| Delaware | 95-2492236 | ||
|---|---|---|---|
| (State or other jurisdiction | (IRS Employer Identification 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 November 5, 2004: 69,437,461 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
Nine Months ended September 30, 2004 and 2003..................................................
Consolidated Condensed Balance Sheets as of September 30, 2004
and December 31, 2003..........................................................................
Consolidated Condensed Statements of Cash Flows for the
Nine Months ended September 30, 2004 and 2003..................................................
Notes to Consolidated Condensed Financial Statements...............................................
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations..................................................................
Item 3. Quantitative and Qualitative Disclosures About Market Risk...................................
Item 4. Controls and Procedures......................................................................
Part II. Other Information:
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds..................................
Item 6. Exhibits.....................................................................................
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 September 30, 2004, and the related consolidated condensed statements of income for each of the three-month and nine-month periods ended September 30, 2004 and 2003, and the consolidated condensed statements of cash flows for the nine-month periods ended September 30, 2004 and 2003. These interim financial statements are the responsibility of the Company’s management.
We conducted our review in accordance with the standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board, the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.
Based on our review, we are not aware of any material modifications that should be made to the accompanying consolidated condensed interim financial statements for them to be in conformity with accounting principles generally accepted in the United States of America.
We previously audited in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet as of December 31, 2003, and the related consolidated statements of income, share-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
November
9, 2004
PROTECTIVE LIFE
CORPORATION
CONSOLIDATED CONDENSED
STATEMENTS OF INCOME
(Dollars in thousands
except per share amounts)
(Unaudited)
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
2004 2003 2004 2003
- ---------------------------------------------------------------------------------------------------------------------------------
REVENUES
Premiums and policy fees $ 460,784 $ 424,590 $1,360,668 $1,209,336
Reinsurance ceded (276,736) (237,996) (811,444) (632,681)
- ---------------------------------------------------------------------------------------------------------------------------------
Premiums and policy fees, net of reinsurance ceded 184,048 186,594 549,224 576,655
Net investment income 279,271 248,915 809,778 769,360
Realized investment gains (losses):
Derivative financial instruments 6,287 (9,048) 20,110 (9,594)
All other investments 8,181 27,042 23,885 55,388
Other income 40,921 26,128 115,903 91,418
- ---------------------------------------------------------------------------------------------------------------------------------
518,708 479,631 1,518,900 1,483,227
- ---------------------------------------------------------------------------------------------------------------------------------
BENEFITS AND EXPENSES
Benefits and settlement expenses
(net of reinsurance ceded:
three months: 2004 - $306,854; 2003 - $217,955;
nine months: 2004 - $801,095; 2003 - $653,171) 288,455 281,693 858,240 883,899
Amortization of deferred policy acquisition costs 52,375 56,241 157,222 176,803
Other operating expenses (net of reinsurance ceded:
three months: 2004 - $41,519; 2003 - $28,662
nine months: 2004 - $124,245; 2003 - $93,139) 75,612 62,905 206,403 198,402
- ---------------------------------------------------------------------------------------------------------------------------------
416,442 400,839 1,221,865 1,259,104
- ---------------------------------------------------------------------------------------------------------------------------------
INCOME BEFORE INCOME TAX 102,266 78,792 297,035 224,123
Income tax expense 35,793 26,383 103,962 74,633
- ---------------------------------------------------------------------------------------------------------------------------------
NET INCOME BEFORE CUMULATIVE EFFECT OF
CHANGE IN ACCOUNTING PRINCIPLE 66,473 52,409 193,073 149,490
- ---------------------------------------------------------------------------------------------------------------------------------
Cumulative effect of change in accounting principle,
net of income tax 0 0 (10,128) 0
- ---------------------------------------------------------------------------------------------------------------------------------
NET INCOME $ 66,473 $ 52,409 $ 182,945 $ 149,490
=================================================================================================================================
NET INCOME BEFORE CUMULATIVE EFFECT OF
CHANGE IN ACCOUNTING PRINCIPLE PER
SHARE - BASIC $.95 $.75 $2.75 $2.14
- ---------------------------------------------------------------------------------------------------------------------------------
NET INCOME BEFORE CUMULATIVE EFFECT OF
CHANGE IN ACCOUNTING PRINCIPLE PER
SHARE - DILUTED $.94 $.74 $2.72 $2.12
- ---------------------------------------------------------------------------------------------------------------------------------
NET INCOME PER SHARE - BASIC $.94 $.75 $2.60 $2.14
- ---------------------------------------------------------------------------------------------------------------------------------
NET INCOME PER SHARE - DILUTED $.94 $.74 $2.58 $2.12
- ---------------------------------------------------------------------------------------------------------------------------------
DIVIDENDS PAID PER SHARE $.175 $.16 $ .51 $ .47
- ---------------------------------------------------------------------------------------------------------------------------------
Average shares outstanding - basic 70,337,248 70,091,080 70,255,051 70,017,724
Average shares outstanding - diluted 71,115,468 70,722,885 71,011,727 70,590,253
See notes to consolidated condensed financial statements
(Dollars in thousands)
(Unaudited)
SEPTEMBER 30 DECEMBER 31
2004 2003
- -------------------------------------------------------------------------------------------------------------------------------------
ASSETS
Investments:
Fixed maturities, at market (amortized cost: 2004 - $12,998,515; 2003 - $12,743,213) $13,679,358 $13,355,911
Equity securities, at market (cost: 2004 - $57,002; 2003 - $45,379) 59,635 46,731
Mortgage loans on real estate 2,904,729 2,733,722
Investment in real estate, net 107,220 18,126
Policy loans 485,282 502,748
Other long-term investments 217,270 249,494
Short-term investments 1,042,278 519,419
- -------------------------------------------------------------------------------------------------------------------------------------
Total investments 18,495,772 17,426,151
Cash 117,118 136,698
Accrued investment income 204,977 189,232
Accounts and premiums receivable, net 51,504 57,944
Reinsurance receivables 2,619,934 2,350,606
Deferred policy acquisition costs 1,841,162 1,861,020
Goodwill 46,619 47,312
Property and equipment, net 46,359 45,640
Other assets 259,389 238,581
Assets related to separate accounts
Variable annuity 2,110,082 2,045,038
Variable universal life 192,478 171,408
Other 4,333 4,361
- -------------------------------------------------------------------------------------------------------------------------------------
$25,989,727 $24,573,991
=====================================================================================================================================
LIABILITIES
Policy liabilities and accruals $10,362,206 $ 9,732,697
Stable value product account balances 5,143,367 4,676,531
Annuity account balances 3,429,473 3,480,577
Other policyholders' funds 155,952 158,875
Other liabilities 965,433 875,652
Accrued income taxes (30,943) (34,261)
Deferred income taxes 332,327 377,990
Liabilities related to variable interest entities 475,953 400,000
Long-term debt 401,541 461,329
Subordinated debt securities 324,743 221,650
Liabilities related to separate accounts
Variable annuity 2,110,082 2,045,038
Variable universal life 192,478 171,408
Other 4,333 4,361
- -------------------------------------------------------------------------------------------------------------------------------------
23,866,945 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 425,181 418,351
Treasury stock, at cost (2004 - 3,816,520 shares; 2003 - 4,260,259 shares) (13,684) (15,275)
Stock held in trust (2004 - 0 shares; 2003 - 97,700 shares) 0 (2,788)
Unallocated stock in Employee Stock Ownership Plan
(2004 - 609,735 shares; 2003 - 724,068 shares) (1,989) (2,367)
Retained earnings 1,382,603 1,235,012
Accumulated other comprehensive income:
Net unrealized gains on investments
(net of income tax: 2004 - $156,308; 2003 - $177,642) 290,287 329,907
Accumulated gain - hedging (net of income tax: 2004 - $2,024; 2003 - $1,442) 3,758 2,678
- -------------------------------------------------------------------------------------------------------------------------------------
2,122,782 2,002,144
- -------------------------------------------------------------------------------------------------------------------------------------
$25,989,727 $24,573,991
=====================================================================================================================================
See notes to consolidated condensed financial statements
(Dollars in thousands)
(Unaudited)
NINE MONTHS ENDED
SEPTEMBER 30
2004 2003
- ---------------------------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM OPERATING ACTIVITIES
Net income $ 182,945 $ 149,490
Adjustments to reconcile net income to net cash provided by operating activities:
Realized investment (gains) losses (20,446) (57,333)
Amortization of deferred policy acquisition costs 157,222 176,803
Capitalization of deferred policy acquisition costs (270,854) (296,211)
Depreciation expense 13,056 14,197
Deferred income tax 13,725 52,397
Accrued income tax (32,540) (46,340)
Interest credited to universal life and investment products 480,789 494,054
Policy fees assessed on universal life and investment products (261,058) (240,747)
Change in accrued investment income and other receivables (278,218) 62,325
Change in policy liabilities and other policyholders' funds
of traditional life and health products 559,144 94,794
Net change in trading securities 3,710 0
Change in other liabilities (80,084) (198,887)
Other, net (25,038) 140,776
- ---------------------------------------------------------------------------------------------------------------------------------
Net cash provided by operating activities 442,353 345,318
- ---------------------------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM INVESTING ACTIVITIES
Investments available for sale, net of short-term investments:
Maturities and principal reductions of investments 1,493,142 4,046,656
Sale of investments 2,905,878 3,167,909
Cost of investments acquired (4,691,103) (7,400,288)
Change in mortgage loans, net (169,707) (160,208)
Change in investment real estate, net 890 3,930
Change in policy loans, net 17,466 19,292
Change in other long-term investments, net 3,909 4,031
Change in short-term investments, net (288,920) (134,431)
Purchase of property and equipment (12,932) (13,308)
- ---------------------------------------------------------------------------------------------------------------------------------
Net cash used in investing activities (741,377) (466,417)
- ---------------------------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM FINANCING ACTIVITIES
Borrowings under line of credit arrangements and long-term debt 257,400 407,499
Principal payments on line of credit arrangement and long-term debt (319,047) (373,265)
Net (payments) proceeds from securities sold under repurchase agreements 0 111,725
Dividends to share owners (35,354) (32,372)
Issuance of subordinated debt securities 103,093 0
Issuance (purchase) of common stock held in trust 2,788 (562)
Investment product deposits and change in universal life deposits 2,109,203 1,325,893
Investment product withdrawals (1,845,728) (1,314,753)
Other financing activities, net 7,089 0
- ---------------------------------------------------------------------------------------------------------------------------------
Net cash provided by financing activities 279,444 124,165
- ---------------------------------------------------------------------------------------------------------------------------------
CHANGE IN CASH (19,580) 3,066
CASH AT BEGINNING OF PERIOD 136,698 101,953
- ---------------------------------------------------------------------------------------------------------------------------------
CASH AT END OF PERIOD $ 117,118 $ 105,019
=================================================================================================================================
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 nine-month period ended September 30, 2004 are not necessarily indicative of the results that may be expected for the year ending December 31, 2004. The year-end consolidated condensed balance sheet data was derived from audited financial statements, but does not include all disclosures required by GAAP. For further information, refer to the consolidated financial statements and notes thereto included in 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 nine-month periods ended September 30, 2004 and 2003, PricewaterhouseCoopers LLP (“PricewaterhouseCoopers”) reported that they have applied limited procedures in accordance with professional standards for a review of such information. However, their separate report dated November 9, 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 small non-strategic lines of business (mostly cancer insurance, residual value insurance, surety insurance, and group annuities), various investment-related transactions, and the operations of several small subsidiaries. The surety and residual value insurance lines were moved from the Asset Protection segment to Corporate and Other in 2004, and prior period segment data was restated to reflect the change. |
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 tables set forth total revenue by segment, segment operating income, and assets for the periods shown. Asset adjustments represent the inclusion of assets related to discontinued operations. The reduction in the goodwill balance in the Asset Protection segment relates to the sale of a small subsidiary in the first quarter of 2004.
