The following table summarizes the properties we lease and own at December 31, 2003:
Our predecessor, AMHC, was originally formed in 1996 as a mutual holding company and therefore, had no shares of common stock outstanding until its demutualization on September 20, 2000. On September 20, 2000, we distributed 17.4 million shares of common stock to our former members and exchanged our common stock for the 12.6 million shares of common stock held by the public in ALHI, our former subsidiary and another of our predecessor entities, on a one-for-one basis. Our operating income for 1999 and 2000 presented above primarily reflects the operating income of ALHI. Therefore, net income from continuing operations per share was calculated based on the number of shares of stock we owned of ALHI through September 20, 2000. Since then, net income from continuing operations per share has been calculated based on the shares of our common stock actually outstanding.
We did not have common stock until our demutualization on September 20, 2000, therefore, there were no dividends to declare on common stock for the year 1999. ALHI, our predecessor to our company did declare dividends on its common stock of $0.40 per share for the year ended December 31, 1999.
Total assets increased $1.2 billion during 2003 primarily as a result of additional invested assets under management resulting from additional life sales and annuity deposits. Stockholders’ equity increased $146.9 million during 2003 as a result of 2003 net income of $161.1 million and the issuance of common stock under various incentive plans of $11.1 million. The 2003 increase was partially offset by dividends declared in 2003 of $15.7 million and fees, expenses and liabilities associated with the issuance of PRIDES, which reduced equity $7.3 million.
Cash flow hedge amortization (amortization of a hedge of a forecasted transaction or of the variability of cash flows to be received or paid related to a recognized asset or liability).
Amortization of deferred policy acquisition costs (DAC) and value of business acquired (VOBA) related to the realized gains and losses on the open block investments and the derivative adjustments.
These items will fluctuate from period to period depending on the prevailing interest rate and economic environment, or are not continuing in nature, or are not part of the core insurance operations. As a result, management believes they do not reflect the ongoing earnings capacity of our operating segments.
position in the industry. We do not believe there is a comparable GAAP financial measure. A summary of our protection products segment operations follows:
Pre-tax operating income from our protection products decreased 1% in 2003 and increased 35% in 2002 compared to the respective prior years. Higher product margins increased open block operating income $3.9 million in 2003; however, operating income of the closed block decreased $5.3 million in 2003 compared to 2002, as the closed block continues to reflect the declining closed block glide path (see Dividends to Policyowners for additional information). The increase in 2002 was due to a slight growth in product margins and the acquisition of ILICO. The key drivers of our protection products business include sales, persistency, net investment income, mortality and expenses.
Sales, Premiums and Product Charges. Sales are a key driver of our business as they are a leading indicator of future revenue trends to emerge in segment operating income. As shown in the Sales Activity Product table presented in “Item 1 Business - Protection Products Segment,” direct sales decreased 9% in 2003 compared to 2002 and increased 74% in 2002 compared to 2001. The decrease in 2003 resulted from lower traditional and universal life insurance product sales as we re-priced our products and discontinued our par whole life product. In addition, interest-sensitive whole life sales were lower due to uncertainty in government tax policy and regulation. Interest-sensitive whole life insurance has cash value accumulation that changes with current interest and mortality rates. The lower traditional and universal sales were partially offset by increased equity-indexed life sales as we continue to focus our marketing efforts on those products. The increase in 2002 was primarily due to the acquisition of ILICO during the second quarter of 2001 and growth we experienced in almost all our protection product lines in 2002, especially in our equity-indexed life products. The equity-indexed life product allows the policyowner to elect an earnings strategy for a portion of the account value whereby earnings are credited based primarily on increases in the S&P 500 Index, excluding dividends. The earnings credit is subject to a participation rate and an annual cap. Sales of equity-indexed life products were $51.6 million in 2003 as compared to $45.8 million in 2002 and $25.9 million in 2001. We are a leading writer of equity-indexed life products in the United States.
Underwriting, Acquisition and Other Expenses. Underwriting, acquisition and other expenses are a key driver of our business as they reflect costs of our operations. Expenses decreased in 2003 compared to 2002 primarily due to increased reimbursement from reinsurers of non-deferrable commission and expense allowances, as more policies are subject to reinsurance, and expense changes resulting from the restructuring activities. Expenses increased in 2002 compared to 2001 primarily due to the acquisition of ILICO for a full year in 2002 compared to a partial year in 2001. ILICO expenses increased $10.6 million in 2002 compared to 2001.
