Contractholder funds deposits increased 90.1% in 2004 compared to 2003 due to increased fixed annuity and interest-sensitive life deposits, partially offset by lower variable annuity and life deposits allocated to fixed accounts. These deposits led to an increase in average contractholder funds, excluding the impact of adopting SOP 03-1, of 37.1% in 2004 compared to 2003. Fixed annuity deposits increased 131.1% in 2004 compared to 2003 due to strong consumer demand, competitive pricing and effective distribution efforts in our bank channel. Contractholder funds deposits decreased 4.0% in 2003 compared to 2002 due to decreased deposits to the fixed account of variable annuities from lower variable annuity contract sales that more than offset a significant increase in fixed annuity deposits. Average contractholder funds increased 35.0% in 2003 compared to 2002 as a result of fixed annuity deposits that increased 31.9% over 2002 due to competitive pricing and our decision to maintain a market presence in our bank distribution channel despite a challenging interest rate environment. Fixed annuities have been attractive to consumers in this distribution channel due to volatile equity markets and the uncertainty of future interest rates. Benefits, surrenders and partial withdrawals increased 68.0% in 2004 compared to 2003 reflecting a withdrawal rate of 11.0% for 2004 based on the beginning of period contractholder funds. This compares to a withdrawal rate of 8.5% and 9.3% for 2003 and 2002, respectively. Surrenders and withdrawals may vary with changes in interest rates and equity market conditions and the aging of our in-force contracts.
Separate accounts liabilities increased $126.7 million during 2004. The increase was primarily attributable to positive investment results and net cash inflows from net deposits and transfers from fixed accounts partially offset by surrenders and benefits. Variable annuity contractholders often allocate a significant portion of their initial variable annuity contract deposit into a fixed rate investment option. The level of this activity is reflected above in the deposits allocated to fixed accounts, while all other transfer activity between the fixed and separate accounts investment options is reflected in net transfers from fixed accounts. The liability for the fixed portion of variable annuity contracts is reflected in contractholder funds. Separate accounts liabilities increased $128.7 million during 2003 reflecting positive investment results and, to a lesser extent, net cash inflows. Net variable annuity deposits decreased in 2003 compared to 2002 as significant deposits in 2002 were made and transferred to the fixed accounts because of the attractive crediting rates. These rates were lowered in late 2002 resulting in lower variable annuity contract sales.
Operating cash flows increased $22.5 million in 2004 compared to 2003 as a result of higher interest received on fixed income securities and mortgage loans and increased premium collections, partially offset by higher contract benefits and expenses paid. Decreased operating cash flows in 2003 compared to 2002 primarily relate to a decline in premiums from immediate annuities with life contingencies and higher acquisition related expenses partially offset by increased investment income. Higher investing cash flows in 2004 compared to 2003 reflect the investment of increased financing and operating cash flows. Cash flows from investing activities declined in 2003 compared to 2002 as a result of decreased operating and financing cash flows. Increased financing cash flows were primarily the result of higher deposits on fixed annuities and interest-sensitive life products, partially offset by lower variable life and annuity deposits to fixed accounts and benefits and withdrawals paid. Declines in cash flow from financing activities during 2003 compared to 2002 primarily reflect a decrease in deposits received from contractholders and an increase in withdrawals from contractholders' accounts. To ensure we have the appropriate level of liquidity, we perform actuarial tests on the impact to cash flows of policy surrenders and other actions under various scenarios. Depending upon the years in which certain policy types were sold with specific surrender provisions, cash flow could vary due to higher surrender of policies exiting their surrender charge periods. We have entered into an inter-company loan agreement with the Corporation. The amount of inter-company loans available to us is at the discretion of the Corporation. The maximum amount of loans the Corporation will have outstanding to all its eligible subsidiaries at any given point in time is limited to $1.00 billion. We had no amounts outstanding under the inter-company loan agreement at December 31, 2004 or 2003. The Corporation uses commercial paper borrowings and bank lines of credit to fund intercompany borrowings. Certain remote events and circumstances could constrain the Corporation's liquidity. Those events and circumstances include, for example, a catastrophe resulting in extraordinary losses, a downgrade in the Corporation's long-term debt rating of A1 and A+ (from Moody's and Standard & Poor's, respectively) to non-investment grade status of below Baa3/BBB-, a downgrade in AIC's financial strength rating from Aa2, AA and A+ (from Moody's, Standard & Poor's and A.M. Best, respectively) to below Baa/BBB/A-, or a downgrade in ALIC's or our financial strength ratings from Aa2, AA and A+ (from Moody's, Standard & Poor's and A.M. Best, respectively) to below Aa3/AA-/A-. The rating agencies also consider the interdependence of the Corporation's individually rated entities, and therefore, a rating change in one entity could potentially affect the ratings of other related entities.
