PREMIUMS AND DEPOSITS is an operating measure used by the Company's management to analyze production trends for sales. Premiums and deposits includes premiums on insurance policies and annuities, and all deposits and other funds received from customers on deposit-type products which are accounted for by the Company as liabilities, rather than as revenue. The Company's method of calculating Premiums and deposits may be different from methods used by other companies to measure sales and therefore comparability may be limited.
The following table illustrates where Premiums and deposits are reflected in the financial statements.
The Company's strategies include developing and delivering market-informed products and services, leveraging and building the Allstate brand in financial services, building profitable long-term relationships, and driving operational scale, efficiency and effectiveness. Consumer and distribution partner research will be used to develop and deliver products and services. The Company will continue to extend the Allstate brand by using it in conjunction with more products and distribution channels, focusing on a consistent experience for both producers and customers. The Company will utilize consumer and producer segmentation and target building profitable, long-term relationships with producers and consumers. To drive operational scale, efficiency and effectiveness, the Company will focus on enhancing operating processes and infrastructure spanning all functional areas including product development, customer service and technology.
The Company writes down to fair value a fixed income security that is classified as other than temporarily impaired in the period the security is deemed to be other than temporarily impaired. The assessment of other than temporary impairment is performed on a case-by-case basis considering a wide range of factors. 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: - The Company's ability and intent to retain the investment for a period of time sufficient to allow for an anticipated recovery in value; - The recoverability of principal and interest; - The duration and extent to which the fair value has been less than amortized cost for fixed income securities; - 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 - The specific reasons that a security is in a significant unrealized loss position, including market conditions which could affect liquidity.
There are a number of risks and uncertainties inherent in the process of monitoring impairments and determining if impairment is other than temporary. These risks and uncertainties include the risks that: - The economic outlook is worse than anticipated and has a greater adverse impact on a particular issuer than anticipated; - The Company's assessment of a particular issuer's ability to meet all of its contractual obligations changes based on changes in the facts and circumstances related to that issuer; and - New information is obtained or facts and circumstances change that cause a change in the Company's ability or intent to hold a security to maturity or until it recovers in value.
DERIVATIVE INSTRUMENTS - Derivative financial instruments include financial futures and a re-investment related risk transfer reinsurance agreement. Derivatives are accounted for on a fair value basis, and reported as Other assets or Other liabilities and accrued expenses. Beginning in January 2001, hedge accounting is not applied to those
strategies that utilize financial futures contracts for interest rate risk management purposes. Therefore, the gains and losses pertaining to the change in the fair value of the financial futures contracts and the reinsurance agreement are recognized in Realized capital gains and losses during the period on a current basis.
DEFERRED POLICY ACQUISITION COSTS ("DAC") - The Company establishes a deferred asset for certain costs that vary with and are primarily related to acquiring business. These costs, principally agents' and brokers' remuneration, certain underwriting costs and direct mail solicitation expenses, are deferred and amortized to income. Amortization of DAC is reflected on the Statements of Operations and Comprehensive Income. All other acquisition expenses are charged to operations as incurred, impacting Operating costs and expenses on the Statements of Operations and Comprehensive Income.
In particular, a significant degree of judgment is involved with estimating future levels of EGP for the Company's variable annuity contracts as future fee income and guaranteed minimum death benefits ("GMDBs") are highly sensitive to equity market performance. The Company's variable annuity DAC amortization methodology includes a long-term market return assumption for account values of approximately 9.25%, or 8.0% after average morality and expense fees of 1.25%. When market returns vary from the 8.0% long-term expectation or mean, the Company assumes a reversion to the mean over a seven-year period, which includes two prior years and five future years. The assumed returns over this period are limited to a range between 0% to 13.25% after mortality and expense fees. The costs associated with GMDBs are included in EGP. Generally, less DAC is amortized during periods in which the GMDBs are higher than projected. However, if projected GMDBs cause DAC to be not fully recoverable, DAC will be written down to an amount deemed recoverable.
The Company currently performs quarterly reviews of DAC recoverability for interest-sensitive life insurance, variable annuities and investment contracts in the aggregate using current assumptions. Future volatility
in the equity markets of similar or greater magnitude may result in disproportionate changes in the amortization of DAC.
If a change in the amount of EGP is significant, it could result in the unamortized DAC not being recoverable, resulting in a charge which is reflected as a component of Amortization of DAC. For quantification of the impact of these estimates and assumptions on the Company, see the Operating income and Forward-looking statements and risk factors sections of the MD&A.
