| TENNESSEE | 63-0169720 | ||
|---|---|---|---|
| (State or other jurisdiction | (IRS Employer Identificiation No.) | ||
| incorporation or organization) |
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No[ ]
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [X]
Number of shares of Common Stock, $1.00 par value, outstanding as of November 12, 2004: 5,000,000 shares.
INDEX
Page Number
Part I. Financial Information:
Item 1. Financial Statements (unaudited):
Report of Independent Registered Public Accounting Firm............................................
Consolidated Condensed Statements of Income for the
Nine Months ended September 30, 2004 and 2003..................................................
Consolidated Condensed Balance Sheets as of September 30, 2004
and December 31, 2003..........................................................................
Consolidated Condensed Statements of Cash Flows for the
Nine Months ended September 30, 2004 and 2003..................................................
Notes to Consolidated Condensed Financial Statements...............................................
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations.......................................................................
Item 3. Quantitative and Qualitative Disclosures About Market Risk....................................
Item 4. Controls and Procedures.......................................................................
Part II. Other Information:
Item 6. Exhibits......................................................................................
Signature.................................................................................................
To the Directors and
Share Owner
Protective Life Insurance Company
We have reviewed the accompanying consolidated condensed balance sheet of Protective Life Insurance Company and its subsidiaries as of September 30, 2004, and the related consolidated condensed statements of income for each of the three-month and nine-month periods ended September 30, 2004 and 2003 and the consolidated condensed statements of cash flows for the nine-month periods ended September 30, 2004 and 2003. These interim financial statements are the responsibility of the Company’s management.
We conducted our review in accordance with the standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board, the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.
Based on our review, we are not aware of any material modifications that should be made to the accompanying consolidated condensed interim financial statements for them to be in conformity with accounting principles generally accepted in the United States of America.
We previously audited in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet as of December 31, 2003, and the related consolidated statements of income, share-owner’s equity and cash flows for the year then ended (not presented herein), and in our report dated March 11, 2004, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying consolidated condensed balance sheet as of December 31, 2003, is fairly stated in all material respects in relation to the consolidated balance sheet from which it has been derived.
/s/PricewaterhouseCoopers
LLP
PricewaterhouseCoopers LLP
Birmingham, Alabama
November
15, 2004
(Dollars in thousands)
(Unaudited)
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
2004 2003 2004 2003
- --------------------------------------------------------------------------------------------------------------------------------
REVENUES
Premiums and policy fees $ 456,973 $420,244 $1,347,532 $1,197,430
Reinsurance ceded (273,074) (233,768) (798,664) (620,874)
- --------------------------------------------------------------------------------------------------------------------------------
Premiums and policy fees, net of reinsurance ceded 183,899 186,476 548,868 576,556
Net investment income 259,945 236,633 767,709 733,065
Realized investment gains (losses):
Derivative financial instruments (4,218) (4,868) 6,814 (15,133)
All other investments 9,647 27,042 26,351 62,288
Other income 14,766 9,586 41,087 40,709
- --------------------------------------------------------------------------------------------------------------------------------
464,039 454,869 1,390,829 1,397,485
- --------------------------------------------------------------------------------------------------------------------------------
BENEFITS AND EXPENSES
Benefits and settlement expenses
(net of reinsurance ceded:
three months: 2004 - $304,134; 2003 - $214,347
nine months: 2004 - $791,122; 2003 - $643,118) 280,302 281,692 844,278 863,901
Amortization of deferred policy acquisition costs 52,375 56,243 157,222 176,804
Other operating expenses (net of reinsurance ceded:
three months: 2004 - $40,660; 2003 - $27,767
nine months: 2004 - $121,774; 2003 - $90,781) 40,739 33,343 100,196 112,922
- --------------------------------------------------------------------------------------------------------------------------------
373,416 371,278 1,101,696 1,153,627
- --------------------------------------------------------------------------------------------------------------------------------
INCOME BEFORE INCOME TAX 90,623 83,591 289,133 243,858
Income tax expense 34,979 28,811 101,023 82,180
- --------------------------------------------------------------------------------------------------------------------------------
NET INCOME BEFORE CUMULATIVE
EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE 55,644 54,780 188,110 161,678
- --------------------------------------------------------------------------------------------------------------------------------
Cumulative effect of change in accounting principle,
net of income tax 0 0 (10,128) 0
- --------------------------------------------------------------------------------------------------------------------------------
NET INCOME $ 55,644 $ 54,780 $ 177,982 $ 161,678
================================================================================================================================
See notes to consolidated condensed financial statements
(Dollars in thousands)
(Unaudited)
SEPTEMBER 30 DECEMBER 31
2004 2003
- --------------------------------------------------------------------------------------------------------------------------------
ASSETS
Investments:
Fixed maturities, at market (amortized cost: 2004 - $12,650,266; 2003 - $12,314,822) $13,324,485 $12,927,520
Equity securities, at market (cost: 2004 - $27,250; 2003 - $29,169) 29,883 30,521
Mortgage loans on real estate 2,904,729 2,733,722
Investment in real estate, net 81,691 13,152
Policy loans 485,282 502,748
Other long-term investments 213,868 244,913
Short-term investments 967,388 510,635
- --------------------------------------------------------------------------------------------------------------------------------
Total investments 18,007,326 16,963,211
Cash 81,113 111,059
Accrued investment income 200,574 184,439
Accounts and premiums receivable, net 41,731 43,095
Reinsurance receivables 2,574,962 2,308,153
Deferred policy acquisition costs 1,844,207 1,863,568
Goodwill 36,182 35,143
Property and equipment, net 44,339 43,156
Other assets 217,944 198,581
Assets related to separate accounts
Variable annuity 2,110,082 2,045,038
Variable universal life 192,478 171,408
Other 4,333 4,361
- --------------------------------------------------------------------------------------------------------------------------------
$25,355,271 $23,971,212
================================================================================================================================
LIABILITIES
Policy liabilities and accruals $10,320,448 $ 9,693,818
Stable value product account balances 5,143,367 4,676,531
Annuity account balances 3,429,472 3,480,577
Other policyholders' funds 155,480 158,359
Other liabilities 868,954 764,097
Accrued income taxes 1,182 5,718
Deferred income taxes 301,544 339,273
Notes payable 2,210 2,234
Liabilities related to variable interest entities 54,053 0
Liabilities related to separate accounts
Variable annuity 2,110,082 2,045,038
Variable universal life 192,478 171,408
Other 4,333 4,361
- --------------------------------------------------------------------------------------------------------------------------------
22,583,603 21,341,414
- --------------------------------------------------------------------------------------------------------------------------------
COMMITMENTS AND CONTINGENT LIABILITIES - NOTE B
SHARE-OWNER'S EQUITY
Preferred Stock, $1.00 par value, shares authorized and issued: 2,000,
liquidation preference $2,000 2 2
Common Stock, $1.00 par value, shares authorized and issued: 5,000,000 5,000 5,000
Additional paid-in capital 865,805 863,819
Note receivable from PLC Employee Stock Ownership Plan (2,983) (3,426)
Retained earnings 1,609,799 1,431,818
Accumulated other comprehensive income:
Net unrealized gains on investments
(net of income tax: 2004 - $156,308; 2003 - $177,642) 290,287 329,907
Accumulated gain - hedging (net of income tax: 2004 - $2,024; 2003 - $1,442) 3,758 2,678
- --------------------------------------------------------------------------------------------------------------------------------
2,771,668 2,629,798
- --------------------------------------------------------------------------------------------------------------------------------
$25,355,271 $23,971,212
================================================================================================================================
See notes to consolidated condensed financial statements
PROTECTIVE LIFE INSURANCE
COMPANY
CONSOLIDATED CONDENSED
STATEMENTS OF CASH FLOWS
(Dollars in thousands)
(Unaudited)
NINE MONTHS ENDED
SEPTEMBER 30
2004 2003
- ---------------------------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM OPERATING ACTIVITIES $ 177,982 $ 161,678
Net income
Adjustments to reconcile net income to net cash provided by operating activities:
Realized investment (gains) losses (17,629) (37,032)
Amortization of deferred policy acquisition costs 157,222 176,804
Capitalization of deferred policy acquisition costs (271,352) (296,582)
Depreciation expense 12,692 13,535
Deferred income tax 21,659 38,519
Accrued income tax (40,394) (28,075)
Interest credited to universal life and investment products 480,789 494,054
Policy fees assessed on universal life and investment products (261,058) (240,747)
Change in accrued investment income and other receivables (281,665) 69,901
Change in policy liabilities and other policyholders' funds of traditional
life and health products 567,156 92,014
Change in other liabilities (72,146) (119,688)
Other, net (27,322) 19,127
- ---------------------------------------------------------------------------------------------------------------------------------
Net cash provided by operating activities 445,934 343,508
- ---------------------------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM INVESTING ACTIVITIES
Investments available for sale, net of short-term investments:
Maturities and principal reductions of investments 1,493,142 4,046,656
Sale of investments 2,905,106 3,167,909
Cost of investments acquired (4,691,103) (7,796,188)
Change in mortgage loans, net (170,181) (160,209)
Change in investment in real estate, net 123 3,776
Change in policy loans, net 17,466 19,292
Change in other long-term investments, net 3,098 3,630
Change in short-term investments, net (282,214) 256,844
Purchase of property and equipment (13,093) (13,224)
- ---------------------------------------------------------------------------------------------------------------------------------
Net cash used in investing activities (737,656) (471,514)
- ---------------------------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM FINANCING ACTIVITIES
Borrowings under line of credit arrangement and debt 0 111,725
Principal payments on line of credit arrangement and debt (1,699) (15)
Investment product deposits and change in universal life deposits 2,109,203 1,325,893
Investment product withdrawals (1,845,728) (1,314,753)
- ---------------------------------------------------------------------------------------------------------------------------------
Net cash provided by financing activities 261,776 122,850
- ---------------------------------------------------------------------------------------------------------------------------------
CHANGE IN CASH (29,946) (5,156)
CASH AT BEGINNING OF PERIOD 111,059 85,850
- ---------------------------------------------------------------------------------------------------------------------------------
CASH AT END OF PERIOD $ 81,113 $ 80,694
=================================================================================================================================
See notes to consolidated condensed financial statements
NOTE A – BASIS OF PRESENTATION
The accompanying unaudited consolidated condensed financial statements of Protective Life Insurance Company and subsidiaries (“Protective Life”) have been prepared in accordance with accounting principles generally accepted in the United States of America (GAAP) for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the disclosures required by GAAP for complete financial statements. In the opinion of management, all adjustments (consisting only of normal recurring accruals) necessary for a fair statement have been included. Operating results for the nine-month period ended September 30, 2004, are not necessarily indicative of the results that may be expected for the year ending December 31, 2004. The year-end consolidated condensed balance sheet data was derived from audited financial statements, but does not include all disclosures required by GAAP. For further information, refer to the consolidated financial statements and notes thereto included in Protective Life’s annual report on Form 10-K for the year ended December 31, 2003.
Protective Life is a wholly-owned subsidiary of Protective Life Corporation (“PLC”).
Certain reclassifications have been made in the previously reported financial statements and accompanying notes to make the prior year amounts comparable to those of the current year. Such reclassifications had no effect on previously reported net income or share-owner’s equity.
With respect to the unaudited consolidated condensed financial information of Protective Life for the nine-month periods ended September 30, 2004 and 2003, PricewaterhouseCoopers LLP (“PricewaterhouseCoopers”) reported that they have applied limited procedures in accordance with professional standards for a review of such information. However, their separate report dated November 15, 2004, appearing herein, stated that they did not audit and they do not express an opinion on that unaudited consolidated condensed financial information. Accordingly, the degree of reliance on their report on such information should be restricted in light of the limited nature of the review procedures applied. PricewaterhouseCoopers is not subject to the liability provisions of Section 11 of the Securities Act of 1933 for their report on the unaudited consolidated condensed financial information because that report is not a “report” or a “part” of a registration statement prepared or certified by PricewaterhouseCoopers into which this Form 10-Q may be incorporated by reference within the meaning of Sections 7 and 11 of the Act.
NOTE B – COMMITMENTS AND CONTINGENT LIABILITIES
Under insurance guaranty fund laws, in most states insurance companies doing business therein can be assessed up to prescribed limits for policyholder losses incurred by insolvent companies. Protective Life does not believe such assessments will be materially different from amounts already provided for in the financial statements. Most of these laws do provide, however, that an assessment may be excused or deferred if it would threaten an insurer’s own financial strength.
A number of civil jury verdicts have been returned against insurers and other providers of financial services involving sales practices, alleged agent misconduct, failure to properly supervise representatives, relationships with agents or persons with whom the insurer does business, and other matters. Increasingly these lawsuits have resulted in the award of substantial judgments that are disproportionate to the actual damages, including material amounts of punitive and non-economic compensatory damages. In some states, juries, judges, and arbitrators have substantial discretion in awarding punitive and non-economic compensatory damages, which creates the potential for unpredictable material adverse judgments or awards in any given lawsuit or arbitration. Arbitration awards are subject to very little appellate review. In addition, in some class action and other lawsuits, companies have made material settlement payments. Protective Life, like other financial services companies, in the ordinary course of business is involved in such litigation and in arbitration. Although the outcome of any such litigation or arbitration cannot be predicted, Protective Life believes that at the present time there are no pending or threatened lawsuits that are reasonably likely to have a material adverse effect on the financial position, results of operations, or liquidity of Protective Life.
NOTE C – OPERATING SEGMENTS
Protective Life operates several business segments. An operating segment is generally distinguished by products and/or channels of distribution. A brief description of each segment follows:
| Life Marketing. The Life Marketing segment markets level premium term and term-like insurance, universal life, and variable universal life products on a national basis primarily through networks of independent insurance agents and brokers, stockbrokers, and in the “bank owned life insurance” market. |
| Acquisitions. The Acquisitions segment focuses on acquiring, converting, and servicing policies acquired from other companies. The segment’s primary focus is on life insurance policies sold to individuals. |
| Annuities. The Annuities segment manufactures, sells, and supports fixed and variable annuity products. These products are primarily sold through stockbrokers, but are also sold through financial institutions and the Life Marketing segment’s sales force. |
| Stable Value Products. The Stable Value Products segment markets guaranteed investment contracts to 401(k) and other qualified retirement savings plans, and sells guaranteed funding agreements to special purpose entities that in turn issue notes or certificates in smaller, transferable denominations. The segment also markets fixed and floating rate funding agreements directly to the trustees of municipal bond proceeds, institutional investors, bank trust departments, and money market funds. |
| Asset Protection. The Asset Protection segment primarily markets extended service contracts and credit life and disability insurance to protect consumers’ investments in automobiles and watercraft. |
| Corporate and Other. Protective Life has an additional segment herein referred to as Corporate and Other. The Corporate and Other segment primarily consists of net investment income and expenses not attributable to the segments above (including net investment income on unallocated capital). This segment also includes earnings from several small non-strategic lines of business (mostly cancer insurance, residual value insurance, surety insurance, and group annuities), various investment-related transactions, and the operations of several small subsidiaries. The surety and residual value insurance lines were moved from the Asset Protection segment to Corporate and Other in 2004, and prior period segment data was restated to reflect the change. |
Protective Life uses the same accounting policies and procedures to measure segment operating income and assets as it uses to measure its consolidated net income and assets. Segment operating income is generally income before income tax, adjusted to exclude net realized investment gains and losses (and the related amortization of deferred policy acquisition costs) and the cumulative effect of change in accounting principle. Periodic settlements of interest rate swaps associated with certain investments are included in realized gains and losses but are considered part of operating income because the swaps are used to mitigate risk in items affecting operating income. Segment operating income represents the basis on which the performance of Protective Life’s business is assessed by management. Premiums and policy fees, other income, benefits and settlement expenses, and amortization of deferred policy acquisition costs are attributed directly to each operating segment. Net investment income is allocated based on directly related assets required for transacting the business of that segment. Realized investment gains (losses) and other operating expenses are allocated to the segments in a manner which appropriately reflects the operations of that segment.
Assets are allocated based on policy liabilities directly attributable to each segment and deferred policy acquisition costs and goodwill are shown in the segments to which they are attributable. A reclassification adjustment has been made to the December 31, 2003 segment asset information in the Annuities and Corporate and Other segments to reflect segment asset groupings consistently.
There are no significant intersegment transactions.
The following tables set forth total revenue by segment, segment operating income, and assets for the periods shown. Asset adjustments represent the inclusion of assets related to discontinued operations. The increase in the goodwill balance in the Asset Protection segment relates to the merger of an affiliated company with an insurance subsidiary of Protective Life and the sale of a small subsidiary in the first quarter of 2004.
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
Total Revenue 2004 2003 2004 2003
------------------------- --------------------------
Life Marketing $122,639 $108,926 $ 352,486 $ 346,297
Acquisitions 108,760 115,005 331,491 349,500
Annuities 65,041 71,165 192,487 212,485
Stable Value Products 73,465 66,186 210,065 181,366
Asset Protection 68,849 78,626 209,953 243,325
Corporate and Other 25,285 14,961 94,347 64,512
------------------------- --------------------------
$464,039 $454,869 $1,390,829 $1,397,485
========================= ==========================
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
Segment Operating Income 2004 2003 2004 2003
------------------------- --------------------------
Life Marketing $ 37,933 $38,966 $ 121,898 $116,849
Acquisitions 21,275 25,104 65,875 72,844
Annuities 3,753 2,500 10,848 8,884
Stable Value Products 13,313 9,523 38,938 28,759
Asset Protection 5,073 4,612 13,527 15,410
Corporate and Other 7,961 (8,496) 16,888 (19,822)
------------------------- --------------------------
Total segment operating income 89,308 72,209 267,974 222,924
Add back: realized investment gains (losses) 5,429 22,174 33,165 47,155
Less: related amortization of deferred policy acquisition costs 2,669 8,167 6,880 18,265
Less: derivative gains related to investments 1,445 2,625 5,126 7,956
------------------------- --------------------------
Income before income tax 90,623 83,591 289,133 243,858
Income tax expense (34,979) (28,811) (101,023) (82,180)
------------------------- --------------------------
Net income before cumulative effect of change in
accounting principle 55,644 54,780 188,110 161,678
Cumulative effect of change in accounting principle 0 0 (10,128) 0
------------------------- --------------------------
Net income $55,644 $54,780 $ 177,982 $ 161,678
========================= ==========================
Operating Segment Assets
September 30, 2004
- ------------------------------------------------------------------------------------------------------------------------------------
Life Stable Value
Marketing Acquisitions Annuities Products
- ------------------------------------------------------------------------------------------------------------------------------------
Investments and other assets $5,683,653 $4,093,948 $5,573,668 $5,005,407
Deferred policy acquisition costs 1,243,508 311,137 95,098 16,120
Goodwill
- ------------------------------------------------------------------------------------------------------------------------------------
Total assets $6,927,161 $4,405,085 $5,668,766 $5,021,527
- ------------------------------------------------------------------------------------------------------------------------------------
- ------------------------------------------------------------------------------------------------------------------------------------
Asset Corporate Total
Protection and Other Adjustments Consolidated
- ------------------------------------------------------------------------------------------------------------------------------------
Investments and other assets $ 841,955 $2,229,727 $46,524 $23,474,882
Deferred policy acquisition costs 169,252 9,092 1,844,207
Goodwill 36,182 36,182
- ------------------------------------------------------------------------------------------------------------------------------------
Total assets $1,047,389 $2,238,819 $46,524 $25,355,271
====================================================================================================================================
Operating Segment Assets
December 31, 2003
- ------------------------------------------------------------------------------------------------------------------------------------
Life Stable Value
Marketing Acquisitions Annuities Products
- ------------------------------------------------------------------------------------------------------------------------------------
Investments and other assets $4,983,336 $4,356,929 $5,433,465 $4,520,955
Deferred policy acquisition costs 1,185,102 385,042 101,096 7,186
Goodwill
- ------------------------------------------------------------------------------------------------------------------------------------
Total assets $6,168,438 $4,741,971 $5,534,561 $4,528,141
- ------------------------------------------------------------------------------------------------------------------------------------
- ------------------------------------------------------------------------------------------------------------------------------------
Asset Corporate Total
Protection and Other Adjustments Consolidated
- ------------------------------------------------------------------------------------------------------------------------------------
Investments and other assets $ 913,405 $1,807,317 $57,094 $22,072,501
Deferred policy acquisition costs 175,264 9,878 1,863,568
Goodwill 35,143 35,143
- ------------------------------------------------------------------------------------------------------------------------------------
Total assets $1,123,812 $1,817,195 $57,094 $23,971,212
====================================================================================================================================
NOTE D – STATUTORY REPORTING PRACTICES
Financial statements prepared in conformity with GAAP differ in some respects from the statutory accounting practices prescribed or permitted by insurance regulatory authorities. In accordance with statutory reporting practices, at September 30, 2004, and for the nine months then ended, Protective Life and its insurance subsidiaries had combined capital and surplus of $1,167.0 million and net income of $121.3 million. At September 30, 2004, the combined asset valuation reserve held by Protective Life’s insurance subsidiaries was $203.2 million.
NOTE E – REINSURANCE RECEIVABLE
In 2002, Protective Life discovered that it had overpaid reinsurance premiums to several reinsurance companies. In the first nine months of 2003, Protective Life increased premiums and policy fees $18.4 million as a result of cash received and changes in expected receipts at that time. The increase in premiums and policy fees resulted in $6.1 million of additional amortization of deferred policy acquisition costs in the first nine months of 2003. As a result, Protective Life’s pretax income for the first nine months of 2003 increased by $12.3 million. In the second quarter of 2004, Protective Life adjusted its estimate of the expected receipts, resulting in a $1.0 million decrease in pretax income.
NOTE F – RECENTLY ISSUED ACCOUNTING STANDARDS
In January 2003, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. (FIN) 46 “Consolidation of Variable Interest Entities,” which was revised in December 2003. FIN 46 clarifies the application of Accounting Research Bulletin No. 51, “Consolidated Financial Statements,” to certain entities in which equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated support from other parties. Protective Life consolidated, as of March 31, 2004, a real estate investment company that Protective Life had previously reported as an investment. The entity was consolidated based on the determination that Protective Life was the primary beneficiary. The consolidation resulted in Protective Life’s reported assets and liabilities increasing by $54.5 million with an immaterial impact on results of operations.
In July 2003, the American Institute of Certified Public Accountants issued Statement of Position (SOP) 03-1, “Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts.” SOP 03-1 is effective for fiscal years beginning after December 15, 2003. See Note I for discussion of Protective Life’s adoption of SOP 03-1.
NOTE G –COMPREHENSIVE INCOME
The following table sets forth Protective Life’s comprehensive income for the periods presented below:
-----------------------------------------------------------------------------------------------------------------------------
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
2004 2003 2004 2003
-----------------------------------------------------------------------------------------------------------------------------
Net income $ 55,644 $ 54,780 $177,982 $161,678
Change in net unrealized gains/losses on
investments (net of income tax:
three months: 2004 - $98,174; 2003 - $(46,261)
nine months: 2004 - $(12,111); 2003 - $85,817) 182,323 (85,914) (22,492) 159,375
Change in accumulated gain-hedging (net of tax:
three months: 2004 - $(1,623); 2003 - $615
nine months: 2004 - $582; 2003 - $2,361) (3,014) 1,143 1,080 4,385
Reclassification adjustment for amounts included
in net income (net of income tax:
three months: 2004 - $(3,376); 2003 - $(9,465)
nine months: 2004 - $(9,223); 2003 - $(21,801)) (6,270) (17,577) (17,128) (40,487)
-----------------------------------------------------------------------------------------------------------------------------
Comprehensive income (loss) $ 228,683 $(47,568) $139,442 $284,951
=============================================================================================================================
NOTE H –RETIREMENT BENEFIT PLANS
The following table sets forth the amount of net periodic benefit cost recognized for PLC’s defined benefit pension plan and unfunded excess benefits plan:
- ------------------------------------------------------------------------------------------------------------------------------
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
2004 2003 2004 2003
- ------------------------------------------------------------------------------------------------------------------------------
Service cost $1,368 $1,150 $4,581 $3,849
Interest cost 1,566 1,345 5,243 4,503
Expected return on plan assets (1,578) (1,289) (5,285) (4,315)
Amortization of prior service cost 53 53 177 177
Amortization of net loss 512 268 1,716 899
- ------------------------------------------------------------------------------------------------------------------------------
Net periodic benefit cost $1,921 $1,527 $6,432 $5,113
==============================================================================================================================
PLC previously disclosed in its financial statements for the year ended December 31, 2003, that it expected to contribute $6.4 million to its pension plan in 2004. PLC now estimates that it will contribute $19.8 million to its pension plan in 2004. As of September 30, 2004, no contributions had been made. As of November 1, 2004, $12.5 million had been contributed to the pension plan.
PLC’s defined benefit pension plan covers substantially all of its employees, including Protective Life employees. The plan is not separable by affiliates participating in the plan.
In addition to pension benefits, PLC provides limited healthcare benefits and life insurance benefits to eligible retirees. The cost of these plans for the nine months ended September 30, 2004 and 2003 was immaterial.
NOTE I – CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE
In January 2004, Protective Life adopted SOP 03-1 “Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts”. SOP 03-1 provides guidance related to the establishment of reserves for benefit guarantees provided under certain long-duration contracts, as well as the accounting for mortality benefits provided in certain universal life products. In addition, it addresses the capitalization and amortization of sales inducements to contract holders. The adoption of SOP 03-1 in the first quarter of 2004 resulted in a cumulative charge to net income of $10.1 million, net of income tax of $5.5 million. The charge to net income includes a $10.0 million charge to recognize additional liabilities, including an adjustment to deferred policy acquisition costs, on certain universal life contracts. These additional liabilities are required due to a change in the pattern of recognition of mortality benefits called for by the SOP. In addition, Protective Life recorded a $0.1 million adjustment related to guaranteed minimum death benefits (GMDB) on its variable annuity products.
