**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

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**FORM 10-Q**

 

Registrant meets the conditions set forth in General Instruction H(1)(a) and (b) of Form 10-Q and is therefore filing this Form with the reduceddisclosure format.

 

**ý****        QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d)OFTHE SECURITIES EXCHANGE ACT OF 1934**

 

**FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30,2004**

 

**OR**

 

**o****        TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d)OFTHE SECURITIES EXCHANGE ACT OF 1934**

 

Commission filenumber:**000-31248**

 

**ALLSTATE LIFE INSURANCE COMPANY**

(Exact name ofregistrant as specified in its charter)

 

| **Illinois**                                                                          | ** ** | **36-2554642**                        |
|---------------------------------------------------------------------------------------|------------|---------------------------------------|
| (State  of Incorporation)                                                             |       | (I.R.S.  Employer Identification No.) |
|                                                                                  |       |                                  |
| **3100  Sanders Road**                                                                | ** ** | **60062**                             |
| **Northbrook,  Illinois**                                                             | ** ** | (Zip  code)                           |
| (Address  of principal executive offices)                                             |       |                                  |
|                                                                                  |       |                                  |
| **Registrant’s telephone number,  including area code:**  847/402-5000 |

 

**Indicate by check mark whether the registrant:  (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934 duringthe preceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.**

 

**Yes****ý****            No****o**

 

**Indicate by check mark whether the registrant is an accelerated filer(as defined in Rule 12b-2 of the Exchange Act).**

 

**Yes****o****            No****ý**

 

**As of October 31, 2004, the registrant had 23,800common shares, $227 par value, outstanding, all of which are held by AllstateInsurance Company.**

 

 

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**ALLSTATELIFE INSURANCE COMPANY**

**INDEX TOQUARTERLY REPORT ON FORM 10-Q**

##### **September 30, 2004**

 
| ** **  | ** **                                                                                                                                      | PAGE   |
|-------------|-------------------------------------------------------------------------------------------------------------------------------------------------|--------|
| **PART I**  | **FINANCIAL INFORMATION**                                                                                                                       |   |
|        |                                                                                                                                            |   |
| Item 1.     | Financial Statements                                                                                                                            |   |
|        |                                                                                                                                            |   |
|        | Condensed Consolidated Statements of  Operations for the Three-Month and Nine-Month Periods Ended September 30,  2004 and 2003 (unaudited) | 1      |
|        |                                                                                                                                            |   |
|        | Condensed  Consolidated Statements of Financial Position as of September 30, 2004  (unaudited) and December 31, 2003                  | 2      |
|        |                                                                                                                                            |   |
|        | Condensed  Consolidated Statements of Cash Flows for the Nine-Month Periods Ended September 30,  2004 and 2003 (unaudited)                 | 3      |
|        |                                                                                                                                            |   |
|        | Notes  to Condensed Consolidated Financial Statements (unaudited)                                                                               | 4      |
|        |                                                                                                                                            |   |
|        | Report  of Independent Registered Public Accounting Firm                                                                                        | 13     |
|        |                                                                                                                                            |   |
| Item 2.     | Management’s Discussion  and Analysis of Financial Condition and Results of Operations                                                     | 14     |
|        |                                                                                                                                            |   |
| Item 4.     | Controls  and Procedures                                                                                                                        | 27     |
|        |                                                                                                                                            |   |
| **PART II** | **OTHER INFORMATION**                                                                                                                           |   |
|        |                                                                                                                                            |   |
| Item 1.     | Legal Proceedings                                                                                                                               | 28     |
|        |                                                                                                                                            |   |
| Item 6.     | Exhibits                                                                                                                                        | 28     |

 

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##### **PART I. FINANCIALINFORMATION**

**ITEM 1. FINANCIAL STATEMENTS**

 

**ALLSTATELIFE INSURANCE COMPANY AND SUBSIDIARIES**

**CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**

 
| ** **                                                                                                                | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| **(in millions)**                                                                                                         | ** ** | **2004**                                   | ** ** | **2003**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                                                                | ** ** | **(Unaudited)**                            | ** ** | **(Unaudited)**                           | ** ** |
| **Revenues**                                                                                                              |       |                                       |       |                                      |       |   |   |   |   |
| Premiums                                                                                                                  |       | $                                          | 141        |                                      | $          | 204 |   | $ | 443 |   | $ | 725 |   |
| Contract  charges                                                                                                         |       | 244                                        |       | 214                                       |       | 714 |   | 642 |   |
| Net  investment income                                                                                                    |       | 828                                        |       | 775                                       |       | 2,406 |   | 2,295 |   |
| Realized  capital gains and losses                                                                                        |       | (52                                        | )          | 10                                        |       | (147 | ) | (72 | ) |
|                                                                                                                      |       | 1,161                                      |       | 1,203                                     |       | 3,416 |   | 3,590 |   |
|                                                                                                                      |       |                                       |       |                                      |       |   |   |   |   |
| **Costs  and expenses**                                                                                                   |       |                                       |       |                                      |       |   |   |   |   |
| Contract  benefits                                                                                                        |       | 332                                        |       | 351                                       |       | 981 |   | 1,196 |   |
| Interest  credited to contractholder funds                                                                                |       | 485                                        |       | 447                                       |       | 1,397 |   | 1,319 |   |
| Amortization  of deferred policy acquisition costs                                                                        |       | 126                                        |       | 98                                        |       | 350 |   | 355 |   |
| Operating  costs and expenses                                                                                             |       | 104                                        |       | 122                                       |       | 329 |   | 361 |   |
|                                                                                                                      |       | 1,047                                      |       | 1,018                                     |       | 3,057 |   | 3,231 |   |
|                                                                                                                      |       |                                       |       |                                      |       |   |   |   |   |
| Loss on  disposition of operations                                                                                        |       | —                                     |       | (13                                       | )          | (17 | ) | (13 | ) |
|                                                                                                                      |       |                                       |       |                                      |       |   |   |   |   |
| **Income  from operations before income tax expense and cumulative effect of change in  accounting principle, after-tax** |       | 114                                        |       | 172                                       |       | 342 |   | 346 |   |
|                                                                                                                      |       |                                       |       |                                      |       |   |   |   |   |
| Income tax  expense                                                                                                       |       | 38                                         |       | 53                                        |       | 120 |   | 103 |   |
|                                                                                                                      |       |                                       |       |                                      |       |   |   |   |   |
| **Income  before cumulative effect of change in accounting principle, after-tax**                                         |       | 76                                         |       | 119                                       |       | 222 |   | 243 |   |
|                                                                                                                      |       |                                       |       |                                      |       |   |   |   |   |
| Cumulative  effect of change in accounting principle, after-tax                                                           |       | —                                     |       | —                                    |       | (175 | ) | — |   |
|                                                                                                                      |       |                                       |       |                                      |       |   |   |   |   |
| **Net  income**                                                                                                           |       | $                                          | 76         |                                      | $          | 119 |   | $ | 47 |   | $ | 243 |   |

 

See notes to condensed consolidated financialstatements.

 

1

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**ALLSTATE LIFE INSURANCE COMPANY AND SUBSIDIARIES**

**CONDENSED CONSOLIDATED STATEMENTS OF FINANCIALPOSITION**

 
| **(in millions, except par value data)**                                                                                                      | ** ** | **September 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                    | ** ** | **(Unaudited)**              | ** ** | ** **                  | ** ** |
| **Assets**                                                                                                                                    |       |                         |       |                        |       |
| Investments                                                                                                                                   |       |                         |       |                        |       |
| Fixed income  securities, at fair value (amortized cost $53,946 and $48,401)                                                                  |       | $                            | 57,360     |                        | $          | 51,578 |   |
| Mortgage  loans                                                                                                                               |       | 7,240                        |       | 6,354                       |       |
| Equity  securities                                                                                                                            |       | 285                          |       | 164                         |       |
| Short-term                                                                                                                                    |       | 1,995                        |       | 765                         |       |
| Policy loans                                                                                                                                  |       | 705                          |       | 686                         |       |
| Other                                                                                                                                         |       | 523                          |       | 442                         |       |
|                                                                                                                                          |       |                         |       |                        |       |
|   Total  investments                                                                                                                |       | 68,108                       |       | 59,989                      |       |
|                                                                                                                                          |       |                         |       |                        |       |
| Cash                                                                                                                                          |       | 218                          |       | 121                         |       |
| Deferred  policy acquisition costs                                                                                                            |       | 3,039                        |       | 3,202                       |       |
| Reinsurance  recoverables, net                                                                                                                |       | 1,399                        |       | 1,185                       |       |
| Accrued  investment income                                                                                                                    |       | 610                          |       | 567                         |       |
| Other assets                                                                                                                                  |       | 495                          |       | 323                         |       |
| Separate  Accounts                                                                                                                            |       | 13,313                       |       | 13,425                      |       |
|                                                                                                                                          |       |                         |       |                        |       |
| **Total  assets**                                                                                                                             |       | $                            | 87,182     |                        | $          | 78,812 |   |
|                                                                                                                                          |       |                         |       |                        |       |
| **Liabilities**                                                                                                                               |       |                         |       |                        |       |
| Contractholder  funds                                                                                                                         |       | $                            | 51,376     |                        | $          | 44,914 |   |
| Reserve for  life-contingent contract benefits                                                                                                |       | 11,010                       |       | 10,480                      |       |
| Unearned  premiums                                                                                                                            |       | 31                           |       | 32                          |       |
| Payable to  affiliates, net                                                                                                                   |       | 63                           |       | 114                         |       |
| Other  liabilities and accrued expenses                                                                                                       |       | 4,492                        |       | 2,594                       |       |
| Deferred  income taxes                                                                                                                        |       | 609                          |       | 779                         |       |
| Long-term  debt                                                                                                                               |       | 110                          |       | 45                          |       |
| Separate  Accounts                                                                                                                            |       | 13,313                       |       | 13,425                      |       |
|                                                                                                                                          |       |                         |       |                        |       |
| **Total  liabilities**                                                                                                                        |       | 81,004                       |       | 72,383                      |       |
|                                                                                                                                          |       |                         |       |                        |       |
| **Commitments  and Contingent Liabilities (Note 5)**                                                                                          |       |                         |       |                        |       |
|                                                                                                                                          |       |                         |       |                        |       |
| **Shareholder’s  Equity**                                                                                                                |       |                         |       |                        |       |
| Redeemable  preferred stock – series A, $100 par value, 1.5 million shares authorized,  49,230 and 815,460 shares issued and outstanding |       | 5                            |       | 82                          |       |
| Redeemable  preferred stock – series B, $100 par value, 1.5 million shares authorized,  none issued                                      |       |                         |       |                        |       |
| Common  stock, $227 par value, 23,800 shares authorized and outstanding                                                                       |       | 5                            |       | 5                           |       |
| Additional  capital paid-in                                                                                                                   |       | 1,077                        |       | 1,067                       |       |
| Retained  income                                                                                                                              |       | 4,069                        |       | 4,222                       |       |
| Accumulated  other comprehensive income:                                                                                                      |       |                         |       |                        |       |
| Unrealized  net capital gains and losses and net gains and losses on derivative financial  instruments                                        |       | 1,022                        |       | 1,053                       |       |
|                                                                                                                                          |       |                         |       |                        |       |
| **Total  accumulated other comprehensive income**                                                                                             |       | 1,022                        |       | 1,053                       |       |
|                                                                                                                                          |       |                         |       |                        |       |
| **Total  shareholder’s equity**                                                                                                          |       | 6,178                        |       | 6,429                       |       |
|                                                                                                                                          |       |                         |       |                        |       |
| **Total  liabilities and shareholder’s equity**                                                                                          |       | $                            | 87,182     |                        | $          | 78,812 |   |

 

See notes to condensed consolidated financialstatements.

