Protection. In the United States, we are a leading provider of life insurance and long-term care insurance, have developed linked benefit products such as long-term care insurance linked with life insurance or an annuity and offer selected senior services and products including Medicare supplement insurance. We also offer group life and health insurance primarily to companies with fewer than 1,000 employees. In January 2007, we announced an agreement to sell the group life and health business and expect to close the transaction in the second quarter of 2007. Outside the U.S., we offer payment protection insurance, which helps consumers meet specified payment obligations should they become unable to pay due to accident, illness, involuntary unemployment, disability or death. For the year ended December 31, 2006, our Protection segment had segment net operating income of $614 million.
net premiums earned on individual life, individual and group long-term care, Medicare supplement insurance, group life and health and payment protection insurance policies;
policy fees and other income, including fees from contract underwriting services.
In 2006, we began to allocate net investment gains (losses) from Corporate and Other to our Protection (except payment protection insurance) and Retirement Income and Investments segments using an approach based principally upon the investment portfolios established to support each of those segments’ products and targeted capital levels. We do not allocate net investment gains (losses) from Corporate and Other to our Mortgage Insurance segment or to our payment protection insurance business within the Protection segment because they have their own separate investment portfolios, and net investment gains (losses) from those portfolios are reflected in the Mortgage Insurance and Protection segment results, respectively.
Interest rate fluctuations. Fluctuations in market interest rates and the related yield curve may have a significant effect on our sales of insurance and investment products and our margins on these products. Interest rates are highly sensitive to many factors, including governmental monetary policies, domestic and international economic and political conditions and other factors beyond our control.
In our Retirement Income and Investments and Protection segments, low market interest rates may reduce the spreads between the amounts we credit fixed annuity and individual life policyholders and contractholders and the yield we earn on the investments that support these obligations. In response to the unusually low interest rates that have prevailed during the last several years, we have reduced the guaranteed minimum crediting rates on newly issued fixed annuity contracts and have reduced crediting rates on in-force contracts where permitted to do so. These actions have helped mitigate the adverse impact of low interest rates on our spreads and profitability on these products. In addition, the recent inverting of the yield curve reduces the attractiveness of certain fixed annuity products relative to other short-term investment alternatives. A gradual increase in longer-term interest rates along with an upwardly sloping yield curve generally will have a favorable effect on the profitability of these products. However, rapidly rising interest rates also could result in reduced persistency in our spread-based retail products as contractholders shift assets into higher yielding investments.
Investment portfolio. Our current investment strategy is to optimize investment income without relying on realized investment gains. Our overall investment yield increased from 5.5% for the year ended December 31, 2004 to 5.6% for the year ended December 31, 2005 and increased to 5.8% for the year ended December 31, 2006. We seek to improve our investment yield by continuously evaluating our asset class mix, pursuing additional investment classes and accepting additional credit risk with higher returns when we believe that it is prudent to do so.
Globalization. Historically, we have derived a majority of our net income from our operations in the U.S. However, in recent years, our international business has grown and has had an increasing impact on our financial condition and results of operations. For the years ended December 31, 2006, 2005 and 2004, 37%, 32% and 29% of our net income from continuing operations, respectively, were generated by our international operations. These increases were largely due to growth in our international mortgage insurance business. We are exposed to the impact of fluctuations in exchange rates as we translate the operating results of our foreign operations into our financial statements. As a result, period-to-period comparability of our results of operations is affected by fluctuations in exchange rates. Our net income for the years ended December 31, 2006, 2005 and 2004 included approximately $12 million, $4 million and $31 million, respectively, due to the favorable impact of changes in foreign exchange rates. Our four principal foreign currencies are the Canadian dollar, the Australian dollar, the British pound and the Euro.
In addition, Regulation AXXX requires insurers to establish additional statutory reserves for certain universal life policies with secondary guarantees. In 2006, we were the first company to issue non-recourse funding obligations to fund statutory reserves required by Regulation AXXX for certain blocks of our universal life business.
We continue to focus on our Income Distribution Series of variable annuity products and riders. We have witnessed a decline in defined benefit retirement plans in favor of defined contribution plans with more of the responsibility for retirement income planning falling on the individual. Additionally, U.S. savings rates are at historical lows. We believe these factors support demand for individual and group retirement income products that provide various forms of guaranteed benefits with the opportunity to realize upside market performance. Our Income Distribution Series provides the contractholder with the ability to receive a guaranteed minimum income stream that they cannot outlive, along with an opportunity to participate in market appreciation. However,
Mortgage insurance. The results of our Mortgage Insurance segment are affected by employment and other economic and housing markets trends, including interest rate trends, home price appreciation, mortgage origination volume and levels of mortgage delinquencies (including seasonal effects). In addition, movements in foreign currency exchange rates affect our international mortgage insurance results.
We believe the U.S. economy overall remains relatively strong based on continued gross domestic product growth and low levels of unemployment. However, we believe the U.S. housing market has slowed and home price appreciation has declined. In particular, certain areas of the Great Lakes region have experienced an economic slowdown and have seen a more pronounced weakness in their housing market as well as a decline in home prices. While our portfolio concentration in the impacted areas is limited to less than 10% of our total risk in-force, these areas of weakness have contributed disproportionately to the increase in our U.S. losses and loss ratio. Continued low home price appreciation may cause further increases in our U.S. losses and loss ratio.
The demand for flow private mortgage insurance declined in the year ended December 31, 2006 as compared to the same period in 2005, according to data published by Inside Mortgage Finance. We believe this was driven principally by the origination of mortgages that did not meet the eligibility requirements of Fannie Mae and Freddie Mac and mortgages that were securitized in mortgage-backed securities that did not use private mortgage insurance, in addition to the continued usage of simultaneous second mortgages as an alternative to private mortgage insurance. However, we believe the usage of simultaneous second mortgages began to decline during 2006 driven by a smaller spread between short-term and long-term interest rates, which reduced the competitive advantage of simultaneous second loans.
As a result of the significant U.S. refinancing activity since 2002 and the expansion of our international business in recent years, as of December 31, 2006, approximately 63% of our U.S. risk in-force and 61% of our international risk in-force have not yet reached its anticipated highest claim frequency years, which are generally between the third and seventh year of the loan. We expect our loss experience on these loans will increase as these books of business continue to mature.
In the second quarter of 2006, the Canadian government passed legislation expanding its authority to guarantee mortgage insurance to cover any Canadian licensed mortgage insurer without the need for further legislation, which may enable potential new competitors to enter the market. The aggregate cap for all Canadian licensed mortgage insurers guaranteed policies was also increased to CDN $200 billion, which facilitates our ongoing ability to offer mortgage insurance products under the guarantee.
GE historically has provided a variety of products and services to us, and we have provided various products and services to GE. In connection with the IPO, we entered into a transition services agreement and various other agreements with GE that, together with a number of agreements that were in effect before the IPO, govern the relationship between GE and us. Many of these agreements were entered into to provide for our transition to a stand-alone company following the IPO. As of December 31, 2006, we no longer utilize any significant services from GE, although we continue to be a party to the following significant financial arrangements as noted below:
UFLIC reinsurance arrangements. Prior to the completion of the IPO, we entered into several significant reinsurance transactions with UFLIC, an indirect subsidiary of GE. For further discussion of our UFLIC reinsurance arrangements, see note 9 to our consolidated financial statements under “Item 8 - Financial Statements and Supplementary Data.”
For information regarding other arrangements with GE, see note 17 to our consolidated financial statements under “Item 8 - Financial Statements and Supplementary Data.”
Valuation of investment securities. We obtain values for actively traded securities from external pricing services. For infrequently traded securities, we obtain quotes from brokers or we estimate values using internally developed pricing models. These models are based upon common valuation techniques and require us to make assumptions regarding credit quality, liquidity and other factors that affect estimated values. We regularly review investment securities for impairment in accordance with our impairment policy, which includes both quantitative and qualitative criteria. Quantitative criteria include length of time and amount that each security position is in an
unrealized loss position, and for fixed maturities, whether the issue r is in compliance with terms and covenants of the security. Qualitative criteria include the financial strength and specific prospects for the issuer as well as our intent to hold the security until recovery. Our impairment reviews involve our finance, risk and asset management teams, as well as the portfolio management and research capabilities of GEAM, and other third-party managers, as required. We actively perform comprehensive market research, monitor market conditions and segment our investments by credit risk in order to minimize impairment risks.
Deferred acquisition costs. DAC represents costs which vary with and are primarily related to the sale and issuance of our insurance policies and investment contracts that are deferred and amortized over the estimated life of the related insurance policies. These costs include commissions in excess of ultimate renewal commissions, solicitation and printing costs, sales material and some support costs, such as underwriting and contract and policy issuance expenses. DAC is subsequently amortized to expense, over the lives of the underlying contracts, in relation to the anticipated recognition of premiums or gross profits.
The amortization of DAC for mortgage insurance is based on expected gross margins. Expected gross margins, defined as premiums less losses, are set based on assumptions for future persistency and loss development of the business. These assumptions are updated quarterly for actual experience to-date or as our expectations of future experience are revised based on experience studies. Due to the inherent uncertainties in making assumptions about future events, materially different experience from expected results in persistency or loss development could result in a material increase or decrease to DAC amortization for this business. For the years ended December 31, 2006 and 2005, key assumptions were unlocked in our Mortgage Insurance segment to reflect our current expectation of future persistency.
The following table sets forth the increase (decrease) on amortization of DAC related to unlocking of key assumptions by segment for the periods indicated:
As of December 31, 2006, we believe all of our businesses have sufficient future income, where the related DAC would be recoverable under adverse variations in morbidity, mortality, withdrawal or lapse rate, maintenance expense or interest rates that could be considered reasonably likely to occur. For the years ended December 31, 2006, 2005 and 2004, there were no material charges to income as a result of our DAC recoverability testing.
We regularly review our assumptions and periodically test PVFP for recoverability in a manner similar to our treatment of DAC.
Valuation of goodwill. Goodwill represents the excess of the amount paid to acquire a business over the fair value of its net assets at the date of acquisition. Subsequent to acquisition, goodwill could become impaired if the fair value of a reporting unit as a whole were to decline below the value of its individual identifiable assets and liabilities. This may occur for various reasons, including changes in actual or expected income or cash flows of a reporting unit, generation of income by a reporting unit at a lower rate of return than similar businesses or declines in market prices for publicly traded businesses similar to our reporting unit.
The initial recognition of goodwill and subsequent testing for impairment require management to make assumptions concerning how the reporting unit will perform in the future. These assumptions are based on our historical experience and our expectations of future performance. Our estimates are subject to change given the inherent uncertainty in predicting future performance and cash flows, which are impacted by such as things as policyholder behavior, competitor pricing, new product introductions and specific industry and market conditions.
The remaining portion of our unearned premiums relates to our payment protection insurance and long-term care insurance businesses where the underlying assumptions as to risk emergence are not subject to significant uncertainty. Accordingly, changes in underlying assumptions as to premium recognition we consider being reasonably likely for these businesses would not result in a material impact on net income.
2006, we have a net deferred tax liability of $1,550 million with a $56 million valuation allowance related to state and foreign gross deferred tax assets. We have a gross deferred tax asset of $239 million related to net operating loss carryforwards of $684 million at December 31, 2006, which, if not used, will expire beginning in 2020.