Protective Life issues variable universal life and variable annuity products through its separate accounts for which the investment risk is borne by the contract holder. Protective Life also offers, for its variable annuity products, various account value guarantees upon death. The most significant of these guarantees involve (a) return of the highest anniversary date account value, or (b) return of the greater of the highest anniversary date account value or the last anniversary date account value compounded at 5% interest. The GMDB reserve is calculated by applying a benefit ratio, equal to the present value of total expected GMDB claims divided by the present value of total expected contract assessments, to cumulative contract assessments. This amount is then adjusted by the amount of cumulative GMDB claims paid and accrued interest. Assumptions used in the calculation of the GMDB reserve were as follows: mean investment performance of 9%, mortality at 60% of the 1994 MGDB Mortality Table, lapse rates ranging from 1%-20% (depending on product type and duration), and an average discount rate of 7%.
Separate account balances are valued at market and reported separately as assets and liabilities related to separate accounts in the accompanying consolidated balance sheets. Amounts assessed against policy account balances for the costs of insurance, policy administration, and other services are included in premiums and policy fees in the accompanying consolidated statements of income. Changes in the GMDB accrual are included in benefits and settlement expenses in the accompanying consolidated statements of income.
The variable annuity separate account balances subject to GMDB were $2.1 billion at September 30, 2004. The total guaranteed amount payable based on variable annuity account balances at September 30, 2004, was $292.5 million (including $258.5 million in the Annuities segment and $34.0 million in the Acquisitions segment), with a GMDB reserve of $6.1 million (including $5.6 million in the Annuities segment and $0.5 million in the Acquisitions segment). The average attained age of contract holders at September 30, 2004 was 65.
Activity relating to GMDB reserves was as follows:
-----------------------------------------------------------------------------------------------------------------------------
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
2004 2003 2004 2003
-----------------------------------------------------------------------------------------------------------------------------
Incurred claims $1,772 $ 766 $3,071 $6,286
Paid claims 1,244 1,280 2,852 6,256
-----------------------------------------------------------------------------------------------------------------------------
Account balances of variable annuities with guarantees were invested in variable annuity separate accounts as follows:
- -------------------------------------------------------------------------------------------------------------------------
SEPTEMBER 30, 2004 DECEMBER 31, 2003
- -------------------------------------------------------------------------------------------------------------------------
Equity mutual funds $1,905,870 $1,845,952
Fixed income mutual funds 204,212 199,086
- -------------------------------------------------------------------------------------------------------------------------
Total $2,110,082 $2,045,038
=========================================================================================================================
Certain of Protective Life’s universal life products have a sales inducement in the form of a retroactive interest credit (RIC). In addition, certain variable annuity contracts provide a sales inducement in the form of a bonus interest credit. In accordance with SOP 03-1, Protective Life maintains a reserve for all interest credits earned to date. Protective Life defers the expense associated with the RIC and bonus interest credits each period and amortizes these costs in a manner similar to that used for deferred policy acquisition costs.
Activity in Protective Life’s deferred sales inducement asset was as follows:
-----------------------------------------------------------------------------------------------------------------------------
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
2004 2003 2004 2003
-----------------------------------------------------------------------------------------------------------------------------
Deferred asset, beginning of period $27,566 $29,221 $27,713 $31,557
Amounts deferred 3,231 2,941 9,141 7,873
Amortization (3,210) (3,545) (9,267) (10,813)
-----------------------------------------------------------------------------------------------------------------------------
Deferred asset, end of period $27,587 $28,617 $27,587 $28,617
=============================================================================================================================
In September 2004, the AICPA issued a Technical Practice Aid (TPA) which contains additional interpretive guidance on applying certain provisions of SOP 03-1. Among other items, the TPA provides guidance on the definition of an assessment, the accounting for universal life contracts that exhibit losses followed by losses, and the accounting for reinsurance of the additional mortality reserves required by the SOP. Protective Life is currently evaluating the provisions of the TPA to determine what impact, if any, it may have on previously reported earnings, including the cumulative effect adjustment. Protective Life anticipates making any adjustments resulting from the application of this guidance during the fourth quarter of 2004. Adoption of the TPA guidance that results in changes to previously reported information will be recorded in accordance with APB 20, “Accounting Changes”.
Protective Life Insurance Company (“Protective Life”) is a wholly-owned subsidiary of Protective Life Corporation (“PLC”), an insurance holding company whose common stock is traded on the New York Stock Exchange under the symbol “PL”. Founded in 1907, Protective Life provides financial services through the production, distribution, and administration of insurance and investment products. Unless the context otherwise requires, “Protective Life” refers to the consolidated group of Protective Life Insurance Company and its subsidiaries.
For a more complete understanding of Protective Life’s business and its current period results, please read the following Management’s Discussion and Analysis of Financial Condition and Results of Operations in conjunction with Protective Life’s latest annual report on Form 10-K and other filings with the SEC.
Protective Life operates several business segments each having a strategic focus. An operating segment is generally distinguished by products and/or channels of distribution. Protective Life’s operating segments are Life Marketing, Acquisitions, Annuities, Stable Value Products, and Asset Protection. Protective Life also has an additional segment referred to as Corporate and Other.
This report reviews Protective Life’s financial condition and results of operations including its liquidity and capital resources. Historical information is presented and discussed. Where appropriate, factors that may affect future financial performance are also identified and discussed. Certain statements made in this report include “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements include any statement that may predict, forecast, indicate or imply future results, performance or achievements instead of historical facts and may contain words like “believe,” “expect,” “estimate,” “project,” “budget,” “forecast,” “anticipate,” “plan,” “will,” “shall,” “may,” and other words, phrases, or expressions with similar meanings. Forward-looking statements involve risks and uncertainties which may cause actual results to differ materially from the results contained in the forward-looking statements, and Protective Life cannot give assurances that such statements will prove to be correct. Given these risks and uncertainties, investors should not place undue reliance on forward-looking statements as a prediction of actual results.
The factors which could affect Protective Life’s future results include, but are not limited to, general economic conditions and the following known trends and uncertainties: we are exposed to the risks of natural disasters, malicious and terrorist acts that could adversely affect our operations; we operate in a mature, highly competitive industry, which could limit our ability to gain or maintain our position in the industry; a ratings downgrade could adversely affect our ability to compete; our policy claims fluctuate from period to period, and actual results could differ from our expectations; our results may be negatively affected should actual experience differ from management’s assumptions and estimates; the use of reinsurance introduces variability in our statement of income; we could be forced to sell investments at a loss to cover policyholder withdrawals; interest rate fluctuations could negatively affect our spread income or otherwise impact our business; equity market volatility could negatively impact our business; a deficiency in our systems could result in over- or underpayments of amounts owed to or by Protective Life and/or errors in our critical assumptions or reported financial results; insurance companies are highly regulated and subject to numerous legal restrictions and regulations; Protective Life is exposed to potential risks from recent legislation requiring companies to evaluate their internal controls over financial reporting; changes to tax law or interpretations of existing tax law could adversely affect Protective Life and its ability to compete with non-insurance products or reduce the demand for certain insurance products; financial services companies are frequently the targets of litigation, including class action litigation, which could result in substantial judgments; the financial services and insurance industry is sometimes the target of law enforcement investigations; our ability to maintain low unit costs is dependent upon the level of new sales and persistency of existing business; our investments are subject to market and credit risks; we may not realize our anticipated financial results from our acquisitions strategy; we are dependent on the performance of others; our reinsurers could fail to meet assumed obligations, increase rates, limit the availability of reinsurance in the future or be subject to adverse developments that could affect us; computer viruses or network security breaches could affect our data processing systems or those of our business partners; our ability to grow depends in large part upon the continued availability of capital and could be impacted by the availability of reasonably priced reinsurance; and new accounting rules or changes to existing accounting rules could negatively impact Protective Life. Please refer to Exhibit 99, incorporated by reference herein, about these factors that could affect future results.
Protective Life’s results may fluctuate from period to period due to fluctuations in mortality, persistency, claims, expenses, interest rates, and other factors. Therefore, it is management’s opinion that quarterly operating results for an insurance company are not necessarily indicative of results to be achieved in future periods, and that a review of operating results over a longer period is necessary to assess an insurance company’s performance.
In the following discussion, segment operating income is defined as income before income tax excluding net realized investment gains and losses and related amortization of deferred policy acquisition costs (DAC), and the cumulative effect of change in accounting principle. Periodic settlements of interest rate swaps associated with certain investments are included in realized gains and losses but are considered part of segment operating income because the swaps are used to mitigate risk in items affecting segment operating income. Management believes that segment operating income provides relevant and useful information to investors, as it represents the basis on which the performance of Protective Life’s business is internally assessed. Although the items excluded from segment operating income may be significant components in understanding and assessing Protective Life’s overall financial performance, management believes that segment operating income enhances an investor’s understanding of Protective Life’s results of operations. Note that Protective Life’s segment operating income measures may not be comparable to similarly titled measures reported by other companies.
The following table sets forth a summary of results and reconciles segment operating income (loss) to consolidated net income:
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
2004 2003 CHANGE 2004 2003 CHANGE
------------------------------------- -----------------------------------
Life Marketing $ 37,933 $ 38,966 (2.7)% $121,898 $116,849 4.3%
Acquisitions 21,275 25,104 (15.3) 65,875 72,844 (9.6)
Annuities 3,753 2,500 50.1 10,848 8,884 22.1
Stable Value Products 13,313 9,523 39.8 38,938 28,759 35.4
Asset Protection 5,073 4,612 10.0 13,527 15,410 (12.2)
Corporate & Other 7,961 (8,496) n/m 16,888 (19,822) n/m
--------------------------- -------------------------
89,308 72,209 23.7 267,974 222,924 20.0
Realized investment gains (losses) - investments(1) 6,978 18,875 19,471 44,023
Realized investment gains (losses) - derivatives(2) (5,663) (7,493) 1,688 (23,089)
Income tax expense (34,979) (28,811) (101,023) (82,180)
--------------------------- -------------------------
Net income before cumulative effect of change
in accounting principle 55,644 54,780 1.6 188,110 161,678 16.3
Cumulative effect of change in accounting
principle, net of income tax (10,128)
--------------------------- -------------------------
Net income $ 55,644 $ 54,780 1.6 $177,982 $161,678 10.1
=========================== =========================
(1) Realized investment gains (losses)-investments $ 9,647 $27,042 $26,351 $62,288
Related amortization of DAC (2,669) (8,167) (6,880) (18,265)
--------------------------- -------------------------
$ 6,978 $18,875 $19,471 $44,023
(2) Realized investment gains (losses)-derivatives $(4,218) $(4,868) $ 6,814 $(15,133)
Settlements on certain interest rate swaps (1,445) (2,625) (5,126) (7,956)
--------------------------- -------------------------
$(5,663) $(7,493) $ 1,688 $(23,089)
Compared to third quarter 2003, net income increased 1.6% reflecting lower investment gains offset by an improvement in segment operating income. Net income for the first nine months of 2004 increased 10.1% due to higher contributions from segment operating income and realized investment gains, somewhat offset by the cumulative effect charge. The reduction in realized investment gains for the quarter was primarily due to higher gains on sales of fixed maturity securities in the prior year quarter as well as a significant increase in impairments recorded during the current quarter. For the first nine months of 2004, a significant reduction in gains from sales of securities was more than offset by higher contributions from derivatives. Excluding the impact of reinsurance recoveries during 2003 (see Note E), Life Marketing’s operating income decreased 2.7% and increased 16.6% over the third quarter and first nine months of 2003, respectively, reflecting continued growth in life insurance in-force through new sales, offset by the impact of significantly lower sales levels in the current quarter. For both the quarter and year-to-date comparisons, an increase in average account values and widening of spreads drove the improvement in the Stable Value Products segment, while improvement in the equity markets and higher sales of fixed annuities contributed to the increase in the Annuities segment’s earnings. Excluding gains from charter sales, Asset Protection segment operating income increased 10.0% and 46.2% over the third quarter and first nine months of 2003, primarily due to significant improvement in the segment’s service contract lines. The Acquisitions segment’s earnings for the quarter and year-to-date declined due to the normal runoff of the segment’s previously acquired blocks of business. The improvement in Corporate and Other earnings primarily reflects reduced losses from runoff insurance lines as well as higher amounts of investment income.
Included in net income for the first nine months of 2004 is a cumulative effect charge of $10.1 million arising from Protective Life’s adoption of SOP 03-1 (see Note I for further discussion of SOP 03-1).
In the following segment discussions, various statistics and other key data Protective Life uses to evaluate its segments are presented. Sales statistics are used by Protective Life to measure the relative progress in its marketing efforts, but typically have little immediate impact on reported segment operating income. Sales data for traditional life insurance are based on annualized premiums, while universal life sales are based on annualized target premiums. Sales of annuities are measured based on the amount of deposits received. Stable value contract sales are measured at the time that the funding commitment is made, based on the amount of deposit to be received. Sales within the Asset Protection segment are generally based on the amount of single premium and fees received.
