Our executive headquarters consist of our main office building at One American Row and one other building in Hartford, Connecticut, which we own and occupy. We lease property in East Greenbush, New York and Greenfield, Massachusetts. We also lease office space elsewhere in the U.S. as needed for our operations.
Our selected historical consolidated financial data as of and for each of the five years in the period ended December 31, 2006 follows. We derived the balance sheet data for 2006 and 2005 and the income statement data for the years 2006, 2005 and 2004 from our consolidated financial statements in this Form 10-K. We derived the balance sheet data for 2004, 2003 and 2002 and the income statement data for the years 2003 and 2002 from audited consolidated financial statements not in this Form 10-K. We have reclassified certain amounts for prior years to conform with our 2006 presentation.
The following should be read in conjunction with Management’s Discussion and Analysis of Financial
Condition and Results of Operations and our consolidated financial statements in this Form 10-K.
Due to our losses during 2003 and 2002, the ratio of earnings to fixed charges for those years was less than 1:1. We would need $11.4 million and $113.6 million in additional earnings for the years 2003 and 2002, respectively, to achieve a 1:1 coverage ratio.
In accordance with accounting practices prescribed by the New York State Insurance Department, Phoenix Life’s capital and surplus includes $156.5 million, $186.7 million, $186.7 million, $157.5 million and $163.3 million of surplus notes outstanding at December 31, 2006, 2005, 2004, 2003 and 2002, respectively.
The AVR is a statutory reserve intended to mitigate changes to the balance sheet as a result of fluctuations in asset values.
The discussion in this Form 10-K may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. We intend for these forward-looking statements to be covered by the safe harbor provisions of the federal securities laws relating to forward-looking statements. These include statements relating to trends in, or representing management’s beliefs about our future strategies, operations and financial results, as well as other statements including, but not limited to, words such as “anticipate,” “believe,” “plan,” “estimate,” “expect,” “intend,” “may,” “should” and other similar expressions. Forward-looking statements are made based upon management’s current expectations and beliefs concerning trends and future developments and their potential effects on us. They are not guarantees of future performance. Actual results may differ materially from those suggested by forward-looking statements as a result of risks and uncertainties which include, among others: (i) movements in the equity markets and interest rates that affect our investment results, the fees we earn from our assets under management, the demand for our variable products and our pension funding obligations; (ii) the possibility that mortality rates or persistency may differ significantly from our pricing expectations; (iii) the availability, pricing and adequacy of reinsurance coverage generally and the inability or unwillingness of our reinsurers to meet their obligations to us specifically; (iv) our dependence on non-affiliated distributors for our product sales, (v) downgrades in the financial strength ratings of our subsidiaries or in our credit ratings; (vi) our dependence on third parties to maintain critical business and administrative functions; (vii) the ability of independent trustees of our mutual funds and closed-end funds, intermediary program sponsors, managed account clients and institutional asset management clients to terminate their relationships with us; (viii) our ability to attract and retain key personnel in a competitive environment; (ix) the poor relative investment performance of some of our equity management strategies and the resulting outflows in our assets under management; (x) the possibility that the goodwill or intangible assets associated with our asset management business could become impaired, requiring a charge to earnings; (xi) heightened competition, including with respect to pricing, entry of new competitors and the development of new products and services by new and existing competitors; (xii) our primary reliance, as a holding company, on dividends and other payments from its subsidiaries to meet debt payment obligations, particularly since our insurance subsidiaries’ ability to pay dividends is subject to regulatory restrictions; (xiii) the
potential need to fund deficiencies in our closed block; (xiv) legislative, regulatory, accounting or tax developments that may affect us directly, or indirectly through the cost of, or demand for, our products or services; (xv) legal or regulatory actions; and (xvi) other risks and uncertainties described herein or in any of our filings with the SEC. We undertake no obligation to update or revise publicly any forward-looking statement, whether as a result of new information, future events or otherwise.
ability to maintain expenses in accordance with our pricing assumptions; and
insurance and investment product fees on variable life and annuity products and universal life products;
Our sales and financial results are always affected by demographic, industry and market trends. For example, the baby boom generation is in its prime savings years, and Americans generally have begun to rely less on defined benefit retirement plans, Social Security and other government programs to meet their postretirement financial needs. In addition, product preferences shift between fixed and variable options depending on market and economic conditions. Our balanced product portfolio, including universal life, variable life and variable annuity products, as well as a broad array of mutual funds and managed accounts, positions us to meet this shifting demand.
The mandatorily redeemable noncontrolling interests in our less than wholly owned asset management subsidiaries were subject to certain agreements, which were executed at the time of the acquisition. Upon acquisition of the remaining outstanding mandatorily redeemable interests, any previous rights under these agreements were nullified. We recorded $77.6 million and $15.2 million of additional redemption or purchase price in 2005 and 2004, respectively, related to the redemption of noncontrolling membership interests that existed at the time of acquisition with certain of our majority-owned subsidiaries.
