10-K 1 a2153630z10-k.txt FORM 10-K UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 ---------- FORM 10-K Registrant meets the conditions set forth in General Instruction I (1)(a) and (b) of Form 10-K and is therefore filing this Form with the reduced disclosure format. /X/ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 2004 OR / / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 COMMISSION FILE NUMBER: 333-100029 ALLSTATE LIFE INSURANCE COMPANY OF NEW YORK (Exact name of registrant as specified in its charter) NEW YORK 36-2608394 (State of Incorporation) (I.R.S. Employer Identification No.) 100 MOTOR PARKWAY, SUITE 132 HAUPPAUGE, NEW YORK 11788 (Address of principal executive offices) (Zip code) Registrant's telephone number, including area code: 631-357-8920 Securities registered pursuant to Section 12(b) or 12(g) of the Securities Exchange Act of 1934: None 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, and (2) has been subject to such filing requirements for the past 90 days. Yes /X/ No / / Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant's knowledge, in definitive proxy or other information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. /X/ Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Securities Exchange Act of 1934). Yes / / No /X/ None of the common equity of the registrant is held by non-affiliates. Therefore, the aggregate market value of common equity held by non-affiliates of the registrant is zero. As of March 15, 2005, the registrant had 100,000 common shares, $25 par value, outstanding, all of which are held by Allstate Life Insurance Company. TABLE OF CONTENTS
PAGE ---- PART I Item 1. Business 1 Item 2. Properties 2 Item 3. Legal Proceedings 2 Item 4. Submission of Matters to a Vote of Security Holders * N/A PART II Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities 2 Item 6. Selected Financial Data * N/A Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations 2 Item 7A. Quantitative and Qualitative Disclosures about Market Risk 31 Item 8. Financial Statements and Supplementary Data 32 Item 9. Change in and Disagreements with Accountants on Accounting and Financial Disclosure 65 Item 9A. Controls and Procedures 65 PART III Item 10. Directors and Executive Officers of the Registrant * N/A Item 11. Executive Compensation * N/A Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters* N/A Item 13. Certain Relationships and Related Transactions * N/A Item 14. Principal Accountant Fees and Services 65 PART IV Item 15. Exhibits and Financial Statement Schedules 66 Signatures 69 Supplemental Information to be Furnished With Reports Filed Pursuant to Section 15(d) of the Securities Exchange Act of 1934 by Registrants Which Have Not Registered Securities Pursuant to Section 12 of the Securities Exchange Act of 1934 70 Financial Statement Schedules S-1 * Omitted pursuant to General Instruction I(2) of Form 10-K
PART I ITEM 1. BUSINESS Allstate Life Insurance Company of New York ("Allstate Life of New York", "ALNY", "we", "us" or "our") was incorporated in 1967 as a stock life insurance company under the laws of the State of New York. In 1984, ALNY was purchased by Allstate Life Insurance Company ("ALIC"). Allstate Life of New York is a wholly owned subsidiary of ALIC, a stock life insurance company incorporated under the laws of the State of Illinois. ALIC is a wholly owned subsidiary of Allstate Insurance Company, a stock property-liability insurance company organized under the laws of the State of Illinois. All of the outstanding capital stock of Allstate Insurance Company ("AIC") is owned by The Allstate Corporation (the "Corporation" or "Allstate"), a publicly owned holding company incorporated under the laws of the State of Delaware. The Corporation is the largest publicly held personal lines insurer in the United States. Widely known through the "You're In Good Hands With Allstate (R)" slogan, Allstate provides insurance products to more than 16 million households and has approximately 13,600 exclusive agencies and exclusive financial specialists in the United States and Canada. Allstate is the second-largest personal property and casualty insurer in the United States on the basis of 2003 statutory premiums earned. In addition, it is the nation's 12th largest life insurance business on the basis of 2003 ordinary life insurance in force and 19th largest on the basis of 2003 statutory admitted assets. Our mission is to assist financial services professionals in meeting their clients' financial protection, savings and retirement needs by providing top-tier products delivered with reliable and efficient service. We will pursue the following to grow our current business profitably: maintain and develop focused, top-tier products; deepen distribution partner relationships; improve our cost structure; and advance our systematic risk management program. We also leverage the strength of the Allstate brand name across products and distribution channels. Our retail products include interest-sensitive and traditional life insurance, variable life insurance, variable and fixed annuities and supplemental accident and health insurance. Products are sold through a variety of distribution channels including Allstate exclusive agencies, independent agents (including master brokerage agencies and workplace enrolling agents), and financial service firms such as banks, broker/dealers and special structured settlement brokers. We compete principally on the basis of the scope of our distribution systems, the breadth of our product offerings, the recognition of our brand, our financial strength and ratings, our product features and prices, and the level of customer service that we provide. In addition, with respect to variable annuity and variable life insurance products in particular, we compete on the basis of the variety of fund managers and choices of funds for our separate accounts and the management and performance of those funds within our separate accounts. The market for life insurance, annuities and personal financial products continues to be highly fragmented and competitive. As of December 31, 2004, there were approximately 770 groups of life insurance companies in the United States, most of which offered one or more similar products. In addition, because many of these products include a savings or investment component, our competition includes domestic and foreign securities firms, investment advisors, mutual funds, banks and other financial institutions. Competitive pressure is growing due to several factors, including cross marketing alliances between unaffiliated businesses, as well as consolidation activity in the financial services industry. Allstate Life of New York is subject to extensive regulation, primarily, but not exclusively, from the New York State Insurance Department. The method, extent and substance of such regulation generally has its source in statutes that establish standards and requirements for conducting the business of insurance and that delegate regulatory authority to the New York State Insurance Department. In general, such regulation is intended for the protection of those who purchase or use our insurance products. These rules have a substantial effect on our business and relate to a wide variety of matters including insurance company licensing and examination, agent licensing and compensation, trade practices, policy forms, accounting methods, the nature and amount of investments, claims practices, participation in guaranty funds, reserve adequacy, insurer solvency, transactions with affiliates, the payment of dividends, and underwriting standards. For a discussion of statutory financial information, see Note 13 of the Financial Statements. For a discussion of regulatory contingencies, see Note 11 of the Financial Statements. Notes 11 and 13 are incorporated in this Part I, Item 1 by reference. In recent years the state insurance regulatory framework has come under increased federal scrutiny. Legislation that would provide for federal chartering of insurance companies has been proposed. In addition, state legislators and insurance regulators continue to examine the appropriate nature and scope of state insurance regulation. We cannot predict whether any specific state or federal measures will be adopted to change the nature or scope of the regulation of the insurance business or what effect any such measures would have on Allstate Life of New York. 1 ITEM 2. PROPERTIES Allstate Life of New York occupies office space in Hauppauge, New York and Northbrook, Illinois that is owned or leased by AIC. Expenses associated with these facilities are allocated to us on both a direct and indirect basis, depending on the nature and use. ITEM 3. LEGAL PROCEEDINGS Information required for Item 3 is incorporated by reference to the discussion under the headings "Regulation" and "Legal proceedings" in Note 11 of our financial statements. PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES No established public trading market exists for our common stock. All of our outstanding common stock is owned by our parent, ALIC. ALIC's outstanding common stock is owned by AIC. All of the outstanding common stock of AIC is owned by the Corporation. Within the past three years, we have not sold or repurchased any of our equity securities. From January 1, 2003 through March 15, 2005, we paid no dividends on our common stock to ALIC. For additional information on dividends, including restrictions on the payment of dividends, see the discussion under the heading "Dividends" in Note 13 of our financial statements, which is incorporated herein by reference. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW The following discussion highlights significant factors influencing the financial position and results of operations of Allstate Life Insurance Company of New York (referred to in this document as "we", "ALNY", "our", "us" or the "Company"). It should be read in conjunction with the financial statements and related notes found under Part II Item 8 contained herein. We are managed as a single segment entity. The most important matters that we monitor to evaluate the financial condition and performance of our company include: - For operations: premiums, deposits, gross margins including investment and benefit margins, the amortization of deferred policy acquisition costs, expenses, operating income, and invested assets; - For Investments: credit quality/experience, stability of long-term returns, cash flows and asset and liability duration; - For financial condition: our financial strength ratings and statutory capital levels and ratios; and - For product distribution: profitably growing distribution partner relationships and Allstate agent sales of all products and services. 2 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONT.) APPLICATION OF CRITICAL ACCOUNTING POLICIES We have identified four accounting policies that require us to make assumptions and estimates that are significant to the financial statements. It is reasonably likely that changes in these assumptions and estimates could occur from period to period and have a material impact on our financial statements. A brief summary of each of these critical accounting policies follows. For a more complete discussion of the effect of these policies on our financial statements, and the judgments and estimates relating to these policies, see the referenced sections of the MD&A. For a complete summary of our significant accounting policies see Note 2 of the financial statements. INVESTMENT VALUATION The fair value of publicly traded fixed income securities is based on independent market quotations, whereas the fair value of non-publicly traded securities is based on either widely accepted pricing valuation models which use internally developed ratings and independent third party data as inputs or independent third party pricing sources. Factors used in our internally developed models, such as liquidity risk associated with privately-placed securities, are difficult to independently observe and to quantify. Because of this, judgment is required in developing certain of these estimates and, as a result, the estimated fair value of non-publicly traded securities may differ from amounts that would be realized upon an immediate sale of the securities. Periodic changes in fair values of investments classified as available for sale are reported as a component of accumulated other comprehensive income on the Statements of Financial Position and are not reflected in the operating results of any period until reclassified to net income upon the consummation of a transaction with an unrelated third party, or when declines in fair values are deemed other than temporary. The assessment of other than temporary impairment of a security's fair value is performed on a case-by-case basis considering a wide range of factors. There are a number of assumptions and estimates inherent in assessing impairments and determining if they are other than temporary, including 1) our ability and intent to retain the investment for a period of time sufficient to allow for an anticipated recovery in value; 2) the expected recoverability of principal and interest; 3) the duration and extent to which the fair value has been less than amortized cost; 4) the financial condition, near-term and long-term prospects of the issuer, including relevant industry conditions and trends, and implications of rating agency actions and offering prices; and 5) the specific reasons that a security is in a significant unrealized loss position, including market conditions which could affect liquidity. Additionally, once assumptions and estimates are made, any number of changes in facts and circumstances could cause us to later determine that an impairment is other than temporary, including 1) general economic conditions that are worse than previously assumed or that have a greater adverse effect on a particular issuer than originally estimated; 2) changes in the facts and circumstances related to a particular issuer's ability to meet all of its contractual obligations; and 3) changes in facts and circumstances or new information that we obtain which causes a change in our ability or intent to hold a security to maturity or until it recovers in value. Changes in assumptions, facts and circumstances could result in additional charges to earnings in future periods to the extent that losses are realized. The charge to earnings, while potentially significant to net income, would not have a significant effect on shareholder's equity since the majority of our portfolio is held at fair value and as a result, any related unrealized loss, net of deferred acquisition costs, deferred sales inducement costs and tax, would already be reflected as accumulated other comprehensive income in shareholder's equity. For a more detailed discussion of the risks relating to changes in investment values and levels of investment impairment, and the potential causes of such changes, see Note 6 of the financial statements and the Investments, Market Risk, and Forward-looking Statements and Risk Factors sections of the MD&A. DERIVATIVE INSTRUMENT HEDGE EFFECTIVENESS In the normal course of business, we primarily use derivative financial instruments to reduce our exposure to market risk and in conjunction with asset/liability management. The fair value of exchange traded derivative contracts is based on independent market quotations, whereas the fair value of non-exchange traded derivative contracts is based on either widely accepted pricing valuation models which use independent third party data as inputs or independent third party pricing sources. When derivatives meet specific criteria, they may be designated as accounting hedges and accounted for as fair value, cash flow, foreign currency fair value, or foreign currency cash flow hedges. When designating a derivative as an accounting hedge, we formally document the hedging relationship, risk management objective and strategy. The documentation identifies the hedging instrument, the hedged item, the nature of the risk being hedged and the assumptions used to assess how effective the hedging instrument is in offsetting the exposure to changes in the hedged item's fair value attributable to the hedged risk. In the case of a cash flow hedge, this documentation includes the exposure to changes in the hedged transaction's variability in cash flows attributable to the hedged risk. We do not exclude any component of the change in fair value of the hedging instrument from the effectiveness assessment. At each reporting date, we confirm that the hedging instrument continues to be 3 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONT.) highly effective in offsetting the hedged risk. The determination of whether a hedging instrument is effective both at its inception and on an on-going basis requires a significant degree of judgment. For further discussion of these policies and quantification of the impact of these estimates and assumptions, see Note 7 of the financial statements and the Investments, Market Risk and Forward-looking Statements and Risk Factors sections of the MD&A. DEFERRED POLICY ACQUISITION COST ("DAC") AMORTIZATION We incur significant costs in connection with acquiring business. In accordance with generally accepted accounting principles ("GAAP"), costs that vary with and are primarily related to acquiring business are deferred and recorded as an asset on the Statements of Financial Position. The amortization methodology for DAC includes significant assumptions and estimates. DAC related to traditional life insurance is amortized over the premium paying period of the related policies in proportion to the estimated revenues on such business. Assumptions relating to estimated premiums, investment income and realized capital gains and losses, as well as to all other aspects of DAC are determined based upon conditions as of the date of policy issuance and are generally not revised during the life of the policy. Any deviations from projected business in force, resulting from actual policy terminations differing from expected levels, and any estimated premium deficiencies, change the rate of amortization in the period such events occur. DAC related to interest-sensitive life, variable annuities and investment contracts is amortized in proportion to the incidence of the present value of estimated gross profits ("EGP") over the estimated lives of the contracts. Generally, the amortization period ranges from 15-30 years. However, an assumption for the rate of contract surrenders is also used, which results in the majority of the DAC being amortized over the surrender charge period. The rate of amortization during the surrender charge period is matched to the actual pattern of EGP. EGP consists of estimates of the following components: benefit margins primarily from mortality, including guaranteed minimum death, income and accumulation benefits; investment margin including realized capital gains and losses; and contract administration, surrender and other contract charges, less maintenance expenses. For variable annuity and life contracts, the most significant assumptions involved in determining EGP are the expected separate accounts fund performance after fees, surrender rates, lapse rates, and investment and mortality margins. Our long-term assumption of separate accounts fund performance net of fees is approximately 8%. Whenever actual separate accounts fund performance, based on the two most recent years, varies from 8%, we project performance levels over the next five years such that the mean return over that seven-year period equals the long-term 8% assumption. This process is referred to as "reversion to the mean" and is commonly used by the life insurance industry. Although the use of a reversion to the mean assumption is common within the industry, the parameters used in the methodology are subject to judgment and vary between companies. For example, when applying this assumption we do not allow the mean future rates of return after fees projected over the five-year period to exceed 12.75% or fall below 0%. Revisions to EGPs result in changes in the amounts expensed as a component of amortization of DAC in the period in which the revision is made. This is commonly known as "DAC unlocking". For quantification of the impact of these estimates and assumptions see the Forward-looking Statements and Risk Factors sections of the MD&A and Note 2 of the financial statements. RESERVE FOR LIFE-CONTINGENT CONTRACT BENEFITS ESTIMATION Long-term actuarial assumptions of future investment yields, mortality, morbidity, policy terminations and expenses are used when establishing the reserve for life-contingent contract benefits. These assumptions, which for traditional life insurance are applied using the net level premium method, include provisions for adverse deviation and generally vary by such characteristics as type of coverage, year of issue and policy duration. Future investment yield assumptions are determined at the time the policy is issued based upon prevailing investment yields as well as estimated reinvestment yields. Mortality, morbidity and policy termination assumptions are based on our experience and industry experience prevailing at the time the policies are issued. Expense assumptions include the estimated effects of inflation and expenses to be incurred beyond the premium-paying period. For further discussion of these policies see Note 8 of the financial statements and the Forward-looking Statements and Risk Factors section of the MD&A. 4 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONT.) OPERATIONS OVERVIEW AND STRATEGY We are a wholly owned subsidiary of Allstate Life Insurance Company ("ALIC"), which is a wholly owned subsidiary of Allstate Insurance Company ("AIC"), a wholly owned subsidiary of The Allstate Corporation (the "Corporation"). ALIC, along with ALNY and its other wholly owned subsidiaries, provide life insurance, retirement and investment products to individual and institutional customers. Our mission is to assist financial services professionals in meeting their clients' financial protection, savings and retirement needs by providing top-tier products delivered with reliable and efficient service. We will pursue the following to grow our current business profitably: maintain and develop focused, top-tier products; deepen distribution partner relationships; improve our cost structure; and advance our systematic risk management program. We also leverage the strength of the Allstate brand name across products and distribution channels. PREMIUMS AND CONTRACT CHARGES Premiums represent revenues generated from traditional life, immediate annuities with life contingencies and other insurance products that have significant mortality or morbidity risk. Contract charges are revenues generated from interest-sensitive life, variable and fixed annuities for which deposits are classified as contractholder funds or separate accounts liabilities. Contract charges are assessed against the contractholder account values for maintenance, administration, cost of insurance and surrender prior to contractually specified dates. As a result, changes in contractholder funds and separate accounts liabilities are considered in the evaluation of growth and as indicators of future levels of revenues. The following table summarizes premiums and contract charges by product.
(IN THOUSANDS) 2004 2003 2002 --------- --------- --------- PREMIUMS Traditional life $ 23,786 $ 22,998 $ 22,379 Immediate annuities with life contingencies 49,877 36,371 62,124 Accident, health and other 2,887 8,642 8,767 --------- --------- --------- TOTAL PREMIUMS 76,550 68,011 93,270 CONTRACT CHARGES Interest-sensitive life 40,400 38,042 36,241 Variable annuities 13,222 10,084 10,657 Fixed annuities 6,212 4,892 3,184 --------- --------- --------- TOTAL CONTRACT CHARGES 59,834 53,018 50,082 --------- --------- --------- TOTAL PREMIUMS AND CONTRACT CHARGES $ 136,384 $ 121,029 $ 143,352 ========= ========= =========
The following table summarizes premiums and contract charges by distribution channel.
(IN THOUSANDS) 2004 2003 2002 --------- --------- --------- PREMIUMS Allstate agencies $ 23,409 $ 22,664 $ 22,309 Broker dealers 107 37 - Specialized brokers 49,768 36,334 62,124 Independent agents 3,162 1,643 89 Direct marketing 104 7,333 8,748 --------- --------- --------- TOTAL PREMIUMS 76,550 68,011 93,270 CONTRACT CHARGES Allstate agencies 39,710 38,296 36,602 Broker dealers 10,892 8,934 9,878 Banks 4,964 2,213 1,293 Specialized brokers 3,802 3,403 2,282 Independent agents 466 172 27 --------- --------- --------- Total contract charges 59,834 53,018 50,082 --------- --------- --------- TOTAL PREMIUMS AND CONTRACT CHARGES $ 136,384 $ 121,029 $ 143,352 ========= ========= =========
5 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONT.) Total premiums increased 12.6% in 2004 compared to 2003. The increase was the result of increased premiums on immediate annuities with life contingencies and supplemental accident and health insurance sold through the workplace, partially offset by decreased other premiums resulting from the disposal of substantially all of our direct response distribution business. Sales of immediate annuities with life contingencies fluctuate due to consumer preference as well as market and competitive conditions, which drive the level and mix of immediate annuities sold with or without life contingencies. Excluding premiums on immediate annuities with life contingencies and premiums from our disposed direct response distribution business, premiums increased 9.3% compared to 2003, due to the continued expansion of our supplemental accident and health insurance sold through the workplace. Total premiums decreased 27.1% in 2003 compared to 2002. The decrease was primarily the result of a decline in sales of immediate annuities with life contingencies and the discontinuance of our direct response business. The decline in premiums from our direct response business reflects management actions to discontinue this business. Excluding the volatility of the immediate annuities with life contingencies, premiums increased a modest 1.6% as an 8.7% increase in traditional life premiums sold through our Allstate exclusive and independent agencies was mostly offset by lower premiums from products sold through direct marketing. Contract charges increased 12.9% in 2004 compared to 2003. The increase was primarily attributable to higher contract charges on variable annuities and interest-sensitive life. The increase in contract charges on variable annuities was driven by a 21.2% increase in the average separate accounts values in 2004 compared to 2003, which was attributable to net deposits and transfers to the separate accounts and positive investment performance exceeding the surrenders and withdrawals. Higher interest-sensitive life contract charges primarily reflect growth in business in-force. Contract charges increased 5.9% in 2003 compared to 2002. Higher interest-sensitive life and fixed annuity contract charges were partially offset by lower variable annuity contract charges, which resulted from lower average separate accounts values during the year. The increase in the interest sensitive-life and fixed annuities is representative of the growth in the amount of business in-force. 6 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONT.) CONTRACTHOLDER FUNDS represent interest-bearing liabilities arising from the sale of fixed annuities, interest-sensitive life and variable annuity and life deposits allocated to fixed accounts. The balance of contractholder funds is equal to the cumulative deposits received and interest credited to the contractholder less cumulative contract maturities, benefits, surrenders, withdrawals and contract charges for mortality or administrative expenses. The following table shows the changes in contractholder funds.
(IN THOUSANDS) 2004 2003 2002 ------------ ------------ ------------ CONTRACTHOLDER FUNDS, BEGINNING BALANCE $ 2,658,325 $ 2,051,429 $ 1,438,640 Impact of adoption of SOP 03-1 (1) 2,031 - - DEPOSITS: Fixed annuities (immediate and deferred) 1,182,719 511,824 388,758 Interest-sensitive life 99,182 69,449 54,961 Variable annuity and life deposits allocated to fixed accounts 103,463 147,515 315,659 ------------ ------------ ------------ Total deposits 1,385,364 728,788 759,378 INTEREST CREDITED 129,243 106,020 87,555 BENEFITS, WITHDRAWALS AND OTHER ADJUSTMENTS Benefits (46,649) (24,103) (17,257) Surrenders and partial withdrawals (246,081) (150,102) (116,485) Contract charges (41,573) (40,554) (33,892) Net transfers to separate accounts (39,906) (16,944) (37,252) Other adjustments 2,092 3,791 (29,258) ------------ ------------ ------------ TOTAL BENEFITS, WITHDRAWALS AND OTHER ADJUSTMENTS (372,117) (227,912) (234,144) ------------ ------------ ------------ CONTRACTHOLDER FUNDS, ENDING BALANCE $ 3,802,846 $ 2,658,325 $ 2,051,429 ============ ============ ============
--------------- (1) The increase in contractholder funds due to the adoption of SOP 03-1 reflects the establishment of reserves for certain liabilities that are primarily related to income benefit guarantees provided under variable annuities and the reclassification of deferred sales inducements ("DSI") from contractholder funds to other assets. Contractholder funds deposits increased 90.1% in 2004 compared to 2003 due to increased fixed annuity and interest-sensitive life deposits, partially offset by lower variable annuity and life deposits allocated to fixed accounts. These deposits led to an increase in average contractholder funds, excluding the impact of adopting SOP 03-1, of 37.1% in 2004 compared to 2003. Fixed annuity deposits increased 131.1% in 2004 compared to 2003 due to strong consumer demand, competitive pricing and effective distribution efforts in our bank channel. Contractholder funds deposits decreased 4.0% in 2003 compared to 2002 due to decreased deposits to the fixed account of variable annuities from lower variable annuity contract sales that more than offset a significant increase in fixed annuity deposits. Average contractholder funds increased 35.0% in 2003 compared to 2002 as a result of fixed annuity deposits that increased 31.9% over 2002 due to competitive pricing and our decision to maintain a market presence in our bank distribution channel despite a challenging interest rate environment. Fixed annuities have been attractive to consumers in this distribution channel due to volatile equity markets and the uncertainty of future interest rates. Benefits, surrenders and partial withdrawals increased 68.0% in 2004 compared to 2003 reflecting a withdrawal rate of 11.0% for 2004 based on the beginning of period contractholder funds. This compares to a withdrawal rate of 8.5% and 9.3% for 2003 and 2002, respectively. Surrenders and withdrawals may vary with changes in interest rates and equity market conditions and the aging of our in-force contracts. 7 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONT.) SEPARATE ACCOUNTS LIABILITIES represent contractholders' claims to the related legally segregated separate accounts assets. Separate accounts liabilities primarily arise from the sale of variable annuity contracts and variable life insurance policies. The following table shows the changes in separate accounts liabilities.
(IN THOUSANDS) 2004 2003 2002 ---------- ---------- ---------- SEPARATE ACCOUNTS LIABILITIES, BEGINNING BALANCE $ 665,875 $ 537,204 $ 602,657 Variable annuity and life deposits 210,601 230,114 420,635 Variable annuity and life deposits allocated to fixed accounts (103,463) (147,515) (315,659) ---------- ---------- ---------- Net deposits 107,138 82,599 104,976 Investment results 70,960 114,539 (98,107) Contract charges (10,399) (7,894) (7,851) Net transfers from fixed accounts 39,906 16,944 37,252 Surrenders and benefits (80,930) (77,517) (101,723) ---------- ---------- ---------- SEPARATE ACCOUNTS LIABILITIES, ENDING BALANCE $ 792,550 $ 665,875 $ 537,204 ========== ========== ==========
Separate accounts liabilities increased $126.7 million during 2004. The increase was primarily attributable to positive investment results and net cash inflows from net deposits and transfers from fixed accounts partially offset by surrenders and benefits. Variable annuity contractholders often allocate a significant portion of their initial variable annuity contract deposit into a fixed rate investment option. The level of this activity is reflected above in the deposits allocated to fixed accounts, while all other transfer activity between the fixed and separate accounts investment options is reflected in net transfers from fixed accounts. The liability for the fixed portion of variable annuity contracts is reflected in contractholder funds. Separate accounts liabilities increased $128.7 million during 2003 reflecting positive investment results and, to a lesser extent, net cash inflows. Net variable annuity deposits decreased in 2003 compared to 2002 as significant deposits in 2002 were made and transferred to the fixed accounts because of the attractive crediting rates. These rates were lowered in late 2002 resulting in lower variable annuity contract sales. NET INVESTMENT INCOME increased 14.0% in 2004 compared to 2003 and 13.7% in 2003 compared to 2002. The increase in both periods was the result of the effect of higher portfolio balances, partially offset by lower portfolio yields. Higher portfolio balances resulted from the investment of cash flows from operating and financing activities related primarily to deposits from fixed annuities and interest-sensitive life policies. Investment balances as of December 31, 2004, increased 27.2% from December 31, 2003 and increased 15.7% as of December 31, 2003 compared to December 31, 2002. The lower portfolio yields were primarily due to purchases, including reinvestments, of fixed income securities with yields lower than the current portfolio average. 8 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONT.) NET INCOME analysis is presented in the following table.
