These forward-looking statements are subject to risks and uncertainties including, but not limited to, the risks that (1) a significant downgrade in our ratings for claims-paying ability and financial strength may lead to policy and contract withdrawals and materially harm our ability to market our products; (2) new laws and regulations, including the recently enacted Sarbanes-Oxley Act of 2002, or changes to existing laws or regulations (including, but not limited to, those relating to the Federal Estate Tax Laws and proposed Bush Administration tax and savings initiatives), and the applications and interpretations given to these laws and regulations, may adversely affect the Company's sales of insurance and investment advisory products; (3) Massachusetts insurance law may restrict the ability of John Hancock Variable Life Insurance Company to pay dividends to us; (4) we face increasing competition in our retail businesses from mutual fund companies, banks and investment management firms as well as from other insurance companies; (5) a decline or increased volatility in the securities markets, and other economic factors, may adversely affect our business, particularly our variable life insurance, mutual fund, variable annuity and investment business; (6) due to acts of terrorism or other hostilities, there could be business disruption, economic contraction, increased mortality, morbidity and liability risks, generally, or investment losses that could adversely affect our business; (7) our life insurance sales are highly dependent on third party distribution relationships; (8) customers may not be responsive to new or existing products or distribution channels, (9) interest rate volatility may adversely affect our profitability; (10) our net income and revenues will suffer if customers surrender annuities and variable and universal life insurance policies or redeem shares of our open-end mutual funds; (11) the independent directors of our variable series trusts and of our mutual funds could reduce the compensation paid to us or could terminate our contracts to manage the funds; (12) under our Plan of Reorganization, we were required to establish the closed block, a special arrangement for the benefit of a group of our policyholders. We may have to fund deficiencies in our closed block, and any overfunding of the closed block will benefit only the holders of policies included in the closed block, not our shareholder; (13) we will face losses if the claims on our insurance products, or reductions in rates of mortality on our annuity products, are greater than we projected; (14) we face investment and credit losses relating to our investment portfolio including without limitation, the risks associated with the evaluation and determination by our investment professionals of the fair value of investments as well as whether or not any investments have been impaired on an other than temporary basis; (15) we may experience volatility in net income due to changes in standards for accounting for derivatives and other changes; (16) our United States insurance companies are subject to risk-based capital requirements and possible guaranty fund assessments; (17) we may be unable to retain personnel who are key to our business; (18) we may incur losses from assumed reinsurance business in respect of personal accident insurance and the occupational accident component of workers compensation insurance; (19) litigation and regulatory proceedings may result in financial losses, harm our reputation and divert management resources, (20) we may incur multiple life insurance claims as a result of a catastrophic event which, because of higher deductibles and lower limits under our reinsurance arrangements, could adversely affect the Company's future net income and financial position.
In December 2003, the Financial Accounting Standards Board re-issued Interpretation 46, "Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51," (FIN 46R) which clarifies the consolidation accounting guidance of Accounting Research Bulletin No. 51, "Consolidated Financial Statements," (ARB No. 51) to certain entities for which controlling interests are not measurable by reference to ownership in the equity of the entity. Such entities are known as variable interest entities (VIEs).
The Company manages invested assets for its customers under various fee-based arrangements using a variety of entities to hold these assets under management, and since 1996, this has included investment vehicles commonly known as collateralized debt obligations funds (CDOs). Various business units of the Company sometimes invest in the debt or equity securities issued by these and other CDOs to support their insurance liabilities.
Additional liabilities recognized as a result of consolidating any of these entities would not represent additional claims on the general assets of the Company; rather, they would represent claims against additional assets recognized by the Company as a result of these consolidations. Conversely, additional assets recognized as a result of these consolidations would not represent additional assets which the Company could use to satisfy claims against its general assets, rather they would be used only to settle additional liabilities recognized as a result of these consolidations.
The Company discloses summary financial data and its maximum exposure to losses for the CDOs, Properties and other entities in Note 4 - Relationships with Variable Interest Entities in the notes to the Consolidated Financial Statements.
Unamortizable assets include goodwill, brand name and investment management contracts. Goodwill is the excess of the cost to Manulife over the fair value of the Company's identifiable net assets acquired by Manulife in the recent merger. Brand name is the fair value assigned to the Company's trademark and trade name. Investment management contracts are fair values of the investment management relationships between the Company and each of the mutual funds managed by the Company.
sales agents and producers responsible for procuring business. Distribution networks had weighted average lives of 21 years at the merger. Other investment management contracts had weighted average lives of 9 years at the merger. Collectively, these amortizable intangible assets had a weighted average life of 14.7 years at the merger.
including inflation. A change in the compensation rate increase assumption can be expected to move in the same direction as a change in the discount rate. A 4.0% compensation rate increase assumption is being used. A 0.25% increase in the salary scale would increase 2004 pension benefits PBO and NPPC by approximately $5.8 million and $0.6 million, respectively. Post employment benefits are independent of compensation.
The Company uses a 10% corridor for the amortization of actuarial gains/losses. At the date of the merger, actuarial gains and losses were set to zero.
