This section reviews our results of operations for the years 2000 through 2005. This discussion should be read in conjunction with our financial statements in this Form 10-K.
insurance and investment product fees on variable life and annuity products and universal life products; and
the adequacy of our product pricing, which is primarily a function of our:
policies’ persistency (the percentage of policies remaining in force from year to year as measured by premiums);
the maintenance of our target spreads between the rate of earnings on our investments and interest rates credited to customers; and
Nontraditional Long-Duration Contracts and Separate Accounts: Effective January 1, 2004, we adopted the AICPA’s Statement of Position 03-1, Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts, or SOP 03-1. SOP 03-1 provides guidance related to the accounting, reporting and disclosure of certain insurance contracts and separate accounts, including guidance for computing reserves for products with guaranteed benefits such as guaranteed minimum death benefits and for products with annuitization benefits such as guaranteed minimum income benefits. In addition, SOP 03-1 addresses the presentation and reporting of separate accounts, as well as rules concerning the capitalization and amortization of sales inducements. Since this new accounting standard largely codifies certain accounting and reserving practices related to applicable nontraditional long-duration contracts and separate accounts that we already followed, our adoption did not have a material effect on our financial statements.
Derivative Financial Instruments. Effective January 1, 2001, we adopted Statement of Financial Accounting Standards (“SFAS”) No. 133, Accounting for Derivative Instruments and Hedging Activities (“SFAS 133”), as amended by SFAS No. 138, Accounting for Certain Derivative Instruments and Certain Hedging Activities (“SFAS 138”). As amended, SFAS 133 requires all derivatives to be recognized on the balance sheet at fair value. Derivatives that are not hedges must be adjusted to fair value through earnings. See our 2001 financial statements in this Form 10-K for more information on the effect of our adoption of SFAS 133.
Business Combinations/Goodwill and Other Intangible Assets. In June 2001, SFAS No. 141, Business Combinations (“SFAS 141”), and SFAS No. 142, Goodwill and Other Intangible Assets (“SFAS 142”), were issued. SFAS 141 and SFAS 142 are effective for July 1, 2001 and January 1, 2002, respectively. SFAS 141 requires that the purchase method of accounting be used for all business combinations initiated after June 30, 2001 and separate recognition of intangible assets apart from goodwill if such intangible assets meet certain criteria. SFAS 141 also requires that upon adoption of SFAS 142 a company reclassify the carrying amounts of certain intangible assets into or out of goodwill, based on certain criteria. SFAS 142 primarily addresses the accounting for goodwill and intangible assets subsequent to their initial recognition. Under SFAS 142, amortization of goodwill, including goodwill and other intangible assets with indefinite lives recorded in past business combinations, will discontinue upon adoption of this standard, and reporting units must be identified for
We amortize DAC and PFVP based on the related policy’s classification. For term life insurance policies, DAC is amortized in projected net premiums. For universal life, variable universal life and accumulation annuities, DAC and PFVP are amortized in proportion to estimated gross profits. Policies may be surrendered for value or exchanged for a different one of our products (internal replacement); The DAC balance associated with the replaced or surrendered policies is amortized to reflect these surrenders.
See Note 2 to our financial statements in this Form 10-K for information regarding policy liabilities and accruals.
Investments whose value, in our judgment, is considered to be other-than-temporarily impaired are written down to fair value as a charge to realized losses included in our earnings. The cost basis of these written-down investments is adjusted to fair value at the date the determination of impairment is made. The new cost basis is not changed for subsequent recoveries in value. For mortgage-backed and other asset-backed debt securities, we recognize income using a constant effective yield based on anticipated prepayments and the estimated economic lives of the securities. When actual prepayments differ significantly from anticipated prepayments, the effective yield is recalculated to reflect actual payments to date and any resulting adjustment is included in net investment income. For certain asset-backed securities, changes in estimated yield are recorded on a prospective basis and specific valuation methods are applied to these securities to determine if there has been an other-than-temporary decline in value.