LIFE INSURANCE RESERVES - Reserves for life-contingent contract benefits, which relate to traditional life insurance and immediate annuities with life contingencies, are computed on the basis of long-term actuarial assumptions of future investment yields, mortality, morbidity, policy terminations and expenses. These assumptions, which for traditional life insurance are applied using the net level premium method, include provisions for adverse deviation and generally vary by such characteristics as type of coverage, year of issue and policy duration. Mortality, morbidity and policy termination assumptions are based on Company and industry experience prevailing at the time of issue. Expense assumptions include the estimated effects of inflation and expenses to be incurred beyond the premium paying period. Future investment yield assumptions are determined at the time of issue based upon prevailing investment yields as well as forecasted reinvestment yields. To the extent that unrealized gains on fixed income securities would result in a premium deficiency had those gains actually been realized, the related increase in reserve is recorded as a reduction in Unrealized net capital gains and losses included in Accumulated other comprehensive income. For further discussion of these policies, see the Forward-looking statements and Risk factors section of the MD&A.
(2) Further information and an illustration of where Premiums and deposits are reflected in the financial statements appear in the Definitions of Non-GAAP and Operating Measures Section of the MD&A.
PREMIUMS AND CONTRACT CHARGES, included in financial results, represent GAAP premiums generated from traditional life and other insurance products and immediate annuities with life contingencies which have significant mortality or morbidity risk. Contract charges are generated from interest-sensitive life insurance products, variable annuities, fixed annuities and other investment products for which deposits are classified as contractholder funds or Separate Accounts liabilities. Contract charges are assessed against the contractholder account balance for maintenance, administration, cost of insurance and surrender prior to the contractually specified dates.
In 2002, total GAAP premiums decreased 12.7% compared to 2001. Premiums from immediate annuities with life contingencies decreased 14.4%. The sales mix of immediate annuities with life contingencies and those without life contingencies can cause fluctuations in premiums and contract charges from year to year. Overall, immediate annuities were down 16.4% compared to prior year as the competitive environment for structured settlement annuities and the Company's focus on new sales meeting targeted returns reduced sales. Traditional life GAAP premiums decreased 13.2% when compared to 2001 as a result of the consumer shift to interest-sensitive life insurance from traditional whole life products.
In 2001, contract charges remained fairly constant with 2000 as lower contract charges from interest-sensitive life insurance were partially offset by increased contract charges from variable annuities and other investment contracts. Contract charges on immediate annuities without life contingencies, included in other investment contract charges, increased due to an increase in new deposits.
PREMIUMS AND DEPOSITS by product line is summarized in the following table:
Premiums and deposits increased $19.0 million or 2.8% in 2001 as compared to 2000. In 2001, fixed annuities increased 10.9% from increased sales in the financial services firms channel and increased focus on investment products sold within the Allstate agencies channel. Traditional life and other life products increased
37.3% and 14.8%, respectively, due to strong sales stemming from a pricing change implemented late in 2000. In 2001, interest-sensitive life insurance products and variable annuities decreased 6.0% and 1.1%, respectively, due to market conditions.
Operating income decreased 15.3% in 2002 from 2001 due primarily to an increase in DAC amortization and higher Operating costs and expenses, partly offset by increases in the investment and mortality margins. Operating income increased 3.3% in 2001 compared to 2000 due to decreases in the mortality margin being more than offset by increases in the investment margin and surrender charges.
The investment margin increased 19.2% during 2001 compared to 2000 as a result of growth in portfolio balances of 17.7% as of December 31, 2001 compared to December 31, 2000. This increase was primarily driven by sales of new fixed annuities, less contract benefits, surrenders and withdrawals.
The following table summarizes the weighted average investment yields and the weighted average interest crediting rates during 2002, 2001 and 2000. These averages are affected by the concentration of structured settlement annuities included in the fixed rate contracts category below.
The following table summarizes Contractholder funds and Reserve for life-contingent contract benefits associated with the weighted average investment yield and weighted average interest crediting rates at December 31.
Mortality margin includes results from both immediate annuities with life contingencies and traditional life insurance. For immediate annuities with life contingencies, an increase in the death rate reduces the number and cost of future contract benefit payments. Conversely, life insurance contracts are favorably affected by decreases in death rates because beneficiaries receive full death benefits but premiums are collected over a longer period of time than expected when the product was priced. The immediate annuities sold with life contingencies act as a hedge or offset to the risk of increased death rates. In determining premium rates, the Company uses underwriting and pricing guidelines with a long-term view of mortality rates. However, the effects of mortality can cause benefit expense to fluctuate from period to period.
OPERATING COSTS AND EXPENSES increased 19.4% during 2002 compared to 2001 due to distribution expenses incurred on new growth initiatives and increased administrative expenses supporting the growth of the Company. Costs and expenses increased 30.4% during 2001 compared to 2000 due to higher marketing, technology and distribution expenses incurred on new growth initiatives.
