Erie Family Life Insurance Company (the Company) is a Pennsylvania life insurance company operating as one reportable segment, offering a range of products and services. These products include nonparticipating individual and group life insurance policies, including fixed universal life. The Company also sells fixed individual and group annuities. The Company markets its products through independent agents throughout 10 states and the District of Columbia. The Company is owned 21.6% by Erie Indemnity Company (EIC), 53.5% by Erie Insurance Exchange (Exchange) and the remaining 24.9% by public shareholders. The Company, EIC and the Exchange and their subsidiaries operate collectively under the name “Erie Insurance Group.”
During 2004, the Company identified a weakness in its internal control over the information systems and processes used to determine actuarially-determined financial statement amounts. The Company undertook a series of initiatives during 2005 to correct this material weakness, including the implementation of improved technologies. As a result, the Company recorded several accounting adjustments related to the remediation of these systems and processes that were determined to be changes in accounting estimates or corrections of errors. The following is a summary of the corrections and changes in estimates made in 2005:
The Company’s profitability depends principally on the ability to develop, price and distribute insurance products, the ability to attract and retain deposit funds, the ability to generate investment returns and the ability to manage expenses. Specific drivers of the Company’s profitability include:
Pricing insurance products at a level enabling the Company to earn a margin over the cost of providing benefits;
Mortality and morbidity experience on individual and group life insurance and annuity products;
Returns on investments, including maintaining interest rate spreads over the amounts credited to deposit funds.
For every investment, a decline in fair value below cost is evaluated monthly for other-than-temporary impairment loss. Some factors considered in evaluating whether or not a decline in fair value is other-than-temporary include: 1) the extent and duration to which fair value is less than cost, 2) historical operating
performance and financial condition of the issuer, 3) near term prospects of the issuer and its industry based on analysts’ recommendations, 4) specific events that occurred affecting the issuer, including a credit downgrade, and 5) the Company’s ability and intent to retain the investment for a period of time sufficient to allow for a recovery in value. An investment deemed impaired is written down to its estimated net realizable value. Impairment charges are included as a realized loss in the Statements of Operations. See Note 2 to the Company’s financial statements for a discussion on recently released Emerging Issues Task Force guidance related to other-than-temporary impairments.
The expense study has shown that due to a combination of decreased sales, non-recurring one-time costs, and increases in operating expenses, unit costs increased substantially from 2003 to 2004. The Company is attempting to lower these unit costs. Maintenance costs have increased in part due to increases in operating expenses that outpaced growth in policies in force.
The Company’s yield on new investments decreased in 2004 and increased slightly in 2005. Interest credited to annuity policyholders has also been adjusted within contractual limits, thereby maintaining the Company’s investment spread on the FAS 97 products. For traditional products, FAS 60 does not allow a change of interest rate spread assumptions, which are set at issue.
FAS 60 contracts are subject to loss recognition testing. The Company periodically verifies the adequacy of reserves as part of its loss recognition testing. There are two types of loss recognition testing: primary (FAS 60) and shadow (FAS 115). Primary loss recognition adjustments decrease DAC
The Company incurs significant costs in connection with acquiring new business, principally commissions and policy issue and underwriting expenses. Acquisition costs, which vary with and are primarily related to the production of new business, are deferred as an asset and amortized over a period of time. At each balance sheet date, the Company evaluates the value of this asset in light of historical and expected results.
The DAC related to traditional life insurance products is amortized in proportion to premiums over the premium-paying period of related policies using assumptions consistent with those used in computing policy liability reserves. Assumptions used for a specific era of issued policies are “locked-in;” therefore, future amortization in subsequent years is not adjusted for changing assumptions. In any period where the Company’s actual policy terminations are higher (lower) than anticipated policy terminations, DAC amortization will be accelerated (decelerated) in that period.
The Company periodically reviews the DAC asset to determine if it continues to be recoverable. For traditional life products, if the benefit reserves plus anticipated future premiums and interest earnings for a line of business are less than the current estimate of future benefits and expenses (including any unamortized DAC), a charge to income is recorded for additional DAC amortization or for increased benefit reserves. For universal life and deferred annuities, if the current present value of future expected gross profits is less than the unamortized DAC, a charge to income is recorded for additional DAC amortization.
See Note 2 of the Notes to Financial Statements for a discussion of recently issued accounting pronouncements.
Net premiums include primarily traditional life, universal life and group life insurance premiums.
Premiums on traditional life insurance policies for the years ended December 31, were:
Ceded renewal reinsurance premiums as a percentage of direct renewal premiums were 32.9%, 30.5% and 23.4% in 2005, 2004 and 2003, respectively. During 2004, the Company recorded corrections to its ceded reinsurance and reinsurance allowance accounts as a result of reinsurance administration and accounting errors. Corrections recorded to its ceded reinsurance accounts in 2004 relating to years prior to 2004 increased ceded renewal premiums by $1.5 million. The 2004 renewal ceded reinsurance premiums as a percentage of direct renewal premiums, excluding the $1.5 million adjustment, was 27.5%. These increases are in line with the Company’s renewal business as more renewal business comes from products that are 50% to 90% reinsured. Total reinsurance premiums ceded on the Flagship and Target Term life insurance products alone amounted to $20.8 million, $18.1 million and $12.8 million in 2005, 2004 and 2003, respectively.
Total annuity and universal life deposits, which do not appear as revenue on the Statements of Operations, were $96.7 million, $90.9 million, $157.5 million and $187.7 million in 2005, 2004, 2003 and 2002, respectively. The large deposits in 2002 and 2003 were primarily from first-year and single premium annuity deposits, excluding deposits for structured settlements and deposits for the Erie Insurance Group Retirement Plan, which were $45.2 million, $31.8 million, $100.7 million, and $140.6 million in 2005, 2004, 2003 and 2002, respectively. The large increases in first year and single premium annuity deposits in 2002 and 2003 were a result of volatile equity market conditions and the Company’s favorable annuity interest rates relative to alternative investments. If such deposits had continued at levels experienced in 2002 and 2003, the Company would have experienced substantial statutory capital strain and greater exposure to interest rate risk. Changes in guaranteed and credited interest rates on annuities in 2003 were designed to maintain the Company’s target spreads, reduce interest rate risk and moderate deposit flows to historic levels providing a capital efficient balance between life and annuity products. Effective August 2005, the Company began offering a new annuity product - ERIE Flagship Annuity. Because this new product uses a “New Money” interest rate method and has other attractive provisions, the Company expects this product to remain competitive in the market place.
Net investment income increased $4.3 million, or 5.3%, in 2005 and $1.9 million, or 2.4%, in 2004. Investment income on fixed maturity holdings increased $3.4 million or 4.5% in 2005 similarly, holdings in fixed maturity securities increased $52.8 million, or $4.1%. Investment income on equity securities, specifically nonredeemable preferred stock, increased $0.4 million, or 8.4%. Nonredeemable preferred stock holdings increased $19.5 million or 32.6% during the same time period. The Company also received $0.2 million in past due interest payments in 2005 on a fixed maturity holding that was previously in default.
The Company’s equity in earnings of limited partnerships increased to $3.5 million in 2005, from $2.1 million in 2004. Included in the 2005 limited partnership earnings are $1.3 million in unrealized gains recognized by the Company from its investments in partnerships. Until 2005, the Company did not account
for unrealized gains/losses from limited partnerships earnings in determining net income but did reflect the unrealized gains/losses in shareholders’ equity. A $0.2 million adjustment was made by the Company during 2005 to correct its recognition of partnership unrealized gains and losses related to 2004 and prior years. While there was an earnings impact related to this correction, there was no impact to the Company’s total shareholders’ equity. There were no impairment charges on limited partnerships in 2004. In 2003, the Company recognized impairment charges of $2.0 million relating to mezzanine debt partnerships.
Surrender and other benefits decreased by $1.9 million to $1.4 million in 2005 and increased by $2.0 million in 2004. Included in surrender and other benefits in 2004 were charges related to the PEGLI pool. PEGLI is a reinsurance pool that provides reinsurance coverage to primary insurers who insure Commonwealth of Pennsylvania employees upon their retirement. The Company was a participant in this pool for a number of years. Beginning July 1, 2001, the Company stopped receiving new business from the PEGLI pool. The Company continued carrying a balance on the Statements of Financial Position for its share of the assets and liabilities of the PEGLI pool. However, due to the Company’s inability to obtain reliable information to verify the recoverability of the $2.0 million net asset, the Company wrote off the net asset in 2004.
The amortization of deferred policy acquisition costs amounted to $8.6 million in 2005 compared to $0.8 million in 2004 and $7.5 million in 2003.
As shown in the table included in the “Financial Overview” section, the valuation system conversion impacted the DAC amortization. For the FAS 60 products, the Company’s estimate of the DAC asset changed as a result of implementing the new valuation system, which resulted in additional DAC amortization during the third quarter of 2005 of $1.1 million.
For the FAS 97 products, DAC amortization decreased by $1.0 million as a result of implementing the new valuation system, resulting in an increase in pre-tax income during the fourth quarter of 2005, or $0.07 per share after taxes. Included in the $1.0 million decrease in amortization related to FAS 97 products, is a $2.0 million decrease in amortization on annuity products offset by a $1.0 million increase in amortization on universal life products.
