Management's discussion and analysis reviews our consolidated and segment financial condition as of December 31, 2003 and 2002, the consolidated results of operations for the years ended December 31, 2003, 2002, and 2001 and, where appropriate, factors that may affect future financial performance. This discussion should be read in conjunction with the audited consolidated financial statements and related notes, included elsewhere in this Form 10-K. All of the Company's United States Securities and Exchange Commission filings are available on the internet at www.sec.gov, under the name Hancock John Life. -----------
These forward-looking statements are subject to risks and uncertainties including, but not limited to, the risks that (1) a significant downgrade in our ratings for claims-paying ability and financial strength may lead to policy and contract withdrawals and materially harm our ability to market our products; (2) new laws and regulations, including the recently enacted Sarbanes-Oxley Act of 2002, or changes to existing laws or regulations, (including, but not limited to, those relating to the Federal Estate Tax Laws and the proposed Bush Administration tax and savings initiatives), and the applications and interpretations given to these laws and regulations, may adversely affect the Company's sales of insurance and investment advisory products; (3) Massachusetts insurance law may restrict the ability of John Hancock Variable Life Insurance Company to pay dividends to us; (4) we face increasing competition in our retail businesses from mutual fund companies, banks and investment management firms as well as from other insurance companies; (5) declines or increased volatility in the securities markets, and other economic factors, may adversely affect our business, particularly our variable life insurance, mutual fund, variable annuity and investment business; (6) due to acts of terrorism or other hostilities, there could be business disruption, economic contraction, increased mortality, morbidity and liability risks, generally, or investment losses that could adversely affect our business; (7) our life insurance sales are highly dependent on a third party distribution relationship; (8) customers may not be responsive to new or existing products or distribution channels, (9) interest rate volatility may adversely affect our profitability; (10) our net income and revenues will suffer if customers surrender annuities and variable and universal life insurance policies or redeem shares of our open-end mutual funds; (11) the independent trustees of our variable series trusts and of our mutual funds could reduce the compensation paid to us or could terminate our contracts to manage the funds; (12) under our Plan of Reorganization, we were required to establish the closed block, a special arrangement for the benefit of a group of our policyholders. We may have to fund deficiencies in our closed block, and any over-funding of the closed block will benefit only the holders of policies included in the closed block, not our sole shareholder; (13) we will face losses if the claims on our insurance products, or reductions in rates of mortality on our annuity products, are greater than we projected; (14) we face investment and credit losses relating to our investment portfolio, including, without limitation, the risk associated with the evaluation and determination by our investment professionals of the fair values of investments as well as whether or not any investments have been impaired on an other than temporary basis; (15) we may experience volatility in net income due to changes in standards for accounting for derivatives and other changes; (16) we are subject to risk-based capital requirements and possible guaranty fund assessments; (17) we may be unable to retain personnel who are key to our business; (18) we may incur losses from assumed reinsurance business in respect of personal accident insurance and the occupational accident component of workers compensation insurance; (19) litigation and regulatory proceedings may result in financial losses, harm our reputation and divert management resources; (20) we face unforeseen liabilities arising from our acquisitions and dispositions of businesses; (21) we may incur multiple life insurance claims as a result of a catastrophic event which, because of higher deductibles and lower limits under our reinsurance arrangements, could adversely affect the Company's future net income and financial position, and (22) in connection with the proposed merger between JHFS and Manulife Financial Corporation: we may not achieve the revenue synergies, cost savings and other synergies contemplated by the proposed merger; we may experience litigation related to the merger; John Hancock's and Manulife's distributors, customers and policyholders may react negatively to the transaction; we may encounter difficulties in promptly and effectively integrating the businesses of John Hancock and Manulife; we may not
be able to retain the professional and management talent necessary to operate the business; the transaction may result in diversion of management time on merger-related issues; and after the merger, we may experience increased exposure to exchange rate fluctuations and other unknown risks associated with the merger.
Our financial reporting and this MD&A of Financial Condition and Results of Operations (MD&A) is organized in the same manner as our business. We present a discussion of our consolidated statement of operations in "Results of Operations" and then proceed to present the business broken down into its operating segments discussed above, focusing the discussion therein on the segments' operating income (see Key Performance Indicators for definition of operating income). In addition to these discussions of segment operating income, we identify and discuss accounting policies critical to understanding our business operations and understanding of our results of operation in Critical Accounting Policies section of this MD&A. We also identify macro economic issues impacting the industry and the Company in the Economic Trends section of this MD&A, while we identify significant transactions affecting the comparability of operating results across reporting period in the section labeled Transactions Affecting the Comparability of the Results of Operation.
o premiums on individual life insurance, individual and group long-term care insurance, annuities with life contingencies, single premium annuity contracts;
o asset management fees from mutual fund and other investment management products ;
Our expenses consist principally of insurance benefits provided to policyholders, which includes: changes in policyholder reserves; interest credited on policyholders' general account balances; dividends to policyholders; and other operating costs and expenses, which include commissions and general business expenses, net of expenses deferred, amortization of deferred policy acquisition costs, and premium and income taxes.
Our profitability depends in large part upon: (1) the adequacy of our product pricing, which is primarily a function of competitive conditions, our ability to assess and manage trends in mortality and morbidity experience, our ability to generate investment earnings and our ability to maintain expenses in accordance with pricing assumptions; (2) the amount of assets under management; and (3) the maintenance of our target spreads between the rate of earnings on our investments and credited rates on policy or contractholders' general account balances.
The Company generates income tax benefits by investing in apartment properties (the Properties) that qualify for low income housing and/or historic tax credits. The Company invests in the Properties directly, and also invests indirectly via limited partnership real estate investment funds. The limited partnership real estate investment funds are consolidated into the Company's financial statements. The Properties are organized as limited partnerships or limited liability companies each having a managing general partner or a managing member. The Company is usually the sole limited partner or investor member in each Property; it is not the general partner or managing member in any Property. The Properties typically raise additional capital by qualifying for long term debt, which at times is guaranteed or otherwise subsidized by Federal or state agencies. In certain cases, the Company invests in these mortgages of the Properties, which are non-recourse to the general assets of the Company. In the event of default by a mortgagee of a Property, the mortgage is subject to foreclosure. The Company has previously determined that each Property is a VIE, but that the Company was not the primary beneficiary of any Property, under FIN 46, which was replaced by FIN 46R in December of 2003, as discussed above. The Company
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 they made to them. Therefore, the Company believes that the application of FIN 46R will have no impact on the Company's liquidity and capital resources beyond what is already presented in the consolidated financial statements and notes thereto.
The Company discloses summary financial data and its maximum exposure to losses for all these candidates in Note 3 - Relationships with Variable Interest Entities in the Notes to Consolidated Financial Statements.
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 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. In recent years, actual results for market experience, or asset growth, have fluctuated considerably from historical trends and the long-term assumptions made in calculating expected gross profits. As a result, we changed some of these long-term assumptions in third quarter of 2002 (Q3 2002 Unlocking), as further described below.
