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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-K
Registrant meets the conditions set forth in General Instruction I (1)(a) and
(b) of Form 10-K and is therefore filing this Form with the reduced disclosure
format.
|X| ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 2006
OR
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
COMMISSION FILE NUMBER: 333-100029
ALLSTATE LIFE INSURANCE COMPANY OF NEW YORK
(Exact name of registrant as specified in its charter)
NEW YORK 36-2608394
(State of Incorporation) (I.R.S. Employer Identification No.)
100 MOTOR PARKWAY, SUITE 132
HAUPPAUGE, NEW YORK 11788
(Address of principal executive offices) (Zip code)
REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: 631-357-8920
SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OR 12(g) OF THE SECURITIES
EXCHANGE ACT OF 1934: NONE
INDICATE BY CHECK MARK IF REGISTRANT IS A WELL-KNOWN SEASONED ISSUER, AS DEFINED
IN RULE 405 OF THE SECURITIES ACT. YES |_| NO |X|
INDICATE BY CHECK MARK IF THE REGISTRANT IS NOT REQUIRED TO FILE REPORTS
PURSUANT TO SECTION 13 OR SECTION 15(d) OF THE SECURITIES ACT.
YES |_| NO |X|
INDICATE BY CHECK MARK WHETHER THE REGISTRANT (1) HAS FILED ALL REPORTS REQUIRED
TO BE FILED BY SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 DURING
THE PRECEDING 12 MONTHS (OR FOR SUCH SHORTER PERIOD THAT THE REGISTRANT WAS
REQUIRED TO FILE SUCH REPORTS), AND (2) HAS BEEN SUBJECT TO SUCH FILING
REQUIREMENTS FOR THE PAST 90 DAYS. YES |X| NO |_|
INDICATE BY CHECK MARK IF DISCLOSURE OF DELINQUENT FILERS PURSUANT TO ITEM 405
OF REGULATION S-K IS NOT CONTAINED HEREIN, AND WILL NOT BE CONTAINED, TO THE
BEST OF THE REGISTRANT'S KNOWLEDGE, IN DEFINITIVE PROXY OR OTHER INFORMATION
STATEMENTS INCORPORATED BY REFERENCE IN PART III OF THIS FORM 10-K OR ANY
AMENDMENT TO THIS FORM 10-K. |X|
INDICATE BY CHECK MARK WHETHER THE REGISTRANT IS A LARGE ACCELERATED FILER, AN
ACCELERATED FILER, OR A NON-ACCELERATED FILER. SEE DEFINITION OF "ACCELERATED
FILER" IN RULE 12b-2 OF THE EXCHANGE.
LARGE ACCELERATED FILER ACCELERATED FILER NON-ACCELERATED FILER
|_| |_| |X|
INDICATE BY CHECK MARK WHETHER THE REGISTRANT IS A SHELL COMPANY (AS DEFINED IN
RULE 12b-2 OF THE EXCHANGE ACT). YES |_| NO |X|
NONE OF THE COMMON EQUITY OF THE REGISTRANT IS HELD BY NON-AFFILIATES.
THEREFORE, THE AGGREGATE MARKET VALUE OF COMMON EQUITY HELD BY NON-AFFILIATES OF
THE REGISTRANT IS ZERO.
AS OF MARCH 13, 2007, THE REGISTRANT HAD 100,000 COMMON SHARES, $25 PAR VALUE,
OUTSTANDING, ALL OF WHICH ARE HELD BY ALLSTATE LIFE INSURANCE COMPANY.
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TABLE OF CONTENTS
PAGE
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PART I
Item 1. Business 1
Item 1A. Risk Factors 2
Item 2. Properties 6
Item 3. Legal Proceedings 6
Item 4. Submission of Matters to a Vote of Security Holders * N/A
PART II
Item 5. Market for Registrant's Common Equity, Related Stockholder
Matters and Issuer Purchases of Equity Securities 7
Item 6. Selected Financial Data * N/A
Item 7. Management's Discussion and Analysis of Financial Condition
and Results of Operation 8
Item 7A. Quantitative and Qualitative Disclosures about Market Risk 32
Item 8. Financial Statements and Supplementary Data 33
Item 9. Change in and Disagreements with Accountants on Accounting and
Financial Disclosure 69
Item 9A. Controls and Procedures 69
Item 9B. Other Information 69
PART III
Item 10. Directors, Executive Officers and Corporate Governance * N/A
Item 11. Executive Compensation * N/A
Item 12. Security Ownership of Certain Beneficial Owners and Management
and Related Stockholder Matters* N/A
Item 13. Certain Relationships and Related Transactions, and Director
Independence * N/A
Item 14. Principal Accounting Fees and Services 70
PART IV
Item 15. Exhibits, Financial Statement Schedules 71
Signatures 74
Supplemental Information to be Furnished With Reports Filed
Pursuant to Section 15(d) of the Securities Exchange Act of
1934 by Registrants Which Have Not Registered Securities
Pursuant to Section 12 of the Securities Exchange Act of 1934 75
Financial Statement Schedules S-1
* Omitted pursuant to General Instruction I(2) of Form 10-K
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PART I
ITEM 1. BUSINESS
Allstate Life Insurance Company of New York ("Allstate Life of New York",
"ALNY", the "Company", "we", "us" or "our") was incorporated in 1967 as a stock
life insurance company under the laws of the State of New York. In 1984, ALNY
was purchased by Allstate Life Insurance Company ("ALIC"). Allstate Life of New
York is a wholly owned subsidiary of ALIC, a stock life insurance company
incorporated under the laws of the State of Illinois. ALIC is a wholly owned
subsidiary of Allstate Insurance Company, a stock property-liability insurance
company organized under the laws of the State of Illinois. All of the
outstanding capital stock of Allstate Insurance Company ("AIC") is owned by The
Allstate Corporation (the "Corporation" or "Allstate"), a publicly owned holding
company incorporated under the laws of the State of Delaware. The Allstate
Corporation is the largest publicly held personal lines insurer in the United
States. Widely known through the "You're In Good Hands With Allstate (R)"
slogan, Allstate provides insurance products to more than 17 million households
through a distribution network that utilizes a total of 14,800 exclusive
agencies and exclusive financial specialists in the United States and Canada.
Allstate is the second-largest personal property and casualty insurer in the
United States on the basis of 2005 statutory premiums earned. In addition,
according to A.M. Best, it is the nation's 13th largest issuer of life insurance
business on the basis of 2005 ordinary life insurance in force and 16th largest
on the basis of 2005 statutory admitted assets.
In this annual report on Form 10-K, we occasionally refer to statutory
financial information that has been prepared in accordance with the National
Association of Insurance Commissioners ("NAIC") Accounting Practices and
Procedure Manual ("Manual"). All domestic U.S. insurance companies are required
to prepare statutory-basis financial statements in accordance with the Manual.
As a result, industry data is available that enables comparisons between
insurance companies, including competitors that are not subject to the
requirement to publish financial statements on the basis of accounting
principles generally accepted in the U.S. ("GAAP"). We frequently use industry
publications containing statutory financial information to assess our
competitive position.
The Company provides life insurance, retirement and investment products to
individuals. Our principal products are deferred and immediate fixed annuities,
and interest-sensitive, traditional and variable life insurance and supplemental
accident and health insurance. We also distribute variable annuities through our
bank distribution partners; however this product is fully reinsured.
We sell products through multiple intermediary distribution channels,
including Allstate exclusive agencies, independent agents (including workplace
enrolling agents), banks, broker-dealers and specialized structured settlement
brokers.
We compete principally on the basis of the scope of our distribution
systems, the breadth of our product offerings, the recognition of our brand, our
financial strength and ratings, our product features and prices, and the level
of customer service that we provide.
The market for life insurance, retirement and investment products continues
to be highly fragmented and competitive. As of December 31, 2006, there were
approximately 690 groups of life insurance companies in the United States, most
of which offered one or more similar products. In addition, because many of
these products include a savings or investment component, our competition
includes domestic and foreign securities firms, investment advisors, mutual
funds, banks and other financial institutions. Competitive pressure continues to
grow due to several factors, including cross marketing alliances between
unaffiliated businesses, as well as consolidation activity in the financial
services industry.
Allstate Life of New York is subject to extensive regulation, primarily but
not exclusively, from the New York State Insurance Department. The method,
extent and substance of such regulation generally has its source in statutes
that establish standards and requirements for conducting the business of
insurance and that delegate regulatory authority to the New York State Insurance
Department. In general, such regulation is intended for the protection of those
who purchase or use our insurance products. These rules have a substantial
effect on our business and relate to a wide variety of matters including
insurance company licensing and examination, agent and adjuster licensing, price
setting, trade practices, policy forms, accounting methods, the nature and
amount of investments, claims practices, participation in guaranty funds,
reserve adequacy, insurer solvency, transactions with affiliates, the payment of
dividends, and underwriting standards. For a discussion of statutory financial
information, see Note 13 of the Financial Statements. For a discussion of
regulatory contingencies, see Note 11 of the Financial Statements. Notes 11 and
13 are incorporated in this Part I, Item 1 by reference.
In recent years the state insurance regulatory framework has come under
increased federal scrutiny. Legislation that would provide for federal
chartering of insurance companies has been proposed. In addition, state
legislators and insurance regulators continue to examine the appropriate nature
and scope of state insurance
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regulation. We cannot predict whether any specific state or federal measures
will be adopted to change the nature or scope of the regulation of the insurance
business or what effect any such measures would have on Allstate Life of New
York.
OTHER INFORMATION
"Allstate" is one of the most recognized brand names in the U.S. According
to independent market research conducted in 2004, "You're in Good Hands with
Allstate" was recognized by 87% of consumers, making it the most recognized
company tagline in the U.S.
ITEM 1A. RISK FACTORS
This document contains "forward-looking statements" that anticipate results
based on our estimates, assumptions and plans that are subject to uncertainty.
These statements are made subject to the safe-harbor provisions of the Private
Securities Litigation Reform Act of 1995. We assume no obligation to update any
forward-looking statements as a result of new information or future events or
developments.
These forward-looking statements do not relate strictly to historical or
current facts and may be identified by their use of words like "plans," "seeks,"
"expects," "will," "should," "anticipates," "estimates," "intends," "believes,"
"likely," "targets" and other words with similar meanings. These statements may
address, among other things, our strategy for growth, product development,
regulatory approvals, market position, expenses, financial results, litigation
and reserves. We believe that these statements are based on reasonable
estimates, assumptions and plans. However, if the estimates, assumptions or
plans underlying the forward-looking statements prove inaccurate or if other
risks or uncertainties arise, actual results could differ materially from those
communicated in these forward-looking statements.
In addition to the normal risks of business, we are subject to significant
risks and uncertainties, including those listed below, which apply to us as an
insurer and a provider of other financial services. These risks constitute our
cautionary statements under the Private Securities Litigation Reform Act of 1995
and readers should carefully review such cautionary statements as they identify
certain important factors that could cause actual results to differ materially
from those in the forward-looking statements and historical trends. These
cautionary statements are not exclusive and are in addition to other factors
discussed elsewhere in this document, in our filings with the Securities and
Exchange Commission ("SEC") or in materials incorporated therein by reference.
Our business operations could also be affected by additional factors that are
not presently known to us or that we currently consider to be immaterial to our
operations.
CHANGES IN UNDERWRITING AND ACTUAL EXPERIENCE COULD MATERIALLY AFFECT
PROFITABILITY
Our product pricing includes long-term assumptions regarding investment
returns, mortality, morbidity, persistency and operating costs and expenses of
the business. Management establishes target returns for each product based upon
these factors and the average amount of capital that the company must hold to
support in-force contracts, satisfy rating agencies and meet regulatory
requirements. We monitor and manage our pricing and overall sales mix to achieve
target returns on a portfolio basis. Profitability from new business emerges
over a period of years depending on the nature and life of the product and is
subject to variability as actual results may differ from pricing assumptions.
Our profitability depends on the adequacy of investment margins, the
management of market and credit risks associated with investments, the
sufficiency of premiums and contract charges to cover mortality and morbidity
benefits, the persistency of policies to ensure recovery of acquisition
expenses, and the management of operating costs and expenses within anticipated
pricing allowances. Legislation and regulation of the insurance marketplace and
products could also affect our profitability.
CHANGES IN RESERVE ESTIMATES MAY REDUCE PROFITABILITY
Reserve for life-contingent contract benefits is computed on the basis of
long-term actuarial assumptions of future investment yields, mortality,
morbidity, policy terminations and expenses. We periodically review the adequacy
of these reserves on an aggregate basis and if future experience differs
significantly from assumptions, adjustments to reserves may be required which
could have a material adverse effect on our operating results and financial
condition.
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CHANGES IN MARKET INTEREST RATES MAY LEAD TO A SIGNIFICANT DECREASE IN THE SALES
AND PROFITABILITY OF SPREAD-BASED PRODUCTS
Our ability to manage our investment margin for spread-based products, such
as fixed annuities, is dependent upon maintaining profitable spreads between
investment yields and interest crediting rates. When market interest rates
decrease or remain at low levels, proceeds from investments that have matured,
prepaid or been sold may be reinvested at lower yields, reducing investment
margin. Lowering interest crediting rates in such an environment can offset
decreases in investment yield on some products. However, these changes could be
limited by market conditions, regulatory or contractual minimum rate guarantees
on many contracts and may not match the timing or magnitude of changes in asset
yields. Decreases in the rates offered on products could make those products
less attractive, leading to lower sales and/or changes in the level of
surrenders and withdrawals for these products. Non-parallel shifts in interest
rates, such as increases in short-term rates without accompanying increases in
medium- and long-term rates, can influence customer demand for fixed annuities,
which could impact the level and profitability of new customer deposits.
Increases in market interest rates can also have negative effects, for example
by increasing the attractiveness of other investments to our customers, which
can lead to higher surrenders at a time when the fixed income investment asset
values are lower as a result of the increase in interest rates. For certain
products, principally fixed annuity and interest-sensitive life products, the
earned rate on assets could lag behind market yields. We may react to market
conditions by increasing crediting rates, which could narrow spreads.
Unanticipated surrenders could result in deferred policy acquisition cost
("DAC") unlocking or affect the recoverability of DAC and thereby increase
expenses and reduce profitability.
CHANGES IN ESTIMATES OF PROFITABILITY ON INTEREST-SENSITIVE LIFE, FIXED
ANNUITIES AND OTHER INVESTMENT CONTRACTS MAY HAVE AN ADVERSE EFFECT ON RESULTS
THROUGH INCREASED AMORTIZATION OF DAC
DAC related to interest-sensitive life, fixed annuities and other
investment contracts is amortized in proportion to actual historical gross
profits ("AGP") and estimated future gross profits ("EGP") over the estimated
lives of the contracts. Assumptions underlying EGP, including those relating to
margins from mortality, investment margin, contract administration, surrender
and other contract charges, are updated from time to time in order to reflect
actual and expected experience and its potential effect on the valuation of DAC.
Updates to these assumptions could result in DAC unlocking, which in turn could
adversely affect our net income and financial condition.
A LOSS OF KEY PRODUCT DISTRIBUTION RELATIONSHIPS COULD MATERIALLY AFFECT SALES
Certain products are distributed under agreements with other members of the
financial services industry that are not affiliated with us. Termination of one
or more of these agreements due to, for example, a change in control of one of
these distributors, could have a detrimental effect on sales.
CHANGES IN TAX LAWS MAY DECREASE SALES AND PROFITABILITY OF PRODUCTS
Under current federal and state income tax law, certain products we offer,
primarily life insurance and annuities, receive favorable tax treatment. This
favorable treatment may give certain of our products a competitive advantage
over noninsurance products. Congress from time to time considers legislation
that would reduce or eliminate the favorable policyholder tax treatment
currently applicable to life insurance and annuities. Congress also considers
proposals to reduce the taxation of certain products or investments that may
compete with life insurance and annuities. Legislation that increases the
taxation on insurance products or reduces the taxation on competing products
could lessen the advantage or create a disadvantage for certain of our products
making them less competitive. Such proposals, if adopted, could have a material
adverse effect on our financial position or ability to sell such products and
could result in the surrender of some existing contracts and policies. In
addition, changes in the federal estate tax laws could negatively affect the
demand for the types of life insurance used in estate planning.
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RISKS RELATING TO THE INSURANCE INDUSTRY
OUR FUTURE RESULTS ARE DEPENDENT IN PART ON OUR ABILITY TO SUCCESSFULLY OPERATE
IN AN INSURANCE INDUSTRY THAT IS HIGHLY COMPETITIVE
The insurance industry is highly competitive. Our competitors include other
insurers and, because many of our products include a savings or investment
component, securities firms, investment advisers, mutual funds, banks and other
financial institutions. Many of our competitors have well-established national
reputations and market similar products. Because of the competitive nature of
the insurance industry, including competition for producers such as exclusive
and independent agents, there can be no assurance that we will continue to
effectively compete with our industry rivals, or that competitive pressure will
not have a material adverse effect on our business, operating results or
financial condition. The ability of banks to affiliate with insurers may have a
material adverse effect on all of our product lines by substantially increasing
the number, size and financial strength of potential competitors. Furthermore,
certain competitors operate using a mutual insurance company structure and
therefore, may have dissimilar profitability and return targets.
WE ARE SUBJECT TO MARKET RISK AND DECLINES IN CREDIT QUALITY
We are subject to market risk, the risk that we will incur losses due to
adverse changes in interest rates and equity prices. Our primary market risk
exposures are to changes in interest rates and, to a lesser degree, equity
prices. In addition, we are subject to potential declines in credit quality,
either related to issues specific to certain industries or to a weakening in the
economy in general. For additional information on market risk, see the "Market
Risk" section of Management's Discussion and Analysis.
A decline in market interest rates could have an adverse effect on our
investment income as we invest cash in new investments that may yield less than
the portfolio's average rate. In a declining interest rate environment,
borrowers may prepay or redeem securities more quickly than expected as they
seek to refinance at lower rates. A decline could also cause the purchase of
longer-term assets in order to obtain adequate investment yields resulting in a
duration gap when compared to the duration of liabilities. An increase in market
interest rates could have an adverse effect on the value of our investment
portfolio by decreasing the fair values of the fixed income securities that
comprise a substantial majority of our investment portfolio. Increases in
interest rates also may lead to an increase in policy loans, surrenders and
withdrawals that generally would be funded at a time when fair values of fixed
income securities are lower. A decline in the quality of our investment
portfolio as a result of adverse economic conditions or otherwise could cause
additional realized losses on securities, including realized losses relating to
derivative strategies.
CONCENTRATION OF OUR INVESTMENT PORTFOLIO IN ANY PARTICULAR SEGMENT OF THE
ECONOMY MAY HAVE ADVERSE EFFECTS
The concentration of our investment portfolio in any particular industry,
group of related industries or geographic sector could have an adverse effect on
our investment portfolio and consequently on our results of operations and
financial position. While we seek to mitigate this risk by having a broadly
diversified portfolio, events or developments that have a negative impact on any
particular industry, group of related industries or geographic region may have a
greater adverse effect on the investment portfolio to the extent that the
portfolio is concentrated rather than diversified.
WE MAY SUFFER LOSSES FROM LITIGATION
As is typical for a large company, we are involved in a substantial amount
of litigation, including class action litigation challenging a range of company
practices and coverage provided by our insurance products. In the event of an
unfavorable outcome in one or more of these matters, the ultimate liability may
be in excess of amounts currently reserved and may be material to our operating
results or cash flows for a particular quarter or annual period. For a
description of our current legal proceedings, see Note 11 of the financial
statements.
In some circumstances, we, or others in the Allstate Group, may be able to
collect on third-party insurance that we carry to recover all or part of the
amounts that we pay in judgments, settlements and litigation expenses. However,
we, or others in the Allstate Group, may not be able to resolve issues
concerning the availability, if any, or the ability to collect such insurance
concurrently with the underlying litigation. Consequently, the timing of the
resolution of a particular piece of litigation and the determination of our
insurance recovery with respect to that litigation may not coincide and,
therefore, may be reflected in our financial statements in different fiscal
quarters.
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WE ARE SUBJECT TO EXTENSIVE REGULATION AND POTENTIAL FURTHER RESTRICTIVE
REGULATION MAY INCREASE OUR OPERATING COSTS AND LIMIT OUR GROWTH
As insurance companies, broker-dealers, investment advisers and/or
investment companies, we are subject to extensive laws and regulations. These
laws and regulations are complex and subject to change. Moreover, they are
administered and enforced by a number of different governmental authorities,
including state insurance regulators, state securities administrators, the SEC,
the National Association of Securities Dealers, the U.S. Department of Justice,
and state attorneys general, each of which exercises a degree of interpretive
latitude. Consequently, we are subject to the risk that compliance with any
particular regulator's or enforcement authority's interpretation of a legal
issue may not result in compliance with another regulator's or enforcement
authority's interpretation of the same issue, particularly when compliance is
judged in hindsight. In addition, there is risk that any particular regulator's
or enforcement authority's interpretation of a legal issue may change over time
to our detriment, or that changes in the overall legal environment may, even
absent any particular regulator's or enforcement authority's interpretation of a
legal issue changing, cause us to change our views regarding the actions we need
to take from a legal risk management perspective, thus necessitating changes to
our practices that may, in some cases, limit our ability to grow and improve the
profitability of our business. Furthermore, in some cases, these laws and
regulations are designed to protect the interests of a specific constituency
rather than a range of constituencies. For example, state insurance laws and
regulations are generally intended to protect or benefit purchasers or users of
insurance products. In many respects, these laws and regulations limit our
ability to grow and improve the profitability of our business.
In recent years, the state insurance regulatory framework has come under
public scrutiny and members of Congress have discussed proposals to provide for
optional federal chartering of insurance companies. We can make no assurances
regarding the potential impact of state or federal measures that may change the
nature or scope of insurance regulation.
REINSURANCE MAY BE UNAVAILABLE AT CURRENT LEVELS AND PRICES, WHICH MAY LIMIT OUR
ABILITY TO WRITE NEW BUSINESS
Market conditions beyond our control determine the availability and cost of
the reinsurance we purchase. No assurances can be made that reinsurance will
remain continuously available to us to the same extent and on the same terms and
rates as are currently available. If we were unable to maintain our current
level of reinsurance or purchase new reinsurance protection in amounts that we
consider sufficient and at prices that we consider acceptable, we would have to
either accept an increase in our exposure risk, reduce our insurance writings,
or develop or seek other alternatives.
REINSURANCE SUBJECTS US TO THE CREDIT RISK OF OUR REINSURERS AND MAY NOT BE
ADEQUATE TO PROTECT US AGAINST LOSSES ARISING FROM CEDED INSURANCE
The collectibility of reinsurance recoverables is subject to uncertainty
arising from a number of factors, including whether insured losses meet the
qualifying conditions of the reinsurance contract and whether reinsurers, or
their affiliates, have the financial capacity and willingness to make payments
under the terms of a reinsurance treaty or contract. Our inability to collect a
material recovery from a reinsurer could have a material adverse effect on our
operating results and financial condition.
THE CONTINUED THREAT OF TERRORISM AND ONGOING MILITARY ACTIONS MAY ADVERSELY
AFFECT THE LEVEL OF CLAIM LOSSES WE INCUR AND THE VALUE OF OUR INVESTMENT
PORTFOLIO
The continued threat of terrorism, both within the United States and
abroad, and ongoing military and other actions and heightened security measures
in response to these types of threats, may cause significant volatility and
losses from declines in the equity markets and from interest rate changes in the
United States, Europe and elsewhere, and may result in loss of life, additional
disruptions to commerce and reduced economic activity. Some of the assets in our
investment portfolio may be adversely affected by declines in the equity markets
and reduced economic activity caused by the continued threat of terrorism. We
seek to mitigate the potential impact of terrorism on our commercial mortgage
portfolio by limiting geographical concentrations in key metropolitan areas and
by requiring terrorism insurance to the extent that it is commercially
available. Additionally, in the event that a terrorist act occurs, we could be
adversely affected, depending on the nature of the event.
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ANY DECREASE IN OUR FINANCIAL STRENGTH RATINGS MAY HAVE AN ADVERSE EFFECT ON OUR
COMPETITIVE POSITION
Financial strength ratings are important factors in establishing the
competitive position of insurance companies and generally have an effect on an
insurance company's business. On an ongoing basis, rating agencies review the
financial performance and condition of insurers and could downgrade or change
the outlook on an insurer's ratings due to, for example, a change in an
insurer's statutory capital; a change in a rating agency's determination of the
amount of risk-adjusted capital required to maintain a particular rating; an
increase in the perceived risk of an insurer's investment portfolio; a reduced
confidence in management or a host of other considerations that may or may not
be under the insurer's control. The insurance financial strength ratings of
ALNY, ALIC and AIC are A+, AA and Aa2 from A.M. Best, Standard & Poor's and
Moody's, respectively. Because all of these ratings are subject to continuous
review, the retention of these ratings cannot be assured. A multiple level
downgrade in any of these ratings could have a material adverse effect on our
sales, our competitiveness, the marketability of our product offerings, and our
liquidity, operating results and financial condition.
CHANGES IN ACCOUNTING STANDARDS ISSUED BY THE FINANCIAL ACCOUNTING STANDARDS
BOARD ("FASB") OR OTHER STANDARD-SETTING BODIES MAY ADVERSELY AFFECT OUR
FINANCIAL STATEMENTS
Our financial statements are subject to the application of generally
accepted accounting principles, which is periodically revised and/or expanded.
Accordingly, we are required to adopt new or revised accounting standards from
time to time issued by recognized authoritative bodies, including the FASB. It
is possible that future changes we are required to adopt could change the
current accounting treatment that we apply to our financial statements and that
such changes could have a material adverse effect on our results and financial
condition. For a description of potential changes in accounting standards that
could affect us currently, see Note 2 of the financial statements.
THE OCCURRENCE OF EVENTS UNANTICIPATED IN OUR DISASTER RECOVERY SYSTEMS AND
MANAGEMENT CONTINUITY PLANNING COULD IMPAIR OUR ABILITY TO CONDUCT BUSINESS
EFFECTIVELY
In the event of a disaster such as a natural catastrophe, an industrial
accident, a terrorist attack or war, events unanticipated in our disaster
recovery systems could have an adverse impact on our ability to conduct business
and on our results of operations and financial condition, particularly if those
events affect our computer-based data processing, transmission, storage and
retrieval systems. In the event that a significant number of our managers could
be unavailable in the event of a disaster, our ability to effectively conduct
our business could be severely compromised.
ITEM 2. PROPERTIES
Allstate Life of New York occupies office space in Hauppauge, New York and
Northbrook, Illinois that is owned or leased by AIC. Expenses associated with
these facilities are allocated to us on both a direct and indirect basis,
depending on the nature and use.
ITEM 3. LEGAL PROCEEDINGS
Information required for Item 3 is incorporated by reference to the
discussion under the headings "Regulation" and "Legal and regulatory proceedings
and inquiries" in Note 11 of our financial statements.
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PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND
ISSUER PURCHASES OF EQUITY SECURITIES
No established public trading market exists for our common stock. All of
our outstanding common stock is owned by our parent, ALIC. ALIC's outstanding
common stock is owned by AIC. All of the outstanding common stock of AIC is
owned by the Corporation. Within the past three years, we have not sold or
repurchased any of our equity securities.
From January 1, 2005 through March 10, 2007, we paid no dividends on our
common stock to ALIC.
For additional information on dividends, including restrictions on the
payment of dividends, see the discussion under the heading "Dividends" in Note
13 of our financial statements, which is incorporated herein by reference.
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ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATION
OVERVIEW
The following discussion highlights significant factors influencing the
financial position and results of operations of Allstate Life Insurance Company
of New York (referred to in this document as "we", "ALNY", "our", "us" or the
"Company"). It should be read in conjunction with the financial statements and
related notes found under Part II Item 8 contained herein. We operate as a
single segment entity based on the manner in which financial information is used
internally to evaluate and determine the allocation of resources.
The most important factors that we monitor to evaluate the financial
condition and performance of our company include:
- For operations: premiums, deposits, gross margin including investment
and benefit margins, amortization of deferred policy acquisition
costs, expenses, operating income, and invested assets;
- For investments: credit quality/experience, stability of long-term
returns, cash flows and asset and liability duration;
- For financial condition: our financial strength ratings and statutory
capital levels and ratios; and
- For product distribution: profitably growing distribution partner
relationships and Allstate exclusive agencies sales of all products
and services.
APPLICATION OF CRITICAL ACCOUNTING ESTIMATES
We have identified four accounting policies that require us to make
estimates that are significant to the financial statements. It is reasonably
likely that changes in these estimates could occur from period to period and
result in a material impact on our financial statements. A brief summary of each
of these critical accounting policies follows. For a more detailed discussion of
the effect of these policies on our financial statements, and the judgments and
estimates relating to these policies, see the referenced sections of the MD&A.
For a complete summary of our significant accounting policies see Note 2 of the
financial statements.
INVESTMENT VALUATION The fair value of publicly traded fixed income securities
is based on independent market quotations, whereas the fair value of
non-publicly traded securities is based on either widely accepted pricing
valuation models, which use internally developed ratings and independent third
party data as inputs, or independent third party pricing sources. Factors used
in our internally developed models, such as liquidity risk associated with
privately-placed securities, are difficult to independently observe and
quantify. Because of this, judgment is required in developing certain of these
estimates and, as a result, the estimated fair value of non-publicly traded
securities may differ from amounts that would be realized upon an immediate sale
of the securities.