Future Life Policy Benefit liabilities for limited-pay traditional life policies, specifically an unearned profit reserve in accordance with FAS 97 and a maintenance expense reserve. The Company also used updated mortality rates, lapse rates, interest rates, and expense factors, developed from recent experience studies in estimating the liability for traditional life policies issued in 2005. Differences in liability estimates between the new and old valuation systems, including changes in assumptions, resulted in a $2.5 million pretax charge to the Company’s net income, or $0.17 per share after taxes. These changes were all related to FAS 60 products.
Also included in the 2005 net increase in future life policy benefits is a $0.7 million charge related to a correction of an error in the determination of reinsurance reserve credits during the first quarter on traditional life business. The prior calculation method overstated the amount of such credits for certain policy types due to an error in determining the inventory of policies qualifying for such credits.
The 2004 future life policy benefits expense was reduced by $0.8 million as a result of corrections relating to reinsurance administration and accounting errors. Corrections of $0.6 million recorded in 2004 pertained to years prior to 2004.
Commissions to independent agents include new and renewal commissions, production bonuses and promotional incentives. These commission expenses are reported on the Statements of Operations net of commissions received from reinsurers. The reported expense is also affected by the amount of commission expenses capitalized as DAC. Commissions, which vary with and are related primarily to the production of new business, are deferrable as DAC. Most first-year and incentive commissions and some renewal commissions qualify for deferral as DAC.
At December 31, 2005, the Company’s investment in fixed maturities totaled $1.4 billion, or 92.0%, of total investments. These resources provide the liquidity the Company requires to meet known and unforeseen demands on its funds.
The Company’s performance of its fixed maturities and preferred stock compared to market indices is presented below.
Company’s portfolio are rated by external rating agencies. If not externally rated, they are rated by the Company on a basis consistent with the basis used by the rating agencies.
Management believes that having all fixed maturities classified as available-for-sale securities will allow the Company to meet its liquidity needs and provide greater flexibility for its investment managers to respond to changes in market conditions or strategic direction. Securities classified as available-for-sale are carried at market value with unrealized gains and losses included in shareholders’ equity net of deferred taxes and offsetting adjustments to DAC and life contingent payout annuities. As of December 31, 2005 and 2004, net unrealized gains on fixed maturities amounted to $18.5 million and $44.8 million, respectively, net of deferred taxes.
Equity securities at December 31, 2005, consist of nonredeemable preferred stock carried on the Statements of Financial Position at market value. As of December 31, 2005 and 2004, nonredeemable preferred stock held by the Company had net unrealized gains of $3.7 million and $4.5 million, respectively, net of deferred taxes. As with the fixed maturities portfolio, the Company’s nonredeemable preferred stock portfolio provides a source of highly predictable current income. These securities are diversified within each market sector and support the investment return provided to policyholders. The nonredeemable preferred stock consist entirely of high quality positions rated investment-grade level (above Ba1/BB+) at December 31, 2005.
The Company’s primary commitment is its obligation to pay future policy benefits under the terms of its life insurance and annuity contracts. To meet these future obligations, the Company establishes life insurance reserves based upon the type of policy, the age, gender and risk class of the insured and the number of years the policy has been in force. The Company also establishes annuity and universal life reserves based on the amount of policyholder deposits (less applicable insurance and expense charges) plus interest earned on those deposits. Life insurance and annuity reserves are supported primarily by the Company’s long-term, fixed income investments as the underlying policy reserves are generally also of a long-term nature.
Another net source of funds from financing in 2005 was the issuance of a $20 million surplus note to the Exchange and the payoff of a $15 million surplus note to EIC. This improved the risk-based capital position of the Company for rating agency purposes.
Interest rate fluctuations can affect the timing of cash flows associated with the insurance and annuity liabilities as well as the value of the assets supporting these obligations. Changes in interest rates and other market conditions can also expose the Company to the risk of accelerated surrenders as policyholders and contract holders are attracted to alternative products. The Company seeks to maintain an appropriate match between assets and liabilities to satisfy the changing cash flow requirements associated with interest rate fluctuations. In response to interest rate changes, the Company adjusts credited interest rates to the extent permitted by contracts.
Includes estimated amounts recoverable from reinsurers on long-term liabilities that are subject to the credit worthiness of the reinsurer.
The Company does not have any off-balance sheet arrangements nor does the Company have relationships with any special purpose entities.