Sales and life insurance in-force amounts are derived from Protective Life’s various sales tracking and administrative systems, and are not derived from Protective Life’s financial reporting systems or financial statements. Mortality variances are derived from actual claims compared to expected claims. These variances do not represent the net impact to earnings due to the interplay of reserves and DAC amortization.
The Life Marketing segment markets level premium term and term-like insurance, universal life (UL), and variable universal life products on a national basis primarily through networks of independent insurance agents and brokers, stockbrokers, and in the “bank owned life insurance” (BOLI) market. Segment results were as follows:
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
2004 2003 CHANGE 2004 2003 CHANGE
-------------------------------- --------------------------------
REVENUES
Gross premiums and policy fees $ 253,951 $219,410 15.7% $ 740,868 $ 607,770 21.9%
Reinsurance ceded (191,228) (167,706) 14.0 (565,086) (433,645) 30.3
---------------------- ----------------------
Net premiums and policy fees 62,723 51,704 21.3 175,782 174,125 1.0
Net investment income 59,710 57,885 3.2 176,117 171,654 2.6
Other income 206 (663) n/m 587 518 13.3
---------------------- ----------------------
Total operating revenues 122,639 108,926 352,486 346,297 1.8
BENEFITS AND EXPENSES
Benefits and settlement expenses 78,361 68,540 14.3 217,079 205,638 5.6
Amortization of deferred policy acquisition costs 14,823 12,788 15.9 46,830 52,705 (11.1)
Other operating expenses (8,478) (11,368) (25.4) (33,321) (28,895) 15.3
---------------------- ----------------------
Total benefits and expenses 84,706 69,960 21.1 230,588 229,448 0.5
OPERATING INCOME 37,933 38,966 (2.7) 121,898 116,849 4.3
---------------------- ----------------------
INCOME BEFORE INCOME TAX $ 37,933 $ 38,966 (2.7) $ 121,898 $ 116,849 4.3
====================== ======================
The following table summarizes key data for the Life Marketing segment:
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
2004 2003 CHANGE 2004 2003 CHANGE
------------------------------------ -------------------------------------
Sales By Product
Traditional $41,046 $56,372 (27.2)% $130,089 $150,576 (13.6)%
Universal life 16,330 20,098 (18.7) 53,293 56,980 (6.5)
Variable universal life 1,492 1,245 19.8 4,091 3,226 26.8
--------------------------- --------------------------
$58,868 $77,715 (24.3) $187,473 $210,782 (11.1)
=========================== ==========================
Sales By Distribution Channel
Brokerage general agents $37,808 $52,427 (27.9) $120,135 $136,198 (11.8)
Independent agents 12,616 13,252 (4.8) 37,926 36,256 4.6
Stockbrokers/banks 7,018 6,634 5.8 19,857 17,880 11.1
Direct response 85 1,270 (93.3) 939 4,885 (80.8)
BOLI 1,341 4,132 (67.5) 8,616 15,563 (44.6)
--------------------------- --------------------------
$58,868 $77,715 (24.3) $187,473 $210,782 (11.1)
=========================== ==========================
Average Life Insurance In-Force(3)
Traditional $303,556,718 $234,824,652 29.3 $289,615,677 $213,512,049 35.6
Universal life 40,756,564 37,013,919 10.1 39,910,123 36,451,614 9.5
--------------------------- --------------------------
$344,313,282 $271,838,571 26.7 $329,525,800 $249,963,663 31.8
=========================== ==========================
Average Account Values
Universal life $3,666,987 $3,213,491 14.1 $3,565,474 $3,083,786 15.6
Variable universal life 190,721 142,769 33.6 183,879 128,873 42.7
--------------------------- --------------------------
$3,857,708 $3,356,260 14.9 $3,749,353 $3,212,659 16.7
=========================== ==========================
Interest Spread - Universal Life(2)
Net investment income yield 6.40% 6.80% 6.44% 6.97%
Interest credited to policyholders 4.88 5.38 4.92 5.49
--------------------------- --------------------------
Interest spread 1.52% 1.42% 1.52% 1.48%
=========================== ==========================
Mortality Experience (1) $166 $1,536 $2,187 $205
(1)
Represents a favorable (unfavorable) variance as compared to pricing
assumptions.
(2) Interest spread on average general account values.
(3) Amounts are not adjusted for reinsurance ceded.
Operating income decreased 2.7% from the third quarter of 2003 and increased 4.3% from the first nine months of 2003, reflecting lower sales in the current year and the positive impact of reinsurance recoveries on 2003 results. During the first nine months of 2003, the segment recognized additional net premiums of $18.4 million, amortization of DAC of $6.1 million, and operating income of $12.3 million as a result of recoveries from previously overpaid reinsurance premiums (see Note E). Excluding the impact from these recoveries, operating income increased 16.6% for the year-to-date. The increase in operating income for the nine-month period reflects continued growth of life insurance in-force through new sales. Current quarter operating income was lower then the third quarter of 2003 as the growth of life insurance in-force was more than offset by higher overall expenses and lower levels of capitalization driven by the decline in sales.
Gross premiums and policy fees grew by 15.7% and 21.9% in the current quarter and year-to-date comparisons due to the growth in life insurance in-force achieved over the last several quarters, while amounts ceded increased 14.0% and 25.0% (excluding reinsurance recoveries in 2003) as the segment continued to reinsure a significant amount of its new business. Net investment income increased approximately 3% over the third quarter and first nine months of 2003 reflecting the growth of the segment’s assets, offset by lower investment yields.
Benefits and settlement expenses were 14.3% and 5.6% higher than the third quarter and first nine months of 2003 due to growth in life insurance in-force, offset by lower crediting rates on UL products, and normal fluctuations in mortality experience. Mortality for the current quarter was $1.4 million less favorable versus the third quarter of 2003, while the first nine months of 2004 were $2.0 million more favorable versus the same period in 2003. Amortization of DAC (excluding the effect of reinsurance recoveries in 2003) was 15.9% and 0.5% higher for the quarter and year-to-date. The increase in amortization in the third quarter of 2004 is the result of the growth of life insurance in-force, somewhat offset by a decrease of $0.3 million due to favorable unlocking, primarily caused by a reduction of interest crediting rates in the current quarter. The change in amortization of DAC for the year-to-date reflects the impact of unlocking on UL products, the impact of the second quarter 2004 reinsurance receivable adjustment, and Protective Life’s adoption of SOP 03-1. Unlocking on UL products reduced amortization by $1.7 million, while the application of SOP 03-1 reduced amortization by $1.3 million for the first nine months of 2004. In addition, the adjustment to the reinsurance receivable in the second quarter of 2004 reduced amortization by $1.0 million.
Other operating expenses for the segment were as follows:
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
2004 2003 CHANGE 2004 2003 CHANGE
---------------------------------- --------------------------------
First year commissions $ 67,778 $ 81,942 (17.3)% $ 209,553 $ 218,313 (4.0)%
Renewal commissions 8,222 7,362 11.7 23,399 20,241 15.6
First year ceding allowances (41,541) (49,596) (16.2) (125,165) (134,587) (7.0)
Renewal ceding allowances (37,900) (29,966) 26.5 (108,185) (80,958) 33.6
General & administrative 41,975 48,426 (13.3) 137,688 136,975 0.5
Taxes, licenses and fees 5,951 5,417 9.9 16,384 14,591 12.3
---------------------- ----------------------
Other operating expenses incurred 44,485 63,585 (30.0) 153,674 174,575 (12.0)
Less commissions, allowances & expenses capitalized (52,963) (74,953) (29.3) (186,995) (203,470) (8.1)
---------------------- ----------------------
Other operating expenses $ (8,478) $(11,368) (25.4) $ (33,321) $ (28,895) 15.3
====================== ======================
Currently, the segment is reinsuring significant amounts of new life insurance sold. Pursuant to the underlying reinsurance contracts, reinsurers pay allowances to the segment as a percentage of both first year and renewal premiums. A portion of these allowances is deferred as part of DAC while the remainder is recognized immediately as a reduction of other operating expenses. While the recognition of reinsurance allowances is consistent with GAAP, non-deferred allowances often exceed the segment’s non-deferred direct costs, causing net other operating expenses to be negative. Consideration of all components of the segment’s income statement, including amortization of DAC, is required to assess the impact of reinsurance on segment operating income.
Other operating expenses were 25.4% less favorable versus the third quarter of 2003, as the 24.3% decrease in sales negatively impacted the segment’s expense capitalization levels. Expenses for the first nine months of 2004 were 15.3% more favorable versus 2003 as the effect of higher reinsurance allowances more than offset the impact of the 11.1% decrease in sales. General and administrative expenses decreased 13.3% versus third quarter 2003, primarily reflecting lower underwriting costs achieved through rate reductions from certain vendors in the fourth quarter of 2003. For the first nine months of 2004, general and administrative expenses were relatively unchanged due to higher expense levels in the first quarter of 2004. Amounts capitalized as DAC generally include first year commissions and allowances, and other deferrable acquisition expenses. The change in these amounts generally reflects the trend in sales for the quarter and year-to-date.
Sales for the segment decreased 24.3% and 11.1% versus the third quarter and first nine months of 2003 primarily due to lower production of traditional life at Empire General, which is included within the brokerage general agent channel. As expected, traditional life business sold through Empire General declined $11.8 million and $17.4 million versus the unusually strong levels achieved in the third quarter and first nine months of 2003. Sales of BOLI business also declined significantly from the strong sales achieved in 2003. BOLI sales will vary widely between periods as the segment responds to opportunities for these products only when the market accommodates required returns. In recent quarters, the segment has changed its direct response business sold through Matrix Direct to focus on a multi-carrier distribution strategy, resulting in the significant decrease in Protective Life’s direct response sales versus 2003.
The Acquisitions segment focuses on acquiring, converting, and servicing policies acquired from other companies. The segment’s primary focus is on life insurance policies sold to individuals. Segment results were as follows:
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
2004 2003 CHANGE 2004 2003 CHANGE
--------------------------------- --------------------------------
REVENUES
Gross premiums and policy fees $ 66,985 $ 71,903 (6.8)% $206,113 $216,292 (4.7)%
Reinsurance ceded (16,562) (17,573) (5.8) (51,503) (54,730) (5.9)
----------------------- ----------------------
Net premiums and policy fees 50,423 54,330 (7.2) 154,610 161,562 (4.3)
Net investment income 57,682 61,004 (5.4) 175,041 185,820 (5.8)
Other income 655 (329) n/m 1,840 2,118 (13.1)
----------------------- ----------------------
Total operating revenues 108,760 115,005 (5.4) 331,491 349,500 (5.2)
BENEFITS AND EXPENSES
Benefits and settlement expenses 71,571 72,500 (1.3) 215,931 218,070 (1.0)
Amortization of deferred policy acquisition costs 7,056 7,817 (9.7) 22,381 26,372 (15.1)
Other operating expenses 8,858 9,584 (7.6) 27,304 32,214 (15.2)
----------------------- ----------------------
Total benefits and expenses 87,485 89,901 (2.7) 265,616 276,656 (4.0)
OPERATING INCOME 21,275 25,104 (15.3) 65,875 72,844 (9.6)
----------------------- ----------------------
INCOME BEFORE INCOME TAX $ 21,275 $ 25,104 (15.3) $ 65,875 $ 72,844 (9.6)
======================= ======================
The following table summarizes key data for the Acquisitions segment:
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
2004 2003 CHANGE 2004 2003 CHANGE
-------------------------------------- -----------------------------------
Average Life Insurance In-Force(2)
Traditional $11,876,806 $13,452,275 (11.7)% $12,058,599 $13,876,283 (13.1)%
Universal life 18,215,608 19,720,935 (7.6) 18,387,091 20,164,841 (8.8)
---------------------------- -------------------------
$30,092,414 $33,173,210 (9.3) $30,445,690 $34,041,124 (10.6)
============================ =========================
Average Account Values
Universal life $1,725,139 $1,747,081 (1.3) $1,729,421 $1,747,735 (1.0)
Fixed annuity(3) 218,668 226,299 (3.4) 219,160 227,139 (3.5)
Variable annuity 90,121 102,896 (12.4) 93,632 103,310 (9.4)
---------------------------- -------------------------
$2,033,928 $2,076,276 (2.0) $2,042,213 $2,078,184 (1.7)
============================ =========================
Interest Spread - UL & Fixed Annuities
Net investment income yield 7.18% 7.43% 7.23% 7.57%
Interest credited to policyholders 5.19 5.61 5.20 5.62
============================ =========================
Interest spread 1.99% 1.82% 2.03% 1.95%
============================ =========================
Mortality Experience (1) $1,071 $23 $3,947 $2,594
(1) Represents a favorable (unfavorable) variance as compared to pricing assumptions.
(2) Amounts are not adjusted for reinsurance ceded.
(3) Includes general account balances held within variable annuity products.
Net premiums and policy fees declined by 7.2% and 4.3% versus the third quarter and first nine months of 2003 due to the continued runoff from acquired blocks of business. Net investment income was also lower for the current quarter and year-to-date, caused by the runoff of business and lower overall earned rates. The segment has continued to review credited rates on UL and annuity business to minimize the impact of lower earned rates on interest spreads.
