FORM 10-Q
Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 


FORM 10-Q

 


 

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.

For the quarterly period ended September 30, 2006

OR

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                     to                    

Commission file number 001-32195

 


LOGO

GENWORTH FINANCIAL, INC.

(Exact Name of Registrant as Specified in its Charter)

 


 

Delaware   33-1073076
(State or Other Jurisdiction of
Incorporation or Organization)
  (I.R.S. Employer
Identification Number)
6620 West Broad Street
Richmond, Virginia
  23230
(Address of Principal Executive Offices)   (Zip Code)

(804) 281-6000

(Registrant’s Telephone Number, Including Area Code)

 


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 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. (Check one):

Large accelerated filer  x                        Accelerated filer  ¨                        Non-accelerated filer  ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x.

At October 25, 2006, 452,204,292 shares of Class A Common Stock, par value $0.001 per share, were outstanding.

 



Table of Contents

TABLE OF CONTENTS

 

     Page

PART I—FINANCIAL INFORMATION

  

Item 1. Condensed Consolidated Financial Statements

   3

Condensed Consolidated Statements of Income for the three and nine months ended September 30, 2006 and 2005 (Unaudited)

   3

Condensed Consolidated Balance Sheets as of September 30, 2006 (Unaudited) and December 31, 2005

   4

Condensed Consolidated Statements of Changes in Stockholders’ Equity for the nine months ended September 30, 2006 and 2005 (Unaudited)

   5

Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2006 and 2005 (Unaudited)

   6

Notes to Condensed Consolidated Financial Statements (Unaudited)

   7

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

   18

Item 3. Quantitative and Qualitative Disclosures About Market Risk

   71

Item 4. Controls and Procedures

   72

PART II—OTHER INFORMATION

  

Item 1. Legal Proceedings

   73

Item 1A. Risk Factors

   75

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

   75

Item 6. Exhibits

   75

Signatures

   76

 

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Table of Contents

PART I—FINANCIAL INFORMATION

Item 1. Financial Statements

GENWORTH FINANCIAL, INC.

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(Amounts in millions, except per share amounts)

(Unaudited)

 

     Three months ended
September 30,
    Nine months ended
September 30,
 
         2006             2005             2006             2005      

Revenues:

        

Premiums

   $ 1,680     $ 1,547     $ 4,867     $ 4,766  

Net investment income

     944       902       2,821       2,595  

Net investment gains (losses)

     (6 )     (7 )     (77 )     (13 )

Policy fees and other income

     186       186       572       501  
                                

Total revenues

     2,804       2,628       8,183       7,849  
                                

Benefits and expenses:

        

Benefits and other changes in policy reserves

     1,183       1,026       3,314       3,152  

Interest credited

     383       364       1,134       1,051  

Acquisition and operating expenses, net of deferrals

     533       506       1,529       1,476  

Amortization of deferred acquisition costs and intangibles

     170       217       551       618  

Interest expense

     87       72       257       213  
                                

Total benefits and expenses

     2,356       2,185       6,785       6,510  
                                

Income before income taxes and accounting change

     448       443       1,398       1,339  

Provision for income taxes

     144       136       447       425  
                                

Net income before accounting change

     304       307       951       914  

Cumulative effect of accounting change, net of taxes

     —         —         4       —    
                                

Net income

   $ 304     $ 307     $ 955     $ 914  
                                

Earnings per common share:

        

Basic

   $ 0.67     $ 0.65     $ 2.08     $ 1.92  
                                

Diluted

   $ 0.65     $ 0.64     $ 2.02     $ 1.88  
                                

Weighted-average common shares outstanding:

        

Basic

     453.8       470.7       458.8       476.7  
                                

Diluted

     467.2       481.1       471.7       484.7  
                                

See Notes to Condensed Consolidated Financial Statements

 

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GENWORTH FINANCIAL, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(Amounts in millions)

 

    

September 30,

2006

    December 31,
2005
 
     (Unaudited)        

Assets

    

Investments:

    

Fixed maturity securities available-for-sale, at fair value

   $ 54,280     $ 53,937  

Equity securities available-for-sale, at fair value

     192       206  

Commercial mortgage loans

     8,315       7,558  

Policy loans

     1,498       1,350  

Restricted investments held by securitization entities

     —         685  

Other invested assets

     3,050       3,174  
                

Total investments

     67,335       66,910  

Cash and cash equivalents

     2,302       1,875  

Accrued investment income

     760       733  

Deferred acquisition costs

     6,166       5,586  

Intangible assets

     884       782  

Goodwill

     1,488       1,450  

Reinsurance recoverable

     17,661       18,245  

Other assets

     1,167       967  

Separate account assets

     10,084       9,106  
                

Total assets

   $ 107,847     $ 105,654  
                

Liabilities and stockholders’ equity

    

Liabilities:

    

Future annuity and contract benefits

   $ 63,593     $ 63,749  

Liability for policy and contract claims

     3,389       3,364  

Unearned premiums

     4,180       3,647  

Other policyholder liabilities

     509       507  

Other liabilities

     5,167       4,937  

Non-recourse funding obligations

     2,450       1,400  

Short-term borrowings

     295       152  

Long-term borrowings

     2,730       2,736  

Senior notes underlying equity units

     600       600  

Mandatorily redeemable preferred stock

     100       100  

Deferred tax liability

     1,441       1,386  

Borrowings related to securitization entities

     —         660  

Separate account liabilities

     10,084       9,106  
                

Total liabilities

     94,538       92,344  
                

Commitments and contingencies

    

Stockholders’ equity:

    

Class A common stock, $0.001 par value; 1.5 billion shares authorized; 492 million and 404 million shares issued as of September 30, 2006 and December 31, 2005, respectively; 452 million and 385 million shares outstanding as of September 30, 2006 and December 31, 2005, respectively

     —         —    

Class B common stock, $0.001 par value; 700 million shares authorized; zero and 86 million shares issued and outstanding as of September 30, 2006 and December 31, 2005, respectively

     —         —    

Additional paid-in capital

     10,737       10,671  
                

Accumulated other comprehensive income (loss):

    

Net unrealized investment gains (losses)

     437       760  

Derivatives qualifying as hedges

     377       389  

Foreign currency translation and other adjustments

     352       255  
                

Total accumulated other comprehensive income (loss)

     1,166       1,404  

Retained earnings

     2,581       1,735  

Treasury stock, at cost (40 million and 19 million shares as of September 30, 2006 and December 31, 2005, respectively)

     (1,175 )     (500 )
                

Total stockholders’ equity

     13,309       13,310  
                

Total liabilities and stockholders’ equity

   $ 107,847     $ 105,654  
                

See Notes to Condensed Consolidated Financial Statements

 

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GENWORTH FINANCIAL, INC.

CONDENSED CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY

(Amounts in millions)

(Unaudited)

 

     Additional
paid-in
capital
   Accumulated other
comprehensive
income (loss)
    Retained
earnings
    Treasury
stock, at
cost
    Total
stockholders’
equity
 

Balances as of December 31, 2004

   $ 10,612    $ 1,608     $ 646     $ —       $ 12,866  

Comprehensive income (loss):

           

Net income

     —        —         914       —         914  

Net unrealized gains (losses) on investment securities

     —        21       —         —         21  

Derivatives qualifying as hedges

     —        131       —         —         131  

Foreign currency translation and other adjustments

     —        (47 )     —         —         (47 )
                 

Total comprehensive income (loss)

              1,019  

Acquisition of treasury stock

     —        —         —         (500 )     (500 )

Dividends to stockholders

     —        —         (96 )     —         (96 )

Stock-based compensation expense and exercises

     35      —         —         —         35  

Capital contributions from GE

     4      —         —         —         4  
                                       

Balances as of September 30, 2005

   $ 10,651    $ 1,713     $ 1,464     $ (500 )   $ 13,328  
                                       
     Additional
paid-in
capital
   Accumulated other
comprehensive
income (loss)
    Retained
earnings
    Treasury
stock, at
cost
    Total
stockholders’
equity
 

Balances as of December 31, 2005

   $ 10,671    $ 1,404     $ 1,735     $ (500 )   $ 13,310  

Comprehensive income (loss):

           

Net income

     —        —         955       —         955  

Net unrealized gains (losses) on investment securities

     —        (323 )     —         —         (323 )

Derivatives qualifying as hedges

     —        (12 )     —         —         (12 )

Foreign currency translation and other adjustments

     —        97       —         —         97  
                 

Total comprehensive income (loss)

              717  

Acquisition of treasury stock

     —        —         —         (675 )     (675 )

Dividends to stockholders

     —        —         (109 )     —         (109 )

Stock-based compensation expense and exercises

     61      —         —         —         61  

Capital contributions from GE

     5      —         —         —         5  
                                       

Balances as of September 30, 2006

   $ 10,737    $ 1,166     $ 2,581     $ (1,175 )   $ 13,309  
                                       

See Notes to Condensed Consolidated Financial Statements

 

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GENWORTH FINANCIAL, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Amounts in millions)

(Unaudited)

 

     Nine months ended
September 30,
 
     2006     2005  

Cash flows from operating activities:

    

Net income

   $ 955     $ 914  

Adjustments to reconcile net income to net cash from operating activities:

    

Amortization of fixed maturity discounts and premiums

     18       42  

Net investment gains (losses)

     77       13  

Charges assessed to policyholders

     (255 )     (248 )

Cumulative effect of accounting policy change

     (4 )     —    

Acquisition costs deferred

     (909 )     (832 )

Amortization of deferred acquisition costs and intangibles

     551       618  

Deferred income taxes

     219       483  

Change in certain assets and liabilities:

    

Accrued investment income and other assets, net

     (10 )     48  

Insurance reserves

     2,427       2,013  

Current tax liabilities

     108       (170 )

Other liabilities and other policy-related balances

     173       (457 )
                

Net cash from operating activities

     3,350       2,424  
                

Cash flows from investing activities:

    

Proceeds from maturities and repayments of investments:

    

Fixed maturities

     4,174       3,750  

Commercial mortgage loans

     830       770  

Proceeds from sales of investments:

    

Fixed maturities and equity securities

     3,683       2,409  

Purchases and originations of investments:

    

Fixed maturities and equity securities

     (8,179 )     (7,851 )

Commercial mortgage loans

     (1,573 )     (2,008 )

Other invested assets, net

     (51 )     204  

Policy loans, net

     (147 )     (129 )

Payments for business purchased, net of cash acquired

     (291 )     —    
                

Net cash from investing activities

     (1,554 )     (2,855 )
                

Cash flows from financing activities:

    

Proceeds from issuance of investment contracts

     5,585       6,359  

Redemption and benefit payments on investment contracts

     (7,396 )     (5,899 )

Short-term borrowings and other, net

     153       (393 )

Proceeds from issuance of non-recourse funding obligations

     1,050       500  

Proceeds from long-term borrowings

     —         348  

Dividends paid to stockholders

     (103 )     (93 )

Stock-based compensation awards exercised

     32       (2 )

Acquisition of treasury stock

     (675 )     (500 )

Capital contribution received from GE

     3       19  
                

Net cash from financing activities

     (1,351 )     339  

Effect of exchange rate changes on cash and cash equivalents

     (