(IN THOUSANDS) 2004 2003 2002 ---------- ---------- ---------- Premiums $ 76,550 $ 68,011 $ 93,270 Contract charges (1) 59,817 53,018 50,082 Net investment income 302,055 264,854 232,967 Periodic settlements and accruals on non-hedge derivative instruments (2) 372 - - Contract benefits (182,150) (167,221) (178,163) Interest credited to contractholder funds (3) (129,044) (106,020) (87,555) ---------- ---------- ---------- Gross margin 127,600 112,642 110,601 Amortization of DAC and DSI (24,579) (28,273) (24,556) Operating costs and expenses (42,115) (36,978) (37,339) Income tax expense (21,845) (17,520) (17,151) Realized capital gains and losses, after-tax (5,844) (5,240) (8,028) DAC and DSI amortization expense on realized capital gains and losses, after-tax (1,342) (1,043) 652 Reclassification of periodic settlements and accruals on non-hedge derivative instruments, after-tax (234) - - Gain (loss) on disposition of operations, after-tax 862 (2,898) - Cumulative effect of change in accounting principle, after-tax (7,586) - - ---------- ---------- ---------- NET INCOME $ 24,917 $ 20,690 $ 24,179 ========== ========== ==========
(1) Loads charged to customers at the inception of interest-sensitive life contracts are deferred and amortized to income in a manner consistent with DAC. Amortization of deferred loads related to capital gains is excluded from contract charges for purposes of calculating gross margin. Amortization of deferred loads related to capital gains totaled $17 thousand in 2004. There were no comparable amounts in 2003 and 2002. (2) Periodic settlements and accruals of non-hedge derivative instruments are reflected as a component of realized capital gains and losses on the Statements of Operations and Comprehensive Income. (3) Beginning in 2004, amortization of deferred sales inducements ("DSI") is excluded from interest credited to contractholder funds for purposes of calculating gross margin. Amortization of DSI totaled $760 thousand in 2004. Prior periods have not been restated. GROSS MARGIN, a non-GAAP measure, represents premiums and contract charges and net investment income, less contract benefits and interest credited to contractholder funds. We use gross margin as a component of our evaluation of the profitability of our life insurance and financial product portfolio. Additionally, for many of our products, including fixed annuities, variable life and annuities, and interest-sensitive life insurance, the amortization of DAC and DSI is determined based on actual and expected gross margin. Gross margin is comprised of four components that are utilized to further analyze the business: investment margin, benefit margin, maintenance charges and surrender charges. We believe gross margin and its components are useful to investors because they allow for the evaluation of income components separately and in the aggregate when reviewing performance. Gross margin, investment margin and benefit margin should not be considered as a substitute for net income and do not reflect the overall profitability of the business. Net income is the GAAP measure that is most directly comparable to these margins. Gross margin is reconciled to GAAP net income in the table above. 9 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONT.) The components of gross margin are reconciled to the corresponding financial statement line items in the following table.
2004 ------------------------------------------------------------------------------ INVESTMENT BENEFIT MAINTENANCE SURRENDER GROSS MARGIN MARGIN CHARGES CHARGES MARGIN -------------- ------------- ------------- ------------- ------------- (IN THOUSANDS) Premiums $ - $ 76,550 $ - $ - $ 76,550 Contract charges (1) - 29,626 24,519 5,672 59,817 Net investment income 302,055 - - - 302,055 Periodic settlements and accruals on non-hedge derivative instruments (2) 372 - - - 372 Contract benefits (98,261) (83,889) - - (182,150) Interest credited to contractholder funds (3) (129,044) - - - (129,044) -------------- ------------- ------------- ------------- ------------- $ 75,122 $ 22,287 $ 24,519 $ 5,672 $ 127,600 ============== ============= ============= ============= ============= 2003 ------------------------------------------------------------------------------ INVESTMENT BENEFIT MAINTENANCE SURRENDER GROSS MARGIN MARGIN CHARGES CHARGES MARGIN -------------- ------------- ------------- ------------- ------------- (IN THOUSANDS) Premiums $ - $ 68,011 $ - $ - $ 68,011 Contract charges - 26,884 21,309 4,825 53,018 Net investment income 264,854 - - - 264,854 Contract benefits (93,331) (73,890) - - (167,221) Interest credited to contractholder funds (106,020) - - - (106,020) -------------- ------------- ------------- ------------- ------------- $ 65,503 $ 21,005 $ 21,309 $ 4,825 $ 112,642 ============== ============= ============= ============= ============= 2002 ------------------------------------------------------------------------------ INVESTMENT BENEFIT MAINTENANCE SURRENDER GROSS MARGIN MARGIN CHARGES CHARGES MARGIN -------------- ------------- ------------- ------------- ------------- (IN THOUSANDS) Premiums $ - $ 93,270 $ - $ - $ 93,270 Contract charges - 23,899 21,637 4,546 50,082 Net investment income 232,967 - - - 232,967 Contract benefits (93,133) (85,030) - - (178,163) Interest credited to contractholder funds (87,555) - - - (87,555) -------------- ------------- ------------- ------------- ------------- $ 52,279 $ 32,139 $ 21,637 $ 4,546 $ 110,601 ============== ============= ============= ============= =============
(1) Loads charged to customers at the inception of interest-sensitive life contracts are deferred and amortized to income in a manner consistent with DAC. Amortization of deferred loads related to capital gains is excluded from contract charges for purposes of calculating gross margin. Amortization of deferred loads related to capital gains totaled $17 thousand in 2004. There were no comparable amounts in 2003 and 2002. (2) Periodic settlements and accruals of non-hedge derivative instruments are reflected as a component of realized capital gains and losses on the Statements of Operations and Comprehensive Income. (3) Beginning in 2004, amortization of DSI is excluded from interest credited to contractholder funds for purposes of calculating gross margin. Amortization of DSI totaled $760 thousand in 2004. Prior periods have not been restated. Gross margin increased 13.3% in 2004 compared to 2003. The increase was attributable to increased investment margin, maintenance charges and benefit margin. Gross margin increased 1.8% in 2003 compared to 2002 as an increased investment margin was almost entirely offset by lower benefit margin. 10 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONT.) INVESTMENT MARGIN is a component of gross margin, both of which are non-GAAP measures. Investment margin represents the excess of net investment income over interest credited to contractholder funds and the implied interest on life-contingent immediate annuities included in the reserve for life-contingent contract benefits. We use investment margin to evaluate our profitability related to the difference between investment returns on assets supporting certain products and amounts credited to customers ("spread") during a fiscal period. Investment margin by product group is shown in the following table.
(IN THOUSANDS) 2004 2003 2002 -------- -------- -------- Annuities $ 64,110 $ 55,541 $ 42,325 Life insurance 11,012 9,962 9,954 -------- -------- -------- Total investment margin $ 75,122 $ 65,503 $ 52,279 ======== ======== ========
Investment margin increased 14.7% in 2004 compared to 2003 and increased 25.3% in 2003 compared to 2002. In both periods, the increase was primarily due to the impact of higher contractholder funds and actions to reduce crediting rates where possible, partially offset by a decline in the fixed income securities portfolio yield resulting from lower market interest rates. Further, in both periods, a yield decline on the assets that support our immediate annuities, capital, traditional life and other products for which we do not have the ability to modify crediting rates, also had a negative impact on the investment margin. The following table summarizes the annualized weighted average investment yields, interest crediting rates and investment spreads during 2004, 2003 and 2002.
WEIGHTED AVERAGE WEIGHTED AVERAGE WEIGHTED AVERAGE INVESTMENT YIELD INTEREST CREDITING RATE INVESTMENT SPREADS -------------------- ------------------------ -------------------- 2004 2003 2002 2004 2003 2002 2004 2003 2002 ---- ---- ---- ---- ---- ---- ---- ---- ---- Interest-sensitive life products 6.1% 6.6% 6.8% 4.8% 4.9% 5.0% 1.3% 1.7% 1.8% Fixed annuities - deferred annuities 5.6 6.1 6.8 3.5 3.8 4.9 2.1 2.3 1.9 Fixed annuities - immediate annuities with and without life contingencies 7.6 7.8 8.1 6.8 6.9 6.9 0.8 0.9 1.2 Investments supporting capital, traditional life and other products 6.0 6.3 6.6 N/A N/A N/A N/A N/A N/A
The following table summarizes the liabilities as of December 31 for these contracts and policies.
(IN THOUSANDS) 2004 2003 2002 -------------- ------------- -------------- Fixed annuities - immediate annuities with life contingencies $ 1,442,055 $ 1,376,898 $ 1,327,112 Other life contingent contracts and other 340,396 306,873 229,515 -------------- ------------- -------------- Reserve for life-contingent contracts $ 1,782,451 $ 1,683,771 $ 1,556,627 ============== ============= ============== Interest-sensitive life $ 368,608 $ 309,076 $ 275,360 Fixed annuities - deferred annuities 2,890,254 1,861,456 1,327,667 Fixed annuities - immediate annuities without life contingencies and other 543,984 487,793 448,402 -------------- ------------- -------------- Contractholder funds $ 3,802,846 $ 2,658,325 2,051,429 ============== ============= ==============
BENEFIT MARGIN is a component of gross margin, both of which are non-GAAP measures. Benefit margin represents life and life-contingent immediate annuity premiums and cost of insurance contract charges less contract benefits. Benefit margin excludes the implied interest on life-contingent immediate annuities, which is included in the calculation of investment margin, and mortality charges on variable annuities, which are included 11 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONT.) as a component of maintenance charges. We use the benefit margin to evaluate our underwriting performance, as it reflects the profitability of our products with respect to mortality or morbidity risk during a fiscal period. Benefit margin by product group is shown in the following table.
(IN THOUSANDS) 2004 2003 2002 ---------- ---------- ---------- Life insurance $ 29,291 $ 25,075 $ 33,686 Annuities (7,004) (4,070) (1,547) ---------- ---------- ---------- Total benefit margin $ 22,287 $ 21,005 $ 32,139 ========== ========== ==========
Benefit margin increased 6.1% in 2004 compared to 2003 as a higher life insurance benefit margin more than offset a decrease in the benefit margin on certain immediate annuities. The increase in the benefit margin on life insurance reflects growth in our interest-sensitive life business in-force and lower mortality benefits on both interest-sensitive and traditional life business. In addition, 2003 was impacted by the strengthening of reserves on certain traditional life policies. These increases were partially offset by the disposal of substantially all of our direct response distribution business. The decrease in the benefit margin on annuities was driven by unfavorable mortality experience on life-contingent immediate annuities, partially offset by an improved benefit margin from lower contract benefits related to guaranteed minimum death benefits ("GMDBs") on variable annuities. As required by SOP 03-1, as of January 1, 2004, reserves were established for benefits provided for under variable annuities. The reserves are primarily for GMDBs and guaranteed minimum income benefits ("GMIBs"). In previous periods, GMDBs were expensed as paid and no costs were recognizable for GMIBs or other guarantees as none were payable pursuant to the contractual terms. Under the SOP, we anticipate that the benefit margin will be less volatile, as contract benefit expense pertaining to product guarantees will be proportionate to the related revenue rather than cash payments made during the period. Included in the benefit margin for 2004 are additions to these secondary product guarantee reserves of $1.8 million. Included in the benefit margin for 2003 and 2002 are GMDB payments of $3.2 million and $2.7 million, respectively. For further explanation of the impacts of the adoption of this accounting guidance, see Note 2 to the Financial Statements. Benefit margin was $21.0 million in 2003, reflecting an $11.1 million or 34.6% decline compared to 2002. The strengthening of reserves on certain traditional life insurance policies in 2003 contributed significantly to the decline, as did higher variable annuity death benefits. AMORTIZATION OF DAC AND DSI decreased 13.1% during 2004 compared to 2003. The decrease was primarily a result of DAC and DSI amortization deceleration (commonly referred to as "DAC unlocking") totaling $10.2 million in 2004 compared to slight amortization acceleration in 2003. This change in DAC unlocking was partially offset by higher amortization attributable to increased gross margins on fixed and variable annuities. The deceleration of amortization in 2004 was the result of favorable projected mortality on our interest-sensitive life products. The adoption of SOP 03-1 required a new modeling approach for estimating expected future gross profits that are used when determining the amortization of DAC. Because of this new modeling approach, effective January 1, 2004, the variable annuity DAC and DSI assets were reduced by $10.7 million. This reduction was recognized as a component of cumulative effect of a change in accounting principle. Amortization of DAC increased 15.1% during 2003 compared to 2002 primarily due to in-force business growth as reflected in our contractholder funds and investment margin increases over 2002 partially offset by lower DAC unlocking. 12 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONT.) The changes in the DAC asset are summarized in the following tables.
BEGINNING BALANCE IMPACT OF IMPACT OF DECEMBER 31, ADOPTION OF DISPOSAL ACQUISITION (IN THOUSANDS) 2003 SOP 03-1 (2) OF DR COSTS DEFERRED ------------ ------------ ---------- -------------- Traditional life $ 33,046 $ - $ - $ 3,098 Interest-sensitive life 60,231 - - 6,747 Variable annuities 52,743 (11,140) - 14,750 Investment contracts 37,308 - - 66,285 Other 4,109 - (3,213) 1,622 ------------ ------------ ---------- -------------- Total $ 187,437 $ (11,140) $ (3,213) $ 92,502 ============ ============ ========== ============== AMORTIZATION (ACCELERATION) DECELERATION EFFECT OF ENDING AMORTIZATION (CHARGED) UNREALIZED BALANCE CHARGED TO CREDITED TO CAPITAL GAINS DECEMBER 31, (IN THOUSANDS) INCOME (3) INCOME (1) AND LOSSES 2004 ------------ ------------ -------------- ------------ Traditional life $ (2,664) $ -- $ -- $ 33,480 Interest-sensitive life (5,841) 9,259 1,733 72,129 Variable annuities (12,801) -- 4,173 47,725 Investment contracts (14,399) 954 (7,348) 82,800 Other (479) -- -- 2,039 ------------ ------------ -------------- ------------ Total $ (36,184) $ 10,213 $ (1,442) $ 238,173 ============ ============ ============== ============
AMORTIZATION (ACCELERATION) BEGINNING DECELERATION EFFECT OF ENDING BALANCE AMORTIZATION (CHARGED) UNREALIZED BALANCE DECEMBER 31, ACQUISITION CHARGED TO CREDITED TO CAPITAL GAINS DECEMBER 31, (IN THOUSANDS) 2002 COSTS DEFERRED INCOME (3) INCOME (1) AND LOSSES 2003 ------------ -------------- ------------ ------------ -------------- ------------ Traditional life $ 32,371 $ 3,291 $ (2,616) $ - $ - $ 33,046 Interest-sensitive life 59,752 7,169 (7,558) (1,158) 2,026 60,231 Variable annuities 61,380 18,055 (8,021) 699 (19,370) 52,743 Investment contracts 9,406 29,233 (10,404) 153 8,920 37,308 Other 4,016 1,157 (1,064) - - 4,109 ------------ -------------- ------------ ------------ -------------- ------------ Total $ 166,925 $ 58,905 $ (29,663) $ (306) $ (8,424) $ 187,437 ============ ============== ============ ============ ============== ============
---------- (1) Included as a component of Amortization of DAC on the Statements of Operations and Comprehensive Income. (2) The impact of adoption of SOP 03-1 includes a write-down in variable annuity DAC of $7.7 million, the reclassification of DSI from DAC to other assets resulting in a decrease to DAC of $4.1 million and an increase to DAC of $691 thousand for an adjustment to the effect of unrealized capital gains and losses. (3) The amortization of DAC for interest-sensitive life, variable annuities and investment contracts is proportionate to the recognition of actual gross profits, which include realized capital gains and losses. The increase in amortization in 2004 compared to 2003 was due in part to the effect of realized capital gains and losses that were in excess of those utilized in the determination of EGP. Amortization related to realized capital gains and losses was $2.1 million and $1.7 million in 2004 and 2003, respectively. Future amortization will be affected by the recognition of actual realized capital gains and losses to the extent that they differ from those utilized in the determination of EGP. OPERATING COSTS AND EXPENSES increased 13.9% in 2004 compared to 2003 and decreased 1.0% in 2003 compared to 2002. The increase in 2004 was attributable to higher non-deferrable sales commissions and employee expenses, partially offset by lower expenses due to the disposal of substantially all of our direct response distribution business. The decrease in 2003 was the result of higher employee related benefits and guaranty fund assessments being more than offset by higher expense reimbursements on reinsured business and aggressive cost management. 13 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONT.) REINSURANCE CEDED We enter into reinsurance agreements with ALIC and unaffiliated carriers to limit our risk of mortality and morbidity losses, and exposure to certain variable annuity contract benefits. In 2004, for certain term life insurance policies, we ceded 25-90% of the mortality risk depending on the length of the term and policy premium guarantees. Comparatively, in 2003 and 2002, mortality risk ceded on certain term life insurance policies was in the range of 80-90%, depending on the length of the term and policy premium guarantees. Mortality risk on policies in excess of $250 thousand per life is ceded to ALIC. As of December 31, 2004 and 2003, 32.4% and 23.2%, respectively, of our face amount of life insurance in force is reinsured to non-affiliates and ALIC. We retain primary liability as a direct insurer for all risks ceded to reinsurers. Estimating amounts of reinsurance recoverables is impacted by the uncertainties involved in the establishment of reserves. Developments in the insurance industry have led to a decline in the financial strength of some of our reinsurance carriers, causing amounts recoverable from them to be considered a higher risk. There has also been consolidation activity between reinsurers in the industry, which has resulted in reinsurance risk across the industry to be concentrated among fewer companies. As a result, we have increased our percentage of underwriting retention of new term life insurance policies. Our reinsurance recoverables, summarized by the reinsurers' Standard & Poor's financial strength ratings as of December 31, are shown in the following table. In certain cases, these ratings refer to the financial strength of the affiliated group or parent company of the reinsurer.
2004 2003 --------------------- --------------------- REINSURANCE REINSURANCE (IN THOUSANDS) RECOVERABLES % RECOVERABLES % ------------ ------ ------------ ------ AAA $ 13 0.1% $ - -% AA 4,206 49.9 3,237 70.6 AA- 2,448 29.1 1,347 29.4 A- 302 3.6 - - Other (1) 1,453 17.3 - - ------------ ------ ------------ ------ Total $ 8,422 100.0% $ 4,584 100.0% ============ ====== ============ ======
---------- (1) As of December 31, 2004, other is comprised of amounts recoverable from one of two of the unrelated third party purchasers of our Direct Response business sold during the year for which Standard and Poor's does not rate. As of December 31, 2004, this company was rated A (Excellent) by A.M. Best. Our reinsurance recoverables, summarized by reinsurer as of December 31, are shown in the following table.
REINSURANCE RECOVERABLE S&P FINANCIAL -------------------------- (IN THOUSANDS) STRENGTH RATING 2004 2003 --------------- ------------ ---------- Transamerica Financial Life Insurance AA 1,885 409 Triton Insurance Company (1) (2) N/A 1,453 - RGA Reinsurance Company AA- 1,181 278 Allstate Life Insurance Company AA 1,062 1,327 Mutual of Omaha Insurance AA- 852 1,347 Generali USA AA 361 178 Security Life of Denver AA 350 175 Swiss Re Life and Health America, Inc. AA 345 161 American United Life AA- 330 170 Scottish Re US (2) A- 232 - Metropolitan Life AA 112 135 Canada Life AA 91 9 Minnesota Mutual AA- 84 81 Scottish Re Life Corp. A- 71 111 Cologne Re AAA 13 - Allianz Life Ins Co AA- - 158 Prudential Insurance Company AA- - 45 ------------ ---------- Total $ 8,422 $ 4,584 ============ ==========
(1) As of December 31, 2004, this company was rated A (Excellent) by A.M. Best. 14 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONT.) (2) Reinsurance recoverables due from Triton Insurance Company and Scottish Re US, as of December 31, 2004, reflect reinsurance arrangements entered into in conjunction with the disposal of substantially all of our direct response distribution business. We continuously monitor the creditworthiness of reinsurers in order to determine our risk of recoverability on an individual and aggregate basis, and a provision for uncollectible reinsurance is recorded if needed. No amounts have been deemed unrecoverable in the three-years ended December 31, 2004. We have a reinsurance treaty through which we cede re-investment related risk on our structured settlement annuities to ALIC. The terms of this treaty meet the accounting definition of a derivative under SFAS No. 133. Accordingly, the treaty is recorded in the Statements of Financial Position at fair value, and changes in the fair value of the treaty and premiums paid to ALIC are recognized in realized capital gains and losses. Effective January 1, 2004, guaranteed minimum accumulation benefits ("GMABs") on variable annuities are 100% ceded to ALIC through a reinsurance treaty. OUTLOOK - Our ability to grow our investment margin depends upon maintaining sufficient spreads between investment yields and interest crediting rates, and growing the amount of business in force. As interest rates rise, we expect a gradual increase in investment yields. The amount by which these higher yields will increase our investment margin depends upon the amount and pace at which we reset interest-crediting rates, which could be influenced by market conditions and the actions of our policyholders. A significant and sudden increase in interest rates could cause policyholders to exercise surrender provisions in their policies that might cause investment margins to decline. As a result, growth in our investment margin from net new business activity could be partially offset by compression in our in-force investment margins. - If equity markets perform at historical norms, we expect to see positive growth in our variable annuity gross margins from increased revenue. However, improvements or deteriorations in our variable annuity gross margins from changes in equity market performance or policyholder retention creates a proportionate increase or decrease in amortization of variable annuity DAC, which will offset a significant portion of the changes in gross margins. - Market conditions beyond our control determine the availability and cost of the reinsurance we purchase. To eliminate some of these market concerns, we are expecting to retain more of our term life insurance mortality risk in 2005. This change will not have a discernable effect on our net income in the short-term, but will provide the foundation to drive increased long-term growth in our life insurance business. Our mortality margins will also be more volatile in the future as we retain and manage more of our mortality risk, which will require increased statutory capital. INVESTMENTS An important component of our financial results is the return on our investment portfolio. The investment portfolios are managed based upon the nature of the business and our corresponding liability structure. OVERVIEW AND STRATEGY Our investment strategy focuses on the need for risk-adjusted spread on the underlying liabilities while maximizing return on capital. We believe investment spread is maximized by selecting assets that perform favorably on a long-term basis and by disposing of certain assets to minimize the effect of downgrades and defaults. We believe this strategy maintains the investment margin necessary to sustain income over time. The portfolio management approach employs a combination of recognized market, analytical and proprietary modeling, including a strategic asset allocation model, as the primary basis for the allocation of interest sensitive, illiquid and credit assets as well as for determining overall below investment grade exposure and diversification requirements. Within the targets set by the strategic asset allocation model, tactical investment decisions are made in consideration of prevailing market conditions. Portfolio reviews, which include identifying securities that are other than temporarily impaired, are conducted regularly. For more information, see the Portfolio Monitoring section of the MD&A. 15 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONT.) PORTFOLIO COMPOSITION The composition of the investment portfolio at December 31, 2004 and 2003 is presented in the table below. Also see Notes 2 and 6 of the financial statements for investment accounting policies and additional information.
DECEMBER 31, 2004 DECEMBER 31, 2003 ------------------------- ------------------------- CARRYING PERCENT CARRYING PERCENT (IN THOUSANDS) VALUE OF TOTAL VALUE OF TOTAL ----------- ----------- ----------- ----------- Fixed income securities (1) $ 5,545,647 89.8% $ 4,415,327 90.9% Mortgage loans 480,280 7.8 385,643 7.9 Short-term 111,509 1.8 22,756 0.5 Policy loans 34,948 0.6 34,107 0.7 Other 4,638 - - - ----------- ----------- ----------- ----------- Total $ 6,177,022 100.0% $ 4,857,833 100.0% =========== =========== =========== ===========
(1) Fixed income securities are carried at fair value. Amortized cost basis for these securities was $5.01 billion and $3.94 billion at December 31, 2004 and 2003, respectively. Total investments increased to $6.18 billion at December 31, 2004 from $4.86 billion at December 31, 2003, primarily due to positive cash flows from financing activities. We use different methodologies to estimate the fair value of publicly and non-publicly traded marketable investment securities and exchange traded and non-exchange traded derivative contracts. For a discussion of these methods, see the Application of Critical Accounting Policies section of the MD&A. The following table shows total investments, categorized by the method used to determine fair value at December 31, 2004.