On December 8, 2003, President Bush signed into law a bill that expands Medicare, primarily by adding a prescription drug benefit for Medicare-eligible retirees starting in 2006. The Medicare Prescription Drug Improvement and Modernization Act of 2003 (the Act) provides for special tax-free subsidies to employers that offer plans with qualifying drug coverages beginning in 2006. There are two broad groups of retirees receiving employer-subsidized prescription drug benefits at the Company. The first group, those who retired prior to January 1, 1992, receives a subsidy of between 90% and 100% of total cost. Since this subsidy level will clearly meet the criteria for qualifying drug coverage, the Company anticipates that the benefits it pays after 2005 for pre-1992 retirees will be lower as a result of the new Medicare provisions. In accordance with Financial Accounting Standards Board Staff Position FAS 106-2 (FSP FAS 106-2), the Company reflected a reduction in the accumulated plan benefit obligation for this group of $40.9 million as of the purchase accounting remeasurement (April 28, 2004) and reduced net periodic postretirement benefit costs by $1.6 million for the period from April 29 through December 31, 2004. With respect to the second group, those who retired on or after January 1, 1992, the employer subsidy on prescription drug benefits is capped and currently provides as low as 25% of total cost. Since final authoritative accounting guidance has not yet been issued on determining whether a benefit meets the actuarial criteria for qualifying drug coverage, the Company has deferred recognition as permitted by FSP FAS 106-2 for this group. The final accounting guidance could require changes to previously reported information.
A number of years may elapse before a particular matter, for which we have established an accrued liability, is audited and finally resolved. The Internal Revenue Service is currently examining our tax returns for 1999 through 2001.
As of January 1, 2001, the Company also entered into agreements with two reinsurers covering 50% of its closed block business. One of these reinsurers is Manulife. Effective April 28, 2004 the Company operates as a subsidiary of Manulife. During the fourth quarter of 2004, the Company entered into an additional agreement covering closed block policies with a Manulife affiliate in order to facilitate its statutory capital management process. This transaction increased the amount of reinsurance of the closed block with Manulife by 20%. Effective December 31, 2003, the Company entered into an agreement with a third reinsurer covering another 5% of its closed block business. The reinsurance agreements are structured so they will not affect policyholder dividends or any other financial items reported within the closed block, which was established at the time of the Life Company's demutualization to protect the reasonable dividend expectations of certain participating life insurance policyholders. In addition, the Company has entered into reinsurance agreements to specifically address insurance exposure to multiple life insurance claims as a result of a catastrophic event. The Company has put into place, effective July 1, 2002, catastrophic reinsurance covering individual life insurance policies written by all of its U.S. life insurance subsidiaries. Effective July 1, 2004, the Company is covered by its parent's catastrophic reinsurance under its global catastrophe reinsurance program which covers the entire Manulife group of companies for losses in excess of $50 million up to $150 million. This global catastrophe reinsurance covers all terrorist acts in Canada; in the United States and elsewhere, nuclear, biological and chemical terrorist acts are not covered. Should catastrophic reinsurance become unavailable to the Company in the future, the absence of, or further limitations on, reinsurance coverage could adversely affect the Company's future net income and financial position.
The acquisition described under the table below was recorded under the purchase method of accounting and, accordingly, the operating results have been included in the Company's consolidated results of operations from each date of acquisition. The purchase price was allocated to the assets acquired and the liabilities assumed based on estimated fair values. No goodwill was recorded on this transaction. This acquisition was made by the Company in execution of its plan to acquire businesses and products that have strategic value, meet its earnings requirements and advance the growth of its current businesses.
Consolidated income from continuing operations before income taxes and cumulative effect of accounting changes decreased 20.8%, or $252.1 million, from the prior year. The decrease was driven by corporate operations and lower earnings in the institutional investment management business in the Corporate and Other Segment and decreased earnings in the long-term care insurance business in the Protection Segment. Consolidated income from continuing operations before income taxes and cumulative effect of accounting changes by operating segment were as follows: a decrease of $300.1 million in the Corporate and Other Segment, a decrease of $22.4 million in the Protection Segment, partially offset by growth of $39.7 million in the Wealth Management Segment and an increase of $30.7 million in the Guaranteed and Structured Financial Products Segment. After consolidated income from continuing operations before income taxes and cumulative effect of accounting changes the Company recorded a decrease to net income of $3.3 million (net of tax of $1.8 million) and $279.0 million (net of tax of $150.2 million) for 2004 and 2003, respectively. There was no cumulative effect of accounting changes in 2002. The cumulative effect of accounting changes in 2004 relates to the Company's adoption of SOP 03-1 effective January 1, 2004. The cumulative effect of accounting changes in 2003 relates to the Company's adoption of DIG B36 effective October 1, 2003. For additional discussion of SOP 03-1 and DIG B36, refer to Note 2 - Summary of Significant Accounting Policies in the notes to the consolidated financial statements.
Premium revenues decreased 2.9%, or $59.4 million, from the prior year. The decrease in premiums was driven by the traditional life insurance business, where premiums decreased by $52.8 million. In addition, premiums in the Wealth Management Segment decreased $25.3 million driven by lower sales of single premium immediate annuities in the fixed annuity business, and $38.1 million due to the sale of the group life insurance business in the prior year. Partially offsetting these decreases in premiums was an increase in premiums of $55.7 million in the long-term care insurance business.
o Investment expenses were reduced $33.4 million in the year ended December 31, 2004 compared to the prior year. Included are reductions in state income tax, home office real estate expenses, and miscellaneous expenses.
Net realized investment and other gains increased 22.0%, or $12.8 million, from prior year. See detail of current year net realized investment and other gains in the table below. For the year ended December 31, 2004 gross losses on impairments and on disposal of investments, including fixed maturity securities, equities, real estate, mortgages and other invested assets were $425.9 million, excluding hedging adjustments, compared to $759.7 in the prior year. For the year ended December 31, 2004, realized gains on disposal of fixed maturities, excluding hedging adjustments, were $297.2 million. These gains resulted from managing the portfolios for tax optimization and ongoing portfolio positioning, as well as $104.8 million of prepayments. The Company recorded $178.8 million of other than temporary impairments of fixed maturity securities for the year ended December 31, 2004. These impairments relate primarily to: securities in the airline industry ($62.8 million), a manufacturer of parcel delivery vans ($28.0 million), private placement securities related to secured lease obligations of a regional retail food chain ($22.0 million), a holding in a privately held pharmaceutical company ($21.3 million), and one of the world's largest dairy companies ($17.5 million). The Company recorded losses due to other than temporary impairments of CDO and CBO equity and other invested assets of $78.1 million for year ended December 31, 2004. These impairments primarily relate to lease investments in the U.S. airline industry ($29.2 million) and an investment in a royalty stream ($25.5 million). The Company recorded a net loss of $63.7 million on mortgage loans for the year ended December 31, 2004 (of which $17.7 million was losses on hedging adjustments). Included in this loss is $65.7 million in impairments. These impairments primarily relate to mortgages on a company that operates flour milling facilities ($20.2 million), a refrigeration warehouse company ($21.5 million), and a commercial office property ($10.0 million). There were also gains of $110.4 million on the sale of equity securities as part of our overall investment strategy of using equity gains to offset credit losses in the long-term, gains of $50.3 million from the sale of other invested assets, and gains of $83.1 million resulting from the sale of real estate for the year ended December 31, 2004. Net derivative activity resulted in a gain of $61.9 million for the year ended December 31, 2004 resulting from a slightly larger impact from interest rate changes on the Company's fair value of hedged items in comparison to the changes in fair value of its derivatives hedging those items and the change in the fair value of derivatives that do not qualify for hedge accounting. For additional analysis regarding net realized investment and other gains (losses), see below and General Account Investments in this management's narrative. The Company recorded total impairments for the period from April 29, 2004 though December 31, 2004 of $210.3 million and $118.5 million for the period from January 1, 2004 through April 28, 2004, compared to $572.7 million for the prior year.
Investment management revenues, commissions, and other fees increased 7.5%, or $37.3 million, from the prior year. The increase in fee revenue was driven by the mutual funds business where fees increased $18.9 million driven by a 10.0%, or $2,702.6 million, increase in average assets under management. In addition, advisory fees increased 3.3%, or $3.8 million, in the institutional asset management business despite a 5.5%, or $1,542.1 million, decrease in average assets under management. This increase in advisory fees was driven by success with the new vertical integration strategy in the Hancock Natural Resource Group. In addition, advisory fees earned in the Signator Financial Network increased due to sales of Manulife products since the merger.
Other revenue decreased 3.5%, or $9.5 million, from the prior year. The decrease in other revenue is due to Signature Fruit, a subsidiary of the Company since April 2, 2001, which acquired certain assets and assumed certain liabilities out of bankruptcy proceedings of Tri Valley Growers, Inc., a co-operative association on that date. The revenues and expenses of Signature Fruit are included in the Company's income statement in other revenue and other operating costs and expenses, respectively, in the Corporate and Other Segment. Signature Fruit generated revenue of $242.6 million in 2004, a decrease of $11.9 million from the prior year. Also included in other revenue is the fee revenue generated in the Federal long-term care insurance business, its primary operating revenue. The Federal long-term care insurance business is a fee business where the Company administers and supports employee long-term care insurance benefits offered by the Federal Government to its employees. Federal long-term care insurance fee revenue increased $1.2 million from the prior year.
Amortization of deferred policy acquisition costs and value of business acquired decreased 11.3%, or $34.9 million, from the prior year. The decrease in amortization of deferred policy acquisition costs and value of business acquired was comprised by a $42.4 million decrease in the non-traditional life insurance business and a decrease of $24.4 million in the traditional life insurance business. The decrease in amortization of deferred policy acquisition costs and value of business acquired was driven by the impact of purchase accounting in the merger with Manulife during the year. Partially offsetting these decreases was an increase in amortization of deferred policy acquisition costs and value of business acquired of $36.4 million in the G&SFP Segment driven by the VOBA asset established in this business due to purchase accounting resulting from the merger with Manulife.
Dividends to policyholders decreased 11.9%, or $63.8 million from the prior year. The decrease in dividends to policyholders was driven by the traditional life insurance business, which decreased 5.1%, or $23.0 million. This decrease was due to the full year impact of lowering of the dividend scale on traditional life insurance products in the prior year. Partially offsetting the decrease in the dividend scale was growth in the traditional life insurance products average reserves, which increased approximately 2.9% from the prior period. Dividends to policyholders decreased $26.7 million due to a return of a claim stabilization reserve to a single customer in the group life business in the prior year. The result of this transaction in the prior year was a reduction in benefits to policyholders and an increase in dividends resulting in no income impact. Group life was sold effective May 1, 2003. In addition, dividends to policyholders declined $15.6 million in the institutional fee-based business on lower average reserves from the prior year.