Policy benefit expenses were down approximately 1% versus the third quarter and first nine months of 2003, due to the decline in in-force as well as favorable mortality. Amortization of DAC decreased during the current quarter and first nine months of 2004 due to the overall decline in business, as well as lower gross profits on certain universal life blocks primarily caused by higher mortality. Other operating expenses decreased 7.6% and 15.2% versus the third quarter and first nine months of 2003, due to conversion costs incurred for the Conseco acquisition during 2003 as well as lower agent commissions incurred as a result of lower net premiums.
The segment’s life insurance in-force and UL and annuity account values have declined from 2003 levels as no new acquisitions have been made since 2002. In the ordinary course of business, the segment regularly considers acquisitions of blocks of policies or smaller insurance companies. However, the level of the segment’s acquisition activity is predicated upon many factors, including available capital, operating capacity, and market dynamics. Protective Life will continue to pursue suitable acquisitions as they become available.
The Annuities segment manufactures, sells, and supports fixed and variable annuity products. These products are primarily sold through stockbrokers, but are also sold through financial institutions and the Life Marketing segment’s sales force. Segment results were as follows:
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
2004 2003 CHANGE 2004 2003 CHANGE
--------------------------------- --------------------------------
REVENUES
Gross premiums and policy fees $ 7,370 $ 6,864 7.4% $ 22,592 $ 19,134 18.1%
Reinsurance ceded
----------------------- ----------------------
Net premiums and policy fees 7,370 6,864 7.4 22,592 19,134 18.1
Net investment income 52,854 54,660 (3.3) 155,965 170,881 (8.7)
Other income 1,293 1,058 22.2 4,112 2,655 54.9
----------------------- ----------------------
Total operating revenues 61,517 62,582 (1.7) 182,669 192,670 (5.2)
BENEFITS AND EXPENSES
Benefits and settlement expenses 46,526 48,385 (3.8) 137,028 152,710 (10.3)
Amortization of deferred policy acquisition costs 5,790 5,341 8.4 17,755 13,596 30.6
Other operating expenses 5,448 6,356 (14.3) 17,038 17,480 (2.5)
----------------------- ----------------------
Total benefits and expenses 57,764 60,082 (3.9) 171,821 183,786 (6.5)
OPERATING INCOME 3,753 2,500 50.1 10,848 8,884 22.1
Realized investment gains (losses) 3,524 8,583 9,818 19,815
Related amortization of DAC (2,669) (8,167) (6,880) (18,265)
----------------------- ----------------------
INCOME BEFORE INCOME TAX $ 4,608 $ 2,916 58.0 $13,786 $ 10,434 32.1
======================= ======================
The following table summarizes key data for the Annuities segment:
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
2004 2003 CHANGE 2004 2003 CHANGE
--------------------------------- --------------------------------
Sales
Fixed annuity $106,391 $ 15,948 567.1% $230,790 $139,734 65.2%
Variable annuity 74,231 87,459 (15.1) 199,272 284,320 (29.9)
----------------------- ----------------------
$180,622 $103,407 74.7 $430,062 $424,054 1.4
======================= ======================
Average Account Values
Fixed annuity(3) $3,227,028 $3,269,706 (1.3) $3,189,657 $3,329,490 (4.2)
Variable annuity 1,992,107 1,674,953 18.9 1,993,651 1,517,772 31.4
----------------------- ----------------------
$5,219,135 $4,944,659 5.6 $5,183,308 $4,847,262 6.9
======================= ======================
Interest Spread - Fixed Annuities(1)
Net investment income yield 6.63% 6.74% 6.49% 6.79%
Interest credited to policyholders 5.74 5.87 5.66 5.85
----------------------- ----------------------
Interest spread 0.89% 0.87% 0.83% 0.94%
======================= ======================
AS OF
SEPTEMBER 30
2004 2003
----------------------
GMDB - Net amount at risk(2) $258,516 $407,613 (36.6)%
GMDB - Reserves $5,606 $5,753 (2.6)
S&P 500 Index 1,115 996 11.9
(1)
Interest spread on average general account values.
(2) Guaranteed
death benefit in excess of contract holder account balance.
(3)
Includes general account balances held within variable annuity products.
Segment operating income increased by 50.1% and 22.1% compared to the third quarter and first nine months of 2003, reflecting higher sales of fixed annuities and the impact of improved equity markets reflected in the variable annuity business.
The improvement in the equity markets caused a significant increase in variable annuity account values, which drove the increase in net premiums and policy fees for the quarter and the year-to-date. The lower interest rate environment and decrease in fixed annuity balances caused net investment income and interest credited to decline from the third quarter and first nine months of 2003. Interest spreads on fixed annuities increased 2 basis points and fell 18 basis points as compared to the third quarter and first nine months of 2003, respectively. Lower rates on new investments and the impact of prepayments in the mortgage backed security portfolio more than offset the effects of crediting rate reductions for the year-to-date comparison. Crediting rate reductions during the current quarter allowed for the slight increase in spreads versus the third quarter of 2003. Other income increased from the third quarter and first nine months of 2003 due to an increase in advisory fees within variable annuity products.
Interest credited decreased $1.8 million compared to third quarter 2003 and $10.6 million from the first nine months of 2003 due to the decline in fixed annuity account values and lower rate environment. In addition, benefits expense benefited during the first nine months of 2004 from lower guaranteed minimum death benefit (GMDB) expenses of $3.9 million. The additional profits on variable annuities were partially offset by higher amortization of DAC, accounting for an increase of $4.2 million for the first nine months of 2004. Other operating expenses decreased 14.3% and 2.5% versus the third quarter and first nine months of 2003. The current quarter benefited from lower administrative expenses, as well as higher expense capitalization caused by the increase in sales. Administrative expenses were lower in the first nine months as well, however, lower sales in the first quarter of 2004 negatively impacted the segment’s expense capitalization levels.
Sales of fixed annuities increased 567.1% and 65.2% from the third quarter and first nine months of 2003 due to higher interest rates and more competitive pricing. Variable annuity sales were 15.1% and 29.9% lower than the historically high levels achieved in the third quarter and first nine months of 2003 as Protective Life maintained its pricing discipline. The improved equity markets reduced the net amount at risk with respect to guaranteed minimum death benefits by 36.6%.
The Stable Value Products segment markets guaranteed investment contracts (GICs) to 401(k) and other qualified retirement savings plans, and sells guaranteed funding agreements (GFA) to special purpose entities that in turn issue notes or certificates in smaller, transferable denominations. The segment also markets fixed and floating rate funding agreements directly to the trustees of municipal bond proceeds, institutional investors, bank trust departments, and money market funds. Segment results were as follows:
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
2004 2003 CHANGE 2004 2003 CHANGE
--------------------------------- --------------------------------
REVENUES
Net investment income $66,472 $56,441 17.8% $197,171 $174,063 13.3%
----------------------- ----------------------
BENEFITS AND EXPENSES
Benefits and settlement expenses 50,301 45,374 10.9 150,790 140,096 7.6
Amortization of deferred policy acquisition costs 894 542 64.9 2,458 1,660 48.1
Other operating expenses 1,964 1,002 96.0 4,985 3,548 40.5
----------------------- ----------------------
Total benefits and expenses 53,159 46,918 13.3 158,233 145,304 8.9
OPERATING INCOME 13,313 9,523 39.8 38,938 28,759 35.4
Realized investment gains (losses) 6,992 9,745 12,893 7,303
----------------------- ----------------------
INCOME BEFORE INCOME TAX $20,305 $19,268 5.4 $ 51,831 $ 36,062 43.7
======================= ======================
The following table summarizes key data for the Stable Value Products segment:
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
2004 2003 CHANGE 2004 2003 CHANGE
--------------------------------- --------------------------------
Sales
GIC $ 15,000 $ 24,500 (38.8)% $ 54,000 $273,500 (80.3)%
GFA - Direct Institutional 0 0 0.0 960 25,000 (96.2)
GFA - Non-Registered Notes 0 100,000 (100.0) 0 400,000 (100.0)
GFA - Registered Notes - Institutional 625,000 0 100.0 925,000 0 100.0
GFA - Registered Notes - Retail 135,520 0 100.0 425,270 0 100.0
----------------------- ----------------------
$775,520 $ 124,500 522.9 $1,405,230 $698,500 101.2
======================= ======================
Average Account Values $5,112,019 $4,147,034 23.3 $5,009,546 $4,111,876 21.8
Operating Spread
Net investment income yield 5.34% 5.61% 5.39% 5.81%
Interest credited 4.04 4.51 4.12 4.68
Operating expenses 0.23 0.15 0.20 0.17
----------------------- ----------------------
Operating spread 1.07% 0.95% 1.07% 0.96%
======================= ======================
Operating income increased 39.8% and 35.4% from the third quarter and first nine months of 2003 due to growth in average account balances, as well as the widening of spreads. The growth in average account balances was primarily driven by sales of the registered funding agreement-backed notes program over the last four quarters. The lower interest rate environment caused both the investment income yield and the interest credited rate to decline from the third quarter and first nine months of 2003. However, a rebalancing of the segment’s portfolio and replacement of higher rate contracts allowed for a widening of interest spreads. Currently, operating spreads are anticipated to be in the range of 105-110 basis points for the remainder of 2004.
The retail registered funding agreement-backed notes program, which was introduced during the first quarter of 2004, experienced sales of $135.5 million and $425.3 million during the current quarter and first nine months of 2004. During the current quarter the segment introduced an inflation adjusted note program, which contributed $124.2 million to total retail sales. The Company currently anticipates sales from the retail note program to range from $75 million to $175 million for the remainder of 2004. In addition, the institutional registered funding agreement-backed notes program, which was launched in the fourth quarter of 2003, experienced strong sales of $625.0 million for the third quarter of 2004. Sales of traditional GICs during 2004 were significantly lower than 2003 levels due to the segment’s continued focus on the registered note programs as well as lower overall market demand for traditional GIC products.
The Asset Protection segment primarily markets extended service contracts and credit life and disability insurance to protect consumers’ investments in automobiles and watercraft. Segment results were as follows:
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
2004 2003 CHANGE 2004 2003 CHANGE
--------------------------------- --------------------------------
REVENUES
Gross premiums and policy fees $116,748 $108,503 7.6% $ 340,956 $ 311,021 9.6%
Reinsurance ceded (65,093) (47,900) 35.9 (181,201) (128,499) 41.0
----------------------- ----------------------
Net premiums and policy fees 51,665 60,603 (14.8) 159,755 182,522 (12.5)
Net investment income 7,892 9,421 (16.2) 22,943 27,689 (17.1)
Other income 9,302 8,602 8.1 27,255 33,114 (17.7)
----------------------- ----------------------
Total operating revenues 68,849 78,626 (12.4) 209,953 243,325 (13.7)
BENEFITS AND EXPENSES
Benefits and settlement expenses 29,074 34,675 (16.2) 94,636 105,005 (9.9)
Amortization of deferred policy acquisition costs 20,043 19,838 1.0 57,520 59,746 (3.7)
Other operating expenses 14,659 19,501 (24.8) 44,270 63,164 (29.9)
----------------------- ----------------------
Total benefits and expenses 63,776 74,014 (13.8) 196,426 227,915 (13.8)
OPERATING INCOME 5,073 4,612 10.0 13,527 15,410 (12.2)
----------------------- ----------------------
INCOME BEFORE INCOME TAX $ 5,073 $ 4,612 10.0 $ 13,527 $ 15,410 (12.2)
======================= ======================
The following table summarizes key data for the Asset Protection segment:
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
2004 2003 CHANGE 2004 2003 CHANGE
------------------------------------- --------------------------------------
Sales
Credit insurance $ 59,543 $ 53,418 11.5% $169,824 $150,228 13.0%
Service contracts 56,627 59,421 (4.7) 155,763 151,999 2.5
Other products 8,883 18,410 (51.7) 25,975 59,446 (56.3)
-------------------------- ---------------------------
$ 125,053 $ 131,249 (4.7) $351,562 $361,673 (2.8)
========================== ===========================
Loss Ratios (1)
Credit insurance 35.7% 33.9% 37.9% 38.0%
Service contracts 78.3 85.0 80.8 86.8
Other products 66.4 98.8 73.8 91.6
(1) Incurred claims as a percentage of earned premiums.
Operating income increased 10.0% versus the third quarter of 2003, as higher service contract earnings were partially offset by lower earnings from credit insurance and other products. Income for the first nine months of 2004 was 12.2% below the same period in 2003 as the impact of gains from charter sales offset improved results in the segment’s remaining operations. The segment realized a gain of $6.9 million in the second quarter of 2003 and a $1.0 million gain in the first quarter of 2004 from the sale of separate inactive charters. Excluding the impact of these charter sales, operating income increased 46.2% from the first nine months of 2003. The improvement in results reflects an increase in earnings from the service contract business, partially offset by reduced earnings from credit insurance and the segment’s other lines of business.