Q3 2002 Unlocking: As of September 30, 2002, the Company changed several future assumptions with respect to the expected gross profits in its variable life insurance business in the Protection Segment and its variable annuity business in the Asset Gathering Segment. First, we lowered the long-term growth rate assumption from 9% to 8% gross of fees (which are approximately 1% to 2%). Second, we lowered the average rates for the next five years from the mid-teens to 13% gross of fees. Finally, we increased certain fee rates on these policies (the variable series trust (VST) fee increase). These three changes are referred to collectively here and elsewhere in this document as the Q3 2002 Unlocking. The performance of the major market indices for the past five quarters has demonstrated the propriety of our changes in assumptions. The result of
The level of DAC amortization in 2004 will vary if separate account growth rates vary from our current assumptions. The table below shows the estimated increased (decreased) quarterly DAC amortization that will result if actual separate account growth rates are different than the rates assumed in our DAC models.
Certain of our fixed income securities classified as held-to-maturity and available-for-sale are not publicly traded, and quoted market prices are not available from brokers or investment bankers on these securities. The change in the fair value of the available-for-sale securities is recorded in other comprehensive income as an unrealized gain or loss. We calculate the fair value of these securities ourselves through the use of consistently applied pricing models and discounted cash flows calling for a substantial level of professional investment management judgment. Our approach is based on currently available information, including information obtained by reviewing similarly traded securities in the market, and we believe it to be appropriate and fundamentally sound. However, different pricing models or assumptions or changes in relevant current information could produce different valuation results. The Company's pricing model takes into account a number of factors based on current market conditions and trading levels of similar securities. These include current market based factors related to credit quality, country of issue, market sector and average investment life. The resulting prices are then reviewed by the pricing analysts and members of the Controller's Department. Our pricing analysts take appropriate action to reduce valuation of securities where an event occurs which negatively impacts their value. Certain events that could impact the valuation of securities include changes in issuer credit ratings, changes in the business climate, actions of issuer management, litigation and government actions, among others.
The Company annually reviews 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. All assumptions are reviewed and approved by the Chief Financial Officer and reviewed with the Audit Committee of the Board of Directors.
The assumed discount rate is set in the range of (a) the rate from the December daily weighted average of long-term corporate bond yields (as published by Moody's Investor Services for rating categories A, Aa, Aaa, and Baa) less a 5% allowance for expenses and default and (b) the rate from the rounded average of the prior year's discount rate and the rate in (a) above. In 2003 the Company set the rate at 6.25%. A 0.25% increase in the discount rate would decrease pension benefits Projected Benefit Obligation (PBO) and 2004 Net Periodic Pension Cost (NPPC) by approximately $56.1 million and $3.7 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 $14.3 million and $1.0 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, it is expected that an 8.75% long term rate of return assumption will be used. A 0.25% increase in the long-term rate of return would decrease 2004 NPPC by approximately $5.0 million and 2003 NPBC by approximately $0.6 million. The expected return on plan assets is based on the fair market value of the plan assets as of December 31, 2003.
The sales and other financial results of our retail business over the last several years have been affected by general economic and industry trends. Variable products, including variable life insurance and variable annuities, until 2001 had accounted for the majority of recent increases in total premiums and deposits for the insurance industry as a result of the strong equity market growth in recent years and the "baby boom" generation reaching its high-earnings years and seeking tax-advantaged investments to prepare for retirement. This trend has changed due to fluctuations in stock market performance and we have seen investors return to fixed income products. Our diverse distribution network and product offerings will assist in the maintenance of assets and provide for sales growth. Although sales of traditional life insurance
(1) Net of related amortization of deferred policy acquisition costs, amounts credited to participating pension contractholders and the policyholder dividend obligation of $(55.8) million, $(74.1) million and $(4.1) million for the years ended December 31, 2003, 2002, and 2001, respectively. (2) Excluding amounts related to net realized investment and other gains (losses) credited to participating pension contractholders and the policyholder dividend obligation of $(61.9) million, $(35.2) million and $25.3 million, for the years ended December 31, 2003, 2002, and 2001, respectively. (3) Excluding amounts related to net realized investment and other gains (losses) of $6.1 million, $(38.9) million and $(29.4) million for the years ended December 31, 2003, 2002, and 2001, respectively. (4) Cumulative effect of accounting changes is shown net of taxes of $150.2 million for 2003 and $(4.2) million for 2001. There was no cumulative effect of accounting changes in 2002. The cumulative effect of accounting change in 2003 relates to the Company's adoption of DIG B36 effective October 1, 2003. For additional discussion of DIG B36, refer to Note 1 -- Summary of Significant Accounting Policies in the notes to the consolidated financial statements.
The impairments in the current period were driven by losses recognized on other than temporary declines in value of fixed maturity securities of $539.2 million, including impairment losses of $515.1 million and $24.1 million of previously recognized gains where the bond was part of a hedging relationship. The largest impairments were write-downs on $113.2 million on public & private fixed maturity securities (including an impairment loss of $112.7 million and $0.5 million in previously recognized gains where the bonds were part of a hedging relationship) on an international dairy company headquartered in Italy, $37.7 million (including an impairment loss of $37.3 million and $0.4 million in previously recognized gains where the bonds were part of a hedging relationship) on public fixed maturity securities relating to a large, national farmer-owned dairy cooperative, $36.8 million on private fixed maturity securities (including an impairment loss of $31.7 million and $5.1 million in previously recognized gains where the bond was part of a hedging relationship) on a toll road in Texas, $36.1 million on private and public fixed maturity securities (including an impairment loss of $34.6 million and $1.5 million in previously recognized gains where the bond was part of a hedging relationship) secured by aircraft leased by a large U.S. airline, and $29.8 million on private fixed maturity securities relating to an Australian mining company. Additional losses were recorded for other than temporary declines in the equity in collateralized bond obligations of $29.8 million and other equity securities of $27.8 million during 2003. For a more complete discussion of impairments see General Accounts Investments in this MD&A.
quarter of 2003. See Note 9 - Sale/Leaseback Transaction and Other Lease Obligations in the notes to the consolidated financial statements. The increased earnings in the G&SFP Segment was primarily due to a $98.5 million improvement in net realized investment and other losses. The increase in the Protection Segment was driven by a $111.0 million increase in net investment income, a $34.0 million increase in net realized investment and other losses, and a $34.6 million increase in universal life product fees. The increase in the Asset Gathering Segment was driven by growth in net investment income, partially offset by a decrease of $34.4 million in management advisory fees due to lower assets under management, partially offset by a decrease in operating expenses. The Investment Management Segment's income before income taxes and cumulative effect of accounting changes increased due to an increase of $9.0 million in net realized investment and other gains and a $7.0 million increase in management advisory fees.
Premium revenues increased 2.8%, or $55.2 million, from the prior year. The increase was primarily due to the Protection Segment which increased $37.5 million driven primarily by long-term care insurance premiums, which increased 17.0%, or $79.4 million, partially offset by a decline in traditional life insurance premiums of 4.0%, or $42.0 million. Also contributing to the increase in premiums was the Corporate and Other Segment which increased $13.3 million. The growth in Corporate and Other was driven by the International Group Program partially offset by the sale of the group life business effective May 1, 2003.
o As of December 31, 2003, the Company's asset portfolio had approximately $13 billion of floating-rate exposure (primarily LIBOR). This compares to approximately $12 billion of exposure as of December 31, 2002. This exposure was created mostly through interest rate swaps designed to match our floating-rate liability portfolio. As of December 31, 2003, approximately 88% of this exposure, excluding cash and short-term investments, was directly offset by exposure to floating-rate liabilities. Most of the remaining 12% 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. As a result of the drop in short term rates over the year, as well as the increase in exposure, this floating-rate exposure reduced the portfolio yield by 11 basis points in 2003 compared to the prior year.