Income taxes were $257.4 million in 2004, compared to $345.3 million for 2003. Our effective tax rate was 26.7% in 2004, compared to 28.4% in 2003. The change in effective tax rate was primarily due to changes in the recognition of tax expense as a result of the purchase accounting for leveraged leases as required by FASB Interpretation No. 21, "Accounting for Leases in a Business Combination" and FASB Statement of Financial Accounting Standards No. 13, "Accounting for Leases".
Cumulative effect of accounting change, net of tax, was a charge of $3.3 million and $279.0 million for the years ended December 31, 2004 and 2003, respectively. During the 2004, the Company adopted SOP 03-1 which requires specialized accounting for insurance companies related to separate accounts, transfers of assets, liability valuations, returns based on a contractually referenced pool of assets or index, accounting for contracts that contain death or other insurance benefit features, accounting for reinsurance and other similar contracts, accounting for annuitization benefits and sales inducements to contractholders. In 2003, the cumulative effect of accounting change related to the adoption of DIG B36 as of October 1, 2003; refer to Note 2 - Summary of Significant Accounting Policies in the notes to the Company's Consolidated Financial Statements in this Form 10-K.
The following discussion has been updated to remain comparable with the current year management's narrative; it therefore reflects the state of the Company's operations subsequent to the merger with Manulife. In the following management's narrative, references to operating segments which have been merged with other operating segments or renamed since the date of the merger have been updated to reflect such business decisions.
Consolidated income before income taxes and cumulative effect of accounting changes increased 114.1%, or $647.3 million, from the prior year. The increase was driven by growth in income before taxes of $289.2 million in the Corporate and Other Segment, $140.6 million in the Protection Segment, $120.2 million in the Guaranteed and Structured Financial Products, and $97.3 million in the Wealth Management Segment.
Net realized investment and other gains increased 112.9%, or $508.7 million, from prior year. See detail of current year net realized investment and other gains in the table below. The change in net realized investment gains is the result of gross gains on disposal of fixed maturity securities of $464.5 million, real estate of $289.7 million driven by the sale of the Home Office properties, equity securities of $101.1 million and mortgage loans on real estate of $75.8 million. These gains are partially offset by impairments on fixed maturity securities of $515.1 million and associated hedging adjustments during the period. The improvement of $508.7 million in net realized investment and other losses in 2003 is net of $3.4 million in net realized investment and other losses allocated to the participating pension contractholders and $58.5 million in net realized investment and other losses allocated to the policyholder dividend obligation.
The impairments in the current period were driven by losses recognized on other than temporary declines in value of fixed maturity securities of $539.2 million, including impairment losses of $515.1 million and $24.1 million of previously recognized gains where the bond was part of a hedging relationship. The largest impairments were $150.9 million on securities in the dairy industry, $73.5 million on securities in the airline industry, and $69.3 million on securities in the power and energy industries. Additional losses were recorded for other than temporary declines in the equity in collateralized bond obligations of $29.8 million and other equity securities of $27.8 million during 2003. For a more complete discussion of impairments see General Accounts Investments in this MD&A.
In addition to impairment losses, the Company incurred losses on disposal of fixed maturity securities of $95.3 million, losses on the disposal of mortgage loans on real estate investments of $40.9 million, losses on the disposal of other invested assets of $30.6 million, losses on the disposal of real estate of $16.8 million and losses on disposal of equity securities of $3.4 million
The increase in income before income taxes and the cumulative effect of an accounting change in the Corporate and Other Segment was driven by growth in net realized investment and other gains due to a gain of $271.4 million (excluding a deferred profit of $209.4 million) on the sale of the Company's Home Office properties during the first quarter of 2003. See Note 8 - Sale/Leaseback Transaction and Other Lease Obligations in the notes to the consolidated financial statements. In addition, earnings in the institutional investment advisory business within the Corporate and Other Segment increased due to an
increase of $9.0 million in net realized investment and other gains and a $7.0 million increase in management advisory fees. The increased earnings in the G&SFP Segment were primarily due to a $98.5 million improvement in net realized investment and other losses. The increase in the Protection Segment was driven by a $109.9 million increase in net investment income, a $36.9 million increase in net realized investment and other losses, and a $34.6 million increase in universal life product fees. The increase in the Wealth Management Segment was driven by growth in net investment income, partially offset by an increase in benefits to policyholders and operating expenses.
Premium revenues increased 2.8%, or $55.2 million, from the prior year. The increase was primarily due to the Corporate and Other Segment which increased $129.0 million. The growth in the Corporate and Other Segment was driven by the International Group Program which generated $396.8 million in premium, an increase of $128.5 million. Partially offsetting the growth in Corporate and Other was a decrease in the Protection Segment of $78.3 million. The decrease in the Protection segment was driven primarily by a decrease in the group life insurance business of $115.0 million and a decline in traditional life insurance premiums of 4.0%, or $42.0 million, partially offset by growth in long-term care insurance premiums, which increased 17.0%, or $79.4 million. The Company sold the group life insurance business effective May 1, 2003.
