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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2002
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
COMMISSION FILE NUMBER 0-23625
ANNUITY AND LIFE RE (HOLDINGS), LTD.
(Exact name of registrant as specified in its charter)
BERMUDA NOT APPLICABLE
(State or other jurisdiction of (IRS Employer
incorporation or organization) Identification Number)
CUMBERLAND HOUSE, 1 VICTORIA STREET, HAMILTON, HM 11, BERMUDA
(Address of principal executive offices)
441-296-7667
(Registrant's Telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [ ] No [X]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act) Yes [X] No [ ]
The number of the registrant's Common Shares (par value $1.00 per share)
outstanding as of November 5, 2002 was 26,106,328.
THIS FILING INCLUDES UNAUDITED FINANCIAL STATEMENTS THAT HAVE NOT BEEN
REVIEWED BY OUR AUDITORS IN ACCORDANCE WITH RULE 10-01(D) OF REGULATION S-X
PROMULGATED BY THE SECURITIES AND EXCHANGE COMMISSION. SEE "STATEMENT REGARDING
REVIEW OF FINANCIAL STATEMENTS" ON PAGE 2 OF THIS REPORT.
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INDEX TO FORM 10-Q
PAGE
----
PART I -- FINANCIAL INFORMATION
Statement Regarding Review of Financial Statements.......... 1
ITEM 1. Unaudited Consolidated Financial Statements
Consolidated Balance Sheets
September 30, 2002 and December 31, 2001 (as restated)...... 2
Consolidated Statements of Operations
Three and Nine Months ended September 30, 2002 and 2001 (as
restated)................................................... 3
Consolidated Statements of Comprehensive Income
Three and Nine Months ended September 30, 2002 and 2001 (as
restated)................................................... 4
Consolidated Statements of Cash Flows
Nine Months ended September 30, 2002 and 2001 (as
restated)................................................... 5
Consolidated Statements of Changes in Stockholders' Equity
Nine Months ended September 30, 2002 and 2001 (as
restated)................................................... 6
Notes to Unaudited Consolidated Financial Statements........ 7
ITEM 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations................................... 16
ITEM 3. Quantitative and Qualitative Disclosures About Market
Risk........................................................ 39
ITEM 4. Controls and Procedures..................................... 39
PART II -- OTHER INFORMATION
ITEM 1. Legal Proceedings........................................... 40
ITEM 2. Changes in Securities and Use of Proceeds................... 40
ITEM 5. Other Information........................................... 40
ITEM 6. Exhibits and Reports on Form 8-K............................ 41
Signatures........................................................... 42
PART I
FINANCIAL INFORMATION
STATEMENT REGARDING REVIEW OF FINANCIAL STATEMENTS
As the Company reported in a Current Report on Form 8-K filed on November
19, 2002, as a result of discussions with the staff of the Securities and
Exchange Commission (the "SEC") regarding certain matters related to the
Company's previous public filings, the Company will restate its financial
statements for the fiscal years ended December 31, 2000 and 2001. The Company
will restate its financial statements for the fiscal year ended December 31,
2001 to reflect the bifurcation and separate accounting for embedded derivatives
contained in certain of the Company's annuity reinsurance contracts in
accordance with Statement of Financial Accounting Standards No.
133 -- Accounting for Derivative Instruments and Hedging Activities. In
addition, the Company will reclassify the $19,500,000 reserve component of a
$33,000,000 charge taken in the fourth quarter of 2001 in connection with
minimum interest guarantees on the Company's largest annuity reinsurance
contract as a reduction of the Company's carried balance for deferred
acquisition costs. This reclassification will not change the Company's reported
net loss for the year. Further, based on information now in the Company's
possession, portions of the $33,000,000 charge will be allocated across certain
prior periods. Similarly, the restatement of the Company's financial statements
for the fiscal year ended December 31, 2000 will recognize certain minimum
interest guarantee payments made during that year as an expense rather than as a
reduction in interest sensitive contracts liabilities. The restatement of the
Company's net income for the fiscal year ended December 31, 2000 is not expected
to reduce reported net income for that fiscal year by more than three percent.
Because the SEC's review of the Company's prior public filings is still
pending, KPMG, the Company's independent auditor, is not able to complete its
audit of the restated financial statements for the fiscal years ended December
31, 2000 or 2001, or its review of the financial statements contained in this
report as of, and for the periods ended, September 30, 2002 and September 30,
2001 (as restated) until the Company has received further guidance from the SEC
on certain matters. Accordingly, this filing includes unaudited financial
statements for the periods ended September 30, 2002 and September 30, 2001 (as
restated) that have not been reviewed in accordance with Rule 10-01(d) of
Regulation S-X promulgated by the SEC, as well as restated financial information
for the year ended December 31, 2001 that has not yet been subject to audit.
If the SEC's or KPMG's reviews result in any material changes to the
financial statements set forth herein, the Company will file an amended
Quarterly Report on Form 10-Q. In addition, following the conclusion of KPMG's
audit, the Company will amend its Annual Report on Form 10-K for the fiscal year
ended December 31, 2001, as well as its Quarterly Reports on Form 10-Q for the
quarters ended March 31, 2002 and June 30, 2002.
No certifications required by 18 U.S.C. Section 1350 or Rule 13a-14
promulgated under the Securities Exchange Act of 1934, as amended, accompany
this report. The Company intends to submit such certifications to the SEC upon
completion of the review and audit described above.
1
ANNUITY AND LIFE RE (HOLDINGS), LTD.
CONSOLIDATED BALANCE SHEETS
(UNAUDITED AND IN U.S. DOLLARS)
SEPTEMBER 30, DECEMBER 31,
2002 2001
-------------- --------------
(AS RESTATED)
ASSETS
Cash and cash equivalents................................... $ 120,052,568 $ 104,793,019
Fixed income investments at fair value (amortized cost of
$338,889,854 and $312,420,719 at September 30, 2002 and
December 31, 2001)........................................ 355,160,595 318,987,432
Funds withheld at interest.................................. 1,415,120,437 1,489,689,347
Accrued investment income................................... 4,063,797 4,897,063
Receivable for investments sold............................. 10,814,271 23,815
Receivable for reinsurance ceded............................ 94,310,286 97,807,529
Deposits and other reinsurance receivables.................. 81,851,829 76,139,222
Deferred policy acquisition costs........................... 228,089,222 209,074,192
Other assets................................................ 11,195,455 9,360,971
-------------- --------------
Total Assets........................................... $2,320,658,460 $2,310,772,590
============== ==============
LIABILITIES
Reserves for future policy benefits......................... $ 280,915,909 $ 221,865,755
Interest sensitive contracts liability...................... 1,464,667,709 1,519,596,075
Other deposit liabilities................................... 147,000,000 137,000,000
Other reinsurance liabilities............................... 22,901,107 17,340,304
Payable for investments purchased........................... 10,194,428 2,030,516
Accounts payable and accrued expenses....................... 15,737,008 10,751,098
-------------- --------------
Total Liabilities...................................... $1,941,416,161 $1,908,583,748
-------------- --------------
STOCKHOLDERS' EQUITY
Preferred shares (par value $1.00; 50,000,000 shares
authorized; no shares outstanding)........................ $ -- $ --
Common shares (par value $1.00; 100,000,000 shares
authorized; 26,106,328 and 25,705,328 shares outstanding
at September 30, 2002 and December 31, 2001).............. 26,106,328 25,705,328
Additional paid-in capital.................................. 335,334,932 332,447,062
Notes receivable from stock sales........................... (1,603,076) (1,317,259)
Restricted stock (367,625 shares at September 30, 2002)..... (2,747,526) --
Accumulated other comprehensive income...................... 16,091,693 6,418,469
Retained earnings........................................... 6,059,948 38,935,242
-------------- --------------
Total Stockholders' Equity............................. $ 379,242,299 $ 402,188,842
-------------- --------------
Total Liabilities and Stockholders' Equity............. $2,320,658,460 $2,310,772,590
============== ==============
See accompanying Notes to Unaudited Consolidated Financial Statements
2
ANNUITY AND LIFE RE (HOLDINGS), LTD.
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED AND IN U.S. DOLLARS)
FOR THE THREE MONTHS ENDED FOR THE NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
---------------------------- -----------------------------
2002 2001 2002 2001
------------ ------------- ------------- -------------
(AS RESTATED) (AS RESTATED) (AS RESTATED)
Net premiums......................... $ 84,934,401 $ 66,813,664 $255,007,035 $181,955,760
Investment income, net of related
expenses........................... 31,127,396 24,239,602 82,083,855 66,934,606
Net realized investment gains........ 9,297,351 1,078,933 10,813,315 1,425,183
Net change in fair value of embedded
derivatives........................ (13,277,823) (5,265,396) (18,254,530) (3,567,342)
Surrender fees and other revenues.... 549,362 5,512,939 13,606,694 13,291,100
------------ ------------ ------------ ------------
Total Revenues.................. $115,630,687 $ 92,379,742 $343,256,369 $260,039,307
------------ ------------ ------------ ------------
Benefits and expenses
Claim and policy benefits............ $ 91,381,831 $ 74,873,807 $224,640,576 $161,699,922
Interest credited to interest
sensitive products................. 18,345,349 14,401,290 57,215,862 30,490,167
Policy acquisition costs and other
insurance expenses................. 17,492,342 43,306,421 73,700,329 95,220,905
Collateral costs..................... 3,731,580 -- 6,080,321 --
Operating expenses................... 3,826,602 2,478,698 10,626,666 7,832,813
------------ ------------ ------------ ------------
Total Benefits and Expenses..... $134,777,704 $135,060,216 $372,263,754 $295,243,807
------------ ------------ ------------ ------------
Net loss before cumulative
effect of a change in
accounting principle.......... $(19,147,017) $(42,680,474) $(29,007,385) $(35,205,400)
Cumulative effect of a change in
accounting principle (note 3)...... -- -- -- (3,665,735)
------------ ------------ ------------ ------------
Net (Loss)...................... $(19,147,017) $(42,680,474) $(29,007,385) $(38,870,235)
============ ============ ============ ============
Net (loss) per common share before
cumulative effect of a change in
accounting principle:
Basic.............................. $ (0.74) $ (1.66) $ (1.13) $ (1.38)
Diluted............................ $ (0.74) $ (1.66) $ (1.13) $ (1.38)
Cumulative effect of a change in
accounting principle
Basic.............................. $ -- $ -- $ -- $ (0.14)
Diluted............................ $ -- $ -- $ -- $ (0.14)
Net (loss)
Basic.............................. $ (0.74) $ (1.66) $ (1.13) $ (1.52)
Diluted............................ $ (0.74) $ (1.66) $ (1.13) $ (1.52)
See accompanying Notes to Unaudited Consolidated Financial Statements
3
ANNUITY AND LIFE RE (HOLDINGS), LTD.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(UNAUDITED AND IN U.S. DOLLARS)
FOR THE THREE MONTHS ENDED FOR THE NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
---------------------------- -----------------------------
2002 2001 2002 2001
------------ ------------- ------------- -------------
(AS RESTATED) (AS RESTATED) (AS RESTATED)
Net (loss) for the period............ $(19,147,017) $(42,680,474) $(29,007,385) $(38,870,235)
Other comprehensive income:
Unrealized holding gains on
securities arising during the
period............................. 17,633,359 7,740,625 20,486,539 9,652,655
Less reclassification adjustment for
realized gains in net income....... 9,297,351 1,078,933 10,813,315 1,425,183
------------ ------------ ------------ ------------
Other comprehensive income........... $ 8,336,008 $ 6,661,692 $ 9,673,224 $ 8,227,472
------------ ------------ ------------ ------------
Total comprehensive (loss)........... $(10,811,009) $(36,018,782) $(19,334,161) $(30,642,763)
============ ============ ============ ============
See accompanying Notes to Unaudited Consolidated Financial Statements
4
ANNUITY AND LIFE RE (HOLDINGS), LTD.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED AND IN U.S. DOLLARS)
FOR THE NINE MONTHS ENDED
SEPTEMBER 30,
-------------------------------
2002 2001
------------- -------------
(AS RESTATED)
CASH FLOWS FROM OPERATING ACTIVITIES
Net loss.................................................... $ (29,007,385) $ (38,870,235)
Adjustments to reconcile net income to cash provided by
operating activities:
Cumulative effect of a change in accounting principle..... -- 3,665,735
Net realized investments (gains).......................... (10,813,315) (1,425,183)
Net change in fair value of embedded derivatives.......... 18,254,530 3,567,342
Unrealized loss on interest rate swap..................... 2,005,000 --
Amortization of restricted stock.......................... 541,344 --
Changes in:
Accrued investment income.............................. 833,266 (288,492)
Deferred policy acquisition costs...................... (19,015,030) 4,114,995
Deposits and other reinsurance receivables............. (2,215,364) (19,165,559)
Other assets........................................... 1,834,484 (1,057,573)
Reserves for future policy benefits.................... 59,050,154 39,726,121
Interest sensitive contracts, net of funds withheld.... 1,386,015 (25,777,751)
Other reinsurance liabilities.......................... 5,560,803 35,146,924
Accounts payable....................................... 2,980,910 3,329,510
------------- -------------
Net cash provided by operating activities.............. $ 27,726,444 $ 2,965,834
------------- -------------
CASH FLOWS FROM INVESTING ACTIVITIES
Proceeds from sales of fixed maturity investments........... $ 467,314,155 $ 186,398,746
Purchase of fixed maturity investments...................... (485,627,324) (196,561,747)
------------- -------------
Net cash (used) by investing activities................ $ (18,313,169) $ (10,163,001)
------------- -------------
CASH FLOWS FROM FINANCING ACTIVITIES
Issuance of shares.......................................... $ -- $ 2,846,205
Interest accrued on notes receivable........................ (74,437) (78,540)
Interest collected on notes receivable...................... 38,620 --
Issuance of note receivable................................. (250,000) --
Dividends paid to stockholders.............................. (3,867,909) (3,834,558)
Increase in deposit liability............................... 10,000,000 --
------------- -------------
Net cash provided (used) by financing activities....... $ 5,846,274 $ (1,066,893)
------------- -------------
Increase (decrease) in cash and cash equivalents............ $ 15,259,549 $ (8,264,060)
Cash and cash equivalents, beginning of period.............. 104,793,019 52,691,974
------------- -------------
Cash and cash equivalents, end of period.................... $ 120,052,568 $ 44,427,914
============= =============
See accompanying Notes to Unaudited Consolidated Financial Statements
5
ANNUITY AND LIFE RE (HOLDINGS), LTD.
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
(UNAUDITED AND IN U.S. DOLLARS)
FOR THE NINE MONTHS ENDED
SEPTEMBER 30,
------------------------------
2002 2001
------------ -------------
(AS RESTATED)
PREFERRED SHARES PAR VALUE $1.00
Balance at beginning and end of period...................... $ -- $ --
------------ ------------
COMMON SHARES PAR VALUE $1.00
Balance at beginning of period.............................. $ 25,705,328 $ 25,499,999
Issuance of shares.......................................... 401,000 185,829
------------ ------------
Balance at end of period.................................... $ 26,106,328 $ 25,685,828
------------ ------------
ADDITIONAL PAID-IN CAPITAL
Balance at beginning of period.............................. $332,447,062 $329,496,091
Issuance of shares.......................................... 2,887,870 2,660,376
------------ ------------
Balance at end of period.................................... $335,334,932 $332,156,467
------------ ------------
NOTES RECEIVABLE FROM STOCK SALES
Balance at beginning of period.............................. $ (1,317,259) $ (1,367,241)
Issuance of note receivable................................. (250,000) --
Interest collected on notes receivable...................... 38,620 --
Accrued interest during period.............................. (74,437) (78,540)
------------ ------------
Balance at end of period.................................... $ (1,603,076) $ (1,445,781)
------------ ------------
Restricted stock
Balance at beginning of period.............................. $ -- $ --
Issuance of shares.......................................... (3,288,870) --
Amortization of restricted stock............................ 541,344 --
------------ ------------
Balance at end of period.................................... $ (2,747,526) $ --
------------ ------------
ACCUMULATED OTHER COMPREHENSIVE INCOME
Balance at beginning of period.............................. $ 6,418,469 $ 2,064,971
Net unrealized gains (losses) on securities................. 9,673,224 8,227,472
------------ ------------
Balance at end of period.................................... $ 16,091,693 $ 10,292,443
------------ ------------
RETAINED EARNINGS
Balance at beginning of period.............................. $ 38,935,242 $ 84,636,497
Net (loss) income........................................... (29,007,385) (38,870,235)
Stockholder dividends....................................... (3,867,909) (3,834,558)
------------ ------------
Balance at end of period.................................... $ 6,059,948 $ 41,931,704
------------ ------------
TOTAL STOCKHOLDERS' EQUITY.................................. $379,242,299 $408,620,661
============ ============
See accompanying Notes to Unaudited Consolidated Financial Statements
6
ANNUITY AND LIFE RE (HOLDINGS), LTD.
