In 2005 and 2006, the Company undertook 2 programs designed to rebalance a portion of its fixed income portfolio (See, Item 7, Management’s Discussion and Analysis, Liquidity and Capital Resources, “Asset/Liability Management.”) This portfolio rebalancing resulted in a decreased yield on assets, as long-term, higher yielding assets were sold with the proceeds being reinvested in shorter term assets with lower yields. The sale of the long-term assets resulted in approximately $75 million of capital gains in 2005. In 2006 and 2007, the purchases of new fixed income assets from portfolio rebalancing resulted in decreased income from investments. Also, during 2008, 2007 and 2006, the Company experienced a decline in overall assets due to a substantial increase in annuity surrenders ($283.1 million in 2008, $535.2 million in 2007 and $480.1 million in 2006), resulting in an overall decline in Total Assets. In 2008, the decline was further impacted by the reduction in market value of its invested assets due to the distressed economic environment that prevailed in the 2nd half of the year. Net income in 2008 was impacted by the Company’s realization of other than temporary impairments in its portfolio. (See Note 2, Investments for further discussion on other than temporary impairments) as well as significantly reduced income attributable to its cash equivalent investments.
When we use the term “We,” “Us” and “Our” we mean the Corporation and its consolidated subsidiaries.
The Corporation’s earnings per share were $0.63 for 2008, as compared to $2.16 in 2007 and $1.69 in 2006. Results in 2008 reflect a decrease in investment income and net realized investment losses in 2008 as compared to a net realized investment gain in 2007. Our total revenues in 2008 were $266 million, compared to $364 million in 2007 and $359 million in 2006. The Corporation’s decreases in earnings and revenues in 2008 resulted primarily from decreases in net investment income and realized capital losses. The difficult current economy, lower yields from the portfolio rebalancing (See, Item 7, Management’s Discussion and Analysis, Liquidity and Capital Resources, “Asset/Liability Management.”), a loss on the payor swaptions (reflected in the realized capital gains), and decreased investment income from the Corporation’s short-term investments and fixed maturities all contributed to lower revenues in 2008.
The long-term profitability of sales of life and most annuity products depends on the degree of margin of the actuarial assumptions that underlie the pricing of such products. Actuarial calculations for such products, and the ultimate profitability of sales of such products, are based on four major factors: (i) persistency; (ii) rate of return on cash invested during the life of the policy or contract; (iii) expenses of acquiring and administering the policy or contract; and (iv) mortality.
The Insurance Company experienced a decline in net investment income of $33.2 million from $294.860 million in 2007 to $261.735 million in 2008. Net invested assets declined from $4.3 billion in 2007 to $3.7 billion in 2008. This was primarily caused by a decline in the market value of invested assets caused by the significant widening in corporate spreads resulting from the economic and capital market tumult. The decline was also attributable to annuity surrenders exceeding premium income for the third straight year. In anticipation of these surrenders, the Insurance Company has maintained cash investments in the vicinity of $300 million for each of the past 3 years. During 2008, the Federal Reserve’s actions in lowering the Fed Funds rate from 4 ¼% at December 31, 2007 to .25% at December 31, 2008 resulted in a $17.2 million decline in investment income from the short-term investment portfolio. Income from fixed, long-term maturities declined by $12.4 million, due to the lower interest rates earned on the proceeds of called securities in 2008. Despite these factors, the portfolio yield rose from 7.14% in 2007 to 7.27% in 2008 due to the excellent returns from the partnership portfolios. Net realized investment gains for 2008 went from a gain of $24.8 million in 2007 to a loss of $47.9 million in 2008. Presidential Life experienced losses of $18.3 million from the sale of Lehman Brothers Holdings bonds and preferred stock that was sold subsequent to the bankruptcy and $ 4.2 million from the exchange of GMAC, LLC bonds. The Company also took write-downs of $5.7 million on its stock holding in ISTAR Financial and $3.5 million on its bond investment in Clear Channel Communications.
As of December 31, 2008, approximately 8.7% of the Insurance Company's total invested assets were invested in limited partnerships and equity securities. Investments in limited partnerships are included in the Corporation's consolidated balance sheet under the heading “Other long-term investments.” See “Note 2 to the Notes to Consolidated Financial Statements.” The Insurance Company is committed, if called upon during a specified period, to contribute an aggregate of approximately $117.9 million of additional capital to certain of these limited partnerships. Commitments of $13.7 million will expire in 2009, $4.7 million in 2010, $45.6 in 2011, and $53.9 in 2012. The Insurance Company may make selective investments in additional limited partnerships as opportunities arise. In general, risks associated with such limited partnerships include those related to their underlying investments (i.e., equity securities, debt securities and real estate), plus a level of illiquidity, which is mitigated by the ability of the Insurance Company to take quarterly distributions of partnership earnings. There can be no assurance that the Insurance Company will continue to achieve the same level of returns on its investments in limited partnerships as it has historically. Further, there can be no assurance that the Insurance Company will receive a return of all or any portion of its current or future capital investments in limited partnerships. The failure of the Insurance Company to receive the return of a material portion of its capital investments in limited partnerships, or to achieve historic levels of return on such investments, could have a material adverse effect on the Corporation's financial condition and results of operations.