The decline in net premiums for the quarter and year-to-date was primarily related to decreases of $9.9 million and $28.4 million, respectively, in the credit insurance lines, due to higher levels of reinsurance. Partially offsetting this decline was an increase in vehicle service contract and other lines of $1.0 million and $5.6 million, respectively, for the quarter and year-to-date, reflecting the continued steady growth of these lines. The 16.2% and 17.1% decrease in net investment income versus the third quarter and first nine months of 2003 was also primarily attributable to the credit insurance business, due to lower policy liabilities and a lower net yield on investments. Other income increased 8.1% over the third quarter of 2003 as a result of higher administration fees. Excluding the impact of the charter sale gains, other income was relatively unchanged from the first nine months of 2003.
Policy and benefit expenses declined 16.2% and 9.9% versus the third quarter and first nine months of 2003 due to the decrease in the segment’s net premiums and the overall improvement in loss ratios. Amortization of DAC in the first nine months of 2004 was lower than the comparable period in 2003 due to the decline in the segment’s credit business. Other operating expenses decreased from the third quarter and first nine months of 2003 due to lower commissions and reductions in other general expenses. A $1.7 million third-party administrator receivable write-off in the first quarter of 2003 contributed to the decline in other general expenses in 2004. The remaining decrease in general expenses was primarily due to the outsourcing of the administration of a portion of the segment’s credit insurance business during 2003 and other cost saving initiatives.
Loss ratios for credit insurance were slightly higher for the quarter and relatively unchanged for the year to date. Service contract loss ratios for the current quarter and year-to-date have improved over prior year levels as a result of segment initiatives to increase pricing and tighten the underwriting and claims processes. Loss ratios for other products have declined significantly from the third quarter and first nine months of 2003 primarily due to lower losses in the segment’s runoff lines.
Sales of credit insurance through financial institutions rose 41.8% and 36.8% from levels achieved in the third quarter and first nine months of 2003 primarily due to a third party administrator relationship. The increase in financial institution credit insurance sales is expected to decline as the third party administrator goes into runoff over the next year. These strong credit insurance sales results were partially offset by a decline in credit insurance sold through automobile dealers. Service contract sales for the current quarter were 4.7% below the strong sales reported in the third quarter of 2003. Sales of service contract business for the first nine months of 2004 were slightly higher than 2003 levels, reflecting modest increases in vehicle lines, partially offset by a decline in marine sales. The decrease in other product sales primarily reflects products sold in 2003 that Protective Life is no longer marketing.
Protective Life has an additional segment herein referred to as Corporate and Other. The Corporate and Other segment primarily consists of net investment income and expenses not attributable to the segments above (including net investment income on unallocated capital). This segment also includes earnings from several small non-strategic lines of business (primarily cancer insurance, residual value insurance, surety insurance, and group annuities). The surety and residual value insurance lines were moved from the Asset Protection segment to Corporate and Other during 2004, and prior period segment data was restated to reflect the change.
The following table summarizes results for this segment:
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
2004 2003 CHANGE 2004 2003 CHANGE
----------------------------------- ----------------------------------
Operating income (loss) (1) $ 7,961 $(8,496) $16,457 $16,888 $(19,822) $ 36,710
Realized gains and losses - investments (170) 9,237 (9,407) 4,745 35,972 (31,227)
Realized gains and losses - derivatives (6,363) (8,016) 1,653 582 (23,891) 24,473
----------------------------------- ----------------------------------
Income (loss) before income tax $ 1,428 $(7,275) $ 8,703 $22,215 $ (7,741) $ 29,956
=================================== ==================================
| (1) | Includes settlements on interest rate swaps of $1,445 and $2,625 for the three months ended September 30, 2004 and 2003, respectively; and $5,126 and $7,956 for the nine months ended September 30, 2004 and 2003, respectively. |
Operating income in the current quarter increased $16.5 million from the third quarter of 2003, as higher operating expenses were more than offset by higher amounts of net investment income. For the first nine months of 2004, operating income increased $36.7 million as significantly lower losses on runoff insurance lines contributed to the factors affecting the current quarter comparison. Results for the runoff insurance lines improved by $11.5 million for the first nine months of 2004, primarily as a result of lower reserve strengthening in 2004. Net investment income increased $18.1 million and $37.5 million versus the third quarter and first nine months of 2003, reflecting increased participating mortgage income and higher amounts of unallocated capital. Participating mortgage income increased $7.6 million and $8.1 million over the third quarter and the first nine months of 2003, reflecting increased transaction activity within Protective Life’s mortgage portfolio. Higher overall expenses and lower amounts of income from interest rate swaps accounted for the remainder of the change in the current year’s results.
The following table sets forth realized investment gains and losses for the periods shown:
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
2004 2003 CHANGE 2004 2003 CHANGE
--------------------------------- --------------------------------
Fixed maturity gains $ 20,713 $33,665 $(12,952) $ 46,565 $ 77,436 $(30,871)
Fixed maturity losses (861) (2,679) 1,818 (6,237) (4,052) (2,185)
Equity gains 1,302 0 1,302 2,692 368 2,324
Equity losses 0 (280) 280 (22) (280) 258
Impairments on fixed maturity securities (12,052) (3,899) (8,153) (14,775) (12,934) (1,841)
Impairments on equity securities 0 0 0 (1,125) 0 (1,125)
Other 545 235 310 (747) 1,750 (2,497)
--------------------------------- --------------------------------
Total realized gains (losses) - investments $ 9,647 $27,042 $(17,395) $ 26,351 $ 62,288 $(35,937)
================================= ================================
Foreign currency swaps $ 1,231 $(22,784) $ 24,015 $(10,286) $ 1,997 $(12,283)
Foreign currency adjustments on stable value contracts (1,013) 23,307 (24,320) 10,911 (1,195) 12,106
Derivatives related to mortgage loan commitments (5,564) (3,777) (1,787) (256) (21,309) 21,053
Derivatives related to various investments 1,128 (1,614) 2,742 6,445 5,374 1,071
--------------------------------- --------------------------------
Total realized gains (losses) - derivatives $(4,218) $ (4,868) $ 650 $ 6,814 $ (15,133) $ 21,947
================================= ================================
Realized gains and losses on investments reflect portfolio management activities designed to maintain proper matching of assets and liabilities and to enhance long-term investment portfolio performance. The overall decline in net realized investment gains for the current quarter and year-to-date, excluding impairments, reflects the normal operation of the Company’s asset/liability program within the context of the changing interest rate environment. Investment impairments for the third quarter of 2004 were higher than 2003 primarily as a result of write-downs taken on airline equipment trust certificates in the current quarter. Additional details on the Company’s investment performance and evaluation is provided in the section entitled “Liquidity and Capital Resources” included herein.
Realized investment gains and losses related to derivatives represent changes in the fair value of derivative financial instruments and gains (losses) on derivative contracts closed during the period. Protective Life has entered into foreign currency swaps to mitigate the risk of changes in the value of principal and interest payments to be made on certain of its foreign currency denominated stable value contracts. The net change in the realized gains (losses) resulting from these securities in the third quarter and first nine months of 2004 was $(0.3) million and $(0.2) million, respectively. These changes were the result of differences in the related foreign currency spot and forward rates used to value the stable value contracts and foreign currency swaps. Protective Life has taken short positions in U.S. Treasury futures to mitigate interest rate risk related to the Company’s mortgage loan commitments. The changes in net gains (losses) from these securities were the result of fluctuations in interest rates and adjustments to Protective Life’s short positions during the respective periods.
Protective Life also uses various swaps and options to mitigate risk related to other interest rate exposures of Protective Life. For the third quarter and first nine months of 2004, a portion of the change, a $3.8 million increase and a $2.0 million increase, respectively, in realized gains (losses) resulted from lower interest rates in the third quarter of 2004, which impacted the fair value of certain interest rate swaps and options. A decrease of $1.1 million and $4.1 million for the third quarter and first nine months of 2004, respectively, related to gains from embedded derivatives within certain bonds that either matured or were called in the first nine months of 2003, with no similar activity in 2004. For the first nine months of 2004, realized gains (losses) improved by $3.4 million due to the impact of embedded derivatives within certain asset swaps that were called in the first nine months of 2004, with no similar activity in the first nine months of 2003.
In accordance with FASB Interpretation No. (FIN) 46 “Consolidation of Variable Interest Entities”, Protective Life consolidated, as of and for the three months ended March 31, 2004, a real estate investment company that Protective Life had previously reported as an investment. The entity was consolidated based on the determination that Protective Life was the primary beneficiary. The consolidation resulted in Protective Life’s reported assets and liabilities increasing by $54.5 million with an immaterial impact on results of operations. See also Note F for further discussion of FIN 46.
In January 2004, Protective Life adopted Statement of Position (SOP) 03-1 “Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts”. SOP 03-1 provides guidance related to the establishment of reserves for benefit guarantees provided under certain long-duration contracts, as well as the accounting for mortality benefits provided in certain universal life products. In addition, it addresses the capitalization and amortization of sales inducements to contract holders. The adoption of SOP 03-1 in the first quarter of 2004 resulted in a cumulative charge to net income of $10.1 million, net of income tax of $5.5 million. The charge to net income includes a $10.0 million charge to recognize additional liabilities, including an adjustment to deferred policy acquisition costs, on certain universal life contracts. These additional liabilities are required due to a change in the pattern of recognition of mortality benefits called for by the SOP. In addition, Protective Life recorded a $0.1 million adjustment related to guaranteed minimum death benefits on its variable annuity products. See also Note I for further discussion of SOP 03-1.
In September 2004, the AICPA issued a Technical Practice Aid (TPA) which contains additional interpretive guidance on applying certain provisions of SOP 03-1. Among other items, the TPA provides guidance on the definition of an assessment, the accounting for universal life contracts that exhibit losses followed by losses, and the accounting for reinsurance of the additional mortality reserves required by the SOP. Protective Life is currently evaluating the provisions of the TPA to determine what impact, if any, it may have on previously reported earnings, including the cumulative effect adjustment. Protective Life anticipates making any adjustments resulting from the application of this guidance during the fourth quarter of 2004. Adoption of the TPA guidance that results in changes to previously reported information will be recorded in accordance with APB 20, “Accounting Changes”.
A proposal to amend Actuarial Guideline 38 (promulgated by the NAIC and part of codification of statutory accounting principles) has been exposed for comment, and certain regulators have indicated a desire for the NAIC to adopt the proposal before year-end 2004, with retroactive effect. Actuarial Guideline 38, also known as AXXX, sets forth the reserve requirements for universal life insurance with secondary guarantees (ULSG). Protective Life believes that the proposal would increase the reserve levels required for many ULSG products, and thus would make those products more expensive and less competitive as compared to other products. Protective Life cannot predict whether the proposal will be adopted and, if so, whether it will be in the form currently proposed and whether it will be retroactive. Protective Life believes that the impact of the proposal on Protective Life will be primarily prospective and relate to the competitiveness of its products as compared to traditional whole life or other high cash value insurance products. To the extent the additional reserves are generally considered to be economically redundant, capital market or other solutions may emerge to reduce the impact of the proposal, if passed in its current form. Protective Life cannot predict when or if these solutions may become available.
The insurance industry has recently become the focus of increased scrutiny by regulatory and law enforcement authorities relating to allegations of improper special payments, price-fixing, bid-rigging and other alleged misconduct, including payments made by insurers to brokers and the practices surrounding the placement of insurance business. Such publicity may generate litigation against insurers, even those who do not engage in the business lines or practices currently at issue. It is impossible to predict the outcome of these investigations or proceedings, whether they will expand into other areas not yet contemplated, whether they will result in changes in insurance regulation, whether activities currently thought to be lawful will be characterized as unlawful, or the impact, if any, of this increased regulatory and law enforcement scrutiny of the insurance industry on Protective Life. As these inquiries appear to encompass a large segment of our industry, perhaps the entire industry, it would not be unusual for large numbers of companies in the life industry to receive subpoenas, requests for information from regulatory authorities or other inquiries relating to these and similar matters. From time to time, Protective Life may receive subpoenas, requests or other inquires.
The California Department of Insurance has promulgated proposed regulations that would characterize some life insurance agents as brokers and impose certain obligations on those agents that may conflict with the interests of insurance carriers or require the agent to, among other things, advise the client with respect to the “best available insurer.” Protective Life cannot predict the outcome of this regulatory proposal or whether any other state will propose or adopt similar actions.
The life reinsurance business continued to consolidate with the acquisition of the life reinsurance business of certain subsidiaries of ING America Insurance Holdings, Inc. (ING) by Scottish Re Group Limited and its affiliates, announced during the third quarter. ING is a major reinsurer in the market at large as well as of Protective Life’s life business. In connection with the acquisition, Protective Life was notified that the treaties between these ING subsidiaries and Protective Life and its subsidiaries would be cancelled with respect to new business, effective for new business after January 18, 2005. Protective Life is currently evaluating various alternatives to ensure that the offering of the affected products can continue without a significant adverse impact; however, Protective Life believes that the reinsurance obtained will not be on terms as favorable to Protective Life as the reinsurance currently in place.
Protective Life’s operations usually produce a positive cash flow. This cash flow is used to fund an investment portfolio to finance future benefit payments. Since future benefit payments largely represent medium- and long-term obligations reserved using certain assumed interest rates, Protective Life’s investments are predominantly in medium- and long-term, fixed-rate investments such as bonds and mortgage loans.
