisions made in the Company's consolidated financial statements, would not have a material adverse effect on its consolidated financial position. However, it is possible that an adverse outcome could, from time to time, have a material adverse effect on the Company's consolidated net income or cash flows in particular quarterly or annual periods. See Notes 14 and 20 to the Consolidated Financial Statements.
Claims and other policy benefits, as a percentage of net premiums (loss ratios), were 82.7%, 79.6%, and 81.1% in 2005, 2004, and 2003, respectively. The first six months of 2005 showed an increase in the severity of claims, which was the primary contributor to the high loss ratio in 2005. Over the past three years, the mortality experience in this sub-segment has fluctuated. This is somewhat expected as death claims are reasonably predictable over a period of many years, but are less predictable over shorter periods and are subject to significant fluctuation.
Net investment income increased $25.1 million, or 11.4%, and $38.2 million, or 21.0%, in 2005 and 2004, respectively. The increase in both years is due to growth in the invested asset base, which in 2004 was greatly affected by the Allianz Life transaction. Increased operating cash flows on traditional reinsurance also contributed to the growth in both years. Investment income and realized investment gains and losses are allocated to the various operating segments based on average assets and related capital levels deemed appropriate to support the segment business volumes. Investment performance varies with the composition of investments and the relative allocation of capital to the operating segments.
That Incorporate Credit Risk Exposures That Are Unrelated or Only Partially Related to the Creditworthiness of the Obligor under Those Instruments" ("Issue B36"). The Company recorded a change in value of embedded derivatives during 2005, 2004 and 2003 of $7.4 million, $26.1 million and $43.6 million within revenues and $7.0 million, $22.9 million and $30.7 million of related deferred acquisition costs, respectively (see Note 2 - "New Accounting Pronouncements" in Notes to Consolidated Financial Statements for further discussion).
Income before income taxes increased in 2005 to $23.3 million compared to $17.3 million in 2004 and decreased from the $25.4 million reported in 2003. The increase over 2004 is primarily due to investment related losses which decreased from $7.2 million in 2004 to $1.1 million in 2005. Offsetting this slightly was the change in the fair value of embedded derivatives which resulted in a net gain of $0.5 million for 2005 compared to a net gain of $3.2 million in 2004. In addition, income for 2004 includes a $2.0 million loss on the conversion of a coinsurance-funds withheld annuity treaty to a coinsurance treaty in the third quarter of 2004. The conversion resulted in $11.7 million of additional investment income offset by $13.7 million in amortization of policy acquisition costs. Income for 2003 includes a net gain of $12.9 million related to the change in fair value of embedded derivatives.
At December 31, 2005, 2004 and 2003, the amount of reinsurance assumed from client companies, as measured by pre-tax statutory surplus, was $1.9 billion, $1.5 billion and $1.1 billion, respectively. The pre-tax statutory surplus includes all business assumed by the Company. Fees resulting from this business can be affected by large transactions and the timing of completion of new transactions and therefore can fluctuate from period to period.
Income before income taxes increased 19.7% and 23.4% in 2005 and 2004, respectively. The increase in 2005 was primarily the result of more favorable mortality experience in the current year offset by a decrease in investment related gains of $6.6 million. Additionally, the Canadian dollar strengthened against the U.S. dollar during 2005 and contributed $6.0 million to income before income taxes in 2005. The increase in 2004 was primarily the result of more favorable mortality experience, offset by a decrease in realized investment gains of $1.9 million. Additionally, the Canadian dollar strengthened against the U.S. dollar during 2004 and contributed $4.4 million to income before income taxes in 2004.
Net investment income increased 20.3% and 14.8% during 2005 and 2004, respectively. Investment performance varies with the composition of investments. In 2005, the increase in investment income was mainly the result of a stronger Canadian dollar during 2005 compared to 2004 which contributed $7.7 million, or 7.7%, an increase in the invested asset base due to operating cash flows on traditional reinsurance and capital injections which contributed $6.3 million, or 6.3%, and interest on an increasing amount of funds withheld at interest related to one treaty which contributed $2.5 million, or 2.5%. In 2004, the increase in investment income was mainly the result of a stronger Canadian dollar during 2004 compared to 2003 which contributed $6.6 million, or 7.6%, an increase in the invested asset base due to operating cash flows on traditional reinsurance which contributed $2.9 million, or 3.3%, and interest on an increasing amount of funds withheld at interest related to one treaty which contributed $2.2 million, or 2.5%. Investment income also includes an allocation to the segments based upon average assets and related capital levels deemed appropriate to support business volumes. The amount of investment income allocated to the Canadian operations was $6.5 million and $4.8 million in 2005 and 2004, respectively.
2003. Death claims are reasonably predictable over a period of many years, but are less predictable over shorter periods and are subject to significant fluctuation.
Policy acquisition costs and other insurance expenses as a percentage of net premiums totaled 16.3% in 2005, 11.2% in 2004 and 9.5% in 2003. Excluding creditor business, policy acquisition costs and other insurance expenses as a percentage of net premiums totaled 11.3% in 2005, 10.2% in 2004 and 8.1% in 2003. Policy acquisition costs and other insurance expenses as a percentage of net premiums vary from period to period primarily due to the mix of the business in the segment.
Other operating expenses increased $4.0 million in 2005 and $0.7 million in 2004 compared to their respective prior-year periods. Other operating expenses as a percentage of net premiums totaled 4.4% in 2005, compared to 4.4% and 4.9% in 2004 and 2003, respectively.
Income before income taxes increased 11.7% and 56.3% in 2005 and 2004, respectively. The increase in 2005 was primarily the result of additional business volume and an increase in net premiums of $74.1 million. Additionally, investment income increased $4.6 million and was offset by a decrease in realized investment gains of $4.7 million and an increase in other operating expenses of $6.3 million. The increase in 2004 was primarily due to additional business volume and an increase in net premiums of $114.4 million partially offset by an increase in other operating expenses of $5.6 million.
Europe & South Africa net premiums grew 15.5% during 2005 and 31.4% in 2004. The growth was primarily the result of new business from both existing treaties and new treaties, combined with a small unfavorable effect from currency exchange rates in 2005 of $2.3 million and a favorable effect from currency exchange rates in 2004 of $49.1 million. In 2004, several foreign currencies, particularly the British pound, the euro, and the South African rand strengthened against the U.S. dollar. Also, a significant portion of the growth of premiums was due to reinsurance of accelerated critical illness, primarily in the UK. This coverage provides a benefit in the event of a death from or the diagnosis of a pre-defined critical illness. Premiums earned from this coverage totaled $199.3 million, $177.4 million and $145.7 million in 2005, 2004 and 2003, respectively. Premium levels are significantly influenced by large transactions and reporting practices of ceding companies and therefore can fluctuate from period to period.
Investment income increased $4.6 million and $1.3 million in 2005 and 2004, respectively. These increases were primarily due to growth in the 2005 and 2004 invested assets in the UK of $25.3 million and $10.7 million, respectively. The growth was also due to growth in allocated investment income. Investment income and investment related gains and losses are allocated to the various operating segments based on average assets and related capital levels deemed appropriate to
Loss ratios were 73.3%, 65.6% and 63.4% for 2005, 2004 and 2003, respectively. Death claims are reasonably predictable over a period of many years, but are less predictable over shorter periods and are subject to significant fluctuation. Policy acquisition costs and other insurance expenses as a percentage of net premiums represented 16.7%, 25.4% and 28.8% for 2005, 2004 and 2003, respectively. These percentages fluctuate due to timing of client company reporting, variations in the mixture of business being reinsured and the relative maturity of the business. In addition, as the segment grows, renewal premiums which have lower allowances than first year premiums, represent a greater percentage of the total premiums. Accordingly, the change in the mixture of business during 2005 and 2004 caused the loss ratios to increase and caused the policy acquisition costs and other insurance expenses as a percentage of net premiums to decrease.