 

2

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**ALLSTATE LIFE INSURANCE COMPANY AND SUBSIDIARIES**

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

 
| ** **                                                                         | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| **(in millions)**                                                                  | ** ** | **2004**                                  | ** ** | **2003** | ** ** |
| ** **                                                                         | ** ** | **(Unaudited)**                           | ** ** | ** ** | ** ** |
| **Cash  flows from operating activities**                                          |       |                                      |       |   |   |
| Net income                                                                         |       | $                                         | 47         |   | $ | 243 |   |
| Adjustments  to reconcile net income to net cash provided by operating activities: |       |                                      |       |   |   |
| Amortization  and other non-cash items                                             |       | (104                                      | )          | (127 | ) |
| Realized  capital gains and losses                                                 |       | 147                                       |       | 72 |   |
| Cumulative  effect of change in accounting principle                               |       | 175                                       |       | — |   |
| Interest  credited to contractholder funds                                         |       | 1,397                                     |       | 1,319 |   |
| Changes in:                                                                        |       |                                      |       |   |   |
| Contract  benefit and other insurance reserves                                     |       | (185                                      | )          | 30 |   |
| Unearned  premiums                                                                 |       | 2                                         |       | 3 |   |
| Deferred  policy acquisition costs                                                 |       | (227                                      | )          | (186 | ) |
| Reinsurance  recoverables, net                                                     |       | (131                                      | )          | (101 | ) |
| Income taxes  payable                                                              |       | (26                                       | )          | 42 |   |
| Other  operating assets and liabilities                                            |       | (54                                       | )          | 150 |   |
| Net cash  provided by operating activities                                         |       | 1,041                                     |       | 1,445 |   |
| **Cash  flows from investing activities**                                          |       |                                      |       |   |   |
| Proceeds  from sales                                                               |       |                                      |       |   |   |
| Fixed income  securities                                                           |       | 6,306                                     |       | 6,171 |   |
| Equity  securities                                                                 |       | 159                                       |       | 63 |   |
| Investment  collections                                                            |       |                                      |       |   |   |
| Fixed income  securities                                                           |       | 3,264                                     |       | 3,495 |   |
| Mortgage  loans                                                                    |       | 525                                       |       | 506 |   |
| Investment  purchases                                                              |       |                                      |       |   |   |
| Fixed income  securities                                                           |       | (14,315                                   | )          | (14,786 | ) |
| Equity  securities                                                                 |       | (225                                      | )          | (32 | ) |
| Mortgage  loans                                                                    |       | (1,422                                    | )          | (866 | ) |
| Change in  short-term investments, net                                             |       | 16                                        |       | 321 |   |
| Change in  other investments, net                                                  |       | (81                                       | )          | (35 | ) |
| Net cash  used in investing activities                                             |       | (5,773                                    | )          | (5,163 | ) |
| **Cash  flows from financing activities**                                          |       |                                      |       |   |   |
| Redemption  of mandatorily redeemable preferred stock                              |       | (13                                       | )          | (11 | ) |
| Contractholder  fund deposits                                                      |       | 9,722                                     |       | 7,492 |   |
| Contractholder  fund withdrawals                                                   |       | (4,680                                    | )          | (3,889 | ) |
| Dividends  paid                                                                    |       | (200                                      | )          | (27 | ) |
| Net cash  provided by financing activities                                         |       | 4,829                                     |       | 3,565 |   |
| **Net increase  (decrease) in cash**                                               |       | 97                                        |       | (153 | ) |
| **Cash at  beginning of the period**                                               |       | 121                                       |       | 252 |   |
| **Cash at  end of period**                                                         |       | $                                         | 218        |   | $ | 99 |   |

 

See notes to condensed consolidated financialstatements.

 

3

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**ALLSTATELIFE INSURANCE COMPANY AND SUBSIDIARIES**

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**(Unaudited)**

 

**1.****             ****Basis of Presentation**

 

The accompanying condensed consolidated financialstatements include the accounts of Allstate Life Insurance Company (“ALIC”) andits wholly owned subsidiaries (together with ALIC, the “Company”). ALIC iswholly owned by Allstate Insurance Company (“AIC”), a wholly owned subsidiaryof The Allstate Corporation (the “Corporation”).

 

The condensed consolidated financial statements andnotes as of September 30, 2004, and for the three-month and nine-monthperiods ended September 30, 2004 and 2003 are unaudited.  The condensed consolidated financialstatements reflect all adjustments (consisting only of normal recurringaccruals), which are, in the opinion of management, necessary for the fairpresentation of the financial position, results of operations and cash flowsfor the interim periods.  These condensedconsolidated financial statements and notes should be read in conjunction withthe consolidated financial statements and notes thereto included in the Company’sAnnual Report on Form 10-K for the year ended December 31, 2003.  The results of operations for the interimperiods should not be considered indicative of results to be expected for thefull year.

 

To conform to the 2004 presentation, certain amountsin the prior year’s condensed consolidated financial statements and notes havebeen reclassified.

 

Equity securities include common stocks,non-redeemable preferred stocks and limited partnership interests.  Common stocks and non-redeemable preferredstocks had a carrying value of $153 million and $83 million, and cost of $147million and $79 million at September 30, 2004 and December 31, 2003,respectively.  Investments in limitedpartnership interests had a carrying value of $132 million and $81 million at September 30,2004 and December 31, 2003, respectively.

 

Non-cash investment exchanges and modifications,which primarily reflect refinancings of fixed income securities and mergers completedwith equity securities, totaled $38 million for both the nine months ended September 30,2004 and 2003.

 

In August 2004, the boards of directors of ALICand Glenbrook Life and Annuity Company (“GLAC”) approved the merger of GLAC, aconsolidated wholly owned subsidiary of ALIC, into ALIC, expected to beeffective January 1, 2005.  ALICwill be the surviving legal entity and GLAC will cease to exist as anindependent entity.  ALIC and GLAC expectto receive all required regulatory approvals.

 

**Adopted Accounting Standards**

 

*Statementof Position No. 03-1, “Accounting and Reporting by Insurance Enterprises forCertain Nontraditional Long-Duration Contracts and for Separate Accounts” (“SOP03-1”)*

 

On January 1, 2004, the Company adopted SOP03-1.  The major provisions of the SOPaffecting the Company require:

 

•                  Establishmentof reserves primarily related to death benefit and income benefit guaranteesprovided under variable annuity contracts;

 

•                  Deferralof sales inducements that meet certain criteria, and amortization using thesame method used for deferred policy acquisition costs (“DAC”); and

 

•                  Reportingand measuring assets and liabilities of certain separate accounts products asinvestments and contractholder funds rather than as separate accounts assetsand liabilities when specified criteria are present.

 

**Effects of adoption**

 

The cumulative effect of the change in accountingprinciple from implementing SOP 03-1 was a loss of $175 million, after-tax($269 million, pre-tax).  It wascomprised of an increase in benefits reserves (primarily for variable annuitycontracts) of $145 million, pre-tax, and a reduction in DAC and deferred salesinducements (“DSI”) of $124 million, pre-tax.

 

4

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The SOP requires consideration of a range ofpotential results to estimate the cost of variable annuity death benefits andincome benefits, which generally necessitates the use of stochastic modelingtechniques.  To maintain consistency withthe assumptions used in the establishment of reserves for variable annuityguarantees, the Company utilized the results of this stochastic modeling toestimate expected gross profits, which form the basis for determining theamortization of DAC and DSI.  This newmodeling approach resulted in a lower estimate of expected gross profits, andtherefore resulted in a write-down of DAC and DSI.

 

In 2004, DSI and related amortization is classifiedwithin the Condensed Consolidated Statements of Financial Position andOperations as other assets and interest credited to contractholder funds,respectively.  The amounts are providedbelow.

 

The Company reclassified $204 million of separateaccounts assets and liabilities to investments and contractholder funds,respectively.

 

**Liabilities for contract guarantees**

 

The Company offers various guarantees to variablecontractholders including a return of no less than (a) total deposits made onthe contract less any customer withdrawals, (b) total deposits made on thecontract less any customer withdrawals plus a minimum return or (c) the highestcontract value on a specified anniversary date minus any customer withdrawalsfollowing the contract anniversary. These guarantees include benefits that are payable in the event of death(death benefits), upon annuitization (income benefits), or at specified datesduring the accumulation period (accumulation benefits).  To manage the risk associated with a portionof its minimum guaranteed death and income benefits, the Company acquiredreinsurance for policies issued prior to January 1, 2000.  Additionally, the Company hedges deathbenefits for substantially all contracts issued since January 1, 2003 andaccumulation benefits for all contracts issued.

 

The table below presents information regarding theCompany’s variable contracts with guarantees. The Company’s variable annuity contracts may offer more than one type ofguarantee in each contract; therefore, the sum of amounts listed exceeds thetotal account balances of variable annuity contracts’ separate accounts withguarantees.

 
| **($ in millions)**                                               | ** ** | **September 30,  2004** | ** ** |
|------------------------------------------------------------------------|------------|------------------------------|------------|
|                                                                   |       |                         |       |
| *In the  event of death*                                               | ** ** | ** **                   | ** ** |
| Account  value                                                         |       | $                            | 13,056     |   |
| Net amount  at risk (1)                                                |       | $                            | 2,398      |   |
| Average  attained age of contractholders                               |       | 63 years                     |       |
|                                                                   |       |                         |       |
| *At  annuitization*                                                    |       |                         |       |
| Account  value                                                         |       | $                            | 3,626      |   |
| Net amount  at risk (2)                                                |       | $                            | 86         |   |
| Weighted  average waiting period until annuitization options available |       | 7 years                      |       |
|                                                                   |       |                         |       |
| *Accumulation  at specified dates*                                     |       |                         |       |
| Account  value                                                         |       | $                            | 377        |   |
| Net amount  at risk (3)                                                |       | $                            | —     |   |
| Weighted  average waiting period until guarantee date                  |       | 11 years                     |       |

 

(1)          Defined as the current guaranteed minimum death benefit in excess ofthe current account balance at the balance sheet date.

(2)          Defined as the present value of the minimum guaranteed annuity paymentsdetermined in accordance with the terms of the contract in excess of thecurrent account balance.

(3)          Defined as the present value of the guaranteed minimum accumulationbalance in excess of the current account balance.

----

 

5

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Account balances of variable contracts’ separateaccounts with guarantees were invested as follows:

 
| **(in millions)**                                                       | ** ** | **September 30, 2004** | ** ** |
|-------------------------------------------------------------------------|------------|-----------------------------|------------|
|                                                                    |       |                        |       |
| Equity  securities (including mutual funds)                             |       | $                           | 12,384     |   |
| Cash and  cash equivalents                                              |       | 672                         |       |
| Total  variable contracts’ separate account assets with guarantees |       | $                           | 13,056     |   |

 

The following table summarizes the liabilities forguarantees:

 
| **(in millions)**                       | ** ** | **Liability for  guarantees  related to death  benefits** | ** ** | **Liability for  guarantees  related to income  benefits** | ** ** | **Liability for  guarantees  related to  accumulation  benefits** | ** ** | **Total** | ** ** |
|-----------------------------------------|------------|-----------------------------------------------------------|------------|------------------------------------------------------------|------------|-------------------------------------------------------------------|------------|-----------|------------|
|                                    |       |                                                      |       |                                                       |       |                                                              |       |      |       |
| Balance at January 1,  2004        |       | $                                                         | 118        |                                                       | $          | 41                                                                |       | $         | —     |   | $ | 159 |   |
| Less  reinsurance recoverables          |       | (12                                                       | )          | (2                                                         | )          | —                                                            |       | (14       | )          |
| Net balance  at January 1, 2004    |       | 106                                                       |       | 39                                                         |       | —                                                            |       | 145       |       |
| Incurred  guaranteed benefits           |       | 30                                                        |       | 5                                                          |       | 1                                                                 |       | 36        |       |
| Paid  guarantee benefits                |       | (49                                                       | )          | —                                                     |       | —                                                            |       | (49       | )          |
| Net change                              |       | (19                                                       | )          | 5                                                          |       | 1                                                                 |       | (13       | )          |
| Net balance  at September 30, 2004 |       | 87                                                        |       | 44                                                         |       | 1                                                                 |       | 132       |       |
| Plus  reinsurance recoverables          |       | 10                                                        |       | —                                                     |       | —                                                            |       | 10        |       |
| Balance, September 30,  2004 (1)   |       | $                                                         | 97         |                                                       | $          | 44                                                                |       | $         | 1          |   | $ | 142 |   |

 

(1)          Included in the total reserve balance are reserves for variable annuitydeath benefits of $81 million, variable annuity income benefits of $17 million,variable annuity accumulation benefits of $1 million and other guarantees of$43 million.

----

 

The liability for death and income benefitguarantees is established equal to a benefit ratio multiplied by the cumulativecontract charges earned, plus accrued interest less contract benefitpayments.  The benefit ratio iscalculated as the estimated present value of all expected contract benefitsdivided by the present value of all expected contract charges.  For guarantees related to death benefits,benefits represent the current guaranteed minimum death benefit payments inexcess of the current account balance. For guarantees related to income benefits, benefits represent thepresent value of the minimum guaranteed annuity benefits in excess of thecurrent account balance.

 

Projected benefits and contract charges used indetermining the liability for guarantees are developed using models andstochastic scenarios that are also used in the development of estimatedexpected gross profits.  Underlyingassumptions for the liability related to income benefits include assumed futureannuitization elections based on factors such as the extent of benefit to thepotential annuitant, eligibility conditions and the annuitant’s attainedage.  The liability for guarantees willbe re-evaluated periodically, and adjustments will be made to the liabilitybalance through a charge or credit to contract benefits.

 

Guarantees related to accumulation benefits areconsidered to be derivative financial instruments; therefore, the liability foraccumulation benefits is established based on its fair value.

 

**Deferred sales inducements**

 

Costs related to sales inducements offered on salesto new customers, principally on investment contracts and primarily in the formof additional credits to the customer’s account value or enhancements tointerest credited for a specified period, which are beyond amounts currentlybeing credited to existing contracts, are deferred and recorded as otherassets.  All other sales inducements areexpensed as incurred and included in interest credited to contractholder fundson the Condensed Consolidated Statements of Operations.  DSI is amortized to income using the samemethodology and assumptions as DAC, and included in interest credited tocontractholder funds.  DSI is periodicallyreviewed for recoverability and written down when necessary.

