| DELAWARE | 95-2492236 | ||
|---|---|---|---|
| (State or other jurisdiction | (IRS Employer Identificiation Number) | ||
| 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 [X] No [ ]
Number of shares of Common Stock, $.50 par value, outstanding as of July 30, 2004: 69,407,945 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 Three and
Six Months ended June 30, 2004 and 2003.......................................................
Consolidated Condensed Balance Sheets as of June 30, 2004
and December 31, 2003.........................................................................
Consolidated Condensed Statements of Cash Flows for the
Six Months ended June 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 2. Changes in Securities and Use of Proceeds....................................................
Item 4. Submission of Matters to a Vote of Security Holders..........................................
Item 6. Exhibits and Reports on Form 8-K.............................................................
Signature................................................................................................
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Directors and
Share Owners
Protective Life Corporation
We have reviewed the accompanying consolidated condensed balance sheet of Protective Life Corporation and its subsidiaries as of June 30, 2004, and the related consolidated condensed statements of income for each of the three-month and six-month periods ended June 30, 2004 and 2003, and the consolidated condensed statement of cash flows for the six-month periods ended June 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-owners’ 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
August 3, 2004
PROTECTIVE LIFE CORPORATION
CONSOLIDATED CONDENSED
STATEMENTS OF INCOME
(Dollars in thousands
except per share amounts)
(Unaudited)
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30 JUNE 30
2004 2003 2004 2003
- ---------------------------------------------------------------------------------------------------------------------------------
REVENUES
Premiums and policy fees $456,088 $397,652 $899,884 $784,746
Reinsurance ceded (285,369) (205,268) (534,708) (394,685)
- ---------------------------------------------------------------------------------------------------------------------------------
Premiums and policy fees, net of reinsurance ceded 170,719 192,384 365,176 390,061
Net investment income 265,899 262,744 530,507 520,445
Realized investment gains (losses):
Derivative financial instruments 8,740 4,334 13,823 (546)
All other investments (923) 29,524 15,704 28,346
Other income 37,563 39,981 74,982 65,290
- ---------------------------------------------------------------------------------------------------------------------------------
481,998 528,697 1,000,192 1,003,596
- ---------------------------------------------------------------------------------------------------------------------------------
BENEFITS AND EXPENSES
Benefits and settlement expenses
(net of reinsurance ceded:
three months: 2004 - $252,954; 2003 - $217,445
six months: 2004 - $494,241; 2003 - $453,216) 282,469 304,933 569,785 602,206
Amortization of deferred policy acquisition costs 45,053 64,803 104,847 120,562
Other operating expenses (net of reinsurance ceded:
three months: 2004 - $43,164; 2003 - $35,444
six months: 2004 - $82,726; 2003 - $64,477) 59,106 69,939 130,791 135,497
- ---------------------------------------------------------------------------------------------------------------------------------
386,628 439,675 805,423 858,265
- ---------------------------------------------------------------------------------------------------------------------------------
INCOME BEFORE INCOME TAX 95,370 89,292 194,769 145,331
Income tax expense 34,075 29,916 68,169 48,250
- ---------------------------------------------------------------------------------------------------------------------------------
NET INCOME BEFORE CUMULATIVE EFFECT OF
CHANGE IN ACCOUNTING PRINCIPLE 61,295 59,376 126,600 97,081
- ---------------------------------------------------------------------------------------------------------------------------------
Cumulative effect of change in accounting principle,
net of income tax 0 0 (10,128) 0
- ---------------------------------------------------------------------------------------------------------------------------------
NET INCOME $ 61,295 $ 59,376 $116,472 $ 97,081
=================================================================================================================================
NET INCOME BEFORE CUMULATIVE EFFECT OF
CHANGE IN ACCOUNTING PRINCIPLE PER
SHARE - BASIC $.87 $.85 $1.80 $1.39
- ---------------------------------------------------------------------------------------------------------------------------------
NET INCOME BEFORE CUMULATIVE EFFECT OF
CHANGE IN ACCOUNTING PRINCIPLE PER
SHARE - DILUTED $.86 $.85 $1.78 $1.38
- ---------------------------------------------------------------------------------------------------------------------------------
NET INCOME PER SHARE - BASIC $.87 $.85 $1.66 $1.39
- ---------------------------------------------------------------------------------------------------------------------------------
NET INCOME PER SHARE - DILUTED $.86 $.85 $1.64 $1.38
- ---------------------------------------------------------------------------------------------------------------------------------
DIVIDENDS PAID PER SHARE $.175 $.16 $ .335 $ .31
- ---------------------------------------------------------------------------------------------------------------------------------
Average shares outstanding - basic 70,284,893 70,004,109 70,213,500 69,980,439
Average shares outstanding - diluted 71,030,983 70,561,795 70,959,287 70,522,838
See notes to consolidated condensed financial statements
PROTECTIVE LIFE
CORPORATION
CONSOLIDATED CONDENSED
BALANCE SHEETS
(Dollars in thousands)
(Unaudited)
JUNE 30 DECEMBER 31
2004 2003
- -------------------------------------------------------------------------------------------------------------------------------------
ASSETS
Investments:
Fixed maturities, at market (amortized cost: 2004 - $13,013,301; 2003 - $12,743,213) $13,295,606 $13,355,911
Equity securities, at market (cost: 2004 - $54,362; 2003 - $45,379) 57,802 46,731
Mortgage loans on real estate 2,836,683 2,733,722
Investment in real estate, net 107,163 18,126
Policy loans 486,661 502,748
Other long-term investments 197,246 249,494
Short-term investments 694,002 519,419
- -------------------------------------------------------------------------------------------------------------------------------------
Total investments 17,675,163 17,426,151
Cash 105,518 136,698
Accrued investment income 194,403 189,232
Accounts and premiums receivable, net 53,958 57,944
Reinsurance receivables 2,515,619 2,350,606
Deferred policy acquisition costs 1,932,737 1,861,020
Goodwill 46,619 47,312
Property and equipment, net 46,821 45,640
Other assets 254,920 238,581
Assets related to separate accounts
Variable annuity 2,121,517 2,045,038
Variable universal life 188,963 171,408
Other 4,349 4,361
- -------------------------------------------------------------------------------------------------------------------------------------
$25,140,587 $24,573,991
- -------------------------------------------------------------------------------------------------------------------------------------
LIABILITIES
Policy liabilities and accruals $10,149,490 $ 9,732,697
Stable value product account balances 4,921,166 4,676,531
Annuity account balances 3,419,225 3,480,577
Other policyholders' funds 157,612 158,875
Other liabilities 899,047 875,652
Accrued income taxes (12,074) (34,261)
Deferred income taxes 213,967 377,990
Liabilities related to variable interest entities 476,591 400,000
Long-term debt 385,449 461,329
Subordinated debt securities 324,743 221,650
Liabilities related to separate accounts
Variable annuity 2,121,517 2,045,038
Variable universal life 188,963 171,408
Other 4,349 4,361
- -------------------------------------------------------------------------------------------------------------------------------------
23,250,045 22,571,847
- -------------------------------------------------------------------------------------------------------------------------------------
COMMITMENTS AND CONTINGENT LIABILITIES - NOTE B
SHARE-OWNERS' EQUITY
Preferred Stock, $1.00 par value, shares authorized: 3,600,000; Issued: None
Junior Participating Cumulative Preferred Stock, $1.00 par value
shares authorized: 400,000; Issued: None
Common Stock, $.50 par value, shares authorized: 160,000,000
shares issued: 2004 and 2003 - 73,251,960 36,626 36,626
Additional paid-in capital 423,257 418,351
Treasury stock, at cost (2004 - 3,844,015 shares; 2003 - 4,260,259 shares) (13,783) (15,275)
Stock held in trust (2004 - 87,588 shares; 2003 - 97,700 shares) (2,855) (2,788)
Unallocated stock in Employee Stock Ownership Plan
(2004 - 609,735 shares; 2003 - 724,068 shares) (1,989) (2,367)
Retained earnings 1,328,280 1,235,012
Accumulated other comprehensive income:
Net unrealized gains on investments
(net of income tax: 2004 - $61,511; 2003 - $177,642) 114,234 329,907
Accumulated gain - hedging (net of income tax: 2004 - $3,646; 2003 - $1,442) 6,772 2,678
- -------------------------------------------------------------------------------------------------------------------------------------
1,890,542 2,002,144
- -------------------------------------------------------------------------------------------------------------------------------------
$25,140,587 $24,573,991
=====================================================================================================================================
See notes to consolidated condensed financial statements
PROTECTIVE LIFE CORPORATION
CONSOLIDATED CONDENSED
STATEMENTS OF CASH FLOWS
(Dollars in thousands)
(Unaudited)
SIX MONTHS ENDED
JUNE 30
2004 2003
- ---------------------------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM OPERATING ACTIVITIES $ 116,472 $ 97,081
Net income
Adjustments to reconcile net income to net cash provided by operating activities:
Realized investment (gains) losses (14,061) (44,125)
Amortization of deferred policy acquisition costs 104,847 120,562
Capitalization of deferred policy acquisition costs (184,876) (187,221)
Depreciation expense 4,355 5,953
Deferred income tax (10,823) 7,956
Accrued income tax (14,343) (23,029)
Interest credited to universal life and investment products 327,199 275,733
Policy fees assessed on universal life and investment products (174,381) (151,732)
Change in accrued investment income and other receivables (165,590) 21,862
Change in policy liabilities and other policyholders' funds
of traditional life and health products 353,728 113,441
Net change in trading securities (13,594) 0
Change in other liabilities (86,310) (152,210)
Other, net (7,105) 43,143
- ---------------------------------------------------------------------------------------------------------------------------------
Net cash provided by operating activities 235,518 127,414
- ---------------------------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM INVESTING ACTIVITIES
Investments available for sale, net of short-term investments:
Maturities and principal reductions of investments 1,119,804 2,718,238
Sale of investments 1,654,206 1,632,541
Cost of investments acquired (2,988,484) (4,770,140)
Change in mortgage loans, net (102,961) (24,861)
Change in investment real estate, net 1,140 3,781
Change in policy loans, net 16,087 10,270
Change in other long-term investments, net 2,779 3,915
Change in short-term investments, net (64,672) 47,199
Purchase of property and equipment (5,536) (10,834)
- ---------------------------------------------------------------------------------------------------------------------------------
Net cash used in investing activities (367,637) (389,891)
- ---------------------------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM FINANCING ACTIVITIES
Borrowings under line of credit arrangements and long-term debt 76,000 372,500
Principal payments on line of credit arrangement and long-term debt (153,101) (342,215)
Dividends to share owners (23,204) (21,346)
Issuance of subordinated debt securities 103,093 0
Issuance (purchase) of common stock held in trust (67) (732)
Investment product deposits and change in universal life deposits 1,301,337 875,749
Investment product withdrawals (1,208,967) (632,339)
Other financing activities, net 5,848 0
- ---------------------------------------------------------------------------------------------------------------------------------
Net cash provided by financing activities 100,939 251,617
- ---------------------------------------------------------------------------------------------------------------------------------
CHANGE IN CASH (31,180) (10,860)
CASH AT BEGINNING OF PERIOD 136,698 101,953
- ---------------------------------------------------------------------------------------------------------------------------------
CASH AT END OF PERIOD $ 105,518 $ 91,093
=================================================================================================================================
See notes to consolidated condensed financial statements
NOTE A – BASIS OF PRESENTATION
The accompanying unaudited consolidated condensed financial statements of Protective Life Corporation and its subsidiaries (the “Company”) 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 six month period ended June 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 the Company’s annual report on Form 10-K for the year ended December 31, 2003.
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-owners’ equity.