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
2004 2003 2004 2003
------------------------- --------------------------
Total Revenue
Life Marketing $147,860 $123,973 $ 421,279 $ 391,400
Acquisitions 108,760 115,005 331,491 349,500
Annuities 65,304 72,474 193,271 216,215
Stable Value Products 73,464 66,186 210,064 181,366
Asset Protection 69,290 79,039 210,817 244,454
Corporate and Other 54,030 22,954 151,978 100,292
------------------------- --------------------------
$518,708 $479,631 $1,518,900 $1,483,227
========================= ==========================
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
2004 2003 2004 2003
------------------------- --------------------------
Segment Operating Income
Life Marketing $ 38,818 $ 39,501 $ 124,016 $ 116,252
Acquisitions 21,262 24,831 65,926 71,884
Annuities 4,008 2,633 11,796 9,339
Stable Value Products 13,313 9,523 38,938 28,759
Asset Protection 5,425 5,112 14,399 16,115
Corporate and Other 12,325 (7,849) 19,758 (29,450)
------------------------- --------------------------
Total segment operating income 95,151 73,751 274,833 212,899
Add back: realized investment gains (losses) 14,468 17,994 43,995 45,794
Less: related amortization of deferred policy acquisition costs 2,669 8,167 6,880 18,265
Less: derivative gains related to corporate debt and investments 4,684 4,786 14,913 16,305
------------------------- --------------------------
Income before income tax 102,266 78,792 297,035 224,123
Income tax expense (35,793) (26,383) (103,962) (74,633)
------------------------- --------------------------
Net income before cumulative effect of change in
accounting principle 66,473 52,409 193,073 149,490
Cumulative effect of change in accounting principle 0 0 (10,128) 0
------------------------- --------------------------
Net income $ 66,473 $ 52,409 $ 182,945 $ 149,490
========================= ==========================
Operating Segment Assets
September 30, 2004
- -----------------------------------------------------------------------------------------------------------------------------------
Life Stable Value
Marketing Acquisitions Annuities Products
- -----------------------------------------------------------------------------------------------------------------------------------
Investments and other assets $5,690,762 $4,093,948 $5,577,073 $5,005,407
Deferred policy acquisition costs 1,243,508 311,137 95,098 16,120
Goodwill 10,354
- -----------------------------------------------------------------------------------------------------------------------------------
Total assets $6,944,624 $4,405,085 $5,672,171 $5,021,527
===================================================================================================================================
- -----------------------------------------------------------------------------------------------------------------------------------
Asset Corporate Total
Protection and Other Adjustments Consolidated
- -----------------------------------------------------------------------------------------------------------------------------------
Investments and other assets $ 905,558 $2,779,518 $49,680 $24,101,946
Deferred policy acquisition costs 166,621 8,678 1,841,162
Goodwill 36,182 83 46,619
- -----------------------------------------------------------------------------------------------------------------------------------
Total assets $1,108,361 $2,788,279 $49,680 $25,989,727
===================================================================================================================================
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 September 30, 2004, and for the nine months then ended, the Company’s insurance subsidiaries had combined capital and surplus of $1,167.0 million and net income of $121.3 million. At September 30, 2004, the combined asset valuation reserve held by the Company's insurance subsidiaries was $203.2 million.
NOTE E – REINSURANCE RECEIVABLE
In 2002, the Company discovered that it had overpaid reinsurance premiums to several reinsurance companies. In the first nine months of 2003, the Company increased premiums and policy fees $18.4 million as a result of cash received and changes in expected receipts at that time. The increase in premiums and policy fees resulted in $6.1 million of additional amortization of deferred policy acquisition costs in the first nine months of 2003. As a result, the Company’s pretax income for the first nine months of 2003 increased by $12.3 million. 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 nine month periods ended September 30, 2004 and 2003 are summarized as follows:
RECONCILIATION OF NET INCOME AND
AVERAGE SHARES OUTSTANDING
- --------------------------------------------------------------------------------------------------------------------------------
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
2004 2003 2004 2003
- --------------------------------------------------------------------------------------------------------------------------------
Net income $66,473 $52,409 $182,945 $149,490
- --------------------------------------------------------------------------------------------------------------------------------
Average shares issued and outstanding 69,428,012 68,912,175 69,330,393 68,868,697
Stock held in trust (73,700) (104,034) (80,784) (103,768)
Issuable under various deferred compensation plans 982,936 1,282,939 1,005,442 1,252,795
- --------------------------------------------------------------------------------------------------------------------------------
Average shares outstanding - basic 70,337,248 70,091,080 70,255,051 70,017,724
Stock held in trust 73,700 104,034 80,784 103,768
Stock appreciation rights 304,623 258,545 301,660 221,664
Performance shares 399,897 269,226 374,232 247,097
- --------------------------------------------------------------------------------------------------------------------------------
Average shares outstanding - diluted 71,115,468 70,722,885 71,011,727 70,590,253
================================================================================================================================
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 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 NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
2004 2003 2004 2003
-----------------------------------------------------------------------------------------------------------------------------
Net income $ 66,473 $ 52,409 $182,945 $149,490
Change in net unrealized gains/losses on
investments (net of income tax:
three months: 2004 - $97,661; 2003 - $(46,261)
nine months: 2004 - $(12,974); 2003 - $83,402) 181,371 (85,914) (24,095) 154,890
Change in accumulated gain-hedging
(net of income tax:
three months: 2004 - $(1,623); 2003 - $615
nine months: 2004 - $582; 2003 - $2,361) (3,014) 1,143 1,080 4,385
Reclassification adjustment for amounts included
in net income (net of income tax:
three months: 2004 - $(2,863); 2003 - $(9,465)
nine months: 2004 - $(8,360); 2003 - $(19,386)) (5,318) (17,577) (15,525) (36,002)
-----------------------------------------------------------------------------------------------------------------------------
Comprehensive income (loss) $239,512 $(49,939) $144,405 $272,763
=============================================================================================================================
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 NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
2004 2003 2004 2003
- -------------------------------------------------------------------------------------------------------------------------------
Service cost $ 1,368 $ 1,150 $ 4,581 $ 3,849
Interest cost 1,566 1,345 5,243 4,503
Expected return on plan assets (1,578) (1,289) (5,285) (4,315)
Amortization of prior service cost 53 53 177 177
Amortization of net loss 512 268 1,716 899
- -------------------------------------------------------------------------------------------------------------------------------
Net periodic benefit cost $ 1,921 $ 1,527 $ 6,432 $ 5,113
===============================================================================================================================
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. The Company now estimates that it will contribute $19.8 million to its pension plan in 2004. As of September 30, 2004, no contributions had been made. As of November 1, 2004, $12.5 million had been contributed to the pension plan.
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 nine months ended September 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 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.
On October 21, 2004, the Company issued $150.0 million of 4.875% Senior Notes that mature on November 1, 2014. The proceeds were used to pay off $100.1 million on the Company’s revolving line of credit and for general corporate purposes.
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 September 30, 2004. The total guaranteed amount payable based on variable annuity account balances at September 30, 2004, was $292.5 million (including $258.5 million in the Annuities segment and $34.0 million in the Acquisitions segment), with a GMDB reserve of $6.1 million (including $5.6 million in the Annuities segment and $0.5 million in the Acquisitions segment). The average attained age of contract holders at September 30, 2004 was 65.
Activity relating to GMDB reserves was as follows:
-----------------------------------------------------------------------------------------------------------------------------
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
2004 2003 2004 2003
-----------------------------------------------------------------------------------------------------------------------------
Incurred claims $1,772 $ 766 $3,071 $6,286
Paid claims 1,244 1,280 2,852 6,256
-----------------------------------------------------------------------------------------------------------------------------
Account balances of variable annuities with guarantees were invested in variable annuity separate accounts as follows:
-----------------------------------------------------------------------------------------------------------------------------
SEPTEMBER 30, 2004 DECEMBER 31, 2003
-----------------------------------------------------------------------------------------------------------------------------
Equity mutual funds $1,905,870 $1,845,952
Fixed income mutual funds 204,212 199,086
-----------------------------------------------------------------------------------------------------------------------------
Total $2,110,082 $2,045,038
=============================================================================================================================
Certain of 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 NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
2004 2003 2004 2003
-----------------------------------------------------------------------------------------------------------------------------
Deferred asset, beginning of period $27,566 $29,221 $27,713 $ 31,557
Amounts deferred 3,231 2,941 9,141 7,873
Amortization (3,210) (3,545) (9,267) (10,813)
-----------------------------------------------------------------------------------------------------------------------------
Deferred asset, end of period $27,587 $28,617 $27,587 $ 28,617
=============================================================================================================================
In September 2004, the AICPA issued a Technical Practice Aid (TPA) which contains additional interpretive guidance on applying certain provisions of SOP 03-1. Among other items, the TPA provides guidance on the definition of an assessment, the accounting for universal life contracts that exhibit losses followed by losses, and the accounting for reinsurance of the additional mortality reserves required by the SOP. The Company is currently evaluating the provisions of the TPA to determine what impact, if any, it may have on the Company’s previously reported earnings, including the cumulative effect adjustment. The Company anticipates making any adjustments resulting from the application of this guidance during the fourth quarter of 2004. Adoption of the TPA guidance that results in changes to previously reported information will be recorded in accordance with APB 20, “Accounting Changes”.