Premiums. Premiums consist primarily of premiums earned on insurance products for individual life, long-term care, Medicare supplement, group life and health, payment protection, single premium immediate annuities and structured settlements with life contingencies and mortgage insurance policies. Increases from our Mortgage Insurance and Protection segments of $250 million and $73 million, respectively, were offset by decreases in Retirement Income and Investments and Corporate and Other of $119 million and $14 million, respectively. Premiums in our Mortgage Insurance segment increased $250 million reflecting growth and aging of our of our international mortgage insurance in-force block of business and the periodic update and methodology refinements to the Australian and Canadian premium recognition factors. Premiums increased $73 million in our Protection segment primarily due to a $178 million increase in our long-term care business mainly from growth in the in-force block principally driven by new sales and renewal premiums and the Continental Life acquisition, which closed in May 2006. Additionally, our Protection segment increased $115 million primarily from growth in the in-force of our term life insurance and group business. Partially offsetting these increases in the Protection segment was a $220 million decrease from our payment protection business as a result of continued runoff of low return blocks of business, our exit from travel insurance and the reclassification of certain reinsurance assumed business from reinsurance accounting to the deposit method of accounting. Our Retirement Income and Investments segment decreased $119 million primarily attributable to a reduction in our life-contingent structured settlement annuities due to our continued pricing discipline in the current relatively low interest rate environment and our decision in the third quarter of 2006 to discontinue sales of this product.
Net investment gains (losses). Net investment gains losses consist of realized gains and losses from sale or impairment of our investments, unrealized and realized gains and losses from our trading securities, fair value hedging relationships, and embedded derivatives. For the year ended December 31, 2006, gross investment gains were $81 million and gross investment (losses) were ($150) million, including ($8) million of impairments. Gross investment gains for the year ended December 31, 2006 were primarily attributable to $72 million in gains on the sale of available-for-sale fixed maturities and equity securities. Gross investment losses include $118 million of interest rate related losses as a result of the disposition of available-for-sale securities primarily for portfolio repositioning activities, $17 million on the derecognition of assets and liabilities associated with certain securitization entities, and $8 million for impairment charges. For the year ended December 31, 2005, gross investment gains on available-for-sale securities were $108 million and gross investment (losses) on available-for-sale securities were ($110) million, including ($71) million of impairments. The available-for-sale securities impairments related primarily to fixed maturity securities issued by companies in the automotive, transportation, finance and retail industries ($17 million, $16 million, $10 million and $9 million, respectively).
Policy fees and other income. Policy fees and other income consist primarily of cost of insurance and surrender charges assessed on universal life insurance policies, fees assessed against policyholder and contractholder account values, and commission income. The increase in policy fees and other income was
Interest credited. Interest credited represents interest credited on behalf of policyholder and contractholder general account balances. The increase in interest credited from our Retirement Income and Investments segment was primarily due to a $129 million increase related to spread-based institutional products as a result of higher crediting rates on floating rate products, as a result of a generally high short-term interest rate environment, and higher assets under management. This increase was partially offset by a $49 million decrease in interest credited related to spread-based retail products, primarily due to fixed annuities crediting rates being reset to current, lower rates as the fixed annuities reach the end of their initial crediting rate guarantee period. In addition, interest credited increased $12 million in our long-term care insurance business mainly driven by growth in account value of our corporate owned life insurance block of business.
Acquisition and operating expenses, net of deferrals. Acquisition and operating expenses, net of deferrals, represent costs and expenses related to the acquisition and ongoing maintenance of insurance and investment contracts, including commissions, policy issuance expenses and other underwriting and general operating costs. These costs and expenses are net of amounts that are capitalized and deferred, which are primarily costs and expenses that vary with and are primarily related to the sale and issuance of our insurance policies and investment contracts, such as first-year commissions in excess of ultimate renewal commissions and other policy issuance expenses. Acquisition and operating expenses, net of deferrals, increased primarily from a $53 million increase in our long-term care business growth of in-force and the Continental Life acquisition. In addition, our Fee-based products in our Retirement Income and Investments segment increased $67 million primarily due to higher sales and growth in assets under management. These increases were partially offset by a $64 million decrease in our payment protection business and a decline of $27 million in our Corporate and Other.
Amortization of deferred acquisition costs and intangibles. Amortization of deferred acquisition costs and intangibles consists primarily of the amortization of acquisition costs that are capitalized, PVFP and capitalized software. Amortization of deferred acquisition costs and intangibles decreased as a result of a $109 million decrease in our Protection segment primarily attributable to an $88 million decrease in our payment protection insurance business and a $12 million decrease in our life insurance business. The decrease in our payment
Provision for income taxes. The effective tax rate decreased to 31.0% for the year ended December 31, 2006 from 32.1% for the year ended December 31, 2005. This decrease in effective tax rate was primarily attributable to favorable examination developments, a reduction in excess foreign tax credits and an increase in lower taxed foreign earnings in 2006.
Net operating income. The increase in net operating income reflects increases in our Protection and Mortgage Insurance segments net operating income, offset by decreases in Retirement Income and Investments and Corporate and Other net operating income, as discussed in the “-Results of Operations by Segment.” Included in net operating income is a $12 million, net of tax, increase attributable to favorable changes in foreign exchange rates.
Net investment income. Net investment income decreased as a result of a decrease in average invested assets, primarily due to the transfer of assets to UFLIC in connection with the reinsurance transactions, partially offset by new asset purchases. The decrease in net investment income was partially offset by an increase in weighted average investment yields to 5.6% for the year ended December 31, 2005 from 5.5% for the year ended December 31, 2004. The increase in weighted average investment yields was primarily attributable to a $32 million release of commercial mortgage loan reserves, higher derivative and limited partnership income, partially offset by purchases of new assets in an interest rate environment where current market yields were lower than existing portfolio yields.
Policy fees and other income. Policy fees and other income decreased primarily due to a $104 million decrease in our Affinity segment resulting from our corporate formation in 2004. Also contributing to the decrease was a $36 million decrease in Corporate and Other primarily attributable to a gain recorded in 2004 related to our waiver of contractual rights under an outsourcing services agreement with GE’s global outsourcing provider, 60% of which was sold in 2004. Our Retirement Income and Investments segment also experienced a $27 million decrease primarily attributable to the reinsurance transactions with UFLIC, partially offset by increased product fees, management fees, commissions earned and other fees driven by the growth in assets under management.
Interest credited. The decrease was primarily driven by a $14 million decrease in our Retirement Income and Investments segment primarily attributable to the reinsurance transactions with UFLIC, partially offset by an increase in interest credited on floating rate products driven by higher average interest crediting rates in 2005 due to an increase in the short-term interest rates.
We offer U.S. customers life insurance, long-term care insurance, linked benefit products, Medicare supplement insurance and, primarily for companies with fewer than 1,000 employees, group life and health insurance. In Europe, we offer payment protection insurance in over 15 countries, which helps consumers meet their payment obligations in the event of illness, involuntary unemployment, disability or death. Effective January 1, 2006, our Mexico-domiciled subsidiary, previously included in Corporate and Other, is now being managed within our Protection segment and whose results are now included as part of the payment protection insurance business for the years ended December 31, 2006, 2005 and 2004.
The following table sets forth the results of operations relating to our Protection segment. Prior to our corporate formation, we entered into several significant reinsurance transactions with UFLIC in which we ceded to UFLIC a block of long-term care insurance policies that we reinsured from Travelers in 2000, and we assumed from UFLIC in-force blocks of Medicare supplement insurance policies. The Travelers long-term care block was ceded to UFLIC in connection with our corporate formation on May 24, 2004, and its results are not included after that date. Similarly, the Medicare supplement blocks were assumed from UFLIC in connection with our corporate formation on May 24, 2004, and its results are included after that date. As a result of the foregoing, our results of operations for the years ended December 31, 2006 and 2005 are not comparable to this segment’s results of operations for the year ended December 31, 2004.
The following table sets forth net operating income for the products included in our Protection segment:
Our long-term care business net operating income in 2006 benefited from $8 million, net of tax, from reserve and other adjustments and $11 million from the Continental Life acquisition. We benefited in 2005 from an $18 million, net of tax, reserve and other adjustments. Net operating income in our life insurance business for 2005 was reduced by an $8 million unfavorable adjustment, net of tax, on reinsured term life insurance policies.
The increase in net investment income was primarily the result of growth of our long-term care in-force block and an increase in assets purchased using proceeds from our issuance of non-recourse funding obligations supporting certain term and universal life insurance policies. Net investment income also includes an $1 million
increase attributable to changes in foreign exchange rates in our payment protection insurance business. The increase in the payment protection business also included $22 million attributed to the reinsurance accounting change.
Policy fees and other income increased $8 million attributable to $8 million in our long-term care insurance business and $8 million in our life insurance business, offset by $4 million decreases in our group and payment protection insurance businesses. The decrease in our group insurance business was related to an expected drop in lives from exiting a third-party administrator business. The decrease in our payment protection business was largely due to the reinsurance accounting change of $8 million. The increase in our life insurance business was largely due to growth of our universal life insurance products. Partially offsetting this was a $13 million decrease related to an adjustment in unearned revenue in 2006, a $9 million increase related to an adjustment to unearned revenue on a closed block of non-standard business in 2005, and a $12 million decrease related to an adjustment on a reinsured block of term life insurance policies in 2005. The increase in our long-term care insurance business for 2006 is primarily the result of a $6 million reclassification from premiums.
Benefits and other changes in policy reserves increased $249 million attributable to a $244 million increase in our long-term care insurance business, a $52 million increase in our life insurance business and a $29 million increase in our group insurance business, partially offset by a decrease of $76 million in our payment protection business. The increase in our long-term care insurance business was the result of aging and growth of the in-force block, continued low termination rates on older issued policies, some with expiring reinsurance coverage, and also included a $80 million increase from the Continental Life acquisition which closed in May 2006. The increase in our life insurance business was due mainly to growth of our term and universal life in-force that was partially offset by continued favorable mortality in 2006. The increase in our group insurance business was principally driven by growth and higher claims in our non-medical insurance products and individual voluntary products. The decrease in our payment protection insurance business was largely due to a decrease of $26 million related to the reinsurance accounting change and a reduction of claims in our run-off block of business within the U.K., offset by a $2 million increase attributable to changes in foreign exchange rates.
Our long-term care business benefits and other changes in policy reserves also included reserve adjustments in both years. 2006 includes a $27 million decrease due to a favorable adjustment related to group long-term care policies. 2005 included $35 million of net favorable reserve adjustments.
Interest credited increased $15 million principally from $12 million in our long-term care insurance business driven by growth in account value of our corporate owned life insurance block of business.
Acquisition and operating expenses, net of deferrals, decreased $11 million driven by decreases of $64 million in our payment protection insurance business and $8 million in our group insurance business, offset by a $53 million increase from our long-term care insurance business and an $8 million increase from our life insurance business. The increase in our long-term care insurance business was largely the result of growth of the in-force block, $17 million from the Continental Life acquisition and $8 million increase related to a reinsurance adjustment in 2006. The increase in our life insurance business was primarily due to 2005 expense favorability that did not recur in 2006. The decrease in our payment protection insurance business was principally from the $13 million reinsurance accounting change and our run-off block and included a $6 million increase attributable to changes in foreign exchange rates. In addition, there was a decrease of $13 million due to the release of a contingent liability resulting from the settlement reached with one of our distribution relationships.
Amortization of deferred acquisition costs and intangibles decreased $109 million largely the result of a $88 million decrease in our payment protection insurance business and a $12 million decrease in our life insurance
Amortization in our life insurance business for 2006 included decreases in our universal life insurance products of $7 million due to an unearned revenue adjustment and $7 million associated with revisions to estimated gross profit assumptions. Amortization for 2005 also included a $10 million adjustment in our universal life product.
