Net income for 2005 reflects moderate growth in segment operating income, offset by net realized investment losses. Net realized investment losses were $26.1 million in 2005, compared to net realized investment gains of $21.7 million in 2004, a change of $47.8 million. Partially offsetting the change in realized investment gains and losses is the cumulative effect charge of $15.8 million recorded in 2004 arising from the Company’s adoption of SOP 03-1 (see Note 1 to Consolidated Financial Statements for further discussion of SOP 03-1). Life Marketing’s operating income decreased slightly primarily due to favorable expense adjustments that increased earnings in 2004, while the decline in earnings in the Acquisitions segment was caused by the normal runoff of the segment’s previously acquired blocks of business. Favorable unlocking of DAC in the market value adjusted annuity and variable annuity lines, increasing account values, and improvement in the equity markets resulted in earnings that nearly doubled in the Annuities segment. Increased average account values and reductions in operating expenses enabled the Stable Value Products segment to increase earnings despite tightening spreads. The Asset Protection segment’s continued focus on pricing and underwriting initiatives continue to yield steady reductions in loss ratios in all core product lines. These improved loss ratios along with continued expense management resulted in an increase to operating income in the current year in the Asset Protection segment. Increased investment income resulting from an increase in unallocated capital and higher participating income and prepayment fees from mortgages and real estate generated the increase in operating income for the Corporate and Other segment in 2005.
Segment operating revenues increased 3.9% in 2005 compared to 2004, primarily as a result of higher net investment income. Average account balances have grown approximately 8% from the prior year, resulting in higher investment income as well as higher other income due to an increase in asset-based fees. The additional income resulting from the larger account balances was partially reduced by lower interest spreads resulting primarily from a rebalancing of the investment portfolio. During 2005, the investment portfolio was rebalanced to improve the duration match between the segment’s assets and liabilities. Approximately $300 million in securities were sold, causing the large increase in realized investment gains. These gains were partially offset by an increase in DAC amortization associated with those gains. The resulting funds from this transaction were reinvested in assets with lower rates than the investments that were sold, causing a decline in the investment income yield for the segment’s portfolio. The segment continually monitors and adjusts credited rates as appropriate in an effort to maintain the interest spread.
Total benefits and expenses decreased in 2005 relative to the prior year. The 2005 decrease is primarily the result of lower DAC amortization. As previously mentioned in the Life Marketing segment discussion, the Company periodically reviews and updates as appropriate its key assumptions including future mortality, expenses, lapses, premium persistency, investment yields and interest spreads. Changes to these assumptions result in adjustments which increase or decrease DAC amortization. The periodic review and updating of assumptions is referred to as “unlocking”. DAC amortization for the Annuities segment was reduced $16.2 million in 2005 due to two separate favorable DAC unlocking events. The first unlocking occurred during the second quarter in the market value adjusted annuity line, when DAC amortization was reduced $5.0 million as a result of the portfolio rebalancing discussed above. While the investment income yield obtained on the reinvested assets resulting from the portfolio rebalancing was lower than the yield obtained prior to the rebalancing, the actual yield on the reinvested assets exceeded previously projected spread income. The higher investment yield resulted in higher future estimated gross profits (“EGPs”) in the segment’s market value adjusted annuity line, causing the favorable unlocking of DAC. The second unlocking occurred in the fourth quarter in the market value adjusted and variable annuity lines, and reduced DAC amortization by $11.2 million. This unlocking was a combination of a review of assumptions underlying future EGPs (prospective unlocking) and a “true-up” of past EGPs to actual gross profits (“AGPs”) in the DAC amortization models (retrospective unlocking). AGPs were higher than the EGPs previously used in the DAC amortization model primarily as a result of general improvement in equity market returns, resulting in the favorable unlocking and reduction in DAC amortization in the current period.
Operating income increased $25.4 million in the current year, primarily due to increased investment income. Net investment income increased $33.4 million in 2005, while income from interest rate swaps decreased $3.7 million. The increased net investment income is primarily the result of higher amounts of unallocated capital and increased participating income and prepayment fees from mortgages and real estate. Results for the runoff insurance lines improved in 2005, adding $3.8 million to operating earnings. These improved results include a $5.0 million reserve strengthening taken in the third quarter of 2005 in the residual value line of business as a result of negative trends in used vehicle prices. Offsetting these positive changes to operating income was a $3.8 million write-off of capitalized costs associated with internally developed software.
The significant improvement in operating income in 2004, as compared to 2003 results, reflects significantly higher net investment income and improved results from runoff insurance lines, partially offset by higher overall expenses. Net investment income increased $38.9 million over 2003, reflecting increased participating mortgage income, and higher amounts of unallocated capital. Participating mortgage income increased $9.5 million, reflecting increased transaction activity within the Company’s mortgage portfolio. Results for the runoff insurance lines improved $9.8 million in 2004, primarily due to reduced reserve strengthening taken in the residual value line of $12.9 million partially offset by higher losses in the cancer line of $3.6 million for 2004. Higher overall expenses and lower amounts of income from interest rate swaps accounted for the remainder of the change in the current year’s results.
The financial services industry has recently become the focus of increased scrutiny by regulatory and law enforcement authorities relating to allegations of improper special payments, price-fixing, bid-rigging and other alleged misconduct, including payments made by insurers and other financial service providers to brokers and the practices surrounding the placement of insurance business and sales of other financial products, as well as practices related to finite reinsurance. Such publicity may generate litigation against financial service providers, even those who do not engage in the business lines or practices currently at issue. It is impossible to predict the outcome of these investigations or proceedings, whether they will expand into other areas not yet contemplated, whether they will result in changes in insurance regulation, whether activities currently thought to be lawful will be characterized as unlawful, or the impact, if any, of this increased regulatory and law enforcement scrutiny of the financial services industry on the Company. As these inquiries appear to encompass a large segment of our industry, it would not be unusual for large numbers of companies in the financial services industry to receive subpoenas, requests for information from regulatory authorities or other inquiries relating to these and similar matters. From time to time, the Company receives subpoenas, requests, or other inquiries and responds to them in the ordinary course of business.
Activity in the Company’s deferred sales inducement asset for the years ended December 31 was as follows:
At December 31, 2005 and 2004, the Company had bonds which were rated less than investment grade of $1,083.6 million and $965.5 million, respectively, having an amortized cost of $1,091.4 million and $933.0 million, respectively. At December 31, 2005, approximately $61.6 million of the bonds rated less than investment grade were securities issued in Company-sponsored commercial mortgage loan securitizations. Approximately $1,802.1 million of bonds are not publicly traded.
The actuarial present value of benefit obligations and the funded status of the defined benefit pension plan at December 31 are as follows: