10-K 1 a2176599z10-k.txt 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, 2006 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 IF REGISTRANT IS A WELL-KNOWN SEASONED ISSUER, AS DEFINED IN RULE 405 OF THE SECURITIES ACT. YES |_| NO |X| INDICATE BY CHECK MARK IF THE REGISTRANT IS NOT REQUIRED TO FILE REPORTS PURSUANT TO SECTION 13 OR SECTION 15(d) OF THE SECURITIES ACT. YES |_| NO |X| INDICATE BY CHECK MARK WHETHER THE REGISTRANT (1) HAS FILED ALL REPORTS REQUIRED TO BE FILED BY SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 DURING THE PRECEDING 12 MONTHS (OR FOR SUCH SHORTER PERIOD THAT THE REGISTRANT WAS REQUIRED TO FILE SUCH REPORTS), AND (2) HAS BEEN SUBJECT TO SUCH FILING REQUIREMENTS FOR THE PAST 90 DAYS. YES |X| NO |_| INDICATE BY CHECK MARK 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 A LARGE ACCELERATED FILER, AN ACCELERATED FILER, OR A NON-ACCELERATED FILER. SEE DEFINITION OF "ACCELERATED FILER" IN RULE 12b-2 OF THE EXCHANGE. LARGE ACCELERATED FILER ACCELERATED FILER NON-ACCELERATED FILER |_| |_| |X| INDICATE BY CHECK MARK WHETHER THE REGISTRANT IS A SHELL COMPANY (AS DEFINED IN RULE 12b-2 OF THE EXCHANGE ACT). 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 13, 2007, 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 1A. Risk Factors 2 Item 2. Properties 6 Item 3. Legal Proceedings 6 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 7 Item 6. Selected Financial Data * N/A Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operation 8 Item 7A. Quantitative and Qualitative Disclosures about Market Risk 32 Item 8. Financial Statements and Supplementary Data 33 Item 9. Change in and Disagreements with Accountants on Accounting and Financial Disclosure 69 Item 9A. Controls and Procedures 69 Item 9B. Other Information 69 PART III Item 10. Directors, Executive Officers and Corporate Governance * 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, and Director Independence * N/A Item 14. Principal Accounting Fees and Services 70 PART IV Item 15. Exhibits, Financial Statement Schedules 71 Signatures 74 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 75 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", the "Company", "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 Allstate 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 17 million households through a distribution network that utilizes a total of 14,800 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 2005 statutory premiums earned. In addition, according to A.M. Best, it is the nation's 13th largest issuer of life insurance business on the basis of 2005 ordinary life insurance in force and 16th largest on the basis of 2005 statutory admitted assets. In this annual report on Form 10-K, we occasionally refer to statutory financial information that has been prepared in accordance with the National Association of Insurance Commissioners ("NAIC") Accounting Practices and Procedure Manual ("Manual"). All domestic U.S. insurance companies are required to prepare statutory-basis financial statements in accordance with the Manual. As a result, industry data is available that enables comparisons between insurance companies, including competitors that are not subject to the requirement to publish financial statements on the basis of accounting principles generally accepted in the U.S. ("GAAP"). We frequently use industry publications containing statutory financial information to assess our competitive position. The Company provides life insurance, retirement and investment products to individuals. Our principal products are deferred and immediate fixed annuities, and interest-sensitive, traditional and variable life insurance and supplemental accident and health insurance. We also distribute variable annuities through our bank distribution partners; however this product is fully reinsured. We sell products through multiple intermediary distribution channels, including Allstate exclusive agencies, independent agents (including workplace enrolling agents), banks, broker-dealers and specialized 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. The market for life insurance, retirement and investment products continues to be highly fragmented and competitive. As of December 31, 2006, there were approximately 690 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 continues to grow 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 and adjuster licensing, price setting, 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 1 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. OTHER INFORMATION "Allstate" is one of the most recognized brand names in the U.S. According to independent market research conducted in 2004, "You're in Good Hands with Allstate" was recognized by 87% of consumers, making it the most recognized company tagline in the U.S. ITEM 1A. 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. 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. These risks constitute our cautionary statements under the Private Securities Litigation Reform Act of 1995 and readers should carefully review such cautionary statements as they identify certain important factors that could cause actual results to differ materially from those in the forward-looking statements and historical trends. These cautionary statements are not exclusive and are in addition to other factors discussed elsewhere in this document, in our filings with the Securities and Exchange Commission ("SEC") or in materials incorporated therein by reference. Our business operations could also be affected by additional factors that are not presently known to us or that we currently consider to be immaterial to our operations. 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 capital that the company must hold to support in-force contracts, satisfy rating agencies and meet regulatory requirements. 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, the sufficiency of premiums and contract charges to cover mortality and morbidity benefits, 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, adjustments to reserves may be required which could have a material adverse effect on our operating results and financial condition. 2 CHANGES IN MARKET INTEREST RATES MAY LEAD TO A SIGNIFICANT DECREASE IN THE SALES AND PROFITABILITY OF SPREAD-BASED PRODUCTS Our ability to manage our investment margin for spread-based products, such as fixed annuities, is dependent upon maintaining profitable spreads between investment yields and interest crediting rates. When market 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 in such an environment can offset decreases in investment yield 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. Non-parallel shifts in interest rates, such as increases in short-term rates without accompanying increases in medium- and long-term rates, can influence customer demand for fixed annuities, which could impact the level and profitability of new customer deposits. Increases in market interest rates can also have negative effects, for example by increasing the attractiveness of other investments to our customers, which can lead to higher surrenders at a time when the fixed income 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 deferred policy acquisition cost ("DAC") unlocking or affect the recoverability of DAC and thereby increase expenses and reduce profitability. CHANGES IN ESTIMATES OF PROFITABILITY ON INTEREST-SENSITIVE LIFE, FIXED ANNUITIES AND OTHER INVESTMENT CONTRACTS MAY HAVE AN ADVERSE EFFECT ON RESULTS THROUGH INCREASED AMORTIZATION OF DAC DAC related to interest-sensitive life, fixed annuities and other investment contracts is amortized in proportion to actual historical gross profits ("AGP") and estimated future gross profits ("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 net income 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 we offer, primarily life insurance and annuities, 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 or create a disadvantage for certain of our products making them less competitive. 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 could negatively affect the demand for the types of life insurance used in estate planning. 3 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 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 DECLINES IN CREDIT QUALITY 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, to a lesser degree, equity prices. In addition, we are subject to potential declines in credit quality, either related to issues specific to certain industries or to a weakening in the economy in general. For additional information on market risk, see the "Market Risk" section of Management's Discussion and Analysis. 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 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 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. CONCENTRATION OF OUR INVESTMENT PORTFOLIO IN ANY PARTICULAR SEGMENT OF THE ECONOMY MAY HAVE ADVERSE EFFECTS The concentration of our investment portfolio in any particular industry, group of related industries or geographic sector could have an adverse effect on our investment portfolio and consequently on our results of operations and financial position. While we seek to mitigate this risk by having a broadly diversified portfolio, events or developments that have a negative impact on any particular industry, group of related industries or geographic region may have a greater adverse effect on the investment portfolio to the extent that the portfolio is concentrated rather than diversified. WE MAY SUFFER LOSSES FROM LITIGATION As is typical for a large company, we are involved in a substantial amount of litigation, including class action litigation challenging a range of company practices and coverage provided by our insurance products. In the event of an unfavorable outcome in one or more of these matters, the ultimate liability may be in excess of amounts currently reserved and may be material to our operating results or cash flows for a particular quarter or annual period. For a description of our current legal proceedings, see Note 11 of the financial statements. In some circumstances, we, or others in the Allstate Group, may be able to collect on third-party insurance that we carry to recover all or part of the amounts that we pay in judgments, settlements and litigation expenses. However, we, or others in the Allstate Group, may not be able to resolve issues concerning the availability, if any, or the ability to collect such insurance concurrently with the underlying litigation. Consequently, the timing of the resolution of a particular piece of litigation and the determination of our insurance recovery with respect to that litigation may not coincide and, therefore, may be reflected in our financial statements in different fiscal quarters. 4 WE ARE SUBJECT TO EXTENSIVE REGULATION AND POTENTIAL FURTHER RESTRICTIVE REGULATION MAY INCREASE OUR OPERATING COSTS AND LIMIT OUR GROWTH As insurance companies, broker-dealers, investment advisers and/or investment companies, 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 governmental authorities, including state insurance regulators, state securities administrators, the SEC, the National Association of Securities Dealers, 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 or benefit purchasers or users of insurance products. 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 CURRENT 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 or purchase new reinsurance protection in amounts that we consider sufficient and at prices that we consider acceptable, we would have to either accept an increase in our exposure risk, 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 losses from declines in the equity markets and from interest rate changes in the United States, Europe and elsewhere, and may result in loss of life, 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 could be adversely affected, depending on the nature of the event. 5 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. 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, the marketability of our product offerings, and our liquidity, operating results and financial condition. CHANGES IN ACCOUNTING STANDARDS ISSUED BY THE FINANCIAL ACCOUNTING STANDARDS BOARD ("FASB") OR OTHER STANDARD-SETTING BODIES MAY ADVERSELY AFFECT OUR FINANCIAL STATEMENTS Our financial statements are subject to the application of generally accepted accounting principles, 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 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 and regulatory proceedings and inquiries" in Note 11 of our financial statements. 6 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, 2005 through March 10, 2007, 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. 7 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION 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 operate as a single segment entity based on the manner in which financial information is used internally to evaluate and determine the allocation of resources. The most important factors that we monitor to evaluate the financial condition and performance of our company include: - For operations: premiums, deposits, gross margin including investment and benefit margins, 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 exclusive agencies sales of all products and services. APPLICATION OF CRITICAL ACCOUNTING ESTIMATES We have identified four accounting policies that require us to make estimates that are significant to the financial statements. It is reasonably likely that changes in these estimates could occur from period to period and result in a material impact on our financial statements. A brief summary of each of these critical accounting policies follows. For a more detailed 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 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. For investments classified as available for sale, the difference between fair value and amortized cost, net of deferred income taxes, is reported as a component of accumulated other comprehensive income on the Statements of Financial Position and is 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 portfolio review as well as a case-by-case basis considering a wide range of factors. For our portfolio review evaluations, we ascertain whether there are any approved programs involving the disposition of investments such as changes in duration, revision to strategic asset allocations and liquidity actions; and any dispositions planned by the portfolio managers. In these instances, we recognize impairment on securities being considered for these approved planned actions if the security is in an unrealized loss position. There are a number of assumptions and estimates inherent in evaluating impairments and determining if they are other-than-temporary, including 1) our ability and intent to hold 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 8 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 obtained 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 carried at fair value and as a result, any related unrealized loss would already be reflected as a component of 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 this document. DERIVATIVE INSTRUMENT HEDGE EFFECTIVENESS 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 highly effective in offsetting the hedged risk. For further discussion 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 this document. 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. 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. Significant 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. Generally, the amortization period for these contracts approximate the estimated lives of the policies. DAC related to interest-sensitive life, annuities and other investment contracts is amortized in proportion to the incidence of the total present value of gross profits which includes both actual historical gross profits ("AGP") and estimated future gross profits ("EGP") expected to be earned over the estimated lives of the contracts. Actual amortization periods range from 15-30 years; however, incorporating estimates of customer surrender rates, partial withdrawals and deaths generally result in the majority of the DAC being amortized over the surrender charge period. AGP and EGP consist of the following components: benefit margin primarily from mortality, investment margin including realized capital gains and losses; and contract administration, surrender and other contract charges, less maintenance expenses. We periodically review and make revisions to EGPs resulting in changes in the cumulative 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 this document and Note 2 of the financial statements. 9 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 this document. OPERATIONS On June 1, 2006, we completed the disposition of our variable annuity business through reinsurance. The following table presents the differences between the 2006 and 2005 results of operations attributable to the variable annuity business. (IN THOUSANDS) 2006 2005 CHANGE -------- -------- -------- FAVORABLE/(UNFAVORABLE) Contract charges $ 8,127 $ 16,728 $ (8,601) Net investment income 8,789 23,781 (14,992) Periodic settlements and accruals on non- hedge derivative instruments (1) 33 -- 33 Contract benefits (2,281) (10,401) 8,120 Interest credited to contractholder funds (2) (6,915) (18,322) 11,407 -------- -------- -------- Gross margin (5) 7,753 11,786 (4,033) Realized capital gains and losses (4,112) (231) (3,881) Amortization of DAC and DSI(3) (4) 7,784 (7,168) 14,952 Operating costs and expenses (4,233) (7,789) 3,556 Loss on disposition of operations (10,694) -- (10,694) -------- -------- -------- Income from operations before income tax expense $ (3,502) $ (3,402) $ (100) ======== ======== ======== Investment margin $ 1,907 $ 5,459 $ (3,552) Benefit margin (1,281) (9,028) 7,747 Contract charges and fees 7,127 15,355 (8,228) -------- -------- -------- Gross margin (5) $ 7,753 $ 11,786 $ (4,033) ======== ======== ======== ---------- (1) Periodic settlements and accruals on non-hedge derivative instruments are reflected as a component of realized capital gains and losses on the Statements of Operations and Comprehensive Income. (2) For purposes of calculating gross margin, amortization of DSI is excluded from interest credited to contractholder funds and aggregated with amortization of DAC due to the similarity in the substance of the two items. Amortization of DSI for variable annuities totaled $507 thousand and $(422) thousand in 2006 and 2005, respectively. (3) Amortization deceleration of $4.3 million was recognized in 2005 for variable annuities. (4) DAC and DSI amortization includes $12.6 million and $(1.2) million of amortization related to realized capital gains and losses in 2006 and 2005, respectively. (5) Gross margin and its components are measures that are not based on generally accepted accounting principals ("non-GAAP"). Gross margin, investment margin and benefit margin are defined on pages 14, 16 and 17, respectively. 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 New York in meeting their clients' financial protection, retirement and investment needs by providing consumer-focused products delivered with reliable and efficient service. 10 Our primary objectives are to improve return on equity and position the Company for profitable growth. In the near term, this will require us to balance sales goals with new business return targets. Our actions to accomplish these objectives include improving returns on new business by increasing sales through Allstate Agencies, increasing sales of life insurance products, and maintaining cost discipline through scale and efficiencies. The execution of our business strategies has and may continue to involve simplifying our business model and focusing on those products and distribution relationships where we can secure strong leadership positions while generating acceptable returns and bringing to market a selection of innovative, consumer-focused products. We plan to continue offering a suite of products that protect consumers financially and help them better prepare for retirement. Our products include deferred and immediate fixed annuities; interest-sensitive, traditional and variable life insurance; and supplemental accident and health insurance. Our products are sold through several 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 specialized structured settlement brokers. PREMIUMS represent revenues generated from traditional life, immediate annuities with life contingencies, and supplemental accident and health insurance products that have significant mortality or morbidity risk. CONTRACT CHARGES are revenues generated from interest-sensitive life, and 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 are considered in the evaluation of growth and as indicators of future levels of revenues. Subsequent to the close of our reinsurance transaction with Prudential Financial Inc. ("Prudential") on June 1, 2006, variable annuity contract charges on the business subject to the transaction are fully reinsured to Prudential and presented net of reinsurance on the Statements of Operations (see Note 3 of the financial statements). The following table summarizes premiums and contract charges by product. (IN THOUSANDS) 2006 2005 2004 -------- -------- -------- PREMIUMS Traditional life $ 24,298 $ 26,067 $ 23,786 Immediate annuities with life contingencies 54,877 38,322 49,877 Accident and health, and other 5,138 4,149 2,887 -------- -------- -------- TOTAL PREMIUMS 84,313 68,538 76,550 CONTRACT CHARGES Interest-sensitive life 46,448 42,315 40,400 Fixed annuities 8,851 7,237 6,212 Variable annuities 8,127 16,728 13,222 -------- -------- -------- TOTAL CONTRACT CHARGES 63,426 66,280 59,834 -------- -------- -------- TOTAL PREMIUMS AND CONTRACT CHARGES $147,739 $134,818 $136,384 ======== ======== ======== Total premiums increased 23.0% in 2006 compared to 2005 due primarily to increased premiums on immediate annuities with life contingencies, due to certain pricing refinements and a more favorable pricing environment in 2006. Total premiums decreased 10.5% in 2005 compared to 2004 as lower premiums on immediate annuities with life contingencies more than offset higher traditional life and supplemental accident and health premiums sold through the workplace. Premiums on immediate annuities with life contingencies declined primarily as a result of pricing actions taken to improve our returns on new business and reflect our current expectations of mortality. Higher traditional life and supplemental accident and health premiums were primarily the result of growth. Contract charges decreased 4.3% in 2006 compared to 2005. Excluding contract charges on variable annuities, all of which are reinsured to Prudential effective June 1, 2006, contract charges increased 11.6% in 2006 compared to 2005. The increase was due to higher contract charges on interest-sensitive life products 11 resulting from growth of business in force, and increased contract charges on fixed annuities due to increased surrender charges. Contract charges increased 10.8% in 2005 compared to 2004. The increase was due to higher contract charges on fixed annuities, interest-sensitive life and variable annuities. Fixed annuity contract charges in 2005 reflect higher surrender charges compared with the prior year. The increase in the interest-sensitive life contract charges was attributable to in-force business growth resulting from deposits and credited interest more than offsetting surrenders and benefits. Higher variable annuity contract charges were primarily the result of higher account values in our separate accounts. CONTRACTHOLDER FUNDS represent interest-bearing liabilities arising from the sale of fixed annuities, interest-sensitive life products 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) 2006 2005 (1) 2004 (1) ---------- ---------- ---------- CONTRACTHOLDER FUNDS, BEGINNING BALANCE $4,349,395 $3,802,846 $2,658,325 Impact of adoption of SOP 03-1 (2) -- -- 2,031 DEPOSITS Fixed annuities 694,085 726,332 1,182,719 Interest-sensitive life 95,221 100,355 99,182 Variable annuity and life deposits allocated to fixed accounts 15,519 57,127 103,463 ---------- ---------- ---------- Total deposits 804,825 883,814 1,385,364 INTEREST CREDITED 178,493 173,984 129,243 BENEFITS, WITHDRAWALS AND OTHER ADJUSTMENTS Benefits (137,090) (168,813) (133,792) Surrenders and partial withdrawals (361,670) (270,161) (158,938) Contract charges (44,954) (41,856) (41,573) Net transfers to separate accounts (18,127) (39,765) (39,906) Other adjustments (62,444) 9,346 2,092 ---------- ---------- ---------- Total benefits, withdrawals and other adjustments (624,285) (511,249) (372,117) ---------- ---------- ---------- CONTRACTHOLDER FUNDS, ENDING BALANCE $4,708,428 $4,349,395 $3,802,846 ========== ========== ==========
---------- (1) To conform to the current period presentation, certain prior period balances have been reclassified. (2) The increase in contractholder funds due to the adoption of Statement of Position No. 03-1, "Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts" ("SOP 03-1") reflects the reclassification of DSI from contractholder funds to other assets and the establishment of reserves for certain liabilities that are primarily related to income benefit guarantees provided under variable annuities. Contractholder funds increased 8.3% and 14.4% in 2006 and 2005, respectively. Average contractholder funds increased 11.1% in 2006 compared to 2005 and 26.2% in 2005 compared to 2004. The reduction in the rate at which contractholder funds grew was due primarily to lower contractholder deposits and increased contractholder surrenders and withdrawals. Contractholder deposits decreased 8.9% in 2006 compared to 2005 due primarily to lower variable annuity and life deposits allocated to fixed accounts due to the disposition of our variable annuity business through reinsurance effective June 1, 2006. Also contributing to the decline were lower deposits on fixed annuities due to lower deposits on traditional deferred annuities and market value adjusted annuities, partially offset by a $42.2 12 million increase in deposits on Allstate(R) Treasury-Linked Annuity contracts. Lower deposits on traditional deferred annuities and market value adjusted annuities were primarily attributable to our actions to improve new business returns and reduced consumer demand. Consumer demand for fixed annuities is influenced by market interest rates on short-term deposit products and equity market conditions, which can increase the relative attractiveness of competing investment alternatives. Contractholder deposits decreased 36.2% in 2005 compared to 2004 due primarily to lower deposits on fixed annuities. Fixed annuity deposits declined 38.6% in 2005 from reduced consumer demand relative to certificates of deposit and other short-term investments due to increases in short-term interest rates without corresponding increases in longer term rates and pricing actions to increase fixed annuity product returns. Surrenders and partial withdrawals on deferred fixed annuities and interest-sensitive life products increased 33.9% in 2006 compared to 2005, while the withdrawal rate, based on the beginning of the period contractholder funds balance, increased to 10.1% for 2006 from 8.3% and 7.3%, for 2005 and 2004, respectively. The increase in the surrender rate in 2006 was influenced by multiple factors, including the relatively low interest rate environment during the last several years, which reduced reinvestment opportunities and increased the number of policies with little or no surrender charge protection. Also influencing the increase was our crediting rate strategies related to renewal business implemented to improve investment spreads on selected contracts. The increase in surrenders and partial withdrawals in 2006 is consistent with management's expectation that in the current interest rate environment and with a larger number of contractholders with relatively low or no surrender charges, more contractholders may choose to move their funds to competing investment alternatives. The aging of our in-force business may cause this trend to continue. Surrenders and partial withdrawals increased 70.0% in 2005 compared to 2004. The lack of surrender charges and market value adjustments combined with the interest rate environment, which included a relatively small difference between short-term and long-term interest rates, caused contractholders to choose competing short-term investment alternatives. NET INVESTMENT INCOME increased 4.7% in 2006 compared to 2005 and 17.9% in 2005 compared to 2004. The increase in both periods was primarily due to higher average portfolio balances. In 2005, the increase due to higher average portfolio balances was partially offset by lower portfolio yields. Higher average balances in both periods resulted from the investment of cash flows from operating and financing activities related primarily to deposits from fixed annuities and interest-sensitive life polices. 13 NET INCOME analysis is presented in the following table.