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 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.
Investment management revenues, commissions, and other fees decreased 5.8%, or $30.6 million, from the prior year. The decrease in fee revenue was driven by the Asset Gathering Segment where fees decline $34.4 million driven by the mutual funds business where distribution and advisory fees declined due to a shift in the product mix. Average mutual fund
Other revenue increased 11.8%, or $28.4 million, from the prior year. The increase in other revenue is due to Signature Fruit, a subsidiary of the Company since April 2, 2001, which acquired certain assets and assumed certain liabilities out of bankruptcy proceedings of Tri Valley Growers, Inc., a cooperative association on that date. The revenues and expenses of Signature Fruit are included in the Company's income statement in other revenue and other operating costs and expenses, respectively, in the Corporate and Other Segment. Signature Fruit generated revenue of $254.5 million in 2003, an increase of $18.6 million from the prior year. Also included in other revenues is the fee revenue generated in the Federal long-term care insurance business, its primary operating revenue. The Federal long-term care insurance business is a fee business where the Company administers and supports employee long-term care insurance benefits offered by the Federal Government to its employees. Federal long-term care insurance fee revenue increased $7.2 million from the prior year, its start-up year.
Other operating costs and expenses increased $155.5 million from the prior year, driven by an increase of $113.6 million in the Corporate and Other Segment driven by increases in net periodic pension costs of $32.0 million, deficiency interest of $22.4 million, $12.3 million in compensation costs, $3.3 million in pension curtailment losses, and administrative service contracts of $4.6 million. In addition, Signature Fruit operating expenses increased $16.5 million. Signature Fruit other operating costs and expenses were $257.8 million in 2003 and $241.3 million in the prior year. G&SFP Segment other operating costs and expenses increased $58.9 million on increased investment income transferred on reinsurance ceded and higher compensation costs. Asset Gathering Segment other operating costs and expenses decreased $19.7 million driven by lower commission expense in the mutual fund business. The Protection Segment other operating costs and expenses decreased $2.3 million driven by general insurance expenses and amortization of intangibles related to the Allmerica acquisition.
Amortization of deferred policy acquisition costs decreased 4.8%, or $15.1 million, from the prior year. The decrease in amortization of deferred policy acquisition costs was primarily due to the $64.0 million Q3 2002 Unlocking of the Company's deferred policy acquisition costs (DAC) asset, which increased amortization of the DAC asset in 2002. The Q3 2002 Unlocking of the DAC asset occurred based on changes in the future investment return assumptions and our lowering of the long-term growth rate assumption from 9% to 8%, gross of fees (which are approximately 1% to 2%). In addition, we lowered the average rates for the next five years from the mid-teens to 13%, gross of fees. The Q3 2002 Unlocking impacted the Asset Gathering and Protection Segments. (See Note 1--Summary of Significant Accounting Policies in the notes to consolidated financial statements and Critical Accounting Policies in this MD&A for further discussion). The decrease in amortization of DAC due to Q3 2002 Unlocking of the DAC asset was partially offset by a $13.6 million increase in amortization in the Protection Segment for growth in the long-term care insurance business and adjusting gross profit margins for term conversions in the non-traditional life insurance business.
The following discussion reflects the adoption of Statement of Position s(SOP) 00-3, "Accounting by Insurance Enterprises for Demutualizations and Formation of Mutual Insurance Holding Companies and Certain Long-Duration Participating Contracts" for all periods subsequent to the adoption of the closed block on February 1, 2000. In addition, the following discussion reflects the December, 2001 transfer of both the Company's remaining portion of John Hancock Canadian Holdings Limited and certain international subsidiaries held by the Company, with a total carrying value of $300.1 million at December 31, 2001 to its parent, JHFS, in the form of a dividend. The transfer has been accounted for as a transfer of entities under common control. As a result of the transfer, all prior period consolidated financial data has been restated to exclude the results of operations, financial position, and cash flows of these transferred foreign subsidiaries from the Company's financial statements. No gain or loss was recognized on the transfer transaction.
The decrease in income before income taxes and cumulative effect of accounting changes was primarily attributable to decreases of $147.4 million in the Guaranteed and Structured Financial Products (G&SFP) Segment, a decrease of $92.6 million in the Corporate and Other Segment, and a decrease of $12.0 million in the Investment Management Segment. These decreases in income before income taxes and cumulative effect of accounting changes were partially offset by an increase of $41.6 million in the Protection Segment, and a $10.3 million increase in the Asset Gathering Segment. The decrease in the G&SFP Segment was primarily due to net realized investment and other losses, which increased $192.8 million, and lower net investment income, which decreased $130.6 million driven by floating interest rates, these decreases in revenue were partially offset by lower reserves. The decrease in the Corporate and Other Segment was primarily due to a $50.3 million decrease in net investment income and a $54.7 million change in net realized investment and other losses, these decreases in revenue were partially offset by lower reserves. The decrease in the Investment Management Segment is driven by a $13.5 million decrease in net investment income and a $3.1 million decrease in management advisory fees due to lower assets under management, partially offset by a decrease in operating expenses driven by lower interest expense. The Protection Segment experienced an increase in income before income taxes and cumulative effect of accounting changes primarily driven by an increase of $17.9 million in universal life product fees, primarily due to growth in non-traditional life insurance products.
In addition, the Asset Gathering Segment's income before income taxes and cumulative effect of accounting changes increased due to a decrease in operating costs and expenses, driven by cost saving in the mutual funds business and company wide cost reduction programs.
Partially offsetting the effects of these decreases to yields on investments was an increase in invested assets and a reduction in investment expenses. In 2002, average invested assets grew $6,583.1 million, or 13.1% from the prior year. In addition, investment expenses were reduced $15.5 million in 2002 compared to the prior year. Also included are reductions in corporate operating expenses and in depreciation expenses associated with the sale of the Company's Home Office properties.
Net realized investment and other losses increased 83.3%, or $204.7 million, from the prior year. The increase was driven by other than temporary declines in value of fixed maturity securities of $603.0 million (including impairment losses of $565.9 million and $37.1 million of preciously recognized gains where the bond was part of a hedging relationship), the largest of which were on securities issued by United Airlines, US Airways, Enron and affiliates, NRG Energy Group, among others; additional detail is provided previously and in General Account Investments in this MD&A. The Company also incurred losses on the other than temporary declines in value of the equity in collateralized bond obligations of $61.3 million
and other equity securities of $26.9 million. In addition, the Company incurred losses on disposal of real estate of $36.5 million. For additional analysis regarding net realized investment and other losses, see General Account Investments in this MD&A.