Policy acquisition costs are capitalized and charged to expense in proportion to premium revenue recognized. Acquisition costs, as a percentage of premiums, associated with some treaties in the United Kingdom are typically higher than those experienced in the Company's other segments. Future recoverability of the capitalized policy acquisition costs on this business is primarily sensitive to mortality and morbidity experience. If actual experience suggests higher mortality and morbidity rates going forward than currently contemplated in management's estimates, the Company may record a charge to income, due to a reduction in the DAC asset and, to the extent there are no unamortized acquisition costs, an increase in future policy benefits. As of December 31, 2005, the Company estimates that a 12 percent increase in anticipated mortality and morbidity experience would have no effect while a 15 percent or 18 percent increase would result in pre-tax income statement charges of approximately $12.3 million and $83.7 million, respectively.
Other operating expenses increased 29.4% during 2005 and 35.3% during 2004. Increases in other operating expenses were due to higher costs associated with maintaining and supporting the significant increase in business over the past two years. As a percentage of premiums, other operating expenses were 5.0%, 4.5% and 4.4% in 2005, 2004 and 2003, respectively. The Company believes that sustained growth in premiums should lessen the burden of start-up expenses and expansion costs over time.
The Asia Pacific segment has operations in Australia, Hong Kong, Japan, Malaysia, Singapore, New Zealand, South Korea, China and Taiwan. The principal types of reinsurance for this segment include life, critical care and illness, disability income, superannuation, and financial reinsurance. Superannuation is the Australian government mandated compulsory retirement savings program. Superannuation funds accumulate retirement funds for employees, and in addition, offer life and disability insurance coverage. Reinsurance agreements may be either facultative or automatic agreements covering primarily individual risks and in some markets, group risks. The Company operates multiple offices throughout each region in an effort to best meet the needs of the local client companies.
Income before income taxes increased 220.2% during 2005 and decreased 34.6% during 2004. The increase in income before taxes for 2005 was primarily the result of the Australian operations. Strong growth in Australian business contributed to an increase in investment income of $6.1 million from 2004 to 2005. Favorable mortality along with an overall reduction of reserves for disabled life reserves contributed to an increase in income before income taxes of approximately $25.1 million in Australia. The decrease in income before income taxes for 2004 was primarily the result of increases in the volume of claims and other policy benefits in relation to net premiums. Operations in which increases in claim activity were most evident were Australia and New Zealand. Additionally, various adjustments related to enhancements of the business administration process in the Australia and New Zealand operations reduced income before income taxes by approximately $2.0 million in 2004. The enhancements were a reaction to the increasing levels of business within those operations and to improve the reliability of the administration functions.
During 2004, growth in premium volume was driven by the Australia, Japan and South Korea markets which added approximately $88.2 million, $21.9 million and $27.9 million, respectively, in premium volume compared to 2003. Growth in Australia was driven primarily by continued success in the group market, as previously noted. Premium growth in the Japan market during 2004 was driven primarily by growth in a single client relationship. Of the $21.9 million in additional premium volume in Japan compared to 2003, approximately $13.0 million of the growth came from this client. In Korea, 2004 premium growth was driven by a $12.3 million increase in premium volume from one existing client relationship, along with approximately $10.0 million of premium from two new clients.
Several foreign currencies, particularly the Korean won and the Australian dollar, continued to strengthen against the U.S. dollar in 2005. The overall effect of the strengthening of local Asia Pacific segment currencies was an increase in 2005 premiums of $20.4 over 2004, and $32.0 million for 2004 over 2003.
Net investment income increased $13.3 million in 2005, as compared to an increase of $5.4 million in 2004. The increase in both years was primarily due to growth in the invested assets in Australia and favorable exchange rates, along with an increase in allocated investment income. Investment income and realized investment gains and losses are allocated to the various operating segments based on average assets and related capital levels deemed appropriate to support the segment business volumes. Investment performance varies with the composition of investments and the relative allocation of capital to the operating segments.
Loss ratios as a percentage of net premiums were 78.5%, 82.7% and 71.6% for 2005, 2004 and 2003, respectively. This percentage will fluctuate due to timing of client company reporting, variations in the mixture of business being reinsured and the relative maturity of the business. Death claims are reasonably predictable over a period of many years, but are less predictable over shorter periods and are subject to significant fluctuation. While loss ratios were relatively stable between 2004 and 2005, the overall segment loss ratio increased 11.1% from 2003 to 2004. The increase in this percentage from 2003 to 2004 was attributable primarily to loss experience in Australia and New Zealand. Australia's loss ratio increased from
Administradoras de Fondos de Jubilaciones y Pensiones ("AFJPs") are privately owned pension fund managers that were formed as a result of reform and privatization of Argentina's social security system. Privatized pension reinsurance covers the life insurance as well as the total and permanent disability components of the pension program. The claims under that program are initially established as units of the underlying pension fund ("AFJP fund units") at the time they are filed. Because AFJP claims payments are linked to the AFJP fund units, the ultimate amounts of claims paid by the reinsurer under the program should vary with the underlying performance of the related pension fund over the period in which the claims were adjudicated. In addition, the reinsurer is subject to the mortality and morbidity risks associated with the underlying plan participants. The Company ceased renewal of reinsurance treaties associated with privatized pension contracts in Argentina during 2001 because of adverse experience with respect to this business, as several aspects of the pension fund claims flow did not develop as was contemplated when the reinsurance programs were initially priced.
reinsurers and retrocessionaires involved have raised substantial defenses upon which to contest claims arising from these coverages, including defenses based upon the failure of the ceding company to disclose the existence of manufactured claims spirals, inappropriate or unauthorized underwriting procedures and other defenses. As a result, there have been a significant number of claims for rescission, arbitration, and litigation among a number of the parties involved in these various coverages. This has had the effect of significantly slowing the reporting of claims between parties, as the various outcomes of a series of arbitrations and similar actions affect the extent to which higher level reinsurers and retrocessionaires may ultimately have exposure to claims.
The calculation of the claim reserve liability for the entire portfolio of accident and health business requires management to make estimates and assumptions that affect the reported claim reserve levels. Management must make estimates and assumptions based on historical loss experience, changes in the nature of the business, anticipated outcomes of claim disputes and claims for rescission, anticipated outcomes of arbitrations, and projected future premium run-off, all of which may affect the level of the claim reserve liability. Due to the significant uncertainty associated with the run-off of this business, net income in future periods could be affected positively or negatively. The consolidated statements of income for all periods presented reflect this line of business as a discontinued operation. Revenues associated with discontinued operations, which are not reported on a gross basis in the Company's consolidated statements of income, totaled $2.5 million, $1.4 million and $4.8 million for 2005, 2004 and 2003, respectively.
The Company periodically reviews the EGP valuation model and assumptions so that the assumptions reflect a view of the future believed to be reasonable. Two assumptions are considered to be most significant: (1) estimated interest spread, and (2) estimated future policy lapses. The following table reflects the possible change that would occur in a given year if assumptions, as a percentage of current deferred policy acquisition costs related to asset-intensive products ($431.5 million as of December 31, 2005), are changed as illustrated:
In general, a change in assumption that improves the Company's expectations regarding EGP is going to have the effect of deferring the amortization of DAC into the future, thus increasing earnings and the current DAC balance. Conversely, a change in assumption that decreases EGP will have the effect of speeding up the amortization of DAC, thus reducing earnings and lowering the DAC balance. The Company also adjusts DAC to reflect changes in the unrealized gains and losses on available for sale fixed maturity securities since this affects EGP. This adjustment to DAC is reflected in accumulated other comprehensive income.
