This Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) addresses the financial condition of American Skandia Life Assurance Corporation as of December 31, 2006, compared with December 31, 2005, and its results of operations for the years ended December 31, 2006 and 2005.
our amount of assets under management and changes in their fair value, which affect the amount of asset management fees we receive;
As prescribed by GAAP, we present our investments classified as available for sale, including fixed maturity and equity securities, and our investments classified as trading, at fair value in the statements of financial position. The fair values for our public fixed maturity securities and our public equity securities are based on quoted market prices or estimates from independent pricing services. However, for our investments in private securities such as private placement fixed maturity securities, which comprise 8% of our investments as of December 31, 2006, this information is not available. For these private investments, fair value is determined typically by using a discounted cash flow model, which relies upon the average of spread surveys collected from private market intermediaries who are active in both primary and secondary transactions and takes into account, among other things, the credit quality of the issuer and the reduced liquidity associated with private placements. Historically, changes in estimated future cash flows or the assessment of an issuer’s credit quality have been the more significant factors in determining fair values.
For fixed maturities classified as available for sale, the impact of changes in fair value is recorded in “Accumulated other comprehensive (loss) income,” a separate component of equity. Adjustments to the costs of fixed maturities of other than temporary impairments are included in “Realized investment (loss) gains, net.” In evaluating whether a decline in value is other than temporary, we consider : the extent (generally if greater than 20%) and duration (generally if greater than six months) of the decline; the reasons for the decline in value (credit event interest related or market fluctuation); our ability and intent to hold the investment for a period of time to allow for a recovery of value; and the financial condition and near-term prospects of the issuer. The level of impairment losses can be expected to increase when economic conditions worsen and decrease when economic conditions improve.
Future rate of return assumptions used in evaluating DAC are derived using a reversion to mean approach, a common industry practice. Under this approach, we consider actual returns over a period of time and project returns for the future period so that the assets grow at the expected rate of return for the entire period. If the projected future rate of return is greater than our maximum future rate of return, we use our maximum reasonable future rate of return. As part of our approach, if the estimated gross profits under the previously projected rate of returns are greater than or less than a range of estimated gross profits determined by statistically generated rate of returns, we change our future assumption to reflect the result of the reversion to the mean approach. Our expected rate of return is 8% per annum, which reflects an expected rate of return of 8.9% per annum for equity type assets. The future equity rate of return used varies by product, but was under 6.0% per annum for our evaluation of deferred policy acquisition costs as of December 31, 2006.
To demonstrate the sensitivity of our DAC balance relative to our future rate of return, increasing or decreasing our future rate of return by 100 basis points would have required us to consider adjustments, subject to the range of estimated gross profits determined by the statistically generated rate of returns described above, to that DAC balance as follows. The information provided in the table below considers only the effect of changes in our future rate of return and not changes in any other assumptions such as persistency, mortality, or expenses included in our evaluation of DAC.
In a series of transactions with ASI, the Company sold certain rights to receive a portion of future fees and contract charges expected to be realized on designated blocks of deferred annuity contracts.
Tax regulations require items to be included in the tax return at different times than the items are reflected in the financial statements. As a result, the effective tax rate reflected in the financial statements is different than the actual rate applied on the tax return. Some of these differences are permanent such as expenses that are not deductible in our tax return, and some differences are temporary, reversing over time, such as valuation of insurance reserves. Timing differences create deferred tax assets and liabilities. Deferred tax assets generally represent items that can be used as a tax deduction or credit in future years for which we have already recorded the tax benefit in our income statement. Deferred tax liabilities generally represent tax expense recognized in our financial statements for which payment has been deferred, or expenditures for which we have already taken a deduction in our tax return but have not yet recognized in our financial statements. The application of GAAP requires us to evaluate the recoverability of our deferred tax assets and establish a valuation allowance if necessary to reduce our deferred tax asset to an amount that is more likely than not to be realized. Realization of certain deferred tax assets is dependent upon generating sufficient taxable income in the appropriate jurisdiction prior to the expiration of the carry-forward periods. Although realization is not assured, management believes it is more likely than not the deferred tax assets, net of valuation allowances, will be realized.
Our accounting represents management’s best estimate of future events that can be appropriately reflected in the accounting estimates. Certain changes or future events, such as changes in tax legislation, geographic mix of earnings and completion of tax audits could have an impact on our estimates and effective tax rate. To the extent our effective tax rate increases or decreases by 1 percent of income from operations before income taxes and cumulative effect of accounting change, income before and cumulative effect of accounting change would have increased or declined by $2.0 million in 2006.
The amount of income taxes paid by the Company is subject to ongoing audits in various jurisdictions. We reserve for our best estimate of potential payments/settlements to be made to the Internal Revenue Service (the “Service”) and other taxing jurisdictions for audits on-going or not yet commenced. In 2006, the Service completed all fieldwork with regards to its examination of the Company’s federal income tax returns for tax years 2002-2003. The Company anticipates the final report being submitted to the Joint Committee on Taxation for their review during the first quarter of 2007. The statute of limitations for the 2002-2003 tax years expires in 2008. In addition, in January 2007, the IRS began an examination of tax years 2004 through 2006.
