10-K 1 a2131964z10-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, 2003 OR / / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 COMMISSION FILE NUMBER: 333-111553 LINCOLN BENEFIT LIFE COMPANY (Exact name of registrant as specified in its charter) NEBRASKA 47-0221457 (State of Incorporation) (I.R.S. Employer Identification No.) 2940 SOUTH 84TH STREET LINCOLN, NEBRASKA 68506 (Address of principal executive offices) (zip code) Registrant's telephone number, including area code: 800-525-9287 Securities registered pursuant to Section 12(b) or 12(g) of the Securities Exchange Act of 1934: None Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months, and (2) has been subject to such filing requirements for the past 90 days. Yes /X/ No / / Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. /X/ Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the 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 15, 2004, the Registrant had 25,000 common shares, $100 par value, outstanding, all of which are held by Allstate Life Insurance Company. Part III of this Form 10-K incorporates by reference certain information from The Allstate Corporation's Notice of Annual Meeting and Proxy Statement dated March 26, 2004, SEC File Number 1-11840. TABLE OF CONTENTS
PAGE ---- PART I Item 1. Business * 2 Item 2. Properties * 3 Item 3. Legal Proceedings 3 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 3 Item 6. Selected Financial Data ** N/A Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations 4 Item 7A. Quantitative and Qualitative Disclosures about Market Risk 16 Item 8. Financial Statements and Supplementary Data 17 Item 9. Change in and Disagreements with Accountants on Accounting and Financial Disclosure 37 Item 9A Controls and Procedures 37 PART III Item 10. Directors and Executive Officers of the Registrant ** N/A Item 11. Executive Compensation** N/A Item 12. Security Ownership of Certain Beneficial Owners and Management and Related N/A Stockholder Matters ** Item 13. Certain Relationships and Related Transactions ** N/A Item 14 Principal Accountant Fees and Services 37 PART IV Item 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K 38 Signatures 41 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 42 Financial Statement Schedules S-1
* Item prepared in accordance with General Instruction I(2) of Form 10-K ** Omitted pursuant to General Instruction I(2) of Form 10-K PART I ITEM 1. BUSINESS Lincoln Benefit Life Company ("Lincoln Benefit", "we", "our" or "us") was incorporated under the laws of the State of Nebraska in 1938. Lincoln Benefit is a wholly owned subsidiary of Allstate Life Insurance Company ("ALIC"), a wholly owned subsidiary of Allstate Insurance Company ("AIC"), 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 is owned by The Allstate Corporation (the "Corporation"), a publicly owned holding company incorporated under the laws of the State of Delaware. The Corporation is the largest publicly held personal lines insurer in the United States. Widely known through the "You're In Good Hands With Allstate(R)" slogan, the Corporation provides insurance products to more than 16 million households and has approximately 12,900 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 2002 statutory premiums earned and the nation's 13th-largest life insurance business on the basis of 2002 ordinary life insurance in force and 19th on the basis of 2002 statutory admitted assets. We are authorized to sell life insurance, savings and retirement products in all states except New York, as well as in the District of Columbia, Guam and the U.S. Virgin Islands. Our mission is to assist financial services professionals in meeting their customers' financial protection, savings and retirement needs by providing top-tier products delivered with reliable and efficient service. Our product line includes a wide variety of financial protection, savings and retirement products aimed at serving the financial needs of our customers. Products include traditional life, interest-sensitive life, variable life and long-term care insurance, and both variable and fixed annuities. Products are sold through a variety of distribution channels including Allstate exclusive agencies, independent agents (including master brokerage agencies) and broker/dealers. We have reinsurance agreements with ALIC and non-affiliated reinsurers. Under the agreements with ALIC, we reinsure all business to ALIC not reinsured to non-affiliated reinsurers. Premiums, contract charges, interest credited to contractholder funds, contract benefits and certain expenses of substantially all general account contracts are reinsured with ALIC. In addition, we reinsure all retained general account liabilities (that have not been ceded to non-affiliated reinsurers) to ALIC via a 100% coinsurance agreement. Assets that support these liabilities are owned and managed by ALIC. The obligations of ALIC under the reinsurance agreements are to us. We continue to have primary liability as the direct insurer for risks reinsured. Separate accounts liabilities related to variable annuity and life contracts are ceded to ALIC via a 100% modified coinsurance agreement whereby assets are maintained in our legally segregated unitized separate accounts. Contract charges assessed against the separate accounts assets and contract benefits are ceded to ALIC. In addition, we cede 90%, 80% or 60% of the mortality risk on certain life policies, depending upon the issue year and product, to a pool of thirteen non-affiliated reinsurers. Beginning in 1998, we cede mortality risk on new business in excess of $2 million per life for individual coverage. For business sold prior to 1998, we ceded mortality risk in excess of $350 thousand per life for individual coverage. The assets and liabilities relating to variable annuities and variable life products are legally segregated and reflected as assets and liabilities of the separate accounts in the financial statements. Assets of the separate accounts are only available for the benefit of the holders of these products and are not available to other creditors or policyholders with a claim solely against our general account assets. Absent any contract provision specifying either a guaranteed minimum return or account value upon death or annuitization, variable annuity and variable life contractholders bear the investment risk that the underlying mutual funds of the separate accounts may not meet their stated investment objectives. The assets and liabilities relating to variable products issued with fixed fund options are divided between the applicable separate accounts for the variable portion of the product and the general account for the fixed portion of the product. The assets and liabilities relating to the other (non-variable) life insurance and annuity products are reflected in our general account. With regard to our personal life insurance, savings, retirement and long-term care products, 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 as well as those of ALIC, our product features and prices, and the 2 level of customer service that we provide. In addition, with respect to variable life and variable annuity products, we compete on the basis of the variety of providers and choices of funds for our separate accounts and the management and performance of those funds within our separate accounts. The market for these products continues to be highly fragmented and competitive. As of December 31, 2002, there were approximately 780 groups of life insurance companies in the United States, most of which offered one or more products similar to our personal life insurance, savings, retirement and long-term care products. In some states, we compete with banks and savings and loan associations in the sale of life insurance products. In addition, because many of our personal life insurance, savings and retirement products include a savings or investment component, our competition includes securities firms, investment advisors, mutual funds, banks and other financial institutions. Competitive pressure is growing due to several factors, including cross marketing alliances between unaffiliated businesses and demutualization and consolidation activity in the financial services industry. Lincoln Benefit is subject to extensive regulation. In the U.S. the method, extent and substance of such regulation varies by state but generally has its source in statutes that delegate regulatory authority to a state regulatory agency and define standards of conduct. In general, such regulation is intended for the protection of insurance policyholders rather than security holders. These rules have a substantial effect on our business and relate to a wide variety of matters including insurance company licensing and examination, agent licensing, 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 discussion of statutory financial information, see Note 10 to the financial statements. For discussion of regulatory contingencies, see Note 8 to the financial statements. Notes 10 and 8 are incorporated in this Part I, Item 1 by reference. In recent years the state insurance regulatory framework has come under increased federal scrutiny and legislation that would provide for federal chartering of insurance companies has been proposed. In addition, state legislators and insurance regulators continue to examine the appropriate nature and scope of state insurance regulation. We cannot predict whether any 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 Lincoln Benefit. ITEM 2. PROPERTIES We occupy office space in Lincoln, Nebraska that is owned by AIC. Expenses associated with this facility are allocated to us on a direct basis. We also lease office space in Lincoln for general operations, file storage and information technology support. ITEM 3. LEGAL PROCEEDINGS Incorporated in this Item 3 by reference to the discussion under the heading "Regulation and legal proceedings" in Note 8 to the financial statements. PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES There is no public trading market for our common stock. All of our outstanding common stock is owned by our parent, ALIC. All of 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, no equity securities have been sold or repurchased by us. From January 1, 2002 through March 15, 2004, we paid no dividends on our common stock to ALIC. For additional information on dividends, including restrictions on the payment of dividends, see the "Liquidity" subsection of the "Capital Resources and Liquidity" section of our "Management's Discussion and Analysis of Financial Condition and Results of Operations". These items are incorporated herein by reference. 3 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS THE FOLLOWING DISCUSSION HIGHLIGHTS SIGNIFICANT FACTORS INFLUENCING THE FINANCIAL POSITION AND RESULTS OF OPERATIONS OF LINCOLN BENEFIT (REFERRED TO IN THIS DOCUMENT AS "WE", "OUR", "US" OR THE "COMPANY"). IT SHOULD BE READ IN CONJUNCTION WITH THE FINANCIAL STATEMENTS AND RELATED NOTES BEGINNING ON PAGE 17. WE ARE MANAGED AS A SINGLE SEGMENT ENTITY. The most important matters that we monitor to evaluate the financial condition and performance of our company include: - For operations: premiums and deposits; invested assets and face amount of life insurance in force; - For Investments: credit quality/experience, stability of long-term returns, cash flows and asset and liability duration; - For financial condition: our financial strength ratings. APPLICATION OF CRITICAL ACCOUNTING POLICIES We have identified two accounting policies that require us to make assumptions and estimates that are significant to the financial statements. It is reasonably likely that changes in these assumptions and estimates could occur from period to period and have a material impact on our financial statements. A brief summary of each of these critical accounting policies follows. For a more complete discussion of the effect of these policies on our financial statements, and the judgments and estimates relating to these policies, see the referenced sections of Management's Discussion and Analysis of Financial Condition and Results of Operations ("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 observe and to characterize. Because of this, judgment is required in developing certain of these estimates and, as a result, the estimated fair value of non-publicly traded securities may differ from amounts that would be realized upon an immediate sale of the securities. Periodic changes in fair values of investments classified as available for sale are reported as a component of accumulated other comprehensive income on the Statements of Financial Position and are not reflected in the operating results of any period until reclassified to net income upon the consummation of a transaction, or when declines in fair values are deemed other than temporary. The assessment of other than temporary impairment of a security's fair value is performed on a case-by-case basis considering a wide range of factors. There are a number of assumptions and estimates inherent when assessing impairments and determining if they are other than temporary, including 1) our ability and intent to retain the investment for a period of time sufficient to allow for an anticipated recovery in value; 2) the expected recoverability of principal and interest; 3) the duration and extent to which the fair value has been less than amortized cost; 4) the financial condition, near-term and long-term prospects of the issuer, including relevant industry conditions and trends, and implications of rating agency actions and offering prices; and 5) the specific reasons that a security is in 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 assumed or that have a greater adverse effect on a particular issuer than originally estimated; 2) changes in the facts and circumstances related to a particular issuer's ability to meet all of its contractual obligations; and 3) changes in facts and circumstances or new information that we obtain which causes a change in our ability or intent to hold a security to maturity or until it recovers in value. Changes in assumptions, facts and circumstances could result in 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 our portfolio is held at fair value and as a result, the related unrealized loss, net of tax, would already be reflected as accumulated other comprehensive income in shareholder's equity. For a more detailed discussion of the risks relating to changes in investment values and levels of investment impairment, and the potential causes of such changes, see Note 4 of the financial statements and the Financial Position, Market Risk and Forward-looking Statements and Risk Factors sections of the MD&A. 4 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONT.) RESERVE FOR LIFE-CONTINGENT CONTRACT BENEFITS ESTIMATION Long-term actuarial assumptions of future investment yields, mortality, morbidity, policy terminations and expenses are used when estimating 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 6 of the financial statements and the Forward-looking Statements and Risk Factors sections of the MD&A. 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 its wholly owned subsidiaries, is a leading provider of life insurance, annuities and other financial services to a broad spectrum of individual and institutional customers. Our mission is to assist financial services professionals in meeting their customers' financial protection, savings and retirement needs by providing top-tier products delivered with reliable and efficient service. We will pursue the following to grow our business organically: develop focused, top-tier products; deepen distribution partner relationships; improve our cost structure and implement a systematic risk management program. Our product line includes a wide variety of financial protection, savings and retirement products aimed at serving the financial needs of our customers. Products include traditional life, interest-sensitive life, variable life and long-term care insurance, and both variable and fixed annuities. Products are sold through a variety of distribution channels including Allstate exclusive agencies, independent agents (including master brokerage agencies) and broker/dealers. RESULTS OF OPERATIONS
