Our selected historical consolidated financial data as of and for each of the five years in the period ended December 31, 2007 follows. We derived the balance sheet data for 2007 and 2006 and the income statement data for the years 2007, 2006 and 2005 from our consolidated financial statements in this Form 10-K. We derived the balance sheet data for 2005, 2004 and 2003 and the income statement data for the years 2004 and 2003 from audited consolidated financial statements not in this Form 10-K. We have reclassified certain amounts for prior years to conform with our 2007 presentation.
Not included in our two operating segments are interest expense, certain corporate expenses, as well as activities that do not constitute reportable operating segments. These include the runoff of our group pension and guaranteed investment contract businesses. See Business-Description of Business-Corporate and Other.
Apart from the Closed Block, our profitability in Life and Annuity is driven by interaction of the following elements:
Investment management fees charged on average fee-earning assets under management. Depending on the product, these fees can be based on average daily market values, beginning-of-quarter market values, or outstanding principal values of the assets being managed. Assets under management are principally driven by the following factors:
An important difference between our businesses is that the Life and Annuity business requires us to hold capital and post reserves against the various insurance and investment risks inherent in the business. We, therefore, view return on equity as an important metric for this business. By contrast, our Asset Management business does not require significant capital. Thus, while Asset Management has significant goodwill and intangibles related to past acquisitions, we do not view return on equity as an important ongoing operating metric for this business, rather, we view earning before interest, taxes, depreciation and amortization, or EBITDA, as an appropriate operating metric. EBITDA represents pre-tax operating income before depreciation and amortization of intangibles.
On February 7, 2008, we announced our intention to spin off our asset management subsidiary, PXP, by way of a dividend of PXP’s stock to the Company’s shareholders. The spin-off is intended to be tax free to the Company’s shareholders and the spin-off and related transactions are expected to be completed in the third quarter of 2008. At this point, decisions regarding the capital structure, expense and overhead support structure and other matters are under review and consideration.
In 2003, we acquired the remaining interest in PFG Holdings, Inc., or PFG, the holding company for our private placement operation. The initial purchase consideration was $16.7 million in addition to a contingent obligation for additional purchase consideration based on the achievement of certain performance targets through 2007 and the appraised value of PFG as of December 31, 2007. Through November 2007, we paid additional consideration of $19.4 million, including $13.4 million, $0.0 million and $3.0 million during 2007, 2006 and 2005 respectively. In November 2007, we amended the original purchase agreement to extend the term of the agreement through the end of 2009 and to establish a more objective mechanism to value PFG and calculate the final amount of contingent consideration. As a result, we may be obligated to make additional cash payments of $17.6 million by June 2010 if certain performance targets are met through December 2009. Since the contingent payments are based on the achievement of performance targets, the actual payments may be lower. If the performance targets are exceeded, the actual payments may be higher, subject to a maximum of $77.1 million. In accordance with EITF 95-8, Accounting for Contingent Consideration Paid to the Shareholders of an Acquired Enterprise in a Purchase Business Combination, a portion of the contingent payments will be accounted for as goodwill, and the amounts related to performance in excess of targets will be expensed, if and when achieved.
As a result of a step acquisition completed in 2005, PXP owns 100% of Kayne Anderson Rudnick Investment Management, LLC, or KAR. In connection with the purchase, we issued promissory notes to the sellers in the amount of $67.0 million to finance the remainder of the acquisition, of which $9.8 million was paid on January 3, 2006. The remainder plus deferred interest was paid on January 2, 2007. The interest rate on the notes was 4.75%.
On January 11, 2005, we disposed of our interests in Lombard International Assurance S.A., or Lombard, for consideration of $59.0 million. In the first quarter of 2007, 2006 and 2005, we realized after-tax gains of $8.9 million, $6.5 million and $9.3 million, respectively, which included earn-out gain consideration received. We are not entitled to any additional consideration related to this sale going forward.
We perform analysis with respect to the sensitivity of a change in the separate account performance assumption as it is critical to the development of the EGPs related to our variable annuity and variable life insurance business. Equity market movements have a significant impact on the account value of variable life and annuity products and the fees earned on these. EGPs could increase or decrease with these movements in the equity market. Sustained and significant changes in the equity markets could therefore have an impact on deferred policy acquisition cost amortization. Periodically, we also perform analysis with respect to the sensitivity of a change in assumed mortality as it is critical to the development of the EGPs related to our universal life insurance business.
