General
We are engaged in the sale of insurance products including individual annuities,
individual life insurance and accident and health insurance. Our revenues are
derived primarily from premiums received from the sale of annuity contracts and
life, accident and health products, investment income and from gains (net of
losses) from our investment portfolio.
Under GAAP, our revenues from the sale of whole life insurance products and
annuity contracts with life contingencies are treated differently from our
revenues from the sale of annuity contracts without life contingencies, deferred
annuities and universal life insurance products. Premiums from the sale of life
insurance products and life contingent annuities are reported as premium income
on our income statement. Premiums from the sale of deferred annuities,
universal life insurance products and annuities without life contingencies are
not reported as revenues, but rather are reported as additions to policyholders'
account balances on our balance sheet. For these products, revenues are
recognized principally through the spread between interest income on invested
assets and interest credited to policyholder's accounts. Additional revenues
are recognized over time in the form of policy fee income, surrender charges and
mortality and other charges deducted from policyholders' account balances.
The profitability of our individual annuities, individual life insurance and
group accident and health products depends largely on the size of our in-force
book of business, the adequacy of product pricing and underwriting discipline,
and the efficiency of our claim and expense management.
This Quarterly Report on Form 10-Q ("Form 10-Q") contains forward-looking
statements that involve risks and uncertainties. Forward-looking statements
reflect management's current expectations of future events, trends or results
based on certain assumptions and include any statement that does not directly
relate to any historical or current fact. Forward-looking statements can be
identified by words such as "anticipates," "believes," "estimates," "expects,"
"intends," "plans," "predicts" and similar terms. Forward-looking statements are
not guarantees of future performance and the Company's actual results may differ
significantly from the results discussed in the forward-looking statements.
Factors that might cause such differences include, but are not limited to, those
set forth in Part I, Item 1A of our 2011 Form 10-K, which are incorporated
herein by reference, and those, if any, discussed in "Risk Factors" under Part
II, Item 1A of this Form 10-Q. The Company assumes no obligation to revise or
update any forward-looking statements for any reason, except as required bylaw.
Executive Overview
Results
Our net income was $6.9 million or $0.23 per share for the six months ended June
30, 2012, compared with net income of $21.3 million or $0.72 per share for the
same period in 2011. The decrease in net income of $14.4 million for the six
months ended June 30, 2012 compared to 2011 is principally due to a decrease in
net realized investment gains of $17.5 million, a decrease in net investment
income of $5.1 million, an increase in other-than-temporary impairment ("OTTI")
losses of $1.4 million, partially offset by decreases in income taxes of $7.7
million and change in policy acquisition costs of $1.9 million. Our total
revenues for the six months ended June 30, 2012 were $117.1 million, a decrease
of 15.9% or $22.1 million from $139.2 million for the six months ended June 30,
2011. Benefits and expenses remained relatively unchanged for the six months
ended June 30, 2012 in comparison to the same six-month period in 2011.
Second quarter 2012 net income was $3.1 million or $0.11 per share, compared
with net income of $13.8 million or $0.47 per share for the comparable quarter
in 2011. Income before income taxes was $4.7 million and $21.1 million for the
second quarters of 2012 and 2011, respectively, a period-over-period decrease of
$16.4 million. The decline in income before income taxes of $16.4 million is
principally due to a decrease in net realized investment gains of $15.1 million,
a decrease in net investment income of $2.2 million, and an increase in general
expenses of $1.3 million partially offset by decreases in other-than-temporary
impairment ("OTTI") losses of $1.7 million and the change in policy acquisition
costs of $1.1 million. Income taxes were $1.6 million and $7.3 million for the
second quarter of 2012 and 2011, respectively, a decline of $5.7 million.
Pricing
Management believes that we are able to offer products at competitive prices to
our targeted markets as a result of: (i) maintaining relatively low issuance
costs by selling through the independent general agency system; (ii) minimizing
home office administrative costs; and (iii) utilizing appropriate underwriting
guidelines.
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The long-term profitability of sales of life and most annuity products depends
on the degree of margin of the actuarial assumptions that underlie the pricing
of such products. Actuarial calculations for such products, and the ultimate
profitability of sales of such products, are based on four major factors: (i)
persistency; (ii) rate of return on cash invested during the life of the policy
or contract; (iii) expenses of acquiring and administering the policy or
contract; and (iv) mortality.
Persistency is the rate at which insurance policies remain in force, expressed
as a percentage of the number of policies remaining in force over the previous
year. Policyholders may not continue to pay premiums/annuity considerations,
thus causing their policies/annuity contracts to lapse.
The assumed rate of return on invested cash and desired spreads during the
period that insurance policies or annuity contracts are in force also affects
pricing of products and currently includes an assumption by the Company of a
specified rate of return and/or spread on its investments for each year that
such insurance or annuity product is in force.
Investments
Our principal investments are in fixed maturities, all of which are exposed to
at least one of three primary sources of investment risk: credit, interest rate
and market valuation. From a financial statement perspective, these factors
must be considered when determining the recognition of impairments and income,
as well as the determination of fair values. See Note 1 to the Condensed
Consolidated Financial Statements "Summary of Significant Accounting Policies"
for a discussion of the evaluation of available-for-sale securities holdings in
accordance with our impairment policy, whereby we evaluate whether such
investments are other-than-temporarily impaired ("OTTI") and factors considered
by security classification in the OTTI evaluation. In addition, the earnings on
certain investments are dependent upon market conditions, which could result in
prepayments and changes in amounts to be earned due to changing interest rates
or equity markets. The determination of fair values in the absence of quoted
market values is based on valuation methodologies, securities we deem to be
comparable and assumptions deemed appropriate given the circumstances. The use
of different methodologies and assumptions may have a material effect on the
estimated fair value amounts.