Amortization of DAC and VOBA. The amortization of DAC and VOBA are expense items which increased in 2003 and 2002 as compared to the respective prior years. DAC and VOBA are generally amortized in proportion to policy gross margins which increased in 2003, resulting in higher amortization expense. Amortization expense increased in 2002 compared to 2001 primarily due to the acquisition of ILICO.
Dividends to Policyowners. Dividend expense decreased in 2003 compared to 2002 and increased in 2002 compared to 2001. Dividend expense includes increases or decreases to the closed block policyowner dividend obligation liability carried on the consolidated balance sheet. To the extent cumulative actual earnings of the closed block exceed the cumulative expected earnings based on the actuarial calculation at the time of formation of the closed block (which we refer to as the closed block glide path), a policyowner dividend obligation is recorded. The higher realized gains in 2003 as compared to losses in 2002 increased closed block earnings, which in turn, were added to the policyowner dividend obligation liability. Lower investment income was experienced in the closed block in 2003 which decreased dividend expense offsetting the increase for realized gains. In addition, the reinsurance adjustment related to the settlement activity of the closed block in the second quarter of 2003, caused an increase in the dividend expense and related policyowner dividend obligation liability for 2003. See the “Reinsurance Adjustments” section for additional information.
The increased dividends in 2002 as compared to 2001 were primarily due to the acquisition of ILICO in 2001 and the dividends associated with its closed block.
Outlook. We expect to continue to shift our sales to higher return products, in particular the equity-indexed life products. We also expect to continue to realize operating efficiencies created by the restructuring of the protection products operations and centralization of our administrative functions as discussed later in “Restructuring Costs.”
Pre-tax operating income from our accumulation products operations increased 8% in 2003 and 26% in 2002 compared to the respective prior years. The increased volume of equity-indexed annuities and additional income from funding agreements increased accumulation products earnings in 2003. The increase was partially offset by reduced product margins and lower contributions from IMO operations. The increase in 2002 was primarily due to increased IMO operating income and the discontinuation of goodwill amortization. The drivers of profitability in our accumulation products business are deposits, persistency, product spread, expenses and IMO operations.
Deposits. Deposits are a key driver of our business as this is a measure which represents collected premiums to be deposited to policyowner accounts for which we will earn a future product spread. Deposits are presented as collected premiums, which are measured in accordance with industry practice, and represent the
amount of new business sold during the period. Deposits are a non-GAAP financial measure for an insurance company for which there is no comparable GAAP financial measure. We use deposits to measure the productivity of our distribution network and as a basis for compensation of sales and marketing employees and agents. As shown in the Deposits by Product table presented in “Item 1 Business - Accumulation Products Segment,” total annuity deposits decreased 2% in 2003 compared to 2002 and decreased 9% in 2002 as compared to 2001. The 2003 decrease was primarily a result of our slowing of our traditional annuity sales due to the low interest rate environment as we focused sales on our higher returning equity-indexed products. The reduced traditional annuity sales offset the increase in equity-indexed products. The 2002 decrease resulted from the deployment of capital to funding agreements which provide a higher return on equity.
We placed fixed rate funding agreements totaling $875 million in 2002. Funding agreements are insurance contracts for which we receive deposit funds and for which we agree to repay the deposit and a contractual return for the duration of the contract. In December 2003, a $250 million funding agreement originally placed in 1999 was terminated. Total funding agreements outstanding as of December 31, 2003 amounted to $875 million compared to $1.125 billion outstanding at December 31, 2002.
The deposits we receive on accumulation products are not recorded as revenue but instead as a policyowner liability. Surrender charges are recorded as revenue as a product charge. Product charges increased in 2003 as compared to 2002 due to the growth in business and increased in 2002 as compared to 2001 due to the acquisition of ILICO.
Persistency. Persistency is a key driver of our business as it refers to the policies which remain in our block of business and is measured by the withdrawal rate. A low withdrawal rate reflects higher persistency indicating more business is remaining in force to generate future revenues. Withdrawals represent funds taken out of accumulation products by policyowners not including those due to the death of policyowners. Annuity withdrawal rates without internal replacements continued to improve in 2003 as compared to 2002 and 2001 and amounted to 9.5%, 10.6% and 11.4%, respectively. Annuity withdrawals without internal replacements totaled $1,196.9 million in 2003, $1,288.2 million in 2002 and $1,324.9 million in 2001.