We account for income taxes in accordance with SFAS No. 109, Accounting for Income Taxes . The deferred tax assets and/or liabilities are determined by multiplying the differences between the financial reporting and tax reporting bases for assets and liabilities by the enacted tax rates expected to be in effect when such differences are recovered or settled. The effect on deferred taxes of a change in tax rates is recognized in income in the period that includes the enactment date. Valuation allowances on deferred tax assets are estimated based on our assessment of the realizability of such amounts.
We have elected to file a consolidated federal income tax return for 2005 and prior years. Within the consolidated tax return, we are required by regulations of the Internal Revenue Service, or the IRS, to segregate our companies into two groups: life insurance companies and non-life insurance companies. We are limited as to the amount of any operating losses from one group that can be offset against taxable income of the other group. These limitations affect the amount of any operating loss carryforwards that we have recorded in our deferred tax assets now or in the future.
could result in an increase or decrease, respectively, to our effective income tax rate to the extent that our estimates differ from the ultimate resolution.
See Note 5 to our 2005 financial statements in this Form 10-K for more information related to income taxes.
See Note 10 to our financial statements in this Form 10-K regarding our statutory financial information and regulatory matters.
The invested assets in our general account are generally of high quality and broadly diversified across fixed income sectors, public and private income securities and individual credits and issuers. Our investment professionals manage these general account assets in investment segments that support specific product liabilities. These investment segments have distinct investment policies that are structured to support the financial characteristics of the related liabilities within them. Segmentation of assets allows us to manage the risks and measure returns on capital for our various products.
Our general account debt securities portfolio consists primarily of investment-grade publicly traded and privately placed corporate bonds, residential mortgage-backed securities, commercial mortgage-backed securities and asset-backed securities. As of December 31, 2005, our general account debt securities, with a carrying value of
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, 2005, our total below investment grade securities totaled $221.4 million, or 7.9%, of our total debt security portfolio. Of that amount, $181.9 million, or 6.5%, 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 $39.5 million, or 1.4%, of our total debt security portfolio.
We manage credit risk through industry and issuer diversification. Maximum exposure to an issuer is defined by quality ratings, with higher quality issuers having larger exposure limits. Our investment approach has been to create a high level of industry diversification. The top five industry holdings as of December 31, 2005 in our debt securities portfolio are diversified financial services (5.7%), banking (4.7%), insurance (3.7%), REITs (2.8%),and broker-dealers (2.6%).
At the end of each reporting period, we review our security holdings for potential recognition of an other-than-temporary impairment. We maintain a watch list of securities in default, near default or otherwise considered by our investment professionals as being distressed, potentially distressed or requiring a heightened level of scrutiny. We also identify securities whose carrying value has been below amortized cost on a continuous basis for zero to six months, greater than six months to 12 months, greater than 12 months to 24 months and greater than 24
In determining that the securities giving rise to the previously mentioned unrealized losses were not other-than-temporarily impaired, we evaluated the factors cited above, which we consider when assessing whether a security is other-than-temporarily impaired. In making these evaluations, we must exercise considerable judgment. Accordingly, there can be no assurance that actual results will not differ from our judgments and that such differences may require the future recognition of other-than-temporary impairment charges that could have a material affect on our financial position and results of operations. In addition, the value of, and the realization of any loss on, a debt security or equity security is subject to numerous risks, including interest rate risk, market risk, credit risk and liquidity risk. The magnitude of any loss incurred by us may be affected by the relative concentration of our investments in any one issuer or industry. We have established specific policies limiting the concentration of our investments in any single issuer and industry and believe our investment portfolio is prudently diversified.
A primary liquidity concern with respect to life insurance and annuity products is the risk of early policyholder and contractholder withdrawal. We closely monitor our liquidity requirements in order to match cash inflows with expected cash outflows, and employ an asset/liability management approach tailored to the specific requirements of each product line, based upon the return objectives, risk tolerance, liquidity, tax and regulatory requirements of the underlying products. In particular, we maintain investment programs generally intended to provide adequate funds to pay benefits without forced sales of investments. Products having liabilities with relatively long lives, such as life insurance, are matched with assets having similar estimated lives, such as long-term bonds and private placement bonds. Shorter-term liabilities are matched with investments with short-term and medium-term fixed maturities.