We derive a predominant portion of our total revenues from investment income. We
manage most of our investments internally. All investments are governed by the
Statement of Investment Policy established and approved by the Finance and
Investment Committee and the Board of Directors of the Insurance Company and
Presidential Life Corporation and by qualitative and quantitative limits
prescribed by applicable insurance laws and regulations. The Finance and
Investment Committee meets regularly to set and review investment policy and to
approve current investment plans. The actions of the Finance and Investment
Committees are subject to review and approval by the Board of Directors of the
Insurance Company and Presidential Life Corporation. Our Statement of
Investment Policy must comply with the New York State Department of Financial
Services ("NYDFS") regulations and the regulations of other applicable
regulatory bodies.
Our investment philosophy generally focuses on purchasing investment-grade
securities with the intention of holding such securities to maturity. Our
investment philosophy also focuses on the intermediate longer-term horizon and
is not oriented towards trading. However, as market opportunities, liquidity or
regulatory considerations may dictate, securities may be sold prior to maturity.
We have categorized all fixed maturity securities as available for sale and
carry such investments at market value.
We manage our investment portfolio to meet the diversification, yield and
liquidity requirements of our insurance policy and annuity contract obligations.
Our liquidity requirements are monitored regularly so that cash flow needs are
met. Adjustments are made periodically to our investment policies to reflect
changes in our short and long-term cash needs, as well as changing business and
economic conditions.
We seek to manage our investment portfolio in part to reduce our exposure to
interest rate fluctuations. In general, the market value of our fixed maturity
portfolio increases or decreases in an inverse relationship with fluctuations in
interest rates, and our net investment income increases or decreases in direct
relationship with interest rate changes. For example, if interest rates
decline, our fixed maturity investments generally will increase in market value,
while net investment income will decrease as fixed income investments mature or
are sold and proceeds are reinvested at the declining rates. If interest rates
increase, our fixed maturity investments generally will decrease in market
value, while net investment income will generally increase. Because prevailing
market interest rates frequently shift, we have adopted strategies that are
designed to address either an increase or decrease in prevailing rates.
The primary market risk in our investment portfolio is interest rate risk and to
a lesser degree, credit risk. Our exposure to foreign exchange risk is not
significant. We have no direct commodity risk. Changes in interest rates can
potentially impact our profitability. In certain scenarios where interest rates
are volatile, we could be exposed to disintermediation risk and reduction in net
interest rate spread or profit margin. (See the discussion below in
"Asset/Liability Management" for additional information related to the Company's
interest risk and its management.)
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Risk-Based Capital
Under the National Association of Insurance Commissioner's ("NAIC") risk-based
capital formula, insurance companies must calculate and report information under
a risk-based capital formula. The standards require the computation of a
risk-based capital amount, which then is compared to a company's actual total
adjusted capital. The computation involves applying factors to various
financial data to address four primary risks: asset default, adverse insurance
experience, disintermediation and external events. This information is intended
to permit insurance regulators to identify and require remedial action for
inadequately capitalized insurance companies, but is not designed to rank
adequately capitalized companies. The NAIC formula provides for four levels of
potential involvement by state regulators for inadequately capitalized insurance
companies, ranging from a requirement for an insurance company to submit a plan
to improve its capital (Company Action Level) to regulatory control of the
insurance company (Mandatory Control Level). At December 31, 2011, the
Insurance Company's Company Action Level was $69.2 million and the Mandatory
Control Level was $24.2 million. The Insurance Company's adjusted capital at
December 31, 2011 was $384.9 million, which exceeds the amounts triggering all
four action levels. The Company's RBC ratio as of December 31, 2011 was 556%.
Given a dividend payment of $34.25 million in the first six months of 2012, we
estimate the RBC ratio would be reduced to approximately 527% as of June 30,
2012.
Agency Ratings
Ratings are an important factor in establishing the competitive position in the
insurance and financial services marketplace. There can be no assurance that
our ratings will continue for any given period of time or that they will not be
changed. In the event the ratings are downgraded, the level of revenues or the
prospects of our business may be adversely impacted.
In April 2012, the A.M. Best Company affirmed the financial strength rating of
the Insurance Company of "B++" (Good) and upgraded the issuer credit rating, or
ICR, to "bbb+" (Good) from "bbb" (Good) of the Insurance Company and upgraded
the ICR of Presidential Life Corporation to "bb+" from "bb". The ratings have
been assigned a stable outlook.
The ratings reflect our strong capitalization and the early stage execution of
our business strategy to move from a regional distributor of annuity products to
a national platform. However, A.M. Best believes that our narrow product
offering, the income volatility of our limited partnership investments and the
high minimum crediting rates on our in-force business partially offset the
positive rating factors.
At the time of the B++ rating, publications of A.M. Best indicated that the
"B++" rating was assigned to those companies that, in A.M. Best's opinion, have
achieved a very good overall performance when compared to the norms of the
insurance industry and that generally have demonstrated a good ability to meet
their respective policyholder and other contractual obligations over a long
period of time. The B++ rating is within A.M Best's "Secure" classification,
along with A++, A+, A, A-, and B+ ratings.
In evaluating a company's statutory financial and operating performance, A.M.
Best reviews the company's profitability, leverage and liquidity, as well as the
company's book of business, the adequacy and soundness of its reinsurance, the
quality and estimated market value of its assets, the adequacy of its reserves
and the experience and competency of its management.
A.M. Best's rating is based on factors that primarily are relevant to
policyholders, agents and intermediaries and is not directed towards the
protection of investors, nor is it intended to allow investors to rely on such a
rating in evaluating our financial condition.
Results of Operations
A comparison of the significant items for the six months ended June 30, 2012
with the same period in 2011 and a comparison of significant items for the three
months ended June 30, 2012 with the same period in 2011 has been set forth
below.
A.
Revenues
Total annuity considerations and life and accident and health insurance premiums
were $16.8 million and $13.4 million for the first six months of 2012 and 2011,
respectively, a period-over-period increase of $3.4 million or 25.9%. Life
insurance and accident and health premiums were $8.3 million and $9.0 million
for the first six months of 2012 and 2011, respectively, a period-over-period
decrease of $0.7 million or 7.6%. Immediate annuity considerations with life
contingencies were approximately $8.5 million and $4.4 million for the first six
months of 2012 and 2011, respectively, a period-over-period increase of $4.1
million or 94.3%. These amounts do not include consideration from the sales of
deferred annuities or immediate annuities without life contingencies. Under
GAAP, such sales are reported as additions to policyholder account balances.
Consideration from such sales was approximately $32.2 million and $29.5 million
in the first six months of 2012 and 2011, respectively, a period-over-period
increase of
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$2.7 million or 9.4%. The increases in annuity sales were primarily due to a
successful sales effort with recent retirees of a targeted company in the first
six months of 2012.
Total annuity considerations and life and accident and health insurance premiums
increased slightly from approximately $7.5 million for the three months ended
June 30, 2011 to approximately $7.9 million for the three months ended June
30,
2012.
Policy Fee Income
Universal life and investment type policy fee income was approximately $1.6
million and $1.8 million for the six months ended June 30, 2012 and 2011,
respectively, a period-over-period decrease of $0.2 million or 8.3%. Policy fee
income consists principally of amounts assessed during the period against
policyholders' account balances for mortality and surrender charges.
Net Investment Income and Equity in Earnings on Limited Partnerships
Net investment income and equity in earnings on limited partnerships totalled
approximately $94.4 million and $100.3 million during the first six months of
2012 and 2011, respectively, a period-over-period decrease of $5.9 million or
5.9%.
The Company had net investment income and equity in earnings (losses) from the
limited partnerships of $47.3 million and $48.7 million for the three month
periods ended June 30, 2012 and 2011, respectively. Income included within
distributions of the limited partnerships accounted for under the fair value
method are classified as realized gains and losses and therefore excluded from
net investment income (see below).
Net investment income totalled approximately $93.2 million and $98.3 million for
the first six months of 2012 and 2011, respectively, a period-over-period
decrease of $5.1 million or 5.2%. Excluding the return on the Company's limited
partnership investments and other realized gains, the investment yield ratios
(net investment income to average cash and invested assets based on book value)
for the first six months of 2012 and 2011 were 5.66% and 5.96%, respectively.
Income from limited partnerships that are accounted for using the equity method
of accounting amounted to approximately $1.1 million and $2.0 million for the
first six months of 2012 and 2011, respectively, a period-over-period decrease
of $0.9 million or 45.0%. Income from limited partnerships accounted for under
the equity method tend to fluctuate since changes in unrealized gains and losses
are reflected within earnings. Income included within distributions of the
limited partnerships accounted for under the fair value method are classified as
realized gains and losses and therefore excluded from net investment income (see
below).
Net Realized Investment Gains and Losses and OTTI losses recognized in earnings
The Company had net realized investment gains, including OTTI losses, of $3.6
million and $16.9 million for the three months ended June 30, 2012 and 2011,
respectively, a period-over-period decrease of $13.3 million. Net realized
investment gains, including OTTI losses, were $2.8 million and $21.8 million for
the first six months of 2012 and 2011, respectively, a period-over-period
reduction of $19.0 million.
The table below details the components of these amounts:
32
Three Months Ended June 30, Six Months Ended June 30,
2012 2011 2012 2011
(In thousands) (In thousands)
Fixed maturities $ 1,246 $ 5,116 $ 1,742 $ 6,183
Common stocks 14 81 14 219
Limited partnerships 4,594 14,964 7,308 19,672
Derivatives (1,288) (531) (1,148) (663)
Net realized investment gains(losses), excluding OTTI losses $ 4,566 $ 19,630 $ 7,916 $ 25,411
OTTI losses recognized in earnings:
Limited partnerships (1,000) -
(4,092) (939)
Fixed maturities and equities - (2,688) (981) (2,689)
Total OTTI losses recognized in
earnings $ (1,000) $ (2,688) $ (5,073) $ (3,628)
Net realized investment gains
(losses), including OTTI losses $ 3,566 $ 16,942 $
2,843 $ 21,783
The decrease in net realized gains, including OTTI, was primarily due to one
hedge fund redemption of $10.6 million within our limited partnership portfolio
in the second quarter of 2011. Realized gains on limited partnerships tend to
fluctuate from period-to-period consistent with fluctuations in distributions.
