Ratio of Earnings to Fixed Charges Ratio of earnings to fixed charges(2) .. 1.7 -- -- -- 1.8 Supplemental ratio of earnings to fixed charges - excluding interest credited on policyholder contract balances(3) .......................... 4.5 -- -- -- 4.1
Our life insurance and annuity businesses are sensitive to interest rate changes. In periods of increasing interest rates, life insurance policy loans and surrenders and withdrawals could increase as policyholders seek investments with higher perceived returns. This could require us to sell invested assets at a time when their prices are depressed by the increase in interest rates, which could cause us to realize investment losses.
Our asset management agreements with institutional clients, intermediary program sponsors (who "wrap," or make available, our investment products within the management agreements they have with their own clients), direct managed account clients and institutional clients are generally terminable by these sponsors and clients upon short notice without penalty. As a result, there would be little impediment to these sponsors or clients terminating our agreements if they became dissatisfied with our performance.
Goodwill or intangible assets associated with our Asset Management business could become impaired requiring a non-cash charge to earnings in the event of significant market declines, net outflows of assets, changes in investment management contracts or the departure of key employees.
In addition, we are involved in disputes relating to certain portions of our discontinued group accident and health reinsurance business. See Note 17 to our consolidated financial statements in this Form 10-K for more information.
During the second quarter of 2004, we sold our retail affiliated broker-dealer operations to LPL. As part of the transaction, advisors affiliated with Griffith and Main Street had the opportunity to move to LPL as independent registered representatives. As of December 31, 2004, LPL had successfully recruited about 45% of Griffith's total representatives, representing about 50% of Griffith's total gross dealer concessions. As of December 31, 2004, we have not determined the ultimate persistency of the business written by these advisors, but our experience through that date shows no material deterioration, reflecting the quality of our in-force products and the professionalism of these advisors. As part of this transaction, we are expanding our distribution relationship with LPL, adding life and annuity products to our existing asset management offerings, and we have recently commenced a marketing plan to position these products within LPL and its more than 5,500 producers.
The above non-cash charges to earnings and stockholders' equity primarily relate to realized and unrealized investment losses within the CDOs. Upon maturity or other liquidation of the trusts, the fair value of the investments pledged as collateral will be used to settle the non-recourse collateralized obligations with any shortfall in such investments inuring to the third-party note and equity holders. To the extent there remains a recorded liability for non-recourse obligations after all the assets pledged as collateral are exhausted, such amount will be reduced to zero with a corresponding benefit to earnings. Accordingly, these investment losses and any future investment losses under this method of consolidation will ultimately reverse upon the maturity or other liquidation of the non-recourse collateralized obligations. These non-recourse obligations mature between 2011 through 2014 but contain call provisions. The call provisions may be triggered at the discretion of the equity investors based on market conditions and are subject to certain contractual limitations.
• Deferred Income Taxes We account for income taxes in accordance with SFAS No. 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.
Summary Consolidated Financial Data: Year Ended December 31, Changes ($ amounts in millions, except per share data) -------------------------------------- ----------------------- 2004 2003 2002 2004/03 2003/02 ------------ ------------ ----------- ----------- -----------
Asset Management achieved a higher operating margin in 2004 as compared to 2003 and 2002, but the business only broke even and continued to have significant net outflows, although expense actions over the course of 2004 offset the consequent decline in revenues to some extent. We are focused on restructuring the asset management business as this represents our largest opportunity for earnings growth in the near term. We are actively working with our partners to address performance and structural issues in the context of our overall strategy. As such, we have identified $17.0 million in additional annualized expense savings, which will begin to benefit Asset Management earnings in 2005. A number of recent developments underscore the opportunity we have to leverage some of our strong track records, especially in our fixed income and specialty strategies.
Income tax expense of $40.5 million in 2004 increased by $58.8 million from a tax benefit of $18.3 million in 2003. This increase is primarily due to the tax effect of the increase to income before continuing operations before minority interest and equity earnings of affiliates.
Broker-dealer commission and distribution fee revenues decreased $3.5 million, or 4%, in 2003 from 2002, due to modest decreases for both Asset Management and Life and Annuity.
Term life insurance revenue increased $1.3 million, or 9%, in 2004 over 2003, primarily due to higher premiums from the growth of in-force policies and modestly higher investment earnings.
• interest rate risk, which relates to the market price and cash flow variability associated with changes in market interest rates; • credit risk, which relates to the uncertainty associated with the ongoing ability of an obligor to make timely payments of principal and interest; and • equity risk, which relates to the volatility of prices for equity and equity-like investments, such as venture capital partnerships.
We manage interest rate risk as part of our asset-liability management and product development processes. Asset-liability management strategies include the segmentation of investments by product line and the construction of investment portfolios designed to satisfy the projected cash needs of the underlying product liability. All asset-liability strategies are approved by the ALCO. We manage the interest rate risk in portfolio segments by modeling and analyzing asset and product liability durations and projected cash flows under a number of interest rate scenarios.
To calculate duration, we project asset and liability cash flows and discount them to a net present value using a risk-free market rate adjusted for credit quality, sector attributes, liquidity and any other relevant specific risks. Duration is calculated by revaluing these cash flows at an alternative level of interest rates and by determining the percentage change in fair value from the base case.
Annuity Deposit Fund Balances: As of December 31, ($ amounts in millions) ------------------------ 2004 2003 ----------- ----------- Policyholder Deposit Funds Retirement Planners Edge GIAs........................................................ $ 1,121.4 $ 1,209.4 Other variable annuity GIAs.......................................................... 817.7 858.0 ----------- ----------- Variable annuity GIAs................................................................ 1,939.1 2,067.4 Fixed annuities...................................................................... 1,038.2 1,056.9 ----------- ----------- Total variable annuity GIAs and fixed annuities...................................... $ 2,977.3 $ 3,124.3 =========== ===========
General Account Debt Securities at Fair Value: As of December 31, ($ amounts in millions) ---------------------------------------------------------------------------- Total Debt Securities Public Debt Securities Private Debt Securities (Fair Value) (Fair Value) (Fair Value) SVO S&P Equivalent ------------------------ ------------------------ ------------------------ Rating Designation 2004 2003 2004 2003 2004 2003 -------- ----------------------- ----------- ----------- ----------- ----------- ----------- -----------
Percentage of total debt securities.......... 8.0% 6.1% 1.1% 0.5% 0.3% =========== =========== =========== =========== ===========
Cash from continuing operations investing activities was $133.9 million for 2004 compared to cash for continuing operations investing activities of $1,139.2 million for 2003. The $1,273.1 million change is primarily due to lower investment purchases resulting from lower cash from operating and financing activities in 2004 and higher cash balances at the beginning of 2003 that were invested during 2003.