 

6

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DSI activity for the nine months ended September 30,2004 was as follows:

 
| **(in millions)**                       | ** ** | ** ** | ** ** |
|-----------------------------------------|------------|------------|------------|
|                                    |       |       |       |
| Balance, January 1,  2004          |       | $          | 99         |   |
| Sales  inducements deferred             |       | 40         |       |
| Amortization  charged to income         |       | (26        | )          |
| Effects of  unrealized gains and losses |       | 6          |       |
| Balance, September 30,  2004       |       | $          | 119        |   |

 

*EmergingIssues Task Force Issue No. 03-1, “The Meaning of Other-Than-TemporaryImpairment and Its Application to Certain Investments” (“EITF 03-1”) and FSPEITF 03-1-1, “Effective Date of Paragraphs 10-20 of EITF Issue No. 03-1, TheMeaning of Other-Than-Temporary Impairment and Its Application to CertainInvestments” (“FSP EITF 03-1-1”)*

 

In March 2004, the Emerging Issues Task Force (“EITF”)reached a final consensus on EITF 03-1, which was to be effective for fiscalperiods beginning after June 15, 2004. EITF 03-1 requires that when the fair value of an investment security isless than its carrying value an impairment exists for which a determinationmust be made as to whether the impairment is temporary orother-than-temporary.  An impairment lossshould be recognized equal to the difference between the investment’s carryingvalue and its fair value when an impairment is other-than-temporary. Subsequentto an other-than temporary impairment loss, a debt security should be accountedfor in accordance with Statement of Position No. 03-3, “Accounting for Loansand Certain Debt Securities Acquired in a Transfer”, which allows the accretionof the discount between the carrying value and expected value of a security ifthe amount and timing of the receipt of the expected cash flows is reasonablyestimable.  EITF 03-1 also indicates thatalthough not presumptive, a pattern of selling investments prior to theforecasted recovery may call into question an investor’s intent to hold thesecurity until it recovers in value or otherwise matures.

 

The EITF 03-1 impairment model applies to allinvestment securities accounted for under SFAS No. 115, “Accounting for CertainInvestments in Debt and Equity Securities” and to investment securitiesaccounted for under the cost method. The final consensus on EITF 03-1 includedadditional disclosure requirements incremental to those adopted by the Companyeffective December 31, 2003 that will be effective December 31, 2004.In September 2004, the FASB issued FSP EITF Issue 03-1-1, which deferredthe effective date of the impairment measurement and recognition provisionscontained in paragraphs 10-20 of EITF 03-1 until proposed FSP EITF 03-1-a isissued. (See Pending Accounting Standard.)

 

**Pending and Recently Issued Accounting Standards**

 

*American Institute of Certified Public Accountants ("AICPA")Technical Practice Aid ("TPA") re. SOP 03-1*

* *

In September 2004, the staff of the AICPA, aided byindustry experts, issued a set of technical questions and answers on financialaccounting and reporting issues related to SOP 03-1 that will be includedin the AICPA's TPAs. The TPA addresses a number of issues related toSOP 03-1 including when it is necessary to establish a liability inaddition to the account balance for certain contracts that meet the definitionof an insurance contract and have amounts assessed against the contractholderin a manner that is expected to result in profits in earlier years and lossesin subsequent years from the insurance benefit function. The Company is in theprocess of evaluating the impact of the TPA. The impact of the TPA is notexpected to be material to the Company's Condensed Consolidated Statements ofOperations or Financial Position.

 

*FSP EITFIssue 03-1-a, “Implementation Guidance for the Application of Paragraph 16 ofEITF Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment andIts Application to Certain Investments” (“FSP EITF Issue 03-1-a”).*

 

In September 2004, the FASB issued proposed FSPEITF 03-1-a, that addresses the application of paragraph 16 of EITF Issue 03-1to debt securities that are impaired because of increases in interest rates,and/or credit sector spread.  Thereafter,in connection with its decision to defer the effective date of paragraphs 10–20of EITF 03-1 through the issuance of FSP EITF Issue 03-1-1, the FASB requestedfrom its constituents information about both the issues set forth in FSP EITF03-1-a as well as the issues that arose during the FSP EITF 03-1-b, “*Effective Date of Paragraph 16 of EITF Issue No. 03-1*,*The Meaning of Other-Than-TemporaryImpairment and Its Application to Certain Investments”,*commentletter process*.*

 

Due to the uncertainty as to how all of the relevantoutstanding issues will be resolved, the Company is unable to determine theimpact of adopting paragraphs 10-20 of EITF 03-1 until final implementationguidance is issued.  Adoption ofparagraphs 10-20 of EITF 03-1 may have a material impact on the Company’sCondensed Consolidated Statements of Operation but is not expected to have amaterial impact on the Company’s Condensed Consolidated Statements of FinancialPosition since fluctuations in fair value are already recorded in accumulatedother comprehensive income.

 

7

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**2.****             ****Disposition**

 

The Company disposed of the majority of its directresponse distribution business in the first quarter of 2004 and is in theprocess of disposing of its remaining direct response distribution business. Inconnection with those disposal activities, the Company recorded a loss ondisposition of $17 million pre-tax ($11 million after-tax)  for the nine months ended September 30,2004.

 

**3.****             ****Reinsurance**

 

The effects of reinsurance on premiums and contractcharges are as follows:

 
| ** **                                         | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|----------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| **(in millions)**                                  | ** ** | **2004**                                   | ** ** | **2003**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                               |       |                                       |       |                                      |       |   |   |   |   |
| **Premiums  and contract charges**                 |       |                                       |       |                                      |       |   |   |   |   |
| Direct                                             |       | $                                          | 516        |                                      | $          | 487 |   | $ | 1,541 |   | $ | 1,591 |   |
| Assumed                                            |       |                                       |       |                                      |       |   |   |   |   |
| Affiliate                                          |       | 4                                          |       | 4                                         |       | 13 |   | 15 |   |
| Non-affiliate                                      |       | 2                                          |       | 22                                        |       | 6 |   | 66 |   |
| Ceded–non-affiliate                           |       | (137                                       | )          | (95                                       | )          | (403 | ) | (305 | ) |
| Premiums and  contract charges, net of reinsurance |       | $                                          | 385        |                                      | $          | 418 |   | $ | 1,157 |   | $ | 1,367 |   |

 

The effects of reinsurance on contract benefits areas follows:

 
| ** **                             | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|----------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| **(in millions)**                      | ** ** | **2004**                                   | ** ** | **2003**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                   |       |                                       |       |                                      |       |   |   |   |   |
| **Contract  benefits**                 |       |                                       |       |                                      |       |   |   |   |   |
| Direct                                 |       | $                                          | 430        |                                      | $          | 426 |   | $ | 1,261 |   | $ | 1,409 |   |
| Assumed                                |       |                                       |       |                                      |       |   |   |   |   |
| Affiliate                              |       | 3                                          |       | 2                                         |       | 10 |   | 4 |   |
| Non-affiliate                          |       | 1                                          |       | 14                                        |       | 4 |   | 34 |   |
| Ceded–non-affiliate               |       | (102                                       | )          | (91                                       | )          | (294 | ) | (251 | ) |
| Contract  benefits, net of reinsurance |       | $                                          | 332        |                                      | $          | 351 |   | $ | 981 |   | $ | 1,196 |   |

 

For the nine-month period ended September 30,2004, income tax expense on the Condensed Consolidated Statement of Operationsincludes $6 million of expense related to the write-off of a tax receivableresulting from the termination of a reinsurance agreement with anonconsolidated affiliate that does not file with ALIC in the consolidated taxreturn.

 

**4.****             ****Debt**

 

As of September 30, 2004, debt includes $64million of mandatorily redeemable preferred stock (“preferred stock”) that wasreclassified to long-term debt during the second quarter of 2004 in accordancewith the provisions of Statement of Financial Accounting Standards No. 150, “Accountingfor Certain Financial Instruments with Characteristics of both Liabilities andEquity”.  The reclassification occurredas a result of changes to contractual arrangements between the Company and theholders of the preferred stock resulting in the preferred stock becomingmandatorily redeemable.  As of December 31,2003, the balance of the preferred stock subject to reclassification amountedto $77 million.  During the first ninemonths of 2004, $13 million of this mandatorily redeemable preferred stock wasredeemed.

 

**5.****             ****Guarantees and ContingentLiabilities**

 

**Guarantees**

 

The Company owns certain fixed income securitiesthat obligate the Company to exchange credit risk or to forfeit principal due,depending on the nature or occurrence of specified credit events for thereferenced entities.  In

 

8

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theevent all such specified credit events were to occur, the Company’s maximumamount at risk on these fixed income securities, as measured by the par value,was $90 million at September 30, 2004. The obligations associated with these fixed income securities expire atvarious times during the next seven years.

 

Lincoln Benefit Life Company (“LBL”), a wholly ownedsubsidiary of ALIC, has issued universal life insurance contracts to thirdparties who finance the premium payments on the universal life insurancecontracts through a commercial paper program. LBL has issued a repayment guarantee on the outstanding commercial paperbalance that is fully collateralized by the cash surrender value of theuniversal life insurance contracts.  At September 30,2004, the amount due under the commercial paper program is $302 million and thecash surrender value of the policies is $309 million.  The repayment guarantee expires April 30,2006.

 

In the normal course of business, the Companyprovides standard indemnifications to counterparties in contracts in connectionwith numerous transactions, including indemnifications for breaches ofrepresentations and warranties, taxes and certain other liabilities, such asthird party lawsuits.  Theindemnification clauses are often standard contractual terms and were enteredinto in the normal course of business based on an assessment that the risk ofloss would be remote.  The terms of theindemnifications vary in duration and nature. In many cases, the maximum obligation is not explicitly stated and thecontingencies triggering the obligation to indemnify have not occurred and arenot expected to occur.  Because theobligated amounts of the indemnifications are not explicitly stated in manycases, the maximum amount of the obligation under such indemnifications is notdeterminable.  Historically, the Companyhas not made any material payments pursuant to these obligations.

 

The aggregate liability balance related to allguarantees was not material as of September 30, 2004.

 

**Regulation**

 

The Company is subject to changing social, economicand regulatory conditions.  Recent stateand federal regulatory initiatives and proceedings have included efforts toremove barriers preventing banks from engaging in the securities and insurancebusinesses, change tax laws affecting the taxation of insurance companies andthe tax treatment of insurance products or competing non-insurance productsthat may impact the relative desirability of various personal investmentproducts and otherwise expand overall regulation of insurance products and theinsurance industry. The ultimate changes and eventual effects of theseinitiatives on the Company’s business, if any, are uncertain.

 

Regulatory bodies have contacted the Company andhave requested information relating to variable insurance products, includingsuch areas as market timing and late trading and sales practices. The Companybelieves that these inquiries are similar to those made to many financialservices companies as part of an industry-wide investigation by variousregulatory agencies into the practices, policies and procedures relating tovariable insurance products sales and subaccount trading practices. The Companyhas and will continue to respond to these information requests andinvestigations. The Company at the present time is not aware of any systemicproblems with respect to such matters that may have a material adverse effecton the Company’s consolidated financial position.

 

9

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**Legal Proceedings**

 

**Background**

 

The Company and certain of its affiliates are namedas defendants in a number of lawsuits and other legal proceedings arising outof various aspects of its business.   Asbackground to the “Proceedings” sub-section below, please note thefollowing:

 

•                  Thesematters raise difficult and complicated factual and legal issues and aresubject to many uncertainties and complexities, including but not limited to,the underlying facts of each matter, novel legal issues, variations betweenjurisdictions in which matters are being litigated, differences in applicablelaws and judicial interpretations, the length of time before many of thesematters might be resolved by settlement or through litigation and, in somecases, the timing of their resolutions relative to other similar cases broughtagainst other companies, the fact that some of these matters are putative classactions in which a class has not been certified and in which the purportedclass may not be clearly defined, the fact that some of these matters involvemulti-state class actions in which the applicable law(s) for the claims atissue is in dispute and therefore unclear, and the current challenging legalenvironment faced by large corporations and insurance companies.

 

•                  Inthese matters, plaintiffs seek a variety of remedies including equitable reliefin the form of injunctive and other remedies and monetary relief in the form ofcontractual and extra-contractual damages. In some cases, the monetary damages sought include punitive or trebledamages or are not specified.  Often morespecific information beyond the type of relief sought is not available becauseplaintiffs have not requested more specific relief in their courtpleadings.  In those cases whereplaintiffs have made a specific demand for monetary damages, they often specifydamages just below a jurisdictional limit regardless of the facts of thecase.  This represents the maximum theycan seek without risking removal from state court to federal court.  In our experience, monetary demands inplaintiffs’ court pleadings bear little relation to the ultimate loss, if any,to the Company.

 

•                  Forthe reasons specified above, it is not possible to make meaningful estimates ofthe amount or range of loss that could result from these matters at thistime.  The Company reviews these matterson an on-going basis and follows the provisions of Statement of FinancialAccounting Standards No. 5, “Accounting for Contingencies” when making accrualand disclosure decisions.  When assessingreasonably possible and probable outcomes, the Company bases its decisions onits assessment of the ultimate outcome following all appeals.

 

•                  Inthe opinion of the Company’s management, while some of these matters may bematerial to the Company’s operating results for any particular period if anunfavorable outcome results, none will have a material adverse effect on theconsolidated financial condition of the Company.

 

**Proceedings**

 

Legal proceedings involving Allstate agencies andAIC may impact the Company, even when the Company is not directly involved,because the Company sells its products through a variety of distributionchannels including Allstate agencies. Consequently, information about the more significant of theseproceedings is provided below.

 

AIC is defending various lawsuits involving workerclassification issues. A putative nationwide class action filed by formeremployee agents includes a worker classification issue; these agents arechallenging certain amendments to the Agents Pension Plan and are seeking tohave exclusive agent independent contractors treated as employees for benefitpurposes.  This matter was dismissed withprejudice in late March 2004 by the trial court but will be the subject offurther proceedings on appeal.  AIC hasbeen vigorously defending this and various other worker classificationlawsuits. The outcome of these disputes is currently uncertain.

