- ----------- (1) Comparability of financial information is affected by acquisitions and other transactions by the Company in the periods presented. For acquisitions and other transactions completed in the last three years see "Acquisitions and Other Transactions."
The Company's income before cumulative effect of change in accounting principle was $1,315 million in 2001 reflecting a 5.8% or $72 million increase compared to $1,243 million in 2000. Income before cumulative effect of change in accounting principle of $1,243 million in 2000 increased $209 million or 20.2% from 1999. The 2001 results were impacted by several factors, including a weak U.S. economy and the normalization of the block of business acquired in the Toho Transfer following the significant surrender activity experienced in 2000. In addition, the Company incurred approximately $25 million in losses related to the events of September 11th.
The 2001 U.S. economic performance included sharp declines in interest rates and volatile equity markets, which adversely impacted production on variable annuity products. In addition, the number of corporations defaulting on debt obligations increased dramatically throughout the year.
To overcome these economic challenges and the anticipated reduction of surrender fee income from the block of business acquired through the Toho Transfer, the Company aggressively managed operating expenses and relied on its investment portfolio to minimize the impact of external economic factors on its results. The Company's diverse product offering drove core growth during the difficult 2001 economic environment. This growth was attributable to the Company's ability to match customers' shifting preferences by offering traditional insurance products.
Operating Results for the Years Ended December 31, 2001, 2000 and 1999
Premiums. Premiums, which include premium revenues from life contingent annuity contracts, health insurance, traditional life, mortgage insurance and automobile insurance, were $6,551 million in 2001 an increase of $499 million from $6,052 million in 2000. Premiums in 2000 increased by $1,910 million from $4,142 million in 1999. The 2001 increase primarily resulted from growth in the Company's structured settlement contracts, long-term care insurance and certain accident and health insurance products. These increases were partially offset by decreased premiums from the anticipated run-off of policies assumed as part of the Toho Transfer. Surrender activity in this block of business in 2000 resulted in a substantial reduction of 2001 premiums. The 2000 increase was primarily a result of (i) the Toho Transfer; (ii) the acquisition of Phoenix American Life in April 2000 and (iii) growth in certain of the Company's life and long-term care products.
Net Investment Income. Net investment income increased $307 million to $4,201 million in 2001 from $3,894 million in 2000. The increase was primarily attributable to higher levels of average invested assets ($69.3 billion in 2001 vs. $63.7 billion in 2000). The weighted average yield on these investments was 6.05% in 2001. Net investment income increased $628 million to $3,894 million in 2000 from $3,266 million in 1999. The increase was primarily attributable to higher levels of average invested assets ($63.7 billion in 2000 vs. $46.1 billion in 1999), due to investments relating to the Toho Transfer
and growth in core invested assets. This increase was partially offset by a decrease in weighted average yields to 6.09% in 2000 from 7.08% in 1999, primarily due to lower yields on investment activity related to the Company's Japanese operations.
Surrender Fee Income. Surrender fee income decreased $895 million in 2001 to $358 million compared to $1,253 million in 2000. Surrender fee income increased by $1,197 million from $56 million in 1999. The decrease in 2001 reflects the normalization of the block of business acquired in the Toho Transfer following the significant surrender activity experienced in 2000. As discussed earlier, these policies became subject to surrender charges under the terms of the restructuring of Toho's in-force insurance contracts. The surrender rates for the insurance policies assumed from Toho were significantly greater than historical averages. The Company believes that this unusual surrender activity was in response to the Toho insolvency, in particular the fact that the former Toho policyholders were not permitted to surrender policies from the date of the issuance of the business suspension order to Toho through the date of the Toho Transfer.
Net Realized Investment Gains. Net realized investment gains were $300 million in 2001, $233 million in 2000, and $232 million in 1999. Net investment gains are comprised of gross investment gains and gross investment (losses), respectively, of $830 million and $(530) million in 2001, $425 million and $(192) million in 2000, and $413 million and $(181) million in 1999. These changes in gross realized investment gains and losses are related to the Company's ongoing review of its investment portfolio positions which vary with market and economic conditions. The Company seeks to offset investment losses realized from other than temporary impairments and portfolio repositioning with investment gains.
Interest Credited. Interest credited increased $174 million in 2001 to $1,671 million from $1,497 million in 2000. Interest credited increased $199 million in 2000 from $1,298 million in 1999. The 2001 increase was primarily attributable to an increase in annuity deposits. The 2000 increase was a result of the increase in underlying reserves arising primarily from sales of fixed annuity products. The increased sales resulted from higher crediting rates that the Company implemented in response to changes in market conditions and other factors.
