The Company occupies office space in Shelton, Connecticut, which is leased from an affiliate, American Skandia Information Services and Technology Corporation. The Company entered into a lease for office space in Westminster, Colorado, effective January 1, 2001, and established an additional customer service center at that location. Effective December 31, 2004, the Company closed its customer service center in Colorado. The Company believes that its current facilities are satisfactory for its near term needs.
You should read the following analysis of the Company’s financial condition and results of operations in conjunction with the Forward-Looking Statements included below the Table of Contents, “Risk Factors”, “Selected Financial Data”, and the Financial Statements included in this Annual Report on Form 10-K.
The Company offers a wide array of annuities, including (1) deferred and immediate variable annuities that are registered with the United States Securities and Exchange Commission, including fixed interest rate annuities that are offered as a companion to certain of our variable annuities and are registered because of their market value adjustment feature and (2) fixed annuities that are not registered with the United States Securities and Exchange Commission. In addition, the Company has in force a relatively small block of variable life insurance policies, but it no longer actively sells such policies. These markets are subject to regulatory oversight with particular emphasis placed on company solvency and sales practices. These markets are also subject to increasing competitive pressure as the legal barriers, that have historically segregated the markets of the financial services industry, have been changed through both legislative and judicial processes. Regulatory changes have opened the insurance industry to competition from other financial institutions, particularly banks and mutual funds that are positioned to deliver competing investment products through large, stable distribution channels.
our cost of administering insurance contracts and providing asset management products and services;
In addition, factors such as regulation, competition, interest rates, taxes and general economic conditions affect the Company’s profitability. See “Risk Factors” for a discussion of risks that could materially affect our business, results of operations or financial condition, or cause our actual results to differ materially from those expected or those expressed in any forward looking statements made by or on behalf of the Company.
In accordance with purchase accounting guidelines, the Company valued at fair value its assets and liabilities as of the date of acquisition. The most significant adjustments related to assigning the unamortized deferred policy acquisition costs (“DAC”) asset a value of zero, the future fees payable to ASI liability was decreased by $256.6 million and an asset for valuation of business acquired (“VOBA”) was established for $440.1 million. See Notes 4, 5 and 6 in the December 31, 2005 financial statements included herein for further discussion.
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 6% of our investments as of December 31, 2005, 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.
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 8.9% per annum for our evaluation of deferred policy acquisition costs as of December 31, 2005.
The Company has determined, using assumptions for lapses, mortality, free withdrawals and a long-term fund growth rate of 8% on the Company’s assets under management, that the discounted estimated future payments to ASI would be $126.7 million and $222.6 million as of December 31, 2005 and 2004, respectively.
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 2005.
The Company’s Changes in Financial Position and Results of Operations are described below.
During the year, liabilities increased by $2.5 billion from $29.6 billion to $32.1 billion. Separate account liabilities increased by $2.8 billion, driven by market value appreciation and positive net flows driven by sales of our new product feature, Lifetime Five. Partially offsetting these increases was a decrease in policyholders’ account balances of $184.9 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 $117.3 million due to lower levels of corporate securities out on loan. In addition, future fees payable to ASI decreased $87.4 million during the year due to amortization.
Net income of $158.4 million for 2005 increased $68.5 million from $89.9 million in 2004. Results for 2004 reflect a charge for the cumulative effect of accounting change of $17.1 million, net of tax, related to the January 1, 2004 adoption of SOP 03-01. Excluding the cumulative effect charge, net income increased $51.4 million. Policy charges and fee income increased by $79.0 million and asset management fees increased by $15.3 million year over year driven by increased net flows and market appreciation during the current year. The current year also includes a $27.1 million adjustment to reserves for the guaranteed minimum death benefit feature of our variable annuity products due to decreased costs of actual and expected death claims. This increase was partially offset by higher general, administrative and other expenses of $66.1 million driven by increased amortization of the DAC and valuation of business acquired and $9.0 million of higher income tax expense driven by higher pre-tax net income. Further details regarding the components of revenues and expenses are described below.
Revenues increased by $92.4 million, from $575.6 million to $668.0 million. Premiums of $23.8 million increased by $6.2 million, from $17.6 million in 2004, reflecting an increase in funds from customers electing to enter into the payout phase of their annuity contracts.
Asset management fees increased by $15.3 million from 2004 to 2005 as a result of higher average assets under management compared to last year. Asset management fees are asset-based fees, which are dependent on the amount of assets under management.
Policyholders’ benefits decreased by $24.0 million from $86.9 million in 2004 to $62.9 million in 2005. This was driven primarily by a $27.1 million adjustment in the current 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 above.