- For investments: credit quality/experience, stability of long-term returns, cash flows and asset duration; and
- For financial condition: our financial strength ratings and capital positions; and
We have identified two accounting policies that require us to make assumptions and estimates that are significant to the financial statements. It is reasonably likely that changes in these assumptions and estimates could occur from period to period and result in a material impact on our financial statements. A brief summary of each of these critical accounting policies follows. For a more detailed discussion of the effect of these estimates on our financial statements, and the judgments and estimates related to these estimates, see the referenced sections of Management's Discussion and Analysis of Financial Condition and Results of Operation ("MD&A"). For a complete summary of our significant accounting policies see Note 2 of the financial statements.
FOR THE YEAR ENDED DECEMBER 31, ------------------------------- (IN THOUSANDS) 2006 2005 2004 -------- -------- --------- Net investment income $13,948 $13,632 $11,234 Realized capital gains and losses (1,255) (174) 5 Income tax expense 4,433 4,671 3,925 ------- ------- ------- Net income $ 8,260 $ 8,787 $ 7,314 ======= ======= =======
We have reinsurance agreements whereby premiums, contract charges, interest credited to contractholder funds, contract benefits and substantially all expenses are ceded to ALIC and other non-affiliated reinsurers, and are reflected net of such reinsurance in the Statements of Operations and Comprehensive Income. Our results of operations include net investment income and realized capital gains and losses earned on the assets that are not transferred under the reinsurance agreements.
NET INVESTMENT INCOME increased 2.3% in 2006 compared to 2005 and 21.3% in 2005 compared to 2004. The increase in 2006 was primarily due to higher average invested assets and higher short-term market interest rates. The increase in 2005 was due to higher average invested assets due to a capital contribution that was received late in 2004 and higher portfolio yields.
NET REALIZED CAPITAL LOSSES were $1.3 million and $174 thousand in 2006 and 2005, respectively. Net realized capital gains of $5 thousand were recognized in 2004. The realized capital gains and losses for 2006, 2005 and 2004 were attributable to dispositions of fixed income securities. For further discussion of realized capital gains and losses see the Realized Capital Gains and Losses section of the MD&A.
Total investments increased to $276.3 million at December 31, 2006 from $271.4 million at December 31, 2005, primarily due to positive cash flows from operating activities, partially offset by unrealized capital losses on fixed income securities at December 31, 2006 compared to unrealized capital gains at December 31, 2005.
FIXED INCOME SECURITIES See Note 4 of the financial statements for a table showing the amortized cost, unrealized gains, unrealized losses and fair value for each type of fixed income security for the years ended December 31, 2006 and 2005.
Fixed income securities issued by U.S. government agencies and U.S. government sponsored agencies comprised 44% of the fixed income securities portfolio and totaled $118.0 million at December 31, 2006, all of which were rated investment grade.
Mortgage-backed securities ("MBS") totaled $29.2 million, all of which were investment grade at December 31, 2006. The credit risk associated with MBS is mitigated due to the fact that 94.7% of the portfolio consists of securities that were issued by, or have underlying collateral that is guaranteed by U.S. government agencies or U.S. government sponsored entities. For the remaining portion of the portfolio not guaranteed by U.S. government agencies or entities, all had a Moody's rating of Aaa or a Standard & Poor's rating of AAA, the highest rating category. The MBS portfolio is subject to interest rate risk since price volatility and ultimate realized yield are affected by the rate of prepayment of the underlying mortgages.
Asset-backed securities ("ABS") totaled $14.5 million at December 31, 2006. Our ABS portfolio is subject to credit and interest rate risk. Credit risk is managed by monitoring the performance of the collateral. In addition, many of the securities in the ABS portfolio are credit enhanced with features such as over-collateralization, subordinated structures, reserve funds, guarantees and/or insurance. All securities in the ABS portfolio had a Moody's rating of Aaa or a Standard & Poor's or Fitch rating of AAA, the highest rating category. A portion of the ABS portfolio is also subject to interest rate risk since, for example, price volatility and ultimate realized yield are affected by the rate of repayment of the underlying assets.