With respect to the unaudited consolidated condensed financial information of the Company for the six-month periods ended June 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 August 3, 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
The Company’s certificate of incorporation provides indemnification for persons serving as officers and directors of the Company. In addition, agreements with the Company’s directors require the Company, upon certain “change-in-control” contingencies, to obtain a $20 million letter of credit to secure the Company’s indemnification obligations. The letter of credit would provide security for the Company’s obligations up to an aggregate amount of $20 million (after taking into account amounts paid by the Company and amounts paid under the Company’s directors and officers or other insurance policies).
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. The Company 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. The Company, 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, the Company 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 the Company.
NOTE C – OPERATING SEGMENTS
The Company 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 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. The Company 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 and interest on substantially all debt). This segment also includes earnings from several lines of business which the Company is not actively marketing (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 the first six months of 2004, and prior period segment data was restated to reflect the change. |
The Company 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 corporate debt and 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 the Company’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 table sets forth total segment operating income and assets for the periods shown. Adjustments represent the cumulative effect of change in accounting principle and the recognition of income tax expense. Asset adjustments represent the inclusion of assets related to discontinued operations. The reduction in the goodwill balance in the Asset Protection segment relates to the sale of a small subsidiary in the first quarter of 2004.
Segment Operating Income for the
Six Months Ended June 30, 2004
- -----------------------------------------------------------------------------------------------------------------------------------
Life Stable Value
Marketing Acquisitions Annuities Products
- -----------------------------------------------------------------------------------------------------------------------------------
Premiums and policy fees $486,917 $139,128 $ 15,222
Reinsurance ceded (373,858) (34,941) 0
- -----------------------------------------------------------------------------------------------------------------------------------
Net of reinsurance ceded 113,059 104,187 15,222
Net investment income 116,869 117,359 103,111 $130,699
Realized investment gains 0 0 6,294 5,901
Other income 43,491 1,185 3,340 0
- -----------------------------------------------------------------------------------------------------------------------------------
Total revenue 273,419 222,731 127,967 136,600
- -----------------------------------------------------------------------------------------------------------------------------------
Benefits and settlement expenses 138,718 144,360 90,502 100,489
Amortization of deferred policy acquisition costs 32,007 15,325 16,176 1,564
Other operating expenses 17,496 18,382 11,418 3,021
- -----------------------------------------------------------------------------------------------------------------------------------
Total benefits and expenses 188,221 178,067 118,096 105,074
- -----------------------------------------------------------------------------------------------------------------------------------
Income before income tax 85,198 44,664 9,871 31,526
Less: realized investment gains 6,294 5,901
Add back: related amortization of deferred
policy acquisition costs 4,211
- -----------------------------------------------------------------------------------------------------------------------------------
Operating income 85,198 44,664 7,788 25,625
- -----------------------------------------------------------------------------------------------------------------------------------
Asset Corporate Total
Protection and Other Adjustments Consolidated
- -----------------------------------------------------------------------------------------------------------------------------------
Premiums and policy fees $233,533 $25,084 $ 899,884
Reinsurance ceded (125,226) (683) (534,708)
- -----------------------------------------------------------------------------------------------------------------------------------
Net of reinsurance ceded 108,307 24,401 365,176
Net investment income 15,041 47,428 530,507
Realized investment gains 0 17,332 29,527
Other income 18,179 8,787 74,982
- -----------------------------------------------------------------------------------------------------------------------------------
Total revenue 141,527 97,948 1,000,192
- -----------------------------------------------------------------------------------------------------------------------------------
Benefits and settlement expenses 65,562 30,154 569,785
Amortization of deferred policy acquisition costs 37,478 2,297 104,847
Other operating expenses 29,513 50,961 130,791
- -----------------------------------------------------------------------------------------------------------------------------------
Total benefits and expenses 132,553 83,412 805,423
- -----------------------------------------------------------------------------------------------------------------------------------
Income before income tax 8,974 14,536 194,769
Less: realized investment gains 17,332
Add back: derivative gains related to corporate
debt and investments 10,229
- -----------------------------------------------------------------------------------------------------------------------------------
Operating income 8,974 7,433
Income tax expense $ 68,169 68,169
- -----------------------------------------------------------------------------------------------------------------------------------
Net income before cumulative effect of change in
accounting principle 126,600
Cumulative effect of change in accounting principle,
net of income tax (10,128) (10,128)
- -----------------------------------------------------------------------------------------------------------------------------------
Net income $ 116,472
===================================================================================================================================
Segment Operating Income for the
Three Months Ended June 30, 2004
- -----------------------------------------------------------------------------------------------------------------------------------
Life Stable Value
Marketing Acquisitions Annuities Products
- -----------------------------------------------------------------------------------------------------------------------------------
Premiums and policy fees $250,931 $69,659 $ 7,594
Reinsurance ceded (205,072) (17,840) 0
- -----------------------------------------------------------------------------------------------------------------------------------
Net of reinsurance ceded 45,859 51,819 7,594
Net investment income 58,929 58,704 51,523 $66,666
Realized investment gains 0 0 290 2,022
Other income 22,348 468 1,555 0
- -----------------------------------------------------------------------------------------------------------------------------------
Total revenue 127,136 110,991 60,962 68,688
- -----------------------------------------------------------------------------------------------------------------------------------
Benefits and settlement expenses 66,692 71,340 44,456 50,720
Amortization of deferred policy acquisition costs 10,926 7,476 7,119 803
Other operating expenses 5,921 8,714 4,673 1,217
- -----------------------------------------------------------------------------------------------------------------------------------
Total benefits and expenses 83,539 87,530 56,248 52,740
- -----------------------------------------------------------------------------------------------------------------------------------
Income before income tax 43,597 23,461 4,714 15,948
Less: realized investment gains 290 2,022
Add back: related amortization of deferred
policy acquisition costs 551
- -----------------------------------------------------------------------------------------------------------------------------------
Operating income 43,597 23,461 4,975 13,926
- -----------------------------------------------------------------------------------------------------------------------------------
Asset Corporate Total
Protection and Other Adjustments Consolidated
- -----------------------------------------------------------------------------------------------------------------------------------
Premiums and policy fees $115,354 $12,550 $456,088
Reinsurance ceded (62,120) (337) (285,369)
- -----------------------------------------------------------------------------------------------------------------------------------
Net of reinsurance ceded 53,234 12,213 170,719
Net investment income 7,500 22,577 265,899
Realized investment gains (losses) 0 5,505 7,817
Other income 9,117 4,075 37,563
- -----------------------------------------------------------------------------------------------------------------------------------
Total revenue 69,851 44,370 481,998
- -----------------------------------------------------------------------------------------------------------------------------------
Benefits and settlement expenses 33,363 15,898 282,469
Amortization of deferred policy acquisition costs 17,522 1,207 45,053
Other operating expenses 14,595 23,986 59,106
- -----------------------------------------------------------------------------------------------------------------------------------
Total benefits and expenses 65,480 41,091 386,628
- -----------------------------------------------------------------------------------------------------------------------------------
Income before income tax 4,371 3,279 95,370
Less: realized investment gains 5,505
Add back: derivative gains related to corporate
debt and investments 5,354
- -----------------------------------------------------------------------------------------------------------------------------------
Operating income 4,371 3,128
Income tax expense $34,075 34,075
- -----------------------------------------------------------------------------------------------------------------------------------
Net income $ 61,295
===================================================================================================================================
Segment Operating Income for the
Six Months Ended June 30, 2003
- -----------------------------------------------------------------------------------------------------------------------------------
Life Stable Value
Marketing Acquisitions Annuities Products
- -----------------------------------------------------------------------------------------------------------------------------------
Premiums and policy fees $388,360 $144,389 $ 12,270
Reinsurance ceded (265,939) (37,157) 0
- -----------------------------------------------------------------------------------------------------------------------------------
Net of reinsurance ceded 122,421 107,232 12,270
Net investment income 114,053 124,816 116,222 $117,622
Realized investment gains (losses) 0 0 11,233 (2,442)
Other income 30,953 2,447 4,016 0
- -----------------------------------------------------------------------------------------------------------------------------------
Total revenue 267,427 234,495 143,741 115,180
- -----------------------------------------------------------------------------------------------------------------------------------
Benefits and settlement expenses 137,098 145,570 104,325 94,722
Amortization of deferred policy acquisition costs 39,917 18,555 18,353 1,118
Other operating expenses 13,661 23,317 13,222 2,546
- -----------------------------------------------------------------------------------------------------------------------------------
Total benefits and expenses 190,676 187,442 135,900 98,386
- -----------------------------------------------------------------------------------------------------------------------------------
Income before income tax 76,751 47,053 7,841 16,794
Less: realized investment gains 11,233 (2,442)
Add back: related amortization of deferred
policy acquisition costs 10,098
- -----------------------------------------------------------------------------------------------------------------------------------
Operating income 76,751 47,053 6,706 19,236
- -----------------------------------------------------------------------------------------------------------------------------------
Asset Corporate Total
Protection and Other Adjustments Consolidated
- -----------------------------------------------------------------------------------------------------------------------------------
Premiums and policy fees $210,077 $29,650 $ 784,746
Reinsurance ceded (88,178) (3,411) (394,685)
- -----------------------------------------------------------------------------------------------------------------------------------
Net of reinsurance ceded 121,899 26,239 390,061
Net investment income 18,378 29,354 520,445
Realized investment gains 0 19,009 27,800
Other income 25,138 2,736 65,290
- -----------------------------------------------------------------------------------------------------------------------------------
Total revenue 165,415 77,338 1,003,596
- -----------------------------------------------------------------------------------------------------------------------------------
Benefits and settlement expenses 70,326 50,165 602,206
Amortization of deferred policy acquisition costs 39,908 2,711 120,562
Other operating expenses 44,178 38,573 135,497
- -----------------------------------------------------------------------------------------------------------------------------------
Total benefits and expenses 154,412 91,449 858,265
- -----------------------------------------------------------------------------------------------------------------------------------
Income before income tax 11,003 (14,111) 145,331
Less: realized investment gains 19,009
Add back: derivative gains related to corporate
debt and investments 11,519
- -----------------------------------------------------------------------------------------------------------------------------------
Operating income (loss) 11,003 (21,601)
Income tax expense $48,250 48,250
- -----------------------------------------------------------------------------------------------------------------------------------
Net income $97,081
===================================================================================================================================
Segment Operating Income for the
Three Months Ended June 30, 2003
- -----------------------------------------------------------------------------------------------------------------------------------
Life Stable Value
Marketing Acquisitions Annuities Products
- -----------------------------------------------------------------------------------------------------------------------------------
Premiums and policy fees $201,813 $71,326 $ 6,387
Reinsurance ceded (141,901) (18,531) 0
- -----------------------------------------------------------------------------------------------------------------------------------
Net of reinsurance ceded 59,912 52,795 6,387
Net investment income 57,515 62,520 57,780 $59,090
Realized investment gains 0 0 11,206 4,260
Other income 16,981 1,542 2,075 0
- -----------------------------------------------------------------------------------------------------------------------------------
Total revenue 134,408 116,857 77,448 63,350
- -----------------------------------------------------------------------------------------------------------------------------------
