We own our headquarters facility in Richmond, Virginia, which consists of approximately 461,000 square feet in four buildings, as well as several facilities with approximately 462,000 square feet in Lynchburg, Virginia. In addition, we lease approximately 750,000 square feet of office space in 63 locations throughout the U.S. We also own two buildings outside the U.S. with approximately 40,000 square feet, and we lease approximately 490,000 square feet in 63 locations outside the U.S.
Most of our leases in the U.S. and other countries have lease terms of three to five years, although some leases have terms of up to 17 years. Our aggregate annual rental expense under all these leases was $27 million during the year ended December 31, 2005.
We are a leading insurance company in the U.S., with an expanding international presence. We have three operating segments: Protection, Retirement Income and Investments, and Mortgage Insurance.
Protection. We offer U.S. customers life insurance, long-term care insurance and, primarily for companies with fewer than 1,000 employees, group life and health insurance. In Europe, we offer payment protection insurance, which helps consumers meet their payment obligations in the event of illness, involuntary unemployment, disability or death. For the year ended December 31, 2005, our Protection segment had segment net earnings of $568 million.
Retirement Income and Investments. We offer U.S. customers fixed and variable deferred annuities, fixed immediate annuities, variable life insurance, asset management and specialized products, including guaranteed investment contracts, funding agreements and structured settlements. For the year ended December 31, 2005, our Retirement Income and Investments segment had segment net earnings of $247 million.
Mortgage Insurance. In the U.S., Canada, Australia, Europe, New Zealand, Mexico and Japan, we offer mortgage insurance products that facilitate homeownership by enabling borrowers to buy homes with low-down-payment mortgages. For the year ended December 31, 2005, our Mortgage Insurance segment had segment net earnings of $507 million.
We were incorporated in Delaware on October 23, 2003 in preparation for our corporate reorganization and the IPO. In connection with the IPO, we acquired substantially all of the assets and liabilities of GEFAHI. GEFAHI is an indirect subsidiary of GE and prior to the completion of the IPO, was a holding company for a group of companies that provide life insurance, long-term care insurance, group life and health insurance, annuities and other investment products and U.S. mortgage insurance. We also acquired certain other insurance businesses that were owned by other GE subsidiaries but managed by members of the Genworth management team. These businesses include international mortgage insurance, payment protection insurance based in Europe, a Bermuda reinsurer and mortgage contract underwriting. In consideration for the assets that we acquired and the liabilities that we assumed in connection with our corporate reorganization, we issued to GEFAHI 489.5 million shares of our Class B Common Stock, $600 million of our Equity Units, $100 million of our Series A Preferred Stock, a $2.4 billion short-term note and a $550 million contingent non-interest-bearing note. We refinanced the $2.4 billion note with $1.9 billion of senior notes and $500 million of commercial paper shortly after the IPO, and we repaid the contingent note in December 2004.
The financial information in this Annual Report on Form 10-K has been derived from our financial statements, which have been prepared as if Genworth had been in existence throughout all periods. Our financial statements include, for all periods, the insurance businesses that we acquired from GE subsidiaries in connection with our corporate reorganization on May 24, 2004. Until the corporate reorganization, our financial statements also included the businesses that were owned by GEFAHI but not transferred to us in connection with our corporate reorganization. In addition to our three operating segments and our Corporate and Other segment, our financial statements also include the results of (1) the Partnership Marketing Group business, which offers life and health insurance, auto club memberships and other financial products and services directly to consumers through affinity marketing arrangements with a variety of organizations, (2) an institutional asset management business owned by GEFAHI, and (3) several other small businesses owned by GEFAHI that are not part of our core ongoing business.
policy fees and other income, including surrender charges, mortality and expense charges, investment management fees and commissions.
In recent years, our business has been, and we expect will continue to be, influenced by a number of industry-wide and product-specific trends and conditions. For discussion of the market and economic environment, see “Item 1 - Business-Market Environment and Opportunities.”
In our Protection segment, the pricing and expected future profitability of our term life and long-term care insurance products are based in part on expected investment returns. Over time, term life and long-term care insurance products generally produce positive cash flows as customers pay periodic premiums, which we invest as we receive them. Low interest rates may reduce our ability to achieve our targeted investment margins and may adversely affect the profitability of our term life and long-term care insurance products. The impact of interest rate fluctuations on our universal life insurance products is similar to its impact on spread-based products in our Retirement Income and Investments segment.
In our Mortgage Insurance segment, increasing interest rates in 2004 and 2005 contributed to a decrease in new mortgage originations in the U.S. since 2003. The level of new mortgage originations was $3,120 billion and $2,920 billion for the years ended December 31, 2005 and December 31, 2004, respectively. This compares to $3,945 billion of new mortgage originations for the year ended December 31, 2003. We believe the decrease in mortgage originations since 2003 was principally driven by two factors. First, increasing interest rates in 2004 and 2005 made refinancing of existing mortgages less attractive to consumers than in recent years. Second, with historically low interest rates in 2002 and 2003, many mortgages for which refinancing would otherwise have been economically attractive were already refinanced. Higher interest rates in 2004 and 2005 and the significant refinancing activity in 2002 and 2003 also resulted in reduced refinancing activity in 2004 and 2005, which had a positive impact on U.S. flow persistency. U.S. flow persistency rates increased from 46% for the year ended December 31, 2003 to 65% for each of the years ended December 31, 2004 and 2005. Continued interest rate increases may have a favorable impact on persistency and could have an adverse impact on new mortgage originations. If home price appreciation slows, policy cancellations may decline, which would positively affect our U.S. flow persistency rate.
Volatile equity markets. Equity market volatility may discourage purchases of separate account products, such as variable annuities and variable life insurance, that have returns linked to the performance of the equity markets and may cause some existing customers to withdraw cash values or reduce investments in those products. Equity market volatility also affects the value of the assets in our separate accounts, which, in turn, affects our earnings from fee-based products. After several years of declines, equity markets increased in 2003 and 2004 and stabilized in 2005. We expect that increases or relative stability in equity markets, along with certain guaranteed product options we offer, could have a favorable impact on our sales of variable products and our earnings from those products. The potential impact of volatile equity markets on our results has been significantly reduced as a result of our reinsurance arrangements with UFLIC, pursuant to which we reinsured, effective as of January 1, 2004, substantially all of our in-force blocks of variable annuities. We retain variable annuities sold after January 1, 2004 for our own account, subject to third-party reinsurance transactions in the ordinary course of business, and therefore we bear the risk of any adverse impact of future equity market fluctuations on those annuities. In addition, fluctuations in the equity markets may affect revenues and returns from our private asset management products and services, which depend on fees related primarily to the value of assets under management.
operating locations, reducing supplier costs, leveraging process improvement efforts, forming dedicated teams to identify opportunities for cost reductions and investing in new technology, particularly for web-based, digital end-to-end processes.
Third-party managed assets. We offer asset management products to affluent individual investors. Our products consist of separately managed accounts, managed mutual funds accounts and managed variable annuity services. We receive a management fee based upon the amount of assets under management. The results of our asset management business are a function of net flows of assets under management which are influenced by relative investment performance of our products and of the overall equity market environment. Third-party managed assets grew by 30% from $4.0 billion at December 31, 2004 to $5.2 billion at December 31, 2005. This increase is primarily due to the net sales over the period and the impact of the equity market appreciation.
In the U.S., the demand for flow private mortgage insurance declined during 2005, according to data published by Inside Mortgage Finance. We believe this was driven principally by increases in (1) the use of simultaneous second mortgages, or “80-10-10” loans, as an alternative to private mortgage insurance, (2) the origination of mortgages that did not meet the eligibility requirements of Fannie Mae and Freddie Mac and (3) mortgages that were securitized in mortgage-backed securities that did not use private mortgage insurance. We believe higher short-term interest rates and a flattening yield curve have caused “80-10-10” penetration into the mortgage insurance market to stabilize. Our U.S. flow new insurance written increased by 3% from $24.4 billion for the year ended December 31, 2004 to $25.2 billion for the year ended December 31, 2005. This increase was attributable to increased customer penetration as a result of executing a more disciplined customer segmentation strategy.
Our international mortgage insurance business has continued to expand with favorable operating results. International flow new insurance written increased by 31% from $49.2 billion for the year ended December 31, 2004 to $64.6 billion for the year ended December 31, 2005. This increase was driven primarily by a larger mortgage originations market in Australia and increased customer penetration in our established international markets, particularly in Australia and Europe, as well as favorable foreign exchange movements. International bulk new insurance written increased from $2.7 billion for the year ended December 31, 2004 to $14.0 billion for the year ended December 31, 2005. This increase was driven by our selective expansion into prime bulk offerings with key customers in Australia and Europe as well as favorable foreign exchange rates. We expect that the growth of our established international mortgage insurance business and our entry into new international markets will continue to contribute an increasing portion of this segment’s total revenues and profits.
As a result of the significant U.S. refinancing activity since 2002 and the significant expansion of our international business in recent years, as of December 31, 2005, approximately 76% of our U.S. risk in-force and 67% of our international risk in-force have not yet reached its anticipated highest claim frequency years, which are generally between the third and seventh year of the loan. We expect our loss experience on these loans will increase as policies continue to mature.
GE historically has provided a variety of products and services to us, and we have provided various products and services to GE. In connection with the IPO, we entered into a transition services agreement and various other agreements with GE that, together with a number of agreements that were in effect before the IPO, govern the relationship between GE and us.
customer service, transaction processing and a variety of functional support services provided by an outsourcing provider in India;
In addition, GE historically has allocated to us a share of its corporate overhead expenses for certain services provided to us, which are not specifically billed to us, including public relations, investor relations, treasury, and internal audit services. Our total expense for this allocation was $14 million and $50 million for the years ended December 31, 2004 and 2003, respectively. We have not reimbursed these amounts to GE, and have recorded them as a capital contribution in each year. Following the completion of the IPO, GE no longer allocates any of its corporate expenses to us.
GE continues to provide us with some of the corporate services described above on a transitional basis, and we are arranging to procure other services pursuant to arrangements with third parties or through our own employees. In the aggregate, we expect that our total costs for procuring corporate services that previously had been provided by GE will not materially exceed the amounts we historically have paid to GE for these services, including GE’s allocation to us for its corporate overhead. However, we have incurred and expect to continue to incur incremental advertising, marketing, investor relations and legal entity transition expenses to establish a new brand identity. We also incurred compensation expense with respect to the establishment of our new equity plans. In addition, we have obtained direct access to a variety of third-party products and services, including technology licenses, as a result of GE’s relationships with those third parties. We have negotiated and are continuing to negotiate our own arrangements with third-party providers for these products and services, and we do not believe these arrangements will result in materially increased costs in the aggregate.