The Company believes that the current recessionary environment coupled with limited credit availability will challenge the partnerships’ ability to monetize investments and generate capital gains until conditions improve.
As of December 31, 2008, the Company had 574 securities in a net unrealized loss position. Of this total, 535 are bonds holdings, 38 represent preferred stocks and 1 is an equity position.
One of the Insurance Company’s Limited Partnership investments has assets of approximately $9 million located at the prime brokerage unit of Lehman Brothers International (Europe) (“LBIE”), located in the United Kingdom. Since September 2008 when Lehman Brothers filed for bankruptcy, the assets were frozen and the claims to such assets are subject to the resolution of the bankruptcy proceedings. Due to the complexities surrounding the LBIE proceeding, we are unable, at this time, to determine the level, if any, of impairments the Limited Partnership may incur.
Corporate Bonds: The predominant investment category for the Company’s investments is the “Corporate Bond” Category (including Public Utilities), which totaled $2.089 billion at December 31, 2008. The unrealized losses increased from $55 million at December 31, 2007 to $311.2 million at December 31, 2008. The 5 largest loss positions consisted of the following holdings: Prudential Insurance Co. 8.30% due July 1, 2025 ($8.1 million); Motorola, Inc. 7 ½% due May 15, 2025 ($6.1 million), American General Institutional Capital 7.57% due December 1, 2045 ($6.0 million), Nationwide Financial 6.60% due April 15, 2034 ($5.9 million) and Limited Brands 5 ¼% due November 1, 2014 ($5.9 million). The Prudential and Nationwide Insurance bonds are A-rated, long term bonds in major insurance companies that have been affected by the financial crisis that climaxed in the months after the Lehman bankruptcy. Spreads on 30 year, A-rated financial bonds widened by 278 basis points and BBB-rated financial bonds widened by 661 basis points in 2008, according to the Merrill Lynch spread indices. The Motorola bonds reflect a decline in the market for telecommunications equipment caused by the economic downturn. The American General bond is a subsidiary of AIG (American International Group), a major recipient of financial aid from the U.S. Treasury following the Lehman Brothers bankruptcy. The Limited Brands bonds reflect the decline in the retail sector caused by the economic recession combined with a ratings downgrade by the 3 rating agencies to Ba1/BB+/BB+, the highest non investment-grade corporate rating.
Common Stock: The Common Stock portfolio totaled 6 positions with a value of $2.6 million at December 31, 2008. One of the positions, JAC Holdings, represented a distribution of a stock holding from one of the limited partnership investments owned by Presidential Life. The unrealized loss in this position is approximately $144,000.
A reconciliation of the Insurance Company’s shareholders’ equity as filed with regulatory authorities to shareholders’ equity reported in the accompanying financial statements as of December 31 is set forth in the following table:
In March 2008, A.M. Best Company reaffirmed the Insurance Company’s rating at “B+” (Good) with a stable outlook. At the time of the B+ rating, publications of A.M. Best indicated that the “B+” rating was assigned to those companies that, in A.M. Best's opinion, have achieved a very good overall performance when compared to the norms of the insurance industry and that generally have demonstrated a good ability to meet their respective policyholder and other contractual obligations over a long period of time. The B+ rating is within A.M Best’s “Secure” classification, along with A++, A+, A, A-, and B++ ratings. In 2007, A.M. Best Company changed the Financial Strength Rating Descriptor for B+ and B++ ratings on insurance companies from “Very Good” to “Good”. The change was made to make the Rating Descriptor consistent with the existing Rating definition and did not, in any way, represent a change in A.M. Best’s opinion of the Company.
A.M. Best's rating is based on factors which primarily are relevant to policyholders, agents and intermediaries and is not directed towards the protection of investors, nor is it intended to allow investors to rely on such a rating in evaluating the financial condition of the Insurance Company.
In July 2008, Moody's Investor Services (“Moody's”) upgraded the financial strength of the Insurance Company to Ba1 (“Questionable financial security”) with a positive outlook, from Ba2 (“Questionable financial security”) with a stable outlook. Moody’s also raised the senior debt rating of the Corporation from B2 to B1 (“Speculative, subject to high credit risk”) with a positive outlook.
Interest credited and benefits paid to policyholders amounted to $208.7 million in fiscal 2008 as compared to $217.7 million in fiscal 2007 and $242.2 million in fiscal 2006. These represent a decrease of 4.1% comparing fiscal 2008 to fiscal 2007 and a 10.1% decrease comparing fiscal 2007 to fiscal 2006.
The interest expense on the Corporation's notes payable amounted to approximately $7.4 million in 2008, approximately $9.1 million in 2007 and approximately $10.4 million in 2006. The decrease in 2008 was primarily due to the repayment of the $50 million line of credit in July of 2007 and the Corporation’s partial repurchase and retirement of its senior notes in 2007 and 2008.