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
1. INFORMATION REGARDING THESE FINANCIAL STATEMENTS
As a result of discussions with the Staff of the SEC, the Company will
restate its financial statements for the fiscal years ended December 31, 2000
and 2001, as well as for the quarters ended March 31, 2002 and June 30, 2002.
Because the SEC's review of the Company's prior public filings is still pending,
the Company's independent auditors are not able to complete their audit of the
restated financial statements for the fiscal years ended December 31, 2000 and
2001, or their review of the financial statements contained in this report for
the periods ended September 30, 2002 and September 30, 2001 (as restated) until
the Company has received further guidance from the SEC on certain matters.
Accordingly, this filing includes unaudited financial statements for the periods
ended September 30, 2002 and September 30, 2001 (as restated) that have not been
reviewed in accordance with Rule 10-01 (d) of Regulation S-X promulgated by the
SEC, as well as restated financial information for the fiscal year ended
December 31, 2001 that has not yet been subject to audit.
2. ORGANIZATION
Annuity and Life Re (Holdings), Ltd. ("Holdings") was incorporated on
December 2, 1997 under the laws of Bermuda. Holdings provides annuity and life
reinsurance to insurers and reinsurers through its wholly-owned subsidiaries:
Annuity and Life Reassurance, Ltd., which is licensed under the laws of Bermuda
as a long term insurer; and Annuity and Life Re America, Inc., an insurance
holding company based in the United States, and Annuity and Life Reassurance
America, Inc., a life insurance company domiciled in the United States.
Holdings, Annuity and Life Reassurance, Annuity and Life Re America and Annuity
and Life Reassurance America are collectively referred to herein as the
"Company."
3. RESTATEMENT
The Company is currently in the process of restating its financial
statements for the fiscal year ended December 31, 2001 to reflect the
application of Statement of Financial Accounting Standard 133 -- Accounting for
Derivative Instruments and Hedging Activities, which requires the Company to
bifurcate and separately account for embedded derivatives contained in certain
of the Company's annuity reinsurance contracts. The Company is required to carry
these embedded derivatives on its balance sheet at fair value and the unrealized
changes in the value of these embedded derivatives are reflected in net income
as Net change in fair value of embedded derivatives. The accumulated fair value
of these embedded derivatives at January 1, 2001 was a loss of $3,665,735 and
this has been accounted for as a cumulative effect of a change in accounting
principle. The change in fair value of the Company's embedded derivatives during
2001 was a gain of $5,029,026. Additionally, an adjustment of $1,320,184 has
been made in 2001 to increase the amortization of deferred acquisition costs to
reflect the revised emergence of profits on the affected reinsurance agreements
as a result of the change in fair value of the embedded derivatives. For the
year ended December 31, 2001, the net impact on reported earnings was a $43,107
gain.
The Company is also in the process of restating its financial statements
for the fiscal year ended December 31, 2001 to reclassify the $19,500,000
reserve component of a $33,000,000 charge taken in the fourth quarter of 2001 in
connection with minimum interest guarantees on the Company's largest annuity
reinsurance contract. The Company had recorded this amount as an increase to its
Interest sensitive contracts liability. In its restated financial statements for
the fiscal year ended December 31, 2001, the Company will reclassify the
$19,500,000 as a write down of deferred acquisition costs. The reclassification
does not change the Company's reported net loss for the year; however, certain
components of the Company's Consolidated Balance Sheet as of December 31, 2001
and Consolidated Statements of Operations for the year then ended will change as
a result of this reclassification.
7
ANNUITY AND LIFE RE (HOLDINGS), LTD.
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Further, based on information now available to the Company, the Company is
also in the process of restating its financial statements for the fiscal years
ended December 31, 2000 and 2001 to recognize approximately $2,800,000 and
$13,500,000, respectively, of payments made during those years in connection
with minimum interest guarantees on the Company's largest annuity reinsurance
contract. The $13,500,000 of payments made in 2001 were included in the
$33,000,000 charge taken in the fourth quarter of 2001. The Company originally
recorded the full $13,500,000 expense in the fourth quarter of 2001 because that
was the quarter in which the Company first received data that enabled it to
estimate the amount of such payments accurately. As part of the restatement of
the Company's financial statements for the fiscal year ended December 31, 2001,
the $13,500,000 expense will be reallocated to the quarterly periods in that
year in which the payments were made. Similarly, the Company will recognize the
$2,800,000 of minimum interest guarantee payments made in 2000 as an expense
rather than as a reduction in interest sensitive contracts liabilities. Certain
components of the Company's Consolidated Balance Sheets as of December 31, 2000
and 2001 and Consolidated Statements of Operations for the years then ended will
change as a result of this restatement.
The following table summarizes the effect of these changes to the Company's
previously issued financial statements for the fiscal year ended December 2001
and for the three and nine month periods ended September 2001:
EFFECT OF
--------------------------------------------
AS MINIMUM AS
REPORTED FAS 133 RECLASSIFICATION GUARANTEE RESTATED
-------------- ----------- ---------------- ----------- --------------
CONSOLIDATED BALANCE
SHEET AT DECEMBER
31, 2001
Funds withheld at
interest............ $1,488,326,056 $ 1,363,291 $ -- $ -- $1,489,689,347
Deferred acquisition
costs............... 229,894,376 (1,320,184) (19,500,000) -- 209,074,192
Interest sensitive
contracts
liability........... 1,536,295,763 -- (19,500,000) 2,800,312 1,519,596,075
Stockholders'
Equity.............. 404,946,047 43,107 -- (2,800,312) 402,188,842
EFFECT OF
--------------------------------------------
AS MINIMUM AS
REPORTED FAS 133 RECLASSIFICATION GUARANTEE RESTATED
------------ ----------- ---------------- ----------- ------------
CONSOLIDATED STATEMENTS
OF OPERATIONS FOR THE
YEAR ENDED DECEMBER 31,
2001
Net change in fair value
of embedded
derivatives............ $ -- $ 5,029,027 $ -- $ -- $ 5,029,027
Interest credited to
interest sensitive
products............... 68,758,418 -- (19,500,000) -- 49,258,418
Policy acquisition and
other insurance
expenses............... 105,045,520 1,320,184 19,500,000 1,914,853 127,780,557
Cumulative effect of a
change in accounting
principle.............. -- (3,665,735) -- -- (3,665,735)
Net (Loss):.............. (38,709,686) 43,107 -- (1,914,853) (40,581,432)
8
ANNUITY AND LIFE RE (HOLDINGS), LTD.
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
EFFECT OF
--------------------------------------------
AS MINIMUM AS
REPORTED FAS 133 RECLASSIFICATION GUARANTEE RESTATED
------------ ----------- ---------------- ----------- ------------
CONSOLIDATED STATEMENTS
OF OPERATIONS FOR THE
THREE MONTH PERIOD
ENDED SEPTEMBER 30,
2001
Net change in fair value
of embedded
derivatives............ $ -- $(5,265,396) $ -- $ -- $ (5,265,396)
Interest credited to
interest sensitive
products............... 10,001,290 -- -- 4,400,000 14,401,290
Policy acquisition and
other insurance
expenses............... 49,117,632 (269,009) -- (5,542,202) 43,306,421
Net (Loss):.............. (38,826,289) (4,996,387) -- 1,142,202 (42,680,474)
EFFECT OF
---------------------------------------------
AS MINIMUM AS
REPORTED FAS 133 RECLASSIFICATION GUARANTEE RESTATED
------------ ----------- ---------------- ------------ ------------
CONSOLIDATED STATEMENTS
OF OPERATIONS FOR THE
NINE MONTH PERIOD
ENDED SEPTEMBER 30,
2001
Net change in fair value
of embedded
derivatives........... $ -- $(3,567,342) $ -- $ -- $ (3,567,342)
Interest credited to
interest sensitive
products.............. 21,190,167 -- -- 9,300,000 30,490,167
Policy acquisition and
other insurance
expenses.............. 86,792,637 (1,410,724) -- 9,838,992 95,220,905
Cumulative effect of a
change in accounting
principle............. -- (3,665,735) -- -- (3,665,735)
Net (Loss):............. (13,908,890) (5,822,353) -- (19,138,992) (38,870,235)
4. BASIS OF PRESENTATION
The accompanying unaudited consolidated financial statements of the Company
have been prepared in accordance with accounting principles generally accepted
in the United States of America ("U.S. GAAP") for interim financial information
and, except as noted in Note 1 above, in accordance with Regulation S-X.
Accordingly, they do not include all of the information and footnotes required
by U.S. GAAP for complete financial statements. In the opinion of management,
all adjustments considered necessary for a fair presentation have been included
in these financial statements. These consolidated financial statements should be
read in conjunction with the notes to the audited consolidated financial
statements contained in the Company's Form 10-K for the fiscal year ended
December 31, 2001. As discussed in Notes 1 and 3 above, the Company is in the
process of restating its financial statements for the fiscal years ended
December 31, 2000 and 2001. The Company plans to file an amended Form 10-K for
the fiscal year ended December 31, 2001 as soon as its auditors have completed
their audit of such restated financial statements. In addition to the accounting
policies noted in the Company's Form 10-K for the fiscal year ended December 31,
2001, the Company notes the following:
9
ANNUITY AND LIFE RE (HOLDINGS), LTD.
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
FUNDS WITHHELD AT INTEREST AND EMBEDDED DERIVATIVES
Funds withheld at interest represents a receivable balance equivalent to
the Company's proportionate share of its ceding companies' statutory reserves
related to policies reinsured by the Company under annuity reinsurance
agreements written on a modified coinsurance or coinsurance funds withheld
basis. The premiums received by a ceding company on the policies underlying
these types of reinsurance agreements are used to purchase investment securities
that are managed by that ceding company or investment managers appointed by it.
Net investment income includes the Company's proportionate share of the
investment income and realized capital gains and losses on the sale of
investments purchased with those premiums, as well as distributions from the
embedded derivatives contained in certain of these agreements.
A portion of the Company's Funds withheld receivable asset contains
embedded derivatives which require bifurcation and separate accounting under FAS
133 -- Accounting for Derivative Instruments and Hedging Activities, which the
Company adopted as of January 1, 2001. The net fair value of these embedded
derivatives is classified as part of the Company's Funds withheld asset on its
balance sheet. The change in fair value of these embedded derivatives is
recorded in the Company's statement of operations as Net change in fair value of
embedded derivatives, which is a non cash item. The Company, with the assistance
of outside advisors, has developed a cash flow model to arrive at an estimate of
the fair value of these embedded derivatives that uses various assumptions
regarding future cash flows under the affected annuity reinsurance contracts.
While the Company has made an estimate of the fair value of these embedded
derivatives using a model that the Company's believes to be appropriate and
based upon reasonable assumptions, the assumptions used are subjective and may
require adjustment in the future. In addition, as industry standards for
estimating the fair value of embedded derivatives develop, it is possible that
the Company may modify its methodology. The Company does not bifurcate and
separately account for the embedded derivatives contained in certain of the
Company's contracts, including its annuity reinsurance agreement with
Transamerica, because the Company acquired those agreements prior to the
transition date elected by it under FAS 133, as amended by FAS 137.
RESERVES FOR GUARANTEES ASSOCIATED WITH VARIABLE ANNUITY CONTRACTS
The Company reinsures certain minimum guarantees associated with variable
annuity contracts. These include guaranteed minimum death benefits, guaranteed
minimum income benefits, and enhanced earnings benefits. The Company's
accounting policy is to establish reserves for expected future claims based upon
the long term view of expected losses over the life of the underlying policies,
based upon the original pricing assumptions. The Company's reserving policy
allows the Company to strengthen reserves if claim amounts or volume exceed what
was anticipated in pricing. During the third quarter of 2002, we increased our
reserves for minimum guarantees associated with variable annuities by
approximately $7,760,000 as a result of increasing claim activity over recent
quarters. The Company may be required to increase these reserves in future
periods if claims activity continues at the current level or higher.
The Accounting Standards Executive Committee (a committee of the American
Institute of Certified Public Accountants) has issued a proposed Statement of
Position that could set a new standard for accounting for Certain Nontraditional
Long-Duration Contracts and for Separate Accounts that, if adopted, could
require the Company to establish additional reserves for certain guarantees
associated with variable annuity contracts. These reserve adjustments will
likely be volatile because they are influenced by the performance of the
financial markets. Had the Company followed these proposed standards, on
December 31, 2001, no reserves would have been necessary, while on June 30,
2002, approximately $2 million of reserves would have been required. Given
recent fluctuations in the financial markets, the reserve required under the
proposed standard
10
ANNUITY AND LIFE RE (HOLDINGS), LTD.
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
would have risen to approximately $22 million by September 30, 2002, and then
fallen to approximately $9 million by October 31, 2002. For all of the periods
mentioned, the assumptions underlying the reserve calculations are the same. The
Company anticipates that this volatility will continue in future periods and, if
the proposed standard is adopted as currently written, this volatility will
affect the Company's reported results of operations.
INTEREST RATE SWAPS
In the third quarter of 2002, the Company entered into two interest rate
swaps with a nominal value of $67,000,000 to manage interest rate risk
associated with a deposit liability whereby the Company is required to pay a
variable rate of interest based upon LIBOR. The interest rate swaps do not meet
the effectiveness criteria specified in FAS 133 to qualify as a hedge. The swaps
are carried at fair value within accounts payable with the change in fair value
recorded as an adjustment to the income statement item to which they relate. In
the third quarter of 2002, the Company charged approximately $2,155,000 related
to these swaps to Collateral costs.
5. EARNINGS PER SHARE
The following table sets forth the computation of basic and diluted
earnings per share for the three and nine month periods ended September 30:
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
---------------------------- -----------------------------
2002 2001 2002 2001
------------ ------------- ------------- -------------
(AS RESTATED) (AS RESTATED) (AS RESTATED)
Net (loss) available to
common shareholders before
cumulative effect of a
change in accounting
principle.................. $(19,147,017) $(42,680,474) $(29,007,385) $(35,204,500)
Cumulative effect of a change
in accounting principle.... -- -- -- (3,665,735)
------------ ------------ ------------ ------------
Net (loss) available to
common shareholders........ $(19,147,017) $(42,680,474) $(29,007,385) $(38,870,235)
============ ============ ============ ============
Basic:
Weighted average number of
common shares
outstanding............. 25,733,141 25,683,328 25,722,016 25,592,914
Net (loss) per share before
cumulative effect of a
change in accounting
principle.................. $ (0.74) $ (1.66) $ (1.13) $ (1.38)
Cumulative effect of a change
in accounting principle.... $ -- $ -- $ -- $ (0.14)
------------ ------------ ------------ ------------
Net (loss) per share......... $ (0.74) $ (1.66) $ (1.13) $ (1.52)
============ ============ ============ ============
11
ANNUITY AND LIFE RE (HOLDINGS), LTD.
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
---------------------------- -----------------------------
2002 2001 2002 2001
------------ ------------- ------------- -------------
(AS RESTATED) (AS RESTATED) (AS RESTATED)
Diluted:
Weighted average number of
common shares
outstanding............. 25,733,141 25,683,328 25,722,016 25,592,914
Net (loss) per share before
cumulative effect of a
change in accounting
principle.................. $ (0.74) $ (1.66) $ (1.13) $ (1.38)
Cumulative effect of a change
in accounting principle.... $ -- $ -- $ -- $ (0.14)
------------ ------------ ------------ ------------
Net (loss) per share......... $ (0.74) $ (1.66) $ (1.13) $ (1.52)
============ ============ ============ ============
6. BUSINESS SEGMENTS
During the first quarter of 2002, the Company's management began to
separately track financial results of its life and annuity operations in
segments, as reflected in this report. Each segment is defined by a dominant
risk characteristic inherent in all products in that segment. The life segment
consists of all products where the dominant risk characteristic is mortality
risk. The annuity segment comprises all products where the dominant risk
characteristic is investment risk, including minimum guarantees associated with
variable annuity products. In addition, as discussed in Note 4 above, certain of
the Company's modified coinsurance and coinsurance funds withheld annuity
reinsurance agreements have features that constitute embedded derivatives that
require bifurcation and separate accounting under FAS 133 -- Accounting for
Derivative Instruments and Hedging Activities. The cumulative effect of the
application of FAS 133 to the agreements through January 1, 2001 and the change
in the fair value of these embedded derivatives are included in the annuity
segment. Both the life and annuity segments have specific assets, liabilities,
stockholders' equity, revenue, benefits and expenses that apply only to them.
The corporate segment contains all stockholders' equity not otherwise deployed
to the life or annuity segment. In addition, the corporate segment includes all
capital gains and losses from sales of securities in our portfolio and
investment income on undeployed invested assets. Operating expenses are
allocated to the segments proportionately based upon the amount of stockholders'
equity deployed to the segment. The Company believes that investors will better
understand the Company's profitability, risk profile, and capital deployment
through this change. There are no intersegment transactions. The following table
displays several key measurements for each of our business segments.
THREE MONTHS ENDED LIFE ANNUITY
SEPTEMBER 30, 2002 REINSURANCE REINSURANCE CORPORATE CONSOLIDATED
------------------ ------------ -------------- ------------ --------------
Revenues.................. $ 86,708,167 $ 18,535,565 $ 10,386,955 $ 115,630,687
Benefits and Expenses..... 96,858,456 36,882,014 1,037,234 134,777,704
------------ -------------- ------------ --------------
Segment Income (Loss)..... $(10,150,289) $ (18,346,449) $ 9,349,721 $ (19,147,017)
============ ============== ============ ==============
Total Assets.............. $655,417,016 $1,549,867,709 $115,373,735 $2,320,658,460
============ ============== ============ ==============
12
ANNUITY AND LIFE RE (HOLDINGS), LTD.
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
THREE MONTHS ENDED
SEPTEMBER 30, 2001 LIFE ANNUITY
(AS RESTATED, SEE NOTE 3) REINSURANCE REINSURANCE CORPORATE CONSOLIDATED
------------------------- ------------ -------------- ------------ --------------
Revenues.................. $ 65,951,358 $ 22,025,046 $ 4,403,338 $ 92,379,742
Benefits and Expenses..... 86,375,896 47,410,846 1,273,474 135,060,216
------------ -------------- ------------ --------------
Segment Income (Loss)..... $(20,424,538) $ (25,385,800) $ 3,129,864 $ (42,680,474)
============ ============== ============ ==============
Total Assets.............. $401,683,367 $1,713,508,054 $218,103,053 $2,333,294,474
============ ============== ============ ==============
NINE MONTHS ENDED
SEPTEMBER 30, 2002
(AS RESTATED, SEE NOTE 3)
-------------------------
Revenues.................. $260,319,388 $ 66,846,669 $ 16,090,312 $ 343,256,369
Benefits and Expenses..... 256,829,025 112,065,166 3,369,563 372,263,754
------------ -------------- ------------ --------------
Segment Income (Loss)..... $ 3,490,363 $ (45,218,497) $ 12,720,749 $ (29,007,385)
============ ============== ============ ==============
NINE MONTHS ENDED
SEPTEMBER 30, 2001
(AS RESTATED, SEE NOTE 3)
-------------------------
Revenues.................. $179,367,569 $ 68,325,130 $ 12,346,608 $ 260,039,307
Benefits and Expenses..... 188,280,834 102,659,123 4,303,850 295,243,807
------------ -------------- ------------ --------------
Segment Income (Loss)
before cumulative effect
of change in accounting
principle............... (8,913,265) (34,333,993) 8,042,758 (35,204,500)
Cumulative effect of a
change in accounting
principle............... -- (3,665,735) (3,665,735)
------------ -------------- ------------ --------------
Segment Income (Loss)..... $ (8,913,265) $ (37,999,728) $ 8,042,758 $ (38,870,235)
============ ============== ============ ==============
7. ACCOUNTING STANDARDS
In July 2001, the FASB issued Statement Number 141 -- Business Combinations
and Statement Number 142 -- Goodwill and Intangible Assets. These statements
changed how the Company accounts for business combinations and for purchased
goodwill and other intangible assets that arise from these combinations. The
Company adopted the new standards on January 1, 2002.
The standards require that all business combinations be accounted for using
the purchase method and establish specific criteria for the recognition of
intangible assets separately from goodwill. Under the standards, goodwill is no
longer amortized but will be subject to an impairment test on at least an annual
basis. At September 30, 2002 and December 31, 2001, Other assets included
unamortized goodwill of $2.1 million. Goodwill amortization for the year ended
December 31, 2001 was $116,000.
13
ANNUITY AND LIFE RE (HOLDINGS), LTD.
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
8. RELATED PARTY TRANSACTIONS
In the first quarter of 2002, the Company purchased a $10,000,000 excess of
loss reinsurance policy from a subsidiary of XL Capital Ltd, a related party, to
provide protection against minimum interest guarantee payments under the
Company's annuity reinsurance contract with Transamerica Occidental Life
Insurance Company occurring after January 1, 2002, in excess of a $33,000,000
deductible. The premium paid for this protection was $1.5 million.
Also during the first quarter of 2002, the Company purchased an aggregate
catastrophe excess of loss cover from a subsidiary of XL Capital providing
protection from a single event, excluding acts of terrorism, causing a claim for
more than five policyholders. The premium for this coverage was $1,000,000.
9. RESTRICTED STOCK
In 2002, the Company adopted a restricted stock incentive compensation
program and made two awards to employees. Under the first award to employees,
133,500 shares of restricted stock that vest on the third anniversary of the
grant date were issued. Under the second award to employees, 267,500 shares of
restricted stock that vest in three equal annual installments commencing on the
first anniversary of the grant date were issued. The fair value of the
restricted stock awards on the date of award and assuming all shares vest was
$3,289,000, which is reflected in the Company's balance sheet as common stock
and paid in capital and as a contra-equity account. The fair value of this grant
is being amortized on a straight line basis over the three year vesting period.
The unamortized balance of the grant is reflected in the balance sheet as
restricted stock.
10. CONTINGENCIES
During the second quarter of 2002, the Company initiated arbitration
proceedings in connection with two of its life reinsurance agreements. During
the third quarter of 2002, the Company settled its arbitration with one of the
ceding companies, resulting in the recapture by that company of the contract
that had been the subject of the arbitration. The impact of that contract on the
third quarter, including the recapture, was a net loss of $6,189,000. With
respect to the remaining life arbitration claim, the Company is seeking monetary
damages and/or equitable relief from the ceding company based upon its
contention that the ceding company failed to disclose material facts, known to
them, about the block of business being reinsured when it was underwritten. No
assurance can be given that monetary recovery or equitable relief will occur.
On January 21, 2002, the Company served written notice of arbitration in
connection with the Company's annuity reinsurance contract with Transamerica
Occidental Life Insurance Company. In the arbitration, the Company was seeking
monetary damages and/or equitable relief from Transamerica based on the
Company's claim that certain actions and/or omissions by Transamerica deprived
the Company of the benefit of the reinsurance transaction. On November 8, 2002,
the Company announced that its claim against Transamerica had been denied by the
arbitration panel assigned to the matter. The arbitration panel upheld
Transamerica's position that the Company's annuity reinsurance contract was a
valid and enforceable contract and that Transamerica had acted in a commercially
reasonable manner.
14
ANNUITY AND LIFE RE (HOLDINGS), LTD.
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Based on the Company's projections of its ceding companies' statutory
reserve cessions, in order to satisfy its obligations under its existing
reinsurance agreements, the Company will need to post up to approximately $210.0
million of additional collateral by December 31, 2002. The Company will seek to
meet or reduce these additional security requirements by negotiating the
recapture, retrocession or sale of certain of its reinsurance agreements,
accessing its collateral funding facility and/or raising capital. The Company
has not been able to successfully raise capital or access its collateral funding
facility in recent months given, among other things, the uncompleted restatement
of the Company's financial statements for 2000 and 2001. If the Company is
unable to meet the security requirements of its cedents, the Company may be
required to cease writing new business and the Company may be in violation of
its existing reinsurance contracts and become subject to the remedies set forth
therein. The Company's cedents may also ask that the agreements be recaptured.
These recaptures could result in losses, but could also improve the Company's
liquidity and its ability to meet the collateral requirements of its remaining
cedents.
The Company currently has unsecured letters of credit of approximately
$49,000,000 outstanding under a letter of credit facility with Citibank. In
October 2002, Citibank agreed to extend this unsecured letter of credit facility
into next year in exchange for the Company's agreement to secure, or otherwise
eliminate, the letter of credit facility by June 30, 2003.
As of September 30, 2002, the Company had $45,000,000 of unsecured letters
of credit outstanding under a letter of credit facility with Manulife Financial
that had been posted as security to allow the Company's United States operating
subsidiary to take credit on its statutory financial statements for reinsurance
ceded to the Company's Bermuda operating company. During October of 2002,
Manulife requested that the unsecured letters of credit it had issued on the
Company's behalf be secured. Consequently, in November 2002, the Company's
Bermuda operating subsidiary deposited $15,000,000 with the Company's United
States operating subsidiary as funds withheld. Further, one of the Company's
United States operating subsidiary's ceding companies has recaptured its
contracts, reducing the subsidiary's collateral needs by an additional
$15,000,000. The Company has committed to securing or eliminating the remaining
$15,000,000 in letters of credit issued by Manulife under the Company's letter
of credit facility by December 31, 2002. Due to Manulife's request to secure its
letter of credit facility and the Company's inability thus far to post
sufficient security for the Company's United States operating subsidiary, the
Connecticut Insurance Department has requested that all financial transactions,
except those related to the normal course of business, between the Company and
its United States operating subsidiary be preapproved by the insurance
department.
15
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
GENERAL
Annuity and Life Re (Holdings), Ltd. was incorporated on December 2, 1997
under the laws of Bermuda. We provide annuity and life reinsurance to select
insurers and reinsurers through our wholly-owned subsidiaries: Annuity and Life
Reassurance, Ltd., which is licensed under the insurance laws of Bermuda as a
long term insurer; and Annuity and Life Re America, Inc., an insurance holding
company based in the United States, and its subsidiary, Annuity and Life
Reassurance America, Inc., a life insurance company authorized to conduct
business in over 40 states of the United States and the District of Columbia. We
acquired Annuity and Life Reassurance America on June 1, 2000.
The business of reinsurance generally consists of reinsurers, such as
Annuity and Life Re, entering into contractual arrangements (known as treaties)
with primary insurers (known as ceding companies or cedents) whereby the
reinsurer agrees to indemnify the ceding company for all or a portion of the
risks associated with an underlying insurance policy in exchange for a
reinsurance premium payable to the reinsurer. Reinsurers also may enter into
retrocessional reinsurance arrangements with other reinsurers, which operate in
a manner similar to the underlying reinsurance arrangement described above.
Under retrocessional reinsurance arrangements, the reinsurer shifts a portion of
the risk associated with an underlying reinsurance contract to other reinsurers.
Reinsurance agreements may be written on an automatic treaty basis or
facultative basis. An automatic treaty provides for a ceding company to cede
contractually agreed-upon risks on identified types of business that meet
established criteria to a reinsurer and binds that reinsurer to accept such
risks without obtaining further approval from that reinsurer. Facultative
reinsurance is the reinsurance of individual risks, which allows a reinsurer the
opportunity to analyze and separately underwrite a risk before agreeing to
accept the risk. Both automatic treaty and facultative reinsurance may be
written on either a quota share basis, where a percentage of each risk in the
reinsured class of risk is assumed by the reinsurer from the ceding company, or
an excess of retention basis, where the amount of risk of each life in excess of
the ceding company's retention is reinsured. Under either basis, premiums are
paid to the reinsurer in proportion to the risk assumed by the reinsurer.
Reinsurance can also be on an excess of loss basis, where a reinsurer
indemnifies the ceding company for a portion of claims exceeding a specified
amount retained by the ceding company in consideration of non-proportional
premiums being paid to the reinsurer. The reinsurer's obligation under an excess
of loss contract may be limited to a specified amount of such excess claim.
We write reinsurance generally in the form of yearly renewable term,
coinsurance, modified coinsurance or coinsurance funds withheld. Under yearly
renewable term, we share only in the mortality risk for which we receive a
premium. In coinsurance, modified coinsurance and coinsurance funds withheld
arrangements, we generally share proportionately in all or a portion of the
risks inherent in the underlying policies, including mortality, persistency and
fluctuations in investment results. Under such agreements, we agree to indemnify
the primary insurer for all or a portion of the risks associated with the
underlying insurance policies in exchange for a proportionate share of premiums.
Coinsurance differs from modified coinsurance and coinsurance funds withheld
with respect to ownership of the assets supporting the reserves. Under our
coinsurance arrangements, ownership of these assets is transferred to us,
whereas, in modified coinsurance and coinsurance funds withheld arrangements,
the ceding company retains ownership of these assets, but we share in the
investment income and risk associated with the assets.
Our reinsurance treaties may provide for recapture rights, permitting the
ceding company to reassume all or a portion of the risk ceded to us after an
agreed-upon period of time (generally 10 years for our life reinsurance
treaties), subject to certain other conditions. Some of our reinsurance treaties
allow the ceding company to recapture the ceded risk if we fail to maintain a
specified rating or if other financial conditions relating to us are not
satisfied. Recapture of business previously ceded does not affect earned
premiums paid to us prior to the recapture of such business and may involve the
payment to us of a recapture fee. Nevertheless, we may have to liquidate
substantial assets in order to return the assets supporting the reserve
liabilities. In addition, we would no longer be entitled to receive any
investment income from the premiums paid by the policyholders underlying the
recaptured business and, consequently, we may have to accelerate the amortiza-
16
tion of any unamortized deferred acquisition costs associated with the
recaptured business, which would reduce our earnings.
RISKS REINSURED
We write reinsurance predominantly on a direct basis with primary life
insurance companies. Our major business lines are traditional life reinsurance
and annuity reinsurance, which expose us to the following categories of risks:
(i) mortality, (ii) investment, (iii) persistency (or lapse) and (iv) expense.
Mortality risk is the risk that death claims differ from what we expect.
With respect to our life segment, a greater frequency or higher average size of
death claims than we expected can cause us to pay greater death benefits,
adversely affecting the profitability of our reinsurance contracts. Even if the
total death benefits paid over the life of our contracts do not exceed the
expected amount, unexpected timing of deaths, such as occurred with the attack
on the World Trade Center, can cause us to pay more death benefits in a given
time period than expected, adversely impacting profitability in that period. We
try to address these risks by analyzing each block of business based on an
evaluation of the ceding company's underwriting efficacy, history, management,
target market, concentration of risk, products and underwriting criteria
relative to the industry. We target primarily "first dollar" quota share pools
of top producing direct writing companies under which we participate
proportionately with other reinsurers on all of the ceded risks. We seek to
mitigate our risk of exposure to any one block of business or any one individual
life by typically requiring our ceding companies to retain at least 10% of every
life insurance risk reinsured. We further address the risk of any one large
claim by limiting our own net liability on any single-life risk to $1,000,000.
Certain of the annuity policies we reinsure are in the payout phase, and are
therefore subject to the risk that policyholders will survive for longer periods
than we assumed when pricing the reinsurance contract. If policyholders live
longer than we assumed, we may be required to pay greater than expected annuity
payout benefits in future periods.
We are subject to investment risk with respect to our own investments and
with respect to the assets held and managed by our ceding companies or others
under our modified coinsurance and coinsurance funds withheld arrangements. Our
investments, which primarily consist of investment grade fixed income
securities, are subject to interest rate and credit risk. Significant changes in
interest rates expose us to the risk of earning less income during periods when
interest rates are falling, or realizing losses if we are forced to sell
securities during periods when interest rates are rising. We are also subject to
prepayment risk on certain securities in our investment portfolio, including
mortgage-backed securities and collateralized mortgage obligations, which
generally prepay faster during periods of falling interest rates as the
underlying mortgage loans are repaid and refinanced by borrowers in order to
take advantage of lower interest rates.
We also have over $1.4 billion in assets that are held and managed by our
ceding companies or others under our modified coinsurance and coinsurance funds
withheld arrangements. While we do not own these assets, they are used to fund
our obligations under our annuity reinsurance contracts. Those assets are
primarily invested in fixed income securities and, with respect to our largest
annuity reinsurance contract, in investment grade convertible bonds. The fixed
income securities in which the assets are invested are subject to risks similar
to those described above with respect to our own investments. The value of
convertible bonds in which these assets are invested is a function of their
investment value (determined by comparing their yield with the yields of other
securities of comparable maturity and quality that do not have a conversion
privilege) and their conversion value (their market value if converted into the
underlying common stock). The investment value of convertible bonds is
influenced by changes in interest rates, with investment value declining as
interest rates increase and increasing as interest rates decline, and by the
credit standing of the issuer and other factors. The conversion value of
convertible bonds is determined by the market price of the underlying common
stock. If the conversion price is below the market value of the underlying
common stock, the price of the convertible bonds is governed principally by
their investment value. To the extent the market price of the underlying common
stock approaches or exceeds the conversion price, the price of the convertible
bonds will be increasingly influenced by their conversion value. Consequently,
the value of convertible bonds may be influenced by changes in the equity
markets.
17
We are also subject to investment risk based on the difference between the
interest rates earned on the investments managed by us or our ceding companies
and the credited interest rates paid under policies reinsured by us. Both rising
and declining interest rates can affect the income we derive from these interest
rate spreads. During periods in which prevailing market interest rates are
falling, any new investments made in fixed income securities to replace
investments that mature or are prepaid will likely bear lower interest rates,
reducing our investment income. We may not be able to fully offset the decline
in our investment income with lower crediting rates on our contracts for the
reinsurance of annuities or life insurance policies with cash value components.
During periods of rising interest rates, our ceding companies may need to
increase the crediting rates on the annuities or life insurance policies with
cash value components that we reinsure. We may not, however, be able to acquire
investments with interest rates sufficient to offset these increased crediting
rates. Significant declines in the financial markets generally also increase our
investment risk, because the return we receive on our assets may not be
sufficient to fully offset the cost of benefits due under certain reinsured
policies. Certain policy benefits, such as guaranteed minimum death benefits,
"ratchet" up the death benefit when policyholder account values increase, but do
not reduce the death benefit when policyholder account values decrease. During
periods in which the general value of the financial markets and policyholder
account values are falling, claims from such guaranteed minimum death benefits
increase because the spread between the policyholder account value and the
ratcheted-up death benefit increases. Further, because the premiums charged for
such benefits are based on policyholder account values, we would receive reduced
premiums for this benefit when financial markets are declining.
We may use interest rate swaps and other hedging instruments as tools to
mitigate the effects of asset/ liability mismatches or the effect of interest
rate changes on our balance sheet. In general, however, we have not hedged our
investment risk, but we may do so in the future.
Persistency or lapse risk is the risk that policyholders maintain their
policies for different periods of time than expected. This includes policy
surrenders and policy lapses. Surrenders are the voluntary termination of a
policy by the policyholder, while lapses are the termination of the policy due
to non-payment of premium. Surrender and lapse rates that are higher than what
we assumed when pricing a contract can cause us to increase the rate of
amortization of our deferred acquisition costs for the annuity policies and
certain types of life insurance that we reinsure, which would adversely affect
our results of operations. If the actual surrender and lapse rates remain too
high for too long, as has been the case with our annuity reinsurance contract
with Transamerica Occidental Life Insurance Company, we may conclude that the
contract could be unprofitable over its expected lifetime, and we could be
required to write down our deferred acquisition costs. Surrenders also usually
involve the return of the policy's cash surrender value to the policyholder,
which reduces the asset base on which we earn investment income and, in some
cases, premiums. In addition, with respect to our Transamerica contract, a
surrendering policyholder is entitled to a guaranteed minimum interest rate on
his or her invested premiums, and we are required to pay our proportionate share
of any shortfall between that guaranteed amount and the actual value of the
policyholder's account. We have been required to make significant minimum
interest guarantee payments under this contract, as discussed below. During
periods in which the financial markets are falling, increases in partial
surrenders under certain reinsurance policies do not reduce the guaranteed
minimum death benefits we are obligated to pay by the same proportion by which
the premiums supporting the guaranteed minimum death benefit obligations are
reduced. The risk of partial surrenders impacting our guaranteed minimum death
benefit obligations may have an effect on the profitability of our reinsurance
contract with Hartford Life.
Certain of our life reinsurance products provide level premiums to us for a
fixed period of time, typically 10 to 20 years. The premiums we receive on these
level premium contracts exceed the death benefits payable to the underlying
policyholders during the early years of the contract. The death benefits we
expect to pay under these contracts generally increase over time, while the
premiums we receive are expected to generally remain level, so the death
benefits payable under the policy ultimately exceed the premiums we receive in
later years. With respect to these level premium contracts, if the surrender and
lapse rates of the policies are significantly lower than we assumed when pricing
the reinsurance contract, the profitability of the contract may be adversely
affected.
18
Expense risk is the risk that our actual expenses will be higher than we
anticipated, or that our operations are less efficient than anticipated.
BUSINESS WRITTEN
The following table sets forth selected information for the indicated
periods concerning our insurance operations:
POLICY REVENUES, INSURANCE IN FORCE AND ANNUITY REINSURANCE DEPOSITS
NINE MONTHS ENDED TWELVE MONTHS ENDED DECEMBER 31,
SEPTEMBER 30, ------------------------------------------------
2002 2001 2000 1999
------------------ -------------- -------------- --------------
Policy revenues
Life reinsurance
First year....... $ 66,463,760 $ 94,746,734 $ 55,047,163 $ 72,268,437
Renewal.......... 180,435,259 141,607,931 96,151,918 28,566,570
Annuity
reinsurance...... 8,108,016 15,438,572 17,204,941 --
-------------- -------------- -------------- --------------
Total.......... $ 255,007,035 $ 251,793,237 $ 168,404,022 $ 100,835,007
============== ============== ============== ==============
Insurance in force at
end of period (in
thousands).......... $ 150,948,700 $ 117,400,000 $ 77,019,000 $ 45,407,000
============== ============== ============== ==============
Annuity reinsurance
deposits............ $1,464,667,709 $1,519,596,075 $1,597,928,818 $1,603,382,955
============== ============== ============== ==============
Our life reinsurance segment is the reinsurance of ordinary life insurance,
primarily for mortality risks. Ordinary life reinsurance generally is the
reinsurance of individual term life insurance policies, whole life insurance
policies and joint and survivor insurance policies on yearly renewable term
basis. In addition, we reinsure the mortality risk inherent in universal life
insurance policies, variable universal life insurance policies and variable life
insurance policies.
Our annuity reinsurance segment is the reinsurance of general account fixed
deferred annuities, general account payout annuity obligations and certain risks
arising from variable annuities. With respect to the general account fixed
annuities we reinsure, our agreements generally relate to individual general
account single premium deferred annuity policies, which either involve the
tax-deferred accumulation of interest on a single premium paid by the
policyholder (accumulation phase policies) or are annuities that pay fixed
amounts periodically to policyholders over a fixed period of time or their lives
(payout phase policies). Accumulation phase policies are subject primarily to
investment risk and persistency (lapse) risk, while payout phase policies are
primarily subject to investment risk and mortality (longevity) risk. Most of the
fixed annuities we reinsure are accumulation phase policies. All of the fixed
annuity products we reinsure have minimum interest guarantee provisions required
under state law that entitle the policyholder to a specified minimum annual
return over the life of the policy. These lifetime guarantees are typically 3%
to 3.5% annually. Further, policyholders are typically guaranteed interest rates
in excess of the state required minimums for the initial year of the policy.
After the expiration of the period in which the crediting rate is guaranteed,
the primary insurer has the discretionary ability to adjust the crediting rate
annually to any rate at or above the guaranteed minimum rate required under
state law. Policyholders are typically permitted to withdraw all or a part of
their premium paid, plus an accumulation amount equal to the accrued interest
credited to the account, subject to the assessment of a surrender charge for
withdrawals in excess of specified limits.
Certain policies reinsured by us guarantee the policyholder a crediting
rate beyond the initial policy year, including those policies covered by our
annuity reinsurance contract with The Ohio National Life Insurance
19
Company. In addition to the lifetime minimum guaranteed interest rate required
under state law, the Ohio National policies reinsured by us guarantee a
crediting rate to the policyholders for six years. During that six year period,
each year's crediting rate is guaranteed to exceed the prior year's rate by
0.15%. For the nine months ended September 30, 2002 and the fiscal year ended
December 31, 2001, the average crediting rate of the policies underlying the
Ohio National contract was 5.3% and 5.6%, respectively. The average yield rate
on the assets managed by Ohio National that are funding these policyholder
obligations for the nine month period ended September 30, 2002 and the fiscal
year ended December 31, 2001 was 7.8% and 7.4%, respectively. The Ohio National
reinsurance contract is our second largest annuity reinsurance contract and
represented approximately 25% and 15% of our Funds withheld receivable as of
September 30, 2002 and December 31, 2001, respectively.
Under our Transamerica annuity reinsurance contract, the minimum interest
guarantee provisions take effect when the policyholder dies, his or her policy
annuitizes or his or her policy is surrendered. Our aggregate minimum interest
guarantee exposure under this contract equals our proportionate share of the
amount by which each policyholder's premiums deposited compounded at the minimum
guarantee interest rate exceeds the policyholder's actual account value. This
excess is calculated after expenses are deducted from the gross investment
returns and such expenses generally accrue at a rate of approximately 2.5% of
the assets annually. Our minimum interest guarantee exposure is calculated on a
policyholder by policyholder basis. The amount by which the value of certain
policyholder accounts exceeds the minimum guarantee amount with respect to those
accounts does not offset our exposure to the amount by which the value of other
policyholder accounts is less than the minimum guarantee amount with respect to
such other accounts. This exposure generally arises during periods in which
investment returns fall near or below the minimum guaranteed rate, as has
occurred in recent years. If we conclude that we are exposed to these minimum
interest guarantees under our reinsurance contract with Transamerica, we then
estimate the expected minimum interest guarantee payments that we may be
required to make by projecting the anticipated future investment performance of
the assets supporting the policyholder accounts and by applying projected
surrender, lapse and mortality assumptions to the exposed amounts. Because we
assume that the investment performance of the underlying assets will exceed the
minimum guaranteed interest rate on the underlying annuity policies over their
life, we anticipate that any minimum interest guarantee exposure we have will
decrease over time. The amount of expected minimum interest guarantee payments
is therefore dependent upon our estimate of the number of policyholders that
will die, annuitize or surrender their policy prior to the value of the
underlying assets increasing to a level where it equals or exceeds the
policyholders' minimum guarantee amounts. Our minimum interest guarantee
exposure can increase during any period in which the actual investment
performance of the underlying assets less expenses deducted from the gross
investment returns lags the minimum guaranteed interest rate.
We also reinsure certain guarantees associated with variable annuity
contracts, including guaranteed minimum death benefits, enhanced earnings
benefits and guaranteed minimum income benefits. Under contracts with a
guaranteed minimum death benefit, a policyholder's beneficiary is entitled at
the time of the policyholder's death to receive the greater of the
policyholder's account value or a guaranteed minimum benefit payment. The
majority of the guaranteed minimum death benefit contracts we reinsure are
written on a "ratchet" basis, which means that the guaranteed minimum death
benefit payable to the policyholder's beneficiary equals the highest
policyholder account value achieved over the course of the contract, as measured
annually on each anniversary date of the policy until the policyholder reaches
the attained age under the policy (typically 80 years of age). Other guaranteed
minimum death benefit contracts are written on a "roll-up" basis, which means
that the guaranteed minimum death benefit equals the premiums paid by the
policyholder compounded at a defined interest rate (typically 3% to 6%), which
accrues until the policyholder reaches the attained age or the roll-up death
benefit reaches a predetermined amount, typically double the premiums paid. Some
policies offer an enhanced version of the guaranteed minimum death benefit,
under which the policyholder's beneficiary receives the greater of the actual
cash value, the ratcheted value or the roll-up value. Such policies may be
particularly disadvantageous to us in light of the recent extended decline in
the financial markets. Regardless of whether a policy is written on a ratchet or
a roll-up basis, if the policyholder survives beyond the policy maturity date,
which is typically when the policyholder reaches
20
90 years of age, he or she is no longer entitled to receive the guaranteed
minimum death benefit amount. Before that time, the issuer of the policy bears
the risk that protracted under-performance of the financial markets could result
in guaranteed minimum death benefits payable to the policyholder's beneficiary
upon the policyholder's death that are higher than the actual policyholder
account value. As a reinsurer, we are obligated to reimburse the issuer of such
policies for our share of any shortfall between the guaranteed minimum death
benefit amount and the actual policyholder account values upon death.
Our two largest contracts reinsuring guaranteed minimum death benefits are
with Hartford Life and Connecticut General Life Insurance Company (CIGNA), which
is a retrocession of policies issued by The Equitable. As of September 30, 2002,
the guaranteed minimum death benefit amount at risk (i.e., the amount by which
guaranteed death benefits exceed related account values) under our contract with
Hartford Life was approximately $1.2 billion. Also as of September 30, 2002, the
guaranteed minimum death benefit amount at risk under our contract with CIGNA
was approximately $42 million. These amounts are an aggregate measure of our
exposure to guaranteed minimum death benefits assuming 100% mortality experience
at September 30, 2002. Our expected liability for future guaranteed minimum
death benefit payments, based on realistic mortality assumptions, is
substantially less. Because the premium paid to Hartford Life, and to us under
the reinsurance agreement, is derived from asset-based charges levied against
the account value, there may be circumstances during periods of reduced
performance in the financial markets when we could be under compensated for
reinsuring the guaranteed minimum death benefit. Under our reinsurance agreement
with Hartford Life, we are subject to additional risks beyond those described
above when the underlying policies are partially surrendered. Unlike the
policies underlying the CIGNA reinsurance contract, the Hartford Life policies
provide that the guaranteed minimum death benefit is not proportionally reduced
when a policyholder withdraws some, but not all, of the policy value (a partial
surrender), but rather is reduced on a dollar for dollar basis. As a result,
partial surrenders under the Hartford Life policies do not reduce the guaranteed
minimum death benefits we are obligated to pay by the same proportion by which
the premiums supporting the guaranteed minimum death benefit obligations are
reduced.
Policies with the enhanced earnings benefit provide that if a policyholder
dies prior to the maturity date of his or her policy, the issuer of the policy
will pay the policyholder's beneficiary the death benefit otherwise payable
under the policy plus an additional amount generally equal to 25% to 40% of the
actual increase in the policyholder's account value. The enhanced earnings
benefit is designed to increase the total payments to the policyholder with an
amount sufficient to pay income taxes on the increase in the account value. Our
largest reinsurance contract reinsuring this benefit is with Hartford Life,
under which our net amount at risk is less than $250,000.
Policies providing a guaranteed minimum income benefit entitle a
policyholder to purchase a lifetime annuity payment stream after the expiration
of a stipulated waiting period of at least 7 years based upon the initial
premium paid by the policyholder compounded at a predetermined rate, usually 3%
or 6%, depending on the age of the policyholder. The annuity purchase rate used
to calculate the income stream the policyholder is entitled to receive is a
predetermined rate that is based upon more conservative investment and mortality
assumptions than would otherwise be used to calculate prevailing annuity
purchase rates following the expiration of the waiting period. We are subject to
investment risk to the extent that investment returns on the assets supporting
the liabilities under these policies will not be sufficient to fund the payment
stream the policyholder is entitled to receive. However, because the annuity
purchase rates applicable to the guaranteed minimum income benefits are often
less favorable than prevailing annuity purchase rates when the underlying policy
annuitizes, policyholders may receive a preferable stream of annuity payments
using the actual account value at prevailing annuity purchase rates as opposed
to utilizing the predetermined guaranteed minimum income benefit purchase rate
under the policy. To the degree this occurs, any difference in annuity purchase
rates will offset the investment risk. Because none of the guaranteed minimum
income benefit policies we reinsure have reached the end of the stipulated
waiting period, we cannot estimate accurately the effect the unfavorable annuity
purchase rates will have on policyholders' desire to utilize this benefit under
various market conditions.
21
CRITICAL ACCOUNTING POLICIES
Our consolidated financial statements are prepared in accordance with
accounting principles generally accepted in the United States of America, which
require our management to make estimates and assumptions that affect the amounts
of our assets, liabilities, stockholders' equity and net income. We believe that
the following critical accounting policies, as well as those set forth in our
Form 10-K for the year ended December 31, 2001, detail the more significant
estimates and assumptions used in the preparation of our consolidated financial
statements. As noted above, the Company is in the process of restating its
financial statements for the fiscal years ended December 31, 2000 and 2001. The
Company plans to file an amended Form 10-K for the fiscal year ended December
31, 2001 as soon as its auditors have completed their audit of such restated
financial statements.
In preparing our financial statements, we make assumptions about our
proportionate share of future investment income that will be earned from the
investment of premiums received from underlying policyholders by our ceding
companies and about future rates of lapse of policies underlying our annuity
reinsurance contracts when estimating expected gross profits arising from such
contracts. These assumptions have a direct impact on the amount of estimated
expected gross profits arising from these annuity reinsurance contracts and,
therefore, on the recoverability of the deferred acquisition costs carried on
our balance sheet for these contracts. While these estimates are based upon
historical results and information provided to us by our cedents, actual results
could differ (and, in the past, have differed) materially from our estimates for
a variety of reasons, including the failure of our ceding companies to report
timely information regarding material developments under our reinsurance
agreements. Such differences could be material to our future results. If our
assumptions for investment returns prove to be inaccurate, or if lapse rates
exceed our assumptions, we may be required to record additional charges, which
would adversely impact our earnings.
In applying the requirements of FAS 133 -- Accounting for Derivative
Instruments and Hedging Activities, we have concluded that there are embedded
derivatives within the Funds withheld at interest receivable related to certain
of our annuity reinsurance contracts written on a modified coinsurance or
coinsurance funds withheld basis that require bifurcation and separate
accounting. These embedded derivatives are similar to a total return swap
arrangement on the underlying assets held by our ceding companies. The net fair
value of these embedded derivatives is classified as part of our Funds withheld
asset on our Balance Sheet. We have developed a cash flow model with the
assistance of outside advisors to arrive at an estimate of the fair value of
this total return swap that uses various assumptions regarding future cash flows
under the affected annuity reinsurance contracts. The change in fair value of
these embedded derivatives is recorded in our statement of operations as Net
change in fair value of embedded derivatives, which is a non cash item. The
change in fair value also impacts expected gross profits for purposes of
amortizing deferred acquisition costs associated with these contracts. The
application of this accounting policy has increased the volatility of our
reported earnings. While we have made an estimate of the fair value of these
embedded derivatives using a model that we believe to be appropriate and based
upon reasonable assumptions, the assumptions used are subjective and may require
adjustment in the future. In addition, as industry standards for estimating the
fair value of embedded derivatives develop, it is possible that we may modify
our methodology. Changes in our assumptions and industry standards could have a
significant impact on the fair value of the embedded derivatives and our
reported earnings. We do not bifurcate and separately account for the embedded
derivatives contained in certain of our contracts, including our Transamerica
annuity reinsurance agreement, because we acquired those agreements prior to the
transition date elected by us under FAS 133, as amended by FAS 137. Because of
the nature of the assets underlying our Transamerica contract, which were
roughly 67% convertible bonds at September 30, 2002, the bifurcation and
separate accounting for the embedded derivatives contained in that contract
would add significant volatility to our reported results.
We reinsure certain minimum guarantees associated with variable annuity
contracts. These include guaranteed minimum death benefits, guaranteed minimum
income benefits, and enhanced earnings benefits. Our accounting policy is to
establish reserves for expected future claims based upon the long term view of
expected losses over the life of the underlying policies, based upon the
original pricing assumptions. Our reserving policy allows us to strengthen
reserves if reported claim amounts or volume exceed what was anticipated in
pricing. During the third quarter of 2002, we increased our reserves for minimum
guarantees
22
associated with variable annuities by approximately $7,760,000 as a result of
increasing claim activity in recent quarters. We may be required to increase
these reserves in future periods if claim activity continues at the current
level or higher.
The Accounting Standards Executive Committee (a committee of the American
Institute of Certified Public Accountants) has issued a proposed Statement of
Position that could set a new standard for accounting for Certain Nontraditional
Long-Duration Contracts and for Separate Accounts that, if adopted, could
require us to establish additional reserves for certain guarantees associated
with variable annuity contracts. These reserve adjustments will likely be
volatile because they are influenced by the performance of the financial
markets. Had we followed this proposed standard, on December 31, 2001, no
reserves would have been necessary, while on June 30, 2002, approximately $2
million in reserves would have been required. Given recent fluctuations in the
financial markets, the reserve required under the proposed standard would have
risen to approximately $22 million by September 30, 2002, and then fallen to
approximately $9 million by October 31, 2002. For all of the periods mentioned,
the assumptions underlying the reserve calculations are the same. We anticipate
that this volatility will continue in future periods and, if the proposed
standard is adopted, this volatility will affect our reported results of
operations.
If actual events differ significantly from the underlying estimates and
assumptions used by us in the application of these accounting policies, there
could be a material adverse effect on our results of operations and financial
condition.
OPERATING RESULTS
Net Income. For the three month period ended September 30, 2002, we had a
net loss of $(19,147,000) or $(0.74) per basic and fully diluted common share,
as compared to a net loss of $(42,680,000) or $(1.66) per basic and fully
diluted common share for the three month period ended September 30, 2001. For
the nine month period ended September 30, 2002, we had a net loss of
$(29,007,000) or $(1.13) per basic and fully diluted common share, as compared
to a net loss of $(38,870,000) or $(1.52) per basic and fully diluted common
share for the nine month period ended September 30, 2001. The following table
summarizes some of the more significant items affecting net income:
FOR THE THREE MONTHS FOR THE NINE MONTHS
ENDED SEPTEMBER 30, ENDED SEPTEMBER 30,
----------------------------- -------------------------------
2002 2001 2002 2001
------------ -------------- -------------- --------------
(AS RESTATED) (AS RESTATED) (AS RESTATED)
Cumulative effect of a change in
accounting principle.......... $ -- $ -- $ -- $ (3,665,735)
Net change in fair value of
embedded derivative........... (13,277,823) (5,265,396) (18,254,530) (3,567,342)
Change in amortization of
deferred acquisition costs
related to embedded
derivatives................... 5,790,244 269,009 7,292,964 1,410,724
Transamerica contract deferred
acquisition cost write
downs......................... -- (19,157,798) (24,796,000) (34,538,991)
Variable annuity minimum
guarantee reserve
strengthening................. (7,760,000) -- (7,760,000) --
Variable annuity minimum
guarantee payments in excess
of premiums................... (3,117,100) 1,364,121 (2,171,700) 3,735,923
World Trade Center.............. -- (12,000,000) -- (12,000,000)
Net realized investment gains... 9,297,351 1,078,933 10,813,315 1,425,183
Unrealized loss on interest rate
swap.......................... (2,005,000) -- (2,005,000) --
------------ ------------ ------------ ------------
Total of significant items...... $(11,072,328) $(33,711,131) $(36,880,950) $(47,200,238)
============ ============ ============ ============
23
The cumulative effect of a change in accounting principle reflected in the
nine month period ended September 30, 2001 is the result of our implementation
of FAS 133 -- Accounting for Derivative Instruments and Hedging Activities as of
the first quarter of 2001. Under FAS 133, we are required to carry the fair
value of the embedded derivatives contained in certain of our annuity
reinsurance contracts on our balance sheet, and unrealized changes in the fair
value of those embedded derivatives are reflected in our net income. The change
in fair value of the embedded derivatives is influenced by changes in credit
risk, yield curve shifts, changes in expected future cash flows under the
annuity reinsurance contracts and, to a lesser extent, interest rate changes.
The change in fair value also impacts the emergence of expected gross profits
under the contracts for purposes of amortizing deferred acquisition coasts.
During the three and nine month periods ended September 30, 2002, the fair value
of the embedded derivatives declined significantly because of credit spreads
widening in the sectors in which the underlying investments are held,
particularly in the telecommunications and energy sectors. The unrealized losses
on the fair value of the embedded derivatives in each of the three and nine
month periods ended September 30, 2001 and 2002 resulted in lower amortization
of deferred acquisition costs in those periods.
Our net income is significantly affected by our annuity reinsurance
contract with Transamerica, which is our largest annuity reinsurance contract
and represents approximately $769 million, or 54%, of our Funds withheld at
interest receivable as of September 30, 2002. The significant losses associated
with the Transamerica contract during the nine months ended September 30, 2002
were the result of a write down of deferred acquisition costs of $24,796,000 in
the second quarter of 2002. The write down was the result of the continued poor
performance of the financial markets during the first half of 2002, which caused
us to reassess the assumptions we used in estimating the impact expected future
minimum interest guarantee payments would have on the profits arising from this
contract. We recorded similar charges against our deferred acquisition cost
asset of $34,500,000 during the nine month period ended September 30, 2001,
$19,200,000 of which was recorded in the three month period ended September 30,
2001. A significant portion of the charges recorded in 2001 related to the high
surrender rates on the polices underlying the contract, which caused us to
review the recoverability of the deferred acquisition costs associated with this
contract, and to expected minimum interest guarantee payments.
We also recorded losses associated with our contracts that reinsure
guarantees associated with variable annuity contracts, including guaranteed
minimum death benefits, of $10,877,000 and $9,932,000 during the three and nine
month periods ended September 30, 2002. These losses were the result of the
protracted decline in the financial markets, which has caused the guaranteed
minimum death benefits payable to the beneficiaries of certain policyholders to
exceed the account values for such policyholders upon their death. These losses
also include a $7,760,000 increase during the third quarter of 2002 in reserves
for these guarantees, which we recorded in light of increasing claims activity
in recent quarters.
The Accounting Standards Executive Committee (a committee of the American
Institute of Certified Public Accountants) has issued a proposed Statement of
Position that could set a new standard for accounting for Certain Nontraditional
Long-Duration Contracts and for Separate Accounts that, if adopted, could
require us to establish additional reserves for our variable annuity death
benefit guarantee contracts. These reserve adjustments will likely be volatile
because they are influenced by the performance of the financial markets. Had we
followed this proposed standard, on December 31, 2001, no reserves would have
been necessary, while on June 30, 2002, approximately $2 million in reserves
would have been required. Given recent fluctuations in the financial markets,
the reserves required under the proposed standard would have risen to
approximately $22 million by September 30, 2002, and then fallen to
approximately $9 million by October 31, 2002. For all of the periods mentioned,
the assumptions underlying the reserve calculations are the same. We anticipate
that this volatility will continue in future periods and, if the proposed
standard is adopted, this volatility will affect our reported results of
operations.
Our net income for the three and nine month periods ended September 30,
2001 was significantly affected by the World Trade Center tragedy. We recorded
an expense of $12,000,000 in the third quarter of 2001 in connection with claims
we received as a result of that event.
24
Net realized investment gains for the three and nine month periods ended
September 30, 2002 were $9,297,000 and $10,813,000, respectively, as compared
with $1,079,000 and $1,425,000 for the comparable periods of 2001. These gains
resulted from normal management of our investment portfolio intended to improve
performance and increase future operating income. We do not consider realized
gains and losses resulting from sales of our invested assets to be recurring
components of earnings. We make decisions concerning the sales of our invested
assets based on a variety of market, business and other factors.
We also recorded an expense of $2,005,000 in the third quarter of 2002 in
connection with the change in fair value of two interest rate swaps entered into
during that quarter.
In addition to each of the items discussed above, our Net loss for the
three month period ended September 30, 2002 also increased relative to the
comparable prior period of 2001 as a result of higher than anticipated mortality
experience under certain of our life reinsurance contracts and variability in
the timing of the receipt of premiums. The three and nine month periods ended
September 30, 2001 and 2002 were both negatively affected by adverse mortality
experience on certain of our life reinsurance contracts, including significant
losses on our life reinsurance contract with Lincoln National, which was
recaptured in the third quarter of 2002.
Net Investment Income. Net investment income for the three and nine month
periods ended September 30, 2002 was $31,127,000 and $82,084,000, respectively,
as compared with $24,240,000 and $66,935,000, respectively, for the comparable
prior periods of 2001. The increases in investment income are primarily due to
investment income on the reinvestment of a deposit of $147,000,000 received from
a reinsurer that is used to fund collateral requirements of our ceding
companies. The average annualized yield rate earned on our invested assets,
excluding Funds withheld, for the nine months ended September 30, 2002 was
approximately 5.28%, as compared with 6.34% for the nine months ended September
30, 2001. The decline in yield reflects our higher than normal commitment to
cash during the nine months ended September 30, 2002 as a result of receiving a
$137,000,000 deposit late in the fourth quarter of 2001 and a generally lower
interest rate environment.
Income earned on Funds Withheld for the three and nine month periods ended
September 30, 2002 was $25,282,000 and $63,004,000, respectively, as compared to
$19,440,000 and $52,054,000, respectively, for the comparable prior periods of
2001. The increases in investment income on our Funds withheld are primarily due
to the growth of our Ohio National reinsurance contract. The average yield rate
earned on Funds withheld was approximately 5.78% for the nine months ended
September 30, 2002, compared with 4.44% for the nine months ended September 30,
2001. For purposes of calculating the average yield rate earned on our Funds
withheld, which are held and managed by our ceding companies, we include net
realized capital gains and losses as reported to us by our ceding companies in
accordance with statutory accounting principles. The increase in yield on our
Funds withheld is primarily due to the increasing size of our contract with Ohio
National relative to the shrinking size of our contract with Transamerica.
Change in the Fair Value of Embedded Derivatives. Embedded derivative
gains and losses represent changes in the value of embedded derivatives hosted
by certain of our fixed annuity reinsurance contracts. For the three and nine
month periods ended September 30, 2002, the change in fair value of our embedded
derivatives was an unrealized loss of $(13,278,000) and $(18,255,000),
respectively. For the three and nine month periods ended September 30, 2001, the
change in fair value of our embedded derivatives was an unrealized loss of
$(5,265,000) and $(3,567,000), respectively. The unrealized loss in the embedded
derivatives during the three and nine month periods ended September 30, 2002 was
primarily the result of credit spreads widening in the sectors in which the
underlying investments are held, particularly in the telecommunications and
energy sectors. The unrealized losses in the embedded derivatives during the
three and nine month periods ending September 30, 2001 were related to
repositioning of the portfolio to increase spreads.
Surrender Fees and Other Revenue. Surrender fees and other revenue for the
three and nine month periods ended September 30, 2002 were $3,549,000 and
$13,607,000, respectively, as compared with $5,513,000 and $13,291,000,
respectively, for the three and nine month periods ended September 30, 2001.
This income is primarily derived from surrender fees related to our fixed
annuity products. The decline in
25
revenue for the three months ended September 30, 2002, as compared to the three
months ended September 30, 2001, is primarily due to a lower volume of
surrenders of policies underlying our Transamerica contract. Similarly, the
volume of surrenders during the nine month periods ended September 30, 2002 and
September 30, 2001 remained relatively constant, so there was little change in
the amount of surrender fees received by us over those comparable periods.
Claims and Policy Benefits. Claims and policy benefits for the three month
periods ended September 30, 2002 and 2001 were $91,382,000 and $74,874,000, or
108% and 112%, respectively, of net premium. For the nine month periods ended
September 30, 2002 and 2001, claims and policy benefits were $224,641,000 and
$161,700,000, or 88% and 89% of net premium, respectively. During the three
months ended September 30, 2002, we experienced an increase in the level of
claims reported to us relative to the level of premiums reported to us and
strengthened our reserves for guaranteed minimum death benefits by $7,760,000.
In addition, we incurred additional costs in connection with Lincoln National's
recapture of business it had previously ceded to us, effective August 1, 2002.
We are currently in arbitration on another life reinsurance contract that has
generated mortality experience beyond our pricing parameters, and is producing
losses. If we are unable to rescind, recapture, reprice, or otherwise
restructure this agreement, we may incur additional losses in future periods.
Although we expect mortality to be fairly constant over long periods of time, it
will fluctuate from period to period. For example, the three and nine months
ended September 30, 2001 were adversely impacted by the World Trade Center
tragedy. Reserves for future policy benefits are determined by claims reported
from ceding companies, our aggregate experience, seasonal claim patterns and
overall mortality trends.
Interest Credited to Interest Sensitive Contracts Liabilities. Interest
credited to Interest sensitive contract liabilities, which are liabilities we
assume under certain annuity reinsurance agreements, for the three and nine
month periods ended September 30, 2002 was $18,345,000 and $57,216,000,
respectively, as compared with $14,401,000 and $30,490,000 for the comparable
prior periods in 2001. Also included in Interest credited to interest sensitive
contracts liability for the three and nine month periods ended September 30,
2002 are minimum interest guarantee payments of approximately $9,070,000 and
$22,454,000, respectively, as compared to minimum interest guarantee payments of
$4,400,000 and $9,300,000 for the comparable prior periods in 2001. The
increases in the three and nine month periods ended September 30, 2002 were
primarily caused by the aforementioned minimum guarantee payments and by growth
in our reinsurance agreement with Ohio National.
Policy Acquisition and Other Insurance Expenses. Policy acquisition and
other insurance expenses, consisting primarily of allowances and amortization of
deferred policy acquisition costs, for the three and nine month periods ended
September 30, 2002 were $17,492,000 and $73,700,000, respectively, and
$43,306,000 and $95,221,000 for the comparable prior periods in 2001. The nine
months ended September 30, 2002 included the write down of $24,796,000 of
deferred acquisition costs associated with our annuity reinsurance contract with
Transamerica in the second quarter of 2002 due to the impact of expected minimum
interest guarantee payments on our expected gross profits on the contract.
Similarly, the nine month period ended September 30, 2001 included a write down
of $34,500,000 of deferred acquisition costs associated with the same contract
due to exposure to minimum interest guarantee payments and higher than expected
lapse rates on the underlying policies.
Collateral Costs. Collateral costs comprise fees charged by a reinsurer to
provide cash deposits to us. These deposits are used to fund excess statutory
reserve requirements of our clients and are recorded on our consolidated balance
sheet as a deposit liability. These costs were $3,732,000 and $6,080,000 for the
three and nine month periods ended September 30, 2002, respectively. The fees in
connection with the facility are determined, in part, by the amount of the
deposits received by us. The fees also have a variable component tied to LIBOR
rates. In the third quarter of 2002, we entered into two interest rate swaps
pursuant to which we effectively transferred a portion of the risk that these
variable fees will increase to a third party. The cost of these swaps to us
during the third quarter of 2002 was approximately $2,155,000, and is included
in our collateral costs. That amount includes $2,005,000 related to the change
in the fair value of the swap, which we record as an expense. Because the
collateral funding facility was not in place until the fourth quarter of 2001,
no costs were incurred for the nine months ended September 30, 2001.
26
Operating Expenses. Operating expenses for the three months ended
September 30, 2002 were $3,827,000 or 3.0% of total revenue (excluding the net
change in fair value of embedded derivatives) compared with $2,479,000 or 2.5%
of total revenue (excluding the net change in fair value of embedded
derivatives) for three months ended September 30, 2001. Operating expenses for
the nine months ended September 30, 2002 were $10,627,000 or 2.9% of total
revenue (excluding the net change in fair value of embedded derivatives)
compared with $7,833,000 or 3.0% of total revenue (excluding the net change in
fair value of embedded derivatives) for the nine months ended September 30,
2001. We have incurred a higher than normal level of legal, consulting, audit,
and other expenses during the three and nine month periods ended September 30,
2002 related to our efforts to raise capital and the review of our prior public
filings by the Securities and Exchange Commission.
SEGMENT RESULTS
During the first quarter of 2002, we began to separately track financial
results of our life and annuity operations in segments. Each segment is defined
by a dominant risk characteristic inherent in all products in that segment. The
life segment consists of all products where the dominant risk characteristic is
mortality risk. The annuity segment comprises all products where the dominant
risk characteristic is investment risk. In addition, as discussed in Note 4 to
the financial statements included in this report, certain of our modified
coinsurance and coinsurance funds withheld annuity reinsurance agreements have
features that constitute embedded derivatives that require bifurcation and
separate accounting under FAS 133 -- Accounting for Derivative Instruments and
Hedging Activities. The cumulative effect of the application of FAS 133 through
January 1, 2001 and the change in the fair value of these embedded derivatives
since that date are included in the annuity segment. Both the life and annuity
segments have specific assets, liabilities, stockholders' equity, revenue,
benefits and expenses that apply only to them. The corporate segment contains
all stockholders' equity not otherwise deployed to the life or annuity segment.
In addition, the corporate segment includes all capital gains and losses from
sales of securities in our portfolio and investment income on undeployed
invested assets. Operating expenses are allocated to the segments
proportionately based upon the amount of stockholders' equity deployed to the
segment. We believe that investors will better understand our profitability,
risk profile and capital deployment through this change.
Life Segment. Our life segment is our largest segment as measured by
profitability. Our life segment income (loss) for the three and nine month
periods ended September 30, 2002 was $(10,150,289) and $3,490,363, compared with
a loss of $(20,424,538) and $(8,913,265) for the comparable prior periods of
2001. The following table summarizes some of the significant items affecting
life segment income:
FOR THE THREE MONTHS ENDED FOR THE NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
--------------------------- -----------------------------
2002 2001 2002 2001
----------- ------------- ------------- -------------
(AS RESTATED) (AS RESTATED) (AS RESTATED)
World Trade Center........... $ -- $(12,000,000) $ -- $(12,000,000)
Unrealized loss on interest
rate swap................. (2,005,000) -- (2,005,000) --
----------- ------------ ----------- ------------
Total of significant items..... $(2,005,000) $(12,000,000) $(2,005,000) $(12,000,000)
=========== ============ =========== ============
The three and nine month periods ended September 30, 2001 were
significantly affected by the World Trade Center tragedy. We recorded an expense
of $12,000,000 in the third quarter of 2001 in connection with claims we
received as a result of that event. The three and nine month periods ended
September 2002 were affected by an unrealized loss of $2,005,000 related to the
change in fair value of two interest rate swaps entered into during the third
quarter of 2002.
27
In the third quarter of 2002, Lincoln National recaptured its life
reinsurance contract with us. We incurred losses under this contract of
$6,189,000 and $6,988,000 during the three and nine month periods ended
September 30, 2002 as a result of mortality experience that was higher than we
anticipated when we priced the contract and certain costs we incurred in
connection with the recapture of the contract. We had also incurred losses under
this contract of $7,883,000 during the three and nine month periods ended
September 30, 2001 as a result of higher than anticipated mortality experience.
Because the contract has been recaptured by Lincoln National, the contract will
not have a negative effect on our net income in future periods.
Segment Net loss also increased in the three month period ended September
30, 2002 relative to the comparable prior period in 2001 as a result of higher
than anticipated mortality experience under certain of our life reinsurance
contracts and variability in the timing of the receipt of premiums. We believe
that some of the adverse mortality experience may be the result of the late
reporting of claims by our cedents. Segment Net income (loss) for the nine month
periods ended September 30, 2001 and 2002 were both negatively affected by
adverse mortality experience on certain of our life reinsurance contracts,
including our life reinsurance contract with Lincoln National.
Segment revenues grew 32% to $86,708,000 from $65,951,000 in the three
months ended September 30, 2002 compared to the comparable period of 2001, and
45% to $260,319,000 from $179,367,000 for the nine months ended September 30,
2002 compared to the comparable period of 2001. Our revenue growth was primarily
related to a 42% growth in life premium to $246,899,000 during the nine months
ended September 30, 2002, as compared to $174,236,000 during the nine months
ended September 30, 2001, reflecting an increase of life reinsurance in force
from $117 billion at December 31, 2001 to $151 billion at September 30, 2002.
For both the three and nine month periods ended September 30, 2002, the balance
of the growth in revenue was derived from investment income earned on the
reinvestment of funds deposited with us by a third party reinsurer that we use
to fund collateral requirements of our clients. However, diminishing investment
returns due to the recent poor performance of the financial markets and our
inability to access additional funds under our collateral funding facility due
to, among other things, the uncompleted restatement of our financial statements,
have caused life segment revenue growth to slow during the quarter ended
September 30, 2002, and may adversely affect life segment revenue in the future.
In addition, we have significant obligations coming due in the next several
weeks and months that will require us to use most or all of any capital raised
to satisfy these existing obligations rather than to collateralize new business.
Segment policy benefits and expenses for the three months ended September
30, 2002 increased 12% to $96,858,000 from $86,376,000 in the comparable prior
period of 2001, and 36% for the nine months ended September 30, 2002 to
$256,829,000 from $188,281,000 for the comparable prior period of 2001. Both
increases reflect the increase in premium volume and face amount of insurance in
force. Segment benefits and expenses for the three and nine month periods ended
September 30, 2002 include collateral costs of $1,576,000 and $6,080,000
associated with our collateral funding facility that were not present for the
comparable periods in 2001. Overall expenses and benefits for the three and nine
month periods ending September 30, 2002, excluding the impact of Lincoln
National and the other life reinsurance contract that is currently in
arbitration, were slightly higher than our expectations. A greater frequency or
average higher size of death claims than we expected can cause us to pay greater
death benefits, adversely affecting the profitability of our life reinsurance
contracts. Even if total death benefits paid over the life of our life
reinsurance contracts do not exceed the expected amount, unexpected timing of
deaths can cause us to pay more death benefits in a given time period than
expected, adversely impacting profitability in that period, as happened this
quarter.
For the nine months ended September 30, 2002 the life segment return on
equity was 2.5% with a return on revenue of 1.3%.
28
Annuity Segment. Our annuity segment contains the majority of our assets.
While we would expect it be a small contributor to our net income, it contains
significant volatility from two sources. First, under FAS 133 -- Accounting for
Derivative Instruments and Hedging Activities we must value embedded derivatives
in certain of our annuity reinsurance agreements. This unrealized change in the
value of the derivative is reported in our income statement each quarter. The
change in the value of the derivative can be large, and is driven by financial
market conditions, most notably credit risk related changes. Second, our
Transamerica annuity reinsurance contract has exhibited volatility due to write
downs of our deferred acquisition cost balance which are based upon management's
estimates of future investment performance and lapse experience. In 2001, we
determined that our Transamerica annuity contract was in a loss position, and
wrote down approximately $46,100,000 of deferred acquisition costs. We also
purchased $10.0 million of reinsurance from a subsidiary of XL Capital, a
related party, for a premium of $1.5 million, to provide an additional layer of
protection against minimum interest guarantee payments under the Transamerica
contract. During the second quarter of 2002, we wrote down an additional
$24,796,000 of deferred acquisition costs based on revised estimates of expected
gross profits on this contract. Our expected gross profits were reduced due to
poor investment performance which triggered minimum interest guarantee payments
under the contract. In estimating these write downs, we were required to make
estimates, including estimates of future lapse rates on the underlying business
and future investment income on the assets supporting this business, each of
which impact our estimates of future minimum interest guarantee payments. Our
annuity reinsurance contract with Transamerica is not expected to generate net
income going forward. There can be no assurance that our estimates will prove to
be accurate, and if they do not, we may be required to recognize additional
losses.
Our annuity segment loss for the three and nine month periods ended
September 30, 2002 was $(18,346,000) and $(45,218,000), respectively, compared
with a loss of $(25,386,000) and $(38,000,000) for the comparable prior periods
of 2001. The following table summarizes the significant items affecting annuity
segment income:
FOR THE THREE MONTHS ENDED FOR THE NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
---------------------------- -----------------------------
2002 2001 2002 2001
------------ ------------- ------------- -------------
(AS RESTATED) (AS RESTATED) (AS RESTATED)
Cumulative effect of a
change in accounting
principle............... $ -- $ -- $ -- $ (3,665,735)
Net change in fair value of
embedded derivatives.... (13,277,823) (5,265,396) (18,254,530) (3,567,342)
Change in amortization of
deferred acquisition
costs related to
embedded derivatives.... 5,790,244 269,009 7,292,964 1,410,724
Transamerica contract
deferred acquisition
cost write downs........ -- (19,157,798) (24,796,000) (34,538,991)
Variable annuity minimum
guarantee reserve
strengthening........... (7,760,000) -- (7,760,000) --
Variable annuity minimum
guarantee payments in
excess of premiums...... (3,117,100) 1,364,121 (2,171,700) 3,735,923
------------ ------------ ------------ ------------
Total of significant items... $(18,364,679) $(22,790,064) $(45,689,266) $(36,625,421)
============ ============ ============ ============
29
The cumulative effect of a change in accounting principle reflected in the
nine month period ended September 30, 2001 is the result of our implementation
of FAS 133 -- Accounting for Derivative Instruments and Hedging Activities as of
the first quarter of 2001. Under FAS 133, we are required to carry the fair
value of the embedded derivatives contained in certain of our annuity
reinsurance contracts on our Balance Sheet, and unrealized changes in the fair
value of those embedded derivatives are reflected in our net income. The change
in fair value of the embedded derivatives is influenced by changes in credit
risk, yield curve shifts, changes in expected future cash flows under the
annuity reinsurance contracts and, to a lesser extent, interest rate changes.
The change in fair value also impacts the emergence of expected gross profits
under the contracts for purposes of amortizing deferred acquisition costs.
During the three and nine month periods ended September 30, 2002, the fair value
of the embedded derivatives declined significantly because of credit spreads
widening in the sectors in which the underlying investments are held,
particularly in the telecommunications and energy sectors. The unrealized losses
on the fair value of the embedded derivatives in each of the three and nine
month periods ended September 30, 2001 and 2002 resulted in lower amortization
of deferred acquisition costs in those periods.
The significant losses associated with the Transamerica contract during the
nine months ended September 30, 2002 were the result of a write down of deferred
acquisition costs of $24,796,000 in the second quarter of 2002. The write down
was the result of the continued poor performance of the financial markets during
the first half of 2002, which caused us to reassess the assumptions we used in
estimating the impact expected future minimum interest guarantee payments would
have on the profits arising from this contract. We recorded similar charges
against our deferred acquisition cost asset of $34,500,000 during the nine month
period ended September 30, 2001, $19,200,000 of which was recorded in the three
month period ended September 30, 2001. A significant portion of the charges
recorded in 2001 related to the high surrender rates on the polices underlying
the contract, which caused us to review the recoverability of the deferred
acquisition costs associated with this contract, and to expected minimum
interest guarantee payments.