UNREALIZED GAINS AND LOSSES See Note 4 of the financial statements for further disclosures regarding unrealized losses on fixed income securities and factors considered in determining whether the securities are not other-than-temporarily impaired. The unrealized net capital losses on fixed income securities at December 31, 2006 totaled $273 thousand compared to unrealized net capital gains of $1.1 million at December 31, 2005. Gross unrealized gains and losses on fixed income securities by type are provided in the table below.
GROSS UNREALIZED AMORTIZED ---------------- FAIR (IN THOUSANDS) COST GAINS LOSSES VALUE --------- ------ -------- -------- AT DECEMBER 31, 2006 Corporate: Financial services $ 18,791 $ 335 $ (212) $ 18,914 Capital goods 19,389 54 (623) 18,820 Consumer goods 11,240 34 (374) 10,900 Banking 10,157 160 (164) 10,153 Transportation 8,058 30 (285) 7,803 Utilities 4,127 -- (196) 3,931 Basic industry 2,993 -- (133) 2,860 -------- ------ ------- -------- Total corporate fixed income portfolio 74,755 613 (1,987) 73,381
U.S. government and agencies 116,821 2,609 (1,467) 117,963 Municipal 502 31 -- 533 Asset-backed securities 14,195 366 (39) 14,522 Mortgage-backed securities 29,963 98 (817) 29,244 Commercial mortgage-backed securities 32,095 635 (315) 32,415 -------- ------ ------- -------- Total fixed income securities $268,331 $4,352 $(4,625) $268,058 ======== ====== ======= ========
(IN THOUSANDS) NAIC UNREALIZED PERCENT FAIR PERCENT RATING MOODY'S EQUIVALENT LOSS OF TOTAL VALUE OF TOTAL ---------- -------- -------- -------- 1 Aaa/Aa/A $(4,266) 92.2% $154,090 95.5% 2 Baa (359) 7.8 7,222 4.5 ------- ----- -------- ----- Total $(4,625) 100.0% $161,312 100.0% ======= ===== ======== =====
As of December 31, 2006, we did not have any fixed income securities categorized as problem, restructured or potential problem.
(IN THOUSANDS) 2006 2005 2004 ------- ----- ---- Realized capital gains and losses, pretax $(1,255) $(174) $ 5 Income tax benefit (expense) 438 60 (2) ------- ----- --- Realized capital gains and losses, after-tax $ (817) $(114) $ 3 ======= ===== ===
We may sell impaired fixed income securities that were in an unrealized loss position at the previous reporting date in situations where new factors such as negative developments, subsequent credit deterioration, changing liquidity needs, and newly identified market opportunities cause a change in our previous intent to hold a security to recovery or maturity.
SHORT-TERM INVESTMENTS Our short-term investment portfolio was $8.3 million and $3.8 million at December 31, 2006 and 2005, respectively. We invest available cash balances primarily in taxable short-term securities having a final maturity date or redemption date of less than one year.
At December 31, 2006, contractholder funds increased to $18.20 billion from $17.46 billion at December 31, 2005 as a result of new and additional deposits from fixed annuities and interest-sensitive life policies and interest credited to contractholder funds partially offset by surrenders, withdrawals and benefit payments. The reserve for life-contingent contract benefits increased $234.3 million to $2.13 billion at December 31, 2006 resulting from sales of immediate annuities with life contingences and other life-contingent products, partially offset by benefits paid and policy lapses. Reinsurance recoverables from ALIC and reinsurance recoverable from non-affiliates increased correspondingly by $780.9 million and $184.0 million, respectively.
We purchase reinsurance after evaluating the financial condition of the reinsurer, as well as the terms and price of coverage. We reinsure certain of our risks to non-affiliated reinsurers under yearly renewable term and coinsurance agreements. Yearly renewable term and coinsurance agreements result in a passing of the agreed-upon portion of risk to the reinsurer in exchange for negotiated reinsurance premium payments.
CAPITAL RESOURCES consist of shareholder's equity. The following table summarizes our capital resources at December 31:
State laws specify regulatory actions if an insurer's risk-based capital ("RBC"), a measure of an insurer's solvency, falls below certain levels. The NAIC has a standard formula for annually assessing RBC. The formula for calculating RBC for life insurance companies takes into account factors relating to insurance, business, asset and interest rate risks. At December 31, 2006, our RBC was above levels that would require regulatory actions.
As reflected in our Statements of Cash Flows, net cash provided by operating activities was $23.0 million in 2006. This compares to net cash provided by operating activities of $11.6 million in 2005 and net cash used in operating activities of $4.2 million in 2004. Fluctuations in net cash provided by or used in operating activities primarily occur as a result of changes in net investment income and differences in the timing of reinsurance payments to and from ALIC.
We have entered into an inter-company loan agreement with the Corporation. The amount of inter-company loans available to us is at the discretion of the Corporation. The maximum amount of loans the Corporation will have outstanding to all its eligible subsidiaries at any given point in time is limited to $1.00 billion. We had no amounts outstanding under the inter-company loan agreement at December 31, 2006 or 2005, respectively. The Corporation uses commercial paper borrowings and bank lines of credit to fund inter-company borrowings.
YEAR ENDED DECEMBER 31, --------------------------- (IN THOUSANDS) 2006 2005 2004 ------- ------- ------- REVENUES Net investment income $13,948 $13,632 $11,234 Realized capital gains and losses (1,255) (174) 5 ------- ------- ------- INCOME FROM OPERATIONS BEFORE INCOME TAX EXPENSE 12,693 13,458 11,239 Income tax expense 4,433 4,671 3,925 ------- ------- ------- NET INCOME 8,260 8,787 7,314 ------- ------- ------- OTHER COMPREHENSIVE LOSS, AFTER-TAX Change in unrealized net capital gains and losses (885) (4,772) (1,786) ------- ------- ------- COMPREHENSIVE INCOME $ 7,375 $ 4,015 $ 5,528 ======= ======= =======
YEAR ENDED DECEMBER 31, ------------------------------ (IN THOUSANDS) 2006 2005 2004 -------- -------- -------- COMMON STOCK $ 2,500 $ 2,500 $ 2,500 -------- -------- -------- ADDITIONAL CAPITAL PAID-IN Balance, beginning of year 180,000 180,000 130,305 Capital contribution -- -- 49,695 -------- -------- -------- Balance, end of year 180,000 180,000 180,000 -------- -------- -------- RETAINED INCOME Balance, beginning of year 86,044 77,257 69,943 Net income 8,260 8,787 7,314 -------- -------- -------- Balance, end of year 94,304 86,044 77,257 -------- -------- -------- ACCUMULATED OTHER COMPREHENSIVE INCOME Balance, beginning of year 707 5,479 7,265 Change in unrealized net capital gains and losses (885) (4,772) (1,786) -------- -------- -------- Balance, end of year (178) 707 5,479 -------- -------- -------- TOTAL SHAREHOLDER'S EQUITY $276,626 $269,251 $265,236 ======== ======== ========
The Company sells life insurance, retirement and investment products to individual customers. The principal products are deferred and immediate fixed annuities, interest-sensitive, traditional and variable life insurance, and accident and health insurance.
Fixed income securities include bonds, commercial mortgage-backed, mortgage-backed and asset-backed securities. Fixed income securities may be sold prior to their contractual maturity ("available for sale") and are carried at fair value. The fair value of publicly traded fixed income securities is based upon independent market quotations. The difference between amortized cost and fair value, net of deferred income taxes, is reflected as a component of accumulated other comprehensive income. Cash received from calls, principal payments and make-whole payments is reflected as a component of proceeds from sales. Cash received from maturities and pay-downs is reflected as a component of investment collections.
Realized capital gains and losses include gains and losses on investment dispositions, and write-downs in value due to other-than-temporary declines in fair value. Dispositions include sales, losses recognized in anticipation of dispositions and other transactions such as calls and prepayments. Realized capital gains and losses on investment dispositions are determined on a specific identification basis.
The Company has reinsurance agreements whereby all premiums, contract charges, interest credited to contractholder funds, contract benefits and substantially all expenses are ceded to ALIC and non-affiliated reinsurers (see Notes 3 and 7). Amounts reflected in the Statements of Operations and Comprehensive Income are presented net of reinsurance.