B.
Benefits and Expenses
Interest Credited and Benefits to Policyholders
Interest credited and benefits paid and accrued to policyholders were $45.6
million and $43.1 million for the three months ended June 30, 2012 and 2011,
respectively, a period-over-period increase of $2.5 million or 5.9%, and were
$89.5 million and $88.0 million for the six months ended June 30, 2012 and 2011,
respectively, a period-over-period increase of $1.5 million or 1.7%. The
increases are principally due to the increase in liabilities for immediate
annuities with life contingencies in 2012 compared to 2011 related to the
increase in sales of this product in 2012.
A significant contributor to our profitability depends, in large part, on the
investment returns generated on our portfolio, (excluding our limited
partnerships), less what we are contractually obligated to credit to our
policyholders. This is referred to as "investment spread". The crediting rates
on reserves for the first six months of 2012 and 2011 were 4.92% and 4.99%,
respectively. The actual investment spreads for the six months ended June 30,
2012 and June 30, 2011 were 0.74% and 0.97%, respectively.
General Expenses and Taxes
General expenses were $13.5 million and $13.1 million for the six months ended
June 30, 2012 and 2011, respectively, a period-over-period increase of $0.4
million or 3.0%, and were $8.2 million and $6.9 million for the three months
ended June 30, 2012 and 2011, respectively, a period-over-period increase of
$1.3 million or 19.3%. The second quarter increase was primarily due to higher
non-recurring charges in 2012 relative to 2011. With respect to second quarter
2012, transaction costs incurred in connection with the sale of the Company were
approximately $2.7 million, primarily including the accrual of an expense
reimbursement obligation with a potential acquirer other than Athene Holding
Ltd. of $2 million and legal costs. With respect to the second quarter 2011,
non-recurring charges included severance costs and legal and accounting expenses
associated with Company's financial restatements.
Commissions
Commissions to agents, net were relatively unchanged at $2.4 million for the
first six months of 2012 and 2011. Commissions to agents, net were $1.0 million
and $1.2 for the three months ended June 30, 2012 and 2011, respectively, a
period-over-period decrease of $0.2 million or 17.1%. Commission expense
declined slightly in the second quarter 2012 relative to 2011 due to lower
annuity sales compared to the previous year.
33
Change in Deferred Policy Acquisition Costs ("DAC")
The net expense from changes in the net DAC was $1.2 million and $ $3.2 million
for the six months ended June 30, 2012 and 2011, respectively, a
period-over-period decrease of $2.0 million, principally related to lower
amortization of DAC on annuity sales due to lower realized gains. Deferred
costs were reduced by 0.4 million for the first six months of 2012 relative to
2011 primarily due to a reduction in deferred costs resulting from the
prospective adoption of a new accounting principle in 2012 that reduced the
scope of deferrable costs to those directly linked to successful sales efforts.
Changes in DAC consist of the following three elements as summarized below:
For the three months For the six months ended
ended June 30, June 30,
2012 2011 2012 2011
(In thousands) (In thousands)
Change in DAC due to deferred costs
associated with product sales $ (1,197) $ (1,547) $ (2,469) $ (2,788)
Amortization of DAC on deferred
annuity business 988 2,538 1,450 3,594
Amortization of DAC on the remainder
of the Company's business 1,126 1,040 2,250 2,356
Net change in DAC $ 917 $ 2,031 $ 1,231 $ 3,162
Under applicable accounting rules, DAC related to deferred annuities is
amortized in proportion to the estimated gross profits over the estimated lives
of the contracts. As estimated profits of the Insurance Company related to
these assets increase, the amount and timing of amortization is accelerated. The
lower level of amortization in the first six months of 2012 results primarily
from lower net income in 2012 relative to 2011.
C.
Income Before Income Taxes
For the reasons discussed above, income before income taxes amounted to
approximately $10.4 million and $32.5 million for the six months ended June 30,
2012 and 2011, respectively, a period-over-period decrease of $22.1 million. For
the quarters ended June 30, 2012 and 2011, the income before income taxes
amounted to approximately $4.7 million and $21.1 million, respectively.
D.
Income Taxes
Income tax expense was approximately $3.5 million and $11.2 million for six
months ended June 30, 2012 and 2011, respectively, a period-over-period decrease
of $7.7 million. The income tax expense was approximately $1.6 million and $7.3
million for the second quarters of 2012 and 2011, respectively. The annual
effective income tax rates were 33.6% and 34.5% for the six months ended June
30, 2012 and 2011, respectively.
E.
Net Income
For the reasons discussed above, net income was approximately $6.9 million and
$21.3 million for the six months ended June 30, 2012 and 2011, respectively, a
period-over-period decrease of $14.3 million. The Company had net income of
$3.1 million and $13.8 million for the three months ended June 30, 2012 and
2011, respectively, a period-over-period decrease of $10.7 million.
Accumulated Other Comprehensive Income
The increase in other comprehensive income, related to the increase in net
unrealized gains, totaled approximately $37.3 million and $20.8 million for the
second quarters of 2012 and 2011, respectively, a period-over-period increase of
$16.5 million. Accumulated other comprehensive income increased from
approximately $192.8 million at December 31, 2011 to $237.6 million at June 30,
2012. The increase was due to an increase in net unrealized investment gains,
net of taxes, during the first six months of 2012 of approximately $44.8
million. A decline in interest rates was the primary reason for these
increases.
