We prepared the following financial data, other than statutory data, in conformity with accounting principles generally accepted in the United States of America, or GAAP. We derived the statutory data from the Annual Statements of our Life Companies filed with state insurance regulatory authorities and prepared it in accordance with statutory accounting practices prescribed or permitted by state insurance regulators, which vary in certain material respects from GAAP.
Due to our losses during 2003 and 2002, the ratio coverages, excluding interest credited on policyholder contract balances, were less than 1:1. We would need $11.4 million and $113.6 million in additional earnings for the years 2003 and 2002, respectively, to achieve a 1:1 coverage ratio.
Management’s discussion and analysis reviews our consolidated financial condition at December 31, 2006 and 2005; our consolidated results of operations for the years 2006, 2005 and 2004; and, where appropriate, factors that may affect our future financial performance. This discussion should be read in conjunction with “Selected Financial Data” and our consolidated financial statements in this Form 10-K.
We are a manufacturer of life insurance, annuity and investment products. We provide these products and services through a wide variety of third-party financial professionals and institutional consultants.
We manufacture our products through two reportable operating segments-Life and Annuity and Asset Management-which include three product lines-life insurance, annuities and investments. Through Life and Annuity we offer a variety of life insurance and annuity products, including universal, variable universal and term life insurance and a range of variable annuity offerings. Within Asset Management, we focus on two customer groups-retail investors and institutional clients. We provide asset management services to retail customers through open-end mutual funds, closed-end funds and managed accounts. Managed accounts include intermediary programs sponsored and distributed by non-affiliated broker-dealers and direct managed accounts which are sold and administered by us. We also provide transfer agency, accounting and administrative services to our open-end mutual funds. Through our institutional group, we provide asset management services primarily to corporations, multi-employer retirement funds and foundations, as well as to endowments and special purpose funds. In addition, we manage structured finance products including collateralized debt obligations backed by public high yield bonds, mortgage-backed and asset-backed securities and bank loans.
Through December 31, 2005, we reported our remaining activities in the Venture Capital segment and Corporate and Other. Venture Capital includes limited partnership interests in venture capital funds, leveraged buyout funds and other private equity partnerships sponsored and managed by third parties. These assets are investments of the general account of Phoenix Life. 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. See Business-Description of Business-Venture Capital. Corporate and Other includes all interest expense, as well as several smaller subsidiaries and investment activities which do not meet the thresholds of reportable operating segments. These include our remaining international operations and the runoff of our group pension and guaranteed investment contract business. See Business-Description of Business-Corporate and Other.
insurance policy benefits provided to policyholders, including interest credited on policies;
Prior to Phoenix Life’s demutualization, we focused on participating life insurance products, which pay policyholder dividends. As of December 31, 2006, 66% of our life insurance reserves were for participating policies. As a result, a significant portion of our expenses consist, and will continue to consist, of such policyholder dividends. Our net income is reduced by the amounts of these dividends. Policyholder dividend expense, which includes both dividends to policyholders and the change in the policyholder dividend obligation, was $399.1 million during 2006, $364.4 million during 2005 and $404.7 million during 2004.
On May 18, 2006, we acquired the rights to advise, distribute and administer the Harris Insight® Funds, now known as the Insight Funds from Harris Investment Management, Inc., or Harris. Harris continues to manage the majority of the Insight Funds as subadviser. The acquisition of the Insight Funds rights added $8.6 billion to assets under management at December 31, 2006.
On May 2, 2005, we completed the acquisition of the minority interest in Seneca Capital Management, or Seneca, thereby increasing our ownership to 100%. The effect of this acquisition was not material to our consolidated financial statements.
