The statements, analyses, and other information contained in this management's narrative and elsewhere in this Form 10-K, relating to trends in John Hancock Life Insurance Company's, (the Company's) operations and financial results, the markets for the Company's products, the future development of the Company's business, and the contingencies and uncertainties to which the Company may be subject, as well as other statements including words such as "anticipate," "believe," "plan," "estimate," "expect," "intend," "will," "should," "may," and other similar expressions, are "forward-looking statements" under the Private Securities Litigation Reform Act of 1995. Such statements are made based upon management's current expectations and beliefs concerning future events and their potential effects on the Company. Future events and their effects on the Company may not be those anticipated by management. The Company's actual results may differ materially from the results anticipated in these forward-looking statements.
Effective April 28, 2004, Manulife Financial Corporation ("Manulife") acquired all of the outstanding common shares of John Hancock Financial Services, Inc. (JHFS) that were not already beneficially owned by Manulife as general fund assets and JHFS became a wholly owned subsidiary of Manulife. The combined entity has a more diversified product line and distribution capabilities and expects to have improved operating efficiencies and a leading position across all its core business lines. In order to more efficiently manage its corporate structure, on October 7, 2004 Manulife transferred all of its shares in JHFS to John Hancock Holdings (Delaware) LLC - a wholly-owned subsidiary of Manulife.
We have identified the accounting policies below as critical to our business operations and understanding of our results of operations. For a detailed discussion of the application of these and other accounting policies, see Note 2--Summary of Significant Accounting Policies in the notes to consolidated financial statements in the Company's 2004 Annual Report on Form 10-K. Note that the application of these accounting policies in the preparation of this report requires management to use judgments involving assumptions and estimates concerning future results or other developments including the likelihood, timing or amount of one or more future transactions or events. There can be no assurance that actual results will not differ from those estimates. These judgments are reviewed frequently by senior management, and an understanding of them may enhance the reader's understanding of the Company's financial statements. We have discussed the identification, selection and disclosure of critical accounting estimates and policies with the Audit Committee of the Board of Directors.
In accordance with SFAS No. 141, "Business Combinations" the merger transaction was accounted for as a purchase of John Hancock by Manulife. In accordance with "push-down accounting," John Hancock, the acquired company, adjusted the cost and reporting basis of its assets and liabilities to their fair values on the acquisition date (the purchase adjustments).
The determination of the purchase adjustments relating to investments included utilization of independent price quotes where available and management's own estimates and assumptions where independent price quotes were unavailable. Other purchase adjustments also required significant management estimates and assumptions. The purchase adjustments relating to intangible assets, including goodwill, value of business acquired (VOBA), brand name and others, and to liabilities, including policyholder reserves, and others, required management to exercise significant judgment in assessing fair values.
The Company has finalized its FIN 46R analysis for all of the entities described below. The Company is not the primary beneficiary of any of them. For many of these, the application of FIN 46R required estimation by the Company of the future periodic cash flows and changes in fair values for each candidate, starting as of the Company's original commitment to invest in and/or manage each candidate, and extending out to the end of the full expected life of each. These
cash flows and fair values were then analyzed for variability, and this expected variability was quantified and compared to total historical amounts invested in each candidate's equity to help determine if each candidate is a VIE. The Company also evaluated quantitative and non-quantitative aspects of control relationships among the owners and decision makers of each candidate to help determine if they are VIEs.
For each candidate determined to be a VIE, the expected variable losses and returns were then theoretically allocated out to the various investors and other participants in each candidate, in order to determine if any party had exposure to the majority of the expected variable losses or returns, in which case that party is the primary beneficiary of the VIE. The Company used significant levels of judgment while performing these quantitative and qualitative assessments.
The Company's maximum exposure to loss in relation to these entities is limited to its investments in them, future debt and equity commitments made to them, and where the Company is the mortgagor to the Properties, the outstanding balance of the mortgages originated for them, and outstanding mortgage commitments made to them. Therefore, the Company believes that the application of FIN 46R has no potential impact on the Company's liquidity and capital resources beyond what is already presented in the consolidated financial statements and notes thereto.
Amortizable assets include value of business acquired (VOBA), distribution networks and other investment management contracts. VOBA is the present value of estimated future profits of insurance policies in force related to the Company's businesses acquired by Manulife in the recent merger. VOBA had weighted average lives ranging from 6 to 17 years for various insurance businesses at the merger. Distribution networks are fair values assigned to the Company's networks of
The Company will test unamortizable intangible assets for impairment on an annual basis, and also in response to any events which both suggest that these assets may be impaired (triggering events). Amortizable intangible assets will be tested only in response to triggering events. The Company will test goodwill using the two-step impairment test set forth in SFAS No. 142 "Goodwill and Other Intangible Assets." VOBA and the Company's other intangible assets will be evaluated by comparing their fair values to their current carrying values whenever they are tested. Impairments will be recorded whenever an asset's fair value is deemed to be less than its carrying value.