Immediate annuities with life contingencies provide insurance protection over a period that extends beyond the period during which premiums are collected. Premiums from these products are recognized as revenue when received at the inception of the contract. Benefits and expenses are recognized in relation to such revenue such that profits are recognized over the lives of the contracts.
("subject to bifurcation"). The change in the fair value of derivatives embedded in liabilities and subject to bifurcation is reported in contract benefits or interest credited to contractholder funds and is ceded to ALIC under the reinsurance agreements.
The Company has reinsurance agreements whereby all premiums, contract charges, interest credited to contractholder funds, contract benefits and substantially all expenses are ceded to ALIC and non-affiliated reinsurers (see Notes 3 and 7). Reinsurance recoverables and the related reserve for life-contingent contract benefits and contractholder funds are reported separately in the Statements of Financial Position. We continuously monitor the creditworthiness of reinsurers in order to determine our risk of recoverability on an individual and aggregate basis and a provision for uncollectible reinsurance is recorded if needed. No amounts have been deemed unrecoverable in the three years ended December 31, 2006. The Company continues to have primary liability as the direct insurer for the risks reinsured.
SOP 03-1, "ACCOUNTING AND REPORTING BY INSURANCE ENTERPRISES FOR CERTAIN NONTRADITIONAL LONG-DURATION CONTRACTS AND FOR SEPARATE ACCOUNTS" ("SOP 03-1")
AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS ("AICPA") TECHNICAL PRACTICE AID ("TPA") RE SOP 03-1
FINANCIAL ACCOUNTING STANDARDS BOARD INTERPRETATION NO. 48, "ACCOUNTING FOR UNCERTAINTY IN INCOME TAXES", ("FIN 48")
In 2006, the Company entered a wholesaling and marketing support agreement with ALFS, Inc. ("ALFS"), an affiliated broker/dealer company, whereby ALFS underwrites and promotes the offer, sale and servicing of variable annuities
The following table summarizes amounts that were ceded to ALIC and reported net in the Statements of Operations under the reinsurance agreements:
The Company has entered into an intercompany loan agreement with the Corporation. The amount of funds available to the Company is at the discretion of the Corporation. The maximum amount of loans the Corporation will have outstanding under the intercompany loan agreement to all its eligible subsidiaries at any given point in time is limited to $1.00 billion. The Company had no amounts outstanding under the agreement at December 31, 2006 and 2005. The Corporation uses commercial paper borrowings, bank lines of credit and repurchase agreements to fund intercompany borrowings.
GROSS UNREALIZED AMORTIZED ----------------- FAIR (IN THOUSANDS) COST GAINS LOSSES VALUE --------- ------ -------- -------- AT DECEMBER 31, 2006 U.S. government and agencies $116,821 $2,609 $(1,467) $117,963 Corporate 74,755 613 (1,987) 73,381 Municipal 502 31 -- 533 Mortgage-backed securities 29,963 98 (817) 29,244 Commercial mortgage-backed securities 32,095 635 (315) 32,415 Asset-backed securities 14,195 366 (39) 14,522 -------- ------ ------- -------- Total fixed income securities $268,331 $4,352 $(4,625) $268,058 ======== ====== ======= ======== AT DECEMBER 31, 2005 U.S. government and agencies $ 99,197 $3,333 $(1,139) $101,391 Corporate 91,424 1,133 (1,746) 90,811 Municipal 503 41 -- 544 Mortgage-backed securities 32,362 209 (606) 31,965 Commercial mortgage-backed securities 27,851 69 (704) 27,216 Asset-backed securities 15,120 546 (48) 15,618 -------- ------ ------- -------- Total fixed income securities $266,457 $5,331 $(4,243) $267,545 ======== ====== ======= ========
AMORTIZED FAIR (IN THOUSANDS) COST VALUE --------- -------- Due in one year or less $ 8,543 $ 8,515 Due after one year through five years 88,818 88,680 Due after five years through ten years 87,213 86,056 Due after ten years 39,599 41,041 -------- -------- 224,173 224,292 Mortgage and asset-backed securities 44,158 43,766 -------- -------- Total $268,331 $268,058 ======== ========
(IN THOUSANDS) 2006 2005 2004 ------- ------- ------- Fixed income securities $13,495 $13,190 $11,297 Short-term investments 762 689 185 ------- ------- ------- Investment income, before expense 14,257 13,879 11,482 Investment expense 309 247 248 ------- ------- ------- Net investment income $13,948 $13,632 $11,234 ======= ======= =======
(IN THOUSANDS) 2006 2005 2004 ------- ----- ---- Fixed income securities $(1,255) $(174) $ 5 Income tax benefit (expense) 438 60 (2) ------- ----- --- Realized capital gains and losses, after-tax $ (817) $(114) $ 3 ======= ===== ===
Inherent in the Company's evaluation of a particular security are assumptions and estimates about the operations of the issuer and its future earnings potential. Some of the factors considered in evaluating
whether a decline in fair value is other-than-temporary are: 1) the Company's ability and intent to retain the investment for a period of time sufficient to allow for an anticipated recovery in value; 2) the recoverability of principal and interest; 3) the duration and extent to which the fair value has been less than amortized cost; 4) the financial condition, near-term and long-term prospects of the issuer, including relevant industry conditions and trends, and implications of rating agency actions and offering prices; and 5) the specific reasons that a security is in a significant unrealized loss position, including market conditions which could affect access to liquidity.
As of December 31, 2006, the Company had the intent and ability to hold the fixed income securities with unrealized losses for a period of time sufficient for them to recover.
In the normal course of business, the Company invests in various financial assets and incurs various financial liabilities. The fair value estimates of financial instruments presented below are not necessarily
(IN THOUSANDS) DECEMBER 31, 2006 DECEMBER 31, 2005 ----------------------- ----------------------- CARRYING FAIR CARRYING FAIR VALUE VALUE VALUE VALUE ---------- ---------- ---------- ---------- Fixed income securities $ 268,058 $ 268,331 $ 267,545 $ 267,545 Short-term investments 8,264 8,264 3,824 3,824 Separate accounts 3,097,550 3,097,550 2,718,509 2,718,509
Fair values of publicly traded fixed income securities are based upon quoted market prices or dealer quotes. Short-term investments are highly liquid investments with maturities of one year or less whose carrying values are deemed to approximate fair value. Separate accounts assets are carried in the Statements of Financial Position at fair value based on quoted market prices.
There were no off-balance-sheet financial instruments at December 31, 2006 or 2005.
As of December 31, 2006, reserves for variable annuity contracts and secondary guarantee liabilities related to death benefits, income benefits, accumulation and withdrawal benefits were $28 million, $33 million, $(1) million and $(43) thousand, respectively. As of December 31, 2005, reserves for variable annuity contracts and secondary guarantee liabilities related to death benefits, income benefits, accumulation and withdrawal benefits were $21 million, $36 million, $(288) thousand and $14 thousand, respectively.
The Company has entered into reinsurance agreements under which it reinsures all of its business to ALIC or other non-affiliated reinsurers. Under the agreements, premiums, contract charges, interest credited to contractholder funds, contract benefits and substantially all expenses are reinsured. The Company purchases reinsurance to limit aggregate and single losses on large risks. The Company cedes a portion of the mortality risk on certain life policies with a pool of twelve non-affiliated reinsurers. The Company continues to have primary liability as the direct insurer for risks reinsured.
The Company leases certain office equipment. Total rent expense for all leases was $198 thousand, $469 thousand and $681 thousand in 2006, 2005 and 2004, respectively, and was ceded to ALIC under the terms of the reinsurance agreements.