Protective Life 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; the Company is exposed to potential risks from recent legislation requiring companies to evaluate their internal controls over financial reporting; changes to tax law or interpretations of existing tax law could adversely affect 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; the financial services and insurance industry is sometimes the target of law enforcement investigations; our ability to maintain low unit costs is dependent upon the level of new sales and persistency of existing business; our investments are subject to market and credit risks; we may not realize our anticipated financial results from our acquisitions strategy; we are dependent on the performance of others; our reinsurers could fail to meet assumed obligations, increase rates, limit the availability of reinsurance in the future or be subject to adverse developments that could affect us; computer viruses or network security breaches could affect our data processing systems or those of our business partners; our ability to grow depends in large part upon the continued availability of capital and could be impacted by the availability of reasonably priced reinsurance; and new accounting rules or changes to existing accounting rules could negatively impact 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 NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
2004 2003 CHANGE 2004 2003 CHANGE
---------------------------------- ------------------------------------
Life Marketing $ 38,818 $ 39,501 (1.7)% $ 124,016 $ 116,252 6.7%
Acquisitions 21,262 24,831 (14.4) 65,926 71,884 (8.3)
Annuities 4,008 2,633 52.2 11,796 9,339 26.3
Stable Value Products 13,313 9,523 39.8 38,938 28,759 35.4
Asset Protection 5,425 5,112 6.1 14,399 16,115 (10.6)
Corporate and Other 12,325 (7,849) n/m 19,758 (29,450) n/m
---------------------- -------------------------
95,151 73,751 29.0 274,833 212,899 29.1
Realized investment gains (losses) -investments(1) 5,512 18,875 17,005 37,123
Realized investment gains (losses) -derivatives(2) 1,603 (13,834) 5,197 (25,899)
Income tax expense (35,793) (26,383) (103,962) (74,633)
---------------------- -------------------------
Net income before cumulative effect of change
in accounting principle 66,473 52,409 26.8 193,073 149,490 29.2
Cumulative effect of change in accounting principle,
net of income tax (10,128)
---------------------- -------------------------
Net income $ 66,473 $ 52,409 26.8 $ 182,945 $ 149,490 22.4
====================== =========================
(1)Realized investment gains (losses) - investments $ 8,181 $ 27,042 $ 23,885 $ 55,388
Related amortization of DAC (2,669) (8,167) (6,880) (18,265)
---------------------- -------------------------
$ 5,512 $ 18,875 $ 17,005 $ 37,123
(2)Realized investment gains (losses) - derivatives $ 6,287 $ (9,048) $ 20,110 $ (9,594)
Settlements on certain interest rate swaps (4,684) (4,786) (14,913) (16,305)
---------------------- -------------------------
$ 1,603 $(13,834) $ 5,197 $(25,899)
Compared to third quarter 2003, net income increased 26.8% reflecting significant improvement in segment operating income as well as slightly higher realized investment gains. Net income for the first nine months of 2004 increased 22.4% due to higher contributions from segment operating income and realized investment gains, somewhat offset by the cumulative effect charge. The increase in realized investment gains for the quarter reflects lower gains on sales of fixed maturity securities and increased impairments in the current quarter, which were offset by higher gains from derivatives. For the first nine 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), Life Marketing’s operating income decreased 1.7% and increased 19.3% over the third quarter and first nine months of 2003, respectively, reflecting continued growth in life insurance in-force through new sales, offset by the impact of significantly lower sales levels in the current quarter. For both the quarter and year-to-date comparisons, an increase in average account values and widening of spreads drove the improvement in the Stable Value Products segment, while improvement in the equity markets and higher sales of fixed annuities contributed to the increase in the Annuities segment’s earnings. Excluding gains from charter sales, Asset Protection segment operating income increased 6.1% and 44.5% over the third quarter and first nine months of 2003, primarily due to significant improvement in the segment’s service contract lines. The Acquisitions segment’s earnings for the quarter and year-to-date declined due to the normal runoff of the segment’s previously acquired blocks of business. The improvement in Corporate and Other earnings primarily reflects reduced losses from runoff insurance lines as well as higher amounts of investment income.
Included in net income for the first nine months of 2004 is a cumulative effect charge of $10.1 million arising from the Company’s adoption of SOP 03-1 (see Note K 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 are measured based on the amount of deposits received. Stable value contract sales are measured at the time that the funding commitment is made, based on the amount of deposit to be received. Sales within the Asset Protection segment are generally based on the amount of single premium and fees received.
Sales and life insurance in-force amounts are derived from 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 NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
2004 2003 CHANGE 2004 2003 CHANGE
-------------------------------- --------------------------------
REVENUES
Gross premiums and policy fees $ 253,952 $ 219,410 15.7% $ 740,869 $ 607,770 21.9%
Reinsurance ceded (191,228) (167,706) 14.0 (565,086) (433,645) 30.3
---------------------- ----------------------
Net premiums and policy fees 62,724 51,704 21.3 175,783 174,125 1.0
Net investment income 59,985 58,699 2.2 176,854 172,752 2.4
Other income 25,151 13,570 85.3 68,642 44,523 54.2
---------------------- ----------------------
Total operating revenues 147,860 123,973 19.3 421,279 391,400 7.6
BENEFITS AND EXPENSES
Benefits and settlement expenses 78,361 68,541 14.3 217,079 205,639 5.6
Amortization of deferred policy acquisition costs 14,823 12,788 15.9 46,830 52,705 (11.1)
Other operating expenses 15,858 3,143 404.5 33,354 16,804 98.5
---------------------- ----------------------
Total benefits and expenses 109,042 84,472 29.1 297,263 275,148 8.0
OPERATING INCOME 38,818 39,501 (1.7) 124,016 116,252 6.7
---------------------- ----------------------
INCOME BEFORE INCOME TAX $ 38,818 $ 39,501 (1.7) $ 124,016 $116,252 6.7
====================== ======================
The following table summarizes key data for the Life Marketing segment:
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
2004 2003 CHANGE 2004 2003 CHANGE
------------------------------------- -----------------------------------
Sales By Product
Traditional $41,046 $56,372 (27.2)% $130,089 $150,576 (13.6)%
Universal life 16,330 20,098 (18.7) 53,293 56,980 (6.5)
Variable universal life 1,492 1,245 19.8 4,091 3,226 26.8
--------------------------- --------------------------
$58,868 $77,715 (24.3) $187,473 $210,782 (11.1)
=========================== ==========================
Sales By Distribution Channel
Brokerage general agents $37,808 $52,427 (27.9) $120,135 $136,198 (11.8)
Independent agents 12,616 13,252 (4.8) 37,926 36,256 4.6
Stockbrokers/banks 7,018 6,634 5.8 19,857 17,880 11.1
Direct response 85 1,270 (93.3) 939 4,885 (80.8)
BOLI 1,341 4,132 (67.5) 8,616 15,563 (44.6)
--------------------------- --------------------------
$58,868 $77,715 (24.3) $187,473 $210,782 (11.1)
=========================== ==========================
Average Life Insurance In-Force(3)
Traditional $303,556,718 $234,824,652 29.3 $289,615,677 $213,512,049 35.6
Universal life 40,756,564 37,013,919 10.1 39,910,123 36,451,614 9.5
--------------------------- --------------------------
$344,313,282 $271,838,571 26.7 $329,525,800 $249,963,663 31.8
=========================== ==========================
Average Account Values
Universal life $3,666,987 $3,213,491 14.1 $3,565,474 $3,083,786 15.6
Variable universal life 190,721 142,769 33.6 183,879 128,873 42.7
--------------------------- --------------------------
$3,857,708 $3,356,260 14.9 $3,749,353 $3,212,659 16.7
=========================== ==========================
Interest Spread - Universal Life(2)
Net investment income yield 6.40% 6.80% 6.44% 6.97%
Interest credited to policyholders 4.88 5.38 4.92 5.49
--------------------------- --------------------------
Interest spread 1.52% 1.42% 1.52% 1.48%
=========================== ==========================
Mortality Experience (1) $166 $1,536 $2,187 $205
(1)
Represents a favorable (unfavorable) variance as compared to pricing
assumptions.
(2)
Interest spread on average general account values.
(3)
Amounts are not adjusted for reinsurance ceded.
Operating income decreased 1.7% from the third quarter of 2003 and increased 6.7% from the first nine months of 2003, reflecting lower sales in the current year and the positive impact of reinsurance recoveries on 2003 results. During the first nine months of 2003, the segment recognized additional net premiums of $18.4 million, amortization of DAC of $6.1 million, and operating income of $12.3 million, as a result of recoveries from previously overpaid reinsurance premiums (see Note E). Excluding the impact from these recoveries, operating income increased 19.3% for the year-to-date. The increase in operating income for the nine month period reflects continued growth of life insurance in-force through new sales as well as improved results in the segment’s non-insurance businesses. Current quarter operating income was lower than the third quarter of 2003 as the growth of life insurance in-force was more than offset by higher overall expenses and lower levels of capitalization driven by the decline in sales.
