The Company owns, and the Insurance Company leases and is the sole occupant of, two adjacent office buildings located at 69 Lydecker Street and 10 North Broadway in Nyack, New York. These buildings contain an aggregate of approximately 45,000 square feet of usable office space.
Our earnings per share were $1.32 for 2011, as compared to $.73 in 2010 and $.17 in 2009. Net income in 2011 was $38.9 million as compared to $21.5 million in 2010 and $4.9 million in 2009. The increase in net income of $.59 per share or $17.4 million for full year 2011 relative to 2010 is principally due to: i) an increase in realized gains, net of OTTI, of $8.4 million, including, among other items, a $17.0 million increase in gains from hedge fund redemptions within our limited partnership portfolio partially offset by an increase in other-than-temporary impairments of $8.9 million; ii) an increase in equity in earnings on limited partnerships accounted for under the equity method of $7.7 million; and iii) the favorable effect of a decrease in the effective tax rate from 38.1% in 2010 to 30.4% in 2011 related to a reduction in liabilities for tax uncertainties in 2011 and a directional change in the effect of true-ups of prior year provisions to returns. Consistent with our strategic plan, during 2011 and 2010, we have sold the hedge fund investments within our limited partnerships portfolio that had redemption rights. Therefore, related gains of $27.7 and $10.7 million in 2011 and 2010, respectively, are not expected to recur in the future. Our total revenues in 2011 were $267.4 million, compared to $297.0 million in 2010 and $247.8 million in 2009. Benefits and expenses in 2011 were $211.6 million, compared to $262.2 million in 2010 and $246.8 million in 2009.
2. Market Conditions. Like all companies, we are affected by the general state of financial markets and economic conditions especially in the U.S. and Europe. The Fed’s recent announcement that it will hold the Fed Funds Rate at .25% until the end of 2014 will significantly challenge us in obtaining desired investment returns.
4. Operational Risk. Our business is dependent on our ability to process, on a daily basis, our payment obligations under outstanding policies and the condition of the investment portfolio. Any failures in our internal processes, personnel or systems could lead to material, adverse consequences. In addition, despite the contingency plans in place, the ability to conduct business may be adversely impacted by a significant disruption in the infrastructure that supports our business and the community in which we are located.
3Net investment income (loss) divided by average cash and total invested assets, based on book value (including accrued investment income).
Our principal goal in managing our investment portfolio is to meet the diversification, yield and liquidity requirements of our insurance policy and annuity contract obligations. Our liquidity requirements are monitored regularly so that cash flow needs are satisfied. Adjustments periodically are made to our investment policies to reflect changes in our short-and long-term cash needs, as well as changing business and economic conditions.
As of December 31, 2011 and 2010, approximately 4.4% and 5.3%, respectively, of our total invested assets were invested in limited partnerships and equity securities. See “Note 2 to the Notes to Consolidated Financial Statements.” As of December 31, 2011, we were committed, if called upon during a specified period, to contribute an aggregate of approximately $41.7 million of additional capital to certain of these limited partnerships. Commitments of $40.6 million are expected to be called or expire in 2012 and $1.1 million in 2013. Based on historical experience, we believe that it is likely that no more than 75% of the maximum commitment will be called. 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. With the exception of hedge funds, these risks are mitigated by our ability to receive quarterly distributions of partnership earnings. During 2011, we redeemed our two hedge fund investments with redemption rights, resulting in proceeds of $40.5 million and a realized gain of $27.7 million, assuming we receive 100% of the $3.1 million holdback amount subject to an annual audit. In 2010, gains on hedge fund redemptions were $10.7 million. At December 31, 2011, our remaining hedge fund investments had a carrying value of $7.8 million, including unrealized gains of $2.6 million.