- - The Company's ability to manage its investment margin is dependent upon maintaining adequately profitable spreads between investment yields and interest crediting rates on inforce business. As interest rates change or remain at historically low levels, assets may be reinvested at lower yields that compress investment margin. The Company has the ability to impact the investment margin by changing the interest crediting rates on flexible rate contracts. However, these changes could be limited by market conditions, and regulatory minimum rates or contractual minimum rate guarantees on many contracts and may not match
- - Variable annuity DAC is amortized in relation to the present value of EGP over the estimated lives of the contracts. Future levels of EGP are highly sensitive to future equity market performance. Changes in the amount or timing of EGP may result in adjustments in the cumulative amortization of DAC.
- - In order to maintain an acceptable target return, the Company needs to design and sell products having interest crediting rates with adequate spreads to investment returns. If investments with appropriate maturity and risk adjusted returns to support pricing targets are not available, product sales will be restricted. For this reason, fixed annuity sales volume will vary in the future as dictated by market conditions.
- - The Company is undertaking various expense-saving initiatives to increase profitability. These initiatives will include creating greater efficiencies, simplifying operations and focusing on distribution among the current channels. The efficacy of these expense-saving initiatives is difficult to predict due to external factors and technology costs.
- - In order to compete with major insurance company competitors, as well as non-traditional competitors such as banks, financial service firms and securities firms, the Company will have to provide products that are considered competitive by its distribution channels and customers. Additionally, to meet its return targets, the Company must distribute its products within its pricing parameters. The Company plans to focus its efforts by deepening relationships with its more productive and more profitable distribution partners.
PRE-TAX NET INVESTMENT INCOME increased 13.9% in 2002 compared to 2001. The increase was due to higher portfolio balances partially offset by slightly lower portfolio yields. In 2002, lower portfolio yields were due to investments made in the low interest rate environment. At December 31, 2002, portfolio balances, excluding Separate Accounts and net unrealized gains and losses on fixed income securities, increased 24.3% compared to December 31, 2001 due to net cash provided from operating and financing activities.
After-tax realized capital losses were $5.8 million in 2002 compared to after-tax realized capital gains of $105 thousand in 2001. After-tax realized capital gains and losses are presented net of the effects of DAC amortization, to the extent that such effects resulted from the recognition of realized capital gains and losses.
The following table describes the factors driving the after-tax realized capital gains and losses results.
For a further discussion of realized capital gains and losses, see the Investments discussion following.
- - The Company expects to incur realized capital losses while the corporate credit environment remains under pressure.
The investment strategy for the Company is based upon a strategic asset allocation framework that takes into account the need to manage on a risk adjusted spread basis for the product portfolio and to maximize return on capital. Generally, a combination of recognized market modeling, analytical models and proprietary models is used to achieve a desired asset mix in the management of the portfolio. The strategic asset allocation model portfolio is the primary basis for setting annual asset allocation targets with respect to interest sensitive, illiquid and credit asset allocations as well as limitations with respect to overall below investment grade exposure and diversification requirements. On a tactical basis, decisions are made on an option adjusted relative value basis staying within the constraints of the strategic asset allocation framework. The Company believes it maximizes asset spread by selecting assets that perform on a long-term basis and by using periodic sales of securities to minimize the effect of downgrades and defaults. Total return measurement is used on a selective basis where the asset risks are significant (e.g., high yield fixed income securities, convertible bonds). The Company expects that employing this strategy will minimize interest rate market impacts on investment income. This strategy is also expected to provide sustainable investment-related income over time.
The composition of the investment portfolio is presented in the table below. See Notes 2 and 4 to the financial statements for investment accounting policies and additional information.
security specific spreads. These spreads are then adjusted for illiquidity based on historical analysis and broker surveys. Some factors, such as the illiquidity premium that differentiates the private market from the public market, are difficult to observe and to characterize. As such, the valuation process involves key assumptions for such factors. Although these assumptions are reviewed on a periodic basis and the Company believes that the valuation model produces estimates that reasonably reflect the fair value of the overall portfolio, there can be specific factors that would cause the fair value of a particular holding to deviate from the calculated valuation.
The following table shows the Company's derivative contracts, and the sources of their fair value, at December 31, 2002.
The Company's fixed income securities include bonds, such as municipal bonds, privately placed bonds and publicly traded corporate bonds, U.S. government bonds, mortgage-backed and asset-backed securities. All fixed income securities are carried at fair value and are classified as available for sale. Periodic changes in fair values are reported as a component of Other comprehensive income net of deferred taxes, certain life and annuity DAC and certain reserves for life-contingent benefits and are reclassified to Net income only when supported by the consummation of a transaction with an unrelated third party, or when declines in fair values are deemed other than temporary.
Municipal bonds, including tax-exempt and taxable securities, comprise $126.2 million or 3.4% of the Company's fixed income securities portfolio at December 31, 2002. Investment grade municipal bonds represent 99.0% of the total $126.2 million. Approximately 4% of the municipal bond portfolio is insured by four bond insurers and the bonds accordingly have a rating of Aaa. The municipal bond portfolio at December 31, 2002 consisted of 13 issues from 11 issuers.