We classify our debt and equity securities held in our general account, as well as those pledged as collateral, as available-for-sale and report them in our balance sheet at fair value. Fair value is based on quoted market price, where available. When quoted market prices are not available, we estimate fair value by discounting debt security cash flows to reflect interest rates currently being offered on similar terms to borrowers of similar credit quality, by quoted market prices of comparable instruments and by independent pricing sources or internally developed pricing models.
See Note 10 to our consolidated financial statements and the Debt and Equity Securities and Enterprise Risk Management sections of Management’s Discussion and Analysis of Financial Condition and Results of Operations in this Form 10-K for more information.
As of December 31, 2007, we had deferred tax assets of $54.4 million and $20.1 million related to net operating and capital losses, respectively, for federal income tax purposes and $14.5 million for state net operating losses. The related federal net operating loss carryovers of $155.4 million are scheduled to expire between the years 2019 and 2027. The related federal capital loss carryovers of $57.4 million are scheduled to expire in 2010 and 2011. The related state net operating loss carryovers relate to the non-life subgroup and are scheduled to expire as follows: $58.0 million in 2012 through 2016 and $125.3 million in 2019 through 2026. Due to the inability to combine the life insurance and non-life insurance subgroups for state income tax purposes, we had established a $14.5 million and a $15.7 million valuation allowance at the end of 2007 and 2006, respectively, relative to the state deferred tax assets.
Our federal income tax returns are routinely audited by the IRS, and estimated provisions are routinely provided in the financial statements in anticipation of the results of these audits. Unfavorable resolution of any particular issue could result in additional use of cash to pay liabilities that would be deemed owed to the IRS. Additionally, any unfavorable or favorable resolution of any particular issue could result in an increase or decrease, respectively, to our effective income tax rate to the extent that our estimates differ from the ultimate resolution. As of December 31, 2007, we had current taxes payable of $25.0 million.
Partially offsetting these decreases to Life and Annuity net income were an increase in mortality margin of $36.5 million and higher net investment income on surplus and assets supporting the open-block traditional life products. Non-deferred expenses were also $19.8 million lower in 2006 than in 2005.
For the years 2007, 2006 and 2005, inflation did not have a material effect on our consolidated results of operations.
We allocate capital to our Life and Annuity segment based on risk-based capital, or RBC, for our insurance products. We used a 300% risk-based capital ratio for allocations in 2005 through 2007. Capital within our Life Companies that is unallocated is included in Corporate and Other. We allocate capital to our Asset Management segment on the basis of the historical capital within that segment. We allocate net investment income based on the assets allocated to the segments. We allocate tax benefits related to tax-advantaged investments to the segment that holds the investment. We allocate certain costs and expenses to the segments based on a review of the nature of the costs, time studies and other methodologies.
Life and Annuity net income and operating income increased primarily as a result of an increase in insurance, investment management and product fees, offset by an increase in policy acquisition cost amortization and other operating expenses.
Life and Annuity net income and operating income reflect higher investment margins in life products and favorable mortality and persistency. Investment margins for annuities declined modestly in 2006, primarily due to higher investment gains in 2005. In 2006, Life and Annuity benefited from an unlocking of assumptions, primarily related to deferred policy acquisition costs. The effects of the unlocking decreased insurance product fee revenues by $3.5 million, increased the change in policyholder reserves by $7.4 million and decreased deferred policy acquisition cost amortization by $19.1 million for a net increase of $8.2 million. This compares to an unlocking benefit of $23.8 million in 2005.
Insurance, investment management and product fees increased primarily due to higher universal life fees from growth in both sales and policies in force, partially offset by modestly lower variable universal life fees. See discussion of “Life and Annuity Segment Revenues by Product” that follows for additional information.
Policy acquisition cost amortization increased primarily due to higher amortization for universal life resulting from growth of policies in force and the effects of unlocking.