Our withdrawal experience remained within our pricing assumptions. Withdrawal rates declined in 2003 and 2002 as compared to the respective prior years as our annuity products provide a favorable investment return in this current low interest rate environment.
Product Spread. Product spread is a key driver of our business as it measures the difference between the income earned on our invested assets and the rate which we credit to policyowners, the difference is reflected as segment operating income. Asset earned rates and liability crediting rates were as follows for annuity segment products:
Funding agreement income increased $5.0 million in 2003 compared to 2002 and increased $4.1 million in 2002 compared to 2001. The increase was due to the $875 million of funding agreements placed throughout 2002.
Underwriting, Acquisition and Other Expenses. Underwriting, acquisition and other expenses are a key driver of our business as they represent costs of our operations. Expenses in 2003 decreased as compared to 2002 due primarily to lower fees associated with a declining block of annuity business processed by a third party administrator. Expenses decreased in 2002 compared to 2001 primarily due to goodwill no longer being amortized effective January 1, 2002 with the adoption of SFAS 142, “Goodwill and Other Intangible Assets.” Goodwill amortization amounted to $7.6 million in 2001.
Outlook. We anticipate increased product sales from our IMOs but decreased product sales from other distribution as we manage our sales in this current low interest rate environment. We also expect to continue the shift of our product mix to higher return products, in particular the equity-indexed annuity products. We will continue to manage our spreads as we strive for our desired profitability in this economic environment.
an unrealized gain of $62.9 million in 2003 and an unrealized loss of $40.0 million in 2002 and an unrealized loss of $54.2 million in 2001. In addition, we also have trading securities that back our total return strategy traditional annuity products. The market value adjustment on the trading securities resulted in an unrealized gain of $26.8 million in 2003, a loss of $5.2 million in 2002 and a loss of $5.9 million in 2001. Most of the unrealized gains and losses on the options and trading securities are offset by similar adjustments to the option portion of the equity-indexed product reserves and to the total return strategy annuity reserves. The reserve adjustments are reflected in policyowner benefits expense in the consolidated statements of income and are included in the fair value change as additional expense of $65.7 million in 2003, reduced expense of $28.8 million in 2002 and reduced expense of $52.7 million in 2001 as explained in the following paragraph.
The fair value change in options embedded within our equity-indexed products and the fair value changes on our total return strategy traditional annuity contracts are being recorded at fair value. As previously discussed, these fair value changes are offset by similar adjustments to unrealized gains (losses) on investments related to the fair value changes on the options that hedge the equity-indexed products and on the trading securities that back the total return strategy products. The reduction in such contract expense is less than the decline in investment income primarily due to the inability to lower crediting rates below minimum guaranteed interest rates.
Reinsurance Adjustments. Reinsurance related adjustments in 2003 consist of the release of a $8.2 million liability in conjunction with the settlement and amendment of a reinsurance arrangement and a $4.3 million true-up of pre-2003 reinsurance settlements under a reinsurance arrangement between ILIC’s open block and closed block.
We listed an office building located in Indianapolis, Indiana, with a real estate broker in 2003, and we vacated the location as a result of staff reductions. In addition, those employees who are going to work in Indianapolis moved to a new location. We determined that the plan of sale criteria in SFAS 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” had been met. Accordingly, the carrying value of the building was adjusted to its fair value less costs to sell, amounting to $15.5 million, which was based upon comparable properties recently marketed in Indianapolis. The resulting $7.7 million pre-tax impairment loss was recorded as restructuring costs in the consolidated statement of income in 2003. The carrying value of the building that is held for sale is included in the other assets line item of the consolidated balance sheet.
Interest Expense. Interest expense increased in 2003 as compared to 2002 and 2001. The increase was primarily due to interest associated with the PRIDES securities of $143.8 million issued in the second quarter of 2003.
We adopted SFAS 133 on January 1, 2001. In accordance with the provisions of the statement, we recorded the differences between the previous carrying amounts of our derivative instruments and the fair value of our derivative instruments, as of this initial application date, as the effect of a change in accounting principle. The gross difference between carrying amounts and fair value amounts of our derivative instruments was a reduction of approximately $11.3 million. The adjustment to the DAC and VOBA amortization related to the impact from the derivative charge was an expense of approximately $1.1 million and the income tax benefit was $4.2 million, resulting in the net cumulative effect of change in accounting for derivatives expense of $8.2 million in 2001.