Estimated gross profits, including net realized investment and other gains (losses), are adjusted periodically to take into consideration the actual experience to date and assumed changes in the remaining gross profits. When estimated gross profits are adjusted, we also adjust the amortization of DAC and VOBA to maintain a constant amortization percentage over the life of the policies. Our current estimated gross profits include certain judgments by our actuaries concerning mortality, lapse and asset growth that are based on a combination of actual Company experience and historical market experience of equity and fixed income returns. Short-term variances of actual results from the judgments made by management can impact quarter to quarter earnings. Our history has shown us that the actual results over time for mortality, lapse and the combination of investment returns and crediting rates (referred in the industry as interest spread) for the life insurance and annuity products have reasonably followed the long-term historical trends. As actual results for market experience or asset growth fluctuate significantly from historical trends and the long-term assumptions made in calculating expected gross profits, management changes these assumptions periodically, as necessary.
The liability for future policy benefits is the largest liability included in our consolidated balance sheets, equal to $42,962.8 million, or 48.0%, of total liabilities as of December 31, 2004. Changes in this liability are generally reflected in the benefits to policyholders in our consolidated statements of income. This liability is primarily comprised of the present value of estimated future payments to holders of life insurance and annuity products based on certain management judgments. Reserves for future policy benefits of certain insurance products are calculated using management's judgments of mortality, morbidity, lapse, investment performance and expense levels that are based primarily on the Company's past experience and are therefore reflective of the Company's proven underwriting and investing abilities. Once these assumptions are made for a given policy or group of policies, they will not be changed over the life of the policy unless the Company recognizes a loss on the entire line of business, or the Company is acquired. The Company periodically reviews its policies for loss recognition and, based on management's judgment, the Company from time to time may recognize a loss on certain lines of business. Short-term variances of actual results from the judgments made by management are reflected in current period earnings and can impact quarter to quarter earnings.
As part of the valuation process we attempt to identify securities which may have experienced an other than temporary decline in value, and thus require the recognition of an other than temporary impairment as a charge against income. To assist in identifying these impairments, at the end of each quarter our Investment Review Committee reviews all securities where market value has been less than ninety percent of amortized cost for three months or more to determine whether other than temporary impairments need to be taken. This committee includes the head of workouts, the head of each industry team, the head of portfolio management, and the Chief Credit Officer of Manulife. The analysis focuses on each investee company's or project's ability to service its debts in a timely fashion and the length of time the security has been trading below amortized cost. The results of this analysis are reviewed quarterly by the Credit Committee at Manulife. This committee includes Manulife's Chief Financial Officer, Chief Investment Officer, Chief Risk Officer, Chief Credit Officer, and other senior management. See "Management's Discussion and Analysis of Financial Condition and Analysis of Financial Condition and Results of Operations--General Account Investments" section of this document for a more detailed discussion of this process and the judgments used therein.
The Company reviewed its pension and other post-employment benefit plan assumptions for the discount rate, the long-term rate of return on plan assets, and the compensation increase rate for incorporation in the measurements made as of April 28, 2004 (the date of the Manulife merger with the Company) and for net periodic costs for the calendar year. These assumptions are normally incorporated in measurements made annually as of each December 31 and for the subsequent calendar year resulting thereon.
The assumed discount rate is set based on the published December 31st Moody's Investor Services long-term corporate bond yield for rating category Aa. The discount rate used in the April 28, 2004 mark to market of 2004's net periodic pension cost was 6.0%. The discount rate originally in effect for 2004 was 6.25%. A 0.25% increase in the discount rate would decrease the Projected Benefit Obligation (PBO) and 2004 Net Periodic Pension Cost (NPPC) by approximately $57.6 million and $1.2 million respectively. A 0.25% increase in the discount rate would decrease other post- employment benefits Accumulated Postretirement Benefit Obligation (APBO) and 2004 Net Periodic Benefit Cost (NPBC) by approximately $15.9 million and $1.2 million, respectively.
The assumed long-term rate of return on plan assets is generally set at the long-term rate expected to be earned (based on the Capital Asset Pricing Model and similar tools) based on the long-term investment policy of the plans and the various classes of the invested funds. For 2004, Net Periodic Pension (and Benefit) Cost, an 8.75% long term rate of return assumption is being used. A 0.25% increase in the long-term rate of return would decrease 2004 NPPC by approximately $5.3 million and 2004 NPBC by approximately $0.6 million. The expected return on plan assets prior to the merger with Manulife was based on the fair market value of the plan assets as of December 31, 2003. Post merger, the expected return on plan assets is based on the fair value of plan assets as of April 28, 2004.