The effective tax rate decreased to 33.8% for the year ended December 31, 2006 from 35.8% for the year ended December 31, 2005. This decrease in effective tax rate was primarily attributable to a reduction in excess foreign tax credits, an increase in lower taxed foreign earnings and favorable examination developments in 2006.
The increase in life insurance net income was primarily attributable to growth of the in-force block, lower claims experience and improved universal life insurance investment spreads. The increase in our payment protection insurance net income business was attributable to an increase resulting from growth of our continental European business and $3 million attributable to changes in foreign exchange rates. Net income in our long-term care business benefited from growth of the in-force block, which was more than offset by lower than expected terminations and lower portfolio yields. In addition, our long-term care business benefited from reserve corrections, which were offset in part by strengthening of certain claim reserves.
Premiums decreased primarily as a result of a $104 million decrease in the payment protection business. This decrease was due to a decrease of $295 million in the U.K. market partially offset by a $163 million increase in continental Europe and an increase of $29 million attributable to changes in foreign exchange rates. The decrease in the U.K. market was attributable to the continued runoff of low return blocks of business. The increase in continental Europe was attributable to the growth due to new distribution relationships and the growth of consumer lending in those markets. The decrease was partially offset by a $54 million increase in our life insurance business primarily related to growth of the term life insurance in-force blocks and a $36 million increase in our group business that was due to growth of the non-medical in-force blocks. Our long-term care business increased modestly as growth in the in-force block was partially offset by an $83 million decrease attributable to the reinsurance transactions with UFLIC.
The increase in net investment income, which included $2 million due to changes in foreign exchange rates, was primarily the result of an increase in average invested assets, partially offset by declining yields on investments. The increase in average invested assets was primarily the result of new assets backing growth of our long-term care in-force block and an increase related to assets purchased using proceeds from our issuance of non-recourse funding obligations supporting certain term life insurance policies. This increase was partially offset by a decrease of $46 million as a result of a decline in average invested assets related to the reinsurance
transactions with UFLIC and a runoff block of payment protection business in Europe. The decrease in weighted average investment yields was attributable to purchases of new assets in an interest rate environment where current market yields are lower than existing portfolio rates as well as investments in floating-rate securities from proceeds of our issuance of non-recourse funding obligations related to our term life insurance capital management strategy.
Benefits and other changes in policy reserves increased primarily due to a $30 million increase in our life business primarily due to growth of term life in-force block and less favorable universal life mortality offset in part by favorable term life mortality, and a $24 million increase in our group business primarily due to growth of the in-force blocks. The increases were partially offset by a $30 million decrease in our payment protection business. The decrease was primarily attributable to a decrease in claims in our runoff business, partially offset by $4 million attributable to changes in foreign exchange rates. Our long-term care business decreased $18 million attributable to a $102 million decrease related to the reinsurance transactions with UFLIC, and a $40 million correction of reserves related to a long-term care policy rider which had been incorrectly coded in our policy valuation system. These decreases were partially offset by an increase of $101 million primarily attributable to lower policy terminations and an increase associated with the aging of the in-force block. Additionally, our long-term care business had a $23 million increase relating to the strengthening of certain claim reserves.
Acquisition and operating expenses, net of deferrals, increased primarily due to a $117 million increase in our payment protection business. This increase was due to an increase in commissions and other expenses in our runoff block and an increase of $11 million attributable to changes in foreign exchange rates. Our long-term care business increased $24 million due to higher non-deferrable acquisition costs partially offset by a $17 million decrease related to the reinsurance transactions with UFLIC. Our life business increased $17 million primarily due to higher non-deferrable acquisition costs related to growth of new business sales.
The following table sets forth selected operating performance measures regarding our life insurance products as of or for the dates indicated:
Term life insurance. The increase in term life insurance net earned premiums and insurance in-force was primarily due to growth of the in-force block of business as a result of an additional layer of annualized first-year premium from the current and prior year. Annualized first-year premiums were flat as a result of increased price competition and a shift to universal life products by our distribution customers.
Term life insurance. The increase in term life insurance in-force during 2005 was primarily due to net growth of the in-force block as a result of increased competitiveness of our product offerings. This increase was
also the primary driver for the increase in term life insurance net earned premiums. Term life annualized first year premiums increased as a result of competitive pricing, our expanded distribution and consistent service performance.
The following table sets forth selected operating performance measures regarding our long-term care insurance business, which includes individual and group long-term care insurance, Medicare supplement insurance, as well as several runoff blocks of accident and health insurance and corporate-owned life insurance for the periods indicated:
The increase in annualized first-year premiums was primarily due to growth in Medicare supplement product sales driven by the Continental Life acquisition and growth in individual long-term care sales primarily from our independent sales channel where we have placed greater focus for our future growth.
We offer U.S. customers fixed annuities, individual variable annuities, group variable annuities designed for retirement plans, single premium immediate annuities, variable life insurance, specialized products, including GICs, funding agreements and FABNs, and asset management products and services. In 2007, we began offering a GMTN program to target primarily non-U.S. investors.
Segment net operating income from spread-based retail products decreased $32 million primarily due to an increase in DAC amortization resulting from higher lapses on fixed annuities, unfavorable mortality on life-contingent annuities, lower assets under management from withdrawals of older pre-2004 issued blocks of business outpacing new deposits. We continue to experience the runoff of older pre-2004 issued blocks as initial bonus crediting rates are being reset to lower rates. The decrease in net operating income was also the result of lower net investment income in 2006 as a result of bond calls, mortgage loan prepayments, derivative income and less favorable release of our commercial mortgage loan loss provision in 2006.
Segment net operating income from fee-based products increased $17 million principally as a result of growth in assets under management, the acquisition of AssetMark, and income tax benefits from dividends received deductions.
Benefits and other changes in policy reserves decreased primarily as a result of a $150 million decrease in life-contingent structured settlement annuities due to our continued pricing discipline in the current relatively low interest rate environment and our decision in the third quarter of 2006 to discontinue sales of this product. These decreases were partially offset by a $60 million increase in life-contingent single premium immediate annuities driven largely by higher sales. Also partially offsetting the decrease is unfavorable mortality experience, primarily on our older blocks, resulting in lower amounts of reserves released upon deaths in 2006 compared to 2005.
The increase in interest credited was principally due to a $129 million increase from spread-based institutional products as a result of higher crediting rates on floating rate products and higher assets under management. This increase was partially offset by a $49 million decrease in interest credited on fixed annuities associated with surrenders outpacing sales and crediting rates being reset to current, lower rates as the fixed annuities reach their initial crediting rate guarantee period.
The increase in acquisition and operating expenses, net of deferrals, was primarily from increased expenses of $68 million associated with higher sales and growth in assets under management in fee-based products. This was partially offset by $11 million of lower expenses associated with our deferred annuities.
The effective tax rate decreased to 29.0% for the year ended December 31, 2006 from 29.8% for the year ended December 31, 2005. This decrease in the effective tax rate was primarily attributable to favorable examination developments and an increase in benefits from dividends received deductions, including a change in prior year estimate, partially offset by an increase in state income taxes.
The effective tax rate decreased to 29.8% for the year ended December 31, 2005 from 35.4% for the year ended December 31, 2004. This decrease in the effective tax rate was primarily attributable to favorable examination developments in 2005.
Fixed annuities. Surrenders have outpaced sales as initial bonus crediting rates have begun to enter their rate reset period resulting in lower crediting rates. In addition, the recent flat-to-inverted yield curve has reduced the attractiveness of certain fixed annuities relative to investment alternatives, such as certificates of deposit. These
Single premium immediate annuities. The account value net of reinsurance increased for 2005 primarily due to the interest credited on the account value for each year.
(1) “Surrenders and benefits” include contracts that have matured but are redeposited with us and reflected as deposits. In the years ended December 31, 2006, 2005 and 2004, surrenders and deposits included $475 million, $1,378 million and $927 million, respectively, that was redeposited and reflected under “Deposits.”
Income Distribution Series. We experienced an increase in assets under management attributable to the launch of our guaranteed minimum withdrawal for life benefit rider in the fourth quarter of 2005. Sales of this product remained strong during 2006, achieving the highest quarterly production to date in the fourth quarter of 2006.
Managed money. Managed money includes third-party assets managed by Genworth Financial Asset Management, AssetMark and Genworth Financial Advisers. The increase in these assets was primarily due to the acquisition of AssetMark and core growth in managed money accounts from new and existing clients, as well as favorable equity market performance. Additional growth in deposits was the result of the expansion of our distribution network, growth in our sales force, and changes in our fee structure. We acquired AssetMark, an investment management and advisor company with more than $9 billion in third-party assets under management in October 2006.
In the U.S., Canada, Australia, Europe, New Zealand, Mexico and Japan, we offer mortgage insurance products that facilitate homeownership by enabling borrowers to buy homes with low-down-payment mortgages. Additionally, we offer mortgage related services for our financial services customers. These products generally also aid financial institutions in managing their capital efficiently by reducing the capital required for low down-payment mortgages.
Our international mortgage insurance premiums increased by $211 million, $19 million of which was attributable to changes in foreign exchange rates, driven by the growth and aging of our international in-force block of business. The increase included a $60 million release of unearned premium in the fourth quarter of 2006 as a result of a periodic update and methodology refinements to the Australian and Canadian premium recognition factors. Premiums in 2005 included a $10 million release of unearned premium in the first quarter due to the completion of a European cancellation study. The increase in our U.S. mortgage insurance business of $39 million was primarily attributable to an increase of $19 million from premiums assumed from our international mortgage insurance business through our intra-segment reinsurance and capital maintenance arrangement as well as growth in primary insurance in-force.
Policy fees and other income decreased by $14 million primarily due to lower contract underwriting fees in our U.S. mortgage insurance business and the elimination of Canadian application fees in our international mortgage insurance business.
Our international mortgage insurance benefits and other changes in policy reserves increased $107 million, including a $3 million increase attributable to changes in foreign exchange rates. This increase was primarily driven by a $34 million increase from a periodic update of loss reserve factors in Australia, higher losses in Australia reflecting the seasoning of more recent in-force blocks of business, increased losses from a limited number of Australian distribution relationships and $9 million of favorable adjustments in 2005 that did not recur. The increase in our U.S. mortgage insurance business of $24 million was primarily attributable to an increase in our average reserve per delinquency associated with higher loan balances in more recent books of business and aging of delinquent loans. This was partially offset by $10 million in paid claims favorability and a decrease in reserves for severely impacted areas associated with Hurricanes Katrina and Rita.
Acquisition and operating expenses, net of deferrals decreased in our U.S. mortgage insurance business primarily driven by continued productivity initiatives and other expense reductions and lower contract underwriting volume. Acquisition and operating expenses, net of deferrals in our international mortgage insurance business increased as a result of continued investment in our existing international mortgage insurance platforms and potential new international platforms as well as a $3 million increase attributable to changes in foreign exchange rates.
Amortization of deferred acquisition costs and intangibles increased $5 million primarily due to growth and seasoning of our insurance in-force in our international mortgage insurance business and $3 million associated with a periodic update and methodology refinements to the Australian premium recognition factors. This was partially offset by an acceleration of amortization of deferred acquisition costs in 2005 related to low persistency rates in our U.S. mortgage insurance business that did not recur in 2006.
2006 from 28.3% for the year ended December 31, 2005. This decrease in effective tax rate was primarily attributable to the reduction in excess foreign tax credits and the increase in lower taxed foreign earnings, largely offset by nonrecurring favorable examination developments in 2005 and a decrease in tax-exempt investment income in proportion to pretax income.
The increase in our U.S. mortgage insurance business net operating income of $14 million was driven primarily by an increase in contract underwriting fees, a reduction in losses, $10 million of additional operating income related to intra-segment reinsurance and capital maintenance agreements with our international mortgage insurance business and a lower effective tax rate primarily due to favorable tax examination developments. Partially offsetting these items was a decline in premiums earned due to the runoff of insurance in-force. The increase in our international mortgage insurance business operating income of $67 million, including $18 million due to changes in foreign exchange rates, was driven primarily by the growth of the business and seasoning of our insurance in-force, offset partially by continued investments in our global expansion. Also included in international operating income was $6 million after-tax as a result of the release of unearned premium reserves on our single premium product relating to the completion of an European cancellation study in the first quarter of 2005, $6 million after-tax decrease in losses due to an adjustment to paid claims and a reserve factor update and the impact of increased reinsurance premiums ceded to our U.S. mortgage business.
In our international mortgage insurance business, premiums increased by $95 million, including $26 million due to changes in foreign exchange rates, driven by the growth and aging of our international in-force block, which resulted in increased earned premiums from new insurance written in prior years. Included in our international premiums was $10 million related to the release of unearned premium reserves on our single premium product due to the completion of a European cancellation study in the first quarter of 2005 and the impact of increased premiums ceded to our U.S. business of $12 million due to a reinsurance support agreement. The increase in international premiums was offset, in part, by a $13 million decrease in U.S. mortgage insurance premiums as a result of the continued decline in our in-force block due to an excess of policy cancellations over new insurance written. Also included in our U.S. premiums was the impact of increased international reinsurance premiums assumed.
Benefits and other changes in policy reserves decreased primarily due to a $10 million decline in losses in our U.S. mortgage insurance business, primarily driven by favorable developments in reserves per delinquency. Included in the year ended December 31, 2006, was a favorable adjustment to reserves on our prime bulk business of $5 million offset by an increase in losses for severely impacted areas associated with Hurricanes Katrina and Rita of $5 million. The reserve impact associated with Hurricanes Katrina and Rita was based on preliminary estimates from available information and may be affected by factors such as the pace of economic recovery in the affected areas. Accordingly, this reserve may change as new information becomes available. The U.S. decline was partially offset by a $7 million increase in our international mortgage business, $3 million of which was attributable to changes in foreign exchange rates. The international increase was primarily due to in-force growth and normal seasoning offset by a $9 million decrease in losses resulting primarily from favorable loss development as a result of updating loss development factors.
The following tables set forth selected operating performance measures regarding our U.S. and international mortgage businesses as of or for the dates indicated:
The increases in primary insurance in-force and risk in-force were driven primarily by new insurance written in our international mortgage insurance business as we continue to execute our global expansion strategy and from higher policy persistency combined with new insurance written in our U.S. mortgage insurance business. Our U.S. flow persistency was 73% and 65% for the years ended December 31, 2006 and 2005, respectively. We believe that sustained higher interest rates, increased persistency and our ongoing growth strategy will lead to stable to growing levels of insurance in-force. Primary insurance in-force in our U.S. mortgage insurance business increased from $100 billion as of December 31, 2005 to $113 billion as of December 31, 2006. This increase in primary insurance in-force reflects an increase in our bulk product writings and the first year-over-year increase in flow insurance in-force in 5 years.
Our businesses in Australia, New Zealand and Canada currently provide 100% coverage on the majority of the loans we insure in those markets. For the purpose of representing our risk in-force, we have computed an “effective risk in-force” amount, which recognizes that the loss on any particular loan will be reduced by the net proceeds received upon sale of the property. Effective risk in-force has been calculated by applying to insurance in-force a factor that represents our highest expected average per-claim payment for any one underwriting year over the life of our businesses in Australia, New Zealand and Canada. For the years ended December 31, 2006 and 2005, this factor was 35%.
For the year ended December 31, 2006, the increase in net premiums written was primarily due to increases in new insurance written in our international mortgage insurance business. The increase in our international business, which included an increase of $29 million attributable to changes in foreign exchange rates, was primarily the result of new insurance written growth in our Canadian and European businesses. The increase in net premiums written in our U.S. mortgage insurance business of $49 million was principally from increased reinsurance premiums assumed from our international mortgage insurance business, growth in primary insurance in-force and higher sales of our single premium product.
Most of our international mortgage insurance policies provide for single premiums at the time that loan proceeds are advanced. We initially record the single premiums to unearned premium reserves and recognize the premiums earned over time in accordance with the expected pattern of risk emergence. As of December 31, 2006, our unearned premium reserves in our international mortgage insurance business increased to $2.3 billion from $1.8 billion as of December 31, 2005.
For the year ended December 31, 2006, the increase in new insurance written was driven by both our U.S. and international mortgage insurance businesses. International new insurance written increased $17.9 billion, which included an increase of $1.4 billion attributable to changes in foreign exchange rates. The increase in international new insurance written was primarily due to growth in international flow new insurance written which was the result of the ongoing expansion of our customer base in Europe, continued account penetration in Canada, and strong sales by key customers in Australia. U.S. new insurance written increased $12.0 billion primarily due to an increase in our bulk product writings and a modest increase in flow new insurance written.
The increase in primary insurance in-force and risk in-force during 2005 was driven primarily by new insurance written in our international business, as we continue to execute our global expansion strategy. Offsetting strong international increases in insurance in-force and risk in-force was a decline in our U.S. business. This decline was driven by continued low persistency rates, which have caused policy cancellations to exceed new insurance written.
The increase in net premiums written during 2005 was driven primarily by increases in new insurance written in our international business, partially offset by a decline in our U.S. net premiums written due to lower levels of insurance in-force. The increase in our international business during 2005 of $100 million, which includes $43 million of favorable foreign exchange movements, was primarily driven by new insurance written growth in our Australian and European businesses.
The expense ratio is the ratio of general expenses to net premiums written. In our business, general expenses consist of acquisition and operating expenses, net of deferrals, and amortization of deferred acquisition cost and intangibles.
For the year ended December 31, 2006, our U.S. loss ratio increased 3 percentage points primarily driven by an increase in our average reserve per delinquency associated with higher loan balances in more recent books of business and aging of delinquent loans. The international loss ratio increased 14 percentage points principally from higher losses in Australia reflecting the seasoning of more recent in-force blocks of business and increased losses from a limited number of Australian distribution relationships.
During the fourth quarter of 2006, we performed a periodic update of our Australian loss reserve factors as well as our Australian and Canadian premium recognition factors. These updates also included certain methodology refinements. The effect of this update was to increase our reserve for losses in Australia by $34 million and to accelerate the recognition of earned premium in Canada and Australia by $60 million in total. Excluding the effect of these updates, our international loss ratio was 20% in 2006.
During 2005, our loss ratio declined primarily due to loss favorability in our U.S. business and favorable reserve adjustments as a result of updating our loss development factors in our international business. Our international loss ratio, without the impact of favorable adjustments in 2005, would have increased modestly as a result of in-force growth and normal seasoning.
Our default management process begins with notification by the loan servicer of a default on an insured loan. “Default” is defined in our master policies as the borrower’s failure to pay when due an amount equal to the scheduled monthly mortgage payment under the terms of the mortgage. Generally, the master policies require an insured to notify us of a default no later than ten days after the borrower has been in default by three monthly payments. In most cases, however, defaults are reported earlier. We generally consider a loan to be in default and establish reserves if the borrower has failed to make a required mortgage payment. Borrowers default for a variety of reasons, including a reduction of income, unemployment, divorce, illness, inability to manage credit and interest rate levels. Borrowers may cure defaults by making all of the delinquent loan payments or by selling the property in full satisfaction of all amounts due under the mortgage. In most cases, defaults that are not cured result in a claim under our policy.
Primary insurance default rates differ from region to region in the U.S. at any one time depending upon economic conditions and cyclical growth patterns. The two tables below set forth our primary default rates for the various regions of the U.S. and the ten largest states by our risk in-force as of December 31, 2006. Default rates are shown by region based upon the location of the underlying property, rather than the location of the lender. We believe that increases in the 2005 default rates for the South Central and Southeast regions reflect increased delinquencies associated with Hurricanes Katrina and Rita. However, this did not have a material impact on our 2005 or 2006 results of operations.
The frequency of defaults may not correlate directly with the number of claims received because the rate at which defaults are cured is influenced by borrowers’ financial resources and circumstances and regional economic differences. Whether an uncured default leads to a claim principally depends upon the borrower’s equity at the time of default and the borrower’s or the insured’s ability to sell the home for an amount sufficient to satisfy all amounts due under the mortgage loan. When we receive notice of a default, we use a proprietary model to determine whether a delinquent loan is a candidate for work out. When the model identifies such a candidate, our loan workout specialists prioritize cases for loss mitigation based upon the likelihood that the loan will result in a claim. Loss mitigation actions include loan modification, extension of credit to bring a loan current, foreclosure forbearance, pre-foreclosure sale, and deed-in-lieu. These loss mitigation efforts often are an effective way to reduce our claim exposure and ultimate payouts.
Claim activity is not spread evenly throughout the coverage period of a primary insurance book of business. Based upon our experience, the majority of claims on primary mortgage insurance loans occur in the third through seventh years after loan origination, and relatively few claims are paid during the first two years after loan origination. Primary insurance written from the period from January 1, 1999 through December 31, 2003 represented 34% of our primary insurance in-force as of December 31, 2006. This portion of our loan portfolio is in its expected peak claim period with respect to traditional primary loans. We believe our “A minus” and “sub-prime” loans will have earlier incidences of default than our prime loans. “A minus” and “sub-prime” loans represented 11.2% and 10.4% of our primary risk in-force as of December 31, 2006 and 2005, respectively.
Primary mortgage insurance claims paid, including loss adjustment expenses, for the year ended December 31, 2006 were $135 million, compared to $145 million and $146 million for the years ended December 31, 2005 and 2004, respectively. Pool insurance claims paid were $1 million for each of the years ended December 31, 2006, 2005 and 2004.
The ratio of the claim paid to the current risk in-force for a loan is referred to as “claim severity.” The current risk in-force is equal to the unpaid principal amount multiplied by the coverage percentage. The main determinants of claim severity are the age of the mortgage loan, the value of the underlying property, accrued interest on the loan, expenses advanced by the insured and foreclosure expenses. These amounts depend partly upon the time required to complete foreclosure, which varies depending upon state laws. Pre-foreclosure sales, acquisitions and other early workout efforts help to reduce overall claim severity. Our average primary mortgage insurance claim severity was 97%, 95% and 94% for the years ended December 31, 2006, 2005 and 2004, respectively.
Our businesses in Australia, New Zealand and Canada currently provide 100% coverage on the majority of the loans we insure in those markets. The table above presents effective risk in-force, which recognizes the loss on any particular loan will be reduced by the net proceeds received upon sale of the property. Effective risk in-force has been calculated by applying to insurance in-force a factor that represents our highest expected average per-claim payment for any one underwriting year over the life of our businesses in Australia, New Zealand and Canada. As of December 31, 2006, this factor was 35%.
The following table sets forth the historical results of operations relating to the Affinity segment. Because we did not acquire any of the Affinity segment businesses from GEFAHI in our corporate formation, this segment’s results of operations are included in our results of operations only for periods through May 24, 2004 and are not included in our financial information.
Yields for fixed maturities and equity securities are based on amortized cost and cost, respectively. Yields for securities lending activity, which is included in other investments, are calculated net of the corresponding
securities lending liability. All other yields are based on average carrying values. Bond calls, prepayments and release of commercial mortgage loan loss reserves were $51 million, $85 million and $57 million for the years ended December 31, 2006, 2005 and 2004, respectively.
