The Company offers a wide array of annuities, including: (1) 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; (2) certain other fixed deferred annuities that are not registered with the Securities and Exchange Commission; and (3) 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 our ability to manufacture and distribute products and services and to introduce new products gaining market acceptance on a timely basis;
o our amount of assets under management and changes in their fair value, which affect the amount of asset management fees we receive;
o our ability to maintain our credit and financial strength ratings.
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 assigning the unamortized deferred policy acquisition costs ("DAC") asset 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, 2004 financial statements included herein for further discussion).
Valuation of investments As prescribed by GAAP, we present our investments classified as available for sale, including fixed maturity and equity securities, and our investments classified as trading, at fair value in the statements of financial position. The fair values for our public fixed maturity securities and our public equity 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 comprise 3% of our investments as of December 31, 2004, this information is not available. For these private investments, 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.
For fixed maturities classified as available for sale, the impact of changes in fair value is recorded in "Accumulated other comprehensive (loss) income," a separate component of equity. However, the carrying value of these securities is reduced, with a corresponding charge to earnings, when a decline in value is considered to be 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 if 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 fair value, with a corresponding charge to earnings. This corresponding charge is referred to as an impairment and is reflected in "Realized investment (losses) gains, net" in the Consolidated Statements of Operations and Comprehensive Income. The level of impairment losses can be expected to increase when economic conditions worsen and decrease when economic conditions improve.
Deferred policy acquisition costs We capitalize costs that vary with and are related primarily to the acquisition of new and renewal annuity contracts. These costs include primarily commissions, costs of policy issuance and underwriting and other variable 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 and 2003, DAC in our annuity business was $300.9 million and $122.5 million, respectively.
DAC associated with our annuity contracts is amortized over the life of these policies in proportion to gross profits. In calculating gross profits, we consider mortality, persistency, and other elements as well as rates of returns on investments associated with these contracts. We regularly evaluate and adjust the related DAC balance with a corresponding charge or credit to current period earnings for the effects of our actual gross profits and changes in our assumptions regarding estimated future gross profits. Our evaluation of DAC related to variable annuity contracts considers expected gross profits that would be generated within a pre-established reasonably possible range, or corridor, of future rate of return scenarios. Adjustments to DAC are made only when our long-term view of investment returns considered in our estimates of future gross profits results in a DAC balance outside of the corridor. However, notwithstanding our corridor approach, we may determine that a revision of our expected gross profits and a related adjustment to our DAC is necessary if changes in additional factors, such as policyholder activity, suggest that our current view of expected gross profits may no longer represent our best estimate. For variable annuity contracts, DAC is more sensitive to these effects due primarily to the significant portion of gross profits that is dependent upon the total rate of return on assets held in separate account investment options, and the shorter average life of the contracts. This rate of return influences the fees we earn, costs we incur associated with minimum death benefit and other contractual guarantees specific to our variable annuity contracts, as well as other sources of profit.
To demonstrate the sensitivity of our variable annuity DAC balance relative to our future rate of return, increasing or decreasing our future rate of return by 100 basis points would have required us to consider adjustments, subject to our application of the corridor approach, to that DAC balance as follows. The information provided in the table below considers only the effect of changes in our projected rate of return and not changes in any other assumptions such as persistency, mortality, or expenses included in our evaluation of DAC.
Increase/(Reduction) in DAC ----------------------- ----------------------- (in millions) Increase in projected rate of return by 100 basis points..... $ 3.6 Decrease in projected rate of return by 100 basis points..... $ (3.7)
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 $222.6 million and $337.1 million as of December 31, 2004 and 2003, respectively.
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. To the extent our effective tax rate increases or decreases by 1 percent of income from operations before income taxes and cumulative effect of accounting change, consolidated income before and cumulative effect of accounting change would have increased or declined by $1.4 million in 2004.
The amount of income taxes paid by the Company is subject to ongoing audits in various jurisdictions. We reserve for our best estimate of potential payments/settlements to be made to the Internal Revenue Service and other taxing jurisdictions for audits on-going or not yet commenced.
From December 31, 2003 to December 31, 2004 total assets increased by $3.1 billion from $27.2 billion to $30.3 billion. Sales activity during the year ended December 31, 2004 resulted in an increase in deferred policy acquisition costs ("DAC") and deferred purchase credits of $178.3 million and $74.2 million, respectively. In addition, fixed maturities increased by $1.3 billion primarily due to the January 1, 2004 adoption of Statement of Position ("SOP") 03-1, "Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts" issued by the Accounting Standards Executive Committee ("AcSEC") of the American Institute of Certified Public Accountants ("AICPA"). SOP 03-1 requires the conversion of certain individual MVA annuity contracts from separate account accounting treatment to general account accounting treatment and has the effect of establishing reserves for guaranteed minimum death benefit ("GMDB") provisions of the Company's annuity contracts. Separate account assets increased by $1.2 billion, which includes a $3.0 billion increase primarily from market value appreciation and positive net flows and a $1.8 billion decrease due to the SOP 03-1 reclassification of the assets supporting the fixed, MVA liability to general account accounting treatment. Short-term investments increased by $384.4 million primarily due to the adoption of SOP 03-1 in addition to the initiation of a securities lending program and the expansion of repurchase agreements. Valuation of business acquired ("VOBA") decreased by $168.0 million, primarily related to the adoption of SOP 03-1.
During the year, liabilities increased by $3.0 billion from $26.6 billion to $29.6 billion. Policyholders' account balances increased by $1.3 billion primarily due to the SOP 03-1 reclassification of the fixed, MVA liability to general account accounting treatment for $1.8 billion partially offset by a $117.1 million decrease in this liability because of the SOP 03-01 requirement to record this liability at accreted value instead of market value as well as negative net flows activity. As a result of favorable market returns during 2004, we experienced significant transfers of customer account values from the MVA option to mutual fund options included in separate account liabilities. Separate account liabilities increased by $1.2 billion, as described above. SOP 03-1 also required the Company to record a GMDB liability for $8.6 million on January 1, 2004 which grew to $26.4 million as of December 31, 2004. During the year, short-term and long-term borrowings increased $24.4 million and $135.0 respectively. The proceeds from these borrowings were used to support working capital needs. During 2004, the Company initiated a securities lending program and expanded its repurchase agreements to enhance yield performance, which resulted in an increase in cash collateral for loan securities and securitizations sold under agreement to repurchase of $291.3 million and $12.5 million, respectively. Future fees payable to ASI decreased $107.3 million during the year due to amortization.
Other liabilities increased by $160.1 million from $208.2 million to $368.3 million due to an increase in drafts outstanding of $103.0 million. In addition, during the third quarter of 2004, the Company identified a system-generated calculation error in its annuity contract administration system. This error related to the calculation of amounts due to customers for certain transactions subject to a market value adjustment upon the surrender or transfer of monies out of their annuity contract's fixed allocation options. The error resulted in an aggregate underpayment to policyholders of approximately $27.0 million. A reserve of $32.0 million for the amount of the underpayment and related costs to the company is included in Other liabilities at December 31, 2004. Current year net income was reduced by $3 million for the effect of the error in respect of transactions that occurred in prior years, net of related amortization and taxes.
Net Income Net income of $89.9 million for 2004 decreased $8.8 million from $98.7 million in 2003. Net income in 2004 includes a cumulative effect of accounting change charge of $17.1 million, net of taxes, related to the January 1, 2004 adoption of SOP 03-1. Excluding the cumulative effect charge, net income increased by $8.3 million. Policy charges and fee income increased $7.4 million and asset management fees increased by $17.9 due to favorable market conditions partially offset by higher general, administrative and other expenses of $6.9 million and higher benefit costs. Further details regarding the components of revenues and expenses are described in the following paragraphs.
Revenues Consolidated revenues increased by $91.5 million, from $484.1 million to $575.6 million. Net investment income increased by $65.0 million primarily due to the adoption of SOP 03-1 as a result of classifying interest credited on account balances of our MVA annuity contracts as interest credited in the current year as opposed to net investment income in the prior year period.
Policy charges and fee income increased by $7.4 million. Mortality and expense charges ("M&E") increased by $56.9 million as a result of the increase 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 increased as a result of favorable valuation changes in the securities market over the past year and positive net flows, resulting in an increase in policy charges and fee income. The increase in M&E fees was partially offset by a $41.7 million realized market value adjustment expense on the Company's fixed, market value adjusted investment option related to the adoption of SOP 03-1. In addition, surrender charges declined by $5.0 million.
In addition to establishing a liability associated with the GMDB feature, SOP 03-1 required a change in valuation and presentation of our liability associated with the market value adjustment ("MVA") feature contained in certain annuity contracts. The MVA feature requires the Company to pay to the contract holder upon surrender the accreted value of the fund as well as a MVA based on the crediting rates on the contract surrendered compared to crediting rates on newly issued contracts.or an index rate at time of surrender, if applicable. The MVA may increase or decrease the amount due to the contract holder. At December 31, 2003, this liability was recorded at market value, which considered the effects of unrealized gains and losses in contract value resulting from changes in crediting rates. Upon adoption of SOP 03-1, the Company reclassified this liability from "Separate account liabilities" to "Policyholders' account balances" and reduced it by $117.1 million to reflect accreted value, which excludes the effect of unrealized gains and losses in contract value resulting from changes in crediting rates. However, in valuing the valuation of business acquired ("VOBA") established at the date of acquisition, we considered the effect of unrealized gains and losses in contract value associated with annuities containing the MVA feature on future cash flows. As a result, the reduction in the liability for the MVA feature resulted in a net decrease in VOBA of $128.9 million, and lower future amortization.
General, administrative, and other expenses increased by $6.9 million from the prior year. There was an increase of allocated corporate overhead from Prudential Financial to the Company of $13.6 million in 2004. There was also a $13.2 million increase in expense related to future fees payable to ASI. Expenses result when the actual cash flow payable to ASI under the sale purchase agreements exceed the amortization of the fees payable liability. Due to purchase accounting and increasing asset values of those annuity contracts, driven by the improving equity markets, cash flows, and therefore expenses have increased from prior year levels. Additionally, commissions, net of capitalization, increased by $12.2 million in the current year as a result of increased average assets under management as well as increased sales levels in the current year. The current year also included a contingent reserve of $5 million for anticipated costs associated with the remediation of a calculation error of amount due to customers upon surrender or transfer from the Company's MVA option. Offsetting the increase was a decrease in DAC amortization of $22.0 million due to the Company's DAC asset being assigned a fair value of zero, consistent with purchase accounting guidance as of the date of the acquisition. Additionally, VOBA amortization decreased by $14.9 million due to the adjustment of VOBA recorded upon adoption of SOP 03-1, as explained above.
Information required with respect to this Item 8 regarding Financial Statements and Supplementary Data is set forth commencing on page hereof. See Index to Consolidated Financial Statements elsewhere in this Annual Report.