Interest Rate Risk: The Insurance Company’s principal products are deferred annuities, which are interest rate sensitive instruments. In an interest rate environment of falling or stable rates the Insurance Company’s annuity holders are less likely to seek to surrender their annuities prior to maturity to seek alternative, higher-yielding investments. However, in an environment of moderately or significantly increasing rates, such surrenders should be expected to increase. The existence currently of surrender fees on approximately 67% of the Insurance Company’s outstanding deferred annuities acts as a deterrent against surrenders. However, if interest rates climb sufficiently, such fees may not have a significant deterrent effect. Moreover, the surrender fees are only in effect for up to the first 7 years of each annuity policy and, therefore, disappear over time (see table below). In the event of a substantial increase in surrenders during a short period of time, the Insurance Company may have to sell off longer-term assets to pay current surrender liabilities. The Insurance Company continually develops strategies to address the match between the timing of its assets and liabilities. To that end, during 2005, it reduced the amount of assets invested in longer-term investments by approximately $800 million and reinvested in short and intermediate return investments at slightly reduced yields. These reduced yields were partially offset by the gains recognized by the Insurance Company from the sale of the longer-term assets. The Insurance Company also benefited in this regard from the consolidation of the issuers of the principal protected note investments in its investment portfolio in 2003, which placed into the Insurance Company’s investment portfolio a par value of approximately $292.3 million in U.S. Treasury Strips and similar instruments with maturity dates commencing in 2009. To protect against a substantial sudden increase in rates (300 basis points), the Company has entered into a series of payor swaption investments. Under these investments, the Company obtained the right to enter into interest rate swap agreements with counterparties under which the Company’s interest rate obligations are fixed and the counterparties’ obligations are variable, thus protecting the Company from sudden rate increases. (See, Item 7, Management’s Discussion and Analysis, Liquidity and Capital Resources, “Asset /Liability Management.”)
The $4.7 million of unrealized losses on assets held longer than 12 months are attributable to a combination of higher interest rates, wider corporate credit spreads, rumors of potential LBO candidates and changes in specific industry conditions (primarily automobile and food retailing). The following represent credits that have experienced losses that exceed 10% of book value and are more than $500,000: Tenet Healthcare ($1.4 million) and Neiman Marcus Group ($.7 million). Tenet has been affected by issues related to a federal investigation of Medicare reimbursement practices and the shutdown of hospitals caused by the 2005 hurricanes. The Company believes that these events should not result in an other than temporary impairment of the investment. Neiman Marcus was the subject of an LBO in 2005, which resulted in increased leverage. However, the Insurance Company’s bonds, which were previously unsecured, have become secured by real estate (various store properties) and other assets of Neiman Marcus. This action should enhance the value of the bonds and reflect a not other than temporary impairment of value.
Preferred Stocks: The Insurance Company had approximately $ 2.1 million of losses on its preferred stock portfolio. The aggregate holdings consist primarily of banks, financial companies, electric utilities and REIT’s (real estate investment trusts). Most of the changes in market value reflect overall increases in interest rates; this condition should result in a not other than temporary impairment in value. None of the individual losses exceed $ 500,000 and 10% of book value.
Interest credited and benefits paid to policyholders amounted to $255.7 million in fiscal 2005 as compared to $254.0 million in fiscal 2004 and $258.1 million in fiscal 2003. These represent an increase of 0.7% comparing fiscal 2005 to fiscal 2004 and a 1.6% decrease comparing fiscal 2004 to fiscal 2003. These amounts are consistent with the Company’s historic expense levels.
The accompanying Notes to Consolidated Financial Statements contain information regarding payments required under existing long-term borrowing arrangements. The following presents a summary of the Corporation’s significant contractual obligations.