On January 14, 2005, we closed the sale of our equity holdings in Aberdeen Asset Management PLC, or Aberdeen, a United Kingdom-based asset management company, for net proceeds of $70.4 million, resulting in an after-tax realized investment loss of $7.0 million, in our 2005 consolidated statement of operations. This sale completed our disposition of our direct financial interests in Aberdeen.
and significant changes in the equity markets could therefore have an impact on deferred policy acquisition cost amortization. We also perform analysis with respect to the sensitivity of a change in assumed mortality as it is critical to the development of the EGPs related to our universal life insurance business.
At our most recent unlocking of separate account performance, we concluded that a revision of 100 basis points to previously projected account returns and related EGPs was required. If at December 31, 2006 we had used a 100 basis points lower separate account return assumption (after fund fees and mortality and expense charges) for both the variable annuity and the variable life businesses and used our current best estimate assumptions for all other assumptions to project account values forward from the current value to reproject EGPs, the estimated increase to amortization and decrease to net income would be approximately $3.8 million, after-tax.
The cost basis of these written-down investments is adjusted to fair value at the date the determination of impairment is made. The new cost basis is not changed for subsequent recoveries in value. For mortgage-backed and other asset-backed debt securities, we recognize income using a constant effective yield based on anticipated prepayments and the estimated economic lives of the securities. When actual prepayments differ significantly from anticipated prepayments, the effective yield is recalculated to reflect actual payments to date and any resulting adjustment is included in net investment income. For certain asset-backed securities, changes in estimated yield are recorded on a prospective basis and specific valuation methods are applied to these securities to determine if there has been an other-than-temporary decline in value. We report mortgage loans at unpaid principal balances, net of valuation reserves on impaired mortgages. We consider a mortgage loan to be impaired if we believe it is probable that we will be unable to collect all amounts of contractual interest and principal as scheduled in the loan agreement. We do not accrue interest income on impaired mortgage loans when the likelihood of collection is doubtful.
We account for income taxes in accordance with SFAS 109, Accounting for Income Taxes. The deferred tax assets and/or liabilities are determined by multiplying the differences between the financial reporting and tax reporting basis for assets and liabilities by the enacted tax rates expected to be in effect when such differences are recovered or settled. The effect on deferred taxes of a change in tax rates is recognized in income in the period that includes the enactment date. Valuation allowances on deferred tax assets are estimated based on our assessment of the realizability of such amounts.
We have elected to file a consolidated federal income tax return for 2006 and prior years. Within the consolidated tax return, we are required by regulations of the Internal Revenue Service, or IRS, to segregate the entities into two groups: life insurance companies and non-life insurance companies. We are limited as to the amount of any operating losses from the non-life group that can be offset against taxable income of the life group. These limitations may affect the amount of any operating loss carryforwards that we have now or in the future.
As of December 31, 2006, our deferred income tax assets of $8.9 million related to foreign tax credit carryovers were expected to expire between the 2008 and 2009 tax years. As of December 31, 2006 and 2005, we had a $5.6 million valuation allowance relative to foreign tax credit carryovers.
As of December 31, 2006, our deferred income tax assets of $14.1 million related to general business tax credits were expected to expire between the years 2022 and 2025.
We have determined, based on our earnings and future income, that it is more likely than not that the deferred income tax assets after valuation allowance already recorded as of December 31, 2006 and 2005 will be realized. In determining the adequacy of future income, we have considered projected future income, reversal of existing temporary differences and available tax planning strategies that could be implemented, if necessary.
Our federal income tax returns are routinely audited by the IRS, and estimated provisions are routinely provided in the financial statements in anticipation of the results of these audits. While it is often difficult to predict the outcome of these audits, including the timing of any resolution of any particular tax matter, we believe that our reserves, as reported on our consolidated balance sheet, are adequate for all open tax years. Unfavorable resolution of any particular issue could result in additional use of cash to pay liabilities that would be deemed owed to the IRS. Additionally, any unfavorable or favorable resolution of any particular issue could result in an increase or decrease, respectively, to our effective income tax rate to the extent that our estimates differ from the ultimate resolution. As of December 31, 2006, we had current taxes payable of $4.5 million.
Premiums decreased $89.0 million primarily due to decreases in premiums on the traditional life insurance block, which is comprised mainly of participating life insurance policies which we no longer sell. However, policyholder benefits decreased $81.4 million related to the reduction of in-force policies for traditional life insurance.
Insurance and investment product fees increased $62.4 million due primarily to an increase in universal life fees from growth in both sales and policies in force and higher annuity fees due to higher funds on deposit.
Total benefits and expenses decreased $37.3 million primarily due to the following:
Other operating expenses decreased $55.4 million due to lower life and annuity expenses of $22.9 million, lower asset management expenses of $22.4 million, lower incentive accruals and the elimination of stock purchase contract payments related to HRH.
Policyholder dividends increased $34.7 million due primarily to the change in the policyholder dividend obligation, partially offset by the reduction to the dividend scale in late 2005.
Policy acquisition cost amortization increased $16.6 million due primarily to higher amortization for universal life resulting from the growth of policies in force and the effects of unlocking in 2006 and 2005.