Investment management services. We have received and will continue to receive investment management services from GE Asset Management Incorporated, or GEAM, a subsidiary of GE, pursuant to agreements that were, with limited exceptions, amended in connection with the IPO. We also entered into new agreements with GE Asset Management Limited, or GEAML, an affiliate of GEAM, for investment management services in the U.K. and Continental Europe. Pursuant to these agreements, the fees charged by GEAM and GEAML are based on a percentage of the value of the assets under management. This percentage is established annually by agreement between us and GEAM or GEAML and is intended to reflect the cost to GEAM or GEAML of providing its services and, for the agreements with GEAML, a premium of 5%. For the years ended December 31, 2005, 2004 and 2003, our aggregate costs for investment management and related administration services provided by GEAM and GEAML were approximately $22 million, $33 million, and $61 million respectively.
Employee benefit plans. Historically, we have reimbursed GE for benefits it has provided to our employees under various employee benefit plans, including GE’s retirement plan, retiree health and life insurance benefit plans, defined contribution savings plan and life and health insurance benefits through the GE benefit program. We incurred expenses associated with these plans of $95 million, $108 million, and $109 million for the years ended December 31, 2005, 2004 and 2003, respectively. GE provided these benefits to our employees until September 27, 2005, at which time GE ceased to own more than 50% of our outstanding common stock. Refer to note 12 in our financial statements under “Item 8 - Financial Statements and Supplementary Data.” In addition to these expenses for which we have reimbursed GE, we have incurred expenses of $2 million and $9 million for certain GE stock option and restricted stock unit grants for the years ended December 31, 2004 and 2003, respectively. As in the case of the allocation of corporate overhead, we have not reimbursed these amounts with respect to stock options and restricted stock units to GE. In connection with the IPO, we established our own equity compensation plans. See “-Equity plans” below.
Institutional asset management services. Prior to the completion of the IPO, we offered a broad range of institutional asset management services to third parties. GEAM provided the portfolio management services for this business, and we provided marketing, sales and support services. We did not acquire the institutional asset management services business from GEFAHI, but we continue to provide services to GEAM and GEFAHI related to this asset management business, including client introduction services, asset retention services and compliance support. GEFAHI has agreed to pay us a fee of up to $10 million per year for four years following the completion of the IPO to provide these services. The fee will be determined based upon the level of third-party assets under management managed by GEAM over the four-year term. The agreement may not be terminated by GEAM or GEFAHI, except for non-performance or in the event that we commence a similar institutional asset management business. Unless renewed, this agreement will expire December 31, 2007.
Tax Matters Agreement. As a consequence of our separation from GE, and our election jointly made with GE to treat that separation as an asset sale under section 338 of the Internal Revenue Code, we became entitled to additional tax deductions for post-IPO periods. We have recorded our estimate of the tax savings associated with these deductions remaining as of December 31, 2005 and December 31, 2004 on our statement of financial position as $659 million and $705 million, respectively. We are obligated, pursuant to our Tax Matters Agreement with GE, to pay to GE, on an after-tax basis, 80% of the amount of tax we are projected to save for each tax period as a result of these increased tax benefits, up to a maximum of $640 million. We have recorded the $379 million and $380 million present value of this obligation to GE as our estimate of this liability at December 31, 2005 and December 31, 2004, respectively, in our Statement of Financial Position. Under the Tax Matters Agreement, we would also be required to pay to GE additional amounts in the event we realize certain other contingent benefits.
We incurred compensation expense of $50 million, $29 million and $9 million for the years ended December 31, 2005, 2004 and 2003, respectively, and expect to incur expenses of $44 million in each of the years ended December 31, 2006 and 2007, respectively, related to 2005 and prior awards for our employees’ under these plans.
We incurred aggregate expenses of $32 million and $23 million for the year ended December 31, 2005 and 2004, respectively, on marketing, advertising and legal entity transition expenses, relating to the costs of establishing our new brand throughout our business, including with sales intermediaries, employees, investors and consumers.
Insurance liabilities and reserves. We calculate and maintain reserves for the estimated future payment of claims to our policyholders and contractholders based on actuarial assumptions and in accordance with industry practice and U.S. GAAP. Many factors can affect these reserves, including economic and social conditions, inflation, healthcare costs, changes in doctrines of legal liability and damage awards in litigation. Therefore, the reserves we establish are necessarily based on estimates, assumptions and our analysis of historical experience. Our results depend significantly upon the extent to which our actual claims experience is consistent with the assumptions we used in determining our reserves and pricing our products. Our reserve assumptions and estimates require significant judgment and, therefore, are inherently uncertain. We cannot determine with precision the ultimate amounts that we will pay for actual claims or the timing of those payments.
Benefits and other changes in policy reserves. Benefits and other changes in policy reserves consist primarily of reserve activity related to current claims and future policy benefits on life, long-term care, Medicare supplement, group life and health, payment protection, structured settlements, income annuities with life contingencies and claim costs incurred related to mortgage insurance products. The decrease in benefits and other changes in policy reserves was primarily driven by a $522 million decrease in our Retirement Income and Investments segment primarily attributable to our reinsurance transactions with UFLIC and lower sales of structured settlements and income annuities resulting from our continued pricing discipline. Also contributing to the decrease was an $80 million decrease in our Affinity segment due to the corporate reorganization in 2004.
Amortization of deferred acquisition costs and intangibles. Amortization of deferred acquisition costs and intangibles consists primarily of the amortization of acquisition costs that are capitalized and PVFP. These amortization costs decreased primarily due to a $190 million decrease in our Protection segment primarily attributable to a decrease in our payment protection insurance business run-off block. Also contributing to the decrease was a $47 million decrease in our Affinity segment due to our corporate reorganization and a $39 million decrease in our Retirement Income and Investments segment primarily due to the reinsurance transactions with UFLIC.
Net realized investment gains. For the year ended December 31, 2004, gross realized gains and (losses) were $90 million and $(64) million, respectively. Realized losses for the year ended December 31, 2004 included $26 million of impairments. These impairments were attributable to fixed maturities, equity securities and other investments ($17 million, $5 million and $4 million, respectively). The fixed maturities impairments primarily related to securities issued by companies in the timber products, healthcare and consumer products industries ($6 million, $4 million and $3 million, respectively). The equity securities impairments primarily related to mutual fund investments. The other investments impairments related to impairment of limited partnership investments. For the year ended December 31, 2003, gross realized gains and (losses) were $473 million and $(463) million, respectively. The realized gains for the year ended December 31, 2003 included a $43 million gain from a securitization of certain financial assets. Realized losses for the year ended December 31, 2003 included $224 million of impairments. These impairments were attributable to fixed maturities, equity securities and other investments ($126 million, $83 million and $15 million, respectively). The fixed maturities impairments primarily related to securities issued by companies in the transportation, mining and metals, utilities and energy and technology and communications industries ($36 million, $28 million, $12 million and $11 million, respectively). In addition, $30 million of fixed maturities impairments were realized on asset-backed securities. The equity securities impairments related to mutual fund and common stock investments ($37 million and $46 million, respectively). The other investments impairments primarily related to impairment of limited partnership investments.
Benefits and other changes in policy reserves. Benefits and other changes in policy reserves decreased primarily as a result of a $253 million decrease in our Retirement Income and Investments segment, a $116 million decrease in our Affinity segment and a $107 million decrease in our Protection segment. The decrease in our Retirement Income and Investments segment was primarily attributable to a decrease related to the reinsurance transactions with UFLIC and a reclassification of variable annuity sales inducements paid to contractholders, which were classified as acquisition and operating expenses, net of deferrals, in 2003. The decrease in our Affinity segment relates to the exclusion of this segment as a result of our corporate reorganization. The decrease in our Protection segment was primarily related to a decrease in our payment protection insurance business attributable to the lower loss ratio in the payment protection insurance run-off block.
Interest credited. Interest credited decreased primarily as a result of a $189 million decrease in our Retirement Income and Investments segment that was primarily attributable to a decrease in interest credited
Amortization of deferred acquisition costs and intangibles. Amortization of deferred acquisition costs and intangibles decreased primarily as the result of a $135 million decrease in our Protection segment and a $58 million decrease in our Affinity segment. The decrease in our Protection segment was primarily attributable to a decrease in payment protection insurance due to our decision not to renew certain distribution relationships, partially offset by the impact of favorable changes in foreign exchange rates. The decrease in our Affinity segment relates to the exclusion of this segment as a result of our corporate reorganization.
Interest expense. Interest expense increased primarily as the result of a our revised debt structure following our corporate reorganization, as well as the full-year contribution of interest expense associated with securitization entities that were consolidated in our financial statements in connection with our adoption of FIN 46 on July 1, 2003 and interest expense on non-recourse funding obligations issued in the third and fourth quarters of 2003 and the fourth quarter of 2004.
Net earnings from continuing operations. The increase in net earnings from continuing operations reflects increases in segment net earnings in each of our segments, except for our Affinity segment, whose net earnings decreased as a result of its exclusion as a result of our corporate reorganization.
We offer U.S. customers life insurance, long-term care insurance, Medicare supplement insurance and, primarily for companies with fewer than 1,000 employees, group life and health insurance. In Europe, we offer payment protection insurance, which helps consumers meet their payment obligations in the event of illness, involuntary unemployment, disability or death.
Premiums decreased primarily as a result of a $103 million decrease in the payment protection business. This decrease was due to a decrease of $295 million in the U.K. market partially offset by a $163 million increase in Continental Europe and an increase of $29 million attributable to changes in foreign exchange rates. The decrease in the U.K. market was attributable to the continued run-off of low return blocks of business. The increase in Continental Europe was attributable to the growth due to new distribution relationships and the growth of consumer lending in those markets. The decrease was partially offset by a $54 million increase in our life insurance business primarily related to growth of the term life insurance in-force blocks and a $36 million increase in our group business that was due to growth of the non-medical in-force blocks. Our long-term care business increased modestly as growth in the in-force block was partially offset by an $83 million decrease attributable to the reinsurance transactions with UFLIC.
Benefits and other changes in policy reserves increased primarily due to a $30 million increase in our life business primarily due to growth of term life in-force block and less favorable universal life mortality offset in part by favorable term life mortality, and a $24 million increase in our group business primarily due to growth of the in-force blocks. The increases were partially offset by a $32 million decrease in our payment protection business. The decrease was primarily attributable to a decrease in claims in our run-off business, partially offset by $4 million attributable to changes in foreign exchange rates. Our long-term care business decreased $18 million attributable to a $102 million decrease related to the reinsurance transactions with UFLIC, and a $40 million correction of reserves related to a long-term care policy rider which had been incorrectly coded in our policy valuation system. These decreases were partially offset by an increase of $101 million primarily attributable to lower policy terminations and an increase associated with the aging of the in-force block. Additionally, our long-term care business had a $23 million increase relating to the strengthening of certain claim reserves.
