insurance products. Premium revenues are derived primarily from the sale of group life, and group disability and individual term insurance products.
In addition to interest credited on general account assets, Institutional also had other contract benefits for limited payment contracts of $292, $279 and $231 for the years ended December 31, 2005, 2004 and 2003, respectively. These amounts need to be deducted from net investment income to understand the net interest spread on these businesses because these contracts are accounted for as traditional insurance products.
The Company performs analyses with respect to the potential impact of an unlock. To illustrate the effects of an unlock, assume the Company had concluded that a revision to previously projected account values and the related EGPs was required as of December 31, 2005. If the Company assumed a separate account return assumption of 7.6% for all U.S. product cohorts and 5.0% for all Japanese product cohorts and used its current best estimate assumptions for mortality and lapses, for all products, to project account values forward from the current account value to reproject future EGPs, the estimated increase to amortization (a decrease to net income) for all business would be approximately $7-$10, after-tax. If, instead, the Company assumed a separate account return assumption of 8.6% in the U.S. (6.0% in Japan) or 6.6% in the U.S. (4.0% in Japan), the estimated after-tax change in amortization for all business would have been a decrease (an increase to net income) of $35-$40 and an increase of $50-$55, respectively.
The overall recoverability of the DAC asset is dependent on the future profitability of the business. The Company tests the aggregate recoverability of the DAC asset by comparing the amounts deferred to the present value of total EGPs. In addition, the Company routinely stress tests its DAC asset for recoverability against severe declines in its separate account assets, which could occur if the equity markets experienced another significant sell-off, as the majority of policyholders’ funds in the separate accounts is invested in the equity market. As of December 31, 2005, the Company believed U.S. individual and Japan individual variable annuity separate account assets could fall, through a combination of negative market returns, lapses and mortality, by at least 39% and 60%, respectively, before portions of its DAC asset would be unrecoverable.
Partially offsetting the increase in income tax expense compared to the prior year was an increase in the DRD benefit related to the 2005 tax year of $50. Additional contributing factors to the decrease in net income can be found below.
Life recorded an after-tax expense of $46 for the year ended December 31, 2005, which related to the termination of a provision of an agreement with a mutual fund distribution partner of the Company’s retail mutual funds.
Net income in Group Benefits increased during 2005, primarily due to a non-recurring tax benefit of $9 related to the acquisition of the group life and accident, and short-term and long-term disability businesses of CNA Financial Corporation (“the CNA Acquisition”) and higher earned premiums and net investment income as well as a favorable loss ratio as compared to the prior year period.
2004 Compared to 2003 - Net income improved in 2004 compared to 2003 primarily as a result of an increase in fee income from significant growth in the Japan variable annuity business. A more expanded discussion of earnings growth can be found below:
Net realized capital gains decreased for the year ended December 31, 2005 due to increasing interest rates and the realized loss associated with the GMWB derivatives.
2004 Compared to 2003 - Net income increased for the year ended December 31, 2004. The following factors contributed to the earnings increase:
Net realized capital losses were recognized for 2005 compared to net realized capital gains for 2004. The significant components driving the changes in net realized capital gain and loss amounts between 2005 and 2004 include lower net gains on the sale of fixed maturity securities, losses associated with GMWB derivatives, Japanese fixed annuity contract hedges and periodic net coupon settlements. These losses were offset in part by gains in Other, net which was primarily related to changes in the value of non-qualifying foreign currency swaps. The circumstances giving rise to the changes in these components are as follows:
Future other-than-temporary impairment levels will depend primarily on economic fundamentals, political stability, issuer and/or collateral performance and future movements in interest rates. If interest rates continue to increase during 2006 or credit spreads widen, other-than-temporary impairments for 2006 may be higher than the 2005 levels. For further discussion of risk factors associated with sectors with significant unrealized loss positions, see the sector risk factor commentary under the Total Available-for-Sale Securities with Unrealized Loss Greater than Six Months by Type table in the Investment Credit Risk section of the MD&A.
The Company is also exposed to interest rate risk based upon the discount rate assumption associated with the Company’s pension and other postretirement benefit obligations. The discount rate assumption is based upon an interest rate yield curve comprised of Aa with maturities between zero and thirty years. Declines in long-term interest rates have had a negative impact on the funded status of the plans.
The Company’s operations are significantly influenced by changes in the equity markets. The Company’s profitability depends largely on the amount of assets under management, which is primarily driven by the level of sales, equity market appreciation and depreciation and the persistency of the in-force block of business. Prolonged and precipitous declines in the equity markets can have a significant effect on the Company’s operations, as sales of variable products may decline and surrender activity may increase, as customer sentiment towards the equity market turns negative. Lower assets under management will have a negative effect on the Company’s financial results, primarily due to lower fee income related to the Retail, Retirement Plans, Institutional and International,and to a lessor extent, the Individual Life segment, where a heavy concentration of equity linked products are administered and sold. Furthermore, the Company may experience a reduction in profit margins if a significant portion of the assets held in the variable annuity separate accounts move to the general account and the Company is unable to earn an acceptable investment spread, particularly in light of the low interest rate environment and the presence of contractually guaranteed minimum interest credited rates, which for the most part are at a 3% rate.
The capital structure of Hartford Life as of December 31, 2005 and 2004 consisted of debt and equity, summarized as follows: