The costs related to acquiring new business, including certain costs of issuing policies and certain other variable selling expenses (principally commissions), defined as deferred policy acquisition costs, are capitalized and amortized as an expense primarily in proportion to expected profits or margins from such policies. This amortization is adjusted when current or estimated future gross profits or margins on the underlying policies vary from previous estimates. For example, the amortization of deferred policy acquisition costs is accelerated when policy terminations are higher than originally estimated or when investments supporting the policies are sold at a gain prior to their anticipated maturity. Death and other policyowner benefits reflect exposure to mortality risk and fluctuate from period to period based on the level of claims incurred within insurance retention limits. The profitability of the Company is primarily affected by expense levels, interest spread results (i.e., the excess of investment earnings over the interest credited to policyowners) and fluctuations in mortality, persistency and other policyowner benefits. The Company has the ability to mitigate adverse experience through adjustments to credited interest rates, policyowner dividends or cost of insurance charges.
The Closed Block was established on June 30, 1996. Insurance policies which had a dividend scale in effect as of June 30, 1996 were included in the Closed Block. The Closed Block was designed to provide reasonable assurance to owners of insurance policies included therein that, after the Reorganization of AmerUs Life, assets would be available to maintain the dividend scales and interest credits in effect prior to the Reorganization if the experience underlying such scales and credits continues.
The contribution to the operating income of the Company from the Closed Block is reported as a single line item in the income statement. Accordingly, premiums, product charges, investment income, realized gains (losses) on investments, policyowner benefits and dividends attributable to the Closed Block, less certain minor expenses including amortization of deferred policy acquisition costs, are shown as a net number under the caption the "Contribution from the Closed Block." This results in material reductions in the respective line items in the income statement while having no effect on net income. The expenses associated with the administration of the policies included in the Closed Block and the renewal commissions on these policies are not charged against the Contribution from the Closed Block, but rather are grouped with underwriting, acquisition and insurance expenses. Also, all assets allocated to the Closed Block are grouped together and shown as a separate item entitled "Closed Block Assets." Likewise, all liabilities attributable to the Closed Block are combined and disclosed as the "Closed Block Liabilities."
Total policyowner benefits were $402.6 million in 1997 compared to $365.8 million in 1996 and $374.6 million in 1995. The 1997 amount included fourth quarter benefits of acquired companies of $23.4 million consisting primarily of interest credited to annuity account balances and other annuity benefits. Traditional life insurance benefits increased by $18.8 million in 1997 compared to a $7.3 million increase in 1996. The increase in 1997 was primarily due to the growth and aging of the business in force and increased death benefits as a result of higher mortality. The increase in traditional life insurance benefits in 1996 was primarily due to the growth and aging of the business in force. Universal life insurance benefits increased by $3.3 million in 1997 and by $2.5 million in 1996. The increased benefits in 1997 and 1996 were due to increased interest credited to policyowner account balances and increased death benefits due to higher mortality. While the weighted average crediting rate for AmerUs Life's universal life liabilities decreased four basis points to 6.23% in 1997 from 6.27% in 1996, AmerUs Life's average liabilities increased by $33.7 million, resulting in the increased credited amounts in 1997. While the weighted average crediting rate for AmerUs Life's universal life liabilities decreased 19 basis points to 6.27% in 1996 from 6.46% in 1995, AmerUs Life's average liabilities increased $39.8 million from 1995 to 1996, resulting in the increased interest credited amounts in 1996.
Excluding recently acquired companies, other underwriting, acquisition and insurance expenses, net of deferrals, decreased by $4.0 million to $45.9 million in 1997. This decrease in expenses during 1997 was primarily due to the establishment of a $5.0 million litigation reserve during 1996 in connection with certain class action litigation, partially offset by a $1.3 million write-off of expenses during 1997 related to the former bank credit facility which was replaced by a new agreement in the fourth quarter of 1997. The increase in expenses in 1996 was due to increased settlements and associated legal fees of $4.7 million, primarily due to the $5.0 million class action litigation reserve; expenses related to changing the name of the Company of $0.7 million; higher premium taxes of $1.1 million due to a one-time adjustment to the amortization of the guaranty association asset and an increased accrual for estimated future assessments; combined with a gain of $3.1 million recorded against 1995 expenses resulting from the curtailment of the Company's defined benefit pension plans effective December 31, 1995.
The amortization of deferred policy acquisition costs decreased by $6.1 million in 1997 and increased by $8.3 million in 1996. Deferred policy acquisition costs are generally amortized in proportion to gross margins, including capital gains. Higher death benefits and lower realized capital gains in 1997, compared to 1996, contributed to lower gross margins in 1997 on products for which deferred costs are amortized, resulting in the lower amortization in 1997. The increased amortization in 1996 was primarily due to higher gross margins, including increased realized capital gains in 1996, on products for which deferred costs are amortized.
Income from operations decreased by $25.7 million to $93.4 million in 1997 compared to $119.1 million in 1996, and $112.9 million in 1995. Recent acquisitions added $3.3 million of income from operations during the fourth quarter, however, the overall decrease in 1997 income from operations was primarily due to the decrease in realized gains on investments in 1997. The increase in 1996 resulted primarily from the increase in realized gains on investments.