The compensation rate increase assumption is generally set at a rate consistent with current and expected long-term compensation and salary policy
Our reported effective tax rate on net income was 26.7%, 28.4% and 19.1% for the years ended December 31, 2004, 2003 and 2002, respectively. The increase in the effective tax rate during the period is due to changes in the recognition of tax expense as a result of the purchase accounting for leveraged leases as required by FASB Interpretation No. 21, "Accounting for Leases in a Business Combination" and FASB Statement of Financial Accounting Standards No. 13, "Accounting for Leases". Our effective tax rate is based on expected income, statutory tax rates and tax planning opportunities available to us. Significant judgment is required in determining our effective tax rate and in evaluating our tax positions. We establish reserves when, despite our belief that our tax return positions are fully supportable, we believe that certain positions are likely to be challenged and that we may not succeed. We adjust these reserves in light of changing facts and circumstances, such as the progress of a tax audit. Our effective tax rate includes the impact of reserve provisions, changes to reserves that we consider appropriate and related interest. This rate is then applied to our year-to-date operating results.
Tax regulations require certain items to be included in the tax return at different times than those items are reflected in the financial statements. As a result, our effective tax rate reflected in our financial statements is different than that reported in our tax return. Some of these differences are permanent, such as affordable housing tax credits, and some are temporary differences, such as depreciation expense. Temporary differences create deferred tax assets and liabilities. Deferred tax assets generally represent items that can be used as a tax deduction or credit in our tax return in future years for which we have already recorded the tax benefit in our income statement. Our policy is to establish valuation allowances for deferred tax assets when the amount of expected future taxable income is not likely to support the use of the deduction or credit. Deferred tax liabilities generally represent tax expense recognized in our financial statements for which payment has been deferred or expense for which we have already taken a deduction on our tax return, but have not yet recognized as expense in our financial statements.
While it is often difficult to predict the final outcome or the timing of resolution of any particular tax matter, we believe that our reserves reflect the probable outcome of known tax contingencies. Our tax reserves are presented in the balance sheet net in the deferred tax asset or in the deferred tax liability for the respective period ends.
The disposal described under the table below was conducted in order to execute the Company's strategy to focus resources on businesses in which it can have a leadership position. The table below presents actual and proforma data for comparative purposes for the periods indicated to demonstrate the proforma effect of the acquisitions and disposal as if they occurred on January 1, 2002.
The company was merged with Manulife Financial Corporation effective April 28, 2004. The following discussion provides an assessment of the consolidated results of operations and liquidity and capital resources for the Company and the Predecessor. Unless otherwise indicated, 2004 historical results represent the combined operating results of the Predecessor from January 1, 2004 through April 28, 2004 and the Company from the date of the merger though December 31, 2004.
As a result of Manulife's merger with JHFS (see Note 1- Change of Control) the Company renamed and reorganized certain businesses within its operating segments to better align the Company with its new parent, Manulife. The Company renamed the Asset Gathering Segment as the Wealth Management Segment. In addition, the Company transferred the Institutional Investment Management Segment to the Corporate and Other Segment. Other realignments include moving Signator Investors, Inc. our agent sales organization, from the Wealth Management Segment to the Protection Segment, and group life, retail discontinued operations, discontinued health insurance operations and creditor from the Corporate and Other Segment to the Protection Segment. International Group Plans (IGP) remains in international operations in our Corporate and Other Segment while in Manulife's segment results IGP will be reported in Reinsurance. The financial results for all periods have been reclassified to conform to the current period presentation.
During the majority of 2004, the Company operated in the following four business segments: two segments primarily served retail customers, one segment served institutional customers and our fourth segment was the Corporate and Other Segment, which includes our institutional advisory business, the remaining international operations, and the corporate account. Our retail segments are the Protection Segment and the Wealth Management Segment, previously called Asset Gathering. Our institutional segment is the Guaranteed and Structured Financial Products Segment (G&SFP). Effective January 27, 2005, the G&SFP Segment will become a division of the Wealth Management Segment. This organizational change reflects G&SFP's increasing focus on retail-oriented products and will enable the company to better leverage the strong distribution channels of the Wealth Management Segment with G&SFP's strong product development, risk management, and immediate annuity servicing capabilities. G&SFP is presented as its own operating segment for the discussion of 2004 results below.
Universal life and investment-type product fees increased 2.9%, or $18.3 million, from the prior year. These product fees consist primarily of cost of insurance fees on our variable life insurance and universal life insurance products and mortality and expense fees on our variable annuity products. The increase was primarily due to an increase of $33.1 million in the universal life insurance business driven by growth in average account values on growth in the existing business. Partially offsetting the growth in the Protection Segment was a decline of $8.8 million in product fees in the Wealth Management Segment as a result of on lower mortality and expense fees in the variable annuity business. In addition, product fees decreased $7.1 million in the G&SFP Segment driven by lowers fees in the single premium annuity business.
