Due to our losses during 2003, 2002 and 2001, the ratio coverages, excluding interest credited on policyholder contract balances, were less than 1:1. We would need $11.4 million, $113.6 million and $131.6 million in additional earnings for the years 2003, 2002 and 2001, respectively, to achieve a 1:1 coverage ratio.
In 1999, we discontinued our reinsurance operations. See Note 14 to our consolidated financial statements in this Form 10-K for detailed information regarding our discontinued operations.
On December 30, 2005, we sold 100% of the common stock held by us in Phoenix National Insurance Company. This transaction was not material to our consolidated financial statements.
On January 14, 2005, we closed the sale to third parties of our equity holdings in Aberdeen for net proceeds of $70.4 million, resulting in an after-tax realized investment loss of $7.0 million. The January 2005 sale of our equity holdings in Aberdeen completed our disposition of our direct financial interests in Aberdeen. On November 19, 2004, we received payment in full of a $27.5 million convertible subordinated note issued by Aberdeen Asset Management PLC, or Aberdeen, a United Kingdom-based asset management company. Concurrently we relinquished our contractual right to one of two Aberdeen board seats we held related to our 16.5% equity interest in Aberdeen, at which point we concluded that in our judgment, we no longer had the ability to significantly influence Aberdeen’s operations. Accordingly, effective November 19, 2004, we changed our method of accounting for our equity holdings in Aberdeen from the equity method of accounting to the fair value method of accounting under SFAS No. 115, Accounting for Investments in Debt and Equity Securities. Based on our intent to sell our equity holdings in Aberdeen in the near-term, we designated our equity holdings as trading securities under the fair value method of accounting. Under the fair value method, the changes in fair value, based on the underlying value of Aberdeen’s shares as traded on the London Stock Exchange, as compared to our carrying value under the equity method are presented as an after-tax realized investment gain of $55.1 million in our consolidated statement of operations for the year ended December 31, 2004. In addition, our 2004 consolidated statement of operations includes a $14.7 million after-tax, non-cash charge related to the accounting for our proportionate share of Aberdeen’s 2004 settlement of alleged misselling activities with the United Kingdom’s Financial Services Authority. This charge has been accounted for by us under the equity method of accounting as it pre-dates our November 19, 2004 change in accounting for Aberdeen from the equity method to the fair value method. See Note 5 to our consolidated financial statements in this Form 10-K for more information on our holdings in Aberdeen.
Variable Interest Entities. A new accounting standard was issued in January 2003 that interprets the existing standard on consolidation. This new accounting standard was revised and reissued in December 2003 as FIN 46(R), Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51, or FIN 46(R). It clarifies the application of standards of consolidation to certain entities in which equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties (“variable interest entities”). As of December 31, 2003, we adopted FIN 46(R) for special purpose entities, or SPEs, where we may hold a variable interest. Our adoption of FIN 46(R) resulted in no additional variable interest entities being consolidated by us.
At the beginning of 2002, we adopted a new accounting standard for goodwill and other intangible assets, including amounts reflected in our carrying value of equity-method investments. Under this new standard, we discontinued recording amortization expense on goodwill and other intangible assets with indefinite lives, but we continue recording amortization expense for those intangible assets with definite estimated lives. For goodwill and intangible assets, we perform impairment tests at the reporting-unit level at least annually. In 2005, in conjunction with our conversion to a wholly-owned structure, we consolidated our asset management related goodwill and intangible assets into a single reporting unit for purposes of impairment testing. For purposes of the impairment test, the fair value of the reporting unit is based on the sum of: a multiple of revenue, plus the fair value of the units’ tangible fixed assets. Prior to 2002, we amortized goodwill principally over 40 years and investment management contracts over five to 16 years. All amortization expense has been and continues, for intangible assets with definite lives, to be calculated on a straight-line basis.
We account for income taxes in accordance with SFAS 109, Accounting for Income Taxes. The deferred tax assets and/or liabilities are determined by multiplying the differences between the financial reporting and tax reporting bases for assets and liabilities by the enacted tax rates expected to be in effect when such differences are recovered or settled. The effect on deferred taxes of a change in tax rates is recognized in income in the period that includes the enactment date. Valuation allowances on deferred tax assets are estimated based on the Company’s assessment of the realizability of such amounts.
We have elected to file a consolidated federal income tax return for 2005 and prior years. Within the consolidated tax return, we are required by regulations of the Internal Revenue Service, or IRS, to segregate the entities into two groups: life insurance companies and non-life insurance companies. We are limited as to the amount of any operating losses from the non-life group that can be offset against taxable income of the life group. These limitations may affect the amount of any operating loss carryforwards that we have now or in the future.
Our federal income tax returns are routinely audited by the IRS, and estimated provisions are routinely provided in the financial statements in anticipation of the results of these audits. While it is often difficult to predict the outcome of these audits, including the timing of any resolution of any particular tax matter, we believe that our reserves, as reported on our consolidated balance sheet, are adequate for all open tax years. Unfavorable resolution of any particular issue could result in additional use of cash to pay liabilities that would be deemed owed to the IRS. Additionally, any unfavorable or favorable resolution of any particular issue could result in an increase or decrease, respectively, to our effective income tax rate to the extent that our estimates differ from the ultimate resolution.