For investments classified as available for sale, the difference between
fair value and amortized cost, net of deferred income taxes, is reported as a
component of accumulated other comprehensive income on the Statements of
Financial Position and is not reflected in the operating results of any period
until reclassified to net income upon the consummation of a transaction with an
unrelated third party or when declines in fair values are deemed
other-than-temporary. The assessment of other-than-temporary impairment of a
security's fair value is performed on a portfolio review as well as a
case-by-case basis considering a wide range of factors. For our portfolio review
evaluations, we ascertain whether there are any approved programs involving the
disposition of investments such as changes in duration, revision to strategic
asset allocations and liquidity actions; and any dispositions planned by the
portfolio managers. In these instances, we recognize impairment on securities
being considered for these approved planned actions if the security is in an
unrealized loss position. There are a number of assumptions and estimates
inherent in evaluating impairments and determining if they are
other-than-temporary, including 1) our ability and intent to hold the investment
for a period of time sufficient to allow for an anticipated recovery in value;
2) the expected recoverability of principal and interest; 3) the duration and
extent to which the fair value has been less than amortized cost; 4) the
financial condition, near-term and long-term prospects of the issuer, including
relevant industry conditions and trends, and implications of rating agency
actions and offering prices; and 5) the specific reasons that a security is in a
significant unrealized loss position, including market conditions which could
affect liquidity. Additionally, once assumptions and estimates are made, any
number of changes in facts and circumstances could cause us to later determine
that an impairment is other-than-temporary, including 1) general economic
conditions that are worse than previously assumed or that have a greater adverse
effect on a
8
<Page>
particular issuer than originally estimated; 2) changes in the facts and
circumstances related to a particular issuer's ability to meet all of its
contractual obligations; and 3) changes in facts and circumstances or new
information obtained which causes a change in our ability or intent to hold a
security to maturity or until it recovers in value. Changes in assumptions,
facts and circumstances could result in additional charges to earnings in future
periods to the extent that losses are realized. The charge to earnings, while
potentially significant to net income, would not have a significant effect on
shareholder's equity since the majority of our portfolio is carried at fair
value and as a result, any related unrealized loss would already be reflected as
a component of accumulated other comprehensive income in shareholder's equity.
For a more detailed discussion of the risks relating to changes in
investment values and levels of investment impairment, and the potential causes
of such changes, see Note 6 of the financial statements and the Investments,
Market Risk, and Forward-looking Statements and Risk Factors sections of this
document.
DERIVATIVE INSTRUMENT HEDGE EFFECTIVENESS We primarily use derivative financial
instruments to reduce our exposure to market risk and in conjunction with
asset/liability management. The fair value of exchange traded derivative
contracts is based on independent market quotations, whereas the fair value of
non-exchange traded derivative contracts is based on either widely accepted
pricing valuation models which use independent third party data as inputs or
independent third party pricing sources.
When derivatives meet specific criteria, they may be designated as
accounting hedges and accounted for as fair value, cash flow, foreign currency
fair value, or foreign currency cash flow hedges. When designating a derivative
as an accounting hedge, we formally document the hedging relationship, risk
management objective and strategy. The documentation identifies the hedging
instrument, the hedged item, the nature of the risk being hedged and the
assumptions used to assess how effective the hedging instrument is in offsetting
the exposure to changes in the hedged item's fair value attributable to the
hedged risk. In the case of a cash flow hedge, this documentation includes the
exposure to changes in the hedged transaction's variability in cash flows
attributable to the hedged risk. We do not exclude any component of the change
in fair value of the hedging instrument from the effectiveness assessment. At
each reporting date, we confirm that the hedging instrument continues to be
highly effective in offsetting the hedged risk. For further discussion of these
estimates and assumptions, see Note 7 of the financial statements and the
Investments, Market Risk and Forward-looking Statements and Risk Factors
sections of this document.
DEFERRED POLICY ACQUISITION COST ("DAC") AMORTIZATION We incur significant costs
in connection with acquiring business. In accordance with generally accepted
accounting principles ("GAAP"), costs that vary with and are primarily related
to acquiring business are deferred and recorded as an asset on the Statements of
Financial Position.
DAC related to traditional life insurance is amortized over the premium
paying period of the related policies in proportion to the estimated revenues on
such business. Significant assumptions relating to estimated premiums,
investment income and realized capital gains and losses, as well as to all other
aspects of DAC are determined based upon conditions as of the date of policy
issuance and are generally not revised during the life of the policy. Any
deviations from projected business in force resulting from actual policy
terminations differing from expected levels and any estimated premium
deficiencies change the rate of amortization in the period such events occur.
Generally, the amortization period for these contracts approximate the estimated
lives of the policies.
DAC related to interest-sensitive life, annuities and other investment
contracts is amortized in proportion to the incidence of the total present value
of gross profits which includes both actual historical gross profits ("AGP") and
estimated future gross profits ("EGP") expected to be earned over the estimated
lives of the contracts. Actual amortization periods range from 15-30 years;
however, incorporating estimates of customer surrender rates, partial
withdrawals and deaths generally result in the majority of the DAC being
amortized over the surrender charge period. AGP and EGP consist of the following
components: benefit margin primarily from mortality, investment margin including
realized capital gains and losses; and contract administration, surrender and
other contract charges, less maintenance expenses.
We periodically review and make revisions to EGPs resulting in changes in
the cumulative amounts expensed as a component of amortization of DAC in the
period in which the revision is made. This is commonly known as "DAC unlocking".
For quantification of the impact of these estimates and assumptions, see
the Forward-looking Statements and Risk Factors sections of this document and
Note 2 of the financial statements.
9
<Page>
RESERVE FOR LIFE-CONTINGENT CONTRACT BENEFITS ESTIMATION Long-term actuarial
assumptions of future investment yields, mortality, morbidity, policy
terminations and expenses are used when establishing the reserve for
life-contingent contract benefits. These assumptions, which for traditional life
insurance are applied using the net level premium method, include provisions for
adverse deviation and generally vary by such characteristics as type of
coverage, year of issue and policy duration. Future investment yield assumptions
are determined at the time the policy is issued based upon prevailing investment
yields as well as estimated reinvestment yields. Mortality, morbidity and policy
termination assumptions are based on our experience and industry experience
prevailing at the time the policies are issued. Expense assumptions include the
estimated effects of inflation and expenses to be incurred beyond the
premium-paying period.
For further discussion of these policies see Note 8 of the financial
statements and the Forward-looking Statements and Risk Factors section of this
document.
OPERATIONS
On June 1, 2006, we completed the disposition of our variable annuity business
through reinsurance. The following table presents the differences between the
2006 and 2005 results of operations attributable to the variable annuity
business.
(IN THOUSANDS) 2006 2005 CHANGE
-------- -------- --------
FAVORABLE/(UNFAVORABLE)
Contract charges $ 8,127 $ 16,728 $ (8,601)
Net investment income 8,789 23,781 (14,992)
Periodic settlements and accruals on non-
hedge derivative instruments (1) 33 -- 33
Contract benefits (2,281) (10,401) 8,120
Interest credited to contractholder funds (2) (6,915) (18,322) 11,407
-------- -------- --------
Gross margin (5) 7,753 11,786 (4,033)
Realized capital gains and losses (4,112) (231) (3,881)
Amortization of DAC and DSI(3) (4) 7,784 (7,168) 14,952
Operating costs and expenses (4,233) (7,789) 3,556
Loss on disposition of operations (10,694) -- (10,694)
-------- -------- --------
Income from operations before income
tax expense $ (3,502) $ (3,402) $ (100)
======== ======== ========
Investment margin $ 1,907 $ 5,459 $ (3,552)
Benefit margin (1,281) (9,028) 7,747
Contract charges and fees 7,127 15,355 (8,228)
-------- -------- --------
Gross margin (5) $ 7,753 $ 11,786 $ (4,033)
======== ======== ========
- ----------
(1) Periodic settlements and accruals on non-hedge derivative instruments are
reflected as a component of realized capital gains and losses on the
Statements of Operations and Comprehensive Income.
(2) For purposes of calculating gross margin, amortization of DSI is excluded
from interest credited to contractholder funds and aggregated with
amortization of DAC due to the similarity in the substance of the two
items. Amortization of DSI for variable annuities totaled $507 thousand and
$(422) thousand in 2006 and 2005, respectively.
(3) Amortization deceleration of $4.3 million was recognized in 2005 for
variable annuities.
(4) DAC and DSI amortization includes $12.6 million and $(1.2) million of
amortization related to realized capital gains and losses in 2006 and 2005,
respectively.
(5) Gross margin and its components are measures that are not based on
generally accepted accounting principals ("non-GAAP"). Gross margin,
investment margin and benefit margin are defined on pages 14, 16 and 17,
respectively.
OVERVIEW AND STRATEGY We are a wholly owned subsidiary of Allstate Life
Insurance Company ("ALIC"), which is a wholly owned subsidiary of Allstate
Insurance Company ("AIC"), a wholly owned subsidiary of The Allstate Corporation
(the "Corporation"). ALIC, along with ALNY and its other wholly owned
subsidiaries, provide life insurance, retirement and investment products to
individual and institutional customers. Our mission is to assist financial
services professionals in New York in meeting their clients' financial
protection, retirement and investment needs by providing consumer-focused
products delivered with reliable and efficient service.
10
<Page>
Our primary objectives are to improve return on equity and position the
Company for profitable growth. In the near term, this will require us to balance
sales goals with new business return targets. Our actions to accomplish these
objectives include improving returns on new business by increasing sales through
Allstate Agencies, increasing sales of life insurance products, and maintaining
cost discipline through scale and efficiencies. The execution of our business
strategies has and may continue to involve simplifying our business model and
focusing on those products and distribution relationships where we can secure
strong leadership positions while generating acceptable returns and bringing to
market a selection of innovative, consumer-focused products.
We plan to continue offering a suite of products that protect consumers
financially and help them better prepare for retirement. Our products include
deferred and immediate fixed annuities; interest-sensitive, traditional and
variable life insurance; and supplemental accident and health insurance. Our
products are sold through several distribution channels including Allstate
exclusive agencies, independent agents (including master brokerage agencies and
workplace enrolling agents), and financial service firms such as banks,
broker/dealers and specialized structured settlement brokers.
PREMIUMS represent revenues generated from traditional life, immediate
annuities with life contingencies, and supplemental accident and health
insurance products that have significant mortality or morbidity risk.
CONTRACT CHARGES are revenues generated from interest-sensitive life, and
variable and fixed annuities for which deposits are classified as contractholder
funds or separate accounts liabilities. Contract charges are assessed against
the contractholder account values for maintenance, administration, cost of
insurance and surrender prior to contractually specified dates. As a result,
changes in contractholder funds are considered in the evaluation of growth and
as indicators of future levels of revenues. Subsequent to the close of our
reinsurance transaction with Prudential Financial Inc. ("Prudential") on June 1,
2006, variable annuity contract charges on the business subject to the
transaction are fully reinsured to Prudential and presented net of reinsurance
on the Statements of Operations (see Note 3 of the financial statements).
The following table summarizes premiums and contract charges by product.
(IN THOUSANDS) 2006 2005 2004
-------- -------- --------
PREMIUMS
Traditional life $ 24,298 $ 26,067 $ 23,786
Immediate annuities with life contingencies 54,877 38,322 49,877
Accident and health, and other 5,138 4,149 2,887
-------- -------- --------
TOTAL PREMIUMS 84,313 68,538 76,550
CONTRACT CHARGES
Interest-sensitive life 46,448 42,315 40,400
Fixed annuities 8,851 7,237 6,212
Variable annuities 8,127 16,728 13,222
-------- -------- --------
TOTAL CONTRACT CHARGES 63,426 66,280 59,834
-------- -------- --------
TOTAL PREMIUMS AND CONTRACT CHARGES $147,739 $134,818 $136,384
======== ======== ========
Total premiums increased 23.0% in 2006 compared to 2005 due primarily to
increased premiums on immediate annuities with life contingencies, due to
certain pricing refinements and a more favorable pricing environment in 2006.
Total premiums decreased 10.5% in 2005 compared to 2004 as lower premiums
on immediate annuities with life contingencies more than offset higher
traditional life and supplemental accident and health premiums sold through the
workplace. Premiums on immediate annuities with life contingencies declined
primarily as a result of pricing actions taken to improve our returns on new
business and reflect our current expectations of mortality. Higher traditional
life and supplemental accident and health premiums were primarily the result of
growth.
Contract charges decreased 4.3% in 2006 compared to 2005. Excluding
contract charges on variable annuities, all of which are reinsured to Prudential
effective June 1, 2006, contract charges increased 11.6% in 2006 compared to
2005. The increase was due to higher contract charges on interest-sensitive life
products
11
<Page>
resulting from growth of business in force, and increased contract charges on
fixed annuities due to increased surrender charges.
Contract charges increased 10.8% in 2005 compared to 2004. The increase was
due to higher contract charges on fixed annuities, interest-sensitive life and
variable annuities. Fixed annuity contract charges in 2005 reflect higher
surrender charges compared with the prior year. The increase in the
interest-sensitive life contract charges was attributable to in-force business
growth resulting from deposits and credited interest more than offsetting
surrenders and benefits. Higher variable annuity contract charges were primarily
the result of higher account values in our separate accounts.
CONTRACTHOLDER FUNDS represent interest-bearing liabilities arising from the
sale of fixed annuities, interest-sensitive life products and variable annuity
and life deposits allocated to fixed accounts. The balance of contractholder
funds is equal to the cumulative deposits received and interest credited to the
contractholder less cumulative contract maturities, benefits, surrenders,
withdrawals and contract charges for mortality or administrative expenses.
The following table shows the changes in contractholder funds.
<Table>
<Caption>
(IN THOUSANDS) 2006 2005 (1) 2004 (1)
---------- ---------- ----------
CONTRACTHOLDER FUNDS, BEGINNING BALANCE $4,349,395 $3,802,846 $2,658,325
Impact of adoption of SOP 03-1 (2) -- -- 2,031
DEPOSITS
Fixed annuities 694,085 726,332 1,182,719
Interest-sensitive life 95,221 100,355 99,182
Variable annuity and life deposits allocated to fixed
accounts 15,519 57,127 103,463
---------- ---------- ----------
Total deposits 804,825 883,814 1,385,364
INTEREST CREDITED 178,493 173,984 129,243
BENEFITS, WITHDRAWALS AND OTHER ADJUSTMENTS
Benefits (137,090) (168,813) (133,792)
Surrenders and partial withdrawals (361,670) (270,161) (158,938)
Contract charges (44,954) (41,856) (41,573)
Net transfers to separate accounts (18,127) (39,765) (39,906)
Other adjustments (62,444) 9,346 2,092
---------- ---------- ----------
Total benefits, withdrawals and other adjustments (624,285) (511,249) (372,117)
---------- ---------- ----------
CONTRACTHOLDER FUNDS, ENDING BALANCE $4,708,428 $4,349,395 $3,802,846
========== ========== ==========
</Table>
- ----------
(1) To conform to the current period presentation, certain prior period
balances have been reclassified.
(2) The increase in contractholder funds due to the adoption of Statement of
Position No. 03-1, "Accounting and Reporting by Insurance Enterprises for
Certain Nontraditional Long-Duration Contracts and for Separate Accounts"
("SOP 03-1") reflects the reclassification of DSI from contractholder funds
to other assets and the establishment of reserves for certain liabilities
that are primarily related to income benefit guarantees provided under
variable annuities.
Contractholder funds increased 8.3% and 14.4% in 2006 and 2005,
respectively. Average contractholder funds increased 11.1% in 2006 compared to
2005 and 26.2% in 2005 compared to 2004. The reduction in the rate at which
contractholder funds grew was due primarily to lower contractholder deposits and
increased contractholder surrenders and withdrawals.
Contractholder deposits decreased 8.9% in 2006 compared to 2005 due
primarily to lower variable annuity and life deposits allocated to fixed
accounts due to the disposition of our variable annuity business through
reinsurance effective June 1, 2006. Also contributing to the decline were lower
deposits on fixed annuities due to lower deposits on traditional deferred
annuities and market value adjusted annuities, partially offset by a $42.2
12
<Page>
million increase in deposits on Allstate(R) Treasury-Linked Annuity contracts.
Lower deposits on traditional deferred annuities and market value adjusted
annuities were primarily attributable to our actions to improve new business
returns and reduced consumer demand. Consumer demand for fixed annuities is
influenced by market interest rates on short-term deposit products and equity
market conditions, which can increase the relative attractiveness of competing
investment alternatives.
Contractholder deposits decreased 36.2% in 2005 compared to 2004 due
primarily to lower deposits on fixed annuities. Fixed annuity deposits declined
38.6% in 2005 from reduced consumer demand relative to certificates of deposit
and other short-term investments due to increases in short-term interest rates
without corresponding increases in longer term rates and pricing actions to
increase fixed annuity product returns.
Surrenders and partial withdrawals on deferred fixed annuities and
interest-sensitive life products increased 33.9% in 2006 compared to 2005, while
the withdrawal rate, based on the beginning of the period contractholder funds
balance, increased to 10.1% for 2006 from 8.3% and 7.3%, for 2005 and 2004,
respectively. The increase in the surrender rate in 2006 was influenced by
multiple factors, including the relatively low interest rate environment during
the last several years, which reduced reinvestment opportunities and increased
the number of policies with little or no surrender charge protection. Also
influencing the increase was our crediting rate strategies related to renewal
business implemented to improve investment spreads on selected contracts. The
increase in surrenders and partial withdrawals in 2006 is consistent with
management's expectation that in the current interest rate environment and with
a larger number of contractholders with relatively low or no surrender charges,
more contractholders may choose to move their funds to competing investment
alternatives. The aging of our in-force business may cause this trend to
continue.
Surrenders and partial withdrawals increased 70.0% in 2005 compared to
2004. The lack of surrender charges and market value adjustments combined with
the interest rate environment, which included a relatively small difference
between short-term and long-term interest rates, caused contractholders to
choose competing short-term investment alternatives.
NET INVESTMENT INCOME increased 4.7% in 2006 compared to 2005 and 17.9% in 2005
compared to 2004. The increase in both periods was primarily due to higher
average portfolio balances. In 2005, the increase due to higher average
portfolio balances was partially offset by lower portfolio yields. Higher
average balances in both periods resulted from the investment of cash flows from
operating and financing activities related primarily to deposits from fixed
annuities and interest-sensitive life polices.
13
<Page>
NET INCOME analysis is presented in the following table.
<Table>
<Caption>
(IN THOUSANDS) 2006 2005 2004
--------- --------- ---------
Premiums $ 84,313 $ 68,538 $ 76,550
Contract charges (1) 63,429 66,274 59,817
Net investment income 373,064 356,162 302,055
Periodic settlements and accruals on non-hedge
derivative instruments (2) 2,395 1,096 372
Contract benefits (190,506) (183,227) (182,150)
Interest credited to contractholder funds (3) (162,754) (159,563) (129,044)
--------- --------- ---------
Gross margin 169,941 149,280 127,600
Amortization of DAC and DSI (3) (4) (51,255) (40,224) (24,579)
Operating costs and expenses (46,578) (43,497) (42,115)
Income tax expense (24,964) (24,779) (21,845)
Realized capital gains and losses, after-tax (13,869) (3,220) (5,844)
DAC and DSI amortization expense on realized
capital gains and losses, after-tax (4) 9,522 (2,360) (1,342)
Reclassification of periodic settlements and
accruals on non-hedge derivative instruments,
after-tax (1,504) (680) (234)
(Loss) gain on disposition of operations, after-tax (6,951) 1 862
Cumulative effect of change in accounting
principle, after-tax -- -- (7,586)
--------- --------- ---------
NET INCOME $ 34,342 $ 34,521 $ 24,917
========= ========= =========
</Table>
- ----------
(1) Loads charged to contractholders at the inception of interest-sensitive
life contracts are deferred and amortized to income in a manner consistent
with DAC. Amortization of deferred loads on interest-sensitive life
products related to realized capital gains and losses is excluded from
contract charges for purposes of calculating gross margin. Amortization of
deferred loads related to realized capital gains and losses totaled $(3)
thousand, $6 thousand and $17 thousand in 2006, 2005 and 2004,
respectively.
(2) Periodic settlements and accruals on non-hedge derivative instruments are
reflected as a component of realized capital gains and losses on the
Statements of Operations and Comprehensive Income.
(3) For purposes of calculating gross margin, amortization of deferred sales
inducements ("DSI") is excluded from interest credited to contractholder
funds and aggregated with amortization of DAC due to the similarity in the
substance of the two items. Amortization of DSI totaled $4.4 million, $2.4
million and $760 thousand in 2006, 2005 and 2004, respectively.
(4) Amortization of DAC and DSI relating to realized capital gains and losses
is analyzed separately because realized capital gains and losses may vary
significantly between periods and obscure trends in our business.
Amortization of DAC and DSI relating to realized capital gains and losses
was $15.2 million, $(3.8) million and $(2.2) million in 2006, 2005 and
2004, respectively
GROSS MARGIN, a non-GAAP measure, is comprised of premiums and contract charges,
and net investment income, less contract benefits and interest credited to
contractholder funds excluding amortization of DSI. Gross margin also includes
periodic settlements and accruals on certain non-hedge derivative instruments
(see additional discussion under "INVESTMENT MARGIN"). We use gross margin as a
component of our evaluation of the profitability of our life insurance and
financial product portfolio. Additionally, for many of our products, including
fixed annuities, variable life and annuities, and interest-sensitive life
insurance, the amortization of DAC and DSI is determined based on actual and
expected gross margin. Gross margin is comprised of three components that are
utilized to further analyze the business: investment margin, benefit margin, and
contract charges and fees. We believe gross margin and its components are useful
to investors because they allow for the evaluation of income components
separately and in the aggregate when reviewing performance. Gross margin,
investment margin and benefit margin should not be considered as a substitute
for net income and do not reflect the overall profitability of the business. Net
income is the GAAP measure that is most directly comparable to these margins.
Gross margin is reconciled to GAAP net income in the table above.
14
<Page>
The components of gross margin are reconciled to the corresponding
financial statement line items in the following table.
2006
-----------------------------------------------
CONTRACT
INVESTMENT BENEFIT CHARGES AND GROSS
(IN THOUSANDS) MARGIN MARGIN FEES MARGIN
---------- -------- ----------- ---------
Premiums $ -- $ 84,313 $ -- $ 84,313
Contract charges (1) -- 32,163 31,266 63,429
Net investment income 373,064 -- -- 373,064
Periodic settlements and
accruals on non-hedge
derivative instruments (2) 2,395 -- -- 2,395
Contract benefits (103,904) (86,602) -- (190,506)
Interest credited to
contractholder funds(3) (162,754) -- -- (162,754)
--------- -------- ------- ---------
$ 108,801 $ 29,874 $31,266 $ 169,941
========= ======== ======= =========
<Table>
<Caption>
2005
-----------------------------------------------
CONTRACT
INVESTMENT BENEFIT CHARGES AND GROSS
(IN THOUSANDS) MARGIN MARGIN FEES MARGIN
---------- -------- ----------- ---------
Premiums $ -- $ 68,538 $ -- $ 68,538
Contract charges (1) -- 33,176 33,098 66,274
Net investment income 356,162 -- -- 356,162
Periodic settlements and
accruals on non-hedge
derivative instruments (2) 1,096 -- -- 1,096
Contract benefits (100,996) (82,231) -- (183,227)
Interest credited to
contractholder funds(3) (159,563) -- -- (159,563)
--------- -------- ------- ---------
$ 96,699 $ 19,483 $33,098 $ 149,280
========= ======== ======= =========
</Table>
2004
-----------------------------------------------
CONTRACT
INVESTMENT BENEFIT CHARGES AND GROSS
(IN THOUSANDS) MARGIN MARGIN FEES MARGIN
---------- -------- ----------- ---------
Premiums $ -- $ 76,550 $ -- $ 76,550
Contract charges (1) -- 30,803 29,014 59,817
Net investment income 302,055 -- -- 302,055
Periodic settlements and
accruals on non-hedge
derivative instruments (2) 372 -- -- 372
Contract benefits (98,261) (83,889) -- (182,150)
Interest credited to
contractholder funds(3) (129,044) -- -- (129,044)
--------- -------- -------- ---------
$ 75,122 $ 23,464 $ 29,014 $ 127,600
========= ======== ======== =========
- ----------
(1) Loads charged to contractholders at the inception of interest-sensitive
life contracts are deferred and amortized to income in a manner consistent
with DAC. Amortization of deferred loads on interest-sensitive life
products related to realized capital gains and losses is excluded from
contract charges for purposes of calculating gross margin. Amortization of
deferred loads related to realized capital gains and losses totaled $(3)
thousand, $6 thousand and $17 thousand in 2006, 2005 and 2004,
respectively.
(2) Periodic settlements and accruals on non-hedge derivative instruments are
reflected as a component of realized capital gains and losses on the
Statements of Operations and Comprehensive Income.
(3) For purposes of calculating gross margin, amortization of DSI is excluded
from interest credited to contractholder funds and aggregated with
amortization of DAC due to similarity in the substance of the two items.
Amortization of DSI totaled $4.4 million, $2.4 million and $760 thousand in
2006, 2005 and 2004, respectively.
15
<Page>
Gross margin increased 13.8% in 2006 compared to 2005 due to increased
investment and benefit margin, partially offset by lower contract charges and
fees. The decline in contract charges and fees was driven by the absence of
contract charges on variable annuities that were reinsured effective June 1,
2006 in conjunction with the disposition of substantially all of our variable
annuity business. Excluding the impact of the reinsurance of our variable
annuity business, gross margin increased 18.0% in 2006 compared to 2005.
Gross margin increased 17.0% in 2005 compared to 2004 due to higher
investment margin and contract charges and fees, partially offset by lower
benefit margin. Gross margin for 2005 includes additional contract benefits
of $15 million that were accrued in accordance with a regulatory matter (see
the "Proceedings" subsection of Note 11 to the financial statements for
discussion of the settlement of this matter).
INVESTMENT MARGIN is a component of gross margin, both of which are
non-GAAP measures. Investment margin represents the excess of net investment
income and periodic settlements and accruals on non-hedge derivative instruments
over interest credited to contractholder funds and the implied interest on
life-contingent immediate annuities included in the reserve for life-contingent
contract benefits. We utilize derivative instruments as economic hedges of
investments or contractholder funds or to replicate fixed income securities.
These instruments either do not qualify for hedge accounting or are not
designated as hedges for accounting purposes. Such derivatives are accounted for
at fair value, and reported in realized capital gains and losses. Periodic
settlements and accruals on these derivative instruments are included as a
component of gross margin, consistent with their intended use to enhance or
maintain investment income and margin, and together with the economically hedged
investments or product attributes (e.g., net investment income or interest
credited to contractholders funds) or replicated investments, to appropriately
reflect trends in product performance. Amortization of DSI is excluded from
interest credited to contractholder funds for purposes of calculating investment
margin. We use investment margin to evaluate our profitability related to the
difference between investment returns on assets supporting certain products and
amounts credited to customers ("spread") during a fiscal period.
Investment margin by product group is shown in the following table.
(IN THOUSANDS) 2006 2005 2004
-------- ------- -------
Annuities $ 98,936 $87,946 $64,110
Life insurance 9,865 8,753 11,012
-------- ------- -------
Total investment margin $108,801 $96,699 $75,122
======== ======= =======
Investment margin increased 12.5% in 2006 compared to 2005 primarily due
to improved yields on assets supporting deferred fixed annuities, growth in
contractholder funds and crediting rate actions relating to renewal business.
Investment margin increased 28.7% in 2005 compared to 2004 primarily due to
growth in our fixed annuity business, partially offset by lower weighted
average investment spreads on interest-sensitive life and immediate annuities
and additional contract benefits accrued in accordance with a regulatory
matter (see the "Proceedings" subsection of Note 11 to the financial
statements for discussion of the settlement of this matter).
The following table summarizes the annualized weighted average investment
yields, interest crediting rates and investment spreads during 2006, 2005 and
2004.
<Table>
<Caption>
WEIGHTED AVERAGE
WEIGHTED AVERAGE INTEREST WEIGHTED AVERAGE
INVESTMENT YIELD CREDITING RATE INVESTMENT SPREADS
------------------ ------------------ ------------------
2006 2005 2004 2006 2005 2004 2006 2005 2004
---- ---- ---- ---- ---- ---- ---- ---- ----
Interest-sensitive life products 5.6% 5.7% 6.1% 4.5% 4.6% 4.8% 1.1% 1.1% 1.3%
Deferred fixed annuities 5.6 5.4 5.6 3.2 3.3 3.5 2.4 2.1 2.1
Immediate fixed annuities with and
without life contingencies 7.5 7.4 7.6 6.7 6.7 6.8 0.8 0.7 0.8
Investments supporting capital,
traditional life and other products 6.2 6.2 6.0 N/A N/A N/A N/A N/A N/A
</Table>
16
<Page>
The following table summarizes the liabilities as of December 31 for these
contracts and policies.
<Table>
<Caption>
(IN THOUSANDS) 2006 2005 2004
---------- ---------- ----------
Immediate fixed annuities with life contingencies $1,567,821 $1,502,918 $1,442,055
Other life contingent contracts and other 358,671 366,957 340,396
---------- ---------- ----------
Reserve for life-contingent contracts $1,926,492 $1,869,875 $1,782,451
========== ========== ==========
Interest-sensitive life $ 476,729 $ 427,523 $ 368,608
Deferred fixed annuities 3,667,459 3,381,034 2,890,254
Immediate fixed annuities without life
contingencies and other 564,240 540,838 543,984
---------- ---------- ----------
Contractholder funds $4,708,428 $4,349,395 $3,802,846
========== ========== ==========
</Table>
BENEFIT MARGIN is a component of gross margin, both of which are non-GAAP
measures. Benefit margin represents life and life-contingent immediate annuity
premiums, cost of insurance contract charges and, prior to the disposal of all
of our variable annuity business through reinsurance, variable annuity contract
charges for contract guarantees less contract benefits. Benefit margin excludes
the implied interest on life-contingent immediate annuities, which is included
in the calculation of investment margin. We use benefit margin to evaluate our
underwriting performance, as it reflects the profitability of our products with
respect to mortality or morbidity risk during a fiscal period.
Benefit margin by product group is shown in the following table.
(IN THOUSANDS) 2006 2005 2004
------- -------- -------
Life insurance $27,536 $ 34,558 $29,291
Annuities 2,338 (15,075) (5,827)
------- -------- -------
Total benefit margin $29,874 $ 19,483 $23,464
======= ======== =======
Benefit margin increased 53.3% in 2006 compared to 2005. Benefit margin
for 2005 includes $3.1 million of amounts that were classified as contract
charges and fees beginning in 2006. Excluding this reclassification, benefit
margin increased 82.8% in 2006 compared to 2005 due primarily to additional
variable annuity contract benefits accrued in 2005 in accordance with a
regulatory matter (see the "Proceedings" subsection of Note 11 to the
financial statements for discussion of the settlement of this matter).
Benefit margin declined 17.0% in 2005 compared to 2004 due to an
increasingly unfavorable benefit margin on annuities partially offset by a
higher benefit margin on life insurance products. The unfavorable change in the
benefit margin on annuities was primarily attributable to additional variable
annuity contract benefits accrued in accordance with a regulatory matter, while
the improvement in the benefit margin on life insurance primarily reflected
growth of our in force business.