For tax year 2007, the Company has chosen to participate in the Service’s new Compliance Assurance Program (the “CAP”). Under CAP, the Service assigns an examination team to review completed transactions contemporaneously during the 2007 tax year in order to reach agreement with the Company on how they should be reported in the tax return. If disagreements arise, accelerated resolutions programs are available to resolve the disagreements in a timely manner before the tax return is filed. It is management’s expectation this new program will significantly shorten the time period between when the Company files its federal income tax return and the Service completes its examination of the return.
reserve reflects management’s best estimate of the probable cost of ultimate resolution of the matter and is revised accordingly as facts and circumstances change and, ultimately, when the matter is brought to closure. In situations in which the Company is to be indemnified by Skandia, there will be no financial impact on the Statements of Operations and Comprehensive Income. See Note 11 to the Financial Statements for a further discussion of indemnification provisions of the Agreement.
From December 31, 2005 to December 31, 2006 total assets increased by $5.7 billion from $32.9 billion to $38.6 billion. Separate account assets increased by $5.8 billion, driven primarily by market value appreciation and positive net flows during 2006. Sales activity during the year ended December 31, 2006 drove an increase in capitalized costs resulting in an increase in deferred policy acquisition costs (“DAC”) and deferred sales inducements of $237.4 million and $132.4 million, respectively. Partially offsetting these increases were decreased fixed maturities of $380.2 million and decreased short term investments of $148.8 million primarily driven by a decline in policyholders’ account balances and cash collateral for loaned securities discussed below. Additionally, the valuation of business acquired decreased $43.4 million due to amortization.
From December 31, 2005 to December 31, 2006, total liabilities increased by $5.6 billion from $32.1 billion to $37.7 billion. Separate account liabilities increased by $5.8 billion, driven by market value appreciation and positive net flows during 2006. Also, borrowings increased $221.0 million in order to fund the growth of the business. Partially offsetting these increases was a decrease in policyholders’ account balances of $233.2 million primarily due to rebalancing of customer account values from the market value adjustment options to the separate account mutual fund options pursuant to contract provisions driven by improved market conditions. In addition, cash collateral for loaned securities decreased by $134.0 million due to lower levels of corporate securities out on loan and future fees payable to ASI decreased $64.6 million during the year due to amortization.
Net income increased $37.3 million from $158.4 million for the year ended December 31, 2005 to $195.7 million for the year ended December 31, 2006. Policy charges and fee income increased by $105.6 million and asset management fees increased by $40.6 million year over year driven by increased net flows and market appreciation during the current year. Income tax expense decreased by $39.9 million, as a result of an increase in the projected amount of nontaxable investment income earned by the Company. This increase was partially offset by a $35.1 million benefit in 2005 from a net reduction in amortization of deferred policy acquisition and other costs and a decrease in reserves for the guaranteed minimum death benefit and guaranteed minimum income benefit features of our variable annuity products, due to decreased costs of actual and expected death claims and an increased estimate of total gross profits used as a basis for amortizing deferred policy acquisition and other costs based on an annual review. In addition, amortization of DAC and other costs, excluding the item mentioned above, increased $55.8 million from 2005 to 2006 due to a higher level of actual gross profits used to amortize DAC. Commissions, net of capitalization, increased $21.7 million driven by increased asset based commissions caused by growth in separate account assets, realized investment losses increased $15.9 million, and interest expense increased $14.5 million. Further details regarding the components of revenues and expenses are described below.
Revenues increased by $142.7 million, from $668.0 million for the year ended December 31, 2005 to $810.7 million for the year ended December 31, 2006. Premiums of $40.5 million increased by $16.7 million, from $23.8 million in 2005, reflecting an increase in funds from customers electing to enter into the payout phase of their annuity contracts driven primarily by settlements in the current year related to the annuitization remediation program. See Item 3, Legal Proceedings for further discussion.
Policyholders’ benefits increased by $38.4 million from $63.0 million in 2005 to $101.4 million in 2006. This was driven primarily by a $27.1 million adjustment in the prior year to reserves for the guaranteed minimum death benefit feature of our variable annuity products due to decreased costs of actual and expected death claims as discussed previously. Also contributing to the increase was an increase in changes in reserves due to increased funds from customers entering into the payout phase of their annuity contracts.
Interest credited to policyholders’ account balances increased by $7.2 million from $69.9 million in 2005 to $77.1 million in 2006. This variance was primarily due to increased amortization of deferred sales inducements of $18.1 million driven by increased gross profits used as a basis for amortizing these costs, partially offset by decreased interest credited on the MVA option of $9.7 million. As a result of improved market conditions, there were significant transfers of customer account values from the market value adjustment options to the separate account mutual fund options which decreased interest credited.
General, administrative, and other expenses increased by $99.6 million from $330.6 million in 2005 to $430.2 million in 2006. The increase was primarily due to an increase in the amortization of DAC and the valuation of business acquired of $52.3 million driven by a higher level of actual gross profits used to amortize DAC driven by increased fee income discussed above as well as a benefit included in the prior year from the increased estimate of total gross profits. In addition, commissions, net of capitalization, also increased $21.7 million driven by increased asset based commissions caused by growth in separate account assets and interest expense increased by $14.5 million resulting from higher borrowing levels. General expenses also increased $11.2 million from 2005 driven by increased benefit and salary expenses.