We currently write three types of reinsurance on a quota share basis: renewable term, coinsurance and modified coinsurance.
net amount of risk we reinsure. The net amount of risk is typically defined as the difference between the death benefit and the cash value of a policy. The ceding life company establishes the policy reserves, which are reduced for the mortality risk reinsured with us, and pays all policy benefits, commissions and expenses involved in issuing and maintaining the business. Correspondingly, we establish reserves specific to the mortality risk reinsured.
Coinsurance. Under a coinsurance arrangement, the insured risks are ceded to us on essentially the same basis as underwritten by the ceding life company. The ceded risks include mortality, persistency, investment and expense. We share the risks pro rata with the ceding life company. We receive a proportionate share of gross premiums from the ceding life company and provide contractual expense allowances to the ceding life company to pay for the expenses associated with the reinsured policies. Expenses include commissions and costs associated with underwriting, marketing, policy issue and maintenance. We also pay our proportionate share of death benefits and other policy benefits to the ceding life company. The reserves on the ceded portion of the policy are held by us and are our obligations. Correspondingly, we invest the assets related to the reserves and receive investment income from those assets.
The preparation of financial statements in conformity with accounting principals generally accepted in the United States requires management to make estimates and assumptions regarding uncertainties that affect certain amounts in the consolidated financial statements and related footnotes. Accounts that we deem to be sensitive to changes in estimates include deferred acquisition costs and future policy benefits. In all instances, actual results could differ from estimates. A summary of significant accounting policies is included in Note 2 to the Consolidated Financial Statements.
claims are reasonably predictable over a period of years, claims become less predictable over shorter periods, and are subject to fluctuation from quarter to quarter and year to year. Similarly, separate account investment returns, upon which a significant portion of our revenues depend, may have relatively stable returns over a period of years but can be volatile over shorter periods. A considerable amount of separate account balances is invested in equities; therefore, prolonged deterioration in the equity markets will result in a decrease in our current and future income.
Under the coinsurance and modified coinsurance agreements, the amortization of the deferred acquisition costs is in proportion to the ratio of gross profits recognized during the then current period to total actual and future expected gross profits. During each accounting period, assumptions used in calculating the amortization of the deferred acquisition costs reflect actual experience for the then current accounting period. We also review, on a periodic basis, our evolving experience concerning our assumptions with regard to mortality, persistency, investment yields and expenses in determining our estimate of anticipated future gross profits. This periodic review is commonly referred to as “unlocking.” Our normal period of observation is from October 1 of the previous calendar year through September 30 of the current calendar year. If we believe variances from expected assumptions are permanent, we will change the assumptions we use with regard to future experience. Upon adoption of any change in assumptions used with regard to future experience, amortization of the deferred acquisition costs will be recalculated and reflected during the then current accounting period.
Future Policy Benefits. Liabilities for future benefits on life insurance policies are established in an amount we estimate is adequate to meet the estimated future obligations on the policies in effect. Policy reserves are included in “future policy benefits” on the consolidated balance sheet.
Liabilities for future policy benefits under our reinsurance agreements may include provisions for claims that have been incurred but have not yet been paid. A portion of these claims represent claims reported to us that are in the course of settlement. The remainder of this liability represents claims that may have been incurred but not yet reported to us.
Investments. We classify all fixed maturity securities and equity securities, that are not classified as trading securities, as “available for sale.” Such securities are reported at fair value. Fixed maturity
securities available for sale are so classified based upon the possibility that such securities could be sold prior to maturity if that action enables us to execute our investment philosophy and appropriately match investment results to operating and liquidity needs. Equity securities available for sale are so classified because we do not intend to actively trade such securities. Unrealized gains and losses on marketable equity securities and fixed maturity securities available for sale, less applicable deferred income taxes, are reported as a separate component of “accumulated other comprehensive income” within stockholders’ equity. Investment income is recognized as it accrues or becomes legally due. Other equity investments, classified as trading securities are bought and held principally for the purpose of selling them in the near term and are reported at fair value. Unrealized gains and losses on trading securities are reported as a separate revenue component on the income statement.
The life insurance and annuity policies that we have reinsured to date are underwritten and issued by Western Reserve, American Skandia, Kemper and Pacific Life. The following table indicates the percentage of our reinsurance revenues derived from our ceding life companies:
The following table indicates, by ceding life company: (1) the names and types of insurance products we currently reinsure; (2) the type of reinsurance agreement applicable to each; (3) policy issue dates reinsured under each agreement; and (4) the commencement date of the reinsurance.
