ERC LIFE REINSURANCE CORPORATION
Statements of Income and Cash Flows
For the Nine-Month Period Ended September 30, 2003
(With Independent Auditors' Report Thereon)
ERC LIFE REINSURANCE CORPORATION
Table of Contents
Page
Independent Auditors' Report..................................................3
Statement of Income, Nine-month period ended September 30, 2003...............4
Statement of Cash Flows, Nine-month period ended September 30, 2003...........5
Notes to Financial Statements.................................................6
Independent Auditors' Report
The Board of Directors
ERC Life Reinsurance Corporation:
We have audited the accompanying statements of income and cash flows of ERC Life
Reinsurance Corporation (the Company) for the nine-month period ended September
30, 2003. These financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these financial
statements based on our audit.
We conducted our audit in accordance with auditing standards generally accepted
in the United States of America. Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audit provides a
reasonable basis for our opinion.
As discussed in note 1, the accompanying financial statements contain certain
adjustments made to reflect the ongoing operations of the Company.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the results of operations and cash flows of ERC Life
Reinsurance Corporation for the nine-month period ended September 30, 2003, in
conformity with accounting principles generally accepted in the United States of
America.
/s/ KPMG LLP
Kansas City, Missouri
February 15, 2004
ERC LIFE REINSURANCE CORPORATION
Statement of Income
For the nine-month period ended September 30, 2003
(Dollars in thousands)
Revenues:
Net premiums earned $ 106,537
Net investment income 28,936
Net realized gains on investments 1,644
Other revenues 3,000
----------
Total revenues 140,117
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Costs and expenses:
Claims, claim expenses and policy benefits 108,936
Commission and expense allowance 11,502
Amortization of insurance acquisition costs and present value of future profits 7,706
Other operating costs and expenses 7,735
----------
Total costs and expenses 135,879
----------
Earnings before taxes and discontinued operations 4,238
Income tax expense 1,084
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Earnings before discontinued operations 3,154
Income from discontinued operations 61,152
----------
Net income $ 64,306
==========
See accompanying notes to financial statements
ERC LIFE REINSURANCE CORPORATION
Statement of Cash Flows
For the nine-month period ended September 30, 2003
(Dollars in thousands)
Cash flows from operating activities:
Net earnings from continuing operations $ 3,154
Net earnings from discontinued operations 61,152
Amortization of insurance acquisition costs and present value of future profits 7,706
Adjustments to reconcile net earnings to cash provided
by operating activities:
Increase in other liabilities 123,198
Decrease in other reinsurance payables (72,245)
Increase in reinsurance recoverables (41,277)
Claims and claim expenses 23,768
Funds held by reinsured companies 25,524
Increase in investment in subsidiary (90,397)
Insurance acquisition costs deferred (1,349)
Realized gains on investments (1,644)
Other operating activities 2,674
---------
Net cash provided by operating activities 40,264
---------
Cash flows from investing activities:
Fixed maturity securities available for sale
Purchases (100,895)
Sales 114,162
---------
Cash from investing activities 13,267
---------
Cash flows from financing activities:
Net contract accumulation payments (9,791)
---------
Net cash used in financing activities (9,791)
---------
Increase in cash and cash equivalents 43,740
Cash and cash equivalents, beginning of year (61,244)
---------
Cash and cash equivalents, end of year $ (17,504)
=========
Supplemental disclosure of cash flow information:
Cash paid during the year for taxes $ 22,200
See accompanying notes to financial statements.
ERC LIFE REINSURANCE CORPORATION
Notes to Financial Statements
For the Nine-month Period Ended September 30, 2003
(1) Basis of Presentation
ERC Life Reinsurance Corporation (ERC Life), referred to as "we", "us" or
"our" in this report, is a wholly owned subsidiary of Employers
Reinsurance Corporation (ERC).
On October 24, 2003, ERC reached agreement to sell 95% of the common stock
of ERC Life to Scottish Holdings, Inc. In order to facilitate the
transaction, on October 23, 2003, 100% of the common stock of ERC Life's
wholly owned subsidiary, Employers Re Corporation (UK) Limited (UK Life)
was dividended to ERC. Additionally, the Company entered into reinsurance
agreements with Employers Reassurance Corporation (ERAC) and ERC effective
October 1, 2003 to retrocede all of its outstanding health reinsurance
business. In addition, other adjustments were recorded to reflect the tax
effect of the UK Life dividend, effects of foreign currency hedging
activities associated with UK Life, and non-recurring adjustments for
administrative activities with the parent. The effect of these
transactions is that ERC, the seller, will have a continuing interest in
the operation of ERC Life, as sold. However, ERC Life will not have any
continuing interest in these activities. Therefore, the effects of these
transactions have been excluded from income from continuing operations in
the financial statements, and are identified as discontinued operations.
The following summarizes the historical ERC Life parent only income and
expense as well as the items identified above that are not being
transferred to Scottish Holdings, Inc.
ERC Life
Parent Only Adjustments
----------- -----------
Revenues:
Net premiums earned $ 117,314 $ (10,777)
Net investment income 121,860 (92,924)
Net realized gains on investments 1,644 -
Other revenues 4,904 (1,904)
---------- ----------
Total revenues 245,722 (105,605)
---------- ----------
Costs and expenses:
Claims, claim expenses and policy benefits 127,245 (18,309)
Commission and expense allowance 15,906 (4,404)
Amortization of insurance acquisition costs and
present value of future profits 9,085 (1,379)
Other operating costs and expenses 7,072 663
---------- ----------
Total costs and expenses 159,308 (23,429)
---------- ----------
Earnings before taxes 86,414 (82,176)
Income tax expense 22,108 (21,024)
---------- ----------
Net income $ 64,306 $ (61,152)
========== ==========
ERC LIFE REINSURANCE CORPORATION
Notes to Financial Statements
For the Nine-month Period Ended September 30, 2003
The accompanying financial statements have been prepared on the basis of
accounting principles generally accepted in the United States of America
(GAAP), which, as to the insurance company businesses, vary from statutory
accounting practices prescribed or permitted by insurance regulatory
authorities. The preparation of financial statements in conformity with
GAAP requires us to make estimates and assumptions that affect reported
amounts and related disclosures. Actual results could differ from those
estimates.
(2) Summary of Significant Accounting Policies
(a) Revenue Recognition and Related Expenses
Revenues from traditional insurance contracts are recognized as
revenues when due or over the terms of the policies. For universal
life contracts and investment contracts, premiums received are
reported as liabilities (accumulated contract values), not as
revenues. Revenues from universal life contracts and investment
contracts are recognized for assessments made against the
policyholder's accumulated contract values for insurance, policy
administration, surrenders and other authorized charges throughout
the life of the policy.
Future policy benefits for traditional life and health contracts
represent the present value of such benefits based on mortality and
other assumptions which were appropriate at the time the policies
were issued or at the date of purchase. Interest rate assumptions
used in calculating the present value generally ranged from 5% to 7%
at September 30, 2003. Interest rates credited to universal life
contracts and investment contracts are generally guaranteed for a
specified time period with renewal rates determined by the issuing
insurance company. Such crediting interest rates generally ranged
from 3% to 6% during the first nine months of 2003.
(b) Investment Income and Realized and Unrealized Gains and Losses
Substantially all of our fixed maturity securities and marketable
equity securities have been designated as available-for-sale. We
regularly review investment securities for impairment based on
criteria that include: (1) the extent to which the investment's
carrying value exceeds its related market value; (2) the duration of
the market decline; and (3) the financial health of and specific
prospects for the issuer. Unrealized losses that are other than
temporary are recognized in earnings. Realized gains and losses on
sales of investments are determined on the specific-identification
method. Investment income is recognized as earned and includes the
accretion of discounts and amortization of premiums related to fixed
maturity securities.
ERC LIFE REINSURANCE CORPORATION
Notes to Financial Statements
For the Nine-month Period Ended September 30, 2003
(c) Deferred Acquisition Costs and Present Value of Future Profits
The costs of acquiring new and renewal business, which vary with and
are primarily related to the production of new and renewal business,
are generally deferred to the extent recoverable from future premiums
or expected gross profits. Deferrable costs include commissions,
underwriting expenses and certain other selling and issue costs.
For traditional life, accident and health and group health products,
deferred policy acquisition costs are amortized over the premium
paying period in proportion to the ratio of annual premium revenues
to ultimate anticipated premium revenues. The ultimate premium
revenues are estimated based upon the same assumptions used to
calculate future policy benefits. For universal life contracts and
investment contracts, the amortization is based on the anticipated
gross profits from investments, surrender and other charges net of
interest credited, mortality and maintenance expenses. As actual
gross profits vary from projected gross profits, the impact on
amortization is included in net income.
Deferred policy acquisition costs are adjusted to reflect the impact
of unrealized gains and losses on fixed maturity securities
available-for-sale.
The actuarially determined present value of anticipated net cash
flows to be realized from insurance, annuity and investment contracts
in force at the date of acquisition of life insurance enterprises is
recorded as the present value of future profits ("PVFP", an
intangible asset) and is amortized over the respective policy terms
in a manner similar to deferred insurance acquisition costs.
Unamortized balances are subject to review for impairment using
updated estimates of future cash flows. Impairments, if any, when
identified are charged to operations when incurred.
(d) Federal Income Taxes
We utilize the liability method in accounting for income taxes,
whereby deferred tax assets and liabilities are determined based on
differences between the financial reporting and tax bases of assets
and liabilities and are measured using the enacted tax rates and
laws.
(e) Cash and Cash Equivalents
Cash includes cash on hand, demand deposits, certificates of deposit
and investments in money-market mutual funds. Investment securities
with an original maturity greater than three months but less than one
year are classified as short-term investment securities and
transactions, as such, are considered investing activities in the
statement of cash flows.