Generally, the various state laws give the state regulators discretion to approve or disapprove requests for dividends in excess of these limits. Based on these limitations and 2002 results, our life insurance subsidiaries could have paid us approximately $82 million in dividends in 2003 without obtaining regulatory approval. Our subsidiaries paid us approximately $85 million in 2003 that included dividends for which we obtained regulatory approval. Based on 2003 results, our subsidiaries can pay an estimated $78 million in dividends without obtaining regulatory approval during 2004. We also consider risk-based capital levels, capital and liquidity operating needs, and other factors prior to paying dividends from the insurance subsidiaries.
We manage liquidity on a continuing basis. One way is to minimize our need for capital. We accomplish this by attempting to use our capital as efficiently as possible and by developing capital-efficient products in our insurance subsidiaries. We manage our mix of sales by focusing on the more capital-efficient products. In addition, we use reinsurance agreements, where cost-effective, to reduce capital strain in the insurance subsidiaries. We also focus on optimizing the consolidated capital structure to properly balance the levels and sources of borrowing and the issuance of equity securities.
The cash flows of our insurance subsidiaries consist primarily of premium income; deposits to policyowner account balances; income from investments; sales, maturities and calls of investments and repayments of investment principal. Cash outflows are primarily related to withdrawals of policyowner account balances, investment purchases, payment of policy acquisition costs, payment of policyowner benefits, payment of debt, income taxes and current operating expenses. Insurance companies generally produce a positive cash flow from operations, as measured by the amount by which cash flows are adequate to meet
We take into account asset/liability management considerations in the product development and design process. Contract terms for the interest-sensitive products include surrender and withdrawal provisions which mitigate the risk of losses due to early withdrawals. These provisions generally do one or more of the following: limit the amount of penalty-free withdrawals, limit the circumstances under which withdrawals are permitted, or assess a surrender charge or market value adjustment relating to the underlying assets.
In addition to the interest-sensitive products, our insurance subsidiaries placed additional funding agreements totaling $875 million primarily in six to ten year fixed rate insurance contracts during 2002. The assets backing the funding agreements are legally segregated and are not subject to claims that arise out of any other business of the insurance subsidiaries. The funding agreements are further backed by the general account assets of the insurance subsidiaries. The segregated assets and liabilities are included with general account assets in the financial statements. The funding agreements may not be cancelled unless there is a default under the agreement, but the insurance subsidiaries may terminate the agreement at any time. During 2003, a $250 million funding agreement which was placed in 1999 was terminated. Total funding agreements of $875 million were outstanding as of December 31, 2003.
In the future, in addition to cash flows from operations and borrowing capacity, the insurance subsidiaries may obtain their required capital from AmerUs Group Co.
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities. The valuation of financial instruments, accounting for derivatives and amortization of DAC and VOBA are considered our critical accounting policies due to their subjective nature and significance to the financial statements.
Securities in our portfolio with a carrying value of approximately $1,605 million and $1,625 million at December 31, 2003 and 2002, respectively, do not have readily determinable market prices. Valuation techniques vary by security type and availability of market data. Fair values for securities which do not have a readily available market price are determined by: 1) a matrix process that uses a current market spread added to an applicable treasury rate to discount expected future cash flows applicable to the coupon rate, credit quality, industry sector and term of the investment; 2) independent third party sources or recent transactions in similar securities, or 3) internally prepared valuations incorporating standard valuation techniques. Certain market conditions that could impact the valuation of securities include credit ratings, business climate, economic environment, industry trends, and regulatory and legal risks/events, among others. All such investments are classified as available-for-sale. Our ability to liquidate our positions in these securities will be impacted to a significant degree by the lack of an actively traded market, and we may not be able to dispose of these investments in a timely manner. Although we believe our estimates reasonably reflect the fair value of those securities, our key assumptions about the risk-free interest rates, risk premiums, performance of underlying collateral (if any), and other factors may not be realized in the event of an actual sale.
Securities are also reviewed to identify potential impairments. In determining if and when a decline in market value below amortized cost is other-than-temporary, we evaluate the market conditions, offering prices, trends of earnings, price multiples and other key measures for our investments in marketable equity securities and debt instruments. For fixed maturity securities, our intent and ability to hold securities is also considered. When such a decline in value is deemed to be other-than-temporary, we recognize an impairment loss in the current period net income to the extent of the decline. For additional information regarding our evaluation of OTTI, see the section titled “Investments - Impairment.”