(IN THOUSANDS) 2006 2005 2004 --------- --------- --------- Premiums $ 84,313 $ 68,538 $ 76,550 Contract charges (1) 63,429 66,274 59,817 Net investment income 373,064 356,162 302,055 Periodic settlements and accruals on non-hedge derivative instruments (2) 2,395 1,096 372 Contract benefits (190,506) (183,227) (182,150) Interest credited to contractholder funds (3) (162,754) (159,563) (129,044) --------- --------- --------- Gross margin 169,941 149,280 127,600 Amortization of DAC and DSI (3) (4) (51,255) (40,224) (24,579) Operating costs and expenses (46,578) (43,497) (42,115) Income tax expense (24,964) (24,779) (21,845) Realized capital gains and losses, after-tax (13,869) (3,220) (5,844) DAC and DSI amortization expense on realized capital gains and losses, after-tax (4) 9,522 (2,360) (1,342) Reclassification of periodic settlements and accruals on non-hedge derivative instruments, after-tax (1,504) (680) (234) (Loss) gain on disposition of operations, after-tax (6,951) 1 862 Cumulative effect of change in accounting principle, after-tax -- -- (7,586) --------- --------- --------- NET INCOME $ 34,342 $ 34,521 $ 24,917 ========= ========= =========
---------- (1) Loads charged to contractholders at the inception of interest-sensitive life contracts are deferred and amortized to income in a manner consistent with DAC. Amortization of deferred loads on interest-sensitive life products related to realized capital gains and losses is excluded from contract charges for purposes of calculating gross margin. Amortization of deferred loads related to realized capital gains and losses totaled $(3) thousand, $6 thousand and $17 thousand in 2006, 2005 and 2004, respectively. (2) Periodic settlements and accruals on non-hedge derivative instruments are reflected as a component of realized capital gains and losses on the Statements of Operations and Comprehensive Income. (3) For purposes of calculating gross margin, amortization of deferred sales inducements ("DSI") is excluded from interest credited to contractholder funds and aggregated with amortization of DAC due to the similarity in the substance of the two items. Amortization of DSI totaled $4.4 million, $2.4 million and $760 thousand in 2006, 2005 and 2004, respectively. (4) Amortization of DAC and DSI relating to realized capital gains and losses is analyzed separately because realized capital gains and losses may vary significantly between periods and obscure trends in our business. Amortization of DAC and DSI relating to realized capital gains and losses was $15.2 million, $(3.8) million and $(2.2) million in 2006, 2005 and 2004, respectively GROSS MARGIN, a non-GAAP measure, is comprised of premiums and contract charges, and net investment income, less contract benefits and interest credited to contractholder funds excluding amortization of DSI. Gross margin also includes periodic settlements and accruals on certain non-hedge derivative instruments (see additional discussion under "INVESTMENT MARGIN"). 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 three components that are utilized to further analyze the business: investment margin, benefit margin, and contract charges and fees. 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. 14 The components of gross margin are reconciled to the corresponding financial statement line items in the following table. 2006 ----------------------------------------------- CONTRACT INVESTMENT BENEFIT CHARGES AND GROSS (IN THOUSANDS) MARGIN MARGIN FEES MARGIN ---------- -------- ----------- --------- Premiums $ -- $ 84,313 $ -- $ 84,313 Contract charges (1) -- 32,163 31,266 63,429 Net investment income 373,064 -- -- 373,064 Periodic settlements and accruals on non-hedge derivative instruments (2) 2,395 -- -- 2,395 Contract benefits (103,904) (86,602) -- (190,506) Interest credited to contractholder funds(3) (162,754) -- -- (162,754) --------- -------- ------- --------- $ 108,801 $ 29,874 $31,266 $ 169,941 ========= ======== ======= =========
2005 ----------------------------------------------- CONTRACT INVESTMENT BENEFIT CHARGES AND GROSS (IN THOUSANDS) MARGIN MARGIN FEES MARGIN ---------- -------- ----------- --------- Premiums $ -- $ 68,538 $ -- $ 68,538 Contract charges (1) -- 33,176 33,098 66,274 Net investment income 356,162 -- -- 356,162 Periodic settlements and accruals on non-hedge derivative instruments (2) 1,096 -- -- 1,096 Contract benefits (100,996) (82,231) -- (183,227) Interest credited to contractholder funds(3) (159,563) -- -- (159,563) --------- -------- ------- --------- $ 96,699 $ 19,483 $33,098 $ 149,280 ========= ======== ======= =========
2004 ----------------------------------------------- CONTRACT INVESTMENT BENEFIT CHARGES AND GROSS (IN THOUSANDS) MARGIN MARGIN FEES MARGIN ---------- -------- ----------- --------- Premiums $ -- $ 76,550 $ -- $ 76,550 Contract charges (1) -- 30,803 29,014 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 $ 23,464 $ 29,014 $ 127,600 ========= ======== ======== ========= ---------- (1) Loads charged to contractholders at the inception of interest-sensitive life contracts are deferred and amortized to income in a manner consistent with DAC. Amortization of deferred loads on interest-sensitive life products related to realized capital gains and losses is excluded from contract charges for purposes of calculating gross margin. Amortization of deferred loads related to realized capital gains and losses totaled $(3) thousand, $6 thousand and $17 thousand in 2006, 2005 and 2004, respectively. (2) Periodic settlements and accruals on non-hedge derivative instruments are reflected as a component of realized capital gains and losses on the Statements of Operations and Comprehensive Income. (3) For purposes of calculating gross margin, amortization of DSI is excluded from interest credited to contractholder funds and aggregated with amortization of DAC due to similarity in the substance of the two items. Amortization of DSI totaled $4.4 million, $2.4 million and $760 thousand in 2006, 2005 and 2004, respectively. 15 Gross margin increased 13.8% in 2006 compared to 2005 due to increased investment and benefit margin, partially offset by lower contract charges and fees. The decline in contract charges and fees was driven by the absence of contract charges on variable annuities that were reinsured effective June 1, 2006 in conjunction with the disposition of substantially all of our variable annuity business. Excluding the impact of the reinsurance of our variable annuity business, gross margin increased 18.0% in 2006 compared to 2005. Gross margin increased 17.0% in 2005 compared to 2004 due to higher investment margin and contract charges and fees, partially offset by lower benefit margin. Gross margin for 2005 includes additional contract benefits of $15 million that were accrued in accordance with a regulatory matter (see the "Proceedings" subsection of Note 11 to the financial statements for discussion of the settlement of this matter). INVESTMENT MARGIN is a component of gross margin, both of which are non-GAAP measures. Investment margin represents the excess of net investment income and periodic settlements and accruals on non-hedge derivative instruments 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 utilize derivative instruments as economic hedges of investments or contractholder funds or to replicate fixed income securities. These instruments either do not qualify for hedge accounting or are not designated as hedges for accounting purposes. Such derivatives are accounted for at fair value, and reported in realized capital gains and losses. Periodic settlements and accruals on these derivative instruments are included as a component of gross margin, consistent with their intended use to enhance or maintain investment income and margin, and together with the economically hedged investments or product attributes (e.g., net investment income or interest credited to contractholders funds) or replicated investments, to appropriately reflect trends in product performance. Amortization of DSI is excluded from interest credited to contractholder funds for purposes of calculating investment margin. 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) 2006 2005 2004 -------- ------- ------- Annuities $ 98,936 $87,946 $64,110 Life insurance 9,865 8,753 11,012 -------- ------- ------- Total investment margin $108,801 $96,699 $75,122 ======== ======= ======= Investment margin increased 12.5% in 2006 compared to 2005 primarily due to improved yields on assets supporting deferred fixed annuities, growth in contractholder funds and crediting rate actions relating to renewal business. Investment margin increased 28.7% in 2005 compared to 2004 primarily due to growth in our fixed annuity business, partially offset by lower weighted average investment spreads on interest-sensitive life and immediate annuities and additional contract benefits accrued in accordance with a regulatory matter (see the "Proceedings" subsection of Note 11 to the financial statements for discussion of the settlement of this matter). The following table summarizes the annualized weighted average investment yields, interest crediting rates and investment spreads during 2006, 2005 and 2004.
WEIGHTED AVERAGE WEIGHTED AVERAGE INTEREST WEIGHTED AVERAGE INVESTMENT YIELD CREDITING RATE INVESTMENT SPREADS ------------------ ------------------ ------------------ 2006 2005 2004 2006 2005 2004 2006 2005 2004 ---- ---- ---- ---- ---- ---- ---- ---- ---- Interest-sensitive life products 5.6% 5.7% 6.1% 4.5% 4.6% 4.8% 1.1% 1.1% 1.3% Deferred fixed annuities 5.6 5.4 5.6 3.2 3.3 3.5 2.4 2.1 2.1 Immediate fixed annuities with and without life contingencies 7.5 7.4 7.6 6.7 6.7 6.8 0.8 0.7 0.8 Investments supporting capital, traditional life and other products 6.2 6.2 6.0 N/A N/A N/A N/A N/A N/A
16 The following table summarizes the liabilities as of December 31 for these contracts and policies.
(IN THOUSANDS) 2006 2005 2004 ---------- ---------- ---------- Immediate fixed annuities with life contingencies $1,567,821 $1,502,918 $1,442,055 Other life contingent contracts and other 358,671 366,957 340,396 ---------- ---------- ---------- Reserve for life-contingent contracts $1,926,492 $1,869,875 $1,782,451 ========== ========== ========== Interest-sensitive life $ 476,729 $ 427,523 $ 368,608 Deferred fixed annuities 3,667,459 3,381,034 2,890,254 Immediate fixed annuities without life contingencies and other 564,240 540,838 543,984 ---------- ---------- ---------- Contractholder funds $4,708,428 $4,349,395 $3,802,846 ========== ========== ==========
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, cost of insurance contract charges and, prior to the disposal of all of our variable annuity business through reinsurance, variable annuity contract charges for contract guarantees less contract benefits. Benefit margin excludes the implied interest on life-contingent immediate annuities, which is included in the calculation of investment margin. We use 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) 2006 2005 2004 ------- -------- ------- Life insurance $27,536 $ 34,558 $29,291 Annuities 2,338 (15,075) (5,827) ------- -------- ------- Total benefit margin $29,874 $ 19,483 $23,464 ======= ======== ======= Benefit margin increased 53.3% in 2006 compared to 2005. Benefit margin for 2005 includes $3.1 million of amounts that were classified as contract charges and fees beginning in 2006. Excluding this reclassification, benefit margin increased 82.8% in 2006 compared to 2005 due primarily to additional variable annuity contract benefits accrued in 2005 in accordance with a regulatory matter (see the "Proceedings" subsection of Note 11 to the financial statements for discussion of the settlement of this matter). Benefit margin declined 17.0% in 2005 compared to 2004 due to an increasingly unfavorable benefit margin on annuities partially offset by a higher benefit margin on life insurance products. The unfavorable change in the benefit margin on annuities was primarily attributable to additional variable annuity contract benefits accrued in accordance with a regulatory matter, while the improvement in the benefit margin on life insurance primarily reflected growth of our in force business. AMORTIZATION OF DAC AND DSI, excluding amortization related to realized capital gains and losses, increased 27.4% in 2006 compared to 2005. Lower variable annuity amortization in 2006 due to the disposition of the business effective June 1, 2006 through reinsurance was more than offset by the recognition of amortization acceleration (commonly referred to as DAC and DSI "unlocking") totaling $544 thousand in 2006 compared to the recognition of amortization deceleration of $7.3 million in 2005, and higher amortization on investment contracts due to improved gross margin. DAC and DSI amortization related to realized capital gains and losses, after-tax, changed by a favorable $11.9 million in 2006 compared to 2005. The impact of realized capital gains and losses on amortization of DAC and DSI is dependent upon the relationship between the assets that give rise to the gain or loss and the product liability supported by the assets. Fluctuations result from changes in the impact of realized capital gains and losses on actual and expected gross profits. The DAC and DSI assets were reduced by $79.7 million and $6.2 million, respectively, in 2006 as a result of the disposition of our variable annuity business. Amortization of DAC and DSI, excluding amortization related to realized capital gains and losses, increased 63.7% in 2005 compared to 2004 as a result of higher gross margin primarily from the growth in our annuity investment margin. 17 The changes in the DAC asset are summarized in the following tables. (IN THOUSANDS)
IMPACT OF AMORTIZATION EFFECT OF BEGINNING DISPOSAL (ACCELERATION) UNREALIZED ENDING BALANCE OF ACQUISITION AMORTIZATION DECELERATION CAPITAL BALANCE DECEMBER 31, VARIABLE COSTS CHARGED TO CHARGED TO GAINS AND DECEMBER 31, 2005 ANNUITIES DEFERRED INCOME (1) INCOME (2) LOSSES 2006 --------- --------- ----------- ------------ ------------- ---------- ----------- Traditional life $ 32,989 $ -- $ 2,568 $ (2,247) $ -- $ -- $ 33,310 Interest-sensitive life 77,308 -- 9,553 (7,706) 2,122 2,572 83,849 Variable annuities 68,154 (79,670) 4,813 7,277 -- (574) -- Investment contracts 136,923 -- 43,995 (28,229) (1,976) 6,481 157,194 Accident, health and other 3,177 -- 2,008 (913) -- -- 4,272 -------- -------- ------- -------- ------- ------ -------- Total $318,551 $(79,670) $62,937 $(31,818) $ 146 $8,479 $278,625 ======== ======== ======= ======== ======= ====== ========
(IN THOUSANDS)
AMORTIZATION EFFECT OF BEGINNING (ACCELERATION) UNREALIZED ENDING BALANCE ACQUISITION AMORTIZATION DECELERATION CAPITAL BALANCE DECEMBER 31, COSTS CHARGED TO CHARGED TO GAINS AND DECEMBER 31, 2004 DEFERRED INCOME (1) INCOME (2) LOSSES 2005 ---------- ----------- ------------ ------------- ---------- ------------ Traditional life $ 33,480 $ 1,713 $ (2,204) $ -- $ -- $ 32,989 Interest-sensitive life 72,129 8,784 (8,435) 3,250 1,580 77,308 Variable annuities 47,725 12,095 (11,014) 4,268 15,080 68,154 Investment contracts 82,800 43,817 (26,879) 9 37,176 136,923 Accident, health and other 2,039 1,796 (658) -- -- 3,177 -------- ------- -------- ------ ------- -------- Total $238,173 $68,205 $(49,190) $7,527 $53,836 $318,551 ======== ======= ======== ====== ======= ========
---------- (1) The amortization of DAC for interest-sensitive life, variable annuities and investment contracts is proportionate to the recognition of gross profits, which include realized capital gains and losses. Fluctuations in amortization for these products may result as actual realized capital gains and losses differ from the amounts utilized in the determination of estimated gross profits. Amortization related to realized capital gains and losses was $14.1 million, $(3.7) million and $(2.1) million in 2006, 2005 and 2004, respectively. (2) Included as a component of amortization of DAC on the Statements of Operations and Comprehensive Income. OPERATING COSTS AND EXPENSES increased 7.1% in 2006 compared to 2005 and 3.3% in 2005 compared to 2004. The increase in 2006 was attributable to higher guaranty fund assessments, restructuring charges and employee benefit expenses, partially offset by the absence of variable annuity related expenses due to the disposition of the business through reinsurance effective June 1, 2006 and lower technology related expenses. The increase in 2005 was primarily attributable to higher technology, distribution, and administrative expenses, which were incurred to support growth in the Company's in-force business. These increases were partially offset by lower non-deferrable commissions, guaranty fund assessments, and expenses related to taxes, licenses, and fees. 18 REINSURANCE CEDED We enter into reinsurance agreements with ALIC and unaffiliated carriers to limit our risk of mortality and morbidity losses. As of December 31, 2006, for certain term life insurance policies, we cede up to 90% of the mortality risk depending on the length of the term. Comparatively, as of December 31, 2005, 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. Mortality risk on policies in excess of $250 thousand per life is ceded to ALIC. As of December 31, 2006 and 2005, 39.4% and 37.6%, respectively, of our face amount of life insurance in force is reinsured to non-affiliates and ALIC. We cede all of the risk associated with variable annuity contracts to Prudential (see Note 3 to the financial statements). The estimation of reinsurance recoverables is impacted by the uncertainties involved in the establishment of reserves. Our reinsurance recoverables, summarized by reinsurer as of December 31, are shown in the following table.