The Company's weighted average crediting rates for annuities decreased to 5.51% in 2001 from 6.14% in 2000, which was relatively unchanged from 6.15% in 1999. Changes in the Company's base crediting rates are implemented in response to changes in market conditions, the prevailing interest rate environment, contractual provisions and other factors. The Company monitors market conditions closely and resets interest crediting rates as deemed appropriate in accordance with the terms of the underlying contracts.
General Expenses. General expenses decreased $190 million in 2001 to $1,928 million from $2,118 million in 2000. General expenses increased $660 million in 2000 from $1,458 million in 1999. The decrease in 2001 primarily relates to reduced compensation and benefit costs and other cost savings initiatives resulting from integration and consolidation activities. The 2000 increase was primarily a result of (i) a full year of operating results of The Signature Group; (ii) the Toho Transfer; (iii) increases in compensation and advertising expenses, commensurate with the Company's growth in revenues and to support the Company's core growth initiatives.
Change in Deferred Acquisition Costs, Net. Deferred acquisition costs include costs and expenses which vary with and are primarily related to the acquisition of insurance and investment contracts, such as first year commissions in excess of ultimate renewal commissions, direct advertising and printing costs, and certain support costs such as underwriting and policy issue expenses. Under U.S. GAAP, these costs are deferred and recognized in relation to either the premiums or gross profits from the underlying contracts. The change in net deferred acquisition costs decreased $236 million in 2001 to $886 million from $1,122 million in 2000. The change in net deferred acquisition costs increased $356 million in 2000 from $766 million in 1999. The decrease in 2001 is a result of lower new term life sales and lower production from variable annuities, offset by increased long-term care insurance production. The increase in 2000 compared to 1999 was related to an increase in deferral of acquisition costs arising from increased product sales as a
The following table sets forth certain summarized financial data for the Company's Mortgage Insurance segment for the years ended December 31, 2001, 2000, and 1999.
The following table sets forth certain summarized financial data for GE Financial Assurance's Lifestyle Protection and Enhancement segment for the years ended December 31, 2001, 2000, and 1999.
Sales of accident and health insurance grew 8.1% in 2001 to $241 million from $223 million in 2000, primarily attributable to growth in the medical stop loss contracts in addition to the acquisition of Phoenix American Life in April 2000. These increases were partially offset by decreased automobile insurance sales, declined club memberships in income protection packages and run-off or exit of certain lines of business. Automobile insurance sales decreased 50.0% to $42 million in 2001 from $84 million in 2000, primarily attributable to certain competitive factors currently existing within the automobile insurance industry. Sales of club memberships declined primarily as a result of lower demand for income protection packages in general, which reduced revenue earned by 23.7% to $277 million in 2001 from $363 million in 2000.
Operating income from this segment represented 19.2%, 11.8%, and 5.9%, of the Company's total results for the years ended December 31, 2001, 2000, and 1999, respectively. The Company's operating income from the Lifestyle Protection and Enhancement segment increased 74.3% in 2001 to $380 million, and increased 153.5% in 2000 from $86 million in 1999. The 2001 and 2000 increase is primarily attributable to growth in the aforementioned products offset by increased benefits and expenses.
Interest rate and currency risk management is important in the normal business activities of the Company. Derivative financial instruments are used by the Company to mitigate or eliminate certain financial and market risks, including those related to changes in interest rates and currency exchange rates. As a matter of policy, the Company does not engage in derivatives trading, derivatives market-making, or other speculative activities. More detailed information regarding these financial instruments, as well as the strategies and policies for their use, is contained in Notes 1, 9 and 14 to the Consolidated Financial Statements.
The Company is exposed to prepayment risk in certain of its business activities, such as in its investment portfolio and annuities activities. The Company uses interest rate swaps, swaptions and option-based financial instruments to mitigate prepayment risks. These instruments generally behave based on limits ("floors") on interest rate environment. These swaps, swaptions and option-based financial instruments are governed by the credit risk policies described below and are transacted in either exchange-traded or over-the-counter markets.
Counterparty credit risk is managed on an individual counterparty basis, which means that gains and losses are netted for each counterparty to determine the amount at risk. When a counterparty exceeds credit exposure limits in terms of amounts due to the Company, typically as a result of changes in market conditions (see table below), no additional transactions are executed until the exposure with that counterparty is reduced to an amount that is within the established limit. All swaps are executed under master swap agreements containing mutual credit downgrade provisions that provide the ability to require assignment or termination in the event either party is downgraded below A3 or A-.
The conversion of interest rate and currency risk into credit risk results in a need to monitor counterparty credit risk actively. At December 31, 2001 and December 31, 2000, there were no notional amounts of long-term derivatives for which the counterparty credit criteria was rated below Aa3/AA-.