Investment management revenues, commissions, and other fees decreased 5.8%, or $30.6 million, from the prior year. The decrease in fee revenue was driven by the mutual funds business where fees declined $23.8 million driven by distribution and advisory fees which declined due to a shift in the product mix. Average mutual fund assets under management were $27,159.7 million, an increase of $356.4 million, or 1.3% from the prior year. Partially offsetting the decline
in the mutual funds business management fees was growth in the institutional investment advisory business of $7.0 million driven by successes with the new vertical integration strategy in the Hancock Natural Resource Group.
Benefits to policyholders increased 1.2%, or $44.0 million, from the prior year. Benefits to policyholders in the Corporate and Other Segment increased $114.9 million driven by growth in the International Group Plans business which increased $111.9 million form the prior year. Benefits to policyholders in the Wealth Management Segment increased 12.1%, or $54.0 million, driven by a $40.3 million increase in interest credit on growing fixed annuity account balances and $9.5 million increase in reserve provisions related to sales of life-contingent immediate fixed annuities. Partially offsetting these increases was the G&SFP Segment's decrease in benefits to policyholders of 8.7%, or $102.8 million, driven by a decrease of $60.5 million in interest credited on spread-based products due to a decline in the average interest crediting rate. The decrease in interest credited was due to a decline in the average interest credited rate on account balances for spread-based products. The average crediting rate fell to 4.19% from 4.85% in the prior year. In addition, the Protection Segment decreased 1.1%, or $22.0 million, from the prior year. The decrease in the Protection Segment was due to the sale of the group life insurance business where benefits to policyholders decreased $127.1 million partially offset by growth in long-term care insurance benefits to policyholders of 21.3%, or $88.7 million. Benefits to policyholders increased in the long-term care insurance business increased primarily due to additions to reserves for premium growth and higher claim volume on growth of the business during the period. In addition, in the Protection Segment the non-traditional life insurance business experienced increased benefits to policyholders of 8.4%, or $24.1 million, primarily due to an increase in interest credited on higher current year account balances, partially offset by a $19.2 million decrease in reserves for lower reserves on term conversions and a decrease in death claims, net of reserves released.
Other operating costs and expenses increased $148.5 million from the prior year, driven by an increase of $120.0 million in the Corporate and Other Segment driven by increases in net periodic pension costs of $32.0 million, deficiency interest of $22.4 million, $12.3 million in compensation costs, $3.3 million in pension curtailment losses, and administrative service contracts of $4.6 million. In addition, Signature Fruit operating expenses increased $16.5 million. Signature Fruit other operating costs and expenses were $257.8 million in 2003 and $241.3 million in the prior year. G&SFP Segment other operating costs and expenses increased $58.9 million on increased investment income transferred on reinsurance ceded and higher compensation costs. Wealth Management Segment other operating costs and expenses decreased $23.0 million driven by business growth. The Protection Segment other operating costs and expenses decreased $58.5 million driven by the sale of the group life insurance business, lower general insurance expenses and amortization of intangibles related to the Allmerica acquisition.
Amortization of deferred policy acquisition costs decreased 2.6%, or $8.1 million, from the prior year. The decrease in amortization of deferred policy acquisition costs was primarily due to the $64.0 million Q3 2002 Unlocking of the Company's deferred policy acquisition costs (DAC) asset, which increased amortization of the DAC asset in 2002. The Q3 2002 Unlocking of the DAC asset occurred based on changes in the future investment return assumptions and our lowering of the long-term growth rate assumption from 9% to 8%, gross of fees (which are approximately 1% to 2%). In addition, we lowered the average rates for the next five years from the mid-teens to 13%, gross of fees. The Q3 2002 Unlocking impacted the Wealth Management and Protection Segments. (See Note 1--Summary of Significant Accounting Policies in the notes to consolidated financial statements and Critical Accounting Policies in this MD&A for further discussion). The decrease in amortization of DAC due to Q3 2002 Unlocking of the DAC asset was partially offset by a $13.6 million increase in amortization in the Protection Segment for growth in the long-term care insurance business and adjusting gross profit margins for term conversions in the non-traditional life insurance business.
Dividends to policyholders decreased 3.3%, or $18.4 million from the prior year. The decrease in dividends to policyholders was driven by the Protection Segment, which decreased 2.4%, or $12.4 million. This decrease was due to the full year impact of lowering of the dividend scale on traditional life insurance products in the prior year. Partially offsetting the decrease in the dividend scale was growth in the traditional life insurance products average reserves, which increased approximately 3.3% from the prior period. The decrease in dividends in the traditional life insurance business was partially offset by a
return of a claim stabilization reserve to a single customer in the group life insurance business during the year. Due to the return of the claim stabilization reserve dividends to policyholders increased $29.2 million in the group life insurance business in 2003.
Our primary investment objective is to maximize after-tax returns within acceptable risk parameters. We are exposed to two primary types of investment risk:
o Interest rate risk, meaning changes in the market value of fixed maturity securities as interest rates change over time, and o Credit risk, meaning uncertainties associated with the continued ability of an obligor to make timely payments of principal and interest.
Insurance product prices are impacted by investment results as well as other results (e.g. mortality, lapse). Accordingly, incorporated in insurance products prices are assumptions of expected default losses over the long-term. Actual losses therefore vary above and below this average, and the market value of the portfolio as a whole also changes as market credit spreads move up and down during an economic cycle.