Foreign government securities totaled $242.2 million and $181.8 million at December 31, 2002 and 2001, respectively. All of the securities were rated investment grade at December 31, 2002.
At December 31, 2002 and 2001, $623.3 million and $442.1 million, respectively, of the fixed income securities portfolio was invested in mortgage-backed securities ("MBS"). The MBS portfolio consists primarily of securities that were issued by, or have underlying collateral that is guaranteed by, U.S. government agencies or sponsored entities. Therefore, the MBS portfolio has relatively low credit risk.
The fixed income securities portfolio contained $58.8 million and $55.0 million of asset-backed securities ("ABS") at December 31, 2002 and 2001, respectively. The ABS portfolio is subject to credit and interest rate risk. Credit risk is mitigated by monitoring the performance of the collateral. Approximately 88.1% of the ABS portfolio is rated in the highest rating category by one or more credit rating agencies. The ABS portfolio is subject to interest rate risk since the price volatility and ultimate realized yield are affected by the rate of repayment of the underlying assets. Approximately 23.6% of the Company's ABS portfolio is invested in securitized credit card receivables. The remainder of the portfolio is backed primarily by securitized home equity, manufactured housing, and auto loans.
At December 31, 2002, 95.4% of the Company's fixed income securities portfolio was rated investment grade, which is defined by the Company as a security having a rating from the NAIC of 1 or 2, a Moody's equivalent rating of Aaa, Aa, A or Baa, or a comparable Company internal rating.
The Company writes down to fair value any fixed income security that is classified as other than temporarily impaired in the period the security is deemed to be other than temporarily impaired. Inherent in the Company's evaluation of a particular security are assumptions and estimates about the operations of the issuer and its future
The following table contains the individual securities as of December 31, 2002, with the ten largest unrealized losses:
The Company recorded, for the year ended December 31, 2002, $3.9 million in net gains from sales of fixed income securities, which is comprised of gross gains of $11.7 million and gross losses of $7.8 million. Gross losses from sales of fixed income securities of $7.8 million combined with investment write-downs of $15.8 million and gross losses on derivatives of $4.1 million, represent the total gross realized losses of $27.7 million on fixed income securities for 2002.
- A $7.0 million write-down on a global energy and utility company, which missed coupon payments due to severely constrained liquidity. Some sectors in the utility industry continue to be under fundamental pressure. The Company is monitoring developments closely and each security in the industry is evaluated for impairment in the watch list process. - A $2.6 million write-down on securities issued by a major U.S. airline that filed for bankruptcy. The Company has no other securities of this issuer and currently expects to hold its existing positions until they recover in value or mature. The U.S. airline industry is under stress. The Company monitors its investments in airline issuers closely, particularly with regard to collateral values. - A $1.9 million write-down on senior unsecured securities issued by a seismic data and related geophysical services company that has been experiencing negative financial results and liquidity pressures. The circumstances of this impairment are not expected to have a material impact on the other investments. - A $1.4 million write-down on collateralized debt obligation notes. The loss resulted from the decline in value of the portfolio of high-yield bonds securing the notes. The circumstances of this impairment are not expected to have a material impact on the other investments. - A $1.3 million write-down on a major U.S. airline that filed for bankruptcy. The loss primarily relates to an unsecured issue whose collateral value is insufficient. The U.S. airline industry is under stress. The Company monitors its investments in airline issuers closely, particularly with regard to collateral values.
The Company's short-term investment portfolio was $104.2 million and $57.5 million at December 31, 2002 and 2001, respectively. The Company invests available cash balances primarily in taxable short-term securities having a final maturity date or redemption date of one year or less.
Reinsurance recoverable decreased $181 thousand, or 7.8%, to $2.1 million at December 31, 2002 from $2.3 million at December 31, 2001. Reinsurance recoverable decreased due to benefits paid partially offset by an increase in traditional life insurance product reserves. The Company purchases reinsurance to limit aggregate and single losses on large risks. The Company continues to have primary liability as a direct insurer for risks reinsured. Estimating amounts of reinsurance recoverable is impacted by the uncertainties involved in the establishment of loss reserves. Failure of reinsurers to honor their obligations could result in losses to the Company.
The Company purchases reinsurance after evaluating the financial condition of the reinsurer, as well as the terms and price of coverage. The Company reinsures certain of its risks to reinsurers under yearly renewable term and coinsurance agreements. Yearly renewable term and coinsurance agreements result in the passing of a portion of the risk to the reinsurers. Generally, the reinsurer receives a proportionate amount of the premiums less commissions and is liable for a corresponding proportionate amount of all benefit payments.
As of December 31, 2002, $3.40 billion or 17.9% of life insurance in force was ceded to other companies.