DERIVATIVE INVESTMENTS CONTRACTS --------------------------- ------------ FAIR PERCENT FAIR (IN THOUSANDS) VALUE OF TOTAL VALUE ------------ ------------ ------------ Value based on independent market quotations $ 4,499,676 72.8% $ 80 Value based on models and other valuation methods 1,155,370 18.7 2,904 Mortgage loans, policy loans and other, valued at cost 521,976 8.5 - ------------ ------------ ------------ Total $ 6,177,022 100.0% $ 2,984 ============ ============ ============
FIXED INCOME SECURITIES See Note 6 of the financial statements for a table showing the amortized cost, unrealized gains, unrealized losses and fair value for each type of fixed income security for the years ended December 31, 2004 and 2003. U.S. government and agencies of the U.S. government securities were all rated investment grade at December 31, 2003. Municipal bonds, primarily taxable securities, totaled $274.0 million at December 31, 2004, all of which were rated investment grade. Approximately 61.2% of the municipal bond portfolio was insured by five bond insurers and accordingly have a rating of Aaa or Aa. The municipal bond portfolio at December 31, 2004 consisted of approximately 45 issues from approximately 40 issuers. Our largest exposure to a single issuer totals 17.8% of the municipal bond portfolio. This issuer, at December 31, 2004, had a Moody's rating of AAA. Corporate bonds totaled $3.19 billion and 93.8% were rated investment grade at December 31, 2004. As of December 31, 2004, the portfolio contained $1.39 billion of privately placed corporate obligations, 43.6% of the total corporate obligations in the portfolio, compared with $1.18 billion at December 31, 2003. Privately placed securities that were rated investment grade totaled 94.0% at December 31, 2004. Approximately $1.36 billion or 97.6% of the privately placed corporate obligations consisted of fixed rate privately placed securities. The benefits of fixed rate privately placed securities when compared to publicly issued securities are generally higher yields, improved cash flow predictability through pro-rata sinking funds, and a combination of 16 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONT.) covenant and call protection features designed to better protect the holder against losses resulting from credit deterioration, reinvestment risk or fluctuations in interest rates. A disadvantage of fixed rate privately placed securities when compared to publicly issued securities is relatively reduced liquidity. Foreign government securities totaled $277.3 million and all were rated investment grade at December 31, 2004. Mortgage-backed securities ("MBS") totaled $572.5 million at December 31, 2004, all of which were investment grade. In our MBS portfolio, the credit risk associated with MBS is mitigated due to the fact that the portfolio consists primarily of securities that were issued by, or have underlying collateral that is guaranteed by, U.S. government agencies or U.S. government sponsored entities. The MBS portfolio is subject to interest rate risk since price volatility and the ultimate realized yield are affected by the rate of prepayment of the underlying mortgages. The current consistently low interest rate environment has resulted in prepayments, which have eroded the prepayment protection in this portfolio over recent years. Commercial Mortgage Backed Securities ("CMBS") totaled $458.9 million at December 31, 2004. CMBS positions primarily represent pools of commercial mortgages, broadly diversified across property types and geographical area. The CMBS portfolio is subject to credit risk, but unlike other structured assets, are generally not subject to prepayment risk. Due to protections within the underlying commercial mortgages, borrowers are restricted from prepaying their mortgages due to changes in interest rates. Credit defaults can result in credit directed prepayments. Approximately 90.1% of the CMBS portfolio had a Moody's rating of Aaa or a Standard & Poor's rating of AAA, the highest rating category, at December 31, 2004. Asset-backed securities ("ABS") totaled $56.6 million at December 31, 2004. Our ABS portfolio is subject to credit and interest rate risk. Credit risk is managed by monitoring the performance of the collateral. In addition, many of the securities in the ABS portfolio are credit enhanced with features such as over-collateralization, subordinated debt, reserve funds, guarantees and/or insurance. Approximately 59.7% of the ABS portfolio had a Moody's rating of Aaa or a Standard & Poor's ("S&P") rating of AAA, the highest rating category. A portion of the ABS portfolio is also subject to interest rate risk since, for example, price volatility and ultimate realized yield are affected by the rate of prepayment of the underlying assets. The ABS portfolio includes collateralized debt obligations and other bonds that are secured by a variety of asset types, predominately home equity loans. At December 31, 2004, 96.2% of the fixed income securities portfolio was rated investment grade, which is defined as a security having a rating from The National Association of Insurance Commissioners ("NAIC") of 1 or 2; a rating of Aaa, Aa, A or Baa from Moody's or a rating of AAA, AA, A or BBB from S&P, Fitch or Dominion; or a comparable internal rating if an externally provided rating is not available. The following table summarizes the credit quality of the fixed income securities portfolio at December 31, 2004. (IN THOUSANDS)
NAIC FAIR PERCENT RATING MOODY'S, S&P OR EQUIVALENT VALUE OF TOTAL ---------- ------------------------------------ ------------ ------------ 1 Aaa/Aa/A $ 3,890,839 70.2% 2 Baa 1,445,483 26.0 3 Ba 116,203 2.1 4 B 71,412 1.3 5 Caa or lower 10,897 0.2 6 In or near default 10,813 0.2 ------------ ------------ $ 5,545,647 100.0% ============ ============
17 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONT.) UNREALIZED GAINS AND LOSSES See Note 6 of the financial statements for further disclosures regarding unrealized losses on fixed income and equity securities and factors considered in determining whether they are not other than temporarily impaired. The unrealized net capital gains on fixed income securities at December 31, 2004 totaled $532.7 million, an increase of $52.8 million since December 31, 2003. Gross unrealized gains and losses on fixed income securities are provided in the table below.
GROSS UNREALIZED AMORTIZED --------------------------- FAIR (IN THOUSANDS) COST GAINS LOSSES VALUE ------------ ------------ ------------ ------------ AT DECEMBER 31, 2004 Corporate: Public utilities $ 526,125 $ 79,598 $ (316) $ 605,407 Consumer (cyclical and non-cyclical) 430,824 26,860 (714) 456,970 Banking 444,233 30,237 (1,272) 473,198 Basic industry 250,840 17,601 (196) 268,245 Capital goods 258,496 11,854 (1,100) 269,250 Communications/media 196,349 19,000 (278) 215,071 Energy 191,368 9,329 (712) 199,985 Financial services 292,644 13,087 (778) 304,953 Other 146,839 22,903 (453) 169,289 Transportation 166,617 13,089 (746) 178,960 Technology 46,104 3,217 (95) 49,226 ------------ ------------ ------------ ------------ Total corporate fixed income portfolio 2,950,439 246,775 (6,660) 3,190,554 U.S. government and agencies 506,971 197,639 - 704,610 Municipal 262,683 12,714 (1,422) 273,975 Foreign government 214,508 62,839 - 277,347 Asset-backed securities 56,215 1,732 (1,321) 56,626 Mortgage-backed securities 566,367 8,719 (2,623) 572,463 Commercial mortgage-backed securities 446,354 13,357 (838) 458,873 Redeemable preferred stock 9,440 1,759 - 11,199 ------------ ------------ ------------ ------------ Total fixed income securities $ 5,012,977 $ 545,534 $ (12,864) $ 5,545,647 ============ ============ ============ ============
The banking and capital goods sectors had the highest concentration of unrealized losses in our corporate fixed income securities portfolio at December 31, 2004. The gross unrealized losses in these sectors are primarily interest rate related or company specific. We expect eventual recovery of these securities. Every security was included in our portfolio monitoring process. The following table shows the composition by credit quality of the fixed income securities with gross unrealized losses at December 31, 2004.
NAIC (IN THOUSANDS) UNREALIZED PERCENT FAIR PERCENT RATING MOODY'S, S&P OR LOSS OF TOTAL VALUE OF TOTAL EQUIVALENT ------------ ------------ ------------ ------------ 1 Aaa/Aa/A $ (7,875) 61.3% $ 695,849 76.4% 2 Baa (2,729) 21.2 163,795 18.0 3 Ba (1,638) 12.7 26,769 2.9 4 B (244) 1.9 19,231 2.1 5 Caa or lower - - - - 6 In or near default (378) 2.9 5,482 0.6 ------------ ------------ ------------ ------------ Total $ (12,864) 100.0% $ 911,126 100.0% ============ ============ ============ ============
At December 31, 2004, $10.6 million, or 82.5%, of the gross unrealized losses were related to investment grade fixed income securities. Unrealized losses on investment grade securities principally relate to changes in interest rates or changes in sector-related credit spreads since the securities were acquired. 18 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONT.) As of December 31, 2004, $2.3 million of the gross unrealized losses were related to below investment grade fixed income securities. Included among the securities rated below investment grade are both public and privately placed high-yield bonds and securities that were investment grade when originally acquired. We mitigate the credit risk of investing in below investment grade fixed income securities by limiting the percentage of our fixed income portfolio invested in such securities, through diversification of the portfolio, and active credit monitoring and portfolio management. The scheduled maturity dates for fixed income securities in an unrealized loss position at December 31, 2004 are shown below. Actual maturities may differ from those scheduled as a result of prepayments by the issuers.
UNREALIZED PERCENT FAIR PERCENT (IN THOUSANDS) LOSS OF TOTAL VALUE OF TOTAL ------------ ------------ ------------ ------------ Due in one year or less $ - -% $ - -% Due after one year through five years (494) 3.8 45,362 5.0 Due after five years through ten years (4,242) 33.0 300,312 33.0 Due after ten years (4,184) 32.5 291,906 32.0 Mortgage- and asset- backed securities(1) (3,944) 30.7 273,546 30.0 ------------ ------------ ------------ ------------ Total $ (12,864) 100.0% $ 911,126 100.0% ============ ============ ============ ============
(1) Because of the potential for prepayment, mortgage- and asset-backed securities are not categorized based on their contractual maturities. PORTFOLIO MONITORING We have a comprehensive portfolio monitoring process to identify and evaluate fixed income securities whose carrying value may be other than temporarily impaired. The process includes a quarterly review of all securities using a screening process to identify those securities whose fair value compared to amortized cost is below established thresholds for certain time periods, or which are identified through other monitoring criteria such as ratings downgrades or payment defaults. The securities identified, in addition to other securities for which we may have a concern, are evaluated based on facts and circumstances for inclusion on our watch-list. The watch-list is reviewed in detail to determine whether any other than temporary impairment exists. The following table contains the individual securities with the largest unrealized losses as of December 31, 2004. No other fixed income security had an unrealized loss greater than $285 thousand or 2.2% of the total unrealized loss on fixed income securities.
UNREALIZED FAIR NAIC (IN THOUSANDS) LOSS VALUE RATING ------------ ------------ ------------ Asset Backed Security $ (543) $ 4,456 3 Asset Backed Security (470) 5,142 3 Mortgage Backed Security (464) 24,614 1 Domestic Bank (413) 6,066 1 Mortgage Backed Security (393) 9,650 1 Major U.S. Airline (378) 5,250 6 County General Obligation for Pension Fund (351) 8,054 1 Mortgage Backed Security (306) 17,315 1 Mortgage Backed Security (302) 9,772 1 Real Estate Investment Trust for a Public Mall (285) 6,715 3 ------------ ------------ Total $ (3,905) $ 97,034 ============ ============
We also monitor the quality of our fixed income portfolio by categorizing certain investments as "problem", "restructured" or "potential problem." Problem fixed income securities are securities in default with respect to principal or interest and/or securities issued by companies that have gone into bankruptcy subsequent to our acquisition of the security. Restructured fixed income securities have rates and terms that are not consistent with market rates or terms prevailing at the time of the restructuring. Potential problem fixed income securities are current with respect to contractual principal and/or interest, but because of other facts and circumstances, we have concerns regarding the borrower's ability to pay future principal and interest, which causes us to believe these securities may be classified as problem or restructured in the future. 19 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONT.) The following table summarizes problem, restructured and potential problem fixed income securities at December 31.
(IN THOUSANDS) 2004 2003 ------------------------------------------ ------------------------------------------ PERCENT PERCENT OF TOTAL OF TOTAL FIXED FIXED AMORTIZED FAIR INCOME AMORTIZED FAIR INCOME COST VALUE PORTFOLIO COST VALUE PORTFOLIO ------------ ------------ ------------ ------------ ------------ ------------ Problem $ 10,637 $ 10,813 0.2% $ 13,186 $ 12,533 0.3% Restructured 5,396 6,151 0.1 5,701 6,303 0.1 Potential problem 11,231 10,539 0.2 17,899 17,843 0.4 ------------ ------------ ------------ ------------ ------------ ------------ Total net carrying value $ 27,264 $ 27,503 0.5% $ 36,786 $ 36,679 0.8% ============ ============ ============ ============ ============ ============ Cumulative write-downs recognized $ 4,606 $ 4,817 ============ ============
We have experienced a decrease in the amortized cost of fixed income securities in all categories as of December 31, 2004 compared to December 31, 2003. The decreases were primarily related to an improvement in the outlook for these securities. We also evaluated each of these securities through our portfolio monitoring process at December 31, 2004 and recorded write-downs when appropriate. We further concluded that any remaining unrealized losses on these securities were temporary in nature. While these balances may increase in the future, particularly if economic conditions are unfavorable, management expects that the total amount of securities in these categories will remain low relative to the total fixed income securities portfolio. NET REALIZED CAPITAL GAINS AND LOSSES The following table presents the components of realized capital gains and losses and the related tax effect for the years ended December 31.
(IN THOUSANDS) 2004 2003 2002 ------------ ------------ ------------ Investment write-downs $ (3,402) $ (7,682) $ (15,760) Dispositions (2,784) (1,587) 4,292 Valuation of derivative instruments (5,777) (2,140) (2,605) Settlement of derivative instruments 2,666 2,891 1,500 ------------ ------------ ------------ Realized capital gains and losses, pretax (9,297) (8,518) (12,573) Income tax benefit 3,453 3,278 4,545 ------------ ------------ ------------ Realized capital gains and losses, after-tax $ (5,844) $ (5,240) $ (8,028) ============ ============ ============
Investment write-downs during 2004 represented approximately 0.1% of the average total investment portfolio value during the year. For the year ended December 31, 2004, the $2.8 million in net losses from sales was comprised of gross gains of $10.5 million and gross losses of $13.3 million. Gross losses from sales of fixed income securities combined with investment write-downs on fixed income securities of $3.4 million, represented total gross realized losses of $16.7 million. Dispositions in the above table include sales and other transactions such as calls and prepayments. We may sell fixed income securities during the period in which fair value has declined below amortized cost. In certain situations new factors such as negative developments, subsequent credit deterioration, relative value opportunities, market liquidity concerns and portfolio reallocations can subsequently change our previous intent to continue holding a security. In a changing interest rate environment we may manage securities differently, for example by changing the targeted duration of our portfolios, leading to cash market transactions, changes in the profile of our investment purchases or moving securities between portfolios supporting differing products or to another affiliate. The five largest losses from sales of individual securities for the year ended December 31, 2004 totaled $3.8 million with the largest being $1.0 million and the smallest being $0.6 million. None of the $3.8 million related to securities that were in an unrealized loss position greater than or equal to 20% of amortized cost for fixed income securities or cost for equity securities for a period of six or more consecutive months prior to sale. 20 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONT.) MORTGAGE LOANS Our mortgage loans portfolio was $480.3 million at December 31, 2004 and $385.6 million at December 31, 2003, and comprised primarily of loans secured by first mortgages on developed commercial real estate. Geographical and property type diversification are key considerations used to manage our mortgage loan risk. We closely monitor our commercial mortgage loan portfolio on a loan-by-loan basis. Loans with an estimated collateral value less than the loan balance, as well as loans with other characteristics indicative of higher than normal credit risk, are reviewed by financial and investment management at least quarterly for purposes of establishing valuation allowances and placing loans on non-accrual status. The underlying collateral values are based upon either discounted property cash flow projections or a commonly used valuation method that utilizes a one-year projection of expected annual income divided by an expected rate of return. SHORT-TERM INVESTMENTS Our short-term investment portfolio was $111.5 million and $22.8 million at December 31, 2004 and 2003, respectively. We invest available cash balances primarily in taxable short-term securities having a final maturity date or redemption date of less than one year. We also participate in securities lending, primarily as an investment yield enhancement, with third parties such as brokerage firms. We obtain collateral in an amount not less than 102% of the fair value of loaned securities and monitor the market value of the securities loaned on a daily basis with additional collateral obtained as necessary. The cash we receive is invested in short-term and fixed income investments, and an offsetting liability is recorded in other liabilities. At December 31, 2004, the amount of securities lending collateral reinvested in short-term investments had a carrying value of $66 million. This compares to $7.1 million at December 31, 2003. MARKET RISK Market risk is the risk that we will incur losses due to adverse changes in interest rates or equity prices. Our primary market risk exposure is to changes in interest rates, although we also have certain exposures to changes in equity prices. The active management of market risk is integral to our results of operations. We may use the following approaches to manage our exposure to market risk within defined tolerance ranges: 1) rebalancing existing asset or liability portfolios, 2) changing the character of investments purchased in the future or 3) using derivative instruments to modify the market risk characteristics of existing assets and liabilities or assets expected to be purchased. For a more detailed discussion of our use of derivative financial instruments, see Note 7 of the financial statements. OVERVIEW We generate substantial investable funds from our business operations. In formulating and implementing guidelines for investing funds, we seek to earn returns that enhance our ability to offer competitive rates and prices to customers while contributing to attractive and stable profits and long-term capital growth. Accordingly, our investment decisions and objectives are a function of our underlying risks and product profiles. Investment policies define the overall framework for managing market and other investment risks, including accountability and control over these risk management activities. In addition, we follow policies that have been approved by our board of directors and that specify the investment limits and strategies that are appropriate given our liquidity, surplus, product profile, and regulatory requirements. Oversight activities are conducted primarily through our board of directors and investment committee. The asset-liability management ("ALM") policy guidelines further define the overall asset-liability framework for managing market and investment risks. ALM activities follow asset-liability policies that have been approved by our board of directors. The ALM policies specify limits, ranges and targets for investments that best meet our business objectives in light of our product liabilities. We manage our exposure to market risk through the use of asset allocation limits and duration limits, through the use of simulation and, as appropriate, through the use of stress tests. We have asset allocation limits that place restrictions on the total funds that may be invested within an asset class. We have duration limits on our investment portfolio, and, as appropriate, on individual components of the portfolio. These duration limits place restrictions on the amount of interest rate risk that may be taken. Comprehensive day-to-day management of market risk within defined tolerance ranges occurs as portfolio managers buy and sell within their respective markets based upon the acceptable boundaries established by the investment policies. This day-to-day management is integrated within the day-to-day activities of the ALM function. One result of this work is the development and implementation of an asset allocation strategy for optimizing our investment income. 21 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONT.) INTEREST RATE RISK is the risk that we will incur loss due to adverse changes in interest rates. This risk arises from many of our primary activities, as we invest substantial funds in interest-sensitive assets and issue interest-sensitive liabilities. We manage the interest rate risk in our assets relative to the interest rate risk inherent in our liabilities. One of the measures used to quantify this exposure is duration. Duration measures the price sensitivity of the assets and liabilities to changes in interest rates. For example, if interest rates increase by 100 basis points, the fair value of an asset with a duration of 5 is expected to decrease in value by approximately 5%. At December 31, 2004, the difference between our asset and liability duration was approximately (0.3), compared to a (0.1) gap at December 31, 2003. A negative duration gap indicates that the fair value of our liabilities is more sensitive to interest rate movements than the fair value of our assets. We seek to invest premiums, contract charges and deposits to generate future cash flows that will fund future claims, benefits and expenses, and that will earn stable margins across a wide variety of interest rate and economic scenarios. In order to achieve this objective and limit interest rate risk, we adhere to a philosophy of managing the duration of assets and related liabilities. This philosophy may include using futures to reduce the interest rate risk resulting from mismatches between existing assets and liabilities, and financial futures to hedge the interest rate risk related to anticipated purchases and sales of investments and product sales to customers. To calculate the duration gap between assets and liabilities, we project asset and liability cash flows and calculate their net present value using a risk-free market interest rate adjusted for credit quality, sector attributes, liquidity and other specific risks. Duration is calculated by revaluing these cash flows at alternative interest rates and determining the percentage change in aggregate fair value. The cash flows used in this calculation include the expected maturity and repricing characteristics of our derivative financial instruments, all other financial instruments (as described in Note 7 of the financial statements), and certain other items including interest-sensitive liabilities and annuity liabilities. The projections include assumptions (based upon historical market experience and our experience) that reflect the effect of changing interest rates on the prepayment, lapse, leverage and/or option features of instruments, where applicable. Such assumptions relate primarily to mortgage-backed securities, collateralized mortgage obligations, municipal housing bonds, callable municipal and corporate obligations, and fixed rate single and flexible premium deferred annuities. Based upon the information and assumptions we use in this duration calculation, and interest rates in effect at December 31, 2004, we estimate that a 100 basis point immediate, parallel increase in interest rates ("rate shock") would decrease the net fair value of the assets and liabilities by approximately $60.6 million, compared to $46.3 million at December 31, 2003. Additionally, there are $383.9 million of assets supporting life insurance products such as traditional and interest-sensitive life that are not financial instruments and as a result have not been included in the above estimate. This amount has increased from the $253.2 million reported at December 31, 2003 due to increases in policies in force. Based on assumptions described above, in the event of a 100 basis point immediate increase in interest rates, these assets would decrease in value by $29.3 million, compared to a decrease of $10.2 million at December 31, 2003. The selection of a 100 basis point immediate parallel change in interest rates should not be construed as our prediction of future market events, but only as an illustration of the potential effect of such an event. To the extent that conditions differ from the assumptions we used in these calculations, duration and rate shock measures could be significantly impacted. Additionally, our calculations assume that the current relationship between short-term and long-term interest rates (the term structure of interest rates) will remain constant over time. As a result, these calculations may not fully capture the effect of non-parallel changes in the term structure of interest rates and/or large changes in interest rates. EQUITY PRICE RISK is the risk that we will incur economic losses due to adverse changes in general levels of the equity markets. At December 31, 2004 and 2003, we had separate accounts assets related to variable annuities and variable life contracts with account values totaling $792.6 million and $665.9 million, respectively. We earn contract charges as a percentage of these account values. In the event of an immediate decline of 10% in the account values due to equity market declines, we would have earned approximately $1.34 million and $684 thousand less in fee income at December 31, 2004 and 2003, respectively. Variable annuity contracts we sell have a GMDB and customers may choose to purchase an enhanced GMDB, guaranteed minimum income benefits ("GMIB") prior to 2004, a TrueReturn(SM) guaranteed minimum accumulation benefit ("GMAB") beginning in 2004, and beginning in 2005, a SureIncome(SM) guaranteed minimum withdrawal benefit ("GMWB"). These guarantees subject us to additional equity market risk because the beneficiary or contractholder may receive a benefit that is greater than their corresponding account value. 22 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONT.) GMDBs are payable upon death. GMIBs may be exercised on or after the tenth-year anniversary (not prior to 2012) of the contract if the contractholder elects to receive a defined stream of payments ("annuitize"). GMABs are credited to the contractholder account on a contract anniversary date that is pre-determined by the contractholder, between the eighth and sixteenth year after contract issue (not prior to 2012). GMABs guarantee an account value of up to 1.6 times (or 160%) of the amount deposited in the contract, depending on the amount of time the contract is in force and adherence to certain fund allocation requirements. GMWBs will be payable if the contractholder elects to take partial withdrawals. GMWBs guarantee that the contractholder can take annual partial withdrawals up to 8% of the amount deposited in the contract until their withdrawals total the initial deposit. The GMABs are 100% ceded to ALIC under a reinsurance agreement and, effective January 1, 2005, a similar agreement has been established for GMDBs and GMWBs. In January 2004, we established reserves for GMDBs and GMIBs in conjunction with the adoption of SOP 03-1. Because of this change in accounting, guarantee payments will be recognized over future periods rather than expensed as paid. For more details see Note 2 of the financial statements. At December 31, 2004 and 2003, the guaranteed value of the death benefits in excess of account values was estimated to be $86 million and $117.9 million, respectively, net of reinsurance. The decrease in this estimate between periods is attributable to improved equity markets during 2004 and customer surrenders of contracts with in-the-money GMDBs. In both periods, approximately two-thirds of this exposure is related to the return of deposits guarantee, while the remaining one-third is attributable to a death benefit guarantee greater than the original deposits. We have reinsurance for a portion of these benefits. In the event of an immediate decline in account values of 10% due to equity market declines, payments for guaranteed death benefits at December 31, 2004 would increase by an estimated $638 thousand in 2005. These payments would be charged against the related reserve rather than directly to earnings as paid. Contributions to the reserve for GMDBs would be reduced by approximately $400 thousand in 2005 in the event of an immediate 10% decline in account values. For discussion of the accounting treatment, see Note 2 of the financial statements. The selection of a 10% immediate decrease should not be construed as our prediction of future market events, but only as an example to illustrate the potential effect on earnings and cash flow of equity market declines as a result of this guarantee. Also, our actual payment experience in the future may not be consistent with the assumptions used in the model. GMIB contracts that we sold provide the contractholder with the right to annuitize based on the highest account value at any anniversary date or on a guaranteed earnings rate based on the initial account value over the specified period. The guaranteed income benefit feature was first offered in our variable annuity products beginning in 2002, with guaranteed benefits available for election by contractholders ten years after issue. Accordingly, the earliest date at which benefits would become payable is 2012. In the event of an immediate decline of 10% in contractholders' account values as of December 31, 2004 due to equity market declines, contributions to the reserve would be reduced by a nominal amount in 2005. For discussion of the accounting treatment, see Note 2 of the financial statements. The selection of a 10% immediate decrease should not be construed as our prediction of future market events, but only as an example to illustrate the potential effect on earnings and cash flow of equity market declines as a result of this guarantee. In the event of an immediate decline of 10% in GMAB contractholders' account values as of December 31, 2004, due to equity market declines, there would be no net impact on our earnings because these benefits are fully reinsured, however the reserve for GMABs would be increased by approximately $500 thousand. We are also exposed to equity risk in DAC. Fluctuations in the value of the variable annuity and life contract account values due to the equity market affect DAC amortization, because the expected fee income and guaranteed benefits payable are components of the EGP for variable annuity and life contracts. For a more detailed discussion of DAC, see Note 2 of the financial statements and the Application of Critical Accounting Policies section of the MD&A. 23 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONT.) CAPITAL RESOURCES AND LIQUIDITY CAPITAL RESOURCES consist of shareholder's equity. The following table summarizes our capital resources at December 31.
(IN THOUSANDS) 2004 2003 2002 ------------ ------------ ------------ Common stock, additional capital paid-in and retained income $ 483,980 $ 394,850 $ 374,160 Accumulated other comprehensive income 155,255 138,724 169,655 ------------ ------------ ------------ Total shareholder's equity $ 639,235 $ 533,574 $ 543,815 ============ ============ ============
SHAREHOLDER'S EQUITY increased in 2004 when compared to 2003 due to a capital contribution from ALIC of $64.2 million, net income and increased unrealized net capital gains on fixed income securities. Shareholder's equity decreased in 2003 when compared to 2002 due to a decrease in accumulated other comprehensive income of $30.9 million, partially offset by net income of $20.7 million. FINANCIAL RATINGS AND STRENGTH Our insurance financial strength was rated Aa2, AA, and A+g by Moody's, Standard & Poor's and A.M. Best, respectively, at December 31, 2004. Our ratings are influenced by many factors including our operating and financial performance, asset quality, liquidity, asset/liability management, overall portfolio mix, financial leverage (i.e., debt), exposure to risks and the current level of operating leverage. In 2004, A.M. Best revised the outlook to stable from positive for the insurance financial strength ratings of the Company, ALIC and certain rated ALIC subsidiaries and affiliates. State laws specify regulatory actions if an insurer's risk-based capital ("RBC"), a measure of an insurer's solvency, falls below certain levels. The NAIC has a standard formula for annually assessing RBC. The formula for calculating RBC takes into account factors relating to insurance, business, asset and interest rate risks. At December 31, 2004, our RBC was above levels that would require regulatory actions. The NAIC has also developed a set of financial relationships or tests known as the Insurance Regulatory Information System to assist state regulators in monitoring the financial condition of insurance companies and identifying companies that require special attention or action from insurance regulatory authorities. The NAIC analyzes data provided by insurance companies using prescribed ratios, each with defined "usual ranges." Generally, regulators will begin to monitor an insurance company if its ratios fall outside the usual ranges for four or more of the ratios. If an insurance company has insufficient capital, regulators may act to reduce the amount of insurance it can issue. Our ratios are within these ranges. 24 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONT.) LIQUIDITY SOURCES AND USES Our potential sources of funds principally include the following activities: Receipt of insurance premiums Contractholder fund deposits Reinsurance recoveries Receipts of principal and interest on investments Sales of investments Funds from securities lending Inter-company loans Capital contributions from parent Our potential uses of funds principally include the following activities: Payment of contract benefits, maturities, surrenders and withdrawals Reinsurance cessions and payments Operating costs and expenses Purchase of investments Repayment of securities lending Repayment of inter-company loans Tax payments/settlements Dividends to shareholder Operating cash flows increased $22.5 million in 2004 compared to 2003 as a result of higher interest received on fixed income securities and mortgage loans and increased premium collections, partially offset by higher contract benefits and expenses paid. Decreased operating cash flows in 2003 compared to 2002 primarily relate to a decline in premiums from immediate annuities with life contingencies and higher acquisition related expenses partially offset by increased investment income. Higher investing cash flows in 2004 compared to 2003 reflect the investment of increased financing and operating cash flows. Cash flows from investing activities declined in 2003 compared to 2002 as a result of decreased operating and financing cash flows. Increased financing cash flows were primarily the result of higher deposits on fixed annuities and interest-sensitive life products, partially offset by lower variable life and annuity deposits to fixed accounts and benefits and withdrawals paid. Declines in cash flow from financing activities during 2003 compared to 2002 primarily reflect a decrease in deposits received from contractholders and an increase in withdrawals from contractholders' accounts. To ensure we have the appropriate level of liquidity, we perform actuarial tests on the impact to cash flows of policy surrenders and other actions under various scenarios. Depending upon the years in which certain policy types were sold with specific surrender provisions, cash flow could vary due to higher surrender of policies exiting their surrender charge periods. We have entered into an inter-company loan agreement with the Corporation. The amount of inter-company loans available to us is at the discretion of the Corporation. The maximum amount of loans the Corporation will have outstanding to all its eligible subsidiaries at any given point in time is limited to $1.00 billion. We had no amounts outstanding under the inter-company loan agreement at December 31, 2004 or 2003. The Corporation uses commercial paper borrowings and bank lines of credit to fund intercompany borrowings. Certain remote events and circumstances could constrain the Corporation's liquidity. Those events and circumstances include, for example, a catastrophe resulting in extraordinary losses, a downgrade in the Corporation's long-term debt rating of A1 and A+ (from Moody's and Standard & Poor's, respectively) to non-investment grade status of below Baa3/BBB-, a downgrade in AIC's financial strength rating from Aa2, AA and A+ (from Moody's, Standard & Poor's and A.M. Best, respectively) to below Baa/BBB/A-, or a downgrade in ALIC's or our financial strength ratings from Aa2, AA and A+ (from Moody's, Standard & Poor's and A.M. Best, respectively) to below Aa3/AA-/A-. The rating agencies also consider the interdependence of the Corporation's individually rated entities, and therefore, a rating change in one entity could potentially affect the ratings of other related entities. 25 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONT.) CONTRACTUAL OBLIGATIONS AND COMMITMENTS Our contractual obligations as of December 31, 2004 and the payments due by period are shown in the following table.