Annuity funds on deposit increased $639.5 million in 2006 compared to an increase of $335.2 million in 2005. This change was due to higher deposits in 2006, including a large private placement deposit of $886.8 million in the fourth quarter, and stronger relative investment performance, partially offset by higher benefits and surrenders, including a $206.6 million scheduled maturity from an institutionally-placed contract in 2006.
Variable universal life funds on deposit increased by $213.1 million in 2006 compared to an increase of $156.7 million in 2005. This improvement was primarily due to higher relative investment performance, partially offset by higher surrenders and benefits and lower deposits in 2006.
Universal life funds on deposit increased $219.8 million in 2007 compared to $170.0 million in 2006 primarily as a result of sales growth, higher interest credited and lower surrenders, partially offset by the increases to fees and cost of insurance.
Universal life insurance revenue increased primarily due to higher fees and cost of insurance charges from the growth of in-force business and increased investment earnings from higher funds on deposit.
Annuity revenue decreased primarily due to lower interest earned as the result of the decline in funds on deposit in general account funds primarily from discontinued products, offset by an increase in separate account fees on higher asset balances.
Traditional life insurance revenue decreased primarily due to lower renewal premiums and slightly lower investment income. Since our demutualization in 2001, we no longer sell participating life insurance policies.
Annuity revenue decreased primarily due to lower interest earned as a result of the decline in funds on deposit in general account funds, primarily for discontinued products.
Traditional life pre-tax operating income increased primarily due to significantly higher operating income for traditional life, excluding Closed Block, partially offset by a modest decline for the Closed Block. Operating income for traditional life, excluding the Closed Block increased due to lower operating expenses, lower amortization of deferred policy acquisition costs and modestly higher investment earnings, partially offset by higher benefit costs related to an old block of corporate-owned life insurance. The amortization of deferred policy acquisition costs was lower primarily due to the effects of unlocking which decreased amortization by $4.7 million in 2006 and increased amortization by $7.9 million in 2005.
Asset Management net income and operating income increased primarily as a result of an intangible asset impairment in the first quarter of 2006 that did not recur in 2007 and an increase in mutual fund ancillary fees and other revenue resulting from higher average mutual fund assets under management. In addition, net income increased because certain employment and lease related charges associated with the restructuring of the asset management business in 2006 did not recur in 2007.
Total revenues increased primarily due to increased mutual fund ancillary fees and other revenue resulting from higher sales and assets under management, particularly the addition of the Insight Funds in May 2006. Partially offsetting the increase in total revenues was a decrease in investment management fees primarily due to $5.2 million of additional fees associated with the termination of an institutional account in the third quarter of 2006. Otherwise, investment management fees declined slightly, as higher fees for mutual funds and structured products due to higher assets under management were offset by lower fees for managed accounts and institutional accounts due to net outflows.
Partially offsetting this decrease in segment expenses was an increase in other operating expenses primarily due to higher distribution and administration expenses relating to higher mutual fund sales and higher average mutual fund assets under management.
There were no other costs, net of income taxes, because the employment and lease related charges associated with the restructuring of the asset management business in 2006 did not recur.
Assets under management decreased $2.4 billion year over year primarily due to an unfavorable $2.3 billion change in market value on structured products. Also contributing to the decrease in assets under management were overall net outflows of $513.1 million and other changes of $(1.1) billion largely driven by a change in the registered investment advisor of certain variable product assets from an asset management subsidiary to a life and annuity subsidiary. Partially offsetting these items were favorable inflows and performance on money market mutual funds of $502.5 million and favorable combined performance on managed accounts, mutual funds and institutional accounts of $1.0 billion.
Allocated income tax benefits increased primarily as a result of higher segment losses in 2006 compared to 2005.
Our venture capital investments are limited partnership interests in venture capital funds, leveraged buyout funds and other private equity partnerships sponsored and managed by third parties. We record our investments in venture capital partnerships in accordance with the equity method of accounting. Venture capital investments are investments of the general account of Phoenix Life.
Through December 31, 2005, we reported venture capital earnings in a Venture Capital segment. In October 2005, we entered into an agreement to sell approximately three quarters of the assets in our Venture Capital segment. As a result of the transaction, the Venture Capital segment was eliminated, effective January 1, 2006, and earnings from the remaining assets are now allocated to the Life and Annuity segment.