INVESTMENTS
Portfolio Description
Protective Life’s investment portfolio consists primarily of fixed maturity securities (bonds and redeemable preferred stocks) and commercial mortgage loans. Protective Life generally purchases its investments with the intent to hold to maturity by purchasing investments that match future cash flow needs. However, Protective Life may sell any of its investments to maintain proper matching of assets and liabilities. Accordingly, Protective Life has classified its fixed maturities and certain other securities as “available for sale.”
Protective Life’s investments in debt and equity securities are reported at market value, and investments in mortgage loans are reported at amortized cost. At September 30, 2004, Protective Life’s fixed maturity investments had a market value of $13.3 billion, which is 5.3% above amortized cost of $12.7 billion. Protective Life had $2.9 billion in mortgage loans at September 30, 2004. While Protective Life’s mortgage loans do not have quoted market values, at September 30, 2004, Protective Life estimates the market value of its mortgage loans to be $3.1 billion (using discounted cash flows from the next call date), which is 6.9% above amortized cost. Most of Protective Life’s mortgage loans have significant prepayment fees. These assets are invested for terms approximately corresponding to anticipated future benefit payments. Thus, market fluctuations are not expected to adversely affect liquidity.
The following table shows the carrying values of Protective Life’s invested assets.
--------------------------------------------------------------------------------------------------------------------
SEPTEMBER 30, 2004 DECEMBER 31, 2003
($ in thousands)
--------------------------------------------------------------------------------------------------------------------
Publicly-issued bonds $11,442,372 63.5% $10,967,622 64.7%
Privately issued bonds 1,878,606 10.4 1,956,734 11.5
Redeemable preferred stock 3,507 0.0 3,164 0.0
--------------------------------------------------------------------------------------------------------------------
Fixed maturities 13,324,485 73.9 12,927,520 76.2
Equity securities 29,883 0.2 30,521 0.2
Mortgage loans 2,904,729 16.1 2,733,722 16.1
Investment real estate 81,691 0.5 13,152 0.1
Policy loans 485,282 2.7 502,748 3.0
Other long-term investments 213,868 1.2 244,913 1.4
Short-term investments 967,388 5.4 510,635 3.0
--------------------------------------------------------------------------------------------------------------------
Total investments $18,007,326 100.0% $16,963,211 100.0%
====================================================================================================================
Market values for private, non-traded securities are determined as follows: 1) Protective Life obtains estimates from independent pricing services or 2) Protective Life estimates market value based upon a comparison to quoted issues of the same issuer or issues of other issuers with similar terms and risk characteristics. The market value of private, non-traded securities was $1,878.6 million at September 30, 2004, representing 10.4% of Protective Life’s total invested assets.
Risk Management and Impairment Review
Protective Life monitors the overall credit quality of its portfolio within general guidelines. The following table shows Protective Life’s fixed maturities by credit rating at September 30, 2004.
--------------------------------------------------------------------------------------------------------------------
S&P or Equivalent Percent of
Designation Market Value Market Value
--------------------------------------------------------------------------------------------------------------------
($ in thousands)
AAA $ 4,569,284 34.3%
AA 854,917 6.4
A 3,139,019 23.6
BBB 3,817,052 28.7
--------------------------------------------------------------------------------------------------------------------
Investment Grade 12,380,272 93.0
--------------------------------------------------------------------------------------------------------------------
BB 620,573 4.6
B 309,304 2.3
CCC or lower 10,769 0.1
In or near default 60 0.0
--------------------------------------------------------------------------------------------------------------------
Below Investment Grade 940,706 7.0
--------------------------------------------------------------------------------------------------------------------
Redeemable preferred stock 3,507 0.0
--------------------------------------------------------------------------------------------------------------------
Total $ 13,324,485 100.0%
====================================================================================================================
Limiting bond exposure to any creditor group is another way Protective Life manages credit risk. The following table summarizes Protective Life’s ten largest fixed maturity exposures to an individual creditor group as of September 30, 2004.
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Creditor Market Value
-----------------------------------------------------------------------------
($ in millions)
Citigroup $78.9
Wachovia 78.0
Dominion Resources 76.5
FPL Group 76.2
Union Pacific 72.5
Berkshire Hathaway 72.1
Duke Energy 69.9
Edison International 69.0
Verizon 67.2
Encana 66.7
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Protective Life’s management considers a number of factors when determining the impairment status of individual securities. These include the economic condition of various industry segments and geographic locations and other areas of identified risks. Although it is possible for the impairment of one investment to affect other investments, Protective Life engages in ongoing risk management to safeguard against and limit any further risk to its investment portfolio. Special attention is given to correlated risks within specific industries, related parties and business markets.
Once management has determined that a particular investment has suffered an other-than-temporary impairment, the asset is written down to its estimated fair value. Protective Life generally considers a number of factors in determining whether the impairment is other than temporary. These include, but are not limited to: 1) actions taken by rating agencies, 2) default by the issuer, 3) the significance of the decline, 4) the intent and ability of Protective Life to hold the investment until recovery, 5) the time period during which the decline has occurred, 6) an economic analysis of the issuer’s industry, and 7) the financial strength, liquidity, and recoverability of the issuer. Management performs a security-by-security review each quarter in evaluating the need for any other-than-temporary impairments. Although no set formula is used in this process, the investment performance, collateral position and continued viability of the issuer are significant measures.
Protective Life generally considers a number of factors relating to the issuer in determining the financial strength, liquidity, and recoverability of an issuer. These include but are not limited to: available collateral, tangible and intangible assets that might be available to repay debt, operating cash flows, financial ratios, access to capital markets, quality of management, market position, exposure to litigation or product warranties, and the effect of general economic conditions on the issuer.
There are certain risks and uncertainties associated with determining whether declines in market values are other-than-temporary. These include significant changes in general economic conditions and business markets, trends in certain industry segments, interest rate fluctuations, rating agency actions, changes in significant accounting estimates and assumptions, commission of fraud and legislative actions. Protective Life continuously monitors these factors as they relate to the investment portfolio in determining the status of each investment. Provided below are additional facts concerning the potential effect upon Protective Life’s earnings should circumstances lead management to conclude that some of the current declines in market value are other-than-temporary.
Unrealized Gains and Losses
The information presented below relates to investments at a certain point in time and is not necessarily indicative of the status of the portfolio at any time after September 30, 2004, the balance sheet date. Information about unrealized gains and losses is subject to rapidly changing conditions, including volatility of financial markets and changes in interest rates. As indicated above, the Company’s management considers a number of factors in determining if an unrealized loss is other-than-temporary, including our ability and intent to hold the security until recovery. Furthermore, since the timing of recognizing realized gains and losses is largely based on management’s decisions as to the timing and selection of investments to be sold, the tables and information provided below should be considered within the context of the overall unrealized gain (loss) position of the portfolio. At September 30, 2004, Protective Life had an overall pretax net unrealized gain of $676.9 million.
For traded and private fixed maturity and equity securities held by Protective Life that are in an unrealized loss position at September 30, 2004, the estimated market value, amortized cost, unrealized loss and total time period that the security has been in an unrealized loss position are presented in the table below.
- ----------------------------------------------------------------------------------------------------------------------------
Estimated % Market Amortized % Amortized Unrealized % Unrealized
Market Value Value Cost Cost Loss Loss
- ----------------------------------------------------------------------------------------------------------------------------
($ in thousands)
‹= 90 days $ 391,693 21.3 % $ 409,497 21.6 % $(17,804) 31.0 %
›90 days but ‹= 180 days 850,183 46.2 863,454 45.5 (13,271) 23.1
›180 days but ‹= 270 days 149,390 8.1 152,703 8.0 (3,313) 5.8
›270 days but ‹= 1 year 58,444 3.2 59,096 3.1 (652) 1.1
›1 year but ‹= 2 years 328,715 17.9 342,444 18.1 (13,729) 23.9
›2 years but ‹= 3 years 34,175 1.8 36,336 1.9 (2,161) 3.8
›3 years but ‹= 4 years 2,144 0.1 2,208 0.1 (64) 0.1
›4 years but ‹= 5 years 4,773 0.2 5,701 0.3 (928) 1.6
›5 years 21,456 1.2 26,985 1.4 (5,529) 9.6
- ----------------------------------------------------------------------------------------------------------------------------
Total $ 1,840,973 100.0% $1,898,424 100.0% $(57,451) 100.0%
============================================================================================================================
At September 30, 2004, securities with a market value of $25.5 million and $21.0 million of unrealized losses were issued in Company sponsored commercial mortgage loan securitizations, including $4.1 million of unrealized losses greater than five years. Protective Life does not consider these unrealized positions to be other-than-temporary, because the underlying mortgage loans continue to perform consistently with Protective Life’s original expectations.
Protective Life has no material concentrations of issuers or guarantors of fixed maturity securities. The industry segment composition of all securities in an unrealized loss position held by Protective Life at September 30, 2004, is presented in the following table.
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Estimated % Market Amortized % Amortized Unrealized % Unrealized
Market Value Value Cost Cost Loss Loss
- ------------------------------------------------------------------------------------------------------------------------------
($ in thousands)
Agency Mortgages $ 491,947 26.7 % $ 495,422 26.1 % $ (3,475) 6.0 %
Banking 107,248 5.8 108,623 5.7 (1,375) 2.4
Basic Industrial 86,495 4.7 89,243 4.7 (2,748) 4.8
Brokerage 45,241 2.5 45,955 2.4 (714) 1.3
Communications 87,901 4.8 92,797 4.9 (4,896) 8.5
Consumer Cyclical 65,917 3.6 66,516 3.5 (599) 1.0
Consumer Noncyclical 51,416 2.8 53,020 2.8 (1,604) 2.8
Electric 241,534 13.1 252,767 13.3 (11,233) 19.6
Energy 81,230 4.4 83,720 4.4 (2,490) 4.3
Finance Companies 23,234 1.3 23,284 1.2 (50) 0.1
Insurance 77,338 4.2 78,772 4.1 (1,434) 2.5
Municipal Agencies 487 0.0 488 0.0 (1) 0.0
Natural Gas 159,033 8.6 162,085 8.6 (3,052) 5.3
Non-Agency Mortgages 197,910 10.8 215,128 11.4 (17,218) 30.0
Other Finance 44,786 2.4 49,851 2.6 (5,065) 8.8
Other Utility 21 0.0 44 0.0 (23) 0.0
Technology 11,428 0.6 11,582 0.6 (154) 0.3
Transportation 60,970 3.3 62,181 3.3 (1,211) 2.1
U. S. Government 6,837 0.4 6,946 0.4 (109) 0.2
- ------------------------------------------------------------------------------------------------------------------------------
Total $1,840,973 100.0% $1,898,424 100.0% $(57,451) 100.0%
==============================================================================================================================
The range of maturity dates for securities in an unrealized loss position at September 30, 2004 varies, with 9.0% maturing in less than 5 years, 25.0% maturing between 5 and 10 years, and 66.0% maturing after 10 years. The following table shows the credit rating of securities in an unrealized loss position at September 30, 2004.
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S&P or Equivalent Estimated % Market Amortized % Amortized Unrealized % Unrealized
Designation Market Value Value Cost Cost Loss Loss
- ----------------------------------------------------------------------------------------------------------------------------
($ in thousands)
AAA/AA/A $1,180,967 64.2% $1,202,005 63.3% $(21,038) 36.6%
BBB 504,462 27.4 517,083 27.2 (12,621) 22.0
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Investment grade 1,685,429 91.6 1,719,088 90.5 (33,659) 58.6
- ----------------------------------------------------------------------------------------------------------------------------
BB 48,254 2.6 49,907 2.7 (1,653) 2.9
B 95,917 5.2 104,596 5.5 (8,679) 15.1
CCC or lower 11,373 0.6 24,833 1.3 (13,460) 23.4
- ----------------------------------------------------------------------------------------------------------------------------
Below investment grade 155,544 8.4 179,336 9.5 (23,792) 41.4
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Total $1,840,973 100.0% $1,898,424 100.0% $(57,451) 100.0%
============================================================================================================================
At September 30, 2004, securities in an unrealized loss position that were rated as below investment grade represented 8.4% of the total market value and 41.4% of the total unrealized loss. Unrealized losses related to below investment grade securities that had been in an unrealized loss position for more than twelve months were $7.7 million. Bonds in an unrealized loss position rated less than investment grade were 0.9% of invested assets. Protective Life does not expect these investments to adversely affect its liquidity or ability to maintain proper matching of assets and liabilities.
The following table shows the estimated market value, amortized cost, unrealized loss and total time period that the security has been in an unrealized loss position for all below investment grade securities.
- ----------------------------------------------------------------------------------------------------------------------------
Estimated % Market Amortized % Amortized Unrealized % Unrealized
Market Value Value Cost Cost Loss Loss
- ----------------------------------------------------------------------------------------------------------------------------
($ in thousands)
‹= 90 days $ 20,451 13.2% $ 31,631 17.6% $(11,180) 47.0%
›90 days but ‹= 180 days 55,585 35.7 59,657 33.3 (4,072) 17.1
›180 days but ‹= 270 days 20,233 13.0 21,082 11.8 (849) 3.6
›270 days but ‹= 1 year 0 0.0 0 0.0 (0) 0.0
›1 year but ‹= 2 years 3,513 2.3 3,593 2.0 (80) 0.3
›2 years but ‹= 3 years 33,531 21.5 35,572 19.8 (2,041) 8.6
›3 years but ‹= 4 years 1,027 0.7 1,070 0.6 (43) 0.2
›4 years but ‹= 5 years 3 0.0 3 0.0 (0) 0.0
›5 years 21,201 13.6 26,728 14.9 (5,527) 23.2
- ----------------------------------------------------------------------------------------------------------------------------
Total $155,544 100.0% $179,336 100.0% $(23,792) 100.0%
============================================================================================================================
At September 30, 2004, below investment grade securities with a market value of $20.2 million and $15.3 million of unrealized losses were securities issued in Protective Life sponsored commercial mortgage loan securitizations, $4.1 million of which are in an unrealized loss position greater than five years. Protective Life does not consider these unrealized positions to be other-than-temporary, because the underlying mortgage loans continue to perform consistently with Protective Life’s original expectations.
Realized Losses
Realized losses are comprised of both write-downs for other-than-temporary impairments and actual sales of investments. For the third quarter and the first nine months of 2004, Protective Life recorded other-than-temporary impairments of $12.1 million and $15.9 million as compared to $3.9 million and $12.9 million for the 2003 periods. The most significant impairments recorded in the current quarter were $11.9 million in write-downs taken on airline equipment trust certificates due to continued difficulties in this industry. Protective Life continues to closely monitor all of its positions in the airline industry for indications of any additional impairment.
As discussed earlier, Protective Life’s management considers several factors when determining other-than-temporary impairments. Although Protective Life generally intends to hold securities until maturity, Protective Life may change its positions as a result of a change in circumstances. Any such decision is consistent with Protective Life’s classification of its investment portfolio as available for sale. During the nine months ended September 30, 2004, Protective Life sold securities in an unrealized loss position with a market value of $185.2 million resulting in a realized loss of $6.2 million. For such securities, the proceeds, realized loss and total time period that the security had been in an unrealized loss position are presented in the table below.
- ----------------------------------------------------------------------------------------------------------------------------
Proceeds % Proceeds Realized Loss % Realized Loss
- ----------------------------------------------------------------------------------------------------------------------------
($ in thousands)
‹= 90 days $ 11,807 6.4% $(2,139) 34.2 %
›90 days but ‹= 180 days 7,061 3.8 (25) 0.4
›180 days but ‹= 270 days 79,518 42.9 (2,229) 35.6
›270 days but ‹= 1 year 76,337 41.2 (1,615) 25.8
› 1 year 10,431 5.7 (251) 4.0
- ----------------------------------------------------------------------------------------------------------------------------
Total $ 185,154 100.0% $(6,259) 100.0%
============================================================================================================================
Mortgage Loans
Protective Life records mortgage loans net of an allowance for credit losses. This allowance is calculated through analysis of specific loans that are believed to be at a higher risk of becoming impaired in the near future. At September 30, 2004 and December 31, 2003, Protective Life’s allowance for mortgage loan credit losses was $3.4 million and $4.7 million, respectively.
For several years Protective Life has offered a type of commercial mortgage loan under which Protective Life will permit a slightly higher loan-to-value ratio in exchange for a participating interest in the cash flows from the underlying real estate. As of September 30, 2004, approximately $436.5 million of Protective Life’s mortgage loans have this participation feature.
In the ordinary course of its commercial mortgage lending operations, Protective Life will commit to provide a mortgage loan before the property to be mortgaged has been built or acquired. The mortgage loan commitment is a contractual obligation to fund a mortgage loan when called upon by the borrower. The commitment is not recognized in Protective Life’s financial statements until the commitment is actually funded. The mortgage loan commitment contains terms, including the rate of interest which may become less than prevailing interest rates. At September 30, 2004, Protective Life had outstanding mortgage loan commitments of $845.1 million at an average rate of 6.24%.
Liabilities
Many of Protective Life’s products contain surrender charges and other features that reward persistency and penalize the early withdrawal of funds. Certain stable value and annuity contracts have market-value adjustments that protect Protective Life against investment losses if interest rates are higher at the time of surrender than at the time of issue.
At September 30, 2004, Protective Life had policy liabilities and accruals of $10.3 billion. Protective Life’s interest-sensitive life insurance policies have a weighted average minimum credited interest rate of approximately 4.5%.
At September 30, 2004, Protective Life had $5.1 billion of stable value contract account balances and $3.4 billion of annuity account balances.
Derivative Financial Instruments
Protective Life utilizes a risk management strategy that incorporates the use of derivative financial instruments, primarily to reduce its exposure to interest rate risk, inflation risk, and currency exchange risk. Combinations of interest rate swap contracts, futures contracts, and option contracts are used to mitigate or eliminate certain financial and market risks, including those related to changes in interest rates for certain investments, primarily outstanding mortgage loan commitments and mortgage-backed securities. Swap contracts are also used to alter the effective durations of assets and liabilities, and to mitigate the inflation risk caused by the issuance of inflation adjusted notes through the Stable Value Products segment. Protective Life uses foreign currency swaps to reduce its exposure to currency exchange risk on certain stable value contracts denominated in foreign currencies, primarily the European euro and the British pound.
Derivative instruments expose Protective Life to credit and market risk and could result in material changes from quarter-to-quarter. Protective Life minimizes its credit risk by entering into transactions with highly rated counterparties. Protective Life manages the market risk associated with interest rate and foreign exchange contracts by establishing and monitoring limits as to the types and degrees of risk that may be undertaken. Protective Life monitors its use of derivatives in connection with its overall asset/liability management programs and procedures.
Asset/Liability Management
Protective Life’s asset/liability management programs and procedures involve the monitoring of asset and liability durations for various product lines; cash flow testing under various interest rate scenarios; and the continuous rebalancing of assets and liabilities with respect to yield, risk, and cash flow characteristics. It is Protective Life’s policy to generally maintain asset and liability durations within one-half year of one another, although, from time to time, a broader interval may be allowed.
Protective Life believes its asset/liability management programs and procedures and certain product features provide protection for Protective Life against the effects of changes in interest rates under various scenarios. Additionally, Protective Life believes its asset/liability management programs and procedures provide sufficient liquidity to enable it to fulfill its obligation to pay benefits under its various insurance and deposit contracts. However, Protective Life’s asset/liability management programs and procedures incorporate assumptions about the relationship between short-term and long-term interest rates (i.e., the slope of the yield curve), relationships between risk-adjusted and risk-free interest rates, market liquidity and other factors, and the effectiveness of Protective Life’s asset/liability management programs and procedures may be negatively affected whenever actual results differ from those assumptions.
Cash outflows related to stable value contracts (primarily maturing contracts, scheduled interest payments and expected withdrawals) were approximately $1,100.1 million during 2003. Cash outflows related to stable value contracts are estimated to be approximately $1,079.0 million in 2004. Protective Life’s asset/liability management programs and procedures take into account maturing contracts and expected withdrawals. Accordingly, Protective Life does not expect stable value contract related cash outflows to have an unusual effect on the future operations and liquidity of Protective Life.
Protective Life was committed at September 30, 2004, to fund mortgage loans in the amount of $845.1 million. Protective Life held $1,048.5 million in cash and short-term investments at September 30, 2004.
While Protective Life generally anticipates that the cash flows of its subsidiaries will be sufficient to meet their investment commitments and operating cash needs, Protective Life recognizes that investment commitments scheduled to be funded may, from time to time, exceed the funds then available. Therefore, Protective Life has arranged sources of credit for its insurance subsidiaries to use when needed. Protective Life expects that the rate received on its investments will equal or exceed its borrowing rate. Additionally, Protective Life may, from time to time, sell short-duration stable value products to complement its cash management practices.
Protective Life has also used securitization transactions involving its commercial mortgage loans to increase its liquidity.
Capital
At June 30, 2004, PLC had $100.1 million outstanding under its $200.0 million revolving line of credit due July 30, 2009, at an interest rate of 1.93%. On October 21, 2004, PLC issued $150.0 million of 4.875% Senior Notes that mature on November 1, 2014. The proceeds from the Senior Notes were used to pay off the $100.1 million balance on the revolving line and for general corporate purposes.
At December 31, 2003, approximately $1,386.9 million of consolidated share-owner’s equity, excluding net unrealized investment gains and losses, represented net assets of Protective Life that cannot be transferred to PLC. In addition, the states in which Protective Life’s insurance subsidiaries are domiciled impose certain restrictions on the insurance subsidiaries’ ability to pay dividends to Protective Life. Protective Life plans to retain substantial portions of its earnings to support future growth.
A life insurance company’s statutory capital is computed according to rules prescribed by the National Association of Insurance Commissioners (“NAIC”), as modified by the insurance company’s state of domicile. Statutory accounting rules are different from GAAP and are intended to reflect a more conservative view by, for example, requiring immediate expensing of policy acquisition costs. The NAIC’s risk-based capital requirements require insurance companies to calculate and report information under a risk-based capital formula. The achievement of long-term growth will require growth in the statutory capital of Protective Life and its insurance subsidiaries. Protective Life may secure additional statutory capital through various sources, such as retained statutory earnings or equity contributions by PLC.
Contractual Obligations
The table below sets forth future maturities of stable value products, notes payable, operating lease obligations, other property lease obligations, mortgage loan commitments, and liabilities related to variable interest entities.
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2004 2005-2006 2007-2008 After 2008
- ------------------------------------------------------------------------------------------------------------------------------
($ in thousands)
Stable value products(a) $279,028 $2,151,173 $1,714,829 $998,337
Note payable 2,210
Operating leases(b) 1,806 12,439 71,894 9,313
Mortgage loan commitments 845,057
Liabilities related to variable interest entities(c) 386 6,519 47,148
- ------------------------------------------------------------------------------------------------------------------------------
(a) Anticipated stable value products cash flows, excluding interest not yet accrued.
(b) Includes all lease payments required under operating lease agreements.
(c) Liabilities related to variable interest entities are not the legal obligations of Protective Life, but will be
repaid with cash flows generated by the variable interest entities. The amounts represent scheduled principal payments.
- ------------------------------------------------------------------------------------------------------------------------------
The table above excludes liabilities related to separate accounts of $2,306.9 million. Separate account liabilities represent funds maintained for contract holders who bear the related investment risk. These liabilities are supported by assets that are legally segregated and are not subject to claims that arise from other business activities of Protective Life. These assets and liabilities are separately identified on the consolidated balance sheets of Protective Life. The table also excludes future cash flows related to certain insurance liabilities due to the uncertainty with respect to the timing of the cash flows.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
There has been no material change from the disclosures in Protective Life’s Annual Report on Form 10-K for the year ended December 31, 2003.
Item 4. Controls and Procedures
(a) Evaluation of disclosure controls and procedures
Under the direction of our Chief Executive Officer and Chief Financial Officer, we evaluated our disclosure controls and procedures and internal control over financial reporting and concluded that our disclosure controls and procedures were effective as of September 30, 2004. It should be noted that any system of controls, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. Further, the design of any control system is based in part upon certain judgments, including the costs and benefits of controls and the likelihood of future events. Because of these and other inherent limitations of control systems, no evaluation of controls can provide absolute assurance that all control issues, if any, within Protective Life have been detected.
(b) Changes in internal control over financial reporting
No significant changes in our internal control over financial reporting occurred during the quarter ended September 30, 2004 that have materially affected, or is reasonably likely to materially affect, such internal control over financial reporting. Our internal controls exist within a dynamic environment and Protective Life continually strives to improve its internal controls and procedures to enhance the quality of its financial reporting.
Item 6. Exhibits
| Exhibit 10 — Amended and Restated Credit Agreement among Protective Life Corporation, Protective Life Insurance Company, The Several Lenders from Time to Time Party Hereto, AmSouth Bank and Wachovia Capital Markets, LLC, dated as of July 30, 2004. |
Exhibit 12 – Consolidated Earnings Ratios.
Exhibit 15 — Letter re: unaudited interim financial information.
Exhibit 31(a) – Certification Pursuant to § 302 of the Sarbanes-Oxley Act of 2003.
Exhibit 31(b) – Certification Pursuant to § 302 of the Sarbanes-Oxley Act of 2003.
| Exhibit 32(a) — Certification Pursuant to 18 U.S.C. § 1350, as Adopted Pursuant to § 906 of the Sarbanes-Oxley Act of 2003. |
| Exhibit 32(b) — Certification Pursuant to 18 U.S.C. § 1350, as Adopted Pursuant to § 906 of the Sarbanes-Oxley Act of 2003. |
Exhibit 99 – Safe Harbor for Forward-Looking Statements.
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
PROTECTIVE LIFE INSURANCE COMPANY
Date: November 15, 2004 /s/ Steven G. Walker
Steven G. Walker
Senior Vice President, Controller and
Chief Accounting Officer
(Duly authorized officer)