The following table displays DAC balances for asset-intensive business and non-asset-intensive business by segment as of December 31, 2005:
The Company believes that it has sufficient liquidity to fund its cash needs under various scenarios that include the potential risk of the early recapture of a reinsurance treaty by the ceding company and significantly higher than expected death claims. Historically, the Company has generated positive net cash flows from operations. However, in the event of significant unanticipated cash requirements beyond normal liquidity, the Company has multiple liquidity alternatives available based on market conditions and the amount and timing of the liquidity need. These options include borrowings under committed credit facilities, secured borrowings, the ability to issue long-term debt, preferred securities or common equity and, if necessary, the sale of invested assets subject to market conditions.
into an accelerated share repurchase ("ASR") agreement with a financial counterparty under which RGA purchased 1,600,000 shares of its outstanding common stock at an aggregate price of approximately $75.9 million. The common shares repurchased have been placed into treasury to be used for general corporate purposes. (See Note 3, "Stock Transactions," of the Notes to Consolidated Financial Statements for additional information regarding the ASR).
In order to reduce the effect of Regulation XXX, RGA Reinsurance has retroceded Regulation XXX reserves to unaffiliated and affiliated unlicensed reinsurers. RGA Reinsurance's statutory capital may be significantly reduced if the unaffiliated or affiliated reinsurer is unable to provide the required collateral to support RGA Reinsurance's statutory reserve credits and RGA Reinsurance cannot find an alternative source for collateral.
The Company maintains three credit facilities. The Company's credit facility that expires in September 2010, is a syndicated credit facility with an overall capacity of $600.0 million. The overall capacity available for issuance of letters of credit is reduced by any cash borrowings made by the Company against this credit facility. The Company may borrow up to $300.0 million of cash under the facility. As of December 31, 2005 the Company's outstanding cash balance was $50.0 million under this credit facility, with an average interest rate of 4.75%. The Company's other credit facilities consist of a L15.0 million credit facility that expires in May 2007 and an AUD$35.0 million credit facility that expires in February 2006, which is expected to be renewed. The Company's foreign credit facilities had a combined balance of $51.5 million as of December 31, 2005.
Some treaties give ceding companies the right to request that the Company place assets in trust for the benefit of the cedant to support reserve credits in the event of a downgrade of the Company's ratings to specified levels. As of December 31, 2005, these treaties had approximately $388.0 million in reserves. Assets placed in trust continue to be owned by the Company, but their use is restricted based on the terms of the trust agreement. Securities with an amortized cost of $769.2 million were held in trust for the benefit of certain subsidiaries of the Company to satisfy collateral requirements for reinsurance business at December 31, 2005. Additionally, securities with an amortized cost of $1,454.3 million as of December 31, 2005 were held in trust to satisfy collateral requirements under certain third-party reinsurance treaties. Under certain conditions, RGA may be obligated to move reinsurance from one RGA subsidiary company to another RGA
The Company has commitments to fund investments in mortgage loans and limited partnerships in the amount of $25.7 million and $31.1 million, respectively, at December 31, 2005. The Company anticipates that the majority of these amounts will be invested over the next five years, however, contractually these commitments could become due at the request of the counterparties. Investments in mortgage loans and limited partnerships are carried at cost and included in total investments in the consolidated balance sheets.
In December 2005, the Company entered into an ASR agreement with a financial counterparty. Under the ASR agreement, the Company purchased 1,600,000 shares of its outstanding common stock at an initial price of $47.43 per share and an aggregate price of approximately $75.9 million. In order to deliver the shares to RGA on December 12, 2005, the counterparty borrowed RGA shares from the stock loan market. Under the ASR agreement, the counterparty purchases an equivalent number of shares of common stock in the open market from time to time in order to pay back the shares it borrowed. At the end of this period, the Company may receive, or may be required to remit, a purchase price adjustment based upon the volume weighted average price of its common shares during the period. The counterparty completed its purchases on February 22, 2006 and as a result, the Company was required to pay $130 thousand to the counterparty for the final settlement.
The Company has not engaged in trading activities involving non-exchange traded contracts reported at fair value, nor has it engaged in relationships or transactions with persons or entities that derive benefits from their non-independent relationship with RGA.
The Company's principal cash inflows from its reinsurance operations are premiums and deposit funds received from ceding companies. The primary liquidity concern with respect to these cash flows is early recapture of the reinsurance contract by the ceding company. The Company's principal cash inflows from its investing activities result from investment income, maturity and sales of invested assets, and repayments of principal. The primary liquidity concern with respect to these cash inflows relates to the risk of default by debtors and interest rate volatility. The Company manages these risks very closely. See -- Investments and --Interest Rate Risk below.
Additional sources of liquidity to meet unexpected cash outflows in excess of operating cash inflows include selling short-term investments or fixed maturity securities and drawing additional funds under existing credit facilities, under which the Company had availability of $230.0 million as of December 31, 2005.
The Company's net cash flows provided by operating activities for the years ended December 31, 2005, 2004 and 2003, were $599.4 million, $710.8 million and $574.6 million, respectively. Cash flows from operating activities are affected by the timing of premiums received, claims paid and working capital changes. Operating cash decreased $111.5 million during 2005 due to higher operating cash outlays of $613.3 million largely offset by increased cash from premiums and investment income of $438.2 million and $63.6 million, respectively. During 2004, operating cash increased $136.2 million as cash from premiums and investment income increased $921.5 million and $116.8 million, respectively, and was largely offset by higher operating net cash outlays of $902.1 million. The Company believes the short-term cash requirements of its business operations will be sufficiently met by the positive cash flows generated. Additionally, the Company believes it maintains a high-quality fixed maturity portfolio with positive liquidity characteristics. These securities are available for sale and could be sold if necessary to meet the Company's short- and long-term obligations, subject to market conditions.
Net cash provided by financing activities was $274.3 million, $120.9 million and $704.1 million in 2005, 2004 and 2003, respectively. Changes in cash provided by financing activities primarily relate to the issuance of equity or debt securities, borrowings or payments under the Company's existing credit agreements, treasury stock activity and excess deposits under investment-type contracts.
The Company has obtained letters of credit, issued by banks, in favor of various affiliated and unaffiliated insurance companies from which the Company assumes business. These letters of credit represent guarantees of performance under the reinsurance agreements and allow ceding companies to take statutory reserve credits. Certain of these letters of credit contain financial covenant restrictions similar to those described in the Debt and Trust Preferred Securities discussion above. At December 31, 2005, there were approximately $17.4 million of outstanding bank letters of credit in favor of third parties. Additionally, the Company utilizes letters of credit to secure statutory reserve credits when it retrocedes business to its offshore subsidiaries, including RGA Americas, RGA Barbados and RGA Worldwide Reinsurance Company, Ltd. ("RGA Worldwide"). The Company cedes business to its offshore affiliates to help reduce the amount of regulatory capital required in certain jurisdictions such as the U.S. and the United Kingdom. The capital required to support the business in the offshore
affiliates reflects more realistic expectations than the original jurisdiction of the business, where capital requirements are often considered to be quite conservative. As of December 31, 2005, $439.8 million in letters of credit from various banks were outstanding between the various subsidiaries of the Company.
The Company's liquidity position (cash and cash equivalents and short-term investments) was $255.0 million and $184.1 million at December 31, 2005 and December 31, 2004, respectively. Liquidity needs are determined from valuation analyses conducted by operational units and are driven by product portfolios. Annual evaluations of demand liabilities and short-term liquid assets are designed to adjust specific portfolios, as well as their durations and maturities, in response to anticipated liquidity needs.
The Company's asset-intensive products are primarily supported by investments in fixed maturity securities. Investment guidelines are established to structure the investment portfolio based upon the type, duration and behavior of products in the liability portfolio so as to achieve targeted levels of profitability. The Company manages the asset-intensive business to provide a targeted spread between the interest rate earned on investments and the interest rate credited to the underlying interest-sensitive contract liabilities. The Company periodically reviews models projecting different interest rate scenarios and their effect on profitability. Certain of these asset-intensive agreements, primarily in the U.S. operating segment, are generally funded by fixed maturity securities that are withheld by the ceding company.