S&P FINANCIAL REINSURANCE RECOVERABLE ON (IN THOUSANDS) STRENGTH RATING PAID AND UNPAID CLAIMS --------------- ---------------------- 2006 2005 ---- ---- Prudential Insurance Company of America AA- $415,709 $ -- Transamerica Financial Life Insurance AA 9,321 4,861 RGA Reinsurance Company AA- 4,262 2,511 Allstate Life Insurance Company AA 2,437 935 Triton Insurance Company NR 1,614 1,407 Generali USA A 722 511 Swiss Re Life and Health America, Inc. AA- 713 478 Security Life of Denver AA 638 516 American United Life AA- 634 534 Canada Life AA 549 331 Scottish Re Group BB 531 409 Cologne Re AAA 130 32 Minnesota Mutual AA- 87 94 Metropolitan Life AA 75 110 -------- ------- Total $437,422 $12,729 ======== =======
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, 2006. 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 Statement of Financial Accounting Standards ("SFAS") No. 133, "Accounting for Derivative Instruments and Hedging Activities". 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. INVESTMENTS An important component of our financial results is the return on our investment portfolio. The investment portfolio is managed based upon the nature of the business and our corresponding liability structure. OVERVIEW AND STRATEGY The 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 ranges set by the strategic asset allocation model, tactical investment decisions are made in consideration of prevailing market conditions. As a result of tactical decisions in each of the portfolios, we may sell fixed income securities during the period in which fair value has declined below amortized cost. Portfolio monitoring, which includes identifying securities that are other-than-temporarily impaired and recognizing impairment on securities in an unrealized loss 19 position for which we do not have the intent and ability to hold until recovery, are conducted regularly. For more information, see the Portfolio Monitoring section of the MD&A. PORTFOLIO COMPOSITION The composition of the investment portfolio at December 31, 2006 is presented in the table below. Also see Notes 2 and 6 to the financial statements for investment accounting policies and additional information. PERCENT (IN THOUSANDS) INVESTMENTS OF TOTAL ----------- -------- Fixed income securities (1) $5,887,139 86.8% Mortgage loans 708,449 10.4 Short-term 142,334 2.1 Policy loans 38,168 0.6 Other 3,784 0.1 ---------- ----- Total $6,779,874 100.0% ========== ===== ---------- (1) Fixed income securities are carried at fair value. Amortized cost basis for these securities was $5.54 billion at December 31, 2006. Total investments increased to $6.78 billion at December 31, 2006 from $6.73 billion at December 31, 2005, primarily due to positive cash flows from financing and operating activities, partially offset by payments totaling approximately $389.6 million related to the disposition through reinsurance of our variable annuity business, and lower unrealized net capital gains on fixed income securities. Total investments at amortized cost related to collateral received in connection with securities lending business activities increased to $199.5 million at December 31, 2006 from $149.5 million at December 31, 2005. 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 Estimates section of MD&A. The following table shows total investments, categorized by the method used to determine fair value at December 31, 2006.
DERIVATIVE INVESTMENTS CONTRACTS (1) --------------------- ------------- FAIR PERCENT FAIR (IN THOUSANDS) VALUE OF TOTAL VALUE ---------- -------- ------------- Fair value based on independent market quotations $4,835,750 71.3% $ 50 Fair value based on models and other valuation methods 1,181,020 17.4 518 Mortgage loans, policy loans and other investments, valued at cost and amortized cost 763,104 11.3 -- ---------- ----- ---- Total $6,779,874 100.0% $568 ========== ===== ====
---------- (1) Derivative fair value includes derivatives classified as assets and liabilities on the Statements of Financial Position and excludes derivatives related to the Company's products (see Note 7 of the financial statements). 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, 2006 and 2005. U.S. government and agencies of the U.S. government securities were all rated investment grade at December 31, 2006. 20 Municipal bonds, including tax-exempt and taxable securities, totaled $323.0 million, all of which were rated investment grade at December 31, 2006. Approximately 59.5% of the municipal bond portfolio was insured by five bond insurers and accordingly have a Moody's equivalent rating of Aaa or Aa. The municipal bond portfolio at December 31, 2006 consisted of approximately 43 issues from approximately 40 issuers. The largest exposure to a single issuer was approximately 11.4% of the municipal bond portfolio. Corporate bonds totaled $3.30 billion and 94.3% were rated investment grade at December 31, 2006. As of December 31, 2006, the portfolio contained $1.50 billion of privately placed corporate obligations or 45.4%, compared with $1.51 billion or 43.9% at December 31, 2005. Approximately $1.48 billion or 98.6% of the privately placed corporate obligations consisted of fixed rate privately placed securities. The primary benefits of fixed rate privately placed securities when compared to publicly issued securities may include generally higher yields, improved cash flow predictability through pro-rata sinking funds, and a combination of 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. At December 31, 2006 94.9% of privately placed securities were rated investment grade. Foreign government securities totaled $304.9 million and all were rated investment grade at December 31, 2006. Mortgage-backed securities ("MBS") totaled $433.2 million, all of which were rated investment grade at December 31, 2006. The credit risk associated with MBS is mitigated due to fact that 81.4% of the portfolio consists 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. Commercial Mortgage Backed Securities ("CMBS") totaled $673.2 million at December 31, 2006, all of which were rated investment grade. CMBS investments 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 products, is generally not subject to prepayment risk due to protections within the underlying commercial mortgages, whereby borrowers are restricted from prepaying their mortgages due to changes in interest rates. Credit defaults can result in credit directed prepayments. Approximately 68.8% of the CMBS portfolio had a Moody's rating of Aaa or an Standard & Poor's or Fitch rating of AAA, the highest rating category, at December 31, 2006. Asset-backed securities ("ABS") totaled $109.0 million at December 31, 2006, all of which were rated investment grade. 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 structures, reserve funds, guarantees and/or insurance. Approximately 82.5% of the ABS portfolio had a Moody's rating of Aaa or an Standard & Poor's or Fitch 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. As of December 31, 2006, 93.2% of the portfolio was less sensitive to interest rate risk due to the payment terms or underlying collateral of the securities. The ABS portfolio includes bonds that are secured by a variety of asset types, predominately home equity loans, credit card receivables and auto loans as well as collateralized debt obligations that are predominately secured by corporate bonds and loans. We may utilize derivative financial instruments to help mange the exposure to interest rate risk from the fixed income securities portfolio. For a more detailed discussion of interest rate risk and our use of derivative financial instruments, see the Market Risk section of MD&A and Note 7 to the financial statements. At December 31, 2006, 96.9% 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 Standard & Poor's, Fitch or Dominion; or a rating of aaa, aa, a or bbb from A.M. Best; or a comparable internal rating if an externally provided rating is not available. 21 The following table summarizes the credit quality of the fixed income securities portfolio at December 31, 2006. (IN THOUSANDS) NAIC FAIR PERCENT RATING MOODY'S EQUIVALENT VALUE OF TOTAL -------------- ------------------ ---------- -------- 1 Aaa/Aa/A $4,266,674 72.5% 2 Baa 1,433,572 24.4 3 Ba 149,943 2.5 4 B 29,478 0.5 5 Caa or lower 639 -- 6 In or near default 6,833 0.1 ---------- ----- Total $5,887,139 100.0% ========== ===== UNREALIZED GAINS AND LOSSES See Note 6 of the financial statements for further disclosures regarding unrealized losses on fixed income securities and factors considered in determining whether the securities are not other-than-temporarily impaired. The unrealized net capital gains on fixed income securities at December 31, 2006 totaled $344.9 million, a decrease of $109.0 million since December 31, 2005. Gross unrealized gains and losses on fixed income securities by type and sector are provided in the table below.
GROSS UNREALIZED AMORTIZED ------------------- FAIR (IN THOUSANDS) COST GAINS LOSSES VALUE ---------- -------- -------- ---------- AT DECEMBER 31, 2006 Corporate: Utilities $ 654,671 $ 43,259 $ (6,271) $ 691,659 Banking 476,011 17,016 (5,204) 487,823 Consumer goods (cyclical and non-cyclical) 409,731 7,524 (5,575) 411,680 Financial services 378,054 8,840 (3,843) 383,051 Capital goods 344,241 5,726 (4,970) 344,997 Communications 205,590 8,151 (1,682) 212,059 Transportation 169,246 11,018 (1,224) 179,040 Basic industry 176,714 3,585 (2,154) 178,145 Other 158,478 15,598 (1,387) 172,689 Energy 154,035 2,935 (2,247) 154,723 Technology 87,733 1,727 (564) 88,896 ---------- -------- -------- ---------- Total corporate fixed income portfolio 3,214,504 125,379 (35,121) 3,304,762 U.S. government and agencies 541,877 187,234 -- 729,111 Municipal 314,768 12,979 (4,744) 323,003 Foreign government 244,544 60,614 (211) 304,947 Asset-backed securities 107,922 1,728 (628) 109,022 Mortgage-backed securities 439,938 2,514 (9,256) 433,196 Commercial mortgage-backed securities 669,303 8,192 (4,316) 673,179 Redeemable preferred stock 9,371 548 -- 9,919 ---------- -------- -------- ---------- Total fixed income securities $5,542,227 $399,188 $(54,276) $5,887,139 ========== ======== ======== ==========
The utilities, consumer goods, banking, capital goods and financial services sectors had the highest concentration of gross unrealized losses in our corporate fixed income securities portfolio at December 31, 2006. The gross unrealized losses in these sectors are primarily interest rate related or company specific. As of December 31, 2006, $32.1 million or 91.5% of the gross unrealized losses in the corporate fixed income portfolio, and all of the remaining fixed income securities with gross unrealized losses, were rated investment grade. Unrealized losses on investment grade securities are principally related to rising interest rates or changes in credit spreads since the securities were acquired. All securities in an unrealized loss position at December 31, 2006 22 were included in our portfolio monitoring process for determining which declines in value were not other-than-temporary. The following table shows the composition by credit quality of the fixed income securities with gross unrealized losses at December 31, 2006.
(IN THOUSANDS) NAIC UNREALIZED PERCENT PERCENT RATING MOODY'S EQUIVALENT LOSS OF TOTAL FAIR VALUE OF TOTAL ---------- -------- ---------- -------- 1 Aaa/Aa/A $(36,291) 66.9% $1,619,944 71.7% 2 Baa (14,994) 27.6 574,125 25.4 3 Ba (2,290) 4.2 52,520 2.3 4 B (701) 1.3 14,136 0.6 5 Caa or lower -- -- -- -- 6 In or near default -- -- -- -- -------- ----- ---------- ----- Total $(54,276) 100.0% $2,260,725 100.0% ======== ===== ========== =====
At December 31, 2006, $51.3 million, or 94.5%, 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. As of December 31, 2006, $3.0 million of the gross unrealized losses were related to below investment grade fixed income securities. Of this amount, there were no significant unrealized loss positions (greater than or equal to 20% of amortized cost) for six or more consecutive months prior to December 31, 2006. 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, 2006 are shown below. Actual maturities may differ from those scheduled as a result of prepayments by the issuers.
PERCENT PERCENT (IN THOUSANDS) UNREALIZED LOSS OF TOTAL FAIR VALUE OF TOTAL --------------- -------- ---------- -------- Due in one year or less $ (62) 0.1% $ 7,936 0.4% Due after one year through five years (7,287) 13.4 377,637 16.7 Due after five years through ten years (19,473) 35.9 717,463 31.7 Due after ten years (17,570) 32.4 804,717 35.6 Mortgage- and asset- backed securities(1) (9,884) 18.2 352,972 15.6 -------- ----- ---------- ----- Total $(54,276) 100.0% $2,260,725 100.0% ======== ===== ========== =====
---------- (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, on a case by case basis, fixed income securities for which 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 for which 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. As a result of approved programs involving the disposition of investments such as changes in duration, revisions to strategic asset allocations and liquidity actions, and certain dispositions anticipated by portfolio managers, we also conduct a portfolio review to recognize impairment on securities in an unrealized loss position for which we do not have the intent and ability to hold until recovery. All securities in an unrealized loss position at December 31, 2006 were included in our portfolio monitoring process for determining which declines in value were not other-than-temporary. 23 The following table summarizes fixed income securities in a gross unrealized loss position according to significance, aging and investment grade classification.
DECEMBER 31, 2006 DECEMBER 31, 2005 ------------------------------------ ------------------------------------ FIXED INCOME FIXED INCOME ----------------------- ----------------------- BELOW BELOW INVESTMENT INVESTMENT INVESTMENT INVESTMENT (IN THOUSANDS, EXCEPT NUMBER OF ISSUES) GRADE GRADE TOTAL GRADE GRADE TOTAL ---------- ---------- ---------- ---------- ---------- ---------- Category (i): Unrealized loss less than 20% of cost (1) Number of Issues 373 36 409 334 34 368 Fair Value $2,194,069 $66,656 $2,260,725 $1,999,082 $61,814 $2,060,896 Unrealized $ (51,285) $(2,991) $ (54,276) $ (39,839) $(2,471) $ (42,310) Category (ii): Unrealized loss greater than or equal to 20% of cost for a period of less than 6 consecutive months (1) Number of Issues -- -- -- 3 -- 3 Fair Value $ -- $ -- $ -- $ 4,344 $ -- $ 4,344 Unrealized $ -- $ -- $ -- $ (1,202) $ -- $ (1,202) Total Number of Issues 373 36 409 337 34 371 ========== ======= ========== =========== ======= ========== Total Fair Value $2,194,069 $66,656 $2,260,725 $ 2,003,426 $61,814 $2,065,240 ========== ======= ========== =========== ======= ========== Total Unrealized Losses $ (51,285) $(2,991) $ (54,276) $ (41,041) $(2,471) $ (43,512) ========== ======= ========== =========== ======= ==========
The largest individual unrealized loss was $952 thousand for category (i) as of December 31, 2006. Categories (i) and (ii) have generally been adversely affected by overall economic conditions including interest rate increases and the market's evaluation of certain sectors. The degree to which and/or length of time that the securities have been in an unrealized loss position does not suggest that these securities pose a high risk of being other-than-temporarily impaired. Whenever our initial analysis indicates that a fixed income security's unrealized loss of 20% or more for at least 36 months or any equity security's unrealized loss of 20% or more for at least 12 months is temporary, additional evaluations and management approvals are required to substantiate that a write-down is not appropriate. As of December 31, 2006, no securities met these criteria. 24 The following table contains the individual securities with the largest unrealized losses as of December 31, 2006. No other fixed income security had an unrealized loss of or greater than $690 thousand or 1.3% of the total unrealized loss on fixed income securities. UNREALIZED UNREALIZED FAIR NAIC LOSS (IN THOUSANDS) LOSS VALUE RATING CATEGORY ---------- ------- ------ ---------- Municipal Obligation $ (952) $14,048 1 (i) Mortgage Backed Security (951) 24,106 1 (i) Mortgage Backed Security (797) 16,883 1 (i) Building Products Company (767) 19,233 2 (i) Municipal Obligation (706) 8,207 1 (i) Utility Company (690) 9,011 1 (i) ------- ------- Total $(4,863) $91,488 ======= ======= We 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. The following table summarizes problem, restructured and potential problem fixed income securities at December 31.