The 2006 increase in overall investment yields was primarily attributable to increased yields on floating rate investments backing spread-based institutional products reflecting the higher short-term interest rate environment. The 2005 increase in overall investment yields was primarily attributable to a $32 million fourth quarter adjustment of our commercial mortgage loan loss reserves, higher derivative income from non-qualifying hedges and limited partnership income, partially offset by purchases of new assets in an interest rate environment where current market yields were lower than existing portfolio yields.
During 2005, we adjusted our process for estimating credit losses in our commercial mortgage loan portfolio. As a result of this adjustment, we released $32 million ($19 million net of deferred acquisition costs and of tax) of commercial mortgage loan reserves to net investment income in the fourth quarter of 2005. During 2006, we reduced our reserve for commercial loan losses from $31 million to $15 million reflecting continued strong credit performance in this portfolio.
Included in other investments are certain securities that are designated as trading and, accordingly, are held at fair value with changes in fair value included in net investment gains (losses) in the consolidated statement of income. As of December 31, 2006 and 2005, the fair value of the trading portfolio was $107 million and $15 million, respectively.
For fixed maturities, we recognize an impairment charge to income in the period in which we determine that we do not expect either to collect principal and interest in accordance with the contractual terms of the instruments or to recover based upon underlying collateral values, considering events such as a payment default, bankruptcy or disclosure of fraud. For equity securities, we recognize an impairment charge in the period in which we determine that the security will not recover to book value within a reasonable period. We determine what constitutes a reasonable period on a security-by-security basis based upon consideration of all the evidence available to us, including the magnitude of an unrealized loss and its duration. In any event, this period does not exceed 18 months for common equity securities. We measure impairment charges based upon the difference between the book value of a security and its fair value. Fair value is based upon quoted market price, except for certain infrequently traded securities where we estimate values using internally developed pricing models. These models are based upon common valuation techniques and require us to make assumptions regarding credit quality, liquidity and other factors that affect estimated values.
The investment securities in an unrealized loss position as of December 31, 2006 consisted of 2,777 securities accounting for unrealized losses of $590 million. Of these unrealized losses 93.4% were investment grade (rated AAA through BBB-) and 97.6% were less than 20% below cost. The amount of the unrealized loss on these securities was primarily attributable to increases in interest rates.
The fair value of derivative instruments, including financial futures, interest rate and foreign currency swaps and equity index options, are based upon pricing valuation models which utilize independent third-party data as inputs. The following table sets forth our positions in derivative instruments and the estimated fair values as of the dates indicated:
The increase in the notional value of derivatives during 2006 was primarily due to a forward starting interest rate swap program with a notional value totaling $8.5 billion to hedge the cash flows of forecasted transactions related to our long-term care business within our Protection segment. In addition, we entered into interest rate swaps with notional value of $0.9 billion to convert fixed rate liabilities into floating rate liabilities consistent with the overall asset-liability management for our FABN business within our Retirement Income and Investments segment.
Cash flows from operating activities are affected by the timing of premiums received, fees received, investment income and expenses paid. Principal sources of cash include sales of our products and services. The increase in cash flows for the year ended December 31, 2006 from operating activities was primarily the result of the timing of cash settlement for other assets and other liabilities.
Changes in cash from financing activities primarily relate to the issuance and repayment of borrowings, dividends to our stockholders and other capital transactions, as well as the issuance of, and redemptions and benefit payments on, investment contracts and changes in the cash collateral for loaned securities under our securities lending program. During 2006, uses of cash included share repurchases amounting to $1.0 billion, dividend payments to our stockholders of $145 million and net redemptions on investment contracts of $1.8 billion. These uses of cash were partially offset by an issuance of $1,365 million in non-recourse funding obligations and $600 million of junior subordinated notes.
Since the completion of the IPO, we declared a dividend on our common stock of $32 million in each of the third and fourth quarters of 2004. The fourth quarter dividend was paid in January 2005. During 2005, we declared dividends on our common stock of $132 million, of which $35 million was paid in January 2006. In the third quarter of 2005, we increased our quarterly dividend 15% from $0.065 per share to $0.075 per share. In the
In December 2004, we received a dividend of $700 million from our U.S. mortgage insurance business (included above in dividends paid by our insurance subsidiaries) following the release of statutory contingency reserves from that business. In December 2004, we used $550 million of those proceeds to repay the Contingent Note issued to GEFAHI as part of our corporate formation, and we retained the remainder at our holding company to pay debt servicing expenses and dividends on our common stock.
Cash flows from investing activities are affected by the capital contributions paid to subsidiaries and investment activity. For the year ended December 31, 2006, we received $117 million from fixed maturity investment maturities. For the year ended December 31, 2006, we paid $223 million, net of cash acquired, for businesses acquired and made $74 million in subsidiary capital contributions.
Cash flows from financing activities are affected by payments and proceeds from our borrowings, dividends paid to our stockholders and treasury stock acquisitions. For the year ended December 31, 2006, we acquired $1.0 billion of treasury stock and paid $145 million in dividends to our stockholders offset by the issuance of $600 million of junior subordinated notes. For the year ended December 31, 2005, we acquired $500 million of treasury stock and paid $128 million in dividends to our stockholders.
We have provided liquidity support to some of our insurance subsidiaries in the form of guarantees of certain obligations, in some cases subject to annual scheduled adjustments, totaling $325 million and $418 million as of December 31, 2006 and 2005, respectively. The majority of these obligations are backed by assets held in our insurance subsidiaries which we believe sufficiently cover the underlying obligations.
As of December 31, 2006, we had approximately $2.7 billion of renewable floating rate funding agreements, which are deposit-type products that generally credit interest on deposits at a floating rate tied to an external market index. Purchasers of renewable funding agreements include money market funds, bank common trust funds and other short-term investors. Some of our funding agreements contain “put” provisions, through which the contractholder has an option to terminate the funding agreement for any reason after giving notice within the contract’s specified notice period. Of the $2.7 billion aggregate amount outstanding as of December 31, 2006, $875 million had put option features including $425 million with put options features of 90 days and $450 million with put options of 180 days.
During 2005, certain of our domestic life insurance subsidiaries transferred primarily foreign-issued investment securities to an affiliated special purpose entity (“SPE”) which is a subsidiary in our Mortgage Insurance segment and consolidated in our financial statements and whose sole purpose is to securitize these investment securities and issue secured notes to various affiliated insurance companies. The securitized investments are owned in their entirety by the SPE and are not available to satisfy the claims of our creditors. These securitized investments provide collateral to the notes issued by the SPE to the insurance companies. The value of those securities as of December 31, 2006 was $1.4 billion.
On May 25, 2006 we entered into a $1.0 billion five-year revolving credit facility, which matures in May 2011, replacing our $1.0 billion five-year revolving credit facility, which was scheduled to mature in May 2009. We also have a $1.0 billion revolving credit facility that matures in April 2010. These facilities bear variable interest rates based on a one-month LIBOR plus margin. As of December 31, 2006, we utilized $172 million of the commitment under these facilities for the issuance of a letter of credit for the benefit of one of our Mortgage Insurance subsidiaries.
The net proceeds from the issuance of $348 million from the 2015 Notes were used to reduce our outstanding commercial paper borrowings. The commercial paper was issued under a $1 billion commercial paper program that we have established. As of December 31, 2006, the aggregate amount of our outstanding commercial paper borrowings was $199 million. We may issue additional commercial paper under this program from time to time.
On December 21, 2005, our Board of Directors approved a stock repurchase program, authorizing the Company to repurchase up to $750 million of its common stock over the next 18 months. In October of 2006, our Board of Directors authorized the repurchase of an additional $250 million of our common stock. On November 8, 2006 we completed our planned repurchases under this program. Additionally, on December 8, 2006, the Board of Directors approved a stock repurchase program, authorizing the Company to repurchase up to $500 million of our common stock over the 12-month period commencing January 1, 2007.
(1) Includes payments of principal and interest of our short- and long-term borrowings, non-recourse funding obligations and senior notes underlying Equity Units and dividend payments on our mandatorily redeemable
Series A Preferred Stock, as described in note 13 to our consolidated financial statements under “Item 8 - Financial Statements and Supplementary Data.” Any payment of principal of, including by redemption, or interest on, the non-recourse funding obligations is subject to regulatory approval. The total amount for borrowings and interest in this table does not equal the amounts on our balance sheet due to interest included in the table that is expected to be incurred in future years.
Securitization transactions typically result in gains or losses that are included in net investment gains (losses) in our financial statements. We recognized an investment loss on sale of $11 million, net of tax, from a resecuritization transaction in 2006 as further discussed in note 19 in our consolidated financial statements under “Item 8 - Financial Statements and Supplementary Data.” There were no off-balance sheet securitization transactions executed in the years ended December 31, 2005 and 2004.
We have entered into credit support arrangements in connection with our securitization transactions. Pursuant to these arrangements, as of December 31, 2006, we provided limited recourse for a maximum of $119 million of credit losses. To date, we have not been required to make any payments under any of the credit support agreements. These agreements will remain in place throughout the life of the related entities.
For a more complete description of the Equity Units, refer to note 13 in our consolidated financial statements under “Item 8 - Financial Statements and Supplementary Data.” The stock purchase contract is, for accounting purposes, a derivative financial instrument indexed to and potentially settled in company stock. We have recorded the stock purchase contract in the equity section of our balance sheet. As such, this derivative financial instrument is not required to be marked to market through income and therefore was included in our balance sheet at the original value of $37 million. Had this forward sale commitment not qualified to be classified in equity, we would be required to record a derivative liability of $279 million and $308 million with a change in value of $28 million and $(158) million recorded currently in income as of and for the years ended December 31, 2006 and 2005, respectively.
Consolidated Statements of Income for the years ended December 31, 2006, 2005 and 2004
Consolidated Statements of Changes in Stockholders’ Equity for the years ended December 31, 2006, 2005 and 2004
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Genworth Financial, Inc. as of December 31, 2006 and 2005, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2006, in conformity with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Genworth Financial Inc.’s internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated February 28, 2007 expressed an unqualified opinion on management’s assessment of, and the effective operation of, internal control over financial reporting.
As of December 31, 2006 we had the following three operating segments:
Protection. In the United States, we are a leading provider of life insurance and long-term care insurance, have developed linked benefit products such as long-term care insurance linked with life insurance or an annuity and offer selected senior services and products including Medicare supplement insurance. We also offer group life and health insurance primarily to companies with fewer than 1,000 employees. In January 2007, we announced an agreement to sell the group life and health business and expect to close the transaction in the second quarter of 2007. Outside the U.S., we offer payment protection insurance, which helps consumers meet specified payment obligations should they become unable to pay due to accident, illness, involuntary unemployment, disability or death.
non-interest-bearing note (“Contingent Note”). The liabilities Genworth assumed included ¥60 billion aggregate principal amount of 1.6% notes due 2011 issued by GEFAHI. The transactions above, which are accounted for at book value as transfers between entities under common control, are referred to as our corporate formation. Class A Common Stock and Class B Common Stock have identical voting rights, except Class B shares have approval rights over certain corporate actions and rights with respect to the election and removal of directors. Shares of Class B Common Stock convert automatically into shares of Class A Common Stock when they are held by any person other than GE or an affiliate of GE or when GE no longer beneficially owns at least 10% of our outstanding common stock. As a result, all of the 146.4 million shares of common stock sold in Genworth’s IPO consisted of Class A Common Stock.