Net income decreased $8.5 million, or 8%, primarily due to the following:
Life insurance sales were very strong for the year. Total life insurance sales of $329.3 million in 2006 well surpassed 2005 sales of $192.5 million. Our sales were well diversified in terms of distribution, with no single relationship accounting for more than 25% of total sales. Annuity sales also gained momentum. Annuity deposits for the year increased 24% to $421.0 million from $339.1 million for 2005. Private placement life and annuity deposits, which are not included in the life sales or annuity deposits, were $1,053.7 million in 2006 compared to $820.3 million for 2005.
A complete and competitive core product portfolio, enhanced by innovative products and programs.
In annuities, we are focused on continued improvement through competitive products, focused leadership and targeted distribution strategy.
In our asset management business, total assets under management were up 20% versus a year ago due to a combination of fund adoptions and market performance partially offset by net outflows. Mutual fund sales in the third and fourth quarters of 2006 were our highest ever since becoming a public company.
We are focused on continued improvement in the profitability of Asset Management, as well as improving net flows. Our strategy for growth is to:
increase mutual fund sales through our enhanced product line-up and focused distribution relationships;
leverage our strong-performing proprietary strategies through institutional mandates in defined contribution and defined benefit markets and through structured products; and
We ended 2006 with a stronger financial position than 2005. Shareholders’ equity was $2,236.1 million at December 31, 2006. Phoenix Life’s statutory capital, surplus and AVR grew $24.0 million to $1,120.3 million at December 31, 2006 even after we paid off $30.2 million of surplus notes, paid a $87.5 million dividend to PNX and made Life Company pension contributions of $21.5 million. Phoenix Life’s risk-based capital, or RBC, is well above 400%, and PNX cash was $80.0 million at December 31, 2006.
Insurance and investment product revenue decreased $20.2 million due primarily to lower average assets under management, decreased volumes in equity trading by certain investment managers, and the sale of our retail affiliated broker-dealer operations and certain non-core businesses.
Broker-dealer commission and distribution fee revenues decreased $28.2 million due primarily to the sale of our retail affiliated broker-dealer operations in May 2004.
Policy benefits decreased $45.5 million due primarily to a reduction of in-force policies for traditional life insurance and lower interest credited, particularly for annuities.
Other operating expenses decreased $82.8 million due to lower restructuring and other costs of $24.5 million, lower Life and Annuity expenses of $21.4 million and lower Asset Management expenses of $35.9 million.
35% growth in Life and Annuity pre-tax operating earnings and a lower effective tax rate.
An increase in net investment income due to partnership and private equity gains, higher funds on deposit, particularly for universal life and an increased invested asset base.
Life sales regained momentum in 2005 after declining in 2004 due to the sale of our retail affiliated distribution and our unwillingness to compete aggressively with products that contain no-lapse guarantees. We continued to benefit from the strength of our distribution relationships that have access to our target market, the value-added services and support we provide as well as our large-case underwriting expertise. Total life premiums and annualized life premiums were up by 33% and 69%, respectively, over 2004. Annuity deposits decreased in 2005, reflecting lower than anticipated sales from new product introductions. However, funds in lower returning discontinued annuity products declined. Private placement life and annuity deposits, which are not included in life sales or annuity deposits, were $820.3 million for 2005, nearly four times the 2004 deposits of $212.7 million.
The effective tax rate for 2006, 2005 and 2004 was 30.1%, 20.2% and 29.5%, respectively. The principal cause of the difference between the effective rate and the U.S. statutory rate of 35% for 2006 was investment income not taxed (i.e., dividend received deduction, or DRD, and low income housing tax credits). For 2005, the principal causes were investment income not taxed (i.e., DRD and low income housing tax credits) and the tax interest associated with a settlement with the IRS. Income taxes paid (received) in 2006, 2005 and 2004 were $0.9 million, $(25.4) million and $(0.5) million, respectively. See Note 16 to our consolidated financial statements in this Form 10-K for more information related to income taxes.
The separate account DRD is estimated for the current year using information from the most recent year-end, adjusted for projected equity market performance. The estimated DRD is updated in the third quarter in conjunction with filing the prior year’s federal income tax return, and in the fourth quarter based on known actual mutual fund distributions and fee income from Phoenix’s variable insurance products. The actual current year DRD can vary from the estimates based on, but not limited to, changes in eligible dividends received by the mutual funds, amounts of distributions from these mutual funds and appropriate levels of taxable income.
We allocate capital to our Life and Annuity segment based on risk-based capital, or RBC, for our insurance products. We used a 300% risk-based capital ratio for allocations in 2004 through 2006. Capital within our Life Companies that is unallocated is included in Corporate and Other. We allocate capital to our Asset Management segment on the basis of the historical capital within that segment. We allocate net investment income based on the assets allocated to the segments. We allocate tax benefits related to tax-advantaged investments to the segment that holds the investment. We allocate certain costs and expenses to the segments based on a review of the nature of the costs, time studies and other methodologies.
Unrealized gains on equity investment in Aberdeen, net of income taxes
Premium revenue decreased 10% due to lower participating life insurance premiums, primarily renewal premiums, partially offset by higher term life premiums. Since our demutualization in 2001, we no longer sell participating life policies. The decline in renewal premiums is significantly offset by the release of policy reserves, which lowers policyholder benefit costs.