Gross premiums and policy fees grew by 15.7% and 21.9% in the current quarter and year-to-date comparisons due to the growth in life insurance in-force achieved over the last several quarters, while amounts ceded increased 14.0% and 25.0% (excluding reinsurance recoveries in 2003) as the segment continued to reinsure a significant amount of its new business. Net investment income increased approximately 2% over the third quarter and first nine 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 14.3% and 5.6% higher than the third quarter and first nine months of 2003 due to growth in life insurance in-force, offset by lower crediting rates on UL products and normal fluctuations in mortality experience. Mortality for the current quarter was $1.4 million less favorable versus the third quarter of 2003, while the first nine months of 2004 were $2.0 million more favorable versus the same period in 2003. Amortization of DAC (excluding the effect of reinsurance recoveries in 2003) was 15.9% and 0.5% higher for the quarter and year-to-date. The increase in amortization in the third quarter of 2004 is the result of the growth of life insurance in-force, somewhat offset by a decrease of $0.3 million due to favorable unlocking, primarily caused by a reduction of interest crediting rates in the current quarter. The change in amortization of DAC for the year-to-date reflects the impact of unlocking on UL products, the impact of the second quarter 2004 reinsurance receivable adjustment, and the Company’s adoption of SOP 03-1. Unlocking on UL products reduced amortization by $1.7 million, while the application of SOP 03-1 reduced amortization by $1.3 million for the first nine months of 2004. In addition, the adjustment to the reinsurance receivable in the second quarter of 2004 reduced amortization by $1.0 million.
Other operating expenses for the segment were as follows:
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
2004 2003 CHANGE 2004 2003 CHANGE
---------------------------------- --------------------------------
Insurance Companies:
First year commissions $ 67,778 $ 81,942 (17.3)% $ 209,553 $ 218,313 (4.0)%
Renewal commissions 8,222 7,362 11.7 23,399 20,241 15.6
First year ceding allowances (41,541) (49,596) (16.2) (125,165) (134,587) (7.0)
Renewal ceding allowances (37,900) (29,966) 26.5 (108,185) (80,958) 33.6
General & administrative 41,978 48,426 (13.3) 137,690 136,975 0.5
Taxes, licenses and fees 5,951 5,417 9.9 16,384 14,591 12.3
---------------------- ----------------------
Other operation expenses incurred 44,488 63,585 (30.0) 153,676 174,575 (12.0)
Less commissions, allowances & expenses capitalized (52,963) (74,953) (29.3) (186,995) (203,470) (8.1)
---------------------- ----------------------
Other operating expenses (8,475) (11,368) (25.4) (33,319) (28,895) 15.3
---------------------- ----------------------
Marketing Companies:
Commissions 15,789 10,889 45.0 46,693 33,745 38.4
Other 8,544 3,622 135.9 19,980 11,954 67.1
---------------------- ----------------------
Other operating expenses 24,333 14,511 67.7 66,673 45,699 45.9
---------------------- ----------------------
Other operating expenses $ 15,858 $ 3,143 404.5 $ 33,354 $ 16,804 98.5
====================== ======================
Currently, the segment is reinsuring significant amounts of new life insurance sold. Pursuant to the underlying reinsurance contracts, reinsurers pay allowances to the segment as a percentage of both first year and renewal premiums. A portion of these allowances is deferred as part of DAC while the remainder is recognized immediately as a reduction of other operating expenses. While the recognition of reinsurance allowances is consistent with GAAP, non-deferred allowances often exceed the segment’s non-deferred direct costs, causing net other operating expenses to be negative. Consideration of all components of the segment’s income statement, including amortization of DAC, is required to assess the impact of reinsurance on segment operating income.
Other operating expenses for the insurance companies were 25.4% less favorable versus the third quarter of 2003, as the 24.3% decrease in sales negatively impacted the segment’s expense capitalization levels. Expenses for the first nine months of 2004 were 15.3% more favorable versus 2003 as the effect of higher reinsurance allowances more than offset the impact of the 11.1% decrease in sales. General and administrative expenses decreased 13.3% versus third quarter 2003, primarily reflecting lower underwriting costs achieved through rate reductions from certain vendors in the fourth quarter of 2003. For the first nine months of 2004, general and administrative expenses were relatively unchanged due to higher expense levels in the first quarter of 2004. Amounts capitalized as DAC generally include first year commissions and allowances, and other deferrable acquisition expenses. The change in these amounts generally reflects the trend in sales for the quarter and year-to-date.
Other operating expenses for the marketing companies increased 67.7% and 45.9% as compared to the third quarter and first nine months of 2003 primarily as a result of higher commissions and other expenses in the segment’s direct response and broker-dealer subsidiaries, resulting from higher revenue.
Sales for the segment decreased 24.3% and 11.1% versus the third quarter and first nine months of 2003 primarily due to lower production of traditional life at Empire General, which is included within the brokerage general agent channel. As expected, traditional life business sold through Empire General declined $11.8 million and $17.4 million versus the unusually strong levels achieved in the third quarter and first nine months of 2003. Sales of BOLI business also declined significantly from the strong sales achieved in 2003. BOLI sales will vary widely between periods as the segment responds to opportunities for these products only when the market accommodates required returns. In recent quarters, the segment has changed its direct response business sold through Matrix Direct to focus on a multi-carrier distribution strategy, resulting in the significant decrease in 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 NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
2004 2003 CHANGE 2004 2003 CHANGE
--------------------------------- --------------------------------
REVENUES
Gross premiums and policy fees $ 66,985 $ 71,903 (6.8)% $206,113 $216,292 (4.7)%
Reinsurance ceded (16,562) (17,573) (5.8) (51,503) (54,730) (5.9)
----------------------- ----------------------
Net premiums and policy fees 50,423 54,330 (7.2) 154,610 161,562 (4.3)
Net investment income 57,682 61,004 (5.4) 175,041 185,820 (5.8)
Other income 655 (329) n/m 1,840 2,118 (13.1)
----------------------- ----------------------
Total operating revenues 108,760 115,005 (5.4) 331,491 349,500 (5.2)
BENEFITS AND EXPENSES
Benefits and settlement expenses 71,571 72,500 (1.3) 215,931 218,070 (1.0)
Amortization of deferred policy acquisition costs 7,056 7,817 (9.7) 22,381 26,372 (15.1)
Other operating expenses 8,871 9,857 (10.0) 27,253 33,174 (17.8)
----------------------- ----------------------
Total benefits and expenses 87,498 90,174 (3.0) 265,565 277,616 (4.3)
OPERATING INCOME 21,262 24,831 (14.4) 65,926 71,884 (8.3)
----------------------- ----------------------
INCOME BEFORE INCOME TAX $ 21,262 $ 24,831 (14.4) $ 65,926 $ 71,884 (8.3)
======================= ======================
The following table summarizes key data for the Acquisitions segment:
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
2004 2003 CHANGE 2004 2003 CHANGE
-------------------------------------- -----------------------------------
Average Life Insurance In-Force(2)
Traditional $11,876,806 $13,452,275 (11.7)% $12,058,599 $13,876,283 (13.1)%
Universal life 18,215,608 19,720,935 (7.6) 18,387,091 20,164,841 (8.8)
---------------------------- -------------------------
$30,092,414 $33,173,210 (9.3) $30,445,690 $34,041,124 (10.6)
============================ =========================
Average Account Values
Universal life $1,725,139 $1,747,081 (1.3) $1,729,421 $1,747,735 (1.0)
Fixed annuity(3) 218,668 226,299 (3.4) 219,160 227,139 (3.5)
Variable annuity 90,121 102,896 (12.4) 93,632 103,310 (9.4)
---------------------------- -------------------------
$2,033,928 $2,076,276 (2.0) $2,042,213 $2,078,184 (1.7)
============================ =========================
Interest Spread - UL & Fixed Annuities
Net investment income yield 7.18% 7.43% 7.23% 7.57%
Interest credited to policyholders 5.19 5.61 5.20 5.62
---------------------------- -------------------------
Interest spread 1.99% 1.82% 2.03% 1.95%
============================ =========================
Mortality Experience (1) $1,071 $23 $3,947 $2,594
(1)
Represents a favorable (unfavorable) variance as compared to pricing
assumptions.
(2) Amounts are not adjusted for reinsurance ceded.
(3) Includes general account balances held within variable annuity
products.
Net premiums and policy fees declined by 7.2% and 4.3% versus the third quarter and first nine months of 2003 due to the continued runoff from acquired blocks of business. Net investment income was also lower for the current quarter and year-to-date, caused by the runoff of business and lower overall earned rates. The segment has continued to review credited rates on UL and annuity business to minimize the impact of lower earned rates on interest spreads.
Policy benefit expenses were down approximately 1% versus the third quarter and first nine months of 2003, due to the decline in in-force as well as favorable mortality. Amortization of DAC decreased during the current quarter and first nine months of 2004 due to the overall decline in business as well as lower gross profits on certain universal life blocks primarily caused by higher mortality. Other operating expenses decreased 10.0% and 17.8% versus the third quarter and first nine months of 2003, due to conversion costs incurred for the Conseco acquisition during 2003 as well as lower agent commissions incurred as a result of lower net premiums.