34
The following information summarizes the components of the unrealized investment
gains:
As of
June 30, 2012 December 31, 2011
(In thousands)
Fixed maturities $ 370,541 $ 313,872
Limited partnerships 30,212 15,994
Common stocks 634 554
Unrealized investment gains 401,387 330,420
Deferred federal income tax expense (127,961)
(103,824)
Amortization (benefit) of deferred (35,784)
(33,781)
acquisition costs
Net unrealized investment gains $ 237,642 $
192,815
Liquidity and Capital Resources
We are an insurance holding company and our primary uses of cash are operating
expenses and dividend payments. Our principal sources of cash are interest on
our investments, dividends from the Insurance Company and rent from our real
estate. During the first and second quarters of 2012, our Board of Directors
declared a quarterly cash dividend of $0.0625 per share payable on April 1, 2012
and July 1, 2012, respectively. During the first six months of 2012, we did not
purchase or retire any shares of common stock.
The Insurance Company is subject to various regulatory restrictions on the
maximum amount of payments, including loans or cash advances, which it may make
to the Company without obtaining prior regulatory approval. Under the New York
Insurance Law, the Insurance Company is permitted, without prior insurance
regulatory clearance, to pay a stockholder dividend to the Company as long as
the aggregate amount of all such dividends in any calendar year does not exceed
the lesser of (i) 10% of its statutory surplus as of the immediately preceding
calendar year or (ii) its net gain from operations for the immediately preceding
calendar year (excluding realized capital gains and losses) on a statutory
basis. The Insurance Company will be permitted to pay a stockholder dividend to
the Company in excess of the lesser of such two amounts only if it files notice
of its intention to declare such a dividend and the amount thereof with the
Superintendent of the NYDFS and the Superintendent does not disapprove the
distribution. Under the New York Insurance Law, the Superintendent has broad
discretion in determining whether the financial condition of a stock life
insurance company would support the payment of such dividends to its
stockholders. The NYDFS has established informal guidelines for such
determinations. The guidelines, among other things, focus on the insurer's
overall financial condition and profitability under statutory accounting
practices. We cannot provide assurance that the Insurance Company will have
statutory earnings to support payment of dividends to us in an amount sufficient
to fund our cash requirements and pay cash dividends or that the Superintendent
will not disapprove any dividends that the Insurance Company must submit for the
Superintendent's consideration. In 2011, the Insurance Company made $26.9
million in dividend payments to us. In the first six months of 2012, the
Insurance Company made $34.25 million in dividend payments to us.
The key need for liquidity in the Insurance Company is the need to fund policy
benefit payments on surrendered or expired annuities. Approximately 36.8% of
the aggregate policyholders' account balances on in-force deferred annuities
held by us have provisions that allow the purchaser to surrender the policy in
exchange for the payment of a surrender fee. In an environment of flat or
falling interest rates, surrender activity is generally low, as annuitants
prefer to lock in the higher rates obtained. In an environment of rising
interest rates, or even in an environment where interest rates are decreasing at
the same time surrender charges are expiring, surrender activity would be
expected to increase, as investors seek to place their money in higher interest
rate instruments. In 2011, annuity surrenders and death claims outpaced new
sales causing a minor decline in total annuity in-force. In 2012, we believe
that surrenders and death claim activity combined with the challenging low
interest rate environment for annuity sales may result in a slight decline in
total annuities in-force. Policyholder account balance surrenders totaled
approximately $49.0 million and $59.2 million for the six-months ended June 30,
2012 and 2011, respectively. In 2012, surrender charges will expire for
approximately 11.2% of aggregate policyholders' account balances on in-force
deferred annuities, or $223.4 million. This allows the annuitant to terminate
or withdraw funds from his or her annuity contract without incurring substantial
penalties in the form of surrender charges. The existing surrender charges act
as a disincentive to surrender, as the annuitant must take into account the cost
of surrender in calculating the likelihood of higher post-surrender returns,
although, if interest rates climb sufficiently, such fees may not have a
significant deterrent effect. Also, our ability to increase the interest rate
on certain of these policies can act as a disincentive to surrender. On the
other hand, a significant reduction in the credited rates at the same time the
surrender charge is expiring can result in an increase in surrenders. We have
operated in the annuity business throughout rising and falling interest rate
periods and have consistently managed this business regardless of the rate
trends. Our ratio of surrenders to average reserves on our deferred annuity
35
business for the second quarter of 2012 and the first six months of 2012 was
approximately 4.1% and 4.8%, respectively, on an annualized basis. As of
December 31, 2011, our ratio of surrenders to average reserves on our deferred
annuity business was 5.5% on an annualized basis.
We conduct testing of our cash flow needs based on varying interest rate
scenarios. These tests are conducted pursuant to the NYDFS requirements and are
filed with that Department. Recent testing indicates that in a moderately
increasing interest rate environment, annuity surrenders would not materially
alter our liquidity needs. This is partially due to the fact that our average
annuity credited rate is somewhat higher than the market average. Our blend of
deferred and immediate annuities and its payor swaption investments operate as a
buffer to us against the impact of interest sensitive surrenders in a possibly
rising interest rate environment.
