In addition to policy charges and fee income, the Company earns revenues from asset management fees calculated on the average separate account fund balances. The Company’s operating expenses principally consist of insurance benefits provided, general business expenses, commissions and other costs of selling and servicing the various products we sell.
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 7% of our investments as of December 31, 2007, 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. In determining the fair value of certain securities, the discounted cash flow model may also use unobservable inputs, which reflect our own assumptions about the inputs market participants would use in pricing the asset.
The future rate of return assumptions used in evaluating DAC are derived using a reversion to the mean approach, a common industry practice. Under this approach, we consider actual returns over a period of time and adjust future projected returns 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 future rate of return. As part of our approach for variable annuity contracts, we develop a range of total estimated gross profits each period using statistically generated rates of return that take into consideration the latest actual rates of return experienced to date. If the
In addition to DAC, we also recognize assets for deferred sales inducements and valuation of business acquired (“VOBA”). The deferred sales inducements are amortized over the anticipated life of the policy using the same methodology and assumptions used to amortize deferred policy acquisition costs. For additional information about our deferred sales inducements, see Note 6 to the Financial Statements. VOBA represents the present value of future profits embedded in acquired businesses, and is determined by estimating the net present value of future cash flows from the contracts in force at the date of acquisition. VOBA is amortized over the effective life of the acquired contracts. For additional information about VOBA including its bases for amortization, see Note 5 of the financial statements.
In a series of transactions with PAI, 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.
An increase or decrease in our effective tax rate by one percent of income from continuing operations before income taxes and equity in earnings of operating joint ventures, would have resulted in a decline or increase in income from continuing operations before cumulative effect of accounting change in 2007 of $3 million.
Our liability for income taxes includes the liability for unrecognized tax benefits, interest and penalties which relate to tax years still subject to review by the Internal Revenue Service (the Service) or other taxing jurisdictions. Audit periods remain open for review until the statute of limitations has passed. Generally, for tax years which produce net operating losses, capital losses or tax credit carryforwards, or tax attributes, the statute of limitations does not close, to the extent of these tax attributes, until the tax year in which they are fully utilized. The completion of review or the expiration of the statute of limitations for a given audit period could result in an adjustment to our liability for income taxes. Any such adjustment could be material to our results of operations for any given quarterly or annual period based, in part, upon the results of operations for the given period.
In January 2007, the Service began an examination of tax years 2004 through 2006. For the tax year 2007, we participated in the Service’s new Compliance Assurance Program, or 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 us 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 our filing of our federal income tax return and the Service’s completion of its examination of the return.
On January 1, 2007, we adopted FIN No. 48, “Accounting for Uncertainty in Income Taxes,” an Interpretation of FASB Statement No. 109. This interpretation prescribes a comprehensive model for how a company should recognize, measure, present, and disclose in its financial statements uncertain tax positions that a company has taken or expects to take on a tax return. FIN No. 48 is a two-step process, the first step being recognition. We determine whether it is more likely than not, based on the technical merits, that the tax position will be sustained upon examination. If a tax position does not meet the more likely than not recognition threshold, the benefit of that position is not recognized in the financial statements.
A contingency is an existing condition that involves a degree of uncertainty that will ultimately be resolved upon the occurrence of future events. Under U.S. GAAP, reserves for contingencies are required to be established when the future event is probable and its impact can be reasonably estimated. An example is the establishment of a reserve for losses in connection with an unresolved legal matter. The initial 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.
In addition to the items discussed above, the application of U.S. GAAP requires management to make other estimates and assumptions.
See Note 2 to the Financial Statements for a discussion of recently issued accounting pronouncements.
mutual fund options to the market value adjustment options. Cash collateral for loaned securities increased $14.1 million due to higher levels of corporate securities lending. Partially offsetting these increases was a decrease in future fees payable to PAI of $36.4 million during the period due to amortization.
Revenues increased by $183.0 million, from $810.6 million for the twelve months ended December 31, 2006 to $993.6 million for the twelve months ended December 31, 2007. Premiums decreased by $12.3 million, from $40.5 million for the twelve months ended December 31, 2006 to $28.2 million for the twelve months ended December 31, 2007, reflecting a reduction in the volume of settlements in the current year related to the previously discussed annuitization remediation program. The majority of these claims were processed in 2006.
Policy charges and fee income increased by $146.1 million, from $561.3 million for the twelve months ended December 31, 2006 to $707.4 million for the twelve months ended December 31, 2007 due to growth of separate account assets driven by net flows and market appreciation resulting in higher mortality and expense charges of $119.2 million. Optional benefit charges on our living and death benefit features increased $23.0 million, primarily driven by the sales of our Lifetime Five, Spousal Lifetime Five and Highest Daily Lifetime Five benefit features. This increase was primarily offset in realized investment losses, net because these features are reinsured with affiliates. Additionally, policy charges and fee income decreased $6.1 million from the prior year due to the change in realized market value adjustments related to the Company’s fixed, market value adjusted investment option (the “MVA option”).
Policyholders’ benefits decreased by $34.0 million, from $101.4 million for the twelve months ended December 31, 2006 to $67.4 million for the twelve months ended December 31, 2007. The decrease was driven primarily by a $25.5 million reserve reduction for the guaranteed minimum death benefit feature of our variable annuity products due to decreased costs of actual and expected death claims, as discussed above, from favorable market performance.
General, administrative and other expenses increased by $99.0 million, from $430.2 million for the twelve months ended December 31, 2006 to $529.2 million for the twelve months ended December 31, 2007. The increase was primarily due to an increase in the amortization of DAC