Benefits and settlement expenses 61,876 72,951 51,339 46,957
Amortization of deferred policy acquisition costs 19,033 8,474 13,967 519
Other operating expenses 7,383 11,151 7,312 1,516
- -----------------------------------------------------------------------------------------------------------------------------------
Total benefits and expenses 88,292 92,576 72,618 48,992
- -----------------------------------------------------------------------------------------------------------------------------------
Income before income tax 46,116 24,281 4,830 14,358
Less: realized investment gains 11,206 4,260
Add back: related amortization of deferred
policy acquisition costs 9,367
- -----------------------------------------------------------------------------------------------------------------------------------
Operating income 46,116 24,281 2,991 10,098
- -----------------------------------------------------------------------------------------------------------------------------------
Asset Corporate Total
Protection and Other Adjustments Consolidated
- -----------------------------------------------------------------------------------------------------------------------------------
Premiums and policy fees $104,153 $13,973 $397,652
Reinsurance ceded (44,026) (810) (205,268)
- -----------------------------------------------------------------------------------------------------------------------------------
Net of reinsurance ceded 60,127 13,163 192,384
Net investment income 9,132 16,707 262,744
Realized investment gains 0 18,392 33,858
Other income 18,167 1,216 39,981
- -----------------------------------------------------------------------------------------------------------------------------------
Total revenue 87,426 49,478 528,967
- -----------------------------------------------------------------------------------------------------------------------------------
Benefits and settlement expenses 33,868 37,942 304,933
Amortization of deferred policy acquisition costs 21,425 1,385 64,803
Other operating expenses 22,372 20,205 69,939
- -----------------------------------------------------------------------------------------------------------------------------------
Total benefits and expenses 77,665 59,532 439,675
- -----------------------------------------------------------------------------------------------------------------------------------
Income before income tax 9,761 (10,054) 89,292
Less: realized investment gains 18,392
Add back: derivative gains related to corporate
debt and investments 5,885
- -----------------------------------------------------------------------------------------------------------------------------------
Operating income (loss) 9,761 (22,561)
Income tax expense $29,916 29,916
- -----------------------------------------------------------------------------------------------------------------------------------
Net income $ 59,376
===================================================================================================================================
Operating Segment Assets
June 30, 2004
- -----------------------------------------------------------------------------------------------------------------------------------
Life Stable Value
Marketing Acquisitions Annuities Products
- -----------------------------------------------------------------------------------------------------------------------------------
Investments and other assets $5,387,968 $4,108,086 $5,527,672 $4,792,581
Deferred policy acquisition costs 1,242,610 371,958 126,738 13,225
Goodwill 10,354
- -----------------------------------------------------------------------------------------------------------------------------------
Total assets $6,640,932 $4,480,044 $5,654,410 $4,805,806
===================================================================================================================================
- -----------------------------------------------------------------------------------------------------------------------------------
Asset Corporate Total
Protection and Other Adjustments Consolidated
- -----------------------------------------------------------------------------------------------------------------------------------
Investments and other assets $895,866 $2,392,153 $56,905 $23,161,231
Deferred policy acquisition costs 169,181 9,025 1,932,737
Goodwill 36,182 83 46,619
- -----------------------------------------------------------------------------------------------------------------------------------
Total assets $1,101,229 $2,401,261 $56,905 $25,140,587
===================================================================================================================================
Operating Segment Assets
December 31, 2003
- -----------------------------------------------------------------------------------------------------------------------------------
Life Stable Value
Marketing Acquisitions Annuities Products
- -----------------------------------------------------------------------------------------------------------------------------------
Investments and other assets $4,987,757 $4,356,929 $5,436,619 $4,520,955
Deferred policy acquisition costs 1,185,102 385,042 101,096 7,186
Goodwill 10,354
- -----------------------------------------------------------------------------------------------------------------------------------
Total assets $6,183,213 $4,741,971 $5,537,715 $4,528,141
===================================================================================================================================
- -----------------------------------------------------------------------------------------------------------------------------------
Asset Corporate Total
Protection and Other Adjustments Consolidated
- -----------------------------------------------------------------------------------------------------------------------------------
Investments and other assets $ 969,742 $2,333,396 $60,261 $22,665,659
Deferred policy acquisition costs 171,863 10,731 1,861,020
Goodwill 36,875 83 47,312
- -----------------------------------------------------------------------------------------------------------------------------------
Total assets $ 1,178,480 $2,344,210 $60,261 $24,573,991
===================================================================================================================================
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 June 30, 2004, and for the six months then ended, the Company’s insurance subsidiaries had combined share-owners’ equity of $1,151.2 million and net income of $46.5 million.
NOTE E – REINSURANCE RECEIVABLE
In 2002, the Company discovered that it had overpaid reinsurance premiums to several reinsurance companies. In the first six months and second quarter of 2003, the Company increased premiums and policy fees $18.4 million and $15.6 million, respectively, 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 and $5.1 million of additional amortization of deferred policy acquisition costs in the first six months and second quarter of 2003, respectively. As a result, the Company’s pretax income for the first six months and second quarter of 2003 increased by $12.3 million and $10.5 million, respectively. In the second quarter of 2004, the Company adjusted its estimate of the expected receipts, resulting in a $1.0 million decrease in pretax income.
NOTE F – NET INCOME PER SHARE
Net income per share – basic is net income divided by the average number of shares of Common Stock outstanding including shares that are issuable under various deferred compensation plans.
Net income per share – diluted is adjusted net income divided by the average number of shares outstanding including all dilutive, potentially issuable shares that are issuable under various stock-based compensation plans and stock purchase contracts.
Net income and a reconciliation of basic and diluted average shares outstanding for the three and six month periods ended June 30, 2004 and 2003 are summarized as follows:
RECONCILIATION OF NET INCOME AND
AVERAGE SHARES OUTSTANDING
- --------------------------------------------------------------------------------------------------------------------------------
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30 JUNE 30
2004 2003 2004 2003
- --------------------------------------------------------------------------------------------------------------------------------
Net income $61,295 $59,376 $116,472 $97,081
- --------------------------------------------------------------------------------------------------------------------------------
Average shares issued and outstanding 69,388,677 68,897,659 69,281,046 68,846,597
Stock held in trust (87,588) (110,922) (84,365) (103,632)
Issuable under various deferred compensation plans 983,804 1,217,372 1,016,819 1,237,474
- --------------------------------------------------------------------------------------------------------------------------------
Average shares outstanding - basic 70,284,893 70,004,109 70,213,500 69,980,439
Stock held in trust 87,588 110,922 84,365 103,632
Stock appreciation rights 286,742 222,048 300,163 202,918
Performance shares 371,760 224,716 361,259 235,849
- --------------------------------------------------------------------------------------------------------------------------------
Average shares outstanding - diluted 71,030,983 70,561,795 70,959,287 70,522,838
================================================================================================================================
NOTE G – 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. The Company consolidated, as of and for the three months ended March 31, 2004, two real estate investment companies that the Company had previously reported as investments. The entities were consolidated based on the determination that the Company was the primary beneficiary. The consolidation resulted in the Company’s reported assets and liabilities increasing by $76.2 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 K for discussion of the Company’s adoption of SOP 03-1.
NOTE H – COMPREHENSIVE INCOME
The following table sets forth the Company’s comprehensive income for the periods presented below:
-----------------------------------------------------------------------------------------------------------------------------
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30 JUNE 30
2004 2003 2004 2003
-----------------------------------------------------------------------------------------------------------------------------
Net income $ 61,295 $ 59,376 $116,472 $ 97,081
Change in net unrealized gains/losses on
investments (net of income tax:
three months: 2004 - $(197,684); 2003 - $98,310
six months: 2004 - $(110,635); 2003 - $129,664) (367,127) 182,575 (205,465) 240,804
Change in accumulated gain-hedging
(net of income tax:
three months: 2004 - $1,070; 2003 - $666
six months: 2004 - $2,204; 2003 - $1,746) 1,987 1,237 4,094 3,242
Reclassification adjustment for amounts included
in net income (net of income tax:
three months: 2004 - $323; 2003 - $(10,333)
six months: 2004 - $(5,496); 2003 - $(9,921)) 600 (19,191) (10,208) (18,425)
-----------------------------------------------------------------------------------------------------------------------------
Comprehensive income (loss) $(303,245) $ 223,997 $(95,107) $322,702
=============================================================================================================================
NOTE I – RETIREMENT BENEFIT PLANS
The following table sets forth the amount of net periodic benefit cost recognized for the Company’s defined benefit pension plan and unfunded excess benefits plan:
- -------------------------------------------------------------------------------------------------------------------------------
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30 JUNE 30
2004 2003 2004 2003
- -------------------------------------------------------------------------------------------------------------------------------
Service cost $1,201 $ 999 $3,213 $2,699
Interest cost 1,352 1,167 3,677 3,158
Expected return on plan assets (1,427) (1,123) (3,707) (3,026)
Amortization of prior service cost 32 46 124 124
Amortization of net loss 734 234 1,204 631
- -------------------------------------------------------------------------------------------------------------------------------
Net periodic benefit cost $1,892 $1,323 $4,511 $3,586
===============================================================================================================================
The Company 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. There has been no change in this estimate. As of June 30, 2004, no contributions have been made.
In addition to pension benefits, the Company provides limited healthcare benefits and life insurance benefits to eligible retirees. The cost of these plans for the six months ended June 30, 2004 and 2003 was immaterial.
NOTE J – SUBORDINATED DEBT SECURITIES AND SENIOR NOTES
On January 27, 2004, a special-purpose entity, PLC Capital Trust V, issued $100 million of 6.125% Trust Originated Preferred Securities (TOPrS). The 6.125% TOPrS are guaranteed on a subordinated basis by the Company. This guarantee, considered together with the other obligations of the Company with respect to the 6.125% TOPrS, constitutes a full and unconditional guarantee by the Company of PLC Capital Trust V’s obligations with respect to the 6.125% TOPrS.
PLC Capital Trust V was formed solely to issue securities and use the proceeds thereof to purchase subordinated debt securities of the Company. The sole assets of PLC Capital Trust V are $103.1 million of Protective Life Corporation 6.125% Subordinated Debentures due 2034, Series F. The Company has the right under the subordinated debt securities to extend interest payment periods up to five consecutive years, and as a consequence, dividends on the 6.125% TOPrS may be deferred (but will continue to accumulate, together with additional dividends on any accumulated but unpaid dividends at the dividend rate) by PLC Capital Trust V during any such extended interest payment period. The 6.125% TOPrS are redeemable by PLC Capital Trust V at any time on or after January 27, 2009. The 6.125% Subordinated Debentures are included within subordinated debt securities in the accompanying balance sheets.
The majority of the proceeds of the 6.125% TOPrS was used to pay down outstanding bank debt, including $59.9 million incurred to redeem the Company’s outstanding 7.50% 15-year Senior Notes on January 1, 2004. In addition, the Company repaid the $25 million outstanding as of December 31, 2003, on its $200 million line of credit. The balance of the proceeds was used for general corporate purposes.
On July 1, 2004, the Company redeemed the $75.0 million 7.95% 10-year Senior Notes that matured on that date. The Company borrowed against its revolving line of credit to redeem the Senior Notes.
NOTE K – CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE
In January 2004, the Company 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 ($0.14 per share on both a basic and diluted basis). 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, the Company recorded a $0.1 million adjustment related to guaranteed minimum death benefits (GMDB) on its variable annuity products.
The Company issues variable universal life and variable annuity products through its separate accounts for which the investment risk is borne by the contract holder. The Company 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 reserve 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 June 30, 2004. The total guaranteed amount payable based on variable annuity account balances at June 30, 2004, was $286.1 million (including $252.9 million in the Annuities segment and $33.2 million in the Acquisitions segment), with a GMDB reserve of $5.6 million (including $5.1 million in the Annuities segment and $0.5 million in the Acquisitions segment). The average attained age of contract holders at June 30, 2004 was 65.