Our life and accident and health insurance liabilities are actuarially
calculated on a regular basis and we are capable of meeting such liabilities.
Reserves for such business are carefully monitored and regulated by the NYDFS.
Because life and accident and health insurance products represent a relatively
small percentage of our product mix and because the business is heavily
reinsured, it is not anticipated that any spike in life and accident and health
insurance claims would have a material impact on our liquidity.
We do not currently rely on credit facilities to fund our liquidity needs for
the payment of policyholder withdrawals or claims and do not anticipate such a
need in the coming year. Moreover, based on projected trends and in the economy
as a whole on our financial condition, we do not anticipate the need to
liquidate a material amount of our investment portfolio to meet surrender and
policy claim liabilities in the coming year.
Principal sources of funds at the Insurance Company are premiums and other
considerations paid, contract charges earned, net investment income received and
proceeds from investments called, redeemed or sold. The principal uses of these
funds are the payment of benefits on life insurance policies and annuity
contracts, operating expenses and the purchase of investments. Net cash used in
our operating activities (reflecting principally: (i) premiums and contract
charges collected less (ii) benefits paid on life insurance and annuity products
plus (iii) income collected on invested assets, less (iv) commissions and other
general expenses paid) was approximately ($8.7) million and ($17.0) million
during the six months ended June 30, 2012 and 2011, respectively. Net cash
(used in) provided by the Company's investing activities (principally reflecting
investments purchased less investments called, redeemed or sold) was
approximately ($11.3) million, and $73.3 million during the six months ended
June 30, 2012 and 2011, respectively.
For purposes of our consolidated statements of cash flows, financing activities
relate primarily to sales and surrenders of our universal life insurance and
annuity products. The payment of dividends by us is also considered to be a
financing activity. Net cash used in our financing activities amounted to
approximately ($21.9) million and ($44.0) million during the six months ended
June 30, 2012 and 2011, respectively. Under GAAP, consideration from single
premium annuity contracts without life contingencies, universal life insurance
products and deferred annuities are not reported as premium revenues, but are
reported as additions to policyholder account balances, which are liabilities on
our consolidated balance sheet.
Given the Insurance Company's historic cash flow and current financial results,
we believe that, for the next twelve months and for the reasonably foreseeable
future, the Insurance Company's cash flow from investments and operating
activities will provide sufficient liquidity for the operations of the Insurance
Company, as well as provide sufficient funds to us, so that we will be able to
pay our other operating expenses. Due to potential changes in the economic
climate, we can make no assurances with respect to the payment of future
dividends.
To meet our anticipated liquidity requirements, we purchase investments taking
into account the anticipated future cash flow requirements of its underlying
liabilities. In managing the relationship between assets and liabilities, we
analyze the cash flows necessary to correspond with the expected cash needs on
the underlying liabilities under various interest rate scenarios. In addition,
we invest a portion of its total assets in short-term investments, approximately
2.9% and 1.5% as of June 30, 2012 and December 31, 2011, respectively. We
manage the investment portfolio focusing on duration management to support our
current and future liabilities. Through periodic monitoring of the effective
duration of the company's assets and liabilities, we ensure that the degree of
duration mismatch is within the guidelines of our policy which provides for a
mismatch of up to one year. As of June 30, 2012 and December 31, 2011, the
effective duration of the Company's fixed income portfolio was approximately
5.95 and 5.92 years, respectively, which was within one year of our liability
duration.
36
The table below summarizes the credit quality of our fixed maturity securities, excluding preferred
stocks, as of June 30, 2012 and December 31, 2011 as rated by Standard and Poor's.
As of June 30, 2012 As of December 31, 2011
% of Fair % of Fair
(In thousands) Fair Value Value Fair Value Value
US Treasuries $ 43,200 1.2% $ 43,354 1.3%
AAA 131,911 3.8% 145,701 4.2%
AA 407,855 11.7% 380,259 11.1%
A 1,132,066 32.5% 1,065,556 31.0%
BBB, BBB+, BBB- 1,582,673 45.4% 1,588,158 46.2%
BB, BB+, BB- 133,900 3.8% 141,408 4.1%
B 36,687 1.1% 58,773 1.7%
CCC, CC, C or lower 15,667 0.4% 15,252 0.3%
Total $ 3,483,959 100.0% $ 3,438,461 100.0%
On a statutory basis, the Insurance Company is subject to Regulation 130 adopted
and promulgated by the NYDFS. Under this Regulation, the Insurance Company's
ownership of below investment grade debt securities is limited to 20.0% of total
admitted assets, as calculated under statutory accounting practices. As of June
30, 2012 and December 31, 2011, approximately 5.2% and 5.1%, respectively, of
the Insurance Company's total admitted assets were invested in below investment
grade debt securities.
Investments in below investment grade securities have different risks than
investments in corporate debt securities rated investment grade. Risk of loss
upon default by the borrower is significantly greater with respect to below
investment grade securities than with other corporate debt securities because
below investment grade securities generally are unsecured and often are
subordinated to other creditors of the issuer. Also, issuers of below
investment grade securities usually have high levels of indebtedness and often
are more sensitive to adverse economic conditions, such as recession or
increasing interest rates, than are investment grade issuers. Typically, there
is only a thinly traded market for such securities and recent market quotations
may not be available for some of these securities. Market quotes generally are
available only from a limited number of dealers and may not represent firm bids
of such dealers or prices for actual sales. We attempt to reduce the overall
risk in our below investment grade portfolio, as in all of our investments,
through careful credit analysis, investment policy limitations, and
diversification by company and by industry. Below investment grade debt
investments, as well as other investments, are being monitored on an ongoing
basis.