The Company continuously monitors the credit worthiness of reinsurers. As of December 31, 2002, all non-affiliated ceded premiums were reinsured under uncollateralized reinsurance agreements with companies that had
The active management of market risk is integral to the Company's results of operations. The Company may use the following approaches to manage its exposure to market risk within defined tolerance ranges: 1) rebalance its existing asset or liability portfolios, 2) change the character of investments purchased in the future or 3) use derivative instruments to modify the market risk characteristics of existing assets and liabilities or assets expected to be purchased. For a more detailed discussion of these derivative financial instruments, see Note 5 to the financial statements.
The Company generates substantial investable funds from its business operations. In formulating and implementing policies for investing funds, the Company seeks to earn returns that enhance its ability to offer competitive rates and prices to customers while contributing to attractive and stable profits and long-term capital growth for the Company. Accordingly, the Company's investment decisions and objectives are a function of its underlying risks and product profiles.
Interest rate risk is the risk that the Company will incur economic losses due to adverse changes in interest rates. This risk arises from the Company's primary activities, as the Company invests substantial funds in interest-sensitive assets and also carries certain interest-sensitive liabilities.
approximately 1.0 and 1.1, respectively. This positive duration gap indicates that the fair value of the Company's liabilities is more sensitive to interest rate movements than the fair value of its assets. The Company's liabilities are more sensitive than the assets due to structured settlement annuities, which make up a significant portion of the liabilities. Structured settlement liabilities have benefits that are paid over an extended period of time and may be significantly longer than the duration of fixed income securities that are available to support the liabilities. The risk introduced by structured settlements is mitigated through the use of reinsurance and by managing the duration of the investment portfolios supporting other liability products so that those liabilities have durations shorter than their assets.
To calculate duration, the Company projects asset and liability cash flows, and discounts them to a net present value basis using a risk-free market rate adjusted for credit quality, sector attributes, liquidity and other specific risks. Duration is calculated by revaluing these cash flows at an alternative level of interest rates, and determining the percentage change in fair value from the base case. The cash flows used in the model reflect the expected maturity and repricing characteristics of the Company's derivative financial instruments, all other financial instruments (as depicted in Note 5 to the financial statements), and certain non-financial instruments including interest-sensitive liabilities and annuity liabilities. The projections include assumptions (based upon historical market experience and Company specific experience) reflecting the impact of changing interest rates on the prepayment, lapse, leverage and/or option features of instruments, where applicable. The assumptions utilized relate primarily to assets such as mortgage-backed securities, collateralized mortgage obligations, callable corporate and municipal obligations, and liabilities including fixed rate single and flexible premium annuities.
Based upon the information and assumptions the Company uses in its duration calculation and interest rates in effect at December 31, 2002, management estimates that a 100 basis point immediate, parallel increase in interest rates ("rate shock") would decrease the net fair value of its assets and liabilities identified above by approximately $6.4 million versus an increase of $5.9 million at December 31, 2001. However, there are $217.6 million of assets supporting life insurance products which are not financial instruments and have not been included in the above analysis. This amount has increased from the $199.3 million in assets reported for December 31, 2001. According to the duration calculation, in the event of a 100 basis point immediate increase in interest rates, these assets would decrease in value by $4.1 million versus a decrease of $5.4 million for December 31, 2001. The selection of a 100 basis point immediate parallel increase in interest rates should not be construed as a prediction by the Company's management of future market events, but only as an illustration of the potential impact of such an event.
To the extent that conditions differ from the assumptions utilized, the Company's duration and rate shock measures could be significantly impacted. Additionally, the Company's calculation assumes that the current relationship between short-term and long-term interest rates (referred to as the term structure of interest rates) will remain constant over time. As a result, these calculations may not fully capture the impact of non-parallel changes in the term structure of interest rates and/or large changes in interest rates.
Equity price risk is the risk that the Company will incur economic losses due to adverse changes in a mutual fund or stock index.
At December 31, 2002 and 2001, the Company had Separate Accounts assets with account values totaling $537.2 million and $602.7 million, respectively. The Company earns contract charges as a percentage of these account values. In the event of an immediate decline of 10% in the account values at December 31, 2002 and 2001 due to equity market declines, the Company would earn approximately $892 thousand and $916 thousand less in annualized fee income, respectively.
Generally at the time of purchase, the contractholders of variable annuity contracts receive a GMDB and, for certain contracts, may elect to purchase an enhanced GMDB or guaranteed minimum income benefit ("GMIB"). The Company charges a fee for this guarantee that is generally calculated as a percentage of the account value. Both types of guarantees subject the Company to additional equity risk as the beneficiary or contractholder may receive a benefit for an amount greater than the account value under contractually defined circumstances and terms. GMDBs may be payable upon death, while GMIBs may be payable on or after the ten-year anniversary of the contract if the contractholder elects to receive a defined stream of payments ("annuitize").