General expenses, taxes and commissions to agents totaled $26.8 million in 2008 as compared to $28.3 million in 2007 and $27.0 million in 2006. This represents a decrease of 2.5% comparing 2008 to 2007 and an increase of 4.9% comparing fiscal 2007 to fiscal 2006. The decrease in 2008 was primarily due to lower first year commissions and lower commissions paid on internal rollovers in an effort to keep policies in-force. The increase in 2007 was primarily due to 2006 refunds in state and franchise taxes, which reduced the taxes in 2006. Consultant fees paid in connection with the Company’s ERM project also contributed to the increase in 2007.
An income tax benefit of approximately $1.7 million was generated in 2008, as compared to expenses of approximately $33 million and $20.5 million in 2007 and 2006, respectively. The benefit in 2008 was primarily attributable to a lower net income and a deferred tax benefit realized on other than temporary impairments incurred on the Corporation’s investment portfolio. Higher income in 2007 generated higher income taxes.
For the reasons discussed above, the Corporation had net income of approximately $18.6 million in 2008, as compared to $63.7 million in 2007 and $49.7 million in 2006.
For purposes of the Corporation's consolidated statements of cash flows, financing activities relate primarily to sales and surrenders of the Insurance Company's annuity and universal life insurance products. The payment of dividends by the Corporation to its stockholders is also considered to be a financing activity. Net cash Used in the Company's financing activities amounted to approximately $203.3 million, $453.7 million and $300.8 million in 2008, 2007 and 2006, respectively. These fluctuations primarily are attributable to changes in policyholder account balances as a result of surrenders, sales and interest earned by the policyholders as well as the repayment of debt.
A persistent focus of the Insurance Company’s management is maintaining the appropriate balance between the duration of its invested assets and the duration of its contractual liabilities to its annuity holders and credit suppliers. Prior to 2005, the Insurance Company had permitted the duration gap between its assets and liabilities to rise during a period in which it expected relatively stable interest rates and, most importantly, in which its liabilities were largely protected by significant annuity surrender charges. This strategy benefited the Company by allowing it to realize enhanced yield from longer duration assets. At the end of 2004, the Insurance Company determined that the prospect of rising rates and declining surrender charges necessitated a reduction in the duration mismatch, as well as increased management of extension risk in its investment portfolio. The Company developed a two-step asset liability management strategy. The first step involved a duration reduction strategy, which involved the sale of certain longer duration assets that were purchased at prices below the existing market prices and reinvested into shorter duration assets. Since December 31, 2004, the Company has completed in excess of $1,238.9 million of asset repositioning.
The accompanying Notes to Consolidated Financial Statements contain information regarding payments required under existing long-term borrowing arrangements. The following presents a summary of the Company’s significant contractual obligations as of December 31, 2008.
(1) See Note 1(D) “Summary of Significant Accounting Policies, Investments”, of the consolidated financial statements
The Insurance Company¢s principal investments are in fixed maturities, all of which are exposed to at least one of three primary sources of investment risk: credit, interest rate and market valuation. The financial statement risks are those associated with the recognition of other than temporary impairments and income, as well as the determination of fair values. Recognition of income ceases when a bond goes into default and management evaluates whether temporary or other than temporary impairments have occurred on a case-by-case basis. Management considers a wide range of factors about the security issuer and uses its best judgment in evaluating the cause and decline in the estimated fair value of the security and in assessing the prospects for near-term recovery. Inherent in management’s evaluation of the security are assumptions and estimates about the operations of the issuer and its future earnings potential. Considerations used by the Company in the other than temporary impairment evaluation process include, but are not limited to: (i) the length of time and the extent to which the market value has been below amortized cost; (ii) whether the issuer is experiencing significant financial difficulties; (iii) financial difficulties being experienced by an entire industry sector or sub-sector; (iv) economically depressed geographic locations; (v) situations where the issuer, series of issuers or industry has a catastrophic type of loss or has exhausted natural resources; (vi) in situations where it is determined that an impairment is attributable to changes in market interest rates, the Corporation’s ability and intent to hold impaired securities until recovery of fair value at or above cost; and (vii) other subjective factors, including concentrations and information obtained from regulators and rating agencies. In addition, the earnings on certain investments are dependent upon market conditions, which could result in prepayments and changes in amounts to be earned due to changing interest rates or equity markets. The determination of fair values in the absence of quoted market values is based on valuation methodologies, securities the Company deems to be comparable and assumptions deemed appropriate given the circumstances. The use of different methodologies and assumptions may have a material effect of the estimated fair value amounts. However, the Company believes that the estimates it uses in determining other than temporary impairment and fair value are realistic, conservative and fairly state the value of its investments.
The reserves reflected in the Corporation's consolidated financial statements are based upon the Corporation's best estimates of mortality, persistency, expenses and investment income, with appropriate provisions for adverse statistical deviation and the use of the net level premium method for all non-interest-sensitive products. For all interest-sensitive products, the policy account value is equal to the accumulation of gross premiums plus interest credited less mortality and expense charges and withdrawals. In determining reserves for its insurance and annuity products, the Insurance Company performs periodic studies to compare current experience for mortality, interest and lapse rates with expected experience in the reserve assumptions. Differences are reflected currently in earnings for each period.