John Hancock is able to hold to this investment strategy over the long term, both because of its strong capital position, the fixed nature of its liabilities and the matching of those liabilities with assets and because of the experience gained through many decades of a consistent investment philosophy. We generally intend to hold all of our fixed maturity investments to maturity to meet liability payments, and to hold securities with any unrealized gains and losses over the long term. However, we do sell bonds under certain circumstances, such as when new information causes us to change our assessment of whether a bond will recover or perform according to its contractual terms, in response to external events (such as a merger or a downgrade) that result in investment guideline violations (such as single issuer or overall portfolio credit quality limits), in response to extreme catastrophic events (such as September 11, 2001) that result in industry or market wide disruption, or to take advantage of tender offers.
Invested assets, excluding separate accounts, totaled $66.7 billion and $66.9 billion as of December 31, 2004 and December 31, 2003, respectively. On April 28, 2004, as a result of Manulife's acquisition of John Hancock, assets were marked to market, which became the new cost basis of those assets, in accordance with purchase accounting guidelines. As of December 31, 2004 general account invested asset included $0.6 billion in investments classified as separate accounts in the prior year. These assets were reclassified from separate accounts to the Company's general account pursuant to the Company's adoption of SOP 03-01, Accounting and Reporting by Insurance Enterprises for Certain Non Traditional Long Duration Contracts and for Separate Accounts, in 2004. The following table shows the composition of investments in the general account portfolio.
Allocations are based on an assessment of relative value and the likelihood of enhancing risk-adjusted portfolio returns. While the Company has profited from the below-investment-grade asset class in the past, care is taken to manage its growth strategically by limiting its size relative to the Company's total assets.
The table above sets forth the SVO ratings for the bond portfolio along with an equivalent S&P rating agency designation. The majority of the rated fixed maturity investments are investment grade, with 90.0% and 87.1% of fixed maturity investments invested in Category 1 and 2 securities as of December 31, 2004 and December 31, 2003, respectively. Below investment grade bonds were 10.1% and 12.9% of the rated fixed maturity investments as of December 31, 2004 and December 31, 2003, respectively, and 7.1% and 9.1% of total invested assets at December 31, 2004 and December 31, 2003, respectively. This allocation
reflects the Company strategy of avoiding the unpredictability of interest rate risk in favor of relying on the Company's bond analysts' ability to better predict credit or default risk. The bond analysts operate in an industry-based, team-oriented structure that permits the evaluation of a wide range of below investment grade offerings in a variety of industries resulting in a well-diversified high yield portfolio.
Valuation techniques for the bond portfolio vary by security type and the availability of market data. Pricing models and their underlying assumptions impact the amount and timing of unrealized gains and losses recognized, and the use of different pricing models or assumptions could produce different financial results. External pricing services are used where available, broker dealer quotes are used for thinly traded securities, and a spread pricing matrix is used when price quotes are not available, which typically is the case for our private placement securities. The spread pricing matrix is based on credit quality, country of issue, market sector and average investment life and is created for these dimensions through brokers' estimates of public spreads derived from their respective publications. When utilizing the spread pricing matrix, securities are valued through a discounted cash flow method where each bond is assigned a spread that is added to the current U.S. Treasury rates to discount the cash flows of the security. The spread assigned to each security is changed from month to month based on changes in the market. Certain market events that could impact the valuation of securities include issuer credit ratings, business climate, management changes, litigation, and government actions among others. The resulting prices are then reviewed by the pricing analysts and members of the Security Operations Department. The Company's pricing analysts take appropriate actions to reduce valuations of securities where such an event occurs that negatively impacts the securities' value. Although the Company believes its estimates reasonably reflect the fair value of those securities, the key assumptions about risk premiums, performance of underlying collateral (if any) and other factors involve significant assumptions and may not reflect those of an active market. To the extent that bonds have longer maturity dates, management's estimate of fair value may involve greater subjectivity since they involve judgment about events well into the future. Every quarter, there is a comprehensive review of all impaired securities and problem loans by Manulife's Credit Committee a group consisting of Manulife's Chief Investment Officer, Chief Financial Officer, Chief Risk Officer and Chief Credit Officer. The valuation of impaired bonds for which there is no quoted price is typically based on the present value of the future cash flows expected to be received. If the company is likely to continue operations, the estimate of future cash flows is typically based on the expected operating cash flows of the company that are available to make payments on the bonds. If the company is likely to liquidate, the estimate of future cash flows is based on an estimate of the liquidation value of its net assets.
As of December 31, 2004 and December 31, 2003, 53.9% and 48.3% of our below investment grade bonds are in Category 3, the highest quality below investment grade. Category 6 bonds, those in or near default, represent securities that were originally acquired as long-term investments, but subsequently became distressed. The carrying value of bonds in or near default was $227.1 million and $398.4 million as of December 31, 2004 and December 31, 2003, respectively. As of December 31, 2004 and December 31, 2003, $0.5 million and $4.1 million, respectively, of interest on bonds near default were included in accrued investment income. Unless the Company reasonably expects to collect investment income on bonds in or near default, the accrual will be ceased and any accrued income reversed. Management judgment is used and the actual results could be materially different.