Activity relating to GMDB reserves was as follows:
- -------------------------------------------------------------------------------------------------------------------------------
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30 JUNE 30
2004 2003 2004 2003
- -------------------------------------------------------------------------------------------------------------------------------
Incurred claims $796 $1,729 $1,637 $5,461
Paid claims 921 1,824 1,947 4,918
- -------------------------------------------------------------------------------------------------------------------------------
Account balances of variable annuities with guarantees were invested in variable annuity separate accounts as follows:
- -------------------------------------------------------------------------------------------------------------------------
JUNE 30, 2004 DECEMBER 31, 2003
- -------------------------------------------------------------------------------------------------------------------------
Equity mutual funds $1,919.0 $1,846.0
Fixed income mutual funds 202.5 199.0
- -------------------------------------------------------------------------------------------------------------------------
Total $2,121.5 $2,045.0
=========================================================================================================================
Certain of the Company’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, the Company maintains a reserve for all interest credits earned to date. The Company 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 the Company’s deferred sales inducement asset was as follows:
- -------------------------------------------------------------------------------------------------------------------------------
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30 JUNE 30
2004 2003 2004 2003
- -------------------------------------------------------------------------------------------------------------------------------
Deferred asset, beginning of period $27,419 $29,369 $27,713 $31,557
Amounts deferred 3,170 3,383 5,911 4,932
Amortization (3,023) (3,531) (6,058) (7,268)
- -------------------------------------------------------------------------------------------------------------------------------
Deferred asset, end of period $27,566 $29,221 $27,566 $29,221
===============================================================================================================================
Protective Life Corporation is a holding company whose subsidiaries provide financial services through the production, distribution, and administration of insurance and investment products. Founded in 1907, Protective Life Insurance Company is the Company’s principal operating subsidiary. Unless the context otherwise requires, the “Company” refers to the consolidated group of Protective Life Corporation and its subsidiaries.
For a more complete understanding of the Company’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 the Company’s latest annual report on Form 10-K and other filings with the SEC.
The Company operates several business segments each having a strategic focus. An operating segment is generally distinguished by products and/or channels of distribution. The Company’s operating segments are Life Marketing, Acquisitions, Annuities, Stable Value Products, and Asset Protection. The Company also has an additional segment referred to as Corporate and Other.
This report reviews the Company’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 the Company 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 the Company’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 the Company and/or errors in our critical assumptions or reported financial results; insurance companies are highly regulated and subject to numerous legal restrictions and regulations; changes to tax law or interpretations of existing tax law could adversely affect the Company 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; 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 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 new accounting rules or changes to existing accounting rules could negatively impact our reported financial results. Please refer to Exhibit 99, incorporated by reference herein, about these factors that could affect future results.
The Company’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 corporate debt and 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 the Company’s business is internally assessed. Although the items excluded from segment operating income may be significant components in understanding and assessing the Company’s overall financial performance, management believes that segment operating income enhances an investor’s understanding of the Company’s results of operations. Note that the Company’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 SIX MONTHS ENDED
JUNE 30 JUNE 30
2004 2003 CHANGE 2004 2003 CHANGE
---------------------------------- ------------------------------------
Life Marketing $ 43,597 $46,116 (5.5)% $ 85,198 $ 76,751 11.0%
Acquisitions 23,461 24,281 (3.4) 44,664 47,053 (5.1)
Annuities 4,975 2,991 66.3 7,788 6,706 16.1
Stable Value Products 13,926 10,098 37.9 25,625 19,236 33.2
Asset Protection 4,371 9,761 (55.2) 8,974 11,003 (18.4)
Corporate and Other 3,128 (22,561) n/m 7,433 (21,601) n/m
---------------------- -------------------------
93,458 70,686 32.2 179,682 139,148 29.1
Realized investment gains (losses)-investments(1) (1,474) 20,157 11,493 18,248
Realized investment gains (losses)-derivatives(2) 3,386 (1,551) 3,594 (12,065)
Income tax expense (34,075) (29,916) (68,169) (48,250)
---------------------- -------------------------
Net income before cumulative effect of change
in accounting principle 61,295 59,376 3.2 126,600 97,081 30.4
Cumulative effect of change in accounting
principle, net of income tax (10,128)
---------------------- -------------------------
Net income $ 61,295 $59,376 3.2 $116,472 $ 97,081 20.0
====================== =========================
(1) Realized investment gains (losses)-investments $ (923) $29,524 $ 15,704 $ 28,346
Less: related amortization of DAC (551) (9,367) (4,211) (10,098)
---------------------- -------------------------
(1,474) 20,157 11,493 18,248
(2) Realized investment gains (losses)-investments 8,740 4,334 13,823 (546)
Less: settlements on certain interest rate swaps (5,354) (5,885) (10,229) (11,519)
---------------------- -------------------------
3,386 (1,551) 3,594 (12,065)
Compared to second quarter 2003, net income increased 3.2% reflecting improvement in segment operating income offset by lower realized investment gains. Net income for the first six months of 2004 increased 20.0% 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, which were partially offset by higher gains from derivatives. For the first six months of 2004, reduced gains from sales of securities were more than offset by lower levels of impairments and higher contributions from derivatives. Excluding the impact of reinsurance recoveries during 2003 (see Note E to the consolidated condensed financial statements included herein), Life Marketing’s operating income increased 22.3% and 32.1% over the second quarter and first six months of 2003, respectively, reflecting continued growth in life insurance in-force through new sales. 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 interest rates in the current quarter contributed to the increase in the Annuities segment’s earnings. Excluding gains from charter sales, Asset Protection segment operating income increased 50.6% and 91.9% over the second quarter and first six months of 2003, primarily due to improved results 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 from unallocated capital.
Included in net income for the first six months of 2004 is a cumulative effect charge of $10.1 million arising from the Company’s adoption of SOP 03-1 (see Note K to the consolidated condensed financial statements included herein for further discussion of SOP 03-1).
In the following segment discussions, various statistics and other key data the Company uses to evaluate its segments are presented. Sales statistics are used by the Company 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 and stable value products are measured based on the amount of deposits 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 the Company’s various sales tracking and administrative systems, and are not derived from the Company’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 SIX MONTHS ENDED
JUNE 30 JUNE 30
2004 2003 CHANGE 2004 2003 CHANGE
-------------------------------- --------------------------------
REVENUES
Gross premiums and policy fees $250,931 $201,813 24.3% $486,917 $388,360 25.4%
Reinsurance ceded (205,072) (141,901) 44.5 (373,858) (265,939) 40.6
---------------------- ----------------------
Net premiums and policy fees 45,859 59,912 (23.5) 113,059 122,421 (7.6)
Net investment income 58,929 57,515 2.5 116,869 114,053 2.5
Other income 22,348 16,981 31.6 43,491 30,953 40.5
---------------------- ----------------------
Total operating revenues 127,136 134,408 (5.4) 273,419 267,427 2.2
BENEFITS AND EXPENSES
Benefits and settlement expenses 66,692 61,876 7.8 138,718 137,098 1.2
Amortization of deferred policy acquisition costs 10,926 19,033 (42.6) 32,007 39,917 (19.8)
Other operating expenses 5,921 7,383 (19.8) 17,496 13,661 28.1
---------------------- ----------------------
Total benefits and expenses 83,539 88,292 (5.4) 188,221 190,676 (1.3)
OPERATING INCOME 43,597 46,116 (5.5) 85,198 76,751 11.0
---------------------- ----------------------
INCOME BEFORE INCOME TAX $ 43,597 $ 46,116 (5.5) $ 85,198 $ 76,751 11.0
====================== ======================
The following table summarizes key data for the Life Marketing segment:
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30 JUNE 30
2004 2003 CHANGE 2004 2003 CHANGE
------------------------------------- -----------------------------------
Sales By Product
Traditional $42,207 $52,994 (20.4)% $ 89,043 $ 94,204 (5.5)%
Universal life 19,266 20,646 (6.7) 36,963 36,882 0.2
Variable universal life 1,474 1,105 33.4 2,599 1,981 31.2
--------------------------- -------------------------
$62,947 $74,745 (15.8) $128,605 $133,067 (3.4)
=========================== =========================
Sales By Distribution Channel
Brokerage general agents $39,580 $47,034 (15.8) $ 82,327 $ 83,771 (1.7)
Independent agents 12,569 12,382 1.5 25,310 23,004 10.0
Stockbrokers/banks 6,780 6,746 0.5 12,839 11,246 14.2
Direct response 221 1,665 (86.7) 854 3,615 (76.4)
BOLI 3,797 6,918 (45.1) 7,275 11,431 (36.4)
--------------------------- -------------------------
$62,947 $74,745 (15.8) $128,605 $133,067 (3.4)
=========================== =========================
Average Life Insurance In-Force(3)
Traditional $291,776,919 $211,549,801 37.9 $284,020,699 $202,338,934 40.4
Universal life 38,819,516 35,607,163 9.0 38,365,473 35,258,221 8.8
--------------------------- -------------------------
$330,596,435 $247,156,964 33.8 $322,386,172 $237,597,155 35.7
=========================== =========================
Average Account Values
Universal life $3,570,737 $3,082,084 15.9 $3,517,826 $3,020,285 16.5
Variable universal life 185,814 126,309 47.1 181,012 122,327 48.0
--------------------------- -------------------------
$3,756,551 $3,208,393 17.1 $3,698,838 $3,142,612 17.7
=========================== =========================
Interest Spread - Universal Life(2)
Net investment income yield 6.45% 6.96% 6.46% 7.05%
Interest credited to policyholders 4.94 5.56 4.95 5.54
--------------------------- -------------------------
Interest spread 1.51% 1.40% 1.51% 1.51%
=========================== =========================
Mortality Experience (1) (12) 783 2,388 (910)
(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 5.5% from the second quarter of 2003 and increased 11.0% from the first six months of 2003 as the effect of reinsurance recoveries positively impacted 2003 results. During the second quarter and first six months of 2003, the segment recognized additional net premiums of $15.6 and $18.4 million, respectively, amortization of DAC of $5.1 and $6.1 million, respectively, and operating income of $10.5 and $12.3 million, respectively, as a result of recoveries from previously overpaid reinsurance premiums (see Note E). Excluding the impact from these recoveries, operating income increased 22.3% and 32.1% for the quarter and year-to-date. The increase in operating income reflects continued growth of life insurance in-force through new sales as well as improved results in the segment’s non-insurance businesses. In addition, current quarter operating income was reduced by $1.0 million due to the adjustment made to the estimate of expected receipts from reinsurance receivables (see Note E).
Gross premiums and policy fees grew by 24.3% and 25.4% 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 30.2% and 31.5% (excluding reinsurance recoveries in 2003) as the segment continued to reinsure a significant amount of its new business. Net investment income increased 2.5% over the second quarter and first six months of 2003 reflecting the growth of the segment’s assets, offset by lower investment yields. The increase in other income for the quarter and year-to-date is due primarily to additional income from the segment’s direct response and broker-dealer subsidiaries. Due to the nature of these businesses, the majority of this additional income is offset by increases in other operating expenses.
Benefits and settlement expenses were 7.8% and 1.2% higher than the second quarter and first six months of 2003 due to growth in life insurance in-force, offset by lower crediting rates on UL products for the quarter and year-to-date comparisons, and improved mortality experience versus 2003 year-to-date. Amortization of DAC (excluding the effect of reinsurance recoveries in 2003) was 21.6% and 5.4% lower for the quarter and year-to-date, primarily due to unlocking on UL products and the impact of the current quarter reinsurance receivable adjustment and the Company’s adoption of SOP 03-1. Unlocking on UL products reduced amortization by $1.4 million in the current quarter, while the application of SOP 03-1 reduced amortization by $1.3 million and $2.6 million for the second quarter and first six months of 2004, respectively. In addition, the adjustment to the reinsurance receivable reduced current quarter amortization by $1.0 million.
