Management's discussion and analysis
Life Insurance
F&G Life
Our life insurance segment consists of Fidelity and Guaranty Life Insurance Company and subsidiaries ("F&G Life"). F&G Life's primary products are deferred annuities (including tax sheltered annuities and equity-indexed annuities), structured settlement annuities, and immediate annuities. F&G Life also underwrites traditional life insurance products. F&G Life's products are sold throughout the United States through independent agents, managing general agents and specialty brokerage firms. Our life insurance segment generated 4% of our total revenues in 1998 and accounted for 13% of our consolidated assets.
Highlights of F&G Life's financial performance for the last three years are as follows:
Year ended December 31
(In millions)
1997
1996
1998
Sales
$ 501
$ 446
$ 427
Premiums and policy changes
119
137
145
Policy surrenders
207
171
471
Net investment income
276
253
269
Pretax earnings (loss)
21
78
(8)
Life insurance in force
$10,774
$10,748
$10,729
F&G Life's pretax earnings in 1998 were reduced by a $41 million charge to reflect a writedown of the carrying value of deferred policy acquisition costs (DPAC) relating to universal life-type and investment-type contracts. According to generally accepted accounting principles, DPAC amortization is based on the present value of estimated gross profits expected to be realized over the life of the contract. Estimates of expected gross profits used as a basis for amortization are evaluated regularly and the total amortization to date should be adjusted if actual experience or other evidence suggests that earlier estimates should be revised.
The $41 million DPAC charge had three components. First, the persistency of certain in-force business, particularly universal life and flexible premium annuities, sold through some USF&G distribution channels, had begun to deteriorate after the USF&G merger announcement. To mitigate this, management decided, in the second quarter, to increase credited rates on certain universal life business. This change lowered the estimated future profits on this business, triggering $19 million of accelerated DPAC amortization. Second, the low interest rate environment during the first half of 1998 led to assumption changes as to the future "spread" on certain interest sensitive products, lowering gross profit expectations and triggering a $16 million DPAC charge. The remaining $6 million charge resulted from a change in annuitization assumptions for certain tax-sheltered annuity products.
We also recorded pretax merger-related charges of $9 million in this segment in 1998, primarily relating to severance and facilities exit costs.
The following table shows life insurance and annuity sales (premiums and deposits) by distribution system and product type.
Year ended December 31
(In millions)
1997
1996
1998
Distribution systems
Brokerage
$367
$268
$255
National wholesaler
68
91
79
Direct structured settlements
55
74
79
Other
11
78
14
Total
$501
$446
$427
Product type
Equity-indexed annuities
$209
-
-
Single premium deferred annuities
134
$248
$231
Tax sheltered annuities
64
84
78
Structured settlement annuities
55
74
79
Other annuities
24
23
27
Life insurance
15
17
12
Total
$501
$446
$427
The 12% increase in sales in 1998 when compared to 1997 was driven by the success of a new equity-indexed annuity product introduced in June 1998, which accounted for $209 million, or 42%, of total sales for the year. Credited interest rates on this product are tied to the performance of the S&P 500 equity index. Sales of fixed interest rate annuities in 1998 declined from 1997 due to the significantly lower level of interest rates and its negative impact on our fixed interest rate products. The demand for our annuity products is affected by fluctuating interest rates and the relative attractiveness of alternative products.
The 13% decline in premiums earned in 1998 was largely due to a reduction in sales of structured settlement annuities, which are sold primarily to property-liability insurers to settle insurance claims. Sales of structured settlement annuities and term life insurance are recognized as premiums earned under GAAP. Sales of investment-type contracts, such as our equity-indexed, deferred and tax sheltered annuities, and our universal life-type contracts are recorded directly to our balance sheet on a deposit accounting basis and are not recognized as premiums under GAAP. Sales of the structured settlement annuities in the middle of the year suffered from disruptions caused by the merger, but rebounded in the fourth quarter as the structured settlement program was expanded into our newly combined property-liability operations.
Our deferred annuity and universal life products are subject to surrender by policyholders. Nearly all of our surrenderable annuity policies allow a refund of the cash value balance less a surrender charge. Surrender activity increased in 1998 due to growth in the size and maturity of our annuity book of business, as well as increased competition from alternative investments, particularly equity-based products.
Net investment income grew 9% in 1998 as a result of an increasing asset base generated by positive cash flow. We incurred pretax realized investment losses of $2 million in 1998, down from gains of $14 million in 1997 primarily due to writedowns in the carrying value of fixed maturity investments, which offset gains of $13 million realized on real estate investments.
Excluding realized investment gains and losses, and the $50 million of charges recorded in 1998, pretax earnings totaled $71 million, compared with $64 million in 1997. The increase resulted from improved investment spread management of annuity and universal life products, and strong expense controls.
1997 vs. 1996 - Sales of $446 million in 1997 were 4% higher than 1996, primarily due to an increase in single premium deferred annuities (SPDA) sales. The $300 million decline in policy surrender activity from 1996 to 1997 primarily resulted from a 1996 transaction whereby we entered into a coinsurance contract with an unaffiliated life insurance company to cede all of our remaining SPDAs that had originally been sold through brokerage firms. This removed an underperforming block of business that had experienced high surrender rates. The $16 million decline in investment income in 1997 when compared with 1996 was due to a lower asset base created by the transfer of $918 million in fixed maturities under the 1996 coinsurance contract. The pretax loss of $8 million in 1996 was driven by writedowns in the carrying value of certain real estate and fixed maturity investments.
Outlook for 1999 - We anticipate the sales momentum generated by our equity-indexed product in the second half of 1998 to carry into 1999. We will focus on repositioning our life products, increasing our marketing efforts and intensifying new product development in an increasingly competitive life insurance marketplace. We will also continue to expand F&G Life's structured settlement program into our property-liability claim operation in 1999.