We also recorded losses associated with our contracts that reinsure
guarantees associated with variable annuity contracts, including guaranteed
minimum death benefits, of $10,877,000 and $9,932,000 during the three and nine
month periods ended September 30, 2002. These losses were the result of the
protracted decline in the financial markets, which has caused the guaranteed
minimum death benefits payable to the beneficiaries of certain policyholders to
exceed the account values for such policyholders upon their death. These losses
also include a $7,760,000 increase during the third quarter of 2002 in reserves
for these guarantees, which we recorded in light of increasing claims activity
in recent quarters.
Total segment revenue for the three months ended September 30, 2002
declined 16% to $18,536,000, as compared to $22,025,000 for the three months
ended September 30, 2001. Revenue for the nine months ended September 30, 2002
declined 2% to $66,846,000 from $68,325,000 for the nine months ended September
30, 2001. These declines are primarily related to the previously mentioned
increases in embedded derivative losses, offset by increased investment income
on our annuity reinsurance contract with Ohio National.
Policy benefits and expenses for the annuity segment includes interest
credited to policyholders, minimum interest guarantee charges, guaranteed
minimum death benefit payments, segment specific expenses, and other allocated
expenses. These expenses declined 22% to $36,882,000 for the three months ended
September 30, 2002 compared to $47,411,000 for the three months ended September
30, 2001. For the nine months ended September 30, 2002 these expenses grew 9% to
$112,065,000 from $102,659,000 for the nine months ended September 30, 2001. The
primary components of these expenses are interest credited to policyholders and
amortization of deferred acquisition costs. The nine month period ended
September 30, 2001 includes write downs of deferred acquisition costs of
approximately $34,500,000, including approximately $19,200,000 incurred in the
three month period ended September 30, 2001, related to our Transamerica
reinsurance contract because we determined that the deferred acquisition costs
were not recoverable. The nine months ended September 30, 2002 includes the
$7,760,000 increase in guaranteed minimum death benefit reserves recorded in the
third quarter of 2002 and a $24,796,000 write down of deferred acquisition costs
associated with our annuity reinsurance agreement with Transamerica recorded in
the second quarter of 2002. The increase in policy benefits and expenses in the
three and nine months ended September 30, 2002, as compared to the comparable
prior period after the aforementioned adjustments, reflects an increase in
30
minimum interest guarantee payments related to our Transamerica contract and
interest credited to policyholders on our annuity contract with Ohio National.
Our annuity segment is not performing well due to losses from embedded
derivatives, guaranteed minimum death benefits and the Transamerica fixed
annuity contract. Return on equity for the three and nine month periods ended
September 30, 2002 was (71)% and (72)%, respectively.
Corporate Segment. The corporate segment includes all capital gains and
losses from our own portfolio, investment income on undeployed invested assets,
and a proportionate share of operating expenses based upon how stockholders'
equity is deployed to the life and annuity segments. As a result, the corporate
segment, while small relative to our total company, will likely have volatile
results. Segment income grew 199% to $9,350,000 for the three months ended
September 30, 2002 compared to $3,130,000 for the three months ended September
30, 2001. For the nine months ended September 30, 2002 segment income grew 58%
to $12,721,000 from $8,043,000 for the nine months ended September 30, 2001. The
growth in corporate segment income was the result of net realized investment
gains of $9,297,000 and $10,813,000 for the three and nine month periods ended
September 30, 2002, as compared to $1,079,000 and $1,425,000, respectively, for
the comparable prior periods of 2001.
Expenses declined 19% to $1,037,000 for the three months ended September
30, 2002 compared to $1,273,000 for the three months ended September 30, 2001.
For the nine months ended September 30, 2002 expenses declined 22% to $3,370,000
from $4,304,000 for the nine months ended September 30, 2001. Both declines were
driven by the deployment of stockholders' equity to the life segment and,
consequently, a greater allocation of overhead expenses to that segment.
FINANCIAL CONDITION
INVESTMENTS
Our investments are governed by investment guidelines established and
approved by our board of directors. Our investment objectives are to achieve
above average risk-adjusted total returns, maintain a high quality portfolio,
maximize current income, maintain an adequate level of liquidity, and match the
cash flows of our investments to our related insurance liabilities. Our
investment guidelines require our overall fixed income portfolio to maintain a
minimum weighted average credit quality of "A." A fixed income security rated
"A" by Standard & Poor's is considered to be somewhat susceptible to the adverse
effects of changes in circumstances and economic conditions, however, the
issuer's capacity to meet its financial commitment on the security is still
considered to be strong. As of July 2002, our investment guidelines do not allow
us to invest in fixed income securities that are rated below investment grade.
We will not invest in any fixed income securities in emerging markets or
securities which are not rated by a major rating agency.
Our investment securities are managed by two professional investment
advisors, Alliance Capital Management Corporation and Prudential Investment
Corporation, each of which manages a segment of the portfolio. Our agreements
with Alliance and Prudential may be terminated by either party with 45 days
notice. The performance of Alliance and Prudential and the fees associated with
the arrangements are periodically reviewed by our board of directors.
At September 30, 2002, our invested assets, including cash and cash
equivalents, had an aggregate fair value of $475,213,000, including unrealized
gains of approximately $15,600,000. A significant portion of our invested assets
are posted as collateral to secure our obligations under reinsurance agreements
and letter of credit facilities and are invested predominately in high quality
U.S. government and U.S. corporate fixed income securities with low to moderate
durations. At September 30, 2002, our portfolio is comprised of fixed income
securities with a weighted average credit quality rating of "AA" and a weighted
average duration of 3.0 years.
We do not engage in trading activities to generate realized investment
gains and, thus, do not have a trading portfolio. However, we evaluate the
desirability of continuing to hold a security when market conditions,
creditworthiness or other measurement factors change. These changes may relate
to a change in the credit risk of an issuer and a decision to sell may be made
to avoid further declines in realizable value.
31
Securities also may be sold prior to maturity to provide liquidity. As a result,
our securities are classified as "available for sale" and are carried at fair
value on our balance sheet.
At September 30, 2002, $1,437,000 at fair value, or 0.40%, of our fixed
income investments (0.38% of Stockholders Equity), consisted of below investment
grade securities. The fair value of such investments may vary depending on
economic and market conditions, the level of interest rates and the perceived
creditworthiness of the issuer. As noted above, our investment guidelines
prohibit the purchase of below investment grade securities, as these investments
are subject to a higher degree of credit risk than investment grade securities.
We monitor the creditworthiness of the portfolio as a whole and when the fair
market value of a security declines for reasons other than changes in interest
rates or other perceived temporary conditions, the security is written down to
its net realizable value. At September 30, 2002, there was one impaired security
in our portfolio, which was written down by $900,000 to a fair value of
approximately $270,000.
At September 30, 2002, mortgage backed securities represented approximately
12.4% of invested assets. Investors in these securities are compensated
primarily for reinvestment risk rather than credit quality risk. Investments in
mortgage backed securities include collateralized mortgage obligations ("CMO's")
and mortgage backed pass-through securities. Mortgage backed securities
generally are collateralized by mortgages issued by the Government National
Mortgage Association ("GNMA"), the Federal National Mortgage Association
("FNMA") and the Federal Home Loan Mortgage Corporation ("FHLMC"). Of these,
only GNMA mortgages are backed by the full faith and credit of the U.S.
government. Credit risk generally is not a consideration when investing in
agency mortgage backed securities. Our mortgage backed securities portfolio had
a weighted average investment quality rating of "AAA" at September 30, 2002.
Our results of operations and our financial condition are significantly
affected by the performance of our investments and by changes in interest rates.
During a period of declining interest rates, if our investments are prematurely
sold, called, prepaid or redeemed, we may be unable to reinvest the proceeds in
securities of equivalent risk with comparable rates of return. During a period
of rising interest rates, the fair value of our invested assets could decline.
In addition, rising interest rates could also cause disintermediation, which in
turn could cause us to sell investments at prices and times when the fair values
of such investments are less than their amortized cost. We believe that our
traditional life insurance liabilities are not highly interest rate sensitive
and, therefore, the effects of fluctuating interest rates on these liabilities
are not significant. For interest sensitive liabilities, we are primarily
dependent upon asset/liability matching or other strategies to minimize the
impact of changes in interest rates. If we do not appropriately match our asset
management strategy to our obligations, we could sustain losses. We have engaged
in hedging activities to mitigate the effects of asset/liability mismatches or
interest rate changes on our balance sheet, and expect to do so in the future.
Our results of operations and our financial condition are also significantly
affected by the performance of assets held and managed by our ceding companies
or others under modified coinsurance and coinsurance funds withheld
arrangements, which are discussed below under "Funds Withheld at
Interest -- Interest Sensitive Contracts Liability."
The following table summarizes our investment results (excluding investment
income on assets held and managed by our ceding companies or others) for the
periods indicated.
32
INVESTMENT RESULTS
TWELVE MONTHS ENDED DECEMBER 31,
NINE MONTHS ENDED -----------------------------------
SEPTEMBER 30, 2002 2001 2000 1999
------------------- ---------- ---------- ---------
(DOLLARS IN THOUSANDS)
Total invested assets, including
cash and equivalents(1)........... $475,213 $423,780 $321,819 $304,060
Investment income, net of related
expenses.......................... $ 19,080 $ 20,165 $ 20,126 $ 20,483
Effective yield rate(2)............. 5.28% 5.74% 6.85% 6.29%
Realized investment gains
(losses).......................... $ 10,813 $ 1,230 $ (4,817) $ (1,285)
---------------
(1) Fair value at end of the indicated period.
(2) The effective yield rate equals (i) net investment income divided by (ii)
the average of total adjusted invested assets (fixed maturities at amortized
cost, including assets on deposit with reinsurers) at the end of each
calendar quarter included in the indicated period.
FUNDS WITHHELD AT INTEREST -- INTEREST SENSITIVE CONTRACTS LIABILITIES
At September 30, 2002, our Funds withheld receivable was $1,415,120,000.
This receivable represents our share of our ceding companies' statutory reserves
related to the policies underlying our annuity reinsurance agreements. The value
of the ceding companies' statutory reserves, and consequently our Funds withheld
receivable, is calculated by reference to the premiums received by the ceding
company with respect to the policies covered by our annuity reinsurance
contracts, plus all interest credited on those premiums, less any amounts paid
to policyholders upon surrender of such policies. Under these arrangements, the
premiums paid to a ceding company by underlying policyholders are held and
managed by the ceding company or investment managers appointed by the ceding
company. We are allocated our proportionate share of the investment income and
realized capital gains and losses from those invested premiums.
We currently have annuity reinsurance contracts with six ceding companies.
At September 30, 2002, the premiums held and managed by our ceding companies
were invested in convertible bonds and fixed income securities having a weighted
average credit quality of "A" and a weighted average duration of 5.0 years. Also
at September 30, 2002, approximately 4.0% of the premiums held and managed by
our ceding companies were invested in below investment grade securities. The
average yield rate earned on the invested premiums held and managed by our
ceding companies was approximately 5.8% for the nine months ended September 30,
2002. At September 30, 2002, approximately 54% and 25% of our Funds withheld at
interest asset represented receivables from Transamerica and Ohio National,
respectively. The average yield rates earned on the assets funding our annuity
obligations to Transamerica and Ohio National were approximately 3.8% and 7.8%,
respectively, for the nine months ended September 30, 2002. For purposes of
calculating the average yield rate earned on assets held and managed by our
ceding companies, including Transamerica and Ohio National, we include net
realized capital gains and losses as reported to us by our ceding companies in
accordance with statutory accounting principles.
The assets underlying the Transamerica contract are managed by AmerUS
Capital Management, the investment manager appointed by IL Annuity and Insurance
Company, the issuer of the annuity policies. At September 30, 2002, the assets
funding the policyholder obligations under the contract had an average credit
quality of "A-" and an average duration of 4.1 years. Also at September 30,
2002, approximately 67% of the assets underlying the contract were invested in
convertible bonds, with the remaining 33% in fixed income securities. The value
of convertible bonds is a function of their investment value (determined by
yield in comparison with the yields of other securities of comparable maturity
and quality that do not have a conversion privilege) and their conversion value
(at market value, if converted into the underlying common stock). To the extent
the market price of the underlying common stock approaches or exceeds the
conversion price, the price of the convertible bonds will be increasingly
influenced by their conversion value. Consequently, the value of convertible
bonds may be influenced by changes in the equity markets.
33
According to data provided to us by Transamerica, at September 30, 2002 the
assets held by IL Annuity and managed by AmerUS Capital were comprised of:
TYPE OF SECURITY BOOK VALUE MARKET VALUE % OF TOTAL
---------------- ------------ ------------ ----------
Convertible bonds............................. $558,874,974 $512,621,786 67.2%
Investment grade U.S. corporate bonds......... 190,248,157 200,218,580 26.2%
Below investment grade U.S. corporate bonds... 41,097,061 36,312,346 4.8%
Short term securities......................... 13,897,670 13,897,670 1.8%
------------ ------------ -----
Total invested assets......................... $804,117,862 $763,050,382 100.0%
============ =====
Accrued investment income..................... 6,473,818
------------
Total market value, including accrued
investment income........................... $769,524,200
============
According to data provided to us by Transamerica, at September 30, 2002 the
credit ratings (as assigned by Standard & Poor's) of the assets (excluding
accrued investment income) held by IL Annuity and managed by AmerUS Capital were
approximately:
RATINGS BOOK VALUE MARKET VALUE % OF TOTAL
------- ------------ ------------ ----------
AAA........................................... $101,531,499 $105,221,951 13.8%
AA............................................ 86,022,763 84,112,943 11.0%
A............................................. 189,407,112 186,251,135 24.4%
BBB........................................... 386,009,827 351,142,087 46.0%
BB and below.................................. 41,146,661 36,322,266 4.8%
------------ ------------ -----
Total invested assets......................... $804,117,862 $763,050,382 100.0%
============ =====
Accrued investment income..................... 6,473,818
------------
Total market value, including accrued
investment income........................... $769,524,200
============
According to data provided to us by Transamerica, at September 30, 2002 the
maturity distribution of the assets (excluding accrued investment income) held
by IL Annuity and managed by AmerUS Capital was approximately:
MATURITY BOOK VALUE MARKET VALUE % OF TOTAL
-------- ------------ ------------ ----------
Within one year............................... $ 39,271,587 $ 39,342,099 5.2%
From one to five years........................ 232,002,606 230,785,613 30.2%
From six to ten years......................... 195,625,045 190,359,956 24.9%
More than ten years........................... 337,218,624 302,562,714 39.7%
------------ ------------ -----
Total all years............................... $804,117,862 $763,050,382 100.0%
============ ============ =====
At September 30, 2002, the assets underlying the Ohio National contract
were comprised entirely of U.S. corporate bonds. The bonds had a book value of
$342,044,000 and a market value of $364,006,000 (including accrued investment
income of $4,675,000). Also at September 30, 2002, the assets funding the
policyholder obligations under the contract had an average credit quality of
"A-" and an average duration of approximately 6.0 years.
34
At September 30, 2002 the credit ratings (as assigned by Standard & Poor's)
of the assets (excluding accrued investment income) held and managed by Ohio
National were approximately:
RATINGS BOOK VALUE MARKET VALUE % OF TOTAL
------- ------------ ------------ ----------
AAA........................................... $ 45,062,847 $ 47,418,937 13.0%
AA............................................ 26,470,559 28,768,680 7.9%
A............................................. 122,424,148 135,247,823 37.2%
BBB........................................... 133,900,776 141,691,439 38.9%
Below BBB..................................... 14,185,775 10,879,191 3.0%
------------ ------------ -----
Total invested assets......................... $342,044,105 $364,006,070 100.0%
============ =====
Accrued investment income..................... 4,674,586
------------
Total market value, including accrued
investment income........................... $368,680,656
============
According to data provided to us by Ohio National, at September 30, 2002
the maturity distribution of the assets (excluding accrued investment income)
held and managed by Ohio National was approximately:
MATURITY BOOK VALUE MARKET VALUE % OF TOTAL
-------- ------------ ------------ ----------
Within one year............................... $ 2,930,515 $ 2,930,515 0.8%
From one to five years........................ 14,916,040 12,147,255 3.3%
From six to ten years......................... 162,185,526 172,431,596 47.4%
More than ten years........................... 162,012,024 176,496,704 48.5%
------------ ------------ -----
Total all years............................... $342,044,105 $364,006,070 100.0%
============ ============ =====
Our remaining four annuity reinsurance contracts guarantee crediting rates
that vary in amount and duration. At September 30, 2002, the assets funding the
policyholder obligations under these contracts had an average credit quality of
"A-" and an average duration of approximately 7.1 years.
