net investment income on the separate investment portfolio held by our payment protection insurance business or allocated to this segment’s other lines of business; and
We allocate net investment income from our Corporate and Other segment to our Protection (except payment protection insurance) and Retirement Income and Investments segments using an approach based principally upon the investment portfolio established to support each of those segments’ products and targeted capital levels. We do not allocate net investment income from our Corporate and Other segment to our Mortgage Insurance segment or to our payment protection insurance business within the Protection segment, because they have their own separate investment portfolios, and the net investment income from those portfolios is reflected in the Mortgage Insurance and Protection segment results. In our financial statements, we allocated net investment income to our Affinity segment in the same manner that we allocated these items to our Protection and Retirement Income and Investments segments.
In our Retirement Income and Investments and Protection segments, low market interest rates may reduce the spreads between the amounts we credit to policyholders and contractholders and the yield we earn on the investments that support these obligations. In response to the unusually low interest rates that have prevailed during the last several years, we have reduced the guaranteed minimum crediting rates on newly issued fixed annuity contracts and have reduced crediting rates on in-force contracts where permitted to do so. These actions have helped mitigate the adverse impact of low interest rates on our spreads and profitability on these products. In addition, the recent flattening of the yield curve reduces the attractiveness of certain fixed annuity products relative to other short-term investment alternatives. A gradual increase in longer term interest rates generally will have a favorable effect on the profitability of these products. However, rapidly rising interest rates also could result in reduced persistency in our spread-based retail products as contractholders shift assets into higher yielding investments.
Investment portfolio. The yield on our investment portfolio is affected by the practice, prior to our IPO, of realizing investment gains through the sale of appreciated securities and other assets during a period of historically low interest rates. This strategy had been pursued to offset impairments and losses in our investment portfolio, fund consolidations and restructurings in our business and provide current income, which resulted in gross realized gains of $473 million for the year ended December 31, 2003. Our current investment strategy is to optimize investment income without relying on realized investment gains. As a result, our gross realized gains decreased to $90 million and $108 million for the years ended December 31, 2004 and 2005, respectively. Although the interest-rate environment since our IPO in mid-2004 has been challenging, the yield on our investment portfolio has stabilized, with the potential for yield increases in a rising interest-rate environment. Our overall investment yield declined from 5.8% for the year ended December 31, 2003 to 5.5% for the year ended December 31, 2004 and increased to 5.6% for the year ended December 31, 2005. We seek to improve our investment yield by continuously evaluating our asset class mix, pursuing additional investment classes and accepting additional credit risk with higher returns when we believe that it is prudent to do so.
The increase in acquisition and operating expenses, net of deferrals, was primarily due to an increase of $30 million in expenses due primarily to increased assets under management on fee-based and spread-based retail products. Partially offsetting the increase was a decrease in costs of $21 million resulting from the UFLIC reinsurance transactions in 2004.
U.S. expense ratio in 2005 has increased as a result of accelerated amortization of deferred acquisition costs, due to continued low persistency throughout the year. Excluding the impact of accelerated deferred acquisition costs, the U.S. expense ratio would be down slightly reflecting the continued focus on expense management.
The increase in net investment income was primarily due to limited partnerships, bond calls and mortgage prepayments partially offset by a decline in net investment income primarily attributable to lower income from consolidated securitization entities.
In connection with our corporate reorganization, we entered into a Tax Matters Agreement with GE, which represents an obligation by us to GE. The balance of this obligation is $477 million as of December 31, 2005.
The transactions we have used involved securitizations of some of our receivables and investments that were secured by commercial mortgage loans, fixed maturities or other receivables, consisting primarily of policy loans. Total securitized assets remaining as of December 31, 2005 and December 31, 2004 were $1.5 billion and $1.6 billion, respectively.
Corporate and Other includes net realized investment gains (losses), interest and other debt financing expenses that are incurred at our holding company level, unallocated corporate income and expenses (including amounts accrued in settlement of class action lawsuits), and the results of small, non-core businesses that are managed outside our operating segments.
For single premium mortgage insurance contracts, we report premiums over the estimated policy life in accordance with the estimated expiration of risk as further described in our accounting policy for unearned premiums.
The liability for policy and contract claims represents the amount needed to provide for the estimated ultimate cost of settling claims relating to insured events that have occurred on or before the end of the respective reporting period. The estimated liability includes requirements for future payments of (a) claims that have been reported to the insurer, (b) claims related to insured events that have occurred but that have not been reported to the insurer as of the date the liability is estimated, and (c) claim adjustment expenses. Claim adjustment expenses include costs incurred in the claim settlement process such as legal fees and costs to record, process, and adjust claims.