2006 2005 ------------------------------- -------------------------------- PERCENT OF PERCENT OF TOTAL TOTAL FIXED FIXED AMORTIZED FAIR INCOME AMORTIZED FAIR INCOME (IN THOUSANDS) COST VALUE PORTFOLIO COST VALUE PORTFOLIO --------- ------ ---------- --------- ------- ---------- Problem $3,444 $6,883 0.1% $14,373 $17,762 0.3% Restructured -- -- -- 163 163 -- Potential problem 2 -- -- 5,609 5,640 0.1 ------ ------ --- ------- ------- --- Total net carrying value $3,446 $6,883 0.1% $20,145 $23,565 0.4% ====== ====== === ======= ======= === Cumulative write-downs recognized (1) $2,491 $ 5,455 ====== =======
---------- (1) Cumulative write-downs recognized only reflect write-downs related to securities within the problem, potential problem or restructured categories. We have experienced a decrease in the amortized cost of fixed income securities in each of the categories as of December 31, 2006 compared to December 31, 2005, due to dispositions and the removal of a security upon improving conditions. We evaluated each of these securities through our portfolio monitoring process at December 31, 2006 and recorded write-downs when appropriate. We further concluded that any remaining unrealized losses on these securities were temporary in nature and that we have the intent and ability to hold the security until recovery. 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. 25 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) 2006 2005 2004 -------- ------- ------- Investment write-downs $ (258) $(1,543) $(3,402) Dispositions (21,568) (2,053) (2,784) Valuation of derivative instruments (5,429) (4,469) (5,777) Settlement of derivative instruments 5,170 2,873 2,666 -------- ------- ------- Realized capital gains and losses, pretax (22,085) (5,192) (9,297) Income tax benefit 8,216 1,972 3,453 -------- ------- ------- Realized capital gains and losses, after-tax $(13,869) $(3,220) $(5,844) ======== ======= ======= Dispositions in the above table include sales, losses recognized in anticipation of dispositions and other transactions such as calls and prepayments. We may sell impaired fixed income securities that were in an unrealized loss position at the previous reporting date in situations where new factors such as negative developments, subsequent credit deterioration, changing liquidity needs, and newly identified market opportunities cause a change in our previous intent to hold a security to recovery or maturity. A changing interest rate environment will drive changes in our portfolio duration targets at a tactical level. A duration target and range is established with an economic view of liabilities relative to a long-term portfolio view. Tactical duration adjustments within management's approved ranges are accomplished through both cash market transactions and derivative activities that generate realized gains and losses and through new purchases. As a component of our approach to managing portfolio duration, realized gains and losses on derivative instruments are most appropriately considered in conjunction with the unrealized gains and losses on the fixed income portfolio. This approach mitigates the impacts of general interest rate changes to the overall financial condition of the Company. Dispositions included net realized losses on sales and other transactions such as calls and prepayments of $5.1 million and losses recorded in connection with anticipated dispositions of $16.5 million. The net realized losses on sales and other transactions were comprised of gross gains of $13.9 million and gross losses of $19.0 million. The $19.0 million in gross losses almost entirely consisted of losses from sales of fixed income securities. During our comprehensive portfolio reviews, we ascertain whether there are any approved programs involving the disposition of investments such as changes in duration, revision to strategic asset allocation and liquidity actions; and any dispositions anticipated by the portfolio managers resulting from their on-going comprehensive reviews of the portfolios. Upon approval of such programs, we identify a population of suitable investments, typically larger than needed to execute the disposition, from which specific securities are selected to sell. Due to our change in intent to hold until recovery, we recognize impairments, which are included in losses from dispositions, on any of these securities in an unrealized loss position. When the objectives of the programs are accomplished, any remaining securities are redesignated as intent to hold until recovery. For the year ended December 31, 2006, we recognized $16.5 million of losses related to a change in our intent to hold certain securities with unrealized losses until they recover in value. The change in our intent was driven by certain approved programs, including funding for the disposition through reinsurance of our variable annuity reinsurance agreement. These programs were completed during 2006. Additionally, ongoing comprehensive reviews of our portfolio resulted in the identification of anticipated dispositions by the portfolio managers. At December 31, 2006, the fair value of securities for which we did not have the intent to hold until recovery totaled $13.7 million. At December 31, 2005, the fair value of the securities for which we did not have the intent to hold until recovery totaled $11.5 million. Approved programs involving the disposition of securities included continued asset-liability management strategies, on-going comprehensive reviews of our portfolios, changes to our strategic asset allocations and yield enhancement strategies on which we recognized $6.8 million of losses during 2005. These objectives were accomplished during 2006. 26 The ten largest losses from sales of individual securities for the year ended December 31, 2006 totaled $8.8 million with the largest being $1.7 million and the smallest being $609 thousand. None of the securities that comprise these ten largest losses were in an unrealized loss position greater than or equal to 20% of amortized cost at the time of sale. MORTGAGE LOANS Our mortgage loans portfolio was $708.4 million at December 31, 2006 and $633.8 million at December 31, 2005, and was 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. We had no realized capital losses related to write-downs on mortgage loans for the years ended December 31, 2006, 2005 and 2004. SHORT-TERM INVESTMENTS Our short-term investment portfolio was $142.3 million and $63.1 million at December 31, 2006 and 2005, 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. As one of our business activities, we conduct securities lending, primarily as an investment yield enhancement, with third parties such as brokerage firms. We obtain collateral in an amount equal to 102% of the fair value of the 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 and accrued expense. At December 31, 2006, the amount of securities lending collateral reinvested in short-term investments had a carrying value of $87 million. This compares to $46 million at December 31, 2005. OUTLOOK - We plan to continue to balance targeted improvements in return on equity with growth in sales and profitability. Initially, our actions to improve returns may reduce the price competitiveness of certain products, such as our fixed annuities, and slow or reduce the growth in sales and income. - We plan to continue to maintain discipline over expenses and improve our operating efficiency. - We plan to increase sales of our financial products by Allstate exclusive agencies by further tailoring products for our customers and making it easier for our agents to distribute our products. - We plan to develop and bring to market new innovative life insurance products or features designed to increase sales of this product line. 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 investiable funds from our business. 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. 27 Investment policies define the overall framework for managing market and other investment risks, including accountability and control over these risk management activities. These investment activities follow policies that have been approved by our board of directors. These investment policies specify the investment limits and strategies that are appropriate given our liquidity, surplus, product profile, and regulatory requirements. Executive oversight of investment activities is conducted primarily through our board of directors and investment committee. Asset-liability management ("ALM") policies further define the overall framework for managing market and investment risks. ALM focuses on strategies to enhance yields, mitigate market risks and optimize capital to improve profitability and returns. ALM activities follow asset-liability policies that have been approved by our board of directors. These ALM policies specify limits, ranges and/or 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, duration and value-at-risk 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. Our value-at-risk limits are intended to restrict the potential loss in fair value that could arise from adverse movements in the fixed income, equity, and currency markets based on historical volatilities and correlations among market risk factors. 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 with and informed by the activities of the ALM organization. This integration results in a prudent, methodical and effective adjudication of market risk and return, conditioned by the unique demands and dynamics of our product liabilities and supported by the application of advanced risk technology and analytics. 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, 2006, the difference between our asset and liability duration was approximately (0.45), compared to a (0.34) gap at December 31, 2005. 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 of 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 in accordance with Statement of Financial Accounting Standards ("SFAS") No. 107, "Disclosures about Fair Value of Financial Instruments"), and certain other items including interest-sensitive liabilities and annuity liabilities, which are not considered financial instruments in accordance with SFAS No.107. 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, 2006, we estimate that a 100 basis point immediate, parallel increase in interest rates ("rate shock") 28 would decrease the net fair value of the assets and liabilities by approximately $23.1 million, compared to $46.8 million at December 31, 2005. 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. There were $393.2 million of assets supporting life insurance products such as traditional and interest-sensitive life, which are not considered financial instruments in accordance with SFAS No. 107. These assets and the associated liabilities have not been included in the above estimate. The $393.2 million of assets excluded from the calculation has decreased from $412.3 million reported at December 31, 2005. Based on assumptions described above, in the event of a 100 basis point immediate increase in interest rates, the assets supporting life insurance products would decrease in value by $29.3 million, compared to a decrease of $32.2 million at December 31, 2005. 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 losses due to adverse changes in general levels of the equity markets. At December 31, 2006 and 2005, we had separate accounts assets related to variable annuity and variable life contracts with account values totaling $1.01 billion and $928.8 million, respectively. Equity risk exists for contract charges based on separate account balances and guarantees for death and/or income benefits provided by our variable products. In 2006, we disposed of all of the variable annuity business through a reinsurance agreement with Prudential as described in Note 3 of the financial statements, and therefore mitigated this aspect of our risk. Equity risk of our variable life business relates to contract charges and policyholder benefits. Total variable life contract charges for 2006 and 2005 were $830 thousand and $554 thousand, respectively. Separate account liabilities related to variable life contracts were $2.7 million and $1.4 million in December 31, 2006 and 2005, respectively. CAPITAL RESOURCES AND LIQUIDITY CAPITAL RESOURCES consist of shareholder's equity. The following table summarizes our capital resources at December 31. (IN THOUSANDS) 2006 2005 2004 -------- -------- -------- Common stock, additional capital paid-in and retained income $574,958 $538,465 $483,980 Accumulated other comprehensive income 78,038 128,968 155,255 -------- -------- -------- Total shareholder's equity $652,996 $667,433 $639,235 ======== ======== ======== SHAREHOLDER'S EQUITY decreased in 2006 due to lower unrealized net capital gains on fixed income securities, partially offset by net income and a gain recorded to retained income related to the recapture of a reinsurance treaty with ALIC. Shareholder's equity increased in 2005 when compared to 2004 as a result of net income and a capital contribution from ALIC of $20.0 million, partially offset by lower unrealized net capital gains on fixed income securities. FINANCIAL RATINGS AND STRENGTH The following table summarizes our financial strength ratings at December 31, 2006. RATING AGENCY RATING ------------- ------ Moody's Investors Service, Inc. Aa2 ("Excellent") Standard & Poor's Ratings Services AA ("Very Strong") A.M. Best Company, Inc. A+ ("Superior") 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), risk exposures, operating leverage, ALIC's ratings, AIC's ratings and other factors. 29 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 for life companies takes into account factors relating to insurance, business, asset and interest rate risks. At December 31, 2006, 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 financial 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. 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, surrenders and withdrawals - Reinsurance cessions and payments - Operating costs and expenses - Purchases of investments - Repayment of securities lending - Payment or repayment of inter-company loans - Tax payments/settlements - Dividends to parent As reflected in our Statements of Cash Flows, higher operating cash flows in 2006, compared to 2005, primarily related to higher interest received on investments and premiums received, partially offset by higher contract benefits and expenses paid. Higher operating cash flows in 2005, compared to 2004, were primarily related to increased interest received on investments and lower expenses paid, partially offset by lower premiums. Cash flows used in investing activities decreased in both 2006 and 2005, compared to the respective prior years, due to decreased net cash provided by financing activities, partially offset by the investment of higher operating cash flows. Cash flows used in investing activities in 2006 also include the settlements related to the disposition through reinsurance of our variable annuity business. Cash provided by financing activities decreased in 2006, compared to 2005, as a result of lower contractholder fund deposits and higher surrenders and partial withdrawals. Lower cash flows provided by financing activities in 2005, compared to 2004, were primarily due to lower deposits on fixed annuities and higher fixed annuity withdrawals. For quantification of the changes in contractholder funds, see the Operations section of MD&A. 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, our 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 Allstate Corporation. The amount of inter-company loans available to us is at the discretion of The Allstate Corporation. The maximum amount of loans The Allstate Corporation will have outstanding to all its eligible subsidiaries at any given point in time is limited to $1.00 billion. We had no amounts outstanding under the inter-company loan agreement at December 31, 2006 or 2005. The Allstate Corporation uses commercial paper borrowings and bank lines of credit to fund inter-company borrowings. 30 Certain remote events and circumstances could constrain our or the Corporation's liquidity. Those events and circumstances include, for example, a catastrophe resulting in extraordinary losses, a downgrade in the Corporation's long-term debt rating of A1, A+ and a (from Moody's, Standard & Poor's and A.M. Best, respectively) to non-investment grade status of below Baa3/BBB-/bb, a downgrade in AIC's financial strength rating from Aa2, AA and A+ (from Moody's, Standard & Poor's and A.M. Best, respectively) to below Baa/BBB/A-, or a downgrade in our financial strength ratings from Aa2, AA and A+ (from Moody's, Standard & Poor's and A.M. Best, respectively) to below Aa3/AA-/A-. The rating agencies also consider the interdependence of the Corporation's individually rated entities; therefore, a rating change in one entity could potentially affect the ratings of other related entities. CONTRACTUAL OBLIGATIONS AND COMMITMENTS Our contractual obligations as of December 31, 2006 and the payments due by period are shown in the following table.
LESS THAN OVER 5 ($ IN THOUSANDS) TOTAL 1 YEAR 1-3 YEARS 4-5 YEARS YEARS ----------- --------- ---------- ---------- ---------- Securities lending (1) $ 199,486 $199,486 $ -- $ -- $ -- Contractholder funds(2) 6,504,588 405,481 1,454,319 1,074,783 3,570,005 Reserve for life-contingent contract benefits(3) 6,547,126 131,181 430,013 290,509 5,695,423 Payable to affiliates, net 30,031 30,031 -- -- -- Reinsurance payable to parent 979 979 -- -- -- Other liabilties and accrued expenses(4)(5) 37,289 35,150 981 317 841 ----------- -------- ---------- ---------- ---------- Total Contractual Cash Obligations $13,319,499 $802,308 $1,885,313 $1,365,609 $9,266,269 =========== ======== ========== ========== ==========
---------- (1) Securities lending transactions are typically fully secured with cash or 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 exceeds the corresponding liability amounts of $4.71 billion included in the Statements of Financial Position as of December 31, 2006 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 exceeds the corresponding liability amounts of $1.93 billion included in the Statements of Financial Position as of December 31, 2006 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 and accrued expenses primarily include accrued expenses and claim payments. 31 ---------- (5) Balance sheet liabilities not included in the table above include unearned and advance premiums of $489 thousand and deferred income taxes of $48 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 $6 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, 2006, we had $14.7 million in contractual conditional commitments to invest in private placements and mortgage loans. REGULATION AND LEGAL PROCEEDINGS 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, 2006, there are several pending accounting standards that we have not implemented either because the standard had 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. 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. 32 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) 2006 2005 2004 -------- -------- -------- REVENUES Premiums (net of reinsurance ceded of $20,837, $16,046 and $16,133) $ 84,313 $ 68,538 $ 76,550 Contract charges (net of reinsurance ceded of $12,295, $835 and $1) 63,426 66,280 59,834 Net investment income 373,064 356,162 302,055 Realized capital gains and losses (22,085) (5,192) (9,297) -------- -------- -------- 498,718 485,788 429,142 -------- -------- -------- COSTS AND EXPENSES Contract benefits (net of reinsurance recoveries of $16,085, $8,510 and $7,536) 190,506 183,227 182,150 Interest credited to contractholder funds 167,171 161,936 129,804 Amortization of deferred policy acquisition costs 31,672 41,663 25,971 Operating costs and expenses 46,578 43,497 42,115 -------- -------- -------- 435,927 430,323 380,040 (Loss) gain on disposition of operations (10,694) 1 1,326 -------- -------- -------- INCOME FROM OPERATIONS BEFORE INCOME TAX EXPENSE AND CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE, AFTER-TAX 52,097 55,466 50,428 Income tax expense 17,755 20,945 17,925 -------- -------- -------- INCOME BEFORE CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE, AFTER-TAX 34,342 34,521 32,503 Cumulative effect of change in accounting principle, after-tax -- -- (7,586) -------- -------- -------- NET INCOME 34,342 34,521 24,917 -------- -------- -------- OTHER COMPREHENSIVE (LOSS) INCOME, AFTER TAX Change in unrealized net capital gains and losses (50,930) (26,287) 16,531 -------- -------- -------- COMPREHENSIVE (LOSS) INCOME $(16,588) $ 8,234 $ 41,448 ======== ======== ========
See notes to financial statements. 33 ALLSTATE LIFE INSURANCE COMPANY OF NEW YORK STATEMENTS OF FINANCIAL POSITION
DECEMBER 31, ----------------------- (IN THOUSANDS, EXCEPT PAR VALUE DATA) 2006 2005 ---------- ---------- ASSETS Investments Fixed income securities, at fair value (amortized cost $5,542,227 and $5,535,396) $5,887,139 $5,989,263 Mortgage loans 708,449 633,789 Short-term 142,334 63,057 Policy loans 38,168 36,698 Other 3,784 3,740 ---------- ---------- Total investments 6,779,874 6,726,547 Cash 7,090 3,818 Deferred policy acquisition costs 278,625 318,551 Accrued investment income 63,843 62,452 Reinsurance recoverables 437,422 12,729 Current income taxes receivable 862 -- Other assets 42,488 35,760 Separate Accounts 1,009,784 928,824 ---------- ---------- TOTAL ASSETS $8,619,988 $8,088,681 ========== ========== LIABILITIES Reserve for life-contingent contract benefits $1,926,492 $1,869,875 Contractholder funds 4,708,428 4,349,395 Deferred income taxes 47,940 73,399 Other liabilities and accrued expenses 243,338 188,123 Payable to affiliates, net 30,031 5,249 Current income tax payable -- 5,412 Reinsurance payable to parent 979 971 Separate Accounts 1,009,784 928,824 ---------- ---------- TOTAL LIABILITIES 7,966,992 7,421,248 ---------- ---------- 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 140,000 140,000 Retained income 432,458 395,965 Accumulated other comprehensive income: Unrealized net capital gains and losses 78,038 128,968 ---------- ---------- Total accumulated other comprehensive income 78,038 128,968 ---------- ---------- TOTAL SHAREHOLDER'S EQUITY 652,996 667,433 ---------- ---------- TOTAL LIABILITIES AND SHAREHOLDER'S EQUITY $8,619,988 $8,088,681 ========== ==========
See notes to financial statements. 34 ALLSTATE LIFE INSURANCE COMPANY OF NEW YORK STATEMENTS OF SHAREHOLDER'S EQUITY
DECEMBER 31, ------------------------------- (IN THOUSANDS) 2006 2005 2004 -------- -------- -------- COMMON STOCK $ 2,500 $ 2,500 $ 2,500 -------- -------- -------- ADDITIONAL CAPITAL PAID IN Balance, beginning of year 140,000 120,000 55,787 Capital contribution -- 20,000 64,213 -------- -------- -------- Balance, end of year 140,000 140,000 120,000 -------- -------- -------- RETAINED INCOME Balance, beginning of year 395,965 361,480 336,563 Net income 34,342 34,521 24,917 Gain on recapture of reinsurance agreement with parent 2,151 -- -- Dividend-in-kind -- (36) -- -------- -------- -------- Balance, end of year 432,458 395,965 361,480 -------- -------- -------- ACCUMULATED OTHER COMPREHENSIVE INCOME Balance, beginning of year 128,968 155,255 138,724 Change in unrealized net capital gains and losses (50,930) (26,287) 16,531 -------- -------- -------- Balance, end of year 78,038 128,968 155,255 -------- -------- -------- TOTAL SHAREHOLDER'S EQUITY $652,996 $667,433 $639,235 ======== ======== ========
See notes to financial statements. 35 ALLSTATE LIFE INSURANCE COMPANY OF NEW YORK STATEMENTS OF CASH FLOWS
YEAR ENDED DECEMBER 31, ------------------------------------- (IN THOUSANDS) 2006 2005 2004 --------- ----------- ----------- CASH FLOWS FROM OPERATING ACTIVITIES Net income $ 34,342 $ 34,521 $ 24,917 Adjustments to reconcile net income to net cash provided by operating activities Amortization and other non-cash items (72,250) (58,887) (51,544) Realized capital gains and losses 22,085 5,192 9,297 Loss (gain) on disposition of operations 10,694 (1) (1,326) Cumulative effect of change in accounting principle -- -- 7,586 Interest credited to contractholder funds 167,171 161,936 129,804 Changes in: Reserve for life-contingent contract benefits and contractholder funds 26,648 36,533 32,492 Deferred policy acquisition costs (31,265) (26,542) (66,532) Income taxes (5,467) 2,591 12,091 Other operating assets and liabilities 23,605 (15,285) (7,442) --------- ----------- ----------- Net cash provided by operating activities 175,563 140,058 89,343 --------- ----------- ----------- CASH FLOWS FROM INVESTING ACTIVITIES Proceeds from sales of fixed income securities 877,430 481,745 485,522 Investment collections Fixed income securities 115,003 160,281 184,317 Mortgage loans 73,110 54,795 26,714 Investments purchases Fixed income securities (954,087) (1,086,370) (1,758,452) Mortgage loans (144,267) (205,389) (119,953) Change in short-term investments, net (28,239) 29,687 (29,248) Change in other investments, net 3,486 2,305 2,678 Disposition of operations (389,601) -- -- Change in policy loans (1,470) (1,750) (841) --------- ----------- ----------- Net cash used in investing activities (448,635) (564,696) (1,209,263) --------- ----------- ----------- CASH FLOWS FROM FINANCING ACTIVITIES Capital contribution -- 20,000 64,213 Contractholder fund deposits 793,233 878,614 1,385,364 Contractholder fund withdrawals (516,889) (478,782) (331,764) --------- ----------- ----------- Net cash provided by financing activities 276,344 419,832 1,117,813 --------- ----------- ----------- NET INCREASE (DECREASE) IN CASH 3,272 (4,806) (2,107) CASH AT BEGINNING OF YEAR 3,818 8,624 10,731 --------- ----------- ----------- CASH AT END OF YEAR $ 7,090 $ 3,818 $ 8,624 ========= =========== ===========
