FORM 10-Q
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D. C. 20549
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 or 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2003
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 or 15 (d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from ___ to ___
Commission File Number 1-12332
Protective Life Corporation
(Exact name of Registrant as specified in its charter)| DELAWARE | 95-2492236 | ||
|---|---|---|---|
| (State or other jurisdiction | (IRS Employer | ||
| incorporation or organization) | Identificiation No.) |
2801 HIGHWAY 280 SOUTH
BIRMINGHAM, ALABAMA 35223
(205) 268-1000
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark whether the registrant is an accelerated filer (as defined by Rule 12b-2 of the Exchange Act). Yes [X] No [ ]
Number of shares of Common Stock, $.50 par value, outstanding as of November 7, 2003: 68,912,705 shares.
PROTECTIVE LIFE CORPORATION
INDEX
Page Number
Part I. Financial Information:
Item 1. Financial Statements:
Report of Independent Auditors.....................................................................
Consolidated Condensed Statements of Income for the Three and
Nine Months ended September 30, 2003 and 2002 (unaudited)......................................
Consolidated Condensed Balance Sheets as of September 30, 2003
(unaudited) and December 31, 2002..............................................................
Consolidated Condensed Statements of Cash Flows for the
Nine Months ended September 30, 2003 and 2002 (unaudited)......................................
Notes to Consolidated Condensed Financial Statements (unaudited)...................................
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations...................................................................
Item 3. Quantitative and Qualitative Disclosures About Market Risk....................................
Item 4. Controls and Procedures.......................................................................
Part II. Other Information:
Item 6. Exhibits and Reports on Form 8-K..............................................................
Signature.................................................................................................
REPORT OF INDEPENDENT AUDITORS
To the Directors and Share Owners
Protective Life Corporation
We have reviewed the accompanying consolidated condensed balance sheet of Protective Life Corporation and its subsidiaries as of September 30, 2003, and the related consolidated condensed statements of income for each of the three-month and nine-month periods ended September 30, 2003 and 2002, and the consolidated condensed statements of cash flows for the nine-month periods ended September 30, 2003 and 2002. These financial statements are the responsibility of the company’s management.
We conducted our review in accordance with standards established by the American Institute of Certified Public Accountants. A review of interim financial information consists principally of applying analytical procedures to financial data and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with auditing standards generally accepted in the United States of America, the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.
Based on our review, we are not aware of any material modifications that should be made to the accompanying consolidated condensed interim financial statements for them to be in conformity with accounting principles generally accepted in the United States of America.
We previously audited in accordance with auditing standards generally accepted in the United States of America, the consolidated balance sheet as of December 31, 2002, and the related consolidated statements of income, share-owners’ equity, and cash flows for the year then ended (not presented herein), and in our report dated March 3, 2003, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying consolidated condensed balance sheet as of December 31, 2002, is fairly stated in all material respects in relation to the consolidated balance sheet from which it has been derived.
/s/ PricewaterhouseCoopers LLP
PricewaterhouseCoopers LLP
Birmingham, Alabama
November 7, 2003
PROTECTIVE LIFE CORPORATION
CONSOLIDATED CONDENSED STATEMENTS OF INCOME
(Dollars in thousands except per share amounts)
(Unaudited)
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
2003 2002 2003 2002
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REVENUES
Premiums and policy fees $424,590 $392,131 $1,209,336 $1,146,545
Reinsurance ceded (237,996) (121,744) (632,681) (498,739)
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Premiums and policy fees, net of reinsurance ceded 186,594 270,387 576,655 647,806
Net investment income 251,539 263,066 777,316 759,761
Realized investment gains (losses):
Derivative financial instruments (13,834) (981) (25,899) 9,445
All other investments 27,042 2,106 55,388 1,895
Other income 26,128 23,927 91,418 78,764
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477,469 558,505 1,474,878 1,497,671
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BENEFITS AND EXPENSES
Benefits and settlement expenses
(net of reinsurance ceded:
three months: 2003 - $217,955; 2002 - $140,939
nine months: 2003 - $653,171; 2002 - $471,083) 281,693 305,952 883,899 873,484
Amortization of deferred policy acquisition costs 56,241 112,021 176,803 214,167
Other operating expenses (net of reinsurance ceded:
three months: 2003 - $28,662; 2002 - $31,183
nine months: 2003 - $93,139; 2002 - $107,412) 60,743 62,896 190,053 188,617
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398,677 480,869 1,250,755 1,276,268
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INCOME BEFORE INCOME TAX 78,792 77,636 224,123 221,403
Income tax expense 26,383 26,661 74,633 74,392
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NET INCOME $ 52,409 $50,975 $ 149,490 $ 147,011
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NET INCOME PER SHARE - BASIC $.75 $.73 $2.14 $2.10
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NET INCOME PER SHARE - DILUTED $.74 $.73 $2.12 $2.09
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DIVIDENDS PAID PER SHARE $.16 $.15 $.47 $.44
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Average shares outstanding - basic 70,091,080 69,948,982 70,017,724 69,912,126
Average shares outstanding - diluted 70,722,885 70,491,409 70,590,253 70,454,250
See notes to consolidated condensed financial statements
PROTECTIVE LIFE CORPORATION
CONSOLIDATED CONDENSED BALANCE SHEETS
(Dollars in thousands)
SEPTEMBER 30 DECEMBER 31
2003 2002
(Unaudited)
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ASSETS
Investments:
Fixed maturities, at market (amortized cost: 2003 - $11,800,656; 2002 - $10,981,234) $12,451,058 $11,664,065
Equity securities, at market (amortized cost: 2003 - $52,623; 2002 - $73,419) 53,582 64,523
Mortgage loans on real estate 2,678,360 2,518,152
Investment in real estate, net 16,781 20,711
Policy loans 523,869 543,161
Other long-term investments 246,177 222,490
Short-term investments 582,830 448,399
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Total investments 16,552,657 15,481,501
Cash 105,019 101,953
Accrued investment income 194,115 181,966
Accounts and premiums receivable, net 55,879 61,425
Reinsurance receivables 2,299,140 2,368,068
Deferred policy acquisition costs 1,815,071 1,707,253
Goodwill 47,312 47,312
Property and equipment, net 45,663 41,324
Other assets 214,499 309,791
Assets related to separate accounts
Variable annuity 1,813,738 1,513,824
Variable universal life 148,511 114,364
Other 4,380 4,330
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$23,295,984 $21,933,111
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LIABILITIES
Policy liabilities and accruals $ 9,539,039 $ 9,124,138
Stable value contract account balances 4,135,212 4,018,552
Annuity account balances 3,538,368 3,697,495
Other policyholders' funds 160,946 174,140
Securities sold under repurchase agreements 111,725 0
Other liabilities 903,128 698,677
Accrued income taxes (43,154) 3,186
Deferred income taxes 362,991 242,593
Debt 440,344 406,110
Guaranteed Preferred Beneficial Interests
7.5% Trust Originated Preferred Securities 100,000 100,000
7.25% Trust Originated Preferred Securities 115,000 115,000
Liabilities related to separate accounts
Variable annuity 1,813,738 1,513,824
Variable universal life 148,511 114,364
Other 4,380 4,330
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21,330,228 20,212,409
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COMMITMENTS AND CONTINGENT LIABILITIES - NOTE B
SHARE-OWNERS' EQUITY
Preferred Stock, $1.00 par value, shares authorized: 3,600,000; Issued: None
Junior Participating Cumulative Preferred Stock, $1.00 par value
shares authorized: 400,000; Issued: None
Common Stock, $.50 par value, shares authorized: 160,000,000
shares issued: 2003 and 2002 - 73,251,960 36,626 36,626
Additional paid-in capital 412,368 408,397
Treasury stock, at cost (2003 - 4,339,255 shares; 2002 - 4,576,066 shares) (15,558) (16,402)
Stock held in trust (2003 - 104,034 shares; 2002 - 79,632 shares) (2,979) (2,417)
Unallocated stock in Employee Stock Ownership Plan
(2003 - 724,068 shares; 2002 - 838,401 shares) (2,367) (2,777)
Retained earnings 1,178,479 1,061,361
Accumulated other comprehensive income:
Net unrealized gains on investments
(net of income tax: 2003 - $192,161; 2002 - 128,145) 356,871 237,983
Accumulated gain (loss) - hedging (net of income tax: 2003 - $1,247; 2002 - $(1,114)) 2,316 (2,069)
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1,965,756 1,720,702
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$23,295,984 $21,933,111
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See notes to consolidated condensed financial statements
PROTECTIVE LIFE CORPORATION
CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS
(Dollars in thousands)
(Unaudited)
NINE MONTHS ENDED
SEPTEMBER 30
2003 2002
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CASH FLOWS FROM OPERATING ACTIVITIES
Net income $ 149,490 $ 147,011
Adjustments to reconcile net income to net cash provided by
operating activities:
Realized investment (gains) losses (29,489) (11,340)
Amortization of deferred policy acquisition costs 176,803 214,167
Capitalization of deferred policy acquisition costs (296,211) (352,443)
Depreciation expense 9,162 8,694
Deferred income tax 52,397 6,672
Accrued income tax (46,340) (35,256)
Interest credited to universal life and investment products 494,054 742,426
Policy fees assessed on universal life and investment products (240,747) (195,393)
Change in accrued investment income and other receivables 62,325 (70,353)
Change in policy liabilities and other policyholders' funds
of traditional life and health products 94,794 152,080
Change in other liabilities (182,168) (3,803)
Other (net) 101,248 4,060
- --------------------------------------------------------------------------------------------------------------------------------
Net cash provided by operating activities 345,318 606,522
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CASH FLOWS FROM INVESTING ACTIVITIES
Maturities and principal reductions of investments
Investments available for sale 10,102,810 7,352,463
Other 314,856 243,138
Sale of investments
Investments available for sale 13,150,557 14,206,741
Other 7,225 14,776
Cost of investments acquired
Investments available for sale (23,570,327) (22,717,431)
Other (458,230) (298,493)
Acquisitions and bulk reinsurance assumptions 0 130,515
Purchase of property and equipment (13,308) (8,091)
Sale of property and equipment 0 48
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Net cash used in investing activities (466,417) (1,076,334)
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CASH FLOW FROM FINANCING ACTIVITIES
Proceeds from borrowings under line of credit arrangements and debt 3,062,000 2,068,272
Principal payments on line of credit arrangements and debt (2,916,041) (2,143,347)
Dividends to share owners (32,372) (30,210)
Sale (Purchase) of common stock held in trust (562) (828)
Issuance of guaranteed preferred beneficial interests 0 115,000
Investment product deposits and changes in universal life deposits 1,325,893 1,244,764
Investment product withdrawals (1,314,753) (832,044)
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Net cash provided by financing activities 124,165 421,607
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(DECREASE)/INCREASE IN CASH 3,066 (48,205)
CASH AT BEGINNING OF PERIOD 101,953 126,558
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CASH AT END OF PERIOD $ 105,019 $ 78,353
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See notes to consolidated condensed financial statements
PROTECTIVE LIFE CORPORATION
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS (Unaudited)
(Amounts in tables are in thousands, except per share amounts)
NOTE A – BASIS OF PRESENTATION
The accompanying unaudited consolidated condensed financial statements of Protective Life Corporation and subsidiaries (the “Company”) have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the disclosures required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments (consisting only of normal recurring accruals) necessary for a fair statement have been included. Operating results for the nine month period ended September 30, 2003 are not necessarily indicative of the results that may be expected for the year ending December 31, 2003. The year-end consolidated condensed balance sheet data was derived from audited financial statements, but does not include all disclosures required by accounting principles generally accepted in the United States of America. For further information, refer to the consolidated financial statements and notes thereto included in the Company’s annual report on Form 10-K for the year ended December 31, 2002.