 

AIC is defending certain matters relating to itsagency program reorganization announced in 1999. These matters include alawsuit filed in December 2001 by the U.S. Equal Employment OpportunityCommission (“EEOC”) alleging retaliation under federal civil rights laws, aclass action filed in August 2001 by former employee

 

10

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agentsalleging retaliation and age discrimination under the Age Discrimination inEmployment Act, breach of contract and ERISA violations, and a lawsuit filed inOctober 2004 by the EEOC alleging age discrimination with respect to apolicy limiting the rehire of agents affected by the agency programreorganization.  AIC is also defendinganother action, in which a class was certified in June 2004, filed byformer employee agents who terminated their employment prior to the agencyprogram reorganization.  These plaintiffshave asserted claims under ERISA and for constructive discharge, and areseeking the benefits provided in connection with the reorganization.  AIC has asked the court to reconsider itsclass certification ruling.  In late March 2004,in the first EEOC lawsuit and class action lawsuit, the trial court issued amemorandum and order that, among other things, certified classes of agents,including a mandatory class of agents who had signed a release, for purposes ofeffecting the court’s declaratory judgment that the release is voidable at theoption of the release signer.  The courtalso ordered that an agent who voids the release must return to AIC “any andall benefits received by the [agent] in exchange for signing the release.”  The court also “concluded that, on theundisputed facts of record, there is no basis for claims of age discrimination.”  The EEOC and plaintiffs have asked the courtto clarify and/or reconsider its memorandum and order.  The case otherwise remains pending.  A putative nationwide class action has also beenfiled by former employee agents alleging various violations of ERISA.  This matter was dismissed with prejudice inlate March 2004 by the trial court but will be the subject of furtherproceedings on appeal.  In these matters,plaintiffs seek compensatory and punitive damages, and equitable relief.  AIC has been vigorously defending theselawsuits and other matters related to its agency program reorganization. Inaddition, AIC is defending certain matters relating to its life agency programreorganization announced in 2000. These matters include an investigation by theEEOC with respect to allegations of age discrimination and retaliation. AIC iscooperating fully with the agency investigation and will continue to vigorouslydefend these and other claims related to the life agency programreorganization. The outcome of these disputes is currently uncertain.

 

The Company is defending various lawsuits andregulatory proceedings that allege that it engaged in business or salespractices inconsistent with state or federal law.  In addition, the Company is defending anumber of lawsuits brought by plaintiffs challenging trading restrictions theCompany adopted in an effort to limit market-timing activity in its variableannuity sub-accounts.  In one case,plaintiffs’ motion for summary judgment on their breach of contract claims wasgranted and the matter will proceed to trial on damages pending the Company’srequest for an interlocutory appeal.   Inthese various lawsuits, plaintiffs seek a variety of remedies includingmonetary and equitable relief.  TheCompany has been vigorously defending these matters, but their outcome iscurrently uncertain.

 

**Other Matters**

 

The Corporation and its affiliates, including theCompany, have received interrogatories and demands to produce information fromseveral regulatory and enforcement authorities.  These authorities are seeking informationrelevant to on-going investigations into the possible violation of antitrust orinsurance laws by unnamed parties and, in particular, are seeking informationas to whether any person engaged in activities for the purpose of price fixing,market allocation, or bid rigging.  Published press reports have indicatedthat numerous demands of this nature have been sent to insurance companies aspart of industry-wide investigations. The Corporation intends to cooperate fully with these and any similarrequests for information.

 

Various other legal and regulatory actions arecurrently pending that involve the Company and specific aspects of its conductof business. Like other members of the insurance industry, the Company is thetarget of a number of class action lawsuits and other types of litigation, someof which involve claims for substantial or indeterminate amounts.  This litigation is based on a variety ofissues including insurance and claim settlement practices. The outcome of thesedisputes is currently unpredictable. However, at this time, based on their present status, it is the opinionof management that the ultimate liability, if any, in one or more of theseother actions in excess of amounts currently reserved is not expected to have amaterial effect on the results of operations, liquidity or financial positionof the Company.

 

11

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**6.****             ****Other Comprehensive Income**

 

The components of other comprehensive income on a pretaxand after-tax basis are as follows:

 
| ** **                                                                                               | ** ** | **Three months ended  September 30,** | ** ** |
|----------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                               | ** ** | **2004**                                   | ** ** | **2003** | ** ** |
| **(in millions)**                                                                                        | ** ** | **Pretax**                                 | ** ** | **Tax** | ** ** | **After-  tax** | ** ** | **Pretax** | ** ** | **Tax** | ** ** | **After-  tax** | ** ** |
| ** **                                                                                               | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| *Unrealized  net capital gains and losses and net gains and losses on derivative financial  instruments* |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Unrealized  holding gains (losses) arising** **during the  period                                   |       | $                                          | 494        |   | $ | (173 | ) | $ | 321 |   | $ | (315 | ) | $ | 110 |   | $ | (205 | ) |
| Less:  reclassification adjustments                                                                      |       | (52                                        | )          | 18 |   | (34 | ) | 11 |   | (4 | ) | 7 |   |
| Unrealized  net capital gains (losses)                                                                   |       | 546                                        |       | (191 | ) | 355 |   | (326 | ) | 114 |   | (212 | ) |
| Net gains  (losses) on derivative financial instruments arising during the period                        |       | —                                     |       | — |   | — |   | — |   | — |   | — |   |
| Less:  reclassification adjustments                                                                      |       | (1                                         | )          | 1 |   | — |   | — |   | — |   | — |   |
| Net gains  (losses) on derivative financial instruments                                                  |       | 1                                          |       | (1 | ) | — |   | — |   | — |   | — |   |
| Other  comprehensive income (loss)                                                                       |       | $                                          | 547        |   | $ | (192 | ) | 355 |   | $ | (326 | ) | $ | 114 |   | (212 | ) |
| Net income                                                                                               |       |                                       |       |   |   | 76 |   |   |   |   |   | 119 |   |
| Comprehensive  income (loss)                                                                             |       |                                       |       |   |   | $ | 431 |   |   |   |   |   | $ | (93 | ) |

 
| ** **                                                                                               | ** ** | **Nine months ended  September 30,** | ** ** |
|----------------------------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                                               | ** ** | **2004**                                  | ** ** | **2003** | ** ** |
| **(in millions)**                                                                                        | ** ** | **Pretax**                                | ** ** | **Tax** | ** ** | **After-  tax** | ** ** | **Pretax** | ** ** | **Tax** | ** ** | **After-  tax** | ** ** |
| ** **                                                                                               | ** ** | ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| *Unrealized  net capital gains and losses and net gains and losses on derivative financial  instruments* |       |                                      |       |   |   |   |   |   |   |   |   |   |   |
| Unrealized  holding gains (losses) arising during the period                                             |       | $                                         | (156       | ) | $ | 54 |   | $ | (102 | ) | $ | 205 |   | $ | (72 | ) | $ | 133 |   |
| Less:  reclassification adjustments                                                                      |       | (107                                      | )          | 37 |   | (70 | ) | (51 | ) | 18 |   | (33 | ) |
| Unrealized  net capital gains (losses)                                                                   |       | (49                                       | )          | 17 |   | (32 | ) | 256 |   | (90 | ) | 166 |   |
| Net gains  (losses) on derivative financial instruments arising during the period                        |       | —                                    |       | — |   | — |   | — |   | — |   | — |   |
| Less:  reclassification adjustments                                                                      |       | (2                                        | )          | 1 |   | (1 | ) | (1 | ) | — |   | (1 | ) |
| Net gains  (losses) on derivative financial instruments                                                  |       | 2                                         |       | (1 | ) | 1 |   | 1 |   | — |   | 1 |   |
| Other  comprehensive income (loss)                                                                       |       | $                                         | (47        | ) | $ | 16 |   | (31 | ) | $ | 257 |   | $ | (90 | ) | 167 |   |
| Net income                                                                                               |       |                                      |       |   |   | 47 |   |   |   |   |   | 243 |   |
| Comprehensive  income                                                                                    |       |                                      |       |   |   | $ | 16 |   |   |   |   |   | $ | 410 |   |

 

12

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**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

 

Tothe Board of Directors and Shareholder ofAllstate Life Insurance Company:

 

We have reviewed the accompanying condensedconsolidated statement of financial position of Allstate Life Insurance Companyand subsidiaries (the “Company”) as of September 30, 2004, and the relatedcondensed consolidated statements of operations for the three-month andnine-month periods ended September 30, 2004 and 2003, and the condensedconsolidated statements of cash flows for the nine-month periods ended September 30,2004 and 2003.  These interim financialstatements are the responsibility of the Company’s management.

 

We conducted our reviews in accordance withstandards of the Public Company Accounting Oversight Board (UnitedStates).  A review of interim financialinformation consists principally of applying analytical procedures and makinginquiries of persons responsible for financial and accounting matters.  It is substantially less in scope than anaudit conducted in accordance with standards of the Public Company AccountingOversight Board (United States), the objective of which is the expression of anopinion regarding the financial statements taken as a whole.  Accordingly, we do not express such anopinion.

 

Based on our reviews, we are not aware of anymaterial modifications that should be made to such condensed consolidatedinterim financial statements for them to be in conformity with accountingprinciples generally accepted in the United States of America.

 

We have previously audited, in accordance withauditing standards of the Public Company Accounting Oversight Board (UnitedStates), the consolidated statement of financial position of Allstate LifeInsurance Company and subsidiaries as of December 31, 2003, and therelated consolidated statements of operations and comprehensive income,shareholder’s equity, and cash flows for the year then ended, not presentedherein.  In our report dated February 4,2004, which report includes an explanatory paragraph as to changes in theCompany’s methods of accounting for embedded derivatives in modifiedcoinsurance agreements and variable interest entities in 2003, we expressed anunqualified opinion on those consolidated financial statements.  In our opinion, the information set forth inthe accompanying condensed consolidated statement of financial position as of December 31,2003 is fairly stated, in all material respects, in relation to theconsolidated statement of financial position from which it has been derived.

 

 
| /s/ Deloitte & Touche LLP |   |
|-------------------------------|--------|
|                          |
| Chicago, Illinois             |
| November 10, 2004        |

 

13

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**Item 2****.  MANAGEMENT’S DISCUSSION AND ANALYSIS OFFINANCIAL CONDITION AND RESULTS OFOPERATIONS FOR THE THREE-MONTH AND NINE-MONTH PERIODS ENDED SEPTEMBER 30,2004 AND 2003**

 

**OVERVIEW**

 

The following discussion highlights significantfactors influencing the consolidated financial position and results ofoperations of Allstate Life Insurance Company (referred to in this document as “we”,“our”, “us”, or the “Company”). It should be read in conjunction with thecondensed consolidated financial statements and notes thereto found under PartI. Item 1. contained herein, and with the discussion, analysis, consolidatedfinancial statements and notes thereto in Part I. Item 1. and Part II. Item 7.and Item 8. of the Allstate Life Insurance Company Annual Report on Form 10-Kfor 2003.  We operate as a single segmententity, consistent with the way in which we use financial information toevaluate business performance and to determine the allocation of resources.

 

**HIGHLIGHTS**

 

•                  Revenues decreasedby $42 million or 3.5% in the third quarter of 2004 and decreased $174 millionor 4.8% in the first nine months of 2004 compared to the same periods in theprior year.   Increases in net investmentincome of $53 million and $111 million in the third quarter and first ninemonths of 2004, respectively, and increases in contract charges on variableannuities and interest-sensitive life of $27 million and $68 million in thethird quarter and first nine months of 2004, respectively, were more thanoffset by lower premiums due to the disposal of the majority of our directresponse distribution business, lower premiums on immediate annuities with lifecontingencies and higher realized capital losses in both periods.

•                  Contractholder deposits totaled $3.39 billionand $9.72 billion for the third quarter and first nine months of 2004,respectively, compared to $3.19 billion and $7.49 billion for the third quarterand first nine months of 2003, respectively. Favorable market conditions for institutional products and competitivepricing on fixed annuities contributed to the increase in deposits.

•                  Net incomedecreased 36.1% to $76 million in the third quarter of 2004 and 80.7% to $47million in the first nine months of 2004 compared to the same periods in theprior year.  Lower operating costs andexpenses and higher gross margin were more than offset by higher realizedcapital losses in both periods.  Inaddition, the first nine months of 2004 included a $175 million after-taxcharge related to the cumulative effect of a change in accounting principle forAICPA Statement of Position 03-1 (“SOP 03-1”), “Accounting and Reporting byInsurance Enterprises for Certain Nontraditional Long-Duration Contracts andfor Separate Accounts”, which was adopted on January 1, 2004.  Income before the cumulative effect of changein accounting principle, after-tax, declined 8.6% or $21 million compared tothe first nine months of 2003.

•                  Total investments increased 13.5% as of September 30,2004 compared to December 31, 2003 due primarily to strong contractholderdeposits.