Benefits to policyholders decreased 12.1%, or $522.9 million, from the prior year. The decrease in benefits to policyholders was driven by a decrease in the G&SFP Segment of 36.5%, or $682.4 million. Benefits to policyholders in G&SFP Segment spread-based products decreased 36.5%, or $682.5 million, from the prior year, due to increased level of reinsurance arrangements and lower interest credited. Interest credited decreased 15.3%, or $184.1 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 billion of liabilities with floating rates and new business added at current market rates. The average crediting rate fell to 4.85% from 6.33% in the prior year. Partially offsetting the decrease in benefits to policyholders in the G&SFP Segment was an increase in the Protection Segment of 11.5%, or $184.3 million primarily due to growth in the long-term care insurance business where the Company increased reserves for premium growth and higher claim volume. In addition, benefits to policyholders increased in the non-traditional life insurance business due to growth in the in-force. The non-traditional life insurance business had an increase in benefits to policyholders of 20.8%, or $50.1 million, primarily due to a $29.0 million increase in interest credited on higher current year account balances, and also driven by a $15.3 million increase in death claims, net of reserves released.
Other operating costs and expenses decreased $0.3 million from the prior year, despite an increase of $58.2 million in other operating costs and expenses related to Signature Fruit., which was included in only part of the prior year's results. The decrease was primarily due to cost containment measures. The Asset Gathering Segment other operating costs and expenses decreased $75.6 million driven by lower salary and commission expense in the mutual fund business. In addition, other operating costs and expenses decreased $5.9 million in the Investment Management Segment driven by lower interest expense from lower average levels of warehoused commercial mortgages held for sale and lower average interest rates during 2002. Included in other operating costs and expenses was $241.3 million in operating costs of Signature Fruit in 2002. The increase in Signature Fruit other operating costs and expenses is due to their inclusion in the 2002 results for the full year while included only for nine months in 2001 after its formation.
Amortization of deferred policy acquisition costs increased 25.9%, or $64.4 million, from the prior year. The increase in amortization of deferred policy acquisition costs was primarily due to the $64.0 million Q3 2002 Unlocking of the Company's deferred policy acquisition costs (DAC) asset, which increased amortization of the DAC asset. Amortization of deferred policy acquisition costs increased due to the Q3 2002 Unlocking of the DAC asset based on changes in the future investment return assumptions and lowering the long-term growth rate assumption from 9% to 8%, gross of fees (which are approximately 1% to 2%). In addition, we lowered the average rates for the next five years from the mid-teens to 13%, gross of fees. We also increased certain fee rates on these policies (the VST fee increase). These changes in assumptions resulted in the Q3 2002 Unlocking of the DAC asset, which impacted the Asset Gathering and Protection Segments (See Note 1 - Summary of Significant Accounting Policies in the notes to consolidated financial statements and Critical Accounting Policies in this MD&A).
Income taxes were $108.6 million in 2002, compared to $200.7 million for 2001. Our effective tax rate was 19.1% in 2002, as compared to 26.2% in 2001. The lower effective tax rate was primarily due to beneficial impact of additional option contracts under the lease residual management strategy, a decrease in the provision for prior year Federal income tax audit issues, and increased affordable housing tax credits.
We evaluate segment performance and base management's incentives on segment after-tax operating income, which excludes the effect of net realized investment gains and losses and unusual or non-recurring events and transactions. In addition, we believe most investors and analysts that follow our industry also measure results on the same basis. Total segment after-tax operating income is a non-GAAP measure which is determined by adjusting GAAP net income for net realized investment gains and losses, and certain other items which we believe are not indicative of overall operating trends. While these items may be significant components in understanding and assessing our consolidated financial performance, we believe that the presentation of segment after-tax operating income enhances the understanding of our results of operations by highlighting net income attributable to the normal, recurring operations of the business. However, segment after-tax operating income is not a substitute for net income determined in accordance with GAAP.
During 1997, the Company entered into a court-approved settlement relating to a class action lawsuit involving certain individual life insurance policies sold from 1979 through 1996. In entering into the settlement, the Company specifically denied any wrongdoing. The total reserve held in connection with the settlement to provide for relief to class members and for legal and administrative costs associated with the settlement amounted to $3.2 million and $11.9 million at December 31, 2003 and 2002, respectively. The Company incurred no costs related to the settlement in 2003 or 2002. Costs incurred related to the settlement were $19.5 million after-tax in 2001. The estimated reserve is based on a number of factors, including the estimated cost per claim and the estimated costs to administer the claims.
We had been subject to the surplus tax imposed on mutual life insurance companies which disallows a portion of mutual life insurance company's policyholder dividends as a deduction from taxable income. Since then, as a stock company, we are no longer subject to the surplus tax and have excluded it from segment after-tax operating income in all periods.
The excess of cost over the fair value of the net assets of businesses acquired was $108.6 million at December 31, 2003 and 2002. Prior to 2002, goodwill was amortized on a systematic basis over periods not exceeding 40 years, which periods corresponded with the benefits estimated to be derived from the acquisitions. Accumulated amortization and other changes was $58.1 million at both December 31, 2003 and 2002. Amortization expense included in other operating costs and
expenses was $11.3 million in 2001. No amortization of goodwill occurred in 2003 and 2002 pursuant to current accounting guidance. The Company evaluates goodwill for impairment using valuations of reporting units and also whenever significant events or changes indicate an impairment may exist. If the fair value analysis did not support the goodwill recorded, an impairment would be recognized resulting in a charge to current operations to reduce the carrying value of the goodwill to its fair value.
Segment after-tax operating income increased 19.7%, or $61.2 million, from the prior year. Non-traditional life insurance segment after-tax operating income increased 26.7%, or $32.0 million, primarily due to increased universal life and product-type fee income and increased net investment income partially offset by increased benefits to policyholders. Long-term care insurance segment after-tax operating income increased 26.1%, or $21.8 million, resulting from increased premiums and higher net investment income, partially offset by higher benefits and expenses and higher amortization of deferred policy acquisition costs. Traditional life insurance business after-tax operating income decreased 5.4%, or $6.0 million, primarily due to run-off of the closed block. Federal long-term care insurance business after-tax operating income increased $5.1 million from its start up phase in the prior year.
Revenues increased 5.8%, or $189.4 million. Premiums increased 2.5%, or $37.5 million, primarily due to long-term care insurance premiums, which increased 17.0%, or $79.4 million, driven by business growth from higher sales and continued lower lapses. This increase was partially offset by a 4.0%, or $42.0 million, decrease in premiums in the traditional life insurance business due to the run off of the closed block. Universal life and investment-type product fees increased 7.8%, or $34.6 million, primarily due to a $37.6 million increase in the cost of insurance fees resulting from growth in the existing business and from the addition of Allmerica block of business assumed as of December 31, 2002. Segment net investment income increased 8.5%, or $111.0 million, primarily due to a 15.5% increase in average asset balances, partially offset by a 45 basis point decrease in yields.
Benefits and expenses increased 4.1%, or $113.5 million. Benefits to policyholders increased 6.8%, or $120.3 million, primarily due to growth in both the long-term care insurance business and non-traditional life insurance business in force. Long-term care insurance benefits to policyholders increased 20.9%, or $108.7 million, primarily due to additions to reserves for premium growth and higher claim volume on growth of the business during the period. The long-term care insurance business claims are being incurred at an aggregate rate lower than assumed in calculating the reserves of the business. Long-term care insurance business policies have increased to 706.2 thousand from 604.2 thousand in the prior year. The non-traditional life insurance business had an increase in benefits to policyholders of 8.4%, or $24.1 million, primarily due to a $51.0 million increase in interest credited on higher current year account balances. This increase was partially offset by a $19.2 million decrease to lower reserves on term conversions and a $7.8 million decrease in death claims, net of reserves
Revenues increased 6.7%, or $205.2 million. Premiums increased 10.4%, or $142.1 million, primarily due to long-term care insurance premiums, which increased 31.9%, or $113.1 million, driven by continued growth overall in the business. In addition, traditional life insurance premiums increased 2.9%, or $29.0 million, primarily due to the return of renewal premiums in the prior year of $34.4 million as part of the resolution of the class action lawsuit, offset by a corresponding change in the benefit reserves. Universal life and investment-type product fees increased 4.2%, or $17.9 million due primarily to increased expense charges of $11.8 million. Mostly offsetting this increase in amortization of deferred revenue was lower amortization in the current year due in part to lower gross profits from lower separate account performance and poor mortality. Segment net investment income increased 4.2%, or $52.2 million, primarily due to a 9.7% increase in average asset balances, partially offset by a 40 basis point decrease in yields.
Benefits and expenses increased 6.3%, or $164.8 million. Benefits to policyholders increased 10.6%, or $170.1 million, primarily due to growth in the long-term care insurance business and non-traditional life insurance business in force. Long-term care insurance benefits and expenses increased 26.8%, or $109.9 million, primarily due to additions to reserves for premium growth and higher claim volume driven by business growth. Long-term care insurance business average policies have increased to 604.2 thousand from 538.7 thousand in the prior year and open claims increased to 5,449 from 4,483 in the prior year. The non-traditional life insurance business had an increase in benefits to policyholders of 21.4%, or $51.7 million, primarily due to a $29.0 million increase in interest credited on higher current year account balances, and also driven by a $15.3 million increase in death claims, net of reserves released. Other operating costs and expenses decreased 4.9%, or $16.7 million primarily due to a decrease of $30.4 million in operating expenses primarily due to expense reductions. Amortization of deferred policy acquisition costs decreased 0.1%, or $0.2 million, primarily due to the non-traditional life insurance business driven by the $27.9 million Q3 2002 Unlocking of DAC asset (See Note 1 - - Summary of Significant Accounting Policies in the notes to the unaudited financial statements and the Critical Accounting Policies in this MD&A). This was offset by a decrease in amortization of deferred policy acquisition costs in the traditional life insurance business of $19.7 million, due to improved persistency of term insurance, and lower margins. Dividends to policyholders increased 2.3%, or $11.6 million, due to a higher dividend scale and aging of the in-force business on traditional life insurance products. The Segment's effective tax rate on operating income was 35.5% for both 2002 and 2001.
Segment after-tax operating income increased 48.7%, or $63.6 million, from the prior year. The increase in segment after-tax operating income was driven by a $34.6 million increase in the variable annuity business. The growth in the variable annuity business was driven by improved separate account performance in the current period. Separate accounts experienced a 19.9% return in 2003 compared to a negative return of 14.6% in 2002. The poor separate account performance in 2002 resulted in a one time unlocking of the deferred policy acquisition cost asset of $36.1 million in the prior year. Partially offsetting the decrease in the amortization of the deferred policy acquisition costs was a $10.5 million increase in operating expenses and a decrease of $6.9 million in universal life and investment product fees. The increase in segment after-tax operating income was also driven by a $32.3 million increase in the fixed annuity business, as net investment income increased 22.9%, or $129.0 million, on higher assets under management, and was partially offset by an increase in benefits to policyholders of $57.9 million driven by interest credited on higher average account values. Mutual fund business after-tax operating income was $50.3 million, declining 3.5%, or $1.8 million, primarily due to a 7.8%, or $23.8 million, decrease in management advisory fees, offset by a 28.0%, or $24.6 million, decrease in commissions. After-tax operating income for Essex, a distribution subsidiary primarily serving the financial institution channel, decreased $0.3 million. Signature Services after-tax operating income decreased $0.3 million and Signator Investors after-tax operating income decreased $0.2 million.
caused by an increase in institutional advisory account redemptions of $916.7 million, partially offset by a decrease in open-end retail mutual fund redemptions of $490.5 million. Investment advisory fees decreased 1.9%, or $2.8 million, to $149.4 million, from the prior period and were 0.55% and 0.57% of average mutual fund assets under management for the years ended December 31, 2003 and 2002. Underwriting and distribution fees decreased 11.3%, or $23.3 million, to $181.4 million compared to the prior period, primarily due to a decrease in contingent deferred sales charges on a decline in open-end mutual fund class B share redemptions. Rule 12b-1 fee revenue also declined due to lower eligible assets under management. The decrease also included a $7.9 million decrease in distribution and other fees. Shareholder service and other fees were $58.0 million compared to $66.3 million in the prior year.
Benefits and expenses increased 1.6%, or $15.2 million from the prior year. Driving the increase in benefits and expenses was an increase of 12.1%, or $54.0 million, in benefits to policyholders. Benefits to policyholders increased $57.9 million in the fixed annuity business primarily due to a $40.3 million increase in interest credited on fixed annuity account balances due to higher average account balances and $9.5 million in higher reserve provisions for life-contingent immediate fixed annuity fund values on higher sales of these contract types. Offsetting the increase in benefits and expenses was a decline of $29.1 million in amortization of deferred policy costs primarily due to the variable annuity business. Amortization of deferred policy costs decreased $54.3 million from the prior year in the variable annuity business due in part to the prior year DAC unlocking of $36.1 million. In 2002, the variable annuity business experienced significant declines in the equity markets, leading to an increase in the amortization of deferred policy costs, resulting in the Q3 2002 Unlocking (See Note 1 - Summary of Significant Accounting Policies in the notes to the consolidated financial statements and Critical Accounting Policies in this MD&A). Amortization of deferred policy costs also decreased $26.9 million due in part to higher variable annuity future profit margins associated with improved separate account performance in the current year, and increased $25.3 million due to higher fixed annuity deferred policy cost asset balances. Other operating costs and expenses decreased 2.6%, or $9.7 million, from the prior year, primarily due to the decrease in commission expense in the mutual funds business. The Segment's effective tax rate on operating income was 31.9% compared to 32.6% for the prior year. The decrease in the rate is due to an increase in affordable housing tax credits and lower dividends received deductions in the current period.
Revenues decreased 2.4%, or $28.7 million, from the prior year. The decrease in revenue was due to a $54.7 million decline in investment management revenues driven by the mutual fund business, a $45.5 million decline in premiums in the fixed annuity business on lower life-contingent fixed annuity sales and a $6.9 million decrease in investment-type product fees, primarily in the variable annuity business on lower average fund values. These declines in revenue were partially offset by an increase of 15.5%, or $77.2 million in net investment income. The increase in net investment income was primarily due to increases in invested assets backing fixed annuity products, partially offset by lower earned yields in the portfolio. Average invested assets backing fixed annuity products increased 29.1% to $7,719.2 million while the average investment yield decreased 77 basis points. Investment-type product fees decreased 5.5%, or $6.9 million, mostly due to a decline in the average variable annuity fund values of 13.9%, or $940.2 million, to $5,812.8 million from the prior year. Both market depreciation of $778.4 million and net outflows of $242.2 drove this decrease in average variable annuity fund values for the current year. For variable annuities the mortality and expense fees as a percentage of average account balances were 1.29% and 1.22% for the current and prior year periods.