Other operating expenses for the segment were as follows:
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30 JUNE 30
2004 2003 CHANGE 2004 2003 CHANGE
---------------------------------- --------------------------------
Insurance Companies:
First year commissions $63,528 $75,860 (16.3)% $141,774 $136,371 4.0%
Renewal commissions 7,496 6,680 12.2 15,177 12,879 17.8
First year ceding allowances (39,002) (47,674) (18.2) (83,624) (84,991) (1.6)
Renewal ceding allowances (39,462) (28,470) 38.6 (70,285) (50,992) 37.8
General & administrative 45,770 46,129 (0.8) 95,712 88,549 8.1
Taxes, licenses and fees 6,144 4,479 37.2 10,434 9,174 13.7
--------------------- ----------------------
Other operation expenses incurred 44,474 57,004 (22.0) 109,188 110,990 (1.6)
Less commissions, allowances & expenses capitalized (60,384) (66,870) (9.7) (134,032) (128,517) 4.3
--------------------- ----------------------
Other operating expenses (15,910) (9,866) 61.3 (24,844) (17,527) 41.7
--------------------- ----------------------
Marketing Companies:
Commissions 15,441 12,472 23.8 30,904 22,856 35.2
Other 6,390 4,777 33.8 11,436 8,332 37.3
--------------------- ----------------------
Other operating expenses 21,831 17,249 26.6 42,340 31,188 35.8
--------------------- ----------------------
Other operating expenses $ 5,921 $ 7,383 (19.8) $ 17,496 $ 13,661 28.1
===================== ======================
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. In accordance with GAAP, 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 for the insurance companies were 61.3% and 41.7% more favorable versus the second quarter and first six months of 2003 as the effect of higher overall reinsurance allowances more than offset the increase in non-commission expenses. General and administrative expenses decreased 0.8% versus second quarter 2003, primarily reflecting lower underwriting costs achieved through rate reductions from certain vendors in the fourth quarter of 2003. For the first six months of 2004, general and administrative expenses increased 8.1% 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.
Other operating expenses for the marketing companies increased 26.6% and 35.8% as compared to the second quarter and first six months of 2003 primarily as a result of higher commissions and other expenses in the segment’s broker-dealer subsidiary, resulting from higher revenue.
Sales for the segment decreased 15.8% and 3.4% versus the second quarter and first six months of 2003 primarily due to lower production of traditional life in the brokerage general agent channel. Excluding BOLI, sales of UL product lines experienced double-digit growth as these products continued to be well accepted in the marketplace. 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 the Company’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 SIX MONTHS ENDED
JUNE 30 JUNE 30
2004 2003 CHANGE 2004 2003 CHANGE
--------------------------------- --------------------------------
REVENUES
Gross premiums and policy fees $ 69,659 $ 71,326 (2.3)% $139,128 $144,389 (3.6)%
Reinsurance ceded (17,840) (18,531) (3.7) (34,941) (37,157) (6.0)
----------------------- ----------------------
Net premiums and policy fees 51,819 52,795 (1.8) 104,187 107,232 (2.8)
Net investment income 58,704 62,520 (6.1) 117,359 124,816 (6.0)
Other income 468 1,542 (69.6) 1,185 2,447 (51.6)
----------------------- ----------------------
Total operating revenues 110,991 116,857 (5.0) 222,731 234,495 (5.0)
BENEFITS AND EXPENSES
Benefits and settlement expenses 71,340 72,951 (2.2) 144,360 145,570 (0.8)
Amortization of deferred policy acquisition costs 7,476 8,474 (11.8) 15,325 18,555 (17.4)
Other operating expenses 8,714 11,151 (21.9) 18,382 23,317 (21.2)
----------------------- ----------------------
Total benefits and expenses 87,530 92,576 (5.5) 178,067 187,442 (5.0)
OPERATING INCOME 23,461 24,281 (3.4) 44,664 47,053 (5.1)
----------------------- ----------------------
INCOME BEFORE INCOME TAX $ 23,461 $ 24,281 (3.4) $ 44,664 $ 47,053 (5.1)
======================= ======================
The following table summarizes key data for the Acquisitions segment:
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30 JUNE 30
2004 2003 CHANGE 2004 2003 CHANGE
-------------------------------------- -----------------------------------
Average Life Insurance In-Force(2)
Traditional $12,243,296 $13,891,510 (11.9)% $12,421,888 $14,099,701 (11.9)%
Universal life 18,546,671 20,223,643 (8.3) 18,720,370 20,411,544 (8.3)
---------------------------- -------------------------
30,789,967 $34,115,153 (9.7) $31,142,258 $34,511,245 (9.8)
============================ =========================
Average Account Values
Universal life $1,732,770 $1,748,388 (0.9) $1,738,442 $1,747,652 (0.5)
Fixed annuity(3) 219,550 227,979 (3.7) 220,821 227,961 (3.1)
Variable annuity 97,447 103,724 (6.1) 99,577 106,071 (6.1)
---------------------------- -------------------------
$2,049,767 $2,080,091 (1.5) $2,058,840 $2,081,684 (1.1)
============================ =========================
Interest Spread - UL & Fixed Annuities
Net investment income yield 7.28% 7.56% 7.25% 7.65%
Interest credited to policyholders 5.21 5.70 5.24 5.63
---------------------------- -------------------------
Interest spread 2.07% 1.86% 2.01% 2.02%
============================ =========================
Mortality Experience (1) 2,216 860 2,876 2,571
(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 1.8% and 2.8% versus the second quarter and first six months of 2003 due to the continued runoff from acquired blocks of business. The change in gross premiums and policy fees were relatively consistent with the overall decline in policies in-force and policy account values. In addition, lower levels of reinsurance in the current quarter and first six months of 2004 impacted the change in net premiums and policy fees. 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 adjust credited rates on UL and annuity business to minimize the impact of lower earned rates on interest spreads.
Policy benefit expenses were down 2.2% versus the second quarter of 2003 and relatively unchanged from the first six 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 six 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 approximately 20% versus the second quarter and first six 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. The Company 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 SIX MONTHS ENDED
JUNE 30 JUNE 30
2004 2003 CHANGE 2004 2003 CHANGE
--------------------------------- --------------------------------
REVENUES
Gross premiums and policy fees $ 7,594 $ 6,387 18.9% $ 15,222 $ 12,270 24.1%
Reinsurance ceded
----------------------- ----------------------
Net premiums and policy fees 7,594 6,387 18.9 15,222 12,270 24.1
Net investment income 51,523 57,780 (10.8) 103,111 116,222 (11.3)
Other income 1,555 2,075 (25.1) 3,340 4,016 (16.8)
----------------------- ----------------------
Total operating revenues 60,672 66,242 (8.4) 121,673 132,508 (8.2)
BENEFITS AND EXPENSES
Benefits and settlement expenses 44,456 51,339 (13.4) 90,502 104,325 (13.2)
Amortization of deferred policy acquisition costs 6,568 4,600 42.8 11,965 8,255 44.9
Other operating expenses 4,673 7,312 (36.1) 11,418 13,222 (13.6)
----------------------- ----------------------
Total benefits and expenses 55,697 63,251 (11.9) 113,885 125,802 (9.5)
OPERATING INCOME 4,975 2,991 66.3 7,788 6,706 16.1
Realized investment gains (losses) 290 11,206 6,294 11,233
Related amortization of DAC (551) (9,367) (4,211) (10,098)
----------------------- ----------------------
INCOME BEFORE INCOME TAX $ 4,714 $ 4,830 (2.4) $ 9,871 $ 7,841 25.9
======================= ======================
The following table summarizes key data for the Annuities segment:
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30 JUNE 30
2004 2003 CHANGE 2004 2003 CHANGE
--------------------------------- --------------------------------
Sales
Fixed annuity $108,305 $ 47,418 128.4% $124,399 $123,786 0.5%
Variable annuity 63,317 94,336 (32.9) 125,041 196,861 (36.5)
----------------------- ----------------------
171,622 $ 141,754 21.1 $249,440 $320,647 (22.2)
======================= ======================
Average Account Values
Fixed annuity(3) $3,161,984 $3,377,398 (6.4) $3,171,000 $3,359,381 (5.6)
Variable annuity 1,992,455 1,510,745 31.9 1,994,422 1,439,182 38.6
----------------------- ----------------------
$5,154,439 $4,888,143 5.4 $5,165,422 $4,798,563 7.6
======================= ======================
Interest Spread - Fixed Annuities(1)
Net investment income yield 6.60% 6.91% 6.54% 6.93%
Interest credited to policyholders 5.72 5.93 5.71 5.92
----------------------- ----------------------
Interest spread 0.88% 0.98% 0.83% 1.01%
======================= ======================
AS OF
JUNE 30
2004 2003
----------------------
GMDB - Net amount at risk(2) $252,932 $416,679 (39.3)
GMDB - Reserves $5,097 $6,246 (18.4)
S&P 500 Index 1,141 975 17.0
(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 66.3% and 16.1% compared to the second quarter and first six months of 2003 as lower spreads on fixed annuities were more than offset by 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 second quarter and first six months of 2003. Interest spreads on fixed annuities fell 10 basis points and 18 basis points as compared to the second quarter and first six months of 2003. Lower rates on new investments and the impact of prepayments in the mortgage backed security portfolio have more than offset the effects of crediting rate reductions. Other income declined from the second quarter and first six months of 2003 due to the elimination of fee income from segment-managed mutual funds that are no longer offered as investment options within variable annuity products.
Interest credited decreased $4.7 million compared to second quarter 2003 and $8.8 million from the first six months of 2003 due to the decline in fixed annuity account values and lower rate environment. Benefits expense also benefited during the current quarter and first six months of 2004 from lower guaranteed minimum death benefit (GMDB) expenses of $1.1 million and $3.6 million, respectively. The additional profits on variable annuities were partially offset by higher amortization of DAC, accounting for an increase of $1.7 million and $4.5 million for the current quarter and year-to-date, respectively. Other operating expenses decreased 36.1% and 13.6% versus the second quarter and first six months of 2003. The current quarter benefited from lower administrative expenses and the elimination of sub-advisor fees paid for the segment-managed mutual funds, as well as higher expense capitalization caused by the increase in sales. Administrative expenses and sub-advisor fees were lower in the first six 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 128.4% from second quarter 2003 due to higher overall interest rates and more competitive pricing, while sales for the first six months of 2004 were relatively unchanged from the level achieved in 2003. Variable annuity sales were 32.9% and 36.5% lower than the historically high levels achieved in the second quarter and first six months of 2003 as the Company maintained its pricing discipline. The improved equity markets reduced the net amount at risk with respect to guaranteed minimum death benefits by 39.3%.
