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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
================================================================================
FORM 10-K
THE REGISTRANT MEETS THE CONDITIONS SET FORTH IN GENERAL INSTRUCTIONS I(1)(a)
AND (b) OF FORM 10-K AND IS THEREFORE FILING THIS FORM WITH THE REDUCED
DISCLOSURE FORMAT.
/X/ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF
THE SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 2005
OR
/ / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF
THE SECURITIES EXCHANGE ACT OF 1934
COMMISSION FILE NUMBER: 0-31248
ALLSTATE LIFE INSURANCE COMPANY
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
ILLINOIS 36-2554642
(STATE OF INCORPORATION) (I.R.S. EMPLOYER IDENTIFICATION NO.)
3100 SANDERS ROAD
NORTHBROOK, ILLINOIS 60062
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)
REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (847) 402-5000
SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE SECURITIES EXCHANGE ACT
OF 1934: NONE
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE SECURITIES EXCHANGE ACT
OF 1934: COMMON STOCK, PAR VALUE $227.00 PER SHARE
INDICATE BY CHECK MARK IF THE REGISTRANT IS A WELL-KNOWN SEASONED ISSUER, AS
DEFINED IN RULE 405 OF THE SECURITIES ACT.
YES / / NO /X/
INDICATE BY CHECK MARK IF THE REGISTRANT IS NOT REQUIRED TO FILE REPORTS
PURSUANT TO SECTION 13 OR SECTION 15(d) OF THE SECURITIES ACT.
YES / / NO /X/
INDICATE BY CHECK MARK WHETHER THE REGISTRANT (1) HAS FILED ALL REPORTS REQUIRED
TO BE FILED BY SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 DURING
THE PRECEDING 12 MONTHS (OR FOR SUCH SHORTER PERIOD THAT THE REGISTRANT WAS
REQUIRED TO FILE SUCH REPORTS), AND (2) HAS BEEN SUBJECT TO SUCH FILING
REQUIREMENTS FOR THE PAST 90 DAYS.
YES /X/ NO / /
INDICATE BY CHECK MARK IF DISCLOSURE OF DELINQUENT FILERS PURSUANT TO ITEM 405
OF REGULATION S-K IS NOT CONTAINED HEREIN, AND WILL NOT BE CONTAINED, TO THE
BEST OF REGISTRANT'S KNOWLEDGE IN DEFINITIVE PROXY OR INFORMATION STATEMENTS
INCORPORATED BY REFERENCE IN PART III OF THIS FORM 10-K OR ANY AMENDMENT TO THIS
FORM 10-K. /X/
INDICATE BY CHECK MARK WHETHER THE REGISTRANT IS A LARGE ACCELERATED FILER, AN
ACCELERATED FILER, OR A NON-ACCELERATED FILER. SEE DEFINITION OF "ACCELERATED
FILER AND LARGE ACCELERATED FILER" IN RULE 12b-2 OF THE EXCHANGE ACT.
LARGE ACCELERATED FILER ACCELERATED FILER NON-ACCELERATED FILER
/ / / / /X/
INDICATE BY CHECK MARK WHETHER THE REGISTRANT IS A SHELL COMPANY (AS DEFINED IN
RULE 12b-2 OF THE EXCHANGE ACT).
YES / / NO /X/
NONE OF THE COMMON EQUITY OF THE REGISTRANT IS HELD BY NON-AFFILIATES.
THEREFORE, THE AGGREGATE MARKET VALUE OF THE COMMON EQUITY HELD BY
NON-AFFILIATES OF THE REGISTRANT IS ZERO.
AS OF MARCH 10, 2006, THE REGISTRANT HAD 23,800 COMMON SHARES, $227 PAR VALUE,
OUTSTANDING, ALL OF WHICH ARE HELD BY ALLSTATE INSURANCE COMPANY.
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ALLSTATE LIFE INSURANCE COMPANY
INDEX TO ANNUAL REPORT ON FORM 10-K
DECEMBER 31, 2005
<Table>
<Caption>
PAGE
PART I
Item 1. Business 1
Item 1A. Risk Factors 5
Item 2. Properties 5
Item 3. Legal Proceedings 5
Item 4. Submission of Matters to a Vote of Security Holder * N/A
PART II
Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases 6
of Equity Securities
Item 6. Selected Financial Data 7
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations 8
Item 7A. Quantitative and Qualitative Disclosures About Market Risk 47
Item 8. Financial Statements and Supplementary Data 48
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 91
Item 9A. Controls and Procedures 91
Item 9B. Other Information 91
PART III
Item 10. Directors and Executive Officers of the Registrant * N/A
Item 11. Executive Compensation * N/A
Item 12. Security Ownership of Certain Beneficial Owners and Management * N/A
Item 13. Certain Relationships and Related Transactions * N/A
Item 14. Principal Accountant Fees and Services 92
PART IV
Item 15. Exhibits and Financial Statement Schedules 93
Signatures 97
Financial Statement Schedules S-1
</Table>
* Omitted pursuant to General Instruction I(2) of Form 10-K
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PART I
ITEM 1. BUSINESS
Allstate Life Insurance Company was organized in 1957 as a stock life
insurance company under the laws of the State of Illinois. Allstate Life
Insurance Company, together with its subsidiaries, provides life insurance,
retirement and investment products for individual and institutional customers.
It conducts substantially all of its operations directly or through wholly owned
U.S. subsidiaries. In this document, we refer to Allstate Life Insurance Company
as "Allstate Life" or "ALIC" and to Allstate Life and its wholly owned
subsidiaries as the "Allstate Life Group" or the "Company."
Allstate Life is a wholly owned subsidiary of Allstate Insurance Company, a
stock property-liability insurance company organized under the laws of the State
of Illinois. All of the outstanding stock of Allstate Insurance Company is owned
by The Allstate Corporation, a publicly owned holding company incorporated under
the laws of the State of Delaware. In this document, we refer to Allstate
Insurance Company as "AIC" and to The Allstate Corporation and its consolidated
subsidiaries as "Allstate", the "Parent Group" or the "Corporation". The
Allstate Corporation is the largest publicly held personal lines insurer in the
United States. Widely known through the "You're In Good Hands With Allstate (R)"
slogan, Allstate provides insurance products to more than 17 million households
through a distribution network that utilizes a total of approximately 14,100
exclusive agencies and exclusive financial specialists in the United States and
Canada. Allstate is the second-largest personal property and casualty insurer in
the United States on the basis of 2004 statutory premiums earned. In addition,
it is the nation's 13th largest life insurance business on the basis of 2004
ordinary life insurance in force and 17th largest on the basis of 2004 statutory
admitted assets.
The Parent Group has four business segments, one of which is Allstate
Financial. Allstate Financial, which is not a separate legal entity, is
comprised of the Allstate Life Group together with other Parent Group
subsidiaries that are not part of the Allstate Life Group. In addition to being
one of the Parent Group's business segments, the name Allstate Financial has
been used from time to time to refer collectively to the Allstate Life Group,
the Allstate Bank and other Parent Group subsidiaries. This document describes
the Allstate Life Group. It does not describe the entire group of companies that
form the Allstate Financial segment of the Parent Group.
In this annual report on Form 10-K, we occasionally refer to statutory
financial information that has been prepared in accordance with the National
Association of Insurance Commissioners ("NAIC") Accounting Practices and
Procedure Manual. All domestic U.S. insurance companies are required to prepare
statutory-basis financial statements in accordance with the Manual. As a result,
industry data is available that enables comparisons between insurance companies,
including competitors that are not subject to the requirement to publish
financial statements on the basis of accounting principles generally accepted in
the U.S. ("GAAP"). We frequently use industry publications containing statutory
financial information to assess our competitive position.
PRODUCTS AND DISTRIBUTION
The Allstate Life Group provides life insurance, retirement and investment
products to individual and institutional customers. Our principal products are
deferred and immediate fixed annuities, variable annuities, and
interest-sensitive and traditional life insurance. Our principal institutional
product is funding agreements backing medium-term notes. The table on page 2
lists our major distribution channels, with the associated products and targeted
customers.
As the table indicates, we sell products to individuals through multiple
intermediary distribution channels, including Allstate exclusive agencies,
independent agents, banks, broker-dealers, and specialized structured settlement
brokers. We have distribution relationships with over half of the 75 largest
banks, most of the national broker-dealers, a number of regional brokerage firms
and many independent broker-dealers. We sell products through independent agents
affiliated with approximately 175 master brokerage
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agencies. We sell funding agreements to unaffiliated trusts used to back
medium-term notes issued to institutional and individual investors.
DISTRIBUTION CHANNELS, PRODUCTS AND TARGET CUSTOMERS
<Table>
<Caption>
DISTRIBUTION CHANNEL PRIMARY PRODUCTS TARGET CUSTOMERS
- -------------------------------------------------------------------------------------------------------------------------
ALLSTATE EXCLUSIVE AGENCIES Term life insurance Moderate and
(Allstate Exclusive Agents Interest-sensitive life insurance middle-income consumers
and Variable life insurance with retirement and
Allstate Exclusive Deferred fixed annuities (including indexed and market value family financial
Financial Specialists) adjusted "MVAA") protection needs
Immediate fixed annuities
Variable annuities
INDEPENDENT AGENTS Term life insurance Affluent and
(Through master brokerage Interest-sensitive life insurance middle-income consumers
agencies) Variable life insurance with retirement and
Deferred fixed annuities (including indexed and MVAA) family financial
Immediate fixed annuities protection needs
Variable annuities
BANKS Deferred fixed annuities (including indexed and MVAA) Middle-income consumers
Variable annuities with retirement needs
Single premium fixed life insurance
BROKER-DEALERS Deferred fixed annuities (including indexed and MVAA) Affluent and
Variable annuities middle-income consumers
with retirement needs
STRUCTURED SETTLEMENT Structured settlement annuities Typically used to fund or
ANNUITY BROKERS annuitize large claims or
litigation settlements
BROKER-DEALERS Funding agreements backing medium-term notes Institutional and
(Funding agreements) individual investors
</Table>
COMPETITION
We compete principally on the basis of the scope of our distribution
systems, the breadth of our product offerings, the recognition of our brands,
our financial strength and ratings, our product features and prices, and the
level of customer service that we provide. In addition, with respect to variable
annuity and variable life insurance products in particular, we compete on the
basis of the variety of fund managers and choices of funds for our separate
accounts and the management and performance of those funds within our separate
accounts. With regard to funding agreements, we compete principally on the basis
of our financial strength and ratings.
The market for life insurance, retirement and investment products continues
to be highly fragmented and competitive. As of December 31, 2005, there were
approximately 740 groups of life insurance companies in the United States, most
of which offered one or more similar products. Based on information contained in
statements filed with state insurance departments, as of December 31, 2004, the
Allstate Life Group ranked 14th based on ordinary life insurance in force and
17th based on statutory admitted assets. In addition, because many of these
products include a savings or investment component, our competition
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includes domestic and foreign securities firms, investment advisors, mutual
funds, banks and other financial institutions. Competitive pressure is growing
due to several factors, including cross marketing alliances between unaffiliated
businesses, as well as consolidation activity in the financial services
industry.
The Allstate Corporation's website for financial professionals,
accessallstate.com, won DALBAR's Communications Seal beginning in 2004. The site
attained DALBAR's highest designation of "Excellent" as of the second, third and
fourth quarter of 2005 based on its overall quarterly rankings for Life
Insurance/Annuity websites for Financial Professionals. DALBAR, Inc., an
independent financial services research organization, recognized
accessallstate.com for providing a means by which financial professionals can
easily and conveniently develop and manage their business online.
GEOGRAPHIC MARKETS
We sell life insurance, retirement and investment products throughout the
United States. The Allstate Life Group is authorized to sell various types of
these products in all 50 states, the District of Columbia, Puerto Rico, the U.S.
Virgin Islands and Guam. We sell funding agreements in the United States and in
the Cayman Islands.
The following table reflects, in percentages, the principal geographic
distribution of statutory premiums and annuity considerations for the Allstate
Life Group for the year ended December 31, 2005, based on information contained
in statements filed with state insurance departments. Approximately 99.0% of the
statutory premiums and annuity considerations generated in Delaware represent
deposits received in connection with funding agreements sold to trusts domiciled
in Delaware. No other jurisdiction accounted for more than five percent of the
statutory premiums and annuity considerations.
<Table>
Delaware 27.4%
California 8.6%
New York 7.1%
Florida 5.3%
</Table>
REGULATION
The Allstate Life Group is subject to extensive regulation, primarily at
the state level. The method, extent and substance of such regulation varies by
state but generally has its source in statutes that establish standards and
requirements for conducting the business of insurance and that delegate
regulatory authority to a state regulatory agency. In general, such regulation
is intended for the protection of those who purchase or use insurance products.
These rules have a substantial effect on our business and relate to a wide
variety of matters including insurance company licensing and examination, agent
licensing and compensation, trade practices, policy forms, accounting methods,
the nature and amount of investments, claims practices, participation in
guaranty funds, reserve adequacy, insurer solvency, transactions with
affiliates, the payment of dividends, and underwriting standards. Some of these
matters are discussed in more detail below. For a discussion of statutory
financial information, see Note 14 of the Consolidated Financial Statements. For
a discussion of regulatory contingencies, see Note 11 of the Consolidated
Financial Statements. Notes 11 and 14 are incorporated in this Part I, Item 1 by
reference.
In recent years the state insurance regulatory framework has come under
increased federal scrutiny. Legislation that would provide for federal
chartering of insurance companies has been proposed. In addition, state
legislators and insurance regulators continue to examine the appropriate nature
and scope of state insurance regulation. We cannot predict whether any specific
state or federal measures will be adopted to change the nature or scope of the
regulation of the insurance business or what effect any such measures would have
on the Allstate Life Group.
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AGENT AND BROKER COMPENSATION. In 2005, several states considered new
legislation or regulations regarding the compensation of agents and brokers by
insurance companies. The proposals ranged in nature from new disclosure
requirements to new duties on insurance agents and brokers in dealing with
customers. As of the end of the year, new disclosure requirements have been
imposed in certain circumstances upon some agents and brokers in several states,
including Texas.
LIMITATIONS ON DIVIDENDS BY INSURANCE SUBSIDIARIES. Allstate Life may
receive dividends from time to time from its subsidiaries. When received, these
dividends represent a source of cash from which Allstate Life may meet some of
its obligations. If a subsidiary is an insurance company, its ability to pay
dividends may be restricted by state laws regulating insurance companies. For
additional information regarding those restrictions, see Note 14 of the
Consolidated Financial Statements.
GUARANTY FUNDS. Under state insurance guaranty fund laws, insurers doing
business in a state can be assessed, up to prescribed limits, in order to cover
certain obligations of insolvent insurance companies.
INVESTMENT REGULATION. Our insurance subsidiaries are subject to
regulations that require investment portfolio diversification and that limit the
amount of investment in certain categories. Failure to comply with these rules
leads to the treatment of non-conforming investments as non-admitted assets for
purposes of measuring statutory surplus. Further, in some instances, these rules
require divestiture of non-conforming investments. As of December 31, 2005, the
investment portfolios of our insurance subsidiaries complied with such laws and
regulations in all material respects.
VARIABLE LIFE INSURANCE, VARIABLE ANNUITIES AND REGISTERED FIXED ANNUITIES.
The sale of variable life insurance, variable annuities and registered fixed
annuities with market value adjustment features are subject to extensive
regulatory oversight at the federal and state level, including regulation and
supervision by the Securities and Exchange Commission and the National
Association of Securities Dealers.
BROKER-DEALERS, INVESTMENT ADVISORS AND INVESTMENT COMPANIES. The Allstate
Life Group entities that operate as broker-dealers, registered investment
advisors and investment companies are subject to regulation and supervision by
the Securities and Exchange Commission, the National Association of Securities
Dealers and/or, in some cases, state securities administrators.
REGULATION AND LEGISLATION AFFECTING CONSOLIDATION IN THE FINANCIAL
SERVICES INDUSTRY. The Gramm-Leach-Bliley Act of 1999 permits mergers that
combine commercial banks, insurers and securities firms within one holding
company group. In addition, it allows grandfathered unitary thrift holding
companies, including our parent company, to engage in activities that are not
financial in nature. The ability of banks to affiliate with insurers may
materially adversely affect our business by substantially increasing the number,
size and financial strength of potential competitors.
PRIVACY REGULATION. Federal law and the laws of some states require
financial institutions to protect the security and confidentiality of customer
information and to notify customers about their policies and practices relating
to collection and disclosure of customer information and their policies relating
to protecting the security and confidentiality of that information. Federal law
and the laws of some states also regulate disclosures of customer information.
Congress, state legislatures and regulatory authorities are expected to consider
additional regulation relating to privacy and other aspects of customer
information.
EMPLOYEES AND OTHER SHARED SERVICES
The Allstate Life Group has no employees. Instead, we primarily use the
services of employees of Allstate Insurance Company, our direct parent. We also
make use of other services and facilities provided by Allstate Insurance Company
and other members of the Parent Group. These services and facilities include
space rental, utilities, building maintenance, human resources, investment
management, finance, information technology and legal services. We reimburse our
affiliates for these services and facilities under a variety of agreements.
4
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OTHER INFORMATION
We use the names "Allstate," "Lincoln Benefit Life" and variations of these
names extensively in our business, along with related logos and slogans, such as
"Goods Hands." Our rights in the United States to these names, logos and slogans
continue so long as we continue to use them in commerce. Most of these service
marks are the subject of renewable U.S. and/or foreign service mark
registrations. We believe that these service marks are important to our business
and we intend to maintain our rights to them by continued use.
"Allstate" is one of the most recognized brand names in the U.S. According
to independent market research conducted in 2004, "You're in Good Hands with
Allstate" is recognized by 87% of consumers, making it the most recognized
company tagline in the U.S.
ITEM 1A. RISK FACTORS
Information required for Item 1A is incorporated by reference to the discussion
under the heading "Forward-Looking Statements and Risk Factors" in Management's
Discussion and Analysis of Financial Condition and Results of Operations.
ITEM 2. PROPERTIES
Our home office is part of the Parent Group's home office complex in
Northbrook, Illinois. As of December 31, 2005, the complex consisted of several
buildings totaling approximately 2.3 million square feet of office space on a
250-acre site. In addition, we operate from various administrative, data
processing, claims handling and support facilities.
All of the facilities from which we operate are owned or leased by our
direct parent, Allstate Insurance Company, except for office space in Lincoln,
Nebraska that is leased by Lincoln Benefit Life Company, a wholly owned
subsidiary of ALIC, for general operations, file storage and information
technology. Expenses associated with facilities owned or leased by Allstate
Insurance Company are allocated to us on both a direct and an indirect basis,
depending on the nature and use of each particular facility. We believe that
these facilities are suitable and adequate for our current operations.
The locations out of which the Parent Group exclusive agencies operate in
the U.S. are normally leased by the agencies as lessees.
ITEM 3. LEGAL PROCEEDINGS
Information required for Item 3 is incorporated by reference to the
discussion under the heading "Regulation" and under the heading "Legal and
regulatory proceedings and inquiries" in Note 11 of the Consolidated Financial
Statements.
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PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
AND ISSUER PURCHASES OF EQUITY SECURITIES
No established public trading market exists for Allstate Life's common
stock. All of its outstanding common stock is owned by its parent, Allstate
Insurance Company ("AIC"). All of the outstanding common stock of AIC is owned
by The Allstate Corporation.
From January 1, 2004 through March 10, 2006, Allstate Life paid the
following amounts to AIC in the aggregate on the dates specified as dividends on
its common stock:
<Table>
<Caption>
PAYMENT DATE AGGREGATE AMOUNT
January 20, 2004 $ 75,000,000
March 12, 2004 25,000,000
June 29, 2004 25,000,000
August 31, 2004 150,000,000
December 22, 2004 24,430,115
April 12, 2005 25,000,000
July 20, 2005 25,000,000
December 15, 2005 49,350,136
December 16, 2005 100,000,000
December 23, 2005 61,000,000
</Table>
For additional information on dividends, including restrictions on the
payment of dividends by Allstate Life and its subsidiaries, see the Limitations
on Dividends by Insurance Subsidiaries subsection of the "Regulation" section of
Item 1. Business of this Form 10-K and the discussion under the heading
"Dividends" in Note 14 of our consolidated financial statements, which are
incorporated herein by reference.
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ITEM 6. SELECTED FINANCIAL DATA.
ALLSTATE LIFE INSURANCE COMPANY AND SUBSIDIARIES
5-YEAR SUMMARY OF SELECTED FINANCIAL DATA
<Table>
<Caption>
(IN MILLIONS) 2005 2004 2003 2002 2001
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CONSOLIDATED OPERATING RESULTS
Premiums $ 474 $ 637 $ 959 $ 1,023 $ 1,046
Contract charges 1,079 961 872 853 821
Net investment income 3,707 3,260 3,082 2,978 2,833
Realized capital gains and losses 19 (11) (84) (422) (207)
Total revenues 5,279 4,847 4,829 4,432 4,493
Income before cumulative effect of change in
accounting principle, after-tax 417 356 291 245 374
Cumulative effect of change in accounting
principle, after-tax -- (175) (13) -- (6)
Net income 417 181 278 245 368
CONSOLIDATED FINANCIAL POSITION
Investments $ 72,756 $ 69,689 $ 59,989 $ 52,670 $ 44,297
Total assets 95,022 90,401 78,812 68,846 62,622
Reserve for life-contingent contract benefits
and contractholder funds 70,071 65,142 55,394 48,591 40,933
Long-term debt 181 104 45 -- --
Shareholder's equity 6,008 6,309 6,429 6,362 5,397
</Table>
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ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
<Table>
<Caption>
PAGE
OVERVIEW ............................................................ 8
2005 HIGHLIGHTS ..................................................... 8
CONSOLIDATED NET INCOME ............................................. 9
APPLICATION OF CRITICAL ACCOUNTING POLICIES ......................... 9
OPERATIONS .......................................................... 12
INVESTMENTS ......................................................... 24
MARKET RISK ......................................................... 33
CAPITAL RESOURCES AND LIQUIDITY ..................................... 37
REGULATION AND LEGAL PROCEEDINGS .................................... 42
PENDING ACCOUNTING STANDARDS ........................................ 42
FORWARD-LOOKING STATEMENTS AND RISK FACTORS ......................... 43
</Table>
OVERVIEW
The following discussion highlights significant factors influencing the
consolidated financial position and results of operations of Allstate Life
Insurance Company (referred to in this document as "we", "our", "us" or the
"Company"). It should be read in conjunction with the 5-year summary of selected
financial data, consolidated financial statements and related notes found under
Part II, Item 6 and Item 8 contained herein. We operate as a single segment
entity, based on the manner in which financial information is used internally to
evaluate performance and determine the allocation of resources.
The most important factors that we monitor to evaluate the financial
condition and performance of our Company include:
- For operations: premiums, deposits, gross margin including investment
and benefit margins, amortization of deferred policy acquisition
costs, expenses, operating income, and invested assets;
- For investments: credit quality/experience, stability of long-term
returns, cash flows and asset and liability duration;
- For financial condition: our financial strength ratings and statutory
capital levels and ratios; and
- For product distribution: profitably growing distribution partner
relationships and Allstate exclusive agencies sales of all products
and services.
2005 HIGHLIGHTS
- - Revenues increased 8.9% in 2005 compared to 2004. Higher net investment
income, increased contract charges and higher net realized capital gains,
were partially offset by lower premiums.
- - Net income improved $236 million to $417 million in 2005 from $181 million
in 2004 primarily due to a $175 million after-tax charge in 2004 for the
cumulative effect of a change in accounting principle related primarily to
guarantees on variable annuities.
- - Investments including separate account assets as of December 31, 2005
increased 4.7% over December 31, 2004 primarily due to sales of fixed
annuities and funding agreements.
- - Contractholder fund deposits totaled $11.41 billion for 2005 compared to
$13.08 billion in 2004. The decline of $1.67 billion was primarily the
result of lower deposits on deferred fixed annuities and, to a lesser
extent, institutional products.
- - Return on average beginning and ending period shareholder's equity
increased 4.0 points to 6.8% primarily due to the cumulative effect of a
change in accounting principle that was included in net income for 2004.
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CONSOLIDATED NET INCOME
<Table>
<Caption>
AS OF AND FOR THE YEARS ENDED DECEMBER 31,
(IN MILLIONS) 2005 2004 2003
---------- ---------- ----------
REVENUES
Premiums $ 474 $ 637 $ 959
Contract charges 1,079 961 872
Net investment income 3,707 3,260 3,082
Realized capital gains and losses 19 (11) (84)
---------- ---------- ----------
Total revenues 5,279 4,847 4,829
COSTS AND EXPENSES
Contract benefits (1,340) (1,359) (1,595)
Interest credited to contractholder funds (2,340) (1,923) (1,764)
Amortization of deferred policy acquisition costs (568) (534) (479)
Operating costs and expenses (433) (462) (493)
---------- ---------- ----------
Total costs and expenses (4,681) (4,278) (4,331)
Loss on disposition of operations (7) (24) (45)
Income tax expense (174) (189) (162)
---------- ---------- ----------
Income before cumulative effect of change in accounting
principle, after-tax 417 356 291
Cumulative effect of change in accounting principle, after-tax -- (175) (13)
---------- ---------- ----------
NET INCOME $ 417 $ 181 $ 278
========== ========== ==========
Investments $ 72,756 $ 69,689 $ 59,989
Separate accounts assets 15,235 14,377 13,425
---------- ---------- ----------
Investments, including Separate accounts assets $ 87,991 $ 84,066 $ 73,414
========== ========== ==========
</Table>
APPLICATION OF CRITICAL ACCOUNTING POLICIES
We have identified four accounting policies that require us to make
assumptions and estimates that are significant to the consolidated financial
statements. It is reasonably likely that changes in these assumptions and
estimates could occur from period to period and result in a material impact on
our consolidated financial statements. A brief summary of each of these critical
accounting policies follows. For a more detailed discussion of the effect of
these policies on our consolidated financial statements, and the judgments and
estimates related to these policies, see the referenced sections of the MD&A.
For a complete summary of our significant accounting policies see Note 2 of the
consolidated financial statements.
INVESTMENT VALUATION The fair value of publicly traded fixed income and equity
securities is based on independent market quotations, whereas 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 as inputs, or independent third party pricing sources. Factors used
in our internally developed models, such as liquidity risk associated with
privately-placed securities, are difficult to independently observe and
quantify. Because of this, judgment is required in developing certain of these
estimates and, as a result, the estimated fair value of non-publicly traded
securities may differ from amounts that would be realized upon an immediate sale
of the securities.
For investments classified as available for sale, the difference between
fair value and amortized cost for fixed income securities or cost for equity
securities, net of deferred income taxes, is reported as a component of
accumulated other comprehensive income on the Consolidated Statements of
Financial Position and is not reflected in the operating results of any period
until reclassified to net income upon the
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consummation of a transaction with an unrelated third party or when declines in
fair values are deemed other than temporary. The assessment of other than
temporary impairment of a security's fair value is performed on a portfolio
review as well as a case-by-case basis considering a wide range of factors. For
our portfolio review evaluations, we ascertain whether there are any approved
programs involving the disposition of investments such as changes in duration,
revision to strategic asset allocations and liquidity actions; and any
dispositions planned by the portfolio managers. In these instances, we recognize
impairment on securities being considered for these approved planned actions if
the security is in an unrealized loss position. There are a number of
assumptions and estimates inherent in evaluating impairments and determining if
they are other than temporary, including 1) our ability and intent to retain the
investment for a period of time sufficient to allow for an anticipated recovery
in value; 2) the expected recoverability of principal and interest; 3) the
duration and extent to which the fair value has been less than cost for equity
securities or amortized cost for fixed income securities; 4) the financial
condition, near-term and long-term prospects of the issuer, including relevant
industry conditions and trends, and implications of rating agency actions and
offering prices; and 5) the specific reasons that a security is in a significant
unrealized loss position, including market conditions which could affect
liquidity. Additionally, once assumptions and estimates are made, any number of
changes in facts and circumstances could cause us to later determine that an
impairment is other than temporary, including 1) general economic conditions
that are worse than previously assumed or that have a greater adverse effect on
a particular issuer than originally estimated; 2) changes in the facts and
circumstances related to a particular issuer's ability to meet all of its
contractual obligations; and 3) changes in facts and circumstances or new
information obtained which causes a change in our ability or intent to hold a
security to maturity or until it recovers in value. Changes in assumptions,
facts and circumstances could result in additional charges to earnings in future
periods to the extent that losses are realized. The charge to earnings, while
potentially significant to net income, would not have a significant effect on
shareholder's equity since the majority of our portfolio is carried at fair
value and as a result, any related unrealized loss, net of deferred acquisition
costs, deferred sales inducement costs and related deferred tax, would already
be reflected as a component of accumulated other comprehensive income in
shareholder's equity.
For a more detailed discussion of the risks relating to changes in
investment values and levels of investment impairment, and the potential causes
of such changes, see Note 6 of the consolidated financial statements and the
Investments, Market Risk, and Forward-looking Statements and Risk Factors
sections of the MD&A.
DERIVATIVE INSTRUMENT HEDGE EFFECTIVENESS We primarily use derivative financial
instruments to reduce our exposure to market risk and in conjunction with
asset/liability management. The fair value of exchange traded derivative
contracts is based on independent market quotations, whereas the fair value of
non-exchange traded derivative contracts is based on either widely accepted
pricing valuation models which use independent third party data as inputs or
independent third party pricing sources.
When derivatives meet specific criteria, they may be designated as
accounting hedges and accounted for as fair value, cash flow, foreign currency
fair value, or foreign currency cash flow hedges. When designating a derivative
as an accounting hedge, we formally document the hedging relationship, risk
management objective and strategy. The documentation identifies the hedging
instrument, the hedged item, the nature of the risk being hedged and the
assumptions used to assess how effective the hedging instrument is in offsetting
the exposure to changes in the hedged item's fair value attributable to the
hedged risk. In the case of a cash flow hedge, this documentation includes the
exposure to changes in the hedged transaction's variability in cash flows
attributable to the hedged risk. We do not exclude any component of the change
in fair value of the hedging instrument from the effectiveness assessment. At
each reporting date, we confirm that the hedging instrument continues to be
highly effective in offsetting the hedged risk. For further discussion of these
policies and quantification of the impact of these estimates and assumptions,
see Note 7 of the consolidated financial statements and the Investments, Market
Risk, and Forward-looking Statements and Risk Factors sections of the MD&A.
10
<Page>
DEFERRED POLICY ACQUISITION COST ("DAC") AMORTIZATION We incur significant costs
in connection with acquiring business. In accordance with generally accepted
accounting principles ("GAAP"), costs that vary with and are primarily related
to acquiring business are deferred and recorded as an asset on the Consolidated
Statements of Financial Position.
DAC related to traditional life insurance is amortized over the premium
paying period of the related policies in proportion to the estimated revenues on
such business. Significant assumptions relating to estimated premiums,
investment income and realized capital gains and losses, as well as to all other
aspects of DAC are determined based upon conditions as of the date of policy
issuance and are generally not revised during the life of the policy. Any
deviations from projected business in force resulting from actual policy
terminations differing from expected levels and any estimated premium
deficiencies change the rate of amortization in the period such events occur.
Generally, the amortization period for these contracts approximate the estimated
lives of the policies.
DAC related to interest-sensitive life, fixed and variable annuities and
other investment contracts is amortized in proportion to the incidence of the
total present value of gross profits which includes both actual historical gross
profits ("AGP") and estimated future gross profits ("EGP") earned over the
estimated lives of the contracts. The amortization periods ranges from 15-30
years; however, estimates of customer surrender rates, partial withdrawals and
deaths generally result in the majority of the DAC being amortized over the
surrender charge period. AGP and EGP consist of the following components:
benefit margins primarily from mortality, including guaranteed minimum death,
income, withdrawal and accumulation benefits; investment margin including
realized capital gains and losses; and contract administration, surrender and
other contract charges, less maintenance expenses.
DAC amortization for variable annuity and life contracts is estimated using
stochastic modeling and is significantly impacted by the anticipated return on
the underlying funds. Our long-term assumption of separate accounts fund
performance, net of fees, was approximately 7% in 2005 and 8% in 2004 and 2003.
Whenever actual separate accounts fund performance, based on the two most recent
years, varies from the expectation, we project performance levels over the next
five years such that the mean return over a seven-year period equals the
long-term expectation. This process is referred to as "reversion to the mean"
and is commonly used by the life insurance industry. Although the use of a
reversion to the mean assumption is common within the industry, the parameters
used in the methodology are subject to judgment and vary between companies. For
example, when applying this assumption we do not allow the future mean rates of
return including fees projected over the five-year period to exceed 12.75% or
fall below 0%. We periodically evaluate the results of utilizing this process to
confirm that it is reasonably possible that variable annuity and life fund
performance will revert to the expected long-term mean within this time horizon.
Revisions to EGPs result in changes in the cumulative amounts expensed as a
component of amortization of DAC in the period in which the revision is made.
This is commonly known as "DAC unlocking".
For quantification of the impact of these estimates and assumptions, see
the Forward-looking Statements and Risk Factors sections of the MD&A and Note 2
of the consolidated financial statements.
RESERVE FOR LIFE-CONTINGENT CONTRACT BENEFITS ESTIMATION Long-term actuarial
assumptions of future investment yields, mortality, morbidity, policy
terminations and expenses are used when establishing the reserve for
life-contingent contract benefits. These assumptions, which for traditional life
insurance are applied using the net level premium method, include provisions for
adverse deviation and generally vary by such characteristics as type of
coverage, year of issue and policy duration. Future investment yield assumptions
are determined at the time the policy is issued based upon prevailing investment
yields as well as estimated reinvestment yields. Mortality, morbidity and policy
termination assumptions are based on our experience and industry experience
prevailing at the time the policies are issued. Expense assumptions include the
estimated effects of inflation and expenses to be incurred beyond the
premium-paying period.
For further discussion of these policies, see Note 8 of the consolidated
financial statements and the Forward-looking Statements and Risk Factors section
of the MD&A.
11
<Page>
OPERATIONS
OVERVIEW AND STRATEGY We are a major provider of life insurance, retirement and
investment products to individual and institutional customers. Our mission is to
assist financial services professionals in meeting their clients' financial
protection, retirement and investment needs by providing top-tier products
delivered with reliable and efficient service.
We are pursuing the following actions and strategies to improve return on
equity: maintaining and developing focused top-tier products, deepening
distribution partner relationships, improving our cost structure through scale
and efficiencies, advancing our enterprise risk management program and
leveraging the strength of the Allstate brand name across products and
distribution channels. The execution of our business strategies has and may
continue to involve simplifying our business model and focusing on those
products and distribution relationships where we can secure strong leadership
positions while generating acceptable returns. This may require modifying the
number and selection of products marketed (for example, through such actions as
our exit from the guaranteed investment contract market and the long-term care
product market and the sale of our direct response distribution business in
2004); terminating underperforming distribution relationships; merging or
disposing of non-strategic legal entities (such as the merger of Glenbrook Life
and Annuity Company in 2005 and the planned sales of three legal entities);
reducing policy administration software systems; and other actions that we may
determine are appropriate to successfully execute our business strategies
(see also "Subsequent Event" in Note 3 to the consolidated financial
statements).
Our individual retail product line includes a wide variety of products
designed to meet the financial protection, retirement and investment needs of
our customers. Individual retail products include traditional life,
interest-sensitive life, variable life, fixed and variable annuities and funding
agreements backing retail medium-term notes. Individual retail products are sold
through a variety of distribution channels including Allstate exclusive
agencies, independent agents (including master brokerage agencies), and
financial service firms such as banks, broker/dealers and specialized structured
settlement brokers. Our institutional product line consists primarily of funding
agreements sold to unaffiliated trusts that use them to back medium-term notes
issued to institutional and individual investors.
PREMIUMS AND CONTRACT CHARGES Premiums represent revenues generated from
traditional life, immediate annuities with life contingencies and other
insurance products that have significant mortality or morbidity risk. Contract
charges are revenues generated from interest-sensitive life, variable annuities,
fixed annuities and institutional products for which deposits are classified as
contractholder funds or separate accounts liabilities. Contract charges are
assessed against the contractholder account values for maintenance,
administration, cost of insurance and surrender prior to contractually specified
dates. As a result, changes in contractholder funds and separate accounts
liabilities are considered in the evaluation of growth and as indicators of
future levels of revenues.
The following table summarizes premiums and contract charges by product.
<Table>
<Caption>
(IN MILLIONS) 2005 2004(1) 2003(1)
---------- ---------- ----------
PREMIUMS
Traditional life $ 250 $ 302 $ 368
Immediate annuities with life contingencies 197 316 413
Other 27 19 178
---------- ---------- ----------
TOTAL PREMIUMS 474 637 959
CONTRACT CHARGES
Interest-sensitive life 734 663 621
Fixed annuities 65 52 37
Variable annuities 280 246 206
Institutional products -- -- 8
---------- ---------- ----------
TOTAL CONTRACT CHARGES 1,079 961 872
---------- ---------- ----------
TOTAL PREMIUMS AND CONTRACT CHARGES $ 1,553 $ 1,598 $ 1,831
========== ========== ==========
</Table>
- ----------
(1) To conform to the current period presentation, certain prior year
amounts have been reclassified.
12
<Page>
The following table summarizes premiums and contract charges by
distribution channel.
<Table>
<Caption>
(IN MILLIONS) 2005 2004 2003
---------- ---------- ----------
PREMIUMS
Allstate agencies $ 256 $ 273 $ 226
Independent agents 74 70 60
Specialized brokers 141 243 390
Other 3 51 283
---------- ---------- ----------
TOTAL PREMIUMS 474 637 959
---------- ---------- ----------
CONTRACT CHARGES
Allstate agencies 521 462 440
Independent agents 253 235 212
Broker dealers 223 199 172
Banks 53 35 15
Specialized brokers 26 27 30
Other 3 3 3
---------- ---------- ----------
TOTAL CONTRACT CHARGES 1,079 961 872
---------- ---------- ----------
TOTAL PREMIUMS AND CONTRACT CHARGES $ 1,553 $ 1,598 $ 1,831
========== ========== ==========
</Table>
Total premiums decreased 25.6% in 2005 compared to 2004 due to lower
premiums on immediate annuities with life contingencies and traditional life
products. Premiums on immediate annuities with life contingencies declined
primarily as a result of pricing actions taken to improve our returns on new
business and reflect our current expectations of mortality. Our new pricing has
led to a shift in our sales mix from immediate annuities with life contingencies
to immediate annuities without life contingencies, which are accounted for as
deposits rather than as premiums. The decline in traditional life premiums was
primarily due to the absence of certain premiums in 2005 resulting from the
disposal of our direct response distribution business in 2004.
Total premiums decreased 33.6% in 2004 compared to 2003. The decrease was
primarily due to the disposal of substantially all of our direct response
distribution business, which resulted in lower other premiums and traditional
life premiums. Additionally, 2004 reflected lower premiums on immediate
annuities with life contingencies as underwriting actions taken in 2003 reduced
the maximum premium received on individual contracts sold.
Contract charges increased 12.3% in 2005 compared to 2004. The increase was
due to higher contract charges on interest-sensitive life, variable annuities
and, to a lesser extent, fixed annuities. The increase in the interest-sensitive
life contract charges was attributable to in-force business growth resulting
from deposits and credited interest more than offsetting surrenders and
benefits. Higher variable annuity contract charges were primarily the result of
higher account values and participation fees. Fixed annuity contract charges in
2005 reflect higher surrender charges compared with the prior year.