Policy benefits, including policyholder dividends, decreased 4% due principally to lower benefit and changes in reserves for participating life insurance, primarily related to lower renewal premiums and lower scheduled withdrawals for corporate-owned life insurance. In addition, dividend expense was lower and interest credited for annuities declined in 2006. Dividend expense decreased due to the change in the dividend scale in the fourth quarter of 2005, partially offset by an increase in the change for the policyholder dividend obligation. Interest credited for annuities decreased due to the decline in general account funds on deposit, related primarily to discontinued products. These decreases were partially offset by higher benefit costs for universal life, which resulted from growth of policies in force.
Full year operating earnings for Life and Annuity reflect strong investment margins for life and annuity lines and continued favorable mortality and persistency. Life and Annuity benefited from an adjustment, or unlocking, of assumptions primarily related to deferred policy acquisition costs, which increased operating income before income taxes by $23.8 million for the second quarter. The unlocking reflected favorable mortality experience offset by interest rate and spread adjustments for annuities. The effects of the unlocking decreased insurance product fee revenues by $0.3 million, increased the change in policyholder reserves by $3.5 million, increased non-deferred expenses by $0.5 million and decreased deferred policy acquisition cost amortization by $28.1 million. However, this initial benefit was partially offset by a resulting increase in deferred policy acquisition cost amortization in future periods.
Premium revenue decreased 6% due primarily to lower premiums on the traditional life insurance block, which is comprised mainly of participating life insurance policies. Since our demutualization in 2001, we no longer sell participating life policies, resulting in a decline in participating life renewal premiums. The decline in renewal premiums is significantly offset by the release of policy reserves, which lowers policyholder benefit costs.
Policy acquisition cost amortization increased 4% due primarily to higher amortization for universal life and annuities offset by the effects of unlocking. Amortization increased for universal life insurance due to higher insurance margins and growth of in-force policies and increased for annuities due to improved investment margins and higher surrenders.
Annuity funds on deposit increased $639.5 million in 2006 compared to an increase of $335.2 million in 2005. This change was due to higher deposits in 2006, including a large private placement deposit of $886.8 million in the fourth quarter, and stronger relative investment performance, partially offset by higher benefits and surrenders, including a $206.6 million scheduled maturity from an institutionally-placed contract in the second quarter of 2006.
Variable universal life funds on deposits increased by $156.7 million in 2005 compared to an increase of $234.5 million in 2004. This change was principally due to lower deposits, lower relative investment performance and higher surrenders and benefits in 2005.
Universal life funds on deposit increased $123.4 million in 2005 compared to an increase of $46.7 million in 2004. This improvement was principally due to higher deposits and lower benefits and surrenders, partially offset by higher fees and cost of insurance charges in 2005.
Universal life insurance revenue increased 39% due to higher cost of insurance fees from growth of in-force business, increased investment earnings from higher funds on deposit and increased fees from higher sales in 2006.
Variable universal life insurance revenue increased 5% due primarily to higher cost of insurance fees, slightly improved investment earnings and increased fees due to the unlocking discussed previously.
Universal life insurance revenue increased 12% due primarily to the higher cost of insurance fees resulting from growth of in-force business and improved investment earnings from higher funds on deposit and strong investment gains. The increase in revenues for 2005 was partially offset by the effect of unlocking on deferred fee income.
Other life insurance revenue decreased 98% due primarily to lower broker-dealer commission and distribution fee revenues resulting from the sale of our retail affiliated broker-dealer operations in May 2004.
Traditional life insurance revenue decreased 3% due primarily to lower renewal premiums, partially offset by improved investment earnings. Since our demutualization in 2001, we no longer sell participating life insurance policies, which comprise the majority of our traditional life insurance block of business.
Annuity revenue increased 4% due primarily to higher investment earnings resulting from the extension of asset duration and higher interest rates, higher fees from increased fee-based funds on deposit and modestly higher surrender charges.
Variable universal life operating income before income taxes decreased 24% due primarily to higher amortization of deferred policy acquisition costs related to unlocking in 2006 versus 2005 and higher claims in 2006. The effect of unlocking decreased amortization of deferred policy acquisition costs by $17.0 million in 2006 compared to a reduction of $29.1 million in 2005.
Universal life operating income before income taxes increased 11% due primarily to higher insurance margins, with the growth in revenues (discussed above) outpacing the increase in benefits, and higher investment earnings. These increases were partially offset by higher amortization of deferred policy acquisition costs, primarily from improved insurance margins and modestly higher expenses. Amortization was also affected by unlocking which decreased amortization by $12.7 million in 2006 compared to a decrease of $17.6 million in 2005.
Traditional life operating income before income taxes increased 64% due primarily to significantly higher operating income for traditional life, excluding closed block, partially offset by a modest decline for the closed block. Operating income for traditional life, excluding the closed block increased due to lower operating expenses, lower amortization of deferred policy acquisition costs and modestly higher investment earnings, partially offset by higher benefit costs related to an old block of corporate-owned life insurance. The amortization of deferred policy acquisition costs was lower due principally to the effects of unlocking which decreased amortization by $4.7 million in 2006 and increased amortization by $7.9 million in 2006.