In December, September and March 2005, GE completed secondary public offerings of 40.9 million, 116.2 million and 80.5 million shares of our Class B Common Stock, respectively. The 237.6 million shares were automatically converted to Class A Common Stock upon the sale of these shares to the public. Concurrently with the March 2005 secondary offering, we repurchased 19.4 million shares of Class B Common Stock from GE at a price of $25.811 per share (a price equal to the net proceeds per share received by the selling stockholder from the underwriters), which were automatically converted to Class A Common Stock upon the transfer of these shares to us and recorded at cost as treasury stock. We did not receive any of the proceeds from these secondary offerings. As of December 31, 2005, approximately 82% of our common stock was owned by public stockholders, and approximately 18% of our common stock was beneficially owned by GE.
For the periods prior to our corporate formation, our consolidated financial statements include the accounts of certain indirect subsidiaries and businesses of GE that represent the predecessor of Genworth. The companies and businesses included in the predecessor combined financial statements are GEFAHI, Financial Insurance Company Ltd., FIG Ireland Ltd., WorldCover Direct Ltd., RD Plus S.A., CFI Administrators Ltd., Financial Assurance Company Ltd., Financial Insurance Group Services Ltd., Consolidated Insurance Group Ltd., Viking Insurance Co. Ltd., Genworth Financial Mortgage Insurance Ltd., GE Mortgage Insurance Pty Ltd., Genworth Mortgage Insurance Ltd., Genworth Financial Mortgage Insurance Company Canada, GE Capital Mortgage Insurance Corp. (Australia) Pty Ltd., Genworth Financial Investment Services, Inc., GE Capital Insurance Agency, Inc., CFI Pension Trustees Ltd., Financial Insurance Guernsey PCC Ltd., GE Financial Assurance Compania De Seguros y Reaseguros de Vida S.A., GE Financial Insurance Compania De Seguros y Reaseguros S.A., and GE Residential Connections Corp., Assocred SA, Ennington Properties Limited and the consumer protection insurance business of Vie Plus S.A. All of the combined companies were indirect subsidiaries of GE. For these periods, we refer to the combined predecessor companies and businesses as the “Company”, “we”, “us”, or “our” unless the context otherwise requires.
We have designated our investment securities as either available-for-sale or trading and report them in our Consolidated Balance Sheets at fair value. We obtain values for actively traded securities from external pricing services. We determine the appropriate classification of investments securities at the time of purchase. For infrequently traded securities, we obtain quotes from brokers, or we estimate values using internally developed pricing models. These models are based upon common valuation techniques and require us to make assumptions regarding credit quality, liquidity and other factors that affect estimated values. Changes in the fair value of available-for-sale investments, net of the effect on deferred acquisition costs (“DAC”), present value of future profits (“PVFP”) and deferred income taxes, are reflected as unrealized investment gains or losses in a separate component of accumulated other comprehensive income. Realized and unrealized gains and losses related to trading securities are reflected in net investment gains (losses). Trading securities are included in other invested assets in our Consolidated Balance Sheets.
Certificates of deposit, money market funds, and other time deposits with original maturities of less than 90 days are considered cash equivalents in the Consolidated Balance Sheets and Consolidated Statements of Cash Flows. Items with maturities greater than 90 days but less than one year at the time of acquisition are included in short-term investments.
We engage in certain securities lending transactions for the purpose of enhancing the yield on our investment securities portfolio, which require the borrower to provide collateral, primarily consisting of cash and government securities, on a daily basis, in amounts equal to or exceeding 102% of the fair value of the applicable securities loaned. We maintain effective control over all loaned securities and, therefore, continue to report such securities as fixed maturity securities in the Consolidated Balance Sheets. Cash and non-cash collateral, such as a security, received by us on securities lending transactions is reflected in other invested assets with an offsetting liability recognized in other liabilities for the obligation to return the collateral. The fair value of collateral held is $2.0 billion and $1.8 billion as of December 31, 2006 and 2005, respectively. We had non-cash collateral of $35 million and $39 million as of December 31, 2006 and 2005, respectively.
We engage in a repurchase program for the purpose of enhancing the yield on our investment securities portfolio in which we sell a security at a specified price and agree to repurchase that security at another specified price at a later date. Repurchase agreements are treated as collateralized financing transactions and are carried at the amounts at which the securities will be subsequently reacquired, including accrued interest, as specified in the respective agreement. The market value of securities to be repurchased is monitored and collateral levels are adjusted where appropriate to protect the counterparty against credit exposure. Cash received is invested in fixed maturities. At December 31, 2006, the fair value of the securities pledged under the repurchase program totaled $712 million and the offsetting repurchase obligation of $690 million is included in other liabilities on the Consolidated Balance Sheets.
Premium revenue, benefits and operating expenses are reported net of the amounts relating to reinsurance ceded to and assumed from other companies. Amounts due from reinsurers for incurred and estimated future claims are reflected in the reinsurance recoverable asset. The cost of reinsurance is accounted for over the terms of the related treaties using assumptions consistent with those used to account for the underlying reinsured policies. Premium revenue, benefits and acquisition and operating expenses, net of deferrals, for reinsurance assumed contracts that do not qualify for reinsurance accounting are accounted for under the deposit method of accounting.
On the date we enter into a derivative contract, management designates the derivative as a hedge of the identified exposure (fair value, cash flow or foreign currency). If a derivative does not qualify for hedge accounting, according to Financial Accounting Standards Board (“FASB”) Statement of Financial Accounting Standards (“SFAS”) No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended, the changes in its fair value and all scheduled periodic settlement receipts and payments are reported in income.
We designate and account for the following as cash flow hedges, when they have met the effectiveness requirements of SFAS No.133: (i) various types of interest rate swaps to convert floating rate investments to fixed rate investments; (ii) various types of interest rate swaps to convert floating rate liabilities into fixed rate liabilities; (iii) receive U.S. dollar fixed on foreign currency swaps to hedge the foreign currency cash flow exposure of foreign currency denominated investments; (iv) pay U.S. dollar fixed on foreign currency swaps to hedge the foreign currency cash flow exposure on liabilities denominated in foreign currencies; and (v) other instruments to hedge the cash flows of various other forecasted transactions. For all qualifying and highly effective cash flow hedges, the effective portion of changes in fair value of the derivative instrument is reported as a component of other comprehensive income. The ineffective portion of changes in fair value of the derivative instrument is reported as a component of income.
We designate and account for the following as fair value hedges when they have met the effectiveness requirements of SFAS No.133: (i) various types of interest rate swaps to convert fixed rate investments to floating rate investments; (ii) various types of interest swaps to convert fixed rate liabilities into floating rate liabilities; and (iii) other instruments to hedge various other fair value exposures of investments. For all qualifying and highly effective fair value hedges, the changes in fair value of the derivative instrument are reported in income. In other situations in which hedge accounting is discontinued on a cash flow hedge, amounts previously deferred in other comprehensive income are reclassified into income when income is impacted by the variability of the cash flow of the hedged item. In addition, changes in fair value attributable to the hedged portion of the underlying instrument are reported in income.
For our mortgage insurance policies, reserves for losses and loss adjustment expenses are based on notices of mortgage loan defaults and estimates of defaults that have been incurred but have not been reported by loan
Some employees participate in defined benefit pension and postretirement benefit plans. We recognize expense for these plans based upon actuarial valuations performed by external experts. We estimate aggregate benefits by using assumptions for employee turnover, future compensation increases, rates of return on pension plan assets and future health care costs. We recognize an expense for differences between actual experience and estimates over the average future service period of participants.
For periods prior to our corporate reorganization, our non-life insurance entities were included in the consolidated federal income tax return of GE and subject to a tax-sharing arrangement that allocates tax on a separate company basis, but provides benefit for current utilization of losses and credits. For periods prior to 2004, our U.S. life insurance entities filed a consolidated life insurance federal income tax return separate from GE and are subject to a separate tax-sharing agreement, as approved by state insurance regulators, which also allocates taxes on a separate company basis but provides benefit for current utilization of losses and credits. For 2004, through the date of our corporate reorganization, our U.S. life insurance entities were included in the consolidated federal income tax return of GE, and subject to separate company principles similar to those applicable to our non-life insurance entities. Intercompany balances under all agreements are settled at least annually.
Effective with our corporate reorganization, our U.S. non-life insurance entities are included in the consolidated federal income tax return of Genworth and subject to a tax-sharing arrangement that allocates tax on a separate company basis, but provides benefit for current utilization of losses and credits. Also effective with our corporate reorganization, our U.S. life insurance entities file a consolidated life insurance federal income tax return, and are subject to a separate tax-sharing agreement, as approved by state insurance regulators, which allocates taxes on a separate company basis but provides benefit for current utilization of losses and credits.
The determination of the functional currency is made based on the appropriate economic and management indicators. The assets and liabilities of foreign operations are translated into U.S. dollars at the exchange rates in effect at the Consolidated Balance Sheet date. Translation adjustments are included as a separate component of accumulated other comprehensive income. Revenue and expenses of the foreign operations are translated into U.S. dollars at the average rates of exchange prevailing during the year. Gains and losses from foreign currency transactions are reported in income and have not been material in all years presented in our Consolidated Statements of Income.
On December 31, 2006, we adopted SFAS No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans that was adopted at December 31, 2006. This statement requires an employer to recognize the overfunded or underfunded status of a defined benefit plan as an asset or liability in its statement of financial position and to recognize changes in that funded status in the year in which the changes occur through comprehensive income. The adoption of SFAS No. 158 resulted in a $31 million reduction of comprehensive income on our Consolidated Balance Sheet as of December 31, 2006.
In September 2005, the American Institute of Certified Public Accountants (“AICPA”) issued Statement of Position (“SOP”) 05-1, Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection With Modifications or Exchanges of Insurance Contracts. This statement provides guidance on accounting for deferred acquisition costs and other balances on an internal replacement, defined broadly as a modification in product benefits, features, rights, or coverages that occurs by the exchange of an existing contract for a new contract, or by amendment, endorsement, or rider to an existing contract, or by the election of a benefit, feature, right, or coverage within an existing contract. SOP 05-1 is effective for internal replacements beginning January 1, 2007. The adoption of SOP 05-1 will result in the shortening of the period over which our group life and health insurance business deferred acquisition costs are amortized. Transition to the shorter amortization period will result in a cumulative effect adjustment to retained earnings of approximately $55 million, net of tax on January 1, 2007.
In February 2007, FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities. This statement provides an option to report selected financial assets and liabilities, including insurance contracts, at fair value. SFAS No. 159 will be effective for us on January 1, 2008. We have not decided whether we will elect the fair value option for any financial assets or liabilities and therefore do not know the impact, if any, SFAS No. 159 will have on our consolidated financial statements.
Basic and diluted earnings per share are calculated by dividing net earnings for the year ended December 31, 2006, 2005 and 2004 by 455.9 million, 475.3 million and 489.5 million weighted average basic shares outstanding and by 469.4 million, 484.6 million and 490.5 million weighted average diluted shares outstanding, respectively. Weighted average shares outstanding for the year ended December 31, 2004 are determined as if our reorganization had occurred at the beginning of the year.
Upon completion of our corporate formation described in note 1, we no longer have continuing involvement with the Japanese life insurance and domestic auto and homeowners’ insurance businesses (together “Japan/Auto”), which was sold in August 2003, and accordingly, those operations were accounted for as discontinued operations.