Contract charges increased 10.2% in 2004 compared to 2003. The increase was
primarily due to higher contract charges on interest-sensitive life and variable
annuities. The increase in the interest-sensitive life contract charges was
attributable to in-force business growth resulting from deposits and credited
interest more than offsetting contract charges, surrenders and benefits. Higher
variable annuity contract charges were the result of increased average account
values during 2004, reflecting positive investment results during 2003 and 2004.
13
<Page>
CONTRACTHOLDER FUNDS represent interest-bearing liabilities arising from the
sale of individual and institutional products, such as interest-sensitive life,
fixed annuities and funding agreements. The balance of contractholder funds is
equal to the cumulative deposits received and interest credited to the
contractholder less cumulative contract maturities, benefits, surrenders,
withdrawals and contract charges for mortality or administrative expenses.
The following table shows the changes in contractholder funds.
<Table>
<Caption>
(IN MILLIONS) 2005 2004 2003
---------- ---------- ----------
CONTRACTHOLDER FUNDS, BEGINNING BALANCE $ 53,939 $ 44,914 $ 38,858
Impact of adoption of SOP 03-1(1) - 421 -
DEPOSITS
Fixed annuities (immediate and deferred) 5,924 7,319 5,263
Institutional products (primarily funding agreements) 3,773 3,987 2,713
Interest-sensitive life 1,318 1,275 972
Variable annuity and life deposits allocated to fixed accounts 395 495 893
---------- ---------- ----------
Total deposits 11,410 13,076 9,841
INTEREST CREDITED 2,340 1,912 1,764
MATURITIES, BENEFITS, WITHDRAWALS AND OTHER ADJUSTMENTS
Maturities of institutional products (3,090) (2,518) (2,163)
Benefits (972) (714) (492)
Surrenders and partial withdrawals (4,203) (2,718) (2,200)
Contract charges (649) (593) (561)
Net transfers to separate accounts (339) (412) (416)
Fair value hedge adjustments for institutional products (289) 45 131
Other adjustments 43 526 152
---------- ---------- ----------
Total maturities, benefits, withdrawals and other adjustments (9,499) (6,384) (5,549)
---------- ---------- ----------
CONTRACTHOLDER FUNDS, ENDING BALANCE $ 58,190 $ 53,939 $ 44,914
========== ========== ==========
</Table>
- ----------
(1) The increase in contractholder funds due to the adoption of Statement of
Position No. 03-1, "Accounting and Reporting by Insurance Enterprises for
Certain Nontraditional Long-Duration Contracts and for Separate Accounts"
("SOP 03-1") reflects the reclassification of certain products previously
included as a component of separate accounts to contractholder funds, the
reclassification of deferred sales inducements ("DSI") from contractholder
funds to other assets and the establishment of reserves for certain
liabilities that are primarily related to income and other guarantees
provided under fixed annuity, variable annuity and interest-sensitive life
contracts.
Lower contractholder deposits and increased surrenders and partial
withdrawals as well as higher institutional product maturities contributed to a
reduction in the growth rate of contractholder funds in 2005 compared to 2004.
Average contractholder funds increased 13.9% in 2005 compared to a 17.5%
increase in 2004.
Contractholder deposits decreased 12.7% in 2005 compared to 2004 due to
lower deposits on fixed annuities. Fixed annuity deposits declined 19.1% in 2005
as lower deposits on traditional deferred fixed annuities and market value
adjusted annuities were partially offset by increased deposits on immediate
annuities without life contingencies. The decline in fixed annuity deposits
resulted from reduced consumer demand relative to certificates of deposit and
other short-term investments due to increases in short-term interest rates
without corresponding increases in longer term rates and pricing actions to
increase fixed annuity product returns. A continuation of the current interest
rate environment may limit the level of future fixed annuity deposits.
Institutional product deposits decreased 5.4% in 2005 compared to 2004. Our
institutional business sales remain opportunistic and, as such, institutional
product deposits were intermittent during the year.
14
<Page>
Contractholder deposits increased 32.9% in 2004 compared to 2003 due
primarily to greater issuances of fixed annuities, interest-sensitive life
policies and retail and institutional funding agreements. Fixed annuity deposits
increased 39.1% in 2004 compared to 2003 due to strong consumer demand,
competitive pricing and effective distribution efforts in our bank channel.
Institutional product deposits increased 43.8% in 2004 compared to 2003, largely
due to favorable market conditions for our funding agreements and the broadening
of our customer base through the development and launch of our new Securities
and Exchange Commission ("SEC") registered program in the second quarter of 2004
and our new registered retail funding agreement program in the fourth quarter.
The registered programs generated $1.74 billion of new funding agreement
deposits during 2004 including $85 million in retail funding agreement deposits.
Surrenders and partial withdrawals increased 54.6% in 2005 compared to 2004
driven mostly by higher surrenders of market value adjusted annuities due to a
portion of these contracts entering a 30-45 day window in which there were no
surrender charges or market value adjustments. The lack of surrender charges and
market value adjustments combined with the interest rate environment, which
included a relatively small difference between short-term and long-term interest
rates, caused contractholders to choose competing short-term investment
alternatives. The withdrawal rate for 2005, 2004 and 2003 was 10.0%, 7.8% and
7.4%, respectively, based on the beginning of period contractholder funds
balance excluding institutional product reserves. 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 represent contractholders' claims to the related
separate accounts assets. Separate accounts liabilities primarily arise from the
sale of variable annuity contracts and variable life insurance policies. The
following table shows the changes in separate accounts liabilities.
<Table>
<Caption>
(IN MILLIONS) 2005 2004 2003
---------- ---------- ----------
SEPARATE ACCOUNTS LIABILITIES, BEGINNING BALANCE $ 14,377 $ 13,425 $ 11,125
Impact of adoption of SOP 03-1(1) - (204) -
Variable annuity and life deposits 1,877 1,763 2,284
Variable annuity and life deposits allocated to fixed accounts (395) (495) (893)
---------- ---------- ----------
Net deposits 1,482 1,268 1,391
Investment results 1,060 1,348 2,393
Contract charges (283) (256) (220)
Net transfers from fixed accounts 339 412 416
Surrenders and benefits (1,740) (1,616) (1,680)
---------- ---------- ----------
SEPARATE ACCOUNTS LIABILITIES, ENDING BALANCE $ 15,235 $ 14,377 $ 13,425
========== ========== ==========
</Table>
- ----------
(1) The decrease in separate accounts due to the adoption of SOP 03-1 reflects
the reclassification of certain products previously included as a component
of separate accounts to contractholder funds.
Separate accounts liabilities increased 6.0% as of December 31, 2005
compared to December 31, 2004. This is compared to an increase of 7.1% as of
December 31, 2004 compared to December 31, 2003. The decline in the rate at
which separate accounts liabilities increased was primarily attributable to less
favorable market performance and increased surrenders and benefits, partially
offset by higher net deposits. Net variable annuity and life deposits increased
16.9% in 2005 compared to 2004 and declined 8.8% in 2004 compared to 2003.
Variable product deposits vary with equity market conditions and consumer
preferences related to our product features. 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.
15
<Page>
NET INVESTMENT INCOME increased 13.7% in 2005 compared to 2004 and 5.8% in 2004
compared to 2003. The increase in 2005 was primarily the result of increased
portfolio balances and, to a lesser extent, increased yields on floating rate
assets due to higher short-term interest rates and increased income on
partnership interests, partially offset by lower yields on fixed income
securities. In 2004, the increase compared to 2003 was due to higher portfolio
balances partially offset by lower portfolio yields. Higher portfolio balances
in both years resulted from the investment of cash flows from operating and
financing activities related primarily to deposits from fixed annuities,
institutional funding agreements and interest-sensitive life policies.
Investment balances as of December 31, 2005, increased 4.4% from December 31,
2004 and increased 16.2% as of December 31, 2004 compared to December 31, 2003.
The decline in the rate at which investments increased in 2005 compared to 2004
was the result of a lesser increase in contractholder funds and a decline in
unrealized capital gains on fixed income securities in 2005 compared with a
slight increase in 2004. Changes in portfolio yields are primarily driven by
purchases, including reinvestments, of fixed income securities with yields
higher or lower than the current portfolio average as well as significant
changes in short-term interest rates.
NET INCOME analysis is presented in the following table.
<Table>
<Caption>
(IN MILLIONS) 2005 2004 2003
---------- ---------- ----------
Premiums $ 474 $ 637 $ 959
Contract charges 1,079 961 872
Net investment income 3,707 3,260 3,082
Periodic settlements and accruals on non-hedge
derivative instruments (1) 63 49 23
Contract benefits (1,340) (1,359) (1,595)
Interest credited to contractholder funds(2) (2,266) (1,878) (1,764)
---------- ---------- ----------
Gross margin 1,717 1,670 1,577
Amortization of DAC and DSI (484) (441) (433)
Operating costs and expenses (433) (462) (493)
Income tax expense (249) (265) (233)
Realized capital gains and losses, after-tax 12 (8) (54)
DAC and DSI amortization relating to realized
capital gains and losses, after-tax (103) (89) (30)
Reclassification of periodic settlements and
accruals on non-hedge derivative
instruments, after-tax (40) (32) (15)
Loss on disposition of operations, after-tax (3) (17) (28)
Cumulative effect of change in accounting
principle, after-tax - (175) (13)
---------- ---------- ----------
NET INCOME $ 417 $ 181 $ 278
========== ========== ==========
</Table>
- ----------
(1) Periodic settlements and accruals on non-hedge derivative instruments
are reflected as a component of realized capital gains and losses on
the Consolidated Statements of Operations and Comprehensive Income.
(2) Beginning in 2004, Amortization of DSI is excluded from interest
credited to contractholder funds for purposes of calculating gross
margin. Amortization of DSI totaled $74 million and $45 million in
2005 and 2004, respectively. Prior periods have not been restated.
GROSS MARGIN, a non-GAAP measure, represents premiums and contract charges, net
investment income and periodic settlements and accruals on non-hedge derivative
instruments, less contract benefits and interest credited to contractholder
funds excluding amortization of DSI. We reclassify periodic settlements and
accruals on non-hedge derivative instruments into gross margin to report them in
a manner consistent with the economically hedged investments, replicated assets
or product attributes (e.g. net investment income or interest credited to
contractholder funds) and by doing so, appropriately reflect trends in product
performance. We use gross margin as a component of our evaluation of the
profitability of our life insurance and financial product portfolio.
Additionally, for many of our products, including fixed
16
<Page>
annuities, variable life and annuities, and interest-sensitive life insurance,
the amortization of DAC and DSI is determined based on actual and expected gross
margin. Gross margin is comprised of three components that are utilized to
further analyze the business: investment margin, benefit margin, and contract
charges and fees. We believe gross margin and its components are useful to
investors because they allow for the evaluation of income components separately
and in the aggregate when reviewing performance. Gross margin, investment margin
and benefit margin should not be considered as a substitute for net income and
do not reflect the overall profitability of the business. Net income is the GAAP
measure that is most directly comparable to these margins. Gross margin is
reconciled to GAAP net income in the previous table.
The components of gross margin are reconciled to the corresponding
financial statement line items in the following table.
<Table>
<Caption>
2005
---------------------------------------------------------------------------
INVESTMENT BENEFIT CONTRACT CHARGES GROSS
MARGIN MARGIN AND FEES MARGIN
---------------- ---------------- ----------------- ----------------
(IN MILLIONS)
Premiums $ -- $ 474 $ -- $ 474
Contract charges -- 621 458 1,079
Net investment income 3,707 -- -- 3,707
Periodic settlements and
accruals on non-hedge
derivative instruments (1) 63 -- -- 63
Contract benefits (529) (811) -- (1,340)
Interest credited to
contractholder funds (2) (2,266) -- -- (2,266)
---------------- ---------------- ---------------- ----------------
$ 975 $ 284 $ 458 $ 1,717
================ ================ ================ ================
<Caption>
2004(3)
---------------------------------------------------------------------------
INVESTMENT BENEFIT CONTRACT GROSS
MARGIN MARGIN CHARGES AND FEES MARGIN
---------------- ---------------- ----------------- ----------------
(IN MILLIONS)
Premiums $ -- $ 637 $ -- $ 637
Contract charges -- 539 422 961
Net investment income 3,260 -- -- 3,260
Periodic settlements and
accruals on non-hedge
derivative instruments (1) 49 -- -- 49
Contract benefits (530) (829) -- (1,359)
Interest credited to
contractholder funds (2) (1,878) -- -- (1,878)
---------------- ---------------- ---------------- ----------------
$ 901 $ 347 $ 422 $ 1,670
================ ================ ================ ================
<Caption>
2003(3)
---------------------------------------------------------------------------
INVESTMENT BENEFIT CONTRACT GROSS
MARGIN MARGIN CHARGES AND FEES MARGIN
---------------- ---------------- ----------------- ----------------
(IN MILLIONS)
Premiums $ -- $ 959 $ -- $ 959
Contract charges -- 489 383 872
Net investment income 3,082 -- -- 3,082
Periodic settlements and
accruals on non-hedge
derivative instruments (1) 23 -- -- 23
Contract benefits (517) (1,078) -- (1,595)
Interest credited to
contractholder funds (2) (1,764) -- -- (1,764)
---------------- ---------------- ---------------- ----------------
$ 824 $ 370 $ 383 $ 1,577
================ ================ ================ ================
</Table>
- ----------
(1) Periodic settlements and accruals on non-hedge derivative instruments are
reflected as a component of realized capital gains and losses on the
Consolidated Statements of Operations and Comprehensive Income.
(2) Beginning in 2004, Amortization of DSI is excluded from interest credited to
contractholder funds for purposes of calculating gross margin. Amortization
of DSI totaled $74 million and $45 million in 2005 and 2004, respectively.
Prior periods have not been restated.
(3) 2004 and 2003 have been restated to conform to the current period
presentation. In connection therewith, contract charges related to
guaranteed minimum death, income, accumulation and withdrawal benefits on
variable annuities have been reclassified to benefit margin from maintenance
charges. Additionally, amounts previously presented as maintenance charges
and surrender charges are now presented in the aggregate as contract charges
and fees. These reclassifications did not result in a change in gross
margin.
17
<Page>
Gross margin increased 2.8% in 2005 compared to 2004 and 5.9% in 2004
compared to 2003. The increase in both periods was the result of higher
investment margin and contract charges and fees, partially offset by lower
benefit margin. Gross margin for 2005 includes additional benefits of $15
million that were accrued in accordance with a regulatory matter (see Note 11
to the consolidated financial statements).
INVESTMENT MARGIN is a component of gross margin, both of which are non-GAAP
measures. Investment margin represents the excess of net investment income and
periodic settlements and accruals on non-hedge derivative instruments over
interest credited to contractholder funds and the implied interest on
life-contingent immediate annuities included in the reserve for life-contingent
contract benefits. Amortization of DSI is excluded from interest credited to
contractholder funds for purposes of calculating investment margin. We use
investment margin to evaluate our profitability related to the difference
between investment returns on assets supporting certain products and amounts
credited to customers ("spread") during a fiscal period.
Investment margin by product group is shown in the following table.
<Table>
<Caption>
(IN MILLIONS) 2005 2004(1) 2003(1)
---------- ---------- ----------
Annuities $ 682 $ 620 $ 546
Life insurance 171 160 171
Institutional products 122 121 107
---------- ---------- ----------
Total investment margin $ 975 $ 901 $ 824
========== ========== ==========
</Table>
- ----------
(1) 2004 and 2003 have been restated to conform to the current period
presentation.
Investment margin increased 8.2% in 2005 compared to 2004 primarily due to
growth in our fixed annuity business, partially offset by lower weighted average
investment spreads on immediate annuities and additional fixed annuity
contract benefits accrued in accordance with a regulatory matter (see Note 11
to the consolidated financial statements). Investment margin increased 9.3% in
2004 compared to 2003 primarily due to higher contractholder funds and actions
to reduce crediting rates, partially offset by lower portfolio yields. As of
December 31, 2005, 71% of our interest-sensitive life and fixed annuity
contracts, excluding market value adjusted annuities and equity-indexed
annuities, had a guaranteed crediting rate of 3% or higher. Of these contracts,
79% have crediting rates that were at the minimum guaranteed rate at December
31, 2005. The approximate difference between the weighted average crediting rate
and the average guaranteed rate on interest-sensitive life and fixed annuity
contracts, excluding market value adjusted annuities and equity-indexed
annuities, was 46 basis points as of December 31, 2005 compared with 52 basis
points as of December 31, 2004 and 70 basis points as of December 31, 2003.
The following table summarizes the annualized weighted average investment
yield, interest crediting rates and investment spreads during 2005, 2004 and
2003.
<Table>
<Caption>
WEIGHTED AVERAGE WEIGHTED AVERAGE WEIGHTED AVERAGE
INVESTMENT YIELD INTEREST CREDITING RATE INVESTMENT SPREADS
---------------- ----------------------- ------------------
2005 2004 2003 2005 2004 2003 2005 2004 2003
------ ------ ------ ------ ------ ------ ------ ------ ------
Interest-sensitive life 6.3% 6.4% 6.9% 4.7% 4.8% 4.9% 1.6% 1.6% 2.0%
Fixed annuities - deferred annuities 5.5 5.8 6.4 3.8 4.1 4.6 1.7 1.7 1.8
Fixed annuities - immediate annuities
with and without life contingencies 7.3 7.6 7.9 6.6 6.8 7.1 0.7 0.8 0.8
Institutional 4.6 3.1 3.5 3.6 2.1 2.5 1.0 1.0 1.0
Investments supporting capital,
traditional life and other products 7.1 7.0 6.6 N/A N/A N/A N/A N/A N/A
</Table>
18
<Page>
The following table summarizes the liabilities as of December 31 for these
contracts and policies.
<Table>
<Caption>
(IN MILLIONS) 2005 2004 2003
---------- ---------- ----------
Fixed annuities - immediate annuities with life contingencies $ 7,888 $ 7,713 $ 7,433
Other life contingent contracts and other 3,993 3,490 3,047
---------- ---------- ----------
Reserve for life-contingent contracts $ 11,881 $ 11,203 $ 10,480
========== ========== ==========
Interest-sensitive life $ 7,917 $ 7,397 $ 6,459
Fixed annuities - deferred annuities 33,853 31,347 25,669
Fixed annuities - immediate annuities without life
contingencies 3,598 3,243 2,855
Institutional 12,431 11,279 9,379
Market value adjustments related to derivative instruments
and other 391 673 552
---------- ---------- ----------
Contractholder funds $ 58,190 $ 53,939 $ 44,914
========== ========== ==========
</Table>
BENEFIT MARGIN is a component of gross margin, both of which are non-GAAP
measures. Benefit margin represents life and life-contingent immediate annuity
premiums, cost of insurance contract charges and variable annuity contract
charges for contract guarantees less contract benefits. Benefit margin excludes
the implied interest on life-contingent immediate annuities, which is included
in the calculation of investment margin. We use the benefit margin to evaluate
our underwriting performance, as it reflects the profitability of our products
with respect to mortality or morbidity risk during a fiscal period.
Benefit margin by product group is shown in the following table.
<Table>
<Caption>
(IN MILLIONS) 2005 2004(1) 2003(1)
---------- ---------- ----------
Life insurance $ 364 $ 400 $ 458
Annuities (80) (53) (88)
---------- ---------- ----------
Total benefit margin $ 284 $ 347 $ 370
========== ========== ==========
</Table>
- ----------
(1) 2004 and 2003 have been restated to conform to the current
period presentation.
Benefit margin declined 18.2% in 2005 compared to 2004. Our life insurance
and annuity business both contributed to the decline in 2005. The decline in our
annuity benefit margin was primarily driven by unfavorable mortality experience
on immediate annuities with life contingencies and an increase in variable
annuity contract benefits including additional benefits accrued in
accordance with a regulatory matter (see Note 11 to the consolidated
financial statements). The decline in our life insurance benefit margin was
primarily due to the absence of margin on certain products resulting from the
disposal of our direct response distribution business in the prior year and
modestly unfavorable mortality experience on our traditional life business,
partially offset by growth in our life insurance in force.
Benefit margin decreased 6.2% in 2004 compared to 2003. This decline was
primarily the result of the disposal of substantially all of our direct response
distribution business and unfavorable mortality experience on life-contingent
immediate annuities, partially offset by an improved benefit margin on life
insurance products and lower contract benefits related to guaranteed minimum
death benefits ("GMDBs") on variable annuities.
As required by SOP 03-1, as of January 1, 2004, a reserve was established
for death and income benefits provided for under variable annuities and
secondary guarantees on certain interest-sensitive life contracts and fixed
annuities. For variable annuities, the reserve includes GMDBs and guaranteed
minimum income benefits ("GMIBs").
Annuity benefit margin will continue to be adversely impacted by certain
closed blocks of life-contingent immediate annuities for which benefit payments
are anticipated to extend beyond their original pricing expectations. The
annuity benefit margin in future periods will fluctuate based on the timing of
annuitant deaths on these life-contingent immediate annuities and the annual
evaluation of assumptions used in our valuation models for variable and fixed
annuity guarantees.
19
<Page>
AMORTIZATION OF DAC AND DSI, excluding amortization related to realized
capital gains and losses, increased 9.8% in 2005 compared to 2004 as a result of
higher gross margin. DAC and DSI amortization related to realized capital gains
and losses, after-tax, increased $14 million in 2005 compared to 2004 primarily
due to increased realized capital gains on investments supporting certain fixed
annuities.
In the first quarter of 2005, we performed our annual comprehensive
evaluation of the assumptions used in our valuation models for all investment
products, including variable and fixed annuities and interest-sensitive and
variable life products, which resulted in net DAC and DSI amortization
acceleration of $7 million (commonly referred to as "DAC and DSI unlocking").
The DAC and DSI unlocking includes amortization acceleration on fixed annuities
of $62 million and $3 million on interest-sensitive and variable life products,
partially offset by amortization deceleration on variable annuities of $58
million. The amortization acceleration on fixed annuities was primarily due to
higher than expected lapses on market value adjusted annuities and faster than
anticipated investment portfolio yield declines. The amortization deceleration
on variable annuities was attributable to better than anticipated gross profits
in 2004.
In the prior year, the comparable DAC and DSI unlocking was a net
acceleration of amortization of $0.5 million, which included deceleration of
amortization related to interest-sensitive life and acceleration of amortization
related to fixed annuities.
Amortization of DAC and DSI increased 1.8% during 2004 compared to 2003.
The higher amortization is reflective of increased gross margins on fixed and
variable annuities. In 2003, amortization of DAC and DSI included an
acceleration of DAC amortization totaling $89 million and $37 million of DAC
amortization on the direct response distribution business sold in 2004.
The adoption of SOP 03-1 in 2004 required a new modeling approach for
estimating expected future gross profits that are used when determining the
amortization of DAC. Because of this new modeling approach, effective January 1,
2004, the variable annuity DAC and DSI assets were reduced by $124 million. This
reduction was recognized as a component of cumulative effect of a change in
accounting principle.
20
<Page>
The changes in the DAC asset are summarized in the following tables.
(IN MILLIONS)
<Table>
<Caption>
BEGINNING
BALANCE IMPACT OF IMPACT OF AMORTIZATION
DECEMBER 31, ADOPTION OF DISPOSAL ACQUISITION CHARGED TO
2004 SOP 03-1 OF DR REINSURANCE COSTS DEFERRED INCOME (3)
-------------- -------------- -------------- -------------- -------------- --------------
Traditional life $ 564 $ -- $ -- $ -- $ 64 $ (47)
Interest-sensitive life 1,380 -- -- -- 226 (134)
Variable annuities 628 -- -- -- 111 (106)
Investment contracts 600 -- -- -- 346 (282)
Other 4 -- -- -- 19 (1)
-------------- -------------- -------------- -------------- -------------- --------------
Total $ 3,176 $ -- $ -- $ -- $ 766 $ (570)
============== ============== ============== ============== ============== ==============
<Caption>
AMORTIZATION
(ACCELERATION) EFFECT OF ENDING
DECELERATION UNREALIZED BALANCE
CHARGED TO CAPITAL GAINS DEC. 31,
INCOME (1) AND LOSSES 2005
-------------- -------------- --------------
Traditional life $ -- $ -- $ 581
Interest-sensitive life (2) 60 1,530
Variable annuities 55 43 731
Investment contracts (51) 471 1,084
Other -- -- 22
-------------- -------------- --------------
Total $ 2 $ 574 $ 3,948
============== ============== ==============
</Table>
(IN MILLIONS)
<Table>
<Caption>
BEGINNING
BALANCE IMPACT OF IMPACT OF ACQUISITION AMORTIZATION
DECEMBER 31, ADOPTION OF DISPOSAL COSTS CHARGED TO
2003 SOP 03-1 (2) OF DR REINSURANCE (4) DEFERRED INCOME (3)
-------------- -------------- -------------- --------------- ------------- --------------
Traditional life $ 689 $ -- $ (145) $ 9 $ 69 $ (58)
Interest-sensitive life 1,221 -- -- 26 190 (120)
Variable annuities 766 (143) -- -- 123 (134)
Investment contracts 446 (1) -- 5 429 (230)
Other 80 -- (93) -- 17 --
-------------- -------------- -------------- --------------- ------------- --------------
Total $ 3,202 $ (144) $ (238) $ 40 $ 828 $ (542)
============== ============== ============== =============== ============= ==============
<Caption>
AMORTIZATION
(ACCELERATION) EFFECT OF ENDING
DECELERATION UNREALIZED BALANCE
CHARGED TO CAPITAL GAINS DEC. 31,
INCOME (1) AND LOSSES 2004
-------------- -------------- --------------
Traditional life $ -- $ -- $ 564
Interest-sensitive life 67 (4) 1,380
Variable annuities -- 16 628
Investment contracts (59) 10 600
Other -- -- 4
-------------- -------------- --------------
Total $ 8 $ 22 $ 3,176
============== ============== ==============
</Table>
- ----------
(1) Included as a component of Amortization of DAC on the Consolidated
Statements of Operations and Comprehensive Income.
(2) The impact of adoption of SOP 03-1 includes a write-down in variable annuity
DAC of $108 million, the reclassification of DSI from DAC to other assets
resulting in a decrease to DAC of $44 million, an increase to DAC of $8
million for an adjustment to the effect of unrealized capital gains and
losses.
(3) The amortization of DAC for interest-sensitive life, variable annuities and
investment contracts is proportionate to the recognition of gross profits,
which include realized capital gains and losses. Fluctuations in
amortization for these products may result as actual realized capital gains
and losses differ from the amounts utilized in the determination of
estimated gross profits. Amortization related to realized capital gains and
losses was $126 million and $120 million in 2005 and 2004, respectively.
(4) The DAC balance was increased $40 million during 2004 as a result of certain
reinsurance transactions. In 2004, ALIC entered into a reinsurance agreement
with American Heritage Life Insurance Company, an affiliate of the Company,
whereby certain interest-sensitive life and fixed annuity business was
assumed by ALIC. In addition, in 2004, an existing reinsurance agreement
between ALIC and Columbia Universal Life Insurance Company, a former
affiliate of the Company, was changed from modified coinsurance to
coinsurance resulting in an increase in traditional life and
interest-sensitive life DAC.
21
<Page>
OPERATING COSTS AND EXPENSES declined 6.3% in 2005 compared to 2004 and 6.3% in
2004 compared to 2003. The following table summarizes operating costs and
expenses.
<Table>
<Caption>
(IN MILLIONS) 2005 2004 2003
---------- ---------- ----------
Non-deferrable acquisition costs $ 149 $ 146 $ 169
Other operating costs and expenses 284 316 324
---------- ---------- ----------
Total operating costs and expenses $ 433 $ 462 $ 493
========== ========== ==========
</Table>
The decline in total operating costs and expenses in 2005 compared to 2004
was primarily attributable to lower employee and technology expenses reflecting
our continuing actions to simplify operations and reduce costs.
The decline in total operating costs and expenses in 2004 compared to 2003
was primarily attributable to the disposal of substantially all of our direct
response distribution business. Excluding the impact of the disposition,
non-deferrable acquisition costs increased due to higher non-deferrable renewal
commissions; and taxes, licenses and fees. For other operating costs and
expenses, the decline due to the disposition was partially offset by higher
technology and employee related expenses.
Net income was impacted favorably in 2005 and 2004 and negatively in 2003
by adjustments of prior years' tax liabilities totaling $23 million, $1 million
and $(11) million, respectively. These amounts were reflected as a component of
income tax expense in the consolidated statements of operations and
comprehensive income.
REINSURANCE CEDED We enter into reinsurance agreements with unaffiliated
carriers to limit our risk of mortality losses. As of December 31, 2005 and
2004, 50% of our face amount of life insurance in force is reinsured. As of
December 31, 2005, for certain term life insurance policies, we ceded 25-90% of
the mortality risk depending on the length of the term, policy premium
guarantees and the date of policy issuance. Comparatively, as of December 31,
2004, for certain term life insurance policies, we ceded 25-100% of the
mortality risk. Additionally, we cede 100% of the morbidity risk on
substantially all of our long-term care contracts. Since 1998, we have ceded the
mortality risk on new life contracts that exceed $2 million per individual,
whereas prior to 1998, we ceded mortality risk in excess of specific amounts up
to $1 million per life for individual coverage. Also, on certain in-force
variable annuity contracts we cede 100% of the mortality and certain other risks
related to product features. We retain primary liability as a direct insurer for
all risks ceded to reinsurers.
The impacts of reinsurance on our reserve for life-contingent contract
benefits at December 31, are summarized in the following table.
<Table>
<Caption>
REINSURANCE RECOVERABLE ON PAID AND
(IN MILLIONS) UNPAID CLAIMS, NET
---------------------------------------
2005 2004
---- ----
Life insurance $ 1,115 $ 1,004
Long-term care 324 238
Other 260 265
------------------ ------------------
Total $ 1,699 $ 1,507
================== ==================
</Table>
The estimation of reinsurance recoverables is impacted by the uncertainties
involved in the establishment of reserves.
Developments in the insurance industry have included consolidation activity
between reinsurers, which has resulted in reinsurance risk across the industry
being concentrated among fewer companies. In 2005, we increased our percentage
of underwriting retention of new term life insurance policies by approximately
10-15% on average depending on product mix.
22
<Page>
Our reinsurance recoverables, summarized by reinsurer as of December 31,
are shown in the following table.
<Table>
<Caption>
S&P FINANCIAL REINSURANCE
STRENGTH RECOVERABLE ON PAID
(IN MILLIONS) RATING AND UNPAID CLAIMS
------ -----------------
2005 2004
---- ----
Employers Reassurance Corporation A $ 336 $ 246
RGA Reinsurance Company AA- 261 229
Transamerica Life Group AA 185 145
Swiss Re Life and Health America, Inc. AA 153 143
Paul Revere Life Insurance Company BBB+ 152 155
Scottish Re Group A- 123 111
Manulife Insurance Company AA+ 87 90
Munich American Reassurance A+ 83 72
Security Life of Denver AA 70 59
Triton Insurance Company NR (2) 62 58
Lincoln National Life Insurance AA- 55 52
American Health & Life Insurance Co. NR (2) 50 60
Other (1) 82 87
------- -------
Total $ 1,699 $ 1,507
======= =======
</Table>
- ----------
(1) As of December 31, 2005 and 2004, the other category includes $57
million and $52 million, respectively, of recoverables due from
reinsurers with an investment grade credit rating from S&P.
(2) Reinsurer not rated by S&P. Rated A by A.M. Best as of December 31,
2005 and 2004.
We continuously monitor the creditworthiness of reinsurers in order to
determine our risk of recoverability on an individual and aggregate basis, and a
provision for uncollectible reinsurance is recorded if needed. No amounts have
been deemed unrecoverable in the three-years ended December 31, 2005.
ALIC's insurance subsidiaries are domiciled in Illinois, New York, South
Carolina and Nebraska. Except for those domiciled in New York and South
Carolina, ALIC has 100% intercompany reinsurance agreements in place with most
of its domestic insurance subsidiaries. With the exception of Allstate Life
Insurance Company of New York, which retains substantially all of its business
up to its per life limit, and ALIC Reinsurance Company, which is a special
purpose financial captive, only invested assets supporting capital and relating
to Separate Accounts remain in ALIC's other subsidiaries. All significant
intercompany transactions have been eliminated in consolidation.
OUTLOOK
- - We are pursuing strategies intended to improve our return on equity. The
strategies include continuing to proactively manage capital and focus our
product portfolio on products where we can secure market leadership and
achieve acceptable returns.
- - We will continue to manage our expenses and improve our operating
efficiency.
- - We plan to reinvigorate sales through the Allstate exclusive agencies by
further tailoring products for our customers and making it easier for our
agents to distribute our products.
- - We prioritize the allocation of fixed income investments to support sales
of products with the best sustainable growth and margins and to maintain a
market presence for fixed annuity and life products in our retail
distribution channels. Our institutional products remain opportunistic.
23
<Page>
INVESTMENTS
An important component of our financial results is the return on our
investment portfolio. The investment portfolio is managed based upon the nature
of the business and its corresponding liability structure.
OVERVIEW AND STRATEGY The investment strategy focuses on the need for
risk-adjusted spread on the underlying liabilities while maximizing return on
capital. We believe investment spread is maximized by selecting assets that
perform favorably on a long-term basis and by disposing of certain assets to
minimize the effect of downgrades and defaults. We believe this strategy
maintains the investment margin necessary to sustain income over time. The
portfolio management approach employs a combination of recognized market,
analytical and proprietary modeling, including a strategic asset allocation
model, as the primary basis for the allocation of interest sensitive, illiquid
and credit assets as well as for determining overall below investment grade
exposure and diversification requirements. Within the ranges set by the
strategic asset allocation model, tactical investment decisions are made in
consideration of prevailing market conditions. As a result of tactical
decisions, we may sell securities during the period in which fair value has
declined below amortized cost for fixed income securities or cost for equity
securities. Portfolio reviews, which include identifying securities that are
other than temporarily impaired and recognizing impairment on securities in an
unrealized loss position for which we do not have the intent and ability to hold
until recovery, are conducted regularly. For more information, see the Portfolio
Monitoring section of the MD&A.
PORTFOLIO COMPOSITION The composition of the investment portfolio at December
31, 2005 is presented in the table below. Also see Notes 2 and 6 to the
consolidated financial statements for investment accounting policies and
additional information.
<Table>
<Caption>
PERCENT TO
(IN MILLIONS) INVESTMENTS TOTAL
------------ ------------
Fixed income securities(1) $ 61,977 85.2%
Mortgage loans 8,108 11.1
Equity securities 324 0.4
Short-term 927 1.3
Policy loans 729 1.0
Other 691 1.0
------------ ------------
Total $ 72,756 100.0%
============ ============
</Table>
(1) Fixed income securities are carried at fair value. Amortized cost
basis for these securities was $59.72 billion.
Total investments increased to $72.76 billion at December 31, 2005 from
$69.69 billion at December 31, 2004, primarily due to positive cash flows from
operating and financing activities, partially offset by decreased unrealized
capital gains on fixed income securities.
Total investments at amortized cost related to collateral received in
connection with securities lending activities, funds received in connection with
securities repurchase agreements, and collateral posted by counterparties
related to derivative transactions decreased to $2.23 billion at December 31,
2005, from $2.93 billion at December 31, 2004.
We use different methodologies to estimate the fair value of publicly and
non-publicly traded marketable investment securities and exchange traded and
non-exchange traded derivative contracts. For a discussion of these methods, see
the Application of Critical Accounting Policies section of the MD&A.
24
<Page>
The following table shows total investments, categorized by the method used
to determine fair value at December 31, 2005.
<Table>
<Caption>
DERIVATIVE
INVESTMENTS CONTRACTS
------------------------- -----------
(IN MILLIONS) CARRYING PERCENT FAIR
VALUE TO TOTAL VALUE
----------- ----------- -----------
Fair value based on independent market quotations $ 49,859 68.5% $ 68
Fair value based on models and other valuation methods 12,678 17.4 705
Mortgage loans, policy loans, certain limited
partnership and other investments, valued at cost,
amortized cost and the equity method 10,219 14.1 --
----------- ----------- -----------
Total $ 72,756 100.0% $ 773
=========== =========== ===========
</Table>
FIXED INCOME SECURITIES See Note 6 of the consolidated financial statements for
a table showing the amortized cost, unrealized gains, unrealized losses and fair
value for each type of fixed income security for the years ended December 31,
2005 and 2004.
Municipal bonds, including tax-exempt and taxable securities, totaled $4.44
billion, all of which were rated investment grade at December 31, 2005.
Approximately 55.4% of the municipal bond portfolio was insured by six bond
insurers and accordingly have a Moody's equivalent rating of Aaa or Aa. The
municipal bond portfolio at December 31, 2005 consisted of approximately 250
issues from approximately 208 issuers. The largest exposure to a single issuer
was approximately 5.2% of the municipal bond portfolio. Corporate entities were
the ultimate obligors of approximately 19.1% of the municipal bond portfolio.
Corporate bonds totaled $34.38 billion and 91.7% were rated investment
grade at December 31, 2005. As of December 31, 2005, the portfolio contained
$16.31 billion of privately placed corporate obligations, 47.5% of the total
corporate obligations in the portfolio, compared with $15.82 billion at December
31, 2004. Approximately $14.35 billion or 87.9% of the privately placed
corporate obligations consisted of fixed rate privately placed securities. The
benefits of fixed rate privately placed securities when compared to publicly
issued securities are generally higher yields, improved cash flow predictability
through pro-rata sinking funds, and a combination of covenant and call
protection features designed to better protect the holder against losses
resulting from credit deterioration, reinvestment risk or fluctuations in
interest rates. A disadvantage of fixed rate privately placed securities when
compared to publicly issued securities is relatively reduced liquidity. At
December 31, 2005, 89.7% of privately placed securities were rated investment
grade.
Foreign government securities totaled $2.10 billion and 93.7% were rated
investment grade at December 31, 2005.
Mortgage-backed securities ("MBS") totaled $5.69 billion at December 31,
2005, all of which were investment grade. Approximately 61.9% of the MBS
portfolio consists of securities that were issued by, or have underlying
collateral that is guaranteed by U.S. government agencies or U.S. government
sponsored entities. For the remaining portion of the portfolio not guaranteed by
U.S. government agencies or entities, approximately 89.6% had a Moody's rating
of Aaa or a Standard & Poor's ("S&P") rating of AAA, the highest rating
category. The MBS portfolio is subject to interest rate risk since price
volatility and the ultimate realized yield are affected by the rate of
prepayment of the underlying mortgages.
Commercial mortgage-backed securities ("CMBS") totaled $6.73 billion at
December 31, 2005. CMBS investments primarily represent pools of commercial
mortgages, broadly diversified across property types and geographical area. The
CMBS portfolio is subject to credit risk, but unlike other structured products,
is generally not subject to prepayment risk due to protections within the
underlying commercial mortgages, whereby borrowers are effectively restricted
from prepaying their mortgages due to changes in interest rates. Credit defaults
can result in credit directed prepayments. Approximately 82.9% of the CMBS
portfolio had a Moody's rating of Aaa or a Standard & Poor's rating of AAA, the
highest rating category, at December 31, 2005.
25
<Page>
Asset-backed securities ("ABS") totaled $5.12 billion at December 31, 2005.
Our ABS portfolio is subject to credit and interest rate risk. Credit risk is
managed by monitoring the performance of the collateral. In addition, many of
the securities in the ABS portfolio are credit enhanced with features such as
over-collateralization, subordinated structures, reserve funds, guarantees
and/or insurance. Approximately 56.2% of the ABS portfolio had a Moody's rating
of Aaa or a Standard & Poor's ("S&P") rating of AAA, the highest rating
category. A portion of the ABS portfolio is also subject to interest rate risk
since, for example, price volatility and ultimate realized yield are affected by
the rate of prepayment of the underlying assets. The ABS portfolio includes
collateralized debt obligations and other bonds that are secured by a variety of
asset types, predominately home equity loans, credit card receivables and auto
loans.
At December 31, 2005, 94.9% of the fixed income securities portfolio was
rated investment grade, which is defined as a security having a rating from the
National Association of Insurance Commissioners ("NAIC") of 1 or 2; a rating of
Aaa, Aa, A or Baa from Moody's, or a rating of AAA, AA, A or BBB from S&P, Fitch
or Dominion; or a comparable internal rating if an externally provided rating is
not available.
The following table summarizes the credit quality of the fixed income
securities portfolio at December 31, 2005.
(IN MILLIONS)
<Table>
<Caption>
NAIC MOODY'S FAIR PERCENT
RATING EQUIVALENT VALUE TO TOTAL
------ ---------- ----- --------
1 Aaa/Aa/A $ 42,039 67.8%
2 Baa 16,809 27.1
3 Ba 2,177 3.5
4 B 801 1.3
5 Caa or lower 59 0.1
6 In or near default 92 0.2
--------- ------
Total $ 61,977 100.0%
========= ======
</Table>
EQUITY SECURITIES Equity securities include limited partnership investments,
non-redeemable preferred stocks and common stocks. The equity securities
portfolio was $324 million at December 31, 2005 compared to $214 million at
December 31, 2004. Investments in limited partnership interests had a carrying
value of $257 million and $172 million at December 31, 2005 and 2004,
respectively. Non-redeemable preferred and common stocks had a carrying value of
$67 million and $42 million, and cost of $62 million and $33 million at December
31, 2005 and 2004, respectively. Gross unrealized gains on common stocks and
non-redeemable preferred stocks totaled $6 million at December 31, 2005 compared
to $9 million at December 31, 2004. Gross unrealized losses totaled $1 million
at December 31, 2005. There were no unrealized losses at December 31, 2004.
26
<Page>
UNREALIZED GAINS AND LOSSES See Note 6 of the consolidated financial statements
for further disclosures regarding unrealized losses on fixed income and equity
securities and factors considered in determining whether the securities are not
other than temporarily impaired. The unrealized net capital gains on fixed
income and equity securities at December 31, 2005 totaled $2.27 billion, a
decrease of $1.08 billion since December 31, 2004. Gross unrealized gains and
losses on fixed income securities are provided in the table below.
<Table>
<Caption>
GROSS UNREALIZED
AMORTIZED -------------------- FAIR
(IN MILLIONS) COST GAINS LOSSES VALUE
--------- ----- ------ -----
AT DECEMBER 31, 2005
Corporate:
Consumer goods $ 5,600 $ 121 $ (57) $ 5,664
Utilities 5,350 420 (22) 5,748
Banking 4,704 139 (34) 4,809
Financial services 3,944 66 (39) 3,971
Capital goods 3,420 92 (28) 3,484
Communications 2,495 83 (19) 2,559
Basic industry 2,099 56 (21) 2,134
Energy 1,990 65 (13) 2,042
Other 1,714 83 (17) 1,780
Transportation 1,598 72 (19) 1,651
Technology 523 19 (4) 538
----------- ----------- ----------- -----------
Total corporate fixed income portfolio 33,437 1,216 (273) 34,380
U.S. government and agencies 2,639 850 (2) 3,487
Municipal 4,291 167 (15) 4,443
Foreign government 1,727 374 (2) 2,099
Mortgage-backed securities 5,742 29 (78) 5,693
Commercial mortgage-backed securities 6,745 50 (63) 6,732
Asset-backed securities 5,114 32 (28) 5,118
Redeemable preferred stock 22 3 -- 25
----------- ----------- ----------- -----------
Total fixed income securities $ 59,717 $ 2,721 $ (461) $ 61,977
=========== =========== =========== ===========
</Table>
The consumer goods, financial services, banking and capital goods sectors
had the highest concentration of gross unrealized losses in our corporate fixed
income securities portfolio at December 31, 2005. The gross unrealized losses in
these sectors were primarily company specific and interest rate related.
Approximately $22 million of the total gross unrealized losses in the corporate
fixed income portfolio were associated with the automobile industry, which
includes direct debt issuances of automobile manufacturers, captive automotive
financing companies and automobile parts and equipment suppliers, which are
reported above in the consumer goods and financial services sectors. Fixed
income security values in the automobile industry were primarily depressed due
to company specific conditions. Additionally, approximately $2 million of the
total gross unrealized losses in the corporate fixed income portfolio and $7
million of the total gross unrealized losses in the asset-backed securities
portfolio were associated with the airline industry for which values were
depressed due to company or issue specific conditions and economic issues,
including fuel costs. All securities in an unrealized loss position at December
31, 2005 were included in our portfolio monitoring process wherein it was
determined that the declines in value were not other than temporary.
27
<Page>
The following table shows the composition by credit quality of the fixed
income securities with gross unrealized losses at December 31, 2005.
(IN MILLIONS)
<Table>
<Caption>
NAIC MOODY'S UNREALIZED PERCENT FAIR PERCENT
RATING EQUIVALENT LOSS TO TOTAL VALUE TO TOTAL
------ ---------- ---- -------- ----- --------
1 Aaa/Aa/A $ (292) 63.3% $ 16,599 71.7%
2 Baa (134) 29.1 5,831 25.2
3 Ba (20) 4.3 561 2.4
4 B (15) 3.3 135 0.6
5 Caa or lower -- -- 7 --
6 In or near default -- -- 15 0.1
------ ------ -------- ------
Total $ (461) 100.0% $ 23,148 100.0%
====== ====== ======== ======
</Table>
The table above includes 48 securities that have not yet received an NAIC
rating, for which we have assigned a comparable internal rating, with a fair
value totaling $560 million and an unrealized loss of $12 million. Due to lags
between the funding of an investment, processing of final legal documents,
filing with the Securities Valuation Office ("SVO") of the NAIC, and rating by
the SVO, we will always have a small number of securities that have a pending
rating.
At December 31, 2005, $426 million, or 92.4%, of the gross unrealized
losses were related to investment grade fixed income securities. Unrealized
losses on investment grade securities principally relate to changes in interest
rates or changes in sector-related credit spreads since the securities were
acquired.
As of December 31, 2005, $35 million of the gross unrealized losses were
related to below investment grade fixed income securities. Of this amount, 20%
were in a significant unrealized loss position (greater than or equal to 20% of
amortized cost) for six or more consecutive months prior to December 31, 2005.
Included among the securities rated below investment grade are both public and
privately placed high-yield bonds and securities that were investment grade when
originally acquired. We mitigate the credit risk of investing in below
investment grade fixed income securities by limiting the percentage of our fixed
income portfolio invested in such securities, through diversification of the
portfolio, and active credit monitoring and portfolio management.
The scheduled maturity dates for fixed income securities in an unrealized
loss position at December 31, 2005 are shown below. Actual maturities may differ
from those scheduled as a result of prepayments by the issuers.
<Table>
<Caption>
UNREALIZED PERCENT FAIR PERCENT
(IN MILLIONS) LOSS TO TOTAL VALUE TO TOTAL
---- -------- ----- --------
Due in one year or less $ (1) 0.2% $ 144 0.6%
Due after one year through five years (74) 16.1 3,904 16.9
Due after five years through ten years (166) 36.0 7,547 32.6
Due after ten years (114) 24.7 5,751 24.8
Mortgage- and asset- backed securities(1) (106) 23.0 5,802 25.1
----------- ----------- ----------- -----------
Total $ (461) 100.0% $ 23,148 100.0%
=========== =========== =========== ===========
</Table>
- ----------
(1) Because of the potential for prepayment, mortgage- and asset-backed
securities are not categorized based on their contractual maturities.
28
<Page>
PORTFOLIO MONITORING We have a comprehensive portfolio monitoring process
to identify and evaluate, on a case by case basis, fixed income and equity
securities for which carrying value may be other than temporarily impaired. The
process includes a quarterly review of all securities using a screening process
to identify those securities for which fair value compared to amortized cost for
fixed income securities or cost for equity securities is below established
thresholds for certain time periods, or which are identified through other
monitoring criteria such as ratings downgrades or payment defaults. The
securities identified, in addition to other securities for which we may have a
concern, are evaluated based on facts and circumstances for inclusion on our
watch-list. As a result of approved programs involving the disposition of
investments such as changes in duration and revisions to strategic asset
allocations, and certain dispositions anticipated by portfolio managers, we also
conduct a portfolio review to recognize impairment on securities in an
unrealized loss position for which we do not have the intent and ability to hold
until recovery. All securities in an unrealized loss position at December 31,
2005 were included in our portfolio monitoring process wherein it was determined
that the declines in value were not other than temporary.
The following table summarizes fixed income and equity securities in a
gross unrealized loss position according to significance, aging and investment
grade classification.
<Table>
<Caption>
December 31, 2005
----------------------------------------------------
Fixed Income
------------------------
Below
Investment Investment
(in millions except number of issues) Grade Grade Equity Total
---------- ---------- ---------- ----------
Category (i): Unrealized loss less than 20%
of cost (1)
Number of Issues 2,558 144 2 2,704
Fair Value $ 22,393 $ 705 $ 9 $ 23,107
Unrealized $ (416) $ (27) $ (1) $ (444)
Category (ii): Unrealized loss greater than
or equal to 20% of cost for a period of
less than 6 consecutive months (1)
Number of Issues 6 2 - 8
Fair Value $ 37 $ 6 $ - $ 43
Unrealized $ (10) $ (1) $ - $ (11)
Category (iii): Unrealized loss greater than
or equal to 20% of cost for a period of 6
or more consecutive months, but less than
12 consecutive months (1)
Number of Issues - - - -
Fair Value $ - $ - $ - $ -
Unrealized $ - $ - $ - $ -
Category (iv): Unrealized loss greater than
or equal to 20% of cost for twelve or more
consecutive months (1)
Number of Issues - 2 - 2
Fair Value $ - $ 7 $ - $ 7
Unrealized $ - $ (7) $ - $ (7)
---------- ---------- ---------- ----------
Total Number of Issues 2,564 148 2 2,714
========== ========== ========== ==========
Total Fair Value $ 22,430 $ 718 $ 9 $ 23,157
========== ========== ========== ==========
Total Unrealized Losses $ (426) $ (35) $ (1) $ (462)
========== ========== ========== ==========
<Caption>
December 31, 2004
----------------------------------------------------
Fixed Income
------------------------
Below
Investment Investment
(in millions except number of issues) Grade Grade Equity Total
---------- ---------- ---------- ----------
Category (i): Unrealized loss less than 20%
of cost (1)
Number of Issues 1,232 80 - 1,312
Fair Value $ 9,794 $ 499 $ - $ 10,293
Unrealized $ (131) $ (20) $ - $ (151)
Category (ii): Unrealized loss greater than
or equal to 20% of cost for a period of
less than 6 consecutive months (1)
Number of Issues 1 2 - 3
Fair Value $ - $ 2 $ - $ 2
Unrealized $ - $ (1) $ - $ (1)
Category (iii): Unrealized loss greater than
or equal to 20% of cost for a period of 6
or more consecutive months, but less than
12 consecutive months (1)
Number of Issues - 1 - 1
Fair Value $ - $ 7 $ - $ 7
Unrealized $ - $ (3) $ - $ (3)
Category (iv): Unrealized loss greater than
or equal to 20% of cost for twelve or more
consecutive months (1)
Number of Issues - 3 - 3
Fair Value $ - $ 12 $ - $ 12
Unrealized $ - $ (8) $ - $ (8)
---------- ---------- ---------- ----------
Total Number of Issues 1,233 86 - 1,319
========== ========== ========== ==========
Total Fair Value $ 9,794 $ 520 $ - $ 10,314
========== ========== ========== ==========
Total Unrealized Losses $ (131) $ (32) $ - $ (163)
========== ========== ========== ==========
</Table>
- ----------
(1) For fixed income securities, cost represents amortized cost.
The largest individual unrealized loss was $4 million for category (i), $5
million for category (ii) and $4 million for category (iv) as of December 31,
2005.
Categories (i) and (ii) have generally been adversely affected by overall
economic conditions including interest rate increases and the market's
evaluation of certain sectors. The degree to which and/or length of time that
the securities have been in an unrealized loss position does not suggest that
these securities pose a high risk of being other than temporarily impaired.
Categories (iii) and (iv) have primarily been adversely
29
<Page>
affected by industry and issue specific conditions. All of the securities in
these categories are monitored for impairment. We expect that the fair values of
these securities will recover over time.
Whenever our initial analysis indicates that a fixed income security's
unrealized loss of 20% or more for at least 36 months or any equity security's
unrealized loss of 20% or more for at least 12 months is temporary, additional
evaluations and management approvals are required to substantiate that a
write-down is not appropriate. As of December 31, 2005, one security with an
unrealized loss of $3 million met these criteria.
The following table contains the individual securities with the largest
unrealized losses as of December 31, 2005. No other fixed income or equity
security had an unrealized loss greater than $3 million, or 0.6% of the total
unrealized loss on fixed income and equity securities.
<Table>
<Caption>
UNREALIZED
(IN MILLIONS) UNREALIZED FAIR NAIC LOSS
LOSS VALUE RATING CATEGORY
----------- ----------- ----------- -----------
Automotive supplier $ (5) $ 18 2 (ii)
Asset backed security (4) 4 4 (iv)
Foreign airport (4) 35 1 (i)
Paper manufacturer and distributor (3) 37 2 (i)
Asset backed security (3) 4 4 (iv)
----------- -----------
Total $ (19) $ 98
=========== ===========
</Table>
We also monitor the quality of our fixed income portfolio by categorizing
certain investments as "problem", "restructured" or "potential problem." Problem
fixed income securities are securities in default with respect to principal or
interest and/or securities issued by companies that have gone into bankruptcy
subsequent to our acquisition of the security. Restructured fixed income
securities have rates and terms that are not consistent with market rates or
terms prevailing at the time of the restructuring. Potential problem fixed
income securities are current with respect to contractual principal and/or
interest, but because of other facts and circumstances, we have concerns
regarding the borrower's ability to pay future principal and interest, which
causes us to believe these securities may be classified as problem or
restructured in the future.
The following table summarizes problem, restructured and potential problem
fixed income securities at December 31.
<Table>
<Caption>
(IN MILLIONS) 2005 2004
----------------------------------- -------------------------------------
PERCENT OF PERCENT OF
TOTAL FIXED TOTAL FIXED
AMORTIZED FAIR INCOME AMORTIZED FAIR INCOME
COST VALUE PORTFOLIO COST VALUE PORTFOLIO
---- ----- --------- ---- ----- ---------
Problem $ 70 $ 80 0.1% $ 71 $ 71 0.1%
Restructured 4 4 -- 43 46 0.1
Potential problem 122 135 0.2 168 179 0.3
---------- ---------- ----------- ----------- ---------- -----------
Total net carrying value $ 196 $ 219 0.3% $ 282 $ 296 0.5%
========== ========== =========== =========== ========== ===========
Cumulative write-downs recognized $ 188 $ 231
========== ===========
</Table>
We have experienced a decrease in the amortized cost of fixed income
securities categorized as restructured and potential problem as of December 31,
2005 compared to December 31, 2004, primarily due to dispositions.
We evaluated each of these securities through our portfolio monitoring
process at December 31, 2005 and recorded write-downs when appropriate. We
further concluded that any remaining unrealized losses on these securities were
temporary in nature and that we have the intent and ability to hold the security
until recovery. While these balances may increase in the future, particularly if
economic conditions are unfavorable, management expects that the total amount of
securities in these categories will remain low relative to the total fixed
income securities portfolio.
30
<Page>
NET REALIZED CAPITAL GAINS AND LOSSES The following table presents the
components of realized capital gains and losses and the related tax effect for
the years ended December 31.
<Table>
<Caption>
(IN MILLIONS) 2005 2004 2003
----------- ----------- -----------
Investment write-downs $ (24) $ (81) $ (178)
Dispositions 88 129 64
Valuation of derivative instruments (105) (66) 12
Settlement of derivative instruments 60 7 18
----------- ----------- -----------
Realized capital gains and losses, pretax 19 (11) (84)
Income tax (expense) benefit (7) 3 30
----------- ----------- -----------
Realized capital gains and losses, after-tax $ 12 $ (8) $ (54)
=========== =========== ===========
</Table>
Dispositions in the above table include sales, losses recognized in
anticipation of dispositions and other transactions such as calls and
prepayments. We may sell securities during the period in which fair value has
declined below amortized cost for fixed income securities or cost for equity
securities. In certain situations new factors such as negative developments,
subsequent credit deterioration, relative value opportunities, market liquidity
concerns and portfolio reallocations can subsequently change our previous intent
to continue holding a security.
Included in investment write-downs were $11 million of realized losses
related to airline industry holdings. For the year ended December 31, 2005,
dispositions included net realized gains on sales of $155 million and losses
recorded in connection with anticipated dispositions of $67 million. The net
realized gains on sales were comprised of gross gains of $292 million and gross
losses of $137 million. The $137 million in gross losses primarily consisted of
$134 million from sales of fixed income securities.
A changing interest rate environment will drive changes in our portfolio
duration targets at a tactical level. A duration target and range is established
with an economic view of liabilities relative to a long-term portfolio view.
Tactical duration adjustments within management's approved ranges are
accomplished through both cash market transactions and derivative activities
that generate realized gains and losses and through new purchases. As a
component of our approach to managing portfolio duration, realized gains and
losses on derivative instruments are most appropriately considered in
conjunction with the unrealized gains and losses on the fixed income portfolio.
This approach mitigates the impacts of general interest rate changes to the
overall financial condition of the Company.
Because of an anticipated rise in interest rates, as well as changes in
existing market conditions and long-term asset return assumptions, certain
changes are planned within various portfolios. These include continued
asset-liability management strategies, on-going comprehensive reviews of our
portfolios, changes to our strategic asset allocations, and yield enhancement
strategies. Certain of the securities we identified were in an unrealized loss
position, for which we recognized $67 million of losses in anticipation of
dispositions due to a change in our intent to hold the securities until
recovery. At December 31, 2005, the fair value of the securities in these
portfolios was $190 million.
The ten largest losses from sales of individual securities for the year
ended December 31, 2005 totaled $30 million with the largest being $4 million
and the smallest being $2 million. None of the $30 million related to securities
that were in an unrealized loss position greater than or equal to 20% of
amortized cost for fixed income securities or cost for equity securities for a
period of six or more consecutive months prior to sale.
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<Page>
Our largest aggregate loss from dispositions and writedowns are shown in
the following table by issuer and its affiliates. No other issuer together with
its affiliates had an aggregated loss on dispositions and writedowns greater
than 1.4% of the total gross loss on dispositions and writedowns on fixed income
and equity securities.
<Table>
<Caption>
FAIR VALUE DECEMBER 31, NET
AT DISPOSITION LOSS ON WRITE- 2005 UNREALIZED
(IN MILLIONS) ("PROCEEDS") DISPOSITIONS(1) DOWNS HOLDINGS (2) GAIN (LOSS)
------------ --------------- ----- ------------ -----------
Automobile Manufacturer (3) $ 45 $ (20) $ -- $ 84 $ (2)
Hydro-electric Energy Company -- -- (5) 4 --
Aircraft Securitized Trust -- -- (8) 6 --
Software and Processing Solutions 16 (4) -- 18 --
State Municipal Holding 11 (3) -- 58 2
Automobile Manufacturer (3) 11 (3) -- 88 (8)
--------------- --------------- --------------- --------------- ---------------
Total $ 83 $ (30) $ (13) $ 258 $ (8)
=============== =============== =============== =============== ===============
</Table>
- ----------
(1) Dispositions include losses recognized in anticipation of dispositions.
(2) Holdings include fixed income securities at amortized cost or equity
securities at cost.
(3) Losses due to a decision to decrease our exposure to two large domestic auto
manufacturers and as a result of changing economic circumstances, including
the decline in their overall market share.
The circumstances of the above losses are considered to be company specific
and are not expected to have an effect on other holdings in our portfolio.
MORTGAGE LOANS Our mortgage loan portfolio totaled $8.11 billion at December 31,
2005 and $7.32 billion at December 31, 2004, and was comprised primarily of
loans secured by first mortgages on developed commercial real estate.
Geographical and property type diversification are key considerations used to
manage our mortgage loan risk.
We closely monitor our commercial mortgage loan portfolio on a loan-by-loan
basis. Loans with an estimated collateral value less than the loan balance, as
well as loans with other characteristics indicative of higher than normal credit
risk, are reviewed by financial and investment management at least quarterly for
purposes of establishing valuation allowances and placing loans on non-accrual
status. The underlying collateral values are based upon either discounted
property cash flow projections or a commonly used valuation method that utilizes
a one-year projection of expected annual income divided by an expected rate of
return. We had no net realized capital losses related to write-downs on mortgage
loans for the year ended December 31, 2005 and had $1 million and $4 million for
the years ended December 31, 2004 and 2003, respectively.
SHORT-TERM INVESTMENTS Our short-term investment portfolio was $927 million and
$1.44 billion at December 31, 2005 and 2004, respectively. We invest available
cash balances primarily in taxable short-term securities having a final maturity
date or redemption date of less than one year.
We also participate in securities lending, primarily as an investment yield
enhancement, with third parties such as brokerage firms. We obtain collateral in
an amount equal to 102% of the fair value of the securities and monitor the
market value of the securities loaned on a daily basis with additional
collateral obtained as necessary. The cash we receive is invested in short-term
and fixed income investments, and an offsetting liability is recorded in other
liabilities and accrued expense. At December 31, 2005, the amount of securities
lending collateral reinvested in short-term investments had a carrying value of
$178 million. This compares to $739 million at December 31, 2004.
32
<Page>
MARKET RISK
Market risk is the risk that we will incur losses due to adverse changes in
equity, interest, commodity, or currency exchange rates and prices. Our primary
market risk exposures are to changes in interest rates and equity prices,
although we also have a smaller exposure to changes in foreign currency exchange
rates.
The active management of market risk is integral to our results of
operations. We may use the following approaches to manage exposure to market
risk within defined tolerance ranges: 1) rebalancing existing asset or liability
portfolios, 2) changing the character of investments purchased in the future and
3) using derivative instruments to modify the market risk characteristics of
existing assets and liabilities or assets expected to be purchased. For a more
detailed discussion of our use of derivative financial instruments, see Note 7
to the consolidated financial statements.
OVERVIEW We generate substantial investable funds from our business. In
formulating and implementing guidelines for investing funds, we seek to earn
returns that enhance our ability to offer competitive rates and prices to
customers while contributing to attractive and stable profits and long-term
capital growth. Accordingly, our investment decisions and objectives are a
function of the underlying risks and our product profiles.
Investment policies define the overall framework for managing market and
other investment risks, including accountability and control over risk
management activities. These investment activities follow policies that have
been approved by our board of directors. These investment policies specify the
investment limits and strategies that are appropriate given our liquidity,
surplus, product profile and regulatory requirements. Executive oversight of
investment activities are conducted primarily through our board of directors and
investment committee. The asset-liability management ("ALM") policies further
define the overall framework for managing market and investment risks. ALM
focuses on strategies to enhance yields, mitigate investment risks and optimize
capital to improve profitability and returns. ALM activities follow
asset-liability policies that have been approved by our board of directors.
These ALM policies specify limits, ranges and/or targets for investments that
best meet our business objectives in light of our product liabilities.
We manage our exposure to market risk through the use of asset allocation,
duration and value-at-risk limits, through the use of simulation and, as
appropriate, through the use of stress tests. We have asset allocation limits
that place restrictions on the total funds that may be invested within an asset
class. We have duration limits on our investment portfolio and, as appropriate,
on individual components of the portfolio. These duration limits place
restrictions on the amount of interest rate risk that may be taken. Our
value-at-risk limits are intended to restrict the potential loss in fair value
that could arise from adverse movements in the fixed income, equity, and
currency markets based on historical volatilities and correlations among market
risk factors. Comprehensive day-to-day management of market risk within defined
tolerance ranges occurs as portfolio managers buy and sell within their
respective markets based upon the acceptable boundaries established by
investment policies. This day-to-day management is integrated with and informed
by the activities of the ALM organization. This integration results in a
prudent, methodical and effective adjudication of market risk and return,
conditioned by the unique demands and dynamics of our product liabilities and
supported by the application of advanced risk technology and analytics.
INTEREST RATE RISK is the risk that we will incur a loss due to adverse changes
in interest rates. This risk arises from many of our primary activities, as we
invest substantial funds in interest rate-sensitive assets and issue interest
rate-sensitive liabilities.
We manage the interest rate risk in our assets relative to the interest
rate risk in our liabilities. One of the measures used to quantify this exposure
is duration. Duration measures the price sensitivity of the assets and
liabilities to changes in interest rates. For example, if interest rates
increase 100 basis points, the fair value of an asset exhibiting a duration of 5
is expected to decrease in value by approximately 5%. At December 31, 2005, the
difference between our asset and liability duration was approximately 0.63,
compared to a 0.72 gap at December 31, 2004. A positive duration gap indicates
that the fair value of our assets is more sensitive to interest rate movements
than the fair value of our liabilities.
We seek to invest premiums, contract charges and deposits to generate
future cash flows that will fund future claims, benefits and expenses, and that
will earn stable margins across a wide variety of interest rate and economic
scenarios. In order to achieve this objective and limit interest rate risk, we
adhere to a
33
<Page>
philosophy of managing the duration of assets and related liabilities. This
philosophy may include using interest rate swaps, futures, forwards, caps and
floors to reduce the interest rate risk resulting from mismatches between
existing assets and liabilities, and financial futures and other derivative
instruments to hedge the interest rate risk of anticipated purchases and sales
of investments and product sales to customers.
We pledge and receive collateral on certain types of derivative contracts.
For futures and option contracts traded on exchanges, we have pledged securities
as margin deposits totaling $22 million as of December 31, 2005. For
over-the-counter derivative transactions involving interest rate swaps, foreign
currency swaps, interest rate caps, interest rate floor agreements, and credit
default swaps, master netting agreements are used. These agreements allow us to
net payments due for transactions covered by the agreements, and when
applicable, we are required to post collateral. As of December 31, 2005, we held
$352 million of cash pledged by counterparties as collateral for
over-the-counter instruments and did not have any collateral pledged to
counterparties.
To calculate duration gap between assets and liabilities, we project asset
and liability cash flows and calculate their net present value using a risk-free
market interest rate adjusted for credit quality, sector attributes, liquidity
and other specific risks. Duration is calculated by revaluing these cash flows
at alternative interest rates and determining the percentage change in aggregate
fair value. The cash flows used in this calculation include the expected
maturity and repricing characteristics of our derivative financial instruments,
all other financial instruments (as described in Note 7 of the consolidated
financial statements), and certain other items including interest-sensitive
liabilities and annuity liabilities. The projections include assumptions (based
upon historical market experience and our experience) that reflect the effect of
changing interest rates on the prepayment, lapse, leverage and/or option
features of instruments, where applicable. Such assumptions relate primarily to
mortgage-backed securities, collateralized mortgage obligations, municipal
housing bonds, callable municipal and corporate obligations, and fixed rate
single and flexible premium deferred annuities.
Based upon the information and assumptions we use in this duration
calculation, and interest rates in effect at December 31, 2005, we estimate that
a 100 basis point immediate, parallel increase in interest rates ("rate shock")
would decrease the net fair value of the assets and liabilities by approximately
$615 million, compared to $750 million at December 31, 2004. There are $6.34
billion of assets supporting life insurance products such as traditional and
interest-sensitive life that are not financial instruments. These assets and the
associated liabilities have not been included in the above estimate. The $6.34
billion of assets excluded from the calculation has decreased from the $6.40
billion reported at December 31, 2004 due to a decrease in the in-force account
value of interest-sensitive life products. Based on assumptions described above,
in the event of a 100 basis point immediate increase in interest rates, the
assets supporting life insurance products would decrease in value by $419
million, compared to a decrease of $383 million at December 31, 2004. The
selection of a 100 basis point immediate parallel change in interest rates
should not be construed as our prediction of future market events, but only as
an illustration of the potential effect of such an event.
To the extent that conditions differ from the assumptions we used in these
calculations, duration and rate shock measures could be significantly impacted.
Additionally, our calculations assume that the current relationship between
short-term and long-term interest rates (the term structure of interest rates)
will remain constant over time. As a result, these calculations may not fully
capture the effect of non-parallel changes in the term structure of interest
rates and/or large changes in interest rates.
EQUITY PRICE RISK is the risk that we will incur losses due to adverse changes
in the general levels of the equity markets. At December 31, 2005, we held
approximately $1 million in common stocks and $682 million in other securities
with equity risk (including primarily convertible securities, limited
partnership funds, non-redeemable preferred securities and equity-linked notes),
compared to approximately $10 million in common stocks and $619 million in other
equity investments at December 31, 2004.
At December 31, 2005, our portfolio of equity instruments had a beta of
approximately 0.63, compared to a beta of approximately 0.48 at December 31,
2004. Beta represents a widely used methodology to describe, quantitatively, an
investment's market risk characteristics relative to an index such as the
Standard & Poor's 500 Composite Price Index ("S&P 500"). Based on the beta
analysis, we estimate that if the S&P 500 decreases by 10%, the fair value of
our equity investments will decrease by approximately 6.3%. Likewise, we
estimate that if the S&P 500 increases by 10%, the fair value of our equity
investments will increase by approximately 6.3%. Based upon the information and
assumptions we used to calculate
34
<Page>
beta at December 31, 2005, we estimate that an immediate decrease in the S&P 500
of 10% would decrease the net fair value of our equity investments identified
above by approximately $43 million, compared to $30 million at December 31,
2004. The selection of a 10% immediate decrease in the S&P 500 should not be
construed as our prediction of future market events, but only as an illustration
of the potential effect of such an event.
The beta of our equity investments was determined by comparing the monthly
total returns of the equity investments to monthly total returns of the S&P 500
over a three-year historical period. Since beta is historically based,
projecting future price volatility using this method involves an inherent
assumption that historical volatility and correlation relationships between
stocks will not change in the future. Therefore, the illustrations noted above
may not reflect our actual experience if future volatility and correlation
relationships differ from the historical relationships.
At December 31, 2005 and 2004, we had separate accounts assets related to
variable annuity and variable life contracts with account values totaling $15.24
billion and $14.38 billion, respectively. We earn contract charges as a
percentage of these account values. In the event of an immediate decline of 10%
in the account values due to equity market declines, we would have earned
approximately $25 million and $24 million less in fee income at December 31,
2005 and December 31, 2004, respectively.
Variable annuity contracts have a GMDB and customers may have chosen to
purchase an enhanced GMDB, a guaranteed minimum income benefit ("GMIB") from
1998 to December 31, 2003, a TrueReturn4 guaranteed minimum accumulation benefit
("GMAB") beginning in 2004, and a SureIncome4 guaranteed minimum withdrawal
benefit ("GMWB") beginning in 2005. These guarantees subject us to additional
equity market risk because the beneficiary or contractholder may receive a
benefit that is greater than their corresponding account value. GMDBs are
payable upon death. GMIBs may be exercised on or after the tenth-year
anniversary (not prior to 2008) of the contract if the contractholder elects to
receive a defined stream of payments ("annuitize"). GMABs are credited to the
contractholder account on a contract anniversary date that is pre-determined by
the contractholder, between the eighth and twentieth year after contract issue
(not prior to 2012). GMABs guarantee an account value of up to 2.5 times (or
250%) of the amount deposited in the contract, depending on the amount of time
the contract is in force and adherence to certain fund allocation requirements.
GMWBs may be payable if the contractholder elects to take partial withdrawals.
GMWBs guarantee that the contractholder can take annual partial withdrawals up
to 8% of the amount deposited in the contract until their withdrawals total the
initial deposit.
In January 2004, we established reserves for GMDBs and GMIBs in conjunction
with the adoption of SOP 03-1. Because of this change in accounting, guarantee
payments are now recognized over future periods rather than expensed as paid.
For more details about this adopted accounting guidance and the calculation of
the related reserves see Notes 2 and 8 of the consolidated financial statements.
At December 31, 2005 and 2004, the guaranteed value of the death benefits
in excess of account values was estimated to be $1.52 billion and $1.90 billion,
respectively, net of reinsurance. The decrease in this estimate between periods
is attributable to improved equity markets during 2005 and customer surrenders
of contracts with in-the-money GMDBs. In both periods, approximately half of
this exposure is related to the return of deposits guarantee, while the
remaining half is attributable to a death benefit guarantee greater than the
original deposits. In addition to reinsurance for a portion of these benefits,
we entered into various derivative instruments beginning in 2003 to offset the
risk of future death claims on substantially all new business issued on or after
January 1, 2003. A similar program was established for GMABs in 2004 and for
GMWBs in 2005.
In the event of an immediate decline in account values of 10% due to equity
market declines, payments for guaranteed death benefits at December 31, 2005
would increase by an estimated $15 million in 2006. These payments would be
charged against the related reserve rather than directly to earnings as paid.
Contributions to the reserve for GMDBs would increase by a nominal amount in
2006 in the event of an immediate 10% decline in account values. The selection
of a 10% immediate decrease should not be construed as our prediction of future
market events, but only as an example to illustrate the potential effect on
earnings and cash flow of equity market declines as a result of this guarantee.
Also, our actual payment experience in the future may not be consistent with the
assumptions used in the model.
GMIB contracts that we sold provide the contractholder with the right to
annuitize based on the highest account value at any anniversary date or on a
guaranteed earnings rate based on the initial account value over the specified
period. The guaranteed income benefit feature was first offered in our variable
annuity products beginning in 1998, with guaranteed benefits available for
election by contractholders ten years after issue. Accordingly, the earliest
date at which benefits could become payable is 2008. Therefore, in
35
<Page>
the event of an immediate decline of 10% in contractholders' account values as
of December 31, 2005 due to equity market declines, contributions to the reserve
would be reduced by approximately $1 million in 2006. The selection of a 10%
immediate decrease should not be construed as our prediction of future market
events, but only as an example to illustrate the potential effect on earnings
and cash flow of equity market declines as a result of this guarantee.
In the event of an immediate decline of 10% in GMAB and GMWB
contractholders' account values as of December 31, 2005, due to equity market
declines, there would be no net impact on our earnings because these benefits
are hedged, however the reserve for GMABs and GMWBs would be increased by
approximately $10 million and $2 million, respectively.
In addition to our GMDB, GMIB and GMAB equity risk, at December 31, 2005
and 2004 we had approximately $2.72 billion and $2.02 billion, respectively, in
equity-indexed annuity liabilities that provide customers with interest
crediting rates based on the performance of the S&P 500. We hedge the equity
risk associated with these liabilities through the purchase and sale of
equity-indexed options and futures, swap futures, and Eurodollar futures,
maintaining risk within specified value-at-risk limits.
We are also exposed to equity risk in DAC. Fluctuations in the value of the
variable annuity and life contract account values due to the equity market
affect DAC amortization, because the expected fee income and guaranteed benefits
payable are components of the EGP for variable annuity and life contracts. For a
more detailed discussion of DAC, see Note 2 of the consolidated financial
statements and the Application of Critical Accounting Policies section of the
MD&A.
FOREIGN CURRENCY EXCHANGE RATE RISK is the risk that we will incur economic
losses due to adverse changes in foreign currency exchange rates. This risk
primarily arises from our foreign equity and real estate investments. We also
have funding agreement programs and a small amount of fixed income securities
that are denominated in foreign currencies, but we use derivatives to
effectively hedge the foreign currency risk of these funding agreements and
securities. At December 31, 2005 and 2004, we had approximately $1.17 billion
and $1.22 billion, respectively, in funding agreements denominated in foreign
currencies.
At December 31, 2005, we had approximately $9 million in foreign currency
denominated equity securities, compared to $4 million at December 31, 2004.
Based upon the information and assumptions we used at December 31, 2005, we
estimate that a 10% immediate unfavorable change in each of the foreign currency
exchange rates that we are exposed to would decrease the value of our foreign
currency denominated instruments by approximately $0.9 million, compared with an
estimated $0.4 million decrease at December 31, 2004. The selection of a 10%
immediate decrease in all currency exchange rates should not be construed as our
prediction of future market events, but only as an illustration of the potential
effect of such an event. Our currency exposure is diversified across 17
countries, compared to 11 countries at December 31, 2004. Our largest individual
currency exchange exposures at December 31, 2005 were to the Mexican Peso
(38.0%) and the Japanese Yen (14.5%). The largest individual currency exchange
exposures at December 31, 2004 were to the Euro (56%) and the British pound
(16%). Our primary regional exposure is to Central America, approximately 38% at
December 31, 2005, compared to 80% in Western Europe at December 31, 2004.
The modeling technique we use to report our currency exposure does not take
into account correlation among foreign currency exchange rates. Even though we
believe it is very unlikely that all of the foreign currency exchange rates that
we are exposed to would simultaneously decrease by 10%, we nonetheless stress
test our portfolio under this and other hypothetical extreme adverse market
scenarios. Our actual experience may differ from these results because of
assumptions we have used or because significant liquidity and market events
could occur that we did not foresee.
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CAPITAL RESOURCES AND LIQUIDITY
CAPITAL RESOURCES consist of shareholder's equity and debt, representing
funds deployed or available to be deployed to support business operations. The
following table summarizes our capital resources at December 31.
<Table>
<Caption>
(IN MILLIONS) 2005 2004 2003
----------- ----------- -----------
Redeemable preferred stock $ 5 $ 5 $ 82
Common stock, retained income and other
shareholder's equity items 5,415 5,291 5,294
Accumulated other comprehensive income 588 1,013 1,053
----------- ----------- -----------
Total shareholder's equity 6,008 6,309 6,429
Debt 181 104 45
----------- ----------- -----------
Total capital resources $ 6,189 $ 6,413 $ 6,474
=========== =========== ===========
</Table>
SHAREHOLDER'S EQUITY declined in 2005 due to lower unrealized net capital
gains on fixed income securities and dividends, partially offset by net income.
The Company paid dividends of $260 million to Allstate Insurance Company ("AIC",
the Company's parent) in 2005. In addition, a dividend of $16 million was
recorded in connection with the purchase of fixed income securities from AIC and
a non-cash dividend of $15 million was recorded as a result of the settlement of
certain reinsurance transactions with an unconsolidated affiliate (see Note 5 to
the Consolidated Financial Statements).
Shareholder's equity decreased in 2004 primarily due to dividends paid to
AIC and the reclassification of a portion of redeemable preferred stock to
long-term debt, partially offset by net income. In addition, a capital
contribution was recorded in conjunction with certain reinsurance transactions.
DEBT increased $77 million in 2005, primarily as a result of the issuance
of surplus notes totaling $100 million by ALIC Reinsurance Company ("ALIC Re"),
a wholly owned subsidiary of ALIC (see Note 5 to the Consolidated Financial
Statements), partially offset by the redemption of $25 million of mandatorily
redeemable preferred stock.
