Management's Discussion and Analysis of Financial Position and Results of Operations ---------------------------------------------------------------------------------------------
Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") addresses the consolidated financial condition of American Skandia Life Assurance Corporation as of December 31, 2003, compared with December 31, 2002, and its consolidated results of operations for the years ended December 31, 2003, 2002 and 2001.
The Company offers a wide array of annuities, including: a) certain deferred and immediate annuities that are registered with the Securities and Exchange Commission, including variable annuities with fixed interest rate investment options that include a market value adjustment feature; b) certain other fixed deferred annuities that are not registered with the Securities and Exchange Commission; and c) fixed, adjustable and variable immediate annuities. These markets are subject to regulatory oversight with particular emphasis placed on company solvency and sales practices. These markets are also subject to increasing competitive pressure as the legal barriers, 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.
o the ability of the Company and Prudential Financial to manufacture and distribute products and services and to introduce new products gaining market acceptance on a timely basis; o the ability to price our insurance products at a level that enables us to earn a margin over the cost of providing benefits and the expense of acquiring customers and administering those products; o the mortality and morbidity experience on annuity products; o persistency experience, which affects our ability to recover the cost of acquiring new business over the lives of the contracts; o the cost of administering insurance contracts and providing asset management products and services; o the returns on invested assets, net of the amounts we credit to policyholders' accounts; o the amount of our assets under management and changes in their fair value, which affect the amount of asset management fees we receive; and o the ability to generate favorable investment results through asset-liability management and strategic and tactical asset allocation.
Purchase accounting In accordance with purchase accounting guidelines, the Company "fair valued" its assets and liabilities as of the date of acquisition. The most significant adjustments related to the value of the unamortized deferred policy acquisition costs ("DAC") asset being assigned a value of zero, the future fees payable to ASI liability was decreased by $256.6 million and an asset for valuation of business acquired ("VOBA") was established for $440.1 million (see Notes 4, 5 and 6 in the December 31, 2003 financial statements included herein for further discussion).
As of the date of acquisition, the Company changed its classification of equity securities held in support of a deferred compensation plan from available-for-sale to trading. New management made this decision to align with Prudential Financial's accounting policy. These equity securities were fair valued on May 1, 2003 under purchase accounting and therefore there was no income statement impact for the change in classification. Such investments are now carried at fair value with changes in unrealized gains and losses reported in the Consolidated Statements of Operations and Comprehensive Income, as a component of "Other income."
Expected profitability considers, among other assumptions, our best estimate of future asset returns to estimate the future fees we expect to earn, the costs associated with GMDB and living benefit guarantees we expect to incur and other profitability factors. For the average remaining life of our variable annuity contracts in force as of December 31, 2003, our evaluation of DAC and VOBA is based on an 8.0% annual blended rate of return. Deterioration of market conditions may result in increases in the amortization of DAC and VOBA, while a further improvement in market conditions may result in a decrease in the amortization of DAC and VOBA. These changes in DAC and VOBA balances are included as a component of "General, administrative and other expenses" in our Consolidated Statements of Operations and Comprehensive Income.
See "Results of Operations" for discussion of the impact of DAC amortization on our results of our annuities products, including increased amortization recorded in 2002 reflecting lower estimates of future gross profits.
The Company has determined, using assumptions for lapses, mortality, free withdrawals and a long-term fund growth rate of 8% on the Company's assets under management, that the discounted estimated future payments to ASI would be $337.1 million and $429.8 million as of December 31, 2003 and 2002, respectively.
From December 31, 2002 to December 31, 2003 there was an increase of $3.5 billion in total assets from $23.7 billion to $27.2 billion. The largest increase was in separate account assets, which increased by $3.9 billion primarily from market value appreciation as a result of recoveries in the equity markets during 2003. DAC decreased by $995.0 million, deferred tax assets increased by $218.7 million and VOBA increased by $402.2 million, all primarily due to or related to purchase accounting.
Policy charges and fee income decreased by $12.3 million. M&E charges decreased by $11.1 million as a result of the decline in the in-force business. Annuity fees are mainly asset-based fees, which are dependent on the fund balances. Average annuity separate account fund balances have declined as a result of unfavorable valuation changes in the securities market over the past several years resulting in a decrease in policy charges and fee income.
Other income increased by $6.5 million due to the Company's change in its classification of equity securities from available-for-sale to trading which resulted in an increase of $6.5 million of realized and unrealized gains in the current year.
As of December 31, 2003, the death benefit coverage in force (representing the amount that we would have to pay if all annuitants had died on that date) was approximately $3.7 billion. The death benefit coverage in force for an annuity contract represents the excess of the guaranteed benefit amount over the account value. The GMDB feature provides annuity contract holders with a guarantee that the benefit received at death will be no less than a prescribed minimum amount. This minimum amount is generally based on the net deposits paid into the contract and, for greater than 80% of the business in force as of December 31, 2003, this minimum guarantee is applicable only for the first ten contract years or until a specified attained age. To the extent that the GMDB is higher than the current account value at the time of death, the Company incurs a cost. This results in increased annuity policy benefits in periods of declining financial markets and in periods of stable financial markets following a decline. Previously, accounting literature did not prescribe the recognition of a liability for the expected future net costs associated with GMDB provisions. However, effective January 1, 2004, we will adopt American Institute of Certified Public Accountants Statement of Position ("SOP") 03-01, "Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts," which requires us to record such a liability based on application of an expected benefit ratio to "cumulative assessments" through the balance sheet date, and then subtracting "cumulative excess payments" from that date. We currently estimate this liability to be approximately $3.0 million based on the difference between the "cumulative assessments" and "cumulative excess payments" measured from May 1, 2003, the date of acquisition. In our periodic evaluation of unamortized VOBA and DAC associated with our variable annuity business, we considered the expected net costs associated with the GMDB in our calculation of expected gross profits from this business. Accordingly, the effect of establishing the GMDB reserve related to this business will be partially offset by an estimated increase of approximately $1.0 million in unamortized VOBA and DAC, resulting in higher future amortization.
Interest credited to policyholder account balances decreased by $65.5 million due to decreased amortization of deferred purchase credits consistent with decreased amortization of DAC primarily as a result of purchase accounting.