Following is an analysis of credit risk exposures as of December 31:
. One means of assessing exposure to interest rate changes is a duration-based analysis that measures the potential loss in net earnings resulting from a hypothetical decrease in interest rates of 100 basis points across all maturities. Under this model, with all else constant, it is estimated that such a decrease, including repricing effects in the securities portfolio, would decrease the 2002 net earnings of the Company based on year-end 2001 positions by approximately $5.0 million.
Adoption of SFAS No. 133 reduced equity by $148 million for the year ended December 31, 2001, including $351 million at the date of adoption. Further information about this accounting change is provided in Note 1 to the Consolidated Financial Statements.
The major debt rating agencies evaluate the financial condition of GE Financial Assurance by analyzing the Company's cash generating ability among other factors. The rating agencies continue to give GE Financial Assurance a long term credit rating of Aa3/A+ and a short term credit rating of A-1 / P-1.
The major rating agencies also evaluate the insurer financial strength of GE Financial Assurance's insurance companies by analyzing cash generating ability to meet contractual obligations to policyholders and annuitants. Contractual obligations include payments of claims under outstanding insurance policies and annuities, contract withdrawals, and surrender benefits. The primary sources for meeting these contractual obligations are investment activities and cash generated from operating activities. In addition, to meet short-term variations in contractual obligations, the Company maintains cash and short-term investments. For insurer financial strength ratings of principal insurance subsidiaries see "Ratings".
The nature and quality of the various types of investments purchased by an insurance company must comply with the statutes and regulations imposed by the various jurisdictions in which those entities are incorporated. Following is a breakdown of the credit quality of the Company's fixed maturity portfolio at December 31, 2001.
BBB/Baa or above 87.6% BB/Ba and below 3.4% Not rated 9.0% ------ Total Portfolio 100.0% ======
Certain securities, such as private placements, have not been assigned a rating by any rating service and are, therefore, categorized as "not rated."
GE Financial Assurance's ability to pay dividends to its shareholder and meet its obligations, including debt service and operating expenses, primarily depends on receiving sufficient funds from its insurance subsidiaries. Insurance companies are restricted by states as to the aggregate amount of dividends they may pay to their parent in any consecutive twelve-month period without regulatory approval. Dividends in excess of the prescribed limits or the Company's earned surplus are deemed extraordinary and require formal state insurance department approval. GE Financial Assurance's U.S. insurance company subsidiaries may pay $542 million in dividends to GE Financial Assurance in 2002 without obtaining regulatory approval. See "Insurance Regulation -- General Regulation at State Level."
Structure. The Company's current securitization process uses entities that meet the accounting criteria for Qualifying Special Purpose Entities ("qualifying entities"). Among other criteria, a qualifying entity's activities must be restricted to passive investment in financial assets and issuance of beneficial interests in those assets. Under U.S. GAAP, entities meeting these criteria are not consolidated in the sponsor's financial statements. The Company sells selected financial assets to the qualifying entities. Examples to date have included policy loans and commercial mortgage loans. On the whole, the credit quality of such assets is equal to or higher than the credit quality of similar assets owned by the Company.
The following table summarizes the current balance of assets sold to qualifying entities by the Company.
December 31 (In millions) 2001 2000 ---- ---- Receivables-secured by: Commercial Mortgage Loans $ 492 $ - Other receivables 824 540 ------------- Total receivables $1,316 $540 -------------
Each of the categories of assets shown in the table above represents portfolios of assets that are highly-rated. Examples of each category follow: commercial mortgage loans - loans on diversified commercial property; other receivable - primarily policy loans.
None of these GE Capital sponsored special purpose entities or qualifying entities are permitted to hold GE stock and there are no commitments or guarantees that provide for the potential purchase of GE stock. These entities do not engage in speculative activities of any description and are not used to hedge any GE positions. Under GE integrity policies, no Company employee or an employee of any other GE company is permitted to invest in any GE Capital sponsored or qualifying entity.
Support. Financial support for certain qualifying entities is provided under credit support agreements, in which GE Financial Assurance provides limited recourse for a maximum of $42 million of credit losses in qualifying entities. Assets with credit support are funded by demand notes that are further enhanced with support provided by GE Capital.
Management has extensive experience in evaluating economic, liquidity and credit risk. In view of this experience, the high quality of assets in these qualifying entities, the historically robust quality of commercial paper markets, the historical reliability of controls applied both to asset servicing and to activities in the credit markets, management believes that, under any reasonable future economic developments, the likelihood is remote that any such arrangements could have other than an inconsequential negative effect on the Company's operations, cash flows or financial position.
Accounting outlook. U.S. GAAP specifies the conditions that the Company observes in not consolidating qualifying entities. Accounting for special purpose entities is under review by the Financial Accounting Standards Board, and their non-consolidated status may change as a result of these reviews.