Debt increased $59 million in 2004 primarily as a result of the
reclassification of a portion of redeemable preferred stock to long-term debt
from Shareholder's equity. The reclassification occurred as a result of changes
to the contractual arrangements between us and the holder of the stock, which
resulted in the stock becoming mandatorily redeemable. As of December 31, 2003,
the balance of the stock subject to the reclassification was $77 million. During
2004, $20 million of this stock was redeemed.
FINANCIAL RATINGS AND STRENGTH The following table summarizes our financial
strength ratings at December 31, 2005.
<Table>
<Caption>
RATING AGENCY RATING
------------- ------
Moody's Investors Service, Inc. Aa2 ("Excellent")
Standard & Poor's Ratings Services AA ("Very Strong")
A.M. Best Company, Inc. A+ ("Superior")
</Table>
Our ratings are influenced by many factors including our operating and
financial performance, asset quality, liquidity, asset/liability management,
overall portfolio mix, financial leverage (i.e., debt), risk exposures,
operating leverage, AIC's ratings and other factors.
State laws specify regulatory actions if an insurer's risk-based capital
("RBC"), a measure of an insurer's solvency, falls below certain levels. The
NAIC has a standard formula for annually assessing RBC. The formula for
calculating RBC for life insurance companies takes into account factors relating
to insurance, business, asset and interest rate risks. At December 31, 2005, our
RBC and the RBC for each of our insurance companies was above levels that would
require regulatory actions.
The NAIC has also developed a set of financial relationships or tests known
as the Insurance Regulatory Information System to assist state regulators in
monitoring the financial condition of insurance companies and identifying
companies that require special attention or actions by insurance regulatory
authorities. The NAIC analyzes financial data provided by insurance companies
using prescribed ratios, each with defined "usual ranges". Generally, regulators
will begin to monitor an insurance company if its
37
<Page>
ratios fall outside the usual ranges for four or more of the ratios. If an
insurance company has insufficient capital, regulators may act to reduce the
amount of insurance it can issue. The ratios of our insurance companies are
within these ranges.
LIQUIDITY SOURCES AND USES Our potential sources of funds principally include
the following activities.
- Receipt of insurance premiums
- Contractholder fund deposits
- Reinsurance recoveries
- Receipts of principal, interest and dividends on investments
- Sales of investments
- Funds from investment repurchase agreements, securities lending,
dollar roll and lines of credit agreements
- Inter-company loans
- Capital contributions from parent
- Dividends from subsidiaries
Our potential uses of funds principally include the following activities.
- Payment of contract benefits, maturities, surrenders and withdrawals
- Reinsurance cessions and payments
- Operating costs and expenses
- Purchase of investments
- Repayment of investment repurchase agreements, securities lending,
dollar roll and lines of credit agreements
- Payment or repayment of inter-company loans
- Capital contributions to subsidiaries
- Tax payments/settlements - Dividends to parent
As reflected in our Consolidated Statements of Cash Flows, higher operating
cash flows in 2005, compared to 2004, primarily related to higher investment
income, partially offset by lower premiums. Lower cash flows from operating
activities in 2004, compared to 2003, were primarily due to lower premium
collections and higher deferrable expenses paid, partially offset by lower
policy and contract benefits paid and higher interest received on fixed income
securities and mortgage loans.
Cash flows used in investing activities decreased in 2005 due to lower cash
provided by financing activities in 2005, compared to 2004, increased proceeds
from sales of securities and higher investment collections, partially offset by
the investment of higher operating cash flows. Cash flows used in investing
activities increased in 2004 compared to 2003 as the investment of higher
financing cash flows was partially offset by lower operating cash flow.
Lower cash flows provided by financing activities in 2005, compared to
2004, were primarily due to higher surrenders of market value adjusted
annuities, lower deposits on fixed annuities and institutional products, and
increased maturities of institutional products. Increased cash flows from
financing activities in 2004, compared to 2003, were primarily attributable to
higher deposits of fixed annuities and institutional products, partially offset
by fixed annuity withdrawals and institutional product maturities.
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<Page>
A portion of our product portfolio, primarily fixed annuity and
interest-sensitive life insurance products, is subject to surrender and
withdrawal at the discretion of contractholders. The following table summarizes
our liabilities for these products by their contractual withdrawal provisions at
December 31, 2005. Approximately 14.5% of these liabilities are subject to
discretionary withdrawal without adjustment.
<Table>
<Caption>
(IN MILLIONS) 2005
-----------
Not subject to discretionary withdrawal $ 16,256
Subject to discretionary withdrawal with adjustments:
Specified surrender charges(1) 23,771
Market value (2) 9,729
Subject to discretionary withdrawal without adjustments 8,434
-----------
Total contractholder funds $ 58,190
===========
</Table>
- ----------
(1) Includes $7.78 billion of liabilities with a contractual
surrender charge of less than 5% of the account balance.
(2) Approximately $8.61 billion of the contracts with market value
adjusted surrenders have a 30-45 day period during which there
is no surrender charge or market value adjustment, including
approximately $1.60 billion of market-value adjusted annuities
with a period commencing during 2006.
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, our cash flow could vary due to higher
surrender of policies exiting their surrender charge periods.
We have entered into an intercompany loan agreement with the Corporation.
The amount of intercompany 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 intercompany loan agreement at
December 31, 2005 or 2004. The Corporation uses commercial paper borrowings and
bank lines of credit to fund intercompany borrowings.
The Corporation has established external sources of short-term liquidity
that include a commercial paper program, lines-of-credit, dollar rolls and
repurchase agreements. In the aggregate, at December 31, 2005, these sources
could provide over $3.48 billion of additional liquidity. For additional
liquidity, we can also issue new insurance contracts, incur additional debt and
sell assets from our investment portfolio. The liquidity of our investment
portfolio varies by type of investment. For example, $16.31 billion of privately
placed corporate obligations that represent 22.4% of the investment portfolio,
and $8.11 billion of mortgage loans that represent 11.1% of the investment
portfolio, generally are considered to be less liquid than many of our other
types of investments, such as our U.S. government and agencies, municipal and
public corporate fixed income security portfolios.
We have access to additional borrowing to support liquidity through the
Corporation as follows:
- A commercial paper program with a borrowing limit of $1.00 billion to cover
short-term cash needs. As of December 31, 2005, the remaining borrowing
capacity was $587 million; however, the outstanding balance fluctuates
daily.
- A five-year revolving credit facility expiring in 2009 totaling $1.00
billion to cover short-term liquidity requirements. This facility contains
an increase provision that would make up to an additional $500 million
available for borrowing provided the increased portion could be fully
syndicated at a later date among existing or new lenders. Although the
right to borrow under the facility is not subject to a minimum rating
requirement, the costs of maintaining the facility and borrowing under it
are based on the ratings of our senior, unsecured, nonguaranteed long-term
debt. There were no borrowings under this line of credit during 2005. The
total amount outstanding at any point in time under the combination of the
commercial paper program and the credit facility cannot exceed the amount
that can be borrowed under the credit facility.
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<Page>
- The capacity of the Corporation to issue up to an additional $1.35 billion
of debt securities, equity securities, warrants for debt and equity
securities, trust preferred securities, stock purchase contracts and stock
purchase units utilizing the shelf registration statement filed with the
SEC in August 2003.
The Corporation's only financial covenant exists with respect to its
primary credit facility and its synthetic lease VIE obligations. The covenant
requires that the Corporation not exceed a 37.5% debt to capital resources
ratio as defined in the agreements. This ratio at December 31, 2005 was
21.5%.
We closely monitor and manage our liquidity through long- and short-term
planning that is integrated throughout our underwriting and investment
operations. We manage the duration of assets and related liabilities through
our ALM organization, using a dynamic process that addresses liquidity
utilizing the investment portfolio, and components of the portfolio as
appropriate, which is routinely subjected to stress testing. We also have
access to funds from the Corporation's commercial paper program.
Certain remote events and circumstances could constrain our or 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, A+ and a (from Moody's, Standard &
Poor's and A.M. Best, respectively) to non-investment grade status of below
Baa3/BBB-/bb, 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 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 our
individually rated entities, therefore, a rating change in one entity could
potentially affect the ratings of other related entities.
40
<Page>
CONTRACTUAL OBLIGATIONS AND COMMITMENTS Our contractual obligations as of
December 31, 2005 and the payments due by period are shown in the following
table.
<Table>
<Caption>
Less Than Over 5
(IN MILLIONS) Total 1 Year 1-3 Years 4-5 Years Years
---------- ---------- ---------- ---------- ----------
Liabilities for collateral and repurchase
agreements(1) $ 2,231 $ 2,231 $ - $ - $ -
Contractholder funds(2) 69,936 7,915 21,319 12,380 28,322
Reserve for life-contingent contract benefits(3) 27,405 1,000 3,085 2,055 21,265
Long-term debt 181 - 49 - 132
Payable to affiliates, net 98 98 - - -
Other liabilities and accrued expenses(4)(5) 621 594 10 6 11
---------- ---------- ---------- ---------- ----------
Total Contractual Cash $ 100,472 $ 11,838 $ 24,463 $ 14,441 $ 49,730
========== ========== ========== ========== ==========
</Table>
- ----------
(1) Liabilities for collateral and repurchase agreements are typically fully
secured with cash or marketable securities. We manage our short-term
liquidity position to ensure the availability of a sufficient amount of
liquid assets to extinguish short-term liabilities as they come due in the
normal course of business.
(2) Contractholder funds represent interest-bearing liabilities arising from
the sale of products such as interest-sensitive life, fixed annuities,
including immediate annuities without life contingencies and institutional
products. These amounts reflect estimated cash payments to be made to
policyholders and contractholders. Certain of these contracts, such as
immediate annuities without life contingencies and institutional products,
involve payment obligations where the amount and timing of the payment is
essentially fixed and determinable. These amounts relate to (i) policies or
contracts where we are currently making payments and will continue to do so
and (ii) contracts where the timing of payments has been determined by the
contract. In addition, as of December 31, 2005, we had $3.45 billion of
extendible funding agreements in force, which provide contractholders the
ability to elect a maturity extension each month so long as the extension
period does not extend beyond the contractually specified final maturity
dates. The contractually specified final maturity dates begin in 2009 and
are definitive unless the contracts are paid out earlier in accordance with
an election to not extend the contracts, in which case the contracts mature
12 months thereafter. Extendible funding agreements are reflected in the
table above at the contractually specified final maturity dates. Other
contracts, such as interest-sensitive life and fixed deferred annuities,
involve payment obligations where the amount and timing of future payments
is uncertain. For these contracts, the Company is not currently making
payments and will not make payments until (i) the occurrence of an
insurable event, such as death, or (ii) the occurrence of a payment
triggering event, such as the surrender of or partial withdrawal on a
policy or deposit contract, which is outside of the control of the Company.
We have estimated the timing of payments related to these contracts based
on historical experience and our expectation of future payment patterns.
Uncertainties relating to these liabilities include mortality, customer
lapse and withdrawal activity, and estimated additional deposits for
interest-sensitive life contracts, which may significantly impact both the
timing and amount of future payments. Such cash outflows reflect
adjustments for the estimated timing of mortality, retirement, and other
appropriate factors, but are undiscounted with respect to interest. As a
result, the sum of the cash outflows shown for all years in the table of
$69.94 billion exceeds the corresponding liability amounts of $58.19
billion included in the Consolidated Statements of Financial Position as of
December 31, 2005 for contractholder funds. The liability amount in the
Consolidated Statements of Financial Position reflects the discounting for
interest as well as adjustments for the timing of other factors as
described above.
(3) The reserve for life-contingent contract benefits relates primarily to
traditional life and immediate annuities with life contingencies and
reflects the present value of estimated cash payments to be made to
policyholders and contractholders. Immediate annuities with life
contingencies include (i) contracts where we are currently making payments
and will continue to do so until the occurrence of a specific event such as
death and (ii) contracts where the timing of a portion of the payments has
been determined by the contract. Other contracts, such as traditional life
and accident and health insurance, involve payment obligations where the
amount and timing of future payments is uncertain. For these contracts, the
Company is not currently making payments and will not make payments until
(i) the occurrence of an insurable event, such as death or illness, or (ii)
the occurrence of a payment triggering event, such as a surrender of a
policy or contract, which is outside of the control of the Company. We have
estimated the timing of cash outflows related to these contracts based on
historical experience and our expectation of future payment patterns.
Uncertainties relating to these liabilities include mortality, morbidity,
expenses, customer lapse and withdrawal activity, and renewal premium for
life policies, which may significantly impact both the timing and amount of
future payments. Such cash outflows reflect adjustments for the estimated
timing of mortality, retirement, and other appropriate factors, but are
undiscounted with respect to interest. As a result, the sum of the cash
outflows shown for all years in the table of $27.41 billion exceeds the
corresponding liability amounts of $11.88 billion included in the
Consolidated Statements of Financial Position as of December 31, 2005 for
reserve for life-contingent contract benefits. The liability amount in the
Consolidated Statements of Financial Position reflects the discounting for
interest as well as adjustments for the timing of other factors as
described above.
(4) Other liabilities and accrued expenses primarily include accrued expenses,
claim payments and other checks outstanding.
(5) Balance sheet liabilities not included in the table above include unearned
and advanced premiums of $44 million and deferred income taxes of $340
million. These items were excluded as they do not meet the definition of a
contractual liability as we are not contractually obligated to pay these
amounts to third parties. Rather, they represent an accounting mechanism
that allows us to present our financial statements on an accrual basis of
accounting. In addition, other liabilities of $195 million were not
included in the table above because they did not represent a contractual
obligation or the amount and timing of their eventual payment was
sufficiently uncertain.
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<Page>
The following is a distribution in U.S. Dollars of funding agreements
(non-putable) by currency at December 31. All foreign currency denominated
funding agreements have been swapped to U.S. Dollars.
(IN MILLIONS)
<Table>
<Caption>
2005 2004
---------- ----------
CURRENCY
Australian Dollar $ 152 $ 152
Swiss Franc 278 336
Euro -- --
British Pound 696 696
Japanese Yen -- --
Singapore Dollar 41 41
United States Dollar 10,855 8,225
---------- ----------
$ 12,022 $ 9,450
========== ==========
</Table>
Our contractual commitments as of December 31, 2005 and the payments due by
period are shown in the following table.
<Table>
<Caption>
LESS THAN OVER 5
(IN MILLIONS) TOTAL 1 YEAR 1-3 YEARS 4-5 YEARS YEARS
----- ------ --------- --------- -----
Other Commitments - Conditional (1) $ 613 $ 547 $ 66 $ -- $ --
Other Commitments - Unconditional (1) 570 18 314 225 13
---------- ---------- ---------- ---------- ----------
Total Commitments $ 1,183 $ 565 $ 380 $ 225 $ 13
========== ========== ========== ========== ==========
</Table>
- ----------
(1) Represents investment commitments such as private placements and
mortgage loans.
We have agreements in place for services we conduct, generally at cost,
between subsidiaries relating to insurance, reinsurance, loans and
capitalization. All material intercompany transactions have appropriately been
eliminated in consolidation. Inter-company transactions among insurance
subsidiaries and affiliates have been approved by the appropriate departments of
insurance as required.
REGULATION AND LEGAL PROCEEDINGS
We are subject to extensive regulation and we are involved in various legal
and regulatory actions, all of which have an effect on specific aspects of our
business. For a detailed discussion of the legal and regulatory actions in which
we are involved, see Note 11 of the consolidated financial statements.
PENDING ACCOUNTING STANDARDS
As of December 31, 2005, there were several pending accounting standards
that we have not implemented either because the standard had not been finalized
or the implementation date had not yet occurred. For a discussion of these
pending standards, see Note 2 of the consolidated financial statements.
The effect of implementing certain accounting standards on our financial
results and financial condition is often based in part on market conditions at
the time of implementation of the standard and other factors we are unable to
determine prior to implementation. For this reason, we are sometimes unable to
estimate the effect of certain pending accounting standards until the relevant
authoritative body finalizes these standards or until we implement them.
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<Page>
FORWARD-LOOKING STATEMENTS AND RISK FACTORS
This document contains "forward-looking statements" that anticipate results
based on our estimates, assumptions and plans that are subject to uncertainty.
These statements are made subject to the safe-harbor provisions of the Private
Securities Litigation Reform Act of 1995. We assume no obligation to update any
forward-looking statements as a result of new information or future events or
developments.
These forward-looking statements do not relate strictly to historical or
current facts and may be identified by their use of words like "plans," "seeks,"
"expects," "will," "should," "anticipates," "estimates," "intends," "believes,"
"likely," "targets" and other words with similar meanings. These statements may
address, among other things, our strategy for growth, product development,
regulatory approvals, market position, expenses, financial results, litigation
and reserves. We believe that these statements are based on reasonable
estimates, assumptions and plans. However, if the estimates, assumptions or
plans underlying the forward-looking statements prove inaccurate or if other
risks or uncertainties arise, actual results could differ materially from those
communicated in these forward-looking statements. Factors which could cause
actual results to differ materially from those suggested by such forward-looking
statements include but are not limited to those discussed or identified in this
document (including the risks described below) and in our public filings with
the SEC.
In addition to the normal risks of business, we are subject to significant
risks and uncertainties, including those listed below, which apply to us as an
insurer and a provider of other financial services.
CHANGES IN UNDERWRITING AND ACTUAL EXPERIENCE COULD MATERIALLY AFFECT
PROFITABILITY
Our product pricing includes long-term assumptions regarding investment
returns, mortality, morbidity, persistency and operating costs and expenses of
the business. Management establishes target returns for each product based upon
these factors and the average amount of capital that the company must hold to
support in-force contracts, satisfy rating agencies and meet regulatory
requirements. We monitor and manage our pricing and overall sales mix to achieve
target returns on a portfolio basis. Profitability from new business emerges
over a period of years depending on the nature and life of the product and is
subject to variability as actual results may differ from pricing assumptions.
Our profitability depends on the adequacy of investment margins, the
management of market and credit risks associated with investments, our ability
to maintain premiums and contract charges at a level adequate to cover mortality
and morbidity benefits, the adequacy of contract charges on variable contracts
to cover the costs of various product features, the persistency of policies to
ensure recovery of acquisition expenses, and the management of operating costs
and expenses within anticipated pricing allowances. Legislation and regulation
of the insurance marketplace and products could also affect our profitability.
CHANGES IN RESERVE ESTIMATES MAY REDUCE PROFITABILITY
Reserve for life-contingent contract benefits is computed on the basis of
long-term actuarial assumptions of future investment yields, mortality,
morbidity, policy terminations and expenses. We periodically review the adequacy
of these reserves on an aggregate basis and if future experience differs
significantly from assumptions, adjustments to reserves may be required which
could have a material adverse effect on our operating results and financial
condition.
CHANGES IN MARKET INTEREST RATES MAY LEAD TO A SIGNIFICANT DECREASE IN THE SALES
AND PROFITABILITY OF SPREAD-BASED PRODUCTS
Our ability to manage our investment margin for spread-based products, such
as fixed annuities and institutional products, is dependent upon maintaining
profitable spreads between investment yields and interest crediting rates. As
interest rates decrease or remain at low levels, proceeds from investments that
have matured, prepaid or been sold may be reinvested at lower yields, reducing
investment margin. Lowering interest crediting rates can offset decreases in
investment margin on some products. However, these changes could be limited by
market conditions, regulatory or contractual minimum rate guarantees on many
contracts and may not match the timing or magnitude of changes in asset yields.
Decreases in the rates offered on products could make those products less
attractive, leading to lower sales and/or changes in the level of surrenders and
withdrawals for these products. Non-parallel shifts in interest rates, such as
increases in short-term rates without accompanying increases in medium- and
long-term rates, can influence customer demand for fixed annuities, which could
impact the level and profitability of new customer deposits. Increases in market
interest rates can also have negative effects, for example by
43
<Page>
increasing the attractiveness of other investments to our customers, which can
lead to higher surrenders at a time when the fixed income investment asset
values are lower as a result of the increase in interest rates. For certain
products, principally fixed annuity and interest-sensitive life products, the
earned rate on assets could lag behind market yields. We may react to market
conditions by increasing crediting rates, which could narrow spreads.
Unanticipated surrenders could result in DAC unlocking or affect the
recoverability of DAC and thereby increase expenses and reduce profitability.
DECLINING EQUITY MARKETS MAY REDUCE BOTH SALES OF PRODUCTS AND INCOME FROM
CONTRACT CHARGES AND MAY ADVERSELY AFFECT OPERATING RESULTS AND FINANCIAL
CONDITION
Conditions in the domestic and international stock markets affect the sale
and profitability of our variable annuities. In general, sales of variable
annuities decrease when stock markets are declining over an extended period of
time. The effect of decreasing separate accounts balances resulting from
volatile equity markets, lower underlying fund performance or declining consumer
confidence could cause contract charges earned to decrease. In addition, it is
possible that the assumptions and projections we use to establish prices for
GMDB, GMIB, GMAB and GMWB products, particularly assumptions and projections
about investment performance, do not accurately reflect the level of costs that
we will ultimately incur in providing those benefits, resulting in adverse
margin trends. These factors may result in accelerated DAC amortization and
require increases in reserves, which would reduce statutory capital and surplus
and/or our net income. Poor fund performance could also result in higher partial
withdrawals of account value which, for some contracts, do not reduce the GMDB
by a proportional amount.
CHANGES IN ESTIMATES OF PROFITABILITY ON INTEREST-SENSITIVE LIFE, FIXED AND
VARIABLE ANNUITIES AND OTHER INVESTMENT PRODUCTS MAY HAVE AN ADVERSE EFFECT ON
RESULTS THROUGH INCREASED AMORTIZATION OF DAC
DAC related to interest-sensitive life, fixed and variable annuities and
other investment contracts is amortized in proportion to AGP and EGP over the
estimated lives of the contracts. Assumptions underlying EGP, including those
relating to margins from mortality, investment margin, contract administration,
surrender and other contract charges, are updated from time to time in order to
reflect actual and expected experience and its potential effect on the valuation
of DAC. Updates to these assumptions could result in DAC unlocking, which in
turn could adversely affect our operating results and financial condition.
A LOSS OF KEY PRODUCT DISTRIBUTION RELATIONSHIPS COULD MATERIALLY AFFECT SALES
Certain products are distributed under agreements with other members of the
financial services industry that are not affiliated with us. Termination of one
or more of these agreements due to, for example, a change in control of one of
these distributors, could have a detrimental effect on sales.
CHANGES IN TAX LAWS MAY DECREASE SALES AND PROFITABILITY OF PRODUCTS
Under current federal and state income tax law, certain products we offer,
primarily life insurance and annuities, receive favorable tax treatment. This
favorable treatment may give certain of our products a competitive advantage
over noninsurance products. Congress from time to time considers legislation
that would reduce or eliminate the favorable policyholder tax treatment
currently applicable to life insurance and annuities. Congress also considers
proposals to reduce the taxation of certain products or investments that may
compete with life insurance and annuities. Legislation that increases the
taxation on insurance products or reduces the taxation on competing products
could lessen the advantage or create a disadvantage for certain of our products
making them less competitive. Such proposals, if adopted, could have a material
adverse effect on our financial position or ability to sell such products and
could result in the surrender of some existing contracts and policies. In
addition, changes in the federal estate tax laws could negatively affect the
demand for the types of life insurance used in estate planning.
ACTIONS TAKEN TO SIMPLIFY OUR BUSINESS MODEL AND IMPROVE PROFITABILITY MAY NOT
BE SUCCESSFUL AND MAY RESULT IN LOSSES AND COSTS
We are pursuing strategies intended to improve return on equity. Actions
that we have taken and may continue to take include changing the number and
selection of products being marketed, terminating underperforming distribution
relationships, merging or disposing of unnecessary and/or non-strategic legal
entities, reducing policy administration software systems, and other actions
that we may determine are appropriate to successfully execute our business
strategies. The actions that we have taken and may take in
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the future may not achieve their intended outcome and could result in lower
premiums and contract charges, restructuring costs, losses on disposition or
losses related to the discontinuance of individual products or distribution
relationships.
RISKS RELATING TO THE INSURANCE INDUSTRY
OUR FUTURE RESULTS ARE DEPENDENT IN PART ON OUR ABILITY TO SUCCESSFULLY OPERATE
IN AN INSURANCE INDUSTRY THAT IS HIGHLY COMPETITIVE
The insurance industry is highly competitive. Our competitors include other
insurers and, because many of our products include a savings or investment
component, securities firms, investment advisers, mutual funds, banks and other
financial institutions. Many of our competitors have well-established national
reputations and market similar products. Because of the competitive nature of
the insurance industry, including competition for producers such as exclusive
and independent agents, there can be no assurance that we will continue to
effectively compete with our industry rivals, or that competitive pressure will
not have a material adverse effect on our business, operating results or
financial condition. The ability of banks to affiliate with insurers may have a
material adverse effect on all of our product lines by substantially increasing
the number, size and financial strength of potential competitors. Furthermore,
certain competitors operate using a mutual insurance company structure and
therefore, may have dissimilar profitability and return targets.
WE ARE SUBJECT TO MARKET RISK AND DECLINES IN CREDIT QUALITY
We are subject to market risk, the risk that we will incur losses due to
adverse changes in equity, interest, commodity or foreign currency exchange
rates and prices. Our primary market risk exposures are to changes in interest
rates and equity prices and, to a lesser degree, changes in foreign currency
exchange rates and commodity prices. For additional information on market risk,
see the "Market Risk" section of MD&A.
A decline in market interest rates could have an adverse effect on our
investment income as we invest cash in new investments that may yield less than
the portfolio's average rate. In a declining interest rate environment,
borrowers may prepay or redeem securities more quickly than expected as they
seek to refinance at lower rates. A decline could also cause the purchase of
longer-term assets in order to obtain adequate investment yields resulting in a
duration gap when compared to the duration of liabilities. An increase in market
interest rates could have an adverse effect on the value of our investment
portfolio. Increases in interest rates also may lead to an increase in policy
loans, surrenders and withdrawals that generally would be funded at a time when
fair values of fixed income securities are lower. A decline in the quality of
our investment portfolio as a result of adverse economic conditions or otherwise
could cause additional realized losses on securities, including realized losses
relating to derivative strategies not adequately addressing portfolio risks.
CONCENTRATION OF OUR INVESTMENT PORTFOLIOS IN ANY PARTICULAR SEGMENT OF THE
ECONOMY MAY HAVE ADVERSE EFFECTS
The concentration of our investment portfolios in any particular industry,
group of related industries or geographic sector could have an adverse effect on
our investment portfolios and consequently on our results of operations and
financial position. While we seek to mitigate this risk by having a broadly
diversified portfolio, events or developments that have a negative impact on any
particular industry, group of related industries or geographic region may have a
greater adverse effect on the investment portfolios to the extent that the
portfolios are concentrated rather than diversified.
WE MAY SUFFER LOSSES FROM LITIGATION
As is typical for a large company, we are involved in a substantial amount
of litigation, including class action litigation challenging a range of company
practices. In the event of an unfavorable outcome in one or more of these
matters, the ultimate liability may be in excess of amounts currently reserved
and may be material to our operating results or cash flows for a particular
quarter or annual period. For a description of our current legal proceedings,
see Note 11 of the consolidated financial statements.
In some circumstances, we may be able to collect on third party insurance
that we carry to recover all or part of amounts that we pay in judgments,
settlements and litigation expenses. However, we may not be able to resolve
issues concerning the availability, if any, or the ability to collect such
insurance
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concurrently with the underlying litigation. Consequently, the timing of the
resolution of a particular piece of litigation and the determination of our
insurance recovery with respect to that litigation may not coincide and may be
reflected in our financial statements in different fiscal quarters.
WE ARE SUBJECT TO EXTENSIVE REGULATION AND POTENTIAL FURTHER RESTRICTIVE
REGULATION MAY INCREASE OUR OPERATING COSTS AND LIMIT OUR GROWTH
As insurance companies, broker-dealers, investment advisers and/or
investment companies, we and many of our subsidiaries are subject to extensive
laws and regulations. These laws and regulations are complex and subject to
change. Moreover, they are administered and enforced by a number of different
governmental authorities, including state insurance regulators, state securities
administrators, the SEC, the National Association of Securities Dealers, the
U.S. Department of Justice, and state attorneys general, each of which exercises
a degree of interpretive latitude. Consequently, we are subject to the risk that
compliance with any particular regulator's or enforcement authority's
interpretation of a legal issue may not result in compliance with another
regulator's or enforcement authority's interpretation of the same issue,
particularly when compliance is judged in hindsight. In addition, there is risk
that any particular regulator's or enforcement authority's interpretation of a
legal issue may change over time to our detriment, or that changes in the
overall legal environment may, even absent any particular regulator's or
enforcement authority's interpretation of a legal issue changing, cause us to
change our views regarding the actions we need to take from a legal risk
management perspective, thus necessitating changes to our practices that may, in
some cases, limit our ability to grow and improve the profitability of our
business. Furthermore, in some cases, these laws and regulations are designed to
protect the interests of a specific constituency rather than a range of
constituencies. For example, state insurance laws and regulations are generally
intended to protect purchasers or users of insurance products. In many respects,
these laws and regulations limit our ability to grow and improve the
profitability of our business.
In recent years, the state insurance regulatory framework has come under
public scrutiny and members of Congress have discussed proposals to provide for
optional federal chartering of insurance companies. We can make no assurances
regarding the potential impact of state or federal measures that may change the
nature or scope of insurance regulation.
REINSURANCE MAY BE UNAVAILABLE AT CURRENT LEVELS AND PRICES, WHICH MAY LIMIT OUR
ABILITY TO WRITE NEW BUSINESS
Market conditions beyond our control determine the availability and cost of
the reinsurance we purchase. No assurances can be made that reinsurance will
remain continuously available to us to the same extent and on the same terms and
rates as are currently available. If we were unable to maintain our current
level of reinsurance or purchase new reinsurance protection in amounts that we
consider sufficient and at prices that we consider acceptable, we would have to
either accept an increase in our exposure risk, reduce our insurance writings,
or develop or seek other alternatives.
REINSURANCE SUBJECTS US TO THE CREDIT RISK OF OUR REINSURERS AND MAY NOT BE
ADEQUATE TO PROTECT US AGAINST LOSSES ARISING FROM CEDED INSURANCE
The collectibility of reinsurance recoverables is subject to uncertainty
arising from a number of factors, including whether insured losses meet the
qualifying conditions of the reinsurance contract and whether reinsurers, or
their affiliates, have the financial capacity and willingness to make payments
under the terms of a reinsurance treaty or contract. Our inability to collect a
material recovery from a reinsurer could have a material adverse effect on our
operating results and financial condition.
THE CONTINUED THREAT OF TERRORISM AND ONGOING MILITARY ACTIONS MAY ADVERSELY
AFFECT THE LEVEL OF CLAIM LOSSES WE INCUR AND THE VALUE OF OUR INVESTMENT
PORTFOLIO
The continued threat of terrorism, both within the United States and
abroad, and ongoing military and other actions and heightened security measures
in response to these types of threats, may cause significant volatility and
losses from declines in the equity markets and from interest rate changes in the
United States, Europe and elsewhere, and may result in loss of life, property
damage, additional disruptions to commerce and reduced economic activity. Some
of the assets in our investment portfolio may be adversely affected by declines
in the equity markets and reduced economic activity caused by the continued
threat of terrorism. We seek to mitigate the potential impact of terrorism on
our commercial mortgage portfolio by limiting geographical concentrations in key
metropolitan areas and by requiring terrorism insurance to the
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extent that it is commercially available. Additionally, in the event that a
terrorist act occurs, our operating results may be adversely affected, depending
on the nature of the event.
ANY DECREASE IN OUR FINANCIAL STRENGTH RATINGS MAY HAVE AN ADVERSE EFFECT ON OUR
COMPETITIVE POSITION
Financial strength ratings are important factors in establishing the
competitive position of insurance companies and generally have an effect on an
insurance company's business. On an ongoing basis, rating agencies review the
financial performance and condition of insurers and could downgrade or change
the outlook on an insurer's ratings due to, for example, a change in an
insurer's statutory capital; a change in a rating agency's determination of the
amount of risk-adjusted capital required to maintain a particular rating; an
increase in the perceived risk of an insurer's investment portfolio; a reduced
confidence in management or a host of other considerations that may or may not
be under the insurer's control. The insurance financial strength ratings of both
AIC and ALIC are A+, AA and Aa2 from A.M. Best, Standard & Poor's and Moody's,
respectively. Because all of these ratings are subject to continuous review, the
retention of these ratings cannot be assured. A multiple level downgrade in any
of these ratings could have a material adverse effect on our sales, our
competitiveness, the marketability of our product offerings, and our liquidity,
operating results and financial condition.
CHANGES IN ACCOUNTING STANDARDS ISSUED BY THE FINANCIAL ACCOUNTING STANDARDS
BOARD ("FASB") OR OTHER STANDARD-SETTING BODIES MAY ADVERSELY AFFECT OUR
FINANCIAL STATEMENTS
Our financial statements are subject to the application of GAAP, which is
periodically revised and/or expanded. Accordingly, we are required to adopt new
or revised accounting standards from time to time issued by recognized
authoritative bodies, including the FASB. It is possible that future changes we
are required to adopt could change the current accounting treatment that we
apply to our consolidated financial statements and that such changes could have
a material adverse effect on our results and financial condition. For a
description of potential changes in accounting standards that could affect us
currently, see Note 2 of the consolidated financial statements.
THE OCCURRENCE OF EVENTS UNANTICIPATED IN OUR DISASTER RECOVERY SYSTEMS AND
MANAGEMENT CONTINUITY PLANNING COULD IMPAIR OUR ABILITY TO CONDUCT BUSINESS
EFFECTIVELY
In the event of a disaster such as a natural catastrophe, an industrial
accident, a terrorist attack or war, events unanticipated in our disaster
recovery systems could have an adverse impact on our ability to conduct business
and on our results of operations and financial condition, particularly if those
events affect our computer-based data processing, transmission, storage and
retrieval systems. In the event that a significant number of our managers could
be unavailable in the event of a disaster, our ability to effectively conduct
our business could be severely compromised.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Information required for Item 7A is incorporated by reference to the
material under caption "Market Risk" in Part II, Item 7 of this report.
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ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
ALLSTATE LIFE INSURANCE COMPANY AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME
<Table>
<Caption>
YEAR ENDED DECEMBER 31,
-----------------------------------------
(IN MILLIONS) 2005 2004 2003
----------- ----------- -----------
REVENUES
Premiums (net of reinsurance ceded of $606, $526 and $418) $ 474 $ 637 $ 959
Contract charges 1,079 961 872
Net investment income 3,707 3,260 3,082
Realized capital gains and losses 19 (11) (84)
----------- ----------- -----------
5,279 4,847 4,829
COSTS AND EXPENSES
Contract benefits (net of reinsurance recoverable of $515,
$418 and $336) 1,340 1,359 1,595
Interest credited to contractholder funds 2,340 1,923 1,764
Amortization of deferred policy acquisition costs 568 534 479
Operating costs and expenses 433 462 493
----------- ----------- -----------
4,681 4,278 4,331
LOSS ON DISPOSITION OF OPERATIONS (7) (24) (45)
----------- ----------- -----------
INCOME FROM OPERATIONS BEFORE INCOME TAX EXPENSE AND CUMULATIVE
EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE, AFTER-TAX 591 545 453
Income tax expense 174 189 162
----------- ----------- -----------
INCOME BEFORE CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING
PRINCIPLE, AFTER-TAX 417 356 291
Cumulative effect of change in accounting principle, after-tax -- (175) (13)
----------- ----------- -----------
NET INCOME 417 181 278
----------- ----------- -----------
OTHER COMPREHENSIVE (LOSS) INCOME, AFTER-TAX
Changes in:
Unrealized net capital gains and losses (425) (40) 1
----------- ----------- -----------
OTHER COMPREHENSIVE (LOSS) INCOME, AFTER-TAX (425) (40) 1
----------- ----------- -----------
COMPREHENSIVE (LOSS) INCOME $ (8) $ 141 $ 279
=========== =========== ===========
</Table>
See notes to consolidated financial statements.
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ALLSTATE LIFE INSURANCE COMPANY AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF FINANCIAL POSITION
<Table>
<Caption>
DECEMBER 31,
-----------------------
2005 2004
---------- ----------
(IN MILLIONS, EXCEPT SHARE AND PAR VALUE DATA)
ASSETS
Investments
Fixed income securities, at fair value (amortized cost $59,717 and
$55,964) $ 61,977 $ 59,291
Mortgage loans 8,108 7,318
Equity securities 324 214
Short-term 927 1,440
Policy loans 729 722
Other 691 704
---------- ----------
Total investments 72,756 69,689
Cash 154 241
Deferred policy acquisition costs 3,948 3,176
Reinsurance recoverables, net 1,699 1,507
Accrued investment income 648 593
Other assets 582 818
Separate Accounts 15,235 14,377
---------- ----------
TOTAL ASSETS $ 95,022 $ 90,401
========== ==========
LIABILITIES
Contractholder funds $ 58,190 $ 53,939
Reserve for life-contingent contract benefits 11,881 11,203
Unearned premiums 35 31
Payable to affiliates, net 98 79
Other liabilities and accrued expenses 3,054 3,721
Deferred income taxes 340 638
Long-term debt 181 104
Separate Accounts 15,235 14,377
---------- ----------
TOTAL LIABILITIES 89,014 84,092
---------- ----------
COMMITMENTS AND CONTINGENT LIABILITIES (NOTES 7 AND 11)
SHAREHOLDER'S EQUITY
Redeemable preferred stock - series A, $100 par value, 1,500,000 shares
authorized, 49,230 shares issued and outstanding 5 5
Redeemable preferred stock - series B, $100 par value, 1,500,000 shares
authorized, none issued -- --
Common stock, $227 par value, 23,800 shares authorized and outstanding 5 5
Additional capital paid-in 1,108 1,108
Retained income 4,302 4,178
Accumulated other comprehensive income:
Unrealized net capital gains and losses 588 1,013
---------- ----------
Total accumulated other comprehensive income 588 1,013
---------- ----------
TOTAL SHAREHOLDER'S EQUITY 6,008 6,309
---------- ----------
TOTAL LIABILITIES AND SHAREHOLDER'S EQUITY $ 95,022 $ 90,401
========== ==========
</Table>
See notes to consolidated financial statements.
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ALLSTATE LIFE INSURANCE COMPANY AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDER'S EQUITY
<Table>
<Caption>
YEAR ENDED DECEMBER 31,
--------------------------------------
(IN MILLIONS) 2005 2004 2003
---------- ---------- ----------
REDEEMABLE PREFERRED STOCK - SERIES A
Balance, beginning of year $ 5 $ 82 $ 93
Redemption of stock - (7) (11)
Reclassification to long-term debt - (70) -
---------- ---------- ----------
Balance, end of year 5 5 82
---------- ---------- ----------
REDEEMABLE PREFERRED STOCK - SERIES B - - -
---------- ---------- ----------
COMMON STOCK 5 5 5
---------- ---------- ----------
ADDITIONAL CAPITAL PAID-IN
Balance, beginning of year 1,108 1,067 1,067
Capital contributions - 41 -
---------- ---------- ----------
Balance, end of year 1,108 1,108 1,067
---------- ---------- ----------
RETAINED INCOME
Balance, beginning of year 4,178 4,222 4,145
Net income 417 181 278
Dividends (293) (225) (201)
---------- ---------- ----------
Balance, end of year 4,302 4,178 4,222
---------- ---------- ----------
ACCUMULATED OTHER COMPREHENSIVE INCOME
Balance, beginning of year 1,013 1,053 1,052
Change in unrealized net capital gains and losses (425) (40) 1
---------- ---------- ----------
Balance, end of year 588 1,013 1,053
---------- ---------- ----------
TOTAL SHAREHOLDER'S EQUITY $ 6,008 $ 6,309 $ 6,429
========== ========== ==========
</Table>
See notes to consolidated financial statements.