NOTE B – COMMITMENTS AND CONTINGENT LIABILITIES
The Company’s certificate of incorporation provides indemnification for persons serving as officers and directors of the Company. In addition, agreements with the Company’s directors require the Company, upon certain “change-in-control” contingencies, to obtain a $20 million letter of credit to secure the Company’s indemnification obligations. The letter of credit would provide security for the Company’s obligations up to an aggregate amount of $20 million (after taking into account amounts paid by the Company and amounts paid under the Company’s directors and officers or other insurance policies).
Under insurance guaranty fund laws, in most states insurance companies doing business therein can be assessed up to prescribed limits for policyholder losses incurred by insolvent companies. The Company does not believe such assessments will be materially different from amounts already provided for in the financial statements. Most of these laws do provide, however, that an assessment may be excused or deferred if it would threaten an insurer’s own financial strength.
A number of civil jury verdicts have been returned against insurers, broker-dealers and other providers of financial services involving sales practices, alleged agent misconduct, failure to properly supervise representatives, relationships with agents or persons with whom the insurer does business, and other matters. Increasingly these lawsuits have resulted in the award of substantial judgments that are disproportionate to the actual damages, including material amounts of punitive and non-economic compensatory damages. In some states, juries, judges, and arbitrators have substantial discretion in awarding punitive and non-economic compensatory damages, which creates the potential for unpredictable material adverse judgments or awards in any given lawsuit or arbitration. Arbitration awards are subject to very little appellate review. In addition, in some class action and other lawsuits, companies have made material settlement payments. The Company, like other financial services companies, in the ordinary course of business is involved in such litigation or, alternatively, in arbitration. Although the outcome of any such litigation or arbitration cannot be predicted, the Company believes that at the present time there are no pending or threatened lawsuits that are reasonably likely to have a material adverse effect on the financial position, results of operations, or liquidity of the Company.
NOTE C – OPERATING SEGMENTS
The Company operates several business segments. An operating segment is generally distinguished by products and/or channels of distribution. A brief description of each segment follows:
| Life Marketing. The Life Marketing segment markets level premium term and term-like insurance, universal life, and variable universal life products on a national basis primarily through networks of independent insurance agents and brokers and in the “bank owned life insurance” market. |
| Acquisitions.The Acquisitions segment focuses on acquiring, converting, and servicing policies acquired from other companies. The segment’s primary focus is on life insurance policies sold to individuals. |
| Annuities.The Annuities segment manufactures, sells, and supports fixed and variable annuity products. These products are primarily sold through stockbrokers, but are also sold through financial institutions and the Life Marketing segment’s sales force. |
| Stable Value Contracts. The Stable Value Contracts segment markets guaranteed investment contracts to 401(k) and other qualified retirement savings plans, and sells funding agreements to special purpose entities that in turn issue notes or certificates in smaller, transferable denominations. The segment also markets fixed and floating rate funding agreements directly to the trustees of municipal bond proceeds, institutional investors, bank trust departments, and money market funds. |
| Asset Protection.The Asset Protection segment primarily markets vehicle and recreational marine extended service contracts. The segment also markets credit life and disability insurance products through banks, consumer finance companies and automobile dealers. On October 30, 2003, the Company announced that it has entered into an agreement with Life of the South Corporation (“LOTS”) in which LOTS will assume the administration and marketing responsibilities for a portion of the Asset Protection segment’s credit insurance business based in Raleigh, North Carolina. |
| Corporate and Other. The Company has an additional business segment herein referred to as Corporate and Other. The Corporate and Other segment primarily consists of net investment income and expenses not attributable to the segments above (including net investment income on unallocated capital and interest on substantially all debt). This segment also includes earnings from several lines of business which the Company is not actively marketing (mostly cancer insurance and group annuities), various investment-related transactions, and the operations of several small subsidiaries. |
The Company uses the same accounting policies and procedures to measure operating segment income and assets as it uses to measure its consolidated net income and assets. The measure used by the Company’s chief operating decision maker to assess segment performance is operating income. Operating segment income is generally income before income tax adjusted to exclude any pretax minority interest in income of consolidated subsidiaries, net realized investment gains and losses, and the related amortization of deferred policy acquisition costs and gains (losses) on derivative instruments. Premiums and policy fees, other income, benefits and settlement expenses, and amortization of deferred policy acquisition costs are attributed directly to each operating segment. Net investment income is allocated based on directly related assets required for transacting the business of that segment. Realized investment gains (losses) and other operating expenses are allocated to the segments in a manner which appropriately reflects the operations of that segment. Unallocated realized investment gains (losses) are deemed not to be associated with any specific segment.
Assets are allocated based on policy liabilities and deferred policy acquisition costs directly attributable to each segment.
There are no significant intersegment transactions.
The following table sets forth total operating segment income and assets for the periods shown. Adjustments represent the inclusion of unallocated realized investment gains (losses) and the recognition of income tax expense. Asset adjustments represent the inclusion of assets related to discontinued operations.
Operating Segment Income for the
Nine Months Ended September 30, 2003
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Life Stable Value
Marketing Acquisitions Annuities Contracts
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Premiums and policy fees $607,770 $216,292 $ 19,134
Reinsurance ceded (433,645) (54,730)
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Net of reinsurance ceded 174,125 161,562 19,134
Net investment income 172,752 185,820 170,882 $174,063
Realized investment gains (losses) 19,815 7,303
Other income 44,523 2,118 6,384
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Total revenue 391,400 349,500 216,215 181,366
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Benefits and settlement expenses 205,639 218,070 152,710 140,096
Amortization of deferred policy acquisition cost 52,705 26,372 31,861 1,660
Other operating expenses 16,804 33,174 20,755 3,548
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Total benefits and expenses 275,148 277,616 205,326 145,304
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Income before income tax 116,252 71,884 10,899 36,062
Less: realized investment gains (losses) 19,815 7,303
Add back: related amortization of deferred
policy acquisition cost 18,265
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Operating income 116,252 71,884 9,339 28,759
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Corporate
Asset and Total
Protection Other Adjustments Consolidated
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Premiums and policy fees $336,621 $29,519 $1,209,336
Reinsurance ceded (140,645) (3,661) (632,681)
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Net of reinsurance ceded 195,976 25,858 576,655
Net investment income 29,901 43,898 777,316
Realized investment gains (losses) $ 2,371 29,489
Other income 33,971 4,422 91,418
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Total revenue 259,848 74,178 2,371 1,474,878
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Benefits and settlement expenses 143,995 23,389 883,899
Amortization of deferred policy acquisition cost 63,324 881 176,803
Other operating expenses 64,569 51,203 190,053
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Total benefits and expenses 271,888 75,473 1,250,755
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Income (loss) before income tax (12,040) (1,295) 224,123
Less: realized investment gains (losses)
Add back: related amortization of deferred
policy acquisition cost
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Operating income (loss) (12,040) (1,295)
Income tax expense 74,633 74,633
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Net income $ 149,490
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Operating Segment Income for the
Three Months Ended September 30, 2003
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Life Stable Value
Marketing Acquisitions Annuities Contracts
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Premiums and policy fees $219,410 $ 71,903 $ 6,864
Reinsurance ceded (167,706) (17,573)
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Net of reinsurance ceded 51,704 54,330 6,864
Net investment income 58,699 61,004 54,660 $56,441
Realized investment gains (losses) 8,582 9,745
Other income 13,570 (329) 2,368
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Total revenue 123,973 115,005 72,474 66,186
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Benefits and settlement expenses 68,541 72,500 48,385 45,374
Amortization of deferred policy acquisition cost 12,788 7,817 13,508 542
Other operating expenses 3,143 9,857 7,533 1,002
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Total benefits and expenses 84,472 90,174 69,426 46,918
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Income from continuing operations before income tax 39,501 24,831 3,048 19,268
Less: realized investment gains (losses) 8,582 9,745
Add back: related amortization of deferred
policy acquisition cost 8,167
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Operating income 39,501 24,831 2,633 9,523
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Corporate
Asset and Total
Protection Other Adjustments Consolidated
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Premiums and policy fees $117,437 $ 8,976 $424,590
Reinsurance ceded (52,234) (483) (237,996)
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Net of reinsurance ceded 65,203 8,493 186,594
Net investment income 10,338 10,397 251,539
Realized investment gains (losses) $(5,119) 13,208
Other income 8,833 1,686 26,128
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Total revenue 84,374 20,576 (5,119) 477,469
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Benefits and settlement expenses 39,302 7,591 281,693
Amortization of deferred policy acquisition cost 21,354 232 56,241
Other operating expenses 19,703 19,505 60,743
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Total benefits and expenses 80,359 27,328 398,677
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Income (loss) before income tax 4,015 (6,752) 78,792
Less: realized investment gains (losses)
Add back: related amortization of deferred
policy acquisition cost
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Operating income 4,015 (6,752)
Income tax expense 26,383 26,383
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Net income (loss) $ 52,409
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Operating Segment Income for the
Nine Months Ended September 30, 2002
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Life Stable Value
Marketing Acquisitions Annuities Contracts
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Premiums and policy fees $474,195 $223,600 $ 19,864
Reinsurance ceded (275,102) (48,360)
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Net of reinsurance ceded $199,093 175,240 19,864
Net investment income 154,328 184,639 162,224 $183,258
Realized investment gains (losses) 3,601 (6,110)
Other income 42,760 1,241 6,954
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Total revenue 396,181 361,120 192,643 177,148
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Benefits and settlement expenses 181,255 227,599 135,914 147,201
Amortization of deferred policy acquisition cost 104,518 28,597 19,411 1,741
Other operating expenses 21,583 36,268 22,741 3,378
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Total benefits and expenses 307,356 292,464 178,066 152,320
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Income before income tax 88,825 68,656 14,577 24,828
Less: realized investment gains (losses) 3,601 (6,110)
Add back: related amortization of deferred
policy acquisition cost 1,684
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Operating income 88,825 68,656 12,660 30,938
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Corporate
Asset and Total
Protection Other Adjustments Consolidated
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Premiums and policy fees $386,332 $42,554 $1,146,545
Reinsurance ceded (159,881) (15,396) (498,739)
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Net of reinsurance ceded 226,451 27,158 647,806
Net investment income 33,422 41,890 759,761
Realized investment gains (losses) $13,849 11,340
Other income 26,041 1,768 78,764
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Total revenue 285,914 70,816 13,849 1,497,671
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Benefits and settlement expenses 153,675 27,840 873,484
Amortization of deferred policy acquisition cost 58,763 1,137 214,167
Other operating expenses 64,859 39,788 188,617
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Total benefits and expenses 277,297 68,765 1,276,268
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Income before income tax 8,617 2,051 221,403
Less: realized investment gains (losses)
Add back: related amortization of deferred
policy acquisition cost
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Operating income 8,617 2,051
Income tax expense 74,392 74,392
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Net income $ 147,011
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Operating Segment Income for the
Three Months Ended September 30, 2002
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Life Stable Value
Marketing Acquisitions Annuities Contracts
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Premiums and policy fees $164,902 $ 79,341 $ 6,415
Reinsurance ceded (51,959) (12,468)
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Net of reinsurance ceded 112,943 66,873 6,415
Net investment income 52,555 67,128 56,759 $61,725
Realized investment gains (losses) 363 (6,366)
Other income 13,510 168 2,060
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Total revenue 179,008 134,169 65,597 55,359
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Benefits and settlement expenses 57,364 83,335 48,466 48,290
Amortization of deferred policy acquisition cost 76,221 11,891 5,734 581
Other operating expenses 4,965 13,825 8,716 1,431
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Total benefits and expenses 138,550 109,051 62,916 50,302
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Income before income tax 40,458 25,118 2,681 5,057
Less: realized investment gains (losses) 363 (6,366)
Add back: related amortization of deferred
policy acquisition cost 365
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Operating income 40,458 25,118 2,683 11,423
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Corporate
Asset and Total
Protection Other Adjustments Consolidated
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Premiums and policy fees $127,534 $13,939 $392,131
Reinsurance ceded (52,304) (5,013) (121,744)
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Net of reinsurance ceded 75,230 8,926 270,387
Net investment income 11,095 13,804 263,066
Realized investment gains (losses) $ 7,128 1,125
Other income 7,259 930 23,927
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Total revenue 93,584 23,660 7,128 558,505
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Benefits and settlement expenses 57,751 10,746 305,952
Amortization of deferred policy acquisition cost 17,267 327 112,021
Other operating expenses 20,678 13,281 62,896
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Total benefits and expenses 95,696 24,354 480,869
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Income (loss) before income tax (2,112) (694) 77,636
Less: realized investment gains (losses)
Add back: related amortization of deferred
policy acquisition cost
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Operating income (loss) (2,112) (694)
Income tax expense 26,661 26,661
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Net income $ 50,975
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Operating Segment Assets
September 30, 2003
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Life Stable Value
Marketing Acquisitions Annuities Contracts
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Investments and other assets $4,830,918 $4,438,724 $4,760,940 $4,010,543
Deferred policy acquisition costs 1,131,814 385,703 94,399 4,301
Goodwill 10,354
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Total assets $5,973,086 $4,824,427 $4,855,339 $4,014,844
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Corporate
Asset and Total
Protection Other Adjustments Consolidated
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Investments and other assets $1,064,906 $2,212,045 $115,525 $21,433,601
Deferred policy acquisition costs 191,699 7,155 1,815,071
Goodwill 36,875 83 47,312
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Total assets $1,293,480 $2,219,283 $115,525 $23,295,984
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Operating Segment Assets
December 31, 2002
- ----------------------------------------------------------------------------------------------------------------------------------------
Life Stable Value
Marketing Acquisitions Annuities Contracts
- ----------------------------------------------------------------------------------------------------------------------------------------
Investments and other assets $4,195,265 $4,565,298 $4,823,710 $3,930,669
Deferred policy acquisition costs 973,631 435,177 93,140 4,908
Goodwill 10,354
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Total assets $5,179,250 $5,000,475 $4,916,850 $3,935,577
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Corporate
Asset and Total
Protection Other Adjustments Consolidated
- ----------------------------------------------------------------------------------------------------------------------------------------
Investments and other assets $1,081,912 $1,455,284 $126,408 $20,178,546
Deferred policy acquisition costs 192,695 7,702 1,707,253
Goodwill 36,875 83 47,312
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Total assets $1,311,482 $1,463,069 $126,408 $21,933,111
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NOTE D – STATUTORY REPORTING PRACTICES
Financial statements prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP”) differ in some respects from the statutory accounting practices prescribed or permitted by insurance regulatory authorities. In accordance with statutory reporting practices, at September 30, 2003, and for the nine months then ended, the Company’s insurance subsidiaries had combined share-owners’ equity of $917.6 million and net income of $94.7 million.
NOTE E – REINSURANCE RECEIVABLE
In 2002, the Company discovered that it had overpaid reinsurance premiums to several reinsurance companies of approximately $94.5 million. At December 31, 2002, the Company had recorded cash and receivables totaling $69.7 million, which reflected the amounts received and the Company’s then current estimate of amounts to be recovered in the future, based upon the information then available. The corresponding increase in premiums and policy fees resulted in $62.5 million of additional amortization of deferred policy acquisition costs in 2002. The amortization of deferred policy acquisition costs took into account the amortization relating to the increase in premiums and policy fees as well as the additional amortization required should the remainder of the overpayment not be collected.
As of the date of this report, the Company has received payment from substantially all of the affected reinsurance companies. As a result, the Company increased premiums and policy fees by $2.8 million in the first quarter of 2003 and $15.6 million in the second quarter of 2003. The increase in premiums and policy fees resulted in $1.0 million of additional amortization of deferred policy acquisition costs in the first quarter of 2003 and $5.1 million in the second quarter of 2003. As a result, the Company’s pretax income for the first quarter of 2003 increased by $1.8 million and $10.5 million in the second quarter of 2003. There were no changes in estimates recorded during the third quarter of 2003.
NOTE F – NET INCOME PER SHARE
Net income per share – basic is net income divided by the average number of shares of Common Stock outstanding including shares that are issuable under various deferred compensation plans.
Net income per share – diluted is adjusted net income divided by the average number of shares outstanding including all dilutive, potentially issuable shares that are issuable under various stock-based compensation plans and stock purchase contracts.
Net income and a reconciliation of basic and diluted average shares outstanding for the three and nine month periods ended September 30, 2003 and 2002 is summarized as follows:
RECONCILIATION OF NET INCOME AND
AVERAGE SHARES OUTSTANDING
- ---------------------------------------------------------------------------------------------------------------------------------
Three Months Ended Nine Months Ended
September 30 September 30
2003 2002 2003 2002
- ---------------------------------------------------------------------------------------------------------------------------------
Net income $52,409 $50,975 $149,490 $147,011
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Average shares issued and outstanding 68,912,175 68,668,346 68,868,697 68,654,483
Stock held in trust (104,034) (73,939) (103,768) (63,499)
Issuable under various deferred compensation plans 1,282,939 1,354,575 1,252,795 1,321,142
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Average shares outstanding - basic 70,091,080 69,948,982 70,017,724 69,912,126
Stock held in trust 104,034 73,939 103,768 63,499
Stock appreciation rights 258,545 265,625 221,664 259,683
Issuable under various other stock-based
compensation plans 269,226 202,863 247,097 218,942
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Average shares outstanding - diluted 70,722,885 70,491,409 70,590,253 70,454,250
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NOTE G – RECENTLY ISSUED ACCOUNTING STANDARDS
In April 2003, the Derivatives Implementation Group of the Financial Accounting Standards Board (FASB) cleared Issue No. B36, “Embedded Derivatives: Modified Coinsurance Arrangements and Debt Instruments That Incorporate Credit Risk Exposures That Are Unrelated or Only Partially Related to the Creditworthiness of the Obligor under Those Instruments” (DIG B36). DIG B36 requires the bifurcation of embedded derivatives within modified coinsurance and funds withheld coinsurance arrangements that expose the creditor to credit risk of a company other than the debtor, even if the debtor owns as investment assets the third-party securities to which the creditor is exposed. The effective date of the implementation guidance in DIG B36 is for the first fiscal quarter beginning after September 15, 2003, and should be applied on a prospective basis. The Company is currently evaluating the impact of this pronouncement on its financial statements, but does not anticipate a material impact on its financial condition or results of operations.
In April 2003, the FASB issued SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities.” SFAS No. 149 amends and clarifies accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under Statement 133. This Statement is effective for contracts entered into or modified after June 30, 2003, and should be applied prospectively. The adoption of SFAS No. 149 did not have a material effect on the Company’s financial position or results of operations.
In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity.” SFAS No. 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. The adoption of SFAS No. 150 did not have a material effect on the Company’s financial position or results of operations.
In July 2003, the American Institute of Certified Public Accountants issued Statement of Position (SOP) 03-1, “Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts.” SOP 03-1 is effective for fiscal years beginning after December 15, 2003. SOP 03-1 provides guidance related to the reporting and disclosure of certain insurance contracts and separate accounts, including the calculation of guaranteed minimum death benefits (GMDB). SOP 03-1 also addresses the capitalization and amortization of sales inducements to contract holders. Had the provision been effective at September 30, 2003, the Company would have reported a GMDB accrual $1.2 million higher than currently reported. The Company is currently evaluating the impact of the other requirements of SOP 03-1, but does not anticipate a material impact on its financial condition or results of operations.
In January 2003, the FASB issued FASB Interpretation No. (FIN) 46 “Consolidation of Variable Interest Entities.” FIN 46 clarifies the application of Accounting Research Bulletin No. 51, “Consolidated Financial Statements,” to certain entities in which equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated support from the other parties. FIN 46 will affect the accounting related to a special purpose vehicle (SPV) whose investments are managed by the Company and potentially the accounting for other investments. The FASB has deferred implementation of FIN 46 for variable interest entities (VIEs) created before February 1, 2003, until periods ending after December 15, 2003. The Company is currently assessing the impact that FIN 46 will have on its financial condition and results of operations. Although the Company does not expect the provisions of FIN 46 to have a material impact on its results of operations, had the provision been effective at September 30, 2003, the Company’s current estimate is that reported assets and liabilities would have increased by approximately $413 million.
NOTE H – DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES
Fair-Value Hedges
As of September 30, 2003, and during the nine months then ended, the Company had no hedging relationships designated as a fair-value hedge.
Cash-Flow Hedges
The Company has entered into a foreign currency swap to hedge the risk of changes in the value of interest and principal payments to be made on certain of its foreign-currency-based stable value contracts. Under the terms of the swap, the Company pays a fixed U.S.-dollar-denominated rate and receives a fixed foreign-currency-denominated rate. Effective July 1, 2002, the Company designated this swap as a cash flow hedge and therefore recorded the change in the fair value of the swap during the period in accumulated other comprehensive income. In the third quarter of 2003, the income recognized by the Company related to the ineffective portion of the hedging instruments was immaterial. For the nine months ended September 30, 2003, the Company recognized income of $0.3 million related to the ineffective portion of the hedging instrument. There were no components of the hedging instrument excluded from the assessment of hedge ineffectiveness. During the three and nine month periods ended September 30, 2003, a pretax loss of $5.3 million and $35.6 million, respectively, representing the change in fair value of the hedged contracts during the period, and a gain of like amount representing the application of hedge accounting to this transaction, were recorded in Realized Investment Gains (Losses) – Derivative Financial Instruments in the Company’s consolidated condensed statements of income. Additionally, at September 30, 2003, the Company reported an increase in accumulated other comprehensive income of $2.3 million (net of income tax of $1.2 million) related to its derivatives designated as cash flow hedges. During the next twelve months, the Company expects to reclassify out of accumulated other comprehensive income and into earnings as a reduction to interest expense, approximately $1.5 million.
Other Derivatives
The Company uses certain interest rate swaps, caps, floors, swaptions, options and futures contracts as economic hedges against the changes in value or cash flows of outstanding mortgage loan commitments and certain owned investments as well as certain debt and preferred security obligations of the Company. For the three and nine months ended September 30, 2003, the Company recognized total pretax losses of $14.9 million and $32.2 million, respectively, representing the change in fair value of these derivative instruments as well as the realized gain or loss on contracts closed during the period.
On its foreign currency swaps, the Company recognized a $1.9 million pretax gain for the first nine months of fiscal 2003 and a $22.6 million pretax loss for the current quarter while recognizing a $1.4 million foreign exchange pretax loss on the related foreign-currency-denominated stable value contracts for the nine month period and a $23.1 million pretax gain for the current quarter. The net change primarily results from the difference in the forward and spot exchange rates used to revalue the currency swaps and the stable value contracts, respectively. This net change is reflected in Realized Investment Gains (Losses) – Derivative Financial Instruments in the Company’s consolidated condensed statements of income.
The Company has entered into asset swap arrangements to, in effect, sell the equity options embedded in owned convertible bonds in exchange for an interest rate swap that converts the remaining host bond to a variable rate instrument. For the nine months ended September 30, 2003, the Company recognized a $1.5 million pretax gain for the change in the asset swaps’ fair value and recognized a $0.7 million pretax gain to separately record the embedded equity options at fair value. For the three months ended September 30, 2003, the Company recognized a $0.5 million pretax gain for the change in the asset swaps’ fair value and recognized a $1.3 million pretax gain to separately record the embedded equity options at fair value.
The Company has also entered into a total return swap in connection with a portfolio of investment securities managed by the Company for an unrelated party. The Company recognized pretax losses of $1.2 million for the three months ended September 30, 2003 for the change in the total return swap’s fair value. The Company recognized pretax gains of $3.4 million for the nine months ended September 30, 2003, for the change in the total return swap’s fair value.
NOTE I – COMPREHENSIVE INCOME
The following table sets forth the Company’s comprehensive income for the periods presented below:
- ---------------------------------------------------------------------------------------------------------------------------------
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
2003 2002 2003 2002
- ---------------------------------------------------------------------------------------------------------------------------------
Net income $ 52,409 $ 50,975 $149,490 $147,011
Change in net unrealized gains/losses
on investments (net of income tax:
three months: 2003 - $(46,261); 2002 - $86,452
nine months: 2003 - $83,402; 2002 - $114,363) (85,914) 160,553 154,890 212,389
Change in accumulated gain-hedging
(net of income tax:
three months: 2003 - $615; 2002 - $(2,652)
nine months: 2003 - $2,361; 2002 - $(2,652)) 1,143 (4,925) 4,385 (4,925)
Reclassification adjustment for amounts included
in net income (net of income tax:
three months: 2003 - $(9,465); 2002 - $(737);
nine months: 2003 - $(19,386); 2002 - $(663)) (17,577) (1,369) (36,002) (1,232)
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Comprehensive income (loss) $(49,939) $205,234 $272,763 $353,243
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NOTE J – RECLASSIFICATIONS
Certain reclassifications have been made in the previously reported financial statements and accompanying notes to make the prior year amounts comparable to those of the current year. Such reclassifications had no effect on previously reported net income or share-owners’ equity.
NOTE K — ACQUISITIONS
In June 2002, the Company coinsured a block of traditional life and interest-sensitive life insurance policies from Conseco Variable Insurance Company. The transaction has been accounted for as a purchase, and the results of the transaction have been included in the accompanying financial statements since the transaction’s effective date.
Summarized below are the consolidated results of operations for the period presented below, on an unaudited pro forma basis, as if the acquisition had occurred as of January 1, 2002. The pro forma financial information does not purport to be indicative of results of operations that would have occurred had the transaction occurred on the basis assumed above nor are they indicative of results of the future operations of the combined enterprises.
- ---------------------------------------------------------------------------------------------------------------------------------
NINE MONTHS ENDED
SEPTEMBER 30, 2002
(UNAUDITED)
- ---------------------------------------------------------------------------------------------------------------------------------
Total revenues $1,529,943
Net income 150,760
Net income per share-basic 2.16
Net income per share-diluted 2.14
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NOTE L – SENIOR NOTES
In May 2003, the Company issued $250 million of 4.3% Senior Notes which are due June 1, 2013. The proceeds from the issuance were used to pay off $150 million of bank borrowings on the Company’s revolving line of credit, and to redeem $50 million of 8.0% Senior Notes due in 2010 and $40 million of 8.1% Senior Notes due in 2015. The Company recorded a $1.6 million charge related to the early extinguishment of debt in the second quarter of 2003. The charge was comprised primarily of the write-off of deferred debt issue costs.
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
Protective Life Corporation is a holding company whose subsidiaries provide financial services through the production, distribution, and administration of insurance and investment products. Founded in 1907, Protective Life Insurance Company is the Company’s principal operating subsidiary.
Unless the context otherwise requires, the “Company” refers to the consolidated group of Protective Life Corporation and its subsidiaries.
For a more complete understanding of the Company’s business and its current period results, please read the following Management’s Discussion and Analysis of Financial Condition and Results of Operations in conjunction with the Company’s latest annual report on Form 10-K and other filings with the SEC.
The Company operates several business segments each having a strategic focus. An operating segment is generally distinguished by products and/or channels of distribution. The Company’s operating segments are Life Marketing, Acquisitions, Annuities, Stable Value Contracts, and Asset Protection. The Company also has an additional business segment referred to as Corporate and Other.
This report reviews the Company’s financial condition and results of operations including its liquidity and capital resources. Historical information is presented and discussed. Where appropriate, factors that may affect future financial performance are also identified and discussed. Certain statements made in this report include “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements include any statement that may predict, forecast, indicate or imply future results, performance or achievements instead of historical facts and may contain words like “believe,” “expect,” “estimate,” “project,” “budget,” “forecast,” “anticipate,” “plan,” “will,” “shall,” “may,” and other words, phrases, or expressions with similar meanings. Forward-looking statements involve risks and uncertainties which may cause actual results to differ materially from the results contained in the forward-looking statements, and the Company cannot give assurances that such statements will prove to be correct. Given these risks and uncertainties, investors should not place undue reliance on forward-looking statements as a prediction of actual results. Please refer to Exhibit 99, incorporated by reference herein, for more information about factors which could affect future results.
The following discussion and analysis primarily relates to the nine months ended September 30, 2003, as it compares to the same period last year. Unless otherwise noted, the general factors discussed also apply to the quarter ended September 30, 2003, as it compares to the same quarter last year. Where needed for a more complete understanding of the Company’s operating results, information related to the quarters ended September 30, 2003, and September 30, 2002, has been provided.
The Company’s results may fluctuate from period to period due to fluctuations in mortality, persistency, claims, expenses, interest rates, and other factors. Therefore, it is management’s opinion that quarterly operating results for an insurance company are not necessarily indicative of results to be achieved in future periods, and that a review of operating results over a longer period is necessary to assess an insurance company’s performance.
RESULTS OF CONTINUING OPERATIONS
Premiums and Policy Fees
The following table sets forth for the periods shown the amount of premiums and policy fees, net of reinsurance ceded (“premiums and policy fees”):
- ---------------------------------------------------------------------------------------------------------------------------------
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
2003 2002 2003 2002
(In thousands)
- ---------------------------------------------------------------------------------------------------------------------------------
Premiums and Policy Fees $186,594 $270,387 $576,655 $647,806
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Premiums and policy fees decreased $71.2 million or 11.0% in the first nine months of 2003 as compared to the first nine months of 2002. Premiums and policy fees in the Life Marketing segment decreased $25.0 million in the first nine months of 2003 as compared to the same period in 2002. In the first nine months of 2003, the Company recorded $18.4 million of additional premiums related to recoveries of overpaid reinsurance, as compared to $69.7 million recorded in the first nine months of 2002. (See Note E in the Notes to Consolidated Condensed Financial Statements.) The growth of the face value of in-force policies resulted in an increase of $26.3 million in net premiums and policy fees in the first nine months of 2003 as compared to the same period of 2002. Premiums and policy fees in the Acquisitions segment decreased $13.7 million in the first nine months of 2003, as compared to the first nine months of 2002. Premiums and policy fees in the Acquisitions segment are expected to decline with time (due to the lapsing of policies resulting from death of insureds or terminations of coverage) unless new acquisitions are made. In June 2002, the Company coinsured a block of insurance policies from Conseco Variable Insurance Company (“Conseco”) which resulted in an increase in premium and policy fees of $5.8 million in the first nine months of 2003. This increase was offset by the declines in premiums and policy fees from older acquired blocks of business. The decrease in premiums and policy fees from the Annuities segment was $0.7 million in the first nine months of 2003 as compared to the first nine months of 2002. Premiums and policy fees related to the Asset Protection segment fell $30.5 million for the first nine months of 2003 compared to the first nine months of 2002. The planned termination of a service contract program at the end of 2002 represented $11.7 million of the decrease, while decreases in credit sales reduced 2003 premiums and policy fees by an additional $16.6 million. Credit sales have been affected by lower auto sales-lending activity and lower sales penetration rates. Premiums and policy fees relating to various health insurance lines in the Corporate and Other segment decreased $1.3 million in the first nine months of 2003 as compared to the first nine months of 2002. Premiums and policy fees on the various health insurance lines are expected to decline as these lines run off.
Net Investment Income
The following table sets forth for the periods shown the amount of net investment income:
- ---------------------------------------------------------------------------------------------------------------------------------
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
2003 2002 2003 2002
(In thousands)
- ---------------------------------------------------------------------------------------------------------------------------------
Net Investment Income $251,539 $263,066 $777,316 $759,761
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Net investment income in the first nine months of 2003 was $777.3 million, which was $17.6 million or 2.3% higher than the corresponding period of the preceding year. Participating mortgage income increased $3.7 million in the first nine months of 2003 as compared to the first nine months of 2002, but decreased by $2.0 million in the third quarter of 2003 as compared to the third quarter of 2002. The Conseco coinsurance transaction, which occurred in June 2002, resulted in a $14.7 million increase in investment income in the first nine months of 2003 as compared to the first nine months of 2002. The percentage earned on average cash and investments was 6.3% in the first nine months of 2003, compared to 7.1% in the first nine months of 2002. Investment returns have been negatively affected in 2003 by higher prepayments on mortgage-backed securities and mortgage loans and by lower interest rates. Prepayments on mortgage-backed securities for the first nine months of 2003 were $2.4 billion, representing 55.6% of the December 31, 2002 balance.
Realized Investment Gains/(Losses)
The Company generally purchases its investments with the intent to hold to maturity by purchasing investments that match future cash-flow needs.
The following table sets forth realized investment gains (losses) for the periods shown:
- ---------------------------------------------------------------------------------------------------------------------------------
THREE MONTHS ENDED NINE MONTHS ENDED
REALIZED INVESTMENT SEPTEMBER 30 SEPTEMBER 30
GAINS/(LOSSES) 2003 2002 2003 2002
(In thousands)
- ---------------------------------------------------------------------------------------------------------------------------------
Derivative Financial Instruments $(13,834) $ (981) $(25,899) $9,445
All Other Investments 27,042 2,106 55,388 1,895
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The sales of investments that have occurred generally have resulted from portfolio management decisions to maintain proper matching of assets and liabilities. Realized investment gains related to all other investments in the first nine months of 2003 of $79.3 million were partially offset by realized investment losses of $23.9 million. The increase in realized investment gains in 2003 is a result of the increases in the market value of the Company’s investments in response to lower current rates. Realized investment gains related to all other investments in the first nine months of 2002 of $32.6 million were largely offset by realized investment losses of $30.7 million. During the first nine months of 2003 and 2002, the Company recorded other-than-temporary impairments in its investments of $18.0 million and $24.0 million, respectively, that were included in realized investment losses related to all other investments.
Each quarter the Company reviews its investments with material unrealized losses and tests for other-than-temporary impairments. Management analyzes various factors to determine if any other-than-temporary asset impairments exist. Once a determination has been made that an other-than-temporary impairment exists, a realized loss is recognized and the cost basis of the impaired asset is adjusted to its fair value. An other-than-temporary impairment loss is recognized based upon all relevant facts and circumstances for each investment. With respect to unrealized losses due to issuer-specific events, the Company considers the creditworthiness and financial performance of the issuer and other available information. With respect to unrealized losses that are not due to issuer-specific events, such as losses due to interest rate fluctuations, general market conditions or industry-related events, the Company considers its intent and ability to hold the investment to allow for a market recovery or to maturity together with an assessment of the likelihood of full recovery.
Realized investment gains and losses related to derivative financial instruments primarily represent changes in the fair values of certain derivative financial instruments. Realized investment losses related to derivative financial instruments were $25.9 million in the nine months ended September 30, 2003, compared to gains of $9.5 million in the nine months ended September 30, 2002. For the nine months ended September 30, 2003 and 2002 the changes in fair value were primarily due to derivative instruments entered into as economic hedges to reduce the Company’s exposure to interest rate risk and realized gains due to closing certain derivative positions. (See also Note H to the Company’s Consolidated Condensed Financial Statements included herein.)
Other Income
The following table sets forth other income for the periods shown:
- ---------------------------------------------------------------------------------------------------------------------------------
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
2003 2002 2003 2002
(In thousands)
- ---------------------------------------------------------------------------------------------------------------------------------
Other Income $26,128 $23,927 $91,418 $78,764
- ---------------------------------------------------------------------------------------------------------------------------------
Other income consists primarily of investment advisory fees from variable insurance products, and revenues from unaffiliated parties relating to the Company’s broker-dealer subsidiary, direct response businesses, service contract businesses, and the Company’s other non-insurance subsidiaries. Other income increased to $91.4 million in the first nine months of 2003 from $78.8 million in the first nine months of 2002. The sale of an inactive charter in the second quarter of 2003 resulted in a $6.9 million gain and represented an increase of $4.2 million over a charter sold during the first quarter in 2002. Revenues from the Company’s broker-dealer subsidiary decreased $1.2 million in the first nine months of 2003 as compared to the same period in 2002. Revenues from the Company’s direct response businesses and service contract businesses increased $1.7 million and $3.4 million, respectively, in the first nine months of 2003 as compared to the first nine months of 2002. Other income from all other sources increased $4.6 million in the first nine months of 2003 as compared to the first nine months of 2002.
Income Before Income Tax and Operating Income
Consistent with the Company’s segment reporting in the Notes to Consolidated Condensed Financial Statements, management evaluates the results of the Company’s segments on a before-income-tax basis as adjusted for certain items which management believes are not indicative of the segment’s core operations. Segment operating income (loss) excludes net realized investment gains and losses and the related amortization of deferred policy acquisition costs and gains (losses) on derivative instruments because fluctuations in these items are due to changes in interest rates and other financial market factors instead of mortality and morbidity. Also, segment operating income (loss) excludes discontinued operations, extraordinary items, and the cumulative effect of changes in accounting principles. Although the items excluded from segment operating income (loss) may be significant components in understanding and assessing the Company’s overall financial performance, management believes that segment operating income (loss) enhances an investor’s understanding of the Company’s results of operations by highlighting the income (loss) attributable to the normal, recurring operations of the insurance business (i.e., mortality and morbidity), consistent with industry practice. However, the Company’s segment operating income (loss) measures may not be comparable to similarly titled measures reported by other companies. Segment operating income (loss) should not be construed as a substitute for net income (loss) determined in accordance with accounting principles generally accepted in the United States of America (GAAP). “Total income before income tax” is a GAAP measure to which the non-GAAP measure “total operating income” may be compared. Unlike total operating income, total income before income tax includes net realized investment gains and losses, the related amortization of deferred policy acquisition costs and gains (losses) on derivative instruments. In the Life Marketing, Acquisitions, Asset Protection, and Corporate and Other segments, operating income equals segment income before income tax for all periods. In the Annuities and Stable Value Contracts segments, operating income excludes realized investment gains and losses and related amortization.
The following table sets forth operating income or loss and income or loss before income tax by business segment for the periods shown:
OPERATING INCOME (LOSS) AND INCOME (LOSS) BEFORE INCOME TAX
(IN THOUSANDS)
- ---------------------------------------------------------------------------------------------------------------------------------
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
2003 2002 2003 2002
- ---------------------------------------------------------------------------------------------------------------------------------
Operating income (Loss) 1
Life marketing $39,501 $40,458 $116,252 $ 88,825
Acquisitions 24,831 25,118 71,884 68,656
Annuities 2,633 2,683 9,339 12,660
Stable value contracts 9,523 11,423 28,759 30,938
Asset protection 4,015 (2,112) (12,040) 8,617
Corporate and other (6,752) (694) (1,295) 2,051
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Realized investment gains (losses)
Annuities 8,582 363 19,815 3,601
Stable value contracts 9,745 (6,366) 7,303 (6,110)
Unallocated realized investment gains (losses) (5,119) 7,128 2,371 13,849
Related amortization of deferred policy
acquisition costs
Annuities (8,167) (365) (18,265) (1,684)
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Income (loss) before income tax
Life marketing 39,501 40,458 116,252 88,825
Acquisitions 24,831 25,118 71,884 68,656
Annuities 3,048 2,681 10,889 14,577
Stable value contracts 19,268 5,057 36,062 24,828
Asset protection 4,015 (2,112) (12,040) 8,617
Corporation and other (6,752) (694) (1,295) 2,051
Unallocated realized investment gains (losses) (5,119) 7,128 2,371 13,849
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Total income before income tax $78,792 $77,636 $224,123 $221,403
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1 Income before income tax excluding realized investment gains and losses and related amortization of deferred policy acquisition costs
The Life Marketing segment’s pretax operating income was $116.3 million in the first nine months of 2003 compared to $88.8 million in the same period of 2002. 2003 earnings include $12.3 million related to recoveries of overpaid reinsurance premiums as compared to $7.2 million in 2002 (See Note E in the Notes to Consolidated Condensed Financial Statements). Excluding earnings from recoveries from overpayments, operating income increased by $22.4 million. The remaining increase is primarily attributable to growth in business-in-force due to strong sales in prior periods. Mortality experience during the first nine months of 2003 was approximately $1.6 million worse than pricing, $7.1 million less favorable than in the same period of 2002.
In the ordinary course of business, the Acquisitions segment regularly considers acquisitions of blocks of policies or smaller insurance companies. Policies acquired through the segment are usually administered as “closed” blocks; i.e., no new policies are being marketed. Therefore, earnings from the Acquisitions segment are normally expected to decline over time (due to the lapsing of policies resulting from deaths of insureds or terminations of coverage) unless new acquisitions are made.
The Acquisitions segment’s pretax operating income was $71.9 million in the first nine months of 2003, an increase of $3.2 million from the first nine months of 2002. The Conseco coinsurance transaction contributed $9.1 million in earnings in the first nine months of 2003 compared to $2.0 million in the first nine months of 2002. Mortality experience was $2.6 million better than pricing in the first nine months of 2003, approximately $1.4 million more favorable than in the first nine months of 2002. Also, earnings from a 2001 acquisition increased $1.5 million in the first nine months of 2003 as compared to the first nine months of 2002. The increase from the two transactions and favorable mortality experience was partially offset by expected declines in the operating results of older blocks of policies and a change to the allocation of investment income which had the effect of transferring $4.3 million of investment income in the first nine months of 2003 from this segment to the Corporate and Other segment.
The Annuities segment’s pretax operating income was $9.3 million in the first nine months of 2003, a decrease from the $12.7 million of operating income for the first nine months of 2002. The decrease is primarily attributable to spread compression and the inability to capitalize excess expenses due to lower sales of fixed annuities caused by lower interest rates in 2003.
The Company offers a guaranteed minimum death benefit feature (GMDB) on its variable annuity products. The Company’s accounting policy has been to calculate its total exposure to GMDB, and then apply a mortality factor to determine the amount of claims that could be expected to occur in the coming twelve months. The Company then accrues to that amount over four quarters. At September 30, 2003, the total GMDB reserve was $5.8 million. The total guaranteed amount payable under the GMDB feature based on variable annuity account balances at September 30, 2003, was $408.0 million, a decrease of $9.0 million from June 30, 2003, caused by an improvement in the equity markets.
In accordance with statutory accounting practices prescribed or permitted by regulatory authorities (which require the assumption that equity markets will significantly worsen), the Company’s insurance subsidiaries reported GMDB related policy liabilities and accruals of $19.3 million at September 30, 2003, a decrease of $0.3 million from June 30, 2003.
Although positive performance in the equity markets in the second and third quarters of 2003 allowed the Company to decrease its GMDB related policy liabilities, the Annuities segment’s future results may be negatively affected by a slow economy. Volatile equity markets could negatively affect sales of variable annuities and the fees the segment assesses on variable annuity contracts. Lower interest rates could negatively affect sales of fixed annuities. In this segment, equity market volatility may create uncertainty regarding the level of future profitability in the variable annuity business and the related rate of amortization of deferred policy acquisition costs.
The Stable Value Contracts segment’s pretax operating income was $28.8 million in the first nine months of 2003, a decrease of $2.2 million from the first nine months of 2002. The decrease is primarily attributable to a narrowing of average spreads from 105 basis points in the first nine months of 2002, to 96 basis points in the first nine months of 2003. The primary reason for the spread compression was a reduction in yield caused by the high level of prepayments in the mortgage-backed securities portfolio in 2003.
The Company’s principal operating subsidiary, Protective Life Insurance Company (PLICO) has registered a program with the Securities and Exchange Commission in which up to $3 billion of secured medium-term notes may be issued to the institutional market and InterNotes® may be issued to the retail market on a delayed (or shelf) basis. Each series of notes will be issued by a separate trust and will be secured by one or more funding agreements issued by PLICO. Notes issued under the program will be accounted for in a manner consistent with the Company’s other stable value products (i.e., included in “stable value products account balances” in the Company’s balance sheet).
The Asset Protection segment had a $12.0 million pretax operating loss in the first nine months of 2003, compared to $8.6 million pretax operating income in the first nine months of 2002. Included in the segment’s loss was a charge of $25.4 million primarily due to reserve strengthening in the Company’s runoff residual value insurance business in the second quarter of 2003. The reserve strengthening was necessitated by a 9.0% decline in used vehicle price levels from that assumed in the reserve analysis performed at December 31, 2002. The Company does not believe used vehicle prices have significantly declined since the reserve analysis was performed. The 2003 operating results include a $6.9 million gain on the sale of an inactive charter held in the segment. In the first nine months of 2002, the segment also sold an inactive charter representing a $2.7 million gain. The segment has several lines of business that are not considered core to the operations of the Company and therefore the segment is exiting those lines. Core operations contributed $10.9 million to income in the first nine months of 2003, compared to $15.9 million in the first nine months of 2002. The decline resulted from lower credit insurance earnings which was partially offset by increased earnings in the service contract lines. Non-core and ancillary lines had a loss of $29.8 million in the first nine months of 2003 (including the reserve strengthening charge of $25.4 million), compared to a loss of $9.9 million in the first nine months of 2002.
The Company also announced that it has entered into an agreement with Life of the South Corporation (“LOTS”) under the terms of which LOTS will assume the administration and marketing responsibilities for a portion of the Asset Protection segment’s financial institutions credit insurance business that is based in Raleigh, North Carolina. The Company anticipates that the transfer of both the administration and marketing responsibilities will be completed by year-end 2003. The Company continues to review strategic alternatives for certain under-performing product lines in the Asset Protection segment.
The Corporate and Other segment consists primarily of net investment income on capital, interest expense on all debt, and various other items not associated with the other segments. The segment had a pretax operating loss of $1.3 million in the first nine months of 2003, compared to income of $2.1 million in the first nine months of 2002. The decrease in income is primarily attributable to a $1.6 million charge for the early extinguishment of debt in the second quarter of 2003, and an increase in interest expense of $5.5 million in the first nine months of 2003 as compared to the first nine months of 2002. The increase in interest expense was primarily due to an increase in the Company’s average debt outstanding. The Company also had $90 million of senior debt outstanding for one month in 2003 after debt had been issued to replace it, but before it could be called. The decrease was partially offset by a $3.7 million increase in participating mortgage income in the first nine months of 2003 as compared to the same period in 2002. Results in the cancer line also improved $3.1 million in the first nine months of 2003. Increases related to employee incentive plans and other expenses in the segment resulted in a $3.1 million decrease in earnings.
Income Taxes
The following table sets forth the effective tax rates for the periods shown:
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THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
2003 2002 2003 2002
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Effective Income Tax Rates 33.5% 34.3% 33.3% 33.6%
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The effective income tax rate for the full year of 2002 was approximately 33.1%. Management’s estimate of the effective income tax rate for the full year 2003 is approximately 33.3%.
Net Income
The following table sets forth net income and related per share information for the periods shown:
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THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
2003 2002 2003 2002
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Net income (in thousands) $52,409 $50,975 $149,490 $147,011
Per share-basic .75 .73 2.14 2.10
Per share-diluted .74 .73 2.12 2.09
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Compared to the same period in 2002, net income per share-diluted in the first nine months of 2003 increased 1.4%, reflecting higher realized investment gains and higher operating earnings in the Life Marketing and Acquisitions segments offset by decreases in operating results in the Annuities, Asset Protection, Stable Value Contract, and Corporate and Other segments.
Known Trends and Uncertainties
The factors which could affect the Company’s future results include, but are not limited to, general economic conditions and the following known trends and uncertainties: we are exposed to the risks of natural disasters, malicious and terrorist acts that could adversely affect our operations; we operate in a mature, highly competitive industry, which could limit our ability to gain or maintain our position in the industry; a ratings downgrade could adversely affect our ability to compete; our policy claims fluctuate from period to period, and actual results could differ from our expectations; our results may be negatively affected should actual experience differ from management’s assumptions and estimates; the use of reinsurance introduces variability in our statement of income; we could be forced to sell investments at a loss to cover policyholder withdrawals; interest rate fluctuations could negatively affect our spread income or otherwise impact our business; equity market volatility could negatively impact our business; a deficiency in our systems could result in over- or underpayments of amounts owed to or by the Company and/or errors in our critical assumptions or reported financial results; insurance companies are highly regulated; changes to tax law or interpretations of existing tax law could adversely affect the Company and its ability to compete with non-insurance products or reduce the demand for certain insurance products; financial services companies are frequently the targets of litigation, including class action litigation, which could result in substantial judgments; our ability to maintain low unit costs is dependent upon the level of new sales and persistency of existing business; our investments are subject to market and credit risks; we may not realize our anticipated financial results from our acquisitions strategy; we are dependent on the performance of others; our reinsurers could fail to meet assumed obligations, increase rates or be subject to adverse developments that could affect us; and computer viruses could affect our data processing systems or those of our business partners. Please refer to Exhibit 99, incorporated by reference herein, about these factors that could affect future results.
Recently Issued Accounting Standards
In April 2003, the Derivatives Implementation Group of the FASB cleared Issue No. B36, “Embedded Derivatives: Modified Coinsurance Arrangements and Debt Instruments That Incorporate Credit Risk Exposures That Are Unrelated or Only Partially Related to the Creditworthiness of the Obligor under Those Instruments” (DIG B36). DIG B36 requires the bifurcation of embedded derivatives within modified coinsurance and funds withheld coinsurance arrangements that expose the creditor to credit risk of a company other than the debtor, even if the debtor owns as investment assets the third-party securities to which the creditor is exposed. The effective date of the implementation guidance in DIG B36 is for the first fiscal quarter beginning after September 15, 2003, and should be applied on a prospective basis. The Company is currently evaluating the impact of this pronouncement on its financial statements, but does not anticipate a material impact on its financial condition or results of operations.
In April 2003, FASB issued SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities.” SFAS No. 149 amends and clarifies accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under Statement 133. This Statement is effective for contracts entered into or modified after June 30, 2003, and should be applied prospectively. The adoption of SFAS No. 149 did not have a material effect on the Company’s financial position or results of operations.
In May 2003, FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” SFAS No. 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. The adoption of SFAS No. 150 did not have a material effect on the Company’s financial position or results of operations.
In July 2003, the American Institute of Certified Public Accountants issued Statement of Position (SOP) 03-1, “Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts.” SOP 03-1 is effective for fiscal years beginning after December 15, 2003. SOP 03-1 provides guidance related to the reporting and disclosure of certain insurance contracts and separate accounts, including the calculation of guaranteed minimum death benefits (GMDB). SOP 03-1 also addresses the capitalization and amortization of sales inducements to contract holders. Had the provision been effective at September 30, 2003, the Company would have reported a GMDB accrual $1.2 million higher than currently reported. The Company is currently evaluating the impact of the other requirements of SOP 03-1, but does not anticipate a material impact on its financial condition or results of operations.
In January 2003, the FASB issued FASB Interpretation No. (FIN) 46 “Consolidation of Variable Interest Entities.” FIN 46 clarifies the application of Accounting Research Bulletin No. 51, “Consolidated Financial Statements,” to certain entities in which equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated support from the other parties. FIN 46 will affect the accounting related to a special purpose vehicle (SPV) whose investments are managed by the Company and potentially the accounting for other investments. The FASB has deferred implementation of FIN 46 for variable interest entities (VIEs) created before February 1, 2003, until periods ending after December 15, 2003. The Company is currently assessing the impact that FIN 46 will have on its financial condition and results of operations. Although the Company does not expect the provisions of FIN 46 to have a material impact on its results of operations, had the provision been effective at September 30, 2003, the Company’s current estimate is that reported assets and liabilities would have increased by approximately $413 million.
Review by Independent Auditors
With respect to the unaudited consolidated condensed financial information of Protective Life Corporation for the three-month and nine-month periods ended September 30, 2003 and 2002, PricewaterhouseCoopers LLP (“PricewaterhouseCoopers”) reported that they have applied limited procedures in accordance with professional standards for a review of such information. However, their separate report dated November 7, 2003, appearing herein, stated that they did not audit and they do not express an opinion on that unaudited consolidated condensed financial information. Accordingly, the degree of reliance on their report on such information should be restricted in light of the limited nature of the review procedures applied. PricewaterhouseCoopers is not subject to the liability provisions of Section 11 of the Securities Act of 1933 for their report on the unaudited consolidated condensed financial information because that report is not a “report” or a “part” of a registration statement prepared or certified by PricewaterhouseCoopers into which this Form 10-Q may be incorporated by reference within the meaning of Sections 7 and 11 of the Act.
LIQUIDITY AND CAPITAL RESOURCES
The Company’s operations usually produce a positive cash flow. This cash flow is used to fund an investment portfolio to finance future benefit payments. Since future benefit payments largely represent medium- and long-term obligations reserved using certain assumed interest rates, the Company’s investments are predominantly in medium- and long-term, fixed-rate investments such as bonds and mortgage loans.
INVESTMENTS
Portfolio Description
The Company’s investment portfolio consists primarily of fixed maturity securities (bonds and redeemable preferred stocks) and commercial mortgage loans. The Company generally purchases its investments with the intent to hold to maturity by purchasing investments that match future cash flow needs. However, the Company may sell any of its investments to maintain proper matching of assets and liabilities. Accordingly, the Company has classified its fixed maturities and certain other securities as “available for sale.”
The Company’s investments in debt and equity securities are reported at market value, and investments in mortgage loans are reported at amortized cost. At September 30, 2003, the Company’s fixed maturity investments had a market value of $12.5 billion, which is 5.5% above amortized cost of $11.8 billion. The Company had $2.7 billion in mortgage loans at September 30, 2003. While the Company’s mortgage loans do not have quoted market values, at September 30, 2003, the Company estimates the market value of its mortgage loans to be $2.9 billion (using discounted cash flows from the next call date), which is 9.7% above amortized cost. Most of the Company’s mortgage loans have significant prepayment fees. These assets are invested for terms approximately corresponding to anticipated future benefit payments. Thus, market fluctuations are not expected to adversely affect liquidity.
The following table shows the carrying values of the Company’s invested assets.
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SEPTEMBER 30, 2003 DECEMBER 31, 2002
(IN THOUSANDS)
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Publicly-issued bonds $10,359,813 62.6% $ 9,694,132 62.6%
Privately issued bonds 2,090,573 12.6 1,968,106 12.7
Redeemable preferred stock 672 0.0 1,827 0.0
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Fixed maturities 12,451,058 75.2 11,664,065 75.3
Equity securities 53,582 0.3 64,523 0.4
Mortgage loans 2,678,360 16.2 2,518,152 16.3
Investment real estate 16,781 0.1 20,711 0.1
Policy loans 523,869 3.2 543,161 3.5
Other long-term investments 246,177 1.5 222,490 1.5
Short-term investments 582,830 3.5 448,399 2.9
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Total investments $16,552,657 100.0% $15,481,501 100.0%
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Risk Management and Impairment Review
The Company monitors the overall credit quality of the Company’s portfolio within general guidelines. The following table shows the Company’s fixed maturities by credit rating at September 30, 2003.
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S&P or Equivalent Market Value Percent of
Designation (In thousands) Market Value
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AAA $ 4,350,737 34.9%
AA 711,337 5.7
A 2,840,021 22.8
BBB 3,526,366 28.3
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Investment Grade 11,428,461 91.7
BB 711,338 5.7
B 237,129 1.9
CCC or lower 52,098 0.4
In or near default 21,360 0.3
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Below Investment Grade 1,021,925 8.3
Redeemable preferred stock 672 0.0
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Total $12,451,058 100.0%
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Limiting bond exposure to any creditor group is another way the Company manages credit risk. The following table summarizes the Company’s ten largest fixed maturity exposures to an individual creditor group as of September 30, 2003.
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Market Value
Creditor (in millions)
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Berkshire Hathaway $74.1
Duke Energy 71.2
Progress Energy 65.5
Verizon 65.1
Wachovia 65.1
Cox Communications 64.9
Constellation Energy Group 60.5
Bank of America 60.0
Inco 59.1
BellSouth Corporation 56.6
The Company’s management considers a number of factors when determining the impairment status of individual securities. These include the economic condition of various industry segments and geographic locations and other areas of identified risks. Although it is possible for the impairment of one investment to affect other investments, the Company engages in ongoing risk management to safeguard against and limit any further risk to its investment portfolio. Special attention is given to correlated risks within specific industries, related parties and business markets.
Once management has determined that a particular investment has suffered an other-than-temporary impairment, the asset is written down to its estimated fair value. The Company generally considers a number of factors in determining whether the impairment is other than temporary. These include, but are not limited to: 1) actions taken by rating agencies, 2) default by the issuer, 3) the significance of the decline, 4) the intent and ability of the Company to hold the investment until recovery, 5) the time period during which the decline has occurred, 6) an economic analysis of the issuer’s industry, and 7) the financial strength, liquidity, and recoverability of the issuer. Management performs a security by security review each quarter in evaluating the need for any other-than-temporary impairments. Although no set formula is used in this process, the investment performance, collateral position and continued viability of the issuer are significant measures considered.
The Company generally considers a number of factors relating to the issuer in determining the financial strength, liquidity, and recoverability of an issuer. These include but are not limited to: available collateral, tangible and intangible assets that might be available to repay debt, operating cash flows, financial ratios, access to capital markets, quality of management, market position, exposure to litigation or product warranties, and the effect of general economic conditions on the issuer.
There are certain risks and uncertainties associated with determining whether declines in market values are other than temporary. These include significant changes in general economic conditions and business markets, trends in certain industry segments, interest rate fluctuations, rating agency actions, changes in significant accounting estimates and assumptions, commission of fraud and legislative actions. The Company continuously monitors these factors as they relate to the investment portfolio in determining the status of each investment. Provided below are additional facts concerning the potential effect upon the Company’s earnings should circumstances lead management to conclude that some of the current declines in market value are other than temporary.
Market values for private, non-traded securities are determined as follows: 1) the Company obtains estimates from independent pricing services or 2) the Company estimates market value based upon a comparison to quoted issues of the same issuer or issues of other issuers with similar terms and risk characteristics. The market value of private, non-traded securities was $2,090.6 million at September 30, 2003, representing 12.6% of the Company’s total invested assets.
Unrealized Gains and Losses
The majority of unrealized losses can be attributed to interest rate fluctuations and are, therefore, deemed temporary. As indicated above, when the Company’s investment management deems an investment’s market value decline as other than temporary, it is written down to estimated market value. In all cases, management will continue to carefully review and monitor each security.
The information presented below relates to investments at a certain point in time and is not necessarily indicative of the status of the portfolio at any time after September 30, 2003, the balance sheet date. Furthermore, since the timing of recognizing realized gains and losses is largely based on management’s decisions as to the timing and selection of investments to be sold, the tables and information provided below should be considered within the context of the overall unrealized gain (loss) position of the portfolio. At September 30, 2003, the Company had an overall pretax net unrealized gain of $651.4 million.
The following table summarizes by category the unrealized gains and losses of the Company’s investments classified as available for sale as of September 30, 2003.
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Gross Gross Estimated
Amortized Unrealized Unrealized Market
Cost Gains Losses Value
(In thousands)
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Fixed maturities:
Bonds
Mortgage-backed securities $ 4,195,065 $138,227 $26,094 $ 4,307,198
United States Government and authorities 84,184 6,682 48 90,818
States, municipalities, and political subdivisions 25,380 1,891 0 27,271
Public utilities 1,329,926 97,770 13,528 1,414,168
Convertibles and bonds with warrants 94,915 1,450 947 95,418
All other corporate bonds 6,070,651 480,765 35,903 6,515,513
Redeemable preferred stock 535 137 0 672
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11,800,656 726,922 76,520 12,451,058
Equity securities 52,623 2,094 1,135 53,582
Short-term investments 582,830 0 0 582,830
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Total $12,436,109 $729,016 $77,655 $13,087,470
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These unrealized gains and losses do not necessarily represent future gains or losses that the Company will realize. Numerous factors, including overall interest rates, new or updated information relating to specific issuers as well as management’s decisions on the timing of sales will affect the gains or losses ultimately realized. Gross unrealized gains and losses at December 31, 2002 were $623.2 million and $182.8 million, respectively.
For traded and private fixed maturity and equity securities held by the Company that are in an unrealized loss position at September 30, 2003, the estimated market value, amortized cost, unrealized loss and total time period that the security has been in an unrealized loss position are presented in the table below.
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Estimated % Market Amortized % Amortized Unrealized % Unrealized
Market Value Value Cost Cost Loss Loss
(In thousands)
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‹= 90 days $1,182,350 57.9% $1,201,529 56.7% $(19,179) 24.7%
›90 days but ‹= 180 days 315,572 15.5 326,699 15.4 (11,127) 14.3
›180 days but ‹= 270 days 120,870 5.9 124,138 5.9 (3,268) 4.2
›270 days but ‹= 1 year 134,866 6.6 140,642 6.6 (5,776) 7.4
›1 year but ‹= 2 years 153,470 7.5 168,114 7.9 (14,644) 18.9
›2 - but ‹= 3 years 15,746 0.8 18,960 0.9 (3,214) 4.1
›3 - but ‹= 4 years 30,142 1.5 33,681 1.6 (3,539) 4.6
›4 - but ‹= 5 years 39,351 1.9 44,171 2.1 (4,820) 6.2
›5 years 50,047 2.4 62,135 2.9 (12,088) 15.6
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Total $2,042,414 100.0% $2,120,069 100.0% $(77,655) 100.0%
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The Company has no material concentrations of issuers or guarantors of fixed maturity securities. The industry segment composition of all securities in an unrealized loss position held by the Company at September 30, 2003, is presented in the following table.
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Estimated % Market Amortized % Amortized Unrealized % Unrealized
Market Value Value Cost Cost Loss Loss
(In thousands)
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Agency Mortgages $ 136,134 6.7% $ 138,866 6.6% $ (2,732) 3.5%
Banking 94,479 4.6 96,533 4.6 (2,054) 2.7
Basic Industrial 72,159 3.5 75,272 3.6 (3,113) 4.0
Brokerage 38,552 1.9 38,951 1.8 (399) 0.5
Capital Goods 12,997 0.6 13,498 0.6 (501) 0.7
Communications 110,001 5.4 114,164 5.4 (4,163) 5.4
Consumer Cyclical 47,822 2.4 49,134 2.3 (1,312) 1.7
Consumer Noncyclical 72,744 3.6 74,480 3.5 (1,736) 2.2
Electric 323,124 15.8 341,941 16.1 (18,817) 24.2
Energy 79,220 3.9 81,364 3.8 (2,144) 2.8
Finance Companies 88,896 4.4 89,301 4.2 (405) 0.5
Insurance 67,694 3.3 69,975 3.3 (2,281) 2.9
Municipal Agencies 489 0.0 489 0.0 (0) 0.0
Natural Gas 162,155 7.9 167,148 7.9 (4,993) 6.4
Non-Agency Mortgages 568,327 27.8 580,012 27.4 (11,685) 15.1
Other Finance 94,795 4.7 105,808 5.0 (11,013) 14.2
Other Industrial 4,842 0.2 4,945 0.2 (103) 0.1
Other Utility 21 0.0 44 0.0 (23) 0.0
Technology 116 0.0 143 0.0 (27) 0.0
Transportation 65,234 3.2 75,336 3.6 (10,102) 13.0
U. S. Government 2,613 0.1 2,665 0.1 (52) 0.1
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Total $2,042,414 100.0% $2,120,069 100.0% $(77,655) 100.0%
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The range of maturity dates for securities in an unrealized loss position at September 30, 2003 varies, with 13.8% maturing in less than 5 years, 18.0% maturing between 5 and 10 years, and 68.2% maturing after 10 years. The following table shows the credit rating of securities in an unrealized loss position at September 30, 2003.
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S&P or Equivalent Estimated % Market Amortized % Amortized Unrealized % Unrealized
Designation Market Value Value Cost Cost Loss Loss
(In thousands)
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AAA/AA/A $1,244,448 60.9% $1,263,936 59.6% $(19,488) 25.1%
BBB 401,628 19.7 421,553 19.9 (19,925) 25.7
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Investment Grade 1,646,076 80.6 1,685,489 79.5 (39,413) 50.8
BB 158,278 7.7 171,895 8.1 (13,617) 17.5
B 173,085 8.5 187,690 8.9 (14,605) 18.8
CCC or lower 46,756 2.3 56,124 2.6 (9,368) 12.1
In or near default 18,219 0.9 18,871 0.9 (652) 0.8
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Below Investment Grade 396,338 19.4 434,580 20.5 (38,242) 49.2
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Total $2,042,414 100.0% $2,120,069 100.0% $(77,655) 100.0%
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At September 30, 2003, 80.6% of total securities in an unrealized loss position were rated as investment grade. The Company generally purchases its investments with the intent to hold to maturity, therefore, the Company does not consider these unrealized losses as other-than-temporary impairments.
At September 30, 2003, securities in an unrealized loss position that were rated as below investment grade represented 19.4% of the total market value and 49.2% of the total unrealized loss. Unrealized losses related to below investment grade securities that had been in an unrealized loss position for more than twelve months were $26.8 million. Bonds rated less than investment grade were 6.2% of invested assets. The Company does not expect these investments to adversely affect its liquidity or ability to maintain proper matching of assets and liabilities.
The following table shows the estimated market value, amortized cost, unrealized loss and total time period that the security has been in an unrealized loss position for all below investment grade securities.
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Estimated % Market Amortized % Amortized Unrealized % Unrealized
Market Value Value Cost Cost Loss Loss
(In thousands)
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‹= 90 days $ 87,710 22.1% $ 92,325 21.2 % $ (4,615) 12.0 %
›90 days but ‹= 180 days 51,747 13.1 52,954 12.2 (1,207) 3.2
›180 days but ‹= 270 day 34,090 8.6 35,644 8.2 (1,554) 4.1
›270 days but ‹= 1 year 41,864 10.6 45,948 10.6 (4,084) 10.7
›1 year but ‹= 2 years 88,951 22.4 97,615 22.5 (8,664) 22.6
›2 - but ‹= 3 years 8,649 2.2 10,034 2.3 (1,385) 3.6
›3 - but ‹= 4 years 7,801 2.0 9,811 2.2 (2,010) 5.3
›4 - but ‹= 5 years 26,355 6.6 29,946 6.9 (3,591) 9.4
›5 years 49,171 12.4 60,303 13.9 (11,132) 29.1
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Total $396,338 100.0% $434,580 100.0% $(38,242) 100.0%
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Realized Losses
Realized losses are comprised of both write-downs on other than temporary impairments and actual sales of investments.
During the nine months ended September 30, 2003, the Company recorded pretax other than temporary impairments in its investments of $19.8 million as compared to $24.0 million in the nine months ended September 30, 2002.
As discussed earlier, the Company’s management considers several factors when determining other than temporary impairments. Although the Company generally intends to hold securities until maturity, the Company may change its position as a result of a change in circumstances. Any such decision is consistent with the Company’s classification of its investment portfolio as available for sale. During the nine months ended September 30, 2003, the Company sold securities in an unrealized loss position with a market value of $428.7 million resulting in a realized loss of $4.0 million. For such securities, the proceeds, realized loss and total time period that the security had been in an unrealized loss position are presented in the table below.
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Proceeds % Proceeds Realized Loss % Realized Loss
(In thousands)
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‹= 90 days $382,091 89.1% $ 501 12.6%
›90 days but ‹= 180 days 6,749 1.6 15 0.4
›180 days but ‹= 270 days 3,000 0.7 1,952 49.0
›270 days but ‹= 1 year 33,109 7.7 239 5.9
› 1 year 3,731 0.9 1,277 32.1
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Total $428,680 100.0% $3,984 100.0%
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Mortgage Loans
The Company records mortgage loans net of an allowance for credit losses. This allowance is calculated through analysis of specific loans that are believed to be at a higher risk of becoming impaired in the near future. At September 30, 2003 and December 31, 2002, this Company’s allowance for mortgage loan credit losses was $4.7 million.
For several years the Company has offered a type of commercial mortgage loan under which the Company will permit a slightly higher loan-to-value ratio in exchange for a participating interest in the cash flows from the underlying real estate. As of September 30, 2003, approximately $362.0 million of the Company’s mortgage loans have this participation feature.
In the ordinary course of its commercial mortgage lending operations, the Company will commit to provide a mortgage loan before the property to be mortgaged has been built or acquired. The mortgage loan commitment is a contractual obligation to fund a mortgage loan when called upon by the borrower. The commitment is not recognized in the Company’s financial statements until the commitment is actually funded. The mortgage loan commitment contains terms, including the rate of interest which may become less than prevailing interest rates. At September 30, 2003, the Company had outstanding mortgage loan commitments of $668.5 million.
At September 30, 2003, delinquent mortgage loans and foreclosed properties were 0.2% of invested assets.
Liabilities
Many of the Company’s products contain surrender charges and other features that reward persistency and penalizes the early withdrawal of funds. Certain stable value and annuity contracts have market-value adjustments that protect the Company against investment losses if interest rates are higher at the time of surrender than at the time of issue.
At September 30, 2003, the Company had policy liabilities and accruals of $9.5 billion. The Company’s interest-sensitive life insurance policies have a weighted average minimum credited interest rate of approximately 4.5%.
At September 30, 2003, the Company had $4.1 billion of stable value contract account balances and $3.5 billion of annuity account balances.
Derivative Financial Instruments
The Company utilizes a risk management strategy that incorporates the use of derivative financial instruments, primarily to reduce its exposure to interest rate risk as well as currency exchange risk.
Combinations of interest rate swap contracts, options and futures contracts are sometimes used as hedges against changes in interest rates for certain investments, primarily outstanding mortgage loan commitments and mortgage-backed securities. Interest rate swap contracts generally involve the exchange of fixed and variable rate interest payments between two parties, based on a common notional principal amount and maturity date. Interest rate futures generally involve exchange traded contracts to buy or sell treasury bonds and notes in the future at specified prices. Interest rate options represent contracts that allow the holder of the option to receive cash or purchase, sell or enter into a financial instrument at a specified price within a specified period of time. The Company used interest rate swap contracts, swaptions (options to enter into interest rate swap contracts), caps, and floors to modify the interest characteristics of certain investments, its Senior Notes, Medium-Term Notes, and Trust Originated Preferred Securities (TOPrS). Swap contracts are also used to alter the effective durations of assets and liabilities. The Company uses foreign currency swaps to reduce its exposure to currency exchange risk on certain stable value contracts denominated in foreign currencies, primarily the European euro and the British pound.
Derivative instruments expose the Company to credit and market risk and could result in material changes from quarter-to-quarter. The Company minimizes its credit risk by entering into transactions with highly rated counterparties. The Company manages the market risk associated with interest rate and foreign exchange contracts by establishing and monitoring limits as to the types and degrees of risk that may be undertaken.
The Company monitors its use of derivatives in connection with its overall asset/liability management programs and procedures. The Company’s asset/liability committee is responsible for implementing various hedging strategies that are developed through its analysis of data from financial simulation models and other internal and industry sources. The resulting hedging strategies are then incorporated into the Company’s overall interest rate and currency exchange risk management strategies.
Asset/Liability Management
The Company’s asset/liability management programs and procedures involve the monitoring of asset and liability durations for various product lines; cash flow testing under various interest rate scenarios; and the continuous rebalancing of assets and liabilities with respect to yield, risk, and cash flow characteristics. It is the Company’s policy to generally maintain asset and liability durations within one-half year of one another, although, from time to time, a broader interval may be allowed.
The Company believes its asset/liability management programs and procedures and certain product features provide protection for the Company against the effects of changes in interest rates under various scenarios. Additionally, the Company believes its asset/liability management programs and procedures provide sufficient liquidity to enable it to fulfill its obligation to pay benefits under its various insurance and deposit contracts. However, the Company’s asset/liability management programs and procedures incorporate assumptions about the relationship between short-term and long-term interest rates (i.e., the slope of the yield curve), relationships between risk-adjusted and risk-free interest rates, market liquidity and other factors, and the effectiveness of the Company’s asset/liability management programs and procedures may be negatively affected whenever actual results differ from those assumptions.
Approximately 20% of the Company’s liabilities relate to products (primarily whole life insurance) the profitability of which may be affected by changes in interest rates. The effect of such changes in any one-year is not expected to be material.
Cash outflows related to stable value contracts (primarily maturing contracts, scheduled interest payments and expected withdrawals) were approximately $1,047.0 million during 2002. Cash outflows related to stable value contracts are estimated to be approximately $1,086.5 million in 2003. The Company’s asset/liability management programs and procedures take into account maturing contracts and expected withdrawals. Accordingly, the Company does not expect stable value contract related cash outflows to have an unusual effect on the future operations and liquidity of the Company.
The life insurance subsidiaries were committed at September 30, 2003, to fund mortgage loans in the amount of $668.5 million. The Company’s subsidiaries held $684.1 million in cash and short-term investments at September 30, 2003. The Company had an additional $3.8 million in cash and short-term investments available for general corporate purposes.
While the Company generally anticipates that the cash flows of its subsidiaries will be sufficient to meet their investment commitments and operating cash needs, the Company recognizes that investment commitments scheduled to be funded may, from time to time, exceed the funds then available. Therefore, the Company has arranged sources of credit for its insurance subsidiaries to use when needed. At September 30, 2003, Protective Life Insurance Company had $111.7 million of securities sold under repurchase agreements with an interest rate of 1.12%. The Company expects that the rate received on its investments will equal or exceed its borrowing rate. Additionally, the Company may from time to time sell short-duration stable value products to complement its cash management practices.
The Company has also used securitization transactions involving its commercial mortgage loans to increase its liquidity.
Capital
At September 30, 2003, the Company had borrowed $4.0 million under its $200.0 million revolving line of credit due October 1, 2005, at an interest rate of 1.61%.
Protective Life Corporation’s cash flow is dependent on cash dividends and payments on surplus notes from its subsidiaries, revenues from investment, data processing, legal and management services rendered to the subsidiaries, and investment income. At December 31, 2002, approximately $543.6 million of consolidated share-owners’ equity, excluding net unrealized investment gains and losses, represented net assets of the Company’s insurance subsidiaries that cannot be transferred to the Company. In addition, the states in which the Company’s insurance subsidiaries are domiciled impose certain restrictions on the insurance subsidiaries’ ability to pay dividends to the Company.
The Company plans to retain substantial portions of the earnings of its life insurance subsidiaries in those companies primarily to support their future growth. The Company’s cash disbursements have from time to time exceeded its cash receipts, and these shortfalls have been funded through various external financings. Therefore, the Company may, from time to time, require additional external financing.
To give the Company flexibility in connection with future acquisitions and other growth opportunities or for other corporate purposes, the Company has registered debt securities, preferred and common stock, and stock purchase contracts of Protective Life Corporation, and additional preferred securities of special purpose finance subsidiaries under the Securities Act of 1933 on a delayed (or shelf) basis.
A life insurance company’s statutory capital is computed according to rules prescribed by the National Association of Insurance Commissioners (“NAIC”), as modified by the insurance company’s state of domicile. Statutory accounting rules are different from GAAP and are intended to reflect a more conservative view by, for example, requiring immediate expensing of policy acquisition costs. The NAIC’s risk-based capital requirements require insurance companies to calculate and report information under a risk-based capital formula. The achievement of long-term growth will require growth in the statutory capital of the Company’s insurance subsidiaries. The subsidiaries may secure additional statutory capital through various sources, such as retained statutory earnings or equity contributions by the Company.
Contractual Obligations
The table below sets forth future maturities of debt, guaranteed preferred beneficial interests in the Company’s subordinated debentures (guaranteed preferred beneficial interests), stable value contracts, notes payable, operating lease obligation, and mortgage loan commitments.
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(in thousands) 2003 2004-2005 2006-2007 After 2007
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Debt $ 79,000 $359,095
Guaranteed preferred beneficial interests 215,000
Stable value contracts $405,022 1,831,752 $1,798,941 99,497
Notes payable 2,249
Operating lease obligation 389 3,113 76,816
Mortgage loan commitments 668,462
Securities sold under repurchase agreements 111,725
Other Developments
Under insurance guaranty fund laws in most states, insurance companies doing business in a participating state can be assessed up to prescribed limits for policyholder losses incurred by insolvent companies. The Company does not currently believe that any such assessments will be materially different from amounts already reflected in the financial statements.
A number of civil jury verdicts have been returned against insurers, broker-dealers, and other providers of financial services involving sales practices, alleged agent misconduct, failure to properly supervise representatives, relationships with agents or persons with whom the insurer does business, and other matters. Increasingly these lawsuits have resulted in the award of substantial judgments that are disproportionate to the actual damages, including material amounts of punitive and non-economic compensatory damages. In some states, juries, judges, and arbitrators have substantial discretion in awarding punitive and non-economic compensatory damages, which creates the potential for unpredictable material adverse judgments or awards in any given lawsuit or arbitration. Arbitration awards are subject to very little appellate review. In addition, in some class action and other lawsuits, companies have made material settlement payments. The Company, like other financial services companies, in the ordinary course of business is involved in such litigation and in arbitration. Although the outcome of any such litigation or arbitration cannot be predicted, the Company believes that at the present time there are no pending or threatened lawsuits that are reasonably likely to have a material adverse effect on the financial position, results of operations, or liquidity of the Company.
The Company and its subsidiaries are subject to examination, review, and investigation by regulatory authorities, including insurance and securities regulators, and tax authorities. Several such examinations are currently ongoing. Although the Company cannot predict what actions may be taken by any regulatory authority, the Company does not believe that this or any other matter currently under examination, review, or investigation or any other pending or threatened regulatory or tax-related action with respect to the Company or any of its subsidiaries is reasonably likely to have a material effect on the Company.
Legislation has been enacted that permits commercial banks, insurance companies and investment banks to combine, provided certain requirements are satisfied. While the Company cannot predict the impact of this legislation, it could cause the Company to experience increased competition as larger, potentially more efficient organizations emerge from such combinations.
Under the Internal Revenue Code of 1986, as amended (the “Code”), income tax payable by policy holders on investment earnings is deferred during the accumulation period of certain life insurance and annuity products. This favorable tax treatment may give certain of the Company’s products a competitive advantage over other non-insurance products. To the extent that the Code is revised to reduce the tax-deferred status of life insurance and annuity products, or to increase the tax-deferred status of competing products, all life insurance companies, including the Company and its subsidiaries, would be adversely affected with respect to their ability to sell such products, and, depending upon grandfathering provisions, would be affected by the surrenders of existing annuity contracts and life insurance policies. For example, changes in laws or regulations could restrict or eliminate the advantages of certain corporate or bank-owned life insurance products. Recent changes in tax law, which have reduced the federal income tax rates on corporate dividends in certain circumstances, could make the tax advantages of investing in certain life insurance or annuity products less attractive. Additionally, changes in tax law based on proposals to establish new tax advantaged retirement and life savings plans, if enacted, could reduce the tax advantage of investing in certain life insurance or annuity products. In addition, life insurance products are often used to fund estate tax obligations. Legislation has been enacted that would, over time, reduce and eventually eliminate the estate tax. If the estate tax is significantly reduced or eliminated, the demand for certain life insurance products could be adversely affected. Additionally, the Company is subject to the federal corporation income tax. The Company cannot predict what changes to tax law or interpretations of existing tax law could adversely affect the Company.
The Company’s Life Marketing segment is implementing and continuing to refine a more sophisticated administrative system capable of facilitating the calculation of more precise estimates of the segment’s deferred policy acquisition costs, policy liabilities and accruals, future earnings, and various components of the segment’s balance sheet. The segment’s future results may be affected, positively or negatively, by changes in such estimates arising from the implementation of this system.
The Company’s ability to grow depends in large part upon the continued availability of capital. The Company has recently deployed significant amounts of capital to support its sales and acquisitions efforts. Capital has also been consumed as the Company has incurred realized and unrealized losses on its invested assets and increased its reserves on the residual value product. Although positive performance in the equity markets has recently allowed the Company to slightly decrease its GMDB related policy liabilities and accruals, deterioration in these markets could lead to further capital consumption. In recent years, most financial services companies, including the Company, experienced a decrease in the market price of their common stock. A lower stock price may limit the Company’s ability to raise capital to fund growth opportunities and acquisitions. Although the Company believes it has sufficient capital to fund its immediate growth and capital needs, the amount of capital available can vary significantly from period to period due to a variety of circumstances, some of which are neither predictable nor foreseeable, nor within the Company’s control. A lack of sufficient capital could impair the Company’s ability to grow.
The Company cedes material amounts of insurance to other companies through reinsurance. The cost of reinsurance is, generally, reflected in the premium rates charged by the Company. Under certain reinsurance agreements, the reinsurer may increase the rate it charges the Company for the reinsurance, though the Company does not anticipate increases to occur. Therefore, if the cost of reinsurance were to increase or if reinsurance were to become unavailable, or if a reinsurer should fail to meet its obligations, the Company could be adversely affected.
Item 3.Quantitative and Qualitative Disclosures About Market Risk
There has been no material change from the disclosures in the Company’s Annual Report on Form 10-K for the year ended December 31, 2002.
Item 4.Controls and Procedures
The Company’s Chief Executive Officer and Chief Financial Officer have evaluated the Company’s disclosure controls and procedures and believe them to be operating effectively to make known to them on a timely basis any material information required to be included in the Company’s periodic filings with the Securities and Exchange Commission. In the ordinary course of business, the Company continues to refine its internal control environment. There have been no changes in the Company’s internal control over financial reporting that occurred during the period covered by this report that have materially affected, or are reasonably likely to materially affect the Company’s internal control over financial reporting.
PART II
Item 6.Exhibits and Reports on Form 8-K
| (a) | Exhibit 15 — Letter re unaudited interim financial information. |
Exhibit 31(a) – Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |
Exhibit 31(b) – Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |
Exhibit 32(a) — Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
Exhibit 32(b) — Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
Exhibit 99 – Safe Harbor for Forward-Looking Statements. |
| (b) | The following 8-K was furnished to the Securities and Exchange Commission during the three months ended September 30, 2003: |
A Form 8-K, Item 12, was furnished to the Securities and Exchange Commission on August 6, 2003. |
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
| PROTECTIVE LIFE CORPORATION | |||
|---|---|---|---|
| Date: | November 14, 2003 | /s/ Steven G. Walker | |
| Steven G. Walker | |||
| Vice President and Controller | |||
| and Chief Accounting Officer | |||
| (Duly authrorized officer) |