credited (investment margin); and surrender and other contract charges less maintenance expenses (expense margin). The amount of EGP is principally dependent on assumptions for investment returns, including capital gains and losses on assets supporting contract liabilities, interest crediting rates to contractholders, and the effects of persistency, mortality, expenses, and hedges if applicable, and these assumptions are reasonably likely to have the greatest impact on the amount of DAC amortization. Changes in these assumptions can be offsetting and the Company is unable to reasonably predict their future movements or offsetting impacts over time.
Total contract charges increased 2.7% in 2008 compared to 2007. This increase includes the impact of the prospective reporting reclassification for certain ceded reinsurance premiums. Excluding the impact of this reclassification, total contract charges increased 7.2% in 2008 due to higher contract charges on interest-sensitive life insurance policies resulting from increased contract charge rates and growth in business in force, partially offset by decreased contract charges on fixed annuities.
Contract charges decreased 6.1% in 2007 compared to 2006 due to the disposal of our variable annuity business through reinsurance effective June 1, 2006. Excluding contract charges on variable annuities, all of which are reinsured to Prudential effective June 1, 2006, contract charges increased 7.7% in 2007 compared to 2006. The increase reflects growth in interest-sensitive life insurance policies in force.
INTEREST CREDITED TO CONTRACTHOLDER FUNDS, which represents non-cash charges for interest accrued on interest-sensitive life and investment contracts, increased 7.8% or $13.8 million in 2008 compared to 2007 and 6.1% or $10.2 million in 2007 compared to 2006. The increase in 2008 compared to 2007 was due to higher average contractholder funds, higher acceleration of amortization of deferred sales inducements ("DSI") due to changes in assumptions, and an increase in the weighted average interest crediting rate on deferred fixed annuities, partially offset by a favorable change in amortization of DSI relating to realized capital gains and losses, and a decline in the weighted average interest crediting rate on immediate fixed annuities. The acceleration of amortization of DSI due to changes in assumptions increased interest credited to contractholder funds by $7.5 million in 2008 compared to $844 thousand in 2007.
- - Continuing risk mitigation efforts will focus on shortening duration of the fixed income portfolio, and reducing exposures to real estate and certain other market sectors.
- - Our portfolio continues to generate significant cash flow from maturities, principal and interest receipts which will be available to manage liabilities and take advantage of market opportunities.
Total investments at amortized cost related to collateral received in connection with securities lending business activities decreased to $117.3 million at December 31, 2008 from $198.1 million at December 31, 2007. As of December 31, 2008, these investments are included as a component of short-term investments. At December 31, 2007, these investments were carried at fair value and $183.0 million were classified in fixed income securities and $12.5 million were classified in short-term investments.
---------- (1) The insurance reserves adjustment represents the amount by which the reserve balance would increase if the net unrealized gains in the applicable product portfolios were realized and reinvested at current lower interest rates, resulting in a premium deficiency. Although we evaluate premium deficiencies on the combined performance of our life insurance and immediate annuities with life contingencies, the adjustment primarily relates to structured settlement annuities with life contingencies, in addition to certain payout annuities with life contingencies.
The following table presents gross unrealized losses for fixed income securities with a fair value below 70% of amortized cost.
With respect to our evaluation of the need for a valuation allowance related to other capital losses that have not yet been recognized for tax purposes, we utilize prudent and feasible tax planning strategies. These include strategies that optimize the Corporation's ability to carry back capital losses as well as the ability to offset capital losses with capital gains that could be recognized for tax purposes in the future. Changes in the market value of our investments may impact the level of capital gains and losses that can be used in the tax planning strategies. No valuation allowance was needed at December 31, 2008.
SUMMARY OF SIGNIFICANT VALUATION TECHNIQUES FOR FINANCIAL ASSETS AND FINANCIAL LIABILITIES ON A RECURRING BASIS
CORPORATE: Valued based on non-binding broker quotes and are categorized as Level 3.