Substantially all of the Company's variable annuity contracts inforce contain some type of GMDBs. In general, the types of guarantees offered include a return of deposits or the highest anniversary value. At December 31, 2002 and 2001, the guaranteed value in excess of contractholders' account values, payable if all contractholders were to die, was estimated to be $200.6 million and $118.8 million, respectively. The increase in this measure is attributable to the decline in equity markets during 2002. In both periods, approximately two-thirds of this exposure is related to the return of deposits guarantee, while the remaining one-third is attributable to a death benefit guarantee greater than the original deposits.
The Company also is exposed to equity risk in its DAC, as equity portfolio valuation fluctuations impact DAC amortization because projected fee income and guaranteed benefits payable are components of the EGP for variable annuity contracts. Poor equity market performance could result in DAC not being recoverable or in accelerated DAC amortization. For a more detailed discussion of DAC, see Note 2 to the financial statements.
Shareholder's equity increased in 2002 when compared to December 31, 2001, due to an increase of $50.7 million in Accumulated other comprehensive income, Net income of $24.2 million and a capital contribution of $10.0 million from ALIC. In 2001, shareholder's equity increased as a result of Net income of $35.4 million and an increase of $753 thousand in Accumulated other comprehensive income.
None of these ratings were changed during 2002. The Company's and ALIC's insurance financial strength ratings have remained at the same consistently high levels for the last five years (Aa2 "excellent" by Moody's, AA and AA+ "very strong" by Standard & Poor's and A+ "superior" by A.M. Best). On a relative basis, these rating positions have improved in light of the significant volume of rating downgrades of other companies in the industry during 2002. Since February 2002, Standard & Poor's rating outlook for ALIC and its rated subsidiaries, including the Company, has been "negative". In November 2002, Standard & Poor's reaffirmed the AA+ rating of ALIC and the Company, but left the outlook unchanged. In January 2003, A.M. Best Company newly assigned a "positive" rating outlook for AIC, ALIC, the Company and selected affiliates.
The Company's ratings are influenced by many factors including operating and financial performance, asset quality, asset/liability management, overall portfolio mix, the amount of financial leverage (i.e., debt), exposure to risks, as well as the current level of operating leverage.
The NAIC has also developed a set of financial relationships or tests known as the Insurance Regulatory Information System to assist state regulators in monitoring the financial condition of insurance companies and identifying companies that require special attention or action from insurance regulatory authorities. The NAIC analyzes data provided by insurance companies using prescribed financial data ratios each with defined "usual ranges." Generally, regulators will begin to monitor an insurance company if its ratios fall outside the usual ranges for four or more of the ratios. If an insurance company has insufficient capital, regulators may act to reduce the amount of insurance it can issue. The Company is currently not under regulatory scrutiny based on these ratios.
Payment of contract benefits, maturities, surrenders and withdrawals Reinsurance cessions and payments Operating costs and expenses Purchase of investments Repayment of securities lending Repayment of inter-company loans Dividends to ALIC
The Company's operations typically generate substantial positive cash flows from operations as most premiums are received in advance of the time when claim and benefit payments are required. These positive operating cash flows are expected to continue to meet the liquidity requirements of the Company.
The Company has entered into an inter-company loan agreement with the Corporation. The amount of inter-company loans available to the Company 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. No amounts were outstanding for the Company under the inter-company loan agreement at December 31, 2002 or 2001. The Corporation uses commercial paper borrowings and bank lines of credit to fund intercompany borrowings.
Although the Corporation considers the occurrence of such events to be remote, certain events and circumstances could constrain the Corporation's liquidity. Those events and circumstances include, for example, a catastrophe resulting in extraordinary losses, a downgrade in the Corporation's long-term debt rating of A1 and A+ (from Moody's and Standard & Poor's, respectively) to non-investment grade status of below Baa3/BBB-, a downgrade in AIC's financial strength rating from Aa2, AA and A+ (from Moody's, Standard & Poor's and A.M. Best, respectively) to below Baa/BBB/B, or a downgrade in ALIC's or the Company's financial strength ratings from Aa2, AA+ and A+ (from Moody's, Standard & Poor's and A.M. Best, respectively) to below Aa3/AA-/A-. The rating agencies also consider the interdependence of the Corporation's individually rated entities, and therefore a rating change in one entity could potentially affect the ratings of other related entities. In addition, management knows of no trends, demands, commitments, events or uncertainties that are reasonable likely to significantly constrain the Corporation's or the Company's liquidity.
The following table summarizes the contractual obligations of the Company as of December 31, 2002 and the payments due by period.