Annuities operating income before income taxes decreased 67% primarily due to lower interest earned (discussed above) and higher amortization of deferred policy acquisition costs, partially offset by lower interest credited and lower operating expenses. Interest earned and interest credited decreased due to lower funds on deposit, primarily related to discontinued products. The increase in amortization of deferred policy acquisition costs was due to the effects of unlocking which increased amortization by $15.3 million in 2006 compared to an increase of $10.7 million in 2005.
Variable universal life operating income before income taxes increased 95% due primarily to the effects of unlocking, increased revenue and favorable mortality.
Annuities operating income before income taxes decreased 6% due primarily to the effects of unlocking and higher deferred policy acquisition cost amortization from higher margins and lower persistency. These decreases to pre-tax income were offset by improved investment margins from higher investment earnings and lower interest credited from lower balances subject to guaranteed crediting rates.
In 2005, the effects of unlocking increased operating income before income taxes by $23.8 million through the second quarter, consisting of increases in variable universal life of $28.6 million and universal life of $13.8 million, partially offset by decreases in annuities of $10.7 million and traditional life of $7.9 million. The favorable effect of unlocking was reduced in the second half of 2005 due to higher deferred policy acquisition cost amortization of $5.8 million, particularly for universal life.
Our investment product fee revenues are based on assets under management. Approximately 45% of our investment product fees were based on beginning of quarter assets under management while the remaining 55% were based on end of day balances. End of year and average assets (based on how fees are calculated) under management follow:
Assets under management increased due to the acquisition of the contracts to manage the Insight Funds and positive investment performance, partially offset by net outflows of $4.0 billion. Assets under management related to the Insight Funds were $8.6 billion as of December 31, 2006.
In addition to our regular annual testing, in the first quarter of 2006 we performed an interim test for impairment on certain definite-lived intangible assets as a result of significant outflows related to the associated retail products. As a result of these tests, we recorded a $32.5 million pre-tax impairment charge against certain definite-lived intangible assets. In connection with this impairment, as required by SFAS No. 142, we also performed a test for impairment of the asset management goodwill. No impairment of goodwill was deemed necessary.
Other operating expenses decreased 11% due to a decrease of $14.5 million in employment expenses, a decrease of $6.7 million in mandatorily redeemable interest costs and a $6.3 million decrease in other operating expenses, partially offset by a $5.0 million increase in distribution and administration expenses. The decrease in employment expenses was due to lower salary expense because of a lower number of employees and a decrease in incentive compensation expense, which was primarily driven by lower investment product fee revenues. Mandatorily redeemable interest costs decreased to zero due to the acquisition of the remaining outstanding mandatorily redeemable noncontrolling interests in certain of our asset management subsidiaries during the second and third quarters of 2005. Other operating expenses were lower in 2006 because of a reduction in office lease expenses and an overall reduction in most general expenses. Distribution and administration expenses increased in 2006 due to the increased amount of mutual fund business.
Investment product fees decreased 16%. This decrease was due primarily to a decrease in average assets under management compared to the prior year. Retail and institutional investment product fees decreased $23.1 million and $12.8 million, respectively, as a result of the decrease in average assets under management. Other investment product fees decreased $1.9 million due to decreased volumes in equity trading by certain investment managers, which resulted in fewer commissions earned. Approximately 52% of our management fee revenues were based on assets as of the beginning of a quarter, which causes fee revenues to lag behind changes in assets under management.
Other operating expenses decreased 15% due primarily to a decrease of $28.7 million in employment expenses. The decrease in employment expenses was due primarily to a decrease in incentive compensation expense, which was primarily driven by lower investment product fee revenues. General and administrative expenses remained relatively constant in 2005 compared to 2004, with increases in investment research fees being offset by decreases in clearance costs. Mandatorily redeemable interest costs decreased $7.6 million decreased to zero due to the acquisition of the remaining outstanding mandatorily redeemable noncontrolling interests in certain of our asset management subsidiaries during the second and third quarters of 2005.
The decrease in venture capital investments for 2005 was due primarily to our sale of certain partnership interests in December 2005 and the return of capital distributions received.
See Notes 4 and 10 to our consolidated financial statements in this Form 10-K for more information regarding our Venture Capital segment.
The operating loss before income taxes for Corporate and Other decreased 13% due primarily to higher investment earnings, lower allocated corporate expenses and the elimination of interest expense related to the HRH purchase contracts, which was $7.9 million in 2005. The HRH stock purchase contracts were settled in 2005.
Separate account assets are managed in accordance with the specific investment contracts and guidelines relating to our variable products. We generally do not bear any investment risk on assets held in separate accounts. Rather, we receive investment management fees based on assets under management. Assets held in separate accounts are not available to satisfy general account obligations.
Market risk is the risk that we will incur losses due to adverse changes in market rates and prices. We have exposure to market risk through both our investment activities and our insurance operations. Our investment objective is to maximize after-tax investment return within defined risk parameters. Our primary sources of investment risk are:
One of the key measures we use to quantify our interest rate exposure is duration, a measure of the sensitivity of the fair value of assets and liabilities to changes in interest rates. For example, if interest rates increase by 100 basis points, or 1%, the fair value of an asset with a duration of five years is expected to decrease by 5%. We believe that as of December 31, 2006, our asset and liability portfolio durations were well matched, especially for our largest and most interest-sensitive segments. We regularly undertake a sensitivity analysis that calculates liability durations under various cash flow scenarios.