Net investment income decreased 10.1%, or $382.6 million, from the prior year. Overall, the 2004 yield, net of investment expenses, on the general account portfolio decreased to 5.11% from 5.96% for the prior year. Yield for the period subsequent to the merger with Manulife, April 29, 2004 through December 31, 2004 was 4.79%. In summary, the change in yields was driven by the following factors:
Benefits to policyholders decreased 6.5%, or $250.4 million, from the prior year. The decrease in benefits to policyholders was driven by a 11.7%, or $126.5 million, decline in the G&SFP Segment on lower interest credited. Interest credited in the G&SFP Segment decreased 14.8%, or $138.4 million, from the prior year. The decrease in interest credited was due to a decline in the average interest credited rate on account balances for spread-based products, due to the reset of approximately $10.4 billion of liabilities with floating rates and new business added at current market rates. Interest credited in the G&SFP Segment also decreased due to the repricing of liability products at the date of the merger with Manulife for purchase accounting which resulted in resetting the crediting rates to a lower market rate. The average crediting rate fell to 3.52% from 4.19% in the prior year. Benefits to policyholders declined 23.0%, or $109.3 million, in the fixed annuity business driven by lower sales of single premium immediate annuities, as noted above, and impact of purchase accounting in the merger with Manulife whereby reserves established at merger date are being amortized to benefits to policyholders. In addition, benefits to policyholders declined 10.3%, or $111.2 million, in the traditional life insurance business driven by lower premiums. Partially offsetting these decreases was growth in benefits to policyholders of $60.3 million in the long-term care insurance business, driven by 10.2%, or $55.7 million, increase in premiums. In addition, benefits to policyholders increased $61.3 million in the non-traditional life insurance business driven by growth in average account balance.
o Certain of our tax-preferenced investments (lease residual management and affordable housing limited partnerships) dilute the Company's net portfolio yield on a pre-tax basis. In 2003, this dilutive effect was 9 basis points, compared to 10 basis points in 2002. However, adjusting for taxes, these investments increased the Company's net income by $7.6 million in 2003 relative to 2002.
o The inflow of new cash for the twelve-month period ending December 31, 2003 was invested at rates that were below the portfolio rate. In addition, maturing assets were rolled over into new investments at rates less favorable than those available in 2002. These two factors account for the majority of the remaining decline in portfolio rates.
Income taxes were $345.3 million in 2003, compared to $108.6 million for 2002. Our effective tax rate was 28.4% in 2003, as compared to 19.1% in 2002. The higher effective tax rate was primarily due to increased pre-tax income driven by improved net realized investment and other gains/losses, partially offset by increased affordable housing tax credits.
Cumulative effect of accounting change, net of tax, was $279.0 million for the year ended December 31, 2003, no cumulative effect of accounting change was recorded in 2002. In 2003 the cumulative effect of accounting change related to the adoption of DIG B36 as of October 1, 2003; refer to Note 2 - Summary of Significant Accounting Policies in the notes to the Consolidated Financial Statements of this Form 10-K.
1) In addition to bonds, the fixed maturity security portfolio contains redeemable preferred stock with a carrying value of $902.4 million and $600.3 million as of December 31, 2004 and December 31, 2003, respectively. The total fair value of the fixed maturity security portfolio was $47,863.2 million and $47,994.9 million, at December 31, 2004 and December 31, 2003, respectively. 2) The fair value for the mortgage loan portfolio was $11,873.1 million and $11,791.4 million as of December 31, 2004 and December 31, 2003, respectively. 3) Policy loans are secured by the cash value of the underlying life insurance policies and do not mature in a conventional sense, but expire in conjunction with the related policy liabilities. 4) Cash and cash equivalents are included in total invested assets in the table above for the purposes of calculating yields on the income producing assets for the Company.
Fixed Maturity Securities. The fixed maturity securities portfolio is predominantly comprised of low risk, investment grade, publicly and privately traded corporate bonds and senior tranches of asset-backed securities (ABS) and mortgage-backed securities (MBS). The fixed maturity securities portfolio also includes redeemable preferred stock. As of December 31, 2004, fixed maturity securities represented 71.8% of general account invested assets with a carrying value of $47.9 billion, comprised of 53.2% public securities and 46.8% private securities. Each year, the Company directs the majority of net cash inflows into investment grade fixed maturity securities. As of December 31, 2004, the below investment grade bonds were 7.1% of invested assets, and 10.1% of total fixed maturities. Rated fixed maturities exclude redeemable preferred stock.
The Securities Valuation Office (SVO) of the National Association of Insurance Commissioners evaluates all public and private bonds purchased as investments by insurance companies. The SVO assigns one of six investment categories to each security it reviews. Category 1 is the highest quality rating, and Category 6 is the lowest. Categories 1 and 2 are the equivalent of investment grade debt as defined by rating agencies such as S&P and Moody's (i.e., BBB /Baa3 or higher), while Categories 3-6 are the equivalent of below-investment grade securities. SVO ratings are reviewed and may be revised at least once a year.