The effective tax rate decreased to 35.8% for the year ended December 31, 2005 from 36.7% for the year ended December 31, 2004. The decrease in effective tax rate was primarily attributable to a reduction in excess foreign tax credits and a favorable examination development in 2005.
The increase in life insurance net earnings was primarily attributable to growth of the in-force block and lower legal expenses. The increase in payment protection insurance net earnings was primarily attributable to $10 million in one-time charges related to employee benefit costs, as well as an $8 million increase due to the favorable impact of foreign exchange rates and an increase due to growth in our continuing business, partially offset by the loss of certain foreign tax benefits. The increase in our long-term care insurance business was primarily attributable to the growth of the block, partially offset by a loss of earnings on invested capital attributable to a reallocation of capital to our Corporate and Other segment and decreased earnings as a result of the reinsurance transactions. The decrease in our group business was attributable to loss experience that was more in line with expectations.
Premiums decreased primarily as a result of a $102 million decrease in long-term care insurance premiums, consisting of a $124 million decrease attributable to the reinsurance transactions with UFLIC, partially offset by a $22 million increase in premiums associated with the growth of the in-force block. The decrease was also the result of a $81 million decrease in payment protection insurance premiums, consisting of a $231 million decrease on a constant-currency basis, net of a $150 million increase attributable to changes in foreign exchange rates. The $231 million decrease consisted of a $393 million decrease in premiums in our run-off block, offset by a $162 million increase in our continuing business due to new distribution relationships and the growth of consumer lending in Continental Europe. These decreases were offset in part by a $61 million increase in life insurance premiums that was primarily attributable to growth of the term life insurance in-force block. The decreases were also offset in part by a $15 million increase in group premiums attributable to growth of the in-force block that was primarily attributable to an increase in sales of non-medical products as the result of enhancements in our life insurance and disability product offerings and the expansion of our dental network.
The increase in net investment income, which included $13 million due to changes in foreign exchange rates, was primarily the result of an increase in average invested assets, offset in part by declining yields on investments and by a decrease in invested capital allocated to this segment in preparation for our corporate reorganization and initial public offering.
Benefits and other changes in policy reserves decreased primarily as a result of a $113 million decrease in our payment protection insurance business attributable to the lower loss ratio in the payment protection insurance run-off block, $27 million of which was attributable to changes in foreign exchange rates. The decrease was also attributable to an $85 million decrease in long-term care benefits and other changes in policy reserves, consisting of a $150 million decrease primarily attributable to the reinsurance transactions with UFLIC, partially offset by a $65 million increase primarily attributable to increased reserves and benefit payments resulting from the normal, expected increases in claims volume associated with the aging and continued growth of the long-term care in-force block. The decrease was partially offset by a $71 million increase in our life insurance business attributable to growth of the in-force block and less favorable claim experience compared to 2003, as well as a $19 million increase in our Group business primarily attributable to growth in the in-force block and loss ratios that were more in line with expectations after favorable results in 2003.
The increase in acquisition and operating expenses, net of deferrals, was primarily attributable to a $116 million increase in our payment protection insurance business related primarily to an increase in commissions and other compensation arrangements in our run-off block. This increase was partially offset by a $27 million decrease in our life insurance business primarily attributable to decreased legal fees following the agreement in principle to settle a class action lawsuit in 2003 and lower other expenses. The increase was also partially offset by an $18 million decrease in our long-term care insurance business primarily attributable to the reinsurance transactions with UFLIC.
Interest expense increased primarily as a result of interest paid on non-recourse funding obligations, issued in the third and fourth quarters of 2003 and the fourth quarter of 2004, supporting certain term life insurance policies.
Term life insurance. The increase in term life insurance in-force during 2005 was primarily due to net growth of the in-force block as a result of increased competitiveness of our product offerings. This increase was also the primary driver for the increase in term life insurance net earned premiums and revenues. Term life annualized first year premiums increased as a result of competitive pricing, our expanded distribution and consistent service performance.
The following table sets forth selected operating performance measures regarding our long-term care insurance business, which includes long-term care insurance, Medicare supplement insurance, as well as several run-off blocks of accident and health insurance and corporate-owned life insurance for the periods indicated:
The increase in revenue during 2005, net of reinsurance was primarily due to an increase in net investment income primarily due to an increase in average invested assets backing growth of our long-term care in-force block. The decrease in revenue, net of reinsurance during 2004 was primarily due to the reinsurance transactions with UFLIC, which reduced premium and investment income.
Gross written premiums increased during 2005 due to growth in the Continental European market. Net earned premiums and revenues decreased due to continued run-off of low return blocks of business in the U.K. market, partially offset by growth in the Continental European market.
The increase in annualized first-year premiums during 2004 is attributable to an increase in sales of non-medical products as the result of enhancements in our life insurance and disability product offerings and the expansion of our dental network. The increase in revenue during 2004 was primarily due to an increase in net earned premiums resulting from an increase in sales of the non-medical products.
The following table sets forth net earnings for the products included in our Retirement Income and Investments segment:
The decrease in premiums was the result of a $238 million decrease in premiums attributable to lower sales in our life-contingent structured settlement and income annuities due to our continued pricing discipline in a continued low long-term interest rate environment.
The decrease in policy fees and other income was primarily due to a $56 million reduction related to the reinsurance transactions with UFLIC in 2004. This decrease was partially offset by a $29 million increase due primarily to growth in assets under management in fee-based products.
The decrease in interest credited decreased primarily due to a $113 million decrease related to the UFLIC reinsurance transactions in 2004. Partially offsetting the decrease was a $94 million increase in interest credited on spread-based institutional products due primarily to higher average interest crediting rates on floating rate products.
Segment net earnings on spread-based retail products decreased $30 million primarily due to a one-time charge of $32 million after-tax during 2004 related to an adjustment of reserving processes related to a small run-off block of equity-indexed annuities. Net income on fee-based products increased $31 million due primarily to an increase in fees received under contracts with GE entered into during 2004 to manage its municipal GIC business, as well as growth in assets under management.
Net investment income decreased as a result of a decrease in average invested assets, primarily associated with assets transferred to UFLIC in connection with the reinsurance transactions, partially offset by new asset purchases. The decrease in net investment income also was the result of declining yields on investments.
Policy fees and other income increased primarily due to a $38 million increase in commission income due to increased sales of third-party products. The increase was also attributable to $34 million of fee income earned pursuant to new arrangements we entered into, effective as of January 1, 2004, to provide investment and administrative services related to a pool of municipal GICs issued by affiliates of GE. The increase was also attributable to a $10 million increase in fee income attributable to increased assets under management and a $10 million increase in asset management service fees. These increases were partially offset by a $62 million decrease in fee income primarily attributable to the reinsurance transactions with UFLIC.
Interest credited decreased primarily due to a $172 million decrease in interest credited as the result of the reinsurance transactions with UFLIC. This decrease was also the result of a $16 million decrease relating to lower interest credited on institutional products due to a decrease in the average size of the in-force block, as well as lower average interest crediting rates.
The effective tax rate increased to 35.4% for the year ended December 31, 2004 from 34.1% for the year ended December 31, 2003. The increase in effective tax rate was primarily the result of the impact of higher dividends received deduction benefits related to separate account annuity products in 2003.
Spread-based institutional account values remained fairly consistent in 2005 and 2004 as we maintained our pricing discipline in order to achieve our targeted returns. Included in deposits is a $300 million funding agreement we issued in the fourth quarter of 2005 from a registered notes program we initiated. The increase in interest credited in 2005 was due to an increase in crediting rates on our floating rate products due to an increase in the short term rates.
The following table sets forth net earnings for the products included in our Mortgage Insurance segment:
Acquisition and operating expenses increase was primarily attributable to an increase in costs in our existing international platforms, continued investment in potential new international mortgage insurance platforms and $5 million from changes in foreign exchange rates.
The increase in amortization of deferred acquisition cost and intangibles was primarily attributable to accelerated amortization of deferred acquisition costs in our U.S. mortgage insurance business principally related to continued low persistency rates during the year.
Provision for income taxes increased $14 million, $9 million of which was attributable to changes in foreign exchange rates. The effective tax rate decreased to 28.3% for the year ended December 31, 2005 from 30.4% for the year ended December 31, 2004. This decrease in effective tax rate was primarily attributable to a favorable examination development and a reduction in excess foreign tax credits. Our Mortgage Insurance segment’s effective tax rate is below the statutory rate primarily as a result of tax-exempt investment income.
The earnings in our U.S. mortgage insurance business remained relatively flat primarily due to lower acquisition and operating expenses, offset by declining earnings due to the continued decrease in the in-force
Net earned premiums increased primarily as a result of a $125 million increase in premiums in our international mortgage insurance business, $35 million of which was attributable to favorable foreign exchange rates. The increase also was partially attributable to the aging of our international in-force block, which resulted in increased earned premiums from prior-year new insurance written. The increase in international premiums was partially offset by a $41 million decrease in our U.S. mortgage insurance premiums. This decrease in U.S. mortgage insurance premiums was primarily the result of the decline in our in-force block due to decreased demand for mortgage insurance as the result of a smaller market for mortgage originations, as well as a reduction in business from some mortgage lenders following our actions to restructure our captive reinsurance arrangements with premium risk cessions in excess of 25%.
Net investment income increased primarily as a result of a $32 million increase in investment income in our international business, $13 million of which was attributable to changes in foreign exchange rates, related to the growth in invested assets. Investment income in our U.S. mortgage insurance business increased $4 million due to increasing yields on invested assets. As discussed below under “Liquidity and Capital Resources,” our U.S. mortgage insurance business paid a $700 million dividend to our parent holding company in December 2004. This dividend reduced the invested assets in our U.S. mortgage insurance business at the end of 2004.
Policy fees and other income decreased primarily as a result of a $19 million decrease in fees for contract underwriting services attributable to lower refinancing activity in the U.S. This decrease was offset in part by a $7 million increase in fees from increased volume in our international mortgage insurance business.
Acquisition and operating expenses, net of deferrals, decreased primarily attributable to a $54 million decrease in expenses that was primarily attributable to lower underwriting expenses due to a decline in refinancing activity in the U.S. and lower administrative costs, and a $17 million decrease in the provision for indemnity liabilities related to a decline in mortgage loan origination primarily attributable to decreased mortgage refinancing activity. These declines were offset in part by a $34 million increase in expenses to support the expansion of our international mortgage insurance business, $8 million of which was attributable to changes in foreign exchange rates.