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ALLSTATE LIFE INSURANCE COMPANY AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
<Table>
<Caption>
YEAR ENDED DECEMBER 31,
--------------------------------------
(IN MILLIONS) 2005 2004 2003
---------- ---------- ----------
CASH FLOWS FROM OPERATING ACTIVITIES
Net income $ 417 $ 181 $ 278
Adjustments to reconcile net income to net cash provided by operating activities:
Amortization and other non-cash items (175) (145) (175)
Realized capital gains and losses (19) 11 84
Loss on disposition of operations 7 24 45
Cumulative effect of change in accounting principle - 175 13
Interest credited to contractholder funds 2,340 1,923 1,764
Changes in:
Policy benefit and other insurance reserves (200) (85) 45
Unearned premiums 4 2 8
Deferred policy acquisition costs (198) (279) (253)
Reinsurance recoverables (197) (241) (141)
Income taxes payable 18 40 3
Other operating assets and liabilities 95 (86) 81
---------- ---------- ----------
Net cash provided by operating activities 2,092 1,520 1,752
---------- ---------- ----------
CASH FLOWS FROM INVESTING ACTIVITIES
Proceeds from sales
Fixed income securities 10,881 9,040 8,158
Equity securities 57 349 80
Investment collections
Fixed income securities 4,575 4,314 4,818
Mortgage loans 1,172 729 679
Investments purchases
Fixed income securities (18,756) (20,295) (19,225)
Equity securities (203) (334) (47)
Mortgage loans (1,976) (1,711) (1,146)
Change in short-term investments, net (352) 11 236
Change in other investments, net (110) (6) 14
---------- ---------- ----------
Net cash used in investing activities (4,712) (7,903) (6,433)
---------- ---------- ----------
CASH FLOWS FROM FINANCING ACTIVITIES
Redemption of redeemable preferred stock (25) (20) (11)
Contractholder fund deposits 11,373 13,076 9,841
Contractholder fund withdrawals (8,604) (6,352) (5,253)
Dividends paid (211) (201) (27)
---------- ---------- ----------
Net cash provided by financing activities 2,533 6,503 4,550
---------- ---------- ----------
NET (DECREASE) INCREASE IN CASH (87) 120 (131)
CASH AT BEGINNING OF YEAR 241 121 252
---------- ---------- ----------
CASH AT END OF YEAR $ 154 $ 241 $ 121
========== ========== ==========
</Table>
See notes to consolidated financial statements.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. GENERAL
BASIS OF PRESENTATION
The accompanying consolidated financial statements include the accounts of
Allstate Life Insurance Company ("ALIC") and its wholly owned subsidiaries
(collectively referred to as the "Company"). ALIC is wholly owned by Allstate
Insurance Company ("AIC"), a wholly owned subsidiary of The Allstate Corporation
(the "Corporation"). These consolidated financial statements have been prepared
in conformity with accounting principles generally accepted in the United States
of America ("GAAP"). All significant intercompany accounts and transactions have
been eliminated.
Effective January 1, 2005, Glenbrook Life and Annuity Company ("GLAC"), a
wholly owned subsidiary of ALIC, was merged into ALIC to achieve future cost
savings and operational efficiency. The merger had no impact on the Company's
results of operations, financial position or cash flows.
To conform to the 2005 presentation, certain amounts in the prior years'
consolidated financial statements and notes have been reclassified.
The preparation of financial statements in conformity with GAAP requires
management to make estimates and assumptions that affect the amounts reported in
the consolidated financial statements and accompanying notes. Actual results
could differ from those estimates.
NATURE OF OPERATIONS
The Company sells life insurance, retirement and investment products to
individual and institutional customers through several distribution channels.
The principal individual products are deferred and immediate fixed annuities,
variable annuities and interest-sensitive and traditional life insurance. The
principal institutional product is funding agreements backing medium-term notes.
The Company, through several companies, is authorized to sell life
insurance, retirement and investment products in all 50 states, the District of
Columbia, Puerto Rico, the U.S. Virgin Islands and Guam. For 2005, the top
geographic locations for statutory premiums and annuity considerations were
Delaware, California, New York and Florida. No other jurisdiction accounted for
more than 5% of statutory premiums and annuity considerations. The Company
distributes its products to individuals through multiple intermediary
distribution channels, including Allstate exclusive agencies, independent
agencies, global and national banks, national and regional broker-dealers, and
specialized structured settlement brokers. The Company sells products through
independent agencies affiliated with master brokerage agencies. The Company
sells funding agreements to unaffiliated trusts used to back medium-term notes
issued to institutional and individual investors. Although the Company currently
benefits from agreements with financial services entities that market and
distribute its products, change in control of these non-affiliated entities
could negatively impact the Company's sales.
The Company monitors economic and regulatory developments that have the
potential to impact its business. The ability of banks to affiliate with
insurers may have a material adverse effect on all of the Company's product
lines by substantially increasing the number, size and financial strength of
potential competitors. Furthermore, federal and state laws and regulations
affect the taxation of insurance companies and life insurance and annuity
products. Congress and various state legislatures have considered proposals
that, if enacted, could impose a greater tax burden on the Company or could have
an adverse impact on the tax treatment of some insurance products offered by the
Company, including favorable policyholder tax treatment currently applicable to
life insurance and annuities. Legislation that reduced the federal income tax
rates applicable to certain dividends and capital gains realized by individuals,
or other proposals, if adopted, that reduce the taxation, or permit the
establishment, of certain products or investments that may compete with life
insurance or annuities could have an adverse effect on the Company's financial
position or ability to sell such products and could result in the surrender of
some existing contracts and policies. In addition, changes in the federal estate
tax laws have negatively affected the demand for the types of life insurance
used in estate planning.
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2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
INVESTMENTS
Fixed income securities include bonds, mortgage-backed, commercial
mortgage-backed and asset-backed securities, bank loans, which are primarily
senior secured corporate loans, and redeemable preferred stocks. Fixed income
securities may be sold prior to their contractual maturity ("available for
sale") and are carried at fair value, with the exception of bank loans that are
carried at amortized cost. 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 of interest rates 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. The difference between amortized cost
and fair value, net of deferred income taxes, certain deferred policy
acquisition costs, certain deferred sales inducement costs, and certain reserves
for life-contingent contract benefits, are reflected as a component of
accumulated other comprehensive income. Cash received from calls, principal
payments and make-whole payments is reflected as a component of proceeds from
sales. Cash received from maturities and pay-downs is reflected as a component
of investment collections.
Equity securities include common stocks, non-redeemable preferred stocks
and limited partnership interests. Common stocks and non-redeemable preferred
stocks had a carrying value of $67 million and $42 million, and cost of $62
million and $33 million at December 31, 2005 and 2004, respectively. Common and
non-redeemable preferred stocks are classified as available for sale and are
carried at fair value. The difference between cost and fair value, net of
deferred income taxes, is reflected as a component of accumulated other
comprehensive income. Investments in limited partnership interests had a
carrying value of $257 million and $172 million at December 31, 2005 and 2004,
respectively, and are accounted for in accordance with the equity method of
accounting except for instances in which the Company's interest is so minor that
it exercises virtually no influence over operating and financial policies, in
which case, the Company applies the cost method of accounting.
Mortgage loans are carried at outstanding principal balances, net of
unamortized premium or discount and valuation allowances. Valuation allowances
are established for impaired loans when it is probable that contractual
principal and interest will not be collected. Valuation allowances for impaired
loans reduce the carrying value to the fair value of the collateral or the
present value of the loan's expected future repayment cash flows discounted at
the loan's original effective interest rate.
Short-term investments are carried at cost or amortized cost that
approximates fair value, and include the reinvestment of collateral received in
connection with securities lending activities, funds received in connection with
securities repurchase agreements, and collateral received from counterparties
related to derivative transactions. For these transactions, the Company records
an offsetting liability in other liabilities and accrued expenses for the
Company's obligation to return the collateral or funds received. We also
purchase securities under agreements to resell.
Policy loans are carried at the unpaid principal balances. Other
investments consist primarily of derivative financial instruments and real
estate investments. Real estate investments are accounted for by the equity
method if held for investment, or depreciated cost, net of valuation allowances,
if the Company has an active plan to sell.
Investment income consists primarily of interest and dividends, net
investment income from partnership interests and income from certain derivative
transactions. Interest is recognized on an accrual basis and dividends are
recorded at the ex-dividend date. Interest income on mortgage-backed, commercial
mortgage-backed and asset-backed securities is determined using the effective
yield method, considering estimated principal repayments. Interest income on
certain beneficial interests in securitized financial assets is determined using
the prospective yield method, based upon projections of expected future cash
flows. Income from investments in partnership interests, accounted for on the
cost basis, is recognized upon receipt of amounts distributed by the
partnerships as income. Accrual of income is suspended for fixed income
securities and mortgage loans that are in default or when the receipt of
interest payments is in doubt.
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Realized capital gains and losses include gains and losses on investment
dispositions, write-downs in value due to other than temporary declines in fair
value and changes in the fair value of certain derivatives including related
periodic and final settlements. Dispositions include sales, losses recognized in
anticipation of dispositions and other transactions such as calls and
prepayments. Realized capital gains and losses on investment dispositions are
determined on a specific identification basis.
The Company recognizes other-than-temporary impairment losses on fixed
income, equity securities and short-term investments when the decline in fair
value is deemed other than temporary (see Note 6).
DERIVATIVE AND EMBEDDED DERIVATIVE FINANCIAL INSTRUMENTS
Derivative financial instruments include swaps, futures, options (including
swaptions), interest rate caps and floors, warrants, certain forward contracts
for purchases of to-be-announced ("TBA") mortgage securities, and certain
investment risk transfer reinsurance agreements. Derivatives that are required
to be separated from the host instrument and accounted for as derivative
financial instruments ("subject to bifurcation") are embedded in fixed income
securities, equity-indexed life and annuity contracts, certain variable life and
annuity contracts and certain funding agreements (see Note 7).
All derivatives are accounted for on a fair value basis and reported as
other investments, other assets, other liabilities and accrued expenses or
contractholder funds. Embedded derivative instruments subject to bifurcation are
also accounted for on a fair value basis and are reported together with the host
contracts. The change in the fair value of derivatives embedded in certain fixed
income securities and subject to bifurcation is reported in realized capital
gains and losses. The change in the fair value of derivatives embedded in
liabilities and subject to bifurcation is reported in contract benefits,
interest credited to contractholder funds or realized capital gains and losses.
When derivatives meet specific criteria, they may be designated as
accounting hedges and accounted for as fair value, cash flow, foreign currency
fair value or foreign currency cash flow hedges. The hedged item may be either
all or a specific portion of a recognized asset, liability or an unrecognized
firm commitment attributable to a particular risk. At the inception of the
hedge, the Company formally documents the hedging relationship and risk
management objective and strategy. The documentation identifies the hedging
instrument, the hedged item, the nature of the risk being hedged and the
methodology used to assess how effective the hedging instrument is in offsetting
the exposure to changes in the hedged item's fair value attributable to the
hedged risk, or in the case of a cash flow hedge, the exposure to changes in the
hedged item's or transaction's variability in cash flows attributable to the
hedged risk. The Company does not exclude any component of the change in fair
value of the hedging instrument from the effectiveness assessment. At each
reporting date, the Company confirms that the hedging instrument continues to be
highly effective in offsetting the hedged risk. Ineffectiveness in fair value
hedges and cash flow hedges is reported in realized capital gains and losses.
The hedge ineffectiveness reported as realized capital gains and losses amounted
to losses of $7 million and $8 million in 2005 and 2004, respectively, and gains
of $16 million in 2003.
FAIR VALUE HEDGES The Company designates certain of its interest rate and
foreign currency swap contracts and certain investment risk transfer reinsurance
agreements as fair value hedges when the hedging instrument is highly effective
in offsetting the risk of changes in the fair value of the hedged item.
For hedging instruments used in fair value hedges, when the hedged items
are investment assets or a portion thereof, the change in the fair value of the
derivatives is reported in net investment income, together with the change in
the fair value of the hedged items. The change in the fair value of hedging
instruments used in fair value hedges of contractholder funds liabilities or a
portion thereof is reported in interest credited to contractholder funds,
together with the change in the fair value of the hedged item. Accrued periodic
settlements on swaps are reported together with the changes in fair value of the
swaps in net investment income or interest credited to contractholder funds. The
book value of the hedged asset or liability is adjusted for the change in the
fair value of the hedged risk.
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 existing asset, liability or a forecasted transaction.
Anticipated transactions must be probable of occurrence and their significant
terms and specific characteristics must be identified.
For hedging instruments used in cash flow hedges, the changes in fair value
of the derivatives are reported in accumulated other comprehensive income.
Amounts are reclassified to net investment income or realized capital gains and
losses as the hedged transaction affects net income or when the forecasted
transaction affects net income. Accrued
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periodic settlements on derivatives used in cash flow hedges are reported in net
investment income. The amount reported in accumulated other comprehensive income
for a hedged transaction is limited to the lesser of the cumulative gain or loss
on the derivative less the amount reclassified to net income; or the cumulative
gain or loss on the derivative needed to offset the cumulative change in the
expected future cash flows on the hedged transaction from inception of the hedge
less the derivative gain or loss previously reclassified from accumulated other
comprehensive income to net income. If the Company expects at any time that the
loss reported in accumulated other comprehensive income would lead to a net loss
on the combination of the hedging instrument and the hedged transaction which
may not be recoverable, a loss is recognized immediately in realized capital
gains and losses. If an impairment loss is recognized on an asset or an
additional obligation is incurred on a liability involved in a hedge
transaction, any offsetting gain in accumulated other comprehensive income is
reclassified and reported together with the impairment loss or recognition of
the obligation.
TERMINATION OF HEDGE ACCOUNTING If, subsequent to entering into a hedge
transaction, the derivative becomes ineffective (including if the hedged item is
sold or otherwise extinguished, the occurrence of a hedged forecasted
transaction is no longer probable, or the hedged asset becomes impaired), the
Company may terminate the derivative position. The Company may also terminate
derivative instruments or redesignate them as non-hedge as a result of other
events or circumstances. If the derivative financial instrument is not
terminated when a fair value hedge is no longer effective, the future gains and
losses recognized on the derivative are reported in realized capital gains and
losses. When a fair value hedge is no longer effective, is redesignated as a
non-hedge, or when the derivative has been terminated, the gain or loss
recognized on the item being hedged and used to adjust the book value of the
asset, liability or portion thereof is amortized over the remaining life of the
hedged item to net investment income or interest credited to contractholder
funds beginning in the period that hedge accounting is no longer applied. If the
hedged item of a fair value hedge is an asset, which has become impaired, the
adjustment made to the book value of the asset is subject to the accounting
policies applied to impaired assets. When a derivative financial instrument used
in a cash flow hedge of an existing asset or liability is no longer effective or
is terminated, the gain or loss recognized on the derivative is reclassified
from accumulated other comprehensive income to net income as the hedged risk
impacts net income, beginning in the period hedge accounting is no longer
applied or the derivative instrument is terminated. If the derivative financial
instrument is not terminated when a cash flow hedge is no longer effective, the
future gains and losses recognized on the derivative are reported in realized
capital gains and losses. When a derivative financial instrument used in a cash
flow hedge of a forecasted transaction is terminated because the forecasted
transaction is no longer probable, the gain or loss recognized on the derivative
is immediately reclassified from accumulated other comprehensive income to
realized capital gains and losses in the period that hedge accounting is no
longer applied. If the cash flow hedge is no longer effective, the gain or loss
recognized on the derivative is reclassified from accumulated other
comprehensive income to net income as the remaining hedged item affects net
income.
NON-HEDGE DERIVATIVE FINANCIAL INSTRUMENTS The Company also has certain
derivatives that are used in interest rate, equity price and credit risk
management strategies for which hedge accounting is not applied. These
derivatives primarily consist of certain interest rate swap agreements, equity
and financial futures contracts, interest rate cap and floor agreements,
swaptions, certain forward contracts for TBA mortgage securities and credit
default swaps.
The Company replicates fixed income securities using a combination of a
credit default swap and one or more highly rated fixed income securities to
synthetically replicate the economic characteristics of one or more cash market
securities. Fixed income securities are replicated when they are either
unavailable in the cash market or more economical to acquire in synthetic form.
Based upon the type of derivative instrument and strategy, the income
statement effects of these derivatives are reported in a single line item, with
the results of the associated risk. Therefore, the derivatives' fair value gains
and losses and accrued periodic settlements are recognized together in one of
the following during the reporting period: net investment income, realized
capital gains and losses, operating costs and expenses, contract benefits or
interest credited to contractholder funds. Cash flows from embedded derivatives
requiring bifurcation and derivatives receiving hedge accounting are reported
consistently with the host contracts and hedged risks respectively within the
Consolidated Statement of Cash Flows. Cash flows on other derivatives are
reported in cash flows from investing activities within the Consolidated
Statement of Cash Flows.
SECURITY REPURCHASE AGREEMENTS AND SECURITIES LOANED
Securities lending transactions, and securities sold under agreements to
repurchase which primarily includes a mortgage dollar roll program
("repurchase agreements"), are used primarily to generate net investment
income. The proceeds received from repurchase agreements
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also provide a source of liquidity. For repurchase agreements and securities
lending transactions used to generate net investment income, the proceeds
received are reinvested in short-term investments or fixed income securities.
These transactions are short-term in nature (usually 30 days or less).
The Company receives collateral for securities loaned in an amount
generally equal to 102% of the fair value of securities and records the related
obligations to return the collateral in other liabilities and accrued expenses.
The carrying value of these obligations approximates fair value because of their
relatively short-term nature. The Company monitors the market value of
securities loaned on a daily basis and obtains additional collateral as
necessary to mitigate counterparty credit risk. The Company maintains the right
and ability to redeem the securities loaned on short notice. Substantially all
of the Company's securities loaned are placed with large brokerage firms.
Securities to be repurchased under repurchase agreements are the same,
or substantially the same, as the securities transferred. The Company's
obligations to return the funds received under repurchase agreements are
carried at the amount at which the securities will subsequently be
reacquired, including accrued interest, as specified in the respective
agreements and are classified as other liabilities and accrued expenses. The
carrying value of these obligations approximates fair value because of their
relatively short-term nature.
RECOGNITION OF PREMIUM REVENUES AND CONTRACT CHARGES, AND RELATED BENEFITS AND
INTEREST CREDITED
Traditional life insurance products consist principally of products with
fixed and guaranteed premiums and benefits, primarily term and whole life
insurance products. Premiums from these products are recognized as revenue when
due from policyholders. Benefits are recognized in relation to such revenue so
as to result in the recognition of profits over the life of the policy and are
reflected in contract benefits.
Immediate annuities with life contingencies, including certain structured
settlement annuities, provide insurance protection over a period that extends
beyond the period during which premiums are collected. Premiums from these
products are recognized as revenue when received at the inception of the
contract. Benefits and expenses are recognized in relation to such revenue such
that profits are recognized over the lives of the contracts.
Interest-sensitive life contracts, such as universal life and single
premium life, are insurance contracts whose terms are not fixed and guaranteed.
The terms that may be changed include premiums paid by the contractholder,
interest credited to the contractholder account balance and any amounts assessed
against the contractholder account balance. Premiums from these contracts are
reported as contractholder fund deposits. Contract charges consist of fees
assessed against the contractholder account balance for cost of insurance
(mortality risk), contract administration and early surrender. These revenues
are recognized when assessed against the contractholder account balance.
Contract benefits include life-contingent benefit payments in excess of the
contractholder account balance.
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, equity-indexed annuities and
immediate annuities without life contingencies, funding agreements (primarily
backing medium-term notes) and certain guaranteed investment contracts ("GICs")
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.
Interest credited to contractholder funds represents interest accrued or
paid on interest-sensitive life contracts and investment contracts. Crediting
rates for certain fixed annuities and interest-sensitive life contracts are
adjusted periodically by the Company to reflect current market conditions
subject to contractually guaranteed minimum rates. Crediting rates for indexed
annuities and indexed funding agreements are based on a specified interest-rate
index, such as LIBOR, or an equity index, such as the S&P 500. Pursuant to the
adoption of Statement of Position No. 03-1, "Accounting and Reporting by
Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for
Separate Accounts" ("SOP 03-1") in 2004, interest credited also includes
amortization of deferred sales inducement ("DSI") expenses. DSI is amortized
into interest credited using the same method used to amortize deferred policy
acquisition costs ("DAC").
Separate account products include variable annuities and variable life
insurance contracts. The assets supporting these products are legally segregated
and available only to settle separate account contract obligations. Deposits
received are reported as separate accounts liabilities. Contract charges for
these products consist of fees assessed against the contractholder account
values for contract maintenance, administration, mortality, expense and early
surrender.
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Contract benefits incurred include guaranteed minimum death, income, withdrawal
and accumulation benefits incurred on variable annuity and life insurance
contracts.
DEFERRED POLICY ACQUISITION AND SALES INDUCEMENT COSTS
Costs that vary with and are primarily related to acquiring life insurance
and investment contracts are deferred and recorded as DAC. These costs are
principally agents' and brokers' remuneration and certain underwriting costs.
DSI costs, which are deferred and recorded as other assets, related to sales
inducements offered on sales to new customers, principally on fixed and variable
annuities and primarily in the form of additional credits to the customer's
account value or enhancements to interest credited for a specified period, which
are beyond amounts currently being credited to existing contracts. All other
acquisition costs are expensed as incurred and included in operating costs and
expenses on the Consolidated Statements of Operations and Comprehensive Income.
DAC is amortized to income and included in amortization of deferred policy
acquisition costs on the Consolidated Statements of Operations and Comprehensive
Income. DSI is amortized to income using the same methodology and assumptions as
DAC and is included in interest credited to contractholder funds on the
Consolidated Statements of Operations and Comprehensive Income. DAC and DSI are
periodically reviewed for recoverability and written down when necessary.
For traditional life insurance and other premium paying contracts, DAC is
amortized in proportion to the estimated revenues on such business. Assumptions
used in amortization of DAC and reserve calculations are determined based upon
conditions as of the date of policy issuance and are generally not revised
during the life of the policy. Any deviations from projected business in force
resulting from actual policy terminations differing from expected levels and any
estimated premium deficiencies change the rate of amortization in the period
such events occur. Generally, the amortization period for these contracts
approximates the estimated lives of the policies.
For internal exchanges of traditional life insurance, the unamortized
balance of costs previously deferred under the original contracts are charged to
income. The new costs associated with the exchange are deferred and amortized to
income.
For interest-sensitive life, fixed and variable annuities and other
investment contracts, DAC and DSI are amortized in proportion to the incidence
of the total present value of gross profits, which includes both actual
historical gross profits ("AGP") and estimated future gross profits ("EGP")
earned over the estimated lives of the contracts. The amortization periods range
from 15-30 years; however, estimates of customer surrender rates, partial
withdrawals and deaths generally result in the majority of deferred costs being
amortized over the surrender charge period. The rate of amortization during this
term is matched to the pattern of total gross profits. AGP and EGP consists of
the following components: benefit margins, primarily from mortality, including
guaranteed minimum death, income, withdrawal and accumulation benefits;
investment margin including realized capital gains and losses; and contract
administration, surrender and other contract charges, less maintenance expenses.
DAC and DSI amortization for variable annuity and life contracts is
estimated using stochastic modeling and is significantly impacted by the
anticipated return on the underlying funds. The Company's long-term expectation
of separate accounts fund performance, net of fees, was approximately 7% in 2005
and 8% in 2004 and 2003. Whenever actual separate accounts fund performance
based on the two most recent years varies from the expectation, the Company
projects performance levels over the next five years such that the mean return
over a seven-year period equals the long-term expectation. This approach is
commonly referred to as "reversion to the mean" and is commonly used by the life
insurance industry as an appropriate method for amortizing variable annuity and
life DAC and DSI. In applying the reversion to the mean process, the Company
does not allow the future mean rates of return including fees projected over the
five-year period to exceed 12.75% or fall below 0%. The Company periodically
evaluates the results of utilization of this process to confirm that it is
reasonably possible that variable annuity and life fund performance will revert
to the expected long-term mean within this time horizon.
Changes in the amount or timing of EGP result in adjustments to the
cumulative amortization of DAC and DSI. All such adjustments are reflected in
the current results of operations.
The Company performs quarterly reviews of DAC and DSI recoverability for
interest-sensitive life, variable annuities and investment contracts in the
aggregate using current assumptions. If a change in the amount of EGP is
significant, it could result in the unamortized DAC and DSI not being
recoverable, resulting in a charge which is included as a component of
amortization of deferred policy acquisition costs or interest credited to
contractholder funds, respectively, on the Consolidated Statements of Operations
and Comprehensive Income.
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Any amortization of DAC or DSI that would result from changes in unrealized
gains or losses had those gains or losses actually been realized during the
reporting period is recorded net of tax in other comprehensive income.
The costs assigned to the right to receive future cash flows from certain
business purchased from other insurers are also classified as deferred policy
acquisition costs in the Consolidated Statements of Financial Position. The
costs capitalized represent the present value of future profits expected to be
earned over the life of the contracts acquired. These costs are amortized as
profits emerge over the life of the acquired business and are periodically
evaluated for recoverability. The present value of future profits was $37
million and $45 million at December 31, 2005 and 2004, respectively.
Amortization expense on the present value of future profits was $8 million, $6
million and $36 million for the years ended December 31, 2005, 2004 and 2003,
respectively.
REINSURANCE
In the normal course of business, the Company seeks to limit aggregate and
single exposure to losses on large risks by purchasing reinsurance from
reinsurers (see Note 9). The amounts reported in the Consolidated Statements of
Financial Position as reinsurance recoverables include amounts billed to
reinsurers on losses paid as well as estimates of amounts expected to be
recovered from reinsurers on incurred losses that have not yet been paid.
Reinsurance recoverables on unpaid losses are estimated based upon assumptions
consistent with those used in establishing the liabilities related to the
underlying reinsured contract. Insurance liabilities are reported gross of
reinsurance recoverables. Reinsurance premiums are generally reflected in income
in a manner consistent with the recognition of premiums on the reinsured
contracts or are earned ratably over the contract period to the extent coverage
remains available. Reinsurance does not extinguish the Company's primary
liability under the policies written. Therefore, the Company regularly evaluates
the financial condition of the reinsurers and establishes allowances for
uncollectible reinsurance recoverables as appropriate.
GOODWILL
Goodwill represents the excess of amounts paid for acquiring businesses
over the fair value of the net assets acquired. The Company annually tests
goodwill for impairment using a trading multiple analysis, which is a widely
accepted valuation technique, to estimate the fair value of its reporting units.
The Company also reviews its goodwill for impairment whenever events or changes
in circumstances indicate that it is more likely than not that the carrying
amount of goodwill may be less than its fair value. Goodwill impairment testing
indicated no impairment at December 31, 2005.
In 2004, the Company recognized an aggregate goodwill and other intangible
assets impairment loss of $4 million ($2 million after-tax), which was
classified as loss on disposition of operations, based on the Company's decision
to sell two life insurance companies.
INCOME TAXES
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 certain investments, 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.
RESERVE FOR LIFE-CONTINGENT CONTRACT BENEFITS
The reserve for life-contingent contract benefits, which relates to
traditional life and accident and health insurance and immediate annuities with
life contingencies, is computed on the basis of long-term actuarial assumptions
as to future investment yields, mortality, morbidity, policy terminations and
expenses (see Note 8). These assumptions, which for traditional life insurance
are applied using the net level premium method, include provisions for adverse
deviation and generally vary by such characteristics as type of coverage, year
of issue and policy duration. To the extent that unrealized gains on fixed
income securities would result in a premium deficiency had those gains actually
been realized, the related increase in reserves for certain immediate annuities
with life contingencies is recorded net of tax as a reduction of the unrealized
net capital gains included in accumulated other comprehensive income.
CONTRACTHOLDER FUNDS
Contractholder funds represent interest-bearing liabilities arising from
the sale of products, such as interest-sensitive life, fixed annuities and
funding agreements. Contractholder funds are comprised primarily of deposits
received and interest credited to the benefit of the contractholder less
surrenders and withdrawals, mortality charges
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and administrative expenses (see Note 8). Contractholder funds also include
reserves for secondary guarantees on interest-sensitive life insurance and
certain fixed annuity contracts.
SEPARATE ACCOUNTS
The Company issues variable annuities and variable life insurance
contracts, the assets and liabilities of which are legally segregated and
recorded as assets and liabilities of the separate accounts. The assets of the
separate accounts are carried at fair value. Separate accounts liabilities
represent the contractholders' claims to the related assets and are carried at
the fair value of the assets. Investment income and realized capital gains and
losses of the separate accounts accrue directly to the contractholders and
therefore, are not included in the Company's Consolidated Statements of
Operations and Comprehensive Income. Revenues to the Company from the separate
accounts consist of contract charges for maintenance, administration, cost of
insurance and surrender of the contract prior to the contractually specified
dates and are reflected in contract charges. Deposits to the separate accounts
are not included in consolidated cash flows.
Absent any contract provision wherein the Company guarantees either a
minimum return or account value upon death, a specified contract anniversary
date, partial withdrawal or annuitization, variable annuity and variable life
insurance contractholders bear the investment risk that the separate accounts'
funds may not meet their stated investment objectives. The account balances of
variable annuities contracts' separate accounts with guarantees included $13.90
billion and $13.41 billion of equity, fixed income and balanced mutual funds and
$580 million and $279 million of money market mutual funds at December 31, 2005
and 2004, respectively.
LIABILITIES FOR VARIABLE CONTRACT GUARANTEES
The Company offers various guarantees to variable annuity contractholders
including a return of no less than (a) total deposits made on the contract less
any customer withdrawals, (b) total deposits made on the contract less any
customer withdrawals plus a minimum return or (c) the highest contract value on
a specified anniversary date minus any customer withdrawals following the
contract anniversary. These guarantees include benefits that are payable in the
event of death (death benefits), upon annuitization (income benefits), upon
periodic withdrawal (withdrawal benefits), or at specified dates during the
accumulation period (accumulation benefits). Liabilities for variable contract
guarantees related to death benefits are included in reserve for life-contingent
contract benefits and the liabilities related to the income, withdrawal and
accumulation benefits are included in contractholder funds in the Consolidated
Statements of Financial Position (see Note 8).
Pursuant to the adoption of SOP 03-1 in 2004, the liability for death and
income benefit guarantees is established equal to a benefit ratio multiplied by
the cumulative contract charges earned, plus accrued interest less contract
benefit payments. The benefit ratio is calculated as the estimated present value
of all expected contract benefits divided by the present value of all expected
contract charges. The establishment of reserves for these guarantees requires
the projection of future separate account fund performance, mortality,
persistency and customer benefit utilization rates. These assumptions are
periodically reviewed and updated. For guarantees related to death benefits,
benefits represent the current guaranteed minimum death benefit payments in
excess of the current account balance. For guarantees related to income
benefits, benefits represent the present value of the minimum guaranteed
annuitization benefits in excess of the current account balance.
Projected benefits and contract charges used in determining the liability
for certain guarantees are developed using models and stochastic scenarios that
are also used in the development of estimated future gross profits. Underlying
assumptions for the liability related to income benefits include assumed future
annuitization elections based on factors such as the extent of benefit to the
potential annuitant, eligibility conditions and the annuitant's attained age.
The liability for guarantees is re-evaluated periodically, and adjustments are
made to the liability balance through a charge or credit to contract benefits.
Guarantees related to withdrawal and accumulation benefits are considered
to be derivative financial instruments; therefore, the liability for these
benefits is established based on its fair value.
CONSOLIDATION OF VARIABLE INTEREST ENTITIES ("VIES")
The Company consolidates VIEs when it is the primary beneficiary of a VIE.
A primary beneficiary has a variable interest that will absorb a majority of the
expected losses if they occur or receive a majority of the entity's expected
returns, or both (see Note 13).
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OFF-BALANCE-SHEET FINANCIAL INSTRUMENTS
Commitments to invest, commitments to purchase private placement
securities, commitments to extend mortgage loans and credit guarantees have
off-balance-sheet risk because their contractual amounts are not recorded in the
Company's Consolidated Statements of Financial Position (see Note 7).
ADOPTED ACCOUNTING STANDARDS
STATEMENT OF POSITION 03-1, "ACCOUNTING AND REPORTING BY INSURANCE ENTERPRISES
FOR CERTAIN NONTRADITIONAL LONG-DURATION CONTRACTS AND FOR SEPARATE ACCOUNTS"
("SOP 03-1")
On January 1, 2004, the Company adopted SOP 03-1. The major provisions of
the SOP affecting the Company require:
- Establishment of reserves primarily related to death benefit and
income benefit guarantees provided under variable annuity contracts;
- Deferral of sales inducements that meet certain criteria, and
amortization using the same method used for DAC; and
- Reporting and measuring assets and liabilities of certain separate
accounts products as investments and contractholder funds rather than
as separate accounts assets and liabilities when specified criteria
are present.
The cumulative effect of the change in accounting principle from
implementing SOP 03-1 was a loss of $175 million, after-tax ($269 million,
pre-tax). It was comprised of an increase in benefit reserves (primarily for
variable annuity contracts) of $145 million, pre-tax, and a reduction in DAC and
DSI of $124 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 2005 and 2004, DSI and related amortization is classified within the
Consolidated Statements of Financial Position and Operations and Comprehensive
Income as other assets and interest credited to contractholder funds,
respectively (see Note 10). Pursuant to adopting this guidance, the Company also
reclassified $204 million of separate accounts assets and liabilities to
investments and contractholder funds, respectively.
AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS ("AICPA") TECHNICAL PRACTICE
AID ("TPA") RE. SOP 03-1
In September 2004, the staff of the AICPA, aided by industry experts,
issued a set of technical questions and answers on financial accounting and
reporting issues related to SOP 03-1 that will be included in the AICPA's TPAs.
The TPA addresses a number of issues related to SOP 03-1 including when it is
necessary to establish a liability in addition to the account balance for
certain contracts such as single premium and universal life that meet the
definition of an insurance contract and have amounts assessed against the
contractholder in a manner that is expected to result in profits in earlier
years and losses in subsequent years from the insurance benefit function. The
impact of adopting the provisions of the TPA did not have a material effect on
the results of operations or financial position of the Company.
FINANCIAL ACCOUNTING STANDARDS BOARD ("FASB") INTERPRETATION NO. 46 AND 46R,
"CONSOLIDATION OF VARIABLE INTEREST ENTITIES" ("FIN 46" AND "FIN 46R")
In December 2003, the FASB revised FIN 46, which was originally issued in
January 2003. FIN 46R addressed whether certain types of entities, referred to
as VIEs, should be consolidated in a company's financial statements. A company
must consolidate a VIE in which it has an investment if it has determined to be
the primary beneficiary. A primary beneficiary has a variable interest that will
absorb a majority of the expected losses if they occur, receive a majority of
the entity's expected returns, or both. The Company elected to adopt FIN 46 as
of July 1, 2003 for its existing VIE. See Note 13 for the impact of adoption.
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DERIVATIVES IMPLEMENTATION GROUP STATEMENT 133 IMPLEMENTATION ISSUE NO. B36,
"EMBEDDED DERIVATIVES: MODIFIED COINSURANCE ARRANGEMENTS AND DEBT INSTRUMENTS
THAT INCORPORATE CREDIT RISK EXPOSURES THAT ARE UNRELATED OR ONLY PARTIALLY
RELATED TO THE CREDITWORTHINESS OF THE OBLIGOR UNDER THOSE INSTRUMENTS"
("IMPLEMENTATION ISSUE B36")
In April 2003, the FASB issued Implementation Issue B36, which became
effective October 1, 2003. Implementation Issue B36 was applied to two of the
Company's modified coinsurance agreements, and as a result, the embedded
derivatives were bifurcated from the agreements and marked to market value at
October 1, 2003. The effect of adopting Implementation Issue B36 was the
recognition of a loss of $13 million, after-tax, which is reflected as a
cumulative effect of a change in accounting principle on the Consolidated
Statements of Operations and Comprehensive Income.
PENDING ACCOUNTING STANDARDS
FINANCIAL ACCOUNTING STANDARDS BOARD STAFF POSITION NO. FAS 115-1, "THE MEANING
OF OTHER-THAN-TEMPORARY IMPAIRMENT AND ITS APPLICATION TO CERTAIN INVESTMENTS"
("FSP FAS 115-1")
In November 2005, the Financial Accounting Standards Board ("FASB") issued
FSP FAS 115-1, which nullifies the guidance in paragraphs 10-18 of EITF Issue
03-1, "The Meaning of Other-Than-Temporary Impairment and Its Application to
Certain Investments" and references existing other than temporary impairment
guidance. FSP FAS 115-1 clarifies that an investor should recognize an
impairment loss no later than when the impairment is deemed
other-than-temporary, even if a decision to sell the security has not been made,
and also provides guidance on the subsequent accounting for an impaired debt
security. FSP FAS 115-1 is effective for reporting periods beginning after
December 15, 2005. The adoption of FSP FAS 115-1 is not expected to have a
material effect on the results of operations or financial position of the
Company.
STATEMENT OF POSITION 05-1, ACCOUNTING BY INSURANCE ENTERPRISES FOR DEFERRED
ACQUISITION COSTS IN CONNECTION WITH MODIFICATIONS OR EXCHANGES OF INSURANCE
CONTRACTS ("SOP 05-1")
In October 2005, the AICPA issued SOP 05-1. SOP 05-1 provides accounting
guidance for deferred policy acquisition costs on internal replacements of
insurance and investment contracts other than those specifically described in
Statement of Financial Accounting Standards ("SFAS") No. 97, "Accounting and
Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for
Realized Gains and Losses from the Sale of Investments." SOP 05-1 defines an
internal replacement as a modification in product benefits, features, rights or
coverages that occurs by the exchange of a contract for a new contract, or by
amendment, endorsement or rider to a contract, or by the election of a feature
or coverage within a contract. Internal replacement contracts are those that are
substantially changed from the replaced contract and are accounted for as an
extinguishment of the replaced contract. Nonintegrated contract features are
accounted for as separately issued contracts. Modifications resulting from the
election of a feature or coverage within a contract or from an integrated
contract feature generally do not result in an internal replacement contract
subject to SOP 05-1 provided certain conditions are met. The provisions of SOP
05-1 are effective for internal replacements occurring in fiscal years beginning
after December 15, 2006. The Company's accounting policy for internal
replacements is generally consistent with the accounting guidance prescribed in
SOP 05-1. The Company is currently assessing the impact of the SOP on its
results of operations and financial position.
STATEMENT OF FINANCIAL ACCOUNTING STANDARDS NO. 154, ACCOUNTING CHANGES AND
ERROR CORRECTIONS ("SFAS NO. 154")
In May 2005, the FASB issued SFAS No. 154, which replaces Accounting
Principles Board ("APB") Opinion No. 20, "Accounting Changes," and FASB
Statement No. 3, "Reporting Accounting Changes in Interim Financial Statements."