•                  When comparing the third quarter and firstnine months of 2004 to the same periods in the prior year, the disposal of themajority of our direct response distribution business resulted in the followingeffects.

 
| ** **                         | ** ** | **Three Months**                  | ** ** | **Nine Months**                   | ** ** |
|------------------------------------|------------|-----------------------------------|------------|-----------------------------------|------------|
| ** **                         | ** ** | **Ended September 30, 2004** | ** ** | **Ended September 30, 2004** | ** ** |
| ** **                         | ** ** | **Compared to the Same**          | ** ** | **Compared to the Same**          | ** ** |
| **(in  millions)**                 | ** ** | **Period in the Prior Year**      | ** ** | **Period in the Prior Year**      | ** ** |
|                               |       |                              |       |                              |       |
| **Favorable (unfavorable):**       |       |                              |       |                              |       |
| Total  revenues                    |       | $                                 | (54        | )                                 | $          | (171 | ) |
| Contract  benefits                 |       | 34                                |       | 87                                |       |
| Amortization  of DAC               |       | 9                                 |       | 26                                |       |
| Operating  costs and expenses      |       | 19                                |       | 56                                |       |
| Loss on  disposition of operations |       | 7                                 |       | (4                                | )          |
| Income tax  expense                |       | (5                                | )          | 2                                 |       |
|                               |       |                              |       |                              |       |
| Net income                         |       | $                                 | 10         |                              | $          | (4 | ) |

 

14

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**OPERATIONS**

 

**Premiums** representrevenues generated from traditional life, immediate annuities with lifecontingencies and other insurance products that have significant mortality ormorbidity risk.

 

**Contract charges** are revenues generated frominterest-sensitive life products, variable annuities, fixed annuities and otherinvestment products for which deposits are classified as contractholder fundsor separate accounts liabilities on the Condensed Consolidated Statements ofFinancial Position.  Contract charges areassessed against the contractholder account values for maintenance,administration, cost of insurance and surrender prior to contractuallyspecified dates.   As a result, changesin contractholder funds and separate accounts liabilities are considered in theevaluation of growth and as indicators of future levels of revenues.

 

The following table summarizes premiums and contractcharges by product.

 
| ** **                                   | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| **(in millions)**                            | ** ** | **2004**                                   | ** ** | **2003**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                   | ** ** | ** **                                 | ** ** | ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Premiums**                                 |       |                                       |       |                                      |       |   |   |   |   |
| Traditional  life                            |       | $                                          | 75         |                                      | $          | 101 |   | $ | 234 |   | $ | 288 |   |
| Immediate  annuities with life contingencies |       | 66                                         |       | 67                                        |       | 209 |   | 318 |   |
| Other                                        |       | —                                     |       | 36                                        |       | — |   | 119 |   |
| **Total  premiums**                          |       | 141                                        |       | 204                                       |       | 443 |   | 725 |   |
|                                         |       |                                       |       |                                      |       |   |   |   |   |
| **Contract  charges**                        |       |                                       |       |                                      |       |   |   |   |   |
| Interest-sensitive  life                     |       | 170                                        |       | 152                                       |       | 491 |   | 456 |   |
| Fixed  annuities                             |       | 13                                         |       | 10                                        |       | 41 |   | 28 |   |
| Variable  annuities                          |       | 61                                         |       | 52                                        |       | 182 |   | 149 |   |
| Institutional  products                      |       | —                                     |       | —                                    |       | — |   | 6 |   |
| Other                                        |       | —                                     |       | —                                    |       | — |   | 3 |   |
| **Total  contract charges**                  |       | 244                                        |       | 214                                       |       | 714 |   | 642 |   |
| **Total  premiums and contract charges**     |       | $                                          | 385        |                                      | $          | 418 |   | $ | 1,157 |   | $ | 1,367 |   |

 

The following table summarizes premiums and contractcharges by distribution channel.

 
| ** **                                 | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|--------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| **(in millions)**                          | ** ** | **2004**                                   | ** ** | **2003**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                 |       |                                       |       |                                      |       |   |   |   |   |
| **Premiums**                               |       |                                       |       |                                      |       |   |   |   |   |
| Allstate  agencies                         |       | $                                          | 67         |                                      | $          | 58 |   | $ | 194 |   | $ | 167 |   |
| Specialized  brokers                       |       | 51                                         |       | 63                                        |       | 165 |   | 314 |   |
| Independent  agents                        |       | 10                                         |       | 18                                        |       | 41 |   | 32 |   |
| Direct response                            |       | 13                                         |       | 65                                        |       | 43 |   | 212 |   |
| **Total  premiums**                        |       | 141                                        |       | 204                                       |       | 443 |   | 725 |   |
| ** **                                 |       |                                       |       |                                      |       |   |   |   |   |
| **Contract  charges**                      | ** ** | ** **                                 | ** ** | ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** |
| Allstate  agencies                         |       | 115                                        |       | 110                                       |       | 344 |   | 327 |   |
| Specialized  brokers                       |       | 7                                          |       | 7                                         |       | 19 |   | 23 |   |
| Independent  agents                        |       | 60                                         |       | 50                                        |       | 177 |   | 155 |   |
| Financial  institutions and broker/dealers |       | 62                                         |       | 47                                        |       | 174 |   | 137 |   |
| **Total  contract charges**                |       | 244                                        |       | 214                                       |       | 714 |   | 642 |   |
| **Total  premiums and contract charges**   |       | $                                          | 385        |                                      | $          | 418 |   | $ | 1,157 |   | $ | 1,367 |   |

 

15

----

 

Total premiums decreased 30.9% to $141 million inthe third quarter of 2004 and 38.9% to $443 million in the first nine months of2004 compared to the same periods of 2003. The decrease in both periods wasdue to the disposal of the majority of our direct response distribution business,which resulted in lower other and traditional life premiums.  Additionally, the nine-month period reflectslower premiums on immediate annuities with life contingencies as stricterunderwriting practices reduced sales of large individual contracts in 2004.

 

Contract charges increased 14.0% to $244 million inthe third quarter of 2004 and 11.2% to $714 million in the first nine months of2004 compared to the same periods of 2003. The increase in both periods was primarily due to higher contractcharges on variable annuities as a result of overall higher account values inthe current periods and increased contract charges on interest-sensitive lifeproducts resulting from in force business growth.  The higher variable annuity account values inthe current periods were primarily attributable to favorable investment resultsduring 2003 and net deposits, partially offset by surrenders and benefits.

 

*Contractholder funds* represent interest-bearing liabilitiesarising from the sale of individual products, such as interest-sensitive lifeand fixed annuities, or institutional products, such as funding agreements. Thebalance of contractholder funds is equal to the cumulative deposits receivedand interest credited to the contractholder less cumulative contract maturities,benefits, surrenders, withdrawals and contract charges for mortality oradministrative expenses.

 

The following table shows the changes incontractholder funds.

 
| ** **                                                      | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-----------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| **(in millions)**                                               | ** ** | **2004**                                   | ** ** | **2003**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                      |       |                                       |       |                                      |       |   |   |   |   |
| **Contractholder  funds, beginning balance**                    |       | $                                          | 49,365     |                                      | $          | 41,393 |   | $ | 44,914 |   | $ | 38,858 |   |
|                                                            |       |                                       |       |                                      |       |   |   |   |   |
| Impact of  adoption of SOP 03-1(1)                              |       | —                                     |       | —                                    |       | 421 |   | — |   |
|                                                            |       |                                       |       |                                      |       |   |   |   |   |
| **Deposits**                                                    |       |                                       |       |                                      |       |   |   |   |   |
| Fixed  annuities (immediate and deferred)                       |       | 2,114                                      |       | 1,578                                     |       | 4,965 |   | 4,050 |   |
| Institutional  products                                         |       | 852                                        |       | 1,076                                     |       | 3,452 |   | 2,062 |   |
| Interest-sensitive  life                                        |       | 323                                        |       | 247                                       |       | 932 |   | 682 |   |
| Variable  annuity and life deposits allocated to fixed accounts |       | 102                                        |       | 289                                       |       | 373 |   | 698 |   |
| Total  deposits                                                 |       | 3,391                                      |       | 3,190                                     |       | 9,722 |   | 7,492 |   |
|                                                            |       |                                       |       |                                      |       |   |   |   |   |
| **Interest  credited**                                          |       | 488                                        |       | 447                                       |       | 1,395 |   | 1,319 |   |
|                                                            |       |                                       |       |                                      |       |   |   |   |   |
| **Maturities,  benefits, withdrawals and other adjustments**    |       |                                       |       |                                      |       |   |   |   |   |
| Maturities  of institutional products                           |       | (820                                       | )          | (569                                      | )          | (1,915 | ) | (1,662 | ) |
| Benefits and  withdrawals                                       |       | (862                                       | )          | (716                                      | )          | (2,445 | ) | (1,973 | ) |
| Contract  charges                                               |       | (155                                       | )          | (140                                      | )          | (442 | ) | (418 | ) |
| Net  transfers to separate accounts                             |       | (94                                        | )          | (129                                      | )          | (328 | ) | (271 | ) |
| Fair value  hedge adjustments for institutional products        |       | 66                                         |       | (27                                       | )          | (46 | ) | 60 |   |
| Other adjustments                                               |       | (3                                         | )          | 30                                        |       | 100 |   | 74 |   |
| Total  maturities, benefits, withdrawals and other adjustments  |       | (1,868                                     | )          | (1,551                                    | )          | (5,076 | ) | (4,190 | ) |
|                                                            |       |                                       |       |                                      |       |   |   |   |   |
| **Contractholder  funds, ending balance**                       |       | $                                          | 51,376     |                                      | $          | 43,479 |   | $ | 51,376 |   | $ | 43,479 |   |

 

(1)          The increase in contractholder funds due to the adoption of SOP 03-1reflects the reclassification of certain products previously included as acomponent of separate accounts to contractholder funds, the reclassification ofdeferred sales inducements from contractholder funds to other assets and theestablishment of reserves for certain liabilities that are primarily related toincome and death benefit guarantees provided under variable annuity contracts.

----

 

16

----

 

Contractholder deposits increased 6.3% in the thirdquarter and 29.8% in the first nine months of 2004 compared to the same periodsin 2003 due to increased fixed annuity deposits in both periods, with higherinstitutional product deposits also contributing to the increase in the firstnine months. These new deposits contributed to increases in averagecontractholder funds, excluding the impact of adopting SOP 03-1, of 18.7% inthe third quarter and 16.4% in the first nine months of 2004 compared to thesame periods in 2003.  Fixed annuitydeposits increased 34.0% and 22.6% in the third quarter and first nine monthsof 2004, respectively, compared to the same periods in 2003. The increases wereattributable to strong consumer demand and competitive pricing.  Institutional product deposits decreased20.8% in the third quarter of 2004 and increased 67.4% in the first nine monthsof 2004 compared to the same periods in 2003, largely due to our assessment ofmarket conditions for these products. Institutional product deposits for the firstnine months of 2004 include the inaugural offering during the second quarter ofour Securities and Exchange Commission (“SEC”) registered program totaling $800million.

 

Benefits and withdrawals increased 20.4% in thethird quarter and 23.9% in the first nine months of 2004 compared to the sameperiods in 2003.  Benefits andwithdrawals for the third quarter and first nine months of 2004 represent anannualized withdrawal rate of 9.1% and 9.3%, respectively, based on thebeginning of period contractholder funds balance excluding institutionalproduct reserves, compared to 8.9% and 8.8% for the third quarter and firstnine months of 2003, respectively.

 

***Separateaccounts liabilities*** represent contractholders’ claims to the related legallysegregated separate accounts assets. Separate accounts liabilities primarily arise from the sale of variableannuity contracts and variable life insurance policies.  The following table shows the changes inseparate accounts liabilities.

 
| ** **                                                      | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-----------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| **(in millions)**                                               | ** ** | **2004**                                   | ** ** | **2003**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                      |       |                                       |       |                                      |       |   |   |   |   |
| **Separate  accounts liabilities, beginning balance**           |       | $                                          | 13,564     |                                      | $          | 11,823 |   | $ | 13,425 |   | $ | 11,125 |   |
|                                                            |       |                                       |       |                                      |       |   |   |   |   |
| Impact of  adoption of SOP 03-1(1)                              |       | —                                     |       | —                                    |       | (204 | ) | — |   |
|                                                            |       |                                       |       |                                      |       |   |   |   |   |
| Variable  annuity and life deposits                             |       | 361                                        |       | 653                                       |       | 1,322 |   | 1,653 |   |
| Variable  annuity and life deposits allocated to fixed accounts |       | (102                                       | )          | (289                                      | )          | (373 | ) | (698 | ) |
| Net deposits                                                    |       | 259                                        |       | 364                                       |       | 949 |   | 955 |   |
| Investment  results                                             |       | (152                                       | )          | 296                                       |       | 209 |   | 1,266 |   |
| Contract  charges                                               |       | (64                                        | )          | (54                                       | )          | (189 | ) | (160 | ) |
| Net  transfers from fixed accounts                              |       | 94                                         |       | 129                                       |       | 328 |   | 271 |   |
| Surrenders  and benefits                                        |       | (388                                       | )          | (381                                      | )          | (1,205 | ) | (1,280 | ) |
|                                                            |       |                                       |       |                                      |       |   |   |   |   |
| **Separate  accounts liabilities, ending balance**              |       | $                                          | 13,313     |                                      | $          | 12,177 |   | $ | 13,313 |   | $ | 12,177 |   |

 

(1) The decrease in separateaccounts due to the adoption of SOP 03-1 reflects the reclassification ofcertain products previously included as a component of separate accounts tocontractholder funds.