As of June 30, 2012, the carrying value of our investments in limited
partnerships was approximately $176.9 million or 4.5% of the Company's total
invested assets. Pursuant to NYDFS regulations, our investments in equity
securities, including limited partnership interests, may not exceed 20% of our
total invested assets. At June 30, 2012 and December 31, 2011, our investments
in equity securities, including limited partnership interests, were
approximately 4.6% and 4.4%, respectively, of our total invested assets. Such
investments are included in our consolidated balance sheet under the heading
"Limited partnerships". We are committed, if called upon during a specified
period, to contribute an aggregate of approximately $35.9 million of additional
capital to certain of these limited partnerships. However, management does not
expect the entire amount to be drawn down, as certain of our investments in
limited partnerships are nearing the end of the period during which investors
are required to make contributions. Commitments of $34.7 million and $1.1
million will expire in 2012 and 2013, respectively. The commitment expirations
are estimates based upon the commitment periods of each of the partnerships.
Certain partnerships provide, however, that in the event capital from the
investments is returned to the limited partners prior to the end of the
commitment period (generally 3-5 years), the capital may be recalled. In
general, risks associated with such limited partnerships include those related
to their underlying investments (i.e., equity securities, debt securities and
real estate), plus a level of illiquidity, which is mitigated by our ability to
typically take quarterly distributions (to the extent that distributions are
available) of partnership earnings, except for earnings of hedge fund limited
partnerships. There can be no assurance that we will continue to achieve the
same level of returns on our investments in limited partnerships as we have
historically or that we will achieve any returns on such investments at all.
Further, there can be no assurance that we will receive a return of all or any
portion of our current or future capital investments in limited partnerships.
The failure to receive the return of a material portion of our capital
investments in limited partnerships, or to achieve historic levels of return on
such investments, could have a material adverse effect on our financial
condition and results of operations.
All 50 states of the United States and the District of Columbia have insurance
guaranty fund laws requiring all life insurance companies doing business within
the jurisdiction to participate in guaranty associations that are organized to
pay contractual obligations under insurance policies (and certificates issued
under group insurance policies) issued by impaired or insolvent life insurance
companies. These associations levy assessments (up to prescribed limits) on all
member insurers in a particular state on the basis of the proportionate share of
the premiums written by member insurers in the lines of business in which the
impaired or insolvent insurer is engaged. Some states permit member insurers to
recover assessments paid through full or partial premium tax offsets. These
assessments may be deferred or forgiven under most guaranty laws if they would
threaten an insurer's solvency. The amount of
37
these assessments in prior years has not been material. However, the amount and
timing of any future assessment on the Insurance Company under these laws cannot
be reasonably estimated and are beyond our control.
Market Risk
Market risk is the risk of loss arising from adverse changes in market rates and
prices, such as interest rates, foreign currency exchange rates and other
relevant market rate or price changes. Market risk is directly influenced by
the volatility and liquidity in the markets in which the related underlying
assets are traded.
We believe that a portfolio composed principally of fixed-rate investments that
generate predictable rates of return should support our fixed-rate liabilities.
We do not have a specific target rate of return. Instead, our rates of return
vary over time depending on the current interest rate environment, the slope of
the yield curve, the spread at which fixed-rate investments are priced over the
yield curve, and general economic conditions. Our portfolio strategy is designed
to achieve adequate risk-adjusted returns consistent with our investment
objectives of effective asset-liability matching, liquidity and safety.
The market value of our fixed maturity portfolio changes as interest rates
change. In general, rate decreases causes asset prices to rise, while rate
increases causes asset prices to fall.
Asset/Liability Management
A persistent focus of the Insurance Company's management is maintaining the
appropriate balance between the duration of its invested assets and the duration
of its contractual liabilities to its annuity holders and credit suppliers.
Towards this end, at least quarterly, our investment department determines the
duration of our invested assets in coordination with our actuaries, who are
responsible for calculating the liability duration. In the event it is
determined that the duration gap between our assets and liabilities exceeds a
one year target level, we re-position our assets through the sale of invested
assets or the purchase of new investments.
As an element of our asset liability management strategy, we have utilized
hedges against the risks posed by a rapid and sustained rise in interest rates
by entering into a form of derivative transaction known as payor swaptions.
Swaptions are options to enter into an interest rate swap arrangement with a
counterparty (major money-center U.S. bank) at a specified future date. At
expiration, the counterparty would be required to pay the Insurance Company the
amount of the present value of the difference between the fixed rate of interest
on the swap agreement and a specified strike rate in the agreement multiplied by
the notional amount of the swap agreement. The total notional amount of our
three payor swaptions at June 30, 2012 was $221.5 million and the swaptions
expire annually from January 2015 through 2017. The effect of these
transactions would be to lessen the negative impact on the Insurance Company of
a significant and prolonged increase in interest rates on the valuation of fixed
maturity investments. With the swaptions, we should be able to maintain more
competitive crediting rates to policyholders when interest rates rise.
We have determined that the payor swaptions represent a "non-qualified hedge".