Net unrealized gains and losses on investment securities classified as available-for-sale are reduced by deferred income taxes and adjustments to PVFP and DAC that would have resulted had such gains and losses
been realized. Net unrealized gains and losses on available-for-sale investment securities reflected as a separate component of accumulated other comprehensive income as of December 31, are summarized as follows:
As of December 31, 2006 and 2005, the amortized cost or cost, gross unrealized gains (losses), and estimated fair value of our fixed maturities and equity securities classified as available-for-sale are as follows:
For fixed maturities, we recognize an impairment charge to income in the period in which we determine that we do not expect either to collect principal and interest in accordance with the contractual terms of the instruments or to recover based upon underlying collateral values, considering events such as a payment default, bankruptcy or disclosure of fraud. For equity securities, we recognize an impairment charge in the period in which we determine that the security will not recover to book value within a reasonable period. We determine what constitutes a reasonable period on a security-by-security basis based upon consideration of all the evidence available to us, including the magnitude of an unrealized loss and its duration. We measure impairment charges based upon the difference between the book value of a security and its fair value.
We generally intend to hold securities in unrealized loss positions until they recover. However, from time to time, we sell securities in the ordinary course of managing our portfolio to meet diversification, credit quality, yield and liquidity requirements. The aggregate fair value of securities sold at a loss during twelve months ended December 31, 2006 was $4,352 million, which was approximately 97.4% of book value.
The investment securities in an unrealized loss position as of December 31, 2006 consisted of 2,777 securities accounting for unrealized losses of $590 million. Of these unrealized losses, 93.4% were investment grade (rated AAA through BBB-) and 97.6% were less than 20% below cost. The amount of the unrealized loss on these securities was primarily attributable to a generally high interest rate environment experienced during 2006.
Because we expect these investments to continue to perform as to their original contractual terms and we have the ability and intent to hold these investment securities until the recovery of the fair value up to the cost of the investment, which may be maturity, we do not consider these investments to be other-than-temporarily impaired at December 31, 2006.
As of December 31, 2006, $7,096 million of our investments (excluding mortgage and asset-backed securities) are subject to certain call provisions.
As of December 31, 2006 and 2005, $364 million and $298 million, respectively, of securities are on deposit with various state or foreign government insurance departments in order to comply with relevant insurance regulations.
Our mortgage loans are collateralized by commercial properties, including multi-family residential buildings. The carrying value of commercial mortgage loans is original cost net of prepayments, amortization and allowance for losses.
“Impaired” loans are defined by U.S. GAAP as loans for which it is probable that the lender will be unable to collect all amounts due according to original contractual terms of the loan agreement.
Under these principles, we may have two types of “impaired” loans: loans requiring specific allowances for losses (none as of December 31, 2006 and 2005) and loans expected to be fully recoverable because the carrying amount has been reduced previously through charge-offs or deferral of income recognition ($3 million and $1 million as of December 31, 2006 and 2005, respectively).
Average investment in specifically impaired loans during 2006, 2005 and 2004 is $1 million, $3 million and $3 million, respectively, and interest income recognized on these loans while they were considered impaired is $0, $0 million and $1 million, respectively.
In October 2005, we acquired C.J.M. Planning Corp. and affiliates for an up-front cost of $5 million, plus potential contingent consideration of $7 million. The initial payment of $5 million was recorded to goodwill in 2005 and an additional $3 million related to the contingent consideration was recorded to goodwill in 2006.
On May 1, 2006, we completed the acquisition of Continental Life Insurance Company of Brentwood, Tennessee (“Continental Life”), for $145 million, plus contingent consideration of $5 million per year for two years based on attaining certain sales production thresholds. Continental Life’s business provides primarily Medicare supplement insurance and is a part of our Protection segment. This acquisition was accounted for using the purchase method. The excess purchase price over the estimated fair value of the net assets acquired of $51 million has been recorded as goodwill. In addition, $54 million of PVFP was recorded in connection with this transaction. The results of operations of Continental Life have been included in our consolidated results beginning May 1, 2006. Such estimated values may change as additional information is obtained and the valuation is finalized.
On January 10, 2007, we entered into a Stock Purchase Agreement, whereby we have agreed to sell our group life and health insurance business for $650 million in cash. We expect to account for this business as part of discontinued operations beginning in first quarter 2007 financial statements. As of December 31, 2006, the group life and health insurance business had goodwill and PVFP of $135 million and $9 million, respectively. We expect to recognize a realized gain on the sale of approximately $45 million to $55 million upon closing, which is expected to occur in the second quarter of 2007.
We reinsure a portion of our policy risks to other companies in order to reduce our ultimate losses and to diversify our exposures. We also assume certain policy risks written by other insurance companies. Reinsurance accounting is followed for assumed and ceded transactions when there is adequate risk transfer. Otherwise, the deposit method of accounting is followed.
As of December 31, 2006, the maximum amount of individual ordinary life insurance normally retained by us on any one individual life policy is $1 million. Beginning January 1, 2007, we increased the maximum amount to $5 million on new policy issues.
To secure the payment of its obligations to us under the reinsurance agreements governing the Reinsurance Transactions, UFLIC has established trust accounts to maintain an aggregate amount of assets with a statutory book value at least equal to the statutory general account reserves attributable to the reinsured business less an amount required to be held in certain claims paying accounts. A trustee administers the trust accounts and we are permitted to withdraw from the trust accounts amounts due to us pursuant to the terms of the reinsurance agreements that are not otherwise paid by UFLIC. In addition, pursuant to a Capital Maintenance Agreement, GE Capital agreed to maintain sufficient capital in UFLIC to maintain UFLIC’s risk-based capital at not less than 150% of its company action level, as defined from time to time by the National Association of Insurance Commissioners (“NAIC”).
Reinsurance recoveries recognized as a reduction of benefits and other changes in policy reserves amounted to $2,204 million, $1,881 million and $1,264 million during 2006, 2005 and 2004, respectively.
Our variable annuities provide a basic guaranteed minimum death benefit (“GMDB”) which provides a minimum account value to be paid upon the annuitant’s death. Our contractholders have the option to purchase through riders, at an additional charge, enhanced death benefits. Our separate account guarantees are predominantly death benefits; we also have some guaranteed minimum withdrawal benefits.
The following table sets forth changes in the liability for policy and contract claims for the years ended December 31:
Effective as of September 27, 2005, GE ceased to own more than 50% of our outstanding common stock. At that time, our applicable employees ceased participating in the GE benefit plans and began participating in employee benefit plans established and maintained by us. During the last half of 2005, all international employees transitioned to Genworth benefits applicable to their country. The following summarizes information related to the Genworth benefit plans.
of which $9 million was charged to accumulated other comprehensive income in compliance with SFAS No. 158 related to these benefits. As of December 31, 2005, we had accrued $21 million in other liabilities associated with these benefits.
We provide retiree health benefits to domestic employees hired prior to January 1, 2005 who meet certain service requirements. Under this plan, retirees over 65 years of age receive Medigap policy coverage, and retirees under 65 years of age receive medical benefits similar to our employees’ medical benefits. We also provide retiree life insurance benefits, which are provided through our Group business. The amount of fees recorded by Group related to the retiree life insurance benefits was insignificant for all periods presented. The plans are funded as claims are incurred. As of December 31, 2006 and 2005, the accumulated postretirement benefit obligation associated with these benefits was $78 and $61 million, respectively, of which we had accrued $78 and $29 million in other liabilities, respectively. In compliance with SFAS No. 158, $22 million of the accrued $78 million was charged to accumulated other comprehensive income as of December 31, 2006.
Our domestic employees participate in qualified and non-qualified defined contribution savings plans that allow employees to contribute a portion of their pay to the plan on a pre-tax basis. We match these contributions, which vest immediately, up to 4% of the employee’s pay. One option available to employees in the defined contribution savings plan is the ClearCourse® variable annuity option offered by our Retirement Income and Investments segment (“RI&I”). The amount of deposits recorded by our RI&I segment in relation to this plan option was $2 million and $0 million as of December 31, 2006 and 2005, respectively. Employees also have the option of purchasing Genworth stock as part of the defined contribution plan. Our cost associated with these plans was $18 million and $3 million for the year ended December 31, 2006 and the period from September 27, 2005 through December 31, 2005, respectively.
We provide health and welfare benefits to our employees, including health, life, disability, dental and long-term care insurance. Our dental insurance is provided through Group, and our long-term care insurance is provided through our group long-term care business. The premiums recorded by these businesses related to these benefits were insignificant during 2006 and 2005.
On June 9, 2004, we established a $1 billion commercial paper program. The notes under the commercial paper program are offered pursuant to an exemption from registration under the Securities Act of 1933 and may have a maturity of up to 364 days from the date of issue. In September 2005, we used the proceeds from our senior notes to pay down $348 million of our commercial paper. In the first and fourth quarter of 2006, we issued $229 million and $223 million of commercial paper, respectively. These issuances were offset by pay downs of commercial paper in the second and fourth quarters of 2006 of $85 million and $319 million, respectively. The fourth quarter reduction of commercial paper was funded by the proceeds received from our $600 million junior subordinated notes issuance. As of December 31, 2006 and 2005, the weighted average interest rate on commercial paper outstanding is 5.24% and 3.29%, respectively, and the weighted average maturity is 37 and 53 days, respectively.
On May 25, 2006, we entered into a $1.0 billion five-year revolving credit facility, which matures in May 2011, replacing our $1.0 billion five-year revolving credit facility, which was scheduled to mature in May 2009. We also have a $1.0 billion revolving credit facility that matures in April 2010. These facilities bear variable interest rates based on one-month LIBOR plus a margin. As of December 31, 2006 and 2005, we had no borrowings under these facilities; however, we utilized $172 million and $171 million of the commitment under these facilities, respectively, for the issuance of letters of credit for the benefit of one of our Mortgage Insurance subsidiaries.
In September 2005, we issued senior notes having an aggregate principal amount of $350 million, with an interest rate equal to 4.95% per year payable semi-annually, and maturing in October 2015 (“2015 Notes”). The 2015 Notes are our direct, unsecured obligations and will rank equally with all of our existing and future unsecured and unsubordinated obligations. We have the option to redeem all or a portion of the 2015 Notes, at any time with proper notice to the note holders at a price equal to the greater of 100% of principal or the sum of
On June 15, 2004, we issued senior notes having an aggregate principal amount of $1.9 billion. As a result of hedging arrangements entered into with respect to these securities, our effective interest rates will be 3.39% on the 2007 Notes, 4.48% on the 2009 Notes, 5.51% on the 2014 Notes and 6.35% on the 2034 Notes. These Notes are direct unsecured obligations and will rank without preference or priority among themselves and equally with all of our existing and future unsecured and unsubordinated obligations. We have the option to redeem all or a portion of the 2009 Notes, the 2014 Notes and the 2034 Notes at any time with proper notice to the note holders at a price equal to the greater of 100% of principal or the sum of the present values of the remaining scheduled payments of principal and interest discounted at the then-current treasury rate plus an applicable spread.
We may redeem the 2066 Notes on November 15, 2036, the “scheduled redemption date,” but only to the extent that we have received net proceeds from the sale of certain qualifying capital securities. We may redeem the 2066 Notes (i) in whole or in part, at any time on or after November 15, 2016 at their principal amount plus accrued and unpaid interest to the date of redemption, or (ii) in whole or in part, prior to November 15, 2016 at their principal amount plus accrued and unpaid interest to the date of redemption or, if greater, a make-whole price.
The following table sets forth the non-recourse funding obligations (surplus notes) of the River Lake and Rivermont Life Insurance Companies, wholly owned, special purpose consolidated captive insurance subsidiaries as of December 31:
(a) Accrual of interest based on one-month LIBOR plus or minus margin
Any payment of principal, including by redemption, or interest on the notes may only be made with the prior approval of the Director of Insurance of the State of South Carolina in accordance with the terms of its licensing orders and in accordance with applicable law. The holders of the notes have no rights to accelerate payment of principal of the notes under any circumstances, including without limitation, for nonpayment or breach of any covenant. Each issuer reserves the right to repay the notes that it has issued at any time, subject to prior regulatory approval.