Less Than After 5 ($ IN THOUSANDS) Total 1 year 1-3 years 4-5 years years ------------ ------------ ------------ ------------ ------------ Securities lending (1) $ 133,368 $ 133,368 $ - $ - $ - Contractholder funds(2) 6,137,441 290,659 1,025,422 752,879 4,068,481 Reserve for life-contingent contract benefits(3) 5,139,824 80,125 265,046 194,495 4,600,158 Payable to affiliates, net 8,831 8,831 - - - Reinsurance payable to parent 1,067 1,067 - - - Other liabilties and accrued expenses(4)(5) 24,101 22,002 67 62 1,970 ------------ ------------ ------------ ------------ ------------ Total Contractual Cash Obligations $ 11,444,632 $ 536,052 $ 1,290,535 $ 947,436 $ 8,670,609 ============ ============ ============ ============ ============
---------- (1) Securities lending transactions are typically fully collateralized with marketable securities. We manage our short-term liquidity position to ensure the availability of a sufficient amount of liquid assets to extinguish short-term liabilities as they come due in the normal course of business. (2) Contractholder funds represent interest-bearing liabilities arising from the sale of products such as interest-sensitive life and fixed annuities, including immediate annuities without life contingencies. These amounts reflect estimated cash payments to be made to policyholders and contractholders. Certain of these contracts, such as immediate annuities without life contingencies, involve payment obligations where the amount and timing of the payment is essentially fixed and determinable. These amounts relate to (i) policies or contracts where we are currently making payments and will continue to do so and (ii) contracts where the timing of payments has been determined by the contract. Other contracts, such as interest-sensitive life and fixed deferred annuities, involve payment obligations where the amount and timing of future payments is uncertain. For these contracts, the Company is not currently making payments and will not make payments until (i) the occurrence of an insurable event, such as death, or (ii) the occurrence of a payment triggering event, such as the surrender of or partial withdrawal on a policy or deposit contract, which is outside of the control of the Company. We have estimated the timing of payments related to these contracts based on historical experience and our expectation of future payment patterns. Uncertainties relating to these liabilities include mortality, customer lapse and withdrawal activity, and estimated additional deposits for interest-sensitive life contracts, which may significantly impact both the timing and amount of future payments. Such cash outflows reflect adjustments for the estimated timing of mortality, retirement, and other appropriate factors, but are undiscounted with respect to interest. As a result, the sum of the cash outflows shown for all years in the table of $6.14 billion exceeds the corresponding liability amounts of $3.80 billion included in the Statements of Financial Position as of December 31, 2004 for contractholder funds. The liability amount in the Statements of Financial Position reflects the discounting for interest as well as adjustments for the timing of other factors as described above. (3) The reserve for life-contingent contract benefits relates primarily to traditional life and immediate annuities with life contingencies and reflects the present value of estimated cash payments to be made to policyholders and contractholders. Immediate annuities with life contingencies include (i) contracts where we are currently making payments and will continue to do so until the occurrence of a specific event such as death and (ii) contracts where the timing of a portion of the payments has been determined by the contract. Other contracts, such as traditional life and supplemental accident and health insurance, involve payment obligations where the amount and timing of future payments is uncertain. For these contracts, the Company is not currently making payments and will not make payments until (i) the occurrence of an insurable event, such as death or illness, or (ii) the occurrence of a payment triggering event, such as a surrender of a policy or contract, which is outside of the control of the Company. We have estimated the timing of cash outflows related to these contracts based on historical experience and our expectation of future payment patterns. Uncertainties relating to these liabilities include mortality, morbidity, expenses, customer lapse and withdrawal activity, and renewal premium for life policies, which may significantly impact both the timing and amount of future payments. Such cash outflows reflect adjustments for the estimated timing of mortality, retirement, and other appropriate factors, but are undiscounted with respect to interest. As a result, the sum of the cash outflows shown for all years in the table of $5.14 billion exceeds the corresponding liability amounts of $1.78 billion included in the Statements of Financial Position as of December 31, 2004 for reserve for life-contingent contract benefits. The liability amount in the Statements of Financial Position reflects the discounting for interest as well as adjustments for the timing of other factors as described above. (4) Other liabilities primarily include accrued expenses and claim payments. (5) Balance sheet liabilities not included in the table above include unearned and advance premiums of $398 million and deferred income taxes of $91 million. These items were excluded as they do not meet the definition of a contractual liability as we are not contractually obligated to pay these amounts to third parties. Rather, they represent an accounting mechanism that allows us to present our financial statements on an accrual basis of accounting. In addition, other liabilities of $23.0 million were not included in the table above because they did not represent a contractual obligation or the amount and timing of their eventual payment was sufficiently uncertain. At December 31, 2004, we had $20.0 million in contractual conditional commitments to invest in mortgage loans. REGULATION AND LEGAL PROCEEDINGS 26 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONT.) We are subject to extensive regulation and we are involved in various legal and regulatory actions, all of which have an effect on specific aspects of our business. For a detailed discussion of the legal and regulatory actions in which we are involved, see Note 11 of the financial statements. PENDING ACCOUNTING STANDARDS As of December 31, 2004, there are pending accounting standards that we have not implemented either because the standard has not been finalized or the implementation date has not yet occurred. For a discussion of these pending standards, see Note 2 of the financial statements. The effect of implementing certain accounting standards on our financial results and financial condition is often based in part on market conditions at the time of implementation of the standard and other factors we are unable to determine prior to implementation. For this reason, we are sometimes unable to estimate the effect of certain pending accounting standards until the relevant authoritative body finalizes these standards or until we implement them. FORWARD-LOOKING STATEMENTS AND RISK FACTORS This document contains "forward-looking statements" that anticipate results based on our estimates, assumptions and plans that are subject to uncertainty. These statements are made subject to the safe-harbor provisions of the Private Securities Litigation Reform Act of 1995. We assume no obligation to update any forward-looking statements as a result of new information or future events or developments. These forward-looking statements do not relate strictly to historical or current facts and may be identified by their use of words like "plans," "seeks," "expects," "will," "should," "anticipates," "estimates," "intends," "believes," "likely," "targets" and other words with similar meanings. These statements may address, among other things, our strategy for growth, product development, regulatory approvals, market position, expenses, financial results, litigation and reserves. We believe that these statements are based on reasonable estimates, assumptions and plans. However, if the estimates, assumptions or plans underlying the forward-looking statements prove inaccurate or if other risks or uncertainties arise, actual results could differ materially from those communicated in these forward-looking statements. Factors which could cause actual results to differ materially from those suggested by such forward-looking statements include but are not limited to those discussed or identified in this document (including the risks described below) and in our public filings with the SEC. In addition to the normal risks of business, we are subject to significant risks and uncertainties, including those listed below, which apply to us as an insurer and a provider of other financial services. RISKS RELATING TO THE BUSINESS CHANGES IN UNDERWRITING AND ACTUAL EXPERIENCE COULD MATERIALLY AFFECT PROFITABILITY Our product pricing includes long-term assumptions regarding investment returns, mortality, morbidity, persistency and operating costs and expenses of the business. Management establishes target returns for each product based upon these factors and the average amount of regulatory and rating agency capital that the Company must hold to support in-force contracts. We monitor and manage our pricing and overall sales mix to achieve target returns on a portfolio basis. Profitability from new business emerges over a period of years depending on the nature and life of the product and is subject to variability as actual results may differ from pricing assumptions. Our profitability depends on the adequacy of investment margins, the management of market and credit risks associated with investments, our ability to maintain premiums and contract charges at a level adequate to cover mortality and morbidity benefits, the adequacy of contract charges on variable contracts to cover the costs of various product features, the persistency of policies to ensure recovery of acquisition expenses, and the management of operating costs and expenses within anticipated pricing allowances. Legislation and regulation of the insurance marketplace and products could also affect our profitability. CHANGES IN RESERVE ESTIMATES MAY REDUCE PROFITABILITY Reserve for life-contingent contract benefits is computed on the basis of long-term actuarial assumptions of future investment yields, mortality, morbidity, policy terminations and expenses. We periodically review the adequacy of these reserves on an aggregate basis and if future experience differs significantly from assumptions, 27 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONT.) adjustments to reserves may be required which could have a material adverse effect on our operating results and financial condition. CHANGES IN MARKET INTEREST RATES MAY LEAD TO A SIGNIFICANT DECREASE IN THE SALES AND PROFITABILITY OF SPREAD-BASED PRODUCTS Our ability to manage the investment margin for spread-based products is dependent upon maintaining profitable spreads between investment yields and interest crediting rates. As interest rates decrease or remain at low levels, proceeds from investments that have matured, prepaid or been sold may be reinvested at lower yields, reducing investment margin. Lowering interest crediting rates can offset decreases in investment margin on some products. However, these changes could be limited by market conditions, regulatory or contractual minimum rate guarantees on many contracts and may not match the timing or magnitude of changes in asset yields. Decreases in the rates offered on products could make those products less attractive, leading to lower sales and/or changes in the level of surrenders and withdrawals for these products. Increases in market interest rates can also have negative effects, for example by increasing the attractiveness of other investments, which can lead to higher surrenders at a time when the investment asset values are lower as a result of the increase in interest rates. For certain products, principally fixed annuity and interest-sensitive life products, the earned rate on assets could lag behind market yields. We may react to market conditions by increasing crediting rates, which could narrow spreads. Unanticipated surrenders could result in DAC unlocking or affect the recoverability of DAC and thereby increase expenses and reduce profitability. DECLINING EQUITY MARKETS MAY REDUCE BOTH SALES OF PRODUCTS AND INCOME FROM CONTRACT CHARGES AND MAY ADVERSELY AFFECT OPERATING RESULTS AND FINANCIAL CONDITION Conditions in the United States and international stock markets affect the sale and profitability of our variable annuities. In general, sales of variable annuities decrease when stock markets are declining over an extended period of time. The effect of decreasing separate accounts balances resulting from volatile equity markets, lower underlying fund performance or declining consumer confidence could cause contract charges earned to decrease. In addition, it is possible that the assumptions and projections we use to establish prices for GMDB, GMIB, GMAB and GMWB products, particularly assumptions and projections about investment performance, do not accurately reflect the level of costs that we will ultimately incur in providing those benefits, resulting in adverse margin trends. These factors may result in accelerated DAC amortization and require increases in reserves, which would reduce statutory capital and surplus and/or net income. Poor fund performance could also result in higher partial withdrawals of account value which, for some contracts, do not reduce the GMDB by a proportional amount. CHANGES IN ESTIMATES OF PROFITABILITY ON INTEREST-SENSITIVE AND VARIABLE PRODUCTS MAY HAVE AN ADVERSE EFFECT ON RESULTS THROUGH INCREASED AMORTIZATION OF DAC DAC related to interest-sensitive life, variable life and annuity and investment contracts is amortized in proportion to EGP over the estimated lives of the contracts. Assumptions underlying EGP, including those relating to margins from mortality, investment margin, contract administration, surrender and other contract charges, are updated from time to time in order to reflect actual and expected experience and its potential effect on the valuation of DAC. Updates to these assumptions could result in DAC unlocking, which in turn could adversely affect our operating results and financial condition. A LOSS OF KEY PRODUCT DISTRIBUTION RELATIONSHIPS COULD MATERIALLY AFFECT SALES Certain products are distributed under agreements with other members of the financial services industry that are not affiliated with us. Termination of one or more of these agreements due to, for example, a change in control of one of these distributors, could have a detrimental effect on sales. CHANGES IN TAX LAWS MAY DECREASE SALES AND PROFITABILITY OF PRODUCTS Under current federal and state income tax law, certain products (primarily life insurance and annuities) we offer receive favorable tax treatment. This favorable treatment may give certain of our products a competitive advantage over noninsurance products. Congress from time to time considers legislation that would reduce or eliminate the favorable policyholder tax treatment currently applicable to life insurance and annuities. Congress also considers proposals to reduce the taxation of certain products or investments that may compete with life insurance and annuities. Legislation that increases the taxation on insurance products or reduces the taxation on competing products could lessen the advantage of certain of our products as compared to competing products. 28 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONT.) Such proposals, if adopted, could have a material adverse effect on our financial position or ability to sell such products and could result in the surrender of some existing contracts and policies. In addition, changes in the federal estate tax laws have negatively affected the demand for the types of life insurance used in estate planning. RISKS RELATING TO THE INSURANCE INDUSTRY OUR FUTURE RESULTS ARE DEPENDENT IN PART ON OUR ABILITY TO SUCCESSFULLY OPERATE IN AN INSURANCE INDUSTRY THAT IS HIGHLY COMPETITIVE The insurance industry is highly competitive. Our competitors include other insurers and, because many of our products include a savings or investment component, securities firms, investment advisers, mutual funds, banks and other financial institutions. Many of our competitors have well-established national reputations and market similar insurance products. Because of the competitive nature of the insurance industry, including competition for producers such as exclusive and independent agents, there can be no assurance that we will continue to effectively compete with our industry rivals, or that competitive pressure will not have a material adverse effect on our business, operating results or financial condition. The ability of banks to affiliate with insurers may have a material adverse effect on all of our product lines by substantially increasing the number, size and financial strength of potential competitors. Furthermore, certain competitors operate using a mutual insurance company structure and therefore, may have dissimilar profitability and return targets. WE ARE SUBJECT TO MARKET RISK AND SO CHANGING INTEREST RATES AND DECLINES IN CREDIT QUALITY MAY HAVE ADVERSE EFFECTS Because we have large investment portfolios, we are subject to market risk, the risk that we will incur losses due to adverse changes in interest rates and equity prices. Our primary market risk exposures are to changes in interest rates and equity prices and, to a lesser degree, changes in foreign currency exchange rates. For additional information on market risk, see the "Market Risk" section of MD&A. A decline in market interest rates could have an adverse effect on our investment income as we invest cash in new investments that may yield less than the portfolio's average rate. In a declining interest rate environment, borrowers may prepay or redeem securities we hold more quickly than expected as they seek to refinance at lower rates. A decline could also cause the purchase of longer-term assets in order to obtain adequate investment yields resulting in a duration gap when compared to the duration of liabilities. An increase in market interest rates could have an adverse effect on the value of our investment portfolio, for example, by decreasing the fair values of the fixed income securities that comprise a substantial majority of our investment portfolio. Increases in interest rates also may lead to an increase in policy loans, surrenders and withdrawals that generally would be funded at a time when fair values of fixed income securities are lower. A decline in the quality of our investment portfolio as a result of adverse economic conditions or otherwise could cause additional realized losses on securities, including realized losses relating to derivative strategies not adequately addressing portfolio risks. CONCENTRATION OF OUR INVESTMENT PORTFOLIOS IN ANY PARTICULAR SEGMENT OF THE ECONOMY MAY HAVE ADVERSE EFFECTS The concentration of our investment portfolios in any particular industry, group of related industries or geographic sector could have an adverse effect on our investment portfolios and consequently on our results of operations and financial position. Events or developments that have a negative impact on any particular industry, group of related industries or geographic sector may have a greater adverse effect on the investment portfolios to the extent that the portfolios are concentrated rather than diversified. WE MAY SUFFER LOSSES FROM LITIGATION As is typical for a large insurance group, the Allstate Group is involved in a substantial amount of litigation, including class action litigation challenging a range of company practices. Our litigation exposure could have a material adverse effect on our operating results and financial condition in a future period in the event of an unexpected adverse outcome or if additional reserves are required to be established for such litigation. For a description of our current legal proceedings, see Note 11 of the financial statements. WE ARE SUBJECT TO EXTENSIVE REGULATION AND POTENTIAL FURTHER RESTRICTIVE REGULATION MAY INCREASE OUR OPERATING COSTS AND LIMIT OUR GROWTH As an insurance company, we are subject to extensive laws and regulations. These laws and regulations are complex and subject to change. Moreover, they are administered and enforced by a number of different 29 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONT.) governmental authorities, including the New York State Insurance Department, state securities administrators, the SEC, the U.S. Department of Justice, and state attorneys general, each of which exercises a degree of interpretive latitude. Consequently, we are subject to the risk that compliance with any particular regulator's or enforcement authority's interpretation of a legal issue may not result in compliance with another regulator's or enforcement authority's interpretation of the same issue, particularly when compliance is judged in hindsight. In addition, there is risk that any particular regulator's or enforcement authority's interpretation of a legal issue may change over time to our detriment, or that changes in the overall legal environment may, even absent any particular regulator's or enforcement authority's interpretation of a legal issue changing, cause us to change our views regarding the actions we need to take from a legal risk management perspective, thus necessitating changes to our practices that may, in some cases, limit our ability to grow and improve the profitability of our business. Furthermore, in some cases, these laws and regulations are designed to protect the interests of a specific constituency rather than a range of constituencies. For example, state insurance laws and regulations are generally intended to protect purchasers or users of insurance products, not holders of securities. In many respects, these laws and regulations limit our ability to grow and improve the profitability of our business. In recent years, the state insurance regulatory framework has come under public scrutiny and members of Congress have discussed proposals to provide for optional federal chartering of insurance companies. We can make no assurances regarding the potential impact of state or federal measures that may change the nature or scope of insurance regulation. REINSURANCE MAY BE UNAVAILABLE AT HISTORICAL LEVELS AND PRICES WHICH MAY LIMIT OUR ABILITY TO WRITE NEW BUSINESS Market conditions beyond our control determine the availability and cost of the reinsurance we purchase. No assurances can be made that reinsurance will remain continuously available to us to the same extent and on the same terms and rates as are currently available. If we were unable to maintain our current level of reinsurance at prices that we consider acceptable, we would have to either accept an increase in our net liability exposure, reduce our insurance writings, or develop or seek other alternatives. REINSURANCE SUBJECTS US TO THE CREDIT RISK OF OUR REINSURERS AND MAY NOT BE ADEQUATE TO PROTECT US AGAINST LOSSES ARISING FROM CEDED INSURANCE The collectibility of reinsurance recoverables is subject to uncertainty arising from a number of factors, including whether insured losses meet the qualifying conditions of the reinsurance contract and whether reinsurers, or their affiliates, have the financial capacity and willingness to make payments under the terms of a reinsurance treaty or contract. Our inability to collect a material recovery from a reinsurer could have a material adverse effect on our operating results and financial condition. THE CONTINUED THREAT OF TERRORISM AND ONGOING MILITARY ACTIONS MAY ADVERSELY AFFECT THE LEVEL OF CLAIM LOSSES WE INCUR AND THE VALUE OF OUR INVESTMENT PORTFOLIO The continued threat of terrorism, both within the United States and abroad, and ongoing military and other actions and heightened security measures in response to these types of threats, may cause significant volatility and declines in the equity markets and with interest rates in the United States, Europe and elsewhere, and result in loss of life, property damage, additional disruptions to commerce and reduced economic activity. Some of the assets in our investment portfolio may be adversely affected by declines in the equity markets and reduced economic activity caused by the continued threat of terrorism. We seek to mitigate the potential impact of terrorism on our commercial mortgage portfolio by limiting geographical concentrations in key metropolitan areas and by requiring terrorism insurance to the extent that it is commercially available. Additionally, in the event that a terrorist act occurs, we may be adversely affected, depending on the nature of the event. ANY DECREASE IN OUR FINANCIAL STRENGTH RATINGS MAY HAVE AN ADVERSE EFFECT ON OUR COMPETITIVE POSITION Financial strength ratings are important factors in establishing the competitive position of insurance companies and generally have an effect on an insurance company's business. On an ongoing basis, rating agencies review the financial performance and condition of insurers and could downgrade or change the outlook on an insurer's ratings due to, for example, a change in an insurer's statutory capital; a change in a rating agency's determination of the amount of risk-adjusted capital required to maintain a particular rating; an increase in the perceived risk of an insurer's investment portfolio; a reduced confidence in management or a host of other considerations that may or may not be under the insurer's control. The insurance financial strength ratings of ALNY, ALIC and AIC are A+, AA and Aa2 (from A.M. Best, Standard & Poor's and Moody's, respectively). 30 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONT.) Several other affiliates of the Corporation have been assigned their own financial strength ratings by one or more rating agencies. Because all of these ratings are subject to continuous review, the retention of these ratings cannot be assured. A multiple level downgrade in any of these ratings could have a material adverse effect on our sales, our competitiveness, and the marketability of our product offerings impacting our liquidity, operating results and financial condition. CHANGES IN ACCOUNTING STANDARDS ISSUED BY THE FASB OR OTHER STANDARD-SETTING BODIES MAY ADVERSELY AFFECT OUR FINANCIAL STATEMENTS Our financial statements are subject to the application of GAAP, which is periodically revised and/or expanded. Accordingly, we are required to adopt new or revised accounting standards from time to time issued by recognized authoritative bodies, including the FASB. It is possible that future changes we are required to adopt could change the current accounting treatment that we apply to our financial statements and that such changes could have a material adverse effect on our results and financial condition. For a description of potential changes in accounting standards that could affect us currently, see Note 2 of the financial statements. THE OCCURRENCE OF EVENTS UNANTICIPATED IN OUR DISASTER RECOVERY SYSTEMS AND MANAGEMENT CONTINUITY PLANNING COULD IMPAIR OUR ABILITY TO CONDUCT BUSINESS EFFECTIVELY In the event of a disaster such as a natural catastrophe, an industrial accident, a terrorist attack or war, events unanticipated in our disaster recovery systems could have an adverse impact on our ability to conduct business and on our results of operations and financial condition, particularly if those events affect our computer-based data processing, transmission, storage and retrieval systems. In the event that a significant number of our managers could be unavailable in the event of a disaster, our ability to effectively conduct our business could be severely compromised. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Information required for Item 7A is incorporated by reference to the material under the caption "Market Risk" in Part II, Item 7 of this report. 31 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA ALLSTATE LIFE INSURANCE COMPANY OF NEW YORK STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME
YEAR ENDED DECEMBER 31, -------------------------------------------- (IN THOUSANDS) 2004 2003 2002 ------------ ------------ ------------ REVENUES Premiums (net of reinsurance ceded of $16,133, $8,021 and $5,868) $ 76,550 $ 68,011 $ 93,270 Contract charges 59,834 53,018 50,082 Net investment income 302,055 264,854 232,967 Realized capital gains and losses (9,297) (8,518) (12,573) ------------ ------------ ------------ 429,142 377,365 363,746 ------------ ------------ ------------ COSTS AND EXPENSES Contract benefits (net of reinsurance recoveries of $7,536, $5,219 and $2,987) 182,150 167,221 178,163 Interest credited to contractholder funds 129,804 106,020 87,555 Amortization of deferred policy acquisition costs 25,971 29,969 23,535 Operating costs and expenses 42,115 36,978 37,339 ------------ ------------ ------------ 380,040 340,188 326,592 GAIN (LOSS) ON DISPOSITION OF OPERATIONS 1,326 (4,458) - ------------ ------------ ------------ INCOME FROM OPERATIONS BEFORE INCOME TAX EXPENSE AND CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE, AFTER-TAX 50,428 32,719 37,154 Income tax expense 17,925 12,029 12,975 ------------ ------------ ------------ INCOME BEFORE CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE, AFTER-TAX 32,503 20,690 24,179 Cumulative effect of change in accounting principle, after-tax (7,586) - - ------------ ------------ ------------ NET INCOME 24,917 20,690 24,179 ------------ ------------ ------------ OTHER COMPREHENSIVE INCOME (LOSS), AFTER TAX Change in unrealized net capital gains and losses 16,531 (30,931) 50,660 ------------ ------------ ------------ COMPREHENSIVE INCOME (LOSS) $ 41,448 $ (10,241) $ 74,839 ============ ============ ============
See notes to financial statements. 32 ALLSTATE LIFE INSURANCE COMPANY OF NEW YORK STATEMENTS OF FINANCIAL POSITION
DECEMBER 31, --------------------------- (IN THOUSANDS, EXCEPT PAR VALUE DATA) 2004 2003 ------------ ------------ ASSETS Investments Fixed income securities, at fair value (amortized cost $5,012,977 and $3,935,447 ) $ 5,545,647 $ 4,415,327 Mortgage loans 480,280 385,643 Short-term 111,509 22,756 Policy loans 34,948 34,107 Other 4,638 - ------------ ------------ Total investments 6,177,022 4,857,833 Cash 8,624 10,731 Deferred policy acquisition costs 238,173 187,437 Accrued investment income 55,821 47,818 Reinsurance recoverables 8,422 4,584 Current income taxes receivable 367 8,170 Other assets 17,665 15,004 Separate Accounts 792,550 665,875 ------------ ------------ TOTAL ASSETS $ 7,298,644 $ 5,797,452 ============ ============ LIABILITIES Reserve for life-contingent contract benefits $ 1,782,451 $ 1,683,771 Contractholder funds 3,802,846 2,658,325 Deferred income taxes 90,760 81,657 Other liabilities and accrued expenses 180,904 168,081 Payable to affiliates, net 8,831 5,061 Reinsurance payable to parent 1,067 1,108 Separate Accounts 792,550 665,875 ------------ ------------ TOTAL LIABILITIES 6,659,409 5,263,878 ------------ ------------ COMMITMENTS AND CONTINGENT LIABILITIES (NOTE 11) SHAREHOLDER'S EQUITY Common stock, $25 par value, 100 thousand shares authorized, issued and outstanding 2,500 2,500 Additional capital paid-in 120,000 55,787 Retained income 361,480 336,563 Accumulated other comprehensive income: Unrealized net capital gains and losses 155,255 138,724 ------------ ------------ Total accumulated other comprehensive income 155,255 138,724 ------------ ------------ TOTAL SHAREHOLDER'S EQUITY 639,235 533,574 ------------ ------------ TOTAL LIABILITIES AND SHAREHOLDER'S EQUITY $ 7,298,644 $ 5,797,452 ============ ============
See notes to financial statements. 33 ALLSTATE LIFE INSURANCE COMPANY OF NEW YORK STATEMENTS OF SHAREHOLDER'S EQUITY
DECEMBER 31, ------------------------------------------- (IN THOUSANDS) 2004 2003 2002 ------------ ------------ ------------ COMMON STOCK $ 2,500 $ 2,500 $ 2,500 ------------ ------------ ------------ ADDITIONAL CAPITAL PAID IN Balance, beginning of year 55,787 55,787 45,787 Capital contribution 64,213 - 10,000 ------------ ------------ ------------ Balance, end of year 120,000 55,787 55,787 ------------ ------------ ------------ RETAINED INCOME Balance, beginning of year 336,563 315,873 291,694 Net income 24,917 20,690 24,179 ------------ ------------ ------------ Balance, end of year 361,480 336,563 315,873 ------------ ------------ ------------ ACCUMULATED OTHER COMPREHENSIVE INCOME Balance, beginning of year 138,724 169,655 118,995 Change in unrealized net capital gains and losses 16,531 (30,931) 50,660 ------------ ------------ ------------ Balance, end of year 155,255 138,724 169,655 ------------ ------------ ------------ TOTAL SHAREHOLDER'S EQUITY $ 639,235 $ 533,574 $ 543,815 ============ ============ ============
See notes to financial statements. 34 ALLSTATE LIFE INSURANCE COMPANY OF NEW YORK STATEMENTS OF CASH FLOWS
YEAR ENDED DECEMBER 31, ------------------------------------------ (IN THOUSANDS) 2004 2003 2002 ------------ ------------ ------------ CASH FLOWS FROM OPERATING ACTIVITIES Net income $ 24,917 $ 20,690 $ 24,179 Adjustments to reconcile net income to net cash provided by operating activities Amortization and other non-cash items (51,544) (49,547) (48,233) Realized capital gains and losses 9,297 8,518 12,573 (Gain) loss on disposition of operations (1,326) 4,458 - Cumulative effect of change in accounting principle 7,586 - - Interest credited to contractholder funds 129,804 106,020 87,555 Changes in: Life-contingent contract benefits and contractholder funds 32,492 21,200 48,192 Deferred policy acquisition costs (66,532) (28,937) (33,316) Income taxes 12,091 (3,715) (4,083) Other operating assets and liabilities (7,442) (11,917) 4,352 ------------ ------------ ------------ Net cash provided by operating activities 89,343 66,770 91,219 ------------ ------------ ------------ CASH FLOWS FROM INVESTING ACTIVITIES Proceeds from sales of fixed income securities 485,522 251,569 242,113 Investment collections Fixed income securities 184,317 210,569 215,774 Mortgage loans 26,714 24,345 17,012 Investments purchases Fixed income securities (1,758,452) (1,027,047) (1,039,671) Mortgage loans (119,953) (87,889) (97,076) Change in short-term investments, net (29,248) 9,866 (13,972) Change in other investments, net 2,678 291 (875) Change in policy loans (841) (349) (598) ------------ ------------ ------------ Net cash used in investing activities (1,209,263) (618,645) (677,293) ------------ ------------ ------------ CASH FLOWS FROM FINANCING ACTIVITIES Capital contribution 64,213 - 10,000 Contractholder fund deposits 1,385,364 728,788 760,116 Contractholder fund withdrawals (331,764) (187,868) (169,731) ------------ ------------ ------------ Net cash provided by financing activities 1,117,813 540,920 600,385 ------------ ------------ ------------ NET (DECREASE) INCREASE IN CASH (2,107) (10,955) 14,311 CASH AT BEGINNING OF YEAR 10,731 21,686 7,375 ------------ ------------ ------------ CASH AT END OF YEAR $ 8,624 $ 10,731 $ 21,686 ============ ============ ============
See notes to financial statements. 35 ALLSTATE LIFE INSURANCE COMPANY OF NEW YORK NOTES TO FINANCIAL STATEMENTS 1. GENERAL BASIS OF PRESENTATION The accompanying financial statements include the accounts of Allstate Life Insurance Company of New York (the "Company"), a wholly owned subsidiary of Allstate Life Insurance Company ("ALIC"), which is wholly owned by Allstate Insurance Company ("AIC"), a wholly owned subsidiary of The Allstate Corporation (the "Corporation"). These financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America ("GAAP"). Management has identified the Company as a single segment entity. To conform to the 2004 presentation, certain amounts in the prior years' financial statements and notes have been reclassified. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. NATURE OF OPERATIONS The Company sells life insurance, retirement and investment products to individual customers through several distribution channels. The principal products are deferred and immediate fixed annuities, variable annuities, interest-sensitive and traditional life insurance, variable life insurance and supplemental accident and health insurance. The Company is authorized to sell life insurance, retirement and investment products in the state of New York. The Company distributes its products through multiple intermediary distribution channels, including Allstate Exclusive Agencies, independent agents, banks, broker-dealers, and specialized structured settlement brokers. The Company sells products through independent agents affiliated with master brokerage agencies. Independent workplace enrolling agents and Allstate Exclusive Agencies also sell the Company's supplemental accident and health insurance products to employees of small and medium size firms. Although the Company currently benefits from agreements with financial services entities that market and distribute its products, change in control of these non-affiliated entities could negatively impact the Company's sales. Approximately 50% of 2004 sales of structured settlement annuities were sold through four specialized structured settlement brokers. The Company monitors economic and regulatory developments that have the potential to impact its business. The ability of banks to affiliate with insurers may have a material adverse effect on all of the Company's product lines by substantially increasing the number, size and financial strength of potential competitors. Furthermore, state and federal laws and regulations affect the taxation of insurance companies and life insurance and annuity products. Congress and various state legislatures have considered proposals that, if enacted, could impose a greater tax burden on the Company or could have an adverse impact on the tax treatment of some insurance products offered by the Company, including favorable policyholder tax treatment currently applicable to life insurance and annuities. Legislation that reduced the federal income tax rates applicable to certain dividends and capital gains realized by individuals, or other proposals, if adopted, that reduce the taxation, or permit the establishment, of certain products or investments that may compete with life insurance or annuities could have an adverse effect on the Company's financial position or ability to sell such products and could result in the surrender of some existing contracts and policies. In addition, recent changes in the federal estate tax laws have negatively affected the demand for the types of life insurance used in estate planning. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES INVESTMENTS Fixed income securities include bonds, mortgage-backed, commercial mortgage-backed and asset-backed securities, and redeemable preferred stocks. Fixed income securities are carried at fair value and may be sold prior to their contractual maturity ("available for sale"). The fair value of publicly traded fixed income securities is based upon independent market quotations. The fair value of non-publicly traded securities is based on either widely accepted pricing valuation models which use internally developed ratings and independent third party data (e.g., term structures and current publicly traded bond prices) as inputs or independent third party pricing sources. The valuation models use indicative information such as ratings, industry, coupon, and maturity along with related third party data and publicly traded bond prices to determine security specific spreads. These spreads are then adjusted for illiquidity based on historical analysis and broker surveys. Periodic changes in fair values, net of deferred income taxes, certain life and annuity deferred policy acquisition costs, certain deferred sales inducement costs, and certain reserves for life-contingent contract benefits, are reflected as a component of other 36 ALLSTATE LIFE INSURANCE COMPANY OF NEW YORK NOTES TO FINANCIAL STATEMENTS comprehensive income. Cash received from calls, principal payments and make-whole payments is reflected as a component of proceeds from sales. Cash received from maturities and pay-downs is reflected as a component of investment collections. Mortgage loans are carried at outstanding principal balances, net of unamortized premium or discount and valuation allowances, if any. Valuation allowances are established for impaired loans when it is probable that contractual principal and interest will not be collected. Valuation allowances for impaired loans reduce the carrying value to the fair value of the collateral or the present value of the loan's expected future repayment cash flows discounted at the loan's original effective interest rate. Short-term investments are carried at cost or amortized cost that approximates fair value, and include the reinvestment of collateral received in connection with securities lending activities. For these transactions, the Company records an offsetting liability in other liabilities and accrued expenses for the Company's obligation to repay the collateral. Other investments, which consist primarily of policy loans, are carried at the unpaid principal balances. Investment income consists primarily of interest and is recognized on an accrual basis. Interest income on mortgage-backed, commercial mortgage-backed and asset-backed securities is determined using the effective yield method, based on estimated principal repayments. Accrual of income is suspended for fixed income securities and mortgage loans that are in default or when the receipt of interest payments is in doubt. Realized capital gains and losses include gains and losses on investment dispositions, write-downs in value due to other than temporary declines in fair value and changes in the fair value of certain derivatives including related periodic and final settlements. Realized capital gains and losses on investment dispositions are determined on a specific identification basis. The Company writes down, to fair value, fixed income securities that are classified as other than temporarily impaired in the period the security is deemed to be other than temporarily impaired (see Note 6). DERIVATIVE AND EMBEDDED DERIVATIVE FINANCIAL INSTRUMENTS Derivative financial instruments utilized by the Company include foreign currency swaps, interest rate caps, interest rate futures, and reinvestment related and equity market risk transfer reinsurance agreements with ALIC that meet the accounting definition of a derivative (see Note 4). Foreign currency swaps involve the future exchange or delivery of foreign currency on terms negotiated at the inception of the contract. Interest rate cap agreements give the holder the right to receive at a future date, the amount, if any, by which a specified market interest rate exceeds the fixed cap, applied to a notional amount. Interest rate futures are defined as commitments to buy or sell designated financial instruments based on specified prices or yields. Derivatives that are required to be separated from the host instrument and accounted for as derivative financial instruments ("subject to bifurcation") are embedded in certain variable life and annuity contracts. All derivatives are accounted for on a fair value basis and reported as other investments, reinsurance recoverables, other assets, other liabilities and accrued expenses or contractholder funds. Embedded derivative instruments subject to bifurcation are also accounted for on a fair value basis and are reported together with the host contract. The change in the fair value of derivatives embedded in assets and subject to bifurcation is reported in realized capital gains and losses. The change in the fair value of derivatives embedded in liabilities and subject to bifurcation is reported in contract benefits or realized capital gains and losses. When derivatives meet specific criteria, they may be designated as accounting hedges and accounted for as fair value, cash flow, foreign currency fair value or foreign currency cash flow hedges. The hedged item may be either all or a specific portion of a recognized asset, liability or an unrecognized firm commitment attributable to a particular risk. At the inception of the hedge, the Company formally documents the hedging relationship and risk management objective and strategy. The documentation identifies the hedging instrument, the hedged item, the nature of the risk being hedged and the methodology used to assess how effective the hedging instrument is in offsetting the exposure to changes in the hedged item's fair value attributable to the hedged risk, or in the case of a cash flow hedge, the exposure to changes in the hedged item's or transaction's variability in cash flows attributable to the hedged risk. The Company does not exclude any component of the change in fair value of the hedging instrument from the effectiveness assessment. At each reporting date, the Company confirms that the hedging instrument continues to be highly effective in offsetting the hedged risk. Ineffectiveness in fair value hedges and cash flow hedges is reported in realized capital gains and losses. CASH FLOW HEDGES The Company designates certain of its foreign currency swap contracts as cash flow hedges when the hedging instrument is highly effective in offsetting the exposure of variations in cash flows for the hedged risk that could affect net income. The Company's cash flow exposure may be associated with an 37 ALLSTATE LIFE INSURANCE COMPANY OF NEW YORK NOTES TO FINANCIAL STATEMENTS existing asset, liability, or a forecasted transaction. Anticipated transactions must be probable of occurrence and their significant terms and specific characteristics must be identified. For hedging instruments used in cash flow hedges, the changes in fair value of the derivatives are reported in accumulated other comprehensive income as unrealized net capital gains and losses. Amounts are reclassified to net investment income or realized capital gains and losses as the hedged transaction affects net income or when the forecasted transaction affects net income. Accrued periodic settlements on derivatives used in cash flow hedges are reported in net investment income. The amount reported in accumulated other comprehensive income for a hedged transaction is limited to the lesser of the cumulative gain or loss on the derivative less the amount reclassified to net income; or the cumulative gain or loss on the derivative needed to offset the cumulative change in the expected future cash flows on the hedged transaction from inception of the hedge less the derivative gain or loss previously reclassified from accumulated other comprehensive income to net income. If the Company expects at any time that the loss reported in accumulated other comprehensive income would lead to a net loss on the combination of the hedging instrument and the hedged transaction which may not be recoverable, a loss is recognized immediately in realized capital gains and losses. If an impairment loss is recognized on an asset or an additional obligation is incurred on a liability involved in a hedge transaction, any offsetting gain in accumulated other comprehensive income is reclassified and reported together with the impairment loss or recognition of the obligation. NON-HEDGE DERIVATIVE FINANCIAL INSTRUMENTS The Company also has certain derivatives that are used in interest rate and equity price risk management strategies for which hedge accounting is not applied. These derivatives consist of interest rate caps, financial futures contracts, and reinvestment related and equity market risk transfer reinsurance agreements with ALIC that meet the accounting definition of a derivative. Based upon the type of derivative instrument and strategy, the income statement effects of these derivatives are reported in a single line item, with the results of the associated risk. Therefore, the derivatives' fair value gains and losses and accrued periodic settlements are recognized together in one of the following during the reporting period: realized capital gains and losses or contract benefits. SECURITIES LOANED Securities loaned are treated as financing arrangements and the collateral received is recorded in short-term investments, fixed income securities and other liabilities and accrued expenses. The Company obtains collateral in an amount not less than 102% of the fair value of the securities. The Company monitors the market value of securities loaned on a daily basis and obtains additional collateral as necessary. Substantially all of the Company's securities loaned are placed with large brokerage firms. RECOGNITION OF PREMIUM REVENUES AND CONTRACT CHARGES, AND RELATED BENEFITS AND INTEREST CREDITED Traditional life insurance products consist principally of products with fixed and guaranteed premiums and benefits, primarily term and whole life insurance products. Premiums from these products are recognized as revenue when due. Benefits are recognized in relation to such revenue so as to result in the recognition of profits over the life of the policy and are reflected in contract benefits. Immediate annuities with life contingencies, including certain structured settlement annuities, provide insurance protection over a period that extends beyond the period during which premiums are collected. Premiums from these products are recognized as revenue when due, at the inception of the contract. Benefits and expenses are recognized in relation to such revenue such that profits are recognized over the lives of the contracts. Interest-sensitive life contracts, such as universal life and single premium life, are insurance contracts whose terms are not fixed and guaranteed. The terms that may be changed include premiums paid by the contractholder, interest credited to the contractholder account balance and any amounts assessed against the contractholder account balance. Premiums from these contracts are reported as contractholder fund deposits. Contract charges consist of fees assessed against the contractholder account balance for cost of insurance (mortality risk), contract administration and early surrender. These revenues are recognized when assessed against the contractholder account balance. Contract benefits include life-contingent benefit payments in excess of the contractholder account balance. Contracts that do not subject the Company to significant risk arising from mortality or morbidity are referred to as investment contracts. Fixed annuities, including market value adjusted annuities and immediate annuities without life contingencies are considered investment contracts. Deposits received for such contracts are reported as contractholder fund deposits. Contract charges for investment contracts consist of fees assessed against the 38 ALLSTATE LIFE INSURANCE COMPANY OF NEW YORK NOTES TO FINANCIAL STATEMENTS contractholder account balance for maintenance, administration, and surrender of the contract prior to contractually specified dates, and are recognized when assessed against the contractholder account balance. Interest credited to contractholder funds represents interest accrued or paid on interest-sensitive life contracts and investment contracts. Crediting rates for certain fixed annuities and interest-sensitive life contracts are adjusted periodically by the Company to reflect current market conditions subject to contractually guaranteed minimum rates. Pursuant to the adoption of SOP 03-1, "Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts" ("SOP 03-1") in 2004, interest credited also includes amortization of deferred sales inducement ("DSI") expenses. DSI is amortized into interest credited using the same method used for deferred policy acquisition costs. Separate account products include variable annuities and variable life insurance contracts. The assets supporting these products are legally segregated and available only to settle separate account contract obligations. Deposits received are reported as separate accounts liabilities. Contract charges for these products consist of fees assessed against the contractholder account values for contract maintenance, administration, mortality, expense and early surrender. Contract benefits incurred include guaranteed minimum death, income and accumulation benefits incurred on variable annuity and life insurance contracts. DEFERRED POLICY ACQUISITION AND SALES INDUCEMENT COSTS Costs that vary with and are primarily related to acquiring life insurance and investment contracts are deferred and recorded as deferred policy acquisition costs ("DAC"). These costs are principally agents' and brokers' remuneration, certain underwriting costs and direct mail solicitation expenses. DSI costs related to sales inducements offered on sales to new customers, principally on investment contracts and primarily in the form of additional credits to the customer's account value or enhancements to interest credited for a specified period, which are beyond amounts currently being credited to existing contracts, are deferred and recorded as other assets. All other acquisition costs are expensed as incurred and included in operating costs and expenses on the Statements of Operations and Comprehensive Income. DAC is amortized to income and included in amortization of deferred policy acquisition costs on the Statements of Operations and Comprehensive Income. DSI is amortized to income using the same methodology and assumptions as DAC and is included in interest credited to contractholder funds on the Statements of Operations and Comprehensive Income. DAC and DSI are periodically reviewed for recoverability and written down when necessary. For traditional life insurance and other premium paying contracts, DAC is amortized in proportion to the estimated revenues on such business. Assumptions used in amortization of DAC and reserve calculations are determined based upon conditions as of the date of policy issue and are generally not revised during the life of the policy. Any deviations from projected business in force, resulting from actual policy terminations differing from expected levels, and any estimated premium deficiencies change the rate of amortization in the period such events occur. Generally, the amortization period for these contracts approximates the estimated lives of the policies. For internal exchanges of traditional life insurance, the unamortized balance of costs previously deferred under the original contracts are charged to income. The new costs associated with the exchange are deferred and amortized to income. For interest-sensitive life, variable annuities and investment contracts, DAC and DSI are amortized in proportion to the incidence of the present value of estimated gross profits ("EGP") on such business over the estimated lives of the contracts. Generally, the amortization period ranges from 15-30 years; however, estimates of customer surrender rates result in the majority of deferred costs being amortized over the surrender charge period. The rate of amortization during this term is matched to the pattern of EGP. EGP consists of estimates of the following components: benefit margins, primarily from mortality, including guaranteed minimum death, income, and accumulation benefits; investment margin including realized capital gains and losses; and contract administration, surrender and other contract charges, less maintenance expenses. DAC and DSI amortization for variable annuity and life contracts is estimated using stochastic modeling and is significantly impacted by the return on the underlying funds. The Company's long-term expectation of separate accounts fund performance net of fees was approximately 8%. Whenever actual separate accounts fund performance based on the two most recent years varies from the 8% expectation, the Company projects performance levels over the next five years such that the mean return over that seven-year period equals the long-term 8% expectation. This approach is commonly referred to as "reversion to the mean" and is commonly used by the life insurance industry as an appropriate method for amortizing variable annuity and life DAC and DSI. In applying the reversion to the mean process, the Company does not allow the future mean rates of return after fees projected over the five-year period to exceed 12.75% or fall below 0%. The Company periodically evaluates the 39 ALLSTATE LIFE INSURANCE COMPANY OF NEW YORK NOTES TO FINANCIAL STATEMENTS results of utilization of this process to confirm that it is reasonably possible that variable annuity and life fund performance will revert to the expected long-term mean within this time horizon. Changes in the amount or timing of EGP result in adjustments to the cumulative amortization of DAC and DSI. All such adjustments are reflected in the current results of operations. The Company performs quarterly reviews of DAC and DSI recoverability for interest-sensitive life, variable annuities and investment contracts in the aggregate using current assumptions. If a change in the amount of EGP is significant, it could result in the unamortized DAC and DSI not being recoverable, resulting in a charge which is included as a component of amortization of deferred policy acquisition costs or interest credited to contractholder funds, respectively, on the Statements of Operations and Comprehensive Income. REINSURANCE RECOVERABLES In the normal course of business, the Company seeks to limit aggregate and single exposure to losses on large risks by purchasing reinsurance from reinsurers (see Note 9). The amounts reported in the Statements of Financial Position include amounts billed to reinsurers on losses paid as well as estimates of amounts expected to be recovered from reinsurers on incurred losses that have not yet been paid. Reinsurance recoverables on unpaid losses are estimated based upon assumptions consistent with those used in establishing the liabilities related to the underlying reinsured contract. Insurance liabilities are reported gross of reinsurance recoverables. Prepaid reinsurance premiums are deferred and reflected in income in a manner consistent with the recognition of premiums on the reinsured contracts. Reinsurance does not extinguish the Company's primary liability under the policies written. Therefore, the Company regularly evaluates the financial condition of the reinsurers and establishes allowances for uncollectible reinsurance recoverables as appropriate. The Company has reinsurance treaties through which it cedes primarily re-investment related risk on its structured settlement annuities and guaranteed minimum accumulation benefits ("GMABs") to ALIC. The terms of these treaties meet the accounting definition of a derivative under SFAS No. 133 "Accounting for Derivative Instruments and Hedging Activities". Accordingly, the treaties are recorded in the Statement of Financial Position at fair value. For the treaty pertaining to the re-investment related risk on structured settlement annuities, changes in the fair value of the treaty and premiums paid to ALIC are recognized in realized capital gains and losses (see Note 4). For the treaty pertaining to the GMABs, changes in the fair value of the treaty are recognized in contract benefits. INCOME TAXES The income tax provision is calculated under the liability method. Deferred tax assets and liabilities are recorded based on the difference between the financial statement and tax bases of assets and liabilities at the enacted tax rates. The principal assets and liabilities giving rise to such differences are unrealized capital gains and losses on fixed income securities, insurance reserves and deferred policy acquisition costs. A deferred tax asset valuation allowance is established when there is uncertainty that such assets would be realized. RESERVE FOR LIFE-CONTINGENT CONTRACT BENEFITS The reserve for life-contingent contract benefits, which relates to traditional life, immediate annuities with life contingencies and supplemental accident and health insurance, is computed on the basis of long-term actuarial assumptions as to future investment yields, mortality, morbidity, terminations and expenses. These assumptions, which for traditional life insurance are applied using the net level premium method, include provisions for adverse deviation and generally vary by such characteristics as type of coverage, year of issue and policy duration. Detailed reserve assumptions and reserve interest rates are outlined in Note 8. To the extent that unrealized gains on fixed income securities would result in a premium deficiency had those gains actually been realized, the related increase in reserves for certain immediate annuities with life contingencies is recorded net of tax as a reduction of the unrealized net capital gains included in accumulated other comprehensive income. CONTRACTHOLDER FUNDS Contractholder funds represent interest-bearing liabilities arising from the sale of products, such as interest-sensitive life, fixed annuities, and variable annuity and life deposits allocated to fixed accounts. Contractholder funds are comprised primarily of deposits received and interest credited to the benefit of the contractholder less surrenders and withdrawals, mortality charges and administrative expenses. Contractholder funds also include reserves for secondary guarantees on variable annuities. Detailed information on crediting rates and surrender and withdrawal provisions on contractholder funds are outlined in Note 8. 