SFAS No. 154 requires retrospective application to prior periods' financial
statements for changes in accounting principle, unless determination of either
the period specific effects or the cumulative effect of the change is
impracticable or otherwise promulgated. SFAS No. 154 is effective for fiscal
years beginning after December 15, 2005. SFAS No. 154, upon adoption, is not
expected to have a material effect on the results of operations or financial
position of the Company.
61
<Page>
SFAS NO. 155, ACCOUNTING FOR CERTAIN HYBRID FINANCIAL INSTRUMENTS - AN AMENDMENT
OF FASB STATEMENTS NO. 133 AND 140 ("SFAS NO. 155")
In February 2006 the FASB issued SFAS No. 155, which resolves issues
addressed in Statement 133 Implementation Issue No. D1, "Application of
Statement 133 to Beneficial Interests in Securitized Financial Assets." SFAS No.
155, among other things, permits the fair value remeasurement of any hybrid
financial instrument that contains an embedded derivative that otherwise would
require bifurcation; clarifies which interest-only strips and principal-only
strips are not subject to the requirements of Statement 133; and establishes a
requirement to evaluate interests in securitized financial assets to identify
interests that are freestanding derivatives or that are hybrid financial
instruments that contain an embedded derivative requiring bifurcation. SFAS No.
155 is effective for all financial instruments acquired or issued in a fiscal
year beginning after September 15, 2006. The Company is currently assessing the
impact of SFAS No. 155 on its results of operations and financial position.
3. DISPOSITIONS
In 2005, the Company entered into negotiations to sell two of its wholly
owned subsidiaries, Charter National Life Insurance Company ("Charter") and
Intramerica Life Insurance Company ("Intramerica"), and recognized an
estimated loss on disposition of $4 million ($1 million, after-tax). During
the third quarter, a definitive agreement was reached for which the buyer
failed to gain regulatory approval. The subsidiaries whose assets, excluding
reinsurance recoverables due from ALIC, totaled approximately $443 million at
December 31, 2005 ($114 million and $297 million are classified as
reinsurance recoverables and separate accounts, respectively) are still
available for sale.
In 2003, the Company announced its intention to exit its direct response
distribution business and, based on its decision to sell the business, reached a
measurement date that resulted in the recognition of an estimated loss on the
disposition of $44 million ($29 million, after-tax). In 2004, the Company
disposed of substantially all of its direct response distribution business
pursuant to reinsurance transactions with subsidiaries of Citigroup and Scottish
Re (U.S.) Inc. In connection with these disposal activities, the Company
recorded an additional loss on disposition of $3 million ($2 million after-tax)
and $21 million ($14 million after-tax) in 2005 and 2004, respectively (see
Notes 9 and 10).
SUBSEQUENT EVENT
On March 8, 2006, ALIC, its subsidiary, Allstate Life Insurance Company
of New York ("ALNY"), and the Corporation, entered into a definitive
agreement ("Agreement") with Prudential Financial, Inc. and its subsidiary
The Prudential Insurance Company of America (collectively, "Prudential") for
the sale pursuant to a combination of coinsurance and modified coinsurance
reinsurance of substantially all of its variable annuity business. Total
consideration is expected to be approximately $581 million, subject to
adjustment for changes in equity markets and interest rates between the
effective date of the Agreement and the closing of the transaction. ALIC has
entered into an economic hedge that it believes will substantially reduce its
economic exposure to the variability of this arrangement from the period
between the effective date of the Agreement and closing. As a result of the
modified coinsurance reinsurance, the separate account assets and liabilities
will remain on ALIC's consolidated statements of financial position, but the
related results of operations will be fully reinsured to Prudential. The
sale is expected to result in the recognition of a small gain, which will be
amortized into earnings over the life of the Agreement. A level of cash or
cash equivalents in an amount equal to the fixed (general) account
liabilities of approximately $1 billion, net of the consideration, will be
needed to settle our obligation to Prudential at closing under the
coinsurance portion of the Agreement. An evaluation will occur in the first
quarter of 2006 regarding available sources of funds for settlements, which
may include such items as cash flows from operations, sales of existing
investments or borrowings.
Under the Agreement, ALIC, ALNY and the Corporation will each indemnify
Prudential for certain pre-closing contingent liabilities (including
extra-contractual liabilities of ALIC and ALNY and liabilities specifically
excluded from the transaction) that ALIC and ALNY have agreed to retain. In
addition, ALIC, ALNY and the Corporation will each indemnify Prudential for
certain post-closing liabilities that may arise from the acts of ALIC, ALNY
and their agents, including in connection with ALIC's and ALNY's provision of
transition services.
The terms of the Agreement will give Prudential the right to be the
exclusive provider of its variable annuity products through the Allstate
proprietary agency force for three years and a non-exclusive preferred
provider for the following two years. During a transition period, ALIC and
ALNY will continue to issue new variable annuity contracts, accept additional
deposits on existing business from existing contractholders on behalf of
Prudential and, for a period of twenty-four months or less, service the
reinsured business while Prudential prepares for the migration of the
business onto its servicing platform. ALIC and ALNY have also agreed to
continue to issue variable annuity contracts in the financial institutions
channel for a period of at least thirty-three months and cede them to
Prudential. The Agreement is subject to regulatory approval and is expected
to be completed by the end of the second quarter of 2006.
In 2005, ALIC's and ALNY's variable annuity business generated
approximately $278 million in contract charges on separate account balances
of $14 billion and general account balances of $2 billion as of December 31,
2005. Separate account balances totaling approximately $1 billion related to
the variable life business and three companies held for sale continue to be
retained by ALIC.
4. SUPPLEMENTAL CASH FLOW INFORMATION
Non-cash investment exchanges and modifications, which primarily reflect
refinancings of fixed income securities and mergers completed with equity
securities, totaled $51 million, $79 million and $41 million for the years ended
December 31, 2005, 2004 and 2003, respectively.
The Company paid dividends of $49 million and $24 million in the form of
investment securities to AIC in 2005 and 2004, respectively. In 2004, the
Company received non-cash capital contributions of $41 million related to
certain reinsurance transactions with American Heritage Life Insurance Company
("AHL"), an unconsolidated affiliate of the Company, and Columbia Universal Life
Insurance Company ("Columbia"), a former unconsolidated affiliate of the
Company, in 2004 (see Note 5).
Liabilities for collateral received in conjunction with securities lending
and other activities and for funds received from security repurchase activities
were $ 2.23 billion, $2.93 billion and $1.92 billion at December 31, 2005, 2004,
and 2003, respectively, and are reported in other liabilities and accrued
expenses in the Consolidated Statements of Financial Position. The accompanying
cash flows are included in cash flows from operating activities in the
Consolidated Statements of Cash Flows along with the related changes in
investments, which for the years ended December 31 are as follows:
<Table>
<Caption>
(IN MILLIONS) 2005 2004 2003
---------- ---------- ----------
Net change in fixed income securities $ (221) $ (305) $ (520)
Net change in short-term investments 918 (705) (162)
---------- ---------- ----------
Operating cash flow provided (used) $ 697 $ (1,010) $ (682)
========== ========== ==========
Liabilities for collateral and security repurchase, beginning of year $ (2,928) $ (1,918) $ (1,236)
Liabilities for collateral and security repurchase, end of year (2,231) (2,928) (1,918)
---------- ---------- ----------
Operating cash flow (used) provided $ (697) $ 1,010 $ 682
========== ========== ==========
</Table>
62
<Page>
5. RELATED PARTY TRANSACTIONS
BUSINESS OPERATIONS
The Company uses services performed by its affiliates, AIC and Allstate
Investments LLC, and business facilities owned or leased and operated by AIC in
conducting its business activities. In addition, the Company shares the services
of employees with AIC. The Company reimburses its affiliates for the operating
expenses incurred on behalf of the Company. The Company is charged for the cost
of these operating expenses based on the level of services provided. Operating
expenses, including compensation, retirement and other benefit programs
allocated to the Company (see Note 15), were $410 million, $322 million, and
$299 million in 2005, 2004 and 2003, respectively. A portion of these expenses
relate to the acquisition of business, which are deferred and amortized into
income.
STRUCTURED SETTLEMENT ANNUITIES
The Company issued $235 million, $98 million and $119 million of structured
settlement annuities, a type of immediate annuity, in 2005, 2004 and 2003,
respectively, at prices determined based upon interest rates in effect at the
time of purchase, to fund structured settlements in matters involving AIC. Of
these amounts, $9 million, $27 million and $21 million relate to structured
settlement annuities with life contingencies and are included in premium income
for 2005, 2004, and 2003, respectively. In most cases, these annuities were
issued under a "qualified assignment," whereby Allstate Settlement Corporation
("ASC"), a wholly-owned subsidiary of ALIC, purchased annuities from the Company
and assumed AIC's obligation to make the future payments.
AIC issued surety bonds to guarantee the payment of structured settlement
benefits assumed by ASC (from both AIC and non-related parties) and funded by
certain annuity contracts issued by the Company through June 30, 2001. ASC
entered into a General Indemnity Agreement pursuant to which it indemnified AIC
for any liabilities associated with the surety bonds and gave AIC certain
collateral security rights with respect to the annuities and certain other
rights in the event of any defaults covered by the surety bonds. For contracts
written on or after July 1, 2001, AIC no longer issues surety bonds to guarantee
the payment of structured settlement benefits. Alternatively, ALIC guarantees
the payment of structured settlement benefits on all contracts issued on or
after July 1, 2001.
Reserves recorded by the Company for annuities that are guaranteed by the
surety bonds of AIC were $4.94 billion and $4.96 billion at December 31, 2005
and 2004, respectively.
BROKER/DEALER AGREEMENT
The Company receives underwriting and distribution services from Allstate
Financial Services, LLC ("AFS"), an affiliated broker/dealer company, for
certain variable annuity and variable life insurance contracts sold by Allstate
exclusive agencies. The Company incurred $46 million, $44 million and $38
million of commission and other distribution expenses for the years ending
December 31, 2005, 2004 and 2003, respectively.
INVESTMENTS
In 2005, the Company purchased fixed income securities from AIC. The
Company paid $655 million in cash for the securities, which includes the fair
value of the securities of $649 million and $6 million for accrued investment
income. Since the transaction was between affiliates under common control,
the securities were recorded at the amortized cost of $623 million as of the
date of sale. The difference between the amortized cost and fair value of the
securities, which increased accumulated other comprehensive income by $26
million, was recorded as a dividend of $26 million ($16 million, after-tax).
Thus, the net effect on shareholder's equity was zero.
REINSURANCE TRANSACTIONS
In 2005, the Company received fixed income securities with a fair value
and amortized cost of $381 million and $358 million, respectively, and $5
million of accrued investment income for the settlement of a $386 million
premium receivable due from AHL, an unconsolidated affiliate of the Company.
The receivable related to two coinsurance agreements entered into in 2004
whereby the Company assumed certain interest-sensitive life insurance and
fixed annuity contracts from AHL. Since the transaction was between
affiliates under common control, the securities were recorded at amortized
cost as of the date of settlement. The difference between the amortized cost
and fair value of the securities, which increased accumulated other
comprehensive income by $23 million, was recorded as a non-cash dividend of
$23 million ($15 million, after-tax). Thus, the net effect on shareholder's
equity was zero. In 2004, as a result of the transaction, the Company
recorded a premium receivable of $386 million, DAC of $24 million, policy
loans of $16 million, and contractholder funds of $379 million. Since the
Company received assets in excess of net liabilities from an affiliate under
common control, the Company recognized a gain of $47 million ($31 million,
after-tax), which was recorded as a non-cash capital contribution.
63
<Page>
The Company has reinsurance contracts with Columbia, a former
unconsolidated affiliate of the Company. In November 2004, the Corporation
disposed of Columbia pursuant to a stock purchase agreement with Verde Financial
Corporation. As of June 1, 2004, the Company converted a modified coinsurance
contract with Columbia to a coinsurance contract to assume 100% of fixed annuity
business in force as of June 30, 2000 and new business written prior to the
disposition of Columbia. In addition, the Company entered into a coinsurance
contract with Columbia to assume 100% of traditional life and accident and
health business in force as of June 1, 2004. As a result of these transactions,
the Company received assets in excess of net liabilities from an affiliate under
common control and recognized a gain of $15 million ($10 million, after-tax),
which was recorded as a non-cash capital contribution. Both agreements are
continuous but may be terminated by the Company in the event of Columbia's
non-payment of reinsurance amounts due. As of May 31, 2001, Columbia ceased
issuing new contracts. During 2005, 2004 and 2003, the Company assumed $0.2
million, $14 million and $17 million, respectively, in premiums and contract
charges from Columbia.
The Company had a modified coinsurance contract with Allstate Reinsurance,
Ltd. ("Allstate Re"), an unconsolidated affiliate of the Company, to cede 50% of
certain fixed annuity business issued under a distribution agreement with PNC
Bank NA. Under the terms of the contract, a trust was established to provide
protection for ceded liabilities. This agreement was terminated in 2004. During
2003, the Company ceded $0.4 million in contract charges to Allstate Re.
The Company has a contract to assume 100% of all credit insurance written
by AIC. This agreement is continuous but may be terminated by either party with
60 days notice. The Company did not assume premiums from AIC in 2005. The
Company assumed premiums from AIC in the amount of $0.3 million and $2 million
in 2004 and 2003, respectively.
ALIC enters into certain intercompany reinsurance transactions with its
wholly owned subsidiaries. ALIC enters into these transactions in order to
maintain underwriting control and spread risk among various legal entities.
These reinsurance agreements have been approved by the appropriate regulatory
authorities. All significant intercompany transactions have been eliminated in
consolidation.
INCOME TAXES
The Company is a party to a federal income tax allocation agreement with
the Corporation (see Note 12).
DEBT
On August 1, 2005, ALIC entered into an agreement with Kennett Capital,
Inc. ("Kennett"), an unconsolidated affiliate of ALIC, whereby ALIC sold to
Kennett $100 million 5.06% surplus notes due July 1, 2035 issued by ALIC
Reinsurance Company ("ALIC Re"), a wholly owned subsidiary of ALIC. As payment,
Kennett issued a full recourse 4.86% note due July 1, 2035 to ALIC for the same
amount. As security for the performance of Kennett's obligations under the
agreement and note, Kennett granted ALIC a pledge of and security interest in
Kennett's right, title and interest in the surplus notes and their proceeds.
Under the terms of the agreement, ALIC may sell and Kennett may choose to buy
additional surplus notes, if and when additional surplus notes are issued. The
note due from Kennett is classified as other investments and the related surplus
notes are classified as long-term debt in the Consolidated Statements of
Financial Position (see Note 13).
As of December 31, 2005 and 2004, the Company has $32 million and $57
million, respectively, of redeemable preferred stock - Series A issued to The
Northbrook Corporation, a wholly owned subsidiary of the Corporation. As of
December 31, 2005, the preferred stock was mandatorily redeemable and, as a
result, it was classified as debt (see Note 13).
The Company has entered into an intercompany loan agreement with the
Corporation. The amount of intercompany loans available to the Company 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. The Company had no amounts outstanding under the
intercompany loan agreement at December 31, 2005 and 2004. The Corporation uses
commercial paper borrowings, bank lines of credit and repurchase agreements to
fund intercompany borrowings.
64
<Page>
6. INVESTMENTS
FAIR VALUES
The amortized cost, gross unrealized gains and losses, and fair value for
fixed income securities are as follows:
<Table>
<Caption>
GROSS UNREALIZED
AMORTIZED ------------------------- FAIR
(IN MILLIONS) COST GAINS LOSSES VALUE
----------- ----------- ----------- -----------
AT DECEMBER 31, 2005
U.S. government and agencies $ 2,639 $ 850 $ (2) $ 3,487
Municipal 4,291 167 (15) 4,443
Corporate (1) 33,437 1,216 (273) 34,380
Foreign government 1,727 374 (2) 2,099
Mortgage-backed securities 5,742 29 (78) 5,693
Commercial mortgage-backed securities 6,745 50 (63) 6,732
Asset-backed securities 5,114 32 (28) 5,118
Redeemable preferred stock 22 3 - 25
----------- ----------- ----------- -----------
Total fixed income securities $ 59,717 $ 2,721 $ (461) $ 61,977
=========== =========== =========== ===========
AT DECEMBER 31, 2004
U.S. government and agencies $ 2,535 $ 798 $ - $ 3,333
Municipal 3,231 106 (14) 3,323
Corporate (1) 32,320 1,975 (89) 34,206
Foreign government 1,511 333 (1) 1,843
Mortgage-backed securities 5,905 84 (15) 5,974
Commercial mortgage-backed securities 6,074 141 (13) 6,202
Asset-backed securities 4,331 46 (31) 4,346
Redeemable preferred stock 57 7 - 64
----------- ----------- ----------- -----------
Total fixed income securities $ 55,964 $ 3,490 $ (163) $ 59,291
=========== =========== =========== ===========
</Table>
(1) Amortized cost and fair value of Corporate fixed income securities
include bank loans which are reflected at amortized cost of $945
million and $1.05 billion at December 31, 2005 and 2004, respectively.
SCHEDULED MATURITIES
The scheduled maturities for fixed income securities are as follows at
December 31, 2005:
<Table>
<Caption>
AMORTIZED FAIR
(IN MILLIONS) COST VALUE
---------- ----------
Due in one year or less $ 1,113 $ 1,124
Due after one year through five years 10,921 11,082
Due after five years through ten years 18,250 18,622
Due after ten years 18,577 20,338
---------- ----------
48,861 51,166
Mortgage- and asset-backed securities 10,856 10,811
---------- ----------
Total $ 59,717 $ 61,977
========== ==========
</Table>
Actual maturities may differ from those scheduled as a result of
prepayments by the issuers. Because of the potential for prepayment on mortgage-
and asset-backed securities, they are not categorized by contractual maturity.
The commercial mortgage-backed securities are categorized by contractual
maturity because they generally are not subject to prepayment risk.
65
<Page>
NET INVESTMENT INCOME
Net investment income for the years ended December 31 is as follows:
<Table>
<Caption>
(IN MILLIONS) 2005 2004 2003
---------- ---------- ----------
Fixed income securities $ 3,377 $ 3,072 $ 2,875
Mortgage loans 469 435 415
Equity securities 37 24 8
Other 19 (143) (121)
---------- ---------- ----------
Investment income, before expense 3,902 3,388 3,177
Investment expense 195 128 95
---------- ---------- ----------
Net investment income $ 3,707 $ 3,260 $ 3,082
========== ========== ==========
</Table>
Net investment income from equity securities includes income from
partnership interests of $35 million, $19 million and $7 million for the years
ended December 31, 2005, 2004 and 2003, respectively.
REALIZED CAPITAL GAINS AND LOSSES, AFTER-TAX
Realized capital gains and losses by security type for the years ended
December 31 are as follows:
<Table>
<Caption>
(IN MILLIONS) 2005 2004 2003
---------- ---------- ----------
Fixed income securities $ (94) $ (87) $ (181)
Equity securities 7 11 (10)
Other investments 106 65 107
---------- ---------- ----------
Realized capital gains and losses, pre-tax 19 (11) (84)
Income tax (expense) benefit (7) 3 30
---------- ---------- ----------
Realized capital gains and losses, after-tax $ 12 $ (8) $ (54)
========== ========== ==========
</Table>
Realized capital gains and losses by transaction type for the years ended
December 31 are as follows:
<Table>
<Caption>
(IN MILLIONS) 2005 2004 2003
---------- ---------- ----------
Investment write-downs $ (24) $ (81) $ (178)
Dispositions (1) 88 129 64
Valuation of derivative instruments (105) (66) 12
Settlement of derivative instruments 60 7 18
---------- ---------- ----------
Realized capital gains and losses, pre-tax 19 (11) (84)
Income tax (expense) benefit (7) 3 30
---------- ---------- ----------
Realized capital gains and losses, after-tax $ 12 $ (8) $ (54)
========== ========== ==========
</Table>
- ----------
(1) Dispositions include sales, losses recognized in anticipation of
dispositions and other transactions such as calls and prepayments. The
Company may sell securities during the period in which fair value has
declined below amortized cost for fixed income securities or cost for
equity securities. In certain situations new factors such as negative
developments, subsequent credit deterioration, relative value
opportunities, market liquidity concerns and portfolio reallocations
can subsequently change our previous intent to continue holding a
security. The Company recognized losses of $67 million due to a change
in intent to hold certain securities during 2005.
Gross gains of $199 million, $189 million and $173 million and gross losses
of $132 million, $157 million and $184 million were realized on sales of fixed
income securities during 2005, 2004 and 2003, respectively.
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<Page>
UNREALIZED NET CAPITAL GAINS AND LOSSES
Unrealized net capital gains and losses included in accumulated other
comprehensive income are as follows:
<Table>
<Caption>
GROSS UNREALIZED
(IN MILLIONS) FAIR ----------------------- UNREALIZED NET
AT DECEMBER 31, 2005 VALUE GAINS LOSSES GAINS (LOSSES)
---------- ---------- ---------- --------------
Fixed income securities $ 61,977 $ 2,721 $ (461) $ 2,260
Equity securities 324 6 (1) 5
Derivative instruments(1) (6) - (6) (6)
--------------
Total 2,259
Amount recognized for: (2)
Premium deficiency reserve (1,343)
Deferred policy acqusition and sales inducement costs (12)
--------------
Total (1,355)
Deferred income taxes (316)
--------------
Unrealized net capital gains and losses $ 588
==============
</Table>
<Table>
<Caption>
GROSS UNREALIZED
(IN MILLIONS) FAIR ----------------------- UNREALIZED NET
AT DECEMBER 31, 2004 VALUE GAINS LOSSES GAINS (LOSSES)
---------- ---------- ---------- --------------
Fixed income securities $ 59,291 $ 3,490 $ (163) $ 3,327
Equity securities 214 9 - 9
Derivative instruments (10) - (23) (23)
--------------
Total 3,313
Amount recognized for:
Premium deficiency reserve (1,089)
Deferred policy acqusition and sales inducement costs (665)
--------------
Total (1,754)
Deferred income taxes (546)
--------------
Unrealized net capital gains and losses $ 1,013
==============
</Table>
- ----------
(1) Included in the fair value of derivative securities is $4 million
classified as assets and $2 million classified as liabilities.
(2) See Note 2, Summary of Significant Accounting Policies for deferred policy
acquisition and sales inducement costs and reserve for life- contingent
contract benefits.
67
<Page>
CHANGE IN UNREALIZED NET CAPITAL GAINS AND LOSSES
The change in unrealized net capital gains and losses for the years ended
December 31 is as follows:
<Table>
<Caption>
(IN MILLIONS) 2005 2004 2003
---------- ---------- ----------
Fixed income securities $ (1,067) $ 150 $ 95
Equity securities (4) 5 12
Derivative instruments 17 (21) (4)
---------- ---------- ----------
Total (1,054) 134 103
Amounts recognized for:
Premium deficiency reserve (254) (157) (136)
Deferred policy acquisition and sales inducement costs 653 (39) 35
---------- ---------- ----------
Total 399 (196) (101)
Deferred income taxes 230 22 (1)
---------- ---------- ----------
(Decrease) increase in unrealized net capital gains and losses $ (425) $ (40) $ 1
========== ========== ==========
</Table>
PORTFOLIO MONITORING
Inherent in the Company's evaluation of a particular security are
assumptions and estimates about the operations of the issuer and its future
earnings potential. Some of the factors considered in evaluating whether a
decline in fair value is other than temporary are: 1) the Company's ability and
intent to retain the investment for a period of time sufficient to allow for an
anticipated recovery in value; 2) the recoverability of principal and interest;
3) the duration and extent to which the fair value has been less than cost for
equity securities or amortized cost for fixed income securities; 4) the
financial condition, near-term and long-term prospects of the issuer, including
relevant industry conditions and trends, and implications of rating agency
actions and offering prices; and 5) the specific reasons that a security is in a
significant unrealized loss position, including market conditions which could
affect access to liquidity.
68
<Page>
The following table summarizes the gross unrealized losses and fair value
of fixed income and equity securities by the length of time that individual
securities have been in a continuous unrealized loss position.
<Table>
<Caption>
LESS THAN 12 MONTHS
---------------------------------------
($ IN MILLIONS) NUMBER OF FAIR UNREALIZED
AT DECEMBER 31, 2005 ISSUES VALUE LOSSES
----------- ----------- -----------
Fixed income securities
U.S. government and agencies 13 $ 99 $ (2)
Municipal 160 878 (12)
Corporate 819 9,936 (193)
Foreign government 21 291 (2)
Mortgage-backed securities 755 3,694 (60)
Commercial mortgage-backed securities 321 3,727 (53)
Asset-backed securities 119 1,162 (12)
Redeemable preferred stock - - -
----------- ----------- -----------
Total fixed income securities 2,208 19,787 (334)
Equity securities 2 9 (1)
----------- ----------- -----------
Total fixed income & equity securities 2,210 $ 19,796 $ (335)
=========== =========== ===========
Investment grade fixed income securities 2,076 $ 19,203 $ (314)
Below investment grade fixed income securities 132 584 (20)
----------- ----------- -----------
Total fixed income securities 2,208 $ 19,787 $ (334)
=========== =========== ===========
AT DECEMBER 31, 2004
Fixed income securities
U.S. government and agencies 7 $ 19 $ -
Municipal 126 525 (8)
Corporate 328 3,762 (45)
Foreign government 6 63 (1)
Mortgage-backed securities 485 1,960 (14)
Commercial mortgage-backed securities 88 1,084 (9)
Asset-backed securities 97 1,011 (12)
Redeemable preferred stock 3 3 -
----------- ----------- -----------
Total fixed income securities 1,140 8,427 (89)
Equity securities - - -
----------- ----------- -----------
Total fixed income & equity securities 1,140 $ 8,427 $ (89)
=========== =========== ===========
Investment grade fixed income securities 1,078 $ 8,159 $ (80)
Below investment grade fixed income securities 62 268 (9)
----------- ----------- -----------
Total fixed income securities 1,140 $ 8,427 $ (89)
=========== =========== ===========
<Caption>
12 MONTHS OR MORE
------------------------------------ TOTAL
($ IN MILLIONS) NUMBER OF FAIR UNREALIZED UNREALIZED
AT DECEMBER 31, 2005 ISSUES VALUE LOSSES LOSSES
----------- ----------- ----------- -----------
Fixed income securities
U.S. government and agencies 3 $ 8 $ - $ (2)
Municipal 25 96 (3) (15)
Corporate 168 1,962 (80) (273)
Foreign government 2 20 - (2)
Mortgage-backed securities 222 587 (18) (78)
Commercial mortgage-backed securities 36 329 (10) (63)
Asset-backed securities 48 359 (16) (28)
Redeemable preferred stock - - - -
----------- ----------- ----------- -----------
Total fixed income securities 504 3,361 (127) (461)
Equity securities - - - (1)
----------- ----------- ----------- -----------
Total fixed income & equity securities 504 $ 3,361 $ (127) $ (462)
=========== =========== =========== ===========
Investment grade fixed income securities 488 $ 3,227 $ (112) $ (426)
Below investment grade fixed income securities 16 134 (15) (35)
----------- ----------- ----------- -----------
Total fixed income securities 504 $ 3,361 $ (127) $ (461)
=========== =========== =========== ===========
AT DECEMBER 31, 2004
Fixed income securities
U.S. government and agencies 1 $ 3 $ - $ -
Municipal 15 130 (6) (14)
Corporate 98 1,251 (44) (89)
Foreign government - - - (1)
Mortgage-backed securities 25 32 (1) (15)
Commercial mortgage-backed securities 15 197 (4) (13)
Asset-backed securities 25 274 (19) (31)
Redeemable preferred stock - - - -
----------- ----------- ----------- -----------
Total fixed income securities 179 1,887 (74) (163)
Equity securities - - - -
----------- ----------- ----------- -----------
Total fixed income & equity securities 179 $ 1,887 $ (74) $ (163)
=========== =========== =========== ===========
Investment grade fixed income securities 155 $ 1,635 $ (51) $ (131)
Below investment grade fixed income securities 24 252 (23) (32)
----------- ----------- ----------- -----------
Total fixed income securities 179 $ 1,887 $ (74) $ (163)
=========== =========== =========== ===========
</Table>
As of December 31, 2005, $444 million of unrealized losses related to
securities with an unrealized loss position less than 20% of cost or amortized
cost, the degree of which suggests that these securities do not pose a high risk
of being other than temporarily impaired. Of the $444 million, $416 million
related to unrealized losses on investment grade fixed income securities.
Investment grade is defined as a security having a rating from the National
Association of Insurance Commissioners ("NAIC") of 1 or 2; a rating of Aaa, Aa,
A or Baa from Moody's or a rating of AAA, AA, A or BBB from Standard & Poor's
("S&P"), Fitch or Dominion; 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.
As of December 31, 2005, the remaining $18 million of unrealized losses
related to securities in unrealized loss positions greater than or equal to 20%
of cost or amortized cost. Of the $18 million, $10 million related to investment
grade fixed income securities, $8 million related to below investment grade
fixed income securities. There were no equity securities with unrealized losses
greater than or equal to 20% of cost or amortized cost. Of these amounts, $7
million of the below investment grade fixed income securities had been in an
unrealized loss position for a period of twelve months or more as of December
31, 2005. Additionally, $8 million of unrealized losses from below investment
grade securities were airline industry issues for which values were depressed
due to company or issue specific conditions and economic issues, including fuel
costs. The $8 million of unrealized losses includes $1 million of corporate
fixed income securities and $7 million of asset-backed securities. The Company
expects eventual recovery of these securities. Every security was included in
our portfolio monitoring process.
69
<Page>
As of December 31, 2005, the securities comprising the $18 million of
unrealized losses were evaluated based on factors such as the financial
condition and near-term and long-term prospects of the issuer and were
determined to have adequate resources to fulfill contractual obligations, such
as recent financings or bank loans, cash flows from operations, collateral or
the position of a subsidiary with respect to its parent's bankruptcy.
As of December 31, 2005, the Company had the intent and ability to hold the
fixed income and equity securities with unrealized losses for a period of time
sufficient for them to recover.
As of December 31, 2005 and 2004, the carrying value for cost method
investments was $213 million and $130 million, respectively, which primarily
included limited partnership interests in fund investments. Each cost method
investment was evaluated utilizing certain criteria such as a measurement of the
Company's percentage share of the investee's equity relative to the carrying
value and certain financial trends to determine if an event or change in
circumstance occurred that could indicate an other-than-temporary impairment
existed. Investments meeting any one of these criteria were further evaluated
and, if it was determined that an other-than-temporary impairment existed, the
investment was written down to the estimated fair value. The estimated fair
value was generally based on the fair value of the underlying investments in the
limited partnership funds. It is not practicable to estimate the fair value of
each cost method investment in accordance with paragraphs 14 and 15 of SFAS 107,
"Disclosures about Fair Value of Financial Instruments" because the investments
are private in nature and do not trade frequently. In addition, the information
that would be utilized to estimate fair value is not readily available. In 2005
and 2004, the Company had write-downs of $0.1 million and $2 million,
respectively, related to cost method investments that were
other-than-temporarily impaired.
MORTGAGE LOAN IMPAIRMENT
A mortgage loan is impaired when it is probable that the Company will be
unable to collect all amounts due according to the contractual terms of the loan
agreement.
The net carrying value of impaired loans at December 31, 2005 and 2004 was
$3 million and $22 million, respectively. No valuation allowances were held at
December 31, 2005 and 2004 because the fair value of the collateral was greater
than the recorded investment in the loans.
Interest income for impaired loans is recognized on an accrual basis if
payments are expected to continue to be received; otherwise the cash basis is
used. The Company recognized interest income on impaired loans of $0.2 million,
$2 million and $2 million during 2005, 2004 and 2003, respectively. The average
balance of impaired loans was $6 million, $29 million and $23 million during
2005, 2004 and 2003, respectively.
No valuation allowances were charged to operations in 2005. Valuation
allowances charged to operations during 2004 and 2003 were $1 million and $3
million, respectively. In 2004 and 2003, $1 million of a balance previously
written off was recovered and $3 million of direct write-downs were charged
against the allowances, respectively.
INVESTMENT CONCENTRATION FOR MUNICIPAL BOND AND COMMERCIAL MORTGAGE PORTFOLIOS
The Company maintains a diversified portfolio of municipal bonds. The
following table shows the principal geographic distribution of municipal bond
issuers represented in the Company's portfolio. No other state represents more
than 5% of the portfolio at December 31, 2005 and 2004.
<Table>
<Caption>
(% OF MUNICIPAL BOND PORTFOLIO CARRYING VALUE) 2005 2004
------- -------
California 22.2% 24.7%
New Jersey 9.6 7.3
Texas 6.8 7.4
New York 6.5 4.5
Illinois 5.7 7.0
</Table>
70
<Page>
The Company's mortgage loans are collateralized by a variety of commercial
real estate property types located throughout the United States. Substantially
all of the commercial mortgage loans are non-recourse to the borrower. The
following table shows the principal geographic distribution of commercial real
estate represented in the Company's mortgage portfolio. No other state
represented more than 5% of the portfolio at December 31, 2005 and 2004.
<Table>
<Caption>
(% OF COMMERCIAL MORTGAGE PORTFOLIO CARRYING VALUE) 2005 2004
------- -------
California 16.6% 14.6%
Illinois 8.5 8.2
Texas 8.1 8.2
Pennsylvania 6.6 6.5
New York 5.7 5.3
New Jersey 5.0 5.7
Georgia 4.5 5.1
</Table>
The types of properties collateralizing the commercial mortgage loans at
December 31 are as follows:
<Table>
<Caption>
(% OF COMMERCIAL MORTGAGE PORTFOLIO CARRYING VALUE) 2005 2004
------- -------
Office buildings 32.4% 30.8%
Warehouse 23.2 24.8
Retail 22.6 25.2
Apartment complex 18.4 15.7
Industrial 1.2 1.3
Other 2.2 2.2
------ ------
100.0% 100.0%
====== ======
</Table>
The contractual maturities of the commercial mortgage loan portfolio as of
December 31, 2005 for loans that were not in foreclosure are as follows:
<Table>
<Caption>
NUMBER CARRYING
($ IN MILLIONS) OF LOANS VALUE PERCENT
---------- ---------- ----------
2006 57 $ 419 5.2%
2007 78 631 7.8
2008 94 756 9.3
2009 126 1,125 13.9
2010 121 1,281 15.8
Thereafter 488 3,896 48.0
---------- ---------- ----------
Total 964 $ 8,108 100.0%
========== ========== ==========
</Table>
In 2005, $329 million of commercial mortgage loans were contractually due.
Of these, 77% were paid as due, 22% were refinanced at prevailing market terms
and 1% were extended for one year or less. None were foreclosed or in the
process of foreclosure, and none were in the process of refinancing or
restructuring discussions.
CONCENTRATION OF CREDIT RISK
The Company is not exposed to any credit concentration of risk of a single
issuer and its affiliates greater than 10% of the Company's shareholder's equity
other than certain U.S. government and government agencies.
SECURITIES LOANED AND SECURITY REPURCHASE
The Company participates in securities lending programs with third parties,
mostly large brokerage firms. At December 31, 2005 and 2004, fixed income
securities with a carrying value of $1.81 billion and $1.67 billion,
respectively, were on loan under these agreements. In return, the Company
receives cash that it invests and includes in short-term investments and fixed
income securities, with an offsetting liability recorded in other liabilities
and accrued expenses to account for the Company's obligation to return the
collateral. Interest income on collateral, net of fees, was $5 million, $4
million and $4 million, for the years ended December 31, 2005, 2004 and 2003,
respectively.
71
<Page>
The Company participates in programs to sell securities under agreements to
repurchase, primarily including a mortgage dollar roll program. At December 31,
2005 and 2004, the Company had $87 million and $721 million, respectively, of
securities that were subject to repurchase agreements. For repurchase
agreements, an offsetting liability is recorded in other liabilities and accrued
expenses to account for the Company's obligation to return these funds. Interest
income recorded as a result of the program was $9 million, $23 million, and $13
million for the years ended December 31, 2005, 2004 and 2003, respectively.
OTHER INVESTMENT INFORMATION
Included in fixed income securities are below investment grade assets
totaling $3.13 billion and $3.72 billion at December 31, 2005 and 2004,
respectively.
At December 31, 2005, fixed income securities with a carrying value of $63
million were on deposit with regulatory authorities as required by law.
At December 31, 2005, the carrying value of investments that were
non-income producing, excluding equity securities, was $11 million of fixed
income securities.
7. FINANCIAL INSTRUMENTS
In the normal course of business, the Company invests in various financial
assets, incurs various financial liabilities and enters into agreements
involving derivative financial instruments and other off-balance-sheet financial
instruments. The fair value estimates of financial instruments presented below
are not necessarily indicative of the amounts the Company might pay or receive
in actual market transactions. Potential taxes and other transaction costs have
not been considered in estimating fair value. The disclosures that follow do not
reflect the fair value of the Company as a whole since a number of the Company's
significant assets (including DAC and DSI and reinsurance recoverables, net) and
liabilities (including reserve for life-contingent contract benefits,
contractholder funds pertaining to interest-sensitive life contracts and
deferred income taxes) are not considered financial instruments and are not
carried at fair value. Other assets and liabilities considered financial
instruments such as accrued investment income and cash are generally of a
short-term nature. Their carrying values are deemed to approximate fair value.
FINANCIAL ASSETS
<Table>
<Caption>
2005 2004
------------------------- --------------------------
(IN MILLIONS) CARRYING FAIR CARRYING FAIR
VALUE VALUE VALUE VALUE
----------- ----------- ----------- -----------
Fixed income securities $ 61,977 $ 61,977 $ 59,291 $ 59,291
Mortgage loans 8,108 8,290 7,318 7,635
Equity securities 67 67 42 42
Short-term investments 927 927 1,440 1,440
Policy loans 729 729 722 722
Separate Accounts 15,235 15,235 14,377 14,377
</Table>
Fair values of publicly traded fixed income securities are based upon
quoted market prices or dealer quotes. The fair value of non-publicly traded
securities, primarily privately placed corporate obligations, 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.
Mortgage loans are valued based on discounted contractual cash flows. Discount
rates are selected using current rates at which similar loans would be made to
borrowers with similar characteristics, using similar properties as collateral.
Loans that exceed 100% loan-to-value are valued at the estimated fair value of
the underlying collateral. At December 31, 2005 and 2004, equity securities in
the table above exclude $257 million and $172 million, respectively, of limited
partnership interests, which are accounted for based on the cost method or
equity method of accounting (see Notes 2 and 6). The remaining equity securities
reflect common and preferred stocks, which are valued based principally on
quoted market prices. Short-term investments are highly liquid investments with
maturities of one year or less whose carrying values are deemed to approximate
fair value. The carrying value of policy loans is deemed to approximate fair
value. Separate accounts assets are carried in the Consolidated Statements of
Financial Position at fair value based on quoted market prices.
72
<Page>
FINANCIAL LIABILITIES
<Table>
<Caption>
2005 2004
------------------- -------------------
CARRYING FAIR CARRYING FAIR
(IN MILLIONS) VALUE VALUE VALUE VALUE
-------- -------- -------- --------
Contractholder funds on investment contracts $ 50,253 $ 48,269 $ 46,384 $ 44,601
Long-term debt 181 181 104 104
Liability for collateral and repurchase agreements 2,231 2,231 2,928 2,928
Separate Accounts 15,235 15,235 14,377 14,377
</Table>
Contractholder funds include interest-sensitive life insurance contracts
and investment contracts. Interest-sensitive life insurance contracts are not
considered financial instruments subject to fair value disclosure requirements.
The fair value of investment contracts is based on the terms of the underlying
contracts. Fixed annuities are valued at the account balance less surrender
charges. Immediate annuities without life contingencies, funding agreements and
GICs are valued at the present value of future benefits using current interest
rates. Market value adjusted annuities' fair value is estimated to be the market
adjusted surrender value. Equity-indexed annuity contracts' fair value
approximates carrying value since the embedded equity options are carried at
fair value in the consolidated financial statements.
The carrying value of long-term debt is deemed to approximate fair value.
Liability for collateral and repurchase agreements is valued at carrying value
due to its short-term nature. Separate accounts liabilities are carried at the
fair value of the underlying assets.
DERIVATIVE FINANCIAL INSTRUMENTS
The Company primarily uses derivatives for risk reduction and asset
replication. In addition, the Company has derivatives embedded in financial
instruments, which are required to be separated and accounted for as derivative
instruments. With the exception of embedded derivatives which are required to be
separated, all of the Company's derivatives are evaluated for their on-going
effectiveness as either accounting or non-hedge derivative financial instruments
on at least a quarterly basis (see Note 2). The Company does not use derivatives
for trading purposes. Non-hedge accounting is used for "portfolio" level hedging
strategies where the terms of the individual hedged items do not meet the strict
homogeneity requirements prescribed in SFAS No. 133, "Accounting for Derivative
Instruments and Hedging Activities" ("SFAS 133") to permit the application of
SFAS 133's hedge accounting model. The principal benefit of a "portfolio" level
strategy is in its cost savings through its ability to use fewer derivatives
with larger notional amounts while hedging on a macro basis.
Asset-liability management is a risk management strategy that is employed
to align the respective interest-rate sensitivities of assets and liabilities.
Depending upon the attributes of the assets acquired and liabilities issued,
derivative instruments such as interest rate swaps, caps and floors are acquired
to change the interest rate characteristics of existing assets and liabilities
to ensure a properly matched relationship is maintained and to reduce exposure
to rising or falling interest rates. The Company uses financial futures for
macro-hedging related primarily to anticipated asset and liability purchases and
financial futures and options for hedging the Company's equity exposure
contained in equity indexed and variable annuity product contracts that offer
equity returns to contractholders. In addition, the Company also uses interest
rate swaps to hedge interest rate risk inherent in funding agreements and
foreign currency swaps primarily to reduce the foreign currency risk associated
with issuing foreign currency denominated funding agreements.
Asset replication refers to the "synthetic" creation of an asset through
the use of a credit derivative and a high quality cash instrument to replicate
fixed income securities that are either unavailable in the cash bond market or
more economical to acquire in synthetic form. The Company replicates fixed
income securities using a combination of a credit default swap and one or more
highly rated fixed income securities to synthetically replicate the economic
characteristics of one or more cash market securities.
The Company has derivatives that are embedded in non-derivative "host"
contracts. The Company's primary embedded derivatives are conversion options in
fixed income investments, which provide the Company with the right to convert
the instrument into a predetermined number of shares of common stock and equity
options in annuity product contracts, which provide equity returns to
contractholders. In addition, the Company owns certain equity-indexed notes
containing equity call options, which provide a coupon payout based upon one or
more indices.
73
<Page>
In the tables that follow:
The notional amounts specified in the contracts are used to calculate the
exchange of contractual payments under the agreements and are not representative
of the potential for gain or loss on these agreements.
Fair value, which is equal to the carrying value, is the estimated amount
that the Company would receive (pay) to terminate the derivative contracts at
the reporting date. For exchange traded derivative contracts, the fair value is
based on dealer or exchange quotes. The exchange requires margin deposits as
well as daily cash settlements of margin. As of December 31, 2005, the Company
pledged $22 million of securities in the form of margin deposits. The fair value
of non-exchange traded derivative contracts, including embedded derivative
financial instruments subject to bifurcation, is based on either independent
third party pricing sources, including broker quotes, or widely accepted pricing
and valuation models which use independent third party data as inputs.
Carrying value amounts include the fair value of the derivatives, including
the embedded derivatives, and exclude the accrued periodic settlements which are
short-term in nature and are reported in accrued investment income or other
invested assets. The carrying value amounts for freestanding derivatives have
been further adjusted for the effects, if any, of legally enforceable master
netting agreements.
The net impact to pretax income includes the settlements for derivatives,
including the accrued periodic settlements, as well as changes in the fair value
of freestanding and embedded derivatives. For those derivatives that qualify for
fair value hedge accounting, it also includes the changes in the fair value of
the hedged risk, and therefore reflects any hedging ineffectiveness. For cash
flow hedges, gains and losses amortized from accumulated other comprehensive
income are included. For embedded derivatives in convertibles and equity-indexed
notes subject to bifurcation, accretion income related to the host instrument
has also been included.
The following table categorizes the accounting hedge (fair value and cash
flow) and non-hedge strategies employed by the Company. The notional amount, the
fair value of the hedge and the impact on pretax income have been provided to
illustrate the relative volume, the Company's exposure and the level of
mark-to-market activity, respectively, for the derivative programs as of
December 31.
<Table>
<Caption>
2005 2004
------------------------------------------ -------------------------------------------
FAIR VALUE FAIR VALUE
------------------------------- --------------------------------
FAIR CASH FAIR CASH
NOTIONAL VALUE FLOW NON- NOTIONAL VALUE FLOW NON-
($ in millions) AMOUNT HEDGE HEDGE HEDGE AMOUNT HEDGE HEDGE HEDGE
-------- -------- -------- -------- -------- -------- -------- --------
RISK REDUCTION
Interest rate exposure $ 22,304 $ 12 $ - $ 82 $ 18,481 $ (215) $ - $ 79
Macro hedging 3,319 - - 1 5,437 - - (1)
Hedging of equity exposure in
annuity contracts 4,523 - - 66 2,417 - - 57
Hedging interest rate and
foreign currency risk inherent
in funding agreements 2,501 327 - - 4,434 612 - -
Other 642 3 (6) (1) 470 14 (23) 1
ASSET REPLICATION 432 - - - 240 - - -
EMBEDDED DERIVATIVES
Convertibles 453 - - 159 466 - - 157
Equity indexed notes 325 - - 133 150 - - 52
Annuity contracts 4,494 (113) 2,590 (104)
-------- -------- -------- -------- -------- -------- -------- --------
TOTAL $ 38,993 $ 342 $ (6) $ 327 $ 34,685 $ 411 $ (23) $ 241
======== ======== ======== ======== ======== ======== ======== ========
<Caption>
IMPACT TO PRETAX INCOME
--------------------------------
($ in millions) 2005 2004 2003
-------- -------- --------
RISK REDUCTION
Interest rate exposure $ (161) $ (241) $ (196)
Macro hedging (9) (32) 10
Hedging of equity exposure in
annuity contracts 20 53 90
Hedging interest rate and
foreign currency risk inherent
in funding agreements (9) 48 (16)
Other (10) (8) (9)
ASSET REPLICATION 2 1 -
EMBEDDED DERIVATIVES
Convertibles 27 14 31
Equity indexed notes 19 - -
Annuity contracts (8) 13 (82)
-------- -------- --------
TOTAL $ (129) $ (152) $ (172)
======== ======== ========
</Table>
74
<Page>
Derivative instruments are recorded at fair value and presented in the
Consolidated Statements of Financial Position as of December 31, as follows:
<Table>
<Caption>
CARRYING VALUE
ASSETS (LIABILITIES)
(IN MILLIONS) 2005 2004 2005 2004
-------- -------- -------- --------
Fixed income securities $ 292 $ 209 $ - $ -
Other investments 522 622 - -
Other assets 3 14 - -
Contractholder funds - - (113) (105)
Other liabilities and accrued expenses - - (41) (111)
-------- -------- -------- --------
Total $ 817 $ 845 $ (154) $ (216)
======== ======== ======== ========
</Table>
For cash flow hedges, unrealized net pre-tax losses included in accumulated
other comprehensive income were $(6) million and $(23) million at December 31,
2005 and 2004, respectively. The net pre-tax changes in accumulated other
comprehensive income due to cash flow hedges resulted from changes in fair value
of $17 million, $(18) million, and $(5) million in 2005, 2004 and 2003,
respectively, and the amortization of gains to income of $3 million in 2004 and
$(1) million in 2003.
The following table summarizes the notional amount, fair value and carrying
value of the Company's derivative financial instruments at December 31, 2005.
<Table>
<Caption>
CARRYING CARRYING
NOTIONAL FAIR VALUE VALUE
(IN MILLIONS) AMOUNT VALUE ASSETS (LIABILITIES)
------------- ------------- ------------- -------------
INTEREST RATE CONTRACTS
Interest rate swap agreements $ 11,512 $ 43 $ 49 $ (6)
Financial futures contracts 4,188 1 1 -
Interest rate cap and floor agreements 10,792 51 49 2
------------- ------------- ------------- -------------
Total interest rate contracts 26,492 95 99 (4)
EQUITY AND INDEX CONTRACTS
Options, financial futures, and warrants 3,948 66 101 (35)
FOREIGN CURRENCY CONTRACTS
Foreign currency swap agreements 2,765 321 323 (2)
Foreign currency futures contracts 31 - - -
------------- ------------- ------------- -------------
Total foreign currency contracts 2,796 321 323 (2)
CREDIT DEFAULT SWAPS USED FOR ASSET REPLICATION 432 - - -
EMBEDDED DERIVATIVE FINANCIAL INSTRUMENTS
Guaranteed accumulation benefit 1,208 2 - 2
Guaranteed withdrawal benefit 532 - - -
Conversion options in fixed income securities 453 159 159 -
Equity indexed call options in fixed income securities 325 133 133 -
Equity-indexed and forward starting options in life and
annuity product contracts 2,650 (120) - (120)
Other embedded derivative financial instruments 132 4 (1) 5
------------- ------------- ------------- -------------
Total embedded derivative financial instruments 5,300 178 291 (113)
OTHER DERIVATIVE FINANCIAL INSTRUMENTS 25 3 3 -
------------- ------------- ------------- -------------
TOTAL DERIVATIVE FINANCIAL INSTRUMENTS $ 38,993 $ 663 $ 817 $ (154)
============= ============= ============= =============
</Table>
75
<Page>
The following table summarizes the notional amount, fair value and carrying
value of the Company's derivative financial instruments at December 31, 2004:
<Table>
<Caption>
CARRYING CARRYING
NOTIONAL FAIR VALUE VALUE
(IN MILLIONS) AMOUNT VALUE ASSETS (LIABILITIES)
------------- ------------- ------------- -------------
INTEREST RATE CONTRACTS
Interest rate swap agreements $ 16,531 $ (124) $ (49) $ (75)
Financial futures contracts 6,002 (1) 1 (2)
Interest rate cap and floor agreements 4,850 43 31 12
------------- ------------- ------------- -------------
Total interest rate contracts 27,383 (82) (17) (65)
EQUITY AND INDEX CONTRACTS
Options, financial futures, and warrants 1,968 58 92 (34)
FOREIGN CURRENCY CONTRACTS
Foreign currency swap agreements 1,704 535 547 (12)
Foreign currency futures contracts 21 - - -
------------- ------------- ------------- -------------
Total foreign currency contracts 1,725 535 547 (12)
CREDIT DEFAULT SWAPS USED FOR ASSET REPLICATION 240 - - -
EMBEDDED DERIVATIVE FINANCIAL INSTRUMENTS
Guaranteed accumulation benefit 623 1 - 1
Conversion options in fixed income securities 466 157 157 -
Equity indexed call options in fixed income securities 150 52 52 -
Equity indexed and forward starting options in life and
annuity product contracts 1,953 (106) - (106)
Other embedded derivative financial instruments 42 (1) (1) -
------------- ------------- ------------- -------------
Total embedded derivative financial instruments 3,234 103 208 (105)
OTHER DERIVATIVE FINANCIAL INSTRUMENTS 135 15 15 -
------------- ------------- ------------- -------------
TOTAL DERIVATIVE FINANCIAL INSTRUMENTS $ 34,685 $ 629 $ 845 $ (216)
============= ============= ============= =============
</Table>
The Company manages its exposure to credit risk by utilizing highly rated
counterparties, establishing risk control limits, executing legally enforceable
master netting agreements and obtaining collateral where appropriate. The
Company uses master netting agreements for over-the-counter derivative
transactions, including interest rate swap, foreign currency swap, interest rate
cap, interest rate floor and credit default swap agreements. These agreements
permit either party to net payments due for transactions covered by the
agreements. Under the provisions of the agreements, collateral is either pledged
or obtained when certain predetermined exposure limits are exceeded. As of
December 31, 2005, counterparties pledged $352 million in cash to the Company
and the Company did not have any collateral pledged to counterparties. The
Company has not incurred any losses on derivative financial instruments due to
counterparty nonperformance. Other derivatives including futures and certain
option contracts are traded on organized exchanges, which require margin
deposits and guarantee the execution of trades, thereby mitigating any
associated potential credit risk.
Credit exposure represents the Company's potential loss if all of the
counterparties concurrently fail to perform under the contractual terms of the
contracts and all collateral, if any, becomes worthless. This exposure is
measured by the fair value of freestanding derivative contracts with a positive
fair value at the reporting date reduced by the effect, if any, of legally
enforceable master netting agreements.
76
<Page>
The following table summarizes the counterparty credit exposure by
counterparty credit rating at December 31, as it relates to interest rate swap,
currency swap, interest rate cap, interest rate floor and credit default swap
agreements.
<Table>
<Caption>
($ IN MILLIONS) 2005 2004
----------------------------------------------------- ---------------------------------------------------------
NUMBER OF EXPOSURE, NUMBER OF EXPOSURE,
COUNTER- NOTIONAL CREDIT NET OF COUNTER- NOTIONAL CREDIT NET OF
RATING (1) PARTIES AMOUNT EXPOSURE(2) COLLATERAL(2) PARTIES AMOUNT EXPOSURE(2) COLLATERAL(2)
- --------------- ----------- ----------- ----------- ------------- ----------- ----------- ----------- -------------
AAA 1 $ 484 $ 10 $ 10 2 $ 1,984 $ - $ -
AA 5 6,171 123 25 2 2,228 183 13
AA- 3 3,484 14 14 4 5,825 8 8
A+ 6 15,337 273 23 5 9,538 322 17
A 1 30 - - 2 3,806 12 2
----------- ----------- ----------- ------------- ----------- ----------- ----------- -------------
Total 16 $ 25,506 $ 420 $ 72 15 $ 23,381 $ 525 $ 40
=========== =========== =========== ============= =========== =========== =========== =============
</Table>
- ----------
(1) Rating is the lower of S&P's or Moody's ratings.
(2) For each counterparty, only over-the-counter derivatives with a net
positive fair value are included.
Market risk is the risk that the Company will incur losses due to adverse
changes in market rates and prices. Market risk exists for all of the derivative
financial instruments the Company currently holds, as these instruments may
become less valuable due to adverse changes in market conditions. To limit the
risk, the Company's senior management has established risk control limits. In
addition, changes in fair value of the derivative financial instruments that the
Company uses for risk management purposes are generally offset by the change in
the fair value or cash flows of the hedged risk component of the related assets,
liabilities or forecasted transactions.
OFF-BALANCE-SHEET FINANCIAL INSTRUMENTS
The contractual amounts and fair values of off-balance-sheet financial
instruments at December 31 are as follows:
<Table>
<Caption>
2005 2004
------------------------- -------------------------
CONTRACTUAL FAIR CONTRACTUAL FAIR
(IN MILLIONS) AMOUNT VALUE AMOUNT VALUE
----------- ----------- ----------- -----------
Commitments to invest $ 569 $ - $ 363 $ -
Private placement commitments 205 - 39 -
Commitments to extend mortgage loans 407 4 85 1
Credit guarantees 212 - 146 -
</Table>
Except for credit guarantees, the contractual amounts represent the amount
at risk if the contract is fully drawn upon, the counterparty defaults and the
value of any underlying security becomes worthless. Unless noted otherwise, the
Company does not require collateral or other security to support
off-balance-sheet financial instruments with credit risk.
Commitments to invest generally represent commitments to acquire financial
interests or instruments. The Company enters into these agreements to allow for
additional participation in certain limited partnership investments. Because the
equity investments in the limited partnerships are not actively traded, it is
not practical to estimate the fair value of these commitments.
Private placement commitments represent conditional commitments to purchase
private placement debt and equity securities at a specified future date. The
Company regularly enters into these agreements in the normal course of business.
The fair value of these commitments generally cannot be estimated on the date
the commitment is made as the terms and conditions of the underlying private
placement securities are not yet final.
Commitments to extend mortgage loans are agreements to lend to a borrower
provided there is no violation of any condition established in the contract. The
Company enters these agreements to commit to future loan fundings at a
predetermined interest rate. Commitments generally have fixed expiration dates
or other termination clauses. Commitments to extend mortgage loans, which are
secured by the underlying properties, are valued based on estimates of fees
charged by other institutions to make similar commitments to similar borrowers.
Credit guarantees represent conditional commitments included in certain
fixed income securities owned by the Company, and exclude those credit
guarantees reported as derivatives under SFAS No. 133, "Accounting for
Derivative Instruments and Hedging Activities". These commitments provide for
obligations to exchange credit risk or to forfeit principal due, depending on
the nature or occurrence of credit events for the referenced entities. The
Company enters
77
<Page>
into these transactions in order to achieve higher yields than direct investment
in referenced entities. The fees for assuming the conditional commitments are
reflected in the interest receipts reported in net investment income over the
lives of the contracts. The fair value of the credit guarantees are estimates of
the conditional commitments only and are calculated using quoted market prices
or valuation models, which incorporate external market data. In the event of
bankruptcy or other default of the referenced entities, the Company's maximum
amount at risk, assuming the value of the referenced credits becomes worthless,
is the amount of the aggregate initial investment, which totaled approximately
$212 million at December 31, 2005. The Company includes the impact of credit
guarantees in its analysis of credit risk, and the referenced credits were
current to their contractual terms at December 31, 2005.
8. RESERVE FOR LIFE-CONTINGENT CONTRACT BENEFITS AND CONTRACTHOLDER FUNDS
At December 31, the reserve for life-contingent contract benefits consists
of the following:
<Table>
<Caption>
(IN MILLIONS) 2005 2004
---------- ----------
Immediate annuities:
Structured settlement annuities $ 6,813 $ 6,392
Other immediate annuities 2,414 2,407
Traditional Life 2,094 1,961
Other 560 443
---------- ----------
Total reserve for life-contingent contract benefits $ 11,881 $ 11,203
========== ==========
</Table>
The following table highlights the key assumptions generally used in
calculating the reserve for life-contingent contract benefits:
<Table>
<Caption>
INTEREST ESTIMATION
PRODUCT MORTALITY RATE METHOD
Structured settlement annuities U.S. population with projected Interest rate Present value of
calendar year improvements; assumptions range contractually
mortality rates adjusted for from 4.0% to 11.7% specified future
each impaired life based on benefits
reduction in life expectancy and
nature of impairment
Other immediate annuities 1983 group annuity mortality Interest rate Present value of
table assumptions range expected future
1983 individual annuity from 1.9% to 11.5% benefits based on
mortality table historical experience
1983-a annuity mortality table
Traditional life Actual company experience plus Interest rate Net level premium
loading assumptions range reserve method using
from 4.0% to 11.3% the Company's
withdrawal experience
rates
Other:
Variable annuity guaranteed 90% of 1994 group annuity 7% Projected benefit
minimum death benefits mortality table with internal ratio applied to
modifications cumulative assessments
Accident & health Actual company experience plus Unearned premium;
loading additional contract
reserves for
traditional life
</Table>
78
<Page>
To the extent the unrealized gains on fixed income securities would result
in a premium deficiency had those gains actually been realized, a premium
deficiency reserve has been recorded for certain immediate annuities with life
contingencies. A liability of $1.34 billion and $1.09 billion is included in the
reserve for life-contingent contract benefits with respect to this deficiency as
of December 31, 2005 and 2004, respectively. The offset to this liability is
recorded as a reduction of the unrealized net capital gains included in
accumulated other comprehensive income.
At December 31, contractholder funds consists of the following:
<Table>
<Caption>
(IN MILLIONS) 2005 2004
----------- -----------
Interest-sensitive life $ 7,917 $ 7,397
Investment contracts:
Fixed annuities 37,451 34,590
Guaranteed investment contracts 198 485
Funding agreements backing medium-term notes 12,454 10,135
Other investment contacts 170 1,332
----------- -----------
Total contractholder funds $ 58,190 $ 53,939
=========== ===========
</Table>
The following table highlights the key contract provisions relating to
contractholder funds:
<Table>
<Caption>
PRODUCT INTEREST RATE WITHDRAWAL/SURRENDER CHARGES
Interest-sensitive life Interest rates credited range Either a percentage of account balance or dollar
from 2.0% to 6.0% amount grading off generally over 20 years
Fixed annuities Interest rates credited range Either a declining or a level percentage charge
from 1.3% to 11.5% for immediate generally over nine years or less. Additionally,
annuities and 0% to 16% for fixed approximately 28.7% of fixed annuities are
annuities (which include subject to market value adjustment for
equity-indexed annuities whose discretionary withdrawals.
returns are indexed to the S&P
500)
Guaranteed investment contracts Interest rates credited range Generally not subject to discretionary withdrawal
from 2.95% to 7.85%
Funding agreements backing Interest rates credited range Not applicable
medium-term notes from 2.5% to 7.0% (excluding
currency-swapped medium-term
notes)
Other investment contracts:
Variable guaranteed minimum Interest rates used in Withdrawal and surrender charges are based on
income benefit and establishing reserves range from the terms of the related interest-sensitive life
secondary guarantees on 1.75% to 10.3% or fixed annuity contract.
interest-sensitive life and
fixed annuities
Other investment contracts Interest rates credited equaled 4.5% Not applicable
</Table>
Contractholder funds include funding agreements held by VIEs issuing
medium-term notes. The VIEs are Allstate Life Funding, LLC, Allstate Financial
Global Funding, LLC, Allstate Life Global Funding and Allstate Life Global
Funding II, and their primary assets are funding agreements used exclusively to
back medium-term note programs.
79
<Page>
Contractholder funds activity for the years ended December 31 is as
follows:
<Table>
<Caption>
(IN MILLIONS) 2005 2004
----------- -----------
Balance, beginning of year $ 53,939 $ 44,914
Impact of adoption of SOP 03-1(1) - 421
Deposits 11,410 13,076
Interest credited 2,340 1,912
Benefits (972) (714)
Surrenders and partial withdrawals (4,203) (2,718)
Maturities of institutional products (3,090) (2,518)
Contract charges (649) (593)
Net transfers to separate accounts (339) (412)
Fair value hedge adjustments for institutional products (289) 45
Other adjustments (2) 43 526
----------- -----------
Balance, end of year $ 58,190 $ 53,939
=========== ===========
</Table>
- ----------
(1) The increase in contractholder funds due to the adoption of SOP 03-1
reflects the reclassification of certain products previously included as a
component of separate accounts to contractholder funds, the reclassification
of DSI from contractholder funds to other assets and the establishment of
reserves for certain liabilities that are primarily related to income
benefit guarantees provided under variable annuity contracts and secondary
guarantees on interest-sensitive life and certain fixed annuity contracts.
(2) In 2004, other adjustments include an increase to contractholder funds of
$379 million and $93 million as a result of certain reinsurance assumed
transactions with AHL and Columbia, respectively (see Note 5).
The table below presents information regarding the Company's variable
annuity contracts with guarantees. The Company's variable annuity contracts may
offer more than one type of guarantee in each contract; therefore, the sum of
amounts listed exceeds the total account balances of variable annuity contracts'
separate accounts with guarantees.
<Table>
<Caption>
DECEMBER 31,
($ IN MILLIONS) 2005 2004
-------------- --------------
IN THE EVENT OF DEATH
Separate account value $ 14,465 $ 13,693
Net amount at risk (1) $ 1,521 $ 1,900
Average attained age of contractholders 65 years 66 years
AT ANNUITIZATION
Separate account value $ 3,836 $ 3,893
Net amount at risk (2) $ 45 $ 72
Weighted average waiting period until annuitization options available 6 years 7 years
FOR CUMULATIVE PERIODIC WITHDRAWALS
Separate account value $ 508 $ -
Net amount at risk (3) $ - $ -
ACCUMULATION AT SPECIFIED DATES
Separate account value $ 1,175 $ 582
Net amount at risk (4) $ - $ -
Weighted average waiting period until guarantee date 11 years 11 years
</Table>
(1) Defined as the estimated current guaranteed minimum death benefit in
excess of the current account balance at the balance sheet date.
(2) Defined as the estimated present value of the guaranteed minimum
annuity payments in excess of the current account balance.
(3) Defined as the estimated current guaranteed minimum withdrawal balance
(initial deposit) in excess of the current account balance at the
balance sheet date.
(4) Defined as the estimated present value of the guaranteed minimum
accumulation balance in excess of the current account balance.
80
<Page>
The following table summarizes the liabilities for guarantees:
<Table>
<Caption>
LIABILITY FOR
GUARANTEES LIABILITY FOR
RELATED TO DEATH LIABILITY FOR GUARANTEES
BENEFITS AND GUARANTEES RELATED TO
INTEREST-SENSITIVE RELATED TO INCOME ACCUMULATION
(IN MILLIONS) LIFE PRODUCTS BENEFITS BENEFITS TOTAL
------------------ ------------------ ------------- -------------
Balance at December 31, 2004 $ 95 $ 45 $ (1) $ 139
Less reinsurance recoverables (10) - - (10)
------------------ ------------------ ------------- --------------
Net balance at December 31, 2004 85 45 (1) 129
Incurred guaranteed benefits 50 6 (1) 55
Paid guarantee benefits (48) - - (48)
------------------ ------------------ ------------- --------------
Net change 2 6 (1) 7
Net balance at December 31, 2005 87 51 (2) 136
Plus reinsurance recoverables 10 - - 10
------------------ ------------------ ------------- --------------
Balance, December 31, 2005 (1) $ 97 $ 51 $ (2) $ 146
================== ================== ============= ==============
</Table>
- ----------
(1) Included in the total liability balance are reserves for variable
annuity death benefits of $77 million, variable annuity income benefits
of $20 million, variable annuity accumulation benefits of $(2) million
and other guarantees of $51 million.
In 2004, incurred guaranteed benefits were $41 million, $6 million and $(1)
million related to death benefits and interest-sensitive life products, income
benefits and accumulation benefits, respectively. Paid guarantee benefits were
$62 million in 2004 related to death benefits and interest-sensitive life
products. There were no paid guarantee benefits in 2004 related to income and
accumulation benefits.
9. REINSURANCE
The Company reinsures certain of its risks to other insurers primarily
under yearly renewable term and coinsurance agreements. These agreements result
in a passing of the agreed-upon percentage of risk to the reinsurer in exchange
for negotiated reinsurance premium payments. The Company cedes 100% of the
morbidity risk on substantially all of its long-term care contracts. The Company
ceded specified percentages of the mortality risk on certain life policies,
depending upon the issue date and product, to a pool of thirteen unaffiliated
reinsurers. Since November 1998, the Company ceded mortality risk on new life
contracts that exceeded $2 million per life for individual coverage. For
business sold prior to October 1998, the Company ceded mortality risk in excess
of specific amounts up to $1 million per life for individual coverage. Also, on
certain in-force variable annuity contracts the Company cedes 100% of the
mortality and certain other risks related to product features.
In addition, the Company has used reinsurance to effect the acquisition or
disposition of certain blocks of business. As of December 31, 2005 and 2004, the
Company had reinsurance recoverables of $150 million and $169 million,
respectively due from subsidiaries of Citigroup and Scottish Re (U.S.) Inc. in
connection with the disposition of substantially all of the direct response
distribution business (see Note 3).
As of December 31, 2005, the gross life insurance in force was $444 billion
of which $223 billion was ceded to the unaffiliated reinsurers.
The effects of reinsurance on premiums and contract charges for the years
ended December 31 are as follows:
<Table>
<Caption>
(IN MILLIONS) 2005 2004 2003
--------------- --------------- -------------
PREMIUMS AND CONTRACT CHARGES
Direct $ 2,115 $ 2,098 $ 2,140
Assumed
Affiliate 17 14 19
Non-affiliate 27 12 90
Ceded--non-affiliate (606) (526) (418)
--------------- --------------- -------------
Premiums and contract charges, net of reinsurance $ 1,553 $ 1,598 $ 1,831
=============== =============== =============
</Table>
81
<Page>
The effects of reinsurance on contract benefits for the years ended
December 31 are as follows:
<Table>
<Caption>
(IN MILLIONS) 2005 2004 2003
--------------- --------------- -------------
CONTRACT BENEFITS
Direct $ 1,824 $ 1,762 $ 1,880
Assumed
Affiliate 10 11 4
Non-affiliate 21 4 47
Ceded--non-affiliate (515) (418) (336)
--------------- --------------- -------------
Contract benefits, net of reinsurance $ 1,340 $ 1,359 $ 1,595
=============== =============== =============
</Table>
Reinsurance recoverables at December 31 are summarized in the following
table.
<Table>
<Caption>
REINSURANCE RECOVERABLE ON
(IN MILLIONS) PAID AND UNPAID CLAIMS
--------------------------
2005 2004
---- ----
Life insurance $ 1,115 $ 1,004
Long-term care 324 238
Other 260 265
------- -------
Total $ 1,699 $ 1,507
======= =======
</Table>
At December 31, 2005 and 2004, approximately 83% and 80%, respectively, of
reinsurance recoverables are due from companies rated A- or better by S&P.
10. DEFERRED POLICY ACQUISITION AND SALES INDUCEMENT COSTS
Deferred policy acquisition costs for the years ended December 31 are as
follows:
<Table>
<Caption>
(IN MILLIONS) 2005 2004 2003
--------- ---------- -----------
BALANCE, BEGINNING OF YEAR $ 3,176 $ 3,202 $ 2,915
Impact of adoption of SOP-03-1(1) - (144) -
Disposition of operation(2) - (238) -
Reinsurance(3) - 40 -
Acquisition costs deferred 766 828 732
Amortization charged to income (568) (534) (479)
Effect of unrealized gains and losses 574 22 34
--------- ---------- -----------
BALANCE, END OF YEAR $ 3,948 $ 3,176 $ 3,202
========= ========== ===========
</Table>
- ----------
(1) In 2004, the impact of adoption of SOP 03-1 includes a write-down in
variable annuity DAC of $108 million, the reclassification of DSI from DAC
to other assets resulting in a decrease to DAC of $44 million, and an
increase to DAC of $8 million for an adjustment to the effect of unrealized
capital gains and losses.
(2) In 2004, DAC was reduced by $238 million related to the disposition of
substantially all of the Company's direct response distribution business
(see Note 3).
(3) In 2004, DAC was increased by $40 million as a result of certain reinsurance
transactions with AHL and Columbia (see Note 5).
Net amortization charged to income includes $126 million, $120 million and
$46 million in 2005, 2004 and 2003, respectively, due to realization realized
capital gains and losses.
82
<Page>
In 2005 and 2004, DSI and related amortization is classified within the
Consolidated Statements of Financial Position and Operations and Comprehensive
Income as other assets and interest credited to contractholder funds,
respectively. Deferred sales inducement activity for the twelve months ended
December 31 was as follows:
<Table>
<Caption>
(IN MILLIONS) 2005 2004
----------- ----------
BALANCE, BEGINNING OF YEAR (1) $ 134 $ 99
Sales inducements deferred 99 55
Amortization charged to income (74) (45)
Effects of unrealized gains and losses 78 25
----------- ----------
BALANCE, END OF YEAR $ 237 $ 134
=========== ==========
</Table>
- ----------
(1) The January 1, 2004 balance includes a $16 million write-down of DSI
due to the adoption of SOP 03-1 (see Note 2).
11. COMMITMENTS, GUARANTEES AND CONTINGENT LIABILITIES
LEASES
The Company leases certain office facilities and computer equipment. Total
rent expense for all leases was $1 million, $1 million and $2 million in 2005,
2004 and 2003, respectively.
GUARANTY FUNDS
Under state insurance guaranty fund laws, insurers doing business in a
state can be assessed, up to prescribed limits, for certain obligations of
insolvent insurance companies to policyholders and claimants. Amounts assessed
to each company are typically related to its proportion of business written in a
particular state. The Company's expenses related to these funds have been
immaterial.
GUARANTEES
The Company owns certain fixed income securities that obligate the Company
to exchange credit risk or to forfeit principal due, depending on the nature or
occurrence of specified credit events for the referenced entities. In the event
all such specified credit events were to occur, the Company's maximum amount at
risk on these fixed income securities, as measured by the amount of the
aggregate initial investment, was $212 million at December 31, 2005. The
obligations associated with these fixed income securities expire at various
times during the next six years.
Lincoln Benefit Life Company ("LBL"), a wholly owned subsidiary of ALIC,
has issued universal life insurance contracts to third parties who finance the
premium payments on the universal life insurance contracts through a commercial
paper program. LBL has issued a repayment guarantee on the outstanding
commercial paper balance that is fully collateralized by the cash surrender
value of the universal life insurance contracts. At December 31, 2005, the
amount due under the commercial paper program is $57 million and the cash
surrender value of the policies is $58 million. The repayment guarantee expires
April 30, 2006.
In the normal course of business, the Company provides standard
indemnifications to counterparties in contracts in connection with numerous
transactions, including acquisitions and divestitures. The types of
indemnifications typically provided include indemnifications for breaches of
representations and warranties, taxes and certain other liabilities, such as
third party lawsuits. The indemnification clauses are often standard contractual
terms and were entered into in the normal course of business based on an
assessment that the risk of loss would be remote. The terms of the
indemnifications vary in duration and nature. In many cases, the maximum
obligation is not explicitly stated and the contingencies triggering the
obligation to indemnify have not occurred and are not expected to occur.
Consequently, the maximum amount of the obligation under such indemnifications
is not determinable. Historically, the Company has not made any material
payments pursuant to these obligations.
The aggregate liability balance related to all guarantees was not material
as of December 31, 2005.
83
<Page>
REGULATION
The Company is subject to changing social, economic and regulatory
conditions. From time to time regulatory authorities seek 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.
LEGAL AND REGULATORY PROCEEDINGS AND INQUIRIES
BACKGROUND
The Company and certain affiliates are involved in a number of lawsuits,
regulatory inquiries, and other legal proceedings arising out of various aspects
of its business. As background to the "Proceedings" sub-section below, please
note the following:
- These matters raise difficult and complicated factual and legal issues
and are subject to many uncertainties and complexities, including but
not limited to, the underlying facts of each matter; novel legal
issues; variations between jurisdictions in which matters are being
litigated, heard or investigated; differences in applicable laws and
judicial interpretations; the length of time before many of these
matters might be resolved by settlement, through litigation or
otherwise and, in some cases, the timing of their resolutions relative
to other similar matters involving other companies; the fact that some
of the lawsuits are putative class actions in which a class has not
been certified and in which the purported class may not be clearly
defined; the fact that some of the lawsuits involve multi-state class
actions in which the applicable law(s) for the claims at issue is in
dispute and therefore unclear; and the current challenging legal
environment faced by large corporations and insurance companies.
- In the lawsuits, plaintiffs seek a variety of remedies including
equitable relief in the form of injunctive and other remedies and
monetary relief in the form of contractual and extra-contractual
damages. In some cases, the monetary damages sought include punitive
damages. Often specific information about the relief sought, such as
the amount of damages, is not available because plaintiffs have not
requested specific relief in their pleadings. In our experience, when
specific monetary demands are made in pleadings, they bear little
relation to the ultimate loss, if any, to the Company.
- In connection with regulatory examinations and proceedings, government
authorities may seek various forms of relief, including penalties,
restitution and changes in business practices. The Company may not be
advised of the nature and extent of relief sought until the final
stages of the examination or proceeding.
- For the reasons specified above, it is not possible at this time to
make meaningful estimates of the amount or range of loss that could
result from these matters described below in the "Proceedings"
subsection. The Company reviews these matters on an on-going 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.
- Due to the complexity and scope of the matters disclosed in the
"Proceedings" subsection below and the many uncertainties that exist,
the ultimate outcome of these matters cannot be reasonably predicted.
In the event of an unfavorable outcome in one or more of these
matters, the ultimate liability may be in excess of amounts currently
reserved and may be material to the Company's operating results or
cash flows for a particular quarter or annual period. However, based
on information currently known to it, management believes that the
ultimate outcome of all matters described below as they are resolved
over time is not likely to have a material adverse effect on the
financial position of the Company.
PROCEEDINGS
Legal proceedings involving Allstate agencies and AIC may impact the
Company, even when the Company is not directly involved, because the Company
sells its products through a variety of distribution channels including Allstate
agencies. Consequently, information about the more significant of these
proceedings is provided in the following paragraph.
AIC is defending certain matters relating to its agency program
reorganization announced in 1999. These matters include a lawsuit filed in
December 2001 by the U.S. Equal Employment Opportunity Commission ("EEOC")
alleging
84
<Page>
retaliation under federal civil rights laws, a class action filed in
August 2001 by former employee agents alleging retaliation and age
discrimination under the Age Discrimination in Employment Act, breach of
contract and ERISA violations, and a lawsuit filed in October 2004 by the EEOC
alleging age discrimination with respect to a policy limiting the rehire of
agents affected by the agency program reorganization. AIC is also defending a
certified class action filed by former employee agents who terminated their
employment prior to the agency program reorganization. These plaintiffs have
asserted breach of contract and ERISA claims and are seeking actual damages
including benefits under Allstate employee benefit plans and payments provided
in connection with the reorganization, as well as punitive damages. In late
March 2004, in the first EEOC lawsuit and class action lawsuit, the trial court
issued a memorandum and order that, among other things, certified classes of
agents, including a mandatory class of agents who had signed a release, for
purposes of effecting the court's declaratory judgment that the release is
voidable at the option of the release signer. The court also ordered that an
agent who voids the release must return to AIC "any and all benefits received by
the [agent] in exchange for signing the release." The court also "concluded
that, on the undisputed facts of record, there is no basis for claims of age
discrimination." The EEOC and plaintiffs have asked the court to clarify and/or
reconsider its memorandum and order. The case otherwise remains pending. A
putative nationwide class action has also been filed by former employee agents
alleging various violations of ERISA, including a worker classification issue.
These plaintiffs are challenging certain amendments to the Agents Pension Plan
and are seeking to have exclusive agent independent contractors treated as
employees for benefit purposes. This matter was dismissed with prejudice by the
trial court, was the subject of further proceedings on appeal, and was reversed
and remanded to the trial court in April 2005. In these matters, plaintiffs seek
compensatory and punitive damages, and equitable relief. AIC has been vigorously
defending these lawsuits and other matters related to its agency program
reorganization. In addition, AIC has been defending certain matters relating to
its life agency program reorganization announced in 2000. These matters have
been the subject of an investigation by the EEOC with respect to allegations of
age discrimination and retaliation and conciliation discussions between AIC and
the EEOC. The outcome of these disputes is currently uncertain.
The Company has resolved through mediation and settlement all but two of
its lawsuits brought by plaintiffs challenging trading restrictions the Company
adopted in an effort to limit market-timing activity in its variable annuity
sub-accounts. In the remaining lawsuits, the plaintiffs seek a variety of
remedies including monetary and equitable relief. The Company has been
vigorously defending these matters, but their outcome is currently uncertain.