Segment after-tax operating income increased 7.0%, or $18.7 million from the prior year. Spread-based products after-tax operating income increased 10.2%, or $25.2 million from the prior year, driven by a 9.2%, or $92.2 million decrease in benefits to policyholders, partially offset by an increase in operating costs and expenses mainly from higher reinsurance expenses and a decrease in net investment income. Lower benefits to policyholders reflect an increased level of reinsurance arrangements, driving a lower increase in policy reserves. Fee-based products after-tax operating income decreased 29.1%, or $6.5 million from the prior year, primarily due to lower separate account risk charges and lower earnings on risk-based capital.
Revenues decreased 25.4%, or $601.1 million from the prior year, driven by a decline in premiums of 96.2%, or $464.9 million from the prior year reflecting the lower sales volume and increased level of reinsurance arrangements. Net investment income also decreased 7.1%, or $130.6 million, driven by lower spread-based net investment income of 6.9%, or $110.0 million, from the prior year, despite growth of 11.1%, or $2.3 billion in the average invested asset base. Net investment income declined as the average investment yield fell to 6.43% from the prior year. The decrease in the average investment yield is a reflection of the declining interest rate environment in the current period. Net investment income varies with market interest rates because the return on approximately $10 billion, or 43%, of the asset portfolio floats with market rates. Matching the interest rate exposure on our asset portfolio to the exposure on our liabilities is a central feature of our asset/liability management process.
- ---------- (1) See "Results of operations by Segment and Adjustments to GAAP Reported Net Income" included in this Management's Discussion and Analysis. (2) Includes general account cash and invested assets of $79.5 million, $383.1 million and $151.3 million, as of December 31, 2003, 2002 and 2001, respectively.
Other operating costs and expenses increased $6.1 million, or 6.7%, from the prior year. Operating expenses were up $8.2 million at Hancock Natural Resource Group, reflecting $4.3 million in increased expenses for the northwest property management division and from an increase of $3.8 million in incentive compensation expenses. Operating expenses at Independence increased $0.1 million, mostly from $1.6 million of higher personnel severance expenses and $0.9 million in higher fixed income commission expenses offset by expense savings primarily from ongoing expense management in 2003. John Hancock Real Estate Finance had $0.4 million, or 4.3%, of lower operating expenses in 2003 on lower interest expenses from lower average levels of borrowings on a lower average level of warehoused commercial mortgages and from lower prevailing interest rates. Operating expenses at John Hancock Realty Advisors declined $0.4 million, or 10.3%, reflecting lower acquisition activity. The segment's effective tax rate on operating income was 37.9% compared to 37.1% in the prior year. The effective tax rate for the Investment Management Segment remains higher than for our other U.S. based business operating segments due to state taxes on certain investment management subsidiaries, and reduced tax benefits from portfolio holdings in this segment.
2002 and 2001, respectively, for the segment. Net realized gains were down $2.0 million, or 62.5% at John Hancock Real Estate Finance, primarily due to a lower level of commercial mortgage securitizations.
Other operating costs and expenses declined $5.5 million, or 5.7% from the prior year. John Hancock Real Estate Finance had $5.7 million of lower interest expense compared to 2001, based on lower average levels of borrowings to support lower average levels of warehoused commercial mortgages, and lower prevailing interest rates. Operating expenses were down $4.9 million at Hancock Natural Resource Group based on ongoing cost reduction efforts partially offset by higher incentive compensation expense this year. Independence Investment LLC operating expenses were up $5.2 million due to compensation increases over the prior year. The segment's effective tax rate on operating income was 37.1% compared to 36.2% in the prior year. The effective tax rate for the Investment Management Segment remains higher than for our other U.S.-based business operating segments due to state taxes on certain investment management subsidiaries, and reduced tax benefits from portfolio holdings in this segment.
After-tax operating income from international operations increased $1.2 million or 16.2% from the prior year. The increase was due to a $2.2 million, or 28.9%, improvement in the earnings of our International Group Program due to growth, higher earned retention income and currency gains. Partially offsetting this increase was a decrease in results from our Indonesia subsidiary of $1.0 million.
After-tax operating loss from corporate operations was $56.6 million, a decrease of $88.9 million from the prior year. Investment income on corporate surplus was $46.1 million lower due to increased surplus requirements from growth in several of our capital intensive businesses. Group Life after-tax operating income was $7.8 million lower, reflecting a sale of the Group Life business to MetLife effective May 1, 2003. Other expense increases in our corporate account were driven by a $32.0 million increase for net periodic pension costs, $4.8 million increase for incentive compensation expense, $3.3 million in first year costs for information technology outsourcing, $1.8 million for other post employment benefits and merger related expenses of $2.5 million. This was partially offset by our corporate owned life insurance program which increased $15.8 million as a result of an increase in the asset base and to improved performance of the separate account assets involved in the program.
After-tax operating income from international operations increased $3.9 million or 111.4% over the prior year primarily due to favorable foreign currency fluctuations within our International Group Program.
Insurance product prices are impacted by investment results. Accordingly, incorporated in insurance products prices are assumptions of expected default losses over the long-term. Actual losses therefore vary above and below this average, and the market value of the portfolio as a whole also changes as market credit spreads move up and down during an economic cycle.
(1) In addition to bonds, the fixed maturity security portfolio contains redeemable preferred stock with a carrying value of $600.3 million and $590.2 million as of December 31, 2003 and December 31, 2002, respectively. The total fair value of the fixed maturity security portfolio was $47,994.9 million and $43,823.5 million at December 31, 2003 and December 31, 2002, respectively. (2) The fair value for the mortgage loan portfolio was $11,791.4 million and $11,220.7 million as of December 31, 2003 and December 31, 2002, 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) Other invested assets as of December 31, 2002 contains a receivable of $471.1 million from Allmerica Financial Corporation pursuant to the Company's agreement to reinsure Allmerica's fixed universal life insurance business. Additional detail about the credit quality of the investments underlying the premium receivable is provided at the end of this investments discussion. (5) 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.
Consistent with the nature of the liabilities associated with the Company's products, assets are heavily oriented toward fixed maturity securities. The Company determines the allocation of assets primarily on the basis of cash flow and return requirements of its products and by the level of investment risk.
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
(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 175 securities that are awaiting an SVO rating, with a carrying value of $4,032.7 million as of 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 $130.0 million notional invested in the Company's credit-linked note program, $110.0 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, 2002 the Company had $55.0 million notional invested in the Company's credit linked program, $10.0 million notional of written credit default swaps on fixed maturity securities in the AAA/AA/A category and $45.0 million notional of 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 a AAA rated financial guarantor in 1996. 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 and $94.0 million of SVO Rating 2, $718.0 million of SVO Rating 3, and $141.3 million of SVO Rating 4 underlying securities are included as $753.2 million of SVO Rating 1, $150.1 million of SVO Rating 2 and $50.0 million of SVO Rating 3 as of December 31, 2002. The guaranty also contains 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 and December 31, 2002, the maximum amount that can be recovered under this provision was $112.8 million and $82.3 million, respectively.
As of December 31, 2002, there were gross unrealized gains of $2,329.2 million, and gross unrealized losses of $1,439.2 million on the fixed maturities portfolio. The 2002 gross unrealized losses of $1,439.2 million included $1,299.2 million, or 90.3%, of gross unrealized losses concentrated in the utilities, manufacturing, oil and gas, transportation, and asset-backed and mortgage-backed securities. Only the utilities sector has net unrealized losses. The tables above show gross unrealized losses before amounts that were allocated to the closed block policyholders or participating pension contractholders. Of the $1,439.2 million of gross unrealized losses in the portfolio at December 31, 2002, $191.0 million was in the closed block and $62.6 million was allocated to participating pension contractholders, leaving $1,185.6 million of gross unrealized losses after such allocations.
All sectors within the below investment grade portfolio saw a dramatic drop in gross unrealized losses. Most notable was the drop in the gross unrealized loss on the utility portfolio, from $360.2 million as of December 31, 2002 to $46.1 million as of December 31, 2003. While the excess capacity in this sector will continue to pressure certain power regions and certain companies for several years, the industry is in much better shape after a year of sharply curtailed capital expenditures and general balance sheet strengthening.
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) declined by $325.0 million in the twelve months ending December 31, 2003 to $199.9 million. The gross unrealized loss on below investment grade bonds (those rated in categories 3, 4, 5, and 6 by the SVO) declined even more over this period, dropping by $643.6 million to a total of $259.2 million as of December 31, 2003.
(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 58 securities with gross unrealized losses that are awaiting an SVO rating with a carrying value of $1,763.4 million and unrealized losses of $27.1 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 18.9% and 5.8% of the total carrying value and total gross unrealized losses of securities in a loss position, including redeemable preferred stock, respectively.
(1) With respect to 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. Recent experience has shown that our ratings are generally comparable to those of the SVO. (2) Comparisons between SVO and S&P ratings are published by the National Association of Insurance Commissioners. (3) Includes 59 securities with gross unrealized losses that are awaiting an SVO rating with a carrying value of $1,658.1 million and unrealized losses of $62.7 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 15.4% and 4.4% of the total carrying value and total gross unrealized losses of securities in a loss position, including redeemable preferred stock, respectively.
The tables above show the Company's investment grade and below investment grade securities that were in a loss position at December 31, 2003 and 2002 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, 2003 and 2002, respectively, the fixed maturity securities had a total gross unrealized loss of $324.2 million and $1,185.0 million, excluding basis adjustments related to hedging relationships. Of these totals, $218.6 million and
$870.1 million, respectively, are due to securities that have had various amounts of unrealized loss for more than nine months. Of this, $48.2 million and $271.7 million, respectively comes from securities rated investment grade. 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.
As of December 31, 2003 and 2002, $170.4 million and $598.4 million, respectively, of the $324.2 million and $1,185.0 million resided in below investment grade securities with various amounts of unrealized loss for over nine months. At December 31, 2003, all of these securities were current as to the payments of principal and interest with the exception of 2 securities with a carrying value of $16.8 million and an unrealized loss of $18.3 million. Of the total $170.4 million, $88.2 million traded above 80% of amortized cost at December 31, 2003 and an additional $11.3 million traded above 80% of amortized cost within the last nine months, for a total of $99.5 million. Of the total $99.5 million, $58.1 million comes from airline related bonds, an industry that continues to experience stress and hence has lagged the general recovery. While, as described earlier, we expect the secured nature of our positions to protect our value, the continued stress in this industry is of concern.
o $28.2 million from a structured investment based on oil and gas payments to an Argentine province. This transaction benefits from (1) rights to 80% of the royalty payments received by the province, (2) a six month debt service reserve located in the U.S., and (3) a political risk insurance policy from a major reinsurer that will take over payments in the event the government imposes transfer or currency conversion limitations. Currently, the major risk is that the local oil and gas companies are making payments to the province based on a fixed exchange rate rather than the market exchange rate. While the province is working to correct this, if it does not change, the coverages on the bond will suffer and should oil and gas prices drop, we may need to restructure our rights to royalty payments to extend beyond the maturity of our bond, so a restructuring would likely extend the term of our bond with interest.
The Company's investment grade and below investment grade bonds trading at less than 80% of amortized cost for more than one year amounted to $75.9 million as of December 31, 2003.
As of December 31, 2003 we had 59 securities representing 9 credit exposures that had unrealized losses of $10 million or more. They include:
Mortgage Loans. As of December 31, 2003 and 2002, the Company held mortgage loans with carrying values of $10.9 billion and $10.3 billion, including $3.0 billion and $2.6 billion respectively, of agricultural loans at each period end and $7.9 billion and $7.7 billion, respectively, of commercial loans. Impaired loans comprised 1.1% of the mortgage portfolio at December 31, 2003. The Company's average historical impaired loan percentage during the period from 1998 through 2003 is
1.2%. This historical percentage is higher than the current 1.1% because the historical percentage includes some remaining problem assets of the 1990's real estate downturn, some of which are still held.
(1) As of December 31, 2003 and 2002 the Company held mortgage loans with carrying values of $10.9 billion and $10.3 billion, respectively. (2) Increase as of December 31, 2003 is from a U.S. based forest products company that filed for bankruptcy in June 2003.
Valuation allowance is maintained at a level that is adequate 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 $65.9 million, or 0.6% of the carrying value of the portfolio as of December 31, 2003.
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 designed to match our floating-rate liability portfolio. As of December 31, 2003, approximately 88% of this exposure, excluding cash and short-term investments, was directly offset by exposure to floating-rate liabilities. Most of the remaining 12% 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. As a result of the drop in short term rates over the year, as well as the increase in exposure, this floating-rate exposure reduced the portfolio yield by 11 basis points in 2003 compared to the prior year.
Net investment income decreased $65.2 million from the prior year. The decrease was primarily the result of lower yields, partially offset by asset growth and lower investment expenses. Overall, the 2002 yield, net of investment expenses, on the general account portfolio decreased to 6.29% from 7.25% in the prior year. The lower portfolio yield was driven primarily by the sharp drop in short-term interest rates during the year, which impacts floating rate investments and lower yields on investment acquisitions. The change in yields was impacted by the following drivers:
In 2003, net realized investment and other gains was a gain of $58.2 million and gross losses on impairments and on disposal of investments - including bonds, equities, real estate, mortgages and other invested assets was $759.7 million, excluding hedging adjustments.
At the end of each quarter, our Investment Review Committee reviews all securities where market value is less than ninety percent of amortized cost for three months or more to determine whether impairments need to be taken. This committee includes the head of workouts, the head of each industry team, the head of portfolio management, the Chief Investment Officer and the Corporate Risk Officer who reports to the Chief Financial Officer. The analysis focuses on each 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 cost. The results of this analysis are reviewed by both our external auditors and the Life Company's Committee of Finance, a subcommittee of the Life Company's Board of Directors, quarterly. This quarterly process includes a fresh assessment of the credit quality of each investment in the entire fixed maturities portfolio.