(1) Securities lending, dollar rolls and repurchase transactions are typically fully collateralized with marketable securities. The Company manages its short-term liquidity position to ensure the availability of a sufficient amount of liquid assets to extinguish liabilities as they come due in the normal course of business. (2) The putable/callable Funding agreement program is very closely asset/liability duration matched by the Company. Accordingly, upon surrender or maturity of the related contracts, the Company maintains assets with a sufficient market value to extinguish the liabilities in the normal course of business.
At December 31, 2002, the Company had $14.0 million in contractual conditional commitments to invest in private placements or mortgage loans.
AIC is also defending certain matters relating to its agency program reorganization announced in 1999. These matters include an investigation by the U.S. Department of Labor and a lawsuit filed in December 2001 by the U.S. Equal Employment Opportunity Commission ("EEOC") with respect to allegations of retaliation under the
Various other legal and regulatory actions are currently pending that involve the Company and specific aspects of its conduct of business. Like other members of the insurance industry, the Company is the potential target of an increasing number of class action lawsuits and other types of litigation, some of which involve claims for substantial and/or indeterminate amounts (including punitive and treble damages) and the outcomes of which are unpredictable. This litigation is based on a variety of issues including insurance and claim settlement practices. However, at this time, based on their present status, it is the opinion of management that the ultimate liability, if any, in one or more of these other actions in excess of amounts currently reserved is not expected to have a material effect on the results of operations, liquidity or financial position of the Company.
State insurance authorities have broad administrative powers with respect to all aspects of the life insurance business including: - Licensing to transact business - Licensing agents - Admittance of assets to support statutory surplus - Approving policy forms - Regulating unfair trade and claims practices - Establishing reserve requirements and solvency standards - Regulating the type, amounts and valuations of investments permitted and other matters
On July 31, 2002, the American Institute of Certified Public Accountants issued an exposure draft Statement of Position ("SOP") entitled "Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts". The accounting guidance contained in the proposed SOP applies to several of the Company's products and product features. The proposed effective date of the SOP is fiscal years beginning after December 15, 2003, with earlier adoption encouraged. If adopted early, the provisions of the SOP must be applied as of the beginning of the fiscal year. Accordingly, if the SOP were adopted during an interim period of 2003, prior interim periods would be restated. A provision of the proposed SOP requires the establishment of a liability in addition to the account balance for contracts and contract features that provide guaranteed death or other insurance benefits. The finalized SOP may also require a liability for guaranteed income benefits. These liabilities are not currently recognized by the Company, and their establishment may have a material impact on the Statements of Operations and Comprehensive Income depending on the market conditions at the time of adoption, but is not expected to have a material impact on the Company's Statements of Financial Position.
- - New York requires insurers to participate in guaranty funds for impaired or insolvent insurance companies. Such funds periodically assess losses to all insurance companies doing business in the state. These assessments may be material to the Company's financial results.
- - There is uncertainty involved in the availability of non-affiliate reinsurance and estimating the collectibility of reinsurance recoverables. This uncertainty arises from a number of factors, including whether losses meet the qualifying conditions of the reinsurance contracts and whether the reinsurers, or their affiliates, have the financial capacity and willingness to pay.
- - The Corporation is continuing to examine the potential exposure of its operations to acts of terrorism and to evaluate methods of addressing this exposure in the best interests of shareholders, policyholders, the lending community and regulators. In the event that a terrorist act occurs, the Company may be adversely impacted, depending on the nature of the event. The Corporation is also evaluating the impact of the federal "Terrorism Risk Insurance Act of 2002" (the "Act") on the nature, availability and affordability of commercial insurance coverage for terrorism and the consequent impact on the Company's investments portfolio, particularly in sectors such as airlines and real estate. The Act established a temporary federal program providing for a system of shared public and private compensation for certain insured commercial property and casualty losses resulting from acts of terrorism, as defined by the Act.
- - Changes in market interest rates can have adverse effects on the Company's investment portfolio, investment income, product sales, results of operations and retention of existing business. Increasing market interest rates have an adverse impact on the value of the investment portfolio, for example, by decreasing the fair values of fixed income securities. Declining market interest rates could have an adverse impact on the Company's investment income as the Company reinvests proceeds from positive cash flows from operations and from maturities, calls and prepayments of investments into new investments that could yield less than the portfolio's average rate.
- - Conditions in the U.S. and international stock markets can have an impact on the Company's variable annuity sales. In general, sales of variable annuities increase when the stock markets are rising over an extended period of time and decrease when stock markets are falling over an extended period of time.
- - In order to meet the anticipated cash flow requirements of its obligations to policyholders, from time to time the Company manages the effective duration gap between investments and liabilities for contractholder funds and reserves for life-contingent contract benefits. Adjustments made to modify durations may have an impact on the value of the investment portfolio, investment income, interest credited to contractholder funds and the investment margin.