To hedge equity market risk, we primarily use S&P 500 Index call options to hedge the growth in interest credited to the customer as provided by our equity-indexed products. We may also use interest rate swaps or options to manage our fixed products’ risk profile. Generally, credit default swaps are coupled with a bond to synthetically create an instrument cheaper than an equivalent investment traded in the cash market.
We have not changed our methods of calculating the fair values of derivatives or the underlying assumptions. The fair values of these derivatives will change over time as cash receipts and payments are made and as market conditions change.
Our derivative instruments are not subject to a multiple or use of leverage on the underlying price index. We do not believe we are exposed to more than a nominal amount of credit risk in our interest rate or equity
hedges as the counterparties are established, well-capitalized financial institutions. Information about the fair values, notional amounts, and contractual terms of these instruments can be found in note 4 to our consolidated financial statements and the section titled “Quantitative and Qualitative Disclosures About Market Risk.”
Because the EGMs are only an estimate of the profits we expect to recognize from these policies, the EGMs are adjusted annually to take into consideration the actual gross profits to date and any changes in the remaining expected future gross margins. When EGMs are adjusted, we also adjust the amortization of the deferred policy acquisition costs amount to maintain a constant percentage over the entire life of the policies.
throughout the product development, introduction and management phases to jointly develop and implement product features, initial and renewal crediting strategies, and investment strategies based on extensive modeling of a variety of factors under a number of interest rate scenarios.
The following table summarizes invested assets by asset category as of December 31, 2003 and 2002:
The portfolio of investment grade fixed maturity securities is diversified by number and type of issuer. As of December 31, 2003, investment grade fixed maturity securities included the securities of 878 issuers, with 2,648 different issues of securities. No non-government/agency issuer represents more than 1% of investment grade fixed maturity securities.
Below-investment grade fixed maturity securities as of December 31, 2003, included the securities of 280 issuers representing 6.9% of total invested assets, with the largest being a $30.5 million investment.
The following table summarizes fixed maturity securities by Standard & Poor’s or equivalent rating, including unrealized losses, at December 31, 2003:
MBS investments are mortgage-related securities including collateralized mortgage obligations (or CMOs) and pass-through mortgage securities. Asset-backed securities are both residential and non-residential including exposure to home equity loans, home improvement loans, manufactured housing loans as well as securities backed by loans on automobiles, credit cards, and other collateral or collateral bond obligations. As of December 31, 2003, asset-backed residential mortgages totaled $320.6 million or 1.8% of total invested assets. As of December 31, 2003, residential mortgage pass-through and CMOs totaled $2,014.8 million or 11.2% of total invested assets. As of December 31, 2003, $1,909.2 million or 94.8% of MBS were from government sponsored enterprises. Other MBS were $105.6 million or 5.2% of MBS as of December 31, 2003. Management believes that the quality of assets in the MBS portfolio is generally high, with 99.9% of such assets representing agency backed or “AAA” rated securities. Collateralized mortgage backed securities (or CMBS) totaled $973.0 million or 6.1% of total invested assets as of December 31, 2003.
Interest rate swaps and options are primarily used to reduce exposure to changes in interest rates and to manage duration mismatches. Call options are primarily used to hedge equity-indexed products. Credit default swaps are coupled with a bond to synthetically create an investment cheaper than the equivalent instrument traded in the cash market. Although we are subject to the risk that counterparties will fail to perform, credit standings of counterparties are monitored regularly. We only enter into transactions with highly rated counterparties. We are also subject to the risk associated with changes in the value of contracts. However, such adverse changes in value generally are offset by changes in the value of the items being hedged. The notional principal amounts of the swaps and options, which represent the extent of our involvement in such contracts but not the risk of loss, at December 31, 2003, amounted to $2,603.3 million. The interest rate swaps had a carrying value of a net receivable position of $3.2 million at December 31, 2003. The credit default swaps had a carrying value of a net receivable position of $0.6 million at December 31, 2003. The carrying value of options amounted to $134.9 million at December 31, 2003. For each of these derivatives, the carrying value is equal to fair value as of December 31, 2003. The derivatives are reflected as other investments on the consolidated financial statements. The net amount payable or receivable from interest rate and credit default swaps are accrued as an adjustment to interest income. Effective October 1, 2003, we adopted DIG Issue B36 and effective January 1, 2001, we adopted SFAS 133. See note 4 to the consolidated financial statements for further discussion of the impact of adopting both accounting pronouncements.