The Company considers relevant facts and circumstances in evaluating whether the impairment of a security is other than temporary. Relevant facts and circumstances considered include (1) the length of time the fair value has been below cost; (2) the financial position of the issuer, including the current and future impact of any specific events; and (3) the Company's ability and intent to hold the security to maturity or until it recovers in value. To the extent the Company determines that a security is deemed to be other than temporarily impaired, the difference between amortized cost and fair value would be charged to earnings.
o $37.7 million (including an impairment loss of $37.3 million and $0.4 million in previously recognized gains where the bonds were part of a hedging relationship) on public fixed maturity securities relating to a large, national farmer-owned dairy co-operative. Margins have been squeezed due to a supply/demand imbalance, high input costs and high leverage, due in part to a recent acquisition. Despite a large favorable outcome on a lawsuit, depressed commodity prices in this environment have continued to put pressure on the company to rationalize their operations as was evident in their recently released annual financial statements. Given our subordinated position in the capital structure, and unlikely improvement near term, we have impaired the security to the market level. We have no other loans to dairy companies that are impacted by this same combination of factors. We have recovered $10.7 million on subsequent sales of this security.
o $26.3 million (including an impairment loss of $23.2 million and $3.1 million in previously recognized gains where the bonds were part of a hedging relationship) on public fixed maturity securities relating to a special purpose company created to sublease aircraft to two major US airlines. This investment is the subordinated tranche in a multi-tier structure of an Enhanced Equipment Trust Certificate (EETC). One of the airlines has recently indicated that it will not honor the original lease rates on the aircraft in this investment. Hence, with the loan exceeding the current value of the securities, we have impaired the security to the market level. While we do have an investment in the senior tranche of this EETC, the senior tranche exposure is still less than the current market value of the underlying planes and the senior tranche enjoys an 18 month liquidity facility. Accordingly, we do not anticipate a loss on the senior tranche.
o $14.2 million on public fixed maturity securities relating to a subordinated holding company structure comprised of ownership interests in three power generation facilities in the western US. Due to the severe overcapacity in the power markets and the lack of an off take provider for the potential power generated from the plants, this subordinated interest in the facilities was not refinanced and we wrote off the investment completely. The overcapacity in the power markets has put stress on all power producers as we discuss in our sector commentary.
o $4.9 million credit loss on the sale of public bonds of a power provider referred to in the above paragraph.
o $1.4 million credit loss on the sale of MBS/CMO of an aircraft lease trust. This loss was due to a downgrade by the rating agencies, which led to a supply/demand imbalance.
The Company also recognized losses on other than temporary impairments of common stock of $27.8 million for the year 2003, as the result of market values falling below cost by greater than 15% for more than six months.
of $116.4 million for the year 2003, resulting from a slightly larger impact from interest rate changes on the Company's fair value of hedged and non-hedged items in comparison to the changes in fair value of its derivatives.
The Company recorded losses due to other than temporary impairments of fixed maturities of $565.9 million for the year 2002, excluding hedging adjustments. The primary other than temporary impairments on fixed maturities for the year ended December 31, 2002 were $113.2 million on fixed maturity securities relating to a national airline that faced heavy operating losses due to the economic downturn, a high cost structure, and competition from low-cost carriers , $56.1 million on a large energy company that filed for bankruptcy in late 2001, $48.0 million on secured financings backed by an airline, or its subsidiaries, that filed for Chapter 11 bankruptcy protection during the third quarter of 2002, $45.5 million on securities issued by the holding company of a large domestic power producer that was downgraded to below investment grade status in July 2002 due to liquidity concerns, $35.3 million on issuers affiliated with the Argentina government and other investments in that country, $33.8 million on securities issued by a large telecommunications company that filed for bankruptcy in July, 2002, $33.5 million on fixed maturity securities for a unregulated power and pipeline energy company, $31.6 million of fixed maturity investments of U.K. based projects providing power and other essential services to an industrial complex, $28.3 million on fixed maturity securities relating to an oil field service company, $24.8 million on a redeemable preferred stock of a large domestic farm cooperative due to the cyclical nature of the business and a heavy debt load, $19.2 million on redeemable preferred stock of a technology based manufacturer of engineering products with a tight liquidity position, $19.0 million on securities of an Australian power project that failed to produce benefits expected from the deregulation of that country's power industry, $16.9 million on securities issued by a Mexican producer of corrugated boxes and newsprint, $13.6 million on securities of a diversified producer of single-use, specialty medical products, and $9.9 million on subordinated private placement securities funding a toll road between the U.S. and Mexico. Writedowns of CBO/CDO fixed maturity investments and other invested assets were $61.3 million for the year ended December 31, 2002.
In June, August and December 2003, the Commissioner of Insurance for the Commonwealth of Massachusetts approved, and the Company paid, dividends to JHFS in the amount of $100.0 million, $14.5 million and $100.0 million, respectively. $100.0 million of the dividend payments were cash transfers, the second $100.0 million was not paid in cash in 2003 but was an accounts payable at year end, and the remaining $14.5 million represents a property transfer of the First Signature Bank to
the Holding Company. None of these dividends were classified as extraordinary by state regulators.
Net cash provided by operating activities was $2,842.4 million, $2,466.6 million and $2,774.9 million for the years ended December 31, 2003, 2002 and 2001, respectively. Cash flows from operating activities are affected by the timing of premiums received, fees received and investment income. The $375.8 million increase in 2003 as compared to 2002 is largely attributable to an increase in investment income received of $353.9, a decrease in policyholder benefits of $339.9 million, and a smaller decrease in other assets net of other liabilities of $109.0 million, partially offset by an increase in operating expenses of $179.0 million and an increase in income taxes paid of $341.1 million. The $308.3 million decrease in 2002 as compared to 2001 is largely attributable to a decrease in premium received of $376.4 million, an increase in operating expenses of $80.4 million and an increase in income taxes paid of $101.8 million, partially offset by a decrease in policyholder benefits of $281.5 million.
Cash flow requirements are also supported by a committed line of credit of $1.0 billion, through a syndication of banks including Fleet National Bank, JPMorgan Chase, Citicorp USA, Inc., The Bank of New York, The Bank of Nova Scotia, Fleet Securities, Inc. and JP Morgan Securities, Inc. The line of credit agreement provides for two facilities: one for $500 million pursuant to a 364-day commitment (renewed effective July 25, 2003) and a second for $500 million (renewable in 2005). The line of credit is available for general corporate purposes. The line of credit agreement contains various covenants, among these being that statutory total capital and surplus plus asset valuation reserve meet certain requirements. To date, we have not borrowed any amounts under the line of credit.
As of December 31, 2003, we had $713.4 million of principal and interest amounts of debt outstanding consisting of $447.6 million of surplus notes, and $265.8 million of other notes payable, including current maturities and a fair value adjustment for interest rate swaps. A new commercial paper program has been established at JHFS that has replaced the commercial paper program that was in place at the Company's indirect subsidiary, John Hancock Capital Corporation, and there were no commercial paper borrowings outstanding at December 31, 2003.
See Index to Consolidated Financial Statements and Schedules elsewhere in this Form 10-K.