The segment’s life insurance in-force and UL and annuity account values have declined from 2003 levels as no new acquisitions have been made since 2002. In the ordinary course of business, the segment regularly considers acquisitions of blocks of policies or smaller insurance companies. However, the level of the segment’s acquisition activity is predicated upon many factors, including available capital, operating capacity, and market dynamics. 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 NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
2004 2003 CHANGE 2004 2003 CHANGE
--------------------------------- --------------------------------
REVENUES
Gross premiums and policy fees $ 7,370 $ 6,864 7.4% $ 22,592 $ 19,134 18.1%
Reinsurance ceded
----------------------- ----------------------
Net premiums and policy fees 7,370 6,864 7.4 22,592 19,134 18.1
Net investment income 52,854 54,660 (3.3) 155,965 170,882 (8.7)
Other income 1,556 2,368 (34.3) 4,896 6,384 (23.3)
----------------------- ----------------------
Total operating revenues 61,780 63,892 (3.3) 183,453 196,400 (6.6)
BENEFITS AND EXPENSES
Benefits and settlement expenses 46,526 48,385 (3.8) 137,028 152,710 (10.3)
Amortization of deferred policy acquisition costs 5,790 5,341 8.4 17,755 13,596 30.6
Other operating expenses 5,456 7,533 (27.6) 16,874 20,755 (18.7)
----------------------- ----------------------
Total benefits and expenses 57,772 61,259 (5.7) 171,657 187,061 (8.2)
OPERATING INCOME 4,008 2,633 52.2 11,796 9,339 26.3
Realized investment gains (losses) 3,524 8,582 9,818 19,815
Related amortization of DAC (2,669) (8,167) (6,880) (18,265)
----------------------- ----------------------
INCOME BEFORE INCOME TAX $ 4,863 $ 3,048 59.5 $ 14,734 $ 10,889 35.3
======================= ======================
The following table summarizes key data for the Annuities segment:
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
2004 2003 CHANGE 2004 2003 CHANGE
--------------------------------- --------------------------------
Sales
Fixed annuity $106,391 $ 15,948 567.1% $230,790 $139,734 65.2%
Variable annuity 74,231 87,459 (15.1) 199,272 284,320 (29.9)
----------------------- ----------------------
$180,622 $103,407 74.7 $430,062 $424,054 1.4
======================= ======================
Average Account Values
Fixed annuity(3) $3,227,028 $3,269,706 (1.3) $3,189,657 $3,329,490 (4.2)
Variable annuity 1,992,107 1,674,953 18.9 1,993,651 1,517,772 31.4
----------------------- ----------------------
$5,219,135 $4,944,659 5.6 $5,183,308 $4,847,262 6.9
======================= ======================
Interest Spread - Fixed Annuities(1)
Net investment income yield 6.63% 6.74% 6.49% 6.79%
Interest credited to policyholders 5.74 5.87 5.66 5.85
----------------------- ----------------------
Interest spread 0.89% 0.87% 0.83% 0.94%
======================= ======================
AS OF
SEPTEMBER 30
2004 2003
----------------------
GMDB - Net amount at risk(2) $258,516 $407,613 (36.6)%
GMDB - Reserves $5,606 $5,753 (2.6)
S&P 500 Index 1,115 996 11.9
(1)
Interest spread on average general account values.
(2) Guaranteed
death benefit in excess of contract holder account balance.
(3)
Includes general account balances held within variable annuity products.
Segment operating income increased by 52.2% and 26.3% compared to the third quarter and first nine months of 2003, reflecting higher sales of fixed annuities and the impact of improved equity markets reflected in the variable annuity business.
The improvement in the equity markets caused a significant increase in variable annuity account values, which drove the increase in net premiums and policy fees for the quarter and the year-to-date. The lower interest rate environment and decrease in fixed annuity balances caused net investment income and interest credited to decline from the third quarter and first nine months of 2003. Interest spreads on fixed annuities increased 2 basis points and fell 18 basis points as compared to the third quarter and first nine months of 2003, respectively. Lower rates on new investments and the impact of prepayments in the mortgage backed security portfolio more than offset the effects of crediting rate reductions for the year to date comparison. Crediting rate reductions during the current quarter allowed for the slight increase in spreads versus the third quarter of 2003. Other income declined from the third quarter and first nine 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 $1.8 million compared to third quarter 2003 and $10.6 million from the first nine months of 2003 due to the decline in fixed annuity account values and lower rate environment. In addition, benefits expense benefited during the first nine months of 2004 from lower guaranteed minimum death benefit (GMDB) expenses of $3.9 million. The additional profits on variable annuities were partially offset by higher amortization of DAC, accounting for an increase of $4.2 million for the first nine months of 2004. Other operating expenses decreased 27.6% and 18.7% versus the third quarter and first nine 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 nine months as well, however, lower sales in the first quarter of 2004 negatively impacted the segment’s expense capitalization levels.
Sales of fixed annuities increased 567.1% and 65.2% from the third quarter and first nine months of 2003 due to higher interest rates and more competitive pricing. Variable annuity sales were 15.1% and 29.9% lower than the historically high levels achieved in the third quarter and first nine months of 2003 as the Company maintained its pricing discipline. The improved equity markets reduced the net amount at risk with respect to guaranteed minimum death benefits by 36.6%.
The Stable Value Products segment markets guaranteed investment contracts (GICs) to 401(k) and other qualified retirement savings plans, and sells guaranteed funding agreements (GFA) to special purpose entities that in turn issue notes or certificates in smaller, transferable denominations. The segment also markets fixed and floating rate funding agreements directly to the trustees of municipal bond proceeds, institutional investors, bank trust departments, and money market funds. Segment results were as follows:
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
2004 2003 CHANGE 2004 2003 CHANGE
--------------------------------- --------------------------------
REVENUES
Net investment income $66,472 $56,441 17.8% $197,171 $174,063 13.3%
----------------------- ----------------------
BENEFITS AND EXPENSES
Benefits and settlement expenses 50,301 45,374 10.9 150,790 140,096 7.6
Amortization of deferred policy acquisition costs 894 542 64.9 2,458 1,660 48.1
Other operating expenses 1,964 1,002 96.0 4,985 3,548 40.5
----------------------- ----------------------
Total benefits and expenses 53,159 46,918 13.3 158,233 145,304 8.9
OPERATING INCOME 13,313 9,523 39.8 38,938 28,759 35.4
Realized investment gains (losses) 6,992 9,745 12,893 7,303
----------------------- ----------------------
INCOME BEFORE INCOME TAX $20,305 $19,268 5.4 $ 51,831 $ 36,062 43.7
======================= ======================
The following table summarizes key data for the Stable Value Products segment:
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
2004 2003 CHANGE 2004 2003 CHANGE
--------------------------------- --------------------------------
Sales
GIC $ 15,000 $ 24,500 (38.8)% $ 54,000 $273,500 (80.3)%
GFA - Direct Institutional 0 0 0.0 960 25,000 (96.2)
GFA - Non-Registered Notes 0 100,000 (100.0) 0 400,000 (100.0)
GFA - Registered Notes - Institutional 625,000 0 100.0 925,000 0 100.0
GFA - Registered Notes - Retail 135,520 0 100.0 425,270 0 100.0
----------------------- ----------------------
$ 775,520 $ 124,500 522.9 $1,405,230 $698,500 101.2
======================= ======================
Average Account Values $5,112,019 $4,147,034 23.3 $5,009,546 $4,111,876 21.8
Operating Spread
Net investment income yield 5.34% 5.61% 5.39% 5.81%
Interest credited 4.04 4.51 4.12 4.68
Operating expenses 0.23 0.15 0.20 0.17
----------------------- ----------------------
Operating spread 1.07% 0.95% 1.07% 0.96%
======================= ======================
Operating income increased 39.8% and 35.4% from the third quarter and first nine months of 2003 due to growth in average account balances, as well as the widening of spreads. The growth in average account balances was primarily driven by sales of the Company’s registered funding agreement-backed notes program over the last four quarters. The lower interest rate environment caused both the investment income yield and the interest credited rate to decline from the third quarter and first nine months of 2003. However, a rebalancing of the segment’s portfolio and replacement of higher rate contracts allowed for a widening of interest spreads. Currently, operating spreads are anticipated to be in the range of 105-110 basis points for the remainder of 2004.
The retail registered funding agreement-backed notes program, which was introduced during the first quarter of 2004, experienced sales of $135.5 million and $425.3 million during the current quarter and first nine months of 2004. During the current quarter the segment introduced an inflation adjusted note program, which contributed $124.2 million to total retail sales. The Company currently anticipates sales from the retail note program to range from $75 million to $175 million for the remainder of 2004. In addition, the institutional registered funding agreement-backed notes program, which was launched in the fourth quarter of 2003, experienced strong sales of $625.0 million for the third quarter of 2004. Sales of traditional GICs during 2004 were significantly lower than 2003 levels due to the segment’s continued focus on the registered note programs as well as lower overall market demand for traditional GIC products.
The Asset Protection segment primarily markets extended service contracts and credit life and disability insurance to protect consumers’ investments in automobiles and watercraft. Segment results were as follows:
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
2004 2003 CHANGE 2004 2003 CHANGE
--------------------------------- --------------------------------
REVENUES
Gross premiums and policy fees $120,558 $112,850 6.8% $ 354,091 $322,927 9.7%
Reinsurance ceded (68,755) (52,128) 31.9 (193,981) (140,306) 38.3
----------------------- ----------------------
Net premiums and policy fees 51,803 60,722 (14.7) 160,110 182,621 (12.3)
Net investment income 7,922 9,484 (16.5) 22,963 27,862 (17.6)
Other income 9,565 8,833 8.3 27,744 33,971 (18.3)
----------------------- ----------------------
Total operating revenues 69,290 79,039 (12.3) 210,817 244,454 (13.8)
BENEFITS AND EXPENSES
Benefits and settlement expenses 29,226 34,676 (15.7) 94,788 105,002 (9.7)
Amortization of deferred policy acquisition costs 20,042 19,838 1.0 57,520 59,746 (3.7)
Other operating expenses 14,597 19,413 (24.8) 44,110 63,591 (30.6)
----------------------- ----------------------
Total benefits and expenses 63,865 73,927 (13.6) 196,418 228,339 (14.0)
OPERATING INCOME 5,425 5,112 6.1 14,399 16,115 (10.6)
----------------------- ----------------------
INCOME BEFORE INCOME TAX $ 5,425 $ 5,112 6.1 $ 14,399 $ 16,115 (10.6)
======================= ======================
The following table summarizes key data for the Asset Protection segment:
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
2004 2003 CHANGE 2004 2003 CHANGE
------------------------------------- --------------------------------------
Sales
Credit insurance $ 59,543 $ 53,418 11.5% $169,824 $150,228 13.0%
Service contracts 56,627 59,421 (4.7) 155,763 151,999 2.5
Other products 8,883 18,410 (51.7) 25,975 59,446 (56.3)
-------------------------- ---------------------------
$125,053 $131,249 (4.7) $351,562 $361,673 (2.8)
========================== ===========================
Loss Ratios (1)
Credit insurance 35.7% 33.9% 37.9% 38.0%
Service contracts 78.3 85.0 80.8 86.8
Other products 66.4 98.8 73.8 91.6
(1) Incurred claims as a percentage of earned premiums.