Approximately $39.5 million or 24% of the limited partnership portfolio is invested in restructuring funds. Approximately 81% of the funds invested in this segment are in four partnerships that are managed by two different general partners, each of which have significant experience in distressed debt investing. These general partners seek to invest in situations that reflect a significant discount to underlying collateral value or enterprise value, or both, with the intent of recovering substantial premiums to acquisition prices. A common element to each general partner’s approach is to identify good companies with weak balance sheets through a rigorous fundamental analysis of each individual investment, combined with an emphasis on the acquisition of securities in the upper part of the capital structure.
The primary market risks in our investment portfolio are interest rate risk, credit risk and market valuation risk. Changes in credit risk are generally measured by changes in corporate yields in relation to the underlying Treasuries or corporate spreads as well as changes in the Credit Default Swap or CDS market, although we are a cash investor and do not buy or sell credit default swaps. Our exposure to foreign exchange risk is insignificant. We have no direct commodity risk. Changes in interest rates can potentially impact our profitability. In certain scenarios where interest rates are volatile, we could be exposed to disintermediation risk (asset/liability mismatch) and reduction in net interest rate spread or profit margin. See “Interest Rate Risk” above.
The following table presents fair value and gross unrealized losses for fixed maturities and common stock where the estimated fair value had declined and remained below amortized cost at December 31, 2011:
As of December 31, 2011, we had 149 securities in a net unrealized loss position. Of this total, 131 are bonds, 17 are preferred stocks and 1 is common stock.
The following table presents the fair value and gross unrealized losses for fixed maturities and common stock where the estimated fair value had declined and remained below amortized cost at December 31, 2010:
The predominant investment category for our investments is the “corporate bond” category (including public utilities), which totaled $2.9 billion at December 31, 2011. Unrealized losses on corporate bonds decreased from $32.0 million at December 31, 2010 to $17.9 million at December 31, 2011. The five largest loss positions at December 31, 2011 consisted of the following holdings:
The Insurance Company prepares its statutory financial statements in accordance with accounting practices prescribed by the NYDFS. Prescribed SAP include state laws, regulations and general administrative rules, as well as a variety of publications from the NAIC. Accounting principles used to prepare statutory financial statements differ from financial statements prepared on the basis of GAAP. See Item 1 - “Business, Insurance Regulation, Statutory Reporting Practices”. A reconciliation of the Insurance Company’s net income as filed with regulatory authorities to net income reported in the accompanying financial statements for the years ended December 31, 2011, 2010 and 2009, is set forth in the following table:
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, 2011 and 2010 is set forth in the following table:
Ratings are an important factor in establishing the competitive position in the insurance and financial services marketplace. There can be no assurance that our ratings will continue for any given period of time or that they will not be changed. In the event the ratings are downgraded, the level of revenues or the prospects of our business may be adversely impacted.
In June 2011, the A.M. Best Company upgraded the financial strength rating of the Insurance Company to “B++” (Good) from “B+” (Good) and upgraded the issuer credit rating, or ICR, to “bbb” (Good) from “bbb-“ (Good) of the Insurance Company and upgraded the ICR to “bb” from “bb-“ of Presidential Life Corporation. The ratings have been assigned 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.
Total annuity considerations and life and health insurance premiums decreased to approximately $29.2 million in 2011 from approximately $70.5 million in 2010, a decrease of approximately 58.6%, and increased from approximately $55.6 million in 2009 to $70.5 million in 2010, an increase of approximately 26.8%. Life insurance premiums were $19.6 million, $19.3 million and $16.1 million in 2011, 2010 and 2009, respectively. Annuity considerations decreased to approximately $9.6 million in 2011 from approximately $51.2 million in 2010, a decrease of approximately $41.6 million, and increased from approximately $39.4 million in 2009 to $51.2 million in 2010, an increase of approximately $11.8 million. These amounts do not include consideration from the sales of deferred annuities or immediate annuities without life contingencies. Under GAAP, such sales are reported as additions to policyholder account balances. Consideration from such sales was approximately $53.5 million, $82.2 million and $185.9 million in 2011, 2010 and 2009, respectively.
Over the last year the continued low interest rate environment directly affected our new annuity sales. In 2011, total annuity sales decreased to $ 63.1 million. Fixed interest rates have hit their lowest levels in decades and have remained at those levels. As a direct result, the sale of fixed rate annuities continues to be severely hampered.
The sales team continues to work with our general agent distribution channel to foster new sales. Life premiums, including universal life deposits not reflected as premium for GAAP were $21.7 million and $20.1 million in 2011 and 2010, respectively, representing an increase of $1.6 million or 8.0%. The independent agent marketplace continues to be our major source of distribution.
Universal life and investment type policy fee income totaled $3.5 million, $2.1 million and $2.1 million in fiscal years 2011, 2010 and 2009, respectively. Revenues from universal life and investment-type contracts consist of amounts assessed against policyholder account balances for mortality, policy administration and surrender charges and are recorded in universal life and investment-type product policy fees in the appropriate period. The increase in 2011 is primarily due to a contractual charge levied on single premium universal life policies in 2011 that had been waived in previous years, which totaled $1.5 million in 2011.
Net investment income and equity in earnings/losses on limited partnerships totaled $196.4 million in 2011, as compared to $193.1 million in 2010 and $197.8 million in 2009. This represents a 1.7% increase comparing 2011 to 2010 and a 2.4% decrease comparing 2010 to 2009. The increase in 2011 was due to greater equity in earnings on our limited partnership portfolio of $7.6 million partially offset by a decline in net investment income of $4.3 million due primarily to the effect of low interest rates on new business as well as the reinvestment of bond maturities and, to a lesser extent, a slightly reduced asset base from negative operating cash flows given low annuity sales in 2011 and increase in investment expense allocation. The decrease in 2010 was largely due to equity in losses on our limited partnership portfolio.
Net investment income was $194.3 million, $198.6 million, and $197.9 million for 2011, 2010, and 2009, respectively. The decline in net investment income of $4.3 million in 2011 relative to 2010 is primarily due to the effect of lower interest rates on new annuities relative to maturing annuities as well as lower reinvestment rates related to bond maturities and, to lesser extent, an increase in investment expenses in 2011 relative to 2010 and slightly reduced asset base from negative operating cash flows given low annuity sales in 2011.
Realized gains from limited partnerships accounted for under the fair value method, depicted in the above table, tend to fluctuate from period-to-period as distributions in the portfolio are not uniform. The increase in such realized gains in 2011 and 2010 is primarily due to realized gains from hedge fund redemptions, which increased by $17.0 million in 2011 relative to 2010 and $10.7 million in 2010 relative to 2009. Similarly, for both fixed maturities and limited partnerships accounted for under the fair value method, the recognition of OTTI losses is not uniform from period to period primarily due to the impact of economic conditions and on valuations as evidenced by the high volume of OTTI write-downs in 2009. The timing of OTTI recognition on limited partnerships accounted for under the fair value method can also be affected by the changing status of a limited partnership position for which unrealized gains and losses change after each distribution. The large decrease in fair value from derivatives in 2011 is due to the purchase of payor swaptions at the end of 2010 (which were purchased to protect against a large increase in interest rates) and the effect of the decline in interest rates between the purchase date and December 31, 2011.
There can be no assurance that our investment spread will not decline in future periods or that such decline will not have a material adverse effect on our financial condition and results of operations. Depending, in part, upon competitive factors affecting the industry in general, and us, in particular, we may, from time to time, change the average credited rates on certain of our products. There can be no assurance that we will be able to reduce such rates or that any such reductions will broaden the spread.
The change in the DAC resulted in charges of $6.3 million, $5.3 million and $1.0 million for 2011, 2010 and 2009, respectively. Changes in DAC consist of three elements: deferred costs associated with product sales, amortization of the DAC on deferred annuity business and amortization of the DAC on the remainder of our business is summarized below:
As a result of the factors and results discussed above, we had net income of approximately $ 38.9 million in 2011, as compared to $ 21.5 million in 2010 and $ 4.9 million in 2009.