“MRT” means monthly renewable term. “YRT” means yearly renewable term. “Co/ Modco” means coinsurance and modified coinsurance.
Following World Financial Group’s purchase of certain assets of WMA Agency in June 2001, we entered into certain agreements with Western Reserve that provide us a first right to reinsure certain new products issued by Western Reserve or its U.S. affiliates that are sold by agents associated with World Financial Group. Concurrently, Global Preferred entered into a directed reinsurance agreement with World Financial Group in July 2001 to help us secure the opportunity to reinsure all insurance products sold by its agents for insurance companies with which it has selling agreements other than Western Reserve and Western Reserve’s affiliates. Refer to Note 5 to the Consolidated Financial Statements for further discussion.
Additionally, for the year ended December 31, 2004, reinsured policy revenues reflect an increase of $130,000 of reinsurance fees resulting from payments to us from Western Reserve to resolve certain settlement differences in the administration of our variable universal life coinsurance and modified
coinsurance reinsurance agreements. These settlement adjustments also resulted in a decrease in benefits, claims and settlement expenses, a decrease in reinsurance expense allowances, net and an increase in amortization of deferred acquisition costs of $63,000, $73,000 and $178,000, respectively, for a total increase in income before income tax of $88,000.
Net Investment Income. Net investment income increased $442,000, or 109%, from $407,000 for the year ended December 31, 2003 to $849,000 for the same period in 2004, primarily due to the increased average size of our fixed maturity and equity securities portfolio during 2004 as compared to the average size of our fixed maturity and equity securities portfolio in 2003. The increase in our fixed maturity and equity securities portfolio resulted from the purchase of $16.8 million of fixed maturity and equity securities during 2003, most of which occurred in the latter half of the year, and $6.8 million of fixed maturity securities purchased during 2004. The purchases and sales activities by quarter are shown in the table below:
Net Realized Gains & Loss on Investments. The sale of $3.0 million of fixed maturity and equity securities available for sale for the year ended December 31, 2004 resulted in a net realized loss on investments of $27,000 and was primarily due to an increase in market yields since the securities were purchased. The sale of $421,000 of fixed maturity and equity securities available for sale for the year ended December 31, 2003 resulted in a net realized gain on investments of $21,000 and was primarily due to a decline in market yields since the securities were purchased.
Benefits, Claims and Settlement Expenses. Benefits, claims, and settlement expenses decreased $2.4 million, or 26%, from $9.3 million for the year ended December 31, 2003 to $6.9 million for the same period in 2004. The decrease was primarily associated with a lower incidence of death claims in 2004 compared to the incidence of death claims in 2003. The decline in benefits, claims, and settlement expenses was primarily due to lower claims in 2004 than historic averages as compared to higher than historic average claims experienced in 2003 and the declining aggregate face value of insurance, which was partially offset by the increasing age of the policies reinsured. The aggregate face value of insurance underlying the policies we reinsured at December 31, 2003 was $7.6 billion compared to $7.0 billion at December 31, 2004.
Amortization of Deferred Acquisition Costs. Amortization of deferred acquisition costs increased $672,000 or 12%, from $5.5 million for the year ended December 31, 2003 to $6.2 million for the same period in 2004. The increase in amortization primarily resulted from higher gross profits in 2004 primarily due to lower death claims, and increases in rates of amortization since policy account balances remain below our long-term expectations.
Under current assumptions, and all else being equal, we do not expect that there would be increased amortization in 2005 from “unlocking” due to lower than expected equity market performance unless market performance caused separate account fund balances to decline by 35% or more in 2005.
Income Taxes. Due to higher levels of income before income taxes, income taxes increased $572,000, or 57%, from $1.0 million for the year ended December 31, 2003 to $1.6 million for the same period in 2004. The “small life insurance company deduction” available under Section 806 of the Internal Revenue Code for qualifying life insurance companies can reduce the effective federal income tax rate from 34% to less than 20% depending upon the amount of current taxable income. Based upon our taxable income in 2004, we have estimated our effective tax rate to be 28% for 2004, as compared to 34% in 2003. The tax rate in 2004 reflects a $315,000 benefit from the small life insurance company deduction. In 2003, our taxable income was not sufficient to take advantage of the small life insurance company deduction.