FOR THE YEAR ENDED DECEMBER 31, ---------------------------------- (IN THOUSANDS) 2003 2002 2001 ---------- --------- --------- Net investment income $ 11,434 $ 11,621 $ 12,144 Realized capital gains and losses 73 (4,084) (1,352) Income tax expense 4,092 2,629 3,768 ---------- --------- --------- Net income $ 7,415 $ 4,908 $ 7,024 ========== ========= =========
We have reinsurance agreements whereby premiums, contract charges, interest credited to contractholder funds, contract benefits and certain expenses are ceded to ALIC and other non-affiliated reinsurers, and are reflected net of such reinsurance in the Statements of Operations and Comprehensive Income. Our results of operations include net investment income and realized capital gains and losses earned on the assets that are not transferred under the reinsurance agreements. NET INCOME increased 51.1% in 2003 compared to 2002 and decreased 30.1% in 2002 compared to 2001. The increase in 2003 was due to realized capital gains in 2003 compared to realized capital losses in 2002 partially offset by increased income tax expense and decreased net investment income. The decrease in 2002 was due to an increase in realized capital losses in 2002 compared to 2001 and decreased net investment income. NET INVESTMENT INCOME decreased 1.6% in 2003 compared to 2002 and 4.3% in 2002 compared to 2001. The decreases were due to lower portfolio yields. Investment balances as of December 31, 2003, excluding unrealized net capital gains, increased 7.0% from December 31, 2002 and were comparable as of December 31, 2002 and 2001. The lower portfolio yields were primarily due to purchases of fixed income securities with yields lower than the current portfolio average. NET REALIZED CAPITAL GAINS were $73 thousand in 2003 compared to realized capital losses of $4.1 million and 5 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONT.) $1.4 million in 2002 and 2001, respectively. In 2003, capital gains resulted from sales of fixed income securities while in 2002, gains on sales of fixed income securities of $239 thousand were more than offset by write-downs on fixed income securities of $4.3 million. The realized capital losses in 2001 resulted from sales of fixed income securities. Period to period fluctuations in realized capital gains and losses are the result of timing of sales decisions reflecting our decision on positioning the portfolio, assessments of individual securities, overall market conditions and write-downs when we determine that a decline in the value of a security is other than temporary. FINANCIAL POSITION (IN THOUSANDS)
2003 2002 ------------- -------------- Fixed income securities (1) $ 209,118 $ 199,406 Short-term 1,107 3,201 ------------- -------------- Total investments $ 210,225 $ 202,607 ============= ============== Cash $ 23,456 $ 130,249 ============= ============== Reinsurance recoverable from ALIC, net $ 14,594,260 $ 12,178,831 ============= ============== Reinsurance recoverable from non-affiliates, net $ 692,971 $ 569,569 ============= ============== Contractholder funds $ 13,802,815 $ 11,658,966 ============= ============== Reserve for life-contingent contract benefits $ 1,476,314 $ 1,082,690 ============= ============== Separate Accounts assets and liabilities $ 1,911,619 $ 1,413,221 ============= ==============
(1) Fixed income securities are carried at fair value. Amortized cost for these securities was $197.9 million and $182.8 million at December 31, 2003 and 2002, respectively. Total investments increased to $210.2 million at December 31, 2003 from $202.6 million at December 31, 2002 due to the investment of positive cash flows from operations after settlement of December 31, 2002 payable to affiliates. At December 31, 2003, unrealized gains on fixed income securities decreased to $11.2 million from $16.6 million at December 31, 2002. FIXED INCOME SECURITIES See Note 4 of the financial statements for a table showing the amortized cost, unrealized gains, unrealized losses and fair value for each type of fixed income securities for the years ended December 31, 2003 and 2002. U.S. government and agencies of the U.S. government securities were all rated investment grade at December 31, 2003. Municipal bonds, including tax-exempt and taxable securities, totaled $571 thousand and were rated Aaa at December 31, 2003 due to insurance by a bond insurer. Corporate bonds totaled $81.4 million and all were rated as investment grade at December 31, 2003. Mortgage-backed securities ("MBS") totaled $41.0 million at December 31, 2003. In our MBS portfolio, the credit risk is mitigated due to the fact that 51.7% 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 also subject to interest rate risk since price volatility and ultimate realized yield are affected by the rate of repayment of the underlying mortgages. We attempt to limit interest rate risk on these securities by investing a portion of the portfolio in securities that provide prepayment protection. At December 31, 2003, approximately 5.7% of the MBS portfolio was invested in planned amortization class bonds or the equivalent. Though these security types offer greater relative prepayment protection than other MBS securities, the degree of protection has been limited in this interest rate environment. Based on market conditions and potential changes in portfolio management objectives, the value of this protection and the significance of these holdings relative to the entire portfolio may be reduced in future periods. Asset-backed securities ("ABS") totaled $15.4 million at December 31, 2003. Our ABS portfolio is subject to credit and interest rate risk. Credit risk is mitigated by monitoring the performance of the collateral. The entire ABS portfolio had a Moody's rating of Aaa or a Standard & Poor's ("S&P") rating of AAA, the highest rating 6 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONT.) category. The ABS portfolio is also subject to interest rate risk since price volatility and ultimate realized yield are affected by the rate of repayment of the underlying assets. The entire ABS portfolio is invested in securitized utilities receivables. At December 31, 2003, our entire 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 Moody's equivalent rating of Aaa, Aa, A or Baa; an S&P equivalent rating of AAA, AA, A or BBB; or a comparable internal rating. The following table summarizes the credit quality of the fixed income securities portfolio at December 31, 2003. (IN THOUSANDS)
NAIC PERCENT OF RATINGS MOODY'S, S&P OR EQUIVALENT FAIR VALUE TOTAL ------- ------------------------------------- ---------- ---------- 1 Aaa/Aa/A $ 193,722 92.6% 2 Baa 15,396 7.4 ---------- ---------- $ 209,118 100.0% ========== ==========
UNREALIZED GAINS AND LOSSES See Note 4 of the financial statements for further disclosures regarding unrealized losses on fixed income securities and factors considered in determining that they are not other than temporarily impaired. The unrealized net capital gains on fixed income securities at December 31, 2003 were $11.2 million, a decrease of $5.5 million or 32.9% since December 31, 2002. Gross unrealized losses were primarily concentrated in the corporate fixed income portfolios and were comprised of securities in the following sectors.
GROSS UNREALIZED AMORTIZED ----------------------- FAIR (IN THOUSANDS) COST GAINS LOSSES VALUE ----------- ---------- ---------- ---------- AT DECEMBER 31, 2003 Corporate: Banking $ 19,209 $ 1,751 $ (85) $ 20,875 Utilities 11,838 487 - 12,325 Financial services 11,535 1,195 (157) 12,573 Capital goods 10,338 500 (261) 10,577 Transportation 9,460 444 (244) 9,660 Communications/media 6,435 557 - 6,992 Consumer noncyclical 4,451 43 - 4,494 Energy 2,150 - (142) 2,008 Basic industry 940 - (3) 937 Consumer cyclical 927 8 - 935 ----------- ---------- ---------- ---------- Total corporate fixed income portfolio 77,283 4,985 (892) 81,376 U.S. government and agencies 65,632 5,448 (376) 70,704 Municipal 503 68 - 571 Asset-backed securities 14,203 1,240 - 15,443 Mortgage-backed securities 40,321 1,015 (312) 41,024 ----------- ---------- ----------- ---------- Total fixed income securities $ 197,942 $ 12,756 $ (1,580) $ 209,118 =========== ========== ========== ==========
The capital goods and transportation sectors had the highest concentration of unrealized losses in our corporate fixed income securities portfolio at December 31, 2003. The gross unrealized losses in these sectors are primarily company specific or interest rate related. While we expect eventual recovery of these securities and the related sectors, we included every security in our portfolio monitoring process at December 31, 2003. At December 31, 2003, all of the gross unrealized losses were related to investment grade fixed income 7 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONT.) 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. The scheduled maturity dates for fixed income securities in an unrealized loss position at December 31, 2003 is shown below. Actual maturities may differ from those scheduled as a result of prepayments by the issuers.
UNREALIZED PERCENT FAIR PERCENT (IN THOUSANDS) LOSS OF TOTAL VALUE OF TOTAL ---------- -------- --------- -------- Due after five years through ten years (742) 47.0% $ 20,694 $ 46.9% Due after ten years (526) 33.3 6,091 13.8 Mortgage- and asset- backed securities(1) (312) 19.7 17,347 39.3 ---------- -------- --------- -------- Total $ (1,580) 100.0% $ 44,132 100.0% ========== ======== ========= ========
(1) Because of the potential for prepayment, mortgage- and asset-backed securities are not categorized based on their contractual maturities. PORTFOLIO MONITORING We have a comprehensive portfolio monitoring process to identify and evaluate fixed income securities whose carrying value may be other than temporarily impaired. The process includes a quarterly review of all securities using a screening process to identify those securities whose fair value compared to amortized cost is below established thresholds for certain time periods, or which are identified through other monitoring criteria such as ratings downgrades or payment defaults. The securities identified, in addition to other securities for which we may have concern, are evaluated based on facts and circumstances for inclusion on our watch-list. The watch-list is reviewed in detail to determine whether any other than temporary impairment exists. We also monitor the quality of our fixed income portfolio by categorizing certain investments as "problem", "restructured" or "potential problem". Problem fixed income securities are securities in default with respect to principal or interest and/or securities issued by companies that have gone into bankruptcy subsequent to our acquisition of the security. Restructured fixed income securities have rates and terms that are not consistent with market rates or terms prevailing at the time of the restructuring. Potential problem fixed income securities are current with respect to contractual principal and/or interest, but because of other facts and circumstances, we have serious 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. As of December 31, 2003, we did not have any fixed income securities categorized as problem, restructured or potential problem. 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) 2003 2002 2001 -------- --------- -------- Investment write-downs $ - $ (4,323) $ - Sales - fixed income securities 73 239 (1,352) -------- --------- -------- Realized capital gains and losses, pretax 73 (4,084) (1,352) Income tax (expense) benefit (26) 1,429 473 -------- --------- -------- Realized capital gains and losses, after-tax $ 47 $ (2,655) $ (879) ======== ========= ========
We recorded realized capital gains on fixed income securities of $73 thousand for the year ended December 31, 2003 resulting from sales of fixed income securities. We recorded losses on fixed income securities of $4.1 million for the year ended December 31, 2002, primarily related to the utility industry. SHORT-TERM INVESTMENTS Our short-term investment portfolio was $1.1 million and $3.2 million at December 31, 2003 and 2002, respectively. We invest available cash balances primarily in taxable short-term securities having a final maturity date or redemption date of one year or less. CASH At December 31, 2003, the cash balance was $23.5 million compared to $130.2 million at December 31, 2002. The decrease is primarily a result of timing differences between when deposits from fixed annuity sales were received in 2002 and when those deposits were transferred to ALIC under our reinsurance agreement in 2003. As a result, there was a corresponding decrease in payable to affiliates. 8 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONT.) REINSURANCE RECOVERABLE, CONTRACTHOLDER FUNDS AND RESERVE FOR LIFE-CONTINGENT CONTRACT BENEFITS Under accounting principles generally accepted in the United States of America ("GAAP"), when reinsurance contracts do not relieve the ceding company of legal liability to contractholders, the ceding company is required to report reinsurance recoverables arising from these contracts separately as assets. The liabilities for the contracts are reported as contractholder funds, reserves for life-contingent contract benefits, or separate accounts liabilities depending on the characteristics of the contracts. We reinsure all reserve liabilities with ALIC or other non-affiliated reinsurers. Reinsurance recoverable and the related reserve for life-contingent contract benefits and contractholder funds are reported separately in the Statements of Financial Position, while the assets which support the separate accounts liabilities are reflected as separate accounts assets. At December 31, 2003, contractholder funds increased to $13.80 billion from $11.66 billion at December 31, 2002 as the result of new and additional deposits from fixed annuities and interest credited to contractholder funds partially offset by surrenders, withdrawals and benefit payments. The reserve for life-contingent contract benefits increased $393.6 million to $1.48 billion at December 31, 2003 resulting from new sales of structured settlement and immediate annuities and other life-contingent products, partially offset by benefits paid and policy lapses. Reinsurance recoverable from ALIC and reinsurance recoverable from non-affiliates increased correspondingly by $2.42 billion and $123.4 million, respectively, due to the increase in contractholder obligations discussed above. We purchase reinsurance after evaluating the financial condition of the reinsurer, as well as the terms and price of coverage. We reinsure certain of our risks to non-affiliated reinsurers under yearly renewable term and coinsurance agreements. Yearly renewable term and coinsurance agreements result in a passing of the agreed-upon portion of risk to the reinsurer in exchange for negotiated reinsurance premium payments. Developments in the insurance industry have recently led to a decline in the financial strength of some of our reinsurance carriers, causing amounts recoverable from them to be considered a higher risk. There has also been recent consolidation activity between reinsurers in the industry, which causes reinsurance risk across the industry to be concentrated among fewer companies. Additionally, one of our primary non-affiliated reinsurers has announced its intention to no longer assume life reinsurance risks. As a result, we plan to increase our reinsurance to ALIC. 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. At December 31, 2003, all non-affiliated ceded premiums were reinsured under uncollateralized reinsurance agreements with companies that had a financial strength rating of A- or above, as measured by AM Best. In certain cases, these ratings refer to the financial strength of the affiliated group or parent company of the reinsurer. SEPARATE ACCOUNTS Separate accounts assets and liabilities increased 35.3% to $1.91 billion at December 31, 2003 compared to the December 31, 2002 balance. The increase was primarily attributable to increases in the fair value of the separate accounts fund values due to improved equity market conditions compared to 2002, sales of variable annuity contracts and transfers from the general account to the separate accounts funds, partially offset by surrenders and withdrawals and expense charges. The assets related to variable contracts are legally segregated and reflected as separate accounts assets. The assets of the separate accounts are carried at fair value. Separate accounts liabilities represent the contractholders' claims to the related assets and are carried at the fair value of the assets. Investment income and realized capital gains and losses of the separate accounts accrue directly to the contractholders and therefore, are not included in our Statements of Operations and Comprehensive Income. Our revenues from the separate accounts consist of contract charges related to maintenance and administration, mortality, early surrender and expenses, which are then ceded to ALIC. Absent any contract provision wherein we guarantee either a minimum return of account value upon death or annuitization, variable annuity and variable life insurance contractholders bear the investment risk that the underlying mutual funds of the separate accounts may not meet their stated investment objectives. The risk and associated cost of these contract guarantees are ceded to ALIC in accordance with the reinsurance agreements. 9 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONT.) MARKET RISK Market risk is the risk that we will incur losses due to adverse changes in equity prices or interest rates. Our primary market risk exposure is to changes in interest rates. Although we also have certain exposures to changes in equity prices in our equity indexed annuities and separate accounts liabilities, this risk is transferred to ALIC in accordance with the reinsurance agreements. OVERVIEW Investment guidelines define the overall framework for managing market and other investment risks, including accountability and control over these risk management activities. In addition, we follow guidelines that have been approved by our board of directors and that specify the investment limits and strategies that are appropriate given our liquidity, surplus, product, and regulatory requirements. Executive oversight of investment risk management processes is conducted primarily through the board of directors and investment committee. Administration and detailed managerial oversight of investment risk, including market risk, is provided through our credit and risk management committee ("CRMC"). We also have an enterprise-wide committee called the Enterprise Risk Council ("ERC") that is responsible for assessing risks, including market and other investment risks, on an integrated basis across subsidiaries and organizations. We manage our exposure to market risk through the use of asset allocation limits and duration limits 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 these portfolios. These duration limits place restrictions on the amount of interest rate risk that may be taken. Comprehensive day-to-day management of market risk within defined tolerance ranges occurs as portfolio managers buy and sell within their respective markets based upon the acceptable boundaries established by the investment guidelines. INTEREST RATE RISK is the risk that we will incur an economic loss due to adverse changes in interest rates. This risk arises as we invest funds in interest-sensitive assets. One of the measures used to quantify exposure is duration. Duration measures the sensitivity of assets 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%. Our asset duration was approximately 5.0 and 3.9 at December 31, 2003 and 2002, respectively. To calculate duration, we project asset 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 levels of interest rates and determining the percentage change in aggregate fair value. 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, and municipal and corporate obligations. Based upon the information and assumptions we use in our duration calculation and interest rates in effect at December 31, 2003, we estimate that a 100 basis point immediate, parallel increase in interest rates ("rate shock") would decrease the net fair value of the assets by approximately $10.5 million compared to $7.8 million at December 31, 2002. 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 impact of such an event. To the extent that conditions differ from the assumptions we used in these calculations, duration and rate shock measures could be significantly impacted. Additionally, our calculation assumes 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 impact of non-parallel changes in the term structure of interest rates and/or large changes in interest rates. EQUITY PRICE RISK is the risk that we will incur economic losses due to adverse changes in a mutual fund or stock index. At December 31, 2003 and 2002, we had separate account assets with account values totaling $1.91 billion and $1.41 billion, respectively. We earn contract charges as a percentage of these account values. In the event of an immediate decline of 10% in the account values due to equity market declines, we would have earned approximately $2.4 million and $2.0 million less in fee income at December 31, 2003 and 2002, respectively, 10 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONT.) which would be ceded to ALIC. Variable annuity contracts we sell have a guaranteed minimum death benefit ("GMDB") and customers may choose to purchase an enhanced GMDB or guaranteed minimum income benefit ("GMIB") prior to 2004 and beginning in 2004, an accumulation benefit ("GMAB") on certain contracts. These guarantees subject us to additional equity risk because the beneficiary or contractholder may receive a benefit that is greater than the current account value, which would be ceded to ALIC. GMDBs are payable upon death, while GMIBs are payable on or after the ten-year anniversary of the contract if the contractholder elects to receive a defined stream of payments ("annuitize"). GMABs are payable on a date that is pre-determined by the contractholder, between the eighth and twentieth year of the contract. GMABs guarantee a return of up to 2.5 times (or 250%) of the amount deposited in the contract, depending on the amount of time the contract is in force and adherence to certain fund allocations. All variable annuity contract charges and fees, liabilities and benefits, including the GMDBs, GMIBs and GMABs are ceded to ALIC in accordance with the reinsurance agreement, thereby limiting our equity risk exposure. CAPITAL RESOURCES AND LIQUIDITY CAPITAL RESOURCES consist of shareholder's equity. The following table summarizes our capital resources at December 31:
(IN THOUSANDS) 2003 2002 2001 ---------- ---------- ---------- Common stock, additional capital paid-in and retained income $ 202,748 $ 191,778 $ 186,870 Accumulated other comprehensive income 7,265 10,822 4,930 ---------- ---------- ---------- Total shareholder's equity $ 210,013 $ 202,600 $ 191,800 ========== ========== ==========
SHAREHOLDER'S EQUITY increased $7.4 million during the year ended December 31, 2003 when compared to December 31, 2002, due to net income of $7.4 million and a non-cash capital contribution of $3.6 million partially offset by a decrease in unrealized net capital gains of $3.6 million. Shareholder's equity increased during 2002, as well as 2001, due to net income of $4.9 million and $7.0 million, respectively, and an increase in unrealized net capital gains of $5.9 million and $2.8 million, respectively. FINANCIAL RATINGS AND STRENGTH We share the insurance financial strength ratings of our parent, ALIC, because business is reinsured to ALIC. Our insurance financial strength was rated Aa2, AA, and A+(r) by Moody's, Standard & Poor's and A.M. Best, respectively, at December 31, 2003. Our ratings are influenced by many factors including our operating and financial performance, asset quality, liquidity, asset/liability management, overall portfolio mix, the amount of financial leverage (i.e., debt), exposure to risks, as well as the current level of operating leverage. In February 2004, A.M. Best revised the outlook to stable from positive for the insurance financial strength ratings of ALIC and certain rated subsidiaries and affiliates. State laws specify regulatory actions if an insurer's risk-based capital ("RBC"), a measure of an insurer's solvency, falls below certain levels. The NAIC has a standard formula for assessing RBC. The formula for calculating RBC takes into account factors relating to insurance, business, asset and interest rate risks. At December 31, 2003, 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. 11 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONT.) LIQUIDITY SOURCES AND USES Our potential sources of funds principally include the following activities: Receipt of insurance premiums Contractholder fund deposits Reinsurance recoveries Receipts of principal and interest on investments Sales of investments Inter-company loans and tax refunds/settlements Capital contributions from parent Our potential uses of funds principally include the following activities: Payment of contract benefits, maturities, surrenders and withdrawals Reinsurance cessions and payments Operating costs and expenses Purchase of investments Repayment of inter-company loans Dividends to shareholder Under the terms of reinsurance agreements, all premiums and deposits, excluding those relating to variable contracts and those reinsured to non-affiliated reinsurers, are transferred to ALIC, which maintains the investment portfolios supporting our products. Payments of contractholder claims, benefits (including GMDBs, GMIBs and GMABs beginning in 2004), contract maturities, contract surrenders and withdrawals and certain operating costs (excluding investment-related expenses), are also reimbursed by ALIC, under the terms of the reinsurance agreements. We continue to have primary liability as a direct insurer for risks reinsured. Our ability to meet liquidity demands is dependent on ALIC's ability to meet those obligations under the reinsurance program. Our ability to pay dividends is dependent on business conditions, income, cash requirements and other relevant factors. The payment of shareholder dividends without the prior approval of the state insurance regulator is limited by Nebraska law to formula amounts based on statutory surplus and statutory net gain from operations, as well as the timing and amount of dividends paid in the preceding twelve months. The maximum amount of dividends that we can distribute during 2004 without prior approval of the Nebraska Department of Insurance is $20.0 million. We have entered into an intercompany loan agreement with the Corporation. The amount of funds available to us is at the discretion of the Corporation. The maximum amount of loans the Corporation will have outstanding to all its eligible subsidiaries at any given point in time is limited to $1.00 billion. No amounts were outstanding for the intercompany loan agreement at December 31, 2003 or 2002, respectively. The Corporation uses commercial paper borrowings and bank lines of credit to fund intercompany borrowings. Certain remote events and circumstances could constrain the Corporation's liquidity. Those events and circumstances include, for example, a catastrophe resulting in extraordinary losses, a downgrade in the Corporation's long-term debt rating of A1 and A+ (from Moody's and Standard & Poor's, respectively) to non-investment grade status of below Baa3/BBB-, a downgrade in AIC's financial strength rating from Aa2, AA and A+ (from Moody's, Standard & Poor's and A.M. Best, respectively) to below Baa/BBB/A-, or a downgrade in ALIC's or our financial strength ratings from Aa2, AA and A+ (from Moody's, Standard & Poor's and A.M. Best, respectively) to below Aa3/AA-/A-. The rating agencies also consider the interdependence of the Corporation's individually rated entities, and therefore, a rating change in one entity could potentially affect the ratings of other related entities. 12 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONT.) CONTRACTUAL OBLIGATIONS Our contractual obligations as of December 31, 2003 and the payments due by period are shown in the following table.