(1) For securities that are awaiting an SVO rating, the Company has assigned a rating based on an analysis that it believes is equivalent to that used by the SVO. (2) Comparisons between SVO and S&P ratings are published by the National Association of Insurance Commissioners. (3) Includes 61 securities that are awaiting an SVO rating, with a carrying value of $876.6 million as of December 31, 2004 and 175 securities that are awaiting an SVO rating, with a carrying value of $4,032.7 million at December 31, 2003. Due to lags between the funding of an investment, the processing of final legal documents, the filing with the SVO, and the rating by the SVO, there will always be a number of unrated securities at each statement date. (4) Includes the effect of $185.0 million notional invested in the Company's credit-linked note program, $165.0 million notional of written credit default swaps on fixed maturity securities in the AAA/AA/A category and $20.0 million notional of written credit default swaps on fixed maturity securities in the BBB category. As of December 31, 2003 the Company had $130.0 million notional invested in the Company's credit linked note program, $110.0 million notional written credit default swaps on fixed maturity securities in the AAA/AA/A category and $20.0 million notional written credit default swaps on fixed maturity securities in the BBB category. (5) The Company entered into a credit enhancement agreement in the form of a guaranty from an AAA rated financial guarantor in 1996 which was terminated during 2004. In 2003, to reflect the impact of this guaranty on the overall portfolio, the Company has presented securities covered in aggregate by the guaranty at rating levels provided by the SVO and Moody's that reflect the guaranty. As a result, $421.0 million of SVO Rating 3, $185.2 million of SVO Rating 4, and $7.6 million of SVO Rating 5 underlying securities are included as $397.6 million of SVO Rating 1, $162.1 million of SVO Rating 2 and $54.1 million of SVO Rating 3 as of December 31, 2003. The guaranty also contained a provision that the guarantor can recover from the Company certain amounts paid over the history of the program in the event a payment is required under the guaranty. As of December 31, 2003, the maximum amount that could be recovered under this provision was $112.8 million.
In keeping with the investment philosophy of tightly managing interest rate risk, the Company's MBS & ABS holdings are heavily concentrated in commercial MBS where the underlying loans are largely call protected, which means they are not pre-payable without penalty prior to maturity at the option of the issuer. By investing in MBS and ABS securities with relatively predictable repayments, the Company adds high quality, liquid assets to our portfolios without incurring the risk of cash flow variability. The Company believes the portion of its MBS/ABS portfolio subject to prepayment risk as of December 31, 2004 and December 31, 2003 was limited to approximately 24.0% and 22.3%, respectively ,of our total MBS/ABS portfolio and 4.8% and 3.4%, respectively, of our total fixed maturity securities holdings, at each period end.
Again, the gross unrealized loss on December 31, 2004 is largely due to interest rate changes since April 28, 2004 and is fairly evenly distributed throughout the fixed maturity portfolio. The following table shows the composition by credit quality of the securities with gross unrealized losses in our fixed maturity securities portfolio. The gross unrealized loss on investment grade bonds (those rated in categories 1 and 2 by the SVO) decreased by $103.4 million in the year ending December 31, 2004 to $96.5 million. The gross unrealized loss on below investment grade bonds (those rated in categories 3, 4, 5, and 6 by the SVO) declined over this period, dropping by $243.1 million to a total of $16.1 million as of December 31, 2004.
1) With respect to securities that are awaiting rating, the Company has assigned a rating based on an analysis that it believes is equivalent to that used by the SVO. 2) Comparisons between SVO and S&P ratings are published by the National Association of Insurance Commissioners. 3) Includes 20 securities with gross unrealized losses that are awaiting an SVO rating with a carrying value of $213.6 million and unrealized losses of $2.9 million. Due to lags between the funding of an investment, the processing of final legal documents, the filing with the SVO, and the rating by the SVO, there will always be a number of unrated securities at each statement date. Unrated securities comprised 2.0% and 2.5% of the total carrying value and total gross unrealized losses of securities in a loss position, including redeemable preferred stock, respectively.
The tables above shows the Company's investment grade and below investment grade securities that were in a loss position at December 31, 2004 and December 31, 2003 by the amount of time the security has been in a loss position. Gross unrealized losses from hedging adjustments represent the amount of the unrealized loss that results from the security being designated as a hedged item in a fair value hedge. When a security is so designated, its cost basis is adjusted in response to movements in interest rates. These adjustments, which are non-cash and reverse with the passage of time as the asset and derivative mature, impact the amount of unrealized loss on a security. The remaining portion of the gross unrealized loss represents the impact of interest rates on the non-hedged portion of the portfolio and unrealized losses due to creditworthiness on the total fixed maturity portfolio.