On August 29, 2003, we completed the sale of our Japan/Auto businesses to American International Group, Inc. for aggregate cash proceeds of approximately $2.1 billion, consisting of $1.6 billion paid to us and $0.5 billion paid to other GE affiliates, plus pre-closing dividends of $495 million. The sale resulted in a loss of $74 million (net of taxes of $158 million). Summary operating results of discontinued operations for the year ended December 31, is as follows:
There were no significant non-cash transactions during the year ended December 31, 2003.
In connection with the IPO, we granted 9,947,500 Genworth stock options and 5,950,000 Genworth SARs to our employees. The exercise price of these options and SARs is equal to the IPO price of our common stock ($19.50), and the exercise term is ten years from the date of the grant. These options and SARs will vest in 25% annual increments commencing on the second anniversary of the date of the grant. During the year ending December 31, 2004, we granted an additional 108,250 Genworth Stock options with vesting and exercise terms consistent with the awards granted in connection with our IPO and with exercise prices ranging from $21.41 to $26.66, which equaled the closing market price on the dates of the grants. During the year ending December 31, 2005 we granted 1,822,350 Genworth Stock options and, 628,500 Genworth SARs with exercise prices ranging from $26.68 to $33.52. These options and SARS will vest in 20% annual increments commencing on the first anniversary of the date of grant. Additionally, during the year ending December 31, 2005 we granted 919,423 RSUs with restriction periods ranging from 3 to 8 years. There were 10,808,095 and 9,646,000 Genworth stock options, 6,578,500 and 5,950,000 Genworth SARs and 893,316 and zero Genworth RSUs outstanding from these grants as of December 31, 2005 and 2004 respectively.
We entered into a master agreement with GE in connection with the IPO. We refer to this agreement as the Master Agreement. The Master Agreement sets forth our agreements with GE regarding the principal transactions that were required to effect the transfer of assets and the assumption of liabilities necessary to separate our company from GE. It also included other agreements governing our relationship after our separation from GE. Most of our obligations under the Master Agreement have terminated as a result of GE ceasing to own at least 20% of our outstanding common stock.
We hold certain derivative instruments that do not qualify for hedge accounting. The changes in fair value of these instruments are recognized currently in earnings. For the periods ended December 31, 2005, 2004 and 2003, the effect on pre-tax earnings was $18 million, $2 million and $(32) million, respectively.
One of the most common forms of off-balance sheet arrangements is asset securitization. We have used GE Capital-sponsored and third-party entities to facilitate asset securitizations. Assets in entities that were either sponsored by GE Capital or to which GE Capital provided financial support were $1.5 billion and $1.7 billion at December 31, 2005 and 2004, respectively. Of the total, $0.7 billion are held by entities that are consolidated and $0.8 billion remain off balance sheet in 2005 and $0.9 billion are held by entities that are consolidated and $0.8 billion remain off balance sheet in 2004. Disclosure requirements related to off-balance sheet arrangements encompass a broader array of arrangements than those at risk for consolidation. These arrangements include transactions with term securitization entities, as well as transactions with conduits that are sponsored by third parties. As of December 31, 2005 and 2004, assets in these entities, which are Qualified Special Purposes Entities
Our holding companies received dividends from our insurance subsidiaries of $639 million ($76 million of which are deemed “extraordinary”), $2,111 million ($1,244 million of which are deemed “extraordinary”) and $1,472 million ($1,400 million of which are deemed “extraordinary”), during 2005, 2004 and 2003, respectively. During 2003, we also received dividends from insurance subsidiaries related to discontinued operations of $495 million.
One of our mortgage insurance subsidiaries is named as a defendant in two lawsuits filed in the U.S. District Court for the Northern District of Illinois, William Portis et al. v. GE Mortgage Insurance Corp. and Karwo v. Citimortgage, Inc. and General Electric Mortgage Insurance Corporation. The Portis complaint was filed on January 15, 2004, and the Karwo complaint was filed on March 15, 2004. Each action seeks certification of a nationwide class of consumers who allegedly were required to pay for our private mortgage insurance at a rate higher than our “best available rate,” based upon credit information we obtained. Each action alleges that the FCRA requires notice to such borrowers and that we violated the FCRA by failing to give such notice. The plaintiffs in Portis allege in the complaint that they are entitled to “actual damages” and “damages within the Court’s discretion of not more than $1,000 for each separate violation” of the FCRA. The plaintiffs in Karwo allege that they are entitled to “appropriate actual, punitive and statutory damages” and “such other or further relief as the Court deems proper.” Similar cases were filed against six other mortgage insurers. We have reached an agreement in principle to settle these cases. If an acceptable definitive settlement cannot be negotiated or approved by the courts, we intend to defend vigorously against the actions to which we are a party, but we cannot predict their outcome.