See notes to financial statements. 36 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 current year 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, investment and supplemental accident and health insurance products to individual customers. The principal products are traditional, interest-sensitive and variable life insurance, supplemental accident and health insurance, and deferred and immediate fixed annuities. The Company is authorized to sell life insurance and retirement products in the state of New York. The Company distributes its products to individuals through several distribution channels, including Allstate exclusive agencies, independent agents (including master brokerage agencies and workplace enrolling agents), financial services firms, such as broker/dealers and specialized structured settlement brokers. 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. 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, federal and state 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, changes in the federal estate tax laws could negatively affect the demand for the types of life insurance used in estate planning. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES INVESTMENTS Fixed income securities include bonds, commercial mortgage-backed, asset-backed and mortgage-backed securities, and redeemable preferred stocks. Fixed income securities may be sold prior to their contractual maturity ("available for sale") and are carried at fair value. 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 of interest rates and current publicly traded bond prices) as inputs or independent third party pricing sources. The valuation models use security specific information such as ratings, industry, coupon, and maturity along with 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. The difference between amortized cost and fair value, 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 accumulated other 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. 37 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 investment of collateral received in connection with securities lending business activities. For these transactions, the Company records an offsetting liability in other liabilities and accrued expenses for the Company's obligation to return the collateral or funds received. We also purchase securities under agreements to resell. Policy loans are carried at the unpaid principle balances. Other investments consist primarily of derivative financial instruments. 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, considering estimated principal repayments when applicable. 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. Dispositions include sales, losses recognized in anticipation of dispositions and other transactions such as calls and prepayments. Realized capital gains and losses on investment dispositions are determined on a specific identification basis. The Company recognizes other-than-temporary impairment losses on fixed income securities when the decline in fair value is deemed other-than-temporary (see Note 6). DERIVATIVE AND EMBEDDED DERIVATIVE FINANCIAL INSTRUMENTS Derivative financial instruments include foreign currency swaps, interest rate caps, interest rate futures, and re-investment related and equity market risk transfer reinsurance agreements with ALIC that meet the accounting definition of a derivative (see Note 5). 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 contracts. 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 the effectiveness of the hedging instrument 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 existing asset, liability, or a forecasted transaction. Anticipated transactions must be probable of occurrence and their significant terms and specific characteristics must be identified. 38 For hedging instruments used in cash flow hedges, the changes in fair value of the derivatives are reported in accumulated other comprehensive income. 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. TERMINATION OF HEDGE ACCOUNTING If, subsequent to entering into a hedge transaction, the derivative becomes ineffective (including if the hedged item is sold or otherwise extinguished, the occurrence of a hedged forecasted transaction is no longer probable, or the hedged asset becomes other-than-temporarily impaired), the Company may terminate the derivative position. The Company may also terminate derivative instruments or redesignate them as non-hedge as a result of other events or circumstances. If the derivative financial instrument is not terminated when a fair value hedge is no longer effective, the future gains and losses recognized on the derivative are reported in realized capital gains and losses. When a fair value hedge is no longer effective, is redesignated as a non-hedge, or when the derivative has been terminated, the fair value gain or loss on the hedged asset, liability or portion thereof used to adjust the book value of the asset, liability or portion thereof, which has already been recognized in income while the hedge was in place, is amortized over the remaining life of the hedged asset, liability or portion thereof to net investment income or interest credited to contractholder funds beginning in the period that hedge accounting is no longer applied. If the hedged item of a fair value hedge is an asset, which has become other-than-temporarily impaired, the adjustment made to the book value of the asset is subject to the accounting policies applied to other-than-temporarily impaired assets. When a derivative financial instrument used in a cash flow hedge of an existing asset or liability is no longer effective or is terminated, the gain or loss recognized on the derivative is reclassified from accumulated other comprehensive income to net income as the hedged risk impacts net income, beginning in the period hedge accounting is no longer applied or the derivative instrument is terminated. If the derivative financial instrument is not terminated when a cash flow hedge is no longer effective, the future gains and losses recognized on the derivative are reported in realized capital gains and losses. When a derivative financial instrument used in a cash flow hedge of a forecasted transaction is terminated because the forecasted transaction is no longer probable, the gain or loss recognized on the derivative is immediately reclassified from accumulated other comprehensive income to realized capital gains and losses in the period that hedge accounting is no longer applied. If the cash flow hedge is no longer effective, the gain or loss recognized on the derivative is reclassified from accumulated other comprehensive income to net income as the remaining hedged item affects net income. 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 re-investment 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. Cash flows from embedded derivatives requiring bifurcation and derivatives receiving hedge accounting are reported consistently with the host contracts and hedged risks respectively within the Statements of Cash Flows. Cash flows from other derivatives are reported in cash flows from investing activities within the Statements of Cash Flows. 39 SECURITIES LOANED The Company's business activities include securities lending transactions, which are used primarily to generate net investment income. These transactions are short-term in nature (usually 30 days or less). The Company receives collateral for securities loaned in an amount generally equal to 102% of the fair value of securities and records the related obligations to return the collateral in other liabilities and accrued expenses. The carrying value of these obligations approximates fair value because of their relatively short-term nature. The Company monitors the market value of securities loaned on a daily basis and obtains additional collateral as necessary under the terms of the agreements to mitigate counterparty credit risk. The Company maintains the right and ability to redeem the securities loaned on short notice. 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 from policyholders. 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 received 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. Consideration received for such contracts is reported as contractholder fund deposits. Contract charges for investment contracts consist of fees assessed against the 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 Statement of Position 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 to amortize deferred policy acquisition costs ("DAC"). Contract charges for variable life and variable annuity 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, withdrawal and accumulation benefits. Subsequent to our disposal of all of our variable annuity business through reinsurance agreements with Prudential in 2006 (see Note 3), the contract charges and contract benefits related thereto are reported net of reinsurance ceded. 40 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 DAC. These costs are principally agents' and brokers' remuneration and certain underwriting costs. DSI costs, which are deferred and recorded as other assets, relate to sales inducements offered on sales to new customers, principally on annuities 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. 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 reported in other assets and 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 if 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 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. 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, annuities and other investment contracts, DAC and DSI are amortized in proportion to the incidence of the total present value of gross profits, which includes both actual historical gross profits ("AGP") and estimated future gross profits ("EGP") earned over the estimated lives of the contracts. Actual amortization periods range from 15-30 years; however, incorporating estimates of customer surrender rates, partial withdrawals and deaths generally 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 total gross profits. AGP and EGP consist of the following components: benefit margins, primarily from mortality; investment margin including realized capital gains and losses; and contract administration, surrender and other contract charges, less maintenance expenses. 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, 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. Any amortization of DAC or DSI that would result from changes in unrealized gains or losses had those gains or losses actually been realized during the reporting period is recorded net of tax in other comprehensive income. REINSURANCE 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 Company has also used reinsurance to effect the disposition of its variable annuity business (see Note 3). The amounts reported in the Statements of Financial Position as reinsurance recoverables include amounts billed to reinsurers on losses paid as well as estimates of amounts expected to be recovered from reinsurers on insurance liabilities and contractholder funds 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. Reinsurance premiums are generally 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. 41 The Company has a reinsurance treaty with ALIC through which it cedes primarily re-investment related risk on its structured settlement annuities. The terms of the treaty meet the accounting definition of a derivative under Statement of Financial Accounting Standards ("SFAS") No. 133 "Accounting for Derivative Instruments and Hedging Activities". Accordingly, the treaty is recorded in the Statement of Financial Position at fair value. Changes in the fair value of the treaty and premiums paid to ALIC are recognized in realized capital gains and losses (see Note 5). Prior to the Company's disposition of the variable annuity business through reinsurance with Prudential effective June 1, 2006 (see Note 3), the Company had a reinsurance treaty through which it ceded contract benefits on its guaranteed minimum accumulation benefits ("GMABs"), guaranteed minimum withdrawal benefits ("GMWBs") and certain guaranteed minimum death benefits ("GMDBs") to ALIC. The terms of the treaty met the accounting definition of a derivative under Statement of Financial Accounting Standards ("SFAS") No. 133 "Accounting for Derivative Instruments and Hedging Activities". Accordingly, the treaty was recorded in the Statement of Financial Position at fair value. Changes in the fair value of the treaty were recognized in contract benefits. The reinsurance treaty was recaptured in 2006 (see Note 5). 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 DAC. 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 and supplemental accident and health insurance and immediate annuities with life contingencies, is computed on the basis of long-term actuarial assumptions as to future investment yields, mortality, morbidity, policy terminations and expenses (see Note 8). 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. 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 (see Note 8). Contractholder funds also include reserves for secondary guarantees on variable annuities, which were reinsured to Prudential in 2006. SEPARATE ACCOUNTS Separate accounts assets and liabilities are carried at fair value. The assets of the separate accounts are legally segregated and available only to settle separate account contract obligations. Separate accounts liabilities represent the contractholders' claims to the related 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. Deposits to, and surrenders and withdrawals from, the separate accounts are not included in cash flows. Absent any contract provision wherein the Company provides a guarantee, which for variable annuities was reinsured to Prudential in 2006, variable annuity and variable life insurance contractholders bear the investment risk that the separate accounts' funds may not meet their stated investment objectives. 42 OFF-BALANCE-SHEET FINANCIAL INSTRUMENTS Commitments to extend mortgage loans and purchase private placement securities have off-balance-sheet risk because their contractual amounts are not recorded in the Company's Statements of Financial Position (see Note 7). ADOPTED ACCOUNTING STANDARDS FINANCIAL ACCOUNTING STANDARDS BOARD STAFF POSITION NO. FAS 115-1, "THE MEANING OF OTHER-THAN-TEMPORARY IMPAIRMENT AND ITS APPLICATION TO CERTAIN INVESTMENTS" ("FSP FAS 115-1") The Company adopted Financial Accounting Standards Board ("FASB") FSP FAS 115-1 as of January 1, 2006. FSP FAS 115-1 nullifies the guidance in paragraphs 10-18 of Emerging Issues Task Force Issue No. 03-1 ("EITF Issue 03-1"), "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments" and references existing other-than-temporary impairment guidance. FSP FAS 115-1 clarifies that an investor should recognize an impairment loss no later than when the impairment is deemed other-than-temporary, even if a decision to sell the security has not been made, and also provides guidance on the subsequent accounting for income recognition on an impaired debt security. The adoption of FSP FAS 115-1 was required on a prospective basis and did not have a material effect on the results of operations or financial position of the Company. STATEMENT OF FINANCIAL ACCOUNTING STANDARDS NO. 154, "ACCOUNTING CHANGES AND ERROR CORRECTIONS" ("SFAS NO. 154") The Company adopted SFAS No. 154 on January 1, 2006. SFAS No. 154 replaces Accounting Principles Board ("APB") Opinion No. 20, "Accounting Changes", and SFAS No. 3, "Reporting Accounting Changes in Interim Financial Statements". SFAS No. 154 requires retrospective application to prior periods' financial statements for changes in accounting principle, unless determination of either the period specific effects or the cumulative effect of the change is impracticable or otherwise promulgated. The Company had no accounting changes or error corrections affected by the new standard. SECURITIES AND EXCHANGE COMMISSION ("SEC") STAFF ACCOUNTING BULLETIN NO. 108, "CONSIDERING THE EFFECTS OF PRIOR YEAR MISSTATEMENTS WHEN QUANTIFYING MISSTATEMENTS IN CURRENT YEAR FINANCIAL STATEMENTS" ("SAB 108") In September 2006, the SEC issued SAB 108 in order to eliminate the diversity of practice in the process by which misstatements are quantified for purposes of assessing materiality on the financial statements. SAB 108 is intended to eliminate the potential for the build up of improper amounts on the balance sheet due to the limitations of certain methods of materiality assessment utilized in current practice. SAB 108 establishes a single quantification framework wherein the significance measurement is based on the effects of the misstatements on each of the financial statements as well as the related financial statement disclosures. If a company's existing methods for assessing the materiality of misstatements are not in compliance with the provisions of SAB 108, the initial application of the provisions may be adopted by restating prior period financial statements under certain circumstances or otherwise by recording the cumulative effect of initially applying the provisions of SAB 108 as adjustments to the carrying values of assets and liabilities as of January 1, 2006 with an offsetting adjustment recorded to the opening balance of retained earnings. The provisions of SAB 108 must be applied no later than the annual financial statements issued for the first fiscal year ending after November 15, 2006. The Company's adoption of SAB 108 in the fourth quarter of 2006 for the fiscal year then ended did not have any effect on its results of operations or financial position. STATEMENT OF POSITION 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 that affected the Company at the time of adoption are listed below. The provisions were primarily applicable to the business that was subsequently reinsured on June 1, 2006 (see Note 3 for more information): - 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. 43 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 required consideration of a range of potential results to estimate the cost of variable annuity death benefits and income benefits, which generally necessitated 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. 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 (see 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. The TPA addresses a number of issues related to SOP 03-1 including when it was 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 TPAs did not have a material effect on the results of operations or financial position of the Company. PENDING ACCOUNTING STANDARDS STATEMENT OF POSITION 05-1, "ACCOUNTING BY INSURANCE ENTERPRISES FOR DEFERRED ACQUISITION COSTS IN CONNECTION WITH MODIFICATIONS OR EXCHANGES OF INSURANCE CONTRACTS" ("SOP 05-1") In October 2005, the American Institute of Certified Public Accountants ("AICPA") issued SOP 05-1. SOP 05-1 provides accounting guidance for deferred policy acquisition costs associated with internal replacements of insurance and investment contracts other than those already described in SFAS No. 97, "Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments". SOP 05-1 defines an internal replacement as a modification in product benefits, features, rights or coverages that occurs by the exchange of a contract for a new contract, or by amendment, endorsement or rider to a contract, or by the election of a feature or coverage within a contract. In February 2007, the AICPA issued a set of twelve TPAs that provide interpretive guidance to be utilized, if applicable, at the date of adoption. The provisions of SOP 05-1 are effective for internal replacements occurring in fiscal years beginning after December 15, 2006. Based on the issued standard and the TPAs released in February 2007, the Company's estimated impact of adoption will not have a material effect on its results of operations or financial position. SFAS NO. 155, "ACCOUNTING FOR CERTAIN HYBRID FINANCIAL INSTRUMENTS - AN AMENDMENT OF FASB STATEMENTS NO. 133 AND 140" ("SFAS NO. 155") In February 2006, the FASB issued SFAS No. 155, which permits the fair value remeasurement at the date of adoption of any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation under paragraph 12 or 13 of SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities"; clarifies which interest-only strips and principal-only strips are not subject to the requirements of SFAS No. 133; establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or hybrid financial instruments that contain embedded derivatives requiring bifurcation; and clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives. The provisions of SFAS No. 155 are effective for all financial instruments acquired, issued or subject to a remeasurement event occurring after the beginning of the first fiscal year that begins after September 15, 2006. The Company elected not to remeasure its existing hybrid financial instruments at the date of adoption that contained embedded derivatives requiring bifurcation pursuant to paragraph 12 or 13 of SFAS No. 133. The adoption of SFAS No. 155 is not expected to have a material effect on the results of operations or financial position of the Company. 44 FINANCIAL ACCOUNTING STANDARDS BOARD INTERPRETATION NO. 48, "ACCOUNTING FOR UNCERTAINTY IN INCOME TAXES", ("FIN 48") In July 2006, the FASB issued FIN 48, which clarifies the accounting for uncertainty in income taxes recognized in an entity's financial statements in accordance with FASB Statement No. 109, "Accounting for Income Taxes". FIN 48 requires an entity to recognize the benefit of tax positions only when it is more likely than not, based on the position's technical merits, that the position would be sustained upon examination by the respective taxing authorities. The tax benefit is measured as the largest benefit that is more than fifty-percent likely of being realized upon final settlement with the respective taxing authorities. FIN 48 is effective for fiscal years beginning after December 15, 2006. FIN 48 will not have a material effect on the results of operations or financial position of the Company. SFAS NO. 157, "FAIR VALUE MEASUREMENTS" ("SFAS NO. 157") In September 2006, the FASB issued SFAS No. 157 which redefines fair value, establishes a framework for measuring fair value in generally accepted accounting principles ("GAAP"), and expands disclosures about fair value measurements. SFAS No. 157 applies where other accounting pronouncements require or permit fair value measurements. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007. The effects of adoption will be determined by the types of instruments carried at fair value in the Company's financial statements at the time of adoption as well as the method utilized to determine their fair values prior to adoption. Based on the Company's current use of fair value measurements, SFAS No. 157 is not expected to have a material effect on the results of operations or financial position of the Company. SFAS NO. 159, "THE FAIR VALUE OPTION FOR FINANCIAL ASSETS AND FINANCIAL LIABILITIES" ("SFAS NO. 159") In February 2007, the FASB issued SFAS No. 159 which provides reporting entities an option to report selected financial assets, including investment securities designated as available for sale, and liabilities, including most insurance contracts, at fair value. SFAS No. 159 establishes presentation and disclosure requirements designed to facilitate comparisons between companies that choose different measurement attributes for similar types of assets and liabilities. The standard also requires additional information to aid financial statement users' understanding of a reporting entity's choice to use fair value on its earnings and also requires entities to display on the face of the balance sheet the fair value of those assets and liabilities for which the reporting entity has chosen to measure at fair value. SFAS No. 159 is effective as of the beginning of a reporting entity's first fiscal year beginning after November 15, 2007. Early adoption is permitted as of the beginning of the previous fiscal year provided the entity makes that choice in the first 120 days of that fiscal year and also elects to apply the provisions of SFAS No. 157. Because application of the standard is optional, any impacts are limited to those financial assets and liabilities to which SFAS No. 159 would be applied, which has yet to be determined, as is any decision concerning the early adoption of the standard. 