As of December 31, 2004 and December 31, 2003, respectively, the fixed maturity securities had a total gross unrealized loss of $114.9 million and $324.2 million, excluding basis adjustments related to hedging relationships. As of December 31, 2004 the aging of securities reflects the mark to market on April 28, 2004, thus the entire gross unrealized loss is less than nine months at December 31, 2004. Unrealized losses on investment grade securities principally relate to changes in interest rates or changes in credit spreads since the securities were acquired. Credit rating agencies statistics indicate that investment grade securities have been found to be less likely to develop credit concerns.
The following table shows the distribution of our mortgage loan portfolio by property type as of the dates indicated. Our commercial mortgage loan portfolio consists primarily of non-recourse fixed-rate mortgages on fully, or nearly fully, leased commercial properties.
The following table shows the carrying values of our mortgage loan portfolio that are delinquent but not in foreclosure, delinquent and in foreclosure, restructured and foreclosed. The table also shows the respective ratios of these items to the total carrying value of our mortgage loan portfolio. Mortgage loans are classified as delinquent when they are 60 days or more past due as to the payment of interest or principal. Mortgage loans are classified as restructured when they are in good standing, but the basic terms, such as interest rate or maturity date, have been modified as a result of a prior actual delinquency or an imminent delinquency. All foreclosure decisions are based on a thorough assessment of the property's quality and location and market conditions. The decision may also reflect a plan to invest additional capital in a property to make tenant improvements or renovations to secure a higher resale value at a later date. Following foreclosure, we rely on our real estate investment group's ability to manage foreclosed real estate for eventual return to investment real estate status or outright sale.
1) As of December 31, 2004 and December 31, 2003 the Company held mortgage loans with a carrying value of $11.8 billion and $10.9 billion, respectively.
The valuation allowance is maintained at a level that is adequate enough to absorb estimated probable credit losses. Management's periodic evaluation of the adequacy of the allowance for losses is based on past experience, known and inherent risks, adverse situations that may affect the borrower's ability to repay (including the timing of future payments), the estimated value of the underlying security, the general composition of the portfolio, current economic conditions and other factors. This evaluation is inherently subjective and is susceptible to significant changes and no assurance can be given that the allowances taken will in fact be adequate to cover all losses or that additional valuation allowances or asset write-downs will not be required in the future. The valuation allowance for the mortgage loan portfolio was $45.3 million, or 0.4% of the carrying value of the portfolio as of December 31, 2004.
Net investment income decreased $382.6 million from the prior year. Overall, the 2004 yield, net of investment expenses, on the general account portfolio decreased to 5.11% from 5.96% for prior year. Yield for the period subsequent to the merger with Manulife, April 29, 2004 through December 31, 2004 was 4.79%. In summary, the change in yields was driven by the following factors:
o As of December 31, 2004, the Company's asset portfolio had approximately $12 billion of floating-rate exposure (primarily LIBOR). This compares to a $13 billion level of exposure as of December 31, 2003. This exposure was created mostly through interest rate swaps designed to match our floating-rate liability portfolio. As of December 31, 2004, approximately 86% of this exposure, excluding cash and short-term investments, was directly offset by exposure to floating-rate liabilities. Most of the remaining 14% of exposure is in floating rate assets acquired for their relative value and is accounted for in the portfolio's interest rate risk management plan. The impact was approximately a reduction of 46 basis points for 2004 compared to 54 basis points for 2003.
o Certain of our tax-preferenced investments (affordable housing limited partnerships and lease residual management) dilute the Company's net portfolio yield on a pre-tax basis. For the year ended December 31, 2004, this dilutive effect was 9 basis points, compared to 9 basis points in the comparable prior year. However, adjusting for taxes, these investments increased the Company's net income by $2.0 million in 2004 compared to 2003.
o The inflow of new cash for the twelve month period ending December 31, 2004 was invested at rates that were below the portfolio rate. In addition, maturing assets were rolling over into new investments at rates below the portfolio rate. In the year ended December 31, 2004, weighted-average invested assets grew $3,074.7 million, or 4.82%, from the prior year.
Net investment income increased $218.4 million from the prior year. The increase was primarily the result of asset growth and lower investment expenses. Overall, the 2003 yield, net of investment expenses, on the general account portfolio decreased to 5.96% from 6.29% in the prior year. The lower portfolio yield was driven primarily by the drop in short-term interest rates during the year, which impacts floating rate investments, and lower yields on investment acquisitions. In summary, the change in yields was driven by the following factors:
o As of December 31, 2003, the Company's asset portfolio had approximately $13 billion of floating-rate exposure (primarily LIBOR). This compares to $12 billion of exposure as of December 31, 2002. This exposure was created mostly through interest rate swaps
o The inflow of new cash for the twelve-month period ending December 31, 2003 was invested at rates that were below the portfolio rate. In addition, maturing assets were rolling over into new investments at rates less favorable than those available in 2002. These two factors account for the majority of the remaining decline in portfolio rates.