The following exhibits show a distribution of gross unrealized gains and losses in the portfolio. As a result of Manulife's acquisition of the Company, the Company's portfolio was marked to market through purchase accounting on April 28, 2004. At December 31, 2004, the gross unrealized loss position of the portfolio is fairly evenly distributed across the portfolio. The following table shows the composition by our internal industry classification of the fixed maturity securities portfolio and the unrealized gains and losses contained therein.
As of December 31, 2004 and December 31, 2003, there were gross unrealized gains of $941.2 million and $3,068.6 million, and gross unrealized losses of $115.2 million and $470.1 million on the fixed maturities portfolio. As of December 31, 2004 gross unrealized losses of $115.2 million included $90.1 million or 78.2% was concentrated in asset-backed/mortgage-backed securities,
Unrealized losses can be created by rising interest rates or by rising credit concerns and hence widening credit spreads. Credit concerns are apt to play a larger role in the unrealized loss on below investment grade bonds and hence the gross unrealized loss on the portfolio has been split between investment grade and below investment grade bonds in the above tables. The gross unrealized loss on below investment grade fixed maturity securities declined from $259.8 million at December 31, 2003 to $18.0 million primarily due to the marking to market of the portfolio on April 28, 2004. The gross unrealized loss on December 31, 2004 was largely due to interest rate changes since April 28, 2004 and is fairly evenly distributed through the fixed maturity portfolio.
The scheduled maturity dates for securities in an unrealized loss position at December 31, 2004 and December 31, 2003 is shown below.
Mortgage Loans. As of December 31, 2004 and December 31, 2003, the Company held mortgage loans with a carrying value of $11.8 billion and $10.9 billion, including $2.9 billion and $3.0 billion, respectively, of agricultural loans at each period end and $8.9 billion and $7.9 billion, respectively, of commercial loans. Impaired loans comprised 1.4% and 1.1% of the mortgage portfolio as of December 31, 2004 and December 31, 2003, respectively. The Company's average historical impaired loan percentage during the period from 1999 through 2004 is 1.0%.
1) Cash and cash equivalents are included in invested assets in the table above for the purposes of calculating yields on income producing assets for the Company.
designed to match our floating-rate liability portfolio. As of December 31, 2003, approximately 88% of this exposure, excluding cash and short-term investments, was directly offset by exposure to floating-rate liabilities. Most of the remaining 12% of exposure is in floating rate assets acquired for their relative value and is accounted for in the portfolio's interest rate risk management plan. As a result of the drop in short term rates over the year, as well as the increase in exposure, this floating-rate exposure reduced the portfolio yield by 11 basis points in 2003 compared to the prior year.
Partially offsetting the effects of these decreases to yields on investments was an increase in invested assets and a reduction in investment expenses. In 2003, weighted-average invested assets grew $6,787.3 million, or 11.9%, from the prior year. In addition, investment expenses were reduced $36.9 million in 2003 compared to the prior year. Included are reductions in corporate complex expenses and in depreciation expenses associated with the sale of the Company's Home Office real estate of $44.9 million.
For the year ended December 31, 2004 the Company realized a gain for net realized investment and other gains and losses of $71.0 million compared to a gain of $58.2 million for the year ended December 31, 2003. For the year ended December 31, 2004 gross losses on impairments and on disposal of investments - including bonds, equities, real estate, mortgages and other invested assets was $425.9 million, excluding hedging adjustments, compared to $759.7 million in prior year. The Company recorded total impairments for the period from April 29, 2004 though December 31, 2004 of $210.3 million and $118.5 million for the period from January 1, 2004 through April 28, 2004, compared to $572.7 million for the prior year.
There are a number of significant risks and uncertainties inherent in the process of monitoring impairments and determining if an impairment is other than temporary. These risks and uncertainties include (1) the risk that our assessment of an issuer's ability to meet all of its contractual obligations will change based on changes in the credit characteristics of that issuer, (2) the risk that the economic outlook will be worse than expected or have more of an impact on the issuer than anticipated, (3) fraudulent information could be provided to our investment professionals who determine the fair value estimates and other than temporary impairments, and (4) the risk that new information obtained by us or changes in other facts and circumstances lead us to change our intent to hold the security to maturity or until it recovers in value. Any of these situations could result in a charge to earnings in a future period.
The Company also recognized losses on other than temporary impairments of common stock of $6.2 million for the year ended December 31, 2004 as the result of market values falling below cost for more than six months.
Realized Gains, Losses and Impairments on Disposals - Year Ended December 31, 2003
Of the $95.3 million of realized losses on sales of fixed maturity securities for the year ended December 31, 2003, there was a total of $28.8 million in credit losses. The significant credit losses for 2003 were $16.7 million of losses related to the sale of public bonds of a major health care service provider and $4.9 million related to the sale of public bonds of a power provider. All other sales were related to general portfolio management, including the sale of a number of below investment grade bonds to maintain the Company's exposure below 10% of invested assets on a statutory basis.
The Company recorded losses due to other than temporary impairments of CBO and CDO equity and other invested assets of $29.8 million for year ended December 31, 2003. These impairments primarily related to an investment in a royalty stream ($11.5 million), a fund investment ($3.8 million) and a power holding company ($3.1 million). There were also $4.6 million in impairments on CBO and CDO equity for the period. Equity in these CBOs and CDOs take the first loss risk in a pool of high yield debt. These impairments are recognized using the guidance of EITF 99-20. At December 31, 2003 the Company had a total remaining carrying value of $60.0 million of CBO and CDO equity, which was supported by expected cash flows.