----

 

Separate accounts liabilities, excluding theimpact of adopting SOP 03-1, decreased $251 million and increased $92 millionduring the third quarter and first nine months of 2004, respectively, comparedto increases of $354 million and $1.05 billion during the third quarter andfirst nine months of 2003, respectively. The decline in the third quarter was due to unfavorable investmentresults and net cash outflows.  In thenine-month period, the increase resulted from positive investment results andnet cash inflows partially offset by increased contract charges.  Variable annuity contractholders oftenallocate a significant portion of their initial variable annuity contractdeposit into a fixed rate investment option. The level of this activity is reflected above in the deposits allocatedto the fixed accounts, while all other transfer activity between the fixed andseparate accounts investment options is reflected in net transfers from fixedaccounts.  The liability for the fixedportion of variable annuity contracts is reflected in contractholder funds.

 

17

----

 

**Net investment income** increased 6.8% in the third quarter of 2004and 4.8% in the first nine months of 2004 compared to the same periods in2003.  The increases in both periods wereprimarily the result of the effect of higher portfolio balances, partiallyoffset by lower portfolio yields.  Higherportfolio balances resulted from the investment of cash flows from operatingand financing activities.  Totalinvestments as of September 30, 2004, increased 13.6% from September 30,2003 due primarily to contractholder deposits, partially offset by a decline inunrealized capital gains on fixed income securities.  The lower portfolio yields were primarily dueto purchases, including reinvestments, of fixed income securities with yieldslower than the current portfolio average.

 

**Net income** analysis is presented in the following table.

 
| ** **                                                                                             | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|--------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| **(in millions)**                                                                                      | ** ** | **2004**                                   | ** ** | **2003**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
| Premiums                                                                                               |       | $                                          | 141        |                                      | $          | 204 |   | $ | 443 |   | $ | 725 |   |
| Contract  charges                                                                                      |       | 244                                        |       | 214                                       |       | 714 |   | 642 |   |
| Net  investment income                                                                                 |       | 828                                        |       | 775                                       |       | 2,406 |   | 2,295 |   |
| Periodic  settlements and accruals on non-hedge derivative instruments                                 |       | 15                                         |       | 10                                        |       | 33 |   | 15 |   |
| Contract  benefits                                                                                     |       | (332                                       | )          | (351                                      | )          | (981 | ) | (1,196 | ) |
| Interest  credited to contractholder funds(1)                                                          |       | (481                                       | )          | (447                                      | )          | (1,372 | ) | (1,319 | ) |
| **Gross  margin**                                                                                      |       | 415                                        |       | 405                                       |       | 1,243 |   | 1,162 |   |
|                                                                                                   |       |                                       |       |                                      |       |   |   |   |   |
| Amortization  of DAC and DSI                                                                           |       | (107                                       | )          | (92                                       | )          | (332 | ) | (324 | ) |
| Operating  costs and expenses                                                                          |       | (104                                       | )          | (122                                      | )          | (329 | ) | (361 | ) |
| Income tax  expense                                                                                    |       | (69                                        | )          | (60                                       | )          | (205 | ) | (150 | ) |
| Realized  capital gains and losses, after-tax                                                          |       | (34                                        | )          | 7                                         |       | (95 | ) | (46 | ) |
| DAC and DSI  amortization relating to realized capital gains and losses, after-tax                     |       | (15                                        | )          | (4                                        | )          | (28 | ) | (20 | ) |
| Reclassification  of periodic settlements and accruals on non-hedge derivative instruments,  after-tax |       | (10                                        | )          | (7                                        | )          | (21 | ) | (10 | ) |
| Loss on  disposition of operations, after-tax                                                          |       | —                                     |       | (8                                        | )          | (11 | ) | (8 | ) |
| Cumulative  effect of change in accounting principle, after-tax                                        |       | —                                     |       | —                                    |       | (175 | ) | — |   |
| **Net  income**                                                                                        |       | $                                          | 76         |                                      | $          | 119 |   | $ | 47 |   | $ | 243 |   |

 

(1)          Beginning in 2004, amortization of DSI is excluded from interestcredited to contractholder funds for purposes of calculating gross margin.   Amortization of DSI totaled $4 million inthe third quarter of 2004 and $25 million in the first nine months of2004.  Prior periods have not beenrestated.

----

 

*Gross margin*, a non-GAAP measure, represents premiums andcontract charges and net investment income, less contract benefits and interestcredited to contractholder funds.  We usegross margin as a component of our evaluation of the profitability of our lifeinsurance and financial product portfolio. Additionally, for many of our products, including fixed annuities,variable contracts, and interest-sensitive life insurance, the amortization ofDAC and DSI is determined based on actual and expected gross margin.  Gross margin is comprised of four componentsthat are utilized to further analyze the business: investment margin, benefitmargin, maintenance charges and surrender charges.  We believe gross margin and its componentsare useful to investors because they allow for the evaluation of incomecomponents separately and in the aggregate when reviewing performance.  Gross margin, investment margin and benefitmargin should not be considered as a substitute for net income and do notreflect the overall profitability of the business.  Net income is the GAAP measure that is mostdirectly comparable to these margins. Gross margin is reconciled to GAAP net income in the table above.

 

18

----

 

The components of gross margin are reconciled to thecorresponding financial statement line items in the following table. 

 
| ** **                                                                 | ** ** | **Three Months Ended September 30,** | ** ** |
|----------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                 | ** ** | **Investment  Margin**                    | ** ** | **Benefit  Margin** | ** ** | **Maintenance  Charges** | ** ** | **Surrender  Charges** | ** ** | **Gross  Margin** | ** ** |
| **(in  millions)**                                                         | ** ** | **2004**                                  | ** ** | **2003** | ** ** | **2004** | ** ** | **2003** | ** ** | **2004** | ** ** | **2003** | ** ** | **2004** | ** ** | **2003** | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                                       |       |                                      |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Premiums                                                                   |       | $                                         | —     |   | $ | — |   | $ | 141 |   | $ | 204 |   | $ | — |   | $ | — |   | $ | — |   | $ | — |   | $ | 141 |   | $ | 204 |   |
| Contract charges                                                           |       | —                                    |       | — |   | 130 |   | 117 |   | 98 |   | 79 |   | 16 |   | 18 |   | 244 |   | 214 |   |
| Net investment income                                                      |       | 828                                       |       | 775 |   | — |   | — |   | — |   | — |   | — |   | — |   | 828 |   | 775 |   |
| Periodic settlements and accruals on non-hedge  derivative instruments (1) |       | 15                                        |       | 10 |   | — |   | — |   | — |   | — |   | — |   | — |   | 15 |   | 10 |   |
| Contract benefits                                                          |       | (132                                      | )          | (127 | ) | (200 | ) | (224 | ) | — |   | — |   | — |   | — |   | (332 | ) | (351 | ) |
| Interest credited to contractholder funds (2)                         |       | (481                                      | )          | (447 | ) | — |   | — |   | — |   | — |   | — |   | — |   | (481 | ) | (447 | ) |
|                                                                       |       | $                                         | 230        |   | $ | 211 |   | $ | 71 |   | $ | 97 |   | $ | 98 |   | $ | 79 |   | $ | 16 |   | $ | 18 |   | $ | 415 |   | $ | 405 |   |

 
| ** **                                                                 | ** ** | **Nine Months Ended September 30,** | ** ** |
|----------------------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                 | ** ** | **Investment  Margin**                   | ** ** | **Benefit  Margin** | ** ** | **Maintenance  Charges** | ** ** | **Surrender  Charges** | ** ** | **Gross  Margin** | ** ** |
| **(in  millions)**                                                         | ** ** | **2004**                                 | ** ** | **2003** | ** ** | **2004** | ** ** | **2003** | ** ** | **2004** | ** ** | **2003** | ** ** | **2004** | ** ** | **2003** | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                                       |       |                                     |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Premiums                                                                   |       | $                                        | —     |   | $ | — |   | $ | 443 |   | $ | 725 |   | $ | — |   | $ | — |   | $ | — |   | $ | — |   | $ | 443 |   | $ | 725 |   |
| Contract charges                                                           |       | —                                   |       | — |   | 380 |   | 348 |   | 281 |   | 239 |   | 53 |   | 55 |   | 714 |   | 642 |   |
| Net investment income                                                      |       | 2,406                                    |       | 2,295 |   | — |   | — |   | — |   | — |   | — |   | — |   | 2,406 |   | 2,295 |   |
| Periodic settlements and accruals on non-hedge  derivative instruments (1) |       | 33                                       |       | 15 |   | — |   | — |   | — |   | — |   | — |   | — |   | 33 |   | 15 |   |
| Contract benefits                                                          |       | (388                                     | )          | (383 | ) | (593 | ) | (813 | ) | — |   | — |   | — |   | — |   | (981 | ) | (1,196 | ) |
| Interest credited to contractholder funds (2)                         |       | (1,372                                   | )          | (1,319 | ) | — |   | — |   | — |   | — |   | — |   | — |   | (1,372 | ) | (1,319 | ) |
|                                                                       |       | $                                        | 679        |   | $ | 608 |   | $ | 230 |   | $ | 260 |   | $ | 281 |   | $ | 239 |   | $ | 53 |   | $ | 55 |   | $ | 1,243 |   | $ | 1,162 |   |

 

(1)          Periodic settlements and accruals on non-hedge derivative instrumentsare reflected as a component of realized capital gains and losses on theCondensed Consolidated Statements of Operations.

 

(2)          Beginning in 2004, amortization of DSI is excluded from interestcredited to contractholder funds for purposes of calculating gross margin.   Amortization of DSI totaled $4 million inthe third quarter of 2004 and $25 million in the first nine months of2004.  Prior periods have not beenrestated.

----

 

Gross margin increased 2.5% in the third quarter and7.0% in the first nine months of 2004 compared to the same periods of2003.  The increases in both periods weredue to increased maintenance charges and investment margin, partially offset bya lower benefit margin.  Additionally,the amount of gross margin in any period influences the amount of DAC and DSIamortization during that period. Therefore, the increases in gross margin for these periods resulted inhigher DAC and DSI amortization.

 

*Investment margin* is a component of gross margin, both ofwhich are non-GAAP measures.  Investmentmargin represents the excess of net investment income over interest credited tocontractholder funds and the implied interest on life-contingent immediateannuities included in the reserve for life-contingent contract benefits.  We use investment margin to evaluate ourprofitability related to the difference between investment returns on assetssupporting certain products and amounts credited to customers (“spread”) duringa fiscal period.

 

19

----

 

Investment margin by product group is shown in thefollowing table.

 
| ** **               | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|--------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| **(in millions)**        | ** ** | **2004**                                   | ** ** | **2003**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
| Life  insurance          |       | $                                          | 37         |                                      | $          | 43 |   | $ | 122 |   | $ | 124 |   |
| Annuities                |       | 161                                        |       | 141                                       |       | 465 |   | 408 |   |
| Institutional  products  |       | 32                                         |       | 27                                        |       | 92 |   | 76 |   |
| Total  investment margin |       | $                                          | 230        |                                      | $          | 211 |   | $ | 679 |   | $ | 608 |   |

 

Investment margin increased 9.0% in the thirdquarter of 2004 and 11.7% in the first nine months of 2004 compared to the sameperiods of 2003.  The increases in bothperiods were primarily due to an increase in contractholder funds and, in addition,for the nine-month period, improved yields on investments supporting capital,traditional life and other products.

 

The following table summarizes the annualizedweighted average investment yield, interest crediting rates and investmentspreads for the three months ended September 30.

 
| ** **                                                           | ** ** | **Weighted Average  Investment Yield** | ** ** | **Weighted Average  Interest Crediting Rate** | ** ** | **Weighted Average  Investment Spreads** | ** ** |
|----------------------------------------------------------------------|------------|----------------------------------------|------------|-----------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                           | ** ** | **2004**                               | ** ** | **2003**                                      | ** ** | **2004**                                 | ** ** | **2003** | ** ** | **2004** | ** ** | **2003** | ** ** |
| Interest-sensitive  life                                             |       | 6.4                                    | %          | 6.8                                           | %          | 4.8                                      | %          | 5.1 | % | 1.6 | % | 1.7 | % |
| Fixed  annuities – deferred                                     |       | 5.8                                    |       | 6.3                                           |       | 4.1                                      |       | 4.5 |   | 1.7 |   | 1.8 |   |
| Fixed  annuities – immediate                                    |       | 7.6                                    |       | 7.8                                           |       | 6.8                                      |       | 7.1 |   | 0.8 |   | 0.7 |   |
| Institutional                                                        |       | 3.1                                    |       | 3.3                                           |       | 2.1                                      |       | 2.3 |   | 1.0 |   | 1.0 |   |
| Investments  supporting capital, traditional life and other products |       | 7.0                                    |       | 7.1                                           |       | N/A                                      |       | N/A |   | N/A |   | N/A |   |

 

The following table summarizes the annualizedweighted average investment yield, interest crediting rates and investmentspreads for the nine months ended September 30.

 
| ** **                                                           | ** ** | **Weighted Average  Investment Yield** | ** ** | **Weighted Average  Interest Crediting Rate** | ** ** | **Weighted Average  Investment Spreads** | ** ** |
|----------------------------------------------------------------------|------------|----------------------------------------|------------|-----------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                           | ** ** | **2004**                               | ** ** | **2003**                                      | ** ** | **2004**                                 | ** ** | **2003** | ** ** | **2004** | ** ** | **2003** | ** ** |
| Interest-sensitive  life                                             |       | 6.5                                    | %          | 6.9                                           | %          | 4.8                                      | %          | 5.0 | % | 1.7 | % | 1.9 | % |
| Fixed  annuities – deferred                                     |       | 5.8                                    |       | 6.5                                           |       | 4.1                                      |       | 4.6 |   | 1.7 |   | 1.9 |   |
| Fixed  annuities – immediate                                    |       | 7.6                                    |       | 7.9                                           |       | 6.9                                      |       | 7.0 |   | 0.7 |   | 0.9 |   |
| Institutional                                                        |       | 3.0                                    |       | 3.5                                           |       | 2.0                                      |       | 2.6 |   | 1.0 |   | 0.9 |   |
| Investments  supporting capital, traditional life and other products |       | 7.0                                    |       | 6.5                                           |       | N/A                                      |       | N/A |   | N/A |   | N/A |   |

 

In the third quarter of 2004, compared to the sameperiod in the prior year, the slightly lower yield on the capital, traditionallife and other products investment portfolio resulted from lower incomerealized on equity investments and declining reinvestment yields more thanoffsetting the effect of more effective cash management**. **Inthe first nine months of 2004 compared to the same period in the prior year,the yield on the capital, traditional life and other products investmentportfolio improved due to more effective cash management and higher investment incomerealized on investments accounted for using the equity method ofaccounting.  This increase was partiallyoffset by a decline in fixed annuity and interest-sensitive life investmentspreads as investment yield declines were not fully offset by crediting ratereductions in the comparable period.  Theweighted average interest crediting rates on deferred fixed annuity andinterest-sensitive life products in force, excluding market value adjustedannuities, were approximately 50 basis points more than the underlyinglong-term guaranteed rates on these products as of September 30,2004.  The crediting rate onapproximately 62% of these contracts was at the contractually guaranteedminimum rate as of September 30, 2004.

 

20

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The following table summarizes the liabilities forthese contracts and policies.

 
| ** **                                                                    | ** ** | **September 30,** | ** ** |
|-------------------------------------------------------------------------------|------------|------------------------|------------|
| **(in millions)**                                                             | ** ** | **2004**               | ** ** | **2003** | ** ** |
|                                                                          |       |                   |       |   |   |
| Interest-sensitive  life                                                      |       | $                      | 7,105      |   | $ | 6,338 |   |
| Fixed  annuities – deferred                                              |       | 29,416                 |       | 24,669 |   |
| Fixed annuities  – immediate                                             |       | 10,427                 |       | 9,770 |   |
| Institutional                                                                 |       | 11,277                 |       | 9,182 |   |
|                                                                          |       | 58,225                 |       | 49,959 |   |
| Life-contingent  contracts                                                    |       | 3,549                  |       | 3,219 |   |
| FAS 133  market value adjustment                                              |       | 517                    |       | 486 |   |
| Ceded  reserves and other                                                     |       | 95                     |       | 212 |   |
| Total  contractholder funds and reserve for life-contingent contract benefits |       | $                      | 62,386     |   | $ | 53,876 |   |

 

*Benefit margin*is a component of gross margin, both of whichare non-GAAP measures.  Benefit marginrepresents premiums and cost of insurance contract charges less contractbenefits.  Benefit margin excludes theimplied interest on life-contingent immediate annuities, which is included inthe calculation of investment margin, and mortality charges on variableannuities, which are included as a component of maintenance charges.  We use the benefit margin to evaluate ourunderwriting performance, as it reflects the profitability of our products withrespect to mortality or morbidity risk during a fiscal period.

 

Benefit margin by product group is shown in thefollowing table.

 
| ** **            | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-----------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| **(in millions)**     | ** ** | **2004**                                   | ** ** | **2003**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
| Life  insurance       |       | $                                          | 98         |                                      | $          | 118 |   | $ | 293 |   | $ | 348 |   |
| Annuities             |       | (27                                        | )          | (21                                       | )          | (63 | ) | (88 | ) |
| Total  benefit margin |       | $                                          | 71         |                                      | $          | 97 |   | $ | 230 |   | $ | 260 |   |

 

Benefit margin decreased 26.8% and 11.5% in thethird quarter and first nine months of 2004 compared to the same periods in theprior year as a result of the disposal of the majority of our direct responsedistribution business and higher mortality losses on life contingent immediateannuities.  These decreases werepartially offset by lower expenses related to guaranteed minimum death benefits(“GMDBs”) on variable annuities and lower mortality benefits on our traditionaland interest-sensitive life products.

 

As required by SOP 03-1, as of January 1, 2004,a reserve was established for GMDBs and guaranteed minimum income benefits (“GMIBs”).  In previous periods, GMDBs were expensed aspaid and no costs were recognizable for GMIBs. Under the SOP, we anticipate that the benefit margin will be lessvolatile in the future, as contract benefit expense pertaining to GMDBs andGMIBs will be proportionate to the related revenue rather than cash paymentsmade during the period.  Included in thebenefit margin for the third quarter and first nine months of 2004 areadditions to the reserve for guarantees of $16 million and $36 million,respectively, net of reinsurance. Included in the benefit margin for the third quarter and first ninemonths of 2003 are GMDB payments of $18 million and $66 million, respectively,net of reinsurance, hedging gains and losses and other contractualarrangements.  For further explanation ofthe impacts of the adoption of this accounting guidance, see Note 1 to theCondensed Consolidated Financial Statements.

 

*Amortization of DAC and DSI* increased 16.3% in the third quarter of 2004compared to the same period in the prior year as a result of higher grossmargin on fixed and variable annuities. This increase was partially offset bythe elimination of DAC amortization on the direct response distributionbusiness that was sold in January of 2004. Amortization of DAC and DSI increased 2.5% in the first nine months of2004 compared to the same period in the prior year.  The higher amortization is reflective of increasedgross margins on fixed and variable annuities. Additionally, in the first nine months of 2003, amortization of DAC andDSI included amortization acceleration (commonly referred to as “DAC unlocking”)totaling $89 million and DAC amortization on the direct response distributionbusiness sold in January of 2004.

 

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The adoption of SOP 03-1 required a new modelingapproach for estimating expected future gross profits that are used whendetermining the amortization of DAC. Because of this new modeling approach, effective January 1, 2004,the variable annuity DAC and DSI assets were reduced by $124 million.  This reduction was recognized as a cumulativeeffect of a change in accounting principle.

 

*Operating costs and expenses* decreased 14.8% and 8.9% in the thirdquarter and first nine months of 2004, respectively, compared to the sameperiods in the prior year. The following table summarizes operating costs andexpenses.

 
| ** **                          | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| **(in millions)**                   | ** ** | **2004**                                   | ** ** | **2003**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                |       |                                       |       |                                      |       |   |   |   |   |
| Non-deferrable  acquisition costs   |       | $                                          | 36         |                                      | $          | 40 |   | $ | 105 |   | $ | 122 |   |
| Other  operating costs and expenses |       | 68                                         |       | 82                                        |       | 224 |   | 239 |   |
| Total  operating costs and expenses |       | $                                          | 104        |                                      | $          | 122 |   | $ | 329 |   | $ | 361 |   |

 

The decrease in total operating costs and expensesin the third quarter of 2004 compared to the same period in the prior year wasprimarily the result of the disposal of the majority of our direct responsedistribution business and lower operational expenses, partially offset byhigher non-deferrable commissions.  Forthe first nine months of 2004 compared to the same period in the prior year,total operating costs and expenses decreased as the disposal of the majority ofour direct response distribution business and lower operational expenses morethan offset costs related to loss experience on certain credit insurancepolicies and higher non-deferrable commissions.

 

**INVESTMENTS**

 

The composition of the investment portfolio at September 30,2004 is presented in the table below.

 
| **(in millions)**            | ** ** | **Investments** | ** ** | **Percent to  total** | ** ** |
|------------------------------|------------|-----------------|------------|-----------------------|------------|
| ** **                   | ** ** | ** **      | ** ** | ** **            | ** ** |
| Fixed income  securities (1) |       | $               | 57,360     |                  | 84.2       | % |
| Mortgage  loans              |       | 7,240           |       | 10.6                  |       |
| Equity  securities           |       | 285             |       | 0.4                   |       |
| Short-term                   |       | 1,995           |       | 2.9                   |       |
| Policy loans                 |       | 705             |       | 1.1                   |       |
| Other  including derivatives |       | 523             |       | 0.8                   |       |
| Total                        |       | $               | 68,108     |                  | 100.0      | % |

 

(1)Fixed income securities are carried at fair value.  Amortized cost basis for these securities was$53.95 billion.

----

 

Total investments increased to $68.11 billion at September 30,2004 from $59.99 billion at December 31, 2003 primarily due to positivecash flows from operating and financing activities and increased fundsassociated with securities lending.

 

Total investments at amortized cost related tocollateral, primarily due to securities lending, increased to $3.63 billion at September 30,2004, from $1.92 billion at December 31, 2003.

 

At September 30, 2004, 92.9% of theconsolidated fixed income securities portfolio was rated investment grade,which is defined as a security having a rating from the National Association ofInsurance Commissioners (“NAIC”) of 1 or 2; a Moody’s equivalent rating of Aaa,Aa, A or Baa; an S&P equivalent rating of AAA, AA, A or BBB; or acomparable internal rating when an external rating is not available.

 

The unrealized net capital gains on fixed income andequity securities at September 30, 2004 were $3.42 billion, an increase of$239 million or 7.5% since December 31, 2003.  The net unrealized gain for the fixed incomeportfolio totaled $3.41 billion, comprised of $3.58 billion of unrealized gainsand $165 million of unrealized losses at September 30, 2004.  This is compared to a net unrealized gain forthe fixed income

 

22

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portfoliototaling $3.18 billion at December 31, 2003, comprised of $3.47 billion ofunrealized gains and $294 million of unrealized losses.

 

Of the gross unrealized losses in the fixed incomeportfolio at September 30, 2004, $124 million or 75.2% were related toinvestment grade securities and are believed to be primarily a result of theinterest rate environment.  Of theremaining $41 million of losses in the fixed income portfolio, $22 million or53.7% were concentrated in the corporate fixed income portfolio, and $19 millionor 46.3% were concentrated in the asset backed securities portfolio.  Approximately $12 million of the total grossunrealized losses in the corporate fixed income portfolio and $11 million ofthe total gross unrealized losses in the asset-backed securities portfolio wereassociated with the airline industry for which values were depressed due tocompany specific issues and economic issues related to fuel costs.  We expect eventual recovery of thesesecurities.  Every security was includedin our portfolio monitoring process.

 

The net unrealized gain for the equity portfoliototaled $6 million, comprised of $9 million of unrealized gains and $3 millionof unrealized losses at September 30, 2004.  This is compared to a net unrealized gain forthe equity portfolio totaling $4 million at December 31, 2003, comprisedsolely of unrealized gains.  Within theequity portfolio, the losses were concentrated in the consumer goods,technology and financial services sectors. The losses in these sectors were company and sector specific.  We expect eventual recovery of thesesecurities and the related sectors. Every security was included in our portfolio monitoring process.

 

Our portfolio monitoring process identifies andevaluates fixed income and equity securities whose carrying value may be otherthan temporarily impaired.  The processincludes a quarterly review of all securities using a screening process toidentify those securities whose fair value compared to cost for equitysecurities or amortized cost for fixed income securities is below establishedthresholds for certain time periods, or which are identified through othermonitoring criteria such as ratings downgrades or payment defaults.

 

We also monitor the quality of our fixed incomeportfolio by categorizing certain investments as “problem”, “restructured” or “potentialproblem.”  Problem fixed incomesecurities are securities in default with respect to principal or interestand/or securities issued by companies that have gone into bankruptcy subsequentto our acquisition of the security. Restructured fixed income securities have rates and terms that are notconsistent with market rates or terms prevailing at the time of therestructuring.  Potential problem fixedincome securities are current with respect to contractual principal and/orinterest, but because of other facts and circumstances, we have seriousconcerns regarding the borrower’s ability to pay future principal and interest,which causes us to believe these securities may be classified as problem orrestructured in the future.

 

The following table summarizes problem, restructuredand potential problem fixed income securities.

 
| ** **                         | ** ** | **September 30, 2004** | ** ** | **December 31, 2003** | ** ** |
|------------------------------------|------------|-----------------------------|------------|----------------------------|------------|
| **(in millions)**                  | ** ** | **Amortized  cost**         | ** ** | **Fair  value**            | ** ** | **Percent of  total Fixed  Income  portfolio** | ** ** | **Amortized  cost** | ** ** | **Fair  value** | ** ** | **Percent of  total Fixed  Income  portfolio** | ** ** |
| Problem                            |       | $                           | 92         |                       | $          | 89 |   | 0.1 | % | $ | 167 |   | $ | 155 |   | 0.3 | % |
| Restructured                       |       | 58                          |       | 62                         |       | 0.1 |   | 42 |   | 46 |   | 0.1 |   |
| Potential  problem                 |       | 198                         |       | 204                        |       | 0.4 |   | 259 |   | 255 |   | 0.5 |   |
| Total net  carrying value          |       | $                           | 348        |                       | $          | 355 |   | 0.6 | % | $ | 468 |   | $ | 456 |   | 0.9 | % |
| Cumulative  write-downs recognized |       | $                           | 281        |                       |       |   |   |   | $ | 228 |   |   |   |   |   |

 

We have experienced a decrease in the amortized costof fixed income securities categorized as problem and potential problem as of September 30,2004 compared to December 31, 2003. The decrease was primarily related to the sale of holdings in thesecategories due to specific developments causing a change in our outlook andintent to hold those securities.