In 1999, we began selling Retirement Planners Edge, or RPE, a no-load variable annuity. RPE was designed to attract contributions into variable sub-accounts on which we earn mortality and expense fees. However, the bulk of the funds were allocated to guaranteed interest accounts, or GIAs, which offered a 3% guaranteed interest rate. We anticipated the liabilities would be of a short duration and with the low level of interest rates, we were unable to invest funds at a rate that guaranteed a spread that covered commissions and interest credited. In September 2002, we stopped accepting applications for RPE, although existing policyholders have the right to make subsequent cumulative gross deposits up to $1 million per contract.
We manage credit risk through the fundamental analysis of the underlying obligors, issuers and transaction structures. Through Goodwin, our Hartford-based asset management affiliate, we employ a staff of experienced credit analysts who review obligors’ management, competitive position, cash flow, coverage ratios, liquidity and other key financial and non-financial information. These analysts recommend the investments needed to fund our liabilities while adhering to diversification and credit rating guidelines. In addition, when investing in private debt securities, we rely upon broad access to management information, negotiated protective covenants, call protection features and collateral protection. We review our debt security portfolio regularly to monitor the performance of obligors and assess the stability of their current credit ratings.
Certain annuity products sold by our Life Companies contain guaranteed minimum death benefits. The guaranteed minimum death benefit feature provides annuity contract holders with a guarantee that the benefit received at death will be no less than a prescribed 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, if a contract has more than one of these features, the greatest of these values. To the extent that the guaranteed minimum death benefit is higher than the current account value at the time of death, the company
incurs a cost. This typically results in an increase in annuity policy benefits in periods of declining financial markets and in periods of stable financial markets following a decline. As of December 31, 2006 and 2005, the difference between the guaranteed minimum death benefit and the current account value (net amount at risk) for all existing contracts was $51.3 million and $82.1 million, respectively. This is our exposure to loss should all of our contractholders have died on either December 31, 2006 or 2005. See Note 13 to our consolidated financial statements in this Form 10-K for more information.
Certain life and annuity products sold by our Life Companies contain guaranteed minimum living benefits. These include guaranteed minimum accumulation, withdrawal, income and payout annuity floor benefits. We have established a hedging program for managing the risk associated with our guaranteed minimum accumulation and withdrawal benefit features. During 2006, we began hedging our GMAB exposure. We continue to analyze and refine our strategies for managing risk exposures associated with all our separate account guarantees. The statutory reserves for these totaled $7.4 million and $4.4 million at December 31, 2006 and 2005, respectively. The GAAP reserves totaled $3.7 million and $3.8 million at December 31, 2006 and 2005, respectively.
We sponsor defined benefit pension plans for our employees. For GAAP accounting purposes, we assumed an 8.5% long-term rate of return on plan assets in the most recent valuations, performed as of December 31, 2006. To the extent there are deviations in actual returns, there will be changes in our projected expense and funding requirements. As of December 31, 2006, the projected benefit obligation for our defined benefit plans was in excess of plan assets by $166.6 million. We made payments totaling $23.9 million to the pension plan during 2006. We do not expect any required contributions in 2007. See Note 18 to our consolidated financial statements in this Form 10-K for more information on our employee benefit plans. In February 2007, we announced a change to our pension plan that will be effective July 1, 2007. The change is designed to decrease the volatility of our pension expense over time.
Foreign currency exchange risk is the risk that we will incur economic losses due to adverse changes in foreign currency exchange rates. Our functional currency is the U.S. dollar. Our exposure to fluctuations in foreign exchange rates against the U.S. dollar primarily results from our holdings in non-U.S. dollar-denominated debt and equity securities which are not material to our consolidated financial statements at December 31, 2006.
Our general account debt securities portfolio consists primarily of investment-grade publicly traded and privately placed corporate bonds, residential mortgage-backed securities, commercial mortgage-backed securities and asset-backed securities. As of December 31, 2006, our general account debt securities, with a carrying value of $12,696.8 million, represented 80.9% of total general account investments. Public debt securities represented 74.4% of total debt securities, with the remaining 25.6% represented by private debt securities.
We manage credit risk through industry and issuer diversification. Maximum exposure to an issuer is defined by quality ratings, with higher quality issuers having larger exposure limits. Our investment approach has been to create a high level of industry diversification. The top five industry holdings as of December 31, 2006 in our debt securities portfolio were banking (7.0%), diversified financial services (4.3%), insurance (3.5%), electrical utilities (3.4%), and other foreign government (2.1%).
There were no realized impairment losses on debt and equity securities pledged as collateral relating to our direct investments in the consolidated collateralized obligation trusts for the years ended December 31, 2006 and 2005. Such losses were $3.7 million for the year ended December 31, 2004.