In 2004 the Company established an agent bonus program. The bonus is calculated based on various factors including levels of life commissions paid to an agency and an agency’s property/casualty insurance production levels. The bonuses are paid to the agents by EIC. The Company in turn reimburses EIC. Cash payments to EIC relating to these bonuses totaled $2.0 million in 2005, which related to bonuses earned and incurred by the Company in 2004. There were no payments relating to this bonus program made to EIC in 2004.
On December 30, 2005, the Company retired a $15 million surplus note due to EIC. Interest paid on this note totaled $1.0 million in 2005, 2004 and 2003. The Company continues to hold a $25 million surplus note outstanding to EIC. This surplus note bears an annual interest rate of 6.70% and is scheduled to be
The Company’s annuity and universal life contracts contain provisions that guarantee interest rates will not decrease below certain levels. If the interest rates earned on the Company’s investments become insufficient to meet targeted interest spreads because of these minimum guarantees, profit margins on annuity and universal life deposits will decrease or in extreme situations could turn negative.
The Company’s deposit-type products compete with a wide variety of investment options. Among other factors affecting the investment decisions of policyholders and potential policyholders are general investment market conditions, particularly the market interest rate environment and the performance of the equity markets. Changes in interest rates affect pricing and the relative attractiveness of interest-sensitive investment options, which bears directly on the ability of the Company to attract new policyholders and retain existing holders of annuity, universal life and certain permanent life insurance products.
The Company’s rating from A.M. Best is A (Excellent). The A (Excellent) rating continues to affirm the Company’s strong financial position, indicating that the Company has an excellent ability to meet its ongoing obligations to policyholders. By virtue of its affiliation with the Erie Insurance Group, the Company is typically rated one financial strength rating lower than the property/casualty companies by A.M. Best Company. The Company is also rated by Standard & Poor’s, but this rating is based solely on public information. Standard & Poor’s rates the Company’s Api, “strong.” The Company also has a rating of B (Good) from Weiss Ratings, Inc. According to Weiss Ratings, the B rating indicates that the Company offers good financial security and has the resources necessary to deal with a variety of adverse conditions.
A comprehensive program of eCommerce initiatives being undertaken by the Erie Insurance Group (the Group) began in 2001. Early in the program, substantial advancements in the organization’s internal infrastructure were put in place, providing the enabling foundation for implementing advanced technology including operating environments and web-based applications.
During 2005, all independent agencies were migrated to a common Windows XP-based agency interface platform called DSpro. Previously, many agencies interfaced with the Company utilizing a DOS-based platform that was commercially unsupportable, while some were on the Windows XP-platform. While this more stable Windows XP platform does not interface to ERIEConnection, this migration mitigated the risk of business interruption posed by the DOS system and gives the Group the time necessary to thoroughly research and plan for its future interface development and rollout strategy using ERIEConnection. In the first quarter 2006, the Group is implementing broadband connectivity with most agencies through DSpro.
“Safe Harbor” Statement Under the Private Securities Litigation Reform Act of 1995: Certain forward-looking statements contained herein involve risks and uncertainties. These statements include certain discussions relating to underwriting, premium and investment income volume, business strategies, profitability and business relationships and the Company’s other business activities during 2005 and beyond. In some cases, you can identify forward-looking statements by terms such as “may,” “will,” “should,” “could,” “would,” “expect,” “plan,” “intend,” “anticipate,” “believe,” “contemplate,” “estimate,” “project,” “predict,” “potential” and similar expressions. These forward-looking statements reflect the Company’s current views about future events, are based on assumptions and are subject to known and unknown risks and uncertainties that may cause results to differ materially from those anticipated in those statements. Many of the factors that will determine future events or achievements are beyond our ability to control or predict.
The management of Erie Family Life Insurance Company is responsible for the preparation of information included in this Form 10-K. The financial statements have been prepared in conformity with Generally Accepted Accounting Principles. The balances in the financial statements are developed from the financial records of the Company and reflect estimates using judgment where amounts cannot be measured precisely or for transactions not yet complete.
In November 2005, the Financial Accounting Standards Board (FASB) issued Staff Position (FSP) FAS 115-1 and FAS 124-1, “The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments.” This FSP nullifies the requirements of measurement and recognition in paragraphs 10-18 of EITF Issue 03-1, carries forward the disclosure requirements included in Issue 03-1 and references existing other-than-temporary impairment guidance. This final FSP is effective for fiscal years beginning after December 15, 2005. The Company had previously adopted the disclosure requirements of EITF 03-1, which were unchanged by this final FSP. Management does not anticipate a change in policy as a result of this pronouncement that would significantly impact the Company’s financial condition or results of operations.
In May 2005, the FASB issued Financial Accounting Standard (FAS) No. 154, “Accounting Changes and Error Corrections”, which changes the requirements for the accounting and reporting of a change in accounting principle. FAS No. 154 applies to all voluntary changes in accounting principle as well as to changes required by an accounting pronouncement that does not include specific transition provisions. FAS No. 154 eliminates the requirement to include the cumulative effect of changes in accounting principle in the income statement and instead requires that changes in accounting principle be retroactively applied. A change in accounting estimate continues to be accounted for in the period of change and future periods if necessary. A correction of an error continues to be reported by restating prior period financial statements. FAS No. 154 is effective for accounting changes and correction of errors for fiscal years beginning after December 15, 2005.
An internal replacement that is determined to result in a replacement that is substantially unchanged from the replaced contract should be accounted for as a continuation of the replaced contract. Unamortized DAC associated with the replaced contract should continue to be deferred and amortized in connection with the replacement contract. Other balances associated with the replaced contract should be accounted for in a similar manner, that is, as if the replacement contract is a continuation of the replaced contract.
Nearly all of the Company’s internal replacements are considered substantially changed based on the definition in this SOP. The Company currently accounts for all internal replacements as if the original contract was extinguished. The Company plans to implement this guidance in 2007 and does not expect implementation to have a material impact on its financial statements.
The accompanying financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America (GAAP) that differ from statutory accounting practices (SAP) prescribed or permitted for insurance companies by state regulatory authorities. For differences between GAAP and SAP, see Note 16.
The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. The most significant estimates relate to valuation of investments, policy acquisition costs and reserves for policy liabilities. While management believes its estimates are appropriate, the ultimate amounts may differ from the estimates provided. The methods for making these estimates are continually reviewed and any adjustments considered necessary are reflected in current earnings.
Fixed maturities and marketable equity securities are classified as available-for-sale. Equity securities consist of nonredeemable preferred stock while fixed maturities consist of bonds, notes and redeemable preferred stock. Available-for-sale securities are stated at fair value, with the unrealized gains and losses, net of deferred taxes and offsetting adjustments to DAC and life contingent payout annuities, reflected in shareholders’ equity in accumulated other comprehensive income. There are no securities classified as trading securities or held-to-maturity securities.
Realized gains and losses on sales of investments are recognized in income on the specific identification method. Interest and dividend income is recorded as earned. The amortized cost of debt securities is adjusted for amortization of premiums and accretion of discounts to lowest yield. Such amortization is included in investment income.
near term prospects of the issuer and its industry, based on analysts recommendations,
specific events that occurred affecting the issuer, including a ratings downgrade, and
the Company’s ability and intent to hold the investment for a period of time sufficient to allow for a recovery in value.
The Company engages in securities lending activities from which it generates investment income from the lending of certain of its investments to other institutions for short periods of time. The Company receives marketable securities as collateral equal to 102% of the market value of the loaned securities. The Company maintains full ownership rights to the securities loaned, and accordingly, the loaned securities remain classified as investments of the Company.
the borrowing institution. In accordance with FAS 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, the Company recognizes the receipt of the collateral held by the third party custodian and the obligation to return the collateral on its Statements of Financial Position.
For primary loss recognition testing, the discount rate used to calculate the present value of policy cash flows is based on the yield on assets currently held by the Company to support the GAAP reserve. To the extent that the sum of the GAAP reserve and the present value of projected policy cash flows on this basis is less than unamortized DAC, a deficiency exists. This deficiency, or loss, must be recognized immediately by amortizing DAC by the amount of the deficiency. If the deficiency exceeds the amount of unamortized DAC, all remaining DAC is immediately amortized, and the GAAP reserve is increased by the remaining deficiency. These primary loss recognition adjustments flow through the Statements of Operations.
For shadow loss recognition testing, the discount rate used to calculate the present value of policy cash flows is based on the yield available on assets that could be or recently have been purchased by the Company in support of the GAAP reserve. This assumes the Company sells all of the Company's invested assets supporting the reserve, recognizes the capital gains/losses, and reinvests the proceeds at current yields. The sum of the GAAP reserve and this new present value of policy cash flows is again compared to the unamortized DAC. If a deficiency exists on this basis, DAC must be decreased and, if necessary, the GAAP reserve is increased. Unlike primary loss recognition adjustments, however, these shadow loss recognition adjustments are included in "Accumulated Other Comprehensive Income" in Shareholders' Equity and do not go through the Statements of Operations.
The liability for policy and contract claims represents the amount needed to provide for the estimated ultimate cost of settling claims relating to insured events that have occurred on or before the end of the respective reporting period. The estimated liability includes requirements for future payments of (a) claims that have been reported to the insurer and (b) claims related to insured events that have occurred but that have not yet been reported to the insurer as of the date the liability is estimated.
Premiums on traditional life insurance products are recognized as earned when due. Reserves for future policy benefits are established as premiums are earned. Premiums received for annuity and universal life products are not reported as revenue, but as deposits, and included in liabilities for annuity and universal life deposits in accordance with FAS 97. For universal life products, revenue is recognized as amounts are assessed against the policyholder’s account for mortality coverage and contract expenses. The primary source of revenue on annuity deposits is derived from the interest earned by the Company, which is reflected in net investment income.
Expense reimbursements received in connection with new reinsurance ceded have been accounted for as a reduction of the related policy acquisition costs. Amounts recoverable from reinsurers for future policy benefits are estimated in a manner consistent with the assumptions used for the underlying policy benefits and are recorded as an asset under “Reserve Credit for Reinsurance Ceded” on the Statements of Financial
The following tables summarize the cost and market value of available-for-sale securities at December 31, 2005 and 2004:
The fixed maturity investments with continuous unrealized losses for less than 12 months were primarily due to the impact of higher market interest rates rather than a decline in credit quality of the specific issuers. Of the fixed maturities that are below amortized cost for less than 12 months, securities that were investment-grade had a fair value of $428.0 million at December 31, 2005. These fixed maturities had unrealized losses as of December 31, 2005 totaling $8.1 million.
The remaining fair value of the fixed maturities for $6.7 million that are below amortized cost for less than 12 months at December 31, 2005, were non-investment grade securities and had unrealized losses of $0.7 million. Comprising this amount are three issuers, all of which were downgraded to non-investment grade in 2005. These three issuers are in the automotive and auto financing industries. The Company is monitoring the financial condition of these three issuers. An impairment charge of $0.8 million was recorded for one of these securities to write it down to market value in 2005. It is possible that these securities may be further impaired resulting in realized losses in future periods.
The remaining $4.8 million of fixed maturities below amortized cost for 12 months or longer were non-investment grade and had unrealized losses of $0.3 million. Of this amount $0.25 million was on a fixed maturity in the automotive finance industry and the remaining $0.05 million on a bond in the airline industry. The Company continues to monitor the financial condition of these issuers.
At December 31, 2005, net unrealized gains on investments of $15.5 million consisted of $47.5 million in gross unrealized gains less $13.4 million in gross unrealized losses, less $10.3 million in other related offsets and deferred taxes of $8.3 million.
Components of realized gains and losses on investments reflected in operations for the years ended December 31 are included below. Impairment charges of $2.9 million are included in 2005 gross realized fixed maturity losses. These charges related to investments in the automotive industry. There were no impairment charges in 2004. Included in 2003 gross realized losses of fixed maturities are impairment charges totaling $3.4 million. These charges related primarily to investments in the communications, energy and finance sectors.
Limited partnerships include U.S. and foreign real estate and mezzanine debt investments. Real estate limited partnerships represent 96.8%, while mezzanine debt limited partnerships represent 3.2% of the total carrying value at December 31, 2005. These partnerships are recorded using the equity method. In the second quarter of 2005, the Company corrected its treatment of unrealized gains and losses on limited partnerships resulting in an increase in pretax income of $1.2 million, or $0.13 per share. Included in the pre-tax adjustment was $0.2 million of unrealized gains related to 2004 and prior years. While there was an earnings impact related to this adjustment, there was no impact on the Company’s shareholders’ equity. The Company previously reflected unrealized gains and losses on limited partnerships in shareholders’ equity in accumulated other comprehensive income, net of deferred taxes.
The components of equity in earnings of limited partnerships as reported in the Statements of Operations for the years ended December 31 are as follows:
In 2005, the Company implemented new valuation software used to estimate insurance liability and DAC balances in accordance with FAS 60 for its traditional life insurance and FAS 97 for its universal life and deferred annuity products. The new valuation systems use more refined methods and calculations to estimate these amounts. As part of the conversion to the new valuation system, estimated deferred net DAC premiums on FAS 60 products, formerly part of the Premiums Receivable from Policyholders asset, are now included as part of the DAC asset. In order to make prior period financial statements comparable, the Company reclassified these estimated deferred net premiums of $7.7 million as of December 31, 2004, from the Premiums Receivable from Policyholders asset to the DAC asset.
Annuity considerations collected in 2005 and 2004 were significantly lower than in 2003, resulting in a decrease in commission amounts capitalized in DAC from 2003 levels. Additions to DAC relating to annuities were $1.7 million, $1.4 million and $4.4 million in 2005, 2004 and 2003, respectively, as annuity premiums for those years were $84.4 million, $78.6 million and $144.2 million.
During 2004, as required under FAS 97, Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments, the Company unlocked certain assumptions used to determine DAC for its universal life and fixed annuity products. As a result of unlocking these assumptions in 2004, the DAC asset was increased and the amortization of DAC was decreased by $7.2 million. Approximately $4.8 million of this amount resulted from updating universal life mortality assumptions, to best estimates, in light of substantially more favorable claims expectations than originally reflected in the DAC amortization models. Another $1.9 million resulted from increasing the interest-spread assumption on universal life policies to reflect anticipated investment earnings rates and actual crediting practices in recent years.
Estimated fair value for financial instruments were determined from market information and if necessary from quotations provided by broker-dealers or internally derived prices. Certain financial instruments, including insurance contracts other than financial guarantees and investment contracts, are exempt from fair value disclosure requirements. The following methods were used in estimating fair value.
Fixed maturities and equity securities: For equity securities, fair values were based on quoted market prices. For fixed maturities, fair values were obtained from independent pricing services. For the few securities where an independent service provides no price, broker-dealer quotations or internally derived prices are used.
Limited partnerships: Estimated fair market values of the limited partnerships are provided to the Company by the general partner of that partnership.
Annuity payouts: Included in this category are annuity contracts that the policyholder cannot surrender at any time and for which the policyholder is locked into a benefit payment schedule for the duration of the contract. These contracts provide benefits that are either guaranteed or contingent upon the survival of the annuitant. Fair values of these contracts were estimated using discounted project cash flows based upon U.S. Treasury spot rates. At December 31, 2005 and 2004, the carrying value of these contracts totaled $300.9 million and $296.4 million, respectively, while the estimated fair value of these contracts totaled $328.4 million and $327.7 million, respectively.
Universal life deposits: The Company retains the right to change interest rates on its universal life deposits subject to minimum interest rates provided in the policy. The Company also retains the right to change the expense and cost of insurance charges that are deducted from universal life deposits, subject to maximum amounts provided in the policy. Therefore, the carrying value of these policies approximates their fair value.
The components of changes to comprehensive income for the years ended December 31 are as follows:
31, 2004 or 2003. The inadequacy at December 31, 2005 amounted to $3.0 million and arose from the revaluation of assets on a current market value basis as prescribed for FAS 115. The shadow loss recognition testing assumes that all asset unrealized gains and losses become realized and the proceeds are reinvested at current yields. Discounted projected benefits using the current yields available on assets produced a GAAP reserve of $3.0 million greater than the carried GAAP reserve for this block of business.
The impact of this adjustment, net of tax, is included in “Accumulated Other Comprehensive Income” in Shareholders’ Equity. As of December 31, 2005, the adjustment resulting from this change in unrealized investment gains was $3.0 million. The amount charged to “Accumulated Other Comprehensive Income” was $2.0 million, net of $1.0 million of deferred federal income tax.
The “Accumulated Other Comprehensive Income” balances reported in the Statements of Financial Position of $15.5 million and $39.3 million as of December 31, 2005 and 2004, respectively, relate to the unrealized appreciation of investments, net of taxes, deferred acquisition costs and life contingent payout annuities.
The Company offers, among other products, annuity and universal life insurance. The amount received as deposits for each of the years ended December 31 are as follows:
The provision for income taxes consists of the following for the years ended December 31:
A reconciliation of the provision for income taxes with amounts determined by applying the statutory federal income tax rates to pretax income is as follows:
The employees of the Company participate in the pension and other employee benefit plans of EIC. The pension benefits are based on years of service and salary. Pension costs are funded by EIC in amounts sufficient to at least meet ERISA minimum funding requirements. The Company, through EIC, also participates in certain deferred compensation and supplemental pension plans for certain executive and senior officers. The amounts recorded by the Company for the deferred compensation and supplemental pension plan totaled $1.3 million in 2005 and $1.1 million in 2004 and 2003. These costs, which are settled in cash to EIC as payments are made under these plans. The pension and related benefit costs allocated to the Company from EIC equaled $0.7 million, $0.6 million and $0.2 million in 2005, 2004 and 2003, respectively.
On December 30, 2005, the Company retired a $15 million surplus note due to EIC. Interest paid on this note totaled $1.0 million in 2005, 2004 and 2003. The Company continues to hold a $25 million surplus note
outstanding to EIC. This surplus note bears an annual interest rate of 6.70% and is scheduled to be paid semi-annually. The surplus note is payable on demand on or after December 31, 2018. Both principal and interest payments were approved by the Pennsylvania Insurance Commissioner. Interest paid on this note totaled $1.7 million in 2005 and 2004 and $0.6 million in 2003.