Consolidated Balance Sheet As of December 31, ($ amounts in millions) ------------------------- 2004 2003 Change ------------ ------------ ------------ ASSETS Available-for-sale debt securities, at fair value...................... $ 13,476.3 $ 13,273.0 $ 203.3 Available-for-sale equity securities, at fair value.................... 304.3 312.0 (7.7) Trading equity securities.............................................. 87.3 -- 87.3 Mortgage loans, at unpaid principal balances........................... 207.9 284.1 (76.2) Venture capital partnerships, at equity in net assets.................. 255.3 234.9 20.4 Affiliate equity securities, at equity in net assets................... -- 47.5 (47.5) Policy loans, at unpaid principal balances............................. 2,196.7 2,241.4 (44.7) Other investments...................................................... 371.8 402.0 (30.2) ------------ ------------ ------------ 16,899.6 16,794.9 104.7 Available-for-sale debt and equity securities pledged as collateral, at fair value........................................................ 1,278.8 1,350.0 (71.2) ------------ ------------ ------------ Total investments...................................................... 18,178.4 18,144.9 33.5 Cash and cash equivalents.............................................. 435.0 447.9 (12.9) Accrued investment income.............................................. 222.3 222.3 -- Receivables............................................................ 135.8 224.9 (89.1) Deferred policy acquisition costs...................................... 1,429.9 1,367.7 62.2 Deferred income taxes.................................................. 30.7 58.7 (28.0) Other intangible assets................................................ 308.4 335.1 (26.7) Goodwill............................................................... 427.2 419.9 7.3 Other assets........................................................... 244.6 254.6 (10.0) Separate account assets................................................ 6,950.3 6,083.2 867.1 ------------ ------------ ------------ Total assets........................................................... $ 28,362.6 $ 27,559.2 $ 803.4 ============ ============ ============ LIABILITIES Policy liabilities and accruals........................................ $ 13,132.3 $ 13,088.6 $ 43.7 Policyholder deposit funds............................................. 3,492.4 3,642.7 (150.3) Stock purchase contracts............................................... 131.9 128.8 3.1 Indebtedness........................................................... 690.8 639.0 51.8 Other liabilities...................................................... 546.3 534.5 11.8 Non-recourse collateralized obligations................................ 1,355.2 1,472.0 (116.8) Separate account liabilities........................................... 6,950.3 6,083.2 867.1 ------------ ------------ ------------ Total liabilities...................................................... 26,299.2 25,588.8 710.4 ------------ ------------ ------------ MINORITY INTEREST Minority interest in net assets of consolidated subsidiaries........... 41.0 22.6 18.4 ------------ ------------ ------------ STOCKHOLDERS' EQUITY Common stock and additional paid in capital............................ 2,436.2 2,432.4 3.8 Deferred compensation on restricted stock units........................ (3.6) (3.6) -- Accumulated deficit.................................................... (285.6) (355.3) 69.7 Accumulated other comprehensive income................................. 58.0 63.7 (5.7) Treasury stock......................................................... (182.6) (189.4) 6.8 ------------ ------------ ------------ Total stockholders' equity............................................. 2,022.4 1,947.8 74.6 ------------ ------------ ------------ Total liabilities, minority interest and stockholders' equity.......... $ 28,362.6 $ 27,559.2 $ 803.4 ============ ============ ============
Available-for-sale debt securities increased $203.3 million in 2004 from December 31 2003, reflecting slight appreciation of bond values as a result of a modest decline in risk-free interest rates and a tightening of credit spreads since December 31, 2003.
There is also an agreement executed at the time of acquisition, which allows for the redemption and reissuance with respect to the remaining 25% of the noncontrolling membership interests. The purchase price for these noncontrolling interests will be equal to investment advisory fees for the relevant contract year multiplied by 4.5 multiplied by the amount of membership interest purchased. The contract year is defined as the twelve months ending December 31, 2006 and each calendar year thereafter. The pricing on the agreements will be determined within 60 days after each such year-end and can be exercised within 60 days of the finalization of the price. These agreements may expire unexercised should Kayne Anderson Rudnick's operating results decline from the acquisition date. Any noncontrolling interests redeemed will be reissued to members/employees of Kayne Anderson Rudnick. The reissuance process involves Phoenix Investment Partners contributing the interests to Kayne Anderson Rudnick and then Kayne Anderson Rudnick selling the interests to the members/employees. The members/employees will not pay cash for these purchases but will enter into a note payable agreement with Kayne Anderson Rudnick. Phoenix Investment Partners will have preferential distribution rights with respect to payments of principal and interest on these notes. Under certain circumstances, these interests can be issued without a note payable or other consideration. In addition, in certain circumstances, the redemptions may be accelerated. Once these interests are redeemed and then reissued, the amount of cash that Phoenix Investment Partners will need to pay to redeem them in the future will be based on the growth in Kayne Anderson Rudnick's revenues since the reissuance dates. There is no expiration date for the agreements. There is no cap or floor on the redemption price.