 

We also evaluated each of these securities throughour portfolio monitoring process and recorded write-downs whenappropriate.  We further concluded thatany remaining unrealized losses on these securities were temporary in nature.  While these balances may increase in thefuture, particularly if economic conditions are unfavorable, we expect that****the total amount of securities in thesecategories will remain low relative to the total fixed income securitiesportfolio.

 

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**Net Realized Capital Gains and Losses **The following table presents the components of realized capital gainsand losses and the related tax effect.

 
| ** **                                   | ** ** | **Three Months  Ended  September 30,** | ** ** | **Nine Months  Ended  September 30,** | ** ** |
|----------------------------------------------|------------|---------------------------------------------|------------|--------------------------------------------|------------|
| **(in millions)**                            | ** ** | **2004**                                    | ** ** | **2003**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                         |       |                                        |       |                                       |       |   |   |   |   |
| Investment write-downs                       |       | $                                           | (27        | )                                          | $          | (26 | ) | $ | (72 | ) | $ | (144 | ) |
| Dispositions                                 |       | 1                                           |       | (13                                        | )          | (11 | ) | 42 |   |
| Valuation of derivative instruments          |       | (22                                         | )          | 35                                         |       | (60 | ) | 10 |   |
| Settlement of derivative instruments         |       | (4                                          | )          | 14                                         |       | (4 | ) | 20 |   |
| Realized capital gains and losses, pretax    |       | (52                                         | )          | 10                                         |       | (147 | ) | (72 | ) |
| Income tax benefit                           |       | 18                                          |       | (3                                         | )          | 52 |   | 26 |   |
| Realized capital gains and losses, after-tax |       | $                                           | (34        | )                                          | $          | 7 |   | $ | (95 | ) | $ | (46 | ) |

 

Dispositions in the above table include sales andother transactions such as calls and prepayments.  We may sell securities during the period inwhich fair value has declined below amortized cost for fixed income securitiesor cost for equity securities.  Incertain situations new factors such as negative developments, subsequent creditdeterioration, relative value opportunities, market liquidity concerns andportfolio reallocations can subsequently change our previous intent to continueholding a security.  Included in lossesfrom written down investments is $27 million related to airline industryholdings in the first nine months of 2004, of which $14 million or 51.9% wasrecognized in the third quarter of 2004.

 

**CAPITAL RESOURCES AND LIQUIDITY**

 

**Capital Resources** consist of shareholder’s equity and debt,representing funds deployed or available to be deployed to support businessoperations.  The following tablesummarizes our capital resources.

 
| **(in millions)**                                                          | ** ** | **September 30, 2004** | ** ** | **December 31, 2003** | ** ** |
|----------------------------------------------------------------------------|------------|-----------------------------|------------|----------------------------|------------|
| Redeemable  preferred stock                                                |       | $                           | 5          |                       | $          | 82 |   |
| Common  stock, retained earnings and other shareholder’s equity items |       | 5,151                       |       | 5,294                      |       |
| Accumulated  other comprehensive income                                    |       | 1,022                       |       | 1,053                      |       |
| Total  shareholder’s equity                                           |       | 6,178                       |       | 6,429                      |       |
| Debt                                                                       |       | 110                         |       | 45                         |       |
| Total  capital resources                                                   |       | $                           | 6,288      |                       | $          | 6,474 |   |

 

*Shareholder’s equity* decreased $251 million as of September 30,2004 when compared to December 31, 2003, primarily as a result ofdividends to Allstate Insurance Company (“AIC”) totaling $200 million and thereclassification of a portion of redeemable preferred stock to long-term debt,partially offset by net income.

 

*Debt*as of September 30, 2004, includes $64 million of mandatorily redeemablepreferred stock that was reclassified to long-term debt from shareholder’sequity during the second quarter of 2004 in accordance with the provisions ofStatement of Financial Accounting Standard No. 150, “Accounting for CertainFinancial Instruments with Characteristics of both Liabilities and Equity”.  This stock was formerly reflected as acomponent of redeemable preferred stock on the Condensed ConsolidatedStatements of Financial Position.  Thereclassification occurred as a result of changes to contractual arrangementsbetween us and the holder of the stock that resulted in the stock becomingmandatorily redeemable.  As of December 31,2003, the balance of the stock subject to reclassification amounted to $77million.  During the first nine months of2004, $13 million of this stock was redeemed.

 

Inaddition, debt as of September 30, 2004, also reflects $46 million relatedto the debt of an investment security consolidated under the provisions of FinancialAccounting Standards Board Interpretation No. 46.  We have no legal ownership of the assets andno obligation to repay the debt, and the holders of this debt have no recourseto the equity of the Company, as the sole source of payment of the liabilitiesis the assets.

 

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**Financial Ratings and Strength **Our ratings are influenced by many factors including our affiliationwith the Corporation, operating and financial performance, asset quality,liquidity, asset/liability management, overall portfolio mix, andcapitalization among other factors. There have been no changes to our insurance financial strength ratingssince December 31, 2003.  However,in February 2004, A.M. Best revised the outlook to stable from positive for theinsurance financial strength ratings of the Company and certain ratedsubsidiaries and affiliates.

 

# **Liquidity Sources andUses **As reflected in our Condensed Consolidated Statements of Cash Flows,lower operating cash flows in the first nine months of 2004 when compared tothe first nine months of 2003 primarily relate to declines in premiums,partially offset by increases in investment income.  Cash flows used in investing activitiesincreased in the first nine months of 2004 as the investment of higherfinancing cash flow from contractholder funds was partially offset by loweroperating cash flows.

# ** **

Higher cash flow fromfinancing activities during the first nine months of 2004 when compared to thefirst nine months of 2003 reflects an increase in deposits received fromcontractholders, partially offset by maturities of institutional products andbenefits and withdrawals from contractholders’ accounts.  For quantification of the changes incontractholder funds, see the Operating section of the MD&A.

# ** **

We have access to additional borrowing to supportliquidity through an intercompany loan agreement with the Corporation, whichincludes the following funding sources:

 

•                  Acommercial paper program with a borrowing limit of $1.00 billion to covershort-term cash needs.  As of September 30,2004, the remaining borrowing capacity was $905 million; however, theoutstanding balance fluctuates daily.

•                  InJune 2004, the Corporation replaced its primary credit facilities.  It currently maintains one primary creditfacility and one additional credit facility totaling $1.05 billion to covershort-term liquidity requirements.  Theprimary facility is a $1 billion five-year revolving line of credit expiring in2009.  It contains an increase provisionthat would make up to an additional $500 million available for borrowingprovided the increased portion could be fully syndicated at a later date amongexisting or new lenders.  The otherfacility is a $50 million one-year revolving line of credit renewed in July 2004for an additional year.  The right toborrow under the five-year facility is subject to requirements to maintain a37.5% debt to capital resources ratio and has no ratings triggers.  The cost to borrow under the five-yearfacility is, however, a function of our ratings at the time funds areaccessed.  These requirements arecurrently being met and we expect to continue to meet them in the future. Therewere no borrowings under either of these lines of credit during the first ninemonths of 2004. The total amount outstanding at any point in time under thecombination of the commercial paper program and the two credit facilitiescannot exceed the amount that can be borrowed under the credit facilities.

•                  Theright to issue up to an additional $2.15 billion of debt securities, equitysecurities, warrants for debt and equity securities, trust preferredsecurities, stock purchase contracts and stock purchase units utilizing theshelf registration statement filed with the SEC in August 2003.

 

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**FORWARD-LOOKING STATEMENTS AND RISK FACTORS**

 

This document contains “forward-looking statements”that anticipate results based on our estimates, assumptions and plans that aresubject to uncertainty.  These statementsare made subject to the safe-harbor provisions of the Private SecuritiesLitigation Reform Act of 1995.  We assumeno obligation to update any forward-looking statements as a result of newinformation or future events or developments.

 

These forward-looking statements do not relatestrictly to historical or current facts and may be identified by their use ofwords like “plans,” “seeks,” “expects,” “will,” “should,” “anticipates,” “estimates,”“intends,” “believes,” “likely,” “targets” and other words with similarmeanings.  These statements may address,among other things, our strategy for growth, product development, regulatoryapprovals, market position, expenses, financial results, litigation andreserves.  We believe that thesestatements are based on reasonable estimates, assumptions and plans.  However, if the estimates, assumptions orplans underlying the forward-looking statements prove inaccurate or if otherrisks or uncertainties arise, actual results could differ materially from thosecommunicated in these forward-looking statements.  Factors which could cause actual results todiffer materially from those suggested by such forward-looking statements areincorporated in this Part I, Item 2 by reference to the information set forthin our Annual Report on Form 10-K, Part II, Item 7, under the caption “Forward-LookingStatements and Risk Factors.”

 

**Anydecrease in our financial strength ratings may have an adverse effect on ourcompetitive position**

 

•                  Financial strength ratings are important factorsin establishing the competitive position of insurance companies and generallyhave an effect on an insurance company’s business.  On an ongoing basis, rating agencies reviewthe financial performance and condition of insurers and could downgrade or changethe outlook on an insurer’s ratings due to, for example, a change in an insurer’sstatutory capital; a change in a rating agency’s determination of the amount ofrisk-adjusted capital required to maintain a particular rating; an increase inthe perceived risk of an insurer’s investment portfolio; a reduced confidencein management or a host of other considerations that may or may not be underthe insurer’s control.  Our insurancefinancial strength ratings are A+, Aa2 and AA (from A.M. Best, Moody’s, andStandard and Poor’s, respectively). Because all of these ratings are subject to continuous review, theretention of these ratings cannot be assured. A multiple level downgrade in any of these ratings could have a materialadverse effect on our sales, our competitiveness, marketability of our productofferings, and our liquidity, operating results and financial condition.

 

26

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**Item 4**. Controls andProcedures

** **

With the participation of our principal executiveofficer and principal financial officer, we carried out an evaluation of theeffectiveness of the design and operation of our disclosure controls andprocedures as of the end of the period covered by this report.  Based upon this evaluation, the principalexecutive officer and the principal financial officer concluded that ourdisclosure controls and procedures are effective in timely alerting them tomaterial information required to be included in our periodic reports filed withthe Securities and Exchange Commission. However, the design of any system of controls and procedures is based inpart upon assumptions about the likelihood of future events and there can be noassurance that any design will succeed in achieving its stated goals under allpotential future conditions, regardless of how remote.  Our disclosure controls and procedures aredesigned to provide reasonable assurance of achieving their objectives and areeffective at the “reasonable assurance” level.

 

During the fiscal quarter ended September 30,2004, there have been no changes in our internal control over financialreporting that have materially affected, or are reasonably likely to materiallyaffect, our internal control over financial reporting.

 

27

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**PART II.  OTHER INFORMATION**

 

**Item 1****.****          ****Legal Proceedings**

 

Informationrequired for this Part II, Item 1 is incorporated by reference to thediscussion under the heading “Regulation” and under the heading “Legalproceedings” in Note 5 of the Condensed Consolidated Financial Statements inPart I, Item 1 of this Form 10-Q.

 

**Item 6****.   Exhibits**

 

(a)                                  Exhibits

 

An Exhibit Index has been filed as part of thisreport on page E-1.

 

28

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**SIGNATURE**

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the Registrant has duly caused this report to be signedon its behalf by the undersigned thereunto duly authorized.

 
|                   | Allstate Life Insurance Company                                           |
|------------------------|---------------------------------------------------------------------------|
|                   | (Registrant)                                                              |
|                   |                                                                      |
|                   |                                                                      |
| November 10, 2004 | By                                                                        |  /s/ Samuel H. Pilch |   |
|                   | Samuel H. Pilch                                                           |
|                   | (chief accounting officer and duly  authorized officer of the Registrant) |

 

29

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| **Exhibit No.** | ** ** | **Description**                                                                                                                                               |
|-----------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------|
|            |       |                                                                                                                                                          |
| 10.1            |       | Amendment to Selling Agreement between  Allstate Life Insurance Company, ALFS, Inc. and Allstate Financial Services,  LLC, effective August 1, 1999.     |
|            |       |                                                                                                                                                          |
| 10.2            |       | Amendment to Selling Agreement between  Allstate Life Insurance Company, ALFS, Inc. and Allstate Financial Services,  LLC, effective September 28, 2001. |
|            |       |                                                                                                                                                          |
| 10.3            |       | Amendment to Selling Agreement between  Allstate Life Insurance Company, ALFS, Inc. and Allstate Financial Services,  LLC, effective February 15, 2002.  |
|            |       |                                                                                                                                                          |
| 10.4            |       | Amendment to Selling Agreement between  Allstate Life Insurance Company, ALFS, Inc. and Allstate Financial Services,  LLC, effective April 21, 2003.     |
|            |       |                                                                                                                                                          |
| 15              |       | Acknowledgment of awareness from Deloitte  & Touche LLP, dated November 10, 2004, concerning unaudited interim  financial information                |
|            |       |                                                                                                                                                          |
| 31.1            |       | Rule 13a-14(a) Certification of Principal Executive Officer                                                                                                   |
|            |       |                                                                                                                                                          |
| 31.2            |       | Rule 13a-14(a) Certification of Principal Financial Officer                                                                                                   |
|            |       |                                                                                                                                                          |
| 32              |       | Section 1350 Certifications                                                                                                                              |

 

E-1

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