AMORTIZATION OF DAC AND DSI, excluding amortization related to realized
capital gains and losses, increased 27.4% in 2006 compared to 2005. Lower
variable annuity amortization in 2006 due to the disposition of the business
effective June 1, 2006 through reinsurance was more than offset by the
recognition of amortization acceleration (commonly referred to as DAC and DSI
"unlocking") totaling $544 thousand in 2006 compared to the recognition of
amortization deceleration of $7.3 million in 2005, and higher amortization on
investment contracts due to improved gross margin. DAC and DSI amortization
related to realized capital gains and losses, after-tax, changed by a favorable
$11.9 million in 2006 compared to 2005. The impact of realized capital gains and
losses on amortization of DAC and DSI is dependent upon the relationship between
the assets that give rise to the gain or loss and the product liability
supported by the assets. Fluctuations result from changes in the impact of
realized capital gains and losses on actual and expected gross profits.
The DAC and DSI assets were reduced by $79.7 million and $6.2 million,
respectively, in 2006 as a result of the disposition of our variable annuity
business.
Amortization of DAC and DSI, excluding amortization related to realized
capital gains and losses, increased 63.7% in 2005 compared to 2004 as a result
of higher gross margin primarily from the growth in our annuity investment
margin.
17
<Page>
The changes in the DAC asset are summarized in the following tables.
(IN THOUSANDS)
<Table>
<Caption>
IMPACT OF AMORTIZATION EFFECT OF
BEGINNING DISPOSAL (ACCELERATION) UNREALIZED ENDING
BALANCE OF ACQUISITION AMORTIZATION DECELERATION CAPITAL BALANCE
DECEMBER 31, VARIABLE COSTS CHARGED TO CHARGED TO GAINS AND DECEMBER 31,
2005 ANNUITIES DEFERRED INCOME (1) INCOME (2) LOSSES 2006
--------- --------- ----------- ------------ ------------- ---------- -----------
Traditional life $ 32,989 $ -- $ 2,568 $ (2,247) $ -- $ -- $ 33,310
Interest-sensitive
life 77,308 -- 9,553 (7,706) 2,122 2,572 83,849
Variable annuities 68,154 (79,670) 4,813 7,277 -- (574) --
Investment
contracts 136,923 -- 43,995 (28,229) (1,976) 6,481 157,194
Accident, health
and other 3,177 -- 2,008 (913) -- -- 4,272
-------- -------- ------- -------- ------- ------ --------
Total $318,551 $(79,670) $62,937 $(31,818) $ 146 $8,479 $278,625
======== ======== ======= ======== ======= ====== ========
</Table>
(IN THOUSANDS)
<Table>
<Caption>
AMORTIZATION EFFECT OF
BEGINNING (ACCELERATION) UNREALIZED ENDING
BALANCE ACQUISITION AMORTIZATION DECELERATION CAPITAL BALANCE
DECEMBER 31, COSTS CHARGED TO CHARGED TO GAINS AND DECEMBER 31,
2004 DEFERRED INCOME (1) INCOME (2) LOSSES 2005
---------- ----------- ------------ ------------- ---------- ------------
Traditional life $ 33,480 $ 1,713 $ (2,204) $ -- $ -- $ 32,989
Interest-sensitive
life 72,129 8,784 (8,435) 3,250 1,580 77,308
Variable annuities 47,725 12,095 (11,014) 4,268 15,080 68,154
Investment
contracts 82,800 43,817 (26,879) 9 37,176 136,923
Accident, health
and other 2,039 1,796 (658) -- -- 3,177
-------- ------- -------- ------ ------- --------
Total $238,173 $68,205 $(49,190) $7,527 $53,836 $318,551
======== ======= ======== ====== ======= ========
</Table>
- ----------
(1) The amortization of DAC for interest-sensitive life, variable annuities and
investment contracts is proportionate to the recognition of gross profits,
which include realized capital gains and losses. Fluctuations in
amortization for these products may result as actual realized capital gains
and losses differ from the amounts utilized in the determination of
estimated gross profits. Amortization related to realized capital gains and
losses was $14.1 million, $(3.7) million and $(2.1) million in 2006, 2005
and 2004, respectively.
(2) Included as a component of amortization of DAC on the Statements of
Operations and Comprehensive Income.
OPERATING COSTS AND EXPENSES increased 7.1% in 2006 compared to 2005 and
3.3% in 2005 compared to 2004. The increase in 2006 was attributable to higher
guaranty fund assessments, restructuring charges and employee benefit expenses,
partially offset by the absence of variable annuity related expenses due to the
disposition of the business through reinsurance effective June 1, 2006 and lower
technology related expenses. The increase in 2005 was primarily attributable to
higher technology, distribution, and administrative expenses, which were
incurred to support growth in the Company's in-force business. These increases
were partially offset by lower non-deferrable commissions, guaranty fund
assessments, and expenses related to taxes, licenses, and fees.
18
<Page>
REINSURANCE CEDED We enter into reinsurance agreements with ALIC and
unaffiliated carriers to limit our risk of mortality and morbidity losses. As
of December 31, 2006, for certain term life insurance policies, we cede up to
90% of the mortality risk depending on the length of the term. Comparatively,
as of December 31, 2005, for certain term life insurance policies, we ceded
25-90% of the mortality risk depending on the length of the term and policy
premium guarantees. Mortality risk on policies in excess of $250 thousand per
life is ceded to ALIC. As of December 31, 2006 and 2005, 39.4% and 37.6%,
respectively, of our face amount of life insurance in force is reinsured to
non-affiliates and ALIC. We cede all of the risk associated with variable
annuity contracts to Prudential (see Note 3 to the financial
statements).
The estimation of reinsurance recoverables is impacted by the uncertainties
involved in the establishment of reserves. Our reinsurance recoverables,
summarized by reinsurer as of December 31, are shown in the following table.
<Table>
<Caption>
S&P FINANCIAL REINSURANCE RECOVERABLE ON
(IN THOUSANDS) STRENGTH RATING PAID AND UNPAID CLAIMS
--------------- ----------------------
2006 2005
---- ----
Prudential Insurance Company of America AA- $415,709 $ --
Transamerica Financial Life Insurance AA 9,321 4,861
RGA Reinsurance Company AA- 4,262 2,511
Allstate Life Insurance Company AA 2,437 935
Triton Insurance Company NR 1,614 1,407
Generali USA A 722 511
Swiss Re Life and Health America, Inc. AA- 713 478
Security Life of Denver AA 638 516
American United Life AA- 634 534
Canada Life AA 549 331
Scottish Re Group BB 531 409
Cologne Re AAA 130 32
Minnesota Mutual AA- 87 94
Metropolitan Life AA 75 110
-------- -------
Total $437,422 $12,729
======== =======
</Table>
We continuously monitor the creditworthiness of reinsurers in order to
determine our risk of recoverability on an individual and aggregate basis, and a
provision for uncollectible reinsurance is recorded if needed. No amounts have
been deemed unrecoverable in the three years ended December 31, 2006.
We have a reinsurance treaty through which we cede re-investment related
risk on our structured settlement annuities to ALIC. The terms of this treaty
meet the accounting definition of a derivative under Statement of Financial
Accounting Standards ("SFAS") No. 133, "Accounting for Derivative Instruments
and Hedging Activities". Accordingly, the treaty is recorded in the Statements
of Financial Position at fair value, and changes in the fair value of the treaty
and premiums paid to ALIC are recognized in realized capital gains and losses.
INVESTMENTS
An important component of our financial results is the return on our
investment portfolio. The investment portfolio is managed based upon the nature
of the business and our corresponding liability structure.
OVERVIEW AND STRATEGY The investment strategy focuses on the need for
risk-adjusted spread on the underlying liabilities while maximizing return on
capital. We believe investment spread is maximized by selecting assets that
perform favorably on a long-term basis and by disposing of certain assets to
minimize the effect of downgrades and defaults. We believe this strategy
maintains the investment margin necessary to sustain income over time. The
portfolio management approach employs a combination of recognized market,
analytical and proprietary modeling, including a strategic asset allocation
model, as the primary basis for the allocation of interest-sensitive, illiquid
and credit assets as well as for determining overall below investment grade
exposure and diversification requirements. Within the ranges set by the
strategic asset allocation model, tactical investment decisions are made in
consideration of prevailing market conditions.
As a result of tactical decisions in each of the portfolios, we may sell
fixed income securities during the period in which fair value has declined below
amortized cost. Portfolio monitoring, which includes identifying securities that
are other-than-temporarily impaired and recognizing impairment on securities in
an unrealized loss
19
<Page>
position for which we do not have the intent and ability to hold until recovery,
are conducted regularly. For more information, see the Portfolio Monitoring
section of the MD&A.
PORTFOLIO COMPOSITION The composition of the investment portfolio at December
31, 2006 is presented in the table below. Also see Notes 2 and 6 to the
financial statements for investment accounting policies and additional
information.
PERCENT
(IN THOUSANDS) INVESTMENTS OF TOTAL
----------- --------
Fixed income securities (1) $5,887,139 86.8%
Mortgage loans 708,449 10.4
Short-term 142,334 2.1
Policy loans 38,168 0.6
Other 3,784 0.1
---------- -----
Total $6,779,874 100.0%
========== =====
- ----------
(1) Fixed income securities are carried at fair value. Amortized cost basis for
these securities was $5.54 billion at December 31, 2006.
Total investments increased to $6.78 billion at December 31, 2006 from
$6.73 billion at December 31, 2005, primarily due to positive cash flows from
financing and operating activities, partially offset by payments totaling
approximately $389.6 million related to the disposition through reinsurance of
our variable annuity business, and lower unrealized net capital gains on fixed
income securities.
Total investments at amortized cost related to collateral received in
connection with securities lending business activities increased to $199.5
million at December 31, 2006 from $149.5 million at December 31, 2005.
We use different methodologies to estimate the fair value of publicly and
non-publicly traded marketable investment securities and exchange traded and
non-exchange traded derivative contracts. For a discussion of these methods, see
the Application of Critical Accounting Estimates section of MD&A.
The following table shows total investments, categorized by the method used
to determine fair value at December 31, 2006.
<Table>
<Caption>
DERIVATIVE
INVESTMENTS CONTRACTS (1)
--------------------- -------------
FAIR PERCENT FAIR
(IN THOUSANDS) VALUE OF TOTAL VALUE
---------- -------- -------------
Fair value based on independent market quotations $4,835,750 71.3% $ 50
Fair value based on models and other valuation
methods 1,181,020 17.4 518
Mortgage loans, policy loans and other
investments, valued at cost and amortized cost 763,104 11.3 --
---------- ----- ----
Total $6,779,874 100.0% $568
========== ===== ====
</Table>
- ----------
(1) Derivative fair value includes derivatives classified as assets and
liabilities on the Statements of Financial Position and excludes
derivatives related to the Company's products (see Note 7 of the financial
statements).
FIXED INCOME SECURITIES
See Note 6 of the financial statements for a table showing the amortized
cost, unrealized gains, unrealized losses and fair value for each type of fixed
income security for the years ended December 31, 2006 and 2005.
U.S. government and agencies of the U.S. government securities were all
rated investment grade at December 31, 2006.
20
<Page>
Municipal bonds, including tax-exempt and taxable securities, totaled
$323.0 million, all of which were rated investment grade at December 31, 2006.
Approximately 59.5% of the municipal bond portfolio was insured by five bond
insurers and accordingly have a Moody's equivalent rating of Aaa or Aa. The
municipal bond portfolio at December 31, 2006 consisted of approximately 43
issues from approximately 40 issuers. The largest exposure to a single issuer
was approximately 11.4% of the municipal bond portfolio.
Corporate bonds totaled $3.30 billion and 94.3% were rated investment grade
at December 31, 2006. As of December 31, 2006, the portfolio contained $1.50
billion of privately placed corporate obligations or 45.4%, compared with $1.51
billion or 43.9% at December 31, 2005. Approximately $1.48 billion or 98.6% of
the privately placed corporate obligations consisted of fixed rate privately
placed securities. The primary benefits of fixed rate privately placed
securities when compared to publicly issued securities may include generally
higher yields, improved cash flow predictability through pro-rata sinking funds,
and a combination of covenant and call protection features designed to better
protect the holder against losses resulting from credit deterioration,
reinvestment risk or fluctuations in interest rates. A disadvantage of fixed
rate privately placed securities when compared to publicly issued securities is
relatively reduced liquidity. At December 31, 2006 94.9% of privately placed
securities were rated investment grade.
Foreign government securities totaled $304.9 million and all were rated
investment grade at December 31, 2006.
Mortgage-backed securities ("MBS") totaled $433.2 million, all of which
were rated investment grade at December 31, 2006. The credit risk associated
with MBS is mitigated due to fact that 81.4% of the portfolio consists of
securities that were issued by, or have underlying collateral that is guaranteed
by U.S. government agencies or U.S. government sponsored entities. The MBS
portfolio is subject to interest rate risk since price volatility and the
ultimate realized yield are affected by the rate of prepayment of the underlying
mortgages.
Commercial Mortgage Backed Securities ("CMBS") totaled $673.2 million at
December 31, 2006, all of which were rated investment grade. CMBS investments
primarily represent pools of commercial mortgages, broadly diversified across
property types and geographical area. The CMBS portfolio is subject to credit
risk, but unlike other structured products, is generally not subject to
prepayment risk due to protections within the underlying commercial mortgages,
whereby borrowers are restricted from prepaying their mortgages due to changes
in interest rates. Credit defaults can result in credit directed prepayments.
Approximately 68.8% of the CMBS portfolio had a Moody's rating of Aaa or an
Standard & Poor's or Fitch rating of AAA, the highest rating category, at
December 31, 2006.
Asset-backed securities ("ABS") totaled $109.0 million at December 31,
2006, all of which were rated investment grade. Our ABS portfolio is subject to
credit and interest rate risk. Credit risk is managed by monitoring the
performance of the collateral. In addition, many of the securities in the ABS
portfolio are credit enhanced with features such as over-collateralization,
subordinated structures, reserve funds, guarantees and/or insurance.
Approximately 82.5% of the ABS portfolio had a Moody's rating of Aaa or an
Standard & Poor's or Fitch rating of AAA, the highest rating category. A portion
of the ABS portfolio is also subject to interest rate risk since, for example,
price volatility and ultimate realized yield are affected by the rate of
prepayment of the underlying assets. As of December 31, 2006, 93.2% of the
portfolio was less sensitive to interest rate risk due to the payment terms or
underlying collateral of the securities. The ABS portfolio includes bonds that
are secured by a variety of asset types, predominately home equity loans, credit
card receivables and auto loans as well as collateralized debt obligations that
are predominately secured by corporate bonds and loans.
We may utilize derivative financial instruments to help mange the exposure
to interest rate risk from the fixed income securities portfolio. For a more
detailed discussion of interest rate risk and our use of derivative financial
instruments, see the Market Risk section of MD&A and Note 7 to the financial
statements.
At December 31, 2006, 96.9% of the fixed income securities portfolio was
rated investment grade, which is defined as a security having a rating from the
National Association of Insurance Commissioners ("NAIC") of 1 or 2; a rating of
Aaa, Aa, A or Baa from Moody's or a rating of AAA, AA, A or BBB from Standard &
Poor's, Fitch or Dominion; or a rating of aaa, aa, a or bbb from A.M. Best; or a
comparable internal rating if an externally provided rating is not available.
21
<Page>
The following table summarizes the credit quality of the fixed income
securities portfolio at December 31, 2006.
(IN THOUSANDS)
NAIC FAIR PERCENT
RATING MOODY'S EQUIVALENT VALUE OF TOTAL
- -------------- ------------------ ---------- --------
1 Aaa/Aa/A $4,266,674 72.5%
2 Baa 1,433,572 24.4
3 Ba 149,943 2.5
4 B 29,478 0.5
5 Caa or lower 639 --
6 In or near default 6,833 0.1
---------- -----
Total $5,887,139 100.0%
========== =====
UNREALIZED GAINS AND LOSSES See Note 6 of the financial statements for further
disclosures regarding unrealized losses on fixed income securities and factors
considered in determining whether the securities are not other-than-temporarily
impaired. The unrealized net capital gains on fixed income securities at
December 31, 2006 totaled $344.9 million, a decrease of $109.0 million since
December 31, 2005. Gross unrealized gains and losses on fixed income securities
by type and sector are provided in the table below.
<Table>
<Caption>
GROSS UNREALIZED
AMORTIZED ------------------- FAIR
(IN THOUSANDS) COST GAINS LOSSES VALUE
---------- -------- -------- ----------
AT DECEMBER 31, 2006
Corporate:
Utilities $ 654,671 $ 43,259 $ (6,271) $ 691,659
Banking 476,011 17,016 (5,204) 487,823
Consumer goods (cyclical and non-cyclical) 409,731 7,524 (5,575) 411,680
Financial services 378,054 8,840 (3,843) 383,051
Capital goods 344,241 5,726 (4,970) 344,997
Communications 205,590 8,151 (1,682) 212,059
Transportation 169,246 11,018 (1,224) 179,040
Basic industry 176,714 3,585 (2,154) 178,145
Other 158,478 15,598 (1,387) 172,689
Energy 154,035 2,935 (2,247) 154,723
Technology 87,733 1,727 (564) 88,896
---------- -------- -------- ----------
Total corporate fixed income portfolio 3,214,504 125,379 (35,121) 3,304,762
U.S. government and agencies 541,877 187,234 -- 729,111
Municipal 314,768 12,979 (4,744) 323,003
Foreign government 244,544 60,614 (211) 304,947
Asset-backed securities 107,922 1,728 (628) 109,022
Mortgage-backed securities 439,938 2,514 (9,256) 433,196
Commercial mortgage-backed securities 669,303 8,192 (4,316) 673,179
Redeemable preferred stock 9,371 548 -- 9,919
---------- -------- -------- ----------
Total fixed income securities $5,542,227 $399,188 $(54,276) $5,887,139
========== ======== ======== ==========
</Table>
The utilities, consumer goods, banking, capital goods and financial
services sectors had the highest concentration of gross unrealized losses in our
corporate fixed income securities portfolio at December 31, 2006. The gross
unrealized losses in these sectors are primarily interest rate related or
company specific. As of December 31, 2006, $32.1 million or 91.5% of the gross
unrealized losses in the corporate fixed income portfolio, and all of the
remaining fixed income securities with gross unrealized losses, were rated
investment grade. Unrealized losses on investment grade securities are
principally related to rising interest rates or changes in credit spreads since
the securities were acquired. All securities in an unrealized loss position at
December 31, 2006
22
<Page>
were included in our portfolio monitoring process for determining which declines
in value were not other-than-temporary.
The following table shows the composition by credit quality of the fixed
income securities with gross unrealized losses at December 31, 2006.
<Table>
<Caption>
(IN THOUSANDS)
NAIC UNREALIZED PERCENT PERCENT
RATING MOODY'S EQUIVALENT LOSS OF TOTAL FAIR VALUE OF TOTAL
---------- -------- ---------- --------
1 Aaa/Aa/A $(36,291) 66.9% $1,619,944 71.7%
2 Baa (14,994) 27.6 574,125 25.4
3 Ba (2,290) 4.2 52,520 2.3
4 B (701) 1.3 14,136 0.6
5 Caa or lower -- -- -- --
6 In or near default -- -- -- --
-------- ----- ---------- -----
Total $(54,276) 100.0% $2,260,725 100.0%
======== ===== ========== =====
</Table>
At December 31, 2006, $51.3 million, or 94.5%, of the gross unrealized
losses were related to investment grade fixed income securities. Unrealized
losses on investment grade securities principally relate to changes in interest
rates or changes in sector-related credit spreads since the securities were
acquired.
As of December 31, 2006, $3.0 million of the gross unrealized losses were
related to below investment grade fixed income securities. Of this amount, there
were no significant unrealized loss positions (greater than or equal to 20% of
amortized cost) for six or more consecutive months prior to December 31, 2006.
Included among the securities rated below investment grade are both public and
privately placed high-yield bonds and securities that were investment grade when
originally acquired. We mitigate the credit risk of investing in below
investment grade fixed income securities by limiting the percentage of our fixed
income portfolio invested in such securities, through diversification of the
portfolio, and active credit monitoring and portfolio management.
The scheduled maturity dates for fixed income securities in an unrealized
loss position at December 31, 2006 are shown below. Actual maturities may differ
from those scheduled as a result of prepayments by the issuers.
<Table>
<Caption>
PERCENT PERCENT
(IN THOUSANDS) UNREALIZED LOSS OF TOTAL FAIR VALUE OF TOTAL
--------------- -------- ---------- --------
Due in one year or less $ (62) 0.1% $ 7,936 0.4%
Due after one year through five years (7,287) 13.4 377,637 16.7
Due after five years through ten years (19,473) 35.9 717,463 31.7
Due after ten years (17,570) 32.4 804,717 35.6
Mortgage- and asset- backed securities(1) (9,884) 18.2 352,972 15.6
-------- ----- ---------- -----
Total $(54,276) 100.0% $2,260,725 100.0%
======== ===== ========== =====
</Table>
- ----------
(1) Because of the potential for prepayment, mortgage- and asset-backed
securities are not categorized based on their contractual maturities.
PORTFOLIO MONITORING We have a comprehensive portfolio monitoring process to
identify and evaluate, on a case by case basis, fixed income securities for
which carrying value may be other-than-temporarily impaired. The process
includes a quarterly review of all securities using a screening process to
identify those securities for which fair value compared to amortized cost is
below established thresholds for certain time periods, or which are identified
through other monitoring criteria such as ratings downgrades or payment
defaults. The securities identified, in addition to other securities for which
we may have a concern, are evaluated based on facts and circumstances for
inclusion on our watch-list. As a result of approved programs involving the
disposition of investments such as changes in duration, revisions to strategic
asset allocations and liquidity actions, and certain dispositions anticipated by
portfolio managers, we also conduct a portfolio review to recognize impairment
on securities in an unrealized loss position for which we do not have the intent
and ability to hold until recovery. All securities in an unrealized loss
position at December 31, 2006 were included in our portfolio monitoring process
for determining which declines in value were not other-than-temporary.
23
<Page>
The following table summarizes fixed income securities in a gross
unrealized loss position according to significance, aging and investment grade
classification.
<Table>
<Caption>
DECEMBER 31, 2006 DECEMBER 31, 2005
------------------------------------ ------------------------------------
FIXED INCOME FIXED INCOME
----------------------- -----------------------
BELOW BELOW
INVESTMENT INVESTMENT INVESTMENT INVESTMENT
(IN THOUSANDS, EXCEPT NUMBER OF ISSUES) GRADE GRADE TOTAL GRADE GRADE TOTAL
---------- ---------- ---------- ---------- ---------- ----------
Category (i): Unrealized
loss less than 20% of cost (1)
Number of Issues 373 36 409 334 34 368
Fair Value $2,194,069 $66,656 $2,260,725 $1,999,082 $61,814 $2,060,896
Unrealized $ (51,285) $(2,991) $ (54,276) $ (39,839) $(2,471) $ (42,310)
Category (ii): Unrealized loss
greater than or equal to 20% of
cost for a period of less than 6
consecutive months (1)
Number of Issues -- -- -- 3 -- 3
Fair Value $ -- $ -- $ -- $ 4,344 $ -- $ 4,344
Unrealized $ -- $ -- $ -- $ (1,202) $ -- $ (1,202)
Total Number of Issues 373 36 409 337 34 371
========== ======= ========== =========== ======= ==========
Total Fair Value $2,194,069 $66,656 $2,260,725 $ 2,003,426 $61,814 $2,065,240
========== ======= ========== =========== ======= ==========
Total Unrealized Losses $ (51,285) $(2,991) $ (54,276) $ (41,041) $(2,471) $ (43,512)
========== ======= ========== =========== ======= ==========
</Table>
The largest individual unrealized loss was $952 thousand for category (i)
as of December 31, 2006. Categories (i) and (ii) have generally been adversely
affected by overall economic conditions including interest rate increases and
the market's evaluation of certain sectors. The degree to which and/or length of
time that the securities have been in an unrealized loss position does not
suggest that these securities pose a high risk of being other-than-temporarily
impaired.
Whenever our initial analysis indicates that a fixed income security's
unrealized loss of 20% or more for at least 36 months or any equity security's
unrealized loss of 20% or more for at least 12 months is temporary, additional
evaluations and management approvals are required to substantiate that a
write-down is not appropriate. As of December 31, 2006, no securities met these
criteria.
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The following table contains the individual securities with the largest
unrealized losses as of December 31, 2006. No other fixed income security had
an unrealized loss of or greater than $690 thousand or 1.3% of the total
unrealized loss on fixed income securities.
UNREALIZED
UNREALIZED FAIR NAIC LOSS
(IN THOUSANDS) LOSS VALUE RATING CATEGORY
---------- ------- ------ ----------
Municipal Obligation $ (952) $14,048 1 (i)
Mortgage Backed Security (951) 24,106 1 (i)
Mortgage Backed Security (797) 16,883 1 (i)
Building Products Company (767) 19,233 2 (i)
Municipal Obligation (706) 8,207 1 (i)
Utility Company (690) 9,011 1 (i)
------- -------
Total $(4,863) $91,488
======= =======
We monitor the quality of our fixed income portfolio by categorizing
certain investments as "problem", "restructured" or "potential problem." Problem
fixed income securities are securities in default with respect to principal or
interest and/or securities issued by companies that have gone into bankruptcy
subsequent to our acquisition of the security. Restructured fixed income
securities have rates and terms that are not consistent with market rates or
terms prevailing at the time of the restructuring. Potential problem fixed
income securities are current with respect to contractual principal and/or
interest, but because of other facts and circumstances, we have concerns
regarding the borrower's ability to pay future principal and interest, which
causes us to believe these securities may be classified as problem or
restructured in the future.
The following table summarizes problem, restructured and potential problem
fixed income securities at December 31.
<Table>
<Caption>
2006 2005
------------------------------- --------------------------------
PERCENT OF PERCENT OF
TOTAL TOTAL
FIXED FIXED
AMORTIZED FAIR INCOME AMORTIZED FAIR INCOME
(IN THOUSANDS) COST VALUE PORTFOLIO COST VALUE PORTFOLIO
--------- ------ ---------- --------- ------- ----------
Problem $3,444 $6,883 0.1% $14,373 $17,762 0.3%
Restructured -- -- -- 163 163 --
Potential problem 2 -- -- 5,609 5,640 0.1
------ ------ --- ------- ------- ---
Total net carrying value $3,446 $6,883 0.1% $20,145 $23,565 0.4%
====== ====== === ======= ======= ===
Cumulative write-downs
recognized (1) $2,491 $ 5,455
====== =======
</Table>
- ----------
(1) Cumulative write-downs recognized only reflect write-downs related to
securities within the problem, potential problem or restructured
categories.
We have experienced a decrease in the amortized cost of fixed income
securities in each of the categories as of December 31, 2006 compared to
December 31, 2005, due to dispositions and the removal of a security upon
improving conditions.
We evaluated each of these securities through our portfolio monitoring
process at December 31, 2006 and recorded write-downs when appropriate. We
further concluded that any remaining unrealized losses on these securities were
temporary in nature and that we have the intent and ability to hold the security
until recovery. While these balances may increase in the future, particularly if
economic conditions are unfavorable, management expects that the total amount of
securities in these categories will remain low relative to the total fixed
income securities portfolio.
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NET REALIZED CAPITAL GAINS AND LOSSES The following table presents the
components of realized capital gains and losses and the related tax effect for
the years ended December 31.
(IN THOUSANDS) 2006 2005 2004
-------- ------- -------
Investment write-downs $ (258) $(1,543) $(3,402)
Dispositions (21,568) (2,053) (2,784)
Valuation of derivative instruments (5,429) (4,469) (5,777)
Settlement of derivative instruments 5,170 2,873 2,666
-------- ------- -------
Realized capital gains and losses, pretax (22,085) (5,192) (9,297)
Income tax benefit 8,216 1,972 3,453
-------- ------- -------
Realized capital gains and losses, after-tax $(13,869) $(3,220) $(5,844)
======== ======= =======
Dispositions in the above table include sales, losses recognized in
anticipation of dispositions and other transactions such as calls and
prepayments. We may sell impaired fixed income securities that were in an
unrealized loss position at the previous reporting date in situations where new
factors such as negative developments, subsequent credit deterioration, changing
liquidity needs, and newly identified market opportunities cause a change in our
previous intent to hold a security to recovery or maturity.
A changing interest rate environment will drive changes in our portfolio
duration targets at a tactical level. A duration target and range is established
with an economic view of liabilities relative to a long-term portfolio view.
Tactical duration adjustments within management's approved ranges are
accomplished through both cash market transactions and derivative activities
that generate realized gains and losses and through new purchases. As a
component of our approach to managing portfolio duration, realized gains and
losses on derivative instruments are most appropriately considered in
conjunction with the unrealized gains and losses on the fixed income portfolio.
This approach mitigates the impacts of general interest rate changes to the
overall financial condition of the Company.
Dispositions included net realized losses on sales and other transactions
such as calls and prepayments of $5.1 million and losses recorded in connection
with anticipated dispositions of $16.5 million. The net realized losses on sales
and other transactions were comprised of gross gains of $13.9 million and gross
losses of $19.0 million. The $19.0 million in gross losses almost entirely
consisted of losses from sales of fixed income securities.
During our comprehensive portfolio reviews, we ascertain whether there are
any approved programs involving the disposition of investments such as changes
in duration, revision to strategic asset allocation and liquidity actions; and
any dispositions anticipated by the portfolio managers resulting from their
on-going comprehensive reviews of the portfolios. Upon approval of such
programs, we identify a population of suitable investments, typically larger
than needed to execute the disposition, from which specific securities are
selected to sell. Due to our change in intent to hold until recovery, we
recognize impairments, which are included in losses from dispositions, on any of
these securities in an unrealized loss position. When the objectives of the
programs are accomplished, any remaining securities are redesignated as intent
to hold until recovery.
For the year ended December 31, 2006, we recognized $16.5 million of losses
related to a change in our intent to hold certain securities with unrealized
losses until they recover in value. The change in our intent was driven by
certain approved programs, including funding for the disposition through
reinsurance of our variable annuity reinsurance agreement. These programs were
completed during 2006. Additionally, ongoing comprehensive reviews of our
portfolio resulted in the identification of anticipated dispositions by the
portfolio managers. At December 31, 2006, the fair value of securities for which
we did not have the intent to hold until recovery totaled $13.7 million.
At December 31, 2005, the fair value of the securities for which we did not
have the intent to hold until recovery totaled $11.5 million. Approved programs
involving the disposition of securities included continued asset-liability
management strategies, on-going comprehensive reviews of our portfolios, changes
to our strategic asset allocations and yield enhancement strategies on which we
recognized $6.8 million of losses during 2005. These objectives were
accomplished during 2006.
26
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The ten largest losses from sales of individual securities for the year
ended December 31, 2006 totaled $8.8 million with the largest being $1.7 million
and the smallest being $609 thousand. None of the securities that comprise these
ten largest losses were in an unrealized loss position greater than or equal to
20% of amortized cost at the time of sale.
MORTGAGE LOANS Our mortgage loans portfolio was $708.4 million at December 31,
2006 and $633.8 million at December 31, 2005, and was comprised primarily of
loans secured by first mortgages on developed commercial real estate.
Geographical and property type diversification are key considerations used to
manage our mortgage loan risk.
We closely monitor our commercial mortgage loan portfolio on a loan-by-loan
basis. Loans with an estimated collateral value less than the loan balance, as
well as loans with other characteristics indicative of higher than normal credit
risk, are reviewed by financial and investment management at least quarterly for
purposes of establishing valuation allowances and placing loans on non-accrual
status. The underlying collateral values are based upon either discounted
property cash flow projections or a commonly used valuation method that utilizes
a one-year projection of expected annual income divided by an expected rate of
return. We had no realized capital losses related to write-downs on mortgage
loans for the years ended December 31, 2006, 2005 and 2004.
SHORT-TERM INVESTMENTS Our short-term investment portfolio was $142.3 million
and $63.1 million at December 31, 2006 and 2005, respectively. We invest
available cash balances primarily in taxable short-term securities having a
final maturity date or redemption date of less than one year.
As one of our business activities, we conduct securities lending, primarily
as an investment yield enhancement, with third parties such as brokerage firms.
We obtain collateral in an amount equal to 102% of the fair value of the
securities and monitor the market value of the securities loaned on a daily
basis with additional collateral obtained as necessary. The cash we receive is
invested in short-term and fixed income investments, and an offsetting liability
is recorded in other liabilities and accrued expense. At December 31, 2006, the
amount of securities lending collateral reinvested in short-term investments had
a carrying value of $87 million. This compares to $46 million at December 31,
2005.
OUTLOOK
- - We plan to continue to balance targeted improvements in return on equity
with growth in sales and profitability. Initially, our actions to improve
returns may reduce the price competitiveness of certain products, such as
our fixed annuities, and slow or reduce the growth in sales and income.
- - We plan to continue to maintain discipline over expenses and improve our
operating efficiency.
- - We plan to increase sales of our financial products by Allstate exclusive
agencies by further tailoring products for our customers and making it
easier for our agents to distribute our products.
- - We plan to develop and bring to market new innovative life insurance
products or features designed to increase sales of this product line.
MARKET RISK
Market risk is the risk that we will incur losses due to adverse changes in
interest rates or equity prices. Our primary market risk exposure is to changes
in interest rates, although we also have certain exposures to changes in equity
prices.
The active management of market risk is integral to our results of
operations. We may use the following approaches to manage our exposure to market
risk within defined tolerance ranges: 1) rebalancing existing asset or liability
portfolios, 2) changing the character of investments purchased in the future or
3) using derivative instruments to modify the market risk characteristics of
existing assets and liabilities or assets expected to be purchased. For a more
detailed discussion of our use of derivative financial instruments, see Note 7
of the financial statements.
OVERVIEW We generate substantial investiable funds from our business. In
formulating and implementing guidelines for investing funds, we seek to earn
returns that enhance our ability to offer competitive rates and prices to
customers while contributing to attractive and stable profits and long-term
capital growth. Accordingly, our investment decisions and objectives are a
function of our underlying risks and product profiles.
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<Page>
Investment policies define the overall framework for managing market and
other investment risks, including accountability and control over these risk
management activities. These investment activities follow policies that have
been approved by our board of directors. These investment policies specify the
investment limits and strategies that are appropriate given our liquidity,
surplus, product profile, and regulatory requirements. Executive oversight of
investment activities is conducted primarily through our board of directors and
investment committee. Asset-liability management ("ALM") policies further define
the overall framework for managing market and investment risks. ALM focuses on
strategies to enhance yields, mitigate market risks and optimize capital to
improve profitability and returns. ALM activities follow asset-liability
policies that have been approved by our board of directors. These ALM policies
specify limits, ranges and/or targets for investments that best meet our
business objectives in light of our product liabilities.
We manage our exposure to market risk through the use of asset allocation,
duration and value-at-risk limits, through the use of simulation and, as
appropriate, through the use of stress tests. We have asset allocation limits
that place restrictions on the total funds that may be invested within an asset
class. We have duration limits on our investment portfolio, and, as appropriate,
on individual components of the portfolio. These duration limits place
restrictions on the amount of interest rate risk that may be taken. Our
value-at-risk limits are intended to restrict the potential loss in fair value
that could arise from adverse movements in the fixed income, equity, and
currency markets based on historical volatilities and correlations among market
risk factors. Comprehensive day-to-day management of market risk within defined
tolerance ranges occurs as portfolio managers buy and sell within their
respective markets based upon the acceptable boundaries established by the
investment policies. This day-to-day management is integrated with and informed
by the activities of the ALM organization. This integration results in a
prudent, methodical and effective adjudication of market risk and return,
conditioned by the unique demands and dynamics of our product liabilities and
supported by the application of advanced risk technology and analytics.
INTEREST RATE RISK is the risk that we will incur loss due to adverse changes in
interest rates. This risk arises from many of our primary activities, as we
invest substantial funds in interest-sensitive assets and issue
interest-sensitive liabilities.
We manage the interest rate risk in our assets relative to the interest
rate risk inherent in our liabilities. One of the measures used to quantify this
exposure is duration. Duration measures the price sensitivity of the assets and
liabilities to changes in interest rates. For example, if interest rates
increase by 100 basis points, the fair value of an asset with a duration of 5 is
expected to decrease in value by approximately 5%. At December 31, 2006, the
difference between our asset and liability duration was approximately (0.45),
compared to a (0.34) gap at December 31, 2005. A negative duration gap indicates
that the fair value of our liabilities is more sensitive to interest rate
movements than the fair value of our assets.
We seek to invest premiums, contract charges and deposits to generate
future cash flows that will fund future claims, benefits and expenses, and that
will earn stable margins across a wide variety of interest rate and economic
scenarios. In order to achieve this objective and limit interest rate risk, we
adhere to a philosophy of managing the duration of assets and related
liabilities. This philosophy may include using futures to reduce the interest
rate risk resulting from mismatches between existing assets and liabilities, and
financial futures to hedge the interest rate risk of anticipated purchases and
sales of investments and product sales to customers.
To calculate the duration gap between assets and liabilities, we project
asset and liability cash flows and calculate their net present value using a
risk-free market interest rate adjusted for credit quality, sector attributes,
liquidity and other specific risks. Duration is calculated by revaluing these
cash flows at alternative interest rates and determining the percentage change
in aggregate fair value. The cash flows used in this calculation include the
expected maturity and repricing characteristics of our derivative financial
instruments, all other financial instruments (as described in Note 7 of the
financial statements in accordance with Statement of Financial Accounting
Standards ("SFAS") No. 107, "Disclosures about Fair Value of Financial
Instruments"), and certain other items including interest-sensitive liabilities
and annuity liabilities, which are not considered financial instruments in
accordance with SFAS No.107. The projections include assumptions (based upon
historical market experience and our experience) that reflect the effect of
changing interest rates on the prepayment, lapse, leverage and/or option
features of instruments, where applicable. Such assumptions relate primarily to
mortgage-backed securities, collateralized mortgage obligations, municipal
housing bonds, callable municipal and corporate obligations, and fixed rate
single and flexible premium deferred annuities.
Based upon the information and assumptions we use in this duration
calculation, and interest rates in effect at December 31, 2006, we estimate that
a 100 basis point immediate, parallel increase in interest rates ("rate shock")
28
<Page>
would decrease the net fair value of the assets and liabilities by approximately
$23.1 million, compared to $46.8 million at December 31, 2005. The selection of
a 100 basis point immediate parallel change in interest rates should not be
construed as our prediction of future market events, but only as an illustration
of the potential effect of such an event. There were $393.2 million of assets
supporting life insurance products such as traditional and interest-sensitive
life, which are not considered financial instruments in accordance with SFAS No.
107. These assets and the associated liabilities have not been included in the
above estimate. The $393.2 million of assets excluded from the calculation has
decreased from $412.3 million reported at December 31, 2005. Based on
assumptions described above, in the event of a 100 basis point immediate
increase in interest rates, the assets supporting life insurance products would
decrease in value by $29.3 million, compared to a decrease of $32.2 million at
December 31, 2005.
To the extent that conditions differ from the assumptions we used in these
calculations, duration and rate shock measures could be significantly impacted.
Additionally, our calculations assume that the current relationship between
short-term and long-term interest rates (the term structure of interest rates)
will remain constant over time. As a result, these calculations may not fully
capture the effect of non-parallel changes in the term structure of interest
rates and/or large changes in interest rates.
EQUITY PRICE RISK is the risk that we will incur losses due to adverse
changes in general levels of the equity markets. At December 31, 2006 and 2005,
we had separate accounts assets related to variable annuity and variable life
contracts with account values totaling $1.01 billion and $928.8 million,
respectively. Equity risk exists for contract charges based on separate account
balances and guarantees for death and/or income benefits provided by our
variable products. In 2006, we disposed of all of the variable annuity business
through a reinsurance agreement with Prudential as described in Note 3 of the
financial statements, and therefore mitigated this aspect of our risk. Equity
risk of our variable life business relates to contract charges and policyholder
benefits. Total variable life contract charges for 2006 and 2005 were $830
thousand and $554 thousand, respectively. Separate account liabilities related
to variable life contracts were $2.7 million and $1.4 million in December 31,
2006 and 2005, respectively.
CAPITAL RESOURCES AND LIQUIDITY
CAPITAL RESOURCES consist of shareholder's equity. The following table
summarizes our capital resources at December 31.
(IN THOUSANDS) 2006 2005 2004
-------- -------- --------
Common stock, additional capital paid-in and
retained income $574,958 $538,465 $483,980
Accumulated other comprehensive income 78,038 128,968 155,255
-------- -------- --------
Total shareholder's equity $652,996 $667,433 $639,235
======== ======== ========
SHAREHOLDER'S EQUITY decreased in 2006 due to lower unrealized net capital
gains on fixed income securities, partially offset by net income and a gain
recorded to retained income related to the recapture of a reinsurance treaty
with ALIC. Shareholder's equity increased in 2005 when compared to 2004 as a
result of net income and a capital contribution from ALIC of $20.0 million,
partially offset by lower unrealized net capital gains on fixed income
securities.
FINANCIAL RATINGS AND STRENGTH The following table summarizes our financial
strength ratings at December 31, 2006.
RATING AGENCY RATING
------------- ------
Moody's Investors Service, Inc. Aa2 ("Excellent")
Standard & Poor's Ratings Services AA ("Very Strong")
A.M. Best Company, Inc. A+ ("Superior")
Our ratings are influenced by many factors including our operating and
financial performance, asset quality, liquidity, asset/liability management,
overall portfolio mix, financial leverage (i.e., debt), risk exposures,
operating leverage, ALIC's ratings, AIC's ratings and other factors.
29
<Page>
State laws specify regulatory actions if an insurer's risk-based capital
("RBC"), a measure of an insurer's solvency, falls below certain levels. The
NAIC has a standard formula for annually assessing RBC. The formula for
calculating RBC for life companies takes into account factors relating to
insurance, business, asset and interest rate risks. At December 31, 2006, our
RBC was above levels that would require regulatory actions.
The NAIC has also developed a set of financial relationships or tests known
as the Insurance Regulatory Information System to assist state regulators in
monitoring the financial condition of insurance companies and identifying
companies that require special attention or action from insurance regulatory
authorities. The NAIC analyzes financial data provided by insurance companies
using prescribed ratios, each with defined "usual ranges." Generally, regulators
will begin to monitor an insurance company if its ratios fall outside the usual
ranges for four or more of the ratios. If an insurance company has insufficient
capital, regulators may act to reduce the amount of insurance it can issue. Our
ratios are within these ranges.
LIQUIDITY SOURCES AND USES Our potential sources of funds principally include
the following activities:
- Receipt of insurance premiums
- Contractholder fund deposits
- Reinsurance recoveries
- Receipts of principal and interest on investments
- Sales of investments
- Funds from securities lending
- Inter-company loans
- Capital contributions from parent
Our potential uses of funds principally include the following activities:
- Payment of contract benefits, surrenders and withdrawals
- Reinsurance cessions and payments
- Operating costs and expenses
- Purchases of investments
- Repayment of securities lending
- Payment or repayment of inter-company loans
- Tax payments/settlements
- Dividends to parent
As reflected in our Statements of Cash Flows, higher operating cash flows
in 2006, compared to 2005, primarily related to higher interest received on
investments and premiums received, partially offset by higher contract benefits
and expenses paid. Higher operating cash flows in 2005, compared to 2004, were
primarily related to increased interest received on investments and lower
expenses paid, partially offset by lower premiums.
Cash flows used in investing activities decreased in both 2006 and 2005,
compared to the respective prior years, due to decreased net cash provided by
financing activities, partially offset by the investment of higher operating
cash flows. Cash flows used in investing activities in 2006 also include the
settlements related to the disposition through reinsurance of our variable
annuity business.
Cash provided by financing activities decreased in 2006, compared to 2005,
as a result of lower contractholder fund deposits and higher surrenders and
partial withdrawals. Lower cash flows provided by financing activities in 2005,
compared to 2004, were primarily due to lower deposits on fixed annuities and
higher fixed annuity withdrawals. For quantification of the changes in
contractholder funds, see the Operations section of MD&A.
To ensure we have the appropriate level of liquidity, we perform actuarial
tests on the impact to cash flows of policy surrenders and other actions under
various scenarios. Depending upon the years in which certain policy types were
sold with specific surrender provisions, our cash flow could vary due to higher
surrender of policies exiting their surrender charge periods.
We have entered into an inter-company loan agreement with The Allstate
Corporation. The amount of inter-company loans available to us is at the
discretion of The Allstate Corporation. The maximum amount of loans The Allstate
Corporation will have outstanding to all its eligible subsidiaries at any given
point in time is limited to $1.00 billion. We had no amounts outstanding under
the inter-company loan agreement at December 31, 2006 or 2005. The Allstate
Corporation uses commercial paper borrowings and bank lines of credit to fund
inter-company borrowings.
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Certain remote events and circumstances could constrain our or the
Corporation's liquidity. Those events and circumstances include, for example, a
catastrophe resulting in extraordinary losses, a downgrade in the Corporation's
long-term debt rating of A1, A+ and a (from Moody's, Standard & Poor's and A.M.
Best, respectively) to non-investment grade status of below Baa3/BBB-/bb, a
downgrade in AIC's financial strength rating from Aa2, AA and A+ (from Moody's,
Standard & Poor's and A.M. Best, respectively) to below Baa/BBB/A-, or a
downgrade in our financial strength ratings from Aa2, AA and A+ (from Moody's,
Standard & Poor's and A.M. Best, respectively) to below Aa3/AA-/A-. The rating
agencies also consider the interdependence of the Corporation's individually
rated entities; therefore, a rating change in one entity could potentially
affect the ratings of other related entities.
CONTRACTUAL OBLIGATIONS AND COMMITMENTS Our contractual obligations as of
December 31, 2006 and the payments due by period are shown in the following
table.
<Table>
<Caption>
LESS THAN OVER 5
($ IN THOUSANDS) TOTAL 1 YEAR 1-3 YEARS 4-5 YEARS YEARS
----------- --------- ---------- ---------- ----------
Securities lending (1) $ 199,486 $199,486 $ -- $ -- $ --
Contractholder funds(2) 6,504,588 405,481 1,454,319 1,074,783 3,570,005
Reserve for life-contingent contract
benefits(3) 6,547,126 131,181 430,013 290,509 5,695,423
Payable to affiliates, net 30,031 30,031 -- -- --
Reinsurance payable to parent 979 979 -- -- --
Other liabilties and accrued
expenses(4)(5) 37,289 35,150 981 317 841
----------- -------- ---------- ---------- ----------
Total Contractual Cash Obligations $13,319,499 $802,308 $1,885,313 $1,365,609 $9,266,269
=========== ======== ========== ========== ==========
</Table>
- ----------
(1) Securities lending transactions are typically fully secured with cash or
marketable securities. We manage our short-term liquidity position to
ensure the availability of a sufficient amount of liquid assets to
extinguish short-term liabilities as they come due in the normal course of
business.
(2) Contractholder funds represent interest-bearing liabilities arising from
the sale of products such as interest-sensitive life and fixed annuities,
including immediate annuities without life contingencies. These amounts
reflect estimated cash payments to be made to policyholders and
contractholders. Certain of these contracts, such as immediate annuities
without life contingencies, involve payment obligations where the amount
and timing of the payment is essentially fixed and determinable. These
amounts relate to (i) policies or contracts where we are currently making
payments and will continue to do so and (ii) contracts where the timing of
payments has been determined by the contract. Other contracts, such as
interest-sensitive life and fixed deferred annuities, involve payment
obligations where the amount and timing of future payments is uncertain.
For these contracts, the Company is not currently making payments and will
not make payments until (i) the occurrence of an insurable event, such as
death, or (ii) the occurrence of a payment triggering event, such as the
surrender of or partial withdrawal on a policy or deposit contract, which
is outside of the control of the Company. We have estimated the timing of
payments related to these contracts based on historical experience and our
expectation of future payment patterns. Uncertainties relating to these
liabilities include mortality, customer lapse and withdrawal activity, and
estimated additional deposits for interest-sensitive life contracts, which
may significantly impact both the timing and amount of future payments.
Such cash outflows reflect adjustments for the estimated timing of
mortality, retirement, and other appropriate factors, but are undiscounted
with respect to interest. As a result, the sum of the cash outflows shown
for all years in the table exceeds the corresponding liability amounts of
$4.71 billion included in the Statements of Financial Position as of
December 31, 2006 for contractholder funds. The liability amount in the
Statements of Financial Position reflects the discounting for interest as
well as adjustments for the timing of other factors as described above.
(3) The reserve for life-contingent contract benefits relates primarily to
traditional life and immediate annuities with life contingencies and
reflects the present value of estimated cash payments to be made to
policyholders and contractholders. Immediate annuities with life
contingencies include (i) contracts where we are currently making payments
and will continue to do so until the occurrence of a specific event such as
death and (ii) contracts where the timing of a portion of the payments has
been determined by the contract. Other contracts, such as traditional life
and supplemental accident and health insurance, involve payment obligations
where the amount and timing of future payments is uncertain. For these
contracts, the Company is not currently making payments and will not make
payments until (i) the occurrence of an insurable event, such as death or
illness, or (ii) the occurrence of a payment triggering event, such as a
surrender of a policy or contract, which is outside of the control of the
Company. We have estimated the timing of cash outflows related to these
contracts based on historical experience and our expectation of future
payment patterns. Uncertainties relating to these liabilities include
mortality, morbidity, expenses, customer lapse and withdrawal activity, and
renewal premium for life policies, which may significantly impact both the
timing and amount of future payments. Such cash outflows reflect
adjustments for the estimated timing of mortality, retirement, and other
appropriate factors, but are undiscounted with respect to interest. As a
result, the sum of the cash outflows shown for all years in the table
exceeds the corresponding liability amounts of $1.93 billion included in
the Statements of Financial Position as of December 31, 2006 for reserve
for life-contingent contract benefits. The liability amount in the
Statements of Financial Position reflects the discounting for interest as
well as adjustments for the timing of other factors as described above.
(4) Other liabilities and accrued expenses primarily include accrued expenses
and claim payments.
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- ----------
(5) Balance sheet liabilities not included in the table above include unearned
and advance premiums of $489 thousand and deferred income taxes of $48
million. These items were excluded as they do not meet the definition of a
contractual liability as we are not contractually obligated to pay these
amounts to third parties. Rather, they represent an accounting mechanism
that allows us to present our financial statements on an accrual basis of
accounting. In addition, other liabilities of $6 million were not included
in the table above because they did not represent a contractual obligation
or the amount and timing of their eventual payment was sufficiently
uncertain.
At December 31, 2006, we had $14.7 million in contractual conditional
commitments to invest in private placements and mortgage loans.
REGULATION AND LEGAL PROCEEDINGS
We are subject to extensive regulation and we are involved in various legal
and regulatory actions, all of which have an effect on specific aspects of our
business. For a detailed discussion of the legal and regulatory actions in which
we are involved, see Note 11 of the financial statements.
PENDING ACCOUNTING STANDARDS
As of December 31, 2006, there are several pending accounting standards
that we have not implemented either because the standard had not been finalized
or the implementation date has not yet occurred. For a discussion of these
pending standards, see Note 2 of the financial statements.
The effect of implementing certain accounting standards on our financial
results and financial condition is often based in part on market conditions at
the time of implementation of the standard and other factors we are unable to
determine prior to implementation. For this reason, we are sometimes unable to
estimate the effect of certain pending accounting standards until the relevant
authoritative body finalizes these standards or until we implement them.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Information required for Item 7A is incorporated by reference to the
material under the caption "Market Risk" in Part II, Item 7 of this report.
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ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
ALLSTATE LIFE INSURANCE COMPANY OF NEW YORK
STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME
<Table>
<Caption>
YEAR ENDED DECEMBER 31,
------------------------------
(IN THOUSANDS) 2006 2005 2004
-------- -------- --------
REVENUES
Premiums (net of reinsurance ceded of $20,837, $16,046 and $16,133) $ 84,313 $ 68,538 $ 76,550
Contract charges (net of reinsurance ceded of $12,295, $835 and $1) 63,426 66,280 59,834
Net investment income 373,064 356,162 302,055
Realized capital gains and losses (22,085) (5,192) (9,297)
-------- -------- --------
498,718 485,788 429,142
-------- -------- --------
COSTS AND EXPENSES
Contract benefits (net of reinsurance recoveries of $16,085, $8,510 and $7,536) 190,506 183,227 182,150
Interest credited to contractholder funds 167,171 161,936 129,804
Amortization of deferred policy acquisition costs 31,672 41,663 25,971
Operating costs and expenses 46,578 43,497 42,115
-------- -------- --------
435,927 430,323 380,040
(Loss) gain on disposition of operations (10,694) 1 1,326
-------- -------- --------
INCOME FROM OPERATIONS BEFORE INCOME TAX EXPENSE AND CUMULATIVE EFFECT OF
CHANGE IN ACCOUNTING PRINCIPLE, AFTER-TAX 52,097 55,466 50,428
Income tax expense 17,755 20,945 17,925
-------- -------- --------
INCOME BEFORE CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE, AFTER-TAX 34,342 34,521 32,503
Cumulative effect of change in accounting principle, after-tax -- -- (7,586)
-------- -------- --------
NET INCOME 34,342 34,521 24,917
-------- -------- --------
OTHER COMPREHENSIVE (LOSS) INCOME, AFTER TAX
Change in unrealized net capital gains and losses (50,930) (26,287) 16,531
-------- -------- --------
COMPREHENSIVE (LOSS) INCOME $(16,588) $ 8,234 $ 41,448
======== ======== ========
</Table>
See notes to financial statements.
33
<Page>
ALLSTATE LIFE INSURANCE COMPANY OF NEW YORK
STATEMENTS OF FINANCIAL POSITION
<Table>
<Caption>
DECEMBER 31,
-----------------------
(IN THOUSANDS, EXCEPT PAR VALUE DATA) 2006 2005
---------- ----------
ASSETS
Investments
Fixed income securities, at fair value (amortized cost $5,542,227 and $5,535,396) $5,887,139 $5,989,263
Mortgage loans 708,449 633,789
Short-term 142,334 63,057
Policy loans 38,168 36,698
Other 3,784 3,740
---------- ----------
Total investments 6,779,874 6,726,547
Cash 7,090 3,818
Deferred policy acquisition costs 278,625 318,551
Accrued investment income 63,843 62,452
Reinsurance recoverables 437,422 12,729
Current income taxes receivable 862 --
Other assets 42,488 35,760
Separate Accounts 1,009,784 928,824
---------- ----------
TOTAL ASSETS $8,619,988 $8,088,681
========== ==========
LIABILITIES
Reserve for life-contingent contract benefits $1,926,492 $1,869,875
Contractholder funds 4,708,428 4,349,395
Deferred income taxes 47,940 73,399
Other liabilities and accrued expenses 243,338 188,123
Payable to affiliates, net 30,031 5,249
Current income tax payable -- 5,412
Reinsurance payable to parent 979 971
Separate Accounts 1,009,784 928,824
---------- ----------
TOTAL LIABILITIES 7,966,992 7,421,248
---------- ----------
COMMITMENTS AND CONTINGENT LIABILITIES (NOTE 11)
SHAREHOLDER'S EQUITY
Common stock, $25 par value, 100 thousand shares authorized, issued and outstanding 2,500 2,500
Additional capital paid-in 140,000 140,000
Retained income 432,458 395,965
Accumulated other comprehensive income:
Unrealized net capital gains and losses 78,038 128,968
---------- ----------
Total accumulated other comprehensive income 78,038 128,968
---------- ----------
TOTAL SHAREHOLDER'S EQUITY 652,996 667,433
---------- ----------
TOTAL LIABILITIES AND SHAREHOLDER'S EQUITY $8,619,988 $8,088,681
========== ==========
</Table>
See notes to financial statements.
34
<Page>
ALLSTATE LIFE INSURANCE COMPANY OF NEW YORK
STATEMENTS OF SHAREHOLDER'S EQUITY
<Table>
<Caption>
DECEMBER 31,
-------------------------------
(IN THOUSANDS) 2006 2005 2004
-------- -------- --------
COMMON STOCK $ 2,500 $ 2,500 $ 2,500
-------- -------- --------
ADDITIONAL CAPITAL PAID IN
Balance, beginning of year 140,000 120,000 55,787
Capital contribution -- 20,000 64,213
-------- -------- --------
Balance, end of year 140,000 140,000 120,000
-------- -------- --------
RETAINED INCOME
Balance, beginning of year 395,965 361,480 336,563
Net income 34,342 34,521 24,917
Gain on recapture of reinsurance agreement with parent 2,151 -- --
Dividend-in-kind -- (36) --
-------- -------- --------
Balance, end of year 432,458 395,965 361,480
-------- -------- --------
ACCUMULATED OTHER COMPREHENSIVE INCOME
Balance, beginning of year 128,968 155,255 138,724
Change in unrealized net capital gains and losses (50,930) (26,287) 16,531
-------- -------- --------
Balance, end of year 78,038 128,968 155,255
-------- -------- --------
TOTAL SHAREHOLDER'S EQUITY $652,996 $667,433 $639,235
======== ======== ========
</Table>
See notes to financial statements.
35
<Page>
ALLSTATE LIFE INSURANCE COMPANY OF NEW YORK
STATEMENTS OF CASH FLOWS
<Table>
<Caption>
YEAR ENDED DECEMBER 31,
-------------------------------------
(IN THOUSANDS) 2006 2005 2004
--------- ----------- -----------
CASH FLOWS FROM OPERATING ACTIVITIES
Net income $ 34,342 $ 34,521 $ 24,917
Adjustments to reconcile net income to net cash provided by operating activities
Amortization and other non-cash items (72,250) (58,887) (51,544)
Realized capital gains and losses 22,085 5,192 9,297
Loss (gain) on disposition of operations 10,694 (1) (1,326)
Cumulative effect of change in accounting principle -- -- 7,586
Interest credited to contractholder funds 167,171 161,936 129,804
Changes in:
Reserve for life-contingent contract benefits and contractholder funds 26,648 36,533 32,492
Deferred policy acquisition costs (31,265) (26,542) (66,532)
Income taxes (5,467) 2,591 12,091
Other operating assets and liabilities 23,605 (15,285) (7,442)
--------- ----------- -----------
Net cash provided by operating activities 175,563 140,058 89,343
--------- ----------- -----------
CASH FLOWS FROM INVESTING ACTIVITIES
Proceeds from sales of fixed income securities 877,430 481,745 485,522
Investment collections
Fixed income securities 115,003 160,281 184,317
Mortgage loans 73,110 54,795 26,714
Investments purchases
Fixed income securities (954,087) (1,086,370) (1,758,452)
Mortgage loans (144,267) (205,389) (119,953)
Change in short-term investments, net (28,239) 29,687 (29,248)
Change in other investments, net 3,486 2,305 2,678
Disposition of operations (389,601) -- --
Change in policy loans (1,470) (1,750) (841)
--------- ----------- -----------
Net cash used in investing activities (448,635) (564,696) (1,209,263)
--------- ----------- -----------
CASH FLOWS FROM FINANCING ACTIVITIES
Capital contribution -- 20,000 64,213
Contractholder fund deposits 793,233 878,614 1,385,364
Contractholder fund withdrawals (516,889) (478,782) (331,764)
--------- ----------- -----------
Net cash provided by financing activities 276,344 419,832 1,117,813
--------- ----------- -----------
NET INCREASE (DECREASE) IN CASH 3,272 (4,806) (2,107)
CASH AT BEGINNING OF YEAR 3,818 8,624 10,731
--------- ----------- -----------
CASH AT END OF YEAR $ 7,090 $ 3,818 $ 8,624
========= =========== ===========
</Table>
See notes to financial statements.
36
<Page>
NOTES TO FINANCIAL STATEMENTS
1. GENERAL
BASIS OF PRESENTATION
The accompanying financial statements include the accounts of Allstate Life
Insurance Company of New York (the "Company"), a wholly owned subsidiary of
Allstate Life Insurance Company ("ALIC"), which is wholly owned by Allstate
Insurance Company ("AIC"), a wholly owned subsidiary of The Allstate Corporation
(the "Corporation"). These financial statements have been prepared in conformity
with accounting principles generally accepted in the United States of America
("GAAP"). Management has identified the Company as a single segment entity.