Mortgage loans written-down to fair value in connection with recognizing other-than-temporary impairments are primarily valued using valuation models that are widely accepted in the financial services industry. Inputs include non-market observable inputs such as credit spreads. At December 31, 2008, mortgage loans with a fair value of $10.6 million were included in the fair value hierarchy in Level 3 since they were subject to remeasurement at fair value at December 31, 2008.
Contracts that do not subject the Company to significant risk arising from mortality or morbidity are referred to as investment contracts. Fixed annuities, including market value adjusted annuities and immediate annuities without life contingencies, are considered investment contracts. Consideration received for such contracts is reported as contractholder fund deposits. Contract charges for investment contracts consist of fees assessed against the contractholder account balance for maintenance, administration, and surrender of the contract prior to contractually specified dates, and are recognized when assessed against the contractholder account balance.
The disposal was effected through reinsurance agreements (the "Reinsurance Agreements") which include both coinsurance and modified coinsurance provisions. Coinsurance and modified coinsurance provisions are commonly used in the reinsurance of variable annuities because variable annuities generally include both separate account and general account liabilities. When contractholders make a variable annuity deposit, they must choose how to allocate their account balances between a selection of variable-return mutual funds that must be held in a separate account and fixed-return funds held in the Company's general account. In addition, variable annuity contracts include various benefit guarantees that are general account obligations of the Company. The Reinsurance Agreements do not extinguish the Company's primary liability under the variable annuity contracts.
Liabilities for collateral received in conjunction with the Company's securities lending business activities were $117.3 million, $198.1 million and $199.5 million at December 31, 2008, 2007 and 2006, respectively, and are reported in other liabilities and accrued expenses in the Statements of Financial Position.
As of December 31, 2008, $196.7 million of unrealized losses are related to securities with an unrealized loss position less than 20% of amortized cost, the degree of which suggests that these securities do not pose a high risk of being other-than-temporarily impaired. Of the $196.7 million, $188.0 million are related to unrealized losses on investment grade fixed income securities. Investment grade is defined as a security having a rating from the NAIC of 1 or 2; a rating of Aaa, Aa, A or Baa from Moody's, a rating of AAA, AA, A or BBB from Standard & Poor's ("S&P"), Fitch or Dominion, or aaa, aa, a or bbb from A.M. Best; or a comparable internal rating if an externally provided rating is not available. Unrealized losses on investment grade securities are principally related to rising interest rates or changes in credit spreads since the securities were acquired.
The fair value of mortgage loans is based on discounted contractual cash flows. Risk adjusted discount rates are selected using current rates at which similar loans would be made to borrowers with similar characteristics, using similar types of properties as collateral.
Beginning in 2008, the fair value of contractholder funds on investment contracts is based on the terms of the underlying contracts utilizing prevailing market rates for similar contracts adjusted for credit risk. Deferred annuities included in contractholder funds are valued using discounted cash flow models which incorporate market value margins, which are based on the cost of holding economic capital, and the Company's own credit risk. Immediate annuities without life contingencies are valued at the present value of future benefits using market implied interest rates which include the Company's own credit risk. In 2007, the fair value of investment contracts was based on the terms of the underlying contracts. Fixed annuities were valued at the account balance less surrender charges. Immediate annuities without life contingencies were valued at the present value of future benefits using current interest rates. Market value adjusted annuities' fair value was estimated to be the market adjusted surrender value.
- ---------- (1) The Company recorded additional expenses for contract benefits in 2008 relating to a rescission of reinsurance coverage for certain traditional and interest-sensitive life insurance policies provided in accordance with an agreement between the Company and ALIC. These contract benefits are reflected as a component of contract benefits ceded to affiliate for 2008 and totaled $7.1 million. See Note 5 for further details.
- For the reasons specified above, it is often not possible to make meaningful estimates of the amount or range of loss that could result from the matters described below in the "Proceedings" subsection. The Company reviews these matters on an ongoing basis and follows the provisions of SFAS No. 5, "Accounting for Contingencies", when making accrual and disclosure decisions. When assessing reasonably possible and probable outcomes, the Company bases its decisions on its assessment of the ultimate outcome following all appeals.