The increase in amortization of deferred acquisition costs and intangibles was partially attributable to a $6 million increase in mortgage insurance amortization in the U.S. primarily due to accelerated amortization reflecting higher-than-expected early-year margins on recently written policies. The increase was also attributable to an $8 million increase in international insurance amortization due primarily to the continued growth of our international business, $2 million of which was attributable to changes in foreign exchange rates.
The increase in net premiums written during 2005 and 2004 was driven primarily by increases in new insurance written in our international business, partially offset by a decline in our U.S. net premiums written due to lower levels of insurance in force. The increase in our international business during 2005 of $100 million,
Most of our international mortgage insurance policies provide for single premiums at the time that loan proceeds are advanced. We initially record the single premiums to unearned premium reserves and recognize the premiums earned over time in accordance with the estimated expiration of risk. As of December 31, 2005, our unearned premium reserves in our international mortgage insurance business were $1.8 billion.
Our 2004 loss ratio increase is consistent with normal seasoning and growth of our businesses.
For a discussion of the change in net realized investment gains, see the comparison for this line item under “-Results of Operations.”
Interest expense consists of interest and other financial charges related to our debt that is not allocated for segment reporting purposes. The increase was principally the result of the changes to our debt structure and increase in short-term interest rates on our outstanding commercial paper.
The increase in segment net earnings for the year ended December 31, 2004 was primarily the result of an increase in net investment income primarily attributable to an increase in invested assets not required to be allocated to our operating segments, a $47 million tax benefit recognized in connection with our corporate reorganization, a $25 million after-tax gain related to our waiver of contractual rights under an outsourcing services agreement with GE’s global outsourcing provider, and an increase in invested assets not required to be allocated to our operating segments partially offset by an increase in interest expense attributable to our revised debt structure following our corporate reorganization.
Net investment income increased primarily as a result of an increase in investment income associated with an increase in invested assets not required to be allocated to our operating segments. The increase was also the result of a $28 million increase in interest income from two securitization entities that were consolidated in our financial statements in connection with our adoption of FIN 46 on July 1, 2003 and an $18 million increase in partnership income.
Benefits and other changes in policy reserves decreased primarily as a result of lower litigation expenses and higher reserves at our Bermuda reinsurer.
Acquisition and operating expenses, net of deferrals, decreased primarily as a result of $36 million lower allocated expenses from GE resulting from our corporate reorganization, $26 million of lower litigation expenses and $13 million of lower operating and other expenses. These decreases were partially offset by expenses of $20 million relating to the issuance of stock options and stock appreciation rights in connection with our corporate reorganization and $23 million relating to the costs of establishing the Genworth brand.
Interest expense increased primarily as a result of $45 million of interest expense associated with our revised debt structure following our corporate reorganization and a $20 million increase attributable to the securitization entities that were consolidated in our financial statements in connection with our adoption of FIN 46 on July 1, 2003.
The following table sets forth information about our investment income, excluding realized gains and losses, for the components of our investment portfolio for the periods indicated:
Yields are based on average carrying values except for fixed maturities, equity securities and securities lending activity. Yields for fixed maturities and equity securities are based on amortized cost and cost, respectively. Yields for securities lending activity, which is included in other investments, are calculated net of the corresponding securities lending liability.
The following table sets forth gross realized investment gains and losses resulting from the sales and impairments of investment securities classified as available for sale:
For a discussion of the change in gross realized investment gains and losses, see the comparison for this line item under “-Results of Operations.”
The following table sets forth our cash, cash equivalents and invested assets as of the dates indicated:
unrealized loss on the automotive investments was primarily caused by legacy issues and declines in market share. The automotive issuer continues to maintain significant liquidity relative to its maturity and we expect to collect full principal and interest.
Because management expects these investments to continue to perform as to their original contractual terms and we have the ability and intent to hold these investment securities until the recovery of the fair value up to the cost of the investment, which may be maturity, we do not consider these investments to be other-than-temporarily impaired at December 31, 2005.
The decrease in net cash used in investing activities for the year ended December 31, 2005 compared to December 31, 2004 was primarily the result of less cash provided by our operating activities, as discussed above, partially offset by a decrease in net cash used in our financing activities. Within our investing activities, during 2003, we received $2,126 million of proceeds and dividends associated with the sale of our Japanese life insurance and domestic auto and homeowners’ insurance businesses.
Changes in cash from financing activities primarily relate to the issuance and repayment of borrowings, dividends to our stockholders and other capital transactions, as well as the issuance of, and redemptions and benefit payments on, investment contracts and changes in the cash collateral for loaned securities under our securities lending program. During 2005, uses of cash included a treasury stock acquisition of $500 million, dividend payments to our stockholders of $128 million and net redemptions on investment contracts of $84 million. These uses of cash were partially offset by an issuance of $500 million in non-recourse funding obligations. During 2004, our financing activities primarily related to our corporate reorganization, including changes to our debt structure, and dividends paid to GE. During 2003, the primary use of cash was the payment of dividends to GE.
We have revised our 2003 statement of cash flows to include cash flow information related to discontinued operations as described in note 15 in our financial statements under “Item 8 - Financial Statements and Supplementary Data.”
In December 2004, we received a dividend of $700 million from our U.S. mortgage insurance business (included above in dividends paid by our insurance subsidiaries) following the release of statutory contingency reserves from that business. In December 2004, we used $550 million of those proceeds to repay the Contingent Note issued to GEFAHI as part of our corporate reorganization, and we retained the remainder at our holding company to pay debt servicing expenses and dividends on our common stock. We anticipate that in the fourth quarter of 2006, the $100 million that remains will be made available for general corporate purposes.
Based on statutory results as of December 31, 2005, we estimate our subsidiaries could pay dividends of approximately $1,300 million to us in 2006 without obtaining regulatory approval. The ability of our insurance subsidiaries to pay dividends to us, and our ability to pay dividends to our stockholders, also are subject to various conditions imposed by the rating agencies for us to maintain our ratings.
The following table sets forth our parent company only cash flows for the periods indicated:
Cash flows from operating activities are primarily affected by the dividends from our subsidiaries and the timing of investment income and expenses paid. During 2005, the increase in cash provided by operating activities was primarily a result of an increase in dividends received from our subsidiaries and the timing of cash settlement for other assets and other liabilities offset by an increase in the net loss of our parent company (excluding earnings from our subsidiaries).
Cash flows from investing activities are affected by the capital contributions paid to subsidiaries and investment activity. For the year ended December 31, 2005, we received $49 million from fixed maturity investment maturities. For the year ended December 31, 2004, we made $72 million in subsidiary capital contributions.
Our insurance subsidiaries maintain investment strategies intended to provide adequate funds to pay benefits without forced sales of investments. Products having liabilities with longer durations, such as certain life insurance and long-term care insurance policies, are matched with investments having similar estimated lives such as long-term fixed maturities and commercial mortgage loans. Shorter-term liabilities are matched with fixed maturities that have short- and medium-term fixed maturities. In addition, our insurance subsidiaries hold highly liquid, high-quality short-term investment securities and other liquid investment-grade fixed maturities to fund anticipated operating expenses, surrenders, and withdrawals. As of December 31, 2005, our total cash and invested assets was $68.4 billion. Our investments in privately placed fixed maturities, commercial mortgage loans, policy loans, limited partnership interests and restricted investments held by securitization entities are relatively illiquid. These asset classes represented approximately 34% of the carrying value of our total cash and invested assets as of December 31, 2005.
During the third quarter of 2005, certain of our domestic life insurance subsidiaries transferred approximately $1.7 billion of primarily foreign-issued investment securities to an affiliated special purpose entity (“SPE”) which is a subsidiary in our Mortgage Insurance segment and consolidated in our financial statements and whose sole purpose is to securitize these investment securities and issue secured notes to various affiliated insurance companies. The securitized investments are owned in their entirety by the SPE and are not available to satisfy the claims of our creditors. These securitized investments provide collateral to the notes issued by the SPE to the insurance companies.
In September 2005, we issued senior notes having an aggregate principal amount of $350 million, with an interest rate equal to 4.95% per year payable semi-annually, and maturing in October 2015 (“2015 Notes”). The 2015 Notes are our direct, unsecured obligations and rank equally with all of our existing and future unsecured and unsubordinated obligations. The 2015 Notes are not guaranteed by any of our subsidiaries. We have the option to redeem all or a portion of the 2015 Notes, at any time with proper notice to the noteholders at a price equal to the greater of 100% of principal or the sum of the present value of the remaining scheduled payments of principal and interest discounted at the then-current treasury rate plus an applicable spread.
The net proceeds from the issuance of $348 million from the 2015 Notes were used to reduce our outstanding commercial paper borrowings. The commercial paper was issued under a $1 billion commercial paper program that we have established. As of December 31, 2005 the aggregate amount of our outstanding commercial paper borrowings was $152 million. We may issue additional commercial paper under this program from time to time.
In 2005, our wholly-owned subsidiaries, River Lake Insurance Company II and River Lake Insurance Company, issued non-recourse funding obligations of $300 million and $200 million, respectively. These issuances are in addition to the $900 million of non-recourse funding obligations previously issued by River Lake Insurance Company and River Lake Insurance Company II. As of December 31, 2005 and 2004 there were $1.4 billion and $900 million of non-recourse funding obligations outstanding, respectively. We may issue additional non-recourse funding obligations from time to time to help satisfy our statutory reserve requirements.
In April 2005, we entered into a five-year revolving credit facility, which matures in April 2010, replacing our 364-day credit facility, which was scheduled to mature in May 2005. We also have a $1.0 billion five-year revolving credit facility that matures in May 2009. As of December 31, 2005, we had utilized $170 million of the commitment under these facilities with the issuance of a letter of credit for the benefit of one of our mortgage insurance subsidiaries.
In 2004 we issued senior notes having an aggregate principal amount of $1.9 billion. The $1.9 billion aggregate principal amount of senior notes included $500 million LIBOR Floating Rate Notes due 2007, $500 million 4.75% Notes due 2009, $600 million 5.75% Notes due 2014, and $300 million 6.50% Notes due 2034. As a result of hedging arrangements entered into with respect to these securities, our effective interest rates are 3.39% on the 2007 Notes, 4.48% on the 2009 Notes, 5.51% on the 2014 Notes and 6.35% on the 2034 Notes.