Operating income increased 6.1% versus the third quarter of 2003, as higher service contract earnings were partially offset by lower earnings from credit insurance and other products. Income for the first nine months of 2004 was 10.6% below the same period in 2003 as the impact of gains from charter sales offset improved results in the segment’s remaining operations. The segment realized a gain of $6.9 million in the second quarter of 2003 and a $1.0 million gain in the first quarter of 2004 from the sale of separate inactive charters. Excluding the impact of these charter sales, operating income increased 44.5% from the first nine months of 2003. The improvement in results reflects an increase in earnings from the service contract business, partially offset by reduced earnings from credit insurance and the segment’s other lines of business.
The decline in net premiums for the quarter and year-to-date was primarily related to decreases of $9.9 million and $28.4 million, respectively, in the credit insurance lines, due to higher levels of reinsurance. Partially offsetting this decline was an increase in vehicle service contract and other lines of $1.0 million and $5.9 million, respectively, for the quarter and year-to-date, reflecting the continued steady growth of these lines. The approximate 17% decrease in net investment income versus the third quarter and first nine months of 2003 was also primarily attributable to the credit insurance business, due to lower policy liabilities and a lower net yield on investments. Other income increased 8.3% over the third quarter of 2003 as a result of higher administration fees. Excluding the impact of the charter sale gains, other income declined 1.4% from the first nine months of 2003, primarily due to lower levels of service contract administration fees in the first six months of 2004.
Policy and benefit expenses declined 15.7% and 9.7% versus the third quarter and first nine months of 2003 due to the decrease in the segment’s net premiums and the overall improvement in loss ratios. Amortization of DAC in the first nine months of 2004 was lower than the comparable period in 2003 due to the decline in the segment’s credit business. Other operating expenses decreased from the third quarter and first nine months of 2003 due to lower commissions and reductions in other general expenses. A $1.7 million third-party administrator receivable write-off in the first quarter of 2003 contributed to the decline in other general expenses in 2004. The remaining decrease in general expenses was primarily due to the outsourcing of the administration of a portion of the segment’s credit insurance business during 2003 and other cost saving initiatives.
Loss ratios for credit insurance were slightly higher for the quarter and relatively unchanged for the year to date. Service contract loss ratios for the current quarter and year-to-date have improved over prior year levels as a result of segment initiatives to increase pricing and tighten the underwriting and claims processes. Loss ratios for other products have declined significantly from the third quarter and first nine months of 2003 primarily due to lower losses in the segment’s runoff lines.
Sales of credit insurance through financial institutions rose 41.8% and 36.8% from levels achieved in the third quarter and first nine months of 2003 primarily due to a third party administrator relationship. The increase in financial institution credit insurance sales is expected to decline as the third party administrator goes into runoff over the next year. These strong credit insurance sales results were partially offset by a decline in credit insurance sold through automobile dealers. Service contract sales for the current quarter were 4.7% below the strong sales reported in the third quarter of 2003. Sales of service contract business for the first nine months of 2004 were slightly higher than 2003 levels, reflecting modest increases in vehicle lines, partially offset by a decline in marine sales. The decrease in other product sales primarily reflects products sold in 2003 that 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 small non-strategic lines of business (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 NINE MONTHS ENDED
SEPTEMBER 30 CHANGE SEPTEMBER 30 CHANGE
2004 2003 2004 2003
----------------------------------- ----------------------------------
Operating income (loss)(1) $12,325 $ (7,849) $ 20,174 $19,758 $(29,450) $ 49,208
Realized gains and losses - investments (1,635) 9,238 (10,873) 2,280 29,072 (26,792)
Realized gains and losses - derivatives 903 (14,357) 15,260 4,091 (26,701) 30,792
----------------------------------- ----------------------------------
Income (loss) before income tax $11,593 $(12,968) $ 24,561 $26,129 $(27,079) $ 53,208
=================================== ==================================
| (1) | Includes settlements on interest rate swaps of $4,684 and $4,786 for the three months ended September 30, 2004 and 2003, respectively, and $14,913 and $16,305 for the nine months ended September 30, 2004 and 2003, respectively. |
Operating income in the current quarter increased $20.2 million from the third quarter of 2003, as higher operating expenses were more than offset by higher amounts of net investment income. For the first nine months of 2004, operating income increased $49.2 million as significantly lower losses on runoff insurance lines contributed to the factors affecting the current quarter comparison. Results for the runoff insurance lines improved by $17.7 million for the first nine months of 2004, primarily as a result of the $25.4 million reserve strengthening taken during the second quarter of 2003 on the residual value business. In addition, reserves were strengthened by $7.0 million during the first nine months of 2004 for the residual value and surety lines. Net investment income increased $25.7 million and $43.8 million versus the third quarter and first nine months of 2003, reflecting mark-to-market gains on trading securities, increased participating mortgage income, and higher amounts of unallocated capital. Mark-to-market gains on the Company’s trading portfolio were $5.9 million and $4.2 million for the third quarter and first nine months of 2004, with no similar activity in 2003. Participating mortgage income increased $7.6 million and $8.1 million over the third quarter and the first nine months of 2003, reflecting increased transaction activity within the Company’s mortgage portfolio. Higher overall expenses and lower amounts of income from interest rate swaps accounted for the remainder of the change in the current year’s results.
The following table sets forth realized investment gains and losses for the periods shown:
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
2004 2003 CHANGE 2004 2003 CHANGE
------------------------------------- --------------------------------
Fixed maturity gains $ 20,713 $33,665 $(12,952) $ 46,565 $ 77,436 $(30,871)
Fixed maturity losses (861) (2,679) 1,818 (6,237) (4,052) (2,185)
Equity gains 1,302 0 1,302 2,692 368 2,324
Equity losses 0 (280) 280 (22) (280) 258
Impairments on fixed maturity securities (12,052) (3,899) (8,153) (14,775) (19,834) 5,059
Impairments on equity securities (1,466) 0 (1,466) (3,591) 0 (3,591)
Other 545 235 310 (747) 1,750 (2,497)
------------------------------------- --------------------------------
Total realized gains (losses) - investments $ 8,181 $27,042 $(18,861) $ 23,885 $ 55,388 $(31,503)
===================================== ================================
Foreign currency swaps $ 1,231 $(22,784) $24,015 $(10,286) $ 1,997 $(12,283)
Foreign currency adjustments on stable value
contracts (1,013) 23,307 (24,320) 10,911 (1,195) 12,106
Derivatives related to corporate debt 10,685 (3,023) 13,708 13,848 2,165 11,683
Derivatives related to mortgage loan commitments (5,564) (3,777) (1,787) (256) (21,309) 21,053
Other derivatives 948 (2,771) 3,719 5,893 8,748 (2,855)
------------------------------------- --------------------------------
Total realized gains (losses) - derivatives $ 6,287 $ (9,048) $15,335 $ 20,110 $ (9,594) $ 29,704
===================================== ================================
Realized gains and losses on investments reflect portfolio management activities designed to maintain proper matching of assets and liabilities and to enhance long-term investment portfolio performance. The overall decline in net realized investment gains for the current quarter and year-to-date, excluding impairments, reflects the normal operation of the Company’s asset/liability program within the context of the changing interest rate environment. Investment impairments for the third quarter of 2004 were higher than 2003 primarily as a result of write-downs taken on airline equipment trust certificates in the current quarter. The reduction in impairments for the first nine months of 2004 reflects the current quarter write-downs and lower overall impairments due to 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 (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 third quarter and first nine months of 2004 was $(0.3) million and $(0.2) million, respectively. These changes were the result of differences in the related foreign currency spot and forward rates used to value the stable value contracts and foreign currency swaps. The Company also uses interest rate swaps to mitigate interest rate risk related to its Senior Notes, Medium-Term Notes, and subordinated debt securities. Interest rates moved lower in the current quarter and caused the 2004 results from these swaps to compare favorably with both the third quarter and first nine 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 changes in net gains (losses) from these securities were the result of fluctuations in interest rates and adjustments to the Company’s short positions during the respective periods.
The Company also uses various swaps and options to mitigate risk related to other interest rate exposures of the Company. For the third quarter and first nine months of 2004, a portion of the change, a $3.8 million increase and $2.0 million increase, respectively, in realized gains (losses) resulted from lower interest rates in the third quarter of 2004, which impacted the fair value of certain interest rate swaps and options. Further, the third quarter and first nine months of 2003 reflected a $1.2 million loss and $3.4 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 $1.1 million and $4.1 million for the third quarter and first nine months of 2004, respectively, related to gains from embedded derivatives within certain bonds that either matured or were called in the first nine months of 2003, with no similar activity in 2004. For the first nine months of 2004, realized gains (losses) improved by $3.4 million due to the impact of embedded derivatives within certain asset swaps that were called in the first nine months of 2004, with no similar activity in the first nine months of 2003.
In accordance with FASB Interpretation No. (FIN) 46 “Consolidation of Variable Interest Entities”, 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.
In September 2004, the AICPA issued a Technical Practice Aid (TPA) which contains additional interpretive guidance on applying certain provisions of SOP 03-1. Among other items, the TPA provides guidance on the definition of an assessment, the accounting for universal life contracts that exhibit losses followed by losses, and the accounting for reinsurance of the additional mortality reserves required by the SOP. The Company is currently evaluating the provisions of the TPA to determine what impact, if any, it may have on the Company’s previously reported earnings, including the cumulative effect adjustment. The Company anticipates making any adjustments resulting from the application of this guidance during the fourth quarter of 2004. Adoption of the TPA guidance that results in changes to previously reported information will be recorded in accordance with APB 20, “Accounting Changes”.
A proposal to amend Actuarial Guideline 38 (promulgated by the NAIC and part of codification of statutory accounting principles) has been exposed for comment, and certain regulators have indicated a desire for the NAIC to adopt the proposal before year-end 2004, with retroactive effect. Actuarial Guideline 38, also known as AXXX, sets forth the reserve requirements for universal life insurance with secondary guarantees (ULSG). The Company believes that the proposal would increase the reserve levels required for many ULSG products, and thus would make those products more expensive and less competitive as compared to other products. The Company cannot predict whether the proposal will be adopted and, if so, whether it will be in the form currently proposed and whether it will be retroactive. The Company believes that the impact of the proposal on the Company will be primarily prospective and relate to the competitiveness of its products as compared to traditional whole life or other high cash value insurance products. To the extent the additional reserves are generally considered to be economically redundant, capital market or other solutions may emerge to reduce the impact of the proposal, if passed in its current form. The Company cannot predict when or if these solutions may become available.
