The fixed income markets are experiencing a period of extreme volatility and limited market liquidity conditions, which has affected a broad range of asset classes and sectors. In addition, there have been credit downgrade events and an increased probability of default for many fixed income instruments. Equity markets have also been experiencing heightened volatility. These events and the continuing market upheavals have had and may continue to have an adverse effect on us. These volatile market conditions have also increased the difficulty of valuing certain securities as trading is less frequent and/or market data is less observable. There were certain securities that were in active markets with significant observable data that became illiquid due to the current financial environment or market conditions. As a result, certain valuations require greater estimation and judgment as well as valuation methods which are more complex. These values may not ultimately be realizable in a market transaction, and such values may change very rapidly as market conditions change and valuation assumptions are modified.
Our fixed annuity products contain features that allow contract holders to surrender a policy. To encourage persistency, we impose a surrender charge against the account balance for early termination of a contract within a specified period after its effective date. Most of the fixed annuity products sold by the EquiTrust Life independent channel offer a market value adjustment feature which is based on U.S. Treasury rates. This feature provides us interest rate protection when U.S. Treasury interest rates are greater than the rates in effect when a contract is issued and provides a benefit to contract holders when U.S. Treasury interest rates are less than the rates in effect when a contract is issued. Late in 2008 and continuing into early 2009, market conditions emerged with unprecedented low U.S. Treasury yields providing an environment where contract holders were able to surrender with smaller net surrender charges, increasing the level of surrender activity. The unanticipated increase in surrenders required us to update assumptions in the models used to calculate amortization of deferred acquisition costs and deferred sales inducements, which negatively impacted our results of operations in the fourth quarter of 2008.
Net income (loss) totaled ($18.1) million in 2008, $86.3 million in 2007 and $90.1 million in 2006. A detailed discussion of changes in net income (loss) is included below.
Gross Unrealized Gains and Gross Unrealized Losses by Internal Industry Classification
Deferred policy acquisition costs increased 37.8% to $1,365.6 million and deferred sales inducements increased 30.8% to $420.1 million at December 31, 2008 primarily due to the impact of the change in unrealized appreciation/depreciation on fixed maturity securities and the capitalization of costs incurred with new sales, partially offset by amortization and the impact of the change in net unrealized gains/losses on derivatives. The impact of the change in unrealized appreciation/depreciation on fixed maturity securities increased deferred policy acquisition costs $398.2 million and deferred sales inducements $134.2 million during 2008. The impact of the change in net unrealized gain/losses on derivatives decreased deferred policy acquisition costs $4.3 million and deferred sales inducements $27.4 million during 2008. The change in unrealized appreciation/depreciation on fixed maturity securities totaling $1,399.2 million also contributed to the $335.0 million change in deferred income taxes from a liability of $28.2 million at December 31, 2007 to an asset of $306.8 million at December 31, 2008. Other assets increased 28.2% to $41.6 million, primarily due to a $13.7 million increase for receivables for securities sold. Assets held in separate accounts decreased 33.1% to $577.4 million primarily due to unrealized losses on the underlying investment portfolios.
For a substantial portion of our direct business in force, we have the ability to adjust interest or dividend crediting rates in reaction to changes in portfolio yield. We had the ability to adjust rates on 97% of our policyholder liabilities at December 31, 2008 and 96% of our policyholder liabilities at December 31, 2007. However, the ability to adjust these rates is limited by competitive factors. Surrender rates could increase and new sales could be negatively impacted if the crediting rates are not competitive with the rates on similar products offered by other insurance companies and financial services institutions. In addition, if market rates were to decrease substantially and stay at a low level for an extended period of time, our spread could be lowered due to interest rate guarantees on many of our interest sensitive products. At December 31, 2008, interest rate guarantees on our direct interest sensitive products ranged from 1.50% to 5.50%, with a weighted average guarantee of 2.19%.
The sensitivity analysis noted above is performed using interest rates as of January 31, 2009 to demonstrate the surrender charge protection on this business as of a date close to the filing date of this Form 10-K and to better illustrate the sensitivity of the MVA offset to decreases in the U.S. Treasury rate. At December 31, 2008, the 10-year U.S. Treasury rate was at 2.25%. The impact on the MVA of a 50 basis point decrease in the U.S. Treasury rate at December 31, 2008 would have been less than the impact of the decrease noted above because of a floor on the MVA. For most contracts, the MVA offset is floored at an amount equal to the amount of the gross surrender charge.
We have initiated conservation efforts to reduce the surrender activity for existing contracts and are evaluating the terms and conditions for future products. In addition, the surrender charge protection has increased since year end with the increase in U.S. Treasury rates from the historic lows experienced at the end of 2008. However, the increase in surrenders, combined with the reduction in sales to preserve capital, may cause EquiTrust Life to have net negative cash outflows in 2009. We anticipate using cash on hand and to the extent necessary, proceeds from investment sales of fixed maturity securities in an unrealized gain position to meet these needs. At December 31, 2008, EquiTrust Life had cash and short-term investments on hand totaling $99.8 million and fixed maturity securities in an unrealized gain position totaling $1,430.4 million. In addition, in 2009 EquiTrust Life became a member of the Federal Home Loan Bank, which provides a source for securitized borrowings if needed.
In addition, we manage the amount of our capital to be consistent with an A ratings objective from Standard & Poor’s and A.M. Best. As of December 31, 2008, we estimate that we have sufficient capital in the life insurance subsidiaries, combined with capital at the holding company, to meet this rating objective. However, this capital may not be sufficient if significant future losses are incurred and, given the current market conditions, access to additional capital could be limited.
Amortization of deferred policy acquisition costs and deferred sales inducements for participating life insurance and interest sensitive and index products totaled approximately $150.9 million for 2009, excluding the impact of new production in 2009. A 10% increase in estimated gross profits for 2009 would result in $10.0 million of additional amortization expense. Correspondingly, a 10% decrease in estimated gross profits would result in a $10.2 million reduction of amortization expense.
In November 2008, the FASB issued Emerging Issues Task Force (EITF) No. 08-6, “Equity Method Investment Accounting Considerations.” EITF No. 08-6 establishes accounting and reporting standards for valuing equity method investees and their equity transactions. EITF No. 08-6 will be effective in the first quarter of 2009 and early adoption is prohibited. We do not expect the adoption of EITF No. 08-6 to have a material impact on our consolidated financial statements.
For derivatives not designated as a hedging instrument, including the swaps hedging our annuity contracts after April 1, 2007, the change in fair value is recognized in earnings in the period of change. See “Accounting Changes” above and Note 3, “Derivative Instruments,” for more information regarding our derivative instruments, embedded derivatives and the change in accounting change for interest rate swaps.
We also obtain or are required to provide collateral relating to certain derivative transactions. We invest cash collateral received and record a liability for amounts owed to counterparties for these transactions. We record an asset for amounts due from counterparties when we are required to provide collateral. See Note 2, “Investment Operations,” for more information regarding our collateral.
The separate account assets and liabilities reported in our accompanying consolidated balance sheets represent funds that are separately administered for the benefit of certain policyholders that bear the underlying investment risk. The separate account assets and liabilities are carried at fair value. Revenues and expenses related to the separate account assets and liabilities, to the extent of benefits paid or provided to the separate account policyholders, are excluded from the amounts reported in the accompanying consolidated statements of operations.
Available For Sale Fixed Maturity and Equity Securities by Investment Category
In addition, one collateralized debt obligation partially backed by subprime mortgages was written down during the first and second quarters of 2008 to the estimated fair value of $0.2 million. This security had an amortized cost of $10.0 million and a fair value of $1.5 million at December 31, 2007. This security was sold during the third quarter of 2008 for the estimated fair value of $0.2 million.
to this portion of the line of credit. Interest expense was increased by $0.5 million in 2008 and reduced by $0.3 million in 2007 and $0.2 million in 2006 as a result of the net interest settlements on this swap.
Level 3 - Pricing inputs are unobservable for the financial instrument and include situations where there is little, if any, market activity for the financial instrument. The inputs into the determination of fair value require significant management judgment or estimation. Financial instruments that are included in this category generally include
Farm Bureau Life also has an annual 100% quota share accidental death reinsurance agreement. Coverage includes all acts of terrorism including those of a nuclear, chemical or biological origin. Coverage is subject to an annual aggregate retention and was increased from $10.0 million to $11.0 million effective January 1, 2009. A maximum occurrence limit of $50.0 million applies to policies written on agents of the company who are participating in company-sponsored incentive trips. All other occurrence catastrophes are unlimited in amount.
current income tax expense as allocated under a consolidated tax allocation agreement. Generally, this allocation results in profitable companies recognizing a tax provision as if the individual company filed a separate return and loss companies recognizing a benefit to the extent their losses contribute to reduce consolidated taxes.
We have a Director Compensation Plan under which non-employee directors on our Board may elect to receive a portion of their compensation in the form of cash, Class A common shares or deferred stock units. Under this plan, we have deferred stock units outstanding totaling 60,825 at December 31, 2008 and 46,846 at December 31, 2007. At December 31, 2008, shares of Class A common stock available for future issuance under the Director Compensation Plan totaled 35,250. We also have an Executive Salary and Bonus Deferred Compensation Plan under which officers of the Company who are required to meet certain stated common stock ownership guidelines are allowed to use their base salary and annual cash bonus to purchase deferred stock units. Under this plan, we have deferred stock units outstanding totaling 31,843 at December 31, 2008 and 19,600 at December 31, 2007. At December 31, 2008, shares of Class A common stock available for future issuance under this plan totaled 217,094. We also have an Executive Excess 401k Plan under which officers of the Company who meet salary guidelines and