Net Realized Investment and Other Gain/(Loss). The following table shows the Company's net realized investment and other gains (losses) by asset class for the periods presented:
The hedging adjustments in the fixed maturities and mortgage loans asset classes are non-cash adjustments representing the amortization or reversal of prior fair value adjustments on assets in those classes that were or are designated as hedged items in fair value hedge. When an asset or liability is so designated, its cost basis is adjusted in response to movement in interest rate. These adjustments are non-cash and reverse with the passage of time as the asset or liability and derivative mature. The hedging adjustments on the derivatives represent non-cash adjustments on derivative instruments and on assets and liabilities designated as hedged items reflecting the change in fair value of those items.
For the year ended December 31, 2004, realized gains on disposal of fixed maturities, excluding hedging adjustments, were $297.2 million. These gains resulted from managing the portfolios for tax optimization and ongoing portfolio
positioning, as well as $104.8 million of prepayments. There were $42.5 million of recoveries on sales of previously impaired securities for the year ended December 31, 2004.
For the year ended December 31, 2004, the Company realized losses on the disposal of fixed maturities, excluding hedging adjustments, of $64.6 million. The Company generally intends to hold securities in unrealized loss positions until they mature or recover. However, fixed maturities are sold under certain circumstances such as when new information causes a change in the assessment of whether a bond will recover or perform according to its contractual terms, in response to external events (such as a merger or a downgrade) that result in investment guideline violations (such as single issuer or overall portfolio credit quality limits), in response to extreme catastrophic events (such as September 11, 2001) that result in industry or market wide disruption, or to take advantage of tender offers. Sales generate both gains and losses.
Of the $64.6 million of realized losses on sales of fixed maturity securities for the year ended December 31, 2004, there was a total of $7.0 million in credit losses. Most of the sales were related to general portfolio management, largely due to redeploying high quality, liquid public bonds into more permanent investments and the losses resulted from increasing interest rates during the period.
The Company recorded $178.8 million of other than temporary impairments of fixed maturity securities for the year ended December 31, 2004. These impairments relate primarily to: securities in the airline industry ($62.8 million), a manufacturer of parcel delivery vans ($28.0 million), private placement securities related to secured lease obligations of a regional retail food chain ($22.0 million), a holding in a privately held pharmaceutical company ($21.3 million), and one of the world's largest dairy companies ($17.5 million).
The Company recorded losses due to other than temporary impairments of CDO and CBO equity and other invested assets of $78.1 million for year ended December 31, 2004. These impairments primarily relate to lease investments in the U.S. airline industry ($29.2 million) and an investment in a royalty stream ($25.5 million). There were also $12.7 million in impairments on CBO and CDO equity for the period. Equity in these CBOs and CDOs take the first loss risk in a pool of high yield debt. We have a total remaining carrying value of $34.9 million and $60.0 million of CBO and CDO equity as of December 31, 2004 and December 31, 2003, which is currently supported by expected cash flows.
The Company recorded a net loss of $63.7 million on mortgage loans for the year ended December 31, 2004 (of which $17.7 million was losses on hedging adjustments). Included in this loss is $65.7 million in impairments. These impairments primarily relate to mortgages on a company that operates flour milling facilities ($20.2 million), a refrigeration warehouse company ($21.5 million), and a commercial office property ($10.0 million).
There were also gains of $110.4 million on the sale of equity securities as part of our overall investment strategy of using equity gains to offset credit losses in the long term, gains of $50.3 million from the sale of other invested assets, and gains of $83.1 million resulting from the sale of real estate for the year ended December 31, 2004. Net derivative activity resulted in a gain of $61.9 million for the year ended December 31, 2004 resulting from a slightly larger impact from interest rate changes on the Company's fair value of hedged items in comparison to the changes in fair value of its derivatives hedging those items and the change in the fair value of derivatives that do not qualify for hedge accounting.
The Company recorded $539.2 million of other than temporary impairments of fixed maturity securities for the year ended December 31, 2003 (including impairment losses of $515.1 million and $24.1 million of previously recognized gains where the bond was part of a hedging relationship). These impairments relate primarily to: securities in the dairy industry ($150.9 million), securities in the airline industry ($73.5 million), and securities in the power and energy industry ($69.3 million).
There were also gains of $101.1 million on the sale of equity securities as part of our overall investment strategy of using equity gains to offset credit losses in the long term, gains of $25.2 million from the sale of other invested assets, and gains of $289.7 million resulting from the sale of real estate for the year ended December 31, 2003. Net derivative activity resulted in a gain of $116.4 million for the year ended December 31, 2003 resulting from a slightly larger impact from interest rate changes on the Company's fair value of hedged items in comparison to the changes in fair value of its derivatives hedging those items and the change in the fair value of derivatives that do not qualify for hedge accounting.