The insurance industry has recently become the focus of increased scrutiny by regulatory and law enforcement authorities relating to allegations of improper special payments, price-fixing, bid-rigging and other alleged misconduct, including payments made by insurers to brokers and the practices surrounding the placement of insurance business. Such publicity may generate litigation against insurers, even those who do not engage in the business lines or practices currently at issue. It is impossible to predict the outcome of these investigations or proceedings, whether they will expand into other areas not yet contemplated, whether they will result in changes in insurance regulation, whether activities currently thought to be lawful will be characterized as unlawful, or the impact, if any, of this increased regulatory and law enforcement scrutiny of the insurance industry on the Company. As these inquiries appear to encompass a large segment of our industry, perhaps the entire industry, it would not be unusual for large numbers of companies in the life industry to receive subpoenas, requests for information from regulatory authorities or other inquiries relating to these and similar matters. From time to time, the Company may receive subpoenas, requests or other inquires.
The California Department of Insurance has promulgated proposed regulations that would characterize some life insurance agents as brokers and impose certain obligations on those agents that may conflict with the interests of insurance carriers or require the agent to, among other things, advise the client with respect to the “best available insurer.” The Company cannot predict the outcome of this regulatory proposal or whether any other state will propose or adopt similar actions.
The life reinsurance business continued to consolidate with the acquisition of the life reinsurance business of certain subsidiaries of ING America Insurance Holdings, Inc. (ING) by Scottish Re Group Limited and its affiliates, announced during the third quarter. ING is a major reinsurer in the market at large as well as of the Company’s life business. In connection with the acquisition, the Company was notified that the treaties between these ING subsidiaries and the Company’s subsidiaries would be cancelled with respect to new business, effective for new business after January 18, 2005. The Company is currently evaluating various alternatives to ensure that the offering of the affected products can continue without a significant adverse impact; however, the Company believes that the reinsurance obtained will not be on terms as favorable to the Company as the reinsurance currently in place.
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 $13.4 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 $419.9 million at September 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 September 30, 2004, the Company’s fixed maturity investments had a market value of $13.7 billion, which is 5.2% above amortized cost of $13.0 billion. The Company had $2.9 billion in mortgage loans at September 30, 2004. While the Company’s mortgage loans do not have quoted market values, at September 30, 2004, the Company estimates the market value of its mortgage loans to be $3.1 billion (using discounted cash flows from the next call date), which is 6.9% above amortized cost. Most of the Company’s mortgage loans have significant prepayment fees. These assets are invested for terms approximately corresponding to anticipated future benefit payments. Thus, market fluctuations are not expected to adversely affect liquidity.
At September 30, 2004, total bonds rated less than investment grade were 5.1% of invested assets.
The following table shows the carrying values of the Company’s invested assets.
- ------------------------------------------------------------------------------------------------------------------------------
SEPTEMBER 30, 2004 DECEMBER 31, 2003
- ------------------------------------------------------------------------------------------------------------------------------
($ in thousands)
Publicly-issued bonds $11,765,283 63.6% $11,377,474 65.3%
Privately issued bonds 1,910,568 10.4 1,975,273 11.3
Redeemable preferred stock 3,507 0.0 3,164 0.0
- ------------------------------------------------------------------------------------------------------------------------------
Fixed maturities 13,679,358 74.0 13,355,911 76.6
Equity securities 59,635 0.3 46,731 0.3
Mortgage loans 2,904,729 15.7 2,733,722 15.7
Investment real estate 107,220 0.6 18,126 0.1
Policy loans 485,282 2.6 502,748 2.9
Other long-term investments 217,270 1.2 249,494 1.4
Short-term investments 1,042,278 5.6 519,419 3.0
- ------------------------------------------------------------------------------------------------------------------------------
Total investments $18,495,772 100.0% $17,426,151 100.0%
==============================================================================================================================
Included in the above table are $354.2 million of fixed maturities and $65.7 million of short term investments at September 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 $1,910.6 million at September 30, 2004, representing 10.4% of the Company’s total invested assets.
Risk Management and Impairment Review
The Company monitors the overall credit quality of the Company’s portfolio within general guidelines. The following table shows the Company’s available for sale fixed maturities by credit rating at September 30, 2004.
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S&P or Equivalent Percent of
Designation Market Value Market Value
- ----------------------------------------------------------------------------------------------------------------------------
($ in thousands)
AAA $ 4,569,284 34.3%
AA 854,918 6.4
A 3,139,019 23.6
BBB 3,817,052 28.7
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Investment grade 12,380,273 93.0
- ----------------------------------------------------------------------------------------------------------------------------
BB 621,233 4.6
B 309,304 2.3
CCC or lower 10,769 0.1
In or near default 60 0.0
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Below investment grade 941,366 7.0
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Redeemable preferred stock 3,507 0.0
- ----------------------------------------------------------------------------------------------------------------------------
Total $ 13,325,146 100.0%
============================================================================================================================
Not included in the table above are $354.2 million of investment grade fixed maturities classified by the Company as trading securities.
Limiting bond exposure to any creditor group is another way the Company manages credit risk. The following table summarizes the Company’s ten largest fixed maturity exposures to an individual creditor group as of September 30, 2004.
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Creditor Market Value
---------------------------------------------------------------------------------------------
($ in millions)
Citigroup $78.9
Wachovia 78.0
Dominion Resources 76.5
FPL Group 76.2
Duke Energy 74.9
Union Pacific 72.5
Berkshire Hathaway 72.1
Merrill Lynch 71.0
Edison International 69.0
Verizon 67.2
---------------------------------------------------------------------------------------------
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 September 30, 2004, the balance sheet date. Information about unrealized gains and losses is subject to rapidly changing conditions, including volatility of financial markets and changes in interest rates. As indicated above, the Company’s management considers a number of factors in determining if an unrealized loss is other-than-temporary, including its ability and intent to hold the security until recovery. Furthermore, since the timing of recognizing realized gains and losses is largely based on management’s decisions as to the timing and selection of investments to be sold, the tables and information provided below should be considered within the context of the overall unrealized gain (loss) position of the portfolio. At September 30, 2004, the Company had an overall pretax net unrealized gain of $676.9 million.
For traded and private fixed maturity and equity securities held by the Company that are in an unrealized loss position at September 30, 2004, the estimated market value, amortized cost, unrealized loss and total time period that the security has been in an unrealized loss position are presented in the table below.
- ----------------------------------------------------------------------------------------------------------------------------
Estimated % Market Amortized % Amortized Unrealized % Unrealized
Market Value Value Cost Cost Loss Loss
- ----------------------------------------------------------------------------------------------------------------------------
($ in thousands)
‹= 90 days $ 391,693 21.3% $ 409,497 21.6% $(17,804) 31.0%
›90 days but ‹= 180 days 850,183 46.2 863,454 45.5 (13,271) 23.1
›180 days but ‹= 270 days 149,390 8.1 152,703 8.0 (3,313) 5.8
›270 days but ‹= 1 year 58,444 3.2 59,096 3.1 (652) 1.1
›1 year but ‹= 2 years 328,715 17.9 342,444 18.1 (13,729) 23.9
›2 years but ‹= 3 years 34,175 1.8 36,336 1.9 (2,161) 3.8
›3 years but ‹= 4 years 2,144 0.1 2,208 0.1 (64) 0.1
›4 years but ‹= 5 years 4,773 0.2 5,701 0.3 (928) 1.6
›5 years 21,456 1.2 26,985 1.4 (5,529) 9.6
- ----------------------------------------------------------------------------------------------------------------------------
Total $1,840,973 100.0% $1,898,424 100.0% $(57,451) 100.0%
============================================================================================================================
At September 30, 2004, securities with a market value of $25.5 million and $21.0 million of unrealized losses were issued in Company sponsored commercial mortgage loan securitizations, including $4.1 million of unrealized losses greater than five years. The Company does not consider these unrealized positions to be other-than-temporary, because the underlying mortgage loans continue to perform consistently with the Company’s original expectations.
The Company has no material concentrations of issuers or guarantors of fixed maturity securities. The industry segment composition of all securities in an unrealized loss position held by the Company at September 30, 2004, is presented in the following table.
- ------------------------------------------------------------------------------------------------------------------------------
Estimated % Market Amortized % Amortized Unrealized % Unrealized
Market Value Value Cost Cost Loss Loss
- ------------------------------------------------------------------------------------------------------------------------------
($ in thousands)
Agency Mortgages $ 491,947 26.7% $ 495,422 26.1% $ (3,475) 6.0%
Banking 107,248 5.8 108,623 5.7 (1,375) 2.4
Basic Industrial 86,495 4.7 89,243 4.7 (2,748) 4.8
Brokerage 45,241 2.5 45,955 2.4 (714) 1.3
Communications 87,901 4.8 92,797 4.9 (4,896) 8.5
Consumer Cyclical 65,917 3.6 66,516 3.5 (599) 1.0
Consumer Noncyclical 51,416 2.8 53,020 2.8 (1,604) 2.8
Electric 241,534 13.1 252,767 13.3 (11,233) 19.6
Energy 81,230 4.4 83,720 4.4 (2,490) 4.3
Finance Companies 23,234 1.3 23,284 1.2 (50) 0.1
Insurance 77,338 4.2 78,772 4.1 (1,434) 2.5
Municipal Agencies 487 0.0 488 0.0 (1) 0.0
Natural Gas 159,033 8.6 162,085 8.6 (3,052) 5.3
Non-Agency Mortgages 197,910 10.8 215,128 11.4 (17,218) 30.0
Other Finance 44,786 2.4 49,851 2.6 (5,065) 8.8
Other Utility 21 0.0 44 0.0 (23) 0.0
Technology 11,428 0.6 11,582 0.6 (154) 0.3
Transportation 60,970 3.3 62,181 3.3 (1,211) 2.1
U. S. Government 6,837 0.4 6,946 0.4 (109) 0.2
- ------------------------------------------------------------------------------------------------------------------------------
Total $ 1,840,973 100.0% $ 1,898,424 100.0% $(57,451) 100.0%
==============================================================================================================================
The range of maturity dates for securities in an unrealized loss position at September 30, 2004 varies, with 9.0% maturing in less than 5 years, 25.0% maturing between 5 and 10 years, and 66.0% maturing after 10 years. The following table shows the credit rating of securities in an unrealized loss position at September 30, 2004.