The Company is currently undergoing periodic market conduct examinations
by state insurance regulators. Regulators in the state of New York are
focusing, as they have with other insurers, on the Company's compliance with
the state's replacement sales and record-keeping processes with regard to life
insurance and annuities among other issues. They have alleged that the Company
failed to meet the requirements of certain applicable regulations. In relation
to this examination, the Company accrued $15 million of additional
contractholder benefits in 2005. The ultimate outcome of these examinations
including potential New York customer remediation related to replacement sales
is currently pending.
OTHER MATTERS
The Corporation and some of its subsidiaries, including the Company, have
received interrogatories and demands for information from regulatory and
enforcement authorities relating to various insurance products and practices.
The areas of inquiry include variable annuity market timing, late trading and
the issuance of funding agreements backing medium-term notes. The Corporation
and some of its subsidiaries, including the Company, have also received
interrogatories and demands for information from authorities seeking information
relevant to on-going investigations into the possible violation of antitrust or
insurance laws by unnamed parties and, in particular, seeking information as to
whether any person engaged in activities for the purpose of price fixing, market
allocation, or bid rigging. The Company believes that these inquiries are
similar to those made to many financial services companies as part of
industry-wide investigations by various authorities into the practices, policies
and procedures relating to insurance and financial services products. The
Corporation and its subsidiaries have responded and will continue to respond to
these inquiries.
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
class action lawsuits and other types of proceedings, some of which involve
claims for substantial or indeterminate amounts. These actions are based on a
variety of issues and target a range of the Company's practices. The outcome of
these disputes is currently unpredictable.
One or more of these matters could have an adverse effect on the Company's
operating results or cash flows for a particular quarter or annual period.
However, based on information currently known to it, management believes that
the ultimate outcome of all matters described in this "Other Matters" subsection
in excess of amounts currently reserved, as they are resolved over time is not
likely to have a material effect on the operating results, cash flows or
financial position of the Company.
85
<Page>
12. INCOME TAXES
ALIC and its eligible domestic subsidiaries (the "Allstate Life Group")
join with the Corporation (the "Allstate Group") in the filing of a
consolidated federal income tax return and are party to a federal income tax
allocation agreement (the "Allstate Tax Sharing Agreement"). Under the
Allstate Tax Sharing Agreement, the Allstate Life Group pays to or receives
from the Corporation the amount, if any, by which the Allstate Group's
federal income tax liability is affected by virtue of inclusion of the
Allstate Life Group in the consolidated federal income tax return.
Effectively, this results in the Allstate Life Group's annual income tax
provision being computed, with adjustments, as if the Allstate Life Group
filed a separate return. Certain subsidiaries are not eligible to join in the
consolidated federal income tax return and file separate tax returns.
The Internal Revenue Service ("IRS") has completed its review of the
Corporation's federal income tax returns through the 2002 tax year. Any
adjustments that may result from IRS examinations of tax returns are not
expected to have a material effect on the results of operations, cash flows or
financial position of the Company.
The components of the deferred income tax assets and liabilities at
December 31 are as follows:
<Table>
<Caption>
(IN MILLIONS) 2005 2004
-------------- --------------
DEFERRED ASSETS
Life and annuity reserves $ 925 $ 914
Other assets 70 94
-------------- --------------
Total deferred assets 995 1,008
DEFERRED LIABILITIES
Deferred policy acquisition costs (981) (958)
Unrealized net capital gains (317) (546)
Other liabilities (37) (142)
-------------- --------------
Total deferred liabilities (1,335) (1,646)
-------------- --------------
Net deferred liability $ (340) $ (638)
============== ==============
</Table>
Although realization is not assured, management believes it is more likely
than not that the deferred tax assets will be realized based on the assumption
that certain levels of income will be achieved.
The components of income tax expense for the years ended December 31 are as
follows:
<Table>
<Caption>
(IN MILLIONS) 2005 2004 2003
---------- ---------- ---------
Current $ 225 $ 236 $ 86
Deferred (51) (47) 76
---------- ---------- ---------
Total income tax expense $ 174 $ 189 $ 162
========== ========== =========
</Table>
The Company paid income taxes of $156 million, $149 million and $161
million in 2005, 2004 and 2003, respectively. The Company had a current income
tax payable of $133 million and $63 million at December 31, 2005 and 2004,
respectively.
A reconciliation of the statutory federal income tax rate to the effective
income tax rate on income from operations for the years ended December 31 is as
follows:
<Table>
<Caption>
2005 2004 2003
------------- ------------- ------------
Statutory federal income tax rate 35.0% 35.0% 35.0%
Adjustment to prior year tax liabilities (3.9) (0.1) 2.4
Dividends received deduction (2.5) (2.4) (2.6)
Other 0.8 2.1 1.1
------------- ------------- ------------
Effective income tax rate 29.4% 34.6% 35.9%
============= ============= ============
</Table>
86
<Page>
Prior to January 1, 1984, the Company was entitled to exclude certain
amounts from taxable income and accumulate such amounts in a "policyholder
surplus" account. Pursuant to the American Jobs Creation Act of 2004 ("the 2004
Act"), the Company can reduce the policyholder surplus account in 2005 and 2006
without incurring any tax liability. This provision was utilized during 2005 to
reduce the affected policyholder surplus account by $94 million and the related
taxes payable by $33 million. The remaining aggregate balance in this account at
December 31, 2005 was $729 thousand, which prior to the 2004 Act would have
resulted in federal income taxes payable of $255 thousand if such amounts had
been distributed or deemed distributed from the policyholder surplus account. No
provision for taxes has ever been made for this item since the Company had no
prior intention of incurring such tax liability. The Company expects to utilize
the 2004 Act provision in 2006, thereby eliminating this remaining potential tax
liability.
13. CAPITAL STRUCTURE
DEBT OUTSTANDING
Total debt outstanding at December 31 consisted of the following:
<Table>
<Caption>
(IN MILLIONS) 2005 2004
--------------- ---------------
Structured investment security VIE obligations due 2007 $ 49 $ 47
Mandatorily redeemable preferred stock - Series A 32 57
5.06% Surplus Notes, due 2035 100 -
--------------- ---------------
Total debt $ 181 $ 104
=============== ===============
</Table>
Pursuant to the adoption of FIN 46 in 2003, the Company was determined to
be the primary beneficiary of a consolidated structured investment security VIE.
The Company's Consolidated Statements of Financial Position include $54 million
of investments as of December 31, 2005 and 2004, and $49 million and $47 million
of long-term debt as of December 31, 2005 and 2004, respectively. The holders of
the consolidated long-term debt have no recourse to the equity of the Company as
the sole source of payment is the assets of the VIE.
As of December 31, 2005 and 2004, debt includes $32 million and $57
million, respectively, of mandatorily redeemable preferred stock - Series A
("preferred stock") that was reclassified to long-term debt during 2004 in
accordance with the provisions of Statement of Financial Accounting Standards
No. 150, "Accounting for Certain Financial Instruments with Characteristics of
both Liabilities and Equity". The reclassification occurred as a result of
changes to contractual arrangements between the Company and the holders of the
preferred stock resulting in the preferred stock becoming mandatorily
redeemable. As of December 31, 2003, the balance of the preferred stock subject
to reclassification amounted to $77 million. During 2005 and 2004, $25 million
and $20 million, respectively, of this preferred stock was redeemed. All of the
mandatorily redeemable preferred stock will be redeemed by January 30, 2007.
For the redeemable preferred stock--Series A, the Company's Board of
Directors declares and pays cash dividends from time to time, but not more
frequently than quarterly. The dividends are based on the three-month LIBOR
rate. Dividends of $2 million were paid each year during 2005, 2004, and 2003.
As a result of the reclassification, dividends, which were previously reported
in retained earnings, have been reported in operating costs and expenses since
the second quarter of 2004. There were no accrued and unpaid dividends for the
redeemable preferred stock - Series A at December 31, 2005.
On August 1, 2005, ALIC entered into an agreement with Kennett, an
unconsolidated affiliate of ALIC, whereby ALIC sold to Kennett $100 million
5.06% surplus notes due July 1, 2035 ("surplus notes") issued by ALIC Re, a
wholly owned subsidiary of ALIC (see Note 5). In 2005, the Company incurred $2
million of interest expense related to the surplus notes, which is reflected as
a component of operating costs and expenses on the Consolidated Statements of
Operations and Comprehensive Income.
14. STATUTORY FINANCIAL INFORMATION
ALIC and its subsidiaries prepare their statutory-basis financial
statements in conformity with accounting practices prescribed or permitted by
the insurance department of the applicable state of domicile. Prescribed
statutory accounting practices include a variety of publications of the NAIC, as
well as state laws, regulations and general administrative rules. Permitted
statutory accounting practices encompass all accounting practices not so
prescribed.
87
<Page>
All states require domiciled insurance companies to prepare statutory-basis
financial statements in conformity with the NAIC Accounting Practices and
Procedures Manual, subject to any deviations prescribed or permitted by the
applicable insurance commissioner and/or director.
Statutory accounting practices primarily differ from GAAP since they
require charging policy acquisition and certain sales inducement costs to
expense as incurred, establishing life insurance reserves based on different
actuarial assumptions, and valuing investments and establishing deferred taxes
on a different basis.
Statutory net income of ALIC and its insurance subsidiaries for 2005, 2004
and 2003 was $294 million, $293 million and $609 million, respectively.
Statutory capital and surplus was $3.66 billion as of both December 31, 2005 and
2004.
DIVIDENDS
The ability of ALIC to pay dividends is dependent on business conditions,
income, cash requirements of ALIC, receipt of dividends from its subsidiaries
and other relevant factors. The payment of shareholder dividends by ALIC to AIC
without the prior approval of the state insurance regulator is limited to
formula amounts based on net income and capital and surplus, determined in
conformity with statutory accounting practices, as well as the timing and amount
of dividends paid in the preceding twelve months. Notification and approval of
intercompany lending activities is also required by the Illinois Division of
Insurance ("IL DOI") for transactions that exceed a level that is based on a
formula using statutory admitted assets and statutory surplus.
ALIC paid dividends of $262 million in 2005, which was less than the
maximum amount allowed under Illinois insurance law based on 2004 formula
amounts. Based on 2005 ALIC statutory capital and surplus, the maximum amount of
dividends ALIC will be able to pay without prior IL DOI approval at a given
point in time during 2006 is $366 million, less dividends paid during the
preceding twelve months measured at that point in time.
15. BENEFIT PLANS
PENSION AND OTHER POSTRETIREMENT PLANS
Defined benefit pension plans, sponsored by AIC, cover most full-time
employees, certain part-time employees and employee-agents. Benefits under the
pension plans are based upon the employee's length of service and eligible
annual compensation. A cash balance formula was added to the Allstate Retirement
Plan effective January 1, 2003. All eligible employees hired before August 1,
2002 were provided with a one-time opportunity to choose between the cash
balance formula and the final average pay formula. The cash balance formula
applies to all eligible employees hired after August 1, 2002. AIC's funding
policy for the pension plans is to make annual contributions at a minimum level
that is at least in accordance with regulations under the Internal Revenue Code
and in accordance with generally accepted actuarial principles. The allocated
cost to the Company included in net income for the pension plans in 2005, 2004
and 2003 was $18 million, $17 million and $22 million, respectively.
AIC also provides certain health care and life insurance subsidies for
employees hired before January 1, 2003 when they retire ("Postretirement
benefits"). Qualified employees may become eligible for these benefits if they
retire in accordance with AIC's established retirement policy and are
continuously insured under AIC's group plans or other approved plans in
accordance with the plan's participation requirements. AIC shares the cost of
the retiree medical benefits with retirees based on years of service, with AIC's
share being subject to a 5% limit on annual medical cost inflation after
retirement. AIC has the right to modify or terminate these plans. The allocated
cost to the Company included in net income was $6 million, $8 million and $6
million for postretirement benefits other than pension plans in 2005, 2004 and
2003, respectively.
PROFIT SHARING PLANS
Employees of AIC are eligible to become members of The Savings and Profit
Sharing Fund of Allstate Employees ("Allstate Plan"). The Corporation's
contributions are based on the Corporation's matching obligation and
performance. The Company's allocation of profit sharing expense from the
Corporation was $10 million, $14 million, and $13 million in 2005, 2004 and
2003, respectively.
88
<Page>
16. OTHER COMPREHENSIVE INCOME
The components of other comprehensive (loss) income on a pre-tax and
after-tax basis for the years ended December 31 are as follows:
<Table>
<Caption>
2005 2004 2003
-------------------------- ------------------------- ---------------------------
(IN MILLIONS) PRETAX TAX AFTER-TAX PRETAX TAX AFTER-TAX PRETAX TAX AFTER-TAX
------ ----- --------- ------ ----- --------- ------ ------- ---------
Unrealized holding (losses) gains
arising during the period, net of related
offsets $ (724) $ 254 $ (470) $ (113) $ 40 $ (73) $ (46) $ 16 $ (30)
Less: reclassification adjustment (69) 24 (45) (51) 18 (33) (48) 17 (31)
------ ----- --------- ------ ----- --------- ------ ------- --------
UNREALIZED NET CAPITAL (LOSSES) GAINS (655) 230 (425) (62) 22 (40) 2 (1) 1
Other comprehensive (loss) income $ (655) $ 230 $ (425) $ (62) $ 22 $ (40) $ 2 $ (1) $ 1
====== ===== ========= ====== ===== ========= ====== ======= ========
</Table>
17. QUARTERLY RESULTS (UNAUDITED)
<Table>
<Caption>
FIRST QUARTER SECOND QUARTER THIRD QUARTER FOURTH QUARTER
--------------------- ------------------- ------------------- --------------------
2005 2004 2005 2004 2005 2004 2005 2004
--------- --------- -------- -------- --------- --------- --------- ---------
(IN MILLIONS)
Revenues $ 1,290 $ 1,141 $ 1,315 $ 1,114 $ 1,347 $ 1,161 $ 1,327 $ 1,431
Income before cumulative effect of
change in accounting principle, after-tax 68 91 87 55 159 76 103 134
Net income (loss) 68 (84) 87 55 159 76 103 134
</Table>
89
<Page>
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
TO THE BOARD OF DIRECTORS AND SHAREHOLDER OF
ALLSTATE LIFE INSURANCE COMPANY
We have audited the accompanying Consolidated Statements of Financial Position
of Allstate Life Insurance Company and subsidiaries (the "Company", an affiliate
of The Allstate Corporation) as of December 31, 2005 and 2004, and the related
Consolidated Statements of Operations and Comprehensive Income, Shareholder's
Equity, and Cash Flows for each of the three years in the period ended December
31, 2005. Our audits also included the consolidated financial statement
schedules listed in the Index at Item 15. These financial statements and
financial statement schedules are the responsibility of the Company's
management. Our responsibility is to express an opinion on the financial
statements and financial statement schedules based on our audits.
We conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. The Company is not required to
have, nor were we engaged to perform, an audit of its internal control over
financial reporting. Our audit included consideration of internal control over
financial reporting as a basis for designing audit procedures that are
appropriate in the circumstances, but not for the purpose of expressing an
opinion on the effectiveness of the Company's internal control over financial
reporting. Accordingly, we express no such opinion. An audit also includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements, assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all
material respects, the financial position of the Company as of December 31, 2005
and 2004, and the results of its operations and its cash flows for each of the
three years in the period ended December 31, 2005, in conformity with accounting
principles generally accepted in the United States of America. Also, in our
opinion, such consolidated financial statement schedules, when considered in
relation to the basic consolidated financial statements taken as a whole,
present fairly in all material respects the information set forth therein.
As discussed in Note 2 to the consolidated financial statements, the Company
changed its method of accounting for certain nontraditional long-duration
contracts and separate accounts in 2004 and methods of accounting for embedded
derivatives in modified coinsurance agreements and variable interest entities in
2003.
/s/ Deloitte & Touche LLP
Chicago, Illinois
March 10, 2006
90
<Page>
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None
ITEM 9A. CONTROLS AND PROCEDURES
EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES. We maintain disclosure
controls and procedures as defined in Rule 13a-15(e) under the Securities
Exchange Act of 1934. Under the supervision and with the participation of our
management, including our principal executive officer and principal financial
officer, we conducted an evaluation of the effectiveness of our disclosure
controls and procedures as of the end of the period covered by this report.
Based upon this evaluation, the principal executive officer and the principal
financial officer concluded that our disclosure controls and procedures are
effective in providing reasonable assurance that material information required
to be disclosed in our reports filed with or submitted to the Securities and
Exchange Commission under the Securities Exchange Act is made known to
management, including the principal executive officer and the principal
financial officer, as appropriate to allow timely decisions regarding required
disclosure.
CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING. During the fiscal
quarter ended December 31, 2005, there have been no changes in our internal
control over financial reporting that have materially affected, or are
reasonably likely to materially affect, our internal control over financial
reporting.
ITEM 9B. OTHER INFORMATION
On March 8, 2006, the Corporation issued a press release announcing that
it, ALIC and Allstate Life Insurance Company of New York ("ALNY") had entered
into a definitive agreement ("Agreement") with Prudential Financial, Inc. and
its subsidiary The Prudential Insurance Company of America (collectively
"Prudential") for the sale pursuant to a combination of coinsurance and modified
coinsurance reinsurance of substantially all of its variable annuity business.
Total consideration is expected to be approximately $581 million, subject
to adjustment for changes in equity markets and interest rates between the
effective date of the Agreement and the closing of the transaction. ALIC has
entered into an economic hedge that it believes will substantially reduce its
economic exposure to the variability of this arrangement from the period between
the effective date of the Agreement and closing. As a result of the modified
coinsurance reinsurance, the separate account assets and liabilities will remain
on ALIC's consolidated statements of financial position, but the related results
of operations will be fully reinsured to Prudential. The sale is expected to
result in the recognition of a small gain, which will be amortized into earnings
over the life of the Agreement. A level of cash or cash equivalents in an amount
equal to ALIC's and ALNY's fixed (general) account liabilities of approximately
$1 billion, net of the consideration, will be needed to settle the obligation to
Prudential at closing under the coinsurance portion of the Agreement. An
evaluation will occur in the first quarter of 2006 regarding available sources
of funds for settlements, which may include such items as cash flows from
operations, sales of existing investments or borrowings.
Under the Agreement, ALIC, ALNY and the Corporation will each indemnify
Prudential for certain pre-closing contingent liabilities (including
extra-contractual liabilities of ALIC and ALNY and liabilities specifically
excluded from the transaction) that ALIC and ALNY have agreed to retain. In
addition, ALIC, ALNY, and the Corporation will each indemnify Prudential for
certain post-closing liabilities that may arise from the acts of ALIC and ALNY
and their agents, including in connection with ALIC's and ALNY's provision of
transition services.
The terms of the Agreement will give Prudential the right to be the
exclusive provider of its variable annuity products through the Allstate
proprietary agency force for three years and a non-exclusive preferred provider
for the following two years. During a transition period, ALIC and ALNY will
continue to issue new variable annuity contracts, accept additional deposits on
existing business from existing contractholders on behalf of Prudential and, for
a period of twenty-four months or less, service the reinsured business while
Prudential prepares for the migration of the business onto its servicing
platform. ALIC and ALNY have also agreed to continue to issue variable annuity
contracts in the financial institutions channel for a period of at least
thirty-three months and cede them to Prudential. The Agreement is subject to
regulatory approval and is expected to be completed by the end of the second
quarter of 2006.
In 2005, ALIC's and ALNY's variable annuity business generated
approximately $278 million in contract charges on separate account balances of
$14 billion and general account balances of $2 billion as of December 31, 2005.
Separate account balances totaling approximately $1 billion related to the
variable life business and three companies held for sale continue to be retained
by ALIC.
91
<Page>
PART III
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
(1), (2), (3) AND (4) DISCLOSURE OF FEES -
- ------------------------------------------
The following fees have been, or are anticipated to be billed by Deloitte &
Touche LLP, the member firms of Deloitte & Touche Tohmatsu, and their respective
affiliates, for professional services rendered to us for the fiscal years ending
December 31, 2005 and 2004.
<Table>
<Caption>
2005 2004
-------------- --------------
Audit fees (a) $ 3,255,792 $ 3,417,884
Audit related fees (b) 11,530 26,950
Tax fees (c) - 29,000
-------------- --------------
TOTAL FEES $ 3,267,322 $ 3,473,834
============== ==============
</Table>
(a) Fees for audits of annual financial statements including financial
statements for the separate accounts, reviews of quarterly financial
statements, statutory audits, attest services, comfort letters, consents
and review of documents filed with the Securities and Exchange Commission.
(b) Audit related fees relate to professional services such as accounting
consultations relating to new accounting standards and due diligence
assistance.
(c) Includes fees for tax compliance.
(5)(i) AND (ii) AUDIT COMMITTEE'S PRE-APPROVAL POLICIES AND PROCEDURES -
- ------------------------------------------------------------------------
The Audit Committee of The Allstate Corporation has established
pre-approval policies and procedures for itself and its consolidated
subsidiaries, including Allstate Life. Those policies and procedures are
incorporated into this Item 14 (5) by reference to Exhibit 99(ii) - The Allstate
Corporation Policy Regarding Pre-Approval of Independent Auditors' Services (the
"Pre-Approval Policy"). In addition, in 2005 the Audit Committee of Allstate
Life adopted the Pre-Approval Policy, as it may be amended from time to time by
the Audit Committee or the Board of Directors of the Corporation, as its own
policy, provided that the Designated Member referred to in such policy need not
be independent because the New York Stock Exchange corporate governance
standards do not apply to Allstate Life. All of the services provided by
Deloitte & Touche LLP to Allstate Life in 2005 were pre-approved by The Allstate
Corporation and Allstate Life Audit Committees and all of the services provided
in 2004 were pre-approved by The Allstate Corporation Audit Committee.
92
<Page>
PART IV
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(a)(1) The following Consolidated Financial Statements, Notes Thereto and
Independent Auditors' Report of Allstate Life Insurance Company
are included in Item 8.
Consolidated Statements of Operations and Comprehensive Income
Consolidated Statements of Financial Position
Consolidated Statements of Shareholder's Equity
Consolidated Statements of Cash Flows
Notes to Consolidated Financial Statements
Report of Independent Registered Public Accounting Firm
(a)(2) The following additional financial statement schedules are
furnished herewith pursuant to the requirements of Form 10-K.
Schedules required to be filed under the provisions of Regulation
S-X Article 7:
<Table>
Schedule I - Summary of Investment Other than Investments in Related Parties S-1
Schedule III - Supplementary Insurance Information S-2
Schedule IV - Reinsurance S-3
Schedule V - Valuation and Qualifying Accounts S-4
</Table>
All other schedules are omitted because they are not applicable,
or not required, or because the required information is included
in the Consolidated Financial Statements or notes thereto.
(a)(3) The following is a list of the exhibits filed as part of this Form
10-K. The SEC File Number for the exhibits incorporated by
reference is 0-31248 except as otherwise noted.
<Table>
<Caption>
EXHIBIT NO. DOCUMENT DESCRIPTION
----------- -----------------------------------------------------------------------------
3(i) Articles of Amendment to the Articles of Incorporation of Allstate Life
Insurance Company dated December 29, 1999. Incorporated herein by reference
to Exhibit 3.1 to Allstate Life Insurance Company's Form 10 filed on April
24, 2002.
3(ii) By-Laws of Allstate Life Insurance Company, Amended and Restated June 28,
2000. Incorporated herein by reference to Exhibit 3.2 to Allstate Life
Insurance Company's Form 10 filed on April 24, 2002.
4 See Exhibits 3 (i) and 3 (ii).
10.1 Amended and Restated Service and Expense Agreement between Allstate Insurance
Company, The Allstate Corporation and certain affiliates, effective January
1, 2004. Incorporated herein by reference to Exhibit 10.1 to Allstate Life
Insurance Company's Quarterly Report on Form 10-Q for quarter ended June 30,
2005.
</Table>
93
<Page>
<Table>
10.2 New York Insurer Supplement to Amended and Restated Service and Expense
Agreement between Allstate Insurance Company, The Allstate Corporation,
Allstate Life Insurance Company of New York and Intramerica Life Insurance
Company, effective March 5, 2005. Incorporated herein by reference to Exhibit
10.2 to Allstate Life Insurance Company's Quarterly Report on Form 10-Q for
quarter ended June 30, 2005.
10.3 Service Agreement between Lincoln Benefit Life Company and Allstate Financial
Services, LLC (f/k/a Laughlin Group Advisors, Inc. and LSA Securities, Inc.)
effective April 1, 1998. Incorporated herein by reference to Exhibit 10.3 to
Lincoln Benefit Life Company's Quarterly Report on Form 10-Q for quarter
ended June 30, 2002 (SEC File No. 333-59765).
10.4 Selling Agreement between Allstate Life Insurance Company, ALFS, Inc. (f/k/a
Allstate Life Financial Services, Inc.) and Allstate Financial Services, LLC
(f/k/a LSA Securities, Inc.) effective July 26, 1999. Incorporated herein by
reference to Exhibit 10.6 to Allstate Life Insurance Company's Annual Report
on Form 10-K for 2003.
10.5 Amendment effective August 1, 1999 to Selling Agreement between Allstate Life
Insurance Company, ALFS, Inc. and Allstate Financial Services, LLC effective
July 26, 1999. Incorporated herein by reference to Exhibit 10.1 to Allstate
Life Insurance Company's Quarterly Report on Form 10-Q for quarter ended
September 30, 2004.
10.6 Amendment effective September 28, 2001 to Selling Agreement between Allstate
Life Insurance Company, ALFS, Inc. and Allstate Financial Services, LLC
effective July 26, 1999. Incorporated herein by reference to Exhibit 10.2 to
Allstate Life Insurance Company's Quarterly Report on Form 10-Q for quarter
ended September 30, 2004.
10.7 Amendment effective February 15, 2002 to Selling Agreement between Allstate
Life Insurance Company, ALFS, Inc. and Allstate Financial Services, LLC
effective July 26, 1999. Incorporated herein by reference to Exhibit 10.3 to
Allstate Life Insurance Company's Quarterly Report on Form 10-Q for quarter
ended September 30, 2004.
10.8 Amendment effective April 21, 2003 to Selling Agreement between Allstate Life
Insurance Company, ALFS, Inc. and Allstate Financial Services, LLC effective
July 26, 1999. Incorporated herein by reference to Exhibit 10.4 to Allstate
Life Insurance Company's Quarterly Report on Form 10-Q for quarter ended
September 30, 2004.
10.9 Selling Agreement between Allstate Life Insurance Company of New York, ALFS,
Inc. and Allstate Financial Services, LLC effective May 1, 2005. Incorporated
herein by reference to Exhibit 10.7 to Allstate Life Insurance Company's
Annual Report on Form 10-K for 2003.
10.10 Selling Agreement between Lincoln Benefit Life Company, ALFS, Inc. (f/k/a
Allstate Life Financial Services, Inc.) and Allstate Financial Services, LLC
(f/k/a LSA Securities, Inc.) effective August 2, 1999. Incorporated herein by
reference to Exhibit 10.8 to Allstate Life Insurance Company's Annual Report
on Form 10-K for 2003.
</Table>
94
<Page>
<Table>
10.11 Marketing Coordination and Administrative Services Agreement among Allstate
Insurance Company, Allstate Life Insurance Company and Allstate Financial
Services, LLC effective January 1, 2003. Incorporated herein by reference to
Exhibit 10.9 to Allstate Life Insurance Company's Annual Report on Form 10-K
for 2003.
10.12 Investment Management Agreement and Amendment to Certain Service and Expense
Agreements Among Allstate Investments, LLC and Allstate Insurance Company and
The Allstate Corporation and Certain Affiliates effective as of January 1,
2002. Incorporated herein by reference to Exhibit 10.28 to Allstate Life
Insurance Company's Form 10 filed on April 24, 2002.
10.13 Investment Advisory Agreement by and between Allstate Insurance Company and
Intramerica Life Insurance Company effective July 1, 1999. Incorporated
herein by reference to Exhibit 10.29 to Allstate Life Insurance Company's
Form 10 filed on April 24, 2002.
10.14 Investment Management Agreement between Allstate Investments, LLC and ALIC
Reinsurance Company, effective July 1, 2005. Incorporated herein by reference
to Exhibit 10.1 to Allstate Life Insurance Company's Quarterly Report on Form
10-Q for quarter ended September 30, 2005.
10.15 Assignment and Assumption Agreement dated as of January 1, 2002 among
Allstate Insurance Company, Allstate Investments, LLC and Intramerica Life
Insurance Company. Incorporated herein by reference to Exhibit 10.30 to
Allstate Life Insurance Company's Form 10 filed on April 24, 2002.
10.16 Investment Advisory Agreement and Amendment to Service Agreement as of
January 1, 2002 between Allstate Insurance Company, Allstate Investments, LLC
and Allstate Life Insurance Company of New York. Incorporated herein by
reference to Exhibit 10.31 to Allstate Life Insurance Company's Form 10 filed
on April 24, 2002.
10.17 Cash Management Services Master Agreement between Allstate Insurance Company
and Allstate Bank (f/k/a Allstate Federal Savings Bank) dated March 16, 1999.
Incorporated herein by reference to Exhibit 10.32 to Allstate Life Insurance
Company's Form 10 filed on April 24, 2002.
10.18 Amendment No. 1 effective January 5, 2001 to Cash Management Services Master
Agreement between Allstate Insurance Company and Allstate Bank dated March
16, 1999. Incorporated herein by reference to Exhibit 10.33 to Allstate Life
Insurance Company's Form 10 filed on April 24, 2002.
10.19 Agent Access Agreement among Allstate Insurance Company, Allstate New Jersey
Insurance Company, Allstate Life Insurance Company and Allstate Bank
effective January 1, 2002. Incorporated herein by reference to Exhibit 10.17
to Allstate Life Insurance Company's Annual Report on Form 10-K for 2003.
10.20 Tax Sharing Agreement dated as of November 12, 1996 among The Allstate
Corporation and certain affiliates. Incorporated herein by reference to
Exhibit 10.36 to Allstate Life Insurance Company's Form 10 filed on April 24,
2002.
</Table>
95
<Page>
<Table>
10.21 Surplus Note Purchase Agreement between Allstate Life Insurance Company and
Kennett Capital, Inc. effective, August 1, 2005. Incorporated herein by
reference to Exhibit 10.2 to Allstate Life Insurance Company's Quarterly
Report on Form 10-Q for quarter ended September 30, 2005.
10.22 Pledge and Security Agreement between Allstate Life Insurance Company and
Kennett Capital, Inc. effective August 1, 2005. Incorporated herein by
reference to Exhibit 10.3 to Allstate Life Insurance Company's Quarterly
Report on Form 10-Q for quarter ended September 30, 2005.
10.23 Catastrophe Reinsurance Agreement between Allstate Life Insurance Company and
American Heritage Life Insurance Company effective July 1, 2003. Incorporated
herein by reference to Exhibit 10.29 to Allstate Life Insurance Company's
Annual Report on Form 10-K for 2003.
10.24 Retrocessional Reinsurance Agreement between Allstate Life Insurance Company
and American Heritage Life Insurance Company effective December 31, 2004.
Incorporated herein by reference to Exhibit 10.23 to Allstate Life Insurance
Company's Annual Report on Form 10-K for 2004.
23 Consent of Independent Registered Public Accounting Firm
31.1 Rule 13a-14(a) Certification of Principal Executive Officer
31.2 Rule 13a-14(a) Certification of Principal Financial Officer
32 Section 1350 Certifications
99(i) Press release dated March 8, 2006 issued by The Allstate Corporation.
99(ii) The Allstate Corporation Policy Regarding Pre-Approval of Independent
Auditors' Services effective November 10, 2003. Incorporated herein by
reference to Exhibit 99(ii) to Allstate Life Insurance Company's Annual
Report on Form 10-K for 2004.
</Table>
(b) The exhibits are listed in Item 15. (a) (3) above.
(c) The financial statement schedules are listed in Item 15. (a) (2) above.
96
<Page>
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned thereunto duly authorized.
ALLSTATE LIFE INSURANCE COMPANY
(Registrant)
March 13, 2006 /s/ SAMUEL H. PILCH
-------------------------------
By: Samuel H. Pilch
(chief accounting officer and duly authorized officer
of the registrant)
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.
<Table>
<Caption>
SIGNATURE TITLE DATE
- ------------------------------------------------------------------------------------------------------
/s/ CASEY J. SYLLA Chairman of the Board, President March 13, 2006
- --------------------------- and a Director (Principal Executive Officer)
Casey J. Sylla
/s/ JOHN C. PINTOZZI Senior Vice President, Chief Financial March 13, 2006
- --------------------------- Officer and a Director (Principal Financial Officer)
John C. Pintozzi
/s/ DAVID A. BIRD Director March 13, 2006
- ---------------------------
David A. Bird
/s/ DANNY L. HALE Director March 13, 2006
- ---------------------------
Danny L. Hale
/s/ EDWARD M. LIDDY Director March 13, 2006
- ---------------------------
Edward M. Liddy
/s/ JOHN C. LOUNDS Director March 13, 2006
- ---------------------------
John C. Lounds
/s/ ERIC A. SIMONSON Director March 13, 2006
- ---------------------------
Eric A. Simonson
/s/ KEVIN R. SLAWIN Director March 13, 2006
- ---------------------------
Kevin R. Slawin
/s/ MICHAEL J. VELOTTA Director March 13, 2006
- ---------------------------
Michael J. Velotta
/s/ DOUGLAS B. WELCH Director March 13, 2006
- ---------------------------
Douglas B. Welch
/s/ THOMAS J. WILSON, II Director March 13, 2006
- ---------------------------
Thomas J. Wilson, II
</Table>
97
<Page>
ALLSTATE LIFE INSURANCE COMPANY AND SUBSIDIARIES
SCHEDULE I--SUMMARY OF INVESTMENTS OTHER THAN INVESTMENTS IN RELATED
PARTIES DECEMBER 31, 2005
<Table>
<Caption>
AMOUNT AT
WHICH
COST/ SHOWN ON
AMORTIZED BALANCE
(IN MILLIONS) COST FAIR VALUE SHEET
--------------- -------------- --------------
TYPE OF INVESTMENT
- ------------------
Fixed Maturities:
Bonds:
United States government, government agencies and authorities $ 2,639 $ 3,487 $ 3,487
States, municipalities and political subdivisions 4,291 4,443 4,443
Foreign governments 1,727 2,099 2,099
Public utilities 5,341 5,738 5,738
Convertibles and bonds with warrants attached 760 744 744
All other corporate bonds 27,341 27,903 27,903
Mortgage-backed securities 5,742 5,693 5,693
Commercial mortgage-backed securities 6,745 6,732 6,732
Asset-backed securities 5,114 5,118 5,118
Redeemable preferred stocks 17 20 20
--------------- -------------- --------------
Total fixed maturities 59,717 $ 61,977 61,977
--------------- ============== --------------
Equity Securities:
Common Stocks:
Public utilities 4 $ 4 4
Banks, trusts and insurance companies - - -
Industrial, miscellaneous and all other 270 274 274
Non-redeemable preferred stocks 45 46 46
--------------- -------------- --------------
Total equity securities 319 $ 324 324
--------------- ============== --------------
Mortgage loans on real estate 8,108 8,108
Derivative instruments 578 574
Real estate - -
Real estate acquired in satisfaction of debt 10 10
Policy loans 729 729
Other long-term investments 108 107
Short-term investments 927 927
--------------- --------------
Total investments $ 70,496 $ 72,756
=============== ==============
</Table>
S-1
<Page>
ALLSTATE LIFE INSURANCE COMPANY AND SUBSIDIARIES
SCHEDULE III--SUPPLEMENTARY INSURANCE INFORMATION
<Table>
<Caption>
AT DECEMBER 31 FOR THE YEAR ENDED DECEMBER 31
------------------------------------ -------------------------------------------------------
AMORTIZATION
FUTURE POLICY CONTRACT OF
DEFERRED BENEFITS, PREMIUMS BENEFITS DEFERRED
POLICY LOSSES, AND NET AND POLICY OPERATING
ACQUISITION CLAIMS, UNEARNED CONTRACT INVESTMENT CREDITED ACQUISITION COSTS AND
(IN MILLIONS) COSTS EXPENSES PREMIUMS CHARGES INCOME INTEREST COSTS EXPENSES
- ------------ ----- -------- -------- ------- ------ -------- ----- --------
2005 $3,948 $70,071 $35 $1,553 $3,707 $3,680 $568 $433
2004 $3,176 $65,142 $31 $1,598 $3,260 $3,282 $534 $462
2003 $3,202 $55,394 $32 $1,831 $3,082 $3,359 $479 $493
</Table>
S-2
<Page>
ALLSTATE LIFE INSURANCE COMPANY AND SUBSIDIARIES
SCHEDULE IV--REINSURANCE
<Table>
<Caption>
PERCENTAGE
CEDED ASSUMED OF AMOUNT
GROSS TO OTHER FROM OTHER NET ASSUMED
(IN MILLIONS) AMOUNT COMPANIES COMPANIES AMOUNT TO NET
------ --------- --------- ------ ------
YEAR ENDED DECEMBER 31, 2005
----------------------------
Life insurance in force $434,965 $223,194 $ 9,400 $221,171 4.3%
Premiums and contract charges:
Life and annuities $ 1,928 $ 445 $ 43 $ 1,526 2.8%
Accident and health 187 161 1 27 3.7%
-------- --------- ---------- --------
Total premiums and contract charges $ 2,115 $ 606 $ 44 $ 1,553 2.8%
======== ========= ========== ========
YEAR ENDED DECEMBER 31, 2004
----------------------------
Life insurance in force $406,901 $205,595 $ 6,814 $208,120 3.3%
Premiums and contract charges:
Life and annuities $ 1,917 $ 363 $ 25 $ 1,579 1.6%
Accident and health 181 163 1 19 5.3%
-------- --------- ---------- --------
Total premiums and contract charges $ 2,098 $ 526 $ 26 $ 1,598 1.6%
======== ========= ========== ========
YEAR ENDED DECEMBER 31, 2003
----------------------------
Life insurance in force $382,509 $176,907 $ 4,945 $210,547 2.3%
Premiums and contract charges:
Life and annuities $ 1,924 $ 318 $ 47 $ 1,653 2.8%
Accident and health 216 100 62 178 34.8%
-------- --------- ---------- --------
Total premiums and contract charges $ 2,140 $ 418 $ 109 $ 1,831 6.0%
======== ========= ========== ========
</Table>
S-3
<Page>
ALLSTATE LIFE INSURANCE COMPANY AND SUBSIDIARIES
SCHEDULE V--VALUATION AND QUALIFYING ACCOUNTS
<Table>
<Caption>
BALANCE AT CHARGED TO BALANCE AT
BEGINNING COSTS AND END OF
(IN MILLIONS) OF PERIOD EXPENSES DEDUCTIONS PERIOD
---------- ---------- ---------- ----------
YEAR ENDED DECEMBER 31, 2005
Allowance for estimated losses on mortgage loans and real estate $ - $ - $ - $ -
YEAR ENDED DECEMBER 31, 2004
Allowance for estimated losses on mortgage loans and real estate $ 1 $ 1 $ 2 $ -
YEAR ENDED DECEMBER 31, 2003
Allowance for estimated losses on mortgage loans and real estate $ - $ 1 $ - $ 1
</Table>
S-4