Within the fixed maturity security portfolio, the Company holds approximately $122.1 million in asset-backed securities at December 31, 2005, which include credit card and automobile receivables, home equity loans and collateralized bond obligations. The Company's asset-backed securities are diversified by issuer and contain both floating and fixed-rate securities. Approximately 0.7% of asset-backed securities, or $0.8 million are collateralized bond obligations. In addition to the risks associated with floating rate securities, principal risks in holding asset-backed securities are structural, credit and capital market risks. Structural risks include the securities' priority in the issuer's capital structure, the adequacy of and ability to realize proceeds from collateral, and the potential for prepayments. Credit risks include consumer or corporate credits such as credit card holders, equipment lessees, and corporate obligors. Capital market risks include general level of interest rates and the liquidity for these securities in the marketplace.
The Company monitors its investment securities to determine impairments in value. The Company evaluates factors such as financial condition of the issuer, payment performance, the length of time and the extent to which the market value has been below amortized cost, compliance with covenants, general market conditions and industry sector, intent and ability to hold securities and various other subjective factors. As of December 31, 2005, the Company held fixed maturities with a cost basis of $8.4 million and a market value of $8.7 million, representing 0.1% of fixed maturities at December 31, 2005, that were non-income producing. Based on management's judgment, securities with an other-than-temporary impairment in value are written down to management's estimate of fair value. The Company recorded other-than-temporary write-downs of fixed maturities totaling $0.5 million, $8.5 million and $20.1 million in 2005, 2004 and 2003, respectively. The circumstances that gave rise to these impairments were bankruptcy proceedings or deterioration in collateral value supporting certain asset-backed securities. During 2005 and 2004, the Company sold fixed maturity securities with fair values of $822.3 million and $394.0 million at losses of $21.8 million and $20.6 million, respectively, or at 97.4% and 95.0% of book value, respectively.
Policy loans comprised approximately 8.0% and 9.1% of the Company's investments as of December 31, 2005 and 2004, respectively. These policy loans present no credit risk because the amount of the loan cannot exceed the obligation due the ceding company upon the death of the insured or surrender of the underlying policy. The provisions of the treaties in force and the underlying policies determine the policy loan interest rates. Because policy loans represent premature distributions of policy liabilities, they have the effect of reducing future disintermediation risk. In addition, the Company earns a spread between the interest rate earned on policy loans and the interest rate credited to corresponding liabilities.
Funds withheld at interest comprised approximately 28.1% and 25.9% of the Company's investments as of December 31, 2005 and 2004, respectively. For agreements written on a modified coinsurance basis and certain agreements written on a coinsurance basis, assets equal to the net statutory reserves are withheld and legally owned and managed by the ceding company, and are reflected as funds withheld at interest on the Company's consolidated balance sheets. In the event of a ceding company's insolvency, the Company would need to assert a claim on the assets supporting its reserve liabilities. However, the risk of loss to the Company is mitigated by its ability to offset amounts it owes the ceding company for claims or allowances with amounts owed by the ceding company. Interest accrues to these assets at rates defined by the treaty terms and the Company estimates the yield was approximately 6.63% for the year ended December 31, 2005. The Company is subject to the investment performance on the withheld assets, although it does not directly control them. These assets are primarily fixed maturity investment securities and pose risks similar to the fixed maturity securities the Company owns. To mitigate this risk, the Company helps set the investment guidelines followed by the ceding company and monitors compliance. Ceding companies with funds withheld at interest had an average A.M. Best rating of "A". Certain ceding companies maintain segregated portfolios for the benefit of the Company.
Based on data provided by ceding companies as of December 31, 2005, funds withheld at interest were approximately (in thousands):
Based on data provided by the ceding companies as of December 31, 2005, the maturity distribution of the segregated portfolio portion of funds withheld at interest was approximately (in thousands):
Other invested assets represented approximately 1.9% and 2.0% of the Company's investments as of December 31, 2005 and 2004, respectively. Other invested assets include derivative contracts, equity securities, preferred stocks and limited partnership interests.
The Company has utilized derivative financial instruments on a very limited basis, primarily to improve the management of the investment-related risks associated with the reinsurance of equity-indexed annuities. The Company invests primarily in exchange-traded and customized Standard and Poor's equity index options. The Company has established minimum credit quality standards for counterparties and seeks to obtain collateral or other credit supports. The Company limits its total financial exposure to counterparties. The Company's use of derivative financial instruments historically has not been significant to its financial position. The fair value of derivative investments totaled ($20.0) thousand as of December 31, 2005 and consisted of exchange-traded credit default swaps with a notional amount of $40.0 million.
This risk arises from many of the Company's primary activities, as the Company invests substantial funds in interest-sensitive assets and also has certain interest-sensitive contract liabilities. The Company manages interest rate risk and credit risk to maximize the return on the Company's capital effectively and to preserve the value created by its business operations. As such, certain management monitoring processes are designed to minimize the effect of sudden and sustained changes in interest rates on fair value, cash flows, and net interest income. The Company manages its exposure to interest rates principally by matching floating rate liabilities with corresponding floating rate assets and by matching fixed rate liabilities with corresponding fixed rate assets. On a limited basis, the Company uses equity options to minimize its exposure to movements in equity markets that have a direct correlation with certain of its reinsurance products.
The Company's exposure to interest rate price risk and interest rate cash flow risk is reviewed on a quarterly basis. Interest rate price risk exposure is measured using interest rate sensitivity analysis to determine the change in fair value of the Company's financial instruments in the event of a hypothetical change in interest rates. Interest rate cash flow risk exposure is measured using interest rate sensitivity analysis to determine the Company's variability in cash flows in the event of a hypothetical change in interest rates. If estimated changes in fair value, net interest income, and cash flows are not within the limits established, management may adjust its asset and liability mix to bring interest rate risk within board-approved limits.
value of financial instruments in the event of a 10% unfavorable change in market interest rates at its fiscal years ended December 31, 2005 and 2004 was $262.6 million and $207.6 million, respectively.
At December 31, 2005, the Company's estimated changes in fair value were within the targets outlined in the Company's investment policy.
The Company is subject to foreign currency translation, transaction, and net income exposure. The Company manages its exposure to currency principally by matching invested assets with the underlying reinsurance liabilities to the extent possible, but generally does not hedge the foreign currency translation or net investment exposure related to its investment in foreign subsidiaries as it views these investments to be long-term. Translation differences resulting from translating foreign subsidiary balances to U.S. dollars are reflected in stockholders' equity on the consolidated balance sheets. The Company generally does not hedge the foreign currency exposure of its subsidiaries transacting business in currencies other than their functional currency (transaction exposure). The majority of the Company's foreign currency transactions are denominated in Australian dollars, British pounds, Canadian dollars, Japanese yen, Korean won and the South African rand.
marketable equity securities classified as available-for-sale or held-to-maturity under SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities" ("SFAS 115"), that are impaired at the balance sheet date but for which an other-than-temporary impairment has not been recognized. The FASB decided not to provide additional guidance on the meaning of other-than-temporary impairment but has issued FASB Staff Position ("FSP") 115-1, "The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments" ("FSP 115-1"), which nullifies the accounting guidance on the determination of whether an investment is other-than-temporarily impaired as set forth in EITF 03-1. As required by FSP 115-1, the Company adopted this guidance on a prospective basis, which had no material effect on the Company's consolidated financial statements. The Company has complied with the disclosure requirements of EITF 03-1, which was effective December 31, 2003 and remained in effect until the adoption of FSP 115-1.