LESS THAN 1 1-3 4-5 OVER 5 (IN THOUSANDS) TOTAL YEAR YEARS YEARS YEARS ------------- ------------- ---------- ---------- ---------- Payout Annuities/Structured Settlements(1) $ 1,273,157 $ 117,942 338,062 $ 183,819 $ 633,334 Operating Leases 1,786 953 773 60 - ------------- ------------- ---------- ---------- ---------- Total Contractual Cash Obligations $ 1,274,943 $ 118,895 338,835 $ 183,879 $ 633,334 ============= ============= ========== ========== ==========
(1) ALIC closely manages the assets supporting payout annuities/structured settlement liabilities because they are ceded to ALIC under the terms of the reinsurance agreements. REGULATION AND LEGAL PROCEEDINGS REGULATION We are subject to changing social, economic and regulatory conditions. Recent state and federal regulatory initiatives and proceedings have included efforts to remove barriers preventing banks from engaging in the securities and insurance businesses, change tax laws affecting the taxation of insurance companies and the tax treatment of insurance products or competing non-insurance products that may impact the relative desirability of various personal investment products and otherwise expand overall regulation of insurance products and the insurance industry. The ultimate changes and eventual effects of these initiatives on our business, if any, are uncertain. LEGAL PROCEEDINGS We are involved in various legal and regulatory actions that could have an effect on specific aspects of our business. Like other members of the insurance industry, we are the target of an increasing number of lawsuits, some of which involve claims for substantial or indeterminate amounts. For a description of these actions, see Note 8 of the financial statements. PENDING ACCOUNTING STANDARDS As of December 31, 2003, there are several pending and proposed accounting standards that we have not implemented either because the standard has not been finalized or the implementation date has not yet occurred. These standards include Statement of Position 03-01 and Emerging Issues Task Force Topic number 03-01. For a discussion of these pending and proposed 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 and other factors we are unable to determine prior to implementation. For this reason, we are sometimes unable to estimate the effect of certain pending accounting standards until the relevant authoritative body finalizes these standards or until we implement them. FORWARD-LOOKING STATEMENTS AND RISK FACTORS This document contains "forward-looking statements" that anticipate results based on our estimates, assumptions and plans that are subject to uncertainty. These statements are made subject to the safe-harbor provisions of the Private Securities Litigation Reform Act of 1995. We assume no obligation to update any forward-looking statements as a result of new information or future events or developments. These forward-looking statements do not relate strictly to historical or current facts and may be identified by their use of words like "plans," "seeks," "expects," "will," "should," "anticipates," "estimates," "intends," "believes," "likely," "targets" and other words with similar meanings. These statements may address, among other things, our strategy for growth, product development, regulatory approvals, market position, expenses, financial results, litigation and reserves. We believe that these statements are based on reasonable estimates, assumptions and plans. However, if the estimates, assumptions or plans underlying the forward-looking statements prove inaccurate or if other risks or uncertainties arise, actual results could differ materially from those communicated in these forward-looking statements. Factors which could cause actual results to differ materially from those suggested by such forward-looking statements include but are not limited to those discussed or identified in this document (including the risks described below) and in our public filings with the SEC. In addition to the normal risks of business, we are subject to significant risks and uncertainties, including those listed below, which apply to us as an insurer and a provider of other financial services. 13 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONT.) RISKS RELATING TO THE COMPANY 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 and revise our estimates and if future experience differs from assumptions, adjustments to reserves may be required which could have a material adverse effect on our financial condition and operating results ceded to ALIC. CHANGES IN MARKET INTEREST RATES MAY LEAD TO A SIGNIFICANT DECREASE IN THE SALES AND PROFITABILITY OF SPREAD-BASED PRODUCTS CEDED TO ALIC ALIC's ability to manage the investment margin for spread-based products is dependent upon maintaining profitable spreads between investment yields and interest crediting rates on business ceded to ALIC. As interest rates decrease or remain at historically low levels, assets may be reinvested at lower yields, reducing investment margin. For example, during 2003 the average pre-tax investment yield on assets we retain declined to 6.1% from 6.4% in 2002. ALIC manages the spread on the business assumed from us. Our ability to lower interest crediting rates can offset decreases in investment margin on some products. However, these changes could be limited by market conditions, regulatory minimum rates or contractual minimum rate guarantees on many contracts and may not match the timing or magnitude of changes in asset yields. Decreases in the rates offered on products could make those products less attractive, leading to lower sales and/or changes in the level of surrenders and withdrawals for these products. Increases in market interest rates can also have negative effects on the business ceded to ALIC, for example by increasing the attractiveness of other investments, which can lead to higher surrenders at a time when its investment asset values are lower as a result of the increase in interest rates. Unanticipated surrenders could result in deferred policy acquisition costs ("DAC") unlocking or affect the recoverability of DAC and thereby increase expenses ceded to ALIC and reduce profitability of ALIC. DECLINING EQUITY MARKETS MAY REDUCE BOTH SALES OF PRODUCTS AND INCOME FROM CONTRACT CHARGES AND MAY ADVERSELY AFFECT OPERATING RESULTS AND FINANCIAL CONDITION OF ALIC Conditions in the United States and international stock markets affect our sales of variable annuities. Recent allegations of improper or illegal trading activities at large mutual fund complexes could affect the stock markets. In general, sales of variable annuities decrease when stock markets are declining over an extended period of time. The effect of decreasing separate accounts balances resulting from volatile equity markets, lower underlying fund performance or declining consumer confidence could cause contract charges earned and ceded to ALIC to decrease. In addition, it is possible that the assumptions and projections we use to establish prices for GMDB, GMIB and GMAB products, particularly assumptions and projections about investment performance, do not accurately reflect the level of costs that we will ultimately incur and cede to ALIC in providing those benefits, resulting in adverse margin trends that may have a material effect on ALIC's results of operations. These factors may result in accelerated DAC amortization at ALIC and require increases in reserves, which would reduce ALIC's statutory capital and surplus and/or net income. Poor fund performance could also result in higher partial withdrawals of account value which, for some contracts, do not reduce the GMDB by a proportional amount. CHANGES IN ESTIMATES OF PROFITABILITY ON INTEREST-SENSITIVE PRODUCTS MAY HAVE AN ADVERSE EFFECT ON RESULTS THROUGH INCREASED AMORTIZATION OF DAC FOR ALIC DAC related to interest-sensitive life, variable annuity and investment contracts is amortized in proportion to estimated gross profits over the estimated lives of the contracts. Assumptions underlying estimated gross profits, including those relating to margins from investment, mortality, contract administration, surrender and other contract charges, are updated from time to time in order to reflect actual and expected experience and its potential effect on the valuation of DAC. Updates to these assumptions could result in DAC unlocking, which in turn could adversely affect our operating results ceded to ALIC. 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 our sales. This risk may be heightened by the enactment of the Gramm-Leach-Bliley Act of 1999 (the "GLB Act"), which eliminated many federal and state law barriers to affiliations among banks, securities firms, insurers and other financial service providers. CHANGES IN TAX LAWS MAY DECREASE SALES AND PROFITABILITY OF PRODUCTS Under current federal and state income tax law, certain products (primarily life insurance and annuities) we offer receive favorable tax treatment. This favorable treatment may give certain of our products a competitive 14 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONT.) 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. One such proposal was enacted in May 2003 when President Bush signed the Jobs and Growth Tax Relief Reconciliation Act of 2003, which reduced the federal income tax rates applicable to certain dividends and capital gains realized by individuals. Legislation that increases the taxation on insurance products or reduces the taxation on competing products could lessen the advantage of certain of our products as compared to competing products. Such proposals, if adopted, could have an 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, recent changes in the federal estate tax laws have negatively affected the demand for the types of life insurance used in estate planning. RISKS RELATING TO THE INSURANCE INDUSTRY OUR FUTURE RESULTS ARE DEPENDENT IN PART ON OUR ABILITY TO SUCCESSFULLY OPERATE IN AN INSURANCE INDUSTRY THAT IS HIGHLY COMPETITIVE The insurance industry is highly competitive. Many of our competitors have well-established national reputations and market similar insurance products. Because of the competitive nature of the insurance industry, including competition for producers such as exclusive and independent agents, there can be no assurance that we will continue to effectively compete with our industry rivals, or that competitive pressure will not have a material adverse effect on our business, operating results or financial condition. In addition, we may face increased competition from banks. Until passage of the GLB Act, the ability of banks to engage in securities-related businesses was limited and banks were restricted from being affiliated with insurers. With the passage of the GLB Act, mergers that combine commercial banks, insurers and securities firms under one holding company are now permitted. 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. CHANGING INTEREST RATES AND DECLINES IN CREDIT QUALITY MAY HAVE ADVERSE EFFECTS A decline in market interest rates could have an adverse effect on our investment income as we invest cash in new investments that may yield less than the portfolio's average rate. In a declining interest rate environment, borrowers may prepay or redeem securities we hold more quickly than expected as they seek to refinance at lower rates. An increase in market interest rates could have an adverse effect on the value of our investment portfolio, for example, by decreasing the fair values of the fixed income securities that comprise a substantial majority of our investment portfolio. Increases in interest rates also may lead to an increase in 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. WE MAY SUFFER LOSSES FROM LITIGATION As is typical for an insurance company, we are involved in a substantial amount of litigation. Among other things, we, like other participants in the insurance industry, have been subject in recent years to an increasing volume of class action litigation challenging a range of industry practices. Our litigation exposure could result in a material adverse effect on our financial condition and operating results ceded to ALIC in a future period in the event of an unexpected adverse outcome or if additional reserves are required to be established for such litigation. For a description of our current material litigation matters, see Note 8 of the financial statements. WE ARE SUBJECT TO EXTENSIVE REGULATION AND POTENTIAL FURTHER RESTRICTIVE REGULATION MAY INCREASE OUR OPERATING COSTS AND LIMIT OUR GROWTH We are subject to extensive regulation by state insurance regulators. This regulation is focused on the protection of policyholders and not investors. In many cases, state regulations limit our ability to grow and improve the profitability of our business. The laws regulating securities products and activities are complex, numerous and subject to change. Further, in recent years, the state insurance regulatory framework has come under increased federal scrutiny, and proposals that would provide for optional federal chartering of insurance companies have been discussed by members of Congress. We can make no assurances as to whether further state or federal measures will be adopted to change the nature or scope of the regulation of the insurance industry or as to the effect that any such measures would have on us. 15 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONT.) THE UNAVAILABILITY OF REINSURANCE 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 external reinsurance or purchase new reinsurance protection in amounts that we consider sufficient and at prices that we consider acceptable, either ALIC would have to accept an increase in net liability exposure or we would have to reduce insurance writings. 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 ceded to ALIC and financial condition. THE CONTINUED THREAT OF TERRORISM AND ONGOING MILITARY ACTIONS MAY ADVERSELY AFFECT THE LEVEL OF CLAIM EXPENSE WE INCUR AND THE VALUE OF OUR INVESTMENT PORTFOLIO The continued threat of terrorism, both within the United States and abroad, and ongoing military and other actions and heightened security measures in response to these types of threats, may cause significant volatility and declines in the equity markets in the United States, Europe and elsewhere, and result in loss of life, property damage, additional disruptions to commerce and reduced economic activity. Some of the assets in our investment portfolio may be adversely affected by declines in the equity markets and reduced economic activity caused by the continued threat of terrorism. In the event that a terrorist act occurs, we may be adversely affected, depending on the nature of the event. ANY DECREASE IN OUR FINANCIAL STRENGTH RATINGS MAY HAVE AN ADVERSE EFFECT ON OUR COMPETITIVE POSITION Financial strength ratings are important factors in establishing the competitive position of insurance companies and generally will 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 decline in the value of an insurer's investment portfolio or increased liabilities for variable contracts arising from additional GMDB, GMIB or GMAB exposure resulting from market declines. Currently, the insurance financial strength ratings of the Corporation, AIC and ALIC are Aa2, AA and A+ (from Moody's, Standard & Poor's and A.M. Best, respectively). Because these ratings are subject to periodic review, the continued retention of these ratings cannot be assured. A multiple level downgrade in the ratings of the Corporation, AIC or ALIC could have a material adverse effect on our sales, including the competitiveness and marketability of our product offerings, as well as our liquidity, financial condition and operating results ceded to ALIC. CHANGES IN ACCOUNTING STANDARDS ISSUED BY THE FASB OR OTHER STANDARD-SETTING BODIES MAY ADVERSELY AFFECT OUR FINANCIAL STATEMENTS Our financial statements are subject to the application of GAAP, which is periodically revised and/or expanded. Accordingly, we are required to adopt new or revised accounting standards issued from time to time by recognized authoritative bodies, including the Financial Accounting Standards Board (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 financial condition and results ceded to ALIC. For a description of potential changes in accounting standards that could affect us currently, see Note 2 of the financial statements. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Incorporated in this Item 7a by reference to the "Management's Discussion and Analysis of Financial Condition and Results of Operations" Item 7. 16 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA LINCOLN BENEFIT LIFE COMPANY STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME
YEAR ENDED DECEMBER 31, ------------------------------------ (IN THOUSANDS) 2003 2002 2001 ---------- ---------- ---------- REVENUES Net investment income $ 11,434 $ 11,621 $ 12,144 Realized capital gains and losses 73 (4,084) (1,352) ---------- ---------- ---------- INCOME FROM OPERATIONS BEFORE INCOME TAX EXPENSE 11,507 7,537 10,792 Income tax expense 4,092 2,629 3,768 ---------- ---------- ---------- NET INCOME 7,415 4,908 7,024 ---------- ---------- ---------- OTHER COMPREHENSIVE (LOSS) INCOME, AFTER-TAX Change in unrealized net capital gains and losses (3,557) 5,892 2,818 ---------- ---------- ---------- COMPREHENSIVE INCOME $ 3,858 $ 10,800 $ 9,842 ========== ========== ==========
See notes to financial statements. 17 LINCOLN BENEFIT LIFE COMPANY STATEMENTS OF FINANCIAL POSITION
DECEMBER 31, ------------------------------ (IN THOUSANDS, EXCEPT PAR VALUE DATA) 2003 2002 -------------- ------------- ASSETS Investments Fixed income securities, at fair value (amortized cost $197,942 and $182,757) $ 209,118 $ 199,406 Short-term 1,107 3,201 -------------- ------------- Total investments 210,225 202,607 Cash 23,456 130,249 Reinsurance recoverable from Allstate Life Insurance Company, net 14,594,260 12,178,831 Reinsurance recoverable from non-affiliates, net 692,971 569,569 Current income taxes receivable 1,428 111 Other assets 69,968 56,325 Separate accounts 1,911,619 1,413,221 -------------- ------------- TOTAL ASSETS $ 17,503,927 $ 14,550,913 ============== ============= LIABILITIES Contractholder funds $ 13,802,815 $ 11,658,966 Reserve for life-contingent contract benefits 1,476,314 1,082,690 Unearned premiums 19,974 14,280 Deferred income taxes 4,172 4,587 Payable to affiliates, net 23,332 116,720 Other liabilities and accrued expenses 55,688 57,849 Separate accounts 1,911,619 1,413,221 -------------- ------------- TOTAL LIABILITIES 17,293,914 14,348,313 -------------- ------------- COMMITMENTS AND CONTINGENT LIABILITIES (NOTE 8) SHAREHOLDER'S EQUITY Common stock, $100 par value, 30 thousand shares authorized, 25 thousand shares issued and outstanding 2,500 2,500 Additional capital paid-in 130,305 126,750 Retained income 69,943 62,528 Accumulated other comprehensive income: Unrealized net capital gains and losses 7,265 10,822 -------------- ------------- Total accumulated other comprehensive income 7,265 10,822 -------------- ------------- TOTAL SHAREHOLDER'S EQUITY 210,013 202,600 -------------- ------------- TOTAL LIABILITIES AND SHAREHOLDER'S EQUITY $ 17,503,927 $ 14,550,913 ============== =============
See notes to financial statements. 18 LINCOLN BENEFIT LIFE COMPANY STATEMENTS OF SHAREHOLDER'S EQUITY
YEAR ENDED DECEMBER 31, --------------------------------------------- (IN THOUSANDS) 2003 2002 2001 ------------- ------------- ------------- COMMON STOCK $ 2,500 $ 2,500 $ 2,500 ------------- ------------- ------------- ADDITIONAL CAPITAL PAID-IN Balance, beginning of year 126,750 126,750 126,750 Capital contribution 3,555 -- -- ------------- ------------- ------------- Balance, end of year 130,305 126,750 126,750 ------------- ------------- ------------- RETAINED INCOME Balance, beginning of year 62,528 57,620 50,596 Net income 7,415 4,908 7,024 ------------- ------------- ------------- Balance, end of year 69,943 62,528 57,620 ------------- ------------- ------------- ACCUMULATED OTHER COMPREHENSIVE INCOME Balance, beginning of year 10,822 4,930 2,112 Change in unrealized net capital gains and losses (3,557) 5,892 2,818 ------------- ------------- ------------- Balance, end of year 7,265 10,822 4,930 ------------- ------------- ------------- TOTAL SHAREHOLDER'S EQUITY $ 210,013 $ 202,600 $ 191,800 ============= ============= =============
See notes to financial statements. 19 LINCOLN BENEFIT LIFE COMPANY STATEMENTS OF CASH FLOWS
YEAR ENDED DECEMBER 31, --------------------------------------------- (IN THOUSANDS) 2003 2002 2001 ------------- ------------- ------------- CASH FLOWS FROM OPERATING ACTIVITIES Net income $ 7,415 $ 4,908 $ 7,024 Adjustments to reconcile net income to net cash provided by operating activities: Amortization and other non-cash items 2 (204) (531) Realized capital gains and losses (73) 4,084 1,352 Changes in: Life-contingent contract benefits and contractholder funds, net of reinsurance recoverables (1,358) 4,255 511 Income taxes 184 (5,332) 922 Payable to affiliates, net (89,833) 97,527 (25,138) Other operating assets and liabilities (10,111) (15,031) 68,347 ------------- ------------- ------------- Net cash (used in) provided by operating activities (93,774) 90,207 52,487 ------------- ------------- ------------- CASH FLOWS FROM INVESTING ACTIVITIES Fixed income securities Proceeds from sales 19,930 16,847 10,922 Investment collections 32,686 22,010 15,346 Investments purchases (67,729) (46,266) (39,422) Change in short-term investments 2,094 3,655 4,387 ------------- ------------- ------------- Net cash used in investing activities (13,019) (3,754) (8,767) ------------- ------------- ------------- NET (DECREASE) INCREASE IN CASH (106,793) 86,453 43,720 CASH AT BEGINNING OF YEAR 130,249 43,796 76 ------------- ------------- ------------- CASH AT END OF YEAR $ 23,456 $ 130,249 $ 43,796 ============= ============= =============
See notes to financial statements. 20 LINCOLN BENEFIT LIFE COMPANY NOTES TO FINANCIAL STATEMENTS 1. GENERAL BASIS OF PRESENTATION The accompanying financial statements include the accounts of Lincoln Benefit Life Company ("Lincoln Benefit" or 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 2003 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 mission of Lincoln Benefit is to assist financial services professionals in meeting their customers' financial protection, savings and retirement needs by providing top-tier products delivered with reliable and efficient service. The Company's product line includes a wide variety of financial protection, savings and retirement products aimed at serving the financial needs of the Company's customers. Products include traditional life, interest-sensitive life, variable life and long-term care insurance, and both variable and fixed annuities. Products are sold through a variety of distribution channels including Allstate exclusive agencies, independent agents (including master brokerage agencies) and broker/dealers. Although the Company currently benefits from agreements with financial services entities that market and distribute its products, change in control or other factors affecting these non-affiliated entities with which the Company has distribution agreements could negatively impact the Company's sales. The Company is authorized to sell life insurance and investment products in all states except New York, as well as in the District of Columbia, Guam and the U.S. Virgin Islands. For 2003, the top geographic locations for statutory premiums and annuity considerations for the Company were California, Florida, Texas and Pennsylvania. No other jurisdiction accounted for more than 5% of statutory premiums and annuity considerations. All statutory premiums and annuity considerations are ceded under reinsurance agreements. The Company monitors economic and regulatory developments that have the potential to impact its business. Federal legislation has allowed banks and other financial organizations to have greater participation in the securities and insurance businesses. This legislation may present an increased level of competition for sales of the Company's products. Furthermore, state and federal laws and regulations affect the taxation of insurance companies and life insurance and annuity products. Congress and various state legislatures have considered proposals that, if enacted, could impose a greater tax burden on the Company or could have an adverse impact on the tax treatment of some insurance products offered by the Company, including favorable policyholder tax treatment currently applicable to life insurance and annuities. Recent 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. In addition, recent changes in the federal estate tax laws have negatively affected the demand for the types of life insurance used in estate planning. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES INVESTMENTS Fixed income securities include bonds, asset-backed and mortgage-backed securities. Fixed income securities are carried at fair value and may be sold prior to their contractual maturity ("available for sale"). The fair value of publicly traded fixed income securities is based upon independent market quotations. 21 LINCOLN BENEFIT LIFE COMPANY NOTES TO FINANCIAL STATEMENTS Periodic changes in fair values, net of deferred income taxes, are reflected as a component of other comprehensive income. Short-term investments are carried at cost or amortized cost, which approximates fair value. Investment income consists of interest and is recognized on an accrual basis. Interest income on mortgage-backed and asset-backed securities is determined using the effective yield method, based on estimated principal repayments. Accrual of income is suspended for fixed income securities 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, and write-downs in value due to other than temporary declines in fair value. Realized capital gains and losses on investment dispositions are determined on a specific identification basis. The Company writes down, to fair value, any fixed income security that is classified as other than temporarily impaired in the period the security is deemed to be other than temporarily impaired. RECOGNITION OF PREMIUM REVENUES AND CONTRACT CHARGES, AND RELATED BENEFITS AND INTEREST CREDITED The Company has reinsurance agreements whereby all premiums, contract charges, interest credited to contractholder funds, contract benefits and certain expenses are ceded to ALIC and non-affiliated reinsurers (see Notes 3 and 7). These amounts are reflected net of such reinsurance in the Statements of Operations and Comprehensive Income. Traditional life insurance products consist principally of products with fixed and guaranteed premiums and benefits, primarily term and whole life insurance products. Premiums from these products are recognized as revenue when due. Benefits are recognized in relation to such revenue so as to result in the recognition of profits over the life of the policy and are reflected in contract benefits. Immediate annuities with life contingencies, including certain structured settlement annuities, provide insurance protection over a period that extends beyond the period during which premiums are collected. Gross premiums in excess of the net premium on immediate annuities with life contingencies are deferred and recognized over the contract period. Contract benefits are recognized in relation to such revenue so as to result in the recognition of profits over the life of the policy. 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, market value adjusted annuities, equity-indexed annuities, and immediate annuities without life contingencies are considered investment contracts. Deposits received for such contracts are reported as contractholder funds deposits. Contract charges for investment contracts consist of fees assessed against the contractholder account balance for contract administration and early surrender. These revenues are recognized when assessed against the contractholder account balance. Interest credited to contractholder funds represents interest accrued or paid for interest-sensitive life contracts and investment contracts. Crediting rates for certain fixed rate annuities and interest-sensitive life contracts are adjusted periodically by the Company to reflect current market conditions subject to contractually guaranteed minimum rates. Crediting rates for indexed annuities and indexed life products are based on a specified interest rate index, such as LIBOR or an equity index, such as the S&P 500. Separate accounts products include variable annuities and variable life insurance contracts. The assets supporting these products are legally segregated and available only to settle separate accounts contract obligations. Deposits received are reported as separate accounts liabilities. Contract charges for these products consist of fees assessed against the contractholder account values for contract maintenance, 22 LINCOLN BENEFIT LIFE COMPANY NOTES TO FINANCIAL STATEMENTS administration, mortality, expense and early surrender. Contract benefits incurred include guaranteed minimum death benefits paid on variable annuity contracts. REINSURANCE RECOVERABLE The Company has reinsurance agreements whereby the Company cedes 90%, 80% or 60% of the mortality risk on certain life policies, depending upon the issue year and product, to a pool of thirteen non-affiliated reinsurers. The remaining amounts are ceded to ALIC. Beginning in 1998, the Company cedes mortality risk on new business in excess of $2 million per life for individual coverage. For business sold prior to 1998, the Company ceded mortality risk in excess of $350 thousand per life for individual coverage. Reinsurance recoverable 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 the risks reinsured. Investment income earned on the assets which support contractholder funds and the reserve for life-contingent contract benefits is not included in the Company's financial statements as those assets are owned and managed by ALIC under terms of reinsurance agreements. 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 certain investments and differences in the tax bases of investments. A deferred tax asset valuation allowance is established when there is uncertainty that such assets would be realized. SEPARATE ACCOUNTS The Company issues variable annuities and variable life insurance contracts, the assets and liabilities of which are legally segregated and recorded as assets and liabilities of the separate accounts. The assets of the separate accounts are carried at fair value. Separate accounts liabilities represent the contractholders' claims to the related assets and are carried at the fair value of the assets. Investment income and realized capital gains and losses of the separate accounts accrue directly to the contractholders and therefore, are not included in the Company's Statements of Operations and Comprehensive Income. Revenues to the Company from the separate accounts consist of contract charges for maintenance and administration services, mortality, early surrender and expenses, which are ceded to ALIC. Deposits to the separate accounts are not included in the Statements of Cash Flows. Absent any contract provision wherein the Company guarantees either a minimum return or account value upon death 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 risk and associated cost of these contract guarantees are ceded to ALIC in accordance with the reinsurance agreements. RESERVE FOR LIFE-CONTINGENT CONTRACT BENEFITS The reserve for life-contingent contract benefits, which relates to traditional life insurance and immediate annuities with life contingencies, is computed on the basis of long-term actuarial assumptions as to future investment yields, mortality, morbidity, terminations and expenses. These assumptions, which for traditional life insurance are applied using the net level premium method, include provisions for adverse deviation and generally vary by such characteristics as type of coverage, year of issue and policy duration. Detailed reserve assumptions and reserve interest rates are outlined in Note 6. CONTRACTHOLDER FUNDS Contractholder funds arise from the issuance of interest-sensitive life insurance policies and investment contracts. Deposits received are recorded as interest-bearing liabilities. Contractholder funds are equal to deposits received and interest credited to the benefit of the contractholder less surrenders and withdrawals, mortality charges and administrative expenses. Detailed information on crediting rates and surrender and withdrawal provisions on contractholder funds is outlined in Note 6. 23 LINCOLN BENEFIT LIFE COMPANY NOTES TO FINANCIAL STATEMENTS PENDING ACCOUNTING STANDARDS STATEMENT OF POSITION 03-01, "ACCOUNTING AND REPORTING BY INSURANCE ENTERPRISES FOR CERTAIN NONTRADITIONAL LONG-DURATION CONTRACTS AND FOR SEPARATE ACCOUNTS" ("SOP NO. 03-01") In July 2003, the American Institute of Certified Public Accountants issued SOP 03-01 which applies to several of the Company's insurance products and product features. The effective date of the SOP is for fiscal years beginning after December 15, 2003. A provision of the SOP requires the establishment of reserves in addition to the account balance for contracts containing certain features that provide guaranteed death or other insurance benefits and guaranteed income benefits. These reserves are not currently established by the Company. When established, these reserves will be ceded to ALIC under the terms of the reinsurance agreements. PROPOSED ACCOUNTING STANDARDS EMERGING ISSUES TASK FORCE TOPIC NO. 03-01, "THE MEANING OF OTHER-THAN-TEMPORARY IMPAIRMENT AND ITS APPLICATION TO CERTAIN INVESTMENTS" ("EITF NO. 03-01") The Emerging Issues Task Force ("EITF") is currently deliberating EITF No. 03-01, which attempts to define other-than-temporary impairment and highlight its application to investment securities accounted for under both SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities" ("SFAS No. 115") and Accounting Principles Board Opinion No. 18, "The Equity Method of Accounting for Investments in Common Stocks"("APB No. 18"). The current issue summary, which has yet to be finalized, proposes that if, at the evaluation date, the fair value of an investment security is less than its carrying value then an impairment exists for which a determination must be made as to whether the impairment is other-than-temporary. If it is determined that an impairment is other-than-temporary, then an impairment loss should be recognized equal to the difference between the investment's carrying value and its fair value at the reporting date. In recent deliberations, the EITF discussed different models to assess whether impairment is other-than-temporary for different types of investments (e.g. SFAS No. 115 marketable equity securities, SFAS No. 115 debt securities, and equity and cost method investments subject to APB No. 18) and subsequently decided to use a unified model. Due to the uncertainty of the final model (or models) that may be adopted, the estimated impact to the Company's Statements of Operations and Comprehensive Income and Financial Position is presently not determinable. In November 2003, the EITF reached a consensus with respect to certain disclosures effective for fiscal years ending after December 15, 2003. Quantitative and qualitative disclosures are required for fixed income and marketable equity securities classified as available-for-sale or held-to-maturity under SFAS No. 115. The Company has included those disclosures at December 31, 2003 (see Note 4). 3. RELATED PARTY TRANSACTIONS BUSINESS OPERATIONS The Company utilizes services provided by its affiliates, AIC, ALIC and Allstate Investments LLC, and business facilities owned or leased and operated by AIC in conducting its business activities. In addition, the Company shares the services of employees with AIC. The Company reimburses its affiliates for the operating expenses incurred on behalf of the Company. The Company is charged for the cost of these operating expenses based on the level of services provided. Operating expenses, including compensation and retirement and other benefit programs, allocated to the Company were $112.6 million, $67.4 million and $70.0 million in 2003, 2002 and 2001, respectively. Of these costs, the Company retains investment related expenses on the invested assets of the Company. All other costs are ceded to ALIC under reinsurance agreements. BROKER/DEALER SERVICES The Company receives underwriting and distribution services from Allstate Financial Services, LLC ("AFS"), an affiliated broker/dealer company, for certain variable annuity and variable life insurance contracts sold by Allstate exclusive agencies. The Company recorded commission expense for these services of $35.9 million, $33.0 million and $25.8 million for the years ended December 31, 2003, 2002 and 2001, respectively, that was ceded to ALIC under the terms of the reinsurance agreements. During 2003, the Company entered into a service agreement with Allstate Distributors, LLC 24 LINCOLN BENEFIT LIFE COMPANY NOTES TO FINANCIAL STATEMENTS ("ADLLC"), a broker/dealer affiliate of the Company, whereby ADLLC promotes and markets the fixed and variable annuities sold by the Company to unaffiliated financial services firms. In addition, ADLLC acts as the underwriter of variable annuities sold by the Company. In return for these services, the Company recorded commission expense of $138 thousand for the year ended December 31, 2003 that was ceded to ALIC under the terms of the reinsurance agreements. REINSURANCE The following table summarizes amounts that were ceded to ALIC under reinsurance agreements:
YEAR ENDED DECEMBER 31, --------------------------------------------- (IN THOUSANDS) 2003 2002 2001 ------------- ------------- ------------- Premiums and contract charges $ 546,741 $ 484,684 $ 330,799 Interest credited to contractholder funds, contract benefits and certain expenses 1,272,290 1,012,038 728,750
STRUCTURED SETTLEMENT OBLIGATIONS The Company received premiums of $3.2 million, $19.1 million and $1.5 million from AIC in 2003, 2002 and 2001, respectively, to assume certain structured settlement obligations at prices determined based upon interest rates in effect at the time of purchase. The Company subsequently ceded these premiums to ALIC under the terms of its reinsurance agreements. CAPITAL CONTRIBUTION During the third quarter of 2003, the Executive Committee of ALIC authorized the forgiveness of $3.6 million of intercompany debt that the Company owed to ALIC. This transaction was recognized as a non-cash capital contribution and reflected in additional capital paid-in on the Statements of Financial Position. INCOME TAXES The Company is a party to a federal income tax allocation agreement with the Corporation (Note 9). DEBT The Company has entered into an intercompany loan agreement with the Corporation. The amount of funds available to the Company at a given point in time is dependent upon the debt position of the Corporation. No amounts were outstanding for the Company under the intercompany loan agreement during the three years ended December 31, 2003. 25 LINCOLN BENEFIT LIFE COMPANY NOTES TO FINANCIAL STATEMENTS 4. 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, 2003 U.S. government and agencies $ 65,632 $ 5,448 $ (376) $ 70,704 Corporate 77,283 4,985 (892) 81,376 Municipal 503 68 - 571 Asset-backed securities 14,203 1,240 - 15,443 Mortgage-backed securities 40,321 1,015 (312) 41,024 -------------- -------------- -------------- -------------- Total fixed income securities $ 197,942 $ 12,756 $ (1,580) $ 209,118 ============== ============== ============== ============== AT DECEMBER 31, 2002 U.S. government and agencies $ 57,672 $ 6,730 $ - $ 64,402 Corporate 77,697 6,421 (38) 84,080 Municipal 504 63 - 567 Asset-backed securities 14,246 1,350 - 15,596 Mortgage-backed securities 31,637 2,104 - 33,741 Foreign government 1,001 19 - 1,020 -------------- -------------- -------------- -------------- Total fixed income securities $ 182,757 $ 16,687 $ (38) $ 199,406 ============== ============== ============== ==============
SCHEDULED MATURITIES The scheduled maturities for fixed income securities are as follows at December 31, 2003:
AMORTIZED FAIR (IN THOUSANDS) COST VALUE ---------- ---------- Due in one year or less $ 10,819 $ 11,142 Due after one year through five years 44,384 47,787 Due after five years through ten years 69,547 72,851 Due after ten years 18,668 20,871 ---------- ---------- 143,418 152,651 Mortgage and asset-backed securities 54,524 56,467 ---------- ---------- Total $ 197,942 $ 209,118 ========== ==========
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. NET INVESTMENT INCOME Net investment income for the years ended December 31 is as follows:
(IN THOUSANDS) 2003 2002 2001 ------------- ------------- ------------- Fixed income securities $ 11,324 $ 11,665 $ 11,959 Short-term investments 384 273 598 ------------- ------------- ------------- Investment income, before expense 11,708 11,938 12,557 Investment expense 274 317 413 ------------- ------------- ------------- Net investment income $ 11,434 $ 11,621 $ 12,144 ============= ============= =============
26 LINCOLN BENEFIT LIFE COMPANY NOTES TO FINANCIAL STATEMENTS 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) 2003 2002 2001 ------------- ------------- ------------- Fixed income securities $ 73 $ (4,084) $ (1,352) Income tax (expense) benefit (26) 1,429 473 ------------- ------------- ------------- Realized capital gains and losses, after-tax $ 47 $ (2,655) $ (879) ============= ============= =============
Realized capital gains and losses by transaction type for the years ended December 31 are as follows:
(IN THOUSANDS) 2003 2002 2001 ------------- ------------- ------------- Write-downs in value $ - $ (4,323) $ - Sales - fixed income securities 73 239 (1,352) ------------- ------------- ------------- Realized capital gains and losses 73 (4,084) (1,352) Income tax (expense) benefit (26) 1,429 473 ------------- ------------- ------------- Realized capital gains and losses, after-tax $ 47 $ (2,655) $ (879) ============= ============= =============
Excluding the effects of calls and prepayments, gross gains of $289 thousand, $471 thousand and $123 thousand and gross losses of $216 thousand, $232 thousand and $1.5 million were realized on sales of fixed income securities during 2003, 2002 and 2001, respectively. UNREALIZED NET CAPITAL GAINS AND LOSSES Unrealized net capital gains and losses on fixed income securities included in accumulated other comprehensive income at December 31, 2003 are as follows:
GROSS UNREALIZED FAIR ------------------------------- UNREALIZED (IN THOUSANDS) VALUE GAINS LOSSES NET GAINS -------------- -------------- -------------- -------------- Fixed income securities $ 209,118 $ 12,756 $ (1,580) $ 11,176 Deferred income taxes (3,911) -------------- Unrealized net capital gains and losses $ 7,265 ==============
CHANGE IN UNREALIZED NET CAPITAL GAINS AND LOSSES Change in unrealized net capital gains and losses for the years ended December 31 is as follows:
(IN THOUSANDS) 2003 2002 2001 ------------- ------------- ------------- Fixed income securities $ (5,473) $ 9,064 $ 4,336 Deferred income taxes 1,916 (3,172) (1,518) ------------- ------------- ------------- (Decrease) increase in unrealized net capital gains and losses $ (3,557) $ 5,892 $ 2,818 ============= ============= =============
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. 27 LINCOLN BENEFIT LIFE COMPANY NOTES TO FINANCIAL STATEMENTS At December 31, 2003, the Company has unrealized losses of $1.6 million which relate to 22 holdings of fixed income securities with a fair value of $44.1 million, all of which are investment grade and which have been in an unrealized loss position for a period less than 12 months. Investment grade is defined as a security having a rating from the National Association of Insurance Commissioners ("NAIC") of 1 or 2; a Moody's rating of Aaa, Aa, A or Baa; a Standard & Poor's ("S&P") rating of AAA, AA, A or BBB; or a comparable internal rating. Unrealized losses on investment grade securities are principally related to changes in interest rates or changes in issuer and sector related credit spreads since the securities were acquired. As of December 31, 2003, the Company has the intent and ability to hold these investments for a period of time sufficient for them to recover in value. SECURITIES ON DEPOSIT At December 31, 2003, fixed income securities with a carrying value of $9.9 million were on deposit with regulatory authorities as required by law. 5. FINANCIAL INSTRUMENTS In the normal course of business, the Company invests in various financial assets and incurs various financial liabilities. 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 reinsurance recoverables, net) and liabilities (including reserve for life-contingent contract benefits and deferred income taxes) are not considered financial instruments and are not carried at fair value. Other assets and liabilities considered financial instruments, such as accrued investment income and cash, are generally of a short-term nature. Their carrying values are deemed to approximate fair value. FINANCIAL ASSETS
DECEMBER 31, 2003 DECEMBER 31, 2002 ------------------------- -------------------------- CARRYING FAIR CARRYING FAIR (IN THOUSANDS) VALUE VALUE VALUE VALUE ----------- ----------- ----------- ------------ Fixed income securities $ 209,118 $ 209,118 $ 199,406 $ 199,406 Short-term investments 1,107 1,107 3,201 3,201 Separate accounts 1,911,619 1,911,619 1,413,221 1,413,221
Fair values of publicly traded fixed income securities are based upon quoted market prices or dealer quotes. Short-term investments are highly liquid investments with maturities of less than one year whose carrying values are deemed to approximate fair value. Separate accounts assets are carried in the Statements of Financial Position at fair value based on quoted market prices. FINANCIAL LIABILITIES
DECEMBER 31, 2003 DECEMBER 31, 2002 --------------------------- ------------------------- CARRYING FAIR CARRYING FAIR (IN THOUSANDS) VALUE VALUE VALUE VALUE ------------ ------------ ----------- ----------- Contractholder funds on investment contracts $ 11,646,022 $ 11,201,101 $ 9,702,733 $ 9,445,862 Separate accounts 1,911,619 1,911,619 1,413,221 1,413,221
Contractholder funds include interest-sensitive life insurance contracts and investment contracts. Interest-sensitive life insurance contracts are not considered financial instruments subject to fair value disclosure requirements. The fair value of investment contracts is based on the terms of the underlying contracts. Fixed annuities are valued at the account balance less surrender charges and immediate annuities without life contingencies are valued at the present value of future benefits at current interest rates. Market value adjusted annuities' fair value is estimated to be the market adjusted surrender value. Equity-indexed annuity contracts' fair value approximates carrying value since the embedded equity options are carried at market value in the financial statements. Separate accounts liabilities are carried at the fair value of the underlying assets. 28 LINCOLN BENEFIT LIFE COMPANY NOTES TO FINANCIAL STATEMENTS OFF-BALANCE-SHEET FINANCIAL INSTRUMENTS There were no off-balance-sheet financial instruments at December 31, 2003 or 2002. 6. 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) 2003 2002 ------------ ------------ Immediate annuities: Structured settlement annuities $ 600,275 $ 384,419 Other immediate annuities 74,524 32,872 Traditional life 642,126 569,500 Other 159,389 95,899 ------------ ------------ Total reserve for life-contingent contract benefits $ 1,476,314 $ 1,082,690 ============ ============
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 annuities U.S. population with Interest rate assumptions Present value of projected calendar year range from 5.5% - 7.5% contractually specified improvements; age future benefits setbacks for impaired lives grading to standard Other immediate annuities 1983 group annuity Interest rate assumptions Present value of mortality table range from 3.0% - 8.8% expected future benefits based on historical experience Traditional life Actual company experience Interest rate assumptions Net level premium plus loading range from 4.0% - 8.0% reserve method using the Company's withdrawal experience rates Other Actual company experience Net level premium plus loading reserve method using the Company's withdrawal experience rates
At December 31, contractholder funds consists of the following:
(IN THOUSANDS) 2003 2002 ------------- ------------- Interest-sensitive life $ 2,177,330 $ 2,014,313 Investment contracts: Immediate annuities 356,620 286,722 Fixed annuities 11,268,865 9,357,931 ------------- ------------- Total contractholder funds $ 13,802,815 $ 11,658,966 ============= =============
29 LINCOLN BENEFIT LIFE COMPANY NOTES TO FINANCIAL STATEMENTS The following table highlights the key contract provisions relating to contractholder funds:
PRODUCT INTEREST RATE WITHDRAWAL/SURRENDER CHARGES ------------------------- -------------------------- --------------------------------- Interest-sensitive life Interest rates credited Either a percentage of account range from 2.0% - 6.0% balance or dollar amount grading off generally over 20 years Investment contracts Interest rates credited Either a declining or a level range from 2.8% to 6.0% percentage charge generally over for immediate annuities nine years or less. Additionally, and 0.0% - 15.5% for fixed approximately 50.7% of fixed annuities (which include annuities are subject to market equity-indexed annuities value adjustment for whose returns are indexed discretionary withdrawals. to the S&P 500)
Contractholder funds activity for the years ended December 31 is as follows:
(IN THOUSANDS) 2003 2002 -------------- ------------- Balance, beginning of year $ 11,658,966 $ 9,287,599 Deposits 2,678,157 2,868,550 Benefits and withdrawals (1,022,329) (829,169) Interest credited to contractholder funds 654,439 524,477 Transfers (to) from Separate accounts (64,084) (61,537) Contract charges (135,376) (114,906) Other adjustments 33,042 (16,048) -------------- ------------- Balance, end of year $ 13,802,815 $ 11,658,966 ============== =============