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S&P or Equivalent Estimated % Market Amortized % Amortized Unrealized % Unrealized
Designation Market Value Value Cost Cost Loss Loss
- ------------------------------------------------------------------------------------------------------------------------------
($ in thousands)
AAA/AA/A $1,180,967 64.2% $1,202,005 63.3% $(21,038) 36.6%
BBB 504,462 27.4 517,083 27.2 (12,621) 22.0
- ------------------------------------------------------------------------------------------------------------------------------
Investment grade 1,685,429 91.6 1,719,088 90.5 (33,659) 58.6
- ------------------------------------------------------------------------------------------------------------------------------
BB 48,254 2.6 49,907 2.7 (1,653) 2.9
B 95,917 5.2 104,596 5.5 (8,679) 15.1
CCC or lower 11,373 0.6 24,833 1.3 (13,460) 23.4
- ------------------------------------------------------------------------------------------------------------------------------
Below investment grade 155,544 8.4 179,336 9.5 (23,792) 41.4
- ------------------------------------------------------------------------------------------------------------------------------
Total $1,840,973 100.0% $1,898,424 100.0% $(57,451) 100.0%
==============================================================================================================================
At September 30, 2004, securities in an unrealized loss position that were rated as below investment grade represented 8.4% of the total market value and 41.4% of the total unrealized loss. Unrealized losses related to below investment grade securities that had been in an unrealized loss position for more than twelve months were $7.7 million. Bonds in an unrealized loss position rated less than investment grade were 0.8% of invested assets. The Company does not expect these investments to adversely affect its liquidity or ability to maintain proper matching of assets and liabilities.
The following table shows the estimated market value, amortized cost, unrealized loss and total time period that the security has been in an unrealized loss position for all below investment grade securities.
- ----------------------------------------------------------------------------------------------------------------------------
Estimated % Market Amortized % Amortized Unrealized % Unrealized
Market Value Value Cost Cost Loss Loss
- ----------------------------------------------------------------------------------------------------------------------------
($ in thousands)
‹= 90 days $ 20,451 13.2% $ 31,631 17.6 % $(11,180) 47.0%
›90 days but ‹= 180 days 55,585 35.7 59,657 33.3 (4,072) 17.1
›180 days but ‹= 270 days 20,233 13.0 21,082 11.8 (849) 3.6
›270 days but ‹= 1 year 0 0.0 0 0.0 (0) 0.0
›1 year but ‹= 2 years 3,513 2.3 3,593 2.0 (80) 0.3
›2 years but ‹= 3 years 33,531 21.5 35,572 19.8 (2,041) 8.6
›3 years but ‹= 4 years 1,027 0.7 1,070 0.6 (43) 0.2
›4 years but ‹= 5 years 3 0.0 3 0.0 (0) 0.0
›5 years 21,201 13.6 26,728 14.9 (5,527) 23.2
- ----------------------------------------------------------------------------------------------------------------------------
Total $155,544 100.0% $ 179,336 100.0% $(23,792) 100.0%
============================================================================================================================
At September 30, 2004, below investment grade securities with a market value of $20.2 million and $15.3 million of unrealized losses were issued in Company sponsored commercial mortgage loan securitizations, $4.1 million 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 for other-than-temporary impairments and actual sales of investments. For the third quarter and first nine months of 2004, the Company recorded other-than-temporary impairments of $13.5 million and $18.4 million as compared to $3.9 million and $19.8 million for the 2003 periods. The most significant impairments recorded in the current quarter were $11.9 million in write-downs taken on airline equipment trust certificates due to continued difficulties in this industry. The Company continues to closely monitor all of its positions in the airline industry for indications of any additional impairment.
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 nine months ended September 30, 2004, the Company sold securities in an unrealized loss position with a market value of $185.2 million resulting in a realized loss of $6.2 million. For such securities, the proceeds, realized loss and total time period that the security had been in an unrealized loss position are presented in the table below.
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Proceeds % Proceeds Realized Loss % Realized Loss
- ----------------------------------------------------------------------------------------------------------------------------
($ in thousands)
‹= 90 days $ 11,807 6.4% $(2,139) 34.2%
›90 days but ‹= 180 days 7,061 3.8 (25) 0.4
›180 days but ‹= 270 days 79,518 42.9 (2,229) 35.6
›270 days but ‹= 1 year 76,337 41.2 (1,615) 25.8
› 1 year 10,431 5.7 (251) 4.0
- ----------------------------------------------------------------------------------------------------------------------------
Total $185,154 100.0% $(6,259) 100.0%
============================================================================================================================
Mortgage Loans
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 September 30, 2004 and December 31, 2003, the Company’s allowance for mortgage loan credit losses was $3.4 million and $4.7 million, respectively.
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 September 30, 2004, approximately $436.5 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 September 30, 2004, the Company had outstanding mortgage loan commitments of $845.1 million at an average rate of 6.24%.
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 September 30, 2004, the Company had policy liabilities and accruals of $10.3 billion. The Company’s interest-sensitive life insurance policies have a weighted average minimum credited interest rate of approximately 4.5%.
At September 30, 2004, the Company had $5.1 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, inflation risk, and currency exchange risk. Combinations of interest rate swap contracts, futures contracts, and option contracts are used to mitigate or eliminate certain financial and market risks, including those related to changes in interest rates for certain investments, primarily outstanding mortgage loan commitments and mortgage-backed securities, and the Company’s outstanding debt. Swap contracts are also used to alter the effective durations of assets and liabilities and to mitigate the inflation risk caused by the issuance of inflation adjusted notes through the Stable Value Products segment. 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 $1,079.0 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 September 30, 2004, to fund mortgage loans in the amount of $845.1 million. The Company’s subsidiaries held $1,156.0 million in cash and short-term investments at September 30, 2004. The Company had an additional $3.3 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 September 30, 2004, the Company had $100.1 million outstanding under its $200.0 million revolving line of credit due July 30, 2009, at an interest rate of 1.93%. On October 21, 2004, the Company issued $150.0 million of 4.875% Senior Notes that mature on November 1, 2014. The proceeds from the Senior Notes were used to pay off the $100.1 million balance on the revolving line and for general corporate purposes.
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 $100 million share repurchase program, available through May 2, 2007. There has been no activity under this program, and future activity will be dependent upon many factors, including capital levels, rating agency expectations, and the relative attractiveness of alternative uses for capital.
A life insurance company’s statutory capital is computed according to rules prescribed by the National Association of Insurance Commissioners (“NAIC”), as modified by the insurance company’s state of domicile. Statutory accounting rules are different from GAAP and are intended to reflect a more conservative view by, for example, requiring immediate expensing of policy acquisition costs. The NAIC’s risk-based capital requirements require insurance companies to calculate and report information under a risk-based capital formula. The achievement of long-term growth will require growth in the statutory capital of the Company’s insurance subsidiaries. The subsidiaries may secure additional statutory capital through various sources, such as retained statutory earnings or equity contributions by the Company.
Contractual Obligations
The table below sets forth future maturities of debt, subordinated debt securities, stable value products, notes payable, operating lease obligations, other property lease obligations, mortgage loan commitments, and liabilities related to variable interest entities.
- ------------------------------------------------------------------------------------------------------------------------------
2004 2005-2006 2007-2008 After 2008
- ------------------------------------------------------------------------------------------------------------------------------
($ in thousands)
Long-term debt(a) $399,331
Subordinated debt securities(b) 324,743
Stable value products(c) $279,028 $2,151,173 $1,714,829 998,337
Note payable 2,210
Operating leases(d) 1,806 12,439 71,894 9,313
Mortgage loan commitments 845,057
Liabilities related to variable interest entities(e) 478 412,437 47,645 15,393
- ------------------------------------------------------------------------------------------------------------------------------
(a) Long-term debt includes all principal amounts owed on note agreements, and does not include interest payments due
over the term of the notes.
(b) Subordinated debt securities includes all principal 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 $2,306.9 million. Separate account liabilities represent funds maintained for contract holders who bear the related investment risk. These liabilities are supported by assets that are legally segregated and are not subject to claims that arise from other business activities of 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
(a) Evaluation of disclosure controls and procedures
Under the direction of our Chief Executive Officer and Chief Financial Officer, we evaluated our disclosure controls and procedures and internal control over financial reporting and concluded that our disclosure controls and procedures were effective as of September 30, 2004. It should be noted that any system of controls, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. Further, the design of any control system is based in part upon certain judgments, including the costs and benefits of controls and the likelihood of future events. Because of these and other inherent limitations of control systems, no evaluation of controls can provide absolute assurance that all control issues, if any, within the Company have been detected.
(b) Changes in internal control over financial reporting
No significant changes in our internal control over financial reporting occurred during the quarter ended September 30, 2004 that have materially affected, or is reasonably likely to materially affect, such internal control over financial reporting. Our internal controls exist within a dynamic environment and the Company continually strives to improve its internal controls and procedures to enhance the quality of its financial reporting.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
During the quarter ended September 30, 2004, the Company issued no securities in transactions which were not registered under the Securities Act of 1933, as amended (the “Act”).
Item 6. Exhibits
Exhibit 10(a) — Form of Performance Share Award Letter
Exhibit 10(b) — Form of Stock Appreciation Rights Award Letter
Exhibit
10(c) — Amended and Restated Credit Agreement among Protective Life Corporation,
Protective Life Insurance Company, The Several Lenders from
Time to Time Party Hereto,
AmSouth Bank and Wachovia Capital Markets, LLC, dated as of July 30, 2004.
Exhibit 10(d) — Protective Life Corporation Excess Benefit Plan
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.
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: November 9, 2004 /s/ Steven G. Walker
Steven G. Walker
Senior Vice President, Controller
and Chief Accounting Officer
(Duly authorized officer)