40 ALLSTATE LIFE INSURANCE COMPANY OF NEW YORK NOTES TO FINANCIAL STATEMENTS SEPARATE ACCOUNTS The Company issues variable annuities and variable life insurance contracts, the assets and liabilities of which are legally segregated and recorded as assets and liabilities of the separate accounts. The assets of the separate accounts are carried at fair value. Separate accounts liabilities represent the contractholders' claims to the related assets and are carried at the fair value of the assets. Investment income and realized capital gains and losses of the separate accounts accrue directly to the contractholders and therefore, are not included in the Company's Statements of Operations and Comprehensive Income. Revenues to the Company from the separate accounts consist of contract charges for maintenance, administration, cost of insurance and surrender of the contract prior to the contractually specified dates and are reflected in premiums and contract charges. Deposits to the separate accounts are not included in cash flows. Absent any contract provision wherein the Company guarantees either a minimum return or account value upon death, a specified contract anniversary date, or annuitization, variable annuity and variable life insurance contractholders bear the investment risk that the separate accounts' funds may not meet their stated investment objectives. The account balances of variable contracts' separate accounts with guarantees included $758.4 million of equity, fixed income and balanced mutual funds and $32.3 million of money market mutual funds at December 31, 2004. LIABILITIES FOR VARIABLE CONTRACT GUARANTEES The Company offers various guarantees to variable annuity contractholders including a return of no less than (a) total deposits made on the contract less any customer withdrawals, (b) total deposits made on the contract less any customer withdrawals plus a minimum return or (c) the highest contract value on a specified anniversary date minus any customer withdrawals following the contract anniversary. These guarantees include benefits that are payable in the event of death (death benefits), upon annuitization (income benefits), or at specified dates during the accumulation period (accumulation benefits). Liabilities for variable contract guarantees related to death benefits are included in reserve for life-contingent contract benefits and the liabilities related to the income and accumulation benefits are included in contractholder funds in the Statements of Financial Position. Detailed information regarding the Company's variable contracts with guarantees is outlined in Note 8. Pursuant to the adoption of SOP 03-1 in 2004, the liability for death and income benefit guarantees is established equal to a benefit ratio multiplied by the cumulative contract charges earned, plus accrued interest less contract benefit payments. The benefit ratio is calculated as the estimated present value of all expected contract benefits divided by the present value of all expected contract charges. The establishment of reserves for these guarantees requires the projection of future separate account fund performance, mortality, persistency and customer benefit utilization rates. These assumptions are periodically reviewed and updated. For guarantees related to death benefits, benefits represent the current guaranteed minimum death benefit payments in excess of the current account balance. For guarantees related to income benefits, benefits represent the present value of the minimum guaranteed annuitization benefits in excess of the current account balance. Projected benefits and contract charges used in determining the liability for certain guarantees are developed using models and stochastic scenarios that are also used in the development of estimated expected gross profits. Underlying assumptions for the liability related to income benefits include assumed future annuitization elections based on factors such as the extent of benefit to the potential annuitant, eligibility conditions and the annuitant's attained age. The liability for guarantees is re-evaluated periodically, and adjustments are made to the liability balance through a charge or credit to contract benefits. Guarantees related to accumulation benefits are considered to be derivative financial instruments; therefore, the liability for accumulation benefits is established based on its fair value. OFF-BALANCE-SHEET FINANCIAL INSTRUMENTS Commitments to extend mortgage loans have off-balance-sheet risk because their contractual amounts are not recorded in the Company's Statements of Financial Position. The contractual amounts and fair values of these instruments are outlined in Note 7. 41 ALLSTATE LIFE INSURANCE COMPANY OF NEW YORK NOTES TO FINANCIAL STATEMENTS ADOPTED ACCOUNTING STANDARDS EMERGING ISSUES TASK FORCE ISSUE NO. 03-1, "THE MEANING OF OTHER-THAN-TEMPORARY IMPAIRMENT AND ITS APPLICATION TO CERTAIN INVESTMENTS" ("EITF 03-1") AND FSP EITF 03-1-1, "EFFECTIVE DATE OF PARAGRAPHS 10-20 OF EITF ISSUE NO. 03-1, THE MEANING OF OTHER-THAN-TEMPORARY IMPAIRMENT AND ITS APPLICATION TO CERTAIN INVESTMENTS" ("FSP EITF 03-1-1") In March 2004, the Emerging Issues Task Force ("EITF") reached a final consensus on EITF 03-1, which was to be effective for fiscal periods beginning after June 15, 2004. EITF 03-1 requires that when the fair value of an investment security is less than its carrying value an impairment exists for which a determination must be made as to whether the impairment is temporary or other-than-temporary. In September 2004, the Financial Accounting Standards Board ("FASB") issued, and the Company adopted, FSP EITF Issue 03-1-1, which deferred the effective date of the impairment measurement and recognition provisions contained in paragraphs 10-20 of EITF 03-1 until proposed FSP EITF 03-1-a is issued as final guidance (see Pending Accounting Standards). The disclosure requirements of EITF 03-1 were previously adopted by the Company as of December 31, 2003 for investments accounted for under SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities". For all other investments within the scope of EITF 03-1, the disclosures are effective and have been adopted by the Company as of December 31, 2004. SOP 03-1, "ACCOUNTING AND REPORTING BY INSURANCE ENTERPRISES FOR CERTAIN NONTRADITIONAL LONG-DURATION CONTRACTS AND FOR SEPARATE ACCOUNTS" ("SOP 03-1") On January 1, 2004, the Company adopted SOP 03-1. The major provisions of the SOP affecting the Company require: - Establishment of reserves primarily related to death benefit and income benefit guarantees provided under variable annuity contracts; - Deferral of sales inducements that meet certain criteria, and amortization using the same method used for DAC. The cumulative effect of the change in accounting principle from implementing SOP 03-1 was a loss of $7.6 million, after-tax ($11.7 million, pre-tax). It was comprised of an increase in benefit reserves (primarily for variable annuity contracts) of $942 thousand, pre-tax, and a reduction in DAC and DSI of $10.7 million, pre-tax. The SOP requires consideration of a range of potential results to estimate the cost of variable annuity death benefits and income benefits, which generally necessitates the use of stochastic modeling techniques. To maintain consistency with the assumptions used in the establishment of reserves for variable annuity guarantees, the Company utilized the results of this stochastic modeling to estimate expected gross profits, which form the basis for determining the amortization of DAC and DSI. This new modeling approach resulted in a lower estimate of expected gross profits, and therefore resulted in a write-down of DAC and DSI. In 2004, DSI and related amortization is classified within the Statements of Financial Position and Operations and Comprehensive Income as other assets and interest credited to contractholder funds, respectively. The amounts are provided in Note 10. AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS ("AICPA") TECHNICAL PRACTICE AID ("TPA") RE. SOP 03-1 In September 2004, the staff of the AICPA, aided by industry experts, issued a set of technical questions and answers on financial accounting and reporting issues related to SOP 03-1 that will be included in the AICPA's TPAs. The TPA addresses a number of issues related to SOP 03-1 including when it is necessary to establish a liability in addition to the account balance for certain contracts such as single premium and universal life that meet the definition of an insurance contract and have amounts assessed against the contractholder in a manner that is expected to result in profits in earlier years and losses in subsequent years from the insurance benefit function. The impact of adopting the provisions of the TPA was not material to the Company's Consolidated Statements of Operations and Comprehensive Income or Financial Position. 42 ALLSTATE LIFE INSURANCE COMPANY OF NEW YORK NOTES TO FINANCIAL STATEMENTS SFAS NO. 149, "AMENDMENT OF STATEMENT 133 ON DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES" ("SFAS NO. 149") In April 2003, the FASB issued SFAS No. 149, which amends, clarifies and codifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts and used for hedging activities under SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities". While this statement applies primarily to certain derivative contracts and embedded derivatives entered into or modified after June 30, 2003, it also codifies conclusions previously reached by the FASB at various dates on certain implementation issues. The impact of adopting the provisions of the statement was not material to the Company's Statements of Operations and Comprehensive Income or Financial Position. PENDING ACCOUNTING STANDARD FSP EITF ISSUE 03-1-a, "IMPLEMENTATION GUIDANCE FOR THE APPLICATION OF PARAGRAPH 16 OF EITF ISSUE NO. 03-1, "THE MEANING OF OTHER-THAN-TEMPORARY IMPAIRMENT AND ITS APPLICATION TO CERTAIN INVESTMENTS" ("FSP EITF ISSUE 03-1-a"). In September 2004, the FASB issued proposed FSP EITF 03-1-a to address the application of paragraph 16 of EITF Issue 03-1 to debt securities that are impaired because of increases in interest rates, and/or sector spreads. Thereafter, in connection with its decision to defer the effective date of paragraphs 10-20 of EITF 03-1 through the issuance of FSP EITF Issue 03-1-1, the FASB requested from its constituents comments on the issues set forth in FSP EITF 03-1-a and the issues that arose during the comment letter process for FSP EITF 03-1-b, "EFFECTIVE DATE OF PARAGRAPH 16 OF EITF ISSUE NO. 03-1, THE MEANING OF OTHER-THAN-TEMPORARY IMPAIRMENT AND ITS APPLICATION TO CERTAIN INVESTMENTS". Due to the uncertainty as to how the outstanding issues will be resolved, the Company is unable to determine the impact of adopting paragraphs 10-20 of EITF 03-1 until final implementation guidance is issued. Adoption of paragraphs 10-20 of EITF 03-1 may have a material impact on the Company's Statements of Operations and Comprehensive Income but is not expected to have a material impact on the Company's Statements of Financial Position as fluctuations in fair value are already recorded in accumulated other comprehensive income. 3. DISPOSITIONS In 2003, the Company announced its intention to exit the direct response distribution business and, based on its decision to sell the business, reached a measurement date that resulted in the recognition of an estimated loss on the disposition of $4.5 million ($2.9 million, after-tax). In 2004, the Company disposed of substantially all of the direct response distribution business pursuant to reinsurance transactions with a subsidiary of Citigroup and Scottish Re (U.S.) Inc. In connection with those disposal activities, the Company recorded a gain on disposition of $1.3 million pretax ($862 thousand after-tax) in 2004 (see Notes 9 and 10). 4. RELATED PARTY TRANSACTIONS BUSINESS OPERATIONS The Company utilizes services performed by its affiliates, AIC, ALIC and Allstate Investments LLC, and business facilities owned or leased and operated by AIC in conducting its business activities. In addition, the Company shares the services of employees with AIC. The Company reimburses its affiliates for the operating expenses incurred on behalf of the Company. The Company is charged for the cost of these operating expenses based on the level of services provided. Operating expenses, including compensation, retirement and other benefit programs, allocated to the Company were $44.8 million, $37.2 million and $34.9 million in 2004, 2003 and 2002, respectively. A portion of these expenses relates to the acquisition of business and is deferred and amortized over the contract period. STRUCTURED SETTLEMENT ANNUITIES The Company issued $19.4 million, $19.2 million and $23.8 million of structured settlement annuities, a type of immediate annuity, in 2004, 2003 and 2002, respectively, at prices based upon interest rates in effect at the time of issuance, to fund structured settlement annuities in matters involving AIC. Of these amounts, $5.4 million, $3.9 million and $7.5 million relate to structured settlement annuities with life contingencies and are included in premium income in 2004, 2003 and 2002, respectively. In most cases, these annuities were issued under a "qualified assignment," whereby Allstate Settlement Corporation ("ASC"), a wholly owned subsidiary of ALIC, purchased annuities from the Company and assumed AIC's obligation to make future payments. 43 ALLSTATE LIFE INSURANCE COMPANY OF NEW YORK NOTES TO FINANCIAL STATEMENTS AIC has issued surety bonds to guarantee the payment of structured settlement benefits assumed by Allstate Assignment Company ("AAC"), a wholly owned subsidiary of ALIC, (from both AIC and non-related parties) and funded by certain annuity contracts issued by the Company. AAC has entered into General Indemnity Agreements pursuant to which it indemnified AIC for any liabilities associated with the surety bonds and gives AIC certain collateral security rights with respect to the annuities and certain other rights in the event of any defaults covered by the surety bonds. For contracts written on or after July 1, 2001, AIC no longer issues surety bonds to guarantee the payment of structured settlement benefits. Alternatively, ALIC guarantees the payment of structured settlement benefits on all contracts issued on or after July 1, 2001. Reserves recorded by the Company for annuities that are guaranteed by the surety bonds of AIC were $1.40 billion and $1.45 billion at December 31, 2004 and 2003, respectively. BROKER/DEALER AGREEMENTS The Company received underwriting and distribution services from Allstate Distributors, L.L.C. ("ADLLC"), a broker-dealer company owned by ALIC, for certain variable annuity contracts sold pursuant to a joint venture agreement between the Company and a third party which was dissolved in 2002. The Company incurred $4.2 million of commission expenses and other distribution expenses payable to ADLLC during 2002. Other distribution expenses include administrative, legal, financial management and sales support that the Company provided to ADLLC, for which the Company earned administration fees of $83 thousand for the year ended December 31, 2002. Other distribution expenses also include marketing expenses for subsidized interest rates associated with the Company's dollar cost averaging program offered on variable annuities, for which ADLLC reimbursed the Company $60 thousand for the year ended December 31, 2002. During 2003, the Company entered into a service agreement with ADLLC, whereby ADLLC promotes and markets the fixed and variable annuities sold by the Company to unaffiliated financial services firms. In addition, ADLLC also acts as the underwriter of variable annuities sold by the Company. In return for these services, the Company recorded commission expense of $5.6 million and $4.8 million for the years ended December 31, 2004 and 2003, respectively. The Company receives underwriting and distribution services from Allstate Financial Services, LLC ("AFS"), an affiliated broker/dealer company, for certain variable annuity and variable life insurance contracts sold by Allstate exclusive agencies. The Company recorded commission expense of $1.4 million, $455 thousand and $891 thousand for the years ended December 31, 2004, 2003 and 2002, respectively. REINSURANCE TRANSACTIONS The Company has reinsurance agreements with unaffiliated reinsurers and ALIC in order to limit aggregate and single exposure on large risks. A portion of the Company's premiums and policy benefits are ceded to ALIC and reflected net of such reinsurance in the Statements of Operations and Comprehensive Income. Reinsurance recoverables and the related reserve for life-contingent contract benefits and contractholder funds are reported separately in the Statements of Financial Position. The Company continues to have primary liability as the direct insurer for risks reinsured (see Note 10). Additionally, the Company entered into a reinsurance treaty through which it primarily cedes re-investment related risk on its structured settlement annuities to ALIC. Under the terms of the treaty, the Company pays a premium to ALIC that varies with the aggregate structured settlement annuity statutory reserve balance. In return, ALIC guarantees that the yield on the portion of the Company's investment portfolio that supports structured settlement annuity liabilities will not fall below contractually determined rates. The Company ceded premium related to structured settlement annuities to ALIC of $2.7 million, $2.6 million and $2.4 million for the years ended December 31, 2004, 2003 and 2002, respectively. At December 31, 2004 and 2003, the carrying value of the structured settlement reinsurance treaty was $(995) thousand and $225 thousand, respectively, which is recorded in other assets. The premiums ceded and changes in the fair value of the reinsurance treaty are reflected as a component of realized capital gains and losses on the Statements of Operations and Comprehensive income as the treaty is recorded as a derivative instrument pursuant to the requirements of SFAS No. 133. Beginning in 2004, the Company also has a reinsurance treaty through which it cedes variable annuity GMABs to ALIC. At December 31, 2004, the carrying value of the GMAB reinsurance treaty was $(141) thousand, which is recorded in reinsurance recoverables. 44 ALLSTATE LIFE INSURANCE COMPANY OF NEW YORK NOTES TO FINANCIAL STATEMENTS CAPITAL CONTRIBUTION The Company received a cash capital contribution from ALIC of $64.2 million in 2004, which was recorded as additional capital paid-in on the Statements of Financial Position. DEBT The Company has entered into an intercompany loan agreement with the Corporation. The amount of funds available to the Company at a given point in time is dependent upon the debt position of the Corporation. No amounts were outstanding for the Company under the intercompany loan agreement during the three years ended December 31, 2004. INCOME TAXES The Company is a party to a federal income tax allocation agreement with the Corporation (see Note 12). 5. SUPPLEMENTAL CASH FLOW INFORMATION Non-cash investment modifications, which reflect refinancings of fixed income securities, totaled $1.7 million and $5.4 million for 2004 and 2002, respectively. There were no non-cash investment modifications in 2003. Secured borrowing reinvestment transactions excluded from cash flows from investing activities in the Statements of Cash Flows for the years ended December 31 are as follows:
(IN THOUSANDS) 2004 2003 2002 ---------- ---------- ---------- Purchases $ 240,379 $ 261,872 $ 195,474 Sales (300,235) (215,425) (207,375) Net change in short-term investments 57,764 (72,799) 31,112 ---------- ---------- ---------- Net (sales) purchases $ (2,092) $ (26,352) $ 19,211 ========== ========== ==========
45 ALLSTATE LIFE INSURANCE COMPANY OF NEW YORK NOTES TO FINANCIAL STATEMENTS 6. INVESTMENTS FAIR VALUES The amortized cost, gross unrealized gains and losses, and fair value for fixed income securities are as follows:
GROSS UNREALIZED AMORTIZED --------------------------- FAIR (IN THOUSANDS) COST GAINS LOSSES VALUE ------------ ------------ ------------ ------------ AT DECEMBER 31, 2004 U.S. government and agencies $ 506,971 $ 197,639 $ - $ 704,610 Municipal 262,683 12,714 (1,422) 273,975 Corporate 2,950,439 246,775 (6,660) 3,190,554 Foreign government 214,508 62,839 - 277,347 Mortgage-backed securities 566,367 8,719 (2,623) 572,463 Commercial mortgage-backed securities 446,354 13,357 (838) 458,873 Asset-backed securities 56,215 1,732 (1,321) 56,626 Redeemable preferred stock 9,440 1,759 - 11,199 ------------ ------------ ------------ ------------ Total fixed income securities $ 5,012,977 $ 545,534 $ (12,864) $ 5,545,647 ============ ============ ============ ============ AT DECEMBER 31, 2003 U.S. government and agencies $ 488,037 $ 166,876 $ (1,341) $ 653,572 Municipal 206,364 7,137 (1,121) 212,380 Corporate 2,403,694 248,983 (14,018) 2,638,659 Foreign government 200,682 54,100 - 254,782 Mortgage-backed securities 343,625 10,364 (1,269) 352,720 Commercial mortgage-backed securities 249,603 8,780 (1,167) 257,216 Asset-backed securities 43,442 2,593 (37) 45,998 ------------ ------------ ------------ ------------ Total fixed income securities $ 3,935,447 $ 498,833 $ (18,953) $ 4,415,327 ============ ============ ============ ============
SCHEDULED MATURITIES The scheduled maturities for fixed income securities are as follows at December 31, 2004:
AMORTIZED FAIR (IN THOUSANDS) COST VALUE ------------ ------------ Due in one year or less $ 85,270 $ 86,884 Due after one year through five years 453,059 482,196 Due after five years through ten years 1,577,324 1,679,196 Due after ten years 2,274,742 2,668,282 ------------ ------------ 4,390,395 4,916,558 Mortgage- and asset-backed securities 622,582 629,089 ------------ ------------ Total $ 5,012,977 $ 5,545,647 ============ ============
Actual maturities may differ from those scheduled as a result of prepayments by the issuers. Because of the potential for prepayment on mortgage- and asset-backed securities, they are not categorized by contractual maturity. The commercial mortgage-backed securities are categorized by contractual maturity because they generally are not subject to prepayment risk. 46 ALLSTATE LIFE INSURANCE COMPANY OF NEW YORK NOTES TO FINANCIAL STATEMENTS NET INVESTMENT INCOME Net investment income for the years ended December 31 is as follows:
(IN THOUSANDS) 2004 2003 2002 ---------- ---------- ---------- Fixed income securities $ 278,522 $ 243,684 $ 214,920 Mortgage loans 27,198 24,026 20,336 Other 4,039 3,592 4,501 ---------- ---------- ---------- Investment income, before expense 309,759 271,302 239,757 Investment expense 7,704 6,448 6,790 ---------- ---------- ---------- Net investment income $ 302,055 $ 264,854 $ 232,967 ========== ========== ==========
REALIZED CAPITAL GAINS AND LOSSES, AFTER-TAX Realized capital gains and losses by security type for the years ended December 31 are as follows:
(IN THOUSANDS) 2004 2003 2002 ---------- ---------- ---------- Fixed income securities $ (7,666) $ (8,156) $ (11,886) Mortgage loans 1,480 (1,113) 419 Other (3,111) 751 (1,106) ---------- ---------- ---------- Realized capital gains and losses, pre-tax (9,297) (8,518) (12,573) Income tax benefit 3,453 3,278 4,545 ---------- ---------- ---------- Realized capital gains and losses, after-tax $ (5,844) $ (5,240) $ (8,028) ========== ========== ==========
Realized capital gains and losses by transaction type for the years ended December 31 are as follows:
(IN THOUSANDS) 2004 2003 2002 ---------- ---------- ---------- Investment write-downs $ (3,402) $ (7,682) $ (15,760) Dispositions (1) (2,784) (1,587) 4,292 Valuation of derivative instruments (5,777) (2,140) (2,605) Settlement of derivative instruments 2,666 2,891 1,500 ---------- ---------- ---------- Realized capital gains and losses, pre-tax (9,297) (8,518) (12,573) Income tax benefit 3,453 3,278 4,545 ---------- ---------- ---------- Realized capital gains and losses, after-tax $ (5,844) $ (5,240) $ (8,028) ========== ========== ==========
(1) Dispositions include sales and other transactions such as calls and prepayments. Excluding the effects of calls and prepayments, gross gains of $5.2 million, $4.0 million and $3.0 million and gross losses of $13.3 million, $6.9 million and $7.8 million were realized on sales of fixed income securities during 2004, 2003 and 2002, respectively. UNREALIZED NET CAPITAL GAINS AND LOSSES Unrealized net capital gains and losses on fixed income securities and derivative instruments and other investments included in accumulated other comprehensive income at December 31, 2004 are as follows:
GROSS UNREALIZED FAIR --------------------------- UNREALIZED (IN THOUSANDS) VALUE GAINS LOSSES NET GAINS ------------ ------------ ------------ ------------ Fixed income securities $ 5,545,647 $ 545,534 $ (12,864) $ 532,670 Derivative instruments and other investments 4 4 (724) (720) Deferred income taxes, deferred policy acquisition costs, premium deficiency reserve and deferred sales inducements (376,695) ------------ Unrealized net capital gains and losses $ 155,255 ============
47 ALLSTATE LIFE INSURANCE COMPANY OF NEW YORK NOTES TO FINANCIAL STATEMENTS CHANGE IN UNREALIZED NET CAPITAL GAINS AND LOSSES The change in unrealized net capital gains and losses for the years ended December 31 is as follows:
(IN THOUSANDS) 2004 2003 2002 ---------- ---------- ---------- Fixed income securities $ 52,790 $ 26,738 $ 236,946 Derivative instruments and other investments (720) - - Deferred income taxes, deferred policy acquisition costs, premium deficiency reserve and deferred sales inducements (35,539) (57,669) (186,286) ---------- ---------- ---------- Increase (decrease) in unrealized net capital gains and losses $ 16,531 $ (30,931) $ 50,660 ========== ========== ==========
The change in the deferred income taxes, deferred policy acquisition costs, premium deficiency reserve and deferred sales inducements is primarily due to increases of $24.9 million, $42.8 million and $88.4 million in the premium deficiency reserve for certain immediate annuities with life contingencies at December 31, 2004, 2003 and 2002, respectively. PORTFOLIO MONITORING Inherent in the Company's evaluation of a particular security are assumptions and estimates about the operations of the issuer and its future earnings potential. Some of the factors considered in evaluating whether a decline in fair value is other than temporary are: 1) the Company's ability and intent to retain the investment for a period of time sufficient to allow for an anticipated recovery in value; 2) the recoverability of principal and interest; 3) the duration and extent to which the fair value has been less than amortized cost; 4) the financial condition, near-term and long-term prospects of the issuer, including relevant industry conditions and trends, and implications of rating agency actions and offering prices; and 5) the specific reasons that a security is in a significant unrealized loss position, including market conditions which could affect access to liquidity. The following table summarizes the gross unrealized losses and fair value of fixed income securities by the length of time that individual securities have been in a continuous unrealized loss position as of December 31, 2004.
LESS THAN 12 MONTHS 12 MONTHS OR MORE ------------------------------------ ------------------------------------ TOTAL ($ IN THOUSANDS) NUMBER OF FAIR UNREALIZED NUMBER OF FAIR UNREALIZED UNREALIZED AT DECEMBER 31, 2004 ISSUES VALUE LOSSES ISSUES VALUE LOSSES LOSSES ---------- ---------- ---------- ---------- ---------- ---------- ---------- Fixed income securities Municipal 18 $ 81,432 $ (1,238) 1 $ 9,816 $ (184) (1,422) Corporate 81 369,511 (4,159) 17 84,321 (2,501) (6,660) Mortgage-backed securities 23 224,914 (2,148) 2 30,398 (475) (2,623) Commercial mortgage-backed securities 10 82,850 (445) 1 9,650 (393) (838) Asset-backed securities 5 18,234 (1,321) - - - (1,321) ---------- ---------- ---------- ---------- ---------- ---------- ---------- Total fixed income securities 137 $ 776,941 $ (9,311) 21 $ 134,185 $ (3,553) $ (12,864) ========== ========== ========== ========== ========== ========== ========== Investment grade fixed income securities 114 $ 746,621 $ (7,585) 16 $ 113,024 $ (3,019) $ (10,604) Below investment grade fixed income securities 23 30,320 (1,726) 5 21,161 (534) (2,260) ---------- ---------- ---------- ---------- ---------- ---------- ---------- Total fixed income securities 137 $ 776,941 $ (9,311) 21 $ 134,185 $ (3,553) $ (12,864) ========== ========== ========== ========== ========== ========== ==========
At December 31, 2004, the Company had unrealized losses on fixed income securities of $12.9 million related to 158 holdings with a fair value of $911.1 million. All of the unrealized losses related to securities with an unrealized loss position less than 20% of amortized cost, the degree of which suggests that these securities do not pose a high risk of being other than temporarily impaired. Unrealized losses totaling $9.3 million were in an unrealized loss position for a period less than twelve months and $3.6 million were in an unrealized loss position 48 ALLSTATE LIFE INSURANCE COMPANY OF NEW YORK NOTES TO FINANCIAL STATEMENTS for a period of twelve months or more. Of the $9.3 million and $3.6 million in unrealized losses, 81.5% and 85.0%, respectively, related to investment grade securities. Investment grade is defined as a security having a rating from the National Association of Insurance Commissioners ("NAIC") of 1 or 2; a rating of Aaa, Aa, A or Baa from Moody's or a rating of AAA, AA, A or BBB from Standard & Poor's ("S&P"), Fitch or Dominion; or a comparable internal rating if an externally provided rating is not available. Unrealized losses on investment grade securities are principally related to changes in interest rates or changes in issuer and sector related credit spreads since the securities were acquired. Unrealized losses totaling $414 thousand related to airline issues. As of December 31, 2004, the Company had the intent and ability to hold these investments for a period of time sufficient for them to recover in value. At December 31, 2003, the Company had unrealized losses of $19.0 million which related to 133 holdings of fixed income securities with a fair value of $594.0 million, $16.2 million of which have been in an unrealized loss position for a period less than twelve months. Substantially all of these unrealized losses related to investment grade securities. Unrealized losses on investment grade securities were principally related to changes in interest rates or changes in issuer and sector related credit spreads since the securities were acquired. The remaining unrealized losses of $2.8 million related to securities that had been in an unrealized loss position for a period of twelve months or more and are below investment grade. Approximately $1.0 million relates to unrealized loss positions that represented less than 20% of amortized cost. Also, $2.2 million related to airline industry issues which were evaluated considering factors such as the financial condition and near-term and long-term prospects of the issuer and were determined to have adequate resources to fulfill contractual obligations, such as cash flows from operations or collateral. As of December 31, 2003, the Company had the intent and ability to hold these investments for a period of time sufficient for them to recover in value. MORTGAGE LOAN IMPAIRMENT A mortgage loan is impaired when it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. The Company had no impaired loans at December 31, 2004 or 2003. Interest income for impaired loans is recognized on an accrual basis if payments are expected to continue to be received; otherwise cash basis is used. No interest income was earned on impaired loans in 2004 or 2002. In 2003, the Company recognized interest income on impaired loans of $134 thousand. The average balance of impaired loans was $3.9 million in 2003. There were no impaired loans in 2004 or 2002. INVESTMENT CONCENTRATION FOR MUNICIPAL BOND AND COMMERCIAL MORTGAGE PORTFOLIOS AND OTHER INVESTMENT INFORMATION The Company maintains a diversified portfolio of municipal bonds. The following table shows the principal geographic distribution of municipal bond issuers represented in the Company's portfolio. No other state represents more than 5.0% of the portfolio at December 31, 2004.
(% OF MUNICIPAL BOND PORTFOLIO CARRYING VALUE) 2004 2003 ------------ ------------ California 41.7% 34.8% Texas 10.2 13.4 Oregon 7.4 8.2 Delaware 5.4 6.8
49 ALLSTATE LIFE INSURANCE COMPANY OF NEW YORK NOTES TO FINANCIAL STATEMENTS The Company's mortgage loans are collateralized by a variety of commercial real estate property types located throughout the United States. Substantially all of the commercial mortgage loans are non-recourse to the borrower. The following table shows the principal geographic distribution of commercial real estate represented in the Company's mortgage portfolio. No other state represented more than 5.0% of the portfolio at December 31, 2004 and 2003.
(% OF COMMERCIAL MORTGAGE PORTFOLIO CARRYING VALUE) 2004 2003 ------------ ------------ California 19.8% 21.8% New Jersey 12.3 14.2 Illinois 12.2 15.6 New York 9.5 12.3 Pennsylvania 7.2 11.3 Ohio 6.3 1.8 Texas 6.1 2.5 Arizona 5.5 1.0
The types of properties collateralizing the commercial mortgage loans at December 31 are as follows:
(% OF COMMERCIAL MORTGAGE PORTFOLIO CARRYING VALUE) 2004 2003 ------------ ------------ Warehouse 30.1% 21.3% Office buildings 24.2 24.5 Retail 23.7 27.4 Apartment complex 16.6 18.4 Industrial 1.5 2.4 Other 3.9 6.0 ------------ ------------ 100.0% 100.0% ============ ============
The contractual maturities of the commercial mortgage loan portfolio as of December 31, 2004 for loans that were not in foreclosure are as follows:
NUMBER OF CARRYING ($ IN THOUSANDS) LOANS VALUE PERCENT ---------- ---------- ---------- 2005 2 $ 5,918 1.2% 2006 4 23,406 4.9 2007 5 14,784 3.1 2008 4 24,223 5.0 2009 14 55,182 11.5 Thereafter 86 356,767 74.3 ---------- ---------- ---------- Total 115 $ 480,280 100.0% ========== ========== ==========
In 2004, one commercial mortgage loan in the amount of $798 thousand became contractually due and was paid as due. None were foreclosed or in the process of foreclosure, and none were in the process of refinancing or restructuring discussions. Included in fixed income securities are below investment grade assets totaling $209.3 million and $181.2 million at December 31, 2004 and 2003, respectively. At December 31, 2004, the carrying value of investments that were non-income producing was $232 thousand. At December 31, 2004, fixed income securities with a carrying value of $2.7 million were on deposit with regulatory authorities as required by law. SECURITIES LENDING The Company participates in securities lending programs with third parties, mostly large brokerage firms. At December 31, 2004 and 2003, fixed income securities with a carrying value of $130.8 million and $134.5 million, respectively, were on loan under these agreements. In return, the Company receives cash that it invests and 50 ALLSTATE LIFE INSURANCE COMPANY OF NEW YORK NOTES TO FINANCIAL STATEMENTS includes in short-term investments and fixed income securities, with an offsetting liability recorded in other liabilities and accrued expenses to account for the Company's obligation to return the collateral. Interest income on collateral, net of fees, was $300 thousand, $324 thousand and $370 thousand, for the years ending December 31, 2004, 2003 and 2002, respectively. 7. FINANCIAL INSTRUMENTS In the normal course of business, the Company invests in various financial assets, incurs various financial liabilities and enters into agreements involving derivative financial instruments and other off-balance-sheet financial instruments. The fair value estimates of financial instruments presented below are not necessarily indicative of the amounts the Company might pay or receive in actual market transactions. Potential taxes and other transaction costs have not been considered in estimating fair value. The disclosures that follow do not reflect the fair value of the Company as a whole since a number of the Company's significant assets (including DAC and reinsurance recoverables) and liabilities (including reserve for life-contingent contract benefits and deferred income taxes) are not considered financial instruments and are not carried at fair value. Other assets and liabilities considered financial instruments such as accrued investment income and cash are generally of a short-term nature. Their carrying values are deemed to approximate fair value. FINANCIAL ASSETS
DECEMBER 31, 2004 DECEMBER 31, 2003 --------------------------- --------------------------- CARRYING FAIR CARRYING FAIR (IN THOUSANDS) VALUE VALUE VALUE VALUE ------------ ------------ ------------ ------------ Fixed income securities $ 5,545,647 $ 5,545,647 $ 4,415,327 $ 4,415,327 Mortgage loans 480,280 505,890 385,643 412,554 Short-term investments 111,509 111,509 22,756 22,756 Policy loans 34,948 34,948 34,107 34,107 Separate accounts 792,550 792,550 665,875 665,875
Fair values of publicly traded fixed income securities are based upon quoted market prices or dealer quotes. The fair value of non-publicly traded securities, primarily privately placed corporate obligations, is based on either widely accepted pricing valuation models, which use internally developed ratings and independent third party data (e.g., term structures and current publicly traded bond prices) as inputs, or independent third party pricing sources. Mortgage loans are valued based on discounted contractual cash flows. Discount rates are selected using current rates at which similar loans would be made to borrowers with similar characteristics, using similar properties as collateral. Loans that exceed 100% loan-to-value are valued at the estimated fair value of the underlying collateral. Short-term investments are highly liquid investments with maturities of less than one year whose carrying values are deemed to approximate fair value. The carrying value of policy loans is deemed to approximate fair value. Separate accounts assets are carried in the Statements of Financial Position at fair value based upon quoted market prices. FINANCIAL LIABILITIES
DECEMBER 31, 2004 DECEMBER 31, 2003 --------------------------- --------------------------- CARRYING FAIR CARRYING FAIR (IN THOUSANDS) VALUE VALUE VALUE VALUE ------------ ------------ ------------ ------------ Contractholder funds on investment contracts $ 3,434,238 $ 3,367,458 $ 2,351,896 $ 2,334,800 Separate accounts 792,550 792,550 665,875 665,875
Contractholder funds include interest-sensitive life insurance contracts and investment contracts. Interest-sensitive life insurance contracts are not considered financial instruments subject to fair value disclosure requirements. The fair value of investment contracts is based on the terms of the underlying contracts. Fixed annuities are valued at the account balance less surrender charges. Immediate annuities without life contingencies are valued at the present value of future benefits using current interest rates. Market value adjusted annuities' fair value is estimated to be the market adjusted surrender value. Separate accounts liabilities are carried at the fair value of the underlying assets. 51 ALLSTATE LIFE INSURANCE COMPANY OF NEW YORK NOTES TO FINANCIAL STATEMENTS DERIVATIVE FINANCIAL INSTRUMENTS The Company primarily uses derivative financial instruments to reduce its exposure to market risk, principally interest rate and foreign currency risk, and in conjunction with asset/liability management. The following table summarizes the notional amount, fair value and carrying value of the Company's derivative financial instruments:
CARRYING CARRYING NOTIONAL FAIR VALUE VALUE (IN THOUSANDS) AMOUNT VALUE ASSETS (1) (LIABILITIES)(1) ------------ ------------ ------------ ---------------- AT DECEMBER 31, 2004 Financial futures contracts $ 179,200 $ 80 $ 280 $ (200) Interest rate cap agreements 152,000 3,628 4,262 (634) ------------ ------------ ------------ ---------------- Total interest rate contracts $ 331,200 $ 3,708 $ 4,542 $ (834) ============ ============ ============ ================ Foreign currency swap agreements $ 7,500 $ (724) $ - $ (724) ============ ============ ============ ================ Guaranteed accumulation benefits $ 93,507 $ 141 $ - $ 141 ============ ============ ============ ================ Guaranteed accumulation benefits reinsurance agreement $ 93,507 $ (141) $ (141) $ - ============ ============ ============ ================ Structured settlement annuity reinsurance agreement $ - $ (995) $ (995) $ - ============ ============ ============ ================ AT DECEMBER 31, 2003 Financial futures contracts $ 700 $ (1) $ - $ (1) Structured settlement annuity reinsurance agreement - 225 225 -
(1) Carrying value includes the effects of legally enforceable master netting agreements, if any. Fair value and carrying value of the assets and liabilities exclude accrued periodic settlements, which are reported in accrued investment income or other invested assets. The notional amounts specified in the contracts are used to calculate the exchange of contractual payments under the agreements, and are not representative of the potential for gain or loss on these agreements. Fair value, which is equal to the carrying value, is the estimated amount that the Company would receive (pay) to terminate the derivative contracts at the reporting date. For exchange traded derivative contracts, the fair value is based on dealer or exchange quotes. The fair value of non-exchange traded derivative contracts is based on either independent third party pricing sources, including dealer quotes, or widely accepted pricing and valuation models which use independent third party data as inputs. The Company manages its exposure to credit risk primarily by establishing risk control limits. The Company uses master netting agreements for over-the-counter derivative transactions, including foreign currency swap and interest rate cap agreements. These agreements permit either party to net payments due for transactions covered by the agreements. Under the provisions of the agreements, collateral is either pledged or obtained when certain predetermined exposure limits are exceeded. Futures contracts are traded on organized exchanges, which require margin deposits and guarantee the execution of trades, thereby mitigating any associated potential credit risk. To date, the Company has not incurred any losses on derivative financial instruments due to counterparty nonperformance. Market risk is the risk that the Company will incur losses due to adverse changes in market rates and prices. Market risk exists for all of the derivative financial instruments that the Company currently holds, as these instruments may become less valuable due to adverse changes in market conditions. To limit this risk, the Company's senior management has established risk control limits. In addition, changes in fair value of the derivative financial instruments that the Company uses for risk management purposes are generally offset by the change in the fair value or cash flows of the hedged risk component of the related assets, liabilities or forecasted transactions. 52 ALLSTATE LIFE INSURANCE COMPANY OF NEW YORK NOTES TO FINANCIAL STATEMENTS OFF-BALANCE-SHEET FINANCIAL INSTRUMENTS The contractual amounts and fair values of off-balance-sheet financial instruments at December 31 are as follows:
2004 2003 --------------------------- --------------------------- CONTRACTUAL CONTRACTUAL (IN THOUSANDS) AMOUNT FAIR VALUE AMOUNT FAIR VALUE ------------ ------------ ------------ ------------ Commitments to extend mortgage loans $ 20,031 $ 200 $ 3,000 $ 30
The contractual amounts represent the amount at risk if the contract is fully drawn upon, the counterparty defaults and the value of any underlying security becomes worthless. Unless noted otherwise, the Company does not require collateral or other security to support off-balance-sheet financial instruments with credit risk. Commitments to extend mortgage loans are agreements to lend to a borrower provided there is no violation of any condition established in the contract. The Company enters these agreements to commit to future loan fundings at predetermined interest rates. Commitments generally have fixed expiration dates or other termination clauses. Commitments to extend mortgage loans, which are secured by the underlying properties, are valued based on estimates of fees charged by other institutions to make similar commitments to similar borrowers. 8. RESERVE FOR LIFE-CONTINGENT CONTRACT BENEFITS AND CONTRACTHOLDER FUNDS At December 31, the reserve for life-contingent contract benefits consists of the following:
(IN THOUSANDS) 2004 2003 ------------ ------------ Immediate annuities: Structured settlement annuities $ 1,674,902 $ 1,586,610 Other immediate annuities 7,529 5,688 Traditional life 95,585 87,533 Other 4,435 3,940 ------------ ------------ Total reserve for life-contingent contract benefits $ 1,782,451 $ 1,683,771 ============ ============
The following table highlights the key assumptions generally used in calculating the reserve for life-contingent contract benefits:
PRODUCT MORTALITY INTEREST RATE ESTIMATION METHOD Structured settlement U.S. population with projected Interest rate Present value of annuities calendar year improvements; assumptions range contractually specified age setbacks for impaired from 4.6% to 9.5% future benefits lives grading to standard Other immediate annuities 1983 group annuity mortality Interest rate Present value of expected table assumptions range future benefits based on from 2.6% to 11.5% historical experience Traditional life Actual company experience plus Interest rate Net level premium reserve loading assumptions range method using the from 4.0% to 8.0% Company's withdrawal experience rates Other: Variable annuity 90% of 1994 group annuity 7% Projected benefit ratio guaranteed minimum reserving table applied to cumulative death benefits assessments Supplemental Actual company experience plus Unearned premium; accident and health loading additional contract reserves for traditional life
53 ALLSTATE LIFE INSURANCE COMPANY OF NEW YORK NOTES TO FINANCIAL STATEMENTS To the extent that unrealized gains on fixed income securities would result in a premium deficiency had those gains actually been realized, a premium deficiency reserve has been recorded for certain immediate annuities with life contingencies. A liability of $240.3 million and $215.4 million is included in the reserve for life-contingent contract benefits with respect to this deficiency as of December 31, 2004 and 2003, respectively. The offset to this liability is recorded as a reduction of the unrealized net capital gains included in accumulated other comprehensive income. At December 31, contractholder funds consists of the following:
(IN THOUSANDS) 2004 2003 ------------ ------------ Interest-sensitive life $ 368,608 $ 309,076 Investment contracts: Fixed annuities 2,890,254 1,861,456 Immediate annuities and other 543,984 487,793 ------------ ------------ Total contractholder funds $ 3,802,846 $ 2,658,325 ============ ============
The following table highlights the key contract provisions relating to contractholder funds:
PRODUCT INTEREST RATE WITHDRAWAL/SURRENDER CHARGES Interest-sensitive life Interest rates credited range Either a percentage of account balance or from 4.5% to 6.0% dollar amount grading off generally over 20 years Immediate and fixed Interest rates credited range Either a declining or a level percentage annuities from 1.9% to 11.5% for charge generally over nine years or less. immediate annuities and 0.0% Additionally, approximately 0.4% of fixed to 10.3% for fixed annuities annuities are subject to a market value adjustment for discretionary withdrawals Other: Variable guaranteed Interest rates used in Withdrawal and surrender charges are based on minimum income establishing reserves range the terms of the related variable annuity benefit and secondary from 1.75% to 10.3% contract guarantees on variable annuities
Contractholder funds activity for the years ended December 31 is as follows:
(IN THOUSANDS) 2004 2003 ------------ ------------ CONTRACTHOLDER FUNDS, BEGINNING BALANCE $ 2,658,325 $ 2,051,429 Impact of adoption of SOP 03-1 (1) 2,031 - Deposits 1,385,364 728,788 Interest credited to contractholder funds 129,243 106,020 Benefits and withdrawals (292,730) (174,205) Contract charges (41,573) (40,554) Net transfers to separate accounts (39,906) (16,944) Other adjustments 2,092 3,791 ------------ ------------ CONTRACTHOLDER FUNDS, ENDING BALANCE $ 3,802,846 $ 2,658,325 ============ ============
(1) The increase in contractholder funds due to the adoption of SOP 03-1 reflects the establishment of reserves for certain liabilities that are primarily related to income benefit guarantees provided under variable annuities and the reclassification of deferred sales inducements ("DSI") from contractholder funds to other assets. 54 ALLSTATE LIFE INSURANCE COMPANY OF NEW YORK NOTES TO FINANCIAL STATEMENTS The table below presents information regarding the Company's variable annuity contracts with guarantees. The Company's variable annuity contracts may offer more than one type of guarantee in each contract; therefore, the sum of amounts listed exceeds the total account balances of variable annuity contracts' separate accounts with guarantees.
($ IN MILLIONS) DECEMBER 31, 2004 ------------ IN THE EVENT OF DEATH Separate account value $ 790.7 Net amount at risk (1) $ 85.5 Average attained age of contractholders 62.9 years AT ANNUITIZATION Separate account value $ 40.1 Net amount at risk (2) $ - Weighted average waiting period until annuitization options available 8.5 years ACCUMULATION AT SPECIFIED DATES Separate account value $ 86.7 Net amount at risk (3) $ - Weighted average waiting period until guarantee date 11.0 years
(1) Defined as the estimated current guaranteed minimum death benefit in excess of the current account balance at the balance sheet date. (2) Defined as the estimated present value of the guaranteed minimum annuity payments in excess of the current account balance. (3) Defined as the estimated present value of the guaranteed minimum accumulation balance in excess of the current account balance. The following summarizes the liabilities for guarantees:
LIABILITY FOR LIABILITY FOR LIABILITY FOR GUARANTEES GUARANTEES GUARANTEES RELATED TO RELATED TO RELATED TO INCOME ACCUMULATION (IN THOUSANDS) DEATH BENEFITS BENEFITS BENEFITS TOTAL -------------- -------------- -------------- -------------- Balance at January 1, 2004 $ 868 $ 74 $ - $ 942 Less reinsurance recoverables - - - - -------------- -------------- -------------- -------------- Net balance at January 1, 2004 868 74 - 942 Incurred guaranteed benefits 1,777 7 - 1,784 Paid guarantee benefits (1,983) - - (1,983) -------------- -------------- -------------- -------------- Net change (206) 7 - (199) Net balance at December 31, 2004 662 81 - 743 Plus reinsurance recoverables - - (141) (141) -------------- -------------- -------------- -------------- Balance, December 31, 2004(1) $ 662 $ 81 $ (141) $ 602 ============== ============== ============== ==============
---------- (1) Included in the total liability balance are reserves for variable annuity death benefits of $662 thousand, variable annuity income benefits of $18 thousand, variable annuity accumulation benefits of $(141) thousand and other guarantees of $63 thousand. 55 ALLSTATE LIFE INSURANCE COMPANY OF NEW YORK NOTES TO FINANCIAL STATEMENTS 9. REINSURANCE The Company reinsures certain of its risks to unaffiliated reinsurers and ALIC under yearly renewable term and coinsurance agreements. These agreements result in a passing of specified percentages of mortality risk, depending on the issue date and product, to the reinsurer in exchange for negotiated reinsurance premium payments. Mortality risk on policies in excess of $250 thousand per life is ceded to ALIC. In addition, we used reinsurance to effect the disposal of substantially all of our direct response distribution business. As of December 31, 2004, the Company ceded $5.5 million to a subsidiary of Citigroup and Scottish Re (U.S.) Inc. in connection with the disposal of the direct response business. As of December 31, 2004 and 2003, 32.4% and 23.2%, respectively, of our face amount of life insurance in force was reinsured to non-affiliates and ALIC. We retain primary liability as a direct insurer for all risks ceded to reinsurers. Amounts recoverable from reinsurers are estimated based upon assumptions consistent with those used in establishing the liabilities related to the underlying reinsured contracts. No single reinsurer had a material obligation to the Company nor is the Company's business substantially dependent upon any reinsurance contract. See Note 4 for discussion of reinsurance agreements with ALIC. The effects of reinsurance on premiums and contract charges for the years ended December 31 are as follows:
(IN THOUSANDS) 2004 2003 2002 ---------- ---------- ---------- PREMIUMS AND CONTRACT CHARGES Direct $ 151,799 $ 128,713 $ 148,749 Assumed - non-affiliate 719 337 471 Ceded Affiliate (4,329) (4,530) (4,656) Non-affiliate (11,805) (3,491) (1,212) ---------- ---------- ---------- Premiums and contract charges, net of reinsurance $ 136,384 $ 121,029 $ 143,352 ========== ========== ==========
The effects of reinsurance on contract benefits and interest credited to contractholder funds for the years ended December 31 are as follows:
(IN THOUSANDS) 2004 2003 2002 ---------- ---------- ---------- CONTRACT BENEFITS AND INTEREST CREDITED TO CONTRACTHOLDER FUNDS Direct $ 319,217 $ 278,321 $ 268,620 Assumed - non-affiliate 273 139 85 Ceded Affiliate (985) (1,590) (901) Non-affiliate (6,551) (3,629) (2,086) ---------- ---------- ---------- Contract benefits and interest credited to contractholder funds, net of reinsurance $ 311,954 $ 273,241 $ 265,718 ========== ========== ==========
Included in reinsurance recoverables at December 31, 2004 and 2003 are the amounts due from ALIC of $1.1 million and $1.3 million, respectively. The table above excludes $2.7 million and $2.6 million of premiums and contract charges ceded to ALIC during 2004 and 2003 under the terms of the structured settlement reinsurance treaty and the GMAB reinsurance treaty (See Note 4). 56 ALLSTATE LIFE INSURANCE COMPANY OF NEW YORK NOTES TO FINANCIAL STATEMENTS 10. DEFERRED POLICY ACQUISITION COSTS Deferred policy acquisitions costs for the years ended December 31 are as follows:
(IN THOUSANDS) 2004 2003 2002 ---------- ---------- ---------- Balance, beginning of year $ 187,437 $ 166,925 $ 156,615 Impact of adoption of SOP 03-1 (1) (11,140) - - Disposition of operations (2) (3,213) - - Acquisition costs deferred 92,502 58,905 56,852 Amortization charged to income (25,971) (29,969) (23,535) Effect of unrealized gains and losses (1,442) (8,424) (23,007) ---------- ---------- ---------- Balance, end of year $ 238,173 $ 187,437 $ 166,925 ========== ========== ==========
(1) The impact of adoption of SOP 03-1 includes a write-down in variable annuity DAC of $7.7 million, the reclassification of DSI from DAC to other assets resulting in a decrease to DAC of $4.1 million and an increase to DAC of $691 thousand for an adjustment to the effect of unrealized capital gains and losses. (2) In 2004, DAC was reduced by $3.2 million related to the disposition of substantially all of our direct response distribution business (see Note 3). Amortization charged to income includes $2.1 million, $1.7 million and $(1.0) million in 2004, 2003 and 2002, respectively, due to realized capital gains and losses. In 2004, DSI and related amortization is classified within the Statements of Financial Position and Operations and Comprehensive Income as other assets and interest credited to contractholder funds, respectively. Deferred sales inducement activity for the twelve months ended December 31, 2004 was as follows:
(IN THOUSANDS) Balance, January 1, 2004 (1) $ 2,369 Sales inducements deferred 1,531 Amortization charged to income (760) Effects of unrealized gains and losses (185) ---------- Balance, December 31, 2004 $ 2,955 ==========
(1) The January 1, 2004 balance includes a $3.0 million write-down of DSI due to the adoption of SOP 03-1 (see Note 2). 11. COMMITMENTS, GUARANTEES AND CONTINGENT LIABILITIES GUARANTEES In the normal course of business, the Company provides standard indemnifications to counterparties in contracts in connection with numerous transactions, including acquisitions and divestures. The types of indemnifications typically provided include indemnifications for breach of representations and warranties, taxes and certain other liabilities, such as third party lawsuits. The indemnification clauses are often standard contractual terms and were entered into in the normal course of business based on an assessment that the risk of loss would be remote. The terms of the indemnifications vary in duration and nature. In many cases, the maximum obligation is not explicitly stated and the contingencies triggering the obligation to indemnify have not occurred and are not expected to occur. Consequently, the maximum amount of the obligation under such indemnifications is not determinable. Historically, the Company has not made any material payments pursuant to these obligations. The aggregate liability balance related to all guarantees was not material as of December 31, 2004. 57 ALLSTATE LIFE INSURANCE COMPANY OF NEW YORK NOTES TO FINANCIAL STATEMENTS REGULATION The Company is subject to changing social, economic and regulatory conditions. Recent state and federal regulatory initiatives and proceedings have included efforts to impose additional regulations regarding agent and broker compensation and otherwise expand overall regulation of insurance products and the insurance industry. The ultimate changes and eventual effects of these initiatives on the Company's business, if any, are uncertain. Regulatory bodies have contacted ALIC and some of its subsidiaries, including the Company, and have requested information relating to variable insurance products, including such areas as market timing and late trading and sales practices. The Company believes that these inquiries are similar to those made to many financial services companies as part of an industry-wide investigation by various regulatory agencies into the practices, policies and procedures relating to variable insurance products sales and subaccount trading practices. ALIC and its subsidiaries, including the Company, have responded and will continue to respond to these information requests and investigations. The Company at the present time is not aware of any systemic problems with respect to such matters that may have a material adverse effect on the Company's financial position. LEGAL PROCEEDINGS BACKGROUND The Company and certain of its affiliates are named as defendants in a number of lawsuits and other legal proceedings arising out of various aspects of its business. As background to the "Proceedings" sub-section below, please note the following: - These matters raise difficult and complicated factual and legal issues and are subject to many uncertainties and complexities, including but not limited to, the underlying facts of each matter, novel legal issues, variations between jurisdictions in which matters are being litigated, differences in applicable laws and judicial interpretations, the length of time before many of these matters might be resolved by settlement or through litigation and, in some cases, the timing of their resolutions relative to other similar cases brought against other companies, the fact that some of these matters are putative class actions in which a class has not been certified and in which the purported class may not be clearly defined, the fact that some of these matters involve multi-state class actions in which the applicable law(s) for the claims at issue is in dispute and therefore unclear, and the current challenging legal environment faced by large corporations and insurance companies. - In these matters, plaintiffs seek a variety of remedies including equitable relief in the form of injunctive and other remedies and monetary relief in the form of contractual and extra-contractual damages. In some cases, the monetary damages sought include punitive damages or are not specified. Often more specific information beyond the type of relief sought is not available because plaintiffs have not requested more specific relief in their court pleadings. In our experience, monetary demands in plaintiffs' court pleadings bear little relation to the ultimate loss, if any, to the Company. - For the reasons specified above, it is not possible to make meaningful estimates of the amount or range of loss that could result from these matters at this time. The Company reviews these matters on an on-going basis and follows the provisions of SFAS No. 5, "Accounting for Contingencies" when making accrual and disclosure decisions. When assessing reasonably possible and probable outcomes, the Company bases its decisions on its assessment of the ultimate outcome following all appeals. - In the opinion of the Company's management, while some of these matters may be material to the Company's operating results for any particular period if an unfavorable outcome results, none will have a material adverse effect on the financial condition of the Company. 58 ALLSTATE LIFE INSURANCE COMPANY OF NEW YORK NOTES TO FINANCIAL STATEMENTS PROCEEDINGS Legal proceedings involving Allstate agencies and AIC may impact the Company, even when the Company is not directly involved, because the Company sells its products through a variety of distribution channels including Allstate agencies. Consequently, information about the more significant of these proceedings is provided below. AIC is defending various lawsuits involving worker classification issues. A putative nationwide class action filed by former employee agents includes a worker classification issue; these agents are challenging certain amendments to the Agents Pension Plan and are seeking to have exclusive agent independent contractors treated as employees for benefit purposes. This matter was dismissed with prejudice in late March 2004 by the trial court but is the subject of further proceedings on appeal. AIC has been vigorously defending this and various other worker classification lawsuits. The outcome of these disputes is currently uncertain. AIC is defending certain matters relating to its agency program reorganization announced in 1999. These matters include a lawsuit filed in December 2001 by the U.S. Equal Employment Opportunity Commission ("EEOC") alleging retaliation under federal civil rights laws, a class action filed in August 2001 by former employee agents alleging retaliation and age discrimination under the Age Discrimination in Employment Act, breach of contract and ERISA violations, and a lawsuit filed in October 2004 by the EEOC alleging age discrimination with respect to a policy limiting the rehire of agents affected by the agency program reorganization. AIC is also defending another action, in which a class was certified in June 2004, filed by former employee agents who terminated their employment prior to the agency program reorganization. These plaintiffs have asserted claims under ERISA and for constructive discharge, and are seeking the benefits provided in connection with the reorganization. In late March 2004, in the first EEOC lawsuit and class action lawsuit, the trial court issued a memorandum and order that, among other things, certified classes of agents, including a mandatory class of agents who had signed a release, for purposes of effecting the court's declaratory judgment that the release is voidable at the option of the release signer. The court also ordered that an agent who voids the release must return to Allstate "any and all benefits received by the [agent] in exchange for signing the release." The court also "concluded that, on the undisputed facts of record, there is no basis for claims of age discrimination." The EEOC and plaintiffs have asked the court to clarify and/or reconsider its memorandum and order. The case otherwise remains pending. A putative nationwide class action has also been filed by former employee agents alleging various violations of ERISA. This matter was dismissed with prejudice in late March 2004 by the trial court but is the subject of further proceedings on appeal. In these matters, plaintiffs seek compensatory and punitive damages, and equitable relief. AIC has been vigorously defending these lawsuits and other matters related to its agency program reorganization. The outcome of these disputes is currently uncertain. OTHER MATTERS The Corporation and some of its agents and subsidiaries, including the Company, have received interrogatories and demands to produce information from several regulatory and enforcement authorities. These authorities are seeking information relevant to on-going investigations into the possible violation of antitrust or insurance laws by unnamed parties and, in particular, are seeking information as to whether any person engaged in activities for the purpose of price fixing, market allocation, or bid rigging. Published press reports have indicated that numerous demands of this nature have been sent to insurance companies as part of industry-wide investigations. The Corporation has cooperated and intends to continue to cooperate with these and any similar requests for information. Various other legal and regulatory actions are currently pending that involve the Company and specific aspects of its conduct of business. Like other members of the insurance industry, the Company is the target of a number of lawsuits, some of which involve claims for substantial or indeterminate amounts. This litigation is based on a variety of issues and targets a range of the Company's practices. The outcome of these disputes is currently unpredictable. However, at this time, based on their present status, it is the opinion of management that the ultimate liability, if any, in one or more of these other actions in excess of amounts currently reserved is not expected to have a material effect on the results of operations, liquidity or financial position of the Company. 59 ALLSTATE LIFE INSURANCE COMPANY OF NEW YORK NOTES TO FINANCIAL STATEMENTS 12. INCOME TAXES The Company joins the Corporation and its other eligible domestic subsidiaries (the "Allstate Group") in the filing of a consolidated federal income tax return and is party to a federal income tax allocation agreement (the "Allstate Tax Sharing Agreement"). Under the Allstate Tax Sharing Agreement, the Company pays to or receives from the Corporation the amount, if any, by which the Allstate Group's federal income tax liability is affected by virtue of inclusion of the Company in the consolidated federal income tax return. Effectively, this results in the Company's annual income tax provision being computed with adjustments as if the Company filed a separate return. The Internal Revenue Service ("IRS") has completed its review of the Allstate Group's federal income tax returns through the 1996 tax year. Any adjustments that may result from IRS examinations of tax returns are not expected to have a material impact on the financial position, liquidity or results of operations of the Company. The components of the deferred income tax assets and liabilities at December 31 are as follows:
2004 2003 ------------ ------------ (IN THOUSANDS) DEFERRED ASSETS Life and annuity reserves $ 77,104 $ 56,408 Discontinued operations 339 1,902 Premium installment receivable 2,991 2,328 Other assets 1,509 2,659 ------------ ------------ Total deferred assets 81,943 63,297 ------------ ------------ DEFERRED LIABILITIES Deferred policy acquisition costs (73,583) (60,439) Unrealized net capital gains (83,599) (74,698) Difference in tax bases of investments (11,299) (8,801) Prepaid commission expense (1,826) (699) Other liabilities (2,396) (317) ------------ ------------ Total deferred liabilities (172,703) (144,954) ------------ ------------ Net deferred liability $ (90,760) $ (81,657) ============ ============
Although realization is not assured, management believes it is more likely than not that the deferred tax assets will be realized based on the assumption that certain levels of income will be achieved. The components of income tax expense for the years ended December 31 are as follows:
(IN THOUSANDS) 2004 2003 2002 ---------- ---------- ---------- Current $ 13,640 $ 8,488 $ 10,095 Deferred 4,285 3,541 2,880 ---------- ---------- ---------- Total income tax expense $ 17,925 $ 12,029 $ 12,975 ========== ========== ==========
The Company paid income taxes of $5.8 million, $15.7 million and $17.1 million in 2004, 2003 and 2002, respectively. The Company had a current income tax receivable of $367 thousand and $8.2 million at December 31, 2004 and 2003, respectively. 60 ALLSTATE LIFE INSURANCE COMPANY OF NEW YORK NOTES TO FINANCIAL STATEMENTS A reconciliation of the statutory federal income tax rate to the effective income tax rate on income from operations for the years ended December 31 is as follows:
2004 2003 2002 ---------- ---------- ---------- Statutory federal income tax rate 35.0% 35.0% 35.0% State income tax expense 2.1 4.0 1.2 Other (1.6) (2.2) (1.3) ---------- ---------- ---------- Effective income tax rate 35.5% 36.8% 34.9% ========== ========== ==========
Prior to January 1, 1984, the Company was entitled to exclude certain amounts from taxable income and accumulate such amounts in a "policyholder surplus" account. Pursuant to the American Jobs Creation Act of 2004 ("the 2004 Act"), the Company can reduce the policyholders surplus account in 2005 and 2006 without incurring any tax liability. The balance in this account at December 31, 2004, was $389 thousand, which prior to the 2004 Act would have resulted in federal income taxes payable of $136 thousand if such amounts had been distributed or deemed distributed from the policyholder surplus account. No provision for taxes has ever been made for this item since the Company had no intention of distributing such amounts. The Company expects to utilize this provision, thereby eliminating this potential tax liability. 13. STATUTORY FINANCIAL INFORMATION The Company prepares its statutory-basis financial statements in conformity with accounting practices prescribed or permitted by the State of New York. The State of New York requires insurance companies domiciled in its state to prepare statutory-basis financial statements in conformity with the National Association of Insurance Commissioners ("NAIC") Accounting Practices and Procedures Manual ("Codification"), subject to any deviations prescribed or permitted by the State of New York insurance Superintendent. Statutory accounting practices primarily differ from GAAP since they require charging policy acquisition and certain sales inducement costs to expense as incurred, establishing life insurance reserves based on different actuarial assumptions, and valuing investments and establishing deferred taxes on a different basis. Statutory net income for 2004, 2003 and 2002 was $13.6 million, $36.8 million and $1.2 million, respectively. Statutory capital and surplus as of December 31, 2004 and 2003 was $356.8 million and $294.6 million, respectively. DIVIDENDS The ability of the Company to pay dividends is dependent on business conditions, income, cash requirements of the Company and other relevant factors. The payment of shareholder dividends by the Company without prior approval of the state insurance regulator in any calendar year is limited to formula amounts based on statutory surplus and statutory net gain from operations, determined in conformity with statutory accounting practices, for the immediately preceding calendar year. The maximum amount of dividends that the Company can distribute during 2005 without prior approval of the New York State Insurance Department is $15.2 million. In the twelve-month period beginning January 1, 2004, the Company did not pay any dividends. 61 ALLSTATE LIFE INSURANCE COMPANY OF NEW YORK NOTES TO FINANCIAL STATEMENTS 14. BENEFIT PLANS PENSION AND OTHER POSTRETIREMENT PLANS The Company utilizes the services of AIC employees. AIC provides various benefits, described in the following paragraphs, to its employees. The Company is allocated an appropriate share of the costs associated with these benefits in accordance with a service and expenses agreement. Defined pension plans, sponsored by AIC, cover most full-time employees and certain part-time employees. Benefits under the pension plans are based upon the employee's length of service and eligible annual compensation. The Company uses the accrual method for its defined benefit plans in accordance with accepted actuarial methods. AIC's funding policy for the pension plans is to make annual contributions in accordance with accepted actuarial cost methods. The allocated cost to the Company included in net income was $1.5 million, $1.4 million and $518 thousand for the pension plans in 2004, 2003 and 2002, respectively. AIC also provides certain health care and life insurance subsidies for employees hired before January 1, 2003 when they retire. Qualified employees may become eligible for these benefits if they retire in accordance with AIC's established retirement policy and are continuously insured under AIC's group plans or other approved plans in accordance with the plan's participation requirements. AIC shares the cost of the retiree medical benefits with retirees based on years of service, with AIC's share being subject to a 5% limit on annual medical cost inflation after retirement. AIC's postretirement benefit plans are not funded. AIC has the right to modify or terminate these plans. The allocated cost to the Company included in net income was $588 thousand, $431 thousand and $439 thousand for postretirement benefits other than pension plans in 2004, 2003 and 2002, respectively. PROFIT SHARING PLAN Employees of AIC are eligible to become members of The Savings and Profit Sharing Fund of Allstate Employees ("Allstate Plan"). The Corporation's contributions are based on the Corporation's matching obligation and performance. The Company's allocation of profit sharing expense from the Corporation was $1.3 million, $1.1 million and $1.3 million in 2004, 2003 and 2002, respectively. 62 ALLSTATE LIFE INSURANCE COMPANY OF NEW YORK NOTES TO FINANCIAL STATEMENTS 15. OTHER COMPREHENSIVE INCOME The components of other comprehensive income (loss) on a pretax and after-tax basis for the years ended December 31 are as follows: (IN THOUSANDS)
2004 ------------------------------------ After- UNREALIZED CAPITAL GAINS AND LOSSES: Pretax Tax tax ---------- ---------- ---------- Unrealized holding gains arising during the period $ 20,221 $ (7,077) $ 13,144 Less: reclassification adjustments (5,211) 1,824 (3,387) ---------- ---------- ---------- Unrealized net capital gains and losses 25,432 (8,901) 16,531 ---------- ---------- ---------- Other comprehensive income $ 25,432 $ (8,901) $ 16,531 ========== ========== ==========
(IN THOUSANDS)
2003 ------------------------------------ After- UNREALIZED CAPITAL GAINS AND LOSSES: Pretax Tax tax ---------- ---------- ---------- Unrealized holding losses arising during the period $ (53,362) $ 18,677 $ (34,685) Less: reclassification adjustments (5,776) 2,022 (3,754) ---------- ---------- ---------- Unrealized net capital gains and losses (47,586) 16,655 (30,931) ---------- ---------- ---------- Other comprehensive loss $ (47,586) $ 16,655 $ (30,931) ========== ========== ========== 2002 ------------------------------------ After- UNREALIZED CAPITAL GAINS AND LOSSES: Pretax Tax tax ---------- ---------- ---------- Unrealized holding gains arising during the period $ 66,740 $ (23,359) $ 43,381 Less: reclassification adjustments (11,200) 3,921 (7,279) ---------- ---------- ---------- Unrealized net capital gains and losses 77,940 (27,280) 50,660 ---------- ---------- ---------- Other comprehensive income $ 77,940 $ (27,280) $ 50,660 ========== ========== ==========
63 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM TO THE BOARD OF DIRECTORS AND SHAREHOLDER OF ALLSTATE LIFE INSURANCE COMPANY OF NEW YORK We have audited the accompanying Statements of Financial Position of Allstate Life Insurance Company of New York (the "Company", an affiliate of The Allstate Corporation) as of December 31, 2004 and 2003, and the related Statements of Operations and Comprehensive Income, Shareholder's Equity, and Cash Flows for each of the three years in the period ended December 31, 2004. Our audits also included the financial statement schedules listed in the Index at Item 15. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on the financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2004 and 2003, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2004 in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. As discussed in Note 2 to the financial statements, the Company changed its method of accounting for certain nontraditional long-duration contracts and separate accounts in 2004. /s/ Deloitte & Touche LLP Chicago, Illinois February 24, 2005 64 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. ITEM 9A. CONTROLS AND PROCEDURES EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES. We maintain disclosure controls and procedures as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934. Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of the effectiveness of our disclosure controls and procedures as of the end of the period covered by this report. Based upon this evaluation, the principal executive officer and the principal financial officer concluded that our disclosure controls and procedures are effective in providing reasonable assurance that material information required to be disclosed in our reports filed with or submitted to the Securities and Exchange Commission under the Securities Exchange Act is made known to management, including the principal executive officer and the principal financial officer, as appropriate to allow timely decisions regarding required disclosure. CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING. During the fiscal quarter ended December 31, 2004, there have been no changes in our internal control over financial reporting that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. PART III ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES (1), (2), (3) AND (4) DISCLOSURE OF FEES - The following fees have been, or are anticipated to be billed by Deloitte & Touche LLP for professional services rendered to us for the fiscal year ending December 31, 2004 and 2003.
2004 2003 ------------ ------------ Audit fees (a) $ 330,824 $ 318,218 Audit related fees - - Tax fees - - All other fees - - ------------ ------------ TOTAL FEES $ 330,824 $ 318,218 ============ ============
(a) Fees for audits of annual financial statements including financial statements for the separate accounts, reviews of quarterly financial statements, statutory audits, consents and review of documents filed with the Securities and Exchange Commission. (5)(i) AND (ii) AUDIT COMMITTEE'S PRE-APPROVAL POLICIES AND PROCEDURES - The Audit Committee of The Allstate Corporation has established pre-approval policies and procedures for itself and its consolidated subsidiaries, including Allstate Life of New York. Those policies and procedures are incorporated into this Item 14 (5) by reference to Exhibit 99 (ii) - The Allstate Corporation Policy Regarding Pre-Approval of Independent Auditors' Services. One hundred percent of the services provided by Deloitte and Touche LLP in 2004 and 2003 were pre-approved by The Allstate Corporation Audit Committee. Allstate Life of New York's Board of Directors acts as the audit committee of Allstate Life of New York and also follows The Allstate Corporation Policy Regarding Pre-Approval of Independent Auditors' Services. 65 PART IV ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES (a) (1) The following financial statements, notes thereto and related information of Allstate Life of New York are included in Item 8. Statements of Operations and Comprehensive Income Statements of Financial Position Statements of Shareholder's Equity Statements of Cash Flows Notes to Financial Statements Report of Independent Registered Public Accounting Firm (2) The following additional financial statement schedules are furnished herewith pursuant to the requirements of Form 10-K.
Allstate Life Insurance Company of New York Page ------------------------------------------------------------------------------- ------ Schedules required to be filed under provisions of Regulation S-X Article 7: Schedule I - Summary of Investments - Other Than Investments in Related Parties S-1 Schedule IV - Reinsurance S-2 Schedule V - Valuation and Qualifying Accounts S-3
All other schedules have been omitted because they are not applicable or required or because the required information is included in the financial statements or notes thereto. (3) The following is a list of the exhibits filed as part of this Form 10-K. The SEC file number for the exhibits incorporated by reference is 033-47245 except as otherwise noted.
Exhibit No. Description -------- ---------------------------------------------------------------- 3(i) Restated Certificate of Incorporation of Allstate Life Insurance Company of New York dated December 2, 2003. Incorporated herein by reference to Exhibit 3(i) to Allstate Life Insurance Company of New York's Annual Report on Form 10-K for 2003. 3(ii) Amended By-Laws of Allstate Life Insurance Company of New York dated December 16, 1998. Incorporated herein by reference to Exhibit 3(ii) to Allstate Life Insurance Company of New York's Annual Report on Form 10-K for 1998. 10.1 Service Agreement effective as of July 1, 1989 between Allstate Insurance Company and Allstate Life Insurance Company of New York. Incorporated herein by reference to Exhibit 10.1 to Allstate Life Insurance Company of New York's Quarterly Report on Form 10-Q for quarter ended March 31, 2002. 10.2 Service Agreement between Allstate Life Insurance Company and Allstate Life Insurance Company of New York, effective July 1, 1989. Incorporated herein by reference to Exhibit 10.3 to Allstate Life Insurance Company of New York's Quarterly Report on Form 10-Q for quarter ended June 30, 2002. 10.3 Administrative Services Agreement between Allstate Life Insurance Company of New York and Allstate Distributors, L.L.C. effective May 1, 2000. Incorporated herein by reference to Exhibit 10.5 to Allstate Life Insurance Company of New York's Quarterly Report on Form 10-Q for quarter ended June 30, 2002.
66 10.4 Investment Advisory Agreement and Amendment to Service Agreement as of January 1, 2002 between Allstate Insurance Company, Allstate Investments, LLC and Allstate Life Insurance Company of New York. Incorporated herein by reference to Exhibit 10.2 to Allstate Life Insurance Company of New York's Quarterly Report on Form 10-Q for quarter ended March 31, 2002. 10.5 Tax Sharing Agreement dated as of November 12, 1996 among The Allstate Corporation and certain affiliates. Incorporated herein by reference to Exhibit 10.36 to Allstate Life Insurance Company's Form 10 filed on April 24, 2002. (SEC File No. 000-31248) 10.6 Underwriting Agreement between Allstate Life Insurance Company of New York and ALFS, Inc., effective October 1, 1996. Incorporated herein by reference to Exhibit 10.1 to Allstate Life Insurance Company of New York's Quarterly Report on Form 10-Q for quarter ended June 30, 2002. 10.7 Principal Underwriting Agreement between Allstate Life Insurance Company of New York and Allstate Distributors, L.L.C., effective May 1, 2000. Incorporated herein by reference to Exhibit 10.2 to Allstate Life Insurance Company of New York's Quarterly Report on Form 10-Q for quarter ended June 30, 2002. 10.8 Selling Agreement between Allstate Life Insurance Company of New York, ALFS, Inc. and Allstate Financial Services, LLC effective May 17, 2001. Incorporated herein by reference to Exhibit 10.7 to Allstate Life Insurance Company's Annual Report on Form 10-K for 2003. (SEC File No. 000-31248) 10.9 Business Operations and Service Agreement between Allstate Life Insurance Company of New York and Allstate Life Insurance Company effective October 1,1997. Incorporated herein by reference to Exhibit 10.4 to Allstate Life Insurance Company of New York's Quarterly Report on Form 10-Q for quarter ended June 30, 2002. 10.10 Reinsurance Agreement between Allstate Life Insurance Company and Allstate Life Insurance Company of New York effective January 1, 1984 as amended by Amendment No. 1 effective September 1, 1984, Amendment No.2 effective January 1, 1987, Amendment No.3 effective October 1, 1988, Amendment No.4 effective January 1, 1994 and Amendment No.5 effective December 31, 1995. Incorporated herein by reference to Exhibit 10.6 to Allstate Life Insurance Company of New York's Quarterly Report on Form 10-Q for quarter ended June 30, 2002. 10.11 Assumption Reinsurance Agreement between Allstate Life Insurance Company and Allstate Life Insurance Company of New York effective July 1, 1984. Incorporated herein by reference to Exhibit 10.7 to Allstate Life Insurance Company of New York's Quarterly Report on Form 10-Q for quarter ended June 30, 2002. 10.12 Reinsurance Agreement between Allstate Life Insurance Company and Allstate Life Insurance Company of New York, effective January 1, 1986, as amended by Amendment No.1 effective December 31, 1995 and Amendment No. 2 effective December 1, 1995. Incorporated herein by reference to Exhibit 10.8 to Allstate Life Insurance Company of New York's Quarterly Report on Form 10-Q for quarter ended June 30, 2002. 10.13 Reinsurance Agreement between Allstate Life Insurance Company and Allstate Life Insurance Company of New York, effective January 1, 1991, as amended by Amendment No.1 effective December 31, 1995. Incorporated herein by reference to Exhibit 10.9 to Allstate Life Insurance Company of New York's Quarterly Report on Form 10-Q for quarter ended June 30, 2002.
67 10.14 Stop Loss Reinsurance Agreement between Allstate Life Insurance Company and Allstate Life Insurance Company of New York effective December 31, 2001. Incorporated herein by reference to Exhibit 10.16 to Allstate Life Insurance Company of New York's Annual Report on Form 10-K for 2003. 10.15 Automatic Annuity Reinsurance Agreement between Allstate Life Insurance Company of New York and Allstate Life Insurance Company, effective January 2, 2004. Incorporated herein by reference to Exhibit 10.2 to Allstate Life Insurance Company of New York's Quarterly Report on Form 10-Q for quarter ended June 30, 2004. 23 Consent of Independent Registered Public Accounting Firm 31.1 Rule 15d-14(a) Certification of Principal Executive Officer 31.2 Rule 15d-14(a) Certification of Principal Financial Officer 32 Section 1350 Certifications 99(ii) The Allstate Corporation Policy Regarding Pre-Approval of Independent Auditors' Services effective November 10, 2003
(b) The exhibits are listed in Item 15. (a) (3) above. (c) The financial statement schedules are listed in Item 15. (a) (2) above. 68 SIGNATURES Pursuant to the requirements of the Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. ALLSTATE LIFE INSURANCE COMPANY OF NEW YORK (Registrant) March 15, 2005 /s/ Samuel H. Pilch ------------------- By: Samuel H. Pilch (chief accounting officer and duly authorized officer of the registrant)
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
SIGNATURE TITLE DATE ----------------------------- ----------------------------------- -------------- /s/ Casey J. Sylla Chairman of the Board, March 15, 2005 ------------------ President and a Director Casey J. Sylla (Principal Executive Officer) /s/ Steven E. Shebik Vice President, Chief March 15, 2005 -------------------- Financial Officer and a Director Steven E. Shebik (Principal Financial Officer) /s/ Marcia D. Alazraki Director March 15, 2005 ---------------------- Marcia D. Alazraki /s/ Vincent A. Fusco Director March 15, 2005 -------------------- Vincent A. Fusco /s/ Cleveland Johnson, Jr. Director March 15, 2005 -------------------------- Cleveland Johnson, Jr. Director March 15, 2005 ------------------ John C. Lounds /s/ Kenneth R. O'Brien Director March 15, 2005 ---------------------- Kenneth R. O'Brien /s/ John C. Pintozzi Director March 15, 2005 -------------------- John C. Pintozzi /s/ John R. Raben, Jr. Director March 15, 2005 ---------------------- John R. Raben, Jr. Director March 15, 2005 ----------------------- Phyllis Hill Slater /s/ Kevin R. Slawin Director March 15, 2005 ------------------- Kevin R. Slawin /s/ Michael J. Velotta Director March 15, 2005 ---------------------- Michael J. Velotta /s/ Patricia W. Wilson Director March 15, 2005 ---------------------- Patricia W. Wilson
69 SUPPLEMENTAL INFORMATION TO BE FURNISHED WITH REPORTS FILED PURSUANT TO SECTION 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 BY REGISTRANTS WHICH HAVE NOT REGISTERED SECURITIES PURSUANT TO SECTION 12 OF THE SECURITIES EXCHANGE ACT OF 1934 All of the outstanding common stock of the Company is owned by Allstate Life Insurance Company. The Company has not provided any of the following items to security holders: (1) annual reports to security holders covering the registrant's last fiscal year; or (2) proxy statements, forms of proxy or other proxy soliciting materials. 70 ALLSTATE LIFE INSURANCE COMPANY OF NEW YORK SCHEDULE I - SUMMARY OF INVESTMENTS - OTHER THAN INVESTMENTS IN RELATED PARTIES DECEMBER 31, 2004
CARRYING (IN THOUSANDS) COST FAIR VALUE VALUE ------------ ------------ ------------ TYPE OF INVESTMENT Fixed income securities, available for sale: Bonds: United States government, government agencies and authorities ..... $ 506,971 $ 704,610 $ 704,610 States, municipalities and political subdivisions ................. 262,683 273,975 273,975 Foreign governments ............................................... 214,508 277,347 277,347 Public utilities .................................................. 526,125 605,406 605,406 All other corporate bonds ......................................... 2,424,314 2,585,148 2,585,148 Mortgage-backed securities ........................................... 1,012,721 1,031,336 1,031,336 Asset-backed securities .............................................. 56,215 56,626 56,626 Redeemable preferred stocks ......................................... 9,440 11,199 11,199 ------------ ------------ ------------ Total fixed income securities ..................................... 5,012,977 $ 5,545,647 5,545,647 ------------ ============ ------------ Mortgage loans on real estate ........................................... 480,280 480,280 Policy loans ............................................................ 34,948 34,948 Short-term investments .................................................. 111,509 111,509 Derivative instruments .................................................. 4,634 4,634 Other ................................................................... - 4 ------------ ------------ Total investments ................................................. $ 5,644,348 $ 6,177,022 ============ ============
S-1 ALLSTATE LIFE INSURANCE COMPANY OF NEW YORK SCHEDULE IV--REINSURANCE (IN THOUSANDS)
PERCENT OF AMOUNT GROSS NET ASSUMED AMOUNT CEDED ASSUMED AMOUNT TO NET ------------ ------------ ------------ ------------ ---------- YEAR ENDED DECEMBER 31, 2004 Life insurance in force $ 23,151,807 $ 7,605,444 $ 302,905 $ 15,849,268 1.9% ============ ============ ============ ============ Premiums and contract charges: Life and annuities $ 142,729 $ 9,952 $ 382 $ 133,159 0.3% Accident and health 9,070 $ 6,182 337 3,225 10.4% ------------ ------------ ------------ ------------ $ 151,799 $ 16,134 $ 719 $ 136,384 0.5% ============ ============ ============ ============ YEAR ENDED DECEMBER 31, 2003 Life insurance in force $ 20,491,517 $ 4,772,371 $ 58,002 $ 15,777,148 0.4% ============ ============ ============ ============ Premiums and contract charges: Life and annuities $ 119,247 $ 7,196 $ 336 $ 112,387 0.3% Accident and health 9,467 $ 825 - 8,642 - ------------ ------------ ------------ ------------ $ 128,714 $ 8,021 $ 336 $ 121,029 0.3% ============ ============ ============ ============ YEAR ENDED DECEMBER 31, 2002 Life insurance in force $ 18,981,787 $ 3,404,525 $ - $ 15,577,262 - ============ ============ ============ ============ Premiums and contract charges: Life and annuities $ 139,122 $ 5,005 $ 471 $ 134,588 0.4% Accident and health 9,627 $ 863 - 8,764 - ------------ ------------ ------------ ------------ $ 148,749 $ 5,868 $ 471 $ 143,352 0.3% ============ ============ ============ ============
S-2 ALLSTATE LIFE INSURANCE COMPANY OF NEW YORK SCHEDULE V--VALUATION AND QUALIFYING ACCOUNTS (IN THOUSANDS)
BALANCE AT CHARGED TO BALANCE AT BEGINNING COSTS AND END OF OF PERIOD EXPENSES DEDUCTIONS PERIOD ------------ ------------ ------------ ------------ YEAR ENDED DECEMBER 31, 2004 Allowance for estimated losses on mortgage loans $ - $ - $ - $ - ============ ============ ============ ============ YEAR ENDED DECEMBER 31, 2003 Allowance for estimated losses on mortgage loans $ - $ 982 $ 982 $ - ============ ============ ============ ============ YEAR ENDED DECEMBER 31, 2002 Allowance for estimated losses on mortgage loans $ - $ - $ - $ - ============ ============ ============ ============
S-3