To conform to the current year presentation, certain amounts in the prior
years' financial statements and notes have been reclassified.
The preparation of financial statements in conformity with GAAP requires
management to make estimates and assumptions that affect the amounts reported in
the financial statements and accompanying notes. Actual results could differ
from those estimates.
NATURE OF OPERATIONS
The Company sells life insurance, retirement, investment and supplemental
accident and health insurance products to individual customers. The principal
products are traditional, interest-sensitive and variable life insurance,
supplemental accident and health insurance, and deferred and immediate fixed
annuities.
The Company is authorized to sell life insurance and retirement products in
the state of New York. The Company distributes its products to individuals
through several distribution channels, including Allstate exclusive
agencies, independent agents (including master brokerage agencies and workplace
enrolling agents), financial services firms, such as broker/dealers and
specialized structured settlement brokers. Although the Company currently
benefits from agreements with financial services entities that market and
distribute its products, change in control of these non-affiliated entities
could negatively impact the Company's sales.
The Company monitors economic and regulatory developments that have the
potential to impact its business. The ability of banks to affiliate with
insurers may have a material adverse effect on all of the Company's product
lines by substantially increasing the number, size and financial strength of
potential competitors. Furthermore, federal and state laws and regulations
affect the taxation of insurance companies and life insurance and annuity
products. Congress and various state legislatures have considered proposals
that, if enacted, could impose a greater tax burden on the Company or could have
an adverse impact on the tax treatment of some insurance products offered by the
Company, including favorable policyholder tax treatment currently applicable to
life insurance and annuities. Legislation that reduced the federal income tax
rates applicable to certain dividends and capital gains realized by individuals,
or other proposals, if adopted, that reduce the taxation, or permit the
establishment, of certain products or investments that may compete with life
insurance or annuities could have an adverse effect on the Company's financial
position or ability to sell such products and could result in the surrender of
some existing contracts and policies. In addition, changes in the federal estate
tax laws could negatively affect the demand for the types of life insurance used
in estate planning.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
INVESTMENTS
Fixed income securities include bonds, commercial mortgage-backed,
asset-backed and mortgage-backed securities, and redeemable preferred stocks.
Fixed income securities may be sold prior to their contractual maturity
("available for sale") and are carried at fair value. The fair value of publicly
traded fixed income securities is based upon independent market quotations. The
fair value of non-publicly traded securities is based on either widely accepted
pricing valuation models which use internally developed ratings and independent
third party data (e.g., term structures of interest rates and current publicly
traded bond prices) as inputs or independent third party pricing sources. The
valuation models use security specific information such as ratings, industry,
coupon, and maturity along with third party data and publicly traded bond prices
to determine security specific spreads. These spreads are then adjusted for
illiquidity based on historical analysis and broker surveys. The difference
between amortized cost and fair value, net of deferred income taxes, certain
life and annuity deferred policy acquisition costs, certain deferred sales
inducement costs, and certain reserves for life-contingent contract benefits,
are reflected as a component of accumulated other comprehensive income. Cash
received from calls, principal payments and make-whole payments is reflected as
a component of proceeds from sales. Cash received from maturities and pay-downs
is reflected as a component of investment collections.
37
<Page>
Mortgage loans are carried at outstanding principal balances, net of
unamortized premium or discount and valuation allowances, if any. Valuation
allowances are established for impaired loans when it is probable that
contractual principal and interest will not be collected. Valuation allowances
for impaired loans reduce the carrying value to the fair value of the collateral
or the present value of the loan's expected future repayment cash flows
discounted at the loan's original effective interest rate.
Short-term investments are carried at cost or amortized cost that
approximates fair value, and include the investment of collateral received in
connection with securities lending business activities. For these transactions,
the Company records an offsetting liability in other liabilities and accrued
expenses for the Company's obligation to return the collateral or funds
received. We also purchase securities under agreements to resell.
Policy loans are carried at the unpaid principle balances. Other
investments consist primarily of derivative financial instruments.
Investment income consists primarily of interest and is recognized on an
accrual basis. Interest income on mortgage-backed, commercial mortgage-backed
and asset-backed securities is determined using the effective yield method,
considering estimated principal repayments when applicable. Accrual of income is
suspended for fixed income securities and mortgage loans that are in default or
when the receipt of interest payments is in doubt.
Realized capital gains and losses include gains and losses on investment
dispositions, write-downs in value due to other-than-temporary declines in fair
value and changes in the fair value of certain derivatives including related
periodic and final settlements. Dispositions include sales, losses recognized in
anticipation of dispositions and other transactions such as calls and
prepayments. Realized capital gains and losses on investment dispositions are
determined on a specific identification basis.
The Company recognizes other-than-temporary impairment losses on fixed
income securities when the decline in fair value is deemed other-than-temporary
(see Note 6).
DERIVATIVE AND EMBEDDED DERIVATIVE FINANCIAL INSTRUMENTS
Derivative financial instruments include foreign currency swaps, interest
rate caps, interest rate futures, and re-investment related and equity market
risk transfer reinsurance agreements with ALIC that meet the accounting
definition of a derivative (see Note 5). Foreign currency swaps involve the
future exchange or delivery of foreign currency on terms negotiated at the
inception of the contract. Interest rate cap agreements give the holder the
right to receive at a future date, the amount, if any, by which a specified
market interest rate exceeds the fixed cap, applied to a notional amount.
Interest rate futures are defined as commitments to buy or sell designated
financial instruments based on specified prices or yields. Derivatives that are
required to be separated from the host instrument and accounted for as
derivative financial instruments ("subject to bifurcation") are embedded in
certain variable life and annuity contracts.
All derivatives are accounted for on a fair value basis and reported as
other investments, reinsurance recoverables, other assets, other liabilities and
accrued expenses or contractholder funds. Embedded derivative instruments
subject to bifurcation are also accounted for on a fair value basis and are
reported together with the host contracts. The change in the fair value of
derivatives embedded in liabilities and subject to bifurcation is reported in
contract benefits or realized capital gains and losses.
When derivatives meet specific criteria, they may be designated as
accounting hedges and accounted for as fair value, cash flow, foreign currency
fair value or foreign currency cash flow hedges. The hedged item may be either
all or a specific portion of a recognized asset, liability or an unrecognized
firm commitment attributable to a particular risk. At the inception of the
hedge, the Company formally documents the hedging relationship and risk
management objective and strategy. The documentation identifies the hedging
instrument, the hedged item, the nature of the risk being hedged and the
methodology used to assess the effectiveness of the hedging instrument in
offsetting the exposure to changes in the hedged item's fair value attributable
to the hedged risk, or in the case of a cash flow hedge, the exposure to changes
in the hedged item's or transaction's variability in cash flows attributable to
the hedged risk. The Company does not exclude any component of the change in
fair value of the hedging instrument from the effectiveness assessment. At each
reporting date, the Company confirms that the hedging instrument continues to be
highly effective in offsetting the hedged risk. Ineffectiveness in fair value
hedges and cash flow hedges is reported in realized capital gains and losses.
CASH FLOW HEDGES The Company designates certain of its foreign currency
swap contracts as cash flow hedges when the hedging instrument is highly
effective in offsetting the exposure of variations in cash flows for the hedged
risk that could affect net income. The Company's cash flow exposure may be
associated with an existing asset, liability, or a forecasted transaction.
Anticipated transactions must be probable of occurrence and their significant
terms and specific characteristics must be identified.
38
<Page>
For hedging instruments used in cash flow hedges, the changes in fair value
of the derivatives are reported in accumulated other comprehensive income.
Amounts are reclassified to net investment income or realized capital gains and
losses as the hedged transaction affects net income or when the forecasted
transaction affects net income. Accrued periodic settlements on derivatives used
in cash flow hedges are reported in net investment income. The amount reported
in accumulated other comprehensive income for a hedged transaction is limited to
the lesser of the cumulative gain or loss on the derivative less the amount
reclassified to net income; or the cumulative gain or loss on the derivative
needed to offset the cumulative change in the expected future cash flows on the
hedged transaction from inception of the hedge less the derivative gain or loss
previously reclassified from accumulated other comprehensive income to net
income. If the Company expects at any time that the loss reported in accumulated
other comprehensive income would lead to a net loss on the combination of the
hedging instrument and the hedged transaction which may not be recoverable, a
loss is recognized immediately in realized capital gains and losses. If an
impairment loss is recognized on an asset or an additional obligation is
incurred on a liability involved in a hedge transaction, any offsetting gain in
accumulated other comprehensive income is reclassified and reported together
with the impairment loss or recognition of the obligation.
TERMINATION OF HEDGE ACCOUNTING If, subsequent to entering into a hedge
transaction, the derivative becomes ineffective (including if the hedged item is
sold or otherwise extinguished, the occurrence of a hedged forecasted
transaction is no longer probable, or the hedged asset becomes
other-than-temporarily impaired), the Company may terminate the derivative
position. The Company may also terminate derivative instruments or redesignate
them as non-hedge as a result of other events or circumstances. If the
derivative financial instrument is not terminated when a fair value hedge is no
longer effective, the future gains and losses recognized on the derivative are
reported in realized capital gains and losses. When a fair value hedge is no
longer effective, is redesignated as a non-hedge, or when the derivative has
been terminated, the fair value gain or loss on the hedged asset, liability or
portion thereof used to adjust the book value of the asset, liability or portion
thereof, which has already been recognized in income while the hedge was in
place, is amortized over the remaining life of the hedged asset, liability or
portion thereof to net investment income or interest credited to contractholder
funds beginning in the period that hedge accounting is no longer applied. If the
hedged item of a fair value hedge is an asset, which has become
other-than-temporarily impaired, the adjustment made to the book value of the
asset is subject to the accounting policies applied to other-than-temporarily
impaired assets. When a derivative financial instrument used in a cash flow
hedge of an existing asset or liability is no longer effective or is terminated,
the gain or loss recognized on the derivative is reclassified from accumulated
other comprehensive income to net income as the hedged risk impacts net income,
beginning in the period hedge accounting is no longer applied or the derivative
instrument is terminated. If the derivative financial instrument is not
terminated when a cash flow hedge is no longer effective, the future gains and
losses recognized on the derivative are reported in realized capital gains and
losses. When a derivative financial instrument used in a cash flow hedge of a
forecasted transaction is terminated because the forecasted transaction is no
longer probable, the gain or loss recognized on the derivative is immediately
reclassified from accumulated other comprehensive income to realized capital
gains and losses in the period that hedge accounting is no longer applied. If
the cash flow hedge is no longer effective, the gain or loss recognized on the
derivative is reclassified from accumulated other comprehensive income to net
income as the remaining hedged item affects net income.
NON-HEDGE DERIVATIVE FINANCIAL INSTRUMENTS The Company also has certain
derivatives that are used in interest rate and equity price risk management
strategies for which hedge accounting is not applied. These derivatives consist
of interest rate caps, financial futures contracts, and re-investment related
and equity market risk transfer reinsurance agreements with ALIC that meet the
accounting definition of a derivative.
Based upon the type of derivative instrument and strategy, the income
statement effects of these derivatives are reported in a single line item, with
the results of the associated risk. Therefore, the derivatives' fair value gains
and losses and accrued periodic settlements are recognized together in one of
the following during the reporting period: realized capital gains and losses or
contract benefits. Cash flows from embedded derivatives requiring bifurcation
and derivatives receiving hedge accounting are reported consistently with the
host contracts and hedged risks respectively within the Statements of Cash
Flows. Cash flows from other derivatives are reported in cash flows from
investing activities within the Statements of Cash Flows.
39
<Page>
SECURITIES LOANED
The Company's business activities include securities lending transactions,
which are used primarily to generate net investment income. These transactions
are short-term in nature (usually 30 days or less).
The Company receives collateral for securities loaned in an amount
generally equal to 102% of the fair value of securities and records the related
obligations to return the collateral in other liabilities and accrued expenses.
The carrying value of these obligations approximates fair value because of their
relatively short-term nature. The Company monitors the market value of
securities loaned on a daily basis and obtains additional collateral as
necessary under the terms of the agreements to mitigate counterparty credit
risk. The Company maintains the right and ability to redeem the securities
loaned on short notice. Substantially all of the Company's securities loaned are
placed with large brokerage firms.
RECOGNITION OF PREMIUM REVENUES AND CONTRACT CHARGES, AND RELATED BENEFITS AND
INTEREST CREDITED
Traditional life insurance products consist principally of products with
fixed and guaranteed premiums and benefits, primarily term and whole life
insurance products. Premiums from these products are recognized as revenue when
due from policyholders. Benefits are recognized in relation to such revenue so
as to result in the recognition of profits over the life of the policy and are
reflected in contract benefits.
Immediate annuities with life contingencies, including certain structured
settlement annuities, provide insurance protection over a period that extends
beyond the period during which premiums are collected. Premiums from these
products are recognized as revenue when received at the inception of the
contract. Benefits and expenses are recognized in relation to such revenue such
that profits are recognized over the lives of the contracts.
Interest-sensitive life contracts, such as universal life and single
premium life, are insurance contracts whose terms are not fixed and guaranteed.
The terms that may be changed include premiums paid by the contractholder,
interest credited to the contractholder account balance and any amounts assessed
against the contractholder account balance. Premiums from these contracts are
reported as contractholder fund deposits. Contract charges consist of fees
assessed against the contractholder account balance for cost of insurance
(mortality risk), contract administration and early surrender. These revenues
are recognized when assessed against the contractholder account balance.
Contract benefits include life-contingent benefit payments in excess of the
contractholder account balance.
Contracts that do not subject the Company to significant risk arising from
mortality or morbidity are referred to as investment contracts. Fixed annuities,
including market value adjusted annuities and immediate annuities without life
contingencies are considered investment contracts. Consideration received for
such contracts is reported as contractholder fund deposits. Contract charges for
investment contracts consist of fees assessed against the contractholder account
balance for maintenance, administration, and surrender of the contract prior to
contractually specified dates, and are recognized when assessed against the
contractholder account balance.
Interest credited to contractholder funds represents interest accrued or
paid on interest-sensitive life contracts and investment contracts. Crediting
rates for certain fixed annuities and interest-sensitive life contracts are
adjusted periodically by the Company to reflect current market conditions
subject to contractually guaranteed minimum rates. Pursuant to the adoption of
Statement of Position 03-1, "Accounting and Reporting by Insurance Enterprises
for Certain Nontraditional Long-Duration Contracts and for Separate Accounts"
("SOP 03-1") in 2004, interest credited also includes amortization of deferred
sales inducement ("DSI") expenses. DSI is amortized into interest credited using
the same method used to amortize deferred policy acquisition costs ("DAC").
Contract charges for variable life and variable annuity products consist of
fees assessed against the contractholder account values for contract
maintenance, administration, mortality, expense and early surrender. Contract
benefits incurred include guaranteed minimum death, income, withdrawal and
accumulation benefits. Subsequent to our disposal of all of our variable annuity
business through reinsurance agreements with Prudential in 2006 (see Note 3),
the contract charges and contract benefits related thereto are reported net of
reinsurance ceded.
40
<Page>
DEFERRED POLICY ACQUISITION AND SALES INDUCEMENT COSTS
Costs that vary with and are primarily related to acquiring life insurance
and investment contracts are deferred and recorded as DAC. These costs are
principally agents' and brokers' remuneration and certain underwriting costs.
DSI costs, which are deferred and recorded as other assets, relate to sales
inducements offered on sales to new customers, principally on annuities and
primarily in the form of additional credits to the customer's account value or
enhancements to interest credited for a specified period, which are beyond
amounts currently being credited to existing contracts. All other acquisition
costs are expensed as incurred and included in operating costs and expenses on
the Statements of Operations and Comprehensive Income. DAC is amortized to
income and included in amortization of deferred policy acquisition costs on the
Statements of Operations and Comprehensive Income. DSI is reported in other
assets and amortized to income using the same methodology and assumptions as DAC
and is included in interest credited to contractholder funds on the Statements
of Operations and Comprehensive Income. DAC and DSI are periodically reviewed
for recoverability and written down if necessary.
For traditional life insurance and other premium paying contracts, DAC is
amortized in proportion to the estimated revenues on such business. Assumptions
used in amortization of DAC and reserve calculations are determined based upon
conditions as of the date of policy issuance and are generally not revised
during the life of the policy. Any deviations from projected business in force
resulting from actual policy terminations differing from expected levels and any
estimated premium deficiencies change the rate of amortization in the period
such events occur. Generally, the amortization period for these contracts
approximates the estimated lives of the policies.
For internal exchanges of traditional life insurance, the unamortized
balance of costs previously deferred under the original contracts are charged to
income. The new costs associated with the exchange are deferred and amortized to
income.
For interest-sensitive life, annuities and other investment contracts, DAC
and DSI are amortized in proportion to the incidence of the total present value
of gross profits, which includes both actual historical gross profits ("AGP")
and estimated future gross profits ("EGP") earned over the estimated lives of
the contracts. Actual amortization periods range from 15-30 years; however,
incorporating estimates of customer surrender rates, partial withdrawals and
deaths generally result in the majority of deferred costs being amortized over
the surrender charge period. The rate of amortization during this term is
matched to the pattern of total gross profits. AGP and EGP consist of the
following components: benefit margins, primarily from mortality; investment
margin including realized capital gains and losses; and contract administration,
surrender and other contract charges, less maintenance expenses.
Changes in the amount or timing of EGP result in adjustments to the
cumulative amortization of DAC and DSI. All such adjustments are reflected in
the current results of operations.
The Company performs quarterly reviews of DAC and DSI recoverability for
interest-sensitive life, annuities and investment contracts in the aggregate
using current assumptions. If a change in the amount of EGP is significant, it
could result in the unamortized DAC and DSI not being recoverable, resulting in
a charge which is included as a component of amortization of deferred policy
acquisition costs or interest credited to contractholder funds, respectively, on
the Statements of Operations and Comprehensive Income.
Any amortization of DAC or DSI that would result from changes in unrealized
gains or losses had those gains or losses actually been realized during the
reporting period is recorded net of tax in other comprehensive income.
REINSURANCE
In the normal course of business, the Company seeks to limit aggregate and
single exposure to losses on large risks by purchasing reinsurance from
reinsurers (see Note 9). The Company has also used reinsurance to effect the
disposition of its variable annuity business (see Note 3). The amounts reported
in the Statements of Financial Position as reinsurance recoverables include
amounts billed to reinsurers on losses paid as well as estimates of amounts
expected to be recovered from reinsurers on insurance liabilities and
contractholder funds that have not yet been paid. Reinsurance recoverables on
unpaid losses are estimated based upon assumptions consistent with those used in
establishing the liabilities related to the underlying reinsured contract.
Insurance liabilities are reported gross of reinsurance recoverables.
Reinsurance premiums are generally reflected in income in a manner consistent
with the recognition of premiums on the reinsured contracts. Reinsurance does
not extinguish the Company's primary liability under the policies written.
Therefore, the Company regularly evaluates the financial condition of the
reinsurers and establishes allowances for uncollectible reinsurance recoverables
as appropriate.
41
<Page>
The Company has a reinsurance treaty with ALIC through which it cedes
primarily re-investment related risk on its structured settlement annuities. The
terms of the treaty meet the accounting definition of a derivative under
Statement of Financial Accounting Standards ("SFAS") No. 133 "Accounting for
Derivative Instruments and Hedging Activities". Accordingly, the treaty is
recorded in the Statement of Financial Position at fair value. Changes in the
fair value of the treaty and premiums paid to ALIC are recognized in realized
capital gains and losses (see Note 5).
Prior to the Company's disposition of the variable annuity business through
reinsurance with Prudential effective June 1, 2006 (see Note 3), the Company had
a reinsurance treaty through which it ceded contract benefits on its guaranteed
minimum accumulation benefits ("GMABs"), guaranteed minimum withdrawal benefits
("GMWBs") and certain guaranteed minimum death benefits ("GMDBs") to ALIC. The
terms of the treaty met the accounting definition of a derivative under
Statement of Financial Accounting Standards ("SFAS") No. 133 "Accounting for
Derivative Instruments and Hedging Activities". Accordingly, the treaty was
recorded in the Statement of Financial Position at fair value. Changes in the
fair value of the treaty were recognized in contract benefits. The reinsurance
treaty was recaptured in 2006 (see Note 5).
INCOME TAXES
The income tax provision is calculated under the liability method. Deferred
tax assets and liabilities are recorded based on the difference between the
financial statement and tax bases of assets and liabilities at the enacted tax
rates. The principal assets and liabilities giving rise to such differences are
unrealized capital gains and losses on fixed income securities, insurance
reserves and DAC. A deferred tax asset valuation allowance is established when
there is uncertainty that such assets would be realized.
RESERVE FOR LIFE-CONTINGENT CONTRACT BENEFITS
The reserve for life-contingent contract benefits, which relates to
traditional life and supplemental accident and health insurance and immediate
annuities with life contingencies, is computed on the basis of long-term
actuarial assumptions as to future investment yields, mortality, morbidity,
policy terminations and expenses (see Note 8). These assumptions, which for
traditional life insurance are applied using the net level premium method,
include provisions for adverse deviation and generally vary by such
characteristics as type of coverage, year of issue and policy duration. To the
extent that unrealized gains on fixed income securities would result in a
premium deficiency had those gains actually been realized, the related increase
in reserves for certain immediate annuities with life contingencies is recorded
net of tax as a reduction of the unrealized net capital gains included in
accumulated other comprehensive income.
CONTRACTHOLDER FUNDS
Contractholder funds represent interest-bearing liabilities arising from
the sale of products, such as interest-sensitive life, fixed annuities, and
variable annuity and life deposits allocated to fixed accounts. Contractholder
funds are comprised primarily of deposits received and interest credited to the
benefit of the contractholder less surrenders and withdrawals, mortality charges
and administrative expenses (see Note 8). Contractholder funds also include
reserves for secondary guarantees on variable annuities, which were reinsured to
Prudential in 2006.
SEPARATE ACCOUNTS
Separate accounts assets and liabilities are carried at fair value. The
assets of the separate accounts are legally segregated and available only to
settle separate account contract obligations. Separate accounts liabilities
represent the contractholders' claims to the related assets. Investment income
and realized capital gains and losses of the separate accounts accrue directly
to the contractholders and therefore, are not included in the Company's
Statements of Operations and Comprehensive Income. Deposits to, and surrenders
and withdrawals from, the separate accounts are not included in cash flows.
Absent any contract provision wherein the Company provides a guarantee,
which for variable annuities was reinsured to Prudential in 2006, variable
annuity and variable life insurance contractholders bear the investment risk
that the separate accounts' funds may not meet their stated investment
objectives.
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<Page>
OFF-BALANCE-SHEET FINANCIAL INSTRUMENTS
Commitments to extend mortgage loans and purchase private placement
securities have off-balance-sheet risk because their contractual amounts are not
recorded in the Company's Statements of Financial Position (see Note 7).
ADOPTED ACCOUNTING STANDARDS
FINANCIAL ACCOUNTING STANDARDS BOARD STAFF POSITION NO. FAS 115-1, "THE MEANING
OF OTHER-THAN-TEMPORARY IMPAIRMENT AND ITS APPLICATION TO CERTAIN INVESTMENTS"
("FSP FAS 115-1")
The Company adopted Financial Accounting Standards Board ("FASB") FSP FAS
115-1 as of January 1, 2006. FSP FAS 115-1 nullifies the guidance in paragraphs
10-18 of Emerging Issues Task Force Issue No. 03-1 ("EITF Issue 03-1"), "The
Meaning of Other-Than-Temporary Impairment and Its Application to Certain
Investments" and references existing other-than-temporary impairment guidance.
FSP FAS 115-1 clarifies that an investor should recognize an impairment loss no
later than when the impairment is deemed other-than-temporary, even if a
decision to sell the security has not been made, and also provides guidance on
the subsequent accounting for income recognition on an impaired debt security.
The adoption of FSP FAS 115-1 was required on a prospective basis and did not
have a material effect on the results of operations or financial position of the
Company.
STATEMENT OF FINANCIAL ACCOUNTING STANDARDS NO. 154, "ACCOUNTING CHANGES AND
ERROR CORRECTIONS" ("SFAS NO. 154")
The Company adopted SFAS No. 154 on January 1, 2006. SFAS No. 154 replaces
Accounting Principles Board ("APB") Opinion No. 20, "Accounting Changes", and
SFAS No. 3, "Reporting Accounting Changes in Interim Financial Statements". SFAS
No. 154 requires retrospective application to prior periods' financial
statements for changes in accounting principle, unless determination of either
the period specific effects or the cumulative effect of the change is
impracticable or otherwise promulgated. The Company had no accounting changes or
error corrections affected by the new standard.
SECURITIES AND EXCHANGE COMMISSION ("SEC") STAFF ACCOUNTING BULLETIN NO. 108,
"CONSIDERING THE EFFECTS OF PRIOR YEAR MISSTATEMENTS WHEN QUANTIFYING
MISSTATEMENTS IN CURRENT YEAR FINANCIAL STATEMENTS" ("SAB 108")
In September 2006, the SEC issued SAB 108 in order to eliminate the
diversity of practice in the process by which misstatements are quantified for
purposes of assessing materiality on the financial statements. SAB 108 is
intended to eliminate the potential for the build up of improper amounts on the
balance sheet due to the limitations of certain methods of materiality
assessment utilized in current practice. SAB 108 establishes a single
quantification framework wherein the significance measurement is based on the
effects of the misstatements on each of the financial statements as well as the
related financial statement disclosures. If a company's existing methods for
assessing the materiality of misstatements are not in compliance with the
provisions of SAB 108, the initial application of the provisions may be adopted
by restating prior period financial statements under certain circumstances or
otherwise by recording the cumulative effect of initially applying the
provisions of SAB 108 as adjustments to the carrying values of assets and
liabilities as of January 1, 2006 with an offsetting adjustment recorded to the
opening balance of retained earnings. The provisions of SAB 108 must be applied
no later than the annual financial statements issued for the first fiscal year
ending after November 15, 2006. The Company's adoption of SAB 108 in the fourth
quarter of 2006 for the fiscal year then ended did not have any effect on its
results of operations or financial position.
STATEMENT OF POSITION 03-1, "ACCOUNTING AND REPORTING BY INSURANCE ENTERPRISES
FOR CERTAIN NONTRADITIONAL LONG-DURATION CONTRACTS AND FOR SEPARATE ACCOUNTS"
("SOP 03-1")
On January 1, 2004, the Company adopted SOP 03-1. The major provisions of
the SOP that affected the Company at the time of adoption are listed below. The
provisions were primarily applicable to the business that was subsequently
reinsured on June 1, 2006 (see Note 3 for more information):
- - Establishment of reserves primarily related to death benefit and income
benefit guarantees provided under variable annuity contracts;
- - Deferral of sales inducements that meet certain criteria, and amortization
using the same method used for DAC.
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The cumulative effect of the change in accounting principle from
implementing SOP 03-1 was a loss of $7.6 million, after-tax ($11.7 million,
pre-tax). It was comprised of an increase in benefit reserves (primarily for
variable annuity contracts) of $942 thousand, pre-tax, and a reduction in DAC
and DSI of $10.7 million, pre-tax.
The SOP required consideration of a range of potential results to estimate
the cost of variable annuity death benefits and income benefits, which generally
necessitated the use of stochastic modeling techniques. To maintain consistency
with the assumptions used in the establishment of reserves for variable annuity
guarantees, the Company utilized the results of this stochastic modeling to
estimate expected gross profits, which form the basis for determining the
amortization of DAC and DSI. This new modeling approach resulted in a lower
estimate of expected gross profits, and therefore resulted in a write-down of
DAC and DSI.
DSI and related amortization is classified within the Statements of
Financial Position and Operations and Comprehensive Income as other assets and
interest credited to contractholder funds, respectively (see Note 10).
AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS ("AICPA") TECHNICAL PRACTICE
AID ("TPA") RE. SOP 03-1
In September 2004, the staff of the AICPA, aided by industry experts,
issued a set of technical questions and answers on financial accounting and
reporting issues related to SOP 03-1. The TPA addresses a number of issues
related to SOP 03-1 including when it was necessary to establish a liability in
addition to the account balance for certain contracts such as single premium and
universal life that meet the definition of an insurance contract and have
amounts assessed against the contractholder in a manner that is expected to
result in profits in earlier years and losses in subsequent years from the
insurance benefit function. The impact of adopting the provisions of the TPAs
did not have a material effect on the results of operations or financial
position of the Company.
PENDING ACCOUNTING STANDARDS
STATEMENT OF POSITION 05-1, "ACCOUNTING BY INSURANCE ENTERPRISES FOR DEFERRED
ACQUISITION COSTS IN CONNECTION WITH MODIFICATIONS OR EXCHANGES OF INSURANCE
CONTRACTS" ("SOP 05-1")
In October 2005, the American Institute of Certified Public Accountants
("AICPA") issued SOP 05-1. SOP 05-1 provides accounting guidance for deferred
policy acquisition costs associated with internal replacements of insurance and
investment contracts other than those already described in SFAS No. 97,
"Accounting and Reporting by Insurance Enterprises for Certain Long-Duration
Contracts and for Realized Gains and Losses from the Sale of Investments". SOP
05-1 defines an internal replacement as a modification in product benefits,
features, rights or coverages that occurs by the exchange of a contract for a
new contract, or by amendment, endorsement or rider to a contract, or by the
election of a feature or coverage within a contract. In February 2007, the AICPA
issued a set of twelve TPAs that provide interpretive guidance to be utilized,
if applicable, at the date of adoption. The provisions of SOP 05-1 are effective
for internal replacements occurring in fiscal years beginning after December 15,
2006. Based on the issued standard and the TPAs released in February 2007, the
Company's estimated impact of adoption will not have a material effect on its
results of operations or financial position.
SFAS NO. 155, "ACCOUNTING FOR CERTAIN HYBRID FINANCIAL INSTRUMENTS - AN
AMENDMENT OF FASB STATEMENTS NO. 133 AND 140" ("SFAS NO. 155")
In February 2006, the FASB issued SFAS No. 155, which permits the fair
value remeasurement at the date of adoption of any hybrid financial instrument
that contains an embedded derivative that otherwise would require bifurcation
under paragraph 12 or 13 of SFAS No. 133, "Accounting for Derivative Instruments
and Hedging Activities"; clarifies which interest-only strips and principal-only
strips are not subject to the requirements of SFAS No. 133; establishes a
requirement to evaluate interests in securitized financial assets to identify
interests that are freestanding derivatives or hybrid financial instruments that
contain embedded derivatives requiring bifurcation; and clarifies that
concentrations of credit risk in the form of subordination are not embedded
derivatives. The provisions of SFAS No. 155 are effective for all financial
instruments acquired, issued or subject to a remeasurement event occurring after
the beginning of the first fiscal year that begins after September 15, 2006. The
Company elected not to remeasure its existing hybrid financial instruments at
the date of adoption that contained embedded derivatives requiring bifurcation
pursuant to paragraph 12 or 13 of SFAS No. 133. The adoption of SFAS No. 155 is
not expected to have a material effect on the results of operations or financial
position of the Company.
44
<Page>
FINANCIAL ACCOUNTING STANDARDS BOARD INTERPRETATION NO. 48, "ACCOUNTING FOR
UNCERTAINTY IN INCOME TAXES", ("FIN 48")
In July 2006, the FASB issued FIN 48, which clarifies the accounting for
uncertainty in income taxes recognized in an entity's financial statements in
accordance with FASB Statement No. 109, "Accounting for Income Taxes". FIN 48
requires an entity to recognize the benefit of tax positions only when it is
more likely than not, based on the position's technical merits, that the
position would be sustained upon examination by the respective taxing
authorities. The tax benefit is measured as the largest benefit that is more
than fifty-percent likely of being realized upon final settlement with the
respective taxing authorities. FIN 48 is effective for fiscal years beginning
after December 15, 2006. FIN 48 will not have a material effect on the results
of operations or financial position of the Company.
SFAS NO. 157, "FAIR VALUE MEASUREMENTS" ("SFAS NO. 157")
In September 2006, the FASB issued SFAS No. 157 which redefines fair value,
establishes a framework for measuring fair value in generally accepted
accounting principles ("GAAP"), and expands disclosures about fair value
measurements. SFAS No. 157 applies where other accounting pronouncements require
or permit fair value measurements. SFAS No. 157 is effective for fiscal years
beginning after November 15, 2007. The effects of adoption will be determined by
the types of instruments carried at fair value in the Company's financial
statements at the time of adoption as well as the method utilized to determine
their fair values prior to adoption. Based on the Company's current use of fair
value measurements, SFAS No. 157 is not expected to have a material effect on
the results of operations or financial position of the Company.
SFAS NO. 159, "THE FAIR VALUE OPTION FOR FINANCIAL ASSETS AND FINANCIAL
LIABILITIES" ("SFAS NO. 159")
In February 2007, the FASB issued SFAS No. 159 which provides reporting
entities an option to report selected financial assets, including investment
securities designated as available for sale, and liabilities, including most
insurance contracts, at fair value. SFAS No. 159 establishes presentation and
disclosure requirements designed to facilitate comparisons between companies
that choose different measurement attributes for similar types of assets and
liabilities. The standard also requires additional information to aid financial
statement users' understanding of a reporting entity's choice to use fair value
on its earnings and also requires entities to display on the face of the balance
sheet the fair value of those assets and liabilities for which the reporting
entity has chosen to measure at fair value. SFAS No. 159 is effective as of the
beginning of a reporting entity's first fiscal year beginning after November 15,
2007. Early adoption is permitted as of the beginning of the previous fiscal
year provided the entity makes that choice in the first 120 days of that fiscal
year and also elects to apply the provisions of SFAS No. 157. Because
application of the standard is optional, any impacts are limited to those
financial assets and liabilities to which SFAS No. 159 would be applied, which
has yet to be determined, as is any decision concerning the early adoption of
the standard.
3. DISPOSITION
On June 1, 2006, the Company, its parent ALIC, and the Corporation,
completed the disposal of its variable annuity business pursuant to a definitive
agreement (the "Agreement") with Prudential Financial, Inc. and its subsidiary,
The Prudential Insurance Company of America (collectively "Prudential"). The
disposal was effected through a combination of coinsurance and modified
coinsurance reinsurance agreements (the "Reinsurance Agreements").
As a result of the modified coinsurance reinsurance, the separate account
assets remain on the Company's Statements of Financial Position, but the related
results of operations are fully reinsured to Prudential beginning on June 1,
2006 and presented net of reinsurance on the Statements of Operations and
Comprehensive Income. In contrast, $440.0 million of assets supporting general
account liabilities have been transferred to Prudential, net of consideration,
under the coinsurance reinsurance provisions. The general account liabilities,
however, remain on the Statements of Financial Position with a corresponding
reinsurance recoverable. For purposes of presentation in the Statements of Cash
Flows, the Company treated the reinsurance of its variable annuity business as a
disposition of operations, consistent with the substance of the transaction
which was the disposition of a block of business accomplished through
reinsurance. Accordingly, the net consideration transferred to Prudential of
$388.4 million (computed as $440.0 million of general account insurance
liabilities transferred to Prudential on the closing date less consideration of
$51.6 million) and the costs of executing the transaction of $1.2 million,
pretax, were classified as a disposition of operations in the cash flows from
investing activities section of the Statements of Cash Flows. The Reinsurance
Agreements do not extinguish the Company's primary liability under the variable
annuity contracts.
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Under the Agreement, the Company, ALIC and the Corporation have indemnified
Prudential for certain pre-closing contingent liabilities (including
extra-contractual liabilities of the Company and ALIC and liabilities
specifically excluded from the transaction) that the Company and ALIC have
agreed to retain. In addition, the Company, ALIC and the Corporation will each
indemnify Prudential for certain post-closing liabilities that may arise from
the acts of the Company and ALIC, and their agents, including in connection with
the Company's and ALIC's provision of transition services.
The terms of the Agreement give Prudential the right to be the exclusive
provider of its variable annuity products through the Allstate proprietary
agency force for three years and a non-exclusive preferred provider for the
following two years. During a transition period, the Company and ALIC will
continue to issue new variable annuity contracts, accept additional deposits on
existing business from existing contractholders on behalf of Prudential and, for
a period of twenty-four months or less, service the reinsured business while
Prudential prepares for the migration of the business onto its servicing
platform.
Pursuant to the Agreement, the consideration was $51.6 million. The
disposal resulted in a reinsurance loss of $9.3 million, pretax, which was
included as a component of loss on disposition of operations on the Statements
of Operations and Comprehensive Income along with other transactional expenses
incurred. The total loss for this transaction totaled $10.7 million, pretax
($7.0 million, after-tax). DAC and DSI were reduced by $79.7 million and $6.2
million, respectively, as of the effective date of the transaction for balances
related to the variable annuity business subject to the Reinsurance Agreements.
The separate account balances related to the modified coinsurance
reinsurance were $1.01 billion as of December 31, 2006. Separate account
balances totaling approximately $2.7 million at December 31, 2006 related to the
variable life business retained by the Company.
In the five months of 2006 prior to its disposition, the Company's variable
annuity business generated approximately $7.5 million in contract charges. In
2005 and 2004, the Company's variable annuity business generated approximately
$16.7 million and $13.2 million in contract charges, respectively. The separate
account balances were $927.4 million and general account balances were $501.2
million as of December 31, 2005.
4. SUPPLEMENTAL CASH FLOW INFORMATION
Non-cash investment modifications, which reflect refinancings of fixed
income securities, totaled $5.8 million, $4.5 million and $1.7 million for the
years ended December 31, 2006, 2005 and 2004, respectively.
Liabilities for collateral received in conjunction with the Company's
securities lending business activities were $199.5 million, $149.5 million and
$133.4 million at December 31, 2006, 2005 and 2004, respectively, and are
reported as a component of other liabilities and accrued expenses in Statements
of Financial Position. The accompanying cash flows are included in cash flows
from operating activities in the Statements of Cash Flows along the activities
resulting from management of the proceeds, which for the years ended December 31
are as follows:
<Table>
<Caption>
(IN THOUSANDS) 2006 2005 2004
--------- --------- ---------
NET CHANGE IN PROCEEDS MANAGED
Net change in fixed income securities $ (10,816) $ (36,652) $ 59,856
Net change in short-term investments (39,205) 20,555 (58,735)
--------- --------- ---------
Operating cash flow (used) provided $ (50,021) $ (16,097) $ 1,121
========= ========= =========
NET CHANGE IN LIABILITIES
Liabilities for collateral and security repurchase, beginning of year $(149,465) $(133,368) $(134,489)
Liabilities for collateral and security repurchase, end of year (199,486) (149,465) (133,368)
--------- --------- ---------
Operating cash flow provided (used) $ 50,021 $ 16,097 $ (1,121)
========= ========= =========
</Table>
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5. RELATED PARTY TRANSACTIONS
BUSINESS OPERATIONS
The Company utilizes services performed by its affiliates, AIC, ALIC and
Allstate Investments LLC, and business facilities owned or leased and operated
by AIC in conducting its business activities. In addition, the Company shares
the services of employees with AIC. The Company reimburses its affiliates for
the operating expenses incurred on its behalf. The Company is charged for the
cost of these operating expenses based on the level of services provided.
Operating expenses, including compensation, retirement and other benefit
programs, allocated to the Company were $53.7 million, $53.8 million and $44.8
million in 2006, 2005 and 2004, respectively. A portion of these expenses relate
to the acquisition of business and is deferred and amortized into income.
STRUCTURED SETTLEMENT ANNUITIES
The Company issued $15.0 million, $16.0 million and $19.4 million of
structured settlement annuities, a type of immediate annuity, in 2006, 2005 and
2004, respectively, at prices based upon interest rates in effect at the time of
issuance, to fund structured settlement annuities in matters involving AIC. Of
these amounts, $1.5 million, $2.0 million and $5.4 million relate to structured
settlement annuities with life contingencies and are included in premium income
in 2006, 2005 and 2004, respectively. In most cases, these annuities were issued
under a "qualified assignment," whereby prior to July 1, 2001 Allstate
Settlement Corporation ("ASC"), and on and subsequent to July 1, 2001 Allstate
Assignment Corporation ("AAC"), both wholly owned subsidiaries of ALIC,
purchased annuities from the Company and assumed AIC's obligation to make future
payments.
Reserves recorded by the Company for annuities issued to ASC and AAC,
including annuities to fund structured settlement annuities in matters involving
AIC, were $1.86 billion and $1.78 billion at December 31, 2006 and 2005,
respectively.
BROKER/DEALER AGREEMENTS
The Company has a service agreement with Allstate Distributors, L.L.C.
('ADLLC"), a broker-dealer company owned by ALIC, whereby ADLLC promotes and
markets the fixed and variable annuities sold by the Company to unaffiliated
financial services firms. In addition, ADLLC also acts as the underwriter of
variable annuities sold by the Company. In return for these services, the
Company recorded commission expense of $6.0 million, $7.1 million and $5.6
million for the years ended December 31, 2006, 2005 and 2004, respectively.
The Company receives underwriting and distribution services from Allstate
Financial Services, LLC ("AFS"), an affiliated broker/dealer company, for
certain variable annuity and variable life insurance contracts sold by Allstate
exclusive agencies. The Company incurred $1.4 million, $1.3 million and $1.4
million of commission and other distribution expenses for the years ended
December 31, 2006, 2005 and 2004, respectively.
REINSURANCE TRANSACTIONS
The Company has reinsurance agreements with unaffiliated reinsurers and
ALIC in order to limit aggregate and single exposure on large risks. A portion
of the Company's premiums and policy benefits are ceded to ALIC and reflected
net of such reinsurance in the Statements of Operations and Comprehensive
Income. Reinsurance recoverables and the related reserve for life-contingent
contract benefits and contractholder funds are reported separately in the
Statements of Financial Position. The Company continues to have primary
liability as the direct insurer for risks reinsured (see Note 9).
Additionally, the Company entered into a reinsurance treaty through which
it primarily cedes re-investment related risk on its structured settlement
annuities to ALIC. Under the terms of the treaty, the Company pays a premium to
ALIC that varies with the aggregate structured settlement annuity statutory
reserve balance. In return, ALIC guarantees that the yield on the portion of the
Company's investment portfolio that supports structured settlement annuity
liabilities will not fall below contractually determined rates. The Company
ceded premium related to structured settlement annuities to ALIC of $3.0
million, $2.9 million and $2.7 million for the years ended December 31, 2006,
2005 and 2004, respectively. At December 31, 2006 and 2005, the carrying value
of the structured settlement reinsurance treaty was $(1.9) million and $(1.5)
million, respectively, which is recorded in other assets. The premiums ceded and
changes in the fair value of the reinsurance treaty are reflected as a component
of realized capital gains and losses on the Statements of Operations and
Comprehensive income as the treaty is recorded as a derivative instrument
pursuant to the requirements of SFAS No. 133.
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Prior to the Company's disposition of the variable annuity business
through reinsurance with Prudential effective June 1, 2006 (see Note 3), the
Company had a reinsurance treaty through which it ceded contract benefits on
its GMABs, GMWBs and certain GMDBs to ALIC. The reinsurance treaty was
recaptured in 2006 and, in accordance therewith, the Company received cash in
excess of the liabilities subject to the treaty resulting in a pre-tax gain
of $3.3 million. The after-tax gain of $2.2 million was recorded as an
adjustment to retained income since the transaction was between affiliates
under common control. As of December 31, 2005, the carrying value of the
treaty, which was recorded as a component of reinsurance recoverables was
$(447) thousand.
CAPITAL CONTRIBUTION
The Company received cash capital contributions from ALIC of $20.0 million
and $64.2 million in 2005 and 2004, respectively, which were recorded as
additional capital paid-in on the Statements of Financial Position.
DEBT
The Company has an intercompany loan agreement with The Allstate
Corporation. The amount of intercompany loans available to the Company is at the
discretion of The Allstate Corporation. The maximum amount of loans The Allstate
Corporation will have outstanding to all its eligible subsidiaries at any given
point in time is limited to $1.00 billion. The Company had no amounts
outstanding under the inter-company loan agreement at December 31, 2006 and
2005. The Allstate Corporation uses commercial paper borrowings, bank lines of
credit and repurchase agreements to fund inter-company borrowings.
INCOME TAXES
The Company is a party to a federal income tax allocation agreement with
the Corporation (see Note 12).
6. INVESTMENTS
FAIR VALUES
The amortized cost, gross unrealized gains and losses, and fair value for
fixed income securities are as follows:
<Table>
<Caption>
GROSS UNREALIZED
AMORTIZED ------------------- FAIR
(IN THOUSANDS) COST GAINS LOSSES VALUE
---------- -------- -------- ----------
AT DECEMBER 31, 2006
U.S. government and agencies $ 541,877 $187,234 $ -- $ 729,111
Municipal 314,768 12,979 (4,744) 323,003
Corporate 3,214,504 125,379 (35,121) 3,304,762
Foreign government 244,544 60,614 (211) 304,947
Mortgage-backed securities 439,938 2,514 (9,256) 433,196
Commercial mortgage-backed securities 669,303 8,192 (4,316) 673,179
Asset-backed securities 107,922 1,728 (628) 109,022
Redeemable preferred stock 9,371 548 -- 9,919
---------- -------- -------- ----------
Total fixed income securities $5,542,227 $399,188 $(54,276) $5,887,139
========== ======== ======== ==========
AT DECEMBER 31, 2005
U.S. government and agencies $ 510,362 $213,421 $ -- $ 723,783
Municipal 308,219 20,193 (776) 327,636
Corporate 3,286,652 182,630 (28,020) 3,441,262
Foreign government 236,078 70,433 (176) 306,335
Mortgage-backed securities 569,712 4,050 (10,712) 563,050
Commercial mortgage-backed securities 490,985 3,999 (3,149) 491,835
Asset-backed securities 123,981 1,068 (679) 124,370
Redeemable preferred stock 9,407 1,585 -- 10,992
---------- -------- -------- ----------
Total fixed income securities $5,535,396 $497,379 $(43,512) $5,989,263
========== ======== ======== ==========
</Table>
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<Page>
SCHEDULED MATURITIES
The scheduled maturities for fixed income securities are as follows at December
31, 2006:
AMORTIZED FAIR
(IN THOUSANDS) COST VALUE
---------- ----------
Due in one year or less $ 48,495 $ 48,844
Due after one year through five years 799,478 807,453
Due after five years through ten years 1,494,665 1,564,283
Due after ten years 2,651,729 2,924,341
---------- ----------
4,994,367 5,344,921
Mortgage- and asset-backed securities 547,860 542,218
---------- ----------
Total $5,542,227 $5,887,139
========== =========
Actual maturities may differ from those scheduled as a result of
prepayments by the issuers. Because of the potential for prepayment on mortgage-
and asset-backed securities, they are not categorized by contractual maturity.
The commercial mortgage-backed securities are categorized by contractual
maturity because they generally are not subject to prepayment risk.
NET INVESTMENT INCOME
Net investment income for the years ended December 31 is as follows:
(IN THOUSANDS) 2006 2005 2004
-------- -------- --------
Fixed income securities $343,115 $330,567 $278,522
Mortgage loans 38,576 33,373 27,198
Other 14,763 6,723 4,039
-------- -------- --------
Investment income, before expense 396,454 370,663 309,759
Investment expense 23,390 14,501 7,704
-------- -------- --------
Net investment income $373,064 $356,162 $302,055
======== ======== ========
REALIZED CAPITAL GAINS AND LOSSES, AFTER-TAX
Realized capital gains and losses by security type for the years ended
December 31 are as follows:
(IN THOUSANDS) 2006 2005 2004
-------- ------- -------
Fixed income securities $(25,398) $(6,596) $(7,666)
Mortgage loans 3,572 3,000 1,480
Other (259) (1,596) (3,111)
-------- ------- -------
Realized capital gains and losses, pre-tax (22,085) (5,192) (9,297)
Income tax benefit 8,216 1,972 3,453
-------- ------- -------
Realized capital gains and losses, after-tax $(13,869) $(3,220) $(5,844)
======== ======= =======
Realized capital gains and losses by transaction type for the years ended
December 31 are as follows:
(IN THOUSANDS) 2006 2005 2004
-------- ------- -------
Write-downs $ (258) $(1,543) $(3,402)
Dispositions (1) (21,568) (2,053) (2,784)
Valuation of derivative instruments (5,429) (4,469) (5,777)
Settlement of derivative instruments 5,170 2,873 2,666
-------- ------- -------
Realized capital gains and losses, pre-tax (22,085) (5,192) (9,297)
Income tax benefit 8,216 1,972 3,453
-------- ------- -------
Realized capital gains and losses, after-tax $(13,869) $(3,220) $(5,844)
======== ======= =======
- ----------
(1) Dispositions include sales, losses recognized in anticipation of
dispositions and other transactions such as calls and prepayments. The
Company recognized losses of $16.5 million and $6.8 million in 2006 and
2005, respectively, due to a change in intent to hold impaired securities.
There were no losses recognized due to a change in intent during 2004.
Gross gains of $5.9 million, $5.8 million and $5.2 million and gross losses
of $18.8 million, $7.4 million and $13.3 million were realized on sales of fixed
income securities during 2006, 2005 and 2004, respectively.
49
<Page>
UNREALIZED NET CAPITAL GAINS AND LOSSES
Unrealized net capital gains and losses included in accumulated other
comprehensive income are as follows:
<Table>
<Caption>
GROSS UNREALIZED
FAIR ------------------- UNREALIZED
(IN THOUSANDS) VALUE GAINS LOSSES NET GAINS
---------- -------- -------- ----------
AT DECEMBER 31, 2006
Fixed income securities $5,887,139 $399,188 $(54,276) $ 344,912
Derivative instruments and other investments (892) -- (892) (892)
---------
Total 344,020
Amounts recognized for: (1)
Premium deficiency reserve (235,656)
Deferred policy acquisition and sales inducements costs 11,694
---------
Total (223,962)
Deferred income taxes (42,020)
---------
Unrealized net capital gains and losses $ 78,038
=========
</Table>
<Table>
<Caption>
GROSS UNREALIZED
FAIR ------------------- UNREALIZED
(IN THOUSANDS) VALUE GAINS LOSSES NET GAINS
---------- -------- -------- ----------
AT DECEMBER 31, 2005
Fixed income securities $5,989,263 $497,379 $(43,512) $ 453,867
Derivative instruments and other investments (154) -- (154) (154)
---------
Total 453,713
Amounts recognized for: (1)
Premium deficiency reserve (257,473)
Deferred policy acquisition and sales inducement costs 2,172
---------
Total (255,301)
Deferred income taxes (69,444)
---------
Unrealized net capital gains and losses $ 128,968
=========
</Table>
- ----------
(1) See Note 2, Summary of Significant Accounting Policies for deferred policy
acquisition and sales inducement costs and reserve for life contingent
contract benefits.
CHANGE IN UNREALIZED NET CAPITAL GAINS AND LOSSES
The change in unrealized net capital gains and losses for the years ended
December 31 is as follows:
<Table>
<Caption>
(IN THOUSANDS) 2006 2005 2004
--------- -------- --------
Fixed income securities $(108,955) $(78,803) $ 52,790
Derivative instruments and other investments (738) 566 (720)
--------- -------- --------
Total (109,693) (78,237) 52,070
Amounts recognized for:
Premium deficiency reserve 21,817 (17,063) (25,011)
Deferred policy acquisition and sales inducement
costs 9,522 54,858 (1,627)
--------- -------- --------
Total 31,339 37,795 (26,638)
Deferred income taxes 27,424 14,155 (8,901)
--------- -------- --------
(Decrease) increase in unrealized net capital gains and losses $ (50,930) $(26,287) $ 16,531
========= ======== ========
</Table>
50
<Page>
PORTFOLIO MONITORING
Inherent in the Company's evaluation of a particular security are
assumptions and estimates about the operations of the issuer and its future
earnings potential. Some of the factors considered in evaluating whether a
decline in fair value is other-than-temporary are: 1) the Company's ability and
intent to retain the investment for a period of time sufficient to allow for an
anticipated recovery in value; 2) the recoverability of principal and interest;
3) the duration and extent to which the fair value has been less than amortized
cost; 4) the financial condition, near-term and long-term prospects of the
issuer, including relevant industry conditions and trends, and implications of
rating agency actions and offering prices; and 5) the specific reasons that a
security is in a significant unrealized loss position, including market
conditions which could affect access to liquidity.
The following table summarizes the gross unrealized losses and fair value
of fixed income securities by the length of time that individual securities have
been in a continuous unrealized loss position.
<Table>
<Caption>
LESS THAN 12 MONTHS 12 MONTHS OR MORE
-------------------------------- -------------------------------- TOTAL
($ IN THOUSANDS) NUMBER OF FAIR UNREALIZED NUMBER OF FAIR UNREALIZED UNREALIZED
AT DECEMBER 31, 2006 ISSUES VALUE LOSSES ISSUES VALUE LOSSES LOSSES
------ ---------- ---------- ------ ---------- ---------- ----------
Fixed income securities
Municipal 19 $ 85,322 $ (2,417) 10 $ 52,910 $ (2,327) $ (4,744)
Corporate 118 619,716 (8,721) 164 775,483 (26,400) (35,121)
Foreign government 1 4,934 (41) 2 10,067 (170) (211)
Mortgage-backed securities 7 57,005 (701) 28 267,323 (8,555) (9,256)
Commercial mortgage-backed
securities 18 166,545 (831) 33 192,775 (3,485) (4,316)
Asset-backed securities 6 16,010 (283) 3 12,635 (345) (628)
--- ---------- -------- --- ---------- -------- --------
Total 169 $ 949,532 $(12,994) 240 $1,311,193 $(41,282) $(54,276)
=== ========== ======== === ========== ======== ========
Investment grade fixed income
securities 153 $ 919,918 $(12,448) 220 $1,274,151 $(38,837) $(51,285)
Below investment grade fixed
income securities 16 29,614 (546) 20 37,042 (2,445) (2,991)
--- ---------- -------- --- ---------- -------- --------
Total fixed income
securities 169 $ 949,532 $(12,994) 240 $1,311,193 $(41,282) $(54,276)
=== ========== ======== === ========== ======== ========
AT DECEMBER 31, 2005
Fixed income securities
Municipal 12 $ 80,350 $ (776) -- $ -- $ -- $ (776)
Corporate 227 1,078,813 (20,810) 27 159,782 (7,210) (28,020)
Foreign government 2 10,186 (176) -- -- -- (176)
Mortgage-backed securities 32 313,090 (7,089) 11 101,796 (3,623) (10,712)
Commercial mortgage-backed
securities 46 282,391 (3,149) -- -- -- (3,149)
Asset-backed securities 13 33,085 (427) 1 5,747 (252) (679)
--- ---------- -------- --- ---------- -------- --------
Total 332 $1,797,915 $(32,427) 39 $ 267,325 $(11,085) $(43,512)
=== ========== ======== === ========== ======== ========
Investment grade fixed income
securities 300 $1,746,340 $(30,717) 37 $ 257,086 $(10,324) $(41,041)
Below investment grade fixed
income securities 32 51,575 (1,710) 2 10,239 (761) (2,471)
--- ---------- -------- --- ---------- -------- --------
Total fixed income
securities 332 $1,797,915 $(32,427) 39 $ 267,325 $(11,085) $(43,512)
=== ========== ======== === ========== ======== ========
</Table>
As of December 31, 2006, all of the unrealized losses related to securities
with an unrealized loss position less than 20% of amortized cost, the degree of
which suggests that these securities do not pose a high risk of being
other-than-temporarily impaired. Of the $54.3 million in unrealized losses,
$51.3 million related to unrealized losses on investment grade securities.
Investment grade is defined as a security having a rating from the National
Association of Insurance Commissioners ("NAIC") of 1 or 2; a rating of Aaa, Aa,
A or Baa from Moody's or a rating of AAA, AA, A or BBB from Standard & Poor's
("S&P"), Fitch or Dominion, or a rating of aaa, aa, a or bbb from A.M. Best; or
a comparable internal rating if an externally provided rating is not available.
Unrealized losses on investment grade securities are principally related to
rising interest rates or changes in credit spreads since the securities were
acquired.
As of December 31, 2006, the Company had the intent and ability to hold the
fixed income securities with unrealized losses for a period of time sufficient
for them to recover.
51
<Page>
MORTGAGE LOAN IMPAIRMENT
A mortgage loan is impaired when it is probable that the Company will be
unable to collect all amounts due according to the contractual terms of the loan
agreement. Interest income for impaired loans is recognized on an accrual basis
if payments are expected to continue to be received; otherwise a cash basis is
used. The Company had no impaired loans in 2006 or 2005.
INVESTMENT CONCENTRATION FOR MUNICIPAL BOND AND COMMERCIAL MORTGAGE PORTFOLIOS
The Company maintains a diversified portfolio of municipal bonds. The
following table shows the principal geographic distribution of municipal bond
issuers represented in the Company's portfolio. No other state represented more
than 5% of the portfolio at December 31, 2006 and 2005.
(% OF MUNICIPAL BOND PORTFOLIO CARRYING VALUE) 2006 2005
---- ----
California 30.2% 35.4%
Texas 10.9 9.0
Oregon 7.2 7.3
Virginia 6.3 5.1
New York 5.8 --
Missouri 5.4 8.8
Connecticut 5.0 --
Illinois 4.7 6.1
The Company's mortgage loans are collateralized by a variety of commercial
real estate property types located throughout the United States. Substantially
all of the commercial mortgage loans are non-recourse to the borrower. The
following table shows the principal geographic distribution of commercial real
estate represented in the Company's mortgage portfolio. No other state
represented more than 5.0% of the portfolio at December 31, 2006 and 2005.
(% OF COMMERCIAL MORTGAGE PORTFOLIO CARRYING VALUE) 2006 2005
---- ----
California 18.9% 23.4%
Illinois 14.0 11.5
Pennsylvania 8.6 8.2
Texas 7.2 5.9
Arizona 5.6 3.4
New York 5.6 6.5
Ohio 5.2 6.0
New Jersey 4.6 7.1
The types of properties collateralizing the commercial mortgage loans at
December 31 are as follows:
(% OF COMMERCIAL MORTGAGE PORTFOLIO CARRYING VALUE) 2006 2005
----- -----
Office buildings 31.4% 29.0%
Warehouse 30.6 31.3
Retail 17.1 17.4
Apartment complex 17.0 17.2
Industrial 1.0 2.2
Other 2.9 2.9
----- -----
Total 100.0% 100.0%
===== =====
52
<Page>
The contractual maturities of the commercial mortgage loan portfolio as of
December 31, 2006 for loans that were not in foreclosure are as follows:
NUMBER OF CARRYING
($ IN THOUSANDS) LOANS VALUE PERCENT
--------- -------- -------
2007 4 $ 9,792 1.4%
2008 2 14,236 2.0
2009 17 69,516 9.8
2010 22 103,161 14.6
2011 17 83,873 11.8
Thereafter 88 427,871 60.4
--- -------- -----
Total 150 $708,449 100.0%
=== ======== =====
In 2006, $13.4 million of commercial mortgage loans became contractually
due. Of these, 11.7% were paid as due and 88.3% were refinanced at prevailing
market terms. None were foreclosed or in the process of foreclosure, and none
were in the process of refinancing or restructuring discussions.
CONCENTRATION OF CREDIT RISK
At December 31, 2006, the Company is not exposed to any credit
concentration of risk of a single issuer and its affiliates greater than 10% of
the Company's shareholder's equity.
SECURITIES LOANED
The Company's business activities include securities lending programs with
third parties, mostly large brokerage firms. At December 31, 2006 and 2005,
fixed income securities with a carrying value of $191.9 million and $143.2
million, respectively, were on loan under these agreements. In return, the
Company receives cash that it invests and includes in short-term investments and
fixed income securities, with an offsetting liability recorded in other
liabilities and accrued expenses to account for the Company's obligation to
return the collateral. Interest income on collateral, net of fees, was $455
thousand, $430 thousand and $300 thousand, for the years ending December 31,
2006, 2005 and 2004, respectively.
OTHER INVESTMENT INFORMATION
Included in fixed income securities are below investment grade assets
totaling $186.9 million and $201.7 million at December 31, 2006 and 2005,
respectively.
At December 31, 2006, fixed income securities with a carrying value of $2.6
million were on deposit with regulatory authorities as required by law.
At December 31, 2006, the carrying value of fixed income securities that
were non-income producing was $6.8 million. No other investments were non-income
producing at December 31, 2006.
7. FINANCIAL INSTRUMENTS
In the normal course of business, the Company invests in various financial
assets, incurs various financial liabilities and enters into agreements
involving derivative financial instruments and other off-balance-sheet financial
instruments. The fair value estimates of financial instruments presented below
are not necessarily indicative of the amounts the Company might pay or receive
in actual market transactions. Potential taxes and other transaction costs have
not been considered in estimating fair value. The disclosures that follow do not
reflect the fair value of the Company as a whole since a number of the Company's
significant assets (including DAC and DSI and reinsurance recoverables) and
liabilities (including reserve for life-contingent contract benefits,
contractholoder funds pertaining to interest-sensitive life contracts and
deferred income taxes) are not included in accordance with SFAS No. 107. Other
assets and liabilities considered financial instruments such as accrued
investment income and cash are generally of a short-term nature. Their carrying
values are deemed to approximate fair value.
53
<Page>
FINANCIAL ASSETS
(IN THOUSANDS) DECEMBER 31, 2006 DECEMBER 31, 2005
---------------------- -----------------------
CARRYING FAIR CARRYING FAIR
VALUE VALUE VALUE VALUE
---------- ---------- ---------- ----------
Fixed income securities $5,887,139 $5,887,139 $5,989,263 $5,989,263
Mortgage loans 708,449 711,866 633,789 647,068
Short-term investments 142,334 142,334 63,057 63,057
Policy loans 38,168 38,168 36,698 36,698
Separate accounts 1,009,784 1,009,784 928,824 928,824
Fair values of publicly traded fixed income securities are based upon
quoted market prices or dealer quotes. The fair value of non-publicly traded
securities, primarily privately placed corporate obligations, is based on either
widely accepted pricing valuation models, which use internally developed ratings
and independent third party data (e.g., term structures and current publicly
traded bond prices) as inputs, or independent third party pricing sources.
Mortgage loans are valued based on discounted contractual cash flows. Discount
rates are selected using current rates at which similar loans would be made to
borrowers with similar characteristics, using similar properties as collateral.
Loans that exceed 100% loan-to-value are valued at the estimated fair value of
the underlying collateral. Short-term investments are highly liquid investments
with maturities of one year or less whose carrying values are deemed to
approximate fair value. The carrying value of policy loans is deemed to
approximate fair value. Separate accounts assets are carried in the Statements
of Financial Position at fair value based upon quoted market prices.
FINANCIAL LIABILITIES
<Table>
<Caption>
(IN THOUSANDS) DECEMBER 31, 2006 DECEMBER 31, 2005
---------------------- -----------------------
CARRYING FAIR CARRYING FAIR
VALUE VALUE VALUE VALUE
---------- ---------- ---------- ----------
Contractholder funds on investment contracts $4,231,688 $4,099,923 $3,921,872 $3,815,608
Liability for collateral 199,486 199,486 149,465 149,465
Separate accounts 1,009,784 1,009,784 928,824 928,824
</Table>
Contractholder funds include interest-sensitive life insurance contracts
and investment contracts. Interest-sensitive life insurance contracts are not
considered financial instruments subject to fair value disclosure requirements
under the provisions of SFAS No.107. The fair value of investment contracts is
based on the terms of the underlying contracts. Fixed annuities are valued at
the account balance less surrender charges. Immediate annuities without life
contingencies are valued at the present value of future benefits using current
interest rates. Market value adjusted annuities' fair value is estimated to be
the market adjusted surrender value. The liability for collateral is valued at
carrying value due to its short-term nature. Separate accounts liabilities are
carried at the fair value of the underlying assets.
DERIVATIVE FINANCIAL INSTRUMENTS
The Company primarily uses derivatives for risk reduction. With the
exception of embedded derivatives which are required to be separated, all of the
Company's derivatives are evaluated for their on-going effectiveness as either
accounting or non-hedge derivative financial instruments on at least a quarterly
basis (see Note 2). The Company does not use derivatives for trading purposes.
Non-hedge accounting is used for "portfolio" level hedging strategies where the
terms of the individual hedged items do not meet the strict homogeneity
requirements prescribed in SFAS No. 133, "Accounting for Derivative Instruments
and Hedging Activities" ("SFAS 133") to permit the application of SFAS 133's
hedge accounting model. The principal benefit of a "portfolio" level strategy is
in its cost savings through its ability to use fewer derivatives with larger
notional amounts.
Asset-liability management is a risk management strategy that is
principally employed to align the respective interest-rate sensitivities of
assets and liabilities. Depending upon the attributes of the assets acquired and
liabilities issued, derivative instruments such as interest rate caps are
acquired to change the interest rate characteristics of existing assets and
liabilities to ensure a proper matched relationship is maintained and to reduce
54
<Page>
exposure to rising or falling interest rates. The Company uses financial futures
to hedge anticipated asset and liability purchases.
The notional amounts specified in the contracts are used to calculate the
exchange of contractual payments under the agreements and are not representative
of the potential for gain or loss on these agreements.
Fair value, which is equal to the carrying value, is the estimated amount
that the Company would receive (pay) to terminate the derivative contracts at
the reporting date. For exchange traded derivative contracts, the fair value is
based on dealer or exchange quotes. The fair value of non-exchange traded
derivative contracts is based on either independent third party pricing sources,
including dealer quotes, or widely accepted pricing and valuation models which
use independent third party data as inputs.
The following table summarizes the notional amount, fair value and carrying
value of the Company's derivative financial instruments at December 31, 2006.
<Table>
<Caption>
CARRYING
NOTIONAL FAIR VALUE CARRYING VALUE
(IN THOUSANDS) AMOUNT VALUE ASSETS (1) (LIABILITIES) (1)
-------- ------- ---------- -----------------
AT DECEMBER 31, 2006
Financial futures contracts $194,100 $ 50 $ 93 $ (43)
Interest rate cap agreements 264,300 1,410 1,920 (510)
-------- ------- ------- ------
Total interest rate contracts $458,400 $ 1,460 $ 2,013 $ (553)
======== ======= ======= ======
Foreign currency swap agreements $ 7,500 $ (892) $ -- $ (892)
======== ======= ======= ======
Structured settlement annuity
reinsurance agreement $ -- $(1,927) $(1,927) $ --
======== ======= ======= ======
Guaranteed accumulation benefits (2) $251,825 $ 1,304 $ -- $1,304
======== ======= ======= ======
Guaranteed withdrawal benefits (2) $ 52,757 $ (50) $ -- $ (50)
======== ======= ======= ======
Other embedded derivative financial
instruments (2) $ 1,501 $ (3) $ -- $ (3)
======== ======= ======= ======
</Table>
- ----------
(1) Carrying value includes the effects of legally enforceable master netting
agreements. Fair value and carrying value of the assets and liabilities
exclude accrued periodic settlements, which are reported in accrued
investment income or other invested assets.
(2) These embedded derivative financial instruments relate to the company's
variable annuity business, which was fully reinsured by Prudential
effective June 1, 2006 (see Note 3).
55
<Page>
The following table summarizes the notional amount, fair value and carrying
value of the Company's derivative financial instruments at December 31, 2005.
<Table>
<Caption>
CARRYING
NOTIONAL FAIR VALUE CARRYING VALUE
(IN THOUSANDS) AMOUNT VALUE ASSETS (1) (LIABILITIES) (1)
-------- ------- ---------- -----------------
AT DECEMBER 31, 2005
Financial futures contracts $169,100 $ 25 $ 71 $ (46)
Interest rate cap agreements 186,300 2,721 2,912 (191)
-------- ------- ------- -----
Total interest rate contracts $355,400 $ 2,746 $ 2,983 $(237)
======== ======= ======= =====
Foreign currency swap agreements $ 7,500 $ (154) $ -- $(154)
======== ======= ======= =====
Structured settlement annuity
reinsurance agreement $ -- $(1,473) $(1,473) $ --
======== ======= ======= =====
Guaranteed accumulation benefits $194,098 $ 553 $ -- $ 553
======== ======= ======= =====
Guaranteed accumulation benefits
reinsurance agreement $194,098 $ (553) $ (553) $ --
======== ======= ======= =====
Guaranteed withdrawal benefits $ 21,746 $ (2) $ -- $ (2)
======== ======= ======= =====
Guaranteed withdrawal benefits
reinsurance agreement $ 21,746 $ 2 $ 2 $ --
======== ======= ======= =====
Other embedded derivative financial
instruments $ 1,762 $ (3) $ -- $ (3)
======== ======= ======= =====
</Table>
- ----------
(1) Carrying value includes the effects of legally enforceable master netting
agreements. Fair value and carrying value of the assets and liabilities
exclude accrued periodic settlements, which are reported in accrued
investment income or other invested assets.
The Company manages its exposure to credit risk primarily by establishing
risk control limits. The Company uses master netting agreements for
over-the-counter derivative transactions, including foreign currency swap and
interest rate cap agreements. These agreements permit either party to net
payments due for transactions covered by the agreements. Under the provisions of
the agreements, collateral is either pledged or obtained when certain
predetermined exposure limits are exceeded. The Company has not incurred any
losses on derivative financial instruments due to counterparty nonperformance.
Futures contracts are traded on organized exchanges, which require margin
deposits and guarantee the execution of trades, thereby mitigating any
associated potential credit risk.
Market risk is the risk that the Company will incur losses due to adverse
changes in market rates and prices. Market risk exists for all of the derivative
financial instruments the Company currently holds, as these instruments may
become less valuable due to adverse changes in market conditions. To limit this
risk, the Company's senior management has established risk control limits. In
addition, changes in fair value of the derivative financial instruments that the
Company uses for risk management purposes are generally offset by the change in
the fair value or cash flows of the hedged risk component of the related assets,
liabilities or forecasted transactions.
OFF-BALANCE-SHEET FINANCIAL INSTRUMENTS
The contractual amounts and fair values of off-balance-sheet financial
instruments at December 31 are as follows:
<Table>
<Caption>
2006 2005
------------------------ ------------------------
CONTRACTUAL CONTRACTUAL
(IN THOUSANDS) AMOUNT FAIR VALUE AMOUNT FAIR VALUE
----------- ---------- ----------- ----------
Commitments to extend mortgage loans $14,723 $147 $12,516 $125
Private placement commitments -- -- 15,000 --
</Table>
56
<Page>
The contractual amounts represent the amount at risk if the contract is
fully drawn upon, the counterparty defaults and the value of any underlying
security becomes worthless. Unless noted otherwise, the Company does not require
collateral or other security to support off-balance-sheet financial instruments
with credit risk.
Commitments to extend mortgage loans are agreements to lend to a borrower
provided there is no violation of any condition established in the contract. The
Company enters into these agreements to commit to future loan fundings at a
predetermined interest rate. Commitments generally have fixed expiration dates
or other termination clauses. Commitments to extend mortgage loans, which are
secured by the underlying properties, are valued based on estimates of fees
charged by other institutions to make similar commitments to similar borrowers.
Private placement commitments represent conditional commitments to purchase
private placement debt and equity securities at a specified future date. The
Company regularly enters into these agreements in the normal course of business.
The fair value of these commitments generally cannot be estimated on the date
the commitment is made as the terms and conditions of the underlying private
placement securities are not yet final.
8. RESERVE FOR LIFE-CONTINGENT CONTRACT BENEFITS AND CONTRACTHOLDER FUNDS
At December 31, the reserve for life-contingent contract benefits consists
of the following:
(IN THOUSANDS) 2006 2005
---------- ----------
Immediate annuities:
Structured settlement annuities $1,793,706 $1,752,386
Other immediate annuities 9,815 7,998
Traditional life 117,419 105,393
Other 5,552 4,098
---------- ----------
Total reserve for life-contingent contract benefits $1,926,492 $1,869,875
========== ==========
The following table highlights the key assumptions generally used in
calculating the reserve for life-contingent contract benefits:
<Table>
<Caption>
PRODUCT MORTALITY INTEREST RATE ESTIMATION METHOD
Structured settlement U.S. population with projected Interest rate Present value of
annuities calendar year improvements; assumptions range contractually specified
mortality rates adjusted for from 4.5% to 9.5% future benefits
each impaired live based on
reduction in life expectancy
and nature of impairment
Other immediate annuities 1983 group annuity mortality Interest rate Present value of expected
table assumptions range future benefits based on
1983 individual annuity from 2.4% to 11.5% historical experience
mortality table
Annuity 2000 mortality table
Traditional life Actual company experience plus Interest rate Net level premium reserve
loading assumptions range method using the
from 4.0% to 8.0% Company's withdrawal
experience rates
Other:
Variable annuity 90% of 1994 group annuity Interest rate Projected benefit ratio
guaranteed minimum mortality table with internal assumptions range applied to cumulative
death benefits modifications from 6.5% to 7.0% assessments
Supplemental Actual company experience plus Unearned premium;
accident and health loading additional contract
reserves for traditional
life
</Table>
To the extent that unrealized gains on fixed income securities would result
in a premium deficiency had those gains actually been realized, a premium
deficiency reserve has been recorded for certain immediate annuities with life
contingencies. A liability of $235.7 million and $257.5 million is included in
the reserve for life-contingent
57
<Page>
contract benefits with respect to this deficiency as of December 31, 2006 and
2005, respectively. The offset to this liability is recorded as a reduction of
the unrealized net capital gains included in accumulated other comprehensive
income.
At December 31, contractholder funds consists of the following:
(IN THOUSANDS) 2006 2005
---------- ----------
Interest-sensitive life $ 476,729 $ 427,523
Investment contracts:
Fixed annuities 3,667,459 3,381,034
Immediate annuities and other 564,240 540,838
---------- ----------
Total contractholder funds $4,708,428 $4,349,395
========== ==========
The following table highlights the key contract provisions relating to
contractholder funds:
<Table>
<Caption>
PRODUCT INTEREST RATE WITHDRAWAL/SURRENDER CHARGES
Interest-sensitive life Interest rates credited range Either a percentage of account balance or
from 2.7% to 5.5% dollar amount grading off generally over 20
years
Fixed and immediate Interest rates credited range Either a declining or a level percentage
annuities from 1.8% to 11.5% for charge generally over nine years or less.
immediate annuities and 1.9% Additionally, approximately 5.4% of fixed
to 6.7% for fixed annuities annuities are subject to a market value
adjustment for discretionary withdrawals
Other:
Variable guaranteed Interest rates used in Withdrawal and surrender charges are based on
minimum income establishing reserves range the terms of the related variable annuity or
benefit and secondary from 1.8% to 10.3% interest-sensitive life contract
guarantees on
variable annuities (1)
</Table>
- ----------
(1) In 2006, the Company disposed its variable annuity business through
reinsurance agreements with Prudential (see Note 3).
Contractholder funds activity for the years ended December 31 is as
follows:
(IN THOUSANDS) 2006 2005
---------- ----------
BALANCE, BEGINNING OF YEAR $4,349,395 $3,802,846
Deposits 804,825 883,814
Interest credited 178,493 173,984
Benefits (137,090) (168,813)
Surrenders and partial withdrawals (361,670) (270,161)
Contract charges (44,954) (41,856)
Net transfers to separate accounts (18,127) (39,765)
Other adjustments (62,444) 9,346
---------- ----------
BALANCE, END OF YEAR $4,708,428 $4,349,395
========== ==========
The Company offers various guarantees to variable annuity contractholders
including a return of no less than (a) total deposits made on the contract less
any customer withdrawals, (b) total deposits made on the contract less any
customer withdrawals plus a minimum return or (c) the highest contract value on
a specified anniversary date minus any customer withdrawals following the
contract anniversary. These guarantees include benefits that are payable in the
event of death (death benefits), upon annuitization (income benefits), upon
periodic withdrawal (withdrawal benefits), or at specified dates during the
accumulation period (accumulation benefits). Liabilities for variable contract
guarantees related to death benefits are included in reserve for life-contingent
contract benefits and the liabilities related to the income, withdrawal and
accumulation benefits are included in contractholder funds in the Statements of
Financial Position. All liabilities for variable contracts guarantees are
reported on a
58
<Page>
gross basis on the balance sheet with a corresponding reinsurance recoverable
asset for those contracts subject to the Prudential Reinsurance Agreements as
disclosed in Note 3.
Absent any contract provision wherein the Company guarantees either a
minimum return or account value upon death, a specified contract anniversary
date, partial withdrawal or annuitization, variable annuity and variable life
insurance contractholders bear the investment risk that the separate accounts'
funds may not meet their stated investment objectives. The account balances of
variable annuities contracts' separate accounts with guarantees included $954.2
million and $882.2 million of equity, fixed income and balanced mutual funds and
$51.0 million and $44.0 million of money market mutual funds at December 31,
2006 and 2005, respectively.
The table below presents information regarding the Company's variable
annuity contracts with guarantees. The Company's variable annuity contracts may
offer more than one type of guarantee in each contract; therefore, the sum of
amounts listed exceeds the total account balances of variable annuity contracts'
separate accounts with guarantees.
<Table>
<Caption>
DECEMBER 31,
---------------------
($ IN MILLIONS) 2006 2005
--------- ---------
IN THE EVENT OF DEATH
Separate account value $ 1,005.2 $ 926.3
Net amount at risk (1) $ 24.4 $ 38.2
Average attained age of contractholders 67 years 66 years
AT ANNUITIZATION
Separate account value $ 39.4 $ 41.8
Net amount at risk (2) $ -- $ --
Weighted average waiting period until annuitization options available 7 years 8 years
FOR CUMULATIVE PERIODIC WITHDRAWALS
Separate account value $ 50.3 $ 19.8
Net amount at risk (3) $ -- $ --
ACCUMULATION AT SPECIFIED DATES
Separate account value $ 249.2 $ 188.9
Net amount at risk (4) $ -- $ --
Weighted average waiting period until guarantee date 10 years 11 years
</Table>
- ----------
(1) Defined as the estimated current guaranteed minimum death benefit in excess
of the current account balance at the balance sheet date.
(2) Defined as the estimated present value of the guaranteed minimum annuity
payments in excess of the current account balance.
(3) Defined as the estimated current guaranteed minimum withdrawal balance
(initial deposit) in excess of the current account balance at the balance
sheet date.
(4) Defined as the estimated present value of the guaranteed minimum
accumulation balance in excess of the current account balance.
59
<Page>
The following summarizes the liabilities for guarantees:
<Table>
<Caption>
LIABILITY FOR
LIABILITY GUARANTEES
FOR LIABILITY FOR RELATED TO
GUARANTEES GUARANTEES ACCUMULATION
RELATED TO RELATED TO AND
DEATH INCOME WITHDRAWAL
(IN THOUSANDS) BENEFITS BENEFITS BENEFITS TOTAL
---------- ------------- ------------- -------
Balance at December 31, 2004 $ 662 $ 81 $ (141) $ 602
Less reinsurance recoverables -- -- 141 141
------- ----- ------- -------
Net balance at December 31, 2004 662 81 -- 743
Incurred guaranteed benefits 1,582 28 -- 1,610
Paid guarantee benefits (2,084) (4) -- (2,088)
------- ----- ------- -------
Net change (502) 24 -- (478)
Net balance at December 31, 2005 160 105 -- 265
Plus reinsurance recoverables 104 -- (551) (447)
------- ----- ------- -------
Balance, December 31, 2005 (1) $ 264 $ 105 $ (551) $ (182)
Less reinsurance recoverables (104) -- 551 447
Net balance at December 31, 2005 160 105 -- 265
Variable annuity business disposition
related reinsurance recoverables (304) (97) -- (401)
Incurred guaranteed benefits 648 (7) -- 641
Paid guarantee benefits (504) (1) -- (505)
------- ----- ------- -------
Net change (160) (105) -- (265)
Net balance at December 31, 2006 -- -- -- --
Plus reinsurance recoverables 1,026 99 (1,353) (228)
------- ----- ------- -------
Balance, December 31, 2006 (2) $ 1,026 $ 99 $(1,353) $ (228)
======= ===== ======= =======
</Table>
- ----------
(1) Included in the total liability balance are reserves for variable annuity
death benefits of $264 thousand, variable annuity income benefits of $46
thousand, variable annuity accumulation benefits of $(553) thousand,
variable annuity withdrawal benefits of $2 thousand and other guarantees of
$59 thousand.
(2) Included in the total liability balance at December 31, 2006 are reserves
for variable annuity death benefits of $1.03 million, variable annuity
income benefits of $58 thousand, variable annuity accumulation benefits of
$(1.3) million and other guarantees of $41 thousand.
9. REINSURANCE
The Company reinsures certain of its risks to unaffiliated reinsurers and
ALIC under yearly renewable term, coinsurance and modified coinsurance. These
agreements result in a passing of the agreed-upon percentage of risk to the
reinsurer in exchange for negotiated reinsurance premium payments.
Mortality risk on policies in excess of $250 thousand per life is ceded to
ALIC. As of December 31, 2006 and 2005, 39.4% and 37.6%, respectively, of our
face amount of life insurance in force was reinsured to non-affiliates and ALIC.
In addition, the Company has used reinsurance to effect the disposition of
certain blocks of business. As of December 31, 2006, the Company had reinsurance
recoverables of $415.7 million due from Prudential related to the disposal of
our variable annuity business that was effected through Reinsurance Agreements
(see Note 3). In 2006, premiums and contract charges of $11.6 million, contract
benefits of $1.6 million, interest credited to contractholder funds of $9.7
million, and operating costs and expenses of $4.8 million were ceded to
Prudential pursuant to the Reinsurance Agreements. Prior to this disposal, the
Company ceded 100% of the mortality and certain other risks related to product
features on certain in-force variable annuity contracts. In addition, as of
December 31, 2006 and 2005, the Company had reinsurance recoverables of $1.6
million and $1.4 million, respectively, due from subsidiaries of Citigroup and
Scottish Re (U.S.) Inc. in connection with the disposition of the direct
response distribution business in 2003.
60
<Page>
The effects of reinsurance on premiums and contract charges for the years
ended December 31 are as follows:
<Table>
<Caption>
(IN THOUSANDS) 2006 2005 2004
-------- -------- --------
PREMIUMS AND CONTRACT CHARGES
Direct $179,504 $150,749 $151,799
Assumed - non-affiliate 1,367 950 719
Ceded
Affiliate (4,614) (4,795) (4,329)
Non-affiliate (28,518) (12,086) (11,805)
-------- -------- --------
Premiums and contract charges, net of reinsurance $147,739 $134,818 $136,384
======== ======== ========
</Table>
The effects of reinsurance on contract benefits and interest credited to
contractholder funds for the years ended December 31 are as follows:
<Table>
<Caption>
(IN THOUSANDS) 2006 2005 2004
-------- -------- --------
CONTRACT BENEFITS AND INTEREST CREDITED TO
CONTRACTHOLDER FUNDS
Direct $382,633 $353,277 $319,217
Assumed - non-affiliate 827 396 273
Ceded
Affiliate (1,427) (1,154) (985)
Non-affiliate (24,356) (7,356) (6,551)
-------- -------- --------
Contract benefits and interest credited to
contractholder funds, net of reinsurance $357,677 $345,163 $311,954
======== ======== ========
</Table>
In addition to amounts included in the table above are reinsurance premium
ceded to ALIC of $3.0 million, $2.9 million and $2.7 million of premiums and
contract charges ceded to ALIC during 2006, 2005 and 2004, respectively, under
the terms of the structured settlement annuity reinsurance agreement (See Note
5).
10. DEFERRED POLICY ACQUISITION AND SALES INDUCEMENT COSTS
Deferred policy acquisitions costs for the years ended December 31 are as
follows:
(IN THOUSANDS) 2006 2005 2004
-------- -------- --------
BALANCE, BEGINNING OF YEAR $318,551 $238,173 $187,437
Disposition of operations (1) (2) (79,670) -- (3,213)
Impact of adoption of SOP 03-1 (3) -- -- (11,140)
Acquisition costs deferred 62,937 68,205 92,502
Amortization charged to income (31,672) (41,663) (25,971)
Effect of unrealized gains and losses 8,479 53,836 (1,442)
-------- -------- --------
BALANCE, END OF YEAR $278,625 $318,551 $238,173
======== ======== ========
- ----------
(1) In 2006, DAC was reduced in connection with the disposition through
reinsurance agreements of the Company's variable annuity business (see Note
3).
(2) In 2004, DAC was reduced in connection with the disposition of the
Company's direct response distribution business.
(3) In 2004, the impact of adoption of SOP 03-1 included a write-down in
variable annuity DAC of $7.7 million, the reclassification of DSI from DAC
to other assets resulting in a decrease to DAC of $4.1 million and an
increase to DAC of $691 thousand for an adjustment to the effect of
unrealized capital gains and losses.
Net amortization charged to income includes $14.1 million, $3.7 million and
$2.1 million in 2006, 2005 and 2004, respectively, due to realized capital gains
and losses.
61
<Page>
As disclosed in Note 3, DAC and DSI balances were reduced during 2006
related to the disposal through reinsurance agreements of all of the variable
annuity business. During 2005 and 2004, DAC and DSI amortization was estimated
using stochastic modeling and was significantly impacted by the anticipated
return on the underlying funds. The Company's long-term expectation of separate
accounts fund performance, net of fees, was approximately 7% in 2005 and 8% in
2004. Whenever actual separate accounts fund performance based on the two most
recent years varied from the expectation, the Company projected performance
levels over the next five years such that the mean return over a seven-year
period equaled the long-term expectation. This approach is commonly referred to
as "reversion to the mean" and is commonly used by the life insurance industry
as an appropriate method for amortizing variable annuity and life DAC and DSI.
In applying the reversion to the mean process, the Company did not allow the
future mean rates of return including fees projected over the five-year period
to exceed 12.75% or fall below 0%. The Company periodically evaluated the
results of utilization of this process to confirm that it was reasonably
possible that variable annuity and life fund performance would revert to the
expected long-term mean within this time horizon.
DSI activity for the twelve months ended December 31 was as follows:
(IN THOUSANDS) 2006 2005 2004(2)
------- ------- -------
BALANCE, BEGINNING OF YEAR $18,527 $ 2,955 $2,369
Disposition of operation (1) (6,162) -- --
Sales inducements deferred 15,740 16,923 1,531
Amortization charged to income (4,417) (2,373) (760)
Effect of unrealized gains and losses 1,043 1,022 (185)
------- ------- ------
BALANCE, END OF YEAR $24,731 $18,527 $2,955
======= ======= ======
- ----------
(1) In 2006, DSI was reduced in connection with the disposition through
reinsurance agreements of the Company's variable annuity business (see Note
3).
(2) The January 1, 2004, balance includes a $3.0 million write-down of DSI due
to the adoption of SOP 03-1 (see Note 2).
11. COMMITMENTS, GUARANTEES AND CONTINGENT LIABILITIES
GUARANTEES
In the normal course of business, the Company provides standard
indemnifications to counterparties in contracts in connection with numerous
transactions, including acquisitions and divestures. The types of
indemnifications typically provided include indemnifications for breaches of
representations and warranties, taxes and certain other liabilities, such as
third party lawsuits. The indemnification clauses are often standard contractual
terms and were entered into in the normal course of business based on an
assessment that the risk of loss would be remote. The terms of the
indemnifications vary in duration and nature. In many cases, the maximum
obligation is not explicitly stated and the contingencies triggering the
obligation to indemnify have not occurred and are not expected to occur.
Consequently, the maximum amount of the obligation under such indemnifications
is not determinable. Historically, the Company has not made any material
payments pursuant to these obligations.
The aggregate liability balance related to all guarantees was not material
as of December 31, 2006.
REGULATION
The Company is subject to changing social, economic and regulatory
conditions. From time to time regulatory authorities or legislative bodies seek
to impose additional regulations regarding agent and broker compensation and
otherwise expand overall regulation of insurance products and the insurance
industry. The ultimate changes and eventual effects of these initiatives on the
Company's business, if any, are uncertain.
62
<Page>
LEGAL AND REGULATORY PROCEEDINGS AND INQUIRIES
BACKGROUND
The Company and certain affiliates are involved in a number of lawsuits,
regulatory inquiries, and other legal proceedings arising out of various aspects
of its business. As background to the "Proceedings" sub-section below, please
note the following:
- These matters raise difficult and complicated factual and legal issues
and are subject to many uncertainties and complexities, including but
not limited to, the underlying facts of each matter; novel legal
issues; variations between jurisdictions in which matters are being
litigated, heard or investigated; differences in applicable laws and
judicial interpretations; the length of time before many of these
matters might be resolved by settlement, through litigation or
otherwise and, in some cases, the timing of their resolutions relative
to other similar matters involving other companies; the fact that some
of the lawsuits are putative class actions in which a class has not
been certified and in which the purported class may not be clearly
defined; the fact that some of the lawsuits involve multi-state class
actions in which the applicable law(s) for the claims at issue is in
dispute and therefore unclear; and the current challenging legal
environment faced by large corporations and insurance companies.
- In the lawsuits, plaintiffs seek a variety of remedies including
equitable relief in the form of injunctive and other remedies and
monetary relief in the form of contractual and extra-contractual
damages. In some cases, the monetary damages sought include punitive
damages. Often specific information about the relief sought, such as
the amount of damages, is not available because plaintiffs have not
requested specific relief in their pleadings. In our experience, when
specific monetary demands are made in pleadings, they bear little
relation to the ultimate loss, if any, to the Company.
- In connection with regulatory examinations and proceedings, government
authorities may seek various forms of relief, including penalties,
restitution and changes in business practices. The Company may not be
advised of the nature and extent of relief sought until the final
stages of the examination or proceeding.
- For the reasons specified above, it is often not possible to make
meaningful estimates of the amount or range of loss that could result
from the matters described below in the "Proceedings" subsection. The
Company reviews these matters on an on-going basis and follows the
provisions of SFAS No. 5, "Accounting for Contingencies" when making
accrual and disclosure decisions. When assessing reasonably possible
and probable outcomes, the Company bases its decisions on its
assessment of the ultimate outcome following all appeals.
- Due to the complexity and scope of the matters disclosed in the
"Proceedings" subsection below and the many uncertainties that exist,
the ultimate outcome of these matters cannot be reasonably predicted.
In the event of an unfavorable outcome in one or more of these
matters, the ultimate liability may be in excess of amounts currently
reserved and may be material to the Company's operating results or
cash flows for a particular quarter or annual period. However, based
on information currently known to it, management believes that the
ultimate outcome of all matters described below as they are resolved
over time is not likely to have a material adverse effect on the
financial position of the Company.
PROCEEDINGS
Legal proceedings involving Allstate agencies and AIC may impact the
Company, even when the Company is not directly involved, because the Company
sells its products through several distribution channels including Allstate
agencies. Consequently, information about the more significant of these
proceedings is provided in the following paragraph.