Impairment losses decreased from $35.3 million in 2005 to $8.9 million in 2006. Affiliate transaction gains of $10.4 million for the year ended December 31, 2006 were attributable to the earn-out associated with the sale of Lombard that occurred in the first quarter of 2006. Affiliate transaction gains and losses for the year ended December 31, 2005 included a $14.4 million gain on the sale of our equity investment in Lombard and a $10.7 million realized loss on the sale of our equity investment in Aberdeen. Transaction gains of $85.4 million for the year ended December 31, 2006 were higher than the $69.5 million on December 31, 2005 as a result of realized gains on the sale of certain debt and equity investments. See Note 10 to our consolidated financial statements in this Form 10-K for additional information.
At the end of each reporting period, we review all securities for potential recognition of an other-than-temporary impairment. We maintain a watch list of securities in default, near default or otherwise considered by our investment professionals as being distressed, potentially distressed or requiring a heightened level of scrutiny. We also identify securities whose carrying value has been below amortized cost on a continuous basis for zero to six months, greater than six months to 12 months and greater than 12 months. This analysis is provided for
investment grade and non-investment grade securities and closed block and outside of closed block securities.
Using this analysis, coupled with our watch list, we review all securities whose fair value is less than 80% of
been affected by any other factors that indicate that the fair value of the investment may have been negatively impacted.
The following tables present certain information with respect to our gross unrealized losses related to our investments in general account debt securities, both outside and inside the closed block, as of December 31, 2006. In the tables, we separately present information that is applicable to unrealized losses both outside and inside the closed block. We believe it is unlikely that there would be any effect on our net income related to the realization of investment losses inside the closed block due to the current sufficiency of the policyholder dividend obligation liability in the closed block. See Note 5 to our consolidated financial statements in this Form 10-K for more information regarding the closed block. Applicable deferred policy acquisition costs and deferred income taxes further reduce the effect on our comprehensive income.
For debt securities in the closed block with gross unrealized losses, 89.9% of the unrealized losses pertain to investment grade securities and 10.1% of the unrealized losses pertain to below investment grade securities at December 31, 2006.
On January 11, 2005, we disposed of our interests in Lombard International Assurance S.A., or Lombard, for consideration of $59.0 million. We realized an after-tax gain of $9.3 million in the first quarter of 2005 related to this sale, including earn-out consideration received. In the first quarter of 2006, we recognized an additional $6.5 million after-tax earn-out gain, and we may be entitled to additional consideration based on Lombard’s financial performance through 2006.
Cash from continuing operations decreased due primarily to proceeds from the sale of trading equity securities of $129.7 million in 2005 from the sale of our investments in Aberdeen and Lombard, higher policy acquisition costs of $141.4 million, lower premiums received of $91.5 million and higher benefits paid of $69.7 million. In addition, income taxes changed by $26.3 million to $0.9 million paid in 2006 compared with $25.4 million received in 2005. The decreases to cash were partially offset by increased investment income and fees received of $25.1 million and $77.1 million, respectively, and lower dividends and operating expenses paid of $58.2 million and $80.4 million, respectively.
Cash from continuing operations increased due to proceeds of $129.7 million from the sale of trading equity securities related to Aberdeen and Lombard and to lower payments for operating expenses, policy benefits and tax refunds of $54.0 million, $357.8 million, and $24.9 million, respectively. These positive operating cash flows were partially offset by a reduction in premiums and product fees collected of $126.9 million, lower investment income received of $29.0 million and higher acquisition expenses of $23.0 million. The reduction in policy benefits paid is due primarily to scheduled withdrawals from a group of large corporate-owned life insurance contracts in 2004 that did not recur at the same level in 2005.
Cash from investing activities increased due primarily to the dissolution of the Mistic CBO, offset by higher investment purchases in 2005. See Note 14 to our consolidated financial statements in this Form 10-K for additional information on the Mistic CBO.
Cash from operating activities increased due primarily to receipt of a higher dividend from our largest life insurance subsidiary.
Cash from financing activities increased due to the receipt of equity unit proceeds, as well as stock option exercises.
Cash from operating activities decreased due primarily to a decrease in dividends received from Phoenix Life of $34.5 million.
Our primary sources of liquidity have been dividends from Phoenix Life and interest income received from PXP. Under New York Insurance Law, Phoenix Life can pay stockholder dividends to the holding company in any calendar year without prior approval from the New York Superintendent of Insurance in the amount of the lesser of 10% of Phoenix Life’s surplus to policyholders as of the immediately preceding calendar year or Phoenix Life’s statutory net gain from operations for the immediately preceding calendar year, not including realized capital gains. Phoenix Life paid a dividend of $87.5 million during 2006 and is able to pay a dividend of $92.2 million in 2007 under this provision. See Note 22 to our consolidated financial statements in this Form 10-K for more information on Phoenix Life statutory financial information and regulatory matters.
See Note 26 to our consolidated financial statements in this Form 10-K for more information on the holding company.
Phoenix Life’s current sources of liquidity also include the revolving credit facility under which Phoenix Life has direct borrowing rights, discussed above, subject to our unconditional guarantee. Since the demutualization, Phoenix Life’s access to the cash flows generated by the closed block assets has been restricted to funding the closed block.