Interest expense increased by $12.9 million in 1997 to $15.0 million compared to $2.1 million in 1996, and $2.4 million in 1995. The increase in interest expense in 1997 was primarily due to the interest expense on the capital securities issued by the Company during 1997 and interest expense on the revolving line of credit. This added interest expense was largely offset by investment of the borrowed funds which contributed to the growth in invested assets and the higher investment earnings of 1997.
On October 23, 1997, the Company entered into a $250 million revolving credit facility with a syndicate of lenders (the "Bank Credit Facility") to be used to replace its then existing revolving credit facility, to finance the acquisition of Delta, to finance permitted mergers and acquisitions and for other general corporate purposes. The Bank Credit Facility is secured by a pledge of approximately 49.9% of the outstanding common stock of AmerUs Life, 100% of the outstanding common stock of Delta and a $50 million 9% surplus note payable to the Company by AmerUs Life. As of December 31, 1997, there was an outstanding loan balance of $250 million under the facility. The Bank Credit Facility provides for typical events of default and covenants with respect to the conduct of the business of the Company and its subsidiaries and requires the maintenance of various financial levels and ratios. Among other covenants, the Company (a) cannot have a leverage ratio greater than 0.35:1.0 or an interest coverage ratio less than 2.5:1.0, (b) is prohibited from paying cash dividends on its common stock in excess of an amount equal to 3% of its consolidated net worth as of the last day of the preceding fiscal year, and (c) must cause certain of its subsidiaries including AmerUs Life and Delta Life to maintain certain ratings from A.M. Best and certain levels of adjusted capital and surplus and risk-based capital.
The Company may from time to time review other potential acquisition opportunities. The Company anticipates that funding for any such acquisition may be provided from available cash resources, from debt or equity financing or stock-for-stock acquisitions. In the future, the Company anticipates that its liquidity and capital needs will be met through interest and dividends from its life insurance subsidiaries, accessing the public equity and debt markets depending upon market conditions, or alternatively from bank financing.
The Company takes into account asset-liability management considerations in the product development and design process. Contract terms for the Company's interest-sensitive products include surrender and withdrawal provisions which mitigate the risk of losses due to early withdrawals. These provisions generally do one or more of the following: limit the amount of penalty-free withdrawals, limit the circumstances under which withdrawals are permitted, or assess a surrender charge or market value adjustment relating to the underlying assets. The following table summarizes statutory liabilities for interest-sensitive life products and annuities by their contractual withdrawal provisions at December 31, 1997 (dollars in millions):
At December 31, 1997, the statutory surplus of AmerUs Life, Delta Life, American and FBL were approximately $325 million, $83 million, $112 million and $41 million, respectively. The Company believes that these levels of statutory capital are more than adequate as each life insurance subsidiary's risk-based capital is significantly in excess of required levels.
In the future, in addition to their cash flows from operations and borrowing capacity, the life insurance subsidiaries would anticipate obtaining their required capital from the Company as the Company will have access to the public debt and equity markets.
The Company's asset/liability management approach utilizes separate investment portfolios for specific product lines, such as traditional life, universal life and annuities. Investment policies and strategies have been established based on the specific characteristics of each product line. The portfolio investment policies and strategies establish asset duration, quality and other guidelines. The Company utilizes analytical systems to establish an optimal asset mix for each line of business. The Company seeks to manage the asset/liability mismatch and the associated interest rate risk through active management of the investment portfolio. Financial, actuarial, investment, product development and product marketing professionals work together throughout the product development, introduction and management phases to jointly develop and implement product features, initial and renewal crediting strategies, and investment strategies based on extensive modeling of a variety of factors under a number of interest rate scenarios.
As of December 31, 1997, 88.7% of total invested assets were investment grade fixed maturity securities. The following table sets forth the credit quality, by NAIC designation and Standard & Poor's rating equivalents, of fixed maturity securities as of December 31, 1997:
MBS comprise a core position within the Company's fixed maturity securities investments. MBS investments include residential, commercial MBS, home equity loans (including home equity loans purchased from one of the Company's affiliates), manufactured housing, FHA Title I and CMBS. Residential mortgage pass-throughs and CMOs total $2,794.9 million or 31.8% of total invested assets. As of December 31, 1997, MBS were $3,450.3 million or 38.7%, of total invested assets of which $2,793.6 million, or 81.0% of MBS were guaranteed by the United States government or an agency of the United States government. Other MBS were $656.7 million, or 19.0%, of MBS as of December 31, 1997. Management believes that the quality of assets in the MBS portfolio is generally high, with 91.7% of such assets representing agency backed or "AAA" rated securities.
As of December 31, 1997, mortgage loans in the Company's investment portfolio were $462.5 million, or 5.2% of the aggregate carrying value of invested assets, including the Closed Block. As of December 31, 1997, commercial mortgage loans and residential mortgage loans comprised 96.4% and 3.6%, respectively, of the mortgage loans in the Company's investment portfolio.
The Company held $172.0 million of other invested assets (including short-term investments) on December 31, 1997. Other invested assets consist primarily of various joint venture and limited partnership investments.
The Company does not believe that inflation has had a material effect on its consolidated results of operations.
The NAIC recently approved the codification of statutory accounting practices, which constitutes "prescribed" statutory accounting practices. Additional guidance on its implementation is being developed and is anticipated to be effective January 1, 1999, resulting in changes to certain statutory accounting practices. The codification may result in changes to the permitted or prescribed accounting practices that the Company's insurance subsidiaries use to prepare their statutory-basis financial statements.