Benefits, Claims and Settlement Expenses. Benefits, claims and settlement expenses increased $840,000, or 10%, from $8.4 million for the year ended December 31, 2002 to $9.3 million for the same period in 2003. The increase was primarily associated with a lower incidence of life insurance death claims in 2002 compared to the incidence of death claims in 2003, an increase in the average death claim size and the increasing age of the policies reinsured, partially offset by a decline in the aggregate face value of insurance. The aggregate face value of insurance underlying the policies we reinsured at December 31, 2002 was $8.5 billion compared to $7.6 billion at December 31, 2003.
Operating Expenses. Operating expenses increased $267,000, or 9%, from $3.1 million for the year ended December 31, 2002 to $3.4 million for the same period in 2003. These expenses included salaries and benefits, professional fees for legal, actuarial and accounting services and other operating expenses. The majority of the increase was attributable to an increase of $572,000 resulting from directors’ and officers’ insurance premiums, office operating expenses, professional fees, marketing expenses, taxes and
licenses, and shareholder communications. These increases were partially offset by a $301,000 decrease in salaries, bonuses and recruiting expenses due to the reductions in staffing and employee bonuses.
Costs of Withdrawn Offering. During October 2002, we withdrew the registration statement for our proposed initial public offering of 9.5 million shares of common stock. Offering costs related to our withdrawn offering were $1.7 million for the year ended December 31, 2002. These costs, which consisted primarily of legal, printing, accounting and actuarial fees, were expensed during the quarter ended September 30, 2002. We did not incur any similar expenses in 2003.
Income Taxes. Due to higher levels of income before income taxes, income taxes increased $209,000, or 26%, from $789,000 for the year ended December 31, 2002 to $998,000 for the same period in 2003. Income before income taxes is comprised of income subject to taxes that is recognized and due in the current period and income subject to tax that is recognized during the current period but is due in future periods. The “small life insurance company deduction” available under Section 806 of the Internal Revenue Code for qualifying life insurance companies can reduce the effective federal income tax rate from 34% to less than 20% depending upon the amount of current taxable income. For the years ended December 31, 2002 and 2003, we had no current taxable income and, as a result, we were unable to take advantage of any of the small life insurance company deduction. For 2003, however, we were subject to alternative minimum tax. Our effective tax rate was 34% in both 2002 and 2003.
In accordance with SFAS No. 109, Accounting for Income Taxes, we have $2.4 million of net operating loss carry-forwards, which begin to expire in 2018. These net operating loss carry-forwards at a 34% effective tax rate are included as an offset to the deferred tax liability. It is our belief that it is more likely than not that the deferred tax assets will be realized as an offset against future taxable income, however, if we do not have sufficient taxable income in the future to utilize this asset, a write-off may result thereby reducing our net income.
The following table presents certain unaudited quarterly consolidated statements of income data for the eight-quarter period ended December 31, 2004, as well as the percentage of total revenue represented by each item. The information has been derived from the unaudited consolidated financial statements. The unaudited consolidated financial statements have been prepared on substantially the same basis as the audited consolidated financial statements contained herein and all adjustments, consisting only of normal recurring adjustments, which we consider to be necessary to present fairly this information when read in conjunction with the consolidated financial statements and notes thereto appearing elsewhere herein. The results of operations for any quarter are not necessarily indicative of the results to be expected for any future period.
We have defined our reportable segments based on the nature of our reinsurance agreements and the accounting treatment used for the various reinsurance agreements. For definitions of these segments and associated financial information, refer to Note 13 of the Consolidated Financial Statements.
To grow our life and annuity business, we use cash to pay for the initial marketing and underwriting expenses of the policies we reinsure. These same policies thereafter provide cash from premiums, policy charges and policy fees over their lifetime. We also use cash to pay for policy claims, policy benefits and operating expenses which include: salaries and benefits, and professional fees for management, legal, investment, custodial, accounting, tax and consulting services. In addition to operating cash flows, cash is provided by and used in investing and financing activities we undertake to increase our capital position and through activities associated with our invested assets.
Our primary sources of liquidity were $20.1 million in fixed maturity securities available for sale, $12.5 million in consolidated cash and cash equivalents and $0.5 million of equity securities at December 31, 2004. The effective duration of our fixed maturity portfolio is 2.9 years with 100% of the fixed maturity securities having an effective maturity of less than 10 years. Our fixed maturity portfolio represents 60% of our total invested assets, and has an average Moody’s quality rating of Aa2. We have gross unrealized losses of $61,000 and gross unrealized gains of $248,000 on our fixed maturity securities available for sale as of December 31, 2004. We have determined that none of our fixed maturity securities are other-than-temporarily impaired. For additional information pertaining to our investments, refer to Note 3 to the Consolidated Financial Statements.