Fixed income securities include bonds, mortgage-backed, commercial mortgage-backed and asset-backed securities, and redeemable preferred stocks. Fixed income securities are carried at fair value and may be sold prior to their contractual maturity ("available for sale"). The fair value of publicly traded fixed income securities is based upon independent market quotations. The fair value of non-publicly traded securities is based on either widely accepted pricing valuation models which use internally developed ratings and independent third party data (e.g., term structures and current publicly traded bond prices) as inputs or independent third party pricing sources. The valuation models use indicative information such as ratings, industry, coupon, and maturity along with related third party data and publicly traded bond prices to determine security specific spreads. These spreads are then adjusted for illiquidity based on historical analysis and broker surveys. Periodic changes in fair values, net of deferred income taxes, certain life and annuity deferred policy acquisition costs, certain deferred sales inducement costs, and certain reserves for life-contingent contract benefits, are reflected as a component of other
CASH FLOW HEDGES The Company designates certain of its foreign currency swap contracts as cash flow hedges when the hedging instrument is highly effective in offsetting the exposure of variations in cash flows for the hedged risk that could affect net income. The Company's cash flow exposure may be associated with an
The income tax provision is calculated under the liability method. Deferred tax assets and liabilities are recorded based on the difference between the financial statement and tax bases of assets and liabilities at the enacted tax rates. The principal assets and liabilities giving rise to such differences are unrealized capital gains and losses on fixed income securities, insurance reserves and deferred policy acquisition costs. A deferred tax asset valuation allowance is established when there is uncertainty that such assets would be realized.
The cumulative effect of the change in accounting principle from implementing SOP 03-1 was a loss of $7.6 million, after-tax ($11.7 million, pre-tax). It was comprised of an increase in benefit reserves (primarily for variable annuity contracts) of $942 thousand, pre-tax, and a reduction in DAC and DSI of $10.7 million, pre-tax. The SOP requires consideration of a range of potential results to estimate the cost of variable annuity death benefits and income benefits, which generally necessitates the use of stochastic modeling techniques. To maintain consistency with the assumptions used in the establishment of reserves for variable annuity guarantees, the Company utilized the results of this stochastic modeling to estimate expected gross profits, which form the basis for determining the amortization of DAC and DSI. This new modeling approach resulted in a lower estimate of expected gross profits, and therefore resulted in a write-down of DAC and DSI. In 2004, DSI and related amortization is classified within the Statements of Financial Position and Operations and Comprehensive Income as other assets and interest credited to contractholder funds, respectively. The amounts are provided in Note 10.
(1) The increase in contractholder funds due to the adoption of SOP 03-1 reflects the establishment of reserves for certain liabilities that are primarily related to income benefit guarantees provided under variable annuities and the reclassification of deferred sales inducements ("DSI") from contractholder funds to other assets.
The Company is subject to changing social, economic and regulatory conditions. Recent state and federal regulatory initiatives and proceedings have included efforts to impose additional regulations regarding agent and broker compensation and otherwise expand overall regulation of insurance products and the insurance industry. The ultimate changes and eventual effects of these initiatives on the Company's business, if any, are uncertain.
The Corporation and some of its agents and subsidiaries, including the Company, have received interrogatories and demands to produce information from several regulatory and enforcement authorities. These authorities are seeking information relevant to on-going investigations into the possible violation of antitrust or insurance laws by unnamed parties and, in particular, are seeking information as to whether any person engaged in activities for the purpose of price fixing, market allocation, or bid rigging. Published press reports have indicated that numerous demands of this nature have been sent to insurance companies as part of industry-wide investigations. The Corporation has cooperated and intends to continue to cooperate with these and any similar requests for information. Various other legal and regulatory actions are currently pending that involve the Company and specific aspects of its conduct of business. Like other members of the insurance industry, the Company is the target of a number of lawsuits, some of which involve claims for substantial or indeterminate amounts. This litigation is based on a variety of issues and targets a range of the Company's practices. The outcome of these disputes is currently unpredictable. However, at this time, based on their present status, it is the opinion of management that the ultimate liability, if any, in one or more of these other actions in excess of amounts currently reserved is not expected to have a material effect on the results of operations, liquidity or financial position of the Company.