We believe our revolving credit facilities, further issuances under our commercial paper program and anticipated cash flows from operations, will provide us with sufficient liquidity to meet our operating requirements for the foreseeable future. For further information about our borrowings, refer to note 13 in our financial statements under “Item 8.-Financial Statements and Supplementary Data”.
others depend on future events. Examples of fixed obligations include our obligations to pay principal and interest on fixed-rate borrowings. Examples of obligations that will vary include obligations to pay interest on variable-rate borrowings and insurance liabilities that depend on future interest rates and market performance. Many of our obligations are linked to cash-generating contracts. These obligations include payments to contractholders that assume those contractholders will continue to make deposits in accordance with the terms of their contracts. In addition, our operations involve significant expenditures that are not based upon “commitments.” These include expenditures for income taxes and payroll.
(3) The timing for the return of the collateral associated with our securities lending program is uncertain; therefore, the return of collateral is reflected as being due in 2006.
(4) Includes guaranteed investment contracts and funding agreements, structured settlements and income annuities (including contracts we ceded to UFLIC, because we remain the primary obligor under those contracts), based upon scheduled payouts, as well as those contracts with reasonably determinable cash flow, such as deferred annuities, universal life, term life, long-term care, whole life and other life insurance contracts.
We have used off-balance sheet securitization transactions to mitigate and diversify our asset risk position and to adjust the asset class mix in our investment portfolio by reinvesting securitization proceeds in accordance with our approved investment guidelines.
Securitization transactions typically result in gains or losses that are included in net realized investment gains (losses) in our financial statements. There were no off-balance sheet securitization transactions executed in the years ended December 31, 2005 and 2004. Securitization transactions resulted in net gains, before taxes, of approximately $43 million for the year ended December 31, 2003.
As part of our corporate reorganization, we issued $600 million of our Equity Units. These Equity Units consist of two separate and detachable contracts as follows:
a contract to purchase shares of our Class A Common Stock, which we refer to as the stock purchase contracts or forward sale commitment
(1) Includes $25 million and $31 million of retained interests in securitized assets as of December 31, 2005 and 2004, respectively, that are consolidated.
currently recognize compensation cost using the fair value method for all stock based awards issued after January 1, 2002 and do not expect the adoption of SFAS 123R to have a material impact on our results of operations or financial position.
Statement of Changes in Stockholders’ Equity for the years ended December 31, 2005, 2004 and 2003
We have audited the accompanying statement of financial position of Genworth Financial, Inc. (the Company) as of December 31, 2005 and 2004, and the related statements of earnings, changes in stockholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2005. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Genworth Financial, Inc. as of December 31, 2005 and 2004, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2005, in conformity with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Genworth Financial Inc.’s internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated February 23, 2006 expressed an unqualified opinion on management’s assessment of, and the effective operation of, internal control over financial reporting.
Genworth Financial, Inc. (“Genworth”) was incorporated in Delaware on October 23, 2003 in preparation for the corporate reorganization of certain insurance and related subsidiaries of General Electric Company (“GE”) and an initial public offering of Genworth common stock, which was completed on May 28, 2004 (“IPO”). In connection with the IPO, Genworth acquired substantially all of the assets and liabilities of GEFAHI. Prior to its IPO, Genworth was a wholly-owned subsidiary of GEFAHI. GEFAHI is an indirect subsidiary of General Electric Capital Corporation (“GE Capital”), which in turn is an indirect subsidiary of GE. Prior to the corporate reorganization, GEFAHI was a holding company for a group of companies that provide life insurance, long-term care insurance, group life and health insurance, annuities and other investment products and U.S. mortgage insurance. At the same time, Genworth also acquired certain other insurance businesses previously owned by other GE subsidiaries. These businesses include international mortgage insurance, payment protection insurance based in Europe, a Bermuda reinsurer, and mortgage contract underwriting.
In December, September and March 2005, GE completed secondary public offerings of 40.9 million, 116.2 million and 80.5 million shares of our Class B Common Stock, respectively. The 237.6 million shares were automatically converted to Class A Common Stock upon the sale of these shares to the public. Concurrently with the March 2005 secondary offering, we repurchased 19.4 million shares of Class B Common Stock from GE at a price of $25.811 per share (a price equal to the net proceeds per share received by the selling shareholder from the underwriters), which were automatically converted to Class A Common Stock upon the transfer of these shares to us and recorded at cost as treasury stock. We did not receive any of the proceeds from these secondary offerings. As of December 31, 2005, approximately 82% of our common stock was owned by public stockholders, and approximately 18% of our common stock was beneficially owned by GE. GE indicated in November 2005 that it expects to divest its remaining interest in our company by the end of 2006.
For the periods prior to our corporate reorganization, the accompanying financial statements include the accounts of certain indirect subsidiaries and businesses of GE that represent the predecessor of Genworth. The companies and businesses included in the predecessor combined financial statements are GEFAHI, Financial Insurance Company Ltd., FIG Ireland Ltd., WorldCover Direct Ltd., RD Plus S.A., CFI Administrators Ltd., Financial Assurance Company Ltd., Financial Insurance Group Services Ltd., Consolidated Insurance Group Ltd., Viking Insurance Co. Ltd., Genworth Financial Mortgage Insurance Ltd., GE Mortgage Insurance Pty Ltd., Genworth Mortgage Insurance Ltd., Genworth Financial Mortgage Insurance Company Canada, GE Capital Mortgage Insurance Corp. (Australia) Pty Ltd., Genworth Financial Investment Services, Inc., GE Capital Insurance Agency, Inc., CFI Pension Trustees Ltd., Financial Insurance Guernsey PCC Ltd., GE Financial Assurance Compania De Seguros y Reaseguros de Vida S.A., GE Financial Insurance Compania De Seguros y Reaseguros S.A., and GE Residential Connections Corp., Assocred SA, Ennington Properties Limited and the consumer protection insurance business of Vie Plus S.A. All of the combined companies were indirect subsidiaries of GE. For these periods, we refer to the combined predecessor companies and businesses as the “company”, “we”, “us”, or “our” unless the context otherwise requires.
For the periods subsequent to our reorganization, the accompanying financial statements include on a consolidated basis the accounts of Genworth and our affiliate companies in which we hold a majority voting or economic interest, which for these periods we refer to as the “company,” “we”, “us”, or “our” unless the context otherwise requires.
Our financial statements have been prepared on the basis of U.S. generally accepted accounting principles (“U.S. GAAP”). Preparing financial statements in conformity with U.S. GAAP requires us to make estimates and assumptions that affect reported amounts and related disclosures. Actual results could differ from those estimates. All significant intercompany accounts and transactions have been eliminated. Certain prior year amounts have been reclassified to conform to the current year presentation. Our statement of cash flows for the year ended December 31, 2003 has been revised as further described in note 15 of these financial statements.
b) Net Investment Income and Net Realized Investment Gains and Losses
Investment income on mortgage-backed and asset-backed securities is initially based upon yield, cash flow, and prepayment assumptions at the date of purchase. Subsequent revisions in those assumptions are recorded using the retrospective or prospective method. Under the retrospective method, used for mortgage-backed and asset-backed securities of high credit quality (ratings equal to or greater than AA or that are U.S. Agency backed) which cannot be contractually prepaid, amortized cost of the security is adjusted to the amount that would have existed had the revised assumptions been in place at the date of purchase. The adjustments to amortized cost are recorded as a charge or credit to net investment income. Under the prospective method, which is used for all other mortgage-backed and asset-backed securities, future cash flows are estimated and interest income is recognized going forward using the new internal rate of return. As of December 31, 2005, all our mortgage-backed and asset-backed securities that have had subsequent revisions in yield, cash flow or prepayment assumptions are accounted for under the retrospective method.
Policy fees and other income consists primarily of insurance charges assessed on universal life contracts, fees assessed against policyholder account values and commission income. Charges to policyholder accounts for universal life cost of insurance are recognized as revenue when due. Variable product fees are charged to variable annuity and variable life policyholders based upon the daily net assets of the policyholder’s account values and are recognized as revenue when charged. Policy surrender fees are recognized as income when the policy is surrendered.
Commercial mortgage loans are stated at principal amounts outstanding, net of deferred expenses and allowance for loan loss. Interest on loans is recognized on an accrual basis at the applicable interest rate on the principal amount outstanding. Loan origination fees and direct costs as well as premiums and discounts are amortized as level yield adjustments over the respective loan terms. Unamortized net fees or costs are recognized upon early repayment of the loans. Loan commitment fees are generally deferred and amortized on an effective yield basis over the term of the loan. Impaired loans are generally carried on a non-accrual status. Loans are ordinarily placed on non-accrual status when, in management’s opinion, the collection of principal or interest is unlikely, or when the collection of principal or interest is 90 days or more past due.
The allowance for loan losses is maintained at a level that management determines is adequate to absorb estimated probable incurred losses in the loan portfolio. Management’s evaluation process to determine the adequacy of the allowance utilizes an analytical model based on historical loss experience, adjusted for current events, trends and economic conditions. The actual amounts realized could differ in the near term from the amounts assumed in arriving at the allowance for loan losses reported in the financial statements.
Long-Duration Contracts. Acquisition costs include commissions in excess of ultimate renewal commissions, solicitation and printing costs, sales material and some support costs, such as underwriting and contract and policy issuance expenses. Amortization for traditional long-duration insurance products is determined as a level proportion of premium based on commonly accepted actuarial methods and reasonable assumptions established when the contract or policy is issued about mortality, morbidity, lapse rates, expenses and future yield on related investments. Amortization for annuity contracts without significant mortality risk and investment and universal life products is based on estimated gross profits and is adjusted as those estimates are revised.
We regularly review all of these assumptions and periodically test DAC for recoverability. For deposit products, if the current present value of estimated future gross profits is less than the unamortized DAC for a line of business, a charge to income is recorded for additional DAC amortization. For other products, if the benefit reserve plus anticipated future premiums and interest earnings for a line of business are less than the current estimate of future benefits and expenses (including any unamortized DAC), a charge to income is recorded for additional DAC amortization or for increased benefit reserves. For the periods ending December 31, 2005, 2004 and 2003 there were no significant charges to income recorded as a result of our DAC recoverability testing.
Premium revenue, benefits, and operating expenses are reported net of the amounts relating to reinsurance ceded to other companies. Amounts due from reinsurers for incurred and estimated future claims are reflected in the reinsurance recoverable asset. The cost of reinsurance is accounted for over the terms of the related treaties using assumptions consistent with those used to account for the underlying reinsured policies.
We discontinue hedge accounting prospectively when: (i) it is determined that the derivative is no longer effective in offsetting changes in the fair value or cash flows of a hedged item; (ii) the derivative expires or is sold, terminated, or exercised; (iii) the derivative is de-designated as a hedge instrument; (iv) it is probable that the forecasted transaction will not occur; or (v) management determines that designation of the derivative as a hedge instrument is no longer appropriate.