The operating loss before income taxes for Corporate and Other decreased primarily due to lower deferred compensation expenses and to lower interest expense from the repayment of surplus notes and promissory notes in late 2006 and early 2007, respectively. We also had higher investment income, driven by higher holding company investment balances resulting from dividends received from Phoenix Life.
Realized investment losses increased $26.8 million to a loss of $5.8 million in 2007 from a gain of $21.0 million in 2006 due to a large gain on a collateralized debt obligation in 2006 that did not recur in 2007.
Operational risk is the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. We have established an Operational Risk Committee, chaired by the Chief Risk Officer, to develop an enterprise-wide framework for managing and measuring operational risks. This committee meets monthly and has a membership that represents all significant operating, financial and staff departments of the Company.
One of the key measures we use to quantify our interest rate exposure is duration, a measure of the sensitivity of the fair value of assets and liabilities to changes in interest rates. For example, if interest rates increase by 100 basis points, or 1%, the fair value of an asset or liability with a duration of five is expected to decrease by 5%. We believe that as of December 31, 2007, our asset and liability portfolio durations were well matched, especially for our largest and most interest-sensitive segments. We regularly undertake a sensitivity analysis that calculates liability durations under various cash flow scenarios. We also calculate key rate durations for assets and liabilities that show the impact of interest rate changes at specific points on the yield curve. In addition, we monitor the short- and medium-term asset and liability cash flows profiles by portfolio to manage our liquidity needs.
See Note 15 to our consolidated financial statements in this Form 10-K for more information on derivative instruments.
We also manage credit risk through industry and issuer diversification and asset allocation. Maximum exposure to an issuer or derivatives counterparty is defined by quality ratings, with higher quality issuers having larger exposure limits. We have an overall limit on below investment grade rated issuer exposure.
Equity risk is the risk that we will incur economic losses due to adverse changes in equity prices. Our exposure to changes in equity prices primarily results from our variable annuity and variable life products, as well as from our holdings of common stocks, mutual funds and other equities. We manage our insurance liability risks on an integrated basis with other risks through our liability and risk management and capital and other asset allocation strategies. We also manage equity price risk through industry and issuer diversification and asset allocation techniques. We held $205.3 million in equity securities on our balance sheet as of December 31, 2007. A 10% decline or increase in the relevant equity price would have decreased or increased, respectively, the value of these assets by approximately $20.5 million as of December 31, 2007.
Certain annuity products sold by our Life Companies contain guaranteed minimum death benefits. The guaranteed minimum death benefit feature provides annuity contract holders with a guarantee that the benefit received at death will be no less than a prescribed amount. This minimum amount is based on the net deposits paid into the contract, the net deposits accumulated at a specified rate, the highest historical account value on a contract anniversary or, if a contract has more than one of these features, the greatest of these values. To the extent that the guaranteed minimum death benefit is higher than the current account value at the time of death, the Company incurs a cost. This typically results in an increase in annuity policy benefits in periods of declining financial markets and in periods of stable financial markets following a decline. As of December 31, 2007 and 2006, the difference between the guaranteed minimum death benefit and the current account value (net amount at risk) for all existing contracts was $46.7 million and $51.3 million, respectively. This is our exposure to loss should all of our contractholders have died on either December 31, 2007 or 2006. See Note 13 to our consolidated financial statements in this Form 10-K for more information.
Certain life and annuity products sold by our Life Companies contain guaranteed minimum living benefits. These include guaranteed minimum accumulation, withdrawal, income and payout annuity floor benefits. The guaranteed minimum accumulation benefit guarantees a return of deposit to a policyholder after 10 years regardless of market performance. The guaranteed minimum withdrawal benefit guarantees that a policyholder can withdraw 5% for life regardless of market performance. The guaranteed minimum income benefit guarantees that a policyholder can convert his or her account value into a guaranteed payout annuity at a guaranteed minimum interest rate and a guaranteed mortality basis, while also assuming a certain level of growth in the initial deposit. We have established a hedging program for managing the risk associated with our guaranteed minimum accumulation and withdrawal benefit features. We began hedging our GMAB exposure in 2006 and GMWB exposure during the fourth quarter of 2007. We continue to analyze and refine our strategies for managing risk exposures associated with all our separate account guarantees. The statutory reserves for these totaled $12.2 million and $7.4 million at December 31, 2007 and 2006, respectively. The GAAP reserves totaled $7.6 million and $5.3 million at December 31, 2007 and 2006, respectively.