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 SIX MONTHS ENDED
JUNE 30 JUNE 30
2004 2003 CHANGE 2004 2003 CHANGE
--------------------------------- --------------------------------
REVENUES
Net investment income $66,666 $59,090 12.8% $130,699 $117,622 11.1%
----------------------- ----------------------
BENEFITS AND EXPENSES
Benefits and settlement expenses 50,720 46,957 8.0 100,489 94,722 6.1
Amortization of deferred policy acquisition costs 803 519 54.7 1,564 1,118 39.9
Other operating expenses 1,217 1,516 (19.7) 3,021 2,546 18.6
----------------------- ----------------------
Total benefits and expenses 52,740 48,992 7.6 105,074 98,386 6.8
OPERATING INCOME 13,926 10,098 37.9 25,625 19,236 33.2
Realized investment gains (losses) 2,022 4,260 5,901 (2,442)
----------------------- ----------------------
INCOME BEFORE INCOME TAX $15,948 $14,358 11.1 $ 31,526 $ 16,794 87.7
======================= ======================
The following table summarizes key data for the Stable Value Products segment:
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30 JUNE 30
2004 2003 CHANGE 2004 2003 CHANGE
--------------------------------- --------------------------------
Sales
GIC $ 39,000 $ 30,000 30.0% $ 39,000 $249,000 (84.3)%
GFA - Direct Institutional 960 0 100.0 960 25,000 (96.2)
GFA - Non-Registered Notes 0 100,000 (100.0) 0 300,000 (100.0)
GFA - Registered Notes - Institutional 0 0 0.0 300,000 0 100.0
GFA - Registered Notes - Retail 68,250 0 100.0 289,750 0 100.0
----------------------- ----------------------
$ 108,210 $ 130,000 (16.8) $629,710 $574,000 9.7
======================= ======================
Average Account Values $5,062,014 $4,153,071 21.9 $4,956,987 $4,094,474 21.1
Operating Spread
Net investment income yield 5.40% 5.88% 5.42% 5.91%
Interest credited 4.11 4.67 4.17 4.76
Operating expenses 0.16 0.20 0.19 0.18
----------------------- ----------------------
Operating spread 1.13% 1.01% 1.06% 0.97%
======================= ======================
Operating income increased 37.9% and 33.2% from the second quarter and first six 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 $522 million in the first quarter of 2004 and the $909 million in sales that occurred during the fourth quarter of 2003. The lower interest rate environment caused both the investment income yield and the interest credited rate to decline from the second quarter and first six 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 100-105 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 $68.3 million and $289.8 million during the current quarter and first six months of 2004. The Company currently anticipates sales from this program of approximately $550 million for 2004. In addition, the institutional registered funding agreement-backed notes program, which was launched in the fourth quarter of 2003, experienced sales of $300 million for the first six months of 2004. Sales of traditional GICs during the first six months of 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 SIX MONTHS ENDED
JUNE 30 JUNE 30
2004 2003 CHANGE 2004 2003 CHANGE
--------------------------------------------------------------------
REVENUES
Gross premiums and policy fees $115,354 $104,153 10.8% $233,533 $210,077 11.2%
Reinsurance ceded (62,120) (44,026) 41.1 (125,226) (88,178) 42.0
--------------------------------------------------------------------
Net premiums and policy fees 53,234 60,127 (11.5) 108,307 121,899 (11.2)
Net investment income 7,500 9,132 (17.9) 15,041 18,378 (18.2)
Other income 9,117 18,167 (49.8) 18,179 25,138 (27.7)
--------------------------------------------------------------------
Total operating revenues 69,851 87,426 (20.1) 141,527 165,415 (14.4)
BENEFITS AND EXPENSES
Benefits and settlement expenses 33,363 33,868 (1.5) 65,562 70,326 (6.8)
Amortization of deferred policy acquisition costs 17,522 21,425 (18.2) 37,478 39,908 (6.1)
Other operating expenses 14,595 22,372 (34.8) 29,513 44,178 (33.2)
--------------------------------------------------------------------
Total benefits and expenses 65,480 77,665 (15.7) 132,553 154,412 (14.2)
OPERATING INCOME 4,371 9,761 (55.2) 8,974 11,003 (18.4)
--------------------------------------------------------------------
INCOME BEFORE INCOME TAX $ 4,371 $ 9,761 (55.2) $ 8,974 $ 11,003 (18.4)
====================================================================
The following table summarizes key data for the Asset Protection segment:
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30 JUNE 30
2004 2003 CHANGE 2004 2003 CHANGE
-------------------------------------------------------------------------------
Sales
Credit insurance $ 59,035 $ 51,168 15.4% $109,559 $ 96,810 13.2%
Service contracts 54,861 53,869 1.8 99,136 92,578 7.1
Other products 8,941 23,650 (62.2) 17,814 41,036 (56.6)
-----------------------------------------------------------------------------
$ 122,837 $ 128,687 (4.5) $226,509 $ 230,424 (1.7)
=============================================================================
Loss Ratios (1)
Credit insurance 38.1% 39.9% 38.9% 40.0%
Service contracts 87.6 90.0 82.1 87.8
Other products 77.2 90.7 77.6 88.6
(1) Incurred claims as a percentage of earned premiums.
Operating income decreased 55.2% and 18.4% versus the second quarter and first six months of 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 50.6% and 91.8% from the second quarter and first six 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 $10.1 million and $18.4 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 $1.4 million and $3.3 million, respectively, for the quarter and year-to-date, reflecting the continued steady growth of these lines. The approximate 18% decrease in net investment income versus the second quarter and first six months of 2003 was also primarily attributable to the credit insurance business, due to lower policy liabilities and a lower net yield on investments. Excluding the impact of the charter sale gains, other income declined 19.4% and 6.1% from the second quarter and first six months of 2003, primarily due to lower levels of service contract administration fees.
Policy and benefit expenses declined 1.5% and 6.8% versus the second quarter and first six months of 2003 due to the decrease in the segment’s net premiums. Amortization of DAC in the second quarter and first six months of 2004 was lower than the comparable periods in 2003 due to the decline in the segment’s credit business. Other operating expenses decreased from the second quarter and first six 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 improved slightly over 2003 levels, primarily reflecting improved results in the dealer credit area. 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 second quarter and first six months of 2003 primarily due to lower losses in the inventory protection product line.
Sales of credit insurance through financial institutions rose 32.5% and 34.1% from levels achieved in the second quarter and first six 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 rose slightly over 2003 levels reflecting modest increases in both vehicle and marine lines. The decrease in other product sales primarily reflects products sold in 2003 that the Company is no longer marketing.
The Company 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 and interest on substantially all debt). This segment also includes earnings from several lines of business which the Company is not actively marketing (primarily 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 during the first six months of 2004, and prior period segment data was restated to reflect the change.
The following table summarizes results for this segment:
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30 JUNE 30
2004 2003 CHANGE 2004 2003 CHANGE
------------ ------------- -------- ----------- ------------ ---------
Operating income (loss)(1) $3,128 $(22,561) $25,689 $ 7,433 $(21,601) $29,034
Realized gains and losses - investments (3,100) 14,998 (18,098) 3,915 19,834 (15,919)
Realized gains and losses - derivatives 3,251 (2,491) 5,742 3,188 (12,344) 15,532
------------ ------------- -------- ----------- ------------ ---------
Income (loss) before income tax $3,279 $(10,054) $13,333 $14,536 $(14,111) $28,647
============ ============= ======== =========== ============ =========
(1) Includes settlements on interest rate swaps of $5,354 and $5,885 for the three months ended June 30, 2004 and 2003, respectively, and $10,229 and $11,519 for the six months ended June 30, 2004 and 2003, respectively.
Operating income increased $25.7 million from the second quarter and $29.0 million from the first six months of 2003, as higher operating expenses were more than offset by reduced losses on runoff insurance lines and higher amounts of net investment income. During the second quarter of 2003, a $25.4 million charge was incurred to strengthen reserves in the runoff residual value business as the result of lower used vehicle price levels. For the current quarter, additional reserve strengthening of $3.0 million was taken on this line, while the surety block incurred reserve strengthening of $1.5 million and $4.0 million for the current quarter and first six months of 2004, respectively. Net investment income increased $5.9 million and $18.1 million versus the second quarter and first six months of 2003, reflecting increased participating mortgage income and higher amounts of unallocated capital. 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 SIX MONTHS ENDED
JUNE 30 JUNE 30
2004 2003 CHANGE 2004 2003 CHANGE
-------------------------------------------------------------------------
Fixed maturity gains $ 5,954 $28,836 $(22,882) $25,852 $43,771 $(17,919)
Fixed maturity losses (2,299) (1,277) (1,022) (5,376) (1,373) (4,003)
Equity gains 825 368 457 1,390 368 1,022
Equity losses (22) 0 (22) (22) 0 (22)
Impairments on fixed maturity securities (2,523) 0 (2,523) (2,723) (15,935) 13,212
Impairments on equity securities (2,125) 0 (2,125) (2,125) 0 (2,125)
Other (733) 1,597 (2,330) (1,292) 1,515 (2,807)
-------------------------------------------------------------------------
Total realized gains (losses) - investments $ (923) $29,524 $(30,447) $15,704 $28,346 $(12,642)
=========================================================================
Foreign currency swaps $ (1,799) $17,858 $(19,657) $(11,518) $24,781 $(36,299)
Foreign currency adjustments on stable value
contracts 1,934 (16,917) 18,851 11,924 (24,502) 36,426
Derivatives related to corporate debt (3,736) 3,297 (7,033) 3,163 5,188 (2,025)
Derivatives related to mortgage loan commitments 13,678 (12,499) 26,177 5,308 (17,533) 22,841
Derivatives related to various investments (1,337) 12,595 (13,932) 4,946 11,520 (6,574)
-------------------------------------------------------------------------
Total realized gains (losses) - derivatives $ 8,740 $ 4,334 $ 4,406 $ 13,823 $ (546) $ 14,369
========================================================================
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 recently rising interest rates. Investment impairments for the first six months of 2004 were lower than 2003 as a result of significant improvement in the corporate credit environment and proactive portfolio management. 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 and losses on derivative contracts closed during the period. The Company 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 second quarter and first six months of 2004 was $(0.8) million and $0.1 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. The Company also uses interest rate swaps to mitigate interest rate risk related to certain Senior Notes, Medium-Term Notes, and subordinated debt securities. Higher interest rates in the current quarter caused the 2004 results from these swaps to compare unfavorably with both the second quarter and first six months of 2003. The Company has taken short positions in U.S. Treasury futures to mitigate interest rate risk related to the Company’s mortgage loan commitments. The higher net gains from these securities in the second quarter and first six months of 2004 were the result of interest rates moving higher in the current year.
The Company also uses various swaps and options to mitigate risk related to certain other investments held by the Company. For the second quarter and first six months of 2004, a portion of the change, a $4.9 million decrease and $1.5 million decrease, respectively, in realized gains (losses) resulted from higher interest rates in 2004, which impacted the fair value of certain interest rate swaps and options. Further, the second quarter and first six months of 2003 reflected a $4.3 million gain and $4.6 million gain, respectively, from a total return swap that was not reflected in 2004 due to the implementation of FIN 46. An additional decrease of $4.7 million and $4.5 million for the second quarter and first six months of 2004, respectively, related to gains from embedded derivatives within certain bonds that matured in the second quarter of 2003, with no similar activity in 2004. For the first six months of 2004, realized gains (losses) improved by $4.2 million due to the impact of embedded derivatives within certain asset swaps that were called in the first quarter of 2004, with no similar activity in the first six months of 2003.
In accordance with FASB Interpretation No. (FIN) 46 “Consolidation of Variable Interest Entities”, the Company consolidated, as of and for the three months ended March 31, 2004, two real estate investment companies that the Company had previously reported as investments. The entities were consolidated based on the determination that the Company was the primary beneficiary. The consolidation resulted in the Company’s reported assets and liabilities increasing by $76.2 million with an immaterial impact on results of operations. See also Note G for further discussion of FIN 46.
In January 2004, the Company 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 ($0.14 per share on both a basic and diluted basis). 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, the Company recorded a $0.1 million adjustment related to guaranteed minimum death benefits on its variable annuity products. See also Note K for further discussion of SOP 03-1.
The Company’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, the Company’s investments are predominantly in medium- and long-term, fixed-rate investments such as bonds and mortgage loans.
INVESTMENTS
Portfolio Description
The Company’s investment portfolio consists primarily of fixed maturity securities (bonds and redeemable preferred stocks) and commercial mortgage loans. The Company generally purchases its investments with the intent to hold to maturity by purchasing investments that match future cash flow needs. However, the Company may sell any of its investments to maintain proper matching of assets and liabilities. Accordingly, the Company has classified $12.9 billion of its fixed maturities and certain other securities as “available for sale.”
As of December 31, 2003, the Company consolidated a special-purpose entity, in accordance with FIN 46, whose investments are managed by the Company. These investments with a market value of $432.0 million at June 30, 2004, have been classified as “trading” securities by the Company.