We are an insurance holding company and our primary uses of cash are operating expenses and dividend payments. Our principal sources of cash are sales of and interest on our investments, rent from our real estate and dividends from the Insurance Company. During 2011, 2010 and 2009, we did not repurchase any of our common stock, although at December 31, 2011, we were authorized to purchase approximately 385,000 shares of common stock.
The Insurance Company is subject to various regulatory restrictions on the maximum amount of payments, including loans, dividends or cash advances, that it may make to us without obtaining prior regulatory approval. Under the New York Insurance Law, the Insurance Company is permitted, without prior insurance regulatory clearance, to pay a dividend to us as long as the aggregate amount of all such dividends in any calendar year does not exceed the lesser of (i) 10% of its statutory surplus as of the immediately preceding calendar year or (ii) its statutory net gain from operations for the immediately preceding calendar year (after tax, excluding realized capital gains and losses). The Insurance Company will only be permitted to pay a dividend to us in excess of that amount if it files notice of its intention to declare such a dividend and the amount thereof with the Superintendent and the Superintendent does not disapprove the distribution. The Insurance Company paid $26.9 million, $23.0 million and $24.8 million in dividends to us in fiscal 2011, 2010 and 2009, respectively. In 2012, the Insurance Company would be permitted to pay a stockholder dividend of up to $34.3 million to us without prior regulatory clearance. On a going forward basis, there can be no assurance that the Insurance Company will have sufficient statutory earnings to fund its cash requirements and pay cash dividends or that the Superintendent will not disapprove any dividends that the Insurance Company must submit for the Superintendent’s consideration.
The Insurance Company can potentially be forced to sell fixed maturity investments prior to maturity during a period of significant net cash outflows that exceeds cash and short-term investments held. Such a situation can be the result of annuity surrenders and partial withdrawals, net of surrender charges, exceeding proceeds from new annuity business. This risk is evident in a period of low sales volume or high surrender volume. During a period of low sales volume of deferred annuities caused by low interest rates as in 2011, this risk is mitigated since the fair value of fixed maturities rise as interest rates are lowered and the level of surrenders and partial withdrawals tend to be low. This risk tends to be greatest during periods of rising interest rates when surrenders and partial withdrawals are apt to increase and the fair value of fixed maturities are reduced thereby creating the risk that fixed maturity investments must be sold at a loss. To mitigate this risk, we entered into payor swaptions at the end of 2010. When interest rates rise, the value of these derivatives rise and may be sold to partially offset losses from the sale of fixed maturity investments prior to maturity. For a further discussion regarding interest rate risk, refer to the sections to follow on “Market Risk” and “Effects of Inflation on Interest Rate Risk”.
Principal sources of funds at the Insurance Company are premiums and other considerations paid, net investment income received and proceeds from investments called, redeemed or sold. The principal uses of these funds are the payment of benefits on annuity contracts and life insurance policies (including withdrawals and surrender payments), the payment of policy acquisition costs, operating expenses and the purchase of investments (including funding commitments on our limited partnerships).
· Public or private offerings of common stock, preferred stock or other securities.
Market risk is the risk of loss arising from adverse changes in market rates and prices, such as interest rates, foreign currency exchange rates and other relevant market rate or price changes. Market risk is directly influenced by the volatility and liquidity in the markets in which the related underlying assets are traded. We believe our primary market risk exposure is interest rate risk.
In December 2010, we executed a new series of payor swaptions expiring in January 2015, 2016 and 2017 for a total consideration of $9,975,000. The counterparties were two major U.S. money center banks rated Aaa/AAA and Aa1/AA- by Moody’s and Standard & Poor’s, respectively. Total notional value of the swaptions is $221,500,000 and is designed to cover approximately ½ of the potential portfolio loss in the event of a 500 basis point rise in interest rates from current levels.