We sponsor defined benefit pension plans for our employees. For GAAP accounting purposes, we assumed an 8.5% long-term rate of return on plan assets in the most recent valuations, performed as of December 31, 2007. To the extent there are deviations in actual returns, there will be changes in our projected expense and funding requirements. As of December 31, 2007, the projected benefit obligation for our funded and unfunded defined benefit plans was in excess of plan assets by $25.6 million and $140.7 million, respectively. We made payments totaling $20.0 million and $23.9 million to the pension plan during 2007 and 2006, respectively. We do not expect any required contributions in 2008. See Note 18 to our consolidated financial statements in this Form 10-K for more information on our employee benefit plans. In February 2007, we announced a change to our pension plan that was effective July 1, 2007. The change is designed to decrease the volatility of our pension expense over time.
Foreign currency exchange risk is the risk that we will incur economic losses due to adverse changes in foreign currency exchange rates. Our functional currency is the U.S. dollar. Our exposure to fluctuations in foreign exchange rates against the U.S. dollar primarily results from our holdings in non-U.S. dollar-denominated debt and equity securities which are not material to our consolidated financial statements at December 31, 2007.
Impairment losses increased from $8.9 million in 2006 to $51.9 million in 2007. Affiliate transaction gains of $13.7 million for the year ended December 31, 2007 and $10.4 million for the year ended December 31, 2006 were attributable to the earn-out associated with the sale of Lombard that occurred in the first quarter of 2005. Affiliate transaction gains and losses for the year ended December 31, 2005 included a $14.4 million gain on the sale of our equity investment in Lombard and a $10.7 million realized loss on the sale of our equity investment in Aberdeen. Transaction activity resulted in a gain of $45.1 million for the year ended December 31, 2007 compared to a net gain of $85.4 million for the year ended December 31, 2006. This decrease was primarily due to significant gains realized on certain debt and equity securities in 2006 that did not repeat in 2007 and a significant impairment loss in the fourth quarter of 2007. See Note 10 to our consolidated financial statements in this Form 10-K for additional information.
At the end of each reporting period, we review all securities for potential recognition of an other-than-temporary impairment. We maintain a watch list of securities in default, near default or otherwise considered by our investment professionals as being distressed, potentially distressed or requiring a heightened level of scrutiny. We also identify securities whose carrying value has been below amortized cost on a continuous basis for zero to six months, six months to 12 months and greater than 12 months. This analysis is provided for investment grade and below investment grade securities and Closed Block and outside of Closed Block securities. Using this analysis, coupled with our watch list, we review all securities whose fair value is less than 80% of amortized cost (significant unrealized loss) with emphasis on below investment grade securities with a continuous significant unrealized loss in excess of six months. In addition, we review securities that had experienced lesser percentage declines in value on a more selective basis to determine if a security is other-than-temporarily impaired.
For debt securities in the Closed Block with gross unrealized losses, 84.3% of the unrealized losses pertain to investment grade securities and 15.7% of the unrealized losses pertain to below investment grade securities at December 31, 2007.
Cash for financing activities decreased due to higher policyholder deposits and lower policyholder withdrawals, resulting in part from a $206.6 million scheduled maturity in 2006 which did not recur in 2007.
Cash from (for) operating activities decreased $33.7 million to net outflows of $12.1 million due to higher cash settlements in our discontinued reinsurance business in 2006 compared to the lower settlement activity in 2007.
Cash from investing activities decreased primarily due to the liquidation of the Mistic CDO in 2005, offset by lower cash generated from continuing operations in 2006 and higher sales of investments in 2006 to fund withdrawals of policyholder deposit funds (as described below in financing activities).
See Note 11 to our consolidated financial statements in this Form 10-K for additional information on financing activities.
Cash from operating activities increased primarily due to receipt of a higher dividend from our largest life insurance subsidiary.
On February 7, 2008, we announced our intention to spin off our asset management subsidiary, PXP, by way of a dividend of PXP’s stock to the Company’s shareholders. We expect the spin-off and related transactions, or the “Spin-Off”, to occur during the third quarter of 2008. At this point, decisions regarding the capital structure, expense and overhead support structure and other matters are under review and consideration.
