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 GIC and 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 GIC product, general account life insurance products, fixed annuities and the fixed rate option of variable annuities.
In addition to policy charges and fee income, the Company earns revenues from insurance premiums from term life insurance and asset management fees on the separate account fund balances. The Company's operating expenses principally consist of insurance benefits provided, general business expenses, commissions and other costs of selling and servicing the various products we sell and interest credited on general account liabilities.
o our cost of administering insurance contracts and providing asset management products and services;
For our fixed maturity investments classified as available for sale, the impact of changes in fair value is recorded as an unrealized gain or loss in "Accumulated other comprehensive income (loss), net," a separate component of equity. In addition, investments classified as available for sale are subject to our impairment review to identify when a decline in value is other than temporary. Factors we consider in determining whether a decline in value is other than temporary include: the extent (generally if greater than 20%) and duration (generally greater than six months) of the decline; the reasons for the decline in value (credit event or interest rate related); our ability and intent to hold the investment for a period of time that will allow for a recovery of value; and the financial condition and near-term prospects of the issuer. When it is determined that a decline in value is other than temporary, the carrying value of the security is reduced to its fair value, with a corresponding charge to earnings. This corresponding charge is referred to as an impairment and is reflected in "Realized investment gains (losses), net" in the statements of operations. The level of impairment losses can be expected to increase when economic conditions worsen and decrease when economic conditions improve.
We establish reserves for future policy benefit payments to or on behalf of policyholders in the same period in which the policy is issued. These reserves relate primarily to term life and certain annuity products.
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 $1.031 billion and DAC in our annuity business was $398 million.
See "Results of Operations" for a discussion of the impact of DAC amortization on our results of the life and annuities products.
reversing over time, such as valuation of insurance reserves. Timing differences create deferred tax assets and liabilities. Deferred tax assets generally represent items that can be used as a tax deduction or credit in future years for which we have already recorded the tax benefit in our income statement. Deferred tax liabilities generally represent tax expense recognized in our financial statements for which payment has been deferred, or expenditures for which we have already taken a deduction in our tax return but have not yet recognized in our financial statements. The application of GAAP requires us to evaluate the recoverability of our deferred tax assets and establish a valuation allowance if necessary to reduce our deferred tax asset to an amount that is more likely than not to be realized. Realization of certain deferred tax assets is dependent upon generating sufficient taxable income in the appropriate jurisdiction prior to the expiration of the carry-forward periods. Although realization is not assured, management believes it is more likely than not the deferred tax assets, net of valuation allowances, will be realized.
To the extent our effective tax rate increases or decreases by one percent of income from operations before income taxes and cumulative effect of accounting change, consolidated income from operations before cumulative effect of accounting change would have increased or declined by $1.5 million in 2004.
From December 31, 2003 to December 31, 2004 there was an increase of $2.672 billion in total assets from $25.215 billion to $27.887 billion. The largest increase was in separate account assets, which increased by $1.554 billion primarily from market value appreciation of $1.659 billion as a result of continued strength in the equity markets, positive net sales (sales less withdrawals) and partially offset by the implementation of Statement of Position 03-1 or, "SOP 03-1," in 2004. SOP 03-1 requires among other things, that certain individual market value adjusted annuity or, "MVA," contracts be accounted for under general account accounting treatment. As a result of the adoption, approximately $400 million of fixed maturities formerly classified as separate account assets were reclassified as general account fixed maturities.
Fixed maturities increased by $385 million mainly as a result of the implementation of SOP 03-1 described above, and investing positive cash flows into fixed maturities. Offsetting overall growth in fixed maturities was a decline in the level of unrealized gains resulting from an increasing interest rate environment and in increased cash position as of December 31,2004.
Reinsurance recoverable is higher by $248 million as a result of larger ceded reserves held under the PARCC agreement, and is mentioned in more detail in "Premiums" below. Deferred sales inducements and other assets are higher by $36 million, driven by a $31 million increase in deferred expenses related to sales inducements for annuity products as the Company has sold more annuity contracts that contain these features.
Net Income Consolidated net income of $113 million for 2004 improved $28 million from $85 million earned for 2003. Policy charges and fee income increased $72 million from last year as a result of increased sales and growth in the separate accounts from continued strength in the financial markets. DAC amortization in 2004 is $56 million higher than in 2003 due to increased amortization in the current year from higher gross profits in both the life and annuity businesses and growth in the term life in force. Further details regarding the components of revenues and expenses are described in the following paragraphs.
Net investment income increased by $29 million, up from $345 million in 2003, driven by increased income in fixed maturities due to an increase in the portfolio balance from the above-mentioned reclassification resulting from the adoption of SOP 03-1 in 2004, reinvestment of income, and positive cash flows. This was partially offset by a lower yields, increased transfers from fixed fund annuities to separate accounts and lower income from declining fund balances in the retirement business.
The change in reserves for life products decreased $25 million from $84 million in 2003 to $59 million in 2004, primarily as a result of a decrease in term life reserves, net of reinsurance. The net change in term reserves is lower due to the new coinsurance treaty with PARCC, which generated higher reinsurance reserves than last year. The change in reserves for annuity products increased $5 million to $7 million in 2004, due to guaranteed minimum death benefit or, "GMDB," and guaranteed minimum income benefit "GMIB" reserves that were established as of January 1, 2004. The GMDB feature provides annuity contractholders with a guarantee that the benefit received at death will be no less than a prescribed minimum amount. This minimum amount is based on the net deposits paid into the contract, the net deposits accumulated at a specified rate, the highest historical account value on a contract anniversary, or more typically, the greatest of these values, depending on features offered in various contracts and elected by the contractholders. Prior to adoption of SOP 03-1 a liability for the expected future net costs associated with GMDB provisions was not established for the annuity business.
Interest credited to policyholders' account balances increased by $23 million, from $228 million in 2003 to $251 million in 2004, due to growth in policyholders' account balances, especially for the annuity fixed rate option products. Overall net interest spread revenue, representing net investment income less interest credited, increased from last year as general account assets have increased as described above.