A primary liquidity concern with respect to life insurance and annuity products is the risk of early policyholder and contractholder withdrawal. Our Life Companies closely monitor their liquidity requirements in order to match cash inflows with expected cash outflows, and employ an asset/liability management approach tailored to the specific requirements of each product line, based upon the return objectives, risk tolerance, liquidity, tax and regulatory requirements of the underlying products. In particular, our Life Companies maintain investment programs intended to provide adequate funds to pay benefits without forced sales of investments. Products having liabilities with relatively long lives, such as life insurance, are matched with assets having similar estimated lives, such as long-term bonds, private placement bonds and mortgage loans. Shorter-term liabilities are matched with investments with short-term and medium-term fixed maturities.
During 2006, Phoenix Life paid dividends of $87.5 million to The Phoenix Companies, Inc., as Phoenix Life’s sole shareholder. Under New York Insurance Law, Phoenix Life can pay dividends to The Phoenix Companies in any calendar year without the approval from the New York Superintendent of Insurance in the amount of the lesser of 10% of Phoenix Life’s surplus to policyholders as of the immediately preceding calendar year or Phoenix Life’s statutory net gain from operations for the immediately preceding calendar year, not including realized capital gains. Phoenix Life’s statutory gain from operations was $131.6 million for the year ended December 31, 2006. The maximum dividend that Phoenix Life can pay in 2007 without prior approval is $92.2 million.
PXP’s liquidity requirements are primarily to fund operating expenses and pay its debt and interest obligations. PXP also requires liquidity to fund any potential acquisitions. Historically, PXP’s principal source of liquidity has been cash flow from operations. We expect that cash flow from operations will continue to be its principal source of working capital. Its current sources of liquidity also include a revolving credit facility under which it has direct borrowing rights subject to our unconditional guarantee. We believe that PXP’s current and anticipated sources of liquidity are adequate to meet its present and anticipated needs. See Note 11 to our consolidated financial statements in this Form 10-K for further details on our financing activities.
The fair value of debt securities decreased 5% due primarily to sales of investments related to the reduction in policyholder deposit funds, including the sale of securities related to a $206.6 million scheduled maturity of an annuity contract and an increase in interest rates for the year, which caused a decrease in the fair value of debt securities.
Mortgage loans decreased 44% due to principal pay downs and closings with no new investments in mortgage loans.
Receivables increased 34% as a result of higher receivables for unsettled investments of $28.2 million and reinsurance recoverables of $12.9 million.
Our standby letters of credit automatically renew on an annual basis.
We provide our employees with postemployment benefits that include retirement benefits, through pension and savings plans, and other benefits, including health care and life insurance. Employee benefit expense related to these plans totaled $33.8 million, $28.2 million and $16.5 million for 2006, 2005 and 2004, respectively.
We have entered into agreements with certain key executives of the Company that will, in certain circumstances, provide separation benefits upon the termination of the executive’s employment by the Company for reasons other than death, disability, cause or retirement, or by the executive for “good reason,” as defined in the agreements. For most of these executives, the agreements provide this protection only if the termination occurs following (or is effectively connected with) the occurrence of a change of control, as defined in the agreements. As soon as reasonably possible upon a change in control, as so defined, we are required to make an irrevocable contribution to a trust in an amount sufficient to pay benefits due under these agreements.
Phoenix Life’s consolidated statutory basis capital and surplus (including AVR) increased from $1,102.0 million at December 31, 2005 to $1,134.8 million at December 31, 2006. The principal factors resulting in this increase were net income, offset by dividends to the parent of $87.5 million and $30.2 million for the payoff of the surplus notes that matured in 2006. We also made pension contributions of $21.5 million.
Section 1322 of New York Insurance Law requires that New York life insurers report their risk-based capital. Risk-based capital is based on a formula calculated by applying factors to various asset, premium and statutory reserve items. The formula takes into account the risk characteristics of the insurer, including asset risk, insurance risk, interest rate risk and business risk. Section 1322 gives the New York State Insurance Department explicit regulatory authority to require various actions by, or take various actions against, insurers whose Total Adjusted Capital (capital and surplus plus AVR plus one-half the policyholder dividend liability) does not exceed certain risk-based capital levels. Each of our other life insurance subsidiaries is also subject to these same risk-based capital requirements.
Company Action Level - results when Total Adjusted Capital falls below 200% of Authorized Control Level at which point the company must file a comprehensive plan to the state insurance regulators;
Authorized Control Level - results when Total Adjusted Capital falls below 100% of Authorized Control Level risk-based capital as defined by the NAIC where in addition to the above, the insurance regulators are permitted but not required to place the company under regulatory control; and
See Note 22 to our consolidated financial statements in this Form 10-K regarding the Life Companies’ statutory financial information and regulatory matters.
Our broker-dealer subsidiaries are each subject to the net capital requirements imposed on registered broker-dealers by the Securities Exchange Act of 1934. Each is also required to maintain a ratio of aggregate indebtedness to net capital that does not exceed 15:1. At December 31, 2006 the largest of these subsidiaries had net capital of approximately $5.5 million, which is $4.5 million in excess of its required minimum net capital of $1.0 million. The ratio of aggregate indebtedness to net capital for that subsidiary was 2.61:1. The ratios of aggregate indebtedness to net capital for each of our other broker-dealer subsidiaries were also below the regulatory ratio at December 31, 2006 and their respective net capital each exceeded the applicable regulatory minimum.