7. REINSURANCE The Company has entered into reinsurance agreements under which it reinsures all of its business to ALIC or other non-affiliated reinsurers. Under the agreements, premiums, contract charges, interest credited to contractholder funds, contract benefits and certain expenses are reinsured. The Company purchases reinsurance to limit aggregate and single losses on large risks. The Company continues to have primary liability as the direct insurer for risks reinsured. Estimating the amount of reinsurance recoverable is impacted by many of the uncertainties involved in the establishment of loss reserves. The Company cedes a portion of the mortality risk on certain life policies with a pool of thirteen non-affiliated reinsurers. Amounts recoverable from reinsurers are estimated based upon assumptions consistent with those used in establishing the liabilities related to the underlying reinsured contracts. Except for ALIC, no single reinsurer had a material obligation to the Company. The effects of reinsurance on premiums and contract charges for the years ended December 31 are as follows:
(IN THOUSANDS) 2003 2002 2001 ----------- ---------- ----------- PREMIUMS AND CONTRACT CHARGES Direct $ 870,257 $ 689,970 $ 572,949 Assumed 2 2 4 Ceded: Affiliate (546,741) (484,684) (330,799) Non-affiliate (323,518) (205,288) (242,154) ----------- ---------- ----------- Premiums and contract charges, net of reinsurance $ - $ - $ - =========== ========== ===========
30 LINCOLN BENEFIT LIFE COMPANY NOTES TO FINANCIAL STATEMENTS The effects of reinsurance on interest credited to contractholder funds, contract benefits and certain expenses for the years ended December 31 are as follows:
(IN THOUSANDS) 2003 2002 2001 ------------ ------------ ------------ INTEREST CREDITED TO CONTRACTHOLDER FUNDS, CONTRACT BENEFITS AND CERTAIN EXPENSES Direct $ 1,602,127 $ 1,343,929 $ 1,007,684 Assumed 202 - - Ceded: Affiliate (1,272,290) (1,012,038) (728,750) Non-affiliate (330,039) (331,891) (278,934) ------------ ------------ ------------ Interest credited to contractholder funds, contract benefits and certain expenses, net of reinsurance $ - $ - $ - ============ ============ ============
8. COMMITMENTS, GUARANTEES AND CONTINGENT LIABILITIES LEASES The Company leases certain office facilities and computer equipment. Total rent expense for all leases was $879 thousand, $1.1 million and $1.1 million in 2003, 2002 and 2001, respectively, and was ceded to ALIC under the terms of the reinsurance agreements. Minimum rental commitments under operating leases with an initial or remaining term of more than one year as of December 31, 2003 are as follows:
OPERATING (IN THOUSANDS) LEASES ----------- 2004 $ 953 2005 657 2006 116 2007 56 2008 4 Thereafter - ----------- $ 1,786 ===========
GUARANTEES The Company has issued universal life insurance contracts to third parties who finance the premium payments on the universal life insurance contracts through a commercial paper program. The Company has issued a repayment guarantee on the outstanding commercial paper balance that is fully collateralized by the cash surrender value of the universal life insurance contracts. At December 31, 2003, the amount due under the commercial paper program is $300 million and the cash surrender value of the policies is $306 million. The repayment guarantee expires April 30, 2006. These contracts are ceded to ALIC under the terms of the reinsurance agreements. In the normal course of business, the Company provides standard indemnifications to counterparties in contracts in connection with numerous transactions, including 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. Because the obligated amounts of the indemnifications are not explicitly stated in many cases, 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. In addition, the Company indemnifies its directors, officers and other individuals serving at the request 31 LINCOLN BENEFIT LIFE COMPANY NOTES TO FINANCIAL STATEMENTS of the Company as a director or officer to the extent provided in its charter and by-laws. Since these indemnifications are generally not subject to limitation with respect to duration or amount, the Company does not believe that it is possible to determine the maximum potential amount due under these indemnifications. The aggregate liability balance related to all guarantees was not material as of December 31, 2003. REGULATION The Company is subject to changing social, economic and regulatory conditions. Recent state and federal regulatory initiatives and proceedings have included efforts to remove barriers preventing banks from engaging in the securities and insurance businesses, change tax laws affecting the taxation of insurance companies and the tax treatment of insurance products or competing non-insurance products that may impact the relative desirability of various personal investment products 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. LEGAL PROCEEDINGS Legal proceedings involving Allstate agencies and AIC may impact the Company, even when the Company is not directly involved, because the Company sells its products through a variety of distribution channels including Allstate agencies. Consequently, information about the more significant of these proceedings is provided below. AIC is defending various lawsuits involving worker classification issues. These lawsuits include a number of putative class actions and one certified class action challenging the overtime exemption claimed by AIC under the Fair Labor Standards Act or state wage and hour laws. These class actions mirror similar lawsuits filed recently against other carriers in the industry and other employers. A putative nationwide class action filed by former employee agents also includes a worker classification issue; these agents are challenging certain amendments to the Agents Pension Plan and are seeking to have exclusive agent independent contractors treated as employees for benefit purposes. AIC has been vigorously defending these and various other worker classification lawsuits. The outcome of these disputes is currently uncertain. AIC is also defending certain matters relating to its agency program reorganization announced in 1999. These matters include an investigation by the U.S. Department of Labor and a lawsuit filed in December 2001 by the U.S. Equal Employment Opportunity Commission ("EEOC") with respect to allegations of retaliation under the Age Discrimination in Employment Act, the Americans with Disabilities Act and Title VII of the Civil Rights Act of 1964. A putative nationwide class action has also been filed by former employee agents alleging various violations of ERISA, breach of contract and age discrimination. AIC has been vigorously defending these lawsuits and other matters related to its agency program reorganization. In addition, AIC is defending certain matters relating to its life agency program reorganization announced in 2000. These matters include an investigation by the EEOC with respect to allegations of age discrimination and retaliation. AIC is cooperating fully with the agency investigation and will continue to vigorously defend these and other claims related to the life agency program reorganization. The outcome of these disputes is currently uncertain. The Company is currently defending a nationwide class action alleging, among other things, breach of contract and breach of the implied covenant of good faith and fair dealing as a result of a change in the rate and cap on an annuity product. The court certified the class and entered summary judgment in favor of the Company and against the certified class. Plaintiff filed notice of appeal and the Company filed a cross appeal. The outcome of the appeal is currently uncertain. The Company has been vigorously defending this suit. 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 an increasing number of lawsuits, some of which involve claims for substantial or indeterminate amounts. This litigation is based on a variety of issues including insurance and claim settlement practices. The outcome of these disputes is currently unpredictable. However, at this time, based on their present status and the existence of the reinsurance agreement with ALIC, it is the opinion of management that the ultimate liability, if any, in one or more of these other actions in excess of amounts currently reserved is not 32 LINCOLN BENEFIT LIFE COMPANY NOTES TO FINANCIAL STATEMENTS expected to have a material effect on the results of operations, liquidity or financial position of the Company. 9. 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. The Company has also entered into a supplemental tax sharing agreement with respect to reinsurance ceded to ALIC to allocate the tax benefits and detriments related to such reinsurance. Effectively, these agreements result in the Company's annual income tax provision being computed as if the Company filed a separate return, adjusted for the reinsurance ceded to ALIC. The Internal Revenue Service ("IRS") has completed its review of the Allstate Group's federal income tax returns through the 1996 tax year. Any adjustments that may result from IRS examinations of tax returns are not expected to have a material impact on the financial position, liquidity or result of operations of the Company. The components of the deferred income tax assets and liabilities at December 31 are as follows: (IN THOUSANDS)
2003 2002 --------- --------- DEFERRED ASSETS Difference in tax bases of investments $ - $ 1,195 Other assets - 55 --------- --------- Total deferred assets - 1,250 DEFERRED LIABILITIES Unrealized net capital gains (3,911) (5,827) Difference in tax bases of investments (248) - Other liabilities (13) (10) --------- --------- Total deferred liabilities (4,172) (5,837) --------- --------- Net deferred liabilities $ (4,172) $ (4,587) ========= =========
The components of income tax expense for the years ended December 31 are as follows:
(IN THOUSANDS) 2003 2002 2001 --------- --------- -------- Current $ 2,999 $ 4,204 $ 3,706 Deferred 1,093 (1,575) 62 --------- --------- -------- Total income tax expense $ 4,092 $ 2,629 $ 3,768 ========= ========= ========
The Company paid income taxes of $4.3 million, $8.0 million and $2.8 million in 2003, 2002 and 2001, 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:
2003 2002 2001 ------ ------ ------ Statutory federal income tax rate 35.0% 35.0% 35.0% Adjustment for prior year liabilities 0.7 - - Tax exempt income (0.1) (0.1) (0.1) ------ ------ ------ Effective income tax rate 35.6% 34.9% 34.9% ====== ====== ======
Prior to January 1, 1984, the Company was entitled to exclude certain amounts from taxable income and accumulate such amounts in a "policyholder surplus" account. The balance in this account at 33 LINCOLN BENEFIT LIFE COMPANY NOTES TO FINANCIAL STATEMENTS December 31, 2003, approximately $340 thousand, will result in federal income taxes payable of $119 thousand if distributed by the Company. No provision for taxes has been made as the Company has no plan to distribute amounts from this account. No further additions to the account have been permitted since 1983. 10. STATUTORY FINANCIAL INFORMATION The following table reconciles net income for the years ended December 31, and shareholder's equity at December 31, as reported herein in conformity with GAAP with total statutory net income and capital and surplus of the Company, determined in accordance with statutory accounting practices prescribed or permitted by insurance regulatory authorities:
NET INCOME SHAREHOLDER'S EQUITY --------------------------------- ------------------------ (IN THOUSANDS) 2003 2002 2001 2003 2002 -------- --------- -------- ---------- ---------- Balance per GAAP $ 7,415 $ 4,908 $ 7,024 $ 210,013 $ 202,600 Unrealized gain on fixed income securities - - - (11,176) (16,649) Deferred income taxes 1,093 (1,575) 62 3,956 6,695 Reserves and non-admitted assets 2,990 (315) 245 (91) (2,368) Other (3,108) 9 112 (563) 4,600 -------- --------- -------- ---------- ---------- Balance per statutory accounting practices $ 8,390 $ 3,027 $ 7,443 $ 202,139 $ 194,878 ======== ========= ======== ========== ==========
The Company prepares its statutory-basis financial statements in conformity with accounting practices prescribed or permitted by the State of Nebraska. Effective January 1, 2001, the State of Nebraska required insurance companies domiciled in its state to prepare statutory-basis financial statements in conformity with the National Association of Insurance Commissioner ("NAIC") Accounting Practices and Procedures Manual ("Codification"), subject to any deviations prescribed or permitted by the State of Nebraska insurance commissioner. 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 amount of dividends that can be paid to the shareholder without approval by the state insurance regulator is limited by specific surplus and net income criteria as provided in the dividend restriction provision of the Nebraska Insurance Holding Company System laws. The maximum amount of dividends that the Company can distribute during 2004 without prior approval of the Nebraska Department of Insurance is $20.0 million. RISK-BASED CAPITAL The NAIC has a standard for assessing the solvency of insurance companies, which is referred to as risk-based capital ("RBC"). The requirement consists of a formula for determining each insurer's RBC and a model law specifying regulatory actions if an insurer's RBC falls below specified levels. At December 31, 2003, RBC for the Company was above a level that would require regulatory action. 34 LINCOLN BENEFIT LIFE COMPANY NOTES TO FINANCIAL STATEMENTS 11. OTHER COMPREHENSIVE INCOME The components of other comprehensive income on a pretax and after-tax basis for the years ended December 31 are as follows: (IN THOUSANDS)
2003 --------------------------------- AFTER- UNREALIZED CAPITAL GAINS AND LOSSES: PRETAX TAX TAX --------- --------- --------- Unrealized holding (losses) gains arising during the period $ (5,349) $ 1,873 $ (3,476) Less: reclassification adjustments 124 (43) 81 --------- --------- --------- Unrealized net capital gains and losses (5,473) 1,916 (3,557) --------- --------- --------- Other comprehensive (loss) income $ (5,473) $ 1,916 $ (3,557) ========= ========= ========= 2002 --------------------------------- AFTER- UNREALIZED CAPITAL GAINS AND LOSSES: PRETAX TAX TAX --------- --------- ---------- Unrealized holding gains arising during the period $ 4,980 $ (1,743) $ 3,237 Less: reclassification adjustments (4,084) 1,429 (2,655) --------- --------- ---------- Unrealized net capital gains and losses 9,064 (3,172) 5,892 --------- --------- ---------- Other comprehensive income $ 9,064 $ (3,172) $ 5,892 ========= ========= ========== 2001 --------------------------------- AFTER- UNREALIZED CAPITAL GAINS AND LOSSES: PRETAX TAX TAX --------- --------- --------- Unrealized holding gains arising during the period $ 2,984 $ (1,045) $ 1,939 Less: reclassification adjustments (1,352) 473 (879) --------- --------- --------- Unrealized net capital gains and losses 4,336 (1,518) 2,818 --------- --------- --------- Other comprehensive income $ 4,336 $ (1,518) $ 2,818 ========= ========= =========
35 INDEPENDENT AUDITORS' REPORT TO THE BOARD OF DIRECTORS AND SHAREHOLDER OF LINCOLN BENEFIT LIFE COMPANY: We have audited the accompanying Statements of Financial Position of Lincoln Benefit Life Company (the "Company", an affiliate of The Allstate Corporation) as of December 31, 2003 and 2002, 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, 2003. Our audits also included Schedule I - Summary of Investments - Other Than Investments In Related Parties and Schedule IV - Reinsurance. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2003 and 2002, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2003 in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, Schedule I - Summary of Investments - Other Than Investments in Related Parties and Schedule IV - Reinsurance, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. /s/ Deloitte & Touche LLP Chicago, Illinois February 4, 2004 36 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. ITEM 9A. CONTROLS AND PROCEDURES With the participation of our principal executive officer and principal financial officer, we carried out an evaluation of the effectiveness of the design and operation 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 timely alerting them to material information required to be included in our periodic reports filed with the Securities and Exchange Commission. However, the design of any system of controls and procedures is based in part upon assumptions about the likelihood of future events and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions, regardless of how remote. Our disclosure controls and procedures are designed to provide reasonable assurance of achieving their objectives and are effective at the "reasonable assurance" level. During the fiscal quarter ended December 31, 2003, there have been no changes in our internal control over financial reporting that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. PART III ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES (1), (2), (3), (4) AND (5)(ii) DISCLOSURE OF FEES - The following fees have been, or will 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 year ending December 31, 2003 and 2002.