State insurance laws generally restrict the ability of insurance companies to pay cash dividends in excess of prescribed limitations without prior approval. The Company's limit is the greater of 10% of the statutory surplus at prior year-end or the prior calendar year's statutory net gain from operations of the Company. The ability of the Company to pay shareholder dividends is and will continue to be subject to restrictions set forth in the insurance laws and regulations of Massachusetts, its domiciliary state. The Massachusetts insurance law limits how and when the Company can pay shareholder dividends. The Company, in the future could also be viewed as being commercially domiciled in New York. If so, dividend payments may also be subject to New York's holding company act as well as Massachusetts' law. The Company currently does not expect such regulatory requirements to impair its ability to meet its liquidity and capital needs.
The Company's relative liquidity is reflected in its credit ratings assigned by the major credit rating agencies. At December 31, 2004, The Company's financial strength / claims paying abilities were all rated AA+ by Standard & Poor's Rating Services, a division of the McGraw-Hill Companies, Inc. (S&P), Aa3 by Moody's Investors Service (Moody's), A++ by A.M. Best Company and AA by Fitch Ratings (Fitch). The Company's senior unsecured debt rating was AA+ from S&P and A1 from Moody's.
Individual life insurance policies are less susceptible to withdrawal than are individual annuity contracts because policyholders may incur surrender charges and undergo a new underwriting process in order to obtain a new insurance policy. Annuity benefits under group annuity contracts are generally not subject to early withdrawal. As indicated in the table above, there is a substantial percentage of annuity reserves and deposit fund liabilities that are not subject to withdrawal. As a matter of policy, we seek to include provisions limiting withdrawal rights from general account institutional structured investment products. These include GICs and funding agreements sold to plan sponsors where the contract prohibits the contractholder from making any withdrawals, whether at book value or at market value, other than on a scheduled maturity date. In addition, none of these obligations can be accelerated based on any change in the Company's credit rating. The Company does not sell contracts with put provisions.
Individual life insurance policies (other than term life insurance policies) increase in cash value over their lives. Policyholders have the right to borrow from us an amount generally up to the cash value of their policy at any time. As of December 31, 2004, we had approximately $22.9 billion in cash values in which policyholders have rights to policy loans. The majority of cash values eligible for policy loans are at variable interest rates which are reset annually on the policy anniversary. Moreover, a portion of our fixed interest rate policy loans have features that provide for reduced crediting rates on the portion of cash values loaned. The amount of policy loans has remained consistent over the past three years at approximately $2.0 billion; $1.5 billion of which are in the closed block at December 31, 2004.
The risk-based capital standards for life insurance companies, as prescribed by the National Association of Insurance Commissioners, establish a risk-based capital ratio comparing adjusted surplus to required surplus for each of our United States domiciled insurance subsidiaries. If the risk-based capital ratio falls outside of acceptable ranges, regulatory action may be taken ranging from increased information requirements to mandatory control by the domiciliary insurance department. The risk-based capital ratios of all our insurance subsidiaries as of December 31, 2004, were above the ranges that would require regulatory action.
Net cash used in investing activities was $1,363.0 million, $2,968.6 million and $6,212.6 million for the years ended December 31, 2004, 2003, and 2002, respectively. Changes in the cash provided by investing activities primarily relate to the management of the Company's investment portfolios and the investment of excess capital generated by operating and financing activities. The $1,605.6 million decrease in cash used in 2004 as compared to 2003 resulted primarily from a $2,194.0 million decrease in net acquisitions of fixed maturities, partially offsetting by a $887.6 million decrease in the cash inflow from the sale of Home Office properties. The $3,244.0 million decrease in cash used in 2003 as compared to 2002 resulted primarily from a $887.6 million cash inflow from the sale of Home Office properties in the first quarter of 2003 and a $2,335.6 million decrease in net acquisitions of fixed maturities.
The Manulife line of credit agreement provides for a 364-day credit facility for $1.0 billion. Manulife will commit, when requested, to loan funds at prevailing interest rates as determined in accordance with the line of credit agreement. Under the terms of the agreement, the Company is required to maintain certain minimum levels of net worth and comply with certain other covenants, which were met at December 31, 2004. To date, we have not borrowed any amounts under the external or Manulife lines of credit as of December 31, 2004.
As of December 31, 2004, we had $715.3 million of principal and interest amounts of debt outstanding consisting of $516.7 million of surplus notes, $32.5 million of other notes payable, $144.0 million non-recourse debt for Signature Fruit and an Australian farm management subsidiary, and $22.1 million SFAS No. 133 fair value adjustment to interest rate swaps held for the surplus notes.
These relationships also include credit and collateral support agreements with FNMA and FHMLC, through which the Company securitized some of its mortgage investments, which provided a potential source of liquidity to the Company. These agreements are described in detail in Note 14 - Commitments, Guarantees and Contingencies to the Company's Consolidated Financial Statements.