3. DISPOSITION On June 1, 2006, the Company, its parent ALIC, and the Corporation, completed the disposal of its variable annuity business pursuant to a definitive agreement (the "Agreement") with Prudential Financial, Inc. and its subsidiary, The Prudential Insurance Company of America (collectively "Prudential"). The disposal was effected through a combination of coinsurance and modified coinsurance reinsurance agreements (the "Reinsurance Agreements"). As a result of the modified coinsurance reinsurance, the separate account assets remain on the Company's Statements of Financial Position, but the related results of operations are fully reinsured to Prudential beginning on June 1, 2006 and presented net of reinsurance on the Statements of Operations and Comprehensive Income. In contrast, $440.0 million of assets supporting general account liabilities have been transferred to Prudential, net of consideration, under the coinsurance reinsurance provisions. The general account liabilities, however, remain on the Statements of Financial Position with a corresponding reinsurance recoverable. For purposes of presentation in the Statements of Cash Flows, the Company treated the reinsurance of its variable annuity business as a disposition of operations, consistent with the substance of the transaction which was the disposition of a block of business accomplished through reinsurance. Accordingly, the net consideration transferred to Prudential of $388.4 million (computed as $440.0 million of general account insurance liabilities transferred to Prudential on the closing date less consideration of $51.6 million) and the costs of executing the transaction of $1.2 million, pretax, were classified as a disposition of operations in the cash flows from investing activities section of the Statements of Cash Flows. The Reinsurance Agreements do not extinguish the Company's primary liability under the variable annuity contracts. 45 Under the Agreement, the Company, ALIC and the Corporation have indemnified Prudential for certain pre-closing contingent liabilities (including extra-contractual liabilities of the Company and ALIC and liabilities specifically excluded from the transaction) that the Company and ALIC have agreed to retain. In addition, the Company, ALIC and the Corporation will each indemnify Prudential for certain post-closing liabilities that may arise from the acts of the Company and ALIC, and their agents, including in connection with the Company's and ALIC's provision of transition services. The terms of the Agreement give Prudential the right to be the exclusive provider of its variable annuity products through the Allstate proprietary agency force for three years and a non-exclusive preferred provider for the following two years. During a transition period, the Company and ALIC will continue to issue new variable annuity contracts, accept additional deposits on existing business from existing contractholders on behalf of Prudential and, for a period of twenty-four months or less, service the reinsured business while Prudential prepares for the migration of the business onto its servicing platform. Pursuant to the Agreement, the consideration was $51.6 million. The disposal resulted in a reinsurance loss of $9.3 million, pretax, which was included as a component of loss on disposition of operations on the Statements of Operations and Comprehensive Income along with other transactional expenses incurred. The total loss for this transaction totaled $10.7 million, pretax ($7.0 million, after-tax). DAC and DSI were reduced by $79.7 million and $6.2 million, respectively, as of the effective date of the transaction for balances related to the variable annuity business subject to the Reinsurance Agreements. The separate account balances related to the modified coinsurance reinsurance were $1.01 billion as of December 31, 2006. Separate account balances totaling approximately $2.7 million at December 31, 2006 related to the variable life business retained by the Company. In the five months of 2006 prior to its disposition, the Company's variable annuity business generated approximately $7.5 million in contract charges. In 2005 and 2004, the Company's variable annuity business generated approximately $16.7 million and $13.2 million in contract charges, respectively. The separate account balances were $927.4 million and general account balances were $501.2 million as of December 31, 2005. 4. SUPPLEMENTAL CASH FLOW INFORMATION Non-cash investment modifications, which reflect refinancings of fixed income securities, totaled $5.8 million, $4.5 million and $1.7 million for the years ended December 31, 2006, 2005 and 2004, respectively. Liabilities for collateral received in conjunction with the Company's securities lending business activities were $199.5 million, $149.5 million and $133.4 million at December 31, 2006, 2005 and 2004, respectively, and are reported as a component of other liabilities and accrued expenses in Statements of Financial Position. The accompanying cash flows are included in cash flows from operating activities in the Statements of Cash Flows along the activities resulting from management of the proceeds, which for the years ended December 31 are as follows:
(IN THOUSANDS) 2006 2005 2004 --------- --------- --------- NET CHANGE IN PROCEEDS MANAGED Net change in fixed income securities $ (10,816) $ (36,652) $ 59,856 Net change in short-term investments (39,205) 20,555 (58,735) --------- --------- --------- Operating cash flow (used) provided $ (50,021) $ (16,097) $ 1,121 ========= ========= ========= NET CHANGE IN LIABILITIES Liabilities for collateral and security repurchase, beginning of year $(149,465) $(133,368) $(134,489) Liabilities for collateral and security repurchase, end of year (199,486) (149,465) (133,368) --------- --------- --------- Operating cash flow provided (used) $ 50,021 $ 16,097 $ (1,121) ========= ========= =========
46 5. 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 its behalf. 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 $53.7 million, $53.8 million and $44.8 million in 2006, 2005 and 2004, respectively. A portion of these expenses relate to the acquisition of business and is deferred and amortized into income. STRUCTURED SETTLEMENT ANNUITIES The Company issued $15.0 million, $16.0 million and $19.4 million of structured settlement annuities, a type of immediate annuity, in 2006, 2005 and 2004, 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, $1.5 million, $2.0 million and $5.4 million relate to structured settlement annuities with life contingencies and are included in premium income in 2006, 2005 and 2004, respectively. In most cases, these annuities were issued under a "qualified assignment," whereby prior to July 1, 2001 Allstate Settlement Corporation ("ASC"), and on and subsequent to July 1, 2001 Allstate Assignment Corporation ("AAC"), both wholly owned subsidiaries of ALIC, purchased annuities from the Company and assumed AIC's obligation to make future payments. Reserves recorded by the Company for annuities issued to ASC and AAC, including annuities to fund structured settlement annuities in matters involving AIC, were $1.86 billion and $1.78 billion at December 31, 2006 and 2005, respectively. BROKER/DEALER AGREEMENTS The Company has a service agreement with Allstate Distributors, L.L.C. ('ADLLC"), a broker-dealer company owned by ALIC, 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 $6.0 million, $7.1 million and $5.6 million for the years ended December 31, 2006, 2005 and 2004, 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 incurred $1.4 million, $1.3 million and $1.4 million of commission and other distribution expenses for the years ended December 31, 2006, 2005 and 2004, 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 9). 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 $3.0 million, $2.9 million and $2.7 million for the years ended December 31, 2006, 2005 and 2004, respectively. At December 31, 2006 and 2005, the carrying value of the structured settlement reinsurance treaty was $(1.9) million and $(1.5) million, 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. 47 Prior to the Company's disposition of the variable annuity business through reinsurance with Prudential effective June 1, 2006 (see Note 3), the Company had a reinsurance treaty through which it ceded contract benefits on its GMABs, GMWBs and certain GMDBs to ALIC. The reinsurance treaty was recaptured in 2006 and, in accordance therewith, the Company received cash in excess of the liabilities subject to the treaty resulting in a pre-tax gain of $3.3 million. The after-tax gain of $2.2 million was recorded as an adjustment to retained income since the transaction was between affiliates under common control. As of December 31, 2005, the carrying value of the treaty, which was recorded as a component of reinsurance recoverables was $(447) thousand. CAPITAL CONTRIBUTION The Company received cash capital contributions from ALIC of $20.0 million and $64.2 million in 2005 and 2004, respectively, which were recorded as additional capital paid-in on the Statements of Financial Position. DEBT The Company has an intercompany loan agreement with The Allstate Corporation. The amount of intercompany loans available to the Company is at the discretion of The Allstate Corporation. The maximum amount of loans The Allstate Corporation will have outstanding to all its eligible subsidiaries at any given point in time is limited to $1.00 billion. The Company had no amounts outstanding under the inter-company loan agreement at December 31, 2006 and 2005. The Allstate Corporation uses commercial paper borrowings, bank lines of credit and repurchase agreements to fund inter-company borrowings. INCOME TAXES The Company is a party to a federal income tax allocation agreement with the Corporation (see Note 12). 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, 2006 U.S. government and agencies $ 541,877 $187,234 $ -- $ 729,111 Municipal 314,768 12,979 (4,744) 323,003 Corporate 3,214,504 125,379 (35,121) 3,304,762 Foreign government 244,544 60,614 (211) 304,947 Mortgage-backed securities 439,938 2,514 (9,256) 433,196 Commercial mortgage-backed securities 669,303 8,192 (4,316) 673,179 Asset-backed securities 107,922 1,728 (628) 109,022 Redeemable preferred stock 9,371 548 -- 9,919 ---------- -------- -------- ---------- Total fixed income securities $5,542,227 $399,188 $(54,276) $5,887,139 ========== ======== ======== ========== AT DECEMBER 31, 2005 U.S. government and agencies $ 510,362 $213,421 $ -- $ 723,783 Municipal 308,219 20,193 (776) 327,636 Corporate 3,286,652 182,630 (28,020) 3,441,262 Foreign government 236,078 70,433 (176) 306,335 Mortgage-backed securities 569,712 4,050 (10,712) 563,050 Commercial mortgage-backed securities 490,985 3,999 (3,149) 491,835 Asset-backed securities 123,981 1,068 (679) 124,370 Redeemable preferred stock 9,407 1,585 -- 10,992 ---------- -------- -------- ---------- Total fixed income securities $5,535,396 $497,379 $(43,512) $5,989,263 ========== ======== ======== ==========
48 SCHEDULED MATURITIES The scheduled maturities for fixed income securities are as follows at December 31, 2006: AMORTIZED FAIR (IN THOUSANDS) COST VALUE ---------- ---------- Due in one year or less $ 48,495 $ 48,844 Due after one year through five years 799,478 807,453 Due after five years through ten years 1,494,665 1,564,283 Due after ten years 2,651,729 2,924,341 ---------- ---------- 4,994,367 5,344,921 Mortgage- and asset-backed securities 547,860 542,218 ---------- ---------- Total $5,542,227 $5,887,139 ========== ========= 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. NET INVESTMENT INCOME Net investment income for the years ended December 31 is as follows: (IN THOUSANDS) 2006 2005 2004 -------- -------- -------- Fixed income securities $343,115 $330,567 $278,522 Mortgage loans 38,576 33,373 27,198 Other 14,763 6,723 4,039 -------- -------- -------- Investment income, before expense 396,454 370,663 309,759 Investment expense 23,390 14,501 7,704 -------- -------- -------- Net investment income $373,064 $356,162 $302,055 ======== ======== ======== 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) 2006 2005 2004 -------- ------- ------- Fixed income securities $(25,398) $(6,596) $(7,666) Mortgage loans 3,572 3,000 1,480 Other (259) (1,596) (3,111) -------- ------- ------- Realized capital gains and losses, pre-tax (22,085) (5,192) (9,297) Income tax benefit 8,216 1,972 3,453 -------- ------- ------- Realized capital gains and losses, after-tax $(13,869) $(3,220) $(5,844) ======== ======= ======= Realized capital gains and losses by transaction type for the years ended December 31 are as follows: (IN THOUSANDS) 2006 2005 2004 -------- ------- ------- Write-downs $ (258) $(1,543) $(3,402) Dispositions (1) (21,568) (2,053) (2,784) Valuation of derivative instruments (5,429) (4,469) (5,777) Settlement of derivative instruments 5,170 2,873 2,666 -------- ------- ------- Realized capital gains and losses, pre-tax (22,085) (5,192) (9,297) Income tax benefit 8,216 1,972 3,453 -------- ------- ------- Realized capital gains and losses, after-tax $(13,869) $(3,220) $(5,844) ======== ======= ======= ---------- (1) Dispositions include sales, losses recognized in anticipation of dispositions and other transactions such as calls and prepayments. The Company recognized losses of $16.5 million and $6.8 million in 2006 and 2005, respectively, due to a change in intent to hold impaired securities. There were no losses recognized due to a change in intent during 2004. Gross gains of $5.9 million, $5.8 million and $5.2 million and gross losses of $18.8 million, $7.4 million and $13.3 million were realized on sales of fixed income securities during 2006, 2005 and 2004, respectively. 49 UNREALIZED NET CAPITAL GAINS AND LOSSES Unrealized net capital gains and losses included in accumulated other comprehensive income are as follows:
GROSS UNREALIZED FAIR ------------------- UNREALIZED (IN THOUSANDS) VALUE GAINS LOSSES NET GAINS ---------- -------- -------- ---------- AT DECEMBER 31, 2006 Fixed income securities $5,887,139 $399,188 $(54,276) $ 344,912 Derivative instruments and other investments (892) -- (892) (892) --------- Total 344,020 Amounts recognized for: (1) Premium deficiency reserve (235,656) Deferred policy acquisition and sales inducements costs 11,694 --------- Total (223,962) Deferred income taxes (42,020) --------- Unrealized net capital gains and losses $ 78,038 =========
GROSS UNREALIZED FAIR ------------------- UNREALIZED (IN THOUSANDS) VALUE GAINS LOSSES NET GAINS ---------- -------- -------- ---------- AT DECEMBER 31, 2005 Fixed income securities $5,989,263 $497,379 $(43,512) $ 453,867 Derivative instruments and other investments (154) -- (154) (154) --------- Total 453,713 Amounts recognized for: (1) Premium deficiency reserve (257,473) Deferred policy acquisition and sales inducement costs 2,172 --------- Total (255,301) Deferred income taxes (69,444) --------- Unrealized net capital gains and losses $ 128,968 =========
---------- (1) See Note 2, Summary of Significant Accounting Policies for deferred policy acquisition and sales inducement costs and reserve for life contingent contract benefits. 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) 2006 2005 2004 --------- -------- -------- Fixed income securities $(108,955) $(78,803) $ 52,790 Derivative instruments and other investments (738) 566 (720) --------- -------- -------- Total (109,693) (78,237) 52,070 Amounts recognized for: Premium deficiency reserve 21,817 (17,063) (25,011) Deferred policy acquisition and sales inducement costs 9,522 54,858 (1,627) --------- -------- -------- Total 31,339 37,795 (26,638) Deferred income taxes 27,424 14,155 (8,901) --------- -------- -------- (Decrease) increase in unrealized net capital gains and losses $ (50,930) $(26,287) $ 16,531 ========= ======== ========
50 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.
LESS THAN 12 MONTHS 12 MONTHS OR MORE -------------------------------- -------------------------------- TOTAL ($ IN THOUSANDS) NUMBER OF FAIR UNREALIZED NUMBER OF FAIR UNREALIZED UNREALIZED AT DECEMBER 31, 2006 ISSUES VALUE LOSSES ISSUES VALUE LOSSES LOSSES ------ ---------- ---------- ------ ---------- ---------- ---------- Fixed income securities Municipal 19 $ 85,322 $ (2,417) 10 $ 52,910 $ (2,327) $ (4,744) Corporate 118 619,716 (8,721) 164 775,483 (26,400) (35,121) Foreign government 1 4,934 (41) 2 10,067 (170) (211) Mortgage-backed securities 7 57,005 (701) 28 267,323 (8,555) (9,256) Commercial mortgage-backed securities 18 166,545 (831) 33 192,775 (3,485) (4,316) Asset-backed securities 6 16,010 (283) 3 12,635 (345) (628) --- ---------- -------- --- ---------- -------- -------- Total 169 $ 949,532 $(12,994) 240 $1,311,193 $(41,282) $(54,276) === ========== ======== === ========== ======== ======== Investment grade fixed income securities 153 $ 919,918 $(12,448) 220 $1,274,151 $(38,837) $(51,285) Below investment grade fixed income securities 16 29,614 (546) 20 37,042 (2,445) (2,991) --- ---------- -------- --- ---------- -------- -------- Total fixed income securities 169 $ 949,532 $(12,994) 240 $1,311,193 $(41,282) $(54,276) === ========== ======== === ========== ======== ======== AT DECEMBER 31, 2005 Fixed income securities Municipal 12 $ 80,350 $ (776) -- $ -- $ -- $ (776) Corporate 227 1,078,813 (20,810) 27 159,782 (7,210) (28,020) Foreign government 2 10,186 (176) -- -- -- (176) Mortgage-backed securities 32 313,090 (7,089) 11 101,796 (3,623) (10,712) Commercial mortgage-backed securities 46 282,391 (3,149) -- -- -- (3,149) Asset-backed securities 13 33,085 (427) 1 5,747 (252) (679) --- ---------- -------- --- ---------- -------- -------- Total 332 $1,797,915 $(32,427) 39 $ 267,325 $(11,085) $(43,512) === ========== ======== === ========== ======== ======== Investment grade fixed income securities 300 $1,746,340 $(30,717) 37 $ 257,086 $(10,324) $(41,041) Below investment grade fixed income securities 32 51,575 (1,710) 2 10,239 (761) (2,471) --- ---------- -------- --- ---------- -------- -------- Total fixed income securities 332 $1,797,915 $(32,427) 39 $ 267,325 $(11,085) $(43,512) === ========== ======== === ========== ======== ========
As of December 31, 2006, 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. Of the $54.3 million in unrealized losses, $51.3 million related to unrealized losses on 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 rating of aaa, aa, a or bbb from A.M. Best; or a comparable internal rating if an externally provided rating is not available. Unrealized losses on investment grade securities are principally related to rising interest rates or changes in credit spreads since the securities were acquired. As of December 31, 2006, the Company had the intent and ability to hold the fixed income securities with unrealized losses for a period of time sufficient for them to recover. 51 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. Interest income for impaired loans is recognized on an accrual basis if payments are expected to continue to be received; otherwise a cash basis is used. The Company had no impaired loans in 2006 or 2005. INVESTMENT CONCENTRATION FOR MUNICIPAL BOND AND COMMERCIAL MORTGAGE PORTFOLIOS 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 represented more than 5% of the portfolio at December 31, 2006 and 2005. (% OF MUNICIPAL BOND PORTFOLIO CARRYING VALUE) 2006 2005 ---- ---- California 30.2% 35.4% Texas 10.9 9.0 Oregon 7.2 7.3 Virginia 6.3 5.1 New York 5.8 -- Missouri 5.4 8.8 Connecticut 5.0 -- Illinois 4.7 6.1 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, 2006 and 2005. (% OF COMMERCIAL MORTGAGE PORTFOLIO CARRYING VALUE) 2006 2005 ---- ---- California 18.9% 23.4% Illinois 14.0 11.5 Pennsylvania 8.6 8.2 Texas 7.2 5.9 Arizona 5.6 3.4 New York 5.6 6.5 Ohio 5.2 6.0 New Jersey 4.6 7.1 The types of properties collateralizing the commercial mortgage loans at December 31 are as follows: (% OF COMMERCIAL MORTGAGE PORTFOLIO CARRYING VALUE) 2006 2005 ----- ----- Office buildings 31.4% 29.0% Warehouse 30.6 31.3 Retail 17.1 17.4 Apartment complex 17.0 17.2 Industrial 1.0 2.2 Other 2.9 2.9 ----- ----- Total 100.0% 100.0% ===== ===== 52 The contractual maturities of the commercial mortgage loan portfolio as of December 31, 2006 for loans that were not in foreclosure are as follows: NUMBER OF CARRYING ($ IN THOUSANDS) LOANS VALUE PERCENT --------- -------- ------- 2007 4 $ 9,792 1.4% 2008 2 14,236 2.0 2009 17 69,516 9.8 2010 22 103,161 14.6 2011 17 83,873 11.8 Thereafter 88 427,871 60.4 --- -------- ----- Total 150 $708,449 100.0% === ======== ===== In 2006, $13.4 million of commercial mortgage loans became contractually due. Of these, 11.7% were paid as due and 88.3% were refinanced at prevailing market terms. None were foreclosed or in the process of foreclosure, and none were in the process of refinancing or restructuring discussions. CONCENTRATION OF CREDIT RISK At December 31, 2006, the Company is not exposed to any credit concentration of risk of a single issuer and its affiliates greater than 10% of the Company's shareholder's equity. SECURITIES LOANED The Company's business activities include securities lending programs with third parties, mostly large brokerage firms. At December 31, 2006 and 2005, fixed income securities with a carrying value of $191.9 million and $143.2 million, respectively, were on loan under these agreements. In return, the Company receives cash that it invests and 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 $455 thousand, $430 thousand and $300 thousand, for the years ending December 31, 2006, 2005 and 2004, respectively. OTHER INVESTMENT INFORMATION Included in fixed income securities are below investment grade assets totaling $186.9 million and $201.7 million at December 31, 2006 and 2005, respectively. At December 31, 2006, fixed income securities with a carrying value of $2.6 million were on deposit with regulatory authorities as required by law. At December 31, 2006, the carrying value of fixed income securities that were non-income producing was $6.8 million. No other investments were non-income producing at December 31, 2006. 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 DSI and reinsurance recoverables) and liabilities (including reserve for life-contingent contract benefits, contractholoder funds pertaining to interest-sensitive life contracts and deferred income taxes) are not included in accordance with SFAS No. 107. 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. 53 FINANCIAL ASSETS (IN THOUSANDS) DECEMBER 31, 2006 DECEMBER 31, 2005 ---------------------- ----------------------- CARRYING FAIR CARRYING FAIR VALUE VALUE VALUE VALUE ---------- ---------- ---------- ---------- Fixed income securities $5,887,139 $5,887,139 $5,989,263 $5,989,263 Mortgage loans 708,449 711,866 633,789 647,068 Short-term investments 142,334 142,334 63,057 63,057 Policy loans 38,168 38,168 36,698 36,698 Separate accounts 1,009,784 1,009,784 928,824 928,824 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 one year or less 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
(IN THOUSANDS) DECEMBER 31, 2006 DECEMBER 31, 2005 ---------------------- ----------------------- CARRYING FAIR CARRYING FAIR VALUE VALUE VALUE VALUE ---------- ---------- ---------- ---------- Contractholder funds on investment contracts $4,231,688 $4,099,923 $3,921,872 $3,815,608 Liability for collateral 199,486 199,486 149,465 149,465 Separate accounts 1,009,784 1,009,784 928,824 928,824
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 under the provisions of SFAS No.107. 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. The liability for collateral is valued at carrying value due to its short-term nature. Separate accounts liabilities are carried at the fair value of the underlying assets. DERIVATIVE FINANCIAL INSTRUMENTS The Company primarily uses derivatives for risk reduction. With the exception of embedded derivatives which are required to be separated, all of the Company's derivatives are evaluated for their on-going effectiveness as either accounting or non-hedge derivative financial instruments on at least a quarterly basis (see Note 2). The Company does not use derivatives for trading purposes. Non-hedge accounting is used for "portfolio" level hedging strategies where the terms of the individual hedged items do not meet the strict homogeneity requirements prescribed in SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS 133") to permit the application of SFAS 133's hedge accounting model. The principal benefit of a "portfolio" level strategy is in its cost savings through its ability to use fewer derivatives with larger notional amounts. Asset-liability management is a risk management strategy that is principally employed to align the respective interest-rate sensitivities of assets and liabilities. Depending upon the attributes of the assets acquired and liabilities issued, derivative instruments such as interest rate caps are acquired to change the interest rate characteristics of existing assets and liabilities to ensure a proper matched relationship is maintained and to reduce 54 exposure to rising or falling interest rates. The Company uses financial futures to hedge anticipated asset and liability purchases. 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 following table summarizes the notional amount, fair value and carrying value of the Company's derivative financial instruments at December 31, 2006.
CARRYING NOTIONAL FAIR VALUE CARRYING VALUE (IN THOUSANDS) AMOUNT VALUE ASSETS (1) (LIABILITIES) (1) -------- ------- ---------- ----------------- AT DECEMBER 31, 2006 Financial futures contracts $194,100 $ 50 $ 93 $ (43) Interest rate cap agreements 264,300 1,410 1,920 (510) -------- ------- ------- ------ Total interest rate contracts $458,400 $ 1,460 $ 2,013 $ (553) ======== ======= ======= ====== Foreign currency swap agreements $ 7,500 $ (892) $ -- $ (892) ======== ======= ======= ====== Structured settlement annuity reinsurance agreement $ -- $(1,927) $(1,927) $ -- ======== ======= ======= ====== Guaranteed accumulation benefits (2) $251,825 $ 1,304 $ -- $1,304 ======== ======= ======= ====== Guaranteed withdrawal benefits (2) $ 52,757 $ (50) $ -- $ (50) ======== ======= ======= ====== Other embedded derivative financial instruments (2) $ 1,501 $ (3) $ -- $ (3) ======== ======= ======= ======
---------- (1) Carrying value includes the effects of legally enforceable master netting agreements. 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. (2) These embedded derivative financial instruments relate to the company's variable annuity business, which was fully reinsured by Prudential effective June 1, 2006 (see Note 3). 55 The following table summarizes the notional amount, fair value and carrying value of the Company's derivative financial instruments at December 31, 2005.
CARRYING NOTIONAL FAIR VALUE CARRYING VALUE (IN THOUSANDS) AMOUNT VALUE ASSETS (1) (LIABILITIES) (1) -------- ------- ---------- ----------------- AT DECEMBER 31, 2005 Financial futures contracts $169,100 $ 25 $ 71 $ (46) Interest rate cap agreements 186,300 2,721 2,912 (191) -------- ------- ------- ----- Total interest rate contracts $355,400 $ 2,746 $ 2,983 $(237) ======== ======= ======= ===== Foreign currency swap agreements $ 7,500 $ (154) $ -- $(154) ======== ======= ======= ===== Structured settlement annuity reinsurance agreement $ -- $(1,473) $(1,473) $ -- ======== ======= ======= ===== Guaranteed accumulation benefits $194,098 $ 553 $ -- $ 553 ======== ======= ======= ===== Guaranteed accumulation benefits reinsurance agreement $194,098 $ (553) $ (553) $ -- ======== ======= ======= ===== Guaranteed withdrawal benefits $ 21,746 $ (2) $ -- $ (2) ======== ======= ======= ===== Guaranteed withdrawal benefits reinsurance agreement $ 21,746 $ 2 $ 2 $ -- ======== ======= ======= ===== Other embedded derivative financial instruments $ 1,762 $ (3) $ -- $ (3) ======== ======= ======= =====
---------- (1) Carrying value includes the effects of legally enforceable master netting agreements. 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 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. The Company has not incurred any losses on derivative financial instruments due to counterparty nonperformance. Futures contracts are traded on organized exchanges, which require margin deposits and guarantee the execution of trades, thereby mitigating any associated potential credit risk. 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 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. OFF-BALANCE-SHEET FINANCIAL INSTRUMENTS The contractual amounts and fair values of off-balance-sheet financial instruments at December 31 are as follows:
2006 2005 ------------------------ ------------------------ CONTRACTUAL CONTRACTUAL (IN THOUSANDS) AMOUNT FAIR VALUE AMOUNT FAIR VALUE ----------- ---------- ----------- ---------- Commitments to extend mortgage loans $14,723 $147 $12,516 $125 Private placement commitments -- -- 15,000 --
56 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 into these agreements to commit to future loan fundings at a predetermined interest rate. 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. Private placement commitments represent conditional commitments to purchase private placement debt and equity securities at a specified future date. The Company regularly enters into these agreements in the normal course of business. The fair value of these commitments generally cannot be estimated on the date the commitment is made as the terms and conditions of the underlying private placement securities are not yet final. 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) 2006 2005 ---------- ---------- Immediate annuities: Structured settlement annuities $1,793,706 $1,752,386 Other immediate annuities 9,815 7,998 Traditional life 117,419 105,393 Other 5,552 4,098 ---------- ---------- Total reserve for life-contingent contract benefits $1,926,492 $1,869,875 ========== ========== 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 mortality rates adjusted for from 4.5% to 9.5% future benefits each impaired live based on reduction in life expectancy and nature of impairment Other immediate annuities 1983 group annuity mortality Interest rate Present value of expected table assumptions range future benefits based on 1983 individual annuity from 2.4% to 11.5% historical experience mortality table Annuity 2000 mortality table 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 Interest rate Projected benefit ratio guaranteed minimum mortality table with internal assumptions range applied to cumulative death benefits modifications from 6.5% to 7.0% assessments Supplemental Actual company experience plus Unearned premium; accident and health loading additional contract reserves for traditional life
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 $235.7 million and $257.5 million is included in the reserve for life-contingent 57 contract benefits with respect to this deficiency as of December 31, 2006 and 2005, 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) 2006 2005 ---------- ---------- Interest-sensitive life $ 476,729 $ 427,523 Investment contracts: Fixed annuities 3,667,459 3,381,034 Immediate annuities and other 564,240 540,838 ---------- ---------- Total contractholder funds $4,708,428 $4,349,395 ========== ========== 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 2.7% to 5.5% dollar amount grading off generally over 20 years Fixed and immediate Interest rates credited range Either a declining or a level percentage annuities from 1.8% to 11.5% for charge generally over nine years or less. immediate annuities and 1.9% Additionally, approximately 5.4% of fixed to 6.7% 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 or benefit and secondary from 1.8% to 10.3% interest-sensitive life contract guarantees on variable annuities (1)
---------- (1) In 2006, the Company disposed its variable annuity business through reinsurance agreements with Prudential (see Note 3). Contractholder funds activity for the years ended December 31 is as follows: (IN THOUSANDS) 2006 2005 ---------- ---------- BALANCE, BEGINNING OF YEAR $4,349,395 $3,802,846 Deposits 804,825 883,814 Interest credited 178,493 173,984 Benefits (137,090) (168,813) Surrenders and partial withdrawals (361,670) (270,161) Contract charges (44,954) (41,856) Net transfers to separate accounts (18,127) (39,765) Other adjustments (62,444) 9,346 ---------- ---------- BALANCE, END OF YEAR $4,708,428 $4,349,395 ========== ========== 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), upon periodic withdrawal (withdrawal 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, withdrawal and accumulation benefits are included in contractholder funds in the Statements of Financial Position. All liabilities for variable contracts guarantees are reported on a 58 gross basis on the balance sheet with a corresponding reinsurance recoverable asset for those contracts subject to the Prudential Reinsurance Agreements as disclosed in Note 3. Absent any contract provision wherein the Company guarantees either a minimum return or account value upon death, a specified contract anniversary date, partial withdrawal 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 annuities contracts' separate accounts with guarantees included $954.2 million and $882.2 million of equity, fixed income and balanced mutual funds and $51.0 million and $44.0 million of money market mutual funds at December 31, 2006 and 2005, respectively. The table below presents information regarding the Company's variable annuity contracts with guarantees. The Company's variable annuity contracts may offer more than one type of guarantee in each contract; therefore, the sum of amounts listed exceeds the total account balances of variable annuity contracts' separate accounts with guarantees.
DECEMBER 31, --------------------- ($ IN MILLIONS) 2006 2005 --------- --------- IN THE EVENT OF DEATH Separate account value $ 1,005.2 $ 926.3 Net amount at risk (1) $ 24.4 $ 38.2 Average attained age of contractholders 67 years 66 years AT ANNUITIZATION Separate account value $ 39.4 $ 41.8 Net amount at risk (2) $ -- $ -- Weighted average waiting period until annuitization options available 7 years 8 years FOR CUMULATIVE PERIODIC WITHDRAWALS Separate account value $ 50.3 $ 19.8 Net amount at risk (3) $ -- $ -- ACCUMULATION AT SPECIFIED DATES Separate account value $ 249.2 $ 188.9 Net amount at risk (4) $ -- $ -- Weighted average waiting period until guarantee date 10 years 11 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 current guaranteed minimum withdrawal balance (initial deposit) in excess of the current account balance at the balance sheet date. (4) Defined as the estimated present value of the guaranteed minimum accumulation balance in excess of the current account balance. 59 The following summarizes the liabilities for guarantees:
LIABILITY FOR LIABILITY GUARANTEES FOR LIABILITY FOR RELATED TO GUARANTEES GUARANTEES ACCUMULATION RELATED TO RELATED TO AND DEATH INCOME WITHDRAWAL (IN THOUSANDS) BENEFITS BENEFITS BENEFITS TOTAL ---------- ------------- ------------- ------- Balance at December 31, 2004 $ 662 $ 81 $ (141) $ 602 Less reinsurance recoverables -- -- 141 141 ------- ----- ------- ------- Net balance at December 31, 2004 662 81 -- 743 Incurred guaranteed benefits 1,582 28 -- 1,610 Paid guarantee benefits (2,084) (4) -- (2,088) ------- ----- ------- ------- Net change (502) 24 -- (478) Net balance at December 31, 2005 160 105 -- 265 Plus reinsurance recoverables 104 -- (551) (447) ------- ----- ------- ------- Balance, December 31, 2005 (1) $ 264 $ 105 $ (551) $ (182) Less reinsurance recoverables (104) -- 551 447 Net balance at December 31, 2005 160 105 -- 265 Variable annuity business disposition related reinsurance recoverables (304) (97) -- (401) Incurred guaranteed benefits 648 (7) -- 641 Paid guarantee benefits (504) (1) -- (505) ------- ----- ------- ------- Net change (160) (105) -- (265) Net balance at December 31, 2006 -- -- -- -- Plus reinsurance recoverables 1,026 99 (1,353) (228) ------- ----- ------- ------- Balance, December 31, 2006 (2) $ 1,026 $ 99 $(1,353) $ (228) ======= ===== ======= =======
---------- (1) Included in the total liability balance are reserves for variable annuity death benefits of $264 thousand, variable annuity income benefits of $46 thousand, variable annuity accumulation benefits of $(553) thousand, variable annuity withdrawal benefits of $2 thousand and other guarantees of $59 thousand. (2) Included in the total liability balance at December 31, 2006 are reserves for variable annuity death benefits of $1.03 million, variable annuity income benefits of $58 thousand, variable annuity accumulation benefits of $(1.3) million and other guarantees of $41 thousand. 9. REINSURANCE The Company reinsures certain of its risks to unaffiliated reinsurers and ALIC under yearly renewable term, coinsurance and modified coinsurance. These agreements result in a passing of the agreed-upon percentage of risk 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. As of December 31, 2006 and 2005, 39.4% and 37.6%, respectively, of our face amount of life insurance in force was reinsured to non-affiliates and ALIC. In addition, the Company has used reinsurance to effect the disposition of certain blocks of business. As of December 31, 2006, the Company had reinsurance recoverables of $415.7 million due from Prudential related to the disposal of our variable annuity business that was effected through Reinsurance Agreements (see Note 3). In 2006, premiums and contract charges of $11.6 million, contract benefits of $1.6 million, interest credited to contractholder funds of $9.7 million, and operating costs and expenses of $4.8 million were ceded to Prudential pursuant to the Reinsurance Agreements. Prior to this disposal, the Company ceded 100% of the mortality and certain other risks related to product features on certain in-force variable annuity contracts. In addition, as of December 31, 2006 and 2005, the Company had reinsurance recoverables of $1.6 million and $1.4 million, respectively, due from subsidiaries of Citigroup and Scottish Re (U.S.) Inc. in connection with the disposition of the direct response distribution business in 2003. 60 The effects of reinsurance on premiums and contract charges for the years ended December 31 are as follows:
(IN THOUSANDS) 2006 2005 2004 -------- -------- -------- PREMIUMS AND CONTRACT CHARGES Direct $179,504 $150,749 $151,799 Assumed - non-affiliate 1,367 950 719 Ceded Affiliate (4,614) (4,795) (4,329) Non-affiliate (28,518) (12,086) (11,805) -------- -------- -------- Premiums and contract charges, net of reinsurance $147,739 $134,818 $136,384 ======== ======== ========
The effects of reinsurance on contract benefits and interest credited to contractholder funds for the years ended December 31 are as follows:
(IN THOUSANDS) 2006 2005 2004 -------- -------- -------- CONTRACT BENEFITS AND INTEREST CREDITED TO CONTRACTHOLDER FUNDS Direct $382,633 $353,277 $319,217 Assumed - non-affiliate 827 396 273 Ceded Affiliate (1,427) (1,154) (985) Non-affiliate (24,356) (7,356) (6,551) -------- -------- -------- Contract benefits and interest credited to contractholder funds, net of reinsurance $357,677 $345,163 $311,954 ======== ======== ========
In addition to amounts included in the table above are reinsurance premium ceded to ALIC of $3.0 million, $2.9 million and $2.7 million of premiums and contract charges ceded to ALIC during 2006, 2005 and 2004, respectively, under the terms of the structured settlement annuity reinsurance agreement (See Note 5). 10. DEFERRED POLICY ACQUISITION AND SALES INDUCEMENT COSTS Deferred policy acquisitions costs for the years ended December 31 are as follows: (IN THOUSANDS) 2006 2005 2004 -------- -------- -------- BALANCE, BEGINNING OF YEAR $318,551 $238,173 $187,437 Disposition of operations (1) (2) (79,670) -- (3,213) Impact of adoption of SOP 03-1 (3) -- -- (11,140) Acquisition costs deferred 62,937 68,205 92,502 Amortization charged to income (31,672) (41,663) (25,971) Effect of unrealized gains and losses 8,479 53,836 (1,442) -------- -------- -------- BALANCE, END OF YEAR $278,625 $318,551 $238,173 ======== ======== ======== ---------- (1) In 2006, DAC was reduced in connection with the disposition through reinsurance agreements of the Company's variable annuity business (see Note 3). (2) In 2004, DAC was reduced in connection with the disposition of the Company's direct response distribution business. (3) In 2004, the impact of adoption of SOP 03-1 included 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. Net amortization charged to income includes $14.1 million, $3.7 million and $2.1 million in 2006, 2005 and 2004, respectively, due to realized capital gains and losses. 61 As disclosed in Note 3, DAC and DSI balances were reduced during 2006 related to the disposal through reinsurance agreements of all of the variable annuity business. During 2005 and 2004, DAC and DSI amortization was estimated using stochastic modeling and was significantly impacted by the anticipated return on the underlying funds. The Company's long-term expectation of separate accounts fund performance, net of fees, was approximately 7% in 2005 and 8% in 2004. Whenever actual separate accounts fund performance based on the two most recent years varied from the expectation, the Company projected performance levels over the next five years such that the mean return over a seven-year period equaled the long-term 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 did not allow the future mean rates of return including fees projected over the five-year period to exceed 12.75% or fall below 0%. The Company periodically evaluated the results of utilization of this process to confirm that it was reasonably possible that variable annuity and life fund performance would revert to the expected long-term mean within this time horizon. DSI activity for the twelve months ended December 31 was as follows: (IN THOUSANDS) 2006 2005 2004(2) ------- ------- ------- BALANCE, BEGINNING OF YEAR $18,527 $ 2,955 $2,369 Disposition of operation (1) (6,162) -- -- Sales inducements deferred 15,740 16,923 1,531 Amortization charged to income (4,417) (2,373) (760) Effect of unrealized gains and losses 1,043 1,022 (185) ------- ------- ------ BALANCE, END OF YEAR $24,731 $18,527 $2,955 ======= ======= ====== ---------- (1) In 2006, DSI was reduced in connection with the disposition through reinsurance agreements of the Company's variable annuity business (see Note 3). (2) 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 breaches 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, 2006. REGULATION The Company is subject to changing social, economic and regulatory conditions. From time to time regulatory authorities or legislative bodies seek 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. 62 LEGAL AND REGULATORY PROCEEDINGS AND INQUIRIES BACKGROUND The Company and certain affiliates are involved in a number of lawsuits, regulatory inquiries, 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, heard or investigated; differences in applicable laws and judicial interpretations; the length of time before many of these matters might be resolved by settlement, through litigation or otherwise and, in some cases, the timing of their resolutions relative to other similar matters involving other companies; the fact that some of the lawsuits 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 the lawsuits 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 the lawsuits, 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. Often specific information about the relief sought, such as the amount of damages, is not available because plaintiffs have not requested specific relief in their pleadings. In our experience, when specific monetary demands are made in pleadings, they bear little relation to the ultimate loss, if any, to the Company. - In connection with regulatory examinations and proceedings, government authorities may seek various forms of relief, including penalties, restitution and changes in business practices. The Company may not be advised of the nature and extent of relief sought until the final stages of the examination or proceeding. - For the reasons specified above, it is often not possible to make meaningful estimates of the amount or range of loss that could result from the matters described below in the "Proceedings" subsection. 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. - Due to the complexity and scope of the matters disclosed in the "Proceedings" subsection below and the many uncertainties that exist, the ultimate outcome of these matters cannot be reasonably predicted. In the event of an unfavorable outcome in one or more of these matters, the ultimate liability may be in excess of amounts currently reserved and may be material to the Company's operating results or cash flows for a particular quarter or annual period. However, based on information currently known to it, management believes that the ultimate outcome of all matters described below as they are resolved over time is not likely to have a material adverse effect on the financial position of the Company. 