These investments are classified on the balance sheet as "Derivative
Instruments". The value of the payor swaptions is recognized at "fair value"
(market value), with any change in fair value reflected in the income statement
as a realized gain or loss. The market value of the Payor Swaptions totalled
$2,209,720 at June 30, 2012. This represented a decrease in market value since
December 31, 2011 of $1,148,082.
We conduct periodic cash flow tests assuming different interest rates scenarios
in order to demonstrate the reserve adequacy. If a test reveals a potential
deficiency, we may be required to increase our reserves to satisfy its statutory
accounting requirements. Based on testing as of December 31, 2011, the Insurance
Company holds a reserve of $7.7 million which satisfies the statutory
requirements.
Off-Balance Sheet Arrangements
We have not entered into any off-balance sheet financing arrangements and have
made no financial commitments or guarantees with any unconsolidated subsidiary
or special purpose entity. All of our subsidiaries are wholly owned and their
results are included in the accompanying consolidated financial statements.
38
Less than After
Contractual Obligations 1 Year 1-3 Years 4-5 Years 5 Years Total
(In thousands)
Policy Liabilities (1) $ 561,776 $ 859,200 $ 588,803 $ 2,365,094 $ 4,374,873
Unfunded Limited
Partnership Commitments
(2) $ 34,743 $ 1,138 $ - $ - $ 35,881
FIN 48 Liabilities $ (594) $ 299 $ 325 $ - $ 30
Purchase obligations and $ 400 $ 300 $ 203 $ - $ 903
Other (3)
Total Contractual $ 596,325 $ 860,937 $ 589,331 $ 2,365,094 $ 4,411,687
Obligations
(1) The difference between the recorded liability of $3,035.4 million, and the
total payment obligation amount of $4.374.9 million, is $1,339.5 million and is
comprised of (i) future interest to be credited; (ii) the effect of mortality
discount for those payments that are life contingent; and (iii) the impact of
surrender charges on those contracts that have such charges. Of the total
payment of $4,374.9 million, $2,876.9 million, or approximately 65.8%, is from
our deferred annuity, life, and accident and health business. Determining the
timing of these payments involves significant uncertainties, including
mortality, morbidity, persistency, investment returns, and the timing of
policyholder surrender. Notwithstanding these uncertainties, the table reflects
an estimate of the timing of such payments.
(2) See Note 2 "Investments", of the consolidated financial statements
(3) Purchase obligations include contracts where we have a non-cancelable
commitment to purchase goods and services.
Effects of Inflation and Interest Rate Changes
In a rising interest rate environment, our average cost of funds would be
expected to increase over time, as we price our new and renewing annuities to
maintain a generally competitive market rate. In addition, the market value of
our fixed maturity portfolio would be expected to decrease, resulting in a
decline in shareholders' equity. Concurrently, we would attempt to place new
funds in investments that were matched in duration to, and higher yielding than,
the liabilities associated with such annuities. Moreover, surrenders of our
outstanding annuities would likely accelerate. Management believes that
liquidity necessary in such an interest rate environment to fund withdrawals,
including surrenders, would be available through income, cash flow, our cash
reserves and, if necessary, proceeds from the monetization of the payor swaption
investments described above and the sale of short-term and long-term
investments.
In a declining interest rate environment, our cost of funds would be expected to
decrease over time, reflecting lower interest crediting rates on our fixed
annuities. Conversely, in an increasing interest rate environment, the cost of
funds would be expected to increase, reflecting higher interest crediting rates.
Should increased liquidity be required for withdrawals in such an interest rate
environment, management believes that the portion of our investments that are
designated as available for sale in our consolidated balance sheet could be sold
without materially adverse consequences in light of the general strengthening in
market prices that would be expected in the fixed maturity security market.
Interest rate changes also may have temporary effects on the sale and
profitability of our annuity products. For example, if interest rates rise,
competing investments (such as annuity or life insurance products offered by our
competitors, certificates of deposit, mutual funds and similar instruments) may
become more attractive to potential purchasers of our products until we increase
the rates credited to holders of our annuity products. In contrast, as interest
rates fall, we would attempt to lower our credited rates to compensate for the
corresponding decline in net investment income. As a result, changes in
interest rates could materially adversely affect our financial condition and
results of operations depending on the attractiveness of alternative investments
available to our customers. In that regard, in the current interest rate
environment, we have attempted to maintain our credited rates at competitive
levels designed to discourage surrenders and also to be considered attractive to
purchasers of new annuity products.
CRITICAL ACCOUNTING ESTIMATES
The preparation of financial statements in conformity with accounting principles
generally accepted in the United States of America (²GAAP²) requires management
to adopt accounting policies and make estimates and assumptions that affect
amounts reported in the consolidated financial statements. In applying these
accounting policies, we make subjective and complex judgments that frequently
require estimates about matters that are inherently uncertain. Many of these
policies, estimates and related judgments are common in the insurance and
financial services industries; others are specific to the Insurance Company's
business operations. The accounting policies we considered to be critically
important in the preparation and understanding of our financial statements and
related disclosures are presented in Item 7. Management's Discussion and
Analysis of Financial Condition and Results of Operations
39
of our Annual Report on Form 10-K for the year ended December 31, 2011.
New Accounting Pronouncements
See Note 1(L) of the consolidated financial statements for a full description of
the new accounting pronouncements including the respective dates of adoption and
the effects on the results of our operations and financial condition.