The Company’s investments in debt and equity securities are reported at market value, and investments in mortgage loans are reported at amortized cost. At June 30, 2004, the Company’s fixed maturity investments had a market value of $13.3 billion, which is 2.2% above amortized cost of $13.0 billion. The Company had $2.8 billion in mortgage loans at June 30, 2004. While the Company’s mortgage loans do not have quoted market values, at June 30, 2004, the Company estimates the market value of its mortgage loans to be $2.9 billion (using discounted cash flows from the next call date), which is 3.6% above amortized cost. Most of the Company’s mortgage loans have significant prepayment fees. These assets are invested for terms approximately corresponding to anticipated future benefit payments. Thus, market fluctuations are not expected to adversely affect liquidity.
At June 30, 2004, total bonds rated less than investment grade were 5.5% of invested assets.
The following table shows the carrying values of the Company’s invested assets.
- ------------------------------------------------------------------------------------------------------------------------------
JUNE 30, 2004 DECEMBER 31, 2003
- ------------------------------------------------------------------------------------------------------------------------------
($ in thousands)
Publicly-issued bonds $11,373,046 64.3% $11,377,474 65.3%
Privately issued bonds 1,919,155 10.9 1,975,273 11.3
Redeemable preferred stock 3,405 0.0 3,164 0.0
- ------------------------------------------------------------------------------------------------------------------------------
Fixed maturities 13,295,606 75.2% 13,355,911 76.6%
Equity securities 57,802 0.3 46,731 0.3
Mortgage loans 2,836,683 16.1 2,733,722 15.7
Investment real estate 107,163 0.6 18,126 0.1
Policy loans 486,661 2.8 502,748 2.9
Other long-term investments 197,246 1.1 249,494 1.4
Short-term investments 694,002 3.9 519,419 3.0
- ------------------------------------------------------------------------------------------------------------------------------
Total investments $17,675,163 100.0% $17,426,151 100.0%
==============================================================================================================================
Included in the above table are $417.0 million of fixed maturities and $15.0 million of short term investments at June 30, 2004 and $420.1 million of fixed maturities and $4.8 million of short term investments at December 31, 2003, classified by the Company as trading securities.
Market values for private, non-traded securities are determined as follows: 1) the Company obtains estimates from independent pricing services or 2) the Company 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 $1,919.2 million at June 30, 2004, representing 10.9% of the Company’s total invested assets.
Risk Management and Impairment Review
The Company monitors the overall credit quality of the Company’s portfolio within general guidelines. The following table shows the Company’s available for sale fixed maturities by credit rating at June 30, 2004.
- ----------------------------------------------------------------------------------------------------------------------------
S&P or Equivalent Market Value Percent of
Designation Market Value
- ----------------------------------------------------------------------------------------------------------------------------
($ in thousands)
AAA $ 4,375,227 34.0%
AA 821,598 6.4
A 3,025,256 23.5
BBB 3,687,044 28.6
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Investment grade 11,909,125 92.5%
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BB 684,101 5.3
B 244,619 1.9
CCC or lower 33,837 0.3
In or near default 3,536 0.0
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Below investment grade 966,093 7.5
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Redeemable preferred stock 3,405 0.0
- ----------------------------------------------------------------------------------------------------------------------------
Total $ 12,878,623 100.0%
============================================================================================================================
Not included in the table above are $417.0 million of investment grade fixed maturities classified by the Company as trading securities.
Limiting bond exposure to any creditor group is another way the Company manages credit risk. The following table summarizes the Company’s ten largest fixed maturity exposures to an individual creditor group as of June 30, 2004.
---------------------------------------------------------------------------------------------
Creditor Market Value
---------------------------------------------------------------------------------------------
($ in millions)
Citigroup $74.8
Goldman Sachs 72.6
FPL Group 72.2
Encana 71.5
Duke Energy 70.3
Wachovia 70.1
Berkshire Hathaway 69.8
Dominion Resources 65.7
Edison International 65.5
Verizon 64.0
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The Company’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, the Company 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. The Company 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 the Company 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 considered.
The Company 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. The Company 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 the Company’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 June 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 June 30, 2004, the Company had an overall pretax net unrealized gain of $283.1 million.
For traded and private fixed maturity and equity securities held by the Company that are in an unrealized loss position at June 30, 2004, the estimated market value, amortized cost, unrealized loss and total time period that the security has been in an unrealized loss position are presented in the table below.
- ----------------------------------------------------------------------------------------------------------------------------
Estimated % Market Amortized % Amortized Unrealized % Unrealized
Market Value Value Cost Cost Loss Loss
- ----------------------------------------------------------------------------------------------------------------------------
($ in thousands)
‹= 90 days $3,839,107 85.0% $3,960,769 84.0% $(121,662) 61.7%
›90 days but ‹= 180 days 185,034 4.1 195,638 4.1 (10,604) 5.4
›180 days but ‹= 270 days 65,595 1.5 68,932 1.5 (3,337) 1.7
›270 days but ‹= 1 year 160,131 3.5 173,483 3.7 (13,352) 6.8
›1 year but ‹= 2 years 175,088 3.9 195,336 4.1 (20,248) 10.3
›2 years but ‹= 3 years 28,362 0.6 36,053 0.8 (7,691) 3.9
›3 years but ‹= 4 years 3,827 0.1 4,139 0.1 (312) 0.1
›4 years but ‹= 5 years 12,633 0.3 13,953 0.3 (1,320) 0.7
›5 years 47,570 1.0 66,072 1.4 (18,502) 9.4
- ----------------------------------------------------------------------------------------------------------------------------
Total $4,517,347 100.0% $4,714,375 100.0% $(197,028) 100.0%
============================================================================================================================
At June 30, 2004, securities with a market value of $48.3 million and $22.6 million of unrealized losses were issued in Company sponsored commercial mortgage loan securitizations, including $17.2 million of unrealized losses greater than five years. The Company does not consider these unrealized positions to be other-than-temporary, because the underlying mortgage loans continue to perform consistently with the Company’s original expectations.
The Company has no material concentrations of issuers or guarantors of fixed maturity securities. The industry segment composition of all securities in an unrealized loss position held by the Company at June 30, 2004, is presented in the following table.
- ---------------------------------------------------------------------------------------------------------------------------
Estimated % Market Amortized % Amortized Unrealized % Unrealized
Market Value Value Cost Cost Loss Loss
- ----------------------------------------------------------------------------------------------------------------------------
($ in thousands)
Agency Mortgages $1,385,588 30.7 % $1,424,859 30.3 % $(39,271) 19.9 %
Banking 295,980 6.5 307,199 6.5 (11,219) 5.7
Basic Industrial 125,627 2.8 131,345 2.8 (5,718) 2.9
Brokerage 180,207 4.0 187,738 4.0 (7,531) 3.8
Capital Goods 19,678 0.4 19,766 0.4 (88) 0.0
Communications 90,214 2.0 97,679 2.1 (7,465) 3.8
Consumer Cyclical 93,878 2.1 97,903 2.1 (4,025) 2.0
Consumer Noncyclical 163,162 3.6 169,562 3.6 (6,400) 3.2
Electric 843,724 18.7 883,716 18.7 (39,992) 20.4
Energy 156,179 3.5 163,323 3.5 (7,144) 3.6
Finance Companies 66,605 1.5 67,328 1.4 (723) 0.4
Insurance 174,754 3.9 182,779 3.9 (8,025) 4.1
Municipal Agencies 5,943 0.1 5,992 0.1 (49) 0.0
Natural Gas 288,291 6.4 303,636 6.4 (15,345) 7.8
Non-Agency Mortgages 307,962 6.8 329,010 7.0 (21,048) 10.8
Other Finance 90,792 2.0 98,318 2.1 (7,526) 3.8
Other Government
Agencies 483 0.0 491 0.0 (8) 0.0
Other Utility 21 0.0 44 0.0 (23) 0.0
Technology 31,455 0.7 32,660 0.7 (1,205) 0.6
Transportation 171,890 3.8 185,524 3.9 (13,634) 6.9
U. S. Government 24,914 0.5 25,503 0.5 (589) 0.3
- ------------------------------------------------------------------------------------------------------------------------------
Total $4,517,347 100.0% $4,714,375 100.0% $(197,028) 100.0%
==============================================================================================================================
The range of maturity dates for securities in an unrealized loss position at June 30, 2004 varies, with 6.2% maturing in less than 5 years, 69.3% maturing between 5 and 10 years, and 24.5% maturing after 10 years. The following table shows the credit rating of securities in an unrealized loss position at June 30, 2004.
- -------------------------------------------------------------------------------------------------------------------------
S&P or Equivalent Estimated % Market Amortized % Amortized Unrealized % Unrealized
Designation Market Value Value Cost Cost Loss Loss
- ---------------------------------------------------------------------------------------------------------------------------
($ in thousands)
AAA/AA/A $3,125,114 69.2% $3,236,629 68.6% $(111,515) 56.6%
BBB 1,119,936 24.8 1,168,925 24.8 (48,989) 24.9
- ----------------------------------------------------------------------------------------------------------------------------
Investment grade 4,245,050 94.0 4,405,554 93.4 (160,504) 81.5
- ----------------------------------------------------------------------------------------------------------------------------
BB 138,745 3.1 149,258 3.2 (10,513) 5.3
B 101,891 2.2 114,731 2.4 (12,840) 6.5
CCC or lower 31,661 0.7 44,832 1.0 (13,171) 6.7
- ----------------------------------------------------------------------------------------------------------------------------
Below investment grade 272,297 6.0 308,821 6.6 (36,524) 18.5
- ----------------------------------------------------------------------------------------------------------------------------
Total $4,517,347 100.0% $4,714,375 100.0% $(197,028) 100.0%
============================================================================================================================
At June 30, 2004, securities in an unrealized loss position that were rated as below investment grade represented 6.0% of the total market value and 18.5% 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 $28.8 million. Bonds in an unrealized loss position rated less than investment grade were 1.5% of invested assets. The Company does not expect these investments to adversely affect its liquidity or ability to maintain proper matching of assets and liabilities.
The following table shows the estimated market value, amortized cost, unrealized loss and total time period that the security has been in an unrealized loss position for all below investment grade securities.
----------------------------------------------------------------------------------------------------------------------------
Estimated % Market Amortized % Amortized Unrealized % Unrealized
Market Value Value Cost Cost Loss Loss
- ----------------------------------------------------------------------------------------------------------------------------
($ in thousands)
‹= 90 days $142,753 52.4% $147,961 48.0 % $ (5,208) 14.3 %
›90 days but ‹= 180 days 22,739 8.4 24,657 8.0 (1,918) 5.3
›180 days but ‹= 270 days 1,713 0.6 1,747 0.6 (34) 0.1
›270 days but ‹= 1 year 4,076 1.5 4,482 1.5 (406) 1.1
›1 year but ‹= 2 years 16,189 6.0 20,979 6.8 (4,790) 13.2
›2 years but ‹= 3 years 26,302 9.6 32,401 10.4 (6,099) 16.8
›3 years but ‹= 4 years 3,136 1.2 3,255 1.1 (119) 0.3
›4 years but ‹= 5 years 7,783 2.9 8,001 2.6 (218) 0.6
›5 years 47,270 17.4 64,889 21.0 (17,619) 48.3
- ----------------------------------------------------------------------------------------------------------------------------
Total $271,961 100.0% $308,372 100.0% $(36,411) 100.0%
============================================================================================================================
At June 30, 2004, below investment grade securities with a market value of $42.5 million and $16.4 million of unrealized losses were issued in Company sponsored commercial mortgage loan securitizations, most of which are in an unrealized loss position greater than five years. The Company does not consider these unrealized positions to be other-than-temporary, because the underlying mortgage loans continue to perform consistently with the Company’s original expectations.