On November 19, 2004, we received payment in full of a $27.5 million convertible subordinated note issued by Aberdeen. Concurrently we relinquished our contractual right to one of two Aberdeen board seats we held related to our 16.5% equity interest in Aberdeen, at which point we concluded that in our judgment, we no longer had the ability to significantly influence Aberdeen’s operations. Accordingly, effective November 19, 2004, we changed our method of accounting for our equity holdings in Aberdeen from the equity method of accounting to the fair value method of accounting under SFAS 115, Accounting for Investments in Debt and Equity Securities. Based on our intent to sell our equity holdings in Aberdeen in the near-term, we designated our equity holdings as trading securities under the fair value method of accounting. Under the fair value method, the changes in fair value, based on the underlying value of Aberdeen’s shares as traded on the London Stock Exchange, as compared to our carrying value under the equity method are presented as an after-tax realized investment gain of $55.1 million in our consolidated statement of operations for the year ended December 31, 2004. In addition, our 2004 income from continuing operations include a $14.7 million after-tax, non-cash charge related to the accounting for our proportionate share of Aberdeen’s December 2004 settlement of alleged misselling activities with the United Kingdom’s Financial Services Authority. This charge has been accounted for by us under the equity method of accounting as it pre-dates our November 19, 2004 change in accounting for Aberdeen from the equity method to the fair value method. See Note 10 to our consolidated financial statements in this Form 10-K for more information on our holdings in Aberdeen.
During 2004, we incurred a $3.6 million net after-tax charge for an impairment of goodwill related to Main Street, offset by a $2.7 million after-tax gain on the sale of the retail affiliated broker-dealer operations. Both the charge and the gain were recorded to realized investment gains and losses. In addition, we incurred a $10.2 million net after-tax charge related to severance and lease termination costs, offset by a $4.4 million after-tax gain related to curtailment accounting in connection with employee benefit plans. During the second quarter of 2005, we realized a gain of $1.5 million related to contingent consideration based on gross distribution concessions earned by LPL during the first year following the sale.
For a discussion of accounting standards, see Note 2 to our consolidated financial statements in this Form 10-K.
We amortize deferred policy acquisition costs and present value of future profits based on the related policy’s classification. For individual participating life insurance policies, deferred policy acquisition costs and present value of future profits are amortized in proportion to estimated gross margins. For universal life, variable universal life and accumulation annuities, deferred policy acquisition costs and present value of future profits are amortized in proportion to estimated gross profits, or EGPs. Policies may be surrendered for value or exchanged for a different one of our products (internal replacement). The deferred policy acquisition costs balance associated with the replaced or surrendered policies is amortized to reflect these surrenders.
Each year, we develop future EGPs for the products sold during that year. The EGPs for products sold in a particular year are aggregated into cohorts. Future EGPs are projected for the estimated lives of the contracts. The amortization of deferred policy acquisition costs and present value of future profits requires the use of various assumptions, estimates and judgments about the future. The assumptions, in the aggregate, are considered important in the projections of EGPs. The assumptions developed as part of our annual process are based on our current best estimates of future events, which are likely to be different for each year’s cohort. Assumptions considered to be significant in the development of EGPs include separate account fund performance, surrender and lapse rates, interest margin, mortality, premium persistency and expenses. These assumptions are reviewed on a regular basis and are based on our past experience, industry studies, regulatory requirements and estimates about the future.
To determine the reasonableness of the prior assumptions used and their impact on previously projected account values and the related EGPs, we evaluate, on a quarterly basis, our previously projected EGPs. Our process to assess the reasonableness of our EGPs involves the use of internally developed models, together with studies and actual experience. Incorporated in each scenario are our current best estimate assumptions with respect to separate account returns, surrender and lapse rates, interest margin, mortality, premium persistency and expenses.
Underlying assumptions for future periods of EGPs are not altered unless experience deviates significantly from original assumptions. For example, when lapses of our insurance products meaningfully exceed levels assumed in determining the amortization of deferred policy acquisition costs, we adjust amortization to reflect the change in future premiums or EGPs resulting from the unexpected lapses. In the event that we were to revise assumptions used for prior year cohorts, our estimate of projected account values would change and the related EGPs in the deferred policy acquisition cost amortization model would be adjusted to reflect such change. This process is known as “unlocking”. Continued favorable experience on key assumptions, which could include increasing separate account fund return performance, decreasing lapses or decreasing mortality could result in an unlocking which would result in a decrease to deferred policy acquisition cost amortization and an increase in the deferred policy acquisition costs asset. Finally, an analysis is performed periodically to assess whether there are sufficient gross margins or gross profits to amortize the remaining deferred policy acquisition costs balances.
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
In our current year unlocking, we concluded that a revision had to be made to our assumed mortality assumption. If, at December 31, 2006, we had increased our assumed mortality by 5%, the decrease to net income would have been $8.6 million after tax. If instead, at December 31, 2006, we had decreased our assumed mortality by 5%, the increase to net income would have been $8.1 million.
For goodwill and intangible assets, we perform impairment tests at the reporting-unit level at least annually. In 2005, in conjunction with the conversion of our Asset Management business to a wholly owned structure, we consolidated our asset management related goodwill into a single reporting unit for purposes of goodwill impairment testing. For purposes of the impairment test, the fair value of the reporting unit is based on the sum of: a multiple of revenue plus the fair value of the units’ tangible fixed assets. For purposes of indefinite-lived intangible assets, we calculate the fair value of the assets as a multiple of revenue. For purposes of definite-lived intangible assets, we calculate the fair value based on projected cash flows. Prior to 2002, we amortized goodwill principally over 40 years and investment management contracts over five to 16 years. For intangible assets with definite lives, all amortization expense has been, and continues to be, calculated on a straight-line basis.
*Short-term investments are valued at amortized cost, which approximates fair value.
As of December 31, 2006, we had deferred tax assets of $40.4 million and $3.9 million related to net operating and capital losses, respectively, for federal income tax purposes and $15.7 million for state net operating losses. The related federal net operating losses of $115.4 million are scheduled to expire between the years 2017 and 2026. The federal capital losses of $11.2 million are scheduled to expire in 2010. The state net operating losses relate to the non-life subgroup and are scheduled to expire as follows: $51.9 million in 2012 through 2015 and $148.4 million in 2019 through 2025. Due to the inability to combine the life insurance and non-life insurance subgroups for state income tax purposes, we established a $15.7 million and a $9.4 million valuation allowance at the end of 2006 and 2005, respectively, relative to the state net operating loss carryforwards.
See Note 18 to our consolidated financial statements in this Form 10-K for more information on our pension and other postemployment benefits.
Consolidated net income was $99.9 million, or $0.88 per diluted share, a decrease of 8% from net income of $108.4 million, or $1.06 per diluted share, in 2005. The 2006 results reflected solid earnings growth for our Life and Annuity segment, offset by higher losses for our Asset Management segment due to an impairment of identified intangible assets and a decline in revenues. In addition, the effective tax rate increased in 2006 over 2005. These decreases to net income were largely offset by an increase in Life and Annuity fees, primarily related to universal life, and lower operating expenses for both Life and Annuity and Asset Management. The diluted earnings per share declined 17% in 2006 from 2005, due to lower net income and an increase in shares outstanding due mainly to the issuance of stock in February 2006 for the settlement of the equity units stock purchase contracts.
Total life sales increased 71% to $329.3 million, a record amount since Phoenix became a public company. Annuity deposits increased 24% to $421.0 million. Net flows in annuities were negative for the year, however, driven primarily by outflows from discontinued products. Asset Management deposits of $7.7 billion were driven by increased sales of mutual funds and structured finance products. Net outflows for the year were $4.0 billion, although net flows for the second half of the year were positive.
Stockholders’ equity increased by $229.0 million to $2,236.1 million at December 31, 2006 due primarily to the issuance of common stock to settle the equity units, as discussed above, and net income for 2006. Total assets increased $1.3 billion to $29.0 billion at December 31, 2006, due primarily to a $1.7 billion increase in separate account assets which resulted from strong investment performance for the year and a large private placement deposit. This increase was partially offset by a $0.7 billion decrease in available-for-sale debt securities. This decrease was related to the sales of debt securities that were necessary to fund withdrawals of policyholder deposit funds, primarily related to discontinued products. In addition, goodwill and intangible assets as a percentage of total stockholders’ equity declined to 32% in 2006 from 38% in 2005.
Net investment income decreased $50.4 million primarily due to the sale of our venture capital segment and lower mortgage loan income.
Net realized investment gains increased $42.3 million primarily due to lower impairment losses and higher transaction-related gains.
Intangible asset impairments increased $21.9 million due to identified intangible assets for certain investment contracts that had experienced significant outflows.
Income before income taxes, minority interest and equity in earnings of affiliates increased $6.4 million, or 5%, primarily due to higher insurance and investment product fees, increased net realized investment gains and lower operating expenses.
Income taxes increased $15.6 million due to a refinement of our estimation process of the dividends received deduction, additional tax expense for certain stock options exercised and the absence of tax credits and benefits earned in the prior year that resulted from the completion of an IRS audit.
Expanding distribution, including within our existing State Farm relationship and with new Brokerage General Agency relationships.
In February 2007, we launched an alliance with National Life Group through which we offer our variable annuity products through their career force on a proprietary, co-marketed basis. This allows us a more sustainable, broader distribution opportunity with them. Our largest relationship-State Farm-also continued to expand. Annualized life premiums sold through State Farm grew 35% for the year. In addition, on January 30, 2007 we reached an agreement with State Farm to extend the existing distribution agreement by an additional five years from 2011 to 2016.
build the business around shared operations, using a consolidated platform for both affiliated advisors and sub-advisors.
Premiums decreased $61.9 million due primarily to decreases in premiums on the traditional life insurance block, which is comprised mainly of participating life insurance policies which we no longer sell, resulting in a decline in participating life renewal premiums. However, policyholder benefits decreased $27.0 million related to the reduction of in-force policies for traditional life insurance. In addition, there were large supplemental contract premiums in 2004 that did not recur in 2005.
Total benefits and expenses decreased $134.5 million primarily due to the following:
Dividends decreased $40.3 million due primarily to the change in the policyholder dividend obligation liability.
Policy acquisition cost amortization increased $21.9 million due primarily to an increase of $18.0 million related to the effect of realized gains and higher amortization for universal life and annuities offset by the effects of unlocking.
Net income increased $22.0 million, or 25%, primarily due to the following:
An increase in net realized investment gains related to a $35.1 million gain on the settlement of our HRH stock purchase contracts. Offsetting this increase was a $9.0 million loss on the sale of certain venture capital partnerships and a $7.0 million loss on the sale of our equity investment in Aberdeen.
A decrease in applicable income taxes of $12.8 million due to additional tax credits earned and tax benefits resulting from the completion of an IRS audit.
Mutual fund sales increased 26% due to our emphasis on expanding relationships with advisors and secondary offerings of closed-end funds, as well as institutional sales, which more than doubled in 2005. We also completed the conversion of our asset management operations to a wholly owned structure, refocused on retail distribution, including adding more than 6,000 new producers, and expanded and strengthened our product offerings.
For the years 2006, 2005 and 2004, inflation did not have a material effect on our consolidated results of operations.
Operating income is calculated by excluding realized investment gains (losses) and certain other items because we do not consider them to be related to the operating performance of our segments. The size and timing of realized investment gains and losses are often subject to our discretion. Certain other items are also excluded from operating income if, in our opinion, they are not indicative of overall operating trends. While some of these items may be significant components of net income in accordance with GAAP, we believe that operating income, and measures that are derived from or incorporate operating income, are appropriate measures that are useful to investors because they identify the earnings attributable to the ongoing operations of the business.
Total net income decreased 8% due to lower Asset Management earnings, lower Venture Capital earnings, due to the sale of certain venture capital assets in late 2005, and higher income taxes. These decreases in earnings were partially offset by higher Life and Annuity earnings and lower losses for Corporate and Other. Asset Management earnings decreased due primarily to an intangible asset impairment of $32.5 million in 2006 compared with an impairment of $10.6 million in 2005. Income taxes increased due to a refinement of our estimation process of the dividends received deduction, additional tax expense for certain stock options exercised and tax benefits received in 2005 from the completion of an IRS audit. Corporate and Other losses decreased due to higher investment earnings and lower expenses.
Total net income increased 25% due to higher Life and Annuity earnings offset by lower Asset Management and Venture Capital earnings and a higher loss for Corporate and Other. The decrease in Asset Management was a result of lower revenues due to declines in assets under management, lower performance fees and an intangible asset impairment of $10.6 million. The decrease in Venture Capital resulted from lower portfolio returns in our partnerships. Corporate and Other increased due to higher interest expense on indebtedness plus higher allocated corporate expenses as a result of a change in methodology.
Full year operating earnings for Life and Annuity reflect solid investment margins for life lines of business and continued favorable mortality and persistency. Investment margins for annuities declined modestly in 2006 due primarily to higher investment gains in 2005. In 2006, Life and Annuity benefited from an adjustment, or unlocking, of assumptions primarily related to deferred policy acquisition costs along with related adjustments, which increased operating income before income taxes by $8.2 million. This compares to an unlocking benefit of
$23.8 million in 2005. The effects of the unlocking in 2006 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. As discussed below, the unlocking benefit in 2005 increased deferred policy acquisition cost amortization for the latter part of 2005 and full year 2006.
Insurance and investment product fees increased 25% due principally 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 33% due primarily to higher amortization for universal life resulting from growth of policies in force and the effects of unlocking. The effects of unlocking decreased amortization by $19.1 million in 2006 compared to a decrease of $28.1 million in 2005.
Allocated income taxes increased 32% due primarily to higher operating income before income taxes and the absence of additional tax benefits recorded in 2005 that were associated with the resolution of certain tax matters with the IRS.
Investment income increased 3% due primarily to higher partnership gains and prepayment fees plus higher investment earnings for universal life insurance, from higher funds on deposit and for annuities, from the extension of asset durations and higher interest rates. These increases were particularly offset by lower earnings from the impact of reinvesting bond maturities at lower interest rates.
Policy benefits, including policyholder dividends, decreased 4%. Dividends decreased $24.1 million and policy benefits and changes in reserves decreased $44.6 million. Dividends decreased due primarily to the change in the policyholder dividend obligation, which lowered dividend expense $4.0 million in 2005 compared to 2004 and the reduction in the dividend scale in late 2005. Benefits and changes in reserves decreased due primarily to a reduction of in-force policies for traditional life insurance and lower interest credited, particularly for annuities.
Other operating expenses decreased 9%. Other operating expenses include non-deferrable policy acquisition costs, general and administrative costs and, in 2004, broker-dealer commissions and operating expenses related to our retail affiliated broker-dealer operations. The decrease was due to lower broker-dealer commissions, which resulted from the sale of our retail affiliated broker-dealer operations in May 2004, partially offset by higher expenses due to business growth and investment in product development.
Allocated income taxes increased 41% due primarily to higher operating income before income taxes offset by additional tax credits earned and tax benefits resulting from the completion of an IRS audit.
Annuity funds on deposit increased $335.2 million in 2005 compared to an increase of $354.9 million in 2004 with higher deposits offset by higher surrenders and lower relative performance in 2005. Included in deposits were large private placement deposits in the first and fourth quarters of 2005.
Variable universal life funds on deposits increased by $213.1 million in 2006 compared to an increase of $156.7 million in 2005. This improvement was principally due to higher relative investment performance, partially offset by higher surrenders and benefits and lower deposits in 2006.
Universal life funds on deposit increased $170.0 million in 2006 compared to an increase of $123.4 million in 2005. This improvement was principally due to higher deposits and lower benefits and surrenders, partially offset by higher fees and cost of insurance charges in 2006.
Variable universal life insurance revenue decreased modestly with lower fees being partially offset by higher investment earnings and cost of insurance charges.
Traditional life insurance revenue decreased 6% due primarily 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 14% due principally to lower interest earned as a result of the decline in funds on deposit in general account funds, primarily for discontinued products.
Universal life operating income before income taxes increased 39% due to improved insurance margins from higher cost of insurance fees offset by slightly higher claims, improved investment earnings and a favorable unlocking adjustment. These increases in pre-tax income were partially offset by higher expenses net of deferrals and higher deferred policy acquisition cost amortization from growth of the in-force block, higher margins and, in the second half of 2005, the effects of unlocking.
Traditional life operating income before income taxes increased 5% due primarily to improved investment earnings in participating life insurance, excluding closed block, partially offset by the effects of unlocking, lower earnings in term life insurance from higher non-deferred expenses, and higher claims related to an old block of corporate-owned life insurance. The decrease in premium revenues discussed above is largely offset by lower benefits, changes in reserves and dividends to policyholders.
Investment product fees decreased 12% due primarily to a decrease in average assets under management (excluding money market mutual funds). The retail and institutional investment product fees decreased $7.2 million and $15.6 million, respectively, as a result of the decrease in average assets under management. The structured financial products investment product fees decreased $0.7 million primarily due to lower incentive fees in 2006 versus 2005 associated with liquidations of products. Broker-dealer commissions and distribution fee revenues increased by 13% due to an increased amount of mutual fund assets under management. Approximately 45% of our management fee revenues were based on assets as of the beginning of a quarter, which causes fee revenues to lag behind changes in assets under management.
Sales of retail products in 2006 were $3.7 billion, which were $0.1 billion lower than 2005. There was a 26% increase in mutual fund sales, but this was offset by a 35% decrease in managed account sales. Redemptions from existing accounts were $7.1 billion, a 13% improvement over 2005. Sales of institutional accounts in 2006 were $1.6 billion, a $3.9 billion decrease from 2005. Note that 2005 had one $3.0 billion sale, which made 2005 sales unusually high. Account terminations and withdrawals from existing accounts were $3.5 billion, a 47% improvement over 2005. Sales of structured financial products were $1.4 billion higher in 2006, due to the issuance of three new products in 2006 compared to one new product in 2005. Redemptions for structured products in 2006 were essentially the same amount as 2005. During 2006, three products were liquidated.
Allocated income tax benefits increased $6.0 million primarily as a result of higher segment losses in 2006 compared to 2005.
The decrease in assets under management was due primarily to net outflows of $5.6 billion offset, in part, by positive investment performance of $0.2 billion.
Sales of retail products in 2005 were $3.8 billion, consistent with sales in 2004. Redemptions from existing accounts were $8.2 billion, an increase of 13% over 2004. Sales of institutional accounts in 2005 were $6.5 billion, an increase of 127% over 2004. Account terminations and withdrawals from existing accounts were $7.8 billion, an increase of 28% over 2004. During the third quarter of 2005, one of the collateralized debt obligation trusts we manage, Phoenix-Mistic 2002-1 CDO, Ltd., or Mistic, became callable and was liquidated by its bondholders, which contributed approximately $1.2 billion to the increase in withdrawals.
Two of the three collateralized debt obligation trusts that we consolidate became callable in prior years. The third, Mistic, became callable on September 15, 2005 by its bondholders and was liquidated. As a result of this liquidation, Asset Management recorded approximately $2.2 million of additional fee income in 2005.
In the third quarter of 2005, we performed an interim test for impairment on certain definite-lived intangible assets at one of our reporting units as a result of significant outflows of retail assets during that quarter. In addition, a test for impairment of this unit’s goodwill was also deemed necessary. As a result of these tests, we recorded a $10.6 million pre-tax impairment charge against certain definite-lived intangible assets. No impairment of goodwill was recorded.
Allocated income tax benefits increased $7.0 million primarily as a result of segment losses in 2005 compared to segment income in 2004.
Operating income before income taxes decreased 23% primarily related to the true-up adjustments to partnerships’ audited financial statements from estimated amounts as of December 31, 2004.
The operating loss before income taxes for Corporate and Other increased 18% due primarily to higher allocated corporate expenses and higher interest expense on indebtedness from our surplus notes refinancing transaction in December 2004 and our issuance of notes to finance the KAR acquisition. The decrease in interest income on collateralized debt obligations was fully offset by lower interest and administrative expenses on those collateralized debt obligations.
Debt and Equity Securities Pledged as Collateral and Non-Recourse Collateralized Obligations
Investments pledged as collateral trusts are assets held for the benefit of those institutional clients, which have investments in structured bond products offered and managed by our asset management subsidiary.
During 2003, we implemented a comprehensive, enterprise-wide risk management program. Early in 2004, we appointed a Chief Risk Officer, reporting to the Chief Financial Officer, to oversee all of our risk management activities. We have established an Enterprise Risk Management Committee, chaired by the Chief Executive Officer, to ensure our risk management principles are followed and our objectives are accomplished. In addition, we have established several management committees overseeing and addressing issues pertaining to all our major risks-operational, market and product-as well as capital management.
To calculate duration, we project asset and liability cash flows and discount them to a net present value using a risk-free market rate increased for credit quality, liquidity and any other relevant specific risks. Duration is calculated by revaluing these cash flows at an alternative level of interest rates and by determining the percentage change in fair value from the base case.
The funds in the RPE GIAs decreased by $412.5 million during 2006. We believe most contract holders currently view RPE as an alternative to money market investments and made significant withdrawals in 2006 as money market rates rose significantly above the 3% guaranteed interest rate on the product.
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 $187.1 million in equity securities on our balance sheet as of December 31, 2006. A 10% decline or increase in the relevant equity price would have decreased or increased, respectively, the value of these assets by approximately $18.7 million as of December 31, 2006.
See Note 7 to our consolidated financial statements in this Form 10-K for more information regarding deferred policy acquisition costs.
Our general account debt and equity securities are classified as available-for-sale and are reported at fair value with unrealized gains or losses included in equity. Accordingly, the carrying value of such securities reflects their fair value at the balance sheet date. Fair value is based on quoted market price, where available. When quoted market prices are not available, we estimate fair value for debt securities by discounting projected cash flows based on market 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. Investments whose value, in our judgment, are considered to be other-than-temporarily impaired are written down to fair value as a charge to net realized investment losses included in our earnings. The cost basis of these written-down investments is adjusted to fair value at the date the determination of impairment is made. The new cost basis is not changed for subsequent recoveries in value.
Total net unrealized gains on debt and equity securities were $176.9 million (unrealized gains of $337.4 million less unrealized losses of $160.5 million). Of that net amount, $9.4 million was outside the closed block ($5.9 million after applicable deferred policy acquisition costs and deferred income taxes) and $167.5 million was in the closed block ($0.0 million after applicable policyholder dividend obligation).
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.
a financial condition which suggests that future payments are highly unlikely;
For debt securities outside of the closed block with gross unrealized losses, 86.5% of the unrealized losses after offsets pertain to investment grade securities and 13.5% of the unrealized losses after offsets pertain to below investment grade securities at December 31, 2006.
In determining that the securities giving rise to the previously mentioned unrealized losses were not other-than-temporarily impaired, we considered and evaluated the factors cited above. In making these evaluations, we must exercise considerable judgment. Accordingly, there can be no assurance that actual results will not differ from our judgments and that such differences may require the future recognition of other-than-temporary impairment charges that could have a material effect on our financial position and results of operations. In addition, the value of, and the realization of any loss on, a debt security or equity security is subject to numerous risks, including interest rate risk, market risk, credit risk and liquidity risk. The magnitude of any loss incurred by us may be affected by the relative concentration of our investments in any one issuer or industry. We have established specific policies limiting the concentration of our investments in any single issuer and industry and believe our investment portfolio is prudently diversified.
Cash from continuing operations investing activities decreased due principally 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).
Cash for financing activities increased due primarily to the dissolution of the Mistic CBO, discussed above, and net withdrawals of policyholder deposit funds.
Cash for investing activities increased due to higher capital contributions made to subsidiaries.
PXP pays interest to the holding company on its debt from the holding company. The holding company does not expect to receive dividends from PXP in the near term because this subsidiary will likely use a substantial portion of its cash flows from operations to repay intercompany debt, including debt to the holding company and interest on debt.
On June 6, 2006, we amended and restated our existing $150 million unsecured senior revolving credit facility, dated as of November 22, 2004 (the “Original Facility” and as so amended and restated, the “Amended Facility”). The financing commitments under the Amended Facility will terminate on June 6, 2009. The amendments to the terms of the Original Facility set forth in the Amended Facility include, but are not limited to, (i) the elimination of a $750 million limit on aggregate indebtedness, (ii) the modification of certain covenants and other provisions to permit a monetization or securitization of the closed block of specified life and annuity policies established in the Plan of Reorganization of Phoenix Home Life Mutual Insurance Company, and (iii) the permission of acquisitions and joint ventures which satisfy certain additional specified conditions. These conditions include, among other things, majority lender consent in the event the aggregate amount of consideration payable exceeds $400 million in respect of all acquisitions and joint ventures during the term of the agreement, excluding those to which the lenders have previously provided consent.
We were in compliance with all of our credit facility covenants at December 31, 2006. We obtained a waiver for our requirement to pay down the bank line with equity issuance proceeds in order to simplify the settlement of our existing equity units on February 16, 2006.
