The Company earns its revenues principally from insurance premiums; mortality, expense, and asset management fees from insurance and investment products; and investment of general account and other funds. The Company earned premiums primarily from the sale of individual life insurance. The Company earns mortality, expense, and asset management fees from the sale and servicing of separate account products including variable life insurance and variable annuities. 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 and interest credited on general account liabilities.
our mortality and morbidity experience on individual life insurance and annuity products;
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America, or “GAAP”, requires the application of accounting policies that often involve a significant degree of judgment. Management, on an ongoing basis, reviews estimates and assumptions used in the preparation of financial statements. If management determines that modifications in assumptions and estimates are appropriate given current facts and circumstances, results of operations and financial position as reported in the Consolidated Financial Statements could change significantly.
For our fixed maturity investments classified as available for sale, the impact of changes in fair value is recorded as an unrealized gain or loss in “Accumulated other comprehensive income (loss), net of taxes,” a separate component of equity. In addition, investments classified as available for sale are subject to our impairment review to identify when a decline in value is other than temporary. Factors we consider in determining whether a decline in value is other than temporary include: the extent (generally if greater than 20%) and duration (generally greater than six months) of the decline; the reasons for the decline in value (credit event or interest rate related); our ability and intent to hold the investment for a period of time that will allow for a recovery of value; and the financial condition and near-term prospects of the issuer. When it is determined that a decline in value is other than temporary, the carrying value of the security is reduced to its fair value, with a corresponding charge to earnings. This corresponding charge is referred to as impairment and is reflected in “Realized investment (losses)/gains, net” in the statements of operations. 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 for our domestic annuity and variable life insurance products 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 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 for variable annuity contracts, 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 rates of return, we change our future assumption to reflect the result of the reversion to the mean approach. For variable annuities products, 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 all of our variable annuity products for our evaluation of deferred policy acquisition costs as of December 31, 2006.
Tax regulations require items to be included in the tax return at different times than the items 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. Temporary 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.
From December 31, 2005 to December 31, 2006 there was an increase of $2.829 billion in total assets, from $29.674 billion to $32.503 billion. The largest increase was in separate account assets, which increased $2.858 billion, from $19.094 billion at December 31, 2005 to $21.952 billion at December 31, 2006, primarily due to market performance and sales net of surrenders, benefits and policy charges, in 2006. Commercial loans increased $239 million, from $269 million at December 31, 2005, to $508 million at December 31, 2006, as additional funds were invested in commercial loans.
Fixed maturities decreased by $1.248 billion, from $6.159 billion at December 31, 2005 to $4.911 billion at December 31, 2006. The decrease was primarily driven by the movement of contractholder assets from the fixed rate general account options to the variable separate account investment options. Also contributing were the sales of fixed maturities to fund the acquisition of commercial loans and pay down investment-related borrowings and scheduled withdrawals and maturities within the GIC business and a decline in the level of unrealized gains resulting from an increasing interest rate environment. These decreases are partly offset by investing positive cash flows and reinvestment of investment income.
Cash and cash equivalents increased by $327 million, from $158 million at December 31, 2005 to $485 million at December 31, 2006, due to accumulated portfolio cash flows partially offset by repayments of short term debt.
Total liabilities increased by $2.560 billion, from $27.608 billion at December 31, 2005 to $30.168 billion at December 31, 2006. Corresponding with the asset change, separate account liabilities increased by $2.858 billion, as described above. Policyholder account balances decreased by $310 million, primarily due to continued maturities and surrenders of guaranteed investment contracts in 2006. Future policy benefits and other policyholder liabilities increased by $318 million, primarily due to increases to life reserves as a result of sales and renewals of term products, increased reserves for the Taiwan business, increased guaranteed minimum death and income reserves in the annuity business from growth and aging of the business. The Company’s short-term debt from affiliates used to provide short-term working capital decreased by $81 million from $106 million at December 31, 2005 to $25 million at December 31, 2006, due to repayments. Total securities lending activity decreased by $278 million from $426 million at December 31, 2005. The relative amounts of cash collateral for loaned securities and securities sold under agreements to repurchase decreased $255 million and $23 million, respectively.
Policy charges and fee income, consisting primarily of mortality and expense, loading and other insurance charges assessed on general and separate account policyholders’ fund balances, decreased by $16 million, from $564 million in 2005 to $548 million in 2006, primarily driven by lower amortization of unearned policy charges and fee income in the life business of $37 million due to an increased estimate of total gross profits used as a basis for amortization. This was partly offset by higher fees from growth in assets under management resulting from market appreciation and a growing insurance in force. The gross variable and universal life in force business grew by 5% from $82.1 billion at December 31, 2005 to $86.3 billion at December 31, 2006. Annuity fees are mainly asset-based fees, which are dependent on fund balances that are affected by net sales as well as asset depreciation or appreciation on the underlying investment funds in which customers may invest. Average annuity separate account fund balances are nearly 16% higher than in the prior year as a result of favorable market performance and positive net sales.
Net investment income decreased by $3 million to $401 million in 2006, from $404 million in 2005, primarily due to a declining fund balances in the GIC products in 2006 and $6 million of income resulting from the collection of investment income in 2005 on a previously defaulted bond. This was partially offset by continued investment of positive cash flows from operations, and reinvestment of net investment income in 2006.
Total benefits and expenses decreased $142 million, from $783 million in 2005 to $641 million in 2006, driven by increased estimate of total gross profits used as a basis for amortizing deferred policy acquisitions and other costs.
Policyholders’ benefits, including related changes in reserves, increased by $21 million, from $99 million in 2005 to $120 million in 2006. Higher term and other benefit reserves from growth in the term in force were partially offset by less growth in reserves for guaranteed minimum death benefits in annuities products, as a result of market performance.
Interest credited to policyholders’ account balances decreased by $23 million, from $235 million in 2005 to $212 million in 2006. Interest credited in GIC product was $22 million lower than in the prior year period due to continued maturities and withdrawals in the current year and no additional sales. Also impacting this decrease were lower policyholders’ account balances in the annuity products driven by movement of contractholder assets from the fixed rate general account options to the variable separate account investment options, offset by an increase in growth of policyholders’ account balances of life products which increased due to higher policyholder deposits resulting from universal life sales.
Income tax expense in 2006 increased $41 million, from $21 million in 2005 to $62 million in 2006. The prior year provision included a favorable adjustment of $33 million reflecting the resolution of substantially all issues relating to the “IRS” examination of our consolidated federal income tax returns for the 1997 to 2001 periods, as well as higher income before taxes, as described above.