Realized Losses
Realized losses are comprised of both write-downs on other-than-temporary impairments and actual sales of investments. During the six months ended June 30, 2004, the Company recorded $4.8 million of pretax other-than-temporary impairments in its investments, as compared to $15.9 million in the six months ended June 30, 2003.
As discussed earlier, the Company’s management considers several factors when determining other-than-temporary impairments. Although the Company generally intends to hold securities until maturity, the Company may change its positions as a result of a change in circumstances. Any such decision is consistent with the Company’s classification of all but a specific portion of its investment portfolio as available for sale. During the six months ended June 30, 2004, the Company sold securities in an unrealized loss position with a market value of $164.7 million resulting in a realized loss of $5.4 million. For such securities, the proceeds, realized loss and total time period that the security had been in an unrealized loss position are presented in the table below.
- ----------------------------------------------------------------------------------------------------------------------------
Proceeds % Proceeds Realized Loss % Realized Loss
- ----------------------------------------------------------------------------------------------------------------------------
($ in thousands)
‹= 90 days $ 10,098 6.1% $(1,543) 28.7%
›90 days but ‹= 180 days 0 0.0 (0) 0.0
›180 days but ‹= 270 days 79,518 48.3 (2,229) 41.5
›270 days but ‹= 1 year 74,358 45.6 (1,598) 29.7
› 1 year 711 0.0 (6) 0.1
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Total $ 164,685 100.0% $(5,376) 100.0%
============================================================================================================================
Mortgage Loans
The Company 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 June 30, 2004 and December 31, 2003, the Company’s allowance for mortgage loan credit losses was $4.7 million.
For several years the Company has offered a type of commercial mortgage loan under which the Company 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 June 30, 2004, approximately $412.6 million of the Company’s mortgage loans have this participation feature.
In the ordinary course of its commercial mortgage lending operations, the Company 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 the Company’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 June 30, 2004, the Company had outstanding mortgage loan commitments of $755.3 million at an average rate of 6.29%.
Liabilities
Many of the Company’s products contain surrender charges and other features that reward persistency and penalizes the early withdrawal of funds. Certain stable value and annuity contracts have market-value adjustments that protect the Company against investment losses if interest rates are higher at the time of surrender than at the time of issue.
At June 30, 2004, the Company had policy liabilities and accruals of $10.1 billion. The Company’s interest-sensitive life insurance policies have a weighted average minimum credited interest rate of approximately 4.5%.
At June 30, 2004, the Company had $4.9 billion of stable value product account balances and $3.4 billion of annuity account balances.
Derivative Financial Instruments
The Company utilizes a risk management strategy that incorporates the use of derivative financial instruments, primarily to reduce its exposure to interest rate risk as well as 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, and the Company’s outstanding debt. Swap contracts are also used to alter the effective durations of assets and liabilities. The Company 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 the Company to credit and market risk and could result in material changes from quarter-to-quarter. The Company minimizes its credit risk by entering into transactions with highly rated counterparties. The Company 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. The Company monitors its use of derivatives in connection with its overall asset/liability management programs and procedures.
Asset/Liability Management
The Company’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 the Company’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.
The Company believes its asset/liability management programs and procedures and certain product features provide protection for the Company against the effects of changes in interest rates under various scenarios. Additionally, the Company 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, the Company’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 the Company’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 $1,074.0 million in 2004. The Company’s asset/liability management programs and procedures take into account maturing contracts and expected withdrawals. Accordingly, the Company does not expect stable value contract related cash outflows to have an unusual effect on the future operations and liquidity of the Company.
The life insurance subsidiaries were committed at June 30, 2004, to fund mortgage loans in the amount of $755.3 million. The Company’s subsidiaries held $798.5 million in cash and short-term investments at June 30, 2004. The Company had an additional $1.0 million in cash and short-term investments available for general corporate purposes.
While the Company generally anticipates that the cash flows of its subsidiaries will be sufficient to meet their investment commitments and operating cash needs, the Company recognizes that investment commitments scheduled to be funded may, from time to time, exceed the funds then available. Therefore, the Company has arranged sources of credit for its insurance subsidiaries to use when needed. The Company expects that the rate received on its investments will equal or exceed its borrowing rate. Additionally, the Company may from time to time sell short-duration stable value products to complement its cash management practices.
The Company has also used securitization transactions involving its commercial mortgage loans to increase its liquidity.
Capital
At June 30, 2004, the Company had $9.0 million outstanding under its $200.0 million revolving line of credit due October 1, 2005, at an interest rate of 1.71%. On July 1, 2004, the Company borrowed an additional $75 million under the line of credit in connection with the redemption of the 7.95% 10-year Senior Notes. In addition, on July 30, 2004, the Company amended the line of credit agreement to extend the maturity to July 30, 2009 and to allow Protective Life Insurance Company to borrow amounts under the line.
Protective Life Corporation’s cash flow is dependent on cash dividends from its subsidiaries, revenues from investment, data processing, legal and management services rendered to the subsidiaries, and investment income. At December 31, 2003, approximately $529.8 million of consolidated share-owners’ equity, excluding net unrealized investment gains and losses, represented net assets of the Company’s insurance subsidiaries that cannot be transferred to the Company. In addition, the states in which the Company’s insurance subsidiaries are domiciled impose certain restrictions on the insurance subsidiaries’ ability to pay dividends to the Company.
The Company plans to retain substantial portions of the earnings of its life insurance subsidiaries in those companies primarily to support their future growth. The Company’s cash disbursements have from time to time exceeded its cash receipts, and these shortfalls have been funded through various external financings. Therefore, the Company may, from time to time, require additional external financing.
To give the Company flexibility in connection with future acquisitions and other growth opportunities or for other corporate purposes, the Company has registered debt securities, preferred and common stock, and stock purchase contracts of Protective Life Corporation, and additional preferred securities of special purpose finance subsidiaries under the Securities Act of 1933 on a delayed (or shelf) basis.
On May 3, 2004, the Company’s Board of Directors authorized a $100 million share repurchase program, available through May 2, 2007. There has been no activity under this program, and future activity will be dependent upon many factors, including capital levels, rating agency expectations, and the relative attractiveness of alternative uses for capital.
A life insurance company’s statutory capital is computed according to rules prescribed by the National Association of Insurance Commissioners (“NAIC”), as modified by the insurance company’s state of domicile. Statutory accounting rules are different from GAAP and are intended to reflect a more conservative view by, for example, requiring immediate expensing of policy acquisition costs. The NAIC’s risk-based capital requirements require insurance companies to calculate and report information under a risk-based capital formula. The achievement of long-term growth will require growth in the statutory capital of the Company’s insurance subsidiaries. The subsidiaries may secure additional statutory capital through various sources, such as retained statutory earnings or equity contributions by the Company.
Contractual Obligations
The table below sets forth future maturities of debt, subordinated debt securities, stable value products, notes payable, operating lease obligation, other property lease obligations, mortgage loan commitments, and liabilities related to variable interest entities.
- -----------------------------------------------------------------------------------------------------------------------------
2004 2005-2006 2007-2008 After 2008
- -----------------------------------------------------------------------------------------------------------------------------
($ in thousands)
Long-term debt(a) $ 75,000 $ 9,000 $299,231
Subordinated debt securities(b) 324,743
Stable value products(c) 583,800 2,097,998 $1,408,345 831,021
Note payable 2,218
Operating leases(d) 3,589 12,354 71,887 9,313
Mortgage loan commitments 755,350
Liabilities related to variable interest entities(e) 400,816 12,437 47,945 15,393
- -----------------------------------------------------------------------------------------------------------------------------
| (a) | Long-term debt includes all principle amounts owed on note agreements, and does not include interest payments due over the term of the notes. |
| (b) | Subordinated debt securities includes all principle amounts owed to non-consolidated special purpose finance subsidiaries of the Company, and does not include interest payments due over the term of the obligations. |
| (c) | Anticipated stable value products cash flows, excluding interest not yet accrued. |
| (d) | Includes all lease payments required under operating lease agreements. |
| (e) | Liabilities related to variable interest entities are not the legal obligations of the Company, 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 $2,314.8 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 the Company. These assets and liabilities are separately identified on the consolidated balance sheets of the Company. 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 the Company’s Annual Report on Form 10-K for the year ended December 31, 2003.
Item 4. 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 (i) our disclosure controls and procedures were effective as of June 30, 2004, and (ii) no change in internal control over financial reporting occurred during the quarter ended June 30, 2004 that has materially affected, or is reasonably likely to materially affect, such internal control over financial reporting.
Item 2. Changes in Securities and Use of Proceeds
During the quarter ended June 30, 2004, the Company issued the following securities in transactions which were not registered under the Securities Act of 1933, as amended (the “Act”).
(a) On April 28, 2004, the Company issued 825 shares of Common Stock, par value $.50 per share.
(b) No underwriters participated. The shares were issued to nonemployee Directors of the Company as follows:
Vanessa Leonard 75 shares
J. Gary Cooper 750 shares
(c) The shares were issued in partial payment of the Directors’ retainer fee.
(d) Exemption from registration under the Act was claimed based upon Section 4(2) as a sale by an issuer not involving a public offering.
Item 4. Submission of Matters to a Vote of Security Holders
The Annual Meeting of Share Owners was held on May 3, 2004. Shares entitled to vote at the Annual Meeting totaled 69,291,140 of which 61,769,655 shares were represented. The number of shares entitled to vote was determined as of March 5, 2004.
At the Annual Meeting the following directors were elected. The number of shares cast for and authorization withheld for each nominee is shown below.
Authorization
For Withheld
-------------------------------------------------
John J. McMahon, Jr. 59,996,160 1,773,496
James S. M. French 58,949,050 2,820,606
John D. Johns 59,720,162 2,049,494
Donald M. James 58,814,385 2,955,271
J. Gary Cooper 59,791,677 1,977,979
H. Corbin Day 58,840,911 2,928,744
W. Michael Warren, Jr. 59,983,644 1,786,011
Malcolm Portera 60,991,141 778,514
Thomas L. Hamby 61,012,691 756,964
Vanessa Leonard 60,983,108 786,547
William A. Terry 61,008,308 761,347
At the Annual Meeting, share owners also approved two proposals. The first proposal was to approve the Company’s Stock Plan for Non-Employee Directors. Shares voting for this proposal were 49,784,673 shares, voting against were 4,917,776, and shares abstaining were 372,667.
Additionally, share owners approved a proposal to ratify the appointment by the Board of Directors of PricewaterhouseCoopers LLP as independent registered public accountants for the Company and its subsidiaries for 2004. Shares voting for this proposal were 59,093,240, shares voting against were 2,612,765, and shares abstaining were 63,650.
Item 6. Exhibits and Reports on Form 8-K
Exhibit 10 — Stock Plan for Non-Employee Directors of Protective Life Corporation (Effective May 3, 2004)
Exhibit 15 — Letter re: unaudited interim financial information.
Exhibit 31(a) – Certification Pursuant to §302 of the Sarbanes-Oxley Act of 2002.
Exhibit 31(b) – Certification Pursuant to §302 of the Sarbanes-Oxley Act of 2002.
Exhibit 32(a) — Certification Pursuant to 18 U.S.C. §1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
Exhibit 32(b) — Certification Pursuant to 18 U.S.C. §1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
Exhibit 99 – Safe Harbor for Forward-Looking Statements.
(a) The following Forms 8-K were filed or furnished to the Securities and Exchange Commission during the three months ended June 30, 2004:
A Form 8-K was furnished under Item 12 to the Securities and Exchange Commission on May 4, 2004.
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 CORPORATION
Date: August 9, 2004 /s/ Steven G. Walker
Steven G. Walker
Senior Vice President, Controller
and Chief Accounting Officer
(Duly authorized officer)