PERCENTAGE OF 2003 FEES PRE-APPROVED BY THE ALLSTATE 2003 CORPORATION AUDIT COMMITTEE 2002 --------- ----------------------------------- ----------- Audit fees (a) $ 178,841 100% $ 260,710 Audit related fees - - - Tax fees - - - All other fees - - - ----------- ----------------------------------- ----------- TOTAL FEES $ 178,841 100% $ 260,710 =========== =================================== ===========
(a) Fees for audits of annual financial statements including financial statements for the separate accounts, reviews of quarterly financial statements, statutory audits, consents and review of documents filed with the Commission. These fees are ceded to ALIC under the Company's reinsurance agreements with ALIC. (5)(i) 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 the registrant. Those policies and procedures are incorporated into this Item 14.5(i) by reference to Appendix D to The Allstate Corporation's Notice of Annual Meeting and Proxy Statement dated March 26, 2004. The Board of Directors of ALIC has recently formed an audit committee, which will be responsible for these matters in the future as they relate to ALIC and its subsidiaries, including the registrant. 37 PART IV ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) (1) The following financial statements, notes thereto and related information of Lincoln Benefit 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 Independent Auditors' Report (2) The following additional financial statement schedules are furnished herewith pursuant to the requirements of Form 10-K.
Lincoln Benefit Life Company 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.
Exhibit No. Description ------- ----------- 3(i) Amended and Restated Articles of Incorporation of Lincoln Benefit Life Company dated September 26, 2000. Incorporated herein by reference to Exhibit 3(i) to Lincoln Benefit Life Company's Quarterly Report on Form 10-Q for quarter ended March 31, 2002. 3(ii) Amended and Restated By-Laws of Lincoln Benefit Life Company dated July 23, 1997. Incorporated herein by reference to Exhibit 6(b) to Lincoln Benefit Life Variable Life Account Registration Statement on Form S-6 filed March 11, 1998. (SEC File No. 333-47717) 10.1 Investment Management Agreement and Amendment to Certain Service and Expense Agreements Among Allstate Investments, LLC and Allstate Insurance Company and The Allstate Corporation and Certain Affiliates effective as of January 1, 2002. Incorporated herein by reference to Exhibit 10.3 to Northbrook Life Insurance Company's Quarterly Report on Form 10-Q for quarter ended March 31, 2002. 10.2 Tax Sharing Agreement dated as of November 12, 1996 among The Allstate Corporation and certain affiliates. Incorporated herein by reference to Exhibit 10.4 to Northbrook Life Insurance Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 2002. 10.3 Cash Management Services Master Agreement between Allstate Insurance Company and Allstate Bank (aka Allstate Federal Savings Bank) dated March 16, 1999. Incorporated herein by reference to Exhibit 10.4 to Lincoln Benefit Life Company's Quarterly Report on Form 10-Q for quarter ended March 31, 2002.
38 10.4 Amendment No.1 to Cash Management Services Master Agreement effective January 5, 2001. Incorporated herein by reference to Exhibit 10.5 to Lincoln Benefit Life Company's Quarterly Report on Form 10-Q for quarter ended March 31, 2002. 10.5 Service and Expense Agreement among Allstate Insurance Company and The Allstate Corporation and Certain Insurance Subsidiaries dated January 1, 1999. Incorporated herein by reference to Exhibit 10.2 to Northbrook Life Insurance Company's Quarterly Report on Form 10-Q for quarter ended March 31, 2002. 10.6 Administrative Services Agreement between Allstate Life Insurance Company and Lincoln Benefit Life Company dated October 1, 1996. Incorporated herein by reference to Exhibit 10.1 to Lincoln Benefit Life Company's Quarterly Report on Form 10-Q for quarter ended June 30, 2002. 10.7 Administrative Services Agreement between Allstate Life Insurance Company and Lincoln Benefit Life Company effective February 1, 1998. Incorporated herein by reference to Exhibit 10.2 to Lincoln Benefit Life Company's Quarterly Report on Form 10-Q for quarter ended June 30, 2002. 10.8 Service Agreement between Lincoln Benefit Life Company and Allstate Financial Services, LLC effective April 1, 1998. Incorporated herein by reference to Exhibit 10.3 to Lincoln Benefit Life Company's Quarterly Report on Form 10-Q for quarter ended June 30, 2002. 10.9 Administrative Services Agreement between Allstate Life Insurance Company and Lincoln Benefit Life Company, effective September 1, 1998 and as amended effective June 19, 2000. Incorporated herein by reference to Exhibit 10.4 to Lincoln Benefit Life Company's Quarterly Report on Form 10-Q for quarter ended June 30, 2002. 10.10 Administrative Service Agreement between Lincoln Benefit Life Company and ALFS, Inc., effective December 1, 1998. Incorporated herein by reference to Exhibit 10.5 to Lincoln Benefit Life Company's Quarterly Report on Form 10-Q for quarter ended June 30, 2002. 10.11 Principal Underwriting Agreement between Lincoln Benefit Life Company and ALFS, Inc., effective November 25, 1998. (Variable Universal Life Account). Incorporated herein by reference to Exhibit 10.6 to Lincoln Benefit Life Company's Quarterly Report on Form 10-Q for quarter ended June 30, 2002. 10.12 Principal Underwriting Agreement between Lincoln Benefit Life Company and ALFS, Inc., effective November 25, 1998. (Variable Annuity Account). Incorporated herein by reference to Exhibit 10.7 to Lincoln Benefit Life Company's Quarterly Report on Form 10-Q for quarter ended June 30, 2002. 10.13 Selling Agreement between Lincoln Benefit Life Company, ALFS, Inc. (f/k/a Allstate Life Financial Services, Inc.) and Allstate Financial Services, LLC (f/k/a LSA Securities, Inc.) effective August 2, 1999. Incorporated herein by reference to Exhibit 10.8 to Allstate Life Insurance Company's Annual Report on Form 10-K for 2003. (SEC File No. 000-31248) 10.14 Coinsurance Agreement between Allstate Life Insurance Company and Lincoln Benefit Life Company, effective December 31, 2001. Incorporated herein by reference to Exhibit 10.11 to Lincoln Benefit Life Company's Quarterly Report on Form 10-Q for quarter ended June 30, 2002. 10.15 Modified Coinsurance Agreement between Allstate Life Insurance Company and Lincoln Benefit Life Company, effective December 31, 2001. Incorporated herein by reference to Exhibit 10.12 to Lincoln Benefit Life Company's Quarterly Report on Form 10-Q for quarter ended June 30, 2002. 10.16 Modified Coinsurance Agreement between Allstate Life Insurance Company and Lincoln Benefit Life Company, effective December 31, 2001. Incorporated herein by reference to Exhibit 10.13 to Lincoln Benefit Life Company's Quarterly Report on Form 10-Q for quarter ended June 30, 2002.
39 23 Independent Auditors' Consent. 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
(b) No reports on Form 8-K were filed during the fourth quarter of 2003. (c) The exhibits are listed in Item 15. (a) (3) above. (d) The financial statement schedules are listed in Item 15. (a) (2) above. 40 SIGNATURES Pursuant to the requirements of 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. LINCOLN BENEFIT LIFE COMPANY (Registrant) March 24, 2004 /s/ Samuel H. Pilch -------------------- By: Samuel H. Pilch (chief accounting officer and duly authorized officer of the registrant) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
SIGNATURE TITLE DATE --------- ----- ---- /s/ Casey J. Sylla Chairman of the Board, March 24, 2004 ------------------ Chief Executive Officer and Casey J. Sylla a Director (Principal Executive Officer) /s/ Steven E. Shebik Senior Vice President, March 24, 2004 -------------------- Chief Financial Officer and Steven E. Shebik a Director (Principal Financial Officer) /s/ Lawrence W. Dahl Director March 24, 2004 -------------------- Lawrence W. Dahl /s/ John C. Lounds Director March 24, 2004 ------------------ John C. Lounds /s/ J. Kevin McCarthy Director March 24, 2004 --------------------- J. Kevin McCarthy /s/ Kevin R. Slawin Director March 24, 2004 ------------------- Kevin R. Slawin /s/ Michael J. Velotta Director March 24, 2004 ---------------------- Michael J. Velotta /s/ B. Eugene Wraith Director March 24, 2004 -------------------- B. Eugene Wraith
41 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. 42 LINCOLN BENEFIT LIFE COMPANY SCHEDULE I - SUMMARY OF INVESTMENTS - OTHER THAN INVESTMENT IN RELATED PARTIES DECEMBER 31, 2003
CARRYING (IN THOUSANDS) COST FAIR VALUE VALUE --------- ---------- --------- TYPE OF INVESTMENT ------------------ Fixed income securities, available for sale: Bonds: United States government, government agencies and authorities...... $ 65,632 $ 70,704 70,704 States, municipalities and political subdivisions.................. 503 571 571 Public utilities................................................... 11,838 12,326 12,326 All other corporate bonds.......................................... 65,445 69,050 69,050 Mortgage-backed securities............................................ 14,203 15,443 15,443 Asset-backed securities............................................... 40,321 41,024 41,024 --------- ---------- --------- Total fixed income securities...................................... 197,942 $ 209,118 209,118 --------- ========== --------- Short-term investments................................................... 1,107 1,107 --------- --------- Total investments.................................................. $ 199,049 $ 210,225 ========= =========
S-1 LINCOLN BENEFIT LIFE COMPANY SCHEDULE IV--REINSURANCE (IN THOUSANDS)
GROSS NET YEAR ENDED DECEMBER 31, 2003 AMOUNT CEDED AMOUNT --------------------------------------- -------------- ------------- ---------- Life insurance in force $ 179,908,435 179,908,435 $ - ============== ============= ========== Premiums and contract charges: Life and annuities $ 773,023 773,023 $ - Accident and health 97,236 97,236 - -------------- ------------- ---------- $ 870,259 870,259 $ - ============== ============= ========== GROSS NET YEAR ENDED DECEMBER 31, 2002 AMOUNT CEDED AMOUNT --------------------------------------- -------------- ------------- ---------- Life insurance in force $ 160,133,109 $ 160,133,109 $ - ============== ============= ========== Premiums and contract charges: Life and annuities $ 629,423 $ 629,423 $ - Accident and health 60,549 60,549 - -------------- ------------- ---------- $ 689,972 $ 689,972 $ - ============== ============= ========== GROSS NET YEAR ENDED DECEMBER 31, 2001 AMOUNT CEDED AMOUNT --------------------------------------- -------------- ------------- ---------- Life insurance in force $ 138,566,651 $ 138,566,651 $ - ============== ============= ========== Premiums and contract charges: Life and annuities $ 532,235 $ 532,235 $ - Accident and health 40,718 40,718 - -------------- ------------- ---------- $ 572,953 $ 572,953 $ - ============== ============= ==========
S-2