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 several distribution channels including Allstate agencies. Consequently, information about the more significant of these proceedings is provided in the following paragraph. 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 (the "EEOC I" suit) and a class action filed in August 2001 by former employee agents alleging retaliation and age discrimination under the Age Discrimination in Employment Act ("ADEA"), breach of contract and ERISA violations (the "Romero I" suit). In March 2004, in the consolidated EEOC I and Romero I litigation, 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 63 signer. The court also ordered that an agent who voids the release must return to AIC "any and all benefits received by the [agent] in exchange for signing the release." The court also stated 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 and on January 16, 2007, the judge denied their request. The case otherwise remains pending. The EEOC also filed another lawsuit in October 2004 alleging age discrimination with respect to a policy limiting the rehire of agents affected by the agency program reorganization (the "EEOC II" suit). In EEOC II, in October 2006, the court granted partial summary judgment to the EEOC. Although the court did not determine that AIC was liable for age discrimination under the ADEA, it determined that the rehire policy resulted in a disparate impact, reserving for trial the determination on whether AIC had reasonable factors other than age to support the rehire policy. AIC filed a motion for interlocutory appeal from the partial summary judgment, which was granted by the trial court on January 4, 2007. AIC has filed a petition for immediate review of two controlling issues of law to the Court of Appeals for the Eighth Circuit and that petition is currently pending. AIC is also defending a certified class action filed by former employee agents who terminated their employment prior to the agency program reorganization. These plaintiffs have asserted breach of contract and ERISA claims. A putative nationwide class action has also been filed by former employee agents alleging various violations of ERISA, including a worker classification issue. These plaintiffs 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 by the trial court, was the subject of further proceedings on appeal, and was reversed and remanded to the trial court in April 2005. In all of these various 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. The Company recently concluded a periodic examination by state insurance regulators. Regulators focused, as they have with other insurers, on the Company's compliance with the state's replacement sales and record-keeping processes with regard to life insurance and annuities among other issues. They found that the Company failed to meet the requirements of applicable regulations. The Company has settled this examination and has substantially completed customer remediation related to replacement sales and is completing its other obligations arising from the examination. OTHER MATTERS The Corporation and some of its subsidiaries, including the Company, have received interrogatories and demands for information from regulatory and enforcement authorities relating to various insurance products and practices. The areas of inquiry include variable annuity market timing and late trading. The Corporation and some of its subsidiaries, including the Company, have also received interrogatories and demands for information from authorities seeking information relevant to on-going investigations into the possible violation of antitrust or insurance laws by unnamed parties and, in particular, seeking information as to whether any person engaged in activities for the purpose of price fixing, market allocation, or bid rigging. The Company believes that these inquiries are similar to those made to many financial services companies as part of industry-wide investigations by various authorities into the practices, policies and procedures relating to insurance and financial services products. Moreover, the Corporation has not received any communication from authorities related to the variable annuity market timing and late trading inquiries since November 2005. The Corporation and its subsidiaries have responded and will continue to respond to these inquiries. 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 and proceedings, some of which involve claims for substantial or indeterminate amounts. These actions are based on a variety of issues and target a range of the Company's practices. The outcome of these disputes is currently unpredictable. One or more of these matters could have an adverse effect on the Company's operating results or cash flows for a particular quarter or annual period. However, based on information currently known to it, management believes that the ultimate outcome of all matters described in this "Other Matters" subsection, in excess of amounts currently reserved, as they are resolved over time is not likely to have a material effect on the operating results, cash flows or financial position of the Company. 64 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 Corporation's federal income tax returns through the 2002 tax year and the statute of limitations has expired for these years. Any adjustments that may result from IRS examinations of tax returns are not expected to have a material impact on the results of operations, cash flows or financial position of the Company. The components of the deferred income tax assets and liabilities at December 31 are as follows: (IN THOUSANDS) 2006 2005 --------- --------- DEFERRED ASSETS Life and annuity reserves $ 67,529 $ 80,180 Other assets 1,924 1,376 --------- --------- Total deferred assets 69,453 81,556 --------- --------- DEFERRED LIABILITIES Deferred policy acquisition costs (59,986) (78,316) Unrealized net capital gains (42,020) (69,444) Difference in tax bases of investments (14,127) (6,011) Other liabilities (1,260) (1,184) --------- --------- Total deferred liabilities (117,393) (154,955) --------- --------- Net deferred liability $ (47,940) $ (73,399) ========= ========= 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) 2006 2005 2004 ------- ------- ------- Current $16,949 $24,132 $13,640 Deferred 806 (3,187) 4,285 ------- ------- ------- Total income tax expense $17,755 $20,945 $17,925 ======= ======= ======= The Company paid income taxes of $23.2 million, $18.4 million and $5.8 million in 2006, 2005 and 2004, respectively. 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: 2006 2005 2004 ---- ---- ---- Statutory federal income tax rate 35.0% 35.0% 35.0% State income tax expense 2.7 3.0 2.1 Adjustment for prior year tax liabilities (1.9) 0.3 (0.4) Other (1.7) (0.5) (1.2) ---- ---- ---- Effective income tax rate 34.1% 37.8% 35.5% ==== ==== ==== 65 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 NAIC Accounting Practices and Procedures Manual, subject to any deviations prescribed or permitted by the State of New York Insurance Superintendent. Prescribed statutory accounting practices include a variety of publications of the NAIC, as well as state laws, regulations and general administrative rules. Permitted statutory accounting practices encompass all accounting practices not so prescribed. 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 2006, 2005 and 2004 was $33.4 million, $35.9 million and $13.6 million, respectively. Statutory capital and surplus as of December 31, 2006 and 2005 was $444.6 million and $410.3 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 is limited to formula amounts based on net income and capital and surplus, determined in conformity with statutory accounting practices, as well as the timing and amount of dividends paid in the preceding twelve months. The maximum amount of dividends that the Company can distribute during 2007 without prior approval of the New York State Insurance Department is $26.2 million. In the twelve-month period beginning January 1, 2006, the Company did not pay any dividends. 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 expense 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 at a minimum level that is at least in accordance with regulations under the Internal Revenue Code and in accordance with generally accepted actuarial principles. The allocated cost to the Company included in net income for the pension plans in 2006, 2005 and 2004 was $3.3 million, $1.8 million and $1.5 million, respectively. AIC also provides certain health care and life insurance subsidies for employees hired before January 1, 2003 when they retire ("postretirement benefits"). 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 has the right to modify or terminate these plans. The allocated cost to the Company included in net income was $509 thousand, $543 thousand and $588 thousand for postretirement benefits other than pension plans in 2006, 2005 and 2004, 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 $1.4 million, $764 thousand and $1.3 million in 2006, 2005 and 2004, respectively. 66 15. OTHER COMPREHENSIVE INCOME The components of other comprehensive (loss) income on a pretax and after-tax basis for the years ended December 31 are as follows: 2006 ------------------------------ AFTER- (IN THOUSANDS) PRETAX TAX TAX --------- ------- -------- Unrealized holding losses arising during the period $(102,314) $35,810 $(66,504) Less: reclassification adjustment (23,960) 8,386 (15,574) --------- ------- -------- Unrealized net capital gains and losses (78,354) 27,424 (50,930) --------- ------- -------- Other comprehensive loss $ (78,354) $27,424 $(50,930) ========= ======= ======== 2005 ----------------------------- AFTER- (IN THOUSANDS) PRETAX TAX TAX -------- ------- -------- Unrealized holding losses arising during the period $(46,529) $16,285 $(30,244) Less: reclassification adjustment (6,087) 2,130 (3,957) -------- ------- -------- Unrealized net capital gains and losses (40,442) 14,155 (26,287) -------- ------- -------- Other comprehensive loss $(40,442) $14,155 $(26,287) ======== ======= ======== 2004 --------------------------- AFTER- (IN THOUSANDS) PRETAX TAX TAX ------- ------- ------- Unrealized holding gains arising during the period $20,221 $(7,077) $13,144 Less: reclassification adjustment (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 ======= ======= ======= 67 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, 2006 and 2005 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, 2006. 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 Allstate Life Insurance Company of New York as of December 31, 2006 and 2005, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2006, 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 March 9, 2007 68 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 Rules 13(a)-15(e) and 15d-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 recorded, processed, summarized and reported within the time periods specified by the Securities Exchange Act and 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, 2006, 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. ITEM 9B. OTHER INFORMATION None. 69 PART III ITEM 14. PRINCIPAL ACCOUNTING 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, the member firms of Deloitte & Touche Tohmatsu, and their respective affiliates, for professional services rendered to us for the fiscal years ending December 31, 2006 and 2005. 2006 2005 -------- -------- Audit fees (a) $344,300 $360,599 -------- -------- TOTAL FEES $344,300 $360,599 ======== ======== (a) Fees for audits of annual financial statements including financial statements for the separate accounts, reviews of quarterly financial statements, statutory audits, attest services, comfort letters, 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 Insurance Company of New York. Those policies and procedures are incorporated into this Item 14 (5) by reference to Exhibit 99 - The Allstate Corporation Policy Regarding Pre-Approval of Independent Auditors' Services (the "Pre-Approval Policy"). In addition, in 2005 the Board of Directors of Allstate Life Insurance Company of New York adopted the Pre-Approval Policy, as it may be amended from time to time by the Audit Committee or the Board of Directors of the Corporation, as its own policy, provided that the Designated Member referred to in such policy need not be independent because the New York Stock Exchange corporate governance standards do not apply to Allstate Life Insurance Company of New York and provided that references to the "audit committee" would mean Allstate Life Insurance Company of New York's Board. All of the services provided by Deloitte & Touche LLP to Allstate Life Insurance Company of New York in 2006 and 2005 were pre-approved by The Allstate Corporation Audit Committee and the Allstate Life Insurance Company of New York Board. 70 PART IV ITEM 15. EXHIBITS, 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 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 Amended and Restated Service and Expense Agreement between Allstate Insurance Company, The Allstate Corporation and certain affiliates, effective January 1, 2004, and effective March 5, 2005 with respect to Allstate Life Insurance Company of New York. Incorporated herein by reference to Exhibit 10.1 to Allstate Life Insurance Company's Quarterly Report on Form 10-Q for quarter ended June 30, 2005. 10.2 New York Insurer Supplement to Amended and Restated Service and Expense Agreement between Allstate Insurance Company, The Allstate Corporation, Allstate Life Insurance Company of New York and Intramerica Life Insurance Company, effective March 5, 2005. Incorporated herein by reference to Exhibit 10.2 to Allstate Life Insurance Company's Quarterly Report on Form 10-Q for quarter ended June 30, 2005. 71 10.3 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. 10.4 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) 10.5 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. 10.6 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. 10.7 Amendment Number One to the Principal Underwriting Agreement between Allstate Life Insurance Company of New York and Allstate Distributors, L.L.C. effective October 1, 2002. Incorporated herein by reference to Exhibit 10.1 to Allstate Life Insurance Company of New York's Quarterly Report on Form 10-Q for the quarter ended March 31, 2006. 10.8 Selling Agreement between Allstate Life Insurance Company of New York, ALFS, Inc. and Allstate Financial Services, LLC effective May 1, 2005. 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 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. 10.10 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. 10.11 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. 72 10.12 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. 10.13 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. 10.14 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. 10.15 Amendment No. 1 to Automatic Annuity Reinsurance Agreement between Allstate Life Insurance Company of New York and Allstate Life Insurance Company, effective January 1, 2005. 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, 2005. 10.16 Amendment No. 2 to Automatic Annuity Reinsurance Agreement between Allstate Life Insurance Company of New York and Allstate Life Insurance Company, effective June 1, 2006. Incorporated herein by reference to Exhibit 10.1 to Allstate Life Insurance Company of New York's Current Report on Form 8-K filed June 7, 2006. 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 The Allstate Corporation Policy Regarding Pre-Approval of Independent Auditors' Services effective November 10, 2003. Incorporated herein by reference to Exhibit 99(ii) to Allstate Life Insurance Company of New York's Annual Report on Form 10-K for 2004. 73 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 13, 2007 /s/ Samuel H. Pilch ------------------------------------------- By: Samuel H. Pilch (Controller) 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 13, 2007 ------------------------------ President and a Director Casey J. Sylla (Principal Executive Officer) /s/ John C. Pintozzi Vice President, Chief March 13, 2007 ------------------------------ Financial Officer and a John C. Pintozzi Director (Principal Financial Officer) /s/ Marcia D. Alazraki Director March 12, 2007 ------------------------------ Marcia D. Alazraki /s/ Vincent A. Fusco Director March 12, 2007 ------------------------------ Vincent A. Fusco /s/ Cleveland Johnson, Jr. Director March 12, 2007 ------------------------------ Cleveland Johnson, Jr. /s/ John C. Lounds Director March 12, 2007 ------------------------------ John C. Lounds Director March 12, 2007 ------------------------------ Kenneth R. O'Brien /s/ John R. Raben, Jr. Director March 12, 2007 ------------------------------ John R. Raben, Jr. /s/ Phyllis Hill Slater Director March 12, 2007 ------------------------------ Phyllis Hill Slater /s/ Kevin R. Slawin Director March 12, 2007 ------------------------------ Kevin R. Slawin /s/ Michael J. Velotta Director March 12, 2007 ------------------------------ Michael J. Velotta /s/ Douglas B. Welch Director March 12, 2007 ------------------------------ Douglas B. Welch /s/ Patricia W. Wilson Director March 12, 2007 ------------------------------ Patricia W. Wilson 74 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. 75 ALLSTATE LIFE INSURANCE COMPANY OF NEW YORK SCHEDULE I - SUMMARY OF INVESTMENTS - OTHER THAN INVESTMENTS IN RELATED PARTIES DECEMBER 31, 2006
AMOUNTS AT WHICH SHOWN ON BALANCE (IN THOUSANDS) COST FAIR VALUE SHEET ---------- ---------- ----------- Type of investment Fixed Maturities: Bonds: United States government, government agencies and authorities $ 541,877 $ 729,111 $ 729,111 States, municipalities and political subdivisions 314,768 323,003 323,003 Foreign governments 244,544 304,947 304,947 Public utilities 654,671 691,659 691,659 All other corporate bonds 2,559,833 2,613,103 2,613,103 Commercial mortgage-backed securities 669,303 673,179 673,179 Mortgage-backed securities 439,938 433,196 433,196 Asset-backed securities 107,922 109,022 109,022 Redeemable preferred stocks 9,371 9,919 9,919 ---------- ---------- ---------- Total fixed maturities 5,542,227 $5,887,139 5,887,139 ---------- ========== ---------- Mortgage loans on real estate 708,449 708,449 Policy loans 38,168 38,168 Short-term investments 142,334 142,334 Derivative instruments 3,784 3,784 ---------- ---------- Total investments $6,434,962 $6,779,874 ========== ==========
S-1 ALLSTATE LIFE INSURANCE COMPANY OF NEW YORK SCHEDULE IV--REINSURANCE
PERCENTAGE OF AMOUNT GROSS NET ASSUMED (IN THOUSANDS) AMOUNT CEDED ASSUMED AMOUNT TO NET ----------- ---------- -------- ----------- ---------- YEAR ENDED DECEMBER 31, 2006 Life insurance in force $28,410,800 $11,524,333 $810,202 $17,696,669 4.6% =========== =========== ======== =========== Premiums and contract charges: Life and annuities $ 170,625 $ 29,392 $ 1,367 $ 142,600 0.9% Accident and health 8,878 3,739 -- 5,139 -- ----------- ----------- -------- ----------- $ 179,503 $ 33,131 $ 1,367 $ 147,739 0.9% =========== =========== ======== =========== YEAR ENDED DECEMBER 31, 2005 Life insurance in force $25,508,599 $ 9,806,717 $540,025 $16,241,907 3.3% =========== =========== ======== =========== Premiums and contract charges: Life and annuities $ 142,091 $ 12,372 $ 950 $ 130,669 0.7% Accident and health 8,658 4,509 -- 4,149 -- ----------- ----------- -------- ----------- $ 150,749 $ 16,881 $ 950 $ 134,818 0.7% =========== =========== ======== =========== 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% =========== =========== ======== ===========
S-2