The Company sells individual interest-sensitive life insurance, variable life insurance, term insurance, and individual variable annuities in New Jersey and New York through Prudential Insurance's sales force. These markets are subject to regulatory oversight with particular emphasis placed on company solvency and sales practices. These markets are also subject to increasing competitive pressures as the legal barriers which have historically segregated the markets of the financial services industry have been changed through both legislative and judicial processes. Regulatory changes have opened the insurance industry to competition from other financial institutions, particularly banks and mutual funds that are positioned to deliver competing investment products through large, stable distribution channels.
Generally, policyholders who purchase the Company's products have the option of investing in the separate accounts, segregated funds for which investment risks are borne by the customer, or the Company's portfolio, referred to as the General Account. The Company earns its profits through policy fees charged to separate account annuity and life policyholders and through the interest spread for the General Account annuity and life products. Policy charges and fee income consist mainly of three types, sales charges or loading fees on new sales, mortality and expense charges or, "M&E," assessed on fund balances, and mortality and related charges based on total life insurance in force business. Policyholder fund values are affected by net sales (sales less withdrawals), changes in interest rates and investment returns. The interest spread represents the difference between the investment income earned by the Company on its investment portfolio and the amount of interest credited to policyholders' accounts. Products that generate spread income primarily include the general account life insurance products, fixed annuities and the fixed rate option of variable annuities.
As prescribed by GAAP, we present our fixed maturity investments classified as available for sale at fair value in the statements of financial position. The fair values for our public fixed maturity securities are based on quoted market prices or estimates from independent pricing services. However, for our investments in private securities such as private placement fixed maturity securities, which comprised 12% of our investments as of December 31, 2004, this information is not available. For these private fixed maturities, fair value is determined typically by using a discounted cash flow model, which considers current market credit spreads for publicly traded issues with similar terms by companies of comparable credit quality, and an additional spread component for the reduced liquidity associated with private placements. This additional spread component is determined based on surveys of various third party financial institutions.
We capitalize costs that vary with and are related primarily to the acquisition of new and renewal insurance and annuity contracts. These costs include primarily commissions, costs of policy issuance and underwriting, and variable field office expenses. We amortize these deferred policy acquisition costs, or DAC, over the expected lives of the contracts, based on the level and timing of either gross margins, gross profits, or gross premiums, depending on the type of contract. As of December 31, 2004, DAC in our life business was $147 million and DAC in our annuity business was $36 million.
Increase/(Reduction) in DAC -------------------- (in thousands) Increase in projected rate of return by 100 basis points $ 640 Decrease in projected rate of return by 100 basis points $ (626)
Our accounting represents management's best estimate of future events that can be appropriately reflected in the accounting estimates. Certain changes or future events, such as changes in tax legislation, geographic mix of earnings and completion of tax audits could have an impact on our estimates and effective tax rate.
probable and its impact can be reasonably estimated. An example is the establishment of a reserve for losses in connection with an unresolved legal matter. The initial reserve reflects management's best estimate of the probable cost of ultimate resolution of the matter and is revised accordingly as facts and circumstances change and, ultimately, when the matter is brought to closure.
Refer to Note 2, "Summary of Significant Accounting Policies," of the Notes to Financial Statements.
Stockholder's equity increased by $26 million, from $293 million at December 31, 2003, to $319 million at December 31, 2004, primarily as a result of net income. Details of results of operations are discussed below.
Net income of $25 million for 2004 was $4 million more than the $21 million earned for 2003. The growth in earnings was driven by higher policy charge and fee income from higher sales, growth in the separate accounts from continued strength in the financial markets and increased spread revenue resulting from the adoption of SOP 03-1. DAC amortization dampened the above, increasing $6 million driven by higher gross profits and a lower unlocking in the annuity business.
Net investment income increased by $7 million, from $45 million in 2003 to $52 million in 2004, as a result of increased income from fixed maturities due to an increase in the portfolio balance from the adoption of SOP 03-1 and the investment of positive cash flows into the fixed maturity portfolio. This was partially offset by the effect of lower reinvestment rates for maturing fixed maturities and short-term investments due to the lower interest rate environment.
Total benefits and expenses increased $6 million from $129 million in 2003 to $135 million in 2004, as the effects of higher interest credited to policyholders' account balances and increased DAC amortization were partially offset by lower policyholders' benefits. Interest credited to policyholders' account balances exceeded the 2003 amount of $23 million by $7 million, due to an increase in policyholders' account balances, primarily from the adoption of SOP 03-1 and from positive net sales.
DAC amortization increased by $6 million, from $17 million in 2003 to $23 million in 2004, driven by higher gross profits and lower unlocking in the annuity business. Amortization in the life business was only slightly lower in 2004 as current period amortization was reduced due to ceded DAC amortization associated with the new coinsurance treaty with PARCC described in note 13 below.
Policyholders' benefits, including related changes in reserves, were $6 million lower than 2003. Policyholders' benefits decreased by $3 million, from $32 million in 2003 to $29 million in 2004, due to increased reinsurance coverage from the PARCC reinsurance treaty and a new excess of loss reinsurance treaty with Prudential Insurance that carries lower per policy retention limits. Reserve provisions were also lower, declining $3 million from $19 million in 2003, as a result of increased reinsurance reserves from the new reinsurance agreements mentioned above. Partly offsetting the decreases from reinsurance contracts was $2 million of higher deferred policy charge revenues in the life business from increased sales of the newer variable and universal life products.
General, administrative and other expenses, excluding DAC amortization, were unchanged from last year. Overall, general and administrative expenses are higher as a result of new business and the growing in force. Offsetting the growth in general and administrative expenses are lower net distribution costs resulting from reinsurance expense allowances, net of capitalization, in the life business as a result of the PARCC coinsurance agreement mentioned above. These allowances received are included in net distribution expense within operating expenses and reduce overall distribution costs.
Information required with respect to this Item 8 regarding Financial Statements and Supplementary Data is set forth commencing on page hereof. See Index to Financial Statements elsewhere in this Annual Report on Form 10-K.