According to information provided by the ceding companies under these four
annuity reinsurance contracts, at September 30, 2002 the assets held and managed
by those ceding companies were comprised of:
TYPE OF SECURITY BOOK VALUE MARKET VALUE % OF TOTAL
---------------- ------------ ------------ ----------
Canadian provincial bonds..................... $ 90,364,234 $ 95,318,003 30.0%
Investment grade US corporate bonds........... 85,237,284 88,990,403 28.0%
Investment grade UK corporate bonds........... 82,713,018 82,713,018 26.1%
Investment grade Canadian corporate bonds..... 24,034,560 24,767,271 7.8%
All other securities.......................... 26,529,494 25,651,668 8.1%
------------ ------------ -----
Total invested assets......................... $308,878,590 $317,440,363 100.0%
============ =====
Accrued investment income..................... 6,806,127
------------
Total market value, including accrued
investment income........................... $324,246,490
============
35
According to information provided by the ceding companies under these four
annuity reinsurance contracts, at September 30, 2002 the credit ratings (as
assigned by Standard & Poor's) of the assets (excluding accrued investment
income) held and managed by those ceding companies were approximately:
RATINGS BOOK VALUE MARKET VALUE % OF TOTAL
------- ------------ ------------ ----------
AAA........................................... $ 47,725,488 $ 48,285,677 15.2%
AA............................................ 29,971,717 30,760,155 9.7%
A............................................. 166,986,792 174,887,133 55.1%
BBB........................................... 56,514,218 57,947,273 18.3%
BB and below.................................. 7,680,375 5,560,125 1.7%
------------ ------------ -----
Total invested assets......................... $308,878,590 $317,440,363 100.0%
============ =====
Accrued investment income..................... 6,806,127
------------
Total market value, including accrued
investment income........................... $324,246,490
============
According to information provided by the ceding companies under these four
annuity reinsurance contracts, at September 30, 2002 the maturity distribution
of the assets (excluding accrued investment income) held and managed by those
ceding companies was approximately:
MATURITY BOOK VALUE MARKET VALUE % OF TOTAL
-------- ------------ ------------ ----------
Within one year............................... $ 16,101,151 $ 16,337,330 5.1%
From one to five years........................ 71,589,567 74,101,141 23.3%
From six to ten years......................... 71,928,287 72,720,906 22.9%
More than ten years........................... 149,259,585 154,280,686 48.7%
------------ ------------ -----
Total all years............................... $308,878,590 $317,440,363 100.0%
============ ============ =====
LIQUIDITY AND CAPITAL RESOURCES
Our liquidity and capital resources are a measure of our overall financial
strength and our ability to generate cash flows from our operations to meet our
operating and growth needs. Our principal sources of funds are premiums
received, net investment income, proceeds from investments called, redeemed or
sold and cash and short term investments. The principal obligations and uses of
the funds are the payment of policy benefits, acquisition and operating expenses
and the purchase of investments. In addition, as a Bermuda reinsurer we are
required to post collateral for the statutory reserves ceded to us by U.S. based
insurers and reinsurers. Under the terms of our reinsurance agreements we are
required to provide letters of credit or fund trust accounts with liquid assets
to satisfy these collateral requirements. At both September 30, 2002 and
December 31, 2001, letters of credit totaling $197 million had been issued by
our bankers in favor of certain ceding insurance companies to provide security
and meet regulatory requirements. At September 30, 2002 and December 31, 2001
letters of credit totaling $107 million and $112 million, respectively, were
fully collateralized by our investments. At September 30, 2002 and December 31,
2001, investments of $310 million and $272 million, respectively, were held in
trust for the benefit of certain ceding insurance companies to provide security
and to meet regulatory requirements. For the nine months ended September 30,
2002, we generated $27,790,000 from our operating activities, substantially all
of which has been posted as collateral to our cedents.
Based on our projections of our ceding companies' statutory reserve
cessions, in order to satisfy our obligations under our existing reinsurance
agreements, we will need to post up to approximately $210.0 million of
additional collateral by December 31, 2002. We will seek to meet or reduce these
additional security requirements by negotiating the recapture, retrocession or
sale of certain of our reinsurance agreements, accessing our collateral funding
facility and/or by raising capital. We have not been able to successfully raise
capital or access our collateral funding facility in recent months given, among
other things, the uncompleted
36
restatement of our financial statements for 2000 and 2001. If we are unable to
meet the security requirements of our cedents, we may be required to cease
writing new business and we may be in violation of our existing reinsurance
contracts and become subject to the remedies set forth therein. Our cedents may
also ask that the agreements be recaptured. These recaptures could result in
losses, but could also improve our liquidity and our ability to meet the
collateral requirements of our remaining cedents.
We currently have unsecured letters of credit of approximately $49,000,000
outstanding under a letter of credit facility with Citibank. In October 2002,
Citibank agreed to extend this unsecured letter of credit facility into next
year in exchange for our agreement to secure, or otherwise eliminate, the letter
of credit facility by June 30, 2003.
As of September 30, 2002, we had $45,000,000 of unsecured letters of credit
outstanding under a letter of credit facility with Manulife Financial that had
been posted as security to allow our United States operating subsidiary to take
credit on its statutory financial statements for reinsurance ceded to our
Bermuda operating company. During October 2002, Manulife requested that the
unsecured letters of credit it had issued on our behalf be secured.
Consequently, in November 2002, our Bermuda operating subsidiary deposited
$15,000,000 with our United States operating subsidiary as funds withheld.
Further, one of our United States operating subsidiary's ceding companies has
recaptured its contracts, reducing our subsidiary's collateral needs by an
additional $15,000,000. We have committed to securing or eliminating the
remaining $15,000,000 in letters of credit issued by Manulife under our letter
of credit facility by December 31, 2002. Due to Manulife's request to secure its
letter of credit facility and our inability thus far to post sufficient security
for our United States operating subsidiary, the Connecticut Insurance Department
has requested that all financial transactions, except those related to the
normal course of business, between us and our United States operating subsidiary
be preapproved by the insurance department.
During 2001, we entered into a reinsurance agreement with a reinsurer to
cede excess U.S. Statutory reserves (the amount by which the cedents U.S.
Statutory reserves exceed our U.S. GAAP reserves for certain life insurance
contracts subject to certain state statutory regulations known as Triple-X) to
the reinsurer. Under the agreement, the reinsurer is obligated to fund the
collateral requirements associated with these excess U.S. Statutory reserves by
making cash deposits with us. As of September 30, 2002, we had received deposits
of $147 million from the reinsurer. The reinsurer has the right to terminate the
agreement with 180 days notice, which would require us to return all deposits.
As part of this contract we deposited $41 million with the reinsurer, which is
included in Deposits and other reinsurance receivables on our Balance Sheet. We
receive the benefit of investment income from the investment of the funds
received and our deposit with the reinsurer and we pay the third party reinsurer
certain fees associated with the contract. These fees, in part, are determined
by the amount of deposits received by us. The fees also have a variable
component tied to LIBOR rates. In the third quarter of 2002, we entered into two
interest rate swaps pursuant to which we effectively transferred a portion of
the risk that these variable fees will increase to a third party. We are not
currently able to access additional funds under this collateral funding
facility.
On March 1, 2002 we filed a shelf registration statement on Form S-3 to
register under the Securities Act of 1933 $200,000,000 of senior debt to be sold
in one or more transactions on a delayed basis. We do not currently expect to
issue any of this debt in the near future.
We have no material commitments for capital expenditures as of September
30, 2002, but as noted above, we have significant obligations coming due in the
next several weeks and months that we will not be able to satisfy unless we are
able to establish a new collateral funding facility, negotiate the recapture of,
sell off or otherwise transfer certain of our reinsurance contracts that have
significant collateral requirements or raise additional capital.
In September 2002, we engaged Morgan Stanley to assist us in seeking to
raise capital, and we have been in discussions with several parties regarding
this and other strategic alternatives. There can be no assurances that our
efforts to raise capital or pursue other strategic alternatives will be
successful.
On October 30, 2002, the board of directors declared a quarterly dividend
of $.05 per share payable on November 28, 2002 to shareholders of record on
November 15, 2002. The continued payment of dividends is
37
dependent on the ability of our operating subsidiaries to achieve satisfactory
underwriting and investment results, generate free cash flow and other factors
determined to be relevant by our board of directors.
FORWARD-LOOKING AND CAUTIONARY STATEMENTS
The Company and its representatives may from time to time make written or
oral forward-looking statements, including those contained in the foregoing
Management's Discussion and Analysis. In order to take advantage of the "safe
harbor" provisions of the Private Securities Litigation Reform Act of 1995, the
Company is hereby identifying certain important factors which could cause the
Company's actual results, performance or achievement to differ materially from
those that may be contained in or implied by any forward-looking statement made
by or on behalf of the Company. The factors that could cause the actual results
of operations or financial condition of the Company to differ include, but are
not necessarily limited to, the Company's ability to attract and retain clients;
a decline in the Company's financial ratings; the Company's ability to
underwrite business; the Company's ability to raise sufficient capital to meet
the collateral requirements associated with its current business and to fund the
Company's continuing operations; changes in market conditions, including changes
in interest rate levels; the ability of the Company's cedents to manage
successfully assets they hold on the Company's behalf; unanticipated withdrawal
or surrender activity; changes in mortality, morbidity and claims experience;
the Company's success in managing its investments; the competitive environment;
the impact of recent and possible future terrorist attacks and the U.S.
government's response thereto; the loss of a key executive; regulatory changes
(such as changes in U.S. tax law and insurance regulation which directly affect
the competitive environment for the Company's products); and a prolonged
economic downturn. Further information about these and other factors may be
found in our Current Report on Form 8-K filed on November 19, 2002, as well as
our other filings with the Securities and Exchange Commission. The Company
cautions that the foregoing list of important factors is not intended to be, and
is not, exhaustive. The Company does not undertake to update any forward-looking
statement that may be made from time to time by or on behalf of the Company.
38
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
There have been no material changes since December 31, 2001 with respect to
our market risk exposure described in our Annual Report on Form 10-K for the
year ended December 31, 2001, as supplemented by our Current Report on Form 8-K,
filed November 19, 2002. Please refer to "Item 7A: Quantitative and Qualitative
Disclosure About Market Risk" in our Annual Report on Form 10-K for the year
ended December 31, 2001 and to "Item 5: Other Events and Required FD
Disclosure -- Business -- Quantitative and Qualitative Disclosures About Market
Risk" in our Current Report on Form 8-K filed November 19, 2002.
ITEM 4. CONTROLS AND PROCEDURES
In September 2002, following the resignation of the Company's Chief
Executive Officer, the Company established a Transition Committee to oversee, on
an interim basis, the management and operations of the Company pending his
permanent replacement. The Transition Committee and the Company's Chief
Financial Officer have conducted a review of the effectiveness of the design and
operation of the Company's disclosure controls and procedures. Based on that
review, the Transition Committee and Chief Financial Officer concluded that the
Company's disclosure controls and procedures were adequate. In addition, there
have been no significant changes in the Company's internal controls or in other
factors that could significantly affect those controls subsequent to the date of
their evaluation.
39
PART II
OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
On January 21, 2002, we served written notice of arbitration in connection
with our annuity reinsurance contract with Transamerica Occidental Life
Insurance Company. In the arbitration, we were seeking monetary damages and/or
equitable relief from Transamerica based on our claim that certain actions
and/or omissions by Transamerica deprived us of the benefit of the reinsurance
transaction. On November 8, 2002, we announced that our claim against
Transamerica had been denied by the arbitration panel assigned to the matter.
The arbitration panel upheld Transamerica's position that our annuity
reinsurance contract was a valid and enforceable contract and that Transamerica
had acted in a commercially reasonable manner.
In May 2002, we served written notice of arbitration in connection with two
life reinsurance agreements. During the third quarter of 2002, we settled our
arbitration with Lincoln National, which recaptured the contract that had been
the subject of the arbitration. The other arbitration is continuing.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
On February 25, 2002 and September 30, 2002, we granted 133,500 and 267,500
common shares, respectively, to certain key employees pursuant to the terms of a
restricted stock incentive compensation program. Issuance of the restricted
stock required no investment decision on the part of the recipients. All award
decisions were made by our Compensation Committee, which consists entirely of
non-employee directors. If the grants were deemed to be a sale of securities
under the Securities Act of 1933 (the "Act"), we believe such sales would be
exempt from the Act pursuant to Section 4(2) thereof or Regulation S thereunder.
ITEM 5. OTHER INFORMATION
On September 12, 2002, we announced that Lawrence S. Doyle had retired from
his position as our President and Chief Executive Officer and had resigned from
his seat on our board of directors. We have engaged an executive search firm to
help us identify an appropriate replacement for Mr. Doyle. Until an appropriate
replacement is identified, a transition committee consisting of Frederick S.
Hammer and Robert M. Lichten, each of whom is a director of our Company, will
oversee our management and operations. Half of the supplemental director's fees
payable to Messrs. Hammer and Lichten for their services on the Transition
Committee will be paid instead to their regular employer in consideration of the
substantial amount of time that each will dedicate to our Company until we
secure an appropriate replacement for Mr. Doyle.
In the third quarter of 2002, A.M. Best downgraded the financial strength
ratings of Annuity and Life Reassurance and Annuity and Life Reassurance America
from "A-" to "B++." The financial strength ratings of Annuity and Life
Reassurance and Annuity and Life Reassurance America were also downgraded in the
third quarter of 2002 by Standard & Poor's from "A-" to "BBB+" and from "A" to
"BBB+" by Fitch Ratings. In addition, on November 22, 2002, Fitch Ratings
further reduced our financial strength rating to "CCC." These downgrades in our
ratings have adversely affected our ability to enter into new reinsurance
treaties and raise capital. Further downgrades may adversely affect our ability
to retain existing business, effectively preclude us from writing new business,
and permit some of our ceding companies to terminate certain reinsurance
agreements.
40
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits --
10.1 Letter Agreement dated September 9, 2002 by and between Annuity
and Life Re (Holdings), Ltd. and Frederick S. Hammer
10.2 Letter Agreement dated September 9, 2002 by and between Annuity
and Life Re (Holdings), Ltd. and Robert M. Lichten
(b) Reports on Form 8-K -- None
41
ANNUITY AND LIFE RE (HOLDINGS), LTD.
SIGNATURES
Pursuant to the requirements 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.
Annuity and Life Re (Holdings), Ltd.
/s/ FREDERICK S. HAMMER
--------------------------------------
Name: Frederick S. Hammer
Title: Transition Committee Co-Chair
Date: November 26, 2002
/s/ ROBERT M. LICHTEN
--------------------------------------
Name: Robert M. Lichten
Title: Transition Committee Co-Chair
Date: November 26, 2002
/s/ JOHN F. BURKE
--------------------------------------
Name: John F. Burke
Title: Chief Financial Officer
(Principal Accounting and Financial
Officer)
Date: November 26, 2002
42
EXHIBIT INDEX
10.1 Letter Agreement dated September 9, 2002 by and between
Annuity and Life Re (Holdings), Ltd. and Frederick S. Hammer
10.2 Letter Agreement dated September 9, 2002 by and between
Annuity and Life Re (Holdings), Ltd. and Robert M. Lichten
43