Summary. The special purpose entities described above meet the Company's economic objectives for their use while complying with U.S. GAAP. In the event that accounting rules change in a way that adversely affects sponsored entities, alternative securitization techniques would likely serve as a substitute at insignificant incremental cost.
- -------------------------------------------------------------------------------- ($ In millions) 2002 2003 2004 2005 2006 - -------------------------------------------------------------------------------- Commercial paper $1,463 $ - $ - $ - $ - Other 37 210 32 26 22
Deferred acquisition costs and other intangible assets represent costs that are deferred or assets that are acquired and charged to expense in relation to the anticipated emergence of profits over the estimated lives of the underlying insurance contracts. Other intangible assets include assets acquired in purchase business combinations; principally, PVFP. As of year-end 2001, the Company has $8.9 billion in deferred acquisition costs and other intangible assets. Measurement of amortization expense for both deferred acquisition costs and other intangible assets is based on accepted actuarial methodologies and assumptions about mortality, morbidity, lapse rates and future yield on related investments. Management regularly reviews the potential for changes in these estimates, both positive and negative, and uses the results of these evaluations both to adjust recorded amortization expense and to adjust underwriting criteria, product offerings, and compensation to the various channels of distribution. Further information on these assets is provided in Notes 1, 4 and 5 to the Consolidated Financial Statements.
See Note 1 (p) to the Consolidated Financial Statements for a discussion of recently issued accounting pronouncements.
Consolidated Balance Sheets (Dollar amounts in millions, except per share amounts)
(a) These amounts have been restated to reflect the capital contribution of the Mortgage Insurers to the Company as more fully discussed in Note 1(a).
On June 1, 2001, GE Financial Assurance acquired through a capital contribution made by its sole shareholder, General Electric Capital Corporation ("GE Capital"), all of the outstanding voting securities of the following mortgage insurance companies: General Electric Mortgage Insurance Corporation, General Electric Mortgage Insurance Corporation of North Carolina, Private Residential Mortgage Insurance Corporation, GE Residential Mortgage Insurance Corporation of North Carolina, GE Mortgage Reinsurance Corporation of North Carolina, Sponsored Captive Re, Inc. and Verex Assurance, Inc. (together, the "Mortgage Insurers"). GE Residential Mortgage Insurance Corporation of North Carolina's wholly owned subsidiary, General Electric Home Equity Insurance Corporation of North Carolina, as an asset of its parent, was indirectly contributed.
The contribution was made following the dissolution of GE Capital Mortgage Corporation ("GECMC"), the Mortgage Insurers' former parent company. GECMC was dissolved on June 1, 2001 in a tax-free liquidation under Section 332 of the Internal Revenue Code. In accordance with GECMC's Articles of Dissolution, the Mortgage Insurers, along with other former subsidiaries of GECMC, were distributed to GE Capital, GECMC's sole shareholder. Immediately following receipt of the distribution, GE Capital contributed the Mortgage Insurers to GE Financial Assurance. GE Financial Assurance, in turn, contributed the shares to GE Mortgage Holdings, LLC, a North Carolina limited liability company, of which GE Financial Assurance is the sole member.
Since GE Financial Assurance and the Mortgage Insurers were under control of their common owner, GE Capital, the transaction has been accounted for in a manner similar to a pooling of interests. Accordingly, the Company's Consolidated Financial Statements have been restated for all periods presented to include the results of operations, financial position and cash flows of the Mortgage Insurers as though they had always been a part of GE Financial Assurance.
All of the outstanding common stock of the Company is owned by GE Capital, a wholly-owned subsidiary of General Electric Capital Services, Inc. ("GE Capital Services"), which in turn is wholly-owned, directly or indirectly, by General Electric Company.
The Company's Mortgage Insurance product expands homeownership opportunities by providing coverage on residential first mortgages when individuals purchase homes with less than 20% down payment. Mortgage insurance also facilitates the sale of mortgage loans in the secondary mortgage market, providing increased liquidity to mortgage originators. If the homeowner defaults, mortgage insurance reduces and, in some instances, eliminates the loss to the insured institution.
Investment income is recorded when earned. Realized investment gains and losses are calculated on the basis of specific identification. Premiums on short-duration insurance contracts are reported as revenue over the terms of the related insurance policies. In general, earned premiums are calculated on a pro-rata basis or are recognized in proportion to expected claims. Premiums on long-duration insurance products are recognized as earned when due or, in the case of life contingent immediate annuities, when the contracts are issued. Premiums received under annuity contracts without significant mortality risk and premiums received on universal life products are not reported as revenues but as liabilities for future annuity and contract benefits. Mortgage insurance policies are amortized over the policy life in accordance with the expiration of risk. Surrender fee income consists of charges recognized as income when the policy is surrendered. Policy fees and other income consists primarily of insurance charges made against universal life contracts, club membership revenues, fees assessed against policyholder account values and commission income. Income protection package dues are recognized as income over the membership period. Charges to policyholder accounts for universal life cost of insurance is recognized as revenue when due. Variable product fees are charged to variable annuity and variable life policyholders based upon the daily net assets of the policyholder's account values and are recognized as revenue when charged.
Long-duration contracts - Acquisition costs include first-year commissions in excess of recurring renewal commissions, certain solicitation and printing costs, and certain support costs such as underwriting and policy issue expenses. For investment and universal life type contracts, amortization is based on the present value of anticipated gross profits from investments, interest credited, surrender and other policy charges, and mortality and maintenance expenses. Amortization is adjusted retroactively when current estimates of future gross profits to be realized are revised. For other long-duration insurance contracts, the acquisition costs are amortized in relation to the estimated benefit payments or the present value of expected future premiums.
Income protection packages - Acquisition costs consist primarily of marketing costs and are amortized in proportion to the anticipated revenue to be recognized from club memberships.
Years Ended December 31, 2001, 2000 and 1999 (Dollar amounts in millions)
Present Value of Future Profits - In conjunction with the acquisition of life insurance subsidiaries, a portion of the purchase price is assigned to the right to receive future gross profits arising from existing insurance and investment contracts. This intangible asset, called the present value of future profits ("PVFP"), represents the actuarially determined present value of the projected future cash flows from the acquired policies.
Goodwill - Goodwill is amortized over its estimated period of benefit on the straight-line method. No amortization period exceeds 40 years. Goodwill in excess of associated expected operating cash flows is considered to be impaired and is written down to fair value.
The Company has not established any U.S. deferred income taxes on temporary differences related to the financial statement carrying amounts and tax bases of investments in significant foreign subsidiaries. The Company has elected to permanently reinvest the earnings of its material foreign subsidiaries. The Company's foreign subsidiaries record foreign income taxes in accordance with Statement of Financial Accounting Standards ("SFAS") No. 109 Accounting for Income Taxes.
The separate account assets and liabilities represent funds held, and the related liabilities for, the exclusive benefit of the variable annuity and variable life contract holders. The Company receives mortality risk fees and administration charges from the variable mutual fund portfolios. The separate account assets are carried at fair value and are equal to the liabilities that represent the policyholders' equity in those assets.
Minority interest in and equity of consolidated subsidiaries includes $200 representing 200,000 shares of non-redeemable, cumulative preferred stock and certain ownership interests held by unrelated parties in other consolidated subsidiaries. The preferred stock, issued by a subsidiary to a related party in September 2001, has an annual dividend rate of 7.25%.
At January 1, 2001, the Company's financial statements were adjusted to record a cumulative effect of adopting this accounting change, as follows:
Adjustment to fair value of derivatives (a) $ (23) $ (555) Income tax effects 8 204 -------- ------- Total $ (15) $ (351) ======== =======
The cumulative effect on shareholder's interest was primarily attributable to marking to market currency swap contracts used to hedge non-functional currency investments and swap contracts used to hedge variable-rate borrowings. Decreases in the fair values of these instruments were attributable to declines in interest rates since inception of the hedging arrangement. As a matter of policy, the Company ensures that funding, including the effect of derivatives, of its investment and other financial asset positions are substantially matched in character (e.g., fixed vs. floating) and duration. As a result, declines in the fair values of these effective derivatives are offset by unrecognized gains on the related financing assets and hedged items, and future net earnings will not be subject to volatility arising from interest rate changes.
In November 2000, the Emerging Issues Task Force of the Financial Accounting Standards Board (FASB) reached a consensus on accounting for impairment of retained beneficial interests (EITF 99-20). Under this consensus, impairment of certain beneficial interests in securitized assets must be recognized when (1) the asset's fair value is below its carrying value, and (2) it is probable that there has been an adverse change in estimated cash flows. Previously, impairment on such assets was recognized when the asset's carrying value exceeded estimated cash flows discounted at a risk free rate of return. The effect of adopting EITF 99-20 at January 1, 2001, was not significant to the Company's operating results.
In April 2000, the Company acquired Phoenix American Life Insurance Company, a subsidiary of Phoenix Home Life Mutual Insurance Company for approximately $284. Phoenix American Life Insurance Company, subsequently renamed GE Group Life Assurance Company, provides insurance and administrative services to small companies.
Each of the above referenced acquisitions has been accounted for using the purchase method of accounting and, accordingly, the accompanying consolidated financial statements reflect the corresponding results of operations from the respective dates of acquisition (or date of the Transfer). The Company has reflected its initial allocation of purchase price based on their estimated fair values according to preliminary valuations. Such estimated values may change as additional information is obtained and the valuation is finalized.
