During 2001, we recognized cumulative effect adjustments of accounting changes for venture capital partnerships, derivative instruments and securitized financial instruments.
Effective April 1, 2001, we adopted a new accounting pronouncement for recognition of interest income and impairment on certain investments. This pronouncement requires investors in certain asset-backed securities to record changes in their estimated yield on a prospective basis and to apply specific valuation methods to these securities for an other-than-temporary decline in value. Upon adoption, we recorded a $20.5 million charge to net income as a cumulative effect of accounting change, net of income taxes. Additional information on this accounting change is included in Notes 1 and 5 to our consolidated financial statements in this Form 10-K.
We face strong competition in each of our businesses, comprising life insurance, annuities and asset management. We believe that our ability to compete is based on a number of factors, including product features, investment performance, service, price, distribution, capabilities, scale, commission structure, name recognition and financial strength ratings. While there is no single company that we identify as a dominant competitor in our business overall, the nature of these businesses means that our actual and potential competitors include a large number of mutual fund companies, banks, asset management firms and other insurance companies, many of which have advantages over us in one or more of the above competitive factors. Recent industry consolidation, including acquisitions of insurance and other financial services companies in the United States by international companies, has resulted in larger competitors with financial resources, marketing and distribution capabilities and brand identities that are stronger than ours. Larger firms also may be able to offer, due to economies of scale, more competitive pricing than we can. In addition, some of our competitors are regulated differently than we are,
Changes in insurance and securities regulation could affect our profitability by imposing further restrictions on the conduct of our business.
• insurance policy benefits provided to policyholders, including interest credited on policyholders; general account balances; • policyholder dividends; • deferred policy acquisition costs amortization; • intangible assets amortization; • interest expense; • other operating expenses; and • income taxes.
During the fourth quarter of 2003, we entered into a purchase and sale agreement to sell 100% of the common stock held by us in Phoenix National Trust Company. This sale is expected to close in the first quarter of 2004. The financial statement effect of this transaction is immaterial to our consolidated financial statements.
million decrease in our reserves for minimum death benefit guarantees due to favorable equity markets, partially offset by higher interest credited on guaranteed interest accounts and fixed annuities driven by higher average fund balances and higher mortality expense for universal life insurance.
The decrease in policy acquisition cost amortization of $33.9 million, or 28%, in 2002 compared to 2001 was primarily due to favorable mortality and persistency experience on life products, offset by a $13.5 million acceleration of policy acquisition cost amortization expense related to our annuity business in the third quarter of 2002. This offset resulted from a revision of our long-term market return assumption for annuities from 8% to 7% and an impairment charge related to the recoverability of our deferred acquisition cost asset related to our variable annuities business. The Valley Forge block we acquired at the beginning of the third quarter, which experienced significant declines in assets due to equity market declines, accounts for $4.5 million of this acceleration. DAC costs for individual participating life insurance policies are amortized in proportion to estimated gross margins. The amortization process requires the use of various assumptions, estimates and judgments about the future. The primary assumptions involve expenses, investment performance, mortality and contract cancellations (i.e., lapses, withdrawals and surrenders). These assumptions are reviewed on a regular basis and are generally based on our past experience, industry studies, regulatory requirements and judgments about the future. In the first quarter of 2002, we revised the assumptions on traditional life products used in the development of estimated gross margins to reflect favorable experience and, as a result, the amortization cost expense decreased.
Universal life product revenues increased $5.0 million, or 3%, in 2002 compared to 2001, primarily due to higher cost of insurance and other fees from higher sales and a growing inforce, offset by lower interest earned.
We offer a variety of variable annuities to meet the accumulation and preservation needs of the affluent and high-net-worth market. Our major sources of revenues from separate account variable annuities are mortality and expense fees charged to the contractholder, generally determined as a percentage of the market value of the underlying assets under management. Our major source of profit from fixed annuities and general account variable annuities is from the interest rate spread, or the excess of investment income earned over interest credited.
2003 2002 --------------- --------------- Policyholder Deposit Funds Retirement Planners Edge GIAs.............................................. $ 1,209.4 $ 1,345.6 Other variable annuity GIAs................................................ 858.0 813.7 --------------- --------------- Variable annuity GIAs...................................................... 2,067.4 2,159.3 Fixed annuities............................................................ 1,056.9 737.2 --------------- --------------- Total variable annuity GIAs and fixed annuities............................ $ 3,124.3 $ 2,896.5 =============== ===============
Each year, the majority of our general account's net cash flows are invested in investment grade debt securities. In addition, we maintain a portfolio allocation of between 6% and 10% of debt securities in below investment grade rated bonds. Allocations are based on our assessment of relative value and the likelihood of enhancing risk-adjusted portfolio returns. The size of our allocation to below investment grade bonds is also constrained by the size of our net worth. We are subject to the risk that the issuers of the debt securities we own may default on principal and interest payments, particularly in the event of a major economic downturn. Our investment strategy has been to invest the majority of our below investment grade rated bond exposure in the BB rating category, which is equivalent to a Securities Valuation Office, or SVO, securities rating of 3. The BB rating category is the highest quality tier within the below investment grade universe, and BB rated securities historically experienced lower defaults compared to B or CCC rated bonds. As of December 31, 2003, our total below investment grade securities totaled $1,101.0 million, or 8.3%, of our total debt security portfolio. Of that amount, $764.9 million, or 5.8%, of our debt security portfolio was invested in the BB category. Our debt securities having an increased risk of default (those securities with an SVO rating of four or greater which is equivalent to B or below) totaled $336.1 million, or 2.5%, of our total debt security portfolio.
Percentage of total debt securities................. 91.7% 91.6% 8.3% 8.4% ============ ========== =========== ===========
Percentage of total debt securities.. 8.3% 5.8% 1.6% 0.7% 0.2% ============ =========== =========== ============ ============
Cash and cash equivalents decreased $662.6 million, or 60%, in 2003 compared to 2002, primarily due to cash outflows for the purchase of debt securities, partially offset by policyholder deposit fund receipts, and cash inflows from continuing operations.
Variable universal life........................................... $ 328.7 $ 309.9 $ 18.8 Universal life.................................................... 169.3 105.2 64.1 Variable annuities................................................ 260.3 240.0 20.3 Fixed annuities................................................... 45.2 7.7 37.5 Participating life................................................ 536.7 551.0 (14.3) Other............................................................. 27.5 20.3 7.2 ------------ ------------ ------------ Total deferred acquisition costs.................................. $ 1,367.7 $ 1,234.1 $ 133.6 ============ ============ ============
As of December 31, 2003, we had $2,074.2 million of outstanding contractual obligations, excluding derivative instruments, and $134.0 million in commercial commitments. The following table presents our contractual obligations and commercial commitments, including the years in which such obligations will come due and such commercial commitments expire ($ amounts in millions).
See Note 15 to our consolidated financial statements in this Form 10-K regarding the Life Companies' statutory financial information and regulatory matters.