We have not entered into any off-balance sheet financing arrangements and have made no financial commitments or guarantees with any unconsolidated subsidiary or special purpose entity. All of our subsidiaries are wholly owned and their results are included in the accompanying consolidated financial statements.
In a rising interest rate environment, our average cost of funds would be expected to increase over time, as we price our new and renewing annuities to maintain a generally competitive market rate. In addition, the market value of our fixed maturity portfolio would be expected to decrease, resulting in a decline in shareholders' equity. Concurrently, we would attempt to place new funds in investments that were matched in duration to, and higher yielding than, the liabilities associated with such annuities. Moreover, surrenders of our outstanding annuities would likely accelerate. Management believes that liquidity necessary in such an interest rate environment to fund withdrawals, including surrenders, would be available through income, cash flow, our cash reserves and, if necessary, proceeds from the monetization of the payor swaption investments described above and the sale of short-term and long-term investments.
Interest rate changes also may have temporary effects on the sale and profitability of our annuity products. For example, if interest rates rise, competing investments (such as annuity or life insurance products offered by our competitors, certificates of deposit, mutual funds and similar instruments) may become more attractive to potential purchasers of our products until we increase the rates credited to holders of our annuity products. In contrast, as interest rates fall, we would attempt to lower our credited rates to compensate for the corresponding decline in net investment income. As a result, changes in interest rates could materially adversely affect our financial condition and results of operations depending on the attractiveness of alternative investments available to our customers. In that regard, in the current interest rate environment, we have attempted to maintain our credited rates at competitive levels designed to discourage surrenders and also to be considered attractive to purchasers of new annuity products.
We define fair value as the price that would be received to sell an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. In many cases, the exit price and the transaction (or entry) price will be the same at initial recognition. However, in certain cases, the transaction price may not represent fair value. It requires that fair value be a market-based measurement in which the fair value is determined based on a hypothetical transaction at the measurement date, considered from the perspective of a market participant. When quoted prices are not used to determine fair value, we consider three broad valuation techniques: (i) the market approach, (ii) the income approach and (iii) the cost approach. We determine the most appropriate valuation technique to use, given what is being measured and the availability of sufficient inputs. We prioritize the inputs to fair valuation techniques and allow for the use of unobservable inputs to the extent that observable inputs are not available. We categorize our assets and liabilities measured at estimated fair value into a three-level hierarchy, based on the priority of the inputs to the respective valuation technique. The fair value hierarchy gives the highest priority to quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). An asset or liability’s classification within the fair value hierarchy is based on the lowest level of input to its valuation. The input levels are as follows:
Unobservable inputs that are supported by little or no market activity and are significant to the estimated fair value of the assets or liabilities. Unobservable inputs reflect the reporting entity’s own assumptions about the assumptions that market participants would use in pricing the asset or liability. Level 3 assets and liabilities include financial instruments whose values are determined using pricing models, discounted cash flow methodologies or similar techniques, as well as instruments for which the determination of estimated fair value requires significant management judgment or estimation.
Our 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. Credit losses may occur from either defaults or the sale of a security in an unrealized loss position. A critical judgment affecting income is the timing and measurement of investment losses through the recognition of other than temporary impairments. When assessing our intent to sell a fixed maturity security or if it is more likely than not that we will be required to sell a fixed maturity security before recovery of its cost basis, we evaluate facts and circumstances such as, but not limited to, decisions to reposition our security portfolio and sale of securities to meet cash flow needs.
¨ Length of time and extent to which the fair value has been less than amortized cost;
¨ Failure, if any, of the issuer of the security to make scheduled payments; and
¨ Recoveries or additional declines in fair value subsequent to the balance sheet date.
The timing of OTTI recognition on limited partnerships accounted for under the fair value method can also be affected by the changing status of a limited partnership position whereby the nature of remaining unrealized gains and losses within the investment portfolio of a limited partnership are apt to change after each distribution, particularly large distributions often made near the close date of the fund.
Generally, we do not maintain a sufficient ownership or voting interest in limited partnerships whereby we must make a judgment regarding consolidation. We apply the equity method of accounting consistent with FASB Accounting Standards Codification (“ASC”) 323, Investments - Equity Method and Joint Ventures, to limited partnerships in which we hold either (a) a five percent or greater interest or (b) less than a five percent interest, but with respect to which partnership we have more than virtually no influence over the operating or financial policies of the limited partnership. We consider certain qualitative factors in assessing whether we have more than virtually no influence for partnership interests of less than five percent. In particular, we consider whether or not we maintain a voting interest sufficient to exercise more than virtually no influence. For this purpose, participation in an advisory committee with decision-making responsibilities is considered influence over the limited partnership.
We record realized and unrealized earnings (or losses) of the limited partnerships accounted for under the equity method in net income each period and classify such income in one line, equity in earnings (losses) on limited partnerships. Generally, we record our share of earnings using a three month lag. We apply the fair value method of accounting consistent with ASC 944, Financial Services-Insurance, to those limited partnerships in which we hold less than a five percent interest and do not have more than virtually no influence over the operating or financial policies of the limited partnership. We recognize the unrealized change in fair value of a limited partnership interest accounted for under the fair value method as a component of equity (other comprehensive income or loss) each period. Generally, we record unrealized changes in fair value using a three month lag. We recognize cash distributions from the limited partnerships accounted for under the fair value method as either a return on capital in earnings or a return of capital that reduces the investment’s carrying amount. This distinction is based on whether the cash distribution represents earnings or loss of the investee, or a return of our investment. A cash receipt that does not represent earnings (or loss) of the investee is treated as a return of capital, which we record as a reduction of the basis in the investment, rather than as a credit (or charge) to the income statement. Earnings from distributions are classified as realized capital gains or losses in earnings each period.
Premiums from traditional life and annuity contracts with life contingencies are recognized as income over the premium-paying period. Benefits and expenses are matched with such income so as to result in the recognition of profits over the life of the contracts. This matching is accomplished by means of provision for liabilities for future policy benefits and the deferral and subsequent amortization of policy acquisition costs.
For contracts with a single premium or a limited number of premium payments due over a significantly shorter period than the total period over which benefits are provided (“limited payment contracts”), premiums are recorded as income when due with any excess profit deferred and recognized in income in a constant relationship to insurance in force or, for annuities, the amount of expected future benefit payments.
Premiums from universal life and investment-type contracts are reported as deposits to policyholders’ account balances. Revenues from universal life and investment-type contracts consist of amounts assessed against policyholder account balances for mortality, policy administration fees and surrender charges and are recorded in universal life and investment-type product policy fees in the period in which services are provided. Policy benefits and claims that are charged to expense include benefit claims incurred in the period in excess of related policyholders’ account balances and interest credited to policyholders’ account balances.
The Insurance Company establishes a liability for future policy benefits for amounts payable under annuity contracts with life contingencies as well as life and health insurance policies. Generally, these amounts are payable over a long period of time and the profitability of the products is dependent on the pricing. Principal assumptions used in pricing policies and in the establishment of liabilities for future policy benefits are investment returns, mortality, expenses and persistency.
The reserves reflected in our consolidated financial statements included herein are calculated based on GAAP and differ from those specified by the laws of the various states in which the Insurance Company does business and those reflected in the Insurance Company's statutory financial statements. These differences arise from the use of different mortality and morbidity tables and interest rate assumptions, the introduction of lapse assumptions into the reserve calculation and the use of the net level premium reserve method on all insurance business. See “Notes 1H and 1I to the Notes to the Consolidated Financial Statements.”
For our investment-type products, such as deferred annuities and universal life, where the policy benefit reserve reported is the account balance ($2,323.4 million), a change in expected experience would have no effect on the policy benefit reserve.