Annuity contract reserves and deposit fund liability amounts are reported on a statutory basis, which more accurately reflects the potential cash outflows and include variable product liabilities. Annuity contract reserves and deposit fund liabilities are monetary amounts that an insurer must have available to provide for future obligations with respect to its
Policyholder contractual obligations represent estimated benefit payments, net of reinsurance and offset by expected future deposits and premiums on in-force contracts, from life insurance and annuity contracts issued by us. Future obligations are based on our estimate of future investment earnings, mortality and surrenders. Actual obligations in any single year, or ultimate total obligations, may vary materially from these estimates as actual experience emerges. Because future obligations anticipate future investment earnings, total policyholder contractual obligations exceed policyholder liabilities on our balance sheet at December 31, 2005.
We maintain life reinsurance programs designed to protect against large or unusual losses in our life insurance business. Based on our review of their financial statements and reputations in the reinsurance marketplace, we believe that these third-party reinsurers are financially sound and, therefore, that we have no material exposure to uncollectible life reinsurance.
Net realized investment gains (losses) worsened to a loss of $10,569 thousand in 2005 compared to a gain of $5,121 thousand in 2004 due to debt impairments and higher realized losses on sales of debt securities, in addition of by lower gains on sales of debt and equity securities.
Premiums increased 26% in 2004 over 2003 due primarily to higher sales of our term life insurance products.
Net investment income increased 8% in 2004 over 2003 primarily due to an increase in invested assets related to the guaranteed interest account portion of our annuity business. See policy benefit discussion below for additional information on average account balances.
Net realized investment gains increased $4,353 thousand in 2004 over 2003 due primarily to lower offsets from debt security impairments and higher transaction gains on both debt and equity securities.
Policy benefits increased 7% in 2004 over 2003 primarily due to an increase in net death benefits partially offset by higher interest credited to funds on deposit.
Amortization of deferred policy acquisition costs increased 125% for 2004 from 2003 primarily due to a larger block of business in force and adverse market performance.
Insurance and investment product fees increased 40% in 2003 over 2002 primarily due to the increase in universal life insurance sales. New deposits collected on universal life products increased by $37.9 million in 2003. In addition, in 2003, fee revenue from our assumed variable universal life and variable annuity blocks of business increased over 2002.
Policy benefits increased 29% in 2003 over 2002 primarily due to higher interest credited from higher average funds on deposit in the guaranteed interest account portion of our variable annuity business. The average guaranteed interest account balances for 2003 and 2002 were $1,874.1 million and $1,367.9 million, respectively.
Other operating expenses increased 29% in 2003 over 2002 due to growth in new business.
The increase in insurance and investment product fees of 45% in 2002 was primarily due to the increase in sales of our universal life products. New deposits collected on universal life products increased by $35.9 million in 2002.
Net investment income increased 199% in 2002 over 2001 due to an increase in invested assets related to the guaranteed interest account portion of our annuity business.
Net realized investment losses increased $14,971 thousand during 2002 as a result of debt security impairments recognized during the year. Further, these higher realized losses were only partially offset by realized gains in our debt portfolio.
The increase in policy benefits of 149% in 2002 is primarily due to higher interest credited, resulting from higher average funds on deposit in the guaranteed interest account portion of our variable annuity business. The average guaranteed interest account balances for 2002 and 2001 were $1,048.5 million and $502.4 million, respectively.
Amortization of deferred policy acquisition costs increased 173% in 2002 over 2001, due to increased sales in the annuity block of business and adverse market performance. In addition, in 2002, there was a revision of the long-term market performance assumption, and an impairment charge related to the recoverability of the deferred acquisition cost asset of the variable annuity business.
The decrease in premiums of 17% in 2001 was primarily due to a reduction in sales term life insurance products. This decline reflects the shift of term insurance business from PHL Variable to another Phoenix insurance subsidiary.
Insurance and investment product fees increased 8% in 2001 over 2000, primarily due to the increase in sales of our universal life products. New deposits collected on universal life products increased in 2001 by $9.9 million.
The increase in policy benefits of 133% in 2001 over 2000 was primarily due to higher interest credited on the guaranteed interest account of variable annuities.
Other operating expenses increased by 9% in 2001 over 2000. This increase is related to higher sales of our variable annuity and universal life products.