In June 2005, the FASB cleared SFAS 133 Implementation Issue No. B38, "Embedded Derivatives: Evaluation of Net Settlement with Respect to the Settlement of a Debt Instrument through Exercise of an Embedded Put Option or Call Option" ("Issue B38") and SFAS 133 Implementation Issue No. B39, "Embedded Derivatives: Application of Paragraph 13(b) to Call Options That Are Exercisable Only by the Debtor" ("Issue B39"). Issue B38 clarified that the potential settlement of a debtor's obligation to a creditor occurring upon exercise of a put or call option meets the net settlement criteria of SFAS No. 133. Issue B39 clarified that an embedded call option, in which the underlying is an interest rate or interest rate index, that can accelerate the settlement of a debt host financial instrument should not be bifurcated and fair valued if the right to accelerate the settlement can be exercised only by the debtor (issuer/borrower) and the investor will recover substantially all of its initial net investment. Issues B38 and B39, which must be adopted as of the first day of the first fiscal quarter beginning after December 15, 2005, did not have a material effect on the Company's consolidated financial statements.
In December 2004, the FASB revised SFAS No. 123 "Accounting for Stock Based Compensation" ("SFAS 123") to "Share-Based Payment" ("SFAS 123(r)"). SFAS 123(r) provides additional guidance on determining whether certain financial instruments awarded in share-based payment transactions are liabilities. SFAS 123(r) also requires that the cost of all share-based transactions be recorded in the financial statements. The revised pronouncement will be adopted by the Company during the first quarter of 2006. The Company expects SFAS 123(r) will increase compensation expense by approximately $2.4 million in 2006.
Substantially all of the Company's funds withheld receivable balance is associated with its reinsurance of annuity contracts. The funds withheld receivable balance totaled $3.5 billion and $2.7 billion at December 31, 2005 and 2004, respectively, are subject to the provisions of Issue B36. Management believes the embedded derivative feature in each of these reinsurance treaties is similar to a total return swap on the assets held by the ceding companies. The Company has developed cash flow models as the basis for estimating the value of the total return swap. The cash flow models are based on the Company's expectations of the future cash flows under the reinsurance treaties that in turn are driven by the underlying
REINSURANCE GROUP OF AMERICA, INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2005, 2004, AND 2003
The consolidated financial statements include the assets, liabilities, and results of operations of RGA, RGA Reinsurance Company ("RGA Reinsurance"), RGA Reinsurance Company (Barbados) Ltd. ("RGA Barbados"), RGA Life Reinsurance Company of Canada ("RGA Canada"), RGA Americas Reinsurance Company, Ltd. ("RGA Americas"), RGA Reinsurance Company of Australia, Limited ("RGA Australia") and RGA Reinsurance UK Limited ("RGA UK") as well as other subsidiaries, subject to an ownership position of greater than fifty percent (collectively, the "Company").
Mortgage loans on real estate are carried at unpaid principal balances, net of any unamortized premium or discount and valuation allowances. Valuation allowances on mortgage loans are established based upon losses expected by management to be realized in connection with future dispositions or settlement of mortgage loans, including foreclosures. The valuation allowances are established after management considers, among other things, the value of underlying collateral and payment capabilities of debtors.
For reinsurance transactions executed through December 31, 1994, assets and liabilities related to treaties written on a modified coinsurance basis with funds withheld are reported on a gross basis. For modified coinsurance reinsurance transactions with funds withheld executed on or after December 31, 1994, assets and liabilities are reported on a net or gross basis, depending on the specific details within each treaty. Reinsurance agreements reported on a net basis are generally included in other reinsurance balances on the consolidated balance sheets because a legal right of offset exists.
Change in value of embedded derivatives reflects the change in the market value of specific financial instruments as required upon the adoption of Statement of Financial Accounting Standards ("SFAS") No. 133 Implementation Issue No. B36, "Embedded Derivatives: Modified Coinsurance Arrangements and Debt Instruments That Incorporate Credit Risk Exposures That Are Unrelated or Only Partially Related to the Creditworthiness of the Obligor under Those Instruments" ("Issue B36").
The Company has a variety of reasons to use derivative instruments, such as to attempt to protect the Company against possible changes in the market value of its investment portfolio as a result of interest rate changes and to manage the portfolio's effective yield, maturity, and duration. The Company does not invest in derivatives for speculative purposes. The Company uses both exchange-traded and customized over-the-counter derivative financial instruments. The Company's use of derivatives historically has not been significant to its financial position. Income or expense on derivative financial instruments used to manage interest-rate exposure is recorded on an accrual basis as an adjustment to the yield of the related interest-earning assets or interest-bearing liabilities for the periods covered by the contracts. Upon sale, exercise, expiration or termination, gains or losses on derivatives accounted for as cash flow hedges are reclassified from accumulated other comprehensive income into earnings in the same period or periods during which the hedged transaction affects earnings. As of December 31, 2005 and 2004, the Company did not hold any derivatives accounted for as cash flow hedges. At December 31, 2005, the Company held exchange-traded credit default swaps with a notional amount of $40.0 million, which are carried at a fair value of ($20.0) thousand. Changes in the fair value of these derivatives are recorded as investment related gains/(losses), net on the consolidated statements of income. It is the Company's policy to enter into derivative contracts primarily with highly rated companies.
Goodwill and Value of Business Acquired. The Company reports goodwill pursuant to the provisions of SFAS No. 142. Accordingly, goodwill and certain intangibles are not amortized into results of operations, but instead are reviewed for impairment and written down and charged to results of operations only in the periods in which the recorded value of goodwill and certain intangibles is more than its fair value. From 2003 through 2005, there were no changes to goodwill as a result of acquisitions or disposals. Goodwill as of December 31, 2005 and 2004 totaled $7.0 million and was related to the purchase by the Company's U.S. operations of RGA Financial Group L.L.C. in 2000. The value of business acquired is amortized in proportion to the ratio of annual premium revenues to total anticipated premium revenues or in relation to the present value of estimated profits. Anticipated premium revenues have been estimated using assumptions consistent with those used in estimating reserves for future policy benefits. The carrying value is reviewed at least annually for indicators of impairment in value. The value of business acquired was approximately $3.5 million and $4.5 million, including accumulated amortization of $9.9 million and $8.9 million, as of December 31, 2005 and 2004, respectively. The value of business acquired amortization expense for the years ended December 31, 2005, 2004, and 2003 was $1.0 million, $1.3 million, and $1.7 million, respectively. These amortized balances are included in other assets on the consolidated balance sheets. Amortization of the value of business acquired is estimated to be $0.8 million, $0.6 million, $0.4 million, $0.4 million and $0.3 million during 2006, 2007, 2008, 2009 and 2010, respectively.
Other Policy Claims and Benefits. Claims payable for incurred but not reported losses are determined using case basis estimates and lag studies of past experience. The time lag from the date of the claim or death to when the ceding company reports the claim to the Company can vary significantly by ceding company and business segment, but generally averages around 3.0 months on a consolidated basis. The Company updates its analysis of incurred but not reported, including lag studies, on a quarterly basis and adjusts its claim liabilities accordingly.
Other liabilities primarily include investments in transit, separate accounts, employee benefits, and current federal income taxes payable. The Company occasionally enters into sales of investment securities under agreements to repurchase the same securities and participates in a securitized lending program. These transactions are reported as collateralized financings and the settlement obligation is a component of other liabilities. At December 31, 2005 and 2004, there were no repurchase agreements outstanding.
("Preferred Securities") issued by the Trust with a detachable warrant to purchase 1.2508 shares of RGA common stock. The Trust sold 4.5 million PIERS units. The market value of the Preferred Securities on the date issued ($158.1 million) was recorded in liabilities on the consolidated balance sheets under the caption "Company-obligated mandatorily redeemable preferred securities of subsidiary trust holding solely junior subordinated debentures." The coupon rate of the Preferred Securities is 5.75% on a face amount of $225.0 million.
In the normal course of business, the Company seeks to limit its exposure to losses on any single insured and to recover a portion of benefits paid by ceding reinsurance to other insurance enterprises or reinsurers under excess coverage and coinsurance (quota share) contracts. Effective July 1, 2003, the Company increased its retention amount from $4.0 million of coverage per individual life to $6.0 million. RGA Reinsurance has a number of retrocession arrangements whereby certain business in force is retroceded on an automatic or facultative basis. The Company also retrocedes most of its financial reinsurance business to other insurance companies to alleviate statutory capital requirements created by this business.
Retrocessions are arranged through the Company's retrocession pools for amounts in excess of the Company's retention limit. As of December 31, 2005, all rated retrocession pool participants followed by the A.M. Best Company were rated B++ or better. For a majority of the retrocessionaires that were not rated, security in the form of letters of credit or trust assets has been given as additional security in favor of RGA Reinsurance. In addition, the Company performs annual financial reviews of its retrocessionaires to evaluate financial stability and performance. In addition to its third party retrocessionaires, various RGA reinsurance subsidiaries retrocede amounts in excess of their retention to RGA Reinsurance, RGA Barbados and RGA Americas.
Revenues for interest-sensitive and investment-type products consist of investment income, policy charges for the cost of insurance, policy administration, and surrenders that have been assessed against policy account balances during the period.
Interest-sensitive contract liabilities for these products represent policy account balances before applicable surrender charges. Deferred policy acquisition costs are recognized as expenses over the term of the policies. Policy benefits and claims that are charged to expenses include claims incurred in the period in excess of related policy account balances and interest credited to policy account balances. The weighted average interest-crediting rates for interest-sensitive products were 4.1%, 4.5% and 4.7%, during 2005, 2004 and 2003, respectively. Interest crediting rates for U.S. dollar-denominated investment-type contracts ranged from 3.2% to 5.8% during 2005, 2.8% to 5.9% during 2004 and 4.0% to 9.5% during 2003. Weighted average interest crediting rates for Mexican peso-denominated investment-type contracts were 12.7%, 5.0% and 21.8% for 2005, 2004 and 2003, respectively.
Investment income is recognized as it accrues or is legally due. Realized gains and losses on sales of investments are included in net income, as are write-downs of investments where declines in value are deemed to be other than temporary in nature. The cost of investments sold is determined based upon the specific identification method.
In May 2005, the FASB issued SFAS No. 154, "Accounting Changes and Error Corrections, a replacement of APB Opinion No. 20 and FASB Statement No. 3" ("SFAS 154"). The statement requires retrospective application to prior periods' financial statements for a voluntary change in accounting principle unless it is deemed impracticable. It also requires that a change in the method of depreciation, amortization, or depletion for long-lived, non-financial assets be accounted for as a change in accounting estimate rather than a change in accounting principle. SFAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. SFAS 154 is not expected to have a material effect on the Company's consolidated financial statements.
In July 2003, the Accounting Standards Executive Committee issued Statement of Position ("SOP") 03-1, "Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts." SOP
03-1 provides guidance on separate account presentation and valuation, the accounting for sales inducements and the classification and valuation of long-duration contract liabilities. The Company adopted the provisions of SOP 03-1 on January 1, 2004, recording a charge of $0.4 million as a cumulative effect of change in accounting principle.
In April 2003, the FASB cleared SFAS No. 133 Implementation Issue No. B36, "Embedded Derivatives: Modified Coinsurance Arrangements and Debt Instruments That Incorporate Credit Risk Exposures That Are Unrelated or Only Partially Related to the Creditworthiness of the Obligor under Those Instruments". Issue B36 concluded that (i) a company's funds withheld payable and/or receivable under certain reinsurance arrangements and (ii) a debt instrument that incorporates credit risk exposures that are unrelated or only partially related to the creditworthiness of the obligor include an embedded derivative feature that is not clearly and closely related to the host contract. Therefore, the embedded derivative feature must be measured at fair value on the balance sheet and changes in fair value reported in income. The Company adopted the provisions of Issue B36 during the fourth quarter of 2003 and recorded a net gain of $0.5 million as a cumulative effect of change in accounting principle.
During December 2003, the Company completed a large coinsurance agreement with Allianz Life Insurance Company of North America ("Allianz Life"). Under this agreement, RGA Reinsurance assumed the traditional life reinsurance business of Allianz Life, including yearly renewable term reinsurance and coinsurance of term policies. The business assumed does not include any accident and health risk, annuities or related guaranteed minimum death benefits or guaranteed minimum income benefits. This transaction added additional scale to the Company's U.S. traditional business, but did not significantly add to the Company's client base since most of the underlying ceding companies were already clients. The transaction was effective retroactive to July 1, 2003. Under the agreement, Allianz Life transferred to RGA Reinsurance $425.7 million in cash and statutory reserves. RGA Reinsurance paid Allianz Life a ceding commission of $310.0 million. As a result of this transaction, during the fourth quarter of 2003 the Company's U.S. traditional sub-segment reflected an additional $246.1 million in net premiums and approximately $6.8 million of net income, after tax.
As of December 31, 2005, the Company held securities with a market value of $586.1 million issued by the Federal Home Loan Mortgage Corporation, $407.4 million issued by the Federal National Mortgage Corporation, $485.7 million that were issued by a Canadian province, and $454.0 million in one entity that were guaranteed by a Canadian province, all of which exceeded 10% of consolidated stockholders' equity. As of December 31, 2004, the Company held securities with a market value of $535.7 million issued by the Federal Home Loan Mortgage Corporation, $290.5 million issued by the Federal National Mortgage Corporation, $318.4 million in one entity were guaranteed by a Canadian province, and $260.2 million in one entity that was guaranteed by a Canadian province, all of which exceeded 10% of consolidated stockholders' equity.
The amortized cost and estimated fair value of fixed maturity securities available-for-sale at December 31, 2005 are shown by contractual maturity for all securities except certain U.S. government agencies securities, which are distributed to maturity year based on the Company's estimate of the rate of future prepayments of principal over the remaining lives of the securities. These estimates are developed using prepayment rates provided in broker consensus data. Such estimates are derived from prepayment rates experienced at the interest rate levels projected for the applicable underlying collateral and can be expected to vary from actual experience. Actual maturities can differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
At December 31, 2005, the contractual maturities of investments in fixed maturity securities were as follows (in thousands):
At December 31, 2005, fixed maturity securities held by the Company that were below investment grade had a book value and estimated fair value of approximately $178.7 million and $182.1 million, respectively. At December 31, 2005, the Company owned non-income producing securities with an amortized cost of $8.4 million and market value of $8.7 million. During 2005, 2004, and 2003 the Company sold fixed maturity securities with fair values of $822.3 million, $394.0 million, and $460.3 million, which were below amortized cost, at losses of $21.8 million, $20.6 million and $25.2 million, respectively.
The following table presents the total gross unrealized losses for 679 and 403 fixed maturity securities and equity securities as of December 31, 2005 and 2004, respectively, where the estimated fair value had declined and remained below amortized cost by the indicated amount (in thousands):
The following tables present the estimated fair values and gross unrealized losses for the 679 and 403 fixed maturity securities and equity securities that have estimated fair values below amortized cost as of December 31, 2005 and 2004, respectively. These investments are presented by class and grade of security, as well as the length of time the related market value has remained below amortized cost.