We ended 2005 with a strong financial position. Shareholders’ equity was $2,007.1 million at December 31, 2005 and Phoenix Life’s statutory capital, surplus and AVR grew $68.1 million to $1,096.3 million at December 31, 2005 from $1,028.2 million at December 31, 2004. Phoenix Life’s risk-based capital, or RBC, is well above 350%, and PNX cash was $49.9 million at December 31, 2005. We also took steps to enhance our financial flexibility. In January of 2005, we disposed of our two largest non-strategic assets, Aberdeen and Lombard, which resulted in the receipt of net proceeds of nearly $130.0 million. In 2004 we closed on a tender offer for our 6.95% surplus notes scheduled to mature on December 1, 2006, receiving valid tenders of $144.8 million of
We evaluate segment performance on the basis of segment income and the Company’s financial performance based on total segment return on equity. See Note 2 to our consolidated financial statements in this Form 10-K for more information regarding our presentation of segment income. Realized investment gains and losses and certain other items are excluded from our calculation of segment income because we do not consider them when evaluating the financial performance of the segments. The size and timing of realized investment gains and losses are often subject to our discretion. Certain items are removed from segment after-tax income if, in our opinion, they are not indicative of overall operating trends. While some of these items may be significant components of net income reported in accordance with GAAP, we believe that segment income is an appropriate measure that represents the earnings attributable to the ongoing operations of the business. Investment income on debt and equity securities pledged as collateral as well as interest expense on non-recourse collateralized obligations, both related to two consolidated collateralized obligation trusts we sponsor, are included in the Corporate and Other segment. Excess investment income on debt and equity securities pledged as collateral represents investment advisory fees earned by our asset management subsidiary and are allocated to the Asset Management segment as investment product fees for segment reporting purposes only. Also, all interest expense is included in the Corporate and Other segment, as are several smaller subsidiaries and investment activities which do not meet the criteria of reportable segments. These include our remaining international operations and the run-off of our group pension and guaranteed investment contract businesses.
Accumulated realized losses in retained earnings related to consolidated collateralized obligation trusts
The average adjusted stockholders’ equity represents the 12-month average of the average monthly adjusted stockholders’ equity, where monthly adjusted stockholders’ equity is defined as the average of the total equity at the beginning and end of each month adjusted for accumulated other comprehensive income, accumulated realized losses in retained earnings related to collateralized obligation trusts consolidated under FIN 46(R) and equity attributed to discontinued operations. We adjust shareholders’ equity for these items because they are not related to segment operations and financial results and, therefore, inclusion of these items would not provide meaningful comparisons with other periods.
Other operating expenses, which include non-deferrable policy acquisition costs, general and administrative costs and, in 2004, broker-dealer commissions and operating expenses related to our retail affiliated broker-dealer operations, decreased $21.4 million, or 9%, in 2005 from 2004. The decrease was due to lower broker-dealer commissions, which resulted from the sale of our retail affiliated broker-dealer operations in May 2004, partially offset by higher expenses due to business growth and investment in product development.
Annuity revenue increased $12.9 million, or 6%, in 2004 over 2003, due primarily to higher investment earnings from improved spreads and fees from increased fee-based funds on deposit.
In October 2005, we entered into an agreement to sell $138.5 million of the venture capital assets, approximately three quarters of the assets in our Venture Capital segment. As of December 31, 2005, approximately 76% of the transaction had closed, and the remaining portion is expected to close by March 31, 2006. As a result of the transaction, the Venture Capital segment will be eliminated effective January 1, 2006, and earnings from the remaining assets will be allocated to the Life and Annuity segment.
Realized loss on sale of partnership interests and transfer to closed block
The pre-tax segment loss for Corporate and Other increased $11.3 million, or 24%, in 2004 over 2003, due primarily to higher corporate expenses, lower investment earnings and higher other costs offset by increased international earnings. The increase in corporate expenses related to incremental regulatory compliance and audit costs associated with Section 404 of The Sarbanes-Oxley Act of 2002 and higher information technology costs. Other costs were higher due primarily to losses in a small group pension run-off block, higher expenses related to the collateralized debt obligations, lower investment earnings and slightly higher employee benefit costs. International income increased due primarily to higher earnings from an Argentine affiliate combined with lower losses from our India software services affiliate, which was sold in 2004.
Interest rate risk is the risk that we will incur economic losses due to adverse changes in interest rates. Our exposure to interest rate changes primarily results from our interest-sensitive insurance liabilities and from our significant holdings of fixed rate investments. Our insurance liabilities largely comprise dividend-paying individual whole life and universal life policies and annuity contracts. Our fixed maturity investments include U.S. and foreign government bonds, securities issued by government agencies, corporate bonds, asset-backed securities, mortgage-backed securities and mortgage loans, most of which are mainly exposed to changes in medium-term and long-term U.S. Treasury rates.
We manage interest rate risk as part of our asset-liability management and product development processes. Asset-liability management strategies include the segmentation of investments by product line and the construction of investment portfolios designed to satisfy the projected cash needs of the underlying product liabilities. All asset-liability strategies are approved by the ALCO. We manage the interest rate risk in portfolio segments by modeling and analyzing asset and product liability durations and projected cash flows under a number of interest rate scenarios.
The statutory reserves for these totaled $4.4 million and $2.3 million at December 31, 2005 and 2004, respectively. The GAAP reserves totaled $3.8 million and $1.6 million at December 31, 2005 and 2004, respectively.
We also identify securities whose carrying value has been below amortized cost on a continuous basis for zero to
For debt securities in the closed block with gross unrealized losses, 87.0% of the unrealized losses pertain to investment grade securities and 13.0% of the unrealized losses pertain to below investment grade securities at December 31, 2005.
Additional liquidity to meet cash outflows is available from our Life Companies’ portfolios of liquid assets. These liquid assets include substantial holdings of United States government and agency bonds, short-term investments and marketable debt and equity securities.