The Erie Insurance Group 401(k) plan for employees includes an investment option in a Company annuity. Annuity deposits in 2005, 2004 and 2003 included $2.6 million, $2.3 million and $2.6 million, respectively, of deposits on annuity contracts purchased by Erie Insurance Group employees through the 401(k) plan.
In 2004, the Company evaluated the net asset balance due from the Pennsylvania Employees Group Life Insurance (PEGLI) pool. PEGLI is a voluntary reinsurance pool that provides reinsurance coverage to primary insurers who insure Commonwealth of Pennsylvania employees upon their retirement. The Company was a participant in this pool for a number of years. Beginning July 1, 2001, the Company discontinued accepting new business from the PEGLI pool. The Company continued carrying a balance on the Statement of Financial Position for its share of the assets and liabilities of the PEGLI pool prior to July 1, 2001, however, the Company’s inability to obtain reliable accounting information as to the Company’s share of the pool assets and liabilities during 2004 raised concern over the recoverability of the net asset. During the fourth quarter of 2004, management made the decision to write off the value of the PEGLI net asset and a charge of $2.0 million, or $0.14 per share after taxes, was made to earnings. Management continues to estimate in 2005 that no PEGLI net asset should be recorded by the Company.
Included in the reinsurance treaties are provisions for expense allowances to be provided to the Company by the reinsurer. These allowances are intended to help offset policy acquisition and maintenance costs incurred by the Company. The rate of reimbursement varies by plan and by reinsurer. These allowances are considered in the amount capitalized as DAC. The Company put in place a new ceded arrangement for new issues under certain of its Target Term plans as of January 1, 2005. This change did not have a material impact on the 2005 financial results.
Effective July 1, 2005, the Company no longer issues new policies under its Target Term plans. These plans have been replaced by a new term product, ERIE Flagship Term Plus, which the Company began offering in August 2005. The Company’s retention limit is $0.3 million per life for individual coverage. For its ERIE Flagship Term2, ERIE Target Term and Flagship Term Plus products, the Company has first dollar quota share treaties with several unaffiliated reinsurers. The Company reinsures 50%, 75% and 90% of the ERIE Flagship Term2, ERIE Flagship Term Plus and ERIE Target Term products, respectively, subject to the Company’s $0.3 million retention limit. The Company’s most significant reinsurance relationship is with Generali USA Reassurance Company (Generali), which reinsures a portion of the Company’s life and accident and health business. Policy revenue ceded to Generali totaled $11.1 million, $10.3 million and $8.2 million for the years ended December 31, 2005, 2004 and 2003, respectively. At December 31, 2005 and 2004, the amount of in-force life insurance ceded to Generali totaled approximately $7.5 billion and $6.7 billion, respectively.
The Company offers a range of products and services, but operates as one reportable life insurance segment. The Company’s Traditional Life insurance line includes permanent life, endowment life, term life and whole life policies. The Universal Life line includes all fixed universal life products sold by the Company. Variable universal life products are not sold by the Company. The Fixed Annuities line includes fixed ordinary deferred annuities, tax advantaged deferred annuities, annuities in pay-out and structured settlements. Neither variable nor equity indexed annuity products are sold by the Company. The Group Life and Other line includes group life insurance and disability income products. The Corporate Account includes investment income earned from surplus not specifically allocable to any one product type. Investment-related income is allocated based on the assumption that the fixed maturities and preferred stock portfolios support the insurance product lines and the common stock, limited partnership and remaining fixed maturity investments support the Corporate Account.
The 2005 benefits and expenses for the Traditional Life line include a $3.6 million charge related to the implementation of a new FAS 60 valuation system. See Note 17 for further discussion on this charge. In addition, the 2005 Traditional Life expenses include $0.6 million related to the development of the ERIE Flagship Term Plus product.
The Company prepares its statutory financial statements in accordance with accounting practices prescribed by the Pennsylvania Insurance Department. Prescribed Statutory Accounting Practices (SAP) include state laws, regulations and general administrative rules, as well as a variety of publications from the National Association of Insurance Commissioners (NAIC). Accounting principles used to prepare statutory financial statements differ from financial statements prepared on the basis of generally accepted accounting principles.
A reconciliation of net income as filed with regulatory authorities to net income reported in the accompanying financial statements for the years ended December 31 is as follows:
companies (Section 386 of the PA Insurance Code) amounts to $1.6 million. The Company’s total statutory capital and surplus well exceeded these minimum requirements.