As part of our corporate formation, we issued $600 million of our Equity Units to GEFAHI, and GEFAHI sold all these Equity Units in a public offering concurrent with the IPO. The Equity Units initially were issued in the form of Corporate Units. Each Corporate Unit consisted of:
The stock purchase contract that is a component of an Equity Unit requires the holder to purchase, and us to sell, for $25, on May 16, 2007, which we refer to as the purchase contract settlement date, a number of newly
Long-term borrowings, non-recourse funding obligations, senior notes underlying Equity Units and mandatorily redeemable preferred stock as of December 31, 2006 by maturity are as follows:
Our liquidity requirements are principally met through dividends from our insurance subsidiaries to our parent company, cash flows from operations, the commercial paper program and our revolving credit facilities. As of December 31, 2006, we have an unused credit capacity within our revolving credit facilities of $1.8 billion.
The total provision (benefit) for income taxes for the years ended December 31:
(a) Tax benefit of $47 million arising from our separation from GE on May 24, 2004.
The components of the net deferred income tax liability as of December 31, are as follows:
to GE as of December 31, 2006 and 2005, respectively, as a liability on our Consolidated Balance Sheets. Both our IPO-related deferred tax assets and our obligation to GE are estimates subject to change.
U.S. deferred income taxes are not provided on unremitted foreign earnings that are considered permanently reinvested, which at December 31, 2006 amounted to approximately $300 million. It is not practicable to determine the income tax liability that might be incurred if all such earnings were remitted to the U.S.
The American Jobs Creation Act of 2004 contained a Foreign Earnings Repatriation Provision, which grants a one-time dividend received deduction for repatriation of qualifying foreign earnings to a U.S. taxpayer. On December 22, 2005 we repatriated approximately $61 million of foreign earnings under this provision. As of December 31, 2005, Genworth had provided U.S. deferred tax liabilities on all of its undistributed foreign earnings, including a valuation allowance for excess foreign tax credits. Accordingly, the repatriation did not materially change Genworth’s total tax position, as the current tax benefit associated with the one-time dividends received deduction was offset by a corresponding increase in excess foreign tax credits.
In connection with our corporate formation on May 24, 2004, we completed several non-cash transactions with our then majority stockholder. These transactions included the transfer of the assets and liabilities of entities that did not remain with Genworth, as well as non-cash consideration paid to our then-sole stockholder through the issuance of debt and other liabilities. The following table details these transactions as well as other non-cash items:
For purposes of determining the estimated fair value of stock-based payment awards on the date of grant we use the Black-Scholes Model. The Black-Scholes Model requires the input of certain assumptions that involve judgment. Management periodically evaluates the assumptions and methodologies used to calculate estimated fair value of share-based compensation. Circumstances may change and additional data may become available over time, which could result in changes to these assumptions and methodologies.
For the years ended December 31, 2006 and 2005, we granted stock options with exercise prices ranging from $32.45 to $35.61 and $26.68 to $33.52, respectively, which equaled the closing market prices on the date of grant and have an exercise term of 10 years. The stock options will vest in 20% annual increments commencing on the first anniversary of the date of grant. Additionally, during the year ended December 31, 2006 and 2005 we issued RSUs with restriction periods ranging from 3 to 5 years and a fair value of $34.15 and $30.62, respectively, which is measured at the market price of a share of our nonrestricted stock on the grant date. Additionally, during the years ended December 31, 2006 and 2005, we granted SARs with exercise prices of $34.13 and $32.10, respectively.
A summary of the status of our other equity-based awards as of December 31, 2006 and 2005 is presented below:
customer service, transaction processing and a variety of functional support services provided by GENPACT International formerly GE Capital International Services, or GECIS;
Our total expense for these services was $13 million, $34 million and $65 million for the years ended December 31, 2006, 2005 and 2004, respectively. We also receive investment management and related administrative services provided by GE Asset Management (“GEAM”), for which we incurred expenses of $5 million, $22 million and $33 million for the period ended March 31, 2006 and years ended December 31, 2005 and 2004, respectively.
We entered into three agreements with affiliates of GE, effective as of January 1, 2004, to manage a pool of municipal GICs, issued by those affiliates. Pursuant to these agreements, we have agreed to originate municipal GIC liabilities and advise the GE affiliates regarding the investment, administration and management of their assets that support those liabilities. We recorded fees and reimbursements of $10 million, $40 million and $37 million for the period ended March 31, 2006 and years ended December 31, 2005 and 2004, respectively, for these services. We also will receive reimbursement of our operating expenses under each of the agreements. The three agreements expired December 31, 2006. As of January 1, 2007, we entered into a new agreement with GE relating to the management of their municipal GICs. Under this agreement we agreed to sell the business, which provided services under the agreements outlined above for $1 million. We also agreed to provide consulting services for a 2-year period and in return we expect to receive fees of $19 million in year 1 and $10 million in year 2.
In December 2004, we entered into a Consideration Agreement with GE Capital International (Mauritius) (“GECIM”), a subsidiary of GE. The Consideration Agreement set forth the terms in which we participated in GE’s sale of its global outsourcing business. Pursuant to the Consideration Agreement, upon the closing of the sale we received consideration of $40 million from GECIM related to our waiver of certain contractual rights and entered into an Outsourcing Services Amendment Agreement (“Service Agreement”) with GECIS International Holdings, Luxembourg, Swiss Branch Zug, a Luxembourg company. The consideration of $40 million is included in policy fees and other income on the Consolidated Statements of Income as a result of our waiver of contractual rights under the Service Agreement. We also agreed to purchase a minimum volume of services, at market rates, during an eight-year period. Our minimum volume commitment during the each of the first five years of the service agreement will be $24 million, and our minimum volume commitment during the sixth, seventh and eighth years will be $18 million, $12 million and $6 million, respectively.
Mandatorily redeemable preferred stock. Based on quoted market prices or discounted future cash flows.
Our business activities routinely deal with fluctuations in interest rates, currency exchange rates and other asset prices. We use derivative financial instruments to mitigate or eliminate certain of these risks. We follow strict policies for managing each of these risks, including prohibition on derivatives market-making, speculative derivatives trading or other speculative derivatives activities. These policies require the use of derivative instruments in concert with other techniques to reduce or eliminate these risks.
The $375 million, net of taxes, recorded in stockholders’ equity at December 31, 2006 is expected to be reclassified to future income, concurrently, with and primarily offsetting changes in interest expense and interest income on floating-rate instruments. Of this amount, $25 million, net of income taxes, is expected to be reclassified to income in the year ending December 31, 2007. Actual amounts may vary from this amount as a result of market conditions. All forecasted transactions currently being hedged are expected to occur by 2035. No amounts were reclassified to income during the year ended December 31, 2006 and 2005 in connection with forecasted transactions that were no longer considered probable of occurring.
of changes in market conditions, no additional transactions are executed until the exposure with that counterparty is reduced to an amount that is within the established limit. The swaps that are executed under master swap agreements contain mutual credit downgrade provisions that provide the ability to require assignment or replacement in the event either parties unsecured debt rating is downgraded below Moody’s “Baa” or S&P’s “BBB.” If the downgrade provisions had been triggered as of December 31, 2006, we could have been required to disburse up to $3 million and claim up to $161 million from counterparties. This represents the net fair value of losses and gains by counterparty, less $353 million of available collateral held. As of December 31, 2006 and 2005, gross fair value gains were $514 million and $538 million, respectively. As of December 31, 2006 and 2005, gross fair value losses were $3 million and $5 million, respectively.
We have used third-party entities to facilitate asset securitizations. Disclosure requirements related to off-balance sheet arrangements encompass a broader array of arrangements than those at risk for consolidation. These arrangements include transactions with term securitization entities, as well as transactions with conduits that are sponsored by third parties. As of December 31, 2006 and 2005, assets in these entities, which are Qualified Special Purposes Entities (“QSPE’s”), were $1.8 billion and $1.5 billion, respectively.
An analysis of total “securitized assets” as of December 31 was as follows:
We evaluated the economic, liquidity and credit risk related to the above Special Purpose Entities (“SPE’s”) and believed that the likelihood is remote that any such arrangements could have had a significant adverse effect on our financial position, results of operations, or liquidity. Financial support for certain SPE’s was provided under credit support agreements, in which we provided limited recourse for a maximum of $119 million of credit losses. Assets with credit support were funded by demand notes that were further enhanced with support provided by a third-party. We recorded liabilities for such guarantees based on our best estimate of probable losses. We were not required to make any payments under any of the credit support agreements. These agreements remained in place throughout the life of the related entities.
Recourse liability. As described previously, under credit support agreements we provided recourse for credit losses in special purpose entities. We provided for expected credit losses under these agreements and such amounts approximated fair value.
GE Capital, our former indirect majority stockholder, provides credit and liquidity support to a funding conduit it sponsored, which exposes it to a majority of the risks and rewards of the conduit’s activities and therefore makes GE Capital the primary beneficiary of the funding conduit. Upon adoption of FIN No. 46, Consolidation of Variable Interest Entities, GE Capital was required to consolidate the funding conduit because of this financial support. As a result, assets and liabilities of certain previously off-balance sheet securitization entities, for which we were the transferor, were required to be included in our consolidated financial statements because the funding conduit no longer qualified as a third-party. The assets and liabilities associated with these
securitization entities were reported in the corresponding financial statement captions in our Consolidated Balance Sheet, and the assets are noted as restricted due to the lack of legal control we have over them. We applied the same accounting policies to these restricted assets and liabilities as we do to our unrestricted assets and liabilities.
As of December 31, 2005, the amortized cost, gross unrealized gains and losses, and estimated fair value of our restricted fixed maturities held by securitization entities were as follows:
The scheduled maturity distribution of these restricted fixed maturities as of December 31, 2005 is set forth below. Actual maturities may have differed from contractual maturities because issuers of securities may have had the right to call or prepay obligations with or without call or prepayment penalties.
The following table sets forth the distribution across property type and geographic region for restricted commercial mortgage loans as of December 31, 2005:
There was no allowance for losses related to these restricted commercial mortgage loans.
Our insurance company subsidiaries are restricted by state and foreign laws and regulations as to the amount of dividends they may pay to their parent without regulatory approval in any year, the purpose of which is to protect affected insurance policyholders, depositors or investors. Any dividends in excess of limits are deemed “extraordinary” and require approval. Based on statutory results as of December 31, 2006, we estimate our domestic and international insurance companies could pay dividends of approximately $1,400 million to us in 2007 without obtaining regulatory approval.
In addition to the guarantees discussed in notes 19 and 23, we have provided guarantees to third parties for the performance of certain obligations of our subsidiaries. We estimate that our potential obligations under such guarantees, other than guarantees provided in connection with derivative contracts, were $607 million and $164 million as of December 31, 2006 and 2005, respectively. Our potential obligations under guarantees of derivative contracts were $9 million and $10 million as of December 31, 2006 and 2005, respectively, which reflects the fair value of such derivative contracts. We also provide an unlimited guarantee to third parties for the solvency of our mortgage insurance subsidiary located in the United Kingdom.
For regulatory purposes, our mortgage insurance subsidiaries are required to maintain a statutory contingency reserve. Annual additions to the statutory contingency reserve must equal the greater of (i) 50% of earned premiums or (ii) the required level of policyholders position, as defined by state insurance laws. These contingency reserves generally are held until the earlier of (i) the time that loss ratios exceed 35% or (ii) ten years. The statutory contingency reserves as of December 31, 2006 for our U.S. mortgage insurance subsidiaries was approximately $2.4 billion.