Funds withheld at interest comprised approximately 28.1% and 25.9% of the Company's investments as of December 31, 2005 and 2004, respectively. For agreements written on a modified coinsurance basis and certain agreements written on a coinsurance funds withheld basis, assets equal to the net statutory reserves are withheld and legally owned and managed by the ceding company and are reflected as funds withheld at interest on the Company's consolidated balance sheets. In the event of a ceding company's insolvency, the Company would need to assert a claim on the assets supporting its reserve liabilities. However, the risk of loss to the Company is mitigated by its ability to offset amounts it owes the ceding company for claims or allowances with amounts owed to the Company from the ceding company. Interest accrues to these assets at rates defined by the treaty terms and the Company estimates the yield was approximately 6.63%, 7.51% and 6.51% for the years ended December 31, 2005, 2004 and 2003, respectively. In most cases, the Company is subject to the investment performance on the funds withheld assets, although it does not control them. To mitigate this risk, the Company helps set the investment guidelines followed by the ceding company and monitors compliance.
Other invested assets include equity securities, preferred stocks, limited partnership interests and derivative contracts. Other invested assets represented approximately 1.9% and 2.0% of the Company's investments as of December 31, 2005 and 2004, respectively. During 2005, the Company recorded other-than temporary write-downs of $1.3 million on its investments in limited partnerships based on losses in the underlying holdings.
The following table presents the carrying amounts and estimated fair values of the Company's financial instruments at December 31, 2005 and 2004. Fair values have been determined by using available market information and the valuation methodologies described below. Considerable judgment is often required in interpreting market data to develop estimates of fair value. Accordingly, the estimates presented herein may not necessarily be indicative of amounts that could be realized in a current market exchange. The use of different assumptions or valuation methodologies may have a material effect on the estimated fair value amounts (in thousands):
Retrocession reinsurance treaties do not relieve the Company from its obligations to direct writing companies. Failure of retrocessionaires to honor their obligations could result in losses to the Company. Consequently, allowances would be established for amounts deemed uncollectible. At December 31, 2005 and 2004, no allowances were deemed necessary. The Company regularly evaluates the financial condition of its reinsurers / retrocessionaires.
At December 31, 2005 and 2004, there were no reinsurance ceded receivables associated with a single reinsurer with a carrying value in excess of 5% of total assets.
At December 31, 2005, the Company has provided approximately $1.9 billion of statutory financial reinsurance, as measured by pre-tax statutory surplus, to other insurance companies under financial reinsurance transactions to assist ceding companies in meeting applicable regulatory requirements. Generally, such financial reinsurance is provided by the Company committing cash or assuming insurance liabilities, which are collateralized by future profits on the reinsured business. The Company retrocedes the majority of the assumed financial reinsurance. The Company earns a fee based on the amount of net outstanding financial reinsurance.
The tax effects of temporary differences that give rise to significant portions of the deferred income tax assets and liabilities at December 31, 2005 and 2004, are presented in the following tables (in thousands):
As of December 31, 2005 and 2004, a valuation allowance for deferred tax assets of approximately $4.7 million and $9.5 million, respectively, was provided on the net operating and capital losses of General American Argentina Seguros de Vida,
Note 13 FINANCIAL CONDITION AND NET INCOME ON A STATUTORY BASIS - SIGNIFICANT SUBSIDIARIES
The following table presents selected statutory financial information for the Company's primary life reinsurance legal entities, as of or for the years ended December 31, 2005, 2004, and 2003 (in thousands):
The total capital and surplus positions of RCM, RGA Reinsurance and RGA Canada exceed the risk-based capital requirements of the applicable regulatory bodies. RCM and RGA Reinsurance are subject to Missouri statutory provisions that restrict the payment of dividends. They may not pay dividends in any 12-month period in excess of the greater of the prior year's statutory operating income or 10% of capital and surplus at the preceding year-end, without regulatory approval. The applicable statutory provisions only permit an insurer to pay a shareholder dividend from unassigned surplus. Any dividends paid by RGA Reinsurance would be paid to RCM, its parent company, which in turn has restrictions related to its ability to pay dividends to RGA. The assets of RCM consist primarily of its investment in RGA Reinsurance. As of January 1, 2006, RCM and RGA Reinsurance could pay maximum dividends, without prior approval, of approximately $41.4 million and $97.5 million, respectively. Dividend payments by other subsidiaries are subject to regulations in the jurisdiction of domicile.
The Company is currently a party to three arbitrations that involve its discontinued accident and health business, including personal accident business (including London market excess of loss business) and workers' compensation carve-out business. The Company is also party to one pending and one threatened arbitration related to its life reinsurance business. In addition, the Company has been joined in a suit filed against one of its ceding companies alleging wrongful denial of a life insurance claim. As of January 31, 2006, the parties involved in these actions have raised claims, or established reserves that may result in claims, in the amount of $31.5 million, which is $27.6 million in excess of the amounts held in reserve by the Company. The Company generally has little information regarding any reserves established by the ceding companies, and must rely on management estimates to establish policy claim liabilities. It is possible that any such reserves could be increased in the future. The Company believes it has substantial defenses upon which to contest these claims, including but not limited to misrepresentation and breach of contract by direct and indirect ceding companies. See Note 20, "Discontinued Operations" for more information. Additionally, from time to time, the Company is subject to litigation related to employment-related matters in the normal course of its business. While it is difficult to predict or determine the ultimate outcome of the pending litigation or arbitrations or provide useful ranges of potential losses, it is the opinion of management, after consultation with counsel, that their outcomes, after consideration of the provisions made in the Company's consolidated financial statements, would not have a material adverse effect on its consolidated financial position. However, it is possible that an adverse outcome could, from time to time, have a material adverse effect on the Company's consolidated net income or cash flows in particular quarterly or annual periods.
The Company has reinsured privately-owned pension funds that were formed as a result of reform and privatization of Argentina's social security system. The Company ceased renewal of reinsurance treaties associated with privatized pension contracts in Argentina during 2001 because of adverse experience on this business, as several aspects of the pension fund claims flow did not develop as was contemplated when the reinsurance programs were initially priced. Since 2001, the Company has pursued various courses of action to reduce and eliminate its obligations associated with the reinsurance of Argentine pension accounts. The Company's actions have resulted in one AFJP ceding company demanding arbitration and could result in other litigation or arbitrations in the future. However, as of January 2006, the Company had commuted about 95% of its obligations associated with the AFJP business and is in discussions with the remaining clients regarding settlement of all obligations under the remaining treaties. Therefore, the risk of litigation or arbitrations in the future has significantly declined. While it is not feasible to predict or determine the ultimate outcome of any such future litigations or arbitrations or provide reasonable ranges of potential losses, it is the opinion of management, after consultation with counsel, that their outcomes, after consideration of the provisions made in the Company's consolidated financial statements, would not have a material adverse effect on its consolidated financial position.
The Company has obtained letters of credit, issued by banks, in favor of various affiliated and unaffiliated insurance companies from which the Company assumes business. These letters of credit represent guarantees of performance under the reinsurance agreements and allow ceding companies to take statutory reserve credits. Certain of these letters of credit contain financial covenant restrictions similar to those described in the Debt and Preferred Securities discussion above. At December 31, 2005 and 2004, there were approximately $17.4 million and $32.6 million, respectively, of outstanding bank letters of credit in favor of third parties. Additionally, the Company utilizes letters of credit to secure reserve credits when it retrocedes business to its offshore subsidiaries, including RGA Americas, RGA Barbados and RGA Worldwide. The Company cedes business to its offshore affiliates to help reduce the amount of regulatory capital required in certain jurisdictions such as the U.S. and the United Kingdom. The capital required to support the business in the offshore affiliates reflects more realistic expectations than the original jurisdiction of the business, where capital requirements are often considered to be quite conservative. As of December 31, 2005 and 2004, $439.8 million and $370.5 million, respectively, in letters of credit from various banks were outstanding between the various subsidiaries of the Company. During the third quarter of 2005, the Company entered into a five-year, syndicated credit facility with an overall capacity of $600.0 million. The amount of the overall capacity available for issuance of letters of credit is reduced by any cash borrowings, up to $300.0 million, made by the Company against this credit facility. At December 31, 2005, there were $320.0 million letters of credit outstanding against this credit facility, which is included in the total above. Applicable letter of credit fees and fees payable for the credit facility depend upon the Company's senior unsecured long-term debt rating. Fees associated with the Company's other letters of credit are not fixed for periods in excess of one year and are based on the Company's ratings and the general availability of these instruments in the marketplace.