We designate and account for the following as cash flow hedges, when they have met the effectiveness requirements of SFAS 133: (i) various types of interest rate swaps to convert floating rate investments to fixed rate investments; (ii) various types of interest rate swaps to convert floating rate liabilities into fixed rate liabilities; (iii) receive U.S. dollar fixed on foreign currency swaps to hedge the foreign currency cash flow exposure of foreign currency denominated investments; (iv) pay U.S. dollar fixed on foreign currency swaps to hedge the foreign currency cash flow exposure on liabilities denominated in foreign currencies; and (v) other instruments to hedge the cash flows of various other forecasted transactions. For all qualifying and highly effective cash flow hedges, the effective portion of changes in fair value of the derivative instrument is reported as a component of other comprehensive income. The ineffective portion of changes in fair value of the derivative instrument is reported as a component of earnings.
We designate and account for the following as fair value hedges when they have met the effectiveness requirements of SFAS 133: (i) various types of interest rate swaps to convert fixed rate investments to floating rate investments; and (ii) other instruments to hedge various other fair value exposures of investments. For all qualifying and highly effective fair value hedges, the changes in fair value of the derivative instrument are reported in earnings. In addition, changes in fair value attributable to the hedged portion of the underlying instrument are reported in earnings.
For our mortgage insurance policies, reserves for losses and loss adjustment expenses are based on notices of mortgage loan defaults and estimates of defaults that have been incurred but have not been reported by loan servicers, using assumptions of claim rates for loans in default and the average amount paid for loans that result in a claim. As is common accounting practice in the mortgage insurance industry and in accordance with U.S. GAAP, loss reserves are not established for future claims on insured loans that are not currently in default.
Management considers the liability for policy and contract claims provided to be satisfactory to cover the losses that have occurred. Management monitors actual experience, and where circumstances warrant, will revise
For single premium insurance contracts, we recognize premiums over the policy life in accordance with the estimated expiration of risk. We recognize a portion of the revenue in premiums earned in the current period, while the remaining portion is deferred as unearned premiums and earned over time in accordance with the estimated expiration of risk. If single premium policies are canceled and the premium is non-refundable, then the remaining unearned premium related to each cancelled policy is recognized to earned premiums upon notification of the cancellation. Estimation of risk expiration on which we base premium recognition is inherently judgmental and is based on actuarial analysis of historical experience. We periodically review our premium earnings recognition models with any adjustments to the estimates reflected in current period earnings.
For periods prior to our corporate reorganization, our non-life insurance entities were included in the consolidated federal income tax return of GE and subject to a tax-sharing arrangement that allocates tax on a separate company basis, but provides benefit for current utilization of losses and credits. For periods prior to 2004, our U.S. life insurance entities filed a consolidated life insurance federal income tax return separate from GE and are subject to a separate tax-sharing agreement, as approved by state insurance regulators, which also allocates taxes on a separate company basis but provides benefit for current utilization of losses and credits. For 2004, through the date of our corporate reorganization, our US life insurance entities were included in the consolidated federal income tax return of GE, and subject to separate company principles similar to those applicable to our non-life insurance entities. Intercompany balances under all agreements are settled at least annually.
In July 2003, the AICPA issued Statement of Position (SOP) 03-1, Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts, which we adopted on January 1, 2004. This statement provides guidance on separate account presentation and valuation, the accounting for sales inducements paid to contractholders and the classification and valuation of long-duration contract liabilities. Upon adoption of SOP 03-1, we recorded a $5 million benefit in cumulative effect of accounting changes, net of taxes.
We adopted the stock option expense provisions of SFAS 123, Accounting for Stock-Based Compensation, for stock options granted by us and by GE to our employees after January 1, 2002. A comparison of reported net earnings, including effects of expensing stock options, follows:
In December 2004, the Financial Accounting Standards Board (FASB) issued SFAS 123R, Share-Based Payment-an amendment of FASB Statements No. 123 and 95, which we adopted effective January 1, 2006. This statement provides additional guidance on accounting for share based payments and will require all such awards to be measured at fair value with the related compensation cost recognized in income on a prospective basis. We currently recognize compensation cost using the fair value method for all stock based awards issued after January 1, 2002 and expect the adoption of SFAS 123R will not have a material impact on our results of operations or financial position.
Basic and diluted earnings per share are calculated by dividing net earnings for the year ended December 31, 2005 and 2004 by 475.3 million and 489.5 million weighted average basic shares outstanding and by 484.6 million and 490.5 million weighted average diluted shares outstanding, respectively. Weighted average shares outstanding for the year ended December 31, 2004 are determined as if our reorganization had occurred at the beginning of the year. Basic and diluted earnings per share are calculated by dividing net earnings by 489.5 million shares outstanding for the year ended December 31, 2003.
Upon completion of our corporate reorganization described in note 1, we no longer have continuing involvement with the Japanese life insurance and domestic auto and homeowners’ insurance businesses (together “Japan/Auto”), which was sold in August 2003, and accordingly, those operations have been accounted for as discontinued operations. Therefore, the results of operations of these businesses are reflected as discontinued operations.
For the years ended December 31, gross realized investment gains and losses resulting from the sales and impairments of fixed maturity and equity securities are as follows:
Net unrealized gains and losses on investment securities classified as available for sale are reduced by deferred income taxes and adjustments to PVFP and DAC that would have resulted had such gains and losses been realized. Net unrealized gains and losses on available-for-sale investment securities reflected as a separate component of accumulated other comprehensive income as of December 31, are summarized as follows:
For fixed maturities, we recognize an impairment charge to earnings in the period in which we determine that we do not expect either to collect principal and interest in accordance with the contractual terms of the instruments or to recover based upon underlying collateral values, considering events such as a payment default, bankruptcy or disclosure of fraud. For equity securities, we recognize an impairment charge in the period in which we determine that the security will not recover to book value within a reasonable period. We determine what constitutes a reasonable period on a security-by-security basis based upon consideration of all the evidence available to us, including the magnitude of an unrealized loss and its duration. In any event, this period does not exceed 18 months for common equity securities. We measure impairment charges based upon the difference between the book value of a security and its fair value.
Because we expect these investments to continue to perform as to their original contractual terms and we have the ability and intent to hold these investment securities until the recovery of the fair value up to the cost of the investment, which may be maturity, we do not consider these investments to be other-than-temporarily impaired at December 31, 2005.
Our mortgage loans are collateralized by commercial properties, including multifamily residential buildings. The carrying value of commercial mortgage loans is original cost net of prepayments, amortization and allowance for losses.
Average investment in specifically impaired loans during 2005, 2004 and 2003 is $3 million, $3 million and $5 million, respectively, and interest income recognized on these loans while they were considered impaired is $0, $1 million and $1 million, respectively.
Amortization related to present value of future profits, capitalized software and other intangible assets for the years ended December 31, 2005, 2004 and 2003 was $112 million, $153 million and $169 million, respectively. Amortization expense related to sales inducements of $3 million and $1 million for the years ended December 31, 2005 and 2004 was included in benefits and other changes in policy reserves. There were no deferred sales inducements for the year ended December 31, 2003.
In January 2004, we acquired Hochman & Baker, Inc. and subsidiaries for $10 million, including goodwill of $9 million. In October 2005, we acquired C.J.M. Planning Corp. and affiliates for an up-front cost of $5 million and contingent consideration of up to $7 million, including goodwill of $5 million.
All of our liabilities under the in-force structured settlement annuities reflected as policyholder reserves on December 31, 2003, or reinsured by us under reinsurance agreements in effect prior to January 1, 2004. This block of business had aggregate reserves of $11.7 billion and $11.8 billion as of December 31, 2005 and 2004, respectively.
To secure the payment of its obligations to us under the reinsurance agreements governing the Reinsurance Transactions, UFLIC has established trust accounts to maintain an aggregate amount of assets with a statutory book value at least equal to the statutory general account reserves attributable to the reinsured business less an amount required to be held in certain claims paying accounts. A trustee will administer the trust accounts and we will be permitted to withdraw from the trust accounts amounts due to us pursuant to the terms of the reinsurance agreements that are not otherwise paid by UFLIC. In addition, pursuant to a Capital Maintenance Agreement, GE Capital agreed to maintain sufficient capital in UFLIC to maintain UFLIC’s risk-based capital at not less than 150% of its company action level, as defined from time to time by the National Association of Insurance Commissioners.
The maximum amount of individual ordinary life insurance normally retained by us on any one life policy is $1 million. The following table sets forth net domestic life insurance in-force as of December 31:
Reinsurance recoveries recognized as a reduction of benefit expenses amounted to $1,881 million, $1,264 million and $837 million during 2005, 2004 and 2003, respectively. Reinsurance recoveries recognized as a reduction to changes in policy reserves amounted to $431 million, $256 million and $201 million during 2005, 2004 and 2003, respectively.
Insurance contracts are broadly defined to include contracts with significant mortality and/or morbidity risk. The liability for future benefits of insurance contracts is the present value of such benefits less the present value of future net premiums based on mortality, morbidity, and other assumptions, which are appropriate at the time the policies are issued or acquired. These assumptions are periodically evaluated for potential reserve
As described in note 9, in connection with our corporate reorganization, we reinsured our in-force variable annuities, excluding the RetireReadySM product and a small block of contracts in run-off, to an affiliate, effective as of January 1, 2004. We have continued to sell variable annuities and are retaining that business for our own account, subject to third-party reinsurance transactions in the ordinary course of business.
Our variable annuities provide a basic guaranteed minimum death benefit (“GMDB”), which provides a minimum account value to be paid upon the annuitant’s death. Our contractholders have the option to purchase through riders, at an additional charge, enhanced death benefits. Our separate account guarantees are predominantly death benefits; we also have some guaranteed minimum withdrawal benefits.
The total account value (excluding the block of business reinsured through the transaction mentioned above) of our variable annuities with death benefits, including both separate account and fixed account assets, is approximately $2,135 million and $1,068 million at December 31, 2005 and 2004, respectively, with related death benefit exposure (or net amount at risk) of approximately $8 million and $4 million, respectively.
The liability for our variable annuity contracts with death benefits, net of reinsurance, is $2 million and $1 million at December 31, 2005 and 2004, respectively.
For each of the three years presented above, the change in prior years incurred liabilities primarily relates to favorable development in claims incurred but not reported for our mortgage insurance and certain accident and health insurance businesses. In general, our insurance contracts are not subject to premiums experience adjustments as a result of prior-year effects.
Prior to September 27, 2005, our employees participated in GE’s retirement plan (“GE Pension Plan”), retiree health and life insurance benefit plans and defined contribution savings plan. Our employees also received health and life benefits through GE’s benefit program. The GE Pension Plan currently is in an overfunded position, therefore, we have not been required to contribute to this plan for the three years ended December 31, 2005. Certain company employees also participated in GE’s Supplementary Pension Plan.
We provide retiree health benefits to domestic employees hired prior to January 1, 2005 who meet certain service requirements. Under this plan, retirees over 65 years of age receive Medigap policy coverage, and retirees under 65 years of age receive medical benefits similar to our employees’ medical benefits. We also provide retiree life insurance benefits, which are provided through our Employee Benefits Group business (Group). The amount of fees recorded by Group related to the retiree life insurance benefits was insignificant during 2005. The plans are funded as claims are incurred. As of December 31, 2005, the accumulated postretirement benefit obligation associated with these benefits was $61 million, of which we had accrued $29 million in other liabilities. The difference between the accumulated post retirement benefit obligation and the amount accrued represents unrecognized prior service costs and unrecognized gains and losses which will be recognized over the average remaining service period of active employees.
Our cost associated with these Genworth plans was $11 million for the period from September 27, 2005 through December 31, 2005.
Our domestic employees participate in qualified and non-qualified defined contribution savings plans that allow employees to contribute a portion of their pay to the plan on a pre-tax basis. We match these contributions, which vest immediately, up to 4% of the employee’s pay. One option available to employees in the defined contribution savings plan is the ClearCourseSM variable annuity option offered by our Retirement Income and Investments segment (“RI&I”). The amount of deposits recorded by our RI&I segment in relation to this plan option was insignificant during 2005. Employees also have the option of purchasing Genworth stock as part of the defined contribution plan. Our cost associated with these plans was $3 million for the period from September 27, 2005 through December 31, 2005.
We provide health and welfare benefits to our employees, including health, life, disability, dental and long-term care insurance. Our dental insurance is provided through Group, and our long-term care insurance is provided through our group Long-Term Care business. The premiums recorded by these businesses related to these benefits were insignificant during 2005.
In April 2005, we entered into a $1.0 billion revolving credit facility (“2010 Facility”) which matures in April 2010. The 2010 Facility replaced our 364-day credit facility, which was scheduled to mature in May 2005. We also have a $1.0 billion five-year revolving credit facility that matures in May 2009. As of December 31, 2005 we have utilized $170 million of the commitment under these facilities with the issuance of a letter of credit for the benefit of one of our mortgage insurance subsidiaries. Each of these facilities bears a floating interest rate based on certain indices plus an applicable margin.
On June 15, 2004, we issued senior notes having an aggregate principal amount of $1.9 billion (the “Notes”), consisting of $500 million in aggregate principal amount maturing on June 15, 2007 (“2007 Notes”) with an interest rate equal to three-month LIBOR plus 0.15% per year, $500 million in aggregate principal amount maturing on June 15, 2009 (“2009 Notes”) with a fixed interest rate of 4.75%, $600 million in aggregate principal amount maturing on June 15, 2014 (“2014 Notes”) with a fixed interest rate of 5.75%, and $300 million in aggregate principal amount maturing on June 15, 2034 (“2034 Notes”) with a fixed interest rate of 6.50%. As a result of hedging arrangements entered into with respect to these securities, our effective interest rates will be 3.39% on the 2007 Notes, 4.48% on the 2009 Notes, 5.51% on the 2014 Notes and 6.35% on the 2034 Notes. The Notes are direct unsecured obligations and will rank without preference or priority among themselves and equally with all of our existing and future unsecured and unsubordinated obligations. We have the option to redeem all or a portion of the 2009 Notes, the 2014 Notes and the 2034 Notes at any time with proper notice to the note holders at a price equal to the greater of 100% of principal or the sum of the present values of the remaining scheduled payments of principal and interest discounted at the then-current treasury rate plus an applicable spread.
In June 2001, GEFAHI issued ¥60.0 billion of notes through a public offering at a price of ¥59.9 billion. ¥3.0 billion of the notes were retired during 2004. We have entered into arrangements to swap our obligations under these notes to a U.S. dollar obligation with a notional principal amount of $491 million and bearing interest at a rate of 4.84% per annum. The notes are unsecured and mature at par in 2011. As of December 31, 2005, we had $12.5 million interest accrued relating to these notes.
We have issued non-recourse funding obligations in connection with our capital management strategy related to our term life insurance business.
The floating rate notes have been deposited into a series of trusts that have issued money market or term securities. Both principal and interest payments on the money market and term securities are guaranteed by a third-party insurance company. The holders of the money market or term securities cannot require repayment from us or any of our subsidiaries, other than River Lake Insurance Company or River Lake Insurance Company II, as applicable, the direct issuers of the notes. First Colony Life Insurance Company has agreed to indemnify the issuers and the third-party insurer for certain limited costs related to the issuance of these obligations.
The weighted average interest rate on the non-recourse funding obligations as of December 31, 2005 and 2004 is 4.5% and 2.4%, respectively. Because the non-recourse funding obligations bear variable interest rates, carrying value approximates fair value as of December 31, 2005 and 2004.
The Equity Units are reflected in diluted earnings per share using the treasury stock method, and are dilutive when the weighted-average market price of our Class A Common Stock is greater than or equal to the threshold appreciation price. During the period from the date of issuance through December 31, 2005, our weighted-average market price fluctuated higher or lower than the threshold appreciation price.
(1) Repayment of $1,400 million of non-recourse funding agreements requires regulatory approval.
Our liquidity requirements are principally met through dividends from our insurance subsidiaries to our parent company, cash flow from operations, the Commercial Paper program and our revolving credit facilities. As of December 31, 2005, we have an unused credit capacity within our revolving credit facilities of $1.8 billion.
The change in “Deferred tax benefits related to IPO” in 2005 relates to tax impacts of the IPO that were deferred only until GE’s ownership of our stock fell below 50%, as occurred in 2005. These deferred benefits are wholly separate from the $659 million of deferred tax benefits associated with the section 338 elections, which are incorporated in the relevant line items of the above table rather than being separately stated.
The American Jobs Creation Act of 2004 contained a Foreign Earnings Repatriation Provision, which grants a one-time dividend received deduction for repatriation of qualifying foreign earnings to a U.S. taxpayer. On December 22, 2005 we repatriated approximately $61 million of foreign earnings under this provision. As of year-end 2005, Genworth had provided U.S. deferred tax liabilities on all of its undistributed foreign earnings, including a valuation allowance for excess foreign tax credits. Accordingly, the repatriation did not materially change Genworth’s total tax position, as the current tax benefit associated with the one-time dividends received deduction was offset by a corresponding increase in excess foreign tax credits.
Our current income tax asset (liability) is $39 million and ($291) million, as of December 31, 2005 and 2004 respectively.
We grant stock options, stock appreciation rights (“SARs”), restricted stock units (“RSUs”) and deferred stock units (“DSUs”) to employees and non-employee directors under the 2004 Genworth Financial, Inc. Omnibus Incentive Plan. Under the plan, the Company is authorized to grant 38 million equity awards.
In the past, certain of our employees were granted awards under GE’s 1990 Long-Term Incentive Plan. In connection with the IPO and our separation from GE, unvested GE stock options, vested stock options held by our Chairman, President and Chief Executive Officer, GE stock appreciation rights and GE restricted stock units were canceled and converted into Genworth awards. Prior to the IPO, our employees held 3,607,855 unvested GE stock options, 195,000 unvested GE SARs and 963,739 GE RSUs. In connection with the IPO, these awards were converted to 5,648,154 Genworth stock options, 305,213 Genworth SARs and 1,508,454 Genworth RSUs. The
We have recorded stock-based compensation expense in the amount of $50 million, $29 million and $9 million for the years ending December 31, 2005, 2004 and 2003, respectively, related to the cost of the RSUs, SARs and stock options. Stock-based compensation expense is recognized pro rata over the awards’ respective vesting schedule.
The following table summarizes GE stock option activity related to our employees for the period January 1, 2003 through May 24, 2004.
The following table summarizes Genworth stock option activity related to our employees for the period May 25, 2004 through December 31, 2005.
The following table summarizes information about Genworth employee related stock options outstanding as of December 31, 2005:
Our total expense for these services was $34 million, $65 million and $87 million for the years ended December 31, 2005, 2004 and 2003, respectively. We also receive investment management and related administrative services provided by GEAM, for which we incurred expenses of $22 million, $33 million and $61 million for the years ended December 31, 2005, 2004 and 2003 respectively.
Certain of our insurance subsidiaries are parties to investment management and services agreements with GEAM and GE Asset Management Limited (“GEAML”), each a GE-owned provider of investment management services. We have agreed to pay GEAM or GEAML, as applicable, a quarterly management fee for these services equal to a percentage of the value of the assets under management. The percentage is established annually by agreement between GEAM or GEAML and us and is intended to reflect the cost to GEAM or GEAML of providing its services, and, for the agreements with GEAML, a premium of 5%.
We entered into a Transition Services Agreement with GE in connection with the IPO to provide each other, on a transitional basis, certain administrative and support services and other assistance in the U.S. consistent with the services provided before the separation. To comply with European regulatory requirements, we entered into a separate transition services agreement relating to transition services in Europe with respect to our payment protection insurance business. The types of services to be provided under the European transition services agreement are substantially similar to the services to be provided under the U.S. transition services agreement. Pursuant to the Transition Services Agreement, we provide GE various services related to the businesses not transferred to us that had received services from GEFAHI prior to the separation, including information systems and network services, legal services and sourcing support. GE provided services to us, including:
Under the Transition Services Agreement and other agreements described above, GE was obligated to provide to us a number of services until GE ceased to own at least 50% of our outstanding common stock. These services included, among others, treasury, tax, payroll, employee benefits, email and other network services. We have completed most of the transition of these services from GE to us or to third-party providers.
We have agreed to provide certain management consulting services to GE for a period of five years following the IPO. These services include delivering training, providing consultation and strategic advice with respect to actuarial, regulatory and other emerging issues, planning and participating in meetings with rating agencies and regulators, participating in government relations activities and various other activities. In consideration for these services, GE will pay us a fee of $1 million per month during the first four years following the completion of the IPO and $0.5 million per month during the fifth year. GE cannot terminate this arrangement before the expiration of the five-year term.
For the years ended December 31, 2005, 2004 and 2003 we received an aggregate of $12 million, $7 million and $0 million, respectively, for certain management consulting services.
We entered into the Tax Matters Agreement in connection with the IPO. The Tax Matters Agreement, among other things, governs our continuing tax sharing arrangements with GE relating to pre-separation periods, and also allocates responsibility and benefits associated with the elections made in connection with our separation from GE. The Tax Matters Agreement also allocates rights, obligations and responsibilities in connection with certain administrative matters relating to taxes, as described in note 14.
We entered into certain insurance transactions with affiliates of GE. During each of the years ended December 31, 2005, 2004 and 2003 we collected $24 million, $25 million and $24 million, respectively, of premiums from various GE affiliates for long-term care insurance provided to employees of such affiliates. We have also reinsured some of the risks of our insurance policies with affiliates, and paid premiums of $37 million, $39 million and $56 million for the years ended December 31, 2005, 2004 and 2003, respectively, to Employers Reassurance Corporation and ERC Life Reinsurance Company (an affiliate until December 2003), and $100 million to GE Pension Limited in 2003.
company as to the investment of these assets that support these liabilities and administer these assets. Under each of these agreements, we receive a market rate based administration fee based on the program size. The third agreement is with another GE affiliate. Under this agreement we agreed to provide liability management and other services related to origination and issuance of guaranteed investment contracts or similar liabilities. We will receive an annual management fee calculated using a market rate based on the book value of the investment contracts based on pricing arrangements that will vary depending on the maturities of the contracts. We also receive reimbursement of operating expenses under each of the liability and portfolio management agreements.
The initial term of each liability and portfolio management agreement will expire December 31, 2006, and unless terminated at the option of either party, each agreement automatically will renew on January 1 of each year for successive terms of one year. For the three liability management agreements with GE affiliates we recorded fees and reimbursements of $40 million and $37 million for the years ended December 31, 2005 and 2004, respectively.
As of December 31, 2005 and 2004, we have operating receivables of $2 million and $21 million, respectively, and payables of $16 million and $318 million, respectively, with certain affiliated companies.
In December 2004, we entered into a Consideration Agreement with GE Capital International (Mauritius) (“GECIM”), a subsidiary of GE. The Consideration Agreement set forth the terms in which we participated in GE’s sale of its global outsourcing business. Pursuant to the Consideration Agreement, upon the closing of the sale we received consideration of $40 million from GECIM related to our waiver of certain contractual rights and entered into an Outsourcing Services Amendment Agreement (“Service Agreement”) with GECIS International Holdings, Luxembourg, Swiss Branch Zug, a Luxembourg company. The consideration of $40 million is included in policy fees and other income on the statement of earnings as a result of our waiver of contractual rights under the Service Agreement. We also agreed to purchase a minimum volume of services, at market rates, during an eight-year period. Our minimum volume commitment during the each of the first five years of the service agreement will be $24 million, and our minimum volume commitment during the sixth, seventh and eighth years will be $18 million, $12 million and $6 million, respectively.
Commercial mortgage loans. Based on quoted market prices, recent transactions and/or discounted future cash flows, using current market rates at which similar loans would have been made to similar borrowers.
Borrowings, non-recourse funding obligations, senior notes underlying equity units. Based on market quotes or comparables.
A reconciliation of current period changes for the years ended December 31, 2005 and 2004, net of applicable income taxes in the separate component of stockholders’ equity labeled “derivatives qualifying as hedges”, follows:
Positions in derivative instruments. The following table sets forth our positions in derivative instruments and the estimated fair values as of the dates indicated. The fair value of derivative instruments, including financial futures, interest rate and foreign currency swaps, foreign currency forward contracts and equity index options, are based upon quotations obtained from dealers or other reliable sources.
Earnings effects of derivatives. The table that follows provides additional information about the earnings effects of derivatives. In the context of hedging relationships, “effectiveness” refers to the degree to which fair
(“QSPE’s”), are $1.5 billion and $1.6 billion, respectively. There were no off-balance sheet securitizations in 2005 and 2004. Securitization transactions resulted in net gains, before taxes, of approximately $43 million for the year ended December 31, 2003. An analysis of total “securitized assets” as of December 31 is as follows:
Sales of securitized assets to QSPEs result in a gain or loss amounting to the net of sales proceeds, the carrying amount of net assets sold, the fair value of servicing rights and retained interests and an allowance for losses. Amounts recognized in our financial statements related to sales to QSPEs as of December 31 are as follows:
Recourse liability. As described previously, under credit support agreements we provide recourse for credit losses in special purpose entities. We provide for expected credit losses under these agreements and such amounts approximate fair value.
GE Capital, our former majority shareholder, provides credit and liquidity support to a funding conduit it sponsored, which exposes it to a majority of the risks and rewards of the conduit’s activities and therefore makes GE Capital the primary beneficiary of the funding conduit. Upon adoption of FIN 46, GE Capital was required to consolidate the funding conduit because of this financial support. As a result, assets and liabilities of certain previously off-balance sheet securitization entities, for which we were the transferor, were required to be included in our financial statements because the funding conduit no longer qualified as a third-party. Because these securitization entities lost their qualifying status, we were required to include $1.2 billion of securitized assets and $1.1 billion of associated liabilities in our Statement of Financial Position in July 2003. The assets and liabilities associated with these securitization entities have been reported in the corresponding financial statement captions in our Statement of Financial Position, and the assets are noted as restricted due to the lack of legal control we have over them. We apply the same accounting policies to these restricted assets and liabilities as we do to our unrestricted assets and liabilities.
As of December 31, 2005 and 2004, the amortized cost, gross unrealized gains and losses, and estimated fair value of our restricted fixed maturities held by securitization entities are as follows:
The scheduled maturity distribution of these restricted fixed maturities as of December 31, 2005 is set forth below. Actual maturities may differ from contractual maturities because issuers of securities may have the right to call or prepay obligations with or without call or prepayment penalties.
Our insurance company subsidiaries are restricted by state and foreign laws and regulations as to the amount of dividends they may pay to their parent without regulatory approval in any year, the purpose of which is to protect affected insurance policyholders, depositors or investors. Any dividends in excess of limits are deemed “extraordinary” and require approval. Based on statutory results as of December 31, 2005, we estimate our insurance companies could pay dividends of approximately $1,300 million to us in 2006 without obtaining regulatory approval.
In addition to the guarantees discussed in notes 19 and 23, we have provided guarantees to third parties for the performance of certain obligations of our subsidiaries. We estimate that our potential obligations under such guarantees, other than guarantees provided in connection with derivative contracts, were $164 million and $96 million as of December 31, 2005 and 2004, respectively. Our potential obligations under guarantees of derivative contracts were $10 million and $12 million as of December 31, 2005 and 2004, respectively, which reflects the fair value of such derivative contracts. We also provide an unlimited guarantee to third parties for the solvency of our Mortgage Insurance subsidiary located in the United Kingdom.
Our U.S. domiciled insurance subsidiaries file financial statements with state insurance regulatory authorities and the NAIC that are prepared on an accounting basis prescribed or permitted by such authorities (statutory basis). Statutory accounting practices differ from U.S. GAAP in several respects, causing differences in reported net earnings and stockholders’ equity. Permitted statutory accounting practices encompass all accounting practices not so prescribed but that have been specifically allowed by state insurance authorities. Our insurance subsidiaries have no material permitted accounting practices.
Combined statutory net income for our U.S. domiciled insurance subsidiaries for the years ended December 31, 2005, 2004 and 2003 is $886 million, $638 million and $389 million, respectively. The combined statutory capital and surplus for our U.S. domiciled insurance subsidiaries, including statutorily required contingency reserves held by our U.S. mortgage insurance subsidiaries, as of December 31, 2005 and 2004 is $6.7 billion and $6.4 billion, respectively.
The NAIC has adopted Risk-Based Capital (RBC) requirements to evaluate the adequacy of statutory capital and surplus in relation to risks associated with: (i) asset risk, (ii) insurance risk, (iii) interest rate risk, and (iv) business risk. The RBC formula is designated as an early warning tool for the states to identify possible undercapitalized companies for the purpose of initiating regulatory action. In the course of operations, we periodically monitor the RBC level of each of our insurance subsidiaries. As of December 31, 2005 and 2004, each of our insurance subsidiaries exceeded the minimum required RBC levels.
Prior to our corporate reorganization we conducted our operations in five business segments: (1) Protection, which includes our life insurance, long-term care insurance, group life and health insurance and payment protection insurance business; (2) Retirement Income and Investments, which includes our fixed, variable and income annuities, variable life insurance, asset management and specialized products, including GICs, funding agreements and structured settlements business; (3) Mortgage Insurance, which includes our mortgage insurance products that facilitate homeownership by enabling borrowers to buy homes with low-down-payment mortgages business; (4) Affinity, which includes life and health insurance and other financial products and services offered directly to consumers through affinity marketing arrangements with a variety of organizations, an institutional asset management business and several other small businesses that are not part of our core ongoing business; and (5) Corporate and Other, which includes net realized investment gains (losses), interest and other debt financing expenses and unallocated corporate income and expenses, as well as the results of small, non-core businesses that are managed outside our operating segments. The lines of business and assets and liabilities of our Affinity segment were not transferred to us in our corporate reorganization, therefore the results or operations of the Affinity segment are only included in our results until May 24, 2004.
segment. Segment earnings represent the basis on which the performance of our business is assessed by management. Policy premiums and fees, other income, policy benefits and acquisition and operating expenses and policy related amortization are attributed directly to each operating segment. With the exception of our Mortgage segment and the payment protection business within our Protection segment that have separate investment portfolios, net investment income and invested assets are allocated based on the assets required to support the underlying liabilities and capital of the products included in each segment.
The following is a summary of segment activity as of or for the years ended December 31, 2005, 2004 and 2003:
We conduct our operations in two geographic regions: (1) United States and (2) International.
We face a significant risk of litigation and regulatory investigations and actions in the ordinary course of operating our businesses, including class action lawsuits. Our pending legal and regulatory actions include proceedings specific to us and others generally applicable to business practices in the industries in which we operate. Plaintiffs in class action and other lawsuits against us may seek very large or indeterminate amounts, including punitive and treble damages, which may remain unknown for substantial periods of time. A substantial legal liability or a significant regulatory action against us could have an adverse effect on our financial condition and results of operations. Moreover, even if we ultimately prevail in the litigation, regulatory action or investigation, we could suffer significant reputational harm, which could have an adverse effect on our business, financial condition or results of operations.
As at December 31, 2005, we were committed to fund $210 million in U.S. commercial mortgage loans and $99 million to fund limited partnerships.
In January 2006 we agreed to acquire Continental Life Insurance Company, of Brentwood, Tennessee for $145 million as described in note 8 of these financial statements.