Rating agencies assign Phoenix Life financial strength ratings and assign us debt ratings based in each case on their opinions of the relevant company’s ability to meet its financial obligations. Ratings changes may result in increased or decreased interest costs in connection with future borrowings. Such an increase or decrease would affect our earnings and could affect our ability to finance our future growth. Downgrades may also trigger defaults or repurchase obligations. The financial strength and debt ratings as of December 31, 2006 were as follows:
See Note 24 to our consolidated financial statements in this Form 10-K for more information on our contingent liabilities.
Individual life insurance policies, other than term life insurance policies, increase in cash values over their lives. Policyholders have the right to borrow an amount up to a certain percentage of the cash value of their policies at any time. As of December 31, 2006, our Life Companies had approximately $12.3 billion in cash values with respect to which policyholders had rights to take policy loans. The majority of cash values eligible for policy loans are at variable interest rates that are reset annually on the policy anniversary. Policy loans at December 31, 2006 were $2.3 billion.
Cash increased 34% due primarily to cash from operations of $243.9 million and cash from investing operations of $658.9 million offset by cash used by financing activities of $799.4 million. The cash used for financing principally related to net policyholder deposit fund withdrawals of $832.3 million, including a $206.6 million scheduled maturity, and debt repayments of $65.0 million, partially offset by proceeds from the settlement of our equity units.
Deferred policy acquisition costs increased 13% due to the deferral of policy acquisition costs of $329.2 million related primarily to universal life sales and $16.2 million related to the effect of unrealized investment losses included in other comprehensive income, offset by the amortization of deferred policy acquisition costs of $148.7 million.
Indebtedness decreased 9% due to repayments of $25.0 million on the credit facility, $30.2 million for the surplus notes that matured in the fourth quarter of 2006 and $9.8 million on our promissory notes. See Note 11 of our consolidated financial statements in this Form 10-K for detailed information regarding financing activities.
Common stock and additional paid-in capital increased 7% due primarily to the purchase of 17.4 million shares of common stock, in connection with the settlement of the equity units, for $153.7 million.
Future obligations are based on our estimate of future investment earnings, mortality, surrenders and applicable policyholder dividends. Included in the amounts above are policyholder dividends generated by estimated favorable future investment and mortality, in excess of guaranteed amounts for our closed block. Actual obligations in any single year, or ultimate total obligations, may vary materially from these estimates as actual experience emerges. As described in Note 2 to our consolidated financial statements in this Form 10-K, policy liabilities and accruals are recorded on the balance sheet in amounts adequate to meet the estimated future obligations of the policies in force. The policyholder obligations reflected in the table above exceed the policy liabilities, policyholder deposit fund liabilities and separate account liabilities reported on our
December 31, 2006 Consolidated Balance Sheet because the above amounts do not reflect future investment earnings and future premiums and deposits on those policies. Separate account obligations will be funded by the cash flows from separate account assets, while the remaining obligations will be funded by cash flows from investment earnings on general account assets and premiums and deposits on contracts in force.
Other commercial commitments relate to venture capital partnerships ($132.2 million) and private placements ($49.2 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 2007.
We made payments totaling $23.9 million to the pension plan during 2006. We do not expect any required contributions in 2007.
We also have a postretirement benefit plan, which is unfunded and had projected benefit obligations of $(79.0) million and $(72.4) million as of December 31, 2006 and 2005, respectively.
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.
We maintain life reinsurance programs designed to protect against large or unusual losses in our life insurance business. Based on our review of their financial statements, reputations in the reinsurance marketplace and other relevant information, we believe that we have no material exposure to uncollectible life reinsurance.
At December 31, 2006, Phoenix Life’s and each of its insurance subsidiaries’ Total Adjusted Capital levels were in excess of 300% of Company Action Level.
State Farm currently owns of record more than 5% of our outstanding common stock. During the years ended December 31, 2006 and 2005, our subsidiaries incurred total compensation of $50.1 million and $37.6 million, respectively, to entities which were either subsidiaries of State Farm or owned by State Farm employees, for the sale of our insurance and annuity products. During the years ended December 31, 2006 and 2005, we made payments of $49.5 million and $37.6 million, respectively, to State Farm entities for this compensation.