Net realized investment gains $ 300 $ 233 $ 232 =====================================
The change in the net unrealized gains (losses) on investment securities reported in the accumulated non-owner changes in equity is as follows:
At December 31, the amortized cost, gross unrealized gains and losses, and fair value of the Company's fixed maturities and equity securities available-for-sale were as follows:
Due in one year or less $ 624 $ 624 Due one year through five years 8,585 8,686 Due five years through ten years 15,092 15,217 Due after ten years 26,412 25,541 ---------------------- Subtotal 50,713 50,068 Mortgage and asset-backed securities 10,685 10,900 ---------------------- Totals $61,398 $60,968 ======================
At December 31, 2001, $9,193 of the Company's investments (excluding mortgage and asset-backed securities) were subject to certain call provisions.
At December 31, 2001, the Company did not hold any fixed maturity securities in any single issuer, other than securities issued or guaranteed by the U.S. government, which exceeded 10% of shareholder's interest.
Agencies and treasuries $ 2,599 4.3% $ 4,076 7.8% AAA/Aaa 11,919 19.5% 9,757 18.6% AA/Aa 8,721 14.3% 6,920 13.2% A/A 16,089 26.4% 12,199 23.3% BBB/Baa 14,072 23.1% 12,212 23.3% BB/Ba 1,446 2.4% 1,500 2.8% B/B 510 0.8% 684 1.3% CCC/Caa 135 0.2% 21 --% Not rated 5,477 9.0% 5,099 9.7% ------------------------------------------- Totals $60,968 100.0% $52,468 100.0% ===========================================
At December 31, 2001 and 2000, there were fixed maturities in default (issuer has missed a coupon payment or entered bankruptcy) with a fair value of $86 and $65, respectively.
At December 31, 2001 and 2000, respectively, the Company held $1,011 and $1,001 in U.S. mortgages secured by real estate in California, comprising 17% and 13% of the total mortgage portfolio. For the years ended December 31, 2001, 2000 and 1999, respectively, the Company originated $237, $267 and $201 of mortgages secured by real estate in California, which represent 22%, 19% and 23% of the Company's total U. S. originations for those years.
As of December 31, 2001 and 2000, the Company was committed to fund $120 and $103, respectively, in U. S. mortgage loans.
As a part of the comprehensive transfer the assets of Toho to GE Edison in March 2000, the Company acquired certain individual and corporate loans having a value of $1,643 and $3,328 at December 31, 2001 and 2000, respectively. The loan portfolio consisted of 89% and 68% of loans to banks, large listed companies, and local or foreign governments at December 31, 2001 and 2000, respectively. Of these loans, 10% and 26% were with Japan's four largest banks at December 31, 2001 and 2000, respectively.
Under these principles, the Company may have two types of "impaired" loans: loans requiring allowances for losses (none as of December 31, 2001 and 2000) and loans expected to be fully recoverable because the carrying amount has been reduced previously through charge-offs or deferral of income recognition ($11 and $12, as of December 31, 2001 and 2000, respectively). Average investment in impaired loans during 2001, 2000 and 1999 was $12, $17 and $15, respectively and interest income recognized on these loans while they were considered impaired was $1, $1 and $3, respectively.
Balance at January 1 $ 164 $ 71 $ 65 Transfers (14) 122 -- Provision (benefit) charged (credited) to operations 9 (26) 7 Amounts written off, net of recoveries (2) (3) (1) Impact of foreign currency translation (13) -- -- ----------------------- Balance at December 31 $ 144 $ 164 $ 71 =======================
At December 31, 2001 and 2000, total unamortized goodwill was $2,421 and $2,464, respectively, which is presented net of accumulated amortization of $506 and $389, respectively. Goodwill amortization was $122, $108, and $88 for the years ended December 31, 2001, 2000 and 1999, respectively.
The effects of reinsurance on premiums written and earned for the years ended December 31 were as follows:
Reinsurance recoveries recognized as a reduction of benefits amounted to $451, $394 and $300 during 2001, 2000 and 1999, respectively.
Investment contracts are broadly defined to include contracts without significant mortality or morbidity risk. Payments received from sales of investment contracts are recognized by providing a liability equal to the current account value of the policyholder's contracts. Interest rates credited to investment contracts are guaranteed for the initial policy term with renewal rates determined as necessary by management.
The following chart summarizes the major assumptions underlying the Company's recorded liabilities for future annuity and contract benefits:
(c) The 1958 and 1980 Commissioner's Standard Ordinary Tables, 1964 modified and 1987 Commissioner's Disability Tables and Company experience.
(e) Interest rate assumptions for the Company's Japanese operations range from 1.5% to 2.4%.
For each of the three years presented above, the change in prior years incurred liabilities primarily relates to positive development in claims incurred but not reported for private passenger automobile insurance. In general, the Company's insurance contracts are not subject to premiums experience adjustments as a result of prior-year effects.
Total long-term borrowings at December 31, 2001 and 2000 were as follows:
Commercial Paper $1,463 1.95% $2,013 6.50% Short term line of credit with GE Capital 285 2.80% 245 6.94% Other 50 46 ------ ------ Total $1,798 $2,304 ====== ======
Borrowings of the Company are addressed as follows from two perspectives - liquidity and interest rate risk management.
A variety of instruments, including interest rate and currency swaps and currency forwards (for further discussion see Note 14), are employed to achieve management's interest rate objectives. Effective interest rates are lower under these "synthetic" positions than could have been achieved by issuing debt directly.
The following table shows the Company's borrowing positions at December 31, 2001 and 2000, considering the effects of swaps.
Statutory U.S. federal income tax rate 35.0% 35.0% 35.0% State income tax, net of federal income tax effect (0.2) (0.1) (0.1) Non-deductible goodwill amortization 1.0 1.0 1.0 Sale of minority interest -- -- (3.5) Tax exempt income (2.7) (2.8) (3.1) Other, net (0.1) (0.8) -- ----------------------- Effective rate 33.0% 32.3% 29.3% =======================
Investments (82) (217) Present value of future profits (464) (376) Deferred acquisition costs (1,135) (629) Statutory contingency reserve (652) (521) Other (87) (142) -------------------- Total deferred income tax liabilities (2,420) (1,885) -------------------- Net deferred income tax liability $ (693) $ (281) ====================
At December 31, 2001 and 2000, long term debt included a note receivable from GE Capital with a balance of $175. This note bears interest at 6.625% and matures in August 2003.
At December 31, 2001 and 2000, long term debt included a note payable to affiliates with a balance of $27. The note bears interest at 2.25% and matures in April 2008. In addition a guarantee fee of 0.50% is being paid annually to GE Capital as guarantor.
Under an agreement with a non-consolidated affiliate, the Company's Mortgage Insurance segment sells properties acquired through claim settlement at a price equal to the property's fair value times an agreed upon price factor. During the years ended 2001 and 2000, proceeds from these transactions were $11 and $17, respectively.
The Company's Mortgage Insurance segment provides primary mortgage insurance coverage and other services to a non-consolidated affiliate. During the years ended 2001, 2000 and 1999, proceeds from these services were $14, $18 and $22, respectively.
The Company is a defendant in various litigation considered to be in the normal course of business. The Company believes that the outcome of such litigation will not have a material effect on its financial position or results of operations.
Information about certain financial instruments that were not carried at fair value at December 31, 2001 and 2000, is summarized as follows:
On January 1, 2001, the Company adopted SFAS 133, Accounting for Derivative Instruments and Hedging Activities, as discussed in Note 1. The paragraphs that follow provide additional information about derivatives and hedging relationships in accordance with SFAS 133.
Cash flow hedges. Under SFAS 133, cash flow hedges are hedges that use simple derivatives to offset the variability of expected future cash flows. Variability can appear in floating rate assets, floating rate liabilities or from certain types of forecasted transactions, and can arise from changes in interest rates or currency exchange rates. For example, the Company often borrows funds at a variable rate of interest. If the Company needs these funds to make a floating rate loan, there is no exposure to interest rate changes, and no hedge is necessary. However, if a fixed rate loan is made, the Company will contractually commit to pay a fixed rate of interest to a counterparty who will pay the Company a variable rate of interest (an "interest rate swap"). This swap will then be designated as a cash flow hedge of the associated variable rate borrowing. If, as would be expected, the derivative is perfectly effective in offsetting variable in the borrowing, change in its fair value are recorded in a separate component of equity and released to earnings contemporaneously with the earnings effects of the hedged item. Further information about hedge effectiveness is provided below.
Adoption of SFAS 133 resulted in a reduction of shareholder's interest of $351 at January 1, 2001. Of that amount $183 was transferred to earnings in 2001 along with the earnings effects of the related forecasted transaction for no net impact on earnings. At December 31, 2001, amounts related to derivatives qualifying as cash flow hedges amounted to a reduction of equity of $168, of which $90 was expected to be transferred to earnings in 2002 along with the earnings effects of the related forecasted transactions in 2002. In 2001, there were no forecasted transactions that failed to occur. At December 31, 2001, the term of derivative instruments hedging forecasted transactions except those related to variable interest on existing financial instruments, was zero.
The Company uses interest rate swaps, currency swaps and interest rate and currency forwards to hedge the effect of interest rate and currency exchange rate changes on local and non functional currency denominated fixed rate borrowings and certain types of fixed rate assets. Equity options are used to hedge price changes in the Company's equity indexed annuity liabilities.