- - Management believes the reserves for life-contingent contract benefits are adequate to cover ultimate policy benefits, despite the underlying risks and uncertainties associated with their determination when payments will not be made until well into the future. Reserves are based on many assumptions and estimates, including estimated premiums to be received over the assumed life of the policy, the timing of the event covered by the insurance policy, the amount of contract benefits to be paid and the investment returns on the assets purchased with the premiums received. The Company periodically reviews and revises its estimates. If future experience differs from assumptions, it may have a material impact on results of operations.
- - State and federal laws and regulations affect the taxation of insurance companies and life insurance and annuity products. From time to time, Congress has considered proposals that, if enacted, could impose a greater tax burden on the Company or could have an adverse impact on the federal income tax treatment of some insurance products offered by the Company, including the favorable policyholder tax treatment currently applicable to deferred and immediate annuities, and life insurance, including interest-sensitive life
- - The Company distributes some of its products under agreements with other members of the financial services industry that are not affiliated with the Company. Termination of one or more of these agreements due to, for example, changes in control of any of these entities, could have a detrimental effect on the Company's sales. This risk may be exacerbated due to the enactment of the Gramm-Leach-Bliley Act of 1999, which eliminated many federal and state law barriers to affiliations among banks, securities firms, insurers and other financial service providers.
- - The Company is taking various expense-saving steps to increase profitability. These steps include restructuring management and organizations, simplifying operations and processes and focusing on key distributors in its distribution channels. The efficacy of these expense saving initiatives is difficult to predict due to external factors such as the stock market impact on pension and other benefit expenses, the extent of future guaranty fund assessments, and technology costs. Also, sales could be impacted negatively by distribution being concentrated in fewer partners.
- - The events of September 11, 2001, and the resulting disruption in the financial markets revealed weaknesses in the physical and operational infrastructure that underlies the U.S. and worldwide financial systems. Those weaknesses did not impair the Company's liquidity in the wake of September 11, 2001. However, if an event of similar or greater magnitude occurred in the future and if the weaknesses in the physical and operational infrastructure of the U.S. and worldwide financial systems are not remedied, the Company could encounter significant difficulties in transferring funds, buying and selling securities and engaging in other financial transactions that support its liquidity.
- - Insurance financial strength ratings are an important factor in establishing the competitive position of insurance companies and, generally, may be expected to have an effect on an insurance company's business. On an ongoing basis, rating agencies review the financial performance and condition of insurers and could downgrade or change a company's ratings due to, for example, a decline in the value of a company's investment portfolio or increased liabilities for variable contracts due to additional GMDB and GMIB exposure resulting from market declines. A multiple level downgrade of the Corporation, AIC, ALIC or the Company, while not expected, could have a material adverse affect on the Company's sales, including the
- - An exposure draft SOP entitled "Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts" applies to several of the Company's products and product features. A provision requires the establishment of a liability in addition to the account balance for contracts and contract features that provide guaranteed death or other insurance benefits. The Company does not currently hold liabilities for GMDB features covered by the SOP or GMIBs. However, these benefits are included in the EGP calculation used when evaluating DAC. If the SOP is adopted, the Company's establishment of these liabilities could have a material impact on the Statements of Operations and Comprehensive Income depending on the market conditions at the time of adoption, but it is not expected to have a material impact on the Company's Statements of Financial Position.
- - In recent years, the state insurance regulatory framework has come under increased federal scrutiny and legislation that would provide for optional federal chartering of insurance companies has been introduced in Congress. In addition state legislators and insurance regulators continue to examine the appropriate nature and scope of state insurance regulation. The Company cannot predict whether any state or federal measures will be adopted to change the nature or scope of the regulation of the insurance business or what effect any such measures would have on the Company.
- - The Gramm-Leach-Bliley Act of 1999 permits mergers that combine commercial banks, insurers and securities firms under one holding company. Until passage of the Gramm-Leach-Bliley Act of 1999, the Glass Steagall Act of 1933 had limited the ability of banks to engage in securities-related businesses and the Bank Holding Company Act of 1956 had restricted banks from being affiliated with insurers. With the passage of the Gramm-Leach-Bliley Act of 1999, bank holding companies may acquire insurers and insurance holding companies may acquire banks. In addition, grandfathered unitary thrift holding companies, including the Corporation, may engage in activities that are not financial in nature. The ability of banks to affiliate with insurers may materially adversely affect all of the Company's product lines by substantially increasing the number, size and financial strength of potential competitors.
- - Like other members of the insurance industry, the Company is the potential target of an increasing number of class action lawsuits and other types of litigation, some of which involve claims for substantial and/or indeterminate amounts (including punitive and treble damages) and the outcomes of which are unpredictable. GAAP prescribes when the Company has a contingent liability and may reserve for particular risks, including litigation exposures. Therefore, results for a given period could be significantly adversely affected when a reserve is established for litigation.