As of December 31, 2003, mortgage loans in the investment portfolio were $968.6 million, or 5.4% of the aggregate carrying value of invested assets. As of December 31, 2003, commercial mortgage loans and residential mortgage loans comprised 87.4% and 12.6%, respectively, of total mortgage loans. Commercial mortgage loans consist primarily of fixed-rate mortgage loans. As of December 31, 2003, we held 686 individual commercial mortgage loans with an average balance of $1.2 million.
As of December 31, 2003, four loans in the loan portfolio with a carrying value of $5.5 million were classified as delinquent and no loans were in foreclosure. As of the same date, only two loans with a carrying value aggregating $1.2 million were classified as restructured. During 2003, we had one foreclosure.
We participate in a securities lending program whereby certain fixed maturity securities from the investment portfolio are loaned to other institutions for a short period of time. We receive a fee in exchange for the loan of securities and require initial collateral equal to 102 percent of the market value of the loaned securities to be separately maintained. Securities with a market value of $154.6 million were on loan under the program and the Company has cash collateral under its control of $158.8 million at December 31, 2003. There were no securities on loan at December 31, 2002. We also may enter into securities borrowing arrangements from time to time. At December 31, 2003 and 2002, there were no securities borrowed.
We held $494.6 million of policy loans on individual insurance products as of December 31, 2003. Policy loans are permitted to the extent of a policy’s contractual limits and are fully collateralized by policy cash values. As of December 31, 2003, we held equity securities of $76.5 million of which the largest holding was Federal Home Loan Bank common stock totaling $58.1 million.
We held $368.6 million of other invested assets (including short-term investments and real estate) on December 31, 2003. Other invested assets consist primarily of our Ameritas Joint Venture investment, various other joint ventures and limited partnership investments and derivatives.
Our evaluation of other-than-temporary impairment (OTTI) for fixed income securities follows a three-step process of 1) screen and identify; 2) assess and document; 3) recommend and approve. In identifying potential OTTI’s, we screen for all securities that have a fair value less than 80% of amortized cost. In addition, we monitor securities for general credit issues that have been identified and included on a watch list which may result in the potential impairment list including other securities that have a fair value at or greater than 80% of amortized cost. For asset backed securities, the guidance of EITF 99-20 is followed which requires an impairment loss if the fair value of the security is less than amortized costs and there is an adverse change in estimated cash flows from the cash flows previously projected.
Viability of the business model incorporating an evaluation of default probability and associated recoverable value
If the determination is that the security is OTTI, it is written down to fair value. This is reviewed and approved by senior management. The difference between amortized cost and fair value is charged to net income.
When actively traded market prices are not available, fair values are determined using present value or other standard valuation techniques such as earnings multiples and asset valuations. The fair value
determinations are made at a specific point in time based on then available market information and judgments about the financial instruments. Factors considered in determining fair value include: coupon rate, term, collateral (if any), industry sector outlook, credit rating, expectations regarding going concern status, timing and amounts of expected future cash flows among other factors.
The following table lists material investment impairments in 2003 and 2002. The writedowns occurred due to creditor and/or issue specific circumstances.
There are no securities that were more than 50% underwater at December 31, 2003.
We may decide to sell certain securities within the overall context of our portfolio management strategies. This may include required exposure reductions due to internal credit limits, total rate of return strategies, capital reserve objectives, asset allocation decisions and hedging activities.
annuities or life insurance products offered by competitors, certificates of deposit, mutual funds, and similar instruments) may become more attractive to potential purchasers of our products until we increase the interest rate credited to owners of our protection products and accumulation products. In contrast, as interest rates fall, we attempt to adjust credited rates to compensate for the corresponding decline in reinvestment rates. We monitor interest rates and sell annuities and life insurance policies that permit flexibility to make interest rate changes as part of management of interest spreads. However, the profitability of our products is based upon persistency, mortality and expenses, as well as interest rate spreads.
In July 2002, the Financial Accounting Standards Board issued SFAS 146, “Accounting for Costs Associated with Exit or Disposal Activities.” SFAS 146 provides for costs to exit an activity or dispose of long-lived assets to be recorded when they are incurred and are to be measured at fair value. Under previous accounting guidance, a liability for an exit cost was recognized at the date of the commitment to an exit plan. SFAS 146 is effective for exit or disposal activities initiated after December 31, 2002 and its adoption had no impact on net income or stockholders’ equity as of or for the years ended December 31, 2003 and 2002.