Net investment hedges. The net investment hedge designation under SFAS 133 refers to the use of
derivative contracts or cash instruments to hedge the foreign currency exposure of a net investment in a foreign operation. Currency exposures that result from net investments in affiliates are managed principally by funding assets denominated in local currency with debt denominated in that same currency. In certain circumstances, such exposures are managed using currency forwards and currency swaps.
Derivatives not designated as hedges. SFAS 133 specifies criteria that must be met in order to apply any of the three forms of hedge accounting. For example, hedge accounting is not permitted for hedged items that are marked to market through earnings. The Company uses derivatives to hedge exposures when it makes economic sense to do so, including circumstances in which the hedging relationship does not qualify for hedge accounting as described in the following paragraph. The Company also will occasionally receive derivatives, such as equity warrants, in the ordinary course of business. Under SFAS 133, derivatives that do not qualify for hedge accounting are marked to market through earnings.
The Company uses option contracts, including floors, as an economic hedge of changes in interest rates, currency exchange rates and equity prices on certain types of liabilities. For example, the Company uses equity options to hedge the risk of changes in equity prices embedded in insurance liabilities associated with certain annuity contracts. Although these instruments are considered to be derivatives under SFAS 133, their economic risk is similar to, and managed on the same basis as other equity instruments held by the Company.
Earnings effects of derivatives. The table that follows provides additional information about the earnings effects of derivatives. In the context of hedging relationships, "effectiveness" refers to the degree to which fair value changes in the hedging instrument offset corresponding fair value changes in the hedged item. Certain elements of hedge positions cannot qualify for hedge accounting under SFAS 133 whether effective or not, and must therefore be marked to market through earnings. Time value of purchased options is the most common example of such elements in instruments used by the Company. Earnings effects of such items are shown in the following table as "amounts excluded from the measure of effectiveness."
December 31, 2001 (In millions) Cash flow Fair value hedges hedges --------- ---------- Ineffectiveness...................................... $ 0.3 $ 5.1 Amounts excluded from the measure of effectiveness... - -
December 31, 2000 ----------------------------- Asset (Liabilities) -------------------- Notional Carrying Estimated (in millions) Amount Amount Fair Value ----------------------------- Assets: Integrated interest rate swaps 5,177 $ (53) $ (680) Purchased options 7,200 152 174 Interest rate swaps and futures 3,381 - (25)
Liabilities: Borrowing and related instruments: Interest rate swaps 1,673 - (85) Other firm commitments: Currency forwards 680 - 44
counterparty is reduced to an amount that is within the established limit. All swaps are executed under master swap agreements containing mutual credit downgrade provisions that provide the ability to require assignment or termination in the event either party is downgraded below A3 or A-. If the downgrade provisions had been triggered at December 31, 2001, the Company could have been required to disburse up to $1,167 billion and could have claimed $63 from counterparties -- the net fair value losses and gains. At December 31, 2001 and 2000, gross fair value gains amounted to $157 billion and $232 billion, respectively. At December 31, 2001 and 2000, gross fair value losses amounted to $1,201 billion and $816 billion, respectively.
Except for such positions, all other swaps, purchased options and forwards with contractual maturities longer than one year are conducted within the credit policy constraints provided in the table below. Foreign exchange forwards with contractual maturities shorter than one year must be executed with counterparties having an A-1/ P-1 credit rating and the credit limit for these transactions is $150.
Counterparty credit criteria Credit rating ---------------------- Standard Moody's & Poor's --------- ---------- Term of transaction Between one and five years ....................... Aa3 AA- Greater than five years .......................... Aaa AAA Credit exposure limits Up to $50 million ................................ Aa3 AA- Up to $75 million ................................ Aaa AAA
The NAIC has adopted Risk-Based Capital (RBC) requirements to evaluate the adequacy of statutory capital and surplus in relation to risks associated with: (i) asset risk, (ii) insurance risk, (iii) interest rate risk, and (iv) business risk. The RBC formula is designated as an early warning tool for the states to identify possible under-capitalized companies for the purpose of initiating regulatory action. In the course of operations, the Company periodically monitors the RBC level of each of its insurance subsidiaries. At December 31, 2001 and 2000, each of the Company's insurance subsidiaries exceeded the minimum required RBC levels.
For statutory purposes, the Mortgage Insurers are required to maintain a contingency reserve. Annual additions to the contingency reserve shall equal 50% of earned premiums to be maintained for ten years.
As discussed in Notes 1 and 14 to the consolidated financial statements, the Company changed its method of accounting for derivatives in 2001.
Richmond, Virginia January 15, 2002, except for Note 18 which is dated February 2, 2002