Our capital structure consists only of equity. On July 29, 2004, Global Preferred repaid $5 million plus outstanding interest of $187,500 on a five-year convertible term note due to Money Services, Inc., a subsidiary of AEGON USA, Inc. The principal and interest were paid out of available cash and cash equivalents. Interest was payable on the note at 7.5% per annum, on the 29th of each succeeding January and July through and including July 29, 2004. As of December 31, 2003, we had an outstanding principal balance on the term note of $5 million and accrued interest of $158,000.
and maintenance expenses incurred by the ceding life company that are attributable to the risks reinsured by us.
Net cash flows provided by (used in) operating activities were ($341,000), $10.8 million and $9.1 million for the years ended December 31, 2002, 2003 and 2004, respectively. Cash flows provided by operations in 2004 relating to new policies reinsured under coinsurance and modified coinsurance reflected net payments of $69,000 to Western Reserve to reinsure policies issued in 2004, and cash flows provided by operations for policies previously in force under coinsurance and modified coinsurance and by all policies reinsured under renewable term reinsurance of $14.2 million. Other cash flows used in operating activities of $5.0 million in 2004 were the result of cash payments for operating expenses, income taxes and interest expenses.
Cash flows provided by operations in 2003 relating to new policies reinsured under coinsurance and modified coinsurance reflected net payments of $156,000 to Western Reserve to reinsure policies issued in 2003, and cash flows provided by operations for policies previously in force under coinsurance and modified coinsurance and by all policies reinsured under renewable term reinsurance of $12.0 million. Other cash flows used in operating activities of $1.0 million in 2003 were the result of cash payments for operating expenses and interest expenses.
Cash flows used in operating activities in 2002 relating to new policies reinsured under coinsurance and modified coinsurance were $10.2 million and were primarily the result of the $7.2 million settlement paid to Western Reserve in April 2002 to increase the amount of business we reinsure as a result of the reinsurance amendments, settlements paid to reinsure policies issued in 2002 as a result of those amendments, and settlements paid to American Skandia to reinsure policies issued in 2002. These were offset by $14.8 million of cash flows provided by policies reinsured under coinsurance and modified coinsurance prior to 2002 and by all policies reinsured under renewable term reinsurance. Other cash flows used in operating activities of $4.9 million in 2002 were the result of cash payments for operating expenses, income taxes and interest expenses.
Restrictions. Global Preferred Holdings, Inc. is a holding company with no direct operations, and whose principal assets are the capital stock of Global Preferred Re and $5.9 million of cash and invested assets, as of December 31, 2004. Global Preferred relies primarily on funds retained at the holding company level, management service fees from its subsidiaries and potential dividends from Global Preferred Re to meet ongoing cash requirements. The ability of Global Preferred Re to pay dividends to Global Preferred is subject to, among other things, regulatory restrictions under the insurance laws of Bermuda, which are discussed in Note 9 to the Consolidated Financial Statements. In addition, the Reorganization Agreement specifies that while the agreement is effective Global Preferred Re may not pay Global Preferred cumulative dividends in excess of $6,384 per day and cumulative management fees in excess of $8,000 per day. As of December 31, 2004, Global Preferred Re had estimated total statutory capital and surplus of approximately $28.0 million, which includes up to an estimated $12.7 million available for distribution as dividends without seeking regulatory approval. Global Preferred Re is not required to file its statutory statement for the year ended December 31, 2004 until April 30, 2005. During the year ended December 31, 2004, Global Preferred Re paid no dividends to Global Preferred.
For a discussion of certain recently issued accounting pronouncements, refer to Note 2 to the Consolidated Financial Statements.
that could cause actual results to differ materially from those expressed or implied by such forward-looking statements, including but not limited to:
The passage of federal or state legislation subjecting our business to additional supervision or regulation, including additional tax regulation, in the United States or other jurisdictions in which we operate; and
Consolidated Statements of Income for the years ended December 31, 2002, 2003 and 2004
Notes to Consolidated Financial Statements for the years ended December 31, 2002, 2003 and 2004