In December 2002, the Financial Accounting Standards Board issued SFAS 148, “Accounting for Stock-Based Compensation - Transition and Disclosure.” SFAS 148 amends SFAS 123, “Accounting for Stock-
Based Compensation,” and provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, SFAS 148 requires more prominent and more frequent disclosures in financial statements about the effects of stock-based compensation. As of December 31, 2003, we continue to account for employee stock-based compensation using the intrinsic value method provided under SFAS 123 and SFAS 148. The disclosure requirements of both standards have been provided in note 1 to the consolidated financial statements.
In January 2003, the Financial Accounting Standards Board issued FASB Interpretation No. 46, “Consolidation of Variable Interest Entities,” an Interpretation of ARB 51, or FIN 46. FIN 46 provides guidance to identify variable interest entities, or VIEs, and their consolidation by a primary beneficiary. A VIE is defined as an entity in which either 1) the equity investors, if any, do not have a controlling financial interest, or 2) the equity investment at risk is insufficient to finance that entity’s activities without receiving additional subordinated financial support from other parties. An enterprise whose investment in a VIE absorbs the majority of the VIE’s expected losses or receives a majority of its expected residual returns is considered a primary beneficiary, although not all VIEs will have a primary beneficiary. FIN 46 requires primary
At December 31, 2002, we held interests in structured securities arrangements which met the definition of VIEs; however, most of the interests were sold prior to June 30, 2003. We would have been considered the primary beneficiary for several of those structured securities, which if consolidated at December 31, 2002, would have resulted in an increase in total assets of $167 million, an increase in total liabilities of $154 million and an increase in total stockholders’ equity of $13 million. At December 31, 2003, an investment in a limited partnership, for which we provide indirect management functions, has been consolidated rather than carried as an equity method investment, as provided by FIN 46, resulting in an increase in total assets and total liabilities of $21.1 million and no change in stockholders’ equity or net income. In addition, AmerUs Capital I, a previously consolidated subsidiary which has issued trust preferred securities, was deconsolidated in 2003 as AmerUs Group Co. is not considered the primary beneficiary under FIN 46. Deconsolidation of AmerUs Capital I resulted in an increase of other assets and notes payable of $2.7 million and no change in stockholders’ equity or net income. See notes 3 and 8 to the consolidated financial statements for disclosures and additional information related to our VIE interests.
The Financial Accounting Standards Board’s Derivatives Implementation Group issued SFAS 133 Implementation Issue No. B36, “Embedded Derivatives: Bifurcation of a Debt Instrument that Incorporates both Interest Rate Risk and Credit Risk Exposures that are Unrelated or Only Partially Related to the Creditworthiness of the Issuer of that Instrument,” or DIG Issue B36. DIG Issue 36 applies to modified coinsurance and coinsurance with funds withheld arrangements where interest is determined by reference to a pool of fixed maturity assets or a total return debt index. Such arrangements in which funds are withheld by the ceding insurer cause the reinsurer to recognize a receivable from the ceding insurer as well as a liability representing reserves for the insurance coverage assumed under the reinsurance arrangements. The terms of the reinsurer’s receivable provide for the future payment of principal plus a rate of return on either its general account assets or a specified block of those assets which is typically composed of fixed-rate debt securities. DIG Issue B36 considers the reinsurer’s receivable from the ceding company to contain an embedded derivative that must be bifurcated and accounted for separately under SFAS 133. We adopted DIG Issue B36 on October 1, 2003, which included the reclassification of certain securities supporting the products being reinsured from available for sale to trading. The net cumulative effect of the change in accounting for DIG Issue B36 was a charge to net income of $1.3 million after income taxes and a reduction in accumulated other comprehensive income for the reclassification of securities from available-for-sale to held for trading amounting to $5.2 million after income taxes.
In July 2003, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants issued Statement of Position 03-1, “Accounting and Reporting by Insurance Enterprises for Certain Non-Traditional Long-Duration Insurance Contracts and for Separate Accounts.” SOP 03-1 provides interpretive guidance on separate account presentation and valuation, accounting recognition for sales inducements, and classification and valuation of long-duration contract liabilities. The provisions of SOP 03-1 are effective for financial statements for fiscal years beginning after December 15, 2003. The adoption of SOP 03-1 will not have a material effect on net income or stockholders’ equity in 2004.