Presidential Life: Case Study of a Small Insurance and Annuity Company

Other than its market cap being lower than its book value, I was attracted by Presidential Life insurance (Ticker : PLFE) because its CEO is a 87 year old guy who is still going strong. Herbert Krutz has been the Chairman and CEO of the company since 1977.

This is one of the first pure Life insurance and annuity business that I have analyzed. So it has been a great learning opportunity for me to understand the uniqueness of this industry. The Insurance Company currently emphasizes the sale of a variety of single premium and flexible premium annuity products. Each of these products is designed to meet the needs of increasingly sophisticated consumers for supplemental retirement income and estate planning.

For financial statement purposes, revenues from the sale of ordinary life insurance and annuity contracts with life contingencies are treated as revenues whereas the sale of annuity contracts without life contingencies, deferred annuities and universal life insurance products are reported as additions to policyholders’ account balances.

The long-term profitability of sales of life and most annuity products depends on the degree of margin of the actuarial assumptions that underlie the pricing of such products. Actuarial calculations for such products, and the ultimate profitability of sales of such products, are based on four major factors: (i) persistency; (ii) rate of return on cash invested during the life of the policy or contract; (iii) expenses of acquiring and administering the policy or contract; and (iv) mortality. Persistency is the rate at which insurance policies remain in force, expressed as a percentage of the number of policies remaining in force over the previous year. Policyholders can either surrender policies or cause their policies to lapse by failing to pay premiums.

Deferred annuities are interest rate sensitive instruments. In an interest rate environment of falling or stable rates the Insurance Company’s annuity holders are less likely to seek to surrender their annuities prior to maturity to seek alternative, higher-yielding investments. However, in an environment of moderately or significantly increasing rates, such surrenders should be expected to increase. As of December 31, 2006, the existence of surrender fees on approximately 53% of the Insurance Company’s outstanding deferred annuities acts as a deterrent against surrenders. However, if interest rates climb sufficiently, such fees may not have a significant deterrent effect. Moreover, the surrender fees are only in effect for up to the first 7 years of each annuity policy and, therefore, disappear over time.

In the event of a substantial increase in surrenders during a short period of time, the Insurance Company may have to sell off longer-term assets to pay current surrender liabilities. The Insurance Company continually develops strategies to address the match between the timing of its assets and liabilities.

To that end, during 2005 and 2006, especially in light of the substantial number of policies coming off surrender charges in those years and in 2007, the Insurance Company reduced the amount of assets invested in longer-term investments by approximately $1,239 million and reinvested in short and intermediate return investments at reduced yields. These reduced yields were partially offset by the gains recognized by the Insurance Company from the sale of the longer-term assets. To protect against a substantial sudden increase in rates (300 basis points), the Company has entered into a series of payor swaption investments. Under these investments, the Company obtained the right to enter into interest rate swap agreements with counterparties under which the Company’s interest rate obligations are fixed and the counterparties’ obligations are variable, thus protecting the Company from sudden rate increases.

NET INVESTMENT INCOME : The reduction in the net investment income ratios from 2002 to 2003 was attributable to the low interest rate environment and overall economic conditions, which led to defaults or write-downs within the Company’s investment portfolio. A general improvement in market conditions and an increase in net investment income were the primary factors in the 2003 to 2004 increase, while the rebalancing of the portfolio into lower yield, short-term investments and the need for cash to fund annuity surrenders, caused a decrease in the net investment income ratio in 2005 and 2006.

The sale of long-term investments to support the portfolio rebalancing also resulted in approximately $75 million of realized capital gains in 2005. In 2006, a loss of $14.1 million on the payor swaptions (reflected in the realized capital gains/(losses)), and the absence of the capital gains from portfolio rebalancing realized in 2005, resulted in a difference between a net realized investment gain of $75 million in 2005 and a net realized investment loss of $3.6 million in 2006.

DEFERRED POLICY ACQUISITION COSTS : The costs of acquiring new business (principally commissions, certain underwriting, agency and policy issue expenses), all of which vary with the production of new business, have been deferred. When a policy is surrendered, the remaining unamortized cost is written off. Deferred policy acquisition costs are subject to recoverability testing at time of policy issue and loss recognition testing at the end of each year. For immediate annuities with life contingencies, deferred policy acquisition costs are amortized over the life of the contract, in proportion to expected future benefit payments. For traditional life policies, deferred policy acquisition costs are amortized over the premium paying periods of the related policies using assumptions that are consistent with those used in computing the liability for future policy benefits. Assumptions as to anticipated premiums are estimated at the date of policy issue and are consistently applied during the life of the contracts. For these contracts the amortization periods generally are for the scheduled life of the policy, not to exceed 30 years.

Deferred policy acquisition costs are amortized over periods ranging from 15 to 25 years for universal life products and investment-type products as a constant percentage of estimated gross profits arising principally from surrender charges and interest and mortality margins based on historical and anticipated future experience, updated regularly.

The effects of revisions to reflect actual experience on previous amortization of deferred policy acquisition costs, subject to the limitation that the outstanding DAC asset can never exceed the original DAC plus accrued interest, are reflected in earnings in the period estimated gross profits are revised. DAC is also adjusted for the impact of unrealized gains or losses on investments as if these gains or losses had been realized with corresponding credits or charges included in accumulated other comprehensive income.

For that portion of the business where acquisition costs are not deferred, (i.e., medical stop loss business) management believes the expensing of policy acquisition costs is immaterial.