AIC is defending certain matters relating to its agency program
reorganization announced in 1999. These matters include a lawsuit filed in
December 2001 by the U.S. Equal Employment Opportunity Commission ("EEOC")
alleging retaliation under federal civil rights laws (the "EEOC I" suit) and a
class action filed in August 2001 by former employee agents alleging retaliation
and age discrimination under the Age Discrimination in Employment Act ("ADEA"),
breach of contract and ERISA violations (the "Romero I" suit). In March 2004, in
the consolidated EEOC I and Romero I litigation, the trial court issued a
memorandum and order that, among other things, certified classes of agents,
including a mandatory class of agents who had signed a release, for purposes of
effecting the court's declaratory judgment that the release is voidable at the
option of the release
63
<Page>
signer. The court also ordered that an agent who voids the release must return
to AIC "any and all benefits received by the [agent] in exchange for signing the
release." The court also stated that, "on the undisputed facts of record, there
is no basis for claims of age discrimination." The EEOC and plaintiffs have
asked the court to clarify and/or reconsider its memorandum and order and on
January 16, 2007, the judge denied their request. The case otherwise remains
pending. The EEOC also filed another lawsuit in October 2004 alleging age
discrimination with respect to a policy limiting the rehire of agents affected
by the agency program reorganization (the "EEOC II" suit). In EEOC II, in
October 2006, the court granted partial summary judgment to the EEOC. Although
the court did not determine that AIC was liable for age discrimination under the
ADEA, it determined that the rehire policy resulted in a disparate impact,
reserving for trial the determination on whether AIC had reasonable factors
other than age to support the rehire policy. AIC filed a motion for
interlocutory appeal from the partial summary judgment, which was granted by the
trial court on January 4, 2007. AIC has filed a petition for immediate review of
two controlling issues of law to the Court of Appeals for the Eighth Circuit and
that petition is currently pending. AIC is also defending a certified class
action filed by former employee agents who terminated their employment prior to
the agency program reorganization. These plaintiffs have asserted breach of
contract and ERISA claims. A putative nationwide class action has also been
filed by former employee agents alleging various violations of ERISA, including
a worker classification issue. These plaintiffs are challenging certain
amendments to the Agents Pension Plan and are seeking to have exclusive agent
independent contractors treated as employees for benefit purposes. This matter
was dismissed with prejudice by the trial court, was the subject of further
proceedings on appeal, and was reversed and remanded to the trial court in April
2005. In all of these various matters, plaintiffs seek compensatory and punitive
damages, and equitable relief. AIC has been vigorously defending these lawsuits
and other matters related to its agency program reorganization. The outcome of
these disputes is currently uncertain.
The Company recently concluded a periodic examination by state insurance
regulators. Regulators focused, as they have with other insurers, on the
Company's compliance with the state's replacement sales and record-keeping
processes with regard to life insurance and annuities among other issues.
They found that the Company failed to meet the requirements of applicable
regulations. The Company has settled this examination and has substantially
completed customer remediation related to replacement sales and is completing
its other obligations arising from the examination.
OTHER MATTERS
The Corporation and some of its subsidiaries, including the Company, have
received interrogatories and demands for information from regulatory and
enforcement authorities relating to various insurance products and practices.
The areas of inquiry include variable annuity market timing and late trading.
The Corporation and some of its subsidiaries, including the Company, have also
received interrogatories and demands for information from authorities seeking
information relevant to on-going investigations into the possible violation of
antitrust or insurance laws by unnamed parties and, in particular, seeking
information as to whether any person engaged in activities for the purpose of
price fixing, market allocation, or bid rigging. The Company believes that these
inquiries are similar to those made to many financial services companies as part
of industry-wide investigations by various authorities into the practices,
policies and procedures relating to insurance and financial services products.
Moreover, the Corporation has not received any communication from authorities
related to the variable annuity market timing and late trading inquiries since
November 2005. The Corporation and its subsidiaries have responded and will
continue to respond to these inquiries.
Various other legal and regulatory actions are currently pending that
involve the Company and specific aspects of its conduct of business. Like other
members of the insurance industry, the Company is the target of a number of
lawsuits and proceedings, some of which involve claims for substantial or
indeterminate amounts. These actions are based on a variety of issues and target
a range of the Company's practices. The outcome of these disputes is currently
unpredictable.
One or more of these matters could have an adverse effect on the Company's
operating results or cash flows for a particular quarter or annual period.
However, based on information currently known to it, management believes that
the ultimate outcome of all matters described in this "Other Matters"
subsection, in excess of amounts currently reserved, as they are resolved over
time is not likely to have a material effect on the operating results, cash
flows or financial position of the Company.
64
<Page>
12. INCOME TAXES
The Company joins the Corporation and its other eligible domestic
subsidiaries (the "Allstate Group") in the filing of a consolidated federal
income tax return and is party to a federal income tax allocation agreement (the
"Allstate Tax Sharing Agreement"). Under the Allstate Tax Sharing Agreement, the
Company pays to or receives from the Corporation the amount, if any, by which
the Allstate Group's federal income tax liability is affected by virtue of
inclusion of the Company in the consolidated federal income tax return.
Effectively, this results in the Company's annual income tax provision being
computed, with adjustments, as if the Company filed a separate return.
The Internal Revenue Service ("IRS") has completed its review of the
Corporation's federal income tax returns through the 2002 tax year and the
statute of limitations has expired for these years. Any adjustments that may
result from IRS examinations of tax returns are not expected to have a material
impact on the results of operations, cash flows or financial position of the
Company.
The components of the deferred income tax assets and liabilities at
December 31 are as follows:
(IN THOUSANDS) 2006 2005
--------- ---------
DEFERRED ASSETS
Life and annuity reserves $ 67,529 $ 80,180
Other assets 1,924 1,376
--------- ---------
Total deferred assets 69,453 81,556
--------- ---------
DEFERRED LIABILITIES
Deferred policy acquisition costs (59,986) (78,316)
Unrealized net capital gains (42,020) (69,444)
Difference in tax bases of investments (14,127) (6,011)
Other liabilities (1,260) (1,184)
--------- ---------
Total deferred liabilities (117,393) (154,955)
--------- ---------
Net deferred liability $ (47,940) $ (73,399)
========= =========
Although realization is not assured, management believes it is more likely
than not that the deferred tax assets will be realized based on the assumption
that certain levels of income will be achieved.
The components of income tax expense for the years ended December 31 are as
follows:
(IN THOUSANDS) 2006 2005 2004
------- ------- -------
Current $16,949 $24,132 $13,640
Deferred 806 (3,187) 4,285
------- ------- -------
Total income tax expense $17,755 $20,945 $17,925
======= ======= =======
The Company paid income taxes of $23.2 million, $18.4 million and $5.8
million in 2006, 2005 and 2004, respectively.
A reconciliation of the statutory federal income tax rate to the effective
income tax rate on income from operations for the years ended December 31 is as
follows:
2006 2005 2004
---- ---- ----
Statutory federal income tax rate 35.0% 35.0% 35.0%
State income tax expense 2.7 3.0 2.1
Adjustment for prior year tax liabilities (1.9) 0.3 (0.4)
Other (1.7) (0.5) (1.2)
---- ---- ----
Effective income tax rate 34.1% 37.8% 35.5%
==== ==== ====
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<Page>
13. STATUTORY FINANCIAL INFORMATION
The Company prepares its statutory-basis financial statements in conformity
with accounting practices prescribed or permitted by the State of New York. The
State of New York requires insurance companies domiciled in its state to prepare
statutory-basis financial statements in conformity with the NAIC Accounting
Practices and Procedures Manual, subject to any deviations prescribed or
permitted by the State of New York Insurance Superintendent. Prescribed
statutory accounting practices include a variety of publications of the NAIC, as
well as state laws, regulations and general administrative rules. Permitted
statutory accounting practices encompass all accounting practices not so
prescribed.
Statutory accounting practices primarily differ from GAAP since they
require charging policy acquisition and certain sales inducement costs to
expense as incurred, establishing life insurance reserves based on different
actuarial assumptions, and valuing investments and establishing deferred taxes
on a different basis.
Statutory net income for 2006, 2005 and 2004 was $33.4 million, $35.9
million and $13.6 million, respectively. Statutory capital and surplus as of
December 31, 2006 and 2005 was $444.6 million and $410.3 million, respectively.
DIVIDENDS
The ability of the Company to pay dividends is dependent on business
conditions, income, cash requirements of the Company and other relevant factors.
The payment of shareholder dividends by the Company without prior approval of
the state insurance regulator is limited to formula amounts based on net income
and capital and surplus, determined in conformity with statutory accounting
practices, as well as the timing and amount of dividends paid in the preceding
twelve months. The maximum amount of dividends that the Company can distribute
during 2007 without prior approval of the New York State Insurance Department is
$26.2 million. In the twelve-month period beginning January 1, 2006, the Company
did not pay any dividends.
14. BENEFIT PLANS
PENSION AND OTHER POSTRETIREMENT PLANS
The Company utilizes the services of AIC employees. AIC provides various
benefits, described in the following paragraphs, to its employees. The Company
is allocated an appropriate share of the costs associated with these benefits in
accordance with a service and expense agreement.
Defined pension plans, sponsored by AIC, cover most full-time employees and
certain part-time employees. Benefits under the pension plans are based upon the
employee's length of service and eligible annual compensation. The Company uses
the accrual method for its defined benefit plans in accordance with accepted
actuarial methods. AIC's funding policy for the pension plans is to make annual
contributions at a minimum level that is at least in accordance with regulations
under the Internal Revenue Code and in accordance with generally accepted
actuarial principles. The allocated cost to the Company included in net income
for the pension plans in 2006, 2005 and 2004 was $3.3 million, $1.8 million and
$1.5 million, respectively.
AIC also provides certain health care and life insurance subsidies for
employees hired before January 1, 2003 when they retire ("postretirement
benefits"). Qualified employees may become eligible for these benefits if they
retire in accordance with AIC's established retirement policy and are
continuously insured under AIC's group plans or other approved plans in
accordance with the plan's participation requirements. AIC shares the cost of
the retiree medical benefits with retirees based on years of service, with AIC's
share being subject to a 5% limit on annual medical cost inflation after
retirement. AIC has the right to modify or terminate these plans. The allocated
cost to the Company included in net income was $509 thousand, $543 thousand and
$588 thousand for postretirement benefits other than pension plans in 2006, 2005
and 2004, respectively.
PROFIT SHARING PLAN
Employees of AIC are eligible to become members of The Savings and Profit
Sharing Fund of Allstate Employees ("Allstate Plan"). The Corporation's
contributions are based on the Corporation's matching obligation and
performance. The Company's allocation of profit sharing expense from the
Corporation was $1.4 million, $764 thousand and $1.3 million in 2006, 2005 and
2004, respectively.
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<Page>
15. OTHER COMPREHENSIVE INCOME
The components of other comprehensive (loss) income on a pretax and
after-tax basis for the years ended December 31 are as follows:
2006
------------------------------
AFTER-
(IN THOUSANDS) PRETAX TAX TAX
--------- ------- --------
Unrealized holding losses arising during the
period $(102,314) $35,810 $(66,504)
Less: reclassification adjustment (23,960) 8,386 (15,574)
--------- ------- --------
Unrealized net capital gains and losses (78,354) 27,424 (50,930)
--------- ------- --------
Other comprehensive loss
$ (78,354) $27,424 $(50,930)
========= ======= ========
2005
-----------------------------
AFTER-
(IN THOUSANDS) PRETAX TAX TAX
-------- ------- --------
Unrealized holding losses arising during the
period $(46,529) $16,285 $(30,244)
Less: reclassification adjustment (6,087) 2,130 (3,957)
-------- ------- --------
Unrealized net capital gains and losses (40,442) 14,155 (26,287)
-------- ------- --------
Other comprehensive loss $(40,442) $14,155 $(26,287)
======== ======= ========
2004
---------------------------
AFTER-
(IN THOUSANDS) PRETAX TAX TAX
------- ------- -------
Unrealized holding gains arising during the
period $20,221 $(7,077) $13,144
Less: reclassification adjustment (5,211) 1,824 (3,387)
------- ------- -------
Unrealized net capital gains and losses 25,432 (8,901) 16,531
------- ------- -------
Other comprehensive income $25,432 $(8,901) $16,531
======= ======= =======
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<Page>
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
TO THE BOARD OF DIRECTORS AND SHAREHOLDER OF
ALLSTATE LIFE INSURANCE COMPANY OF NEW YORK
We have audited the accompanying Statements of Financial Position of Allstate
Life Insurance Company of New York (the "Company", an affiliate of The Allstate
Corporation) as of December 31, 2006 and 2005 and the related Statements of
Operations and Comprehensive Income, Shareholder's Equity, and Cash Flows for
each of the three years in the period ended December 31, 2006. Our audits also
included the financial statement schedules listed in the Index at Item 15. These
financial statements and financial statement schedules are the responsibility of
the Company's management. Our responsibility is to express an opinion on the
financial statements and financial statement schedules based on our audits.
We conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. The Company is not required to
have, nor were we engaged to perform, an audit of its internal control over
financial reporting. Our audit included consideration of internal control over
financial reporting as a basis for designing audit procedures that are
appropriate in the circumstances, but not for the purpose of expressing an
opinion on the effectiveness of the Company's internal control over financial
reporting. Accordingly, we express no such opinion. An audit also includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements, assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, such financial statements present fairly, in all material
respects, the financial position of Allstate Life Insurance Company of New York
as of December 31, 2006 and 2005, and the results of its operations and its cash
flows for each of the three years in the period ended December 31, 2006, in
conformity with accounting principles generally accepted in the United States of
America. Also, in our opinion, such financial statement schedules, when
considered in relation to the basic financial statements taken as a whole,
present fairly in all material respects the information set forth therein.
As discussed in Note 2 to the financial statements, the Company changed its
method of accounting for certain nontraditional long-duration contracts and
separate accounts in 2004.
/s/ Deloitte & Touche LLP
- -------------------------
Chicago, Illinois
March 9, 2007
68
<Page>
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
ITEM 9A. CONTROLS AND PROCEDURES
Evaluation of Disclosure Controls and Procedures. We maintain disclosure
controls and procedures as defined in Rules 13(a)-15(e) and 15d-15(e) under the
Securities Exchange Act of 1934. Under the supervision and with the
participation of our management, including our principal executive officer and
principal financial officer, we conducted an evaluation of the effectiveness of
our disclosure controls and procedures as of the end of the period covered by
this report. Based upon this evaluation, the principal executive officer and the
principal financial officer concluded that our disclosure controls and
procedures are effective in providing reasonable assurance that material
information required to be disclosed in our reports filed with or submitted to
the Securities and Exchange Commission under the Securities Exchange Act is
recorded, processed, summarized and reported within the time periods specified
by the Securities Exchange Act and made known to management, including the
principal executive officer and the principal financial officer, as appropriate
to allow timely decisions regarding required disclosure.
Changes in Internal Control over Financial Reporting. During the fiscal
quarter ended December 31, 2006, there have been no changes in our internal
control over financial reporting that have materially affected, or are
reasonably likely to materially affect, our internal control over financial
reporting.
ITEM 9B. OTHER INFORMATION
None.
69
<Page>
PART III
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES
(1), (2), (3) and (4) Disclosure of fees -
The following fees have been, or are anticipated to be billed by Deloitte &
Touche LLP, the member firms of Deloitte & Touche Tohmatsu, and their respective
affiliates, for professional services rendered to us for the fiscal years ending
December 31, 2006 and 2005.
2006 2005
-------- --------
Audit fees (a) $344,300 $360,599
-------- --------
TOTAL FEES $344,300 $360,599
======== ========
(a) Fees for audits of annual financial statements including financial
statements for the separate accounts, reviews of quarterly financial
statements, statutory audits, attest services, comfort letters, consents
and review of documents filed with the Securities and Exchange Commission.
(5)(i) and (ii) Audit committee's pre-approval policies and procedures -
The Audit Committee of The Allstate Corporation has established
pre-approval policies and procedures for itself and its consolidated
subsidiaries, including Allstate Life Insurance Company of New York. Those
policies and procedures are incorporated into this Item 14 (5) by reference to
Exhibit 99 - The Allstate Corporation Policy Regarding Pre-Approval of
Independent Auditors' Services (the "Pre-Approval Policy"). In addition, in 2005
the Board of Directors of Allstate Life Insurance Company of New York adopted
the Pre-Approval Policy, as it may be amended from time to time by the Audit
Committee or the Board of Directors of the Corporation, as its own policy,
provided that the Designated Member referred to in such policy need not be
independent because the New York Stock Exchange corporate governance standards
do not apply to Allstate Life Insurance Company of New York and provided that
references to the "audit committee" would mean Allstate Life Insurance Company
of New York's Board. All of the services provided by Deloitte & Touche LLP to
Allstate Life Insurance Company of New York in 2006 and 2005 were pre-approved
by The Allstate Corporation Audit Committee and the Allstate Life Insurance
Company of New York Board.
70
<Page>
PART IV
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES
(a) (1) The following financial statements, notes thereto and related
information of Allstate Life of New York are included in Item 8.
Statements of Operations and Comprehensive Income
Statements of Financial Position
Statements of Shareholder's Equity
Statements of Cash Flows
Notes to Financial Statements
Report of Independent Registered Public Accounting Firm
(2) The following additional financial statement schedules are
furnished herewith pursuant to the requirements of Form 10-K.
ALLSTATE LIFE INSURANCE COMPANY OF NEW YORK PAGE
------------------------------------------- ----
Schedules required to be filed under provisions of Regulation
S-X Article 7:
Schedule I - Summary of Investments - Other Than Investments in
Related Parties S-1
Schedule IV - Reinsurance S-2
All other schedules have been omitted because they are not applicable
or required or because the required information is included in the
financial statements or notes thereto.
(3) The following is a list of the exhibits filed as part of this Form
10-K. The SEC file number for the exhibits incorporated by reference
is 033-47245 except as otherwise noted.
EXHIBIT
NO. DESCRIPTION
------- -----------
3(i) Restated Certificate of Incorporation of Allstate Life
Insurance Company of New York dated December 2, 2003.
Incorporated herein by reference to Exhibit 3(i) to
Allstate Life Insurance Company of New York's Annual
Report on Form 10-K for 2003.
3(ii) Amended By-Laws of Allstate Life Insurance Company of
New York dated December 16, 1998. Incorporated herein
by reference to Exhibit 3(ii) to Allstate Life
Insurance Company of New York's Annual Report on Form
10-K for 1998.
10.1 Amended and Restated Service and Expense Agreement
between Allstate Insurance Company, The Allstate
Corporation and certain affiliates, effective January
1, 2004, and effective March 5, 2005 with respect to
Allstate Life Insurance Company of New York.
Incorporated herein by reference to Exhibit 10.1 to
Allstate Life Insurance Company's Quarterly Report on
Form 10-Q for quarter ended June 30, 2005.
10.2 New York Insurer Supplement to Amended and Restated
Service and Expense Agreement between Allstate
Insurance Company, The Allstate Corporation, Allstate
Life Insurance Company of New York and Intramerica Life
Insurance Company, effective March 5, 2005.
Incorporated herein by reference to Exhibit 10.2 to
Allstate Life Insurance Company's Quarterly Report on
Form 10-Q for quarter ended June 30, 2005.
71
<Page>
10.3 Investment Advisory Agreement and Amendment to Service
Agreement as of January 1, 2002 between Allstate
Insurance Company, Allstate Investments, LLC and
Allstate Life Insurance Company of New York.
Incorporated herein by reference to Exhibit 10.2 to
Allstate Life Insurance Company of New York's Quarterly
Report on Form 10-Q for quarter ended March 31, 2002.
10.4 Tax Sharing Agreement dated as of November 12, 1996
among The Allstate Corporation and certain affiliates.
Incorporated herein by reference to Exhibit 10.36 to
Allstate Life Insurance Company's Form 10 filed on
April 24, 2002. (SEC File No. 000-31248)
10.5 Underwriting Agreement between Allstate Life Insurance
Company of New York and ALFS, Inc., effective October
1, 1996. Incorporated herein by reference to Exhibit
10.1 to Allstate Life Insurance Company of New York's
Quarterly Report on Form 10-Q for quarter ended June
30, 2002.
10.6 Principal Underwriting Agreement between Allstate Life
Insurance Company of New York and Allstate
Distributors, L.L.C., effective May 1, 2000.
Incorporated herein by reference to Exhibit 10.2 to
Allstate Life Insurance Company of New York's Quarterly
Report on Form 10-Q for quarter ended June 30, 2002.
10.7 Amendment Number One to the Principal Underwriting
Agreement between Allstate Life Insurance Company of
New York and Allstate Distributors, L.L.C. effective
October 1, 2002. Incorporated herein by reference to
Exhibit 10.1 to Allstate Life Insurance Company of New
York's Quarterly Report on Form 10-Q for the quarter
ended March 31, 2006.
10.8 Selling Agreement between Allstate Life Insurance
Company of New York, ALFS, Inc. and Allstate Financial
Services, LLC effective May 1, 2005. Incorporated
herein by reference to Exhibit 10.7 to Allstate Life
Insurance Company's Annual Report on Form 10-K for
2003. (SEC File No. 000-31248)
10.9 Reinsurance Agreement between Allstate Life Insurance
Company and Allstate Life Insurance Company of New York
effective January 1, 1984 as amended by Amendment No. 1
effective September 1, 1984, Amendment No.2 effective
January 1, 1987, Amendment No.3 effective October 1,
1988, Amendment No.4 effective January 1, 1994 and
Amendment No.5 effective December 31, 1995.
Incorporated herein by reference to Exhibit 10.6 to
Allstate Life Insurance Company of New York's Quarterly
Report on Form 10-Q for quarter ended June 30, 2002.
10.10 Assumption Reinsurance Agreement between Allstate Life
Insurance Company and Allstate Life Insurance Company
of New York effective July 1, 1984. Incorporated herein
by reference to Exhibit 10.7 to Allstate Life Insurance
Company of New York's Quarterly Report on Form 10-Q for
quarter ended June 30, 2002.
10.11 Reinsurance Agreement between Allstate Life Insurance
Company and Allstate Life Insurance Company of New
York, effective January 1, 1986, as amended by
Amendment No.1 effective December 31, 1995 and
Amendment No. 2 effective December 1, 1995.
Incorporated herein by reference to Exhibit 10.8 to
Allstate Life Insurance Company of New York's Quarterly
Report on Form 10-Q for quarter ended June 30, 2002.
72
<Page>
10.12 Reinsurance Agreement between Allstate Life Insurance
Company and Allstate Life Insurance Company of New
York, effective January 1, 1991, as amended by
Amendment No.1 effective December 31, 1995.
Incorporated herein by reference to Exhibit 10.9 to
Allstate Life Insurance Company of New York's Quarterly
Report on Form 10-Q for quarter ended June 30, 2002.
10.13 Stop Loss Reinsurance Agreement between Allstate Life
Insurance Company and Allstate Life Insurance Company
of New York effective December 31, 2001. Incorporated
herein by reference to Exhibit 10.16 to Allstate Life
Insurance Company of New York's Annual Report on Form
10-K for 2003.
10.14 Automatic Annuity Reinsurance Agreement between
Allstate Life Insurance Company of New York and
Allstate Life Insurance Company, effective January 2,
2004. Incorporated herein by reference to Exhibit 10.2
to Allstate Life Insurance Company of New York's
Quarterly Report on Form 10-Q for quarter ended June
30, 2004.
10.15 Amendment No. 1 to Automatic Annuity Reinsurance
Agreement between Allstate Life Insurance Company of
New York and Allstate Life Insurance Company, effective
January 1, 2005. Incorporated herein by reference to
Exhibit 10.1 to Allstate Life Insurance Company of New
York's Quarterly Report on Form 10-Q for quarter ended
March 31, 2005.
10.16 Amendment No. 2 to Automatic Annuity Reinsurance
Agreement between Allstate Life Insurance Company of
New York and Allstate Life Insurance Company, effective
June 1, 2006. Incorporated herein by reference to
Exhibit 10.1 to Allstate Life Insurance Company of New
York's Current Report on Form 8-K filed June 7, 2006.
23 Consent of Independent Registered Public Accounting
Firm
31.1 Rule 15d-14(a) Certification of Principal Executive
Officer
31.2 Rule 15d-14(a) Certification of Principal Financial
Officer
32 Section 1350 Certifications
99 The Allstate Corporation Policy Regarding Pre-Approval
of Independent Auditors' Services effective November
10, 2003. Incorporated herein by reference to Exhibit
99(ii) to Allstate Life Insurance Company of New York's
Annual Report on Form 10-K for 2004.
73
<Page>
SIGNATURES
Pursuant to the requirements of the Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned thereunto duly authorized.
ALLSTATE LIFE INSURANCE COMPANY OF NEW YORK
(Registrant)
March 13, 2007 /s/ Samuel H. Pilch
-------------------------------------------
By: Samuel H. Pilch
(Controller)
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.
SIGNATURE TITLE DATE
--------- ----- ----
/s/ Casey J. Sylla Chairman of the Board, March 13, 2007
- ------------------------------ President and a Director
Casey J. Sylla (Principal Executive Officer)
/s/ John C. Pintozzi Vice President, Chief March 13, 2007
- ------------------------------ Financial Officer and a
John C. Pintozzi Director
(Principal Financial Officer)
/s/ Marcia D. Alazraki Director March 12, 2007
- ------------------------------
Marcia D. Alazraki
/s/ Vincent A. Fusco Director March 12, 2007
- ------------------------------
Vincent A. Fusco
/s/ Cleveland Johnson, Jr. Director March 12, 2007
- ------------------------------
Cleveland Johnson, Jr.
/s/ John C. Lounds Director March 12, 2007
- ------------------------------
John C. Lounds
Director March 12, 2007
- ------------------------------
Kenneth R. O'Brien
/s/ John R. Raben, Jr. Director March 12, 2007
- ------------------------------
John R. Raben, Jr.
/s/ Phyllis Hill Slater Director March 12, 2007
- ------------------------------
Phyllis Hill Slater
/s/ Kevin R. Slawin Director March 12, 2007
- ------------------------------
Kevin R. Slawin
/s/ Michael J. Velotta Director March 12, 2007
- ------------------------------
Michael J. Velotta
/s/ Douglas B. Welch Director March 12, 2007
- ------------------------------
Douglas B. Welch
/s/ Patricia W. Wilson Director March 12, 2007
- ------------------------------
Patricia W. Wilson
74
<Page>
SUPPLEMENTAL INFORMATION TO BE FURNISHED WITH REPORTS FILED
PURSUANT TO SECTION 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 BY REGISTRANTS
WHICH HAVE NOT REGISTERED SECURITIES PURSUANT TO SECTION 12
OF THE SECURITIES EXCHANGE ACT OF 1934
All of the outstanding common stock of the Company is owned by Allstate
Life Insurance Company. The Company has not provided any of the following items
to security holders:
(1) annual reports to security holders covering the registrant's last
fiscal year; or
(2) proxy statements, forms of proxy or other proxy soliciting
materials.
75
<Page>
ALLSTATE LIFE INSURANCE COMPANY OF NEW YORK
SCHEDULE I - SUMMARY OF INVESTMENTS - OTHER THAN INVESTMENTS
IN RELATED PARTIES
DECEMBER 31, 2006
<Table>
<Caption>
AMOUNTS AT
WHICH SHOWN
ON BALANCE
(IN THOUSANDS) COST FAIR VALUE SHEET
---------- ---------- -----------
Type of investment
Fixed Maturities:
Bonds:
United States government, government agencies and authorities $ 541,877 $ 729,111 $ 729,111
States, municipalities and political subdivisions 314,768 323,003 323,003
Foreign governments 244,544 304,947 304,947
Public utilities 654,671 691,659 691,659
All other corporate bonds 2,559,833 2,613,103 2,613,103
Commercial mortgage-backed securities 669,303 673,179 673,179
Mortgage-backed securities 439,938 433,196 433,196
Asset-backed securities 107,922 109,022 109,022
Redeemable preferred stocks 9,371 9,919 9,919
---------- ---------- ----------
Total fixed maturities 5,542,227 $5,887,139 5,887,139
---------- ========== ----------
Mortgage loans on real estate 708,449 708,449
Policy loans 38,168 38,168
Short-term investments 142,334 142,334
Derivative instruments 3,784 3,784
---------- ----------
Total investments $6,434,962 $6,779,874
========== ==========
</Table>
S-1
<Page>
ALLSTATE LIFE INSURANCE COMPANY OF NEW YORK
SCHEDULE IV--REINSURANCE
<Table>
<Caption>
PERCENTAGE
OF AMOUNT
GROSS NET ASSUMED
(IN THOUSANDS) AMOUNT CEDED ASSUMED AMOUNT TO NET
----------- ---------- -------- ----------- ----------
YEAR ENDED DECEMBER 31, 2006
Life insurance in force $28,410,800 $11,524,333 $810,202 $17,696,669 4.6%
=========== =========== ======== ===========
Premiums and contract charges:
Life and annuities $ 170,625 $ 29,392 $ 1,367 $ 142,600 0.9%
Accident and health 8,878 3,739 -- 5,139 --
----------- ----------- -------- -----------
$ 179,503 $ 33,131 $ 1,367 $ 147,739 0.9%
=========== =========== ======== ===========
YEAR ENDED DECEMBER 31, 2005
Life insurance in force $25,508,599 $ 9,806,717 $540,025 $16,241,907 3.3%
=========== =========== ======== ===========
Premiums and contract charges:
Life and annuities $ 142,091 $ 12,372 $ 950 $ 130,669 0.7%
Accident and health 8,658 4,509 -- 4,149 --
----------- ----------- -------- -----------
$ 150,749 $ 16,881 $ 950 $ 134,818 0.7%
=========== =========== ======== ===========
YEAR ENDED DECEMBER 31, 2004
Life insurance in force $23,151,807 $ 7,605,444 $302,905 $15,849,268 1.9%
=========== =========== ======== ===========
Premiums and contract charges:
Life and annuities $ 142,729 $ 9,952 $ 382 $ 133,159 0.3%
Accident and health 9,070 6,182 337 3,225 10.4%
----------- ----------- -------- -----------
$ 151,799 $ 16,134 $ 719 $ 136,384 0.5%
=========== =========== ======== ===========
</Table>
S-2