RGA has issued guarantees to third parties on behalf of its subsidiaries' performance for the payment of amounts due under certain credit facilities, reinsurance treaties and an office lease obligation, whereby if a subsidiary fails to meet an obligation, RGA or one of its other subsidiaries will make a payment to fulfill the obligation. In limited circumstances, treaty guarantees are granted to ceding companies in order to provide them additional security, particularly in cases where RGA's subsidiary is relatively new, unrated, or not of a significant size, relative to the ceding company. Liabilities supported by the treaty guarantees, before consideration for any legally offsetting amounts due from the guaranteed party, totaled $256.2 million and $285.4 million as of December 31, 2005 and 2004, respectively, and are reflected on the Company's consolidated balance sheets in future policy benefits. Potential guaranteed amounts of future payments will vary depending on production levels and underwriting results. Guarantees related to trust preferred securities and credit facilities provide additional security to third party banks should a subsidiary fail to make principal and/or interest payments when due. As of December 31, 2005, RGA's exposure related to these guarantees was $184.2 million. RGA has issued a guarantee on behalf of a subsidiary in the event the subsidiary fails to make payment under its office lease obligation, the exposure of which was insignificant as of December 31, 2005.
On December 8, 2005, RGA issued Junior Subordinated Debentures with a face amount of $400.0 million. Interest is payable semi-annually and is fixed at 6.75% per year until December 15, 2015. From December 15, 2015 until December 15, 2065, interest on the debentures will accrue at an annual rate of 3-month LIBOR plus a margin equal to 266.5 basis points, payable quarterly. The Company has the option to defer interest payments, subject to certain limitations. In addition, interest payments are mandatorily deferred if the Company does not meet specified capital adequacy, net income and shareholders' equity levels. Upon an optional or mandatory deferral, the Company is not permitted to pay common-stock dividends or make payments of interest or principal on securities which rank equal or junior to the subordinated debentures, until the accrued and unpaid interest on the subordinated debentures is paid. The subordinated debentures are redeemable at the Company's option. The net proceeds from the offering were approximately $394.6 million, a portion of which was used to purchase $75.9 million of the Company's common stock under an ASR agreement with a financial counterparty. RGA intends to use a portion of the net proceeds from the sale of these debentures to repay approximately $100.0 million of its 7.25% senior notes when they mature on April 1, 2006. Capitalized issue costs were approximately $5.5 million.
require immediate payment of the amount due, including principal, under the various agreements. Additionally, the Company's debt agreements contain cross-default covenants, which would make outstanding borrowings immediately payable in the event of a material uncured covenant default under any of the agreements, including, but not limited to, non-payment of indebtedness when due for amounts greater than $10 million or $25 million depending on the agreement, bankruptcy proceedings, and any other event which results in the acceleration of the maturity of indebtedness. As of December 31, 2005, the Company had $800.0 million in outstanding borrowings under its debt agreements and was in compliance with all covenants under those agreements. The ability of the Company to make debt principal and interest payments depends on the earnings and surplus of subsidiaries, investment earnings on undeployed capital proceeds, and the Company's ability to raise additional funds.
The Company has five main operational segments, each of which is a distinct reportable segment: U.S., Canada, Europe & South Africa, Asia Pacific and Corporate and Other. The U.S. operations provide traditional life, asset-intensive, and financial reinsurance to domestic clients. Asset-intensive products primarily include reinsurance of corporate-owned life insurance and annuities. The Canada operations provide insurers with reinsurance of traditional life products as well as reinsurance of critical illness products. Asia Pacific operations provide primarily traditional life reinsurance, critical illness and, to a lesser extent, financial reinsurance through RGA Australia and RGA Reinsurance. Europe & South Africa operations include traditional life reinsurance and critical illness business from Europe & South Africa, in addition to other markets being developed by the Company. The Company's discontinued accident and health operations are not reflected in the continuing operations of the Company. The Company measures segment performance based on income or loss before income taxes.
Effective January 1, 2003, as a result of the Company's declining presence in Argentina and changes in management responsibilities for part of the Latin America region, Latin America results relating to the Argentine privatized pension business as well as direct insurance operations in Argentina are reported in the Corporate and Other segment. The results for all other Latin America business, primarily traditional reinsurance business in Mexico, are reported as part of the Europe & South Africa segment.
During 2005, two clients generated $143.5 million or 35.3% of gross premiums for the Canada operations. Three clients of the Company's United Kingdom operations generated approximately $337.7 million, or 57.1% of the total gross premiums for the Europe & South Africa operations. Five clients, four in Australia and one in Japan, generated approximately $208.9 million, or 36.7% of the total gross premiums for the Asia Pacific operations.
In February 2006, the Board approved an incentive compensation package including 335,012 incentive stock options at $47.48 per share and 143,374 PCUs under the Plan. In addition, non-employee directors received 4,800 shares of common stock under the Directors Plan.
The following table presents the components of the Company's accumulated other comprehensive income for the years ended December 31, 2005, 2004 and 2003 (in thousands):
A summary of the components of net unrealized appreciation of balances carried at fair value is as follows (in thousands):
The Company is currently a party to three arbitrations that involve personal accident business as mentioned above. As of January 31, 2006, the companies involved in these actions have raised claims, or established reserves that may result in claims, that are $23.5 million in excess of the amounts held in reserve by the Company. The Company generally has little information regarding any reserves established by ceding companies, and must rely on management estimates to establish policy claim liabilities. It is possible that any such reserves could be increased in the future. The Company believes it has substantial defenses upon which to contest these claims, including but not limited to misrepresentation and breach of contract by direct and indirect ceding companies. While it is not feasible to predict or determine the ultimate outcome of the pending litigation or arbitrations or provide reasonable ranges of potential losses, it is the opinion of management, after consultation with counsel, that their outcomes, after consideration of the provisions made in the Company's consolidated financial statements, would not have a material adverse effect on its consolidated financial position. However, it is possible that an
adverse outcome could, from time to time, have a material adverse effect on the Company's consolidated net income or cash flows in particular quarterly or annual periods.
To the Board of Directors and Stockholders of Reinsurance Group of America, Incorporated St. Louis, Missouri
We have audited the accompanying consolidated balance sheets of Reinsurance Group of America, Incorporated and subsidiaries (the "Company") as of December 31, 2005 and 2004, and the related consolidated statements of income, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 2005. Our audits also included the financial statement schedules listed in the Index at Item 15. These consolidated financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Reinsurance Group of America, Incorporated and subsidiaries as of December 31, 2005 and 2004, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2005, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in a all material respects the information set forth therein.
As discussed in Note 2, the Company changed its method of accounting for certain non-traditional long duration contracts and separate accounts, and for embedded derivatives in certain insurance products as required by new accounting guidance which became effective on January 1, 2004 and October 1, 2003, respectively, and recorded the effect as cumulative effects of changes in accounting principles.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company's internal control over financial reporting as of December 31, 2005, based on the criteria established in Internal Control--Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 27, 2006 expressed an unqualified opinion on management's assessment of the effectiveness of the Company's internal control over financial reporting and an unqualified opinion on the effectiveness of the Company's internal control over financial reporting.
(1) Revenues for the first and second quarters of 2004 differ from amounts included in the Company's respective Quarterly Reports on Form 10-Q filed during 2004 due to a change in presentation related to Issue B36. Approximately $4,200 and $13,293 of DAC offsets were netted against "Change in value of embedded derivatives" within revenues in the first and second quarters, respectively, but were reclassed to "Change in deferred acquisition costs associated with change in value of embedded derivatives" within expenses beginning in the third quarter.