Our primary sources of liquidity have been dividends from Phoenix Life and interest income received from PXP. Under New York Insurance Law, Phoenix Life can pay stockholder dividends to the holding company in any calendar year without prior approval from the New York Superintendent of Insurance in the amount of the lesser of 10% of Phoenix Life’s surplus to policyholders as of the immediately preceding calendar year or Phoenix Life’s statutory net gain from operations for the immediately preceding calendar year, not including realized capital gains. Phoenix Life paid a dividend of $92.2 million during 2007 and is able to pay a dividend of $83.8 million in 2008 under this provision. See Note 22 to our consolidated financial statements in this Form 10-K for more information on Phoenix Life statutory financial information and regulatory matters.
We sponsor postemployment benefit plans through pension and savings plans and postretirement health care and life insurance for employees of Phoenix Life and PXP. Funding of these obligations is provided by Phoenix Life and PXP on a 100% cost reimbursement basis through administrative services agreements with the holding company. See Note 18 to our consolidated financial statements in this Form 10-K for additional information.
Under the Amended Facility, the consummation of the Spin-Off may be deemed to be an “Event of Default” which would cause any outstanding indebtedness under the Amended Facility at the time of the Spin-Off to become immediately due and payable and would prevent further borrowings under the Amended Facility following the Spin-Off. The Company and PXP may not be able to refinance outstanding debt, and may not be able to renegotiate or replace the Amended Facility, on favorable terms, which may have an adverse effect on the Company’s and/or PXP’s liquidity and capital resources.
The primary liquidity risks regarding cash inflows from the investment activities of our Life Companies are the risks of default by debtors, interest rate and other market volatility and potential illiquidity of investments. We closely monitor and manage these risks.
Effective as of December 31, 2007, our board of directors has approved the full retirement of the inter-company debt between PNX and PXP by executing a $325.0 million capital contribution from PNX to PXP.
Equity securities increased due to additional funding made in this asset class in 2007.
Mortgage loans decreased due to the sale of the majority of the portfolio in 2007. There were no new investments in mortgage loans.
Venture capital partnerships increased due to new commitments, additional contributions and equity in earnings, partially offset by distributions of $30.1 million. Venture capital investments in the Closed Block increased by $59.3 million while Open Block investments decreased by $2.4 million.
Receivables decreased due to reductions to reinsurance recoverables related to lower death benefit accruals.
See Note 7 to our consolidated financial statements in this Form 10-K for additional information.
Non-recourse obligations are not direct liabilities of ours, as they will be repaid from investments pledged as collateral recorded on our consolidated balance sheet. See Note 14 to our consolidated financial statements in this Form 10-K for additional information.
Other commercial commitments relate to venture capital partnerships ($142.1 million) and private placements ($22.3 million). The venture capital commitments can be drawn down by private equity funds as necessary to fund their portfolio investments through the end of the funding period as stated in each agreement. The obligations related to private placements are all due to be funded during 2008.
We provide our employees with postemployment benefits that include retirement benefits, through pension and savings plans, and other benefits, including health care and life insurance. Employee benefit expense related to these plans totaled $26.1 million, $33.8 million and $28.2 million for 2007, 2006 and 2005, respectively.
As of December 31, 2007, we did not have any significant off-balance sheet arrangements as defined by Item 303(a)(4)(ii) of SEC Regulation S-K. See Note 14 to our consolidated financial statements in this Form 10-K for more information on variable interest entities.
Our broker-dealer subsidiaries are each subject to the net capital requirements imposed on registered broker-dealers by the Securities Exchange Act of 1934. Each is also required to maintain a ratio of aggregate indebtedness to net capital that does not exceed 15:1. At December 31, 2007 the largest of these subsidiaries had net capital of approximately $7.4 million, which is $6.5 million in excess of its required minimum net capital of $0.9 million. The ratio of aggregate indebtedness to net capital for that subsidiary was 1.84:1. The ratios of aggregate indebtedness to net capital for each of our other broker-dealer subsidiaries were also below the regulatory ratio at December 31, 2007 and their respective net capital each exceeded the applicable regulatory minimum.