ERC LIFE REINSURANCE CORPORATION
Notes to Financial Statements
For the Nine-month Period Ended September 30, 2003
(3) Investment Income
Major categories of investment income as of September 30, 2003 are
summarized as follows (in thousands):
Gross investment income:
Fixed maturity securities $ 26,658
Equity securities 232
Short-term investment securities 522
Securities and indebtedness of related parties 1,753
---------
29,165
Investment expenses 229
---------
Net investment income $ 28,936
=========
The sales proceeds and realized gains and losses on investment securities
as of September 30, 2003 are summarized as follows (in thousands):
Sales proceeds from fixed maturity securities $ 114,162
=========
Net realized gains on investments before income taxes:
Fixed maturities:
Gross realized gains $ 2,126
Gross realized losses (482)
---------
Total net realized gains before income taxes $ 1,644
=========
There are no unrealized losses that are other than temporary recognized in
earnings for the nine-month period ended September 30, 2003.
(4) Amortization of Intangible Assets
The Present Value of Future Profits (PVFP) was determined using risk
adjusted discount rates from 5% to 7% and the interest rates selected for
the valuation were determined based on the applicable interest rate and
the risk inherent in the realization of the estimated future profits at
the date of the respective acquisitions. PVFP is being amortized using the
interest method over the duration of the related life business,
approximately 20 years, as the premiums on the books of business are
recognized. Amortization expense for PVFP in future periods will be
affected by acquisitions, realized capital gains/losses or other factors
affecting the ultimate amount of gross profits realized from certain lines
of business. Similarly, future amortization expense for other intangibles
will depend on acquisition activity and other business transactions.
The amortization of DAC and PVFP for the nine-month period ended September
30, 2003 was $4,191 and $3,515, respectively.
ERC LIFE REINSURANCE CORPORATION
Notes to Financial Statements
For the Nine-month Period Ended September 30, 2003
(5) Income Taxes
The impact of income taxes on our operating results as of September 30,
2003 is summarized below (with income tax benefits reflected as positive
amounts and income tax expenses reflected as negative amounts):
Current year tax expense $ 8,283
Deferred tax expense (7,199)
--------
Income taxes incurred $ 1,084
========
Our effective income tax rate on pre-tax income differs from the
prevailing U.S. corporate federal income tax rate and is summarized as
follows for the nine-month period ended September 30, 2003:
Corporate federal income tax rate 35 %
Dividends received deduction (10)%
Meals & entertainment 1 %
--------
Effective Tax rate 26 %
========
(6) Reinsurance
In the normal course of business, the Company seeks to limit its exposure
to loss on any single insured and to recover a portion of benefits paid by
ceding reinsurance to other insurance companies. To the extent that a
reinsurer is unable to meet its obligation under the reinsurance
agreement, the Company remains liable. The Company evaluates the financial
condition of its reinsurers and monitors concentrations of credit risk to
minimize its exposure to significant losses from reinsurer insolvencies.
Allowances are established for amounts deemed to be uncollectible.
Reinsurance is accounted for over the lives of the underlying reinsured
policies using assumptions consistent with those used to account for the
underlying policies.
The effect on reinsurance premiums for the nine-month period ended
September 30, 2003 was as follows (in thousands):
Direct $ 103
Assumed 234,778
Ceded (128,344)
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Net $ 106,537
==========
ERC LIFE REINSURANCE CORPORATION
Notes to Financial Statements
For the Nine-month Period Ended September 30, 2003
The effect on reinsurance claims, claim expenses and policy benefits
incurred during the nine-month period ended September 30, 2003 was as
follows (in thousands):
Direct $ -
Assumed 263,544
Ceded (154,608)
----------
Net $ 108,936
==========
Reinsurance programs remaining after the sale date are primarily related
to traditional life reinsurance business.
(7) Commitments and Contingencies
There are no pending legal proceedings beyond the ordinary course of
business that, in our opinion, based on information available at the date
of this report, would have a material adverse effect on our results of
operations.
(8) Accounting Changes
We adopted Financial Accounting Standards Board (FASB) Interpretation No.
(FIN) 46, Consolidation of Variable Interest Entities, on July 1, 2003.
While FIN 46 represents a significant change in accounting principles
governing consolidation, it does not change the economic or legal
characteristics of asset sales. The adoption of FIN 46 did not have a
material effect on our operating results or cash flows.
Subsequent to these financial statements in December 2003, the Financial
Accounting Standards Board (FASB) modified FIN 46, Consolidation of
Variable Interest Entities (with FIN 46R), amending FIN 46 and deferring
its application in certain cases. Our adoption of FIN 46 on July 1, 2003,
was unchanged by FIN 46R.
In April 2003, the FASB finalized SFAS 133 Implementation Issue No. B36,
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. In summary, the
FASB determined that modified coinsurance arrangements where the ceding
insurer withholds funds may include an embedded derivative that must be
bifurcated from the host instrument if it is not clearly and closely
related to such host instrument. This situation often arises when the
interest rate on the funds held balance is linked to the actual
performance of a specified pool of assets. This guidance is effective on
the first day of the first fiscal quarter beginning after September 15,
2003. This required change in accounting has no impact on cash and does
not change the cumulative yield that will be received and/or paid over the
life of the underlying funds withheld. While we do not believe the impact
of this accounting change will have a material impact on our future
operating results, the requirement to mark to market the credit risk
component within the referenced pool of assets will result in a greater
level of reported income volatility than the accounting approach
previously applied.