Minimum rental commitments under operating leases with an initial or remaining term of more than one year as of December 31, 2006 are as follows:
OPERATING (IN THOUSANDS) LEASES --------- 2007 $57 2008 4 Thereafter -- --- $61 === GUARANTEES
The Company and certain affiliates are involved in a number of lawsuits, regulatory inquiries, and other legal proceedings arising out of various aspects of its business. As background to the "Proceedings" sub-section below, please note the following:
AIC is defending certain matters relating to its agency program reorganization announced in 1999. These matters include a lawsuit filed in December 2001 by the U.S. Equal Employment Opportunity Commission ("EEOC") alleging retaliation under federal civil rights laws (the "EEOC I" suit) and a class action filed in August 2001 by former employee agents alleging retaliation and age discrimination under the Age Discrimination in Employment Act ("ADEA"), breach of contract and ERISA violations (the "Romero I" suit). In March 2004, in the consolidated EEOC I and Romero I litigation, the trial court issued a memorandum and order that, among other things, certified classes of agents, including a mandatory class of agents who had signed a release, for purposes of effecting the court's declaratory judgment that the release is voidable at the option of the release signer. The court also ordered that an agent who voids the release must return to AIC "any and all benefits received by the [agent] in exchange for signing the release." The court also stated that, "on the undisputed facts of record, there is no basis for claims of age discrimination." The EEOC and plaintiffs have asked the court to clarify and/or reconsider its memorandum and order and on January 16, 2007, the judge denied their request. The case otherwise remains pending. The EEOC also filed another lawsuit in October 2004 alleging age discrimination with respect to a policy limiting the rehire of agents affected by the agency program reorganization (the "EEOC II" suit). In EEOC II, in October 2006, the court granted partial summary judgment to the EEOC. Although the court did not determine that AIC was liable for age discrimination under the ADEA, it determined that the rehire policy resulted in a disparate impact, reserving for trial the determination on whether AIC had reasonable factors other than age to support the rehire policy. AIC filed a motion for interlocutory appeal from the partial summary judgment, which was granted by the trial court on January 4, 2007. AIC has filed a petition for immediate review of two controlling issues of law to the Court of Appeals for the Eighth Circuit and that petition is currently pending. AIC is also defending a certified class action filed by former employee agents who terminated their employment prior to the agency program reorganization. These plaintiffs have asserted breach of contract and ERISA claims. A putative nationwide class action has also been filed by former employee agents alleging various violations of ERISA, including a worker classification issue. These plaintiffs are challenging certain amendments to the Agents Pension Plan and are seeking to have exclusive agent independent contractors treated as employees for benefit purposes. This matter was dismissed with prejudice by the trial court, was the subject of further proceedings on appeal, and was reversed and remanded to the trial court in April 2005. In all of these various matters, plaintiffs seek compensatory and punitive damages, and equitable relief. AIC has been vigorously defending these lawsuits and other matters related to its agency program reorganization. The outcome of these disputes is currently uncertain.
The Internal Revenue Service ("IRS") has completed its review of the Corporations's federal income tax returns through the 2002 tax year and the statute of limiations has expired for these years. Any adjustments that may result from IRS examinations of tax returns are not expected to have a material impact on the results of operations, cash flows or financial position of the Company.
(IN THOUSANDS) 2006 2005 2004 ------ ------ ------ Current $4,412 $4,769 $3,877 Deferred 21 (98) 48 ------ ------ ------ Total income tax expense $4,433 $4,671 $3,925 ====== ====== ======
Statutory net income for 2006, 2005, and 2004 was $9.1 million, $8.8 million and $7.4 million, respectively. Statutory capital and surplus was $274.4 million and $267.5 million as of December 31, 2006 and 2005, respectively.
The components of other comprehensive loss on a pretax and after-tax basis for the years ended December 31 are as follows:
------------------------ AFTER- (IN THOUSANDS) PRETAX TAX TAX ------- ------ ------- Unrealized holding losses arising during the period $(2,601) $ 910 $(1,691) Less: reclassification adjustments (1,240) 434 (806) ------- ------ -------- Unrealized net capital gains and losses (1,361) 476 (885) ------- ------ ------- Other comprehensive loss $(1,361) $ 476 $ (885) ======= ====== =======
We have audited the accompanying Statements of Financial Position of Lincoln Benefit Life Company (the "Company", an affiliate of The Allstate Corporation) as of December 31, 2006 and 2005, and the related Statements of Operations and Comprehensive Income, Shareholder's Equity, and Cash Flows for each of the three years in the period ended December 31, 2006. Our audits also included the financial statement schedules listed in the Index at Item 15. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on the financial statements and financial statement schedules based on our audits.