The Company also recognized losses on other than temporary impairments of common stock of $27.8 million for the year ended December 31, 2003 as the result of market values falling below cost for more than six months.
Liquidity describes the ability of a company to generate sufficient cash flows to meet the immediate capital needs to facilitate business operations. The assets of the Company consist of a diversified investment portfolio and investments in operating subsidiaries. The Company's cash flow consists primarily of premiums, deposits, investment income, results of its operating subsidiaries and proceeds from the Company's debt offerings (See Note 9 - Debt and Line of Credit in the notes to the Company's Consolidated Financial Statements) offset by benefits paid to contractholders, operating expenses, policyholder dividends to its participating policyholders and shareholder dividends to it parent company. All of the outstanding common stock of John Hancock Life Insurance Company is owned by its Parent, an insurance holding company, John Hancock Financial Services, Inc.
In 2003, the Commissioner of Insurance for the Commonwealth of Massachusetts (the Commissioner) approved dividends to JHFS in the amount of $214.5 million. The Company paid $100.0 million in cash in 2003, transferred property worth $14.5 million in 2003, and paid the final $100.0 million in cash in 2004. During 2004,the Commissioner approved and the Company paid $200.0 million in dividends to JHFS. None of these dividends were classified as extraordinary by state regulators. Subsequent to year end the Company issued 32,000 shares of common stock to JHFS for consideration of $320.0 million. The Company then paid a $320.0 million dividend to JHFS. The transaction was approved by the Commissioner. The transaction was exempt from registration under Section 4(2) of the Securities Act of 1922.
Sources of cash for the Company include premiums, deposits and charges on policies and contracts, investment income, maturing investments, and proceeds from sales of investment assets. In addition to the need for cash flow to meet operating expenses, our liquidity requirements relate principally to the liabilities associated with various life insurance, annuity, and structured investment products, and to the funding of investments in new products, processes, and technologies. Product liabilities include the payment of benefits under life insurance, annuity and structured investment products and the payment of policy surrenders, withdrawals and policy loans. The Company periodically adjusts its investment policy to respond to changes in short-term and long-term cash requirements and provide adequate funds to pay benefits without forced sales of investments.
The liquidity of our insurance operations is also related to the overall quality of our investments. As of December 31, 2004, $42,235.2 million, or 90.0% of the fixed maturity securities held by us and rated by Standard & Poor's Ratings Services, (S&P) or the National Association of Insurance Commissioners were rated investment grade (BBB- or higher by S&P, Baa3 or higher for Moody's, or 1 or 2 by the National Association of Insurance Commissioners). The remaining $4,725.6 million, or 10.0% of fixed maturity investments were rated non-investment grade. For additional discussion of our investment portfolio see the General Account Investments section of this Management's Discussion and Analysis of Financial Condition and Results of Segment Operations.
Net cash provided by operating activities was $2,333.0 million, $2,842.4 million and $2,466.6 million for the years ended December 31, 2004, 2003 and 2002, respectively. Cash flows from operating activities are affected by the timing of premiums received, fees received and investment income. The $509.4 million decrease in 2004 as compared to 2003 is largely attributable to a $538.3 million decrease in income tax paid, a $93.7 million decrease in change to other assets net of other liabilities, offset by an increase in policy benefits and dividend payment of $1,118.8 million and an increase in operating expense payment of $74.0 million. The $375.8 million increase in 2003 as compared to 2002 is largely attributable to a $353.9 million increase in investment income received, a $339.9 million decrease in policyholder benefits, and a $109.0 million decrease in other assets net of other liabilities, partially offset by a $179.0 million increase in operating expenses and a $341.1 million increase in income taxes paid.
In addition, the Company has outstanding $2,379.1 million of consumer notes which are redeemable upon the death of the holder, subject to an annual overall program redemption limitation of 1% of the aggregate securities outstanding, or an individual redemption limitation of $ 200,000 of aggregate principal, and mature at a various dates in the future. Covenants in this program include, among others, limitations on liens.
The Company has relationships with a number of entities which are not consolidated into the Company's Consolidated Financial Statements. These entities include qualified special purpose entities (QSPEs) and other special purpose entities. In the course of some of its business the Company transfers assets to, and in some cases, retains interests in QSPEs. The Company may also purchase interests in QSPEs on the open market.
These QSPEs and other special purpose entities also include CDO funds we manage and may also invest in, which are considered variable interest entities and are discussed in detail in Note 4 - Relationships with Variable Interest Entities to our consolidated financial statements. The Company generates fee income from the CDO funds we manage, and generates net investment income from CDOs we invest in, whether we manage them or not.
The Company's risk of loss from these entities is limited to its investment in them. Consolidation of unconsolidated accounts from these entities would inflate the Company's balance sheet but would not be reflective of additional risk in these entities. In each, there are no potential liabilities which might arise in the future as a result of these relationships that would not be completely satisfied by the assets of that entity.
The following table summarizes the Company's information about contractual obligations by due date as of December 31, 2004. Contractual obligations of the Company are those obligations fixed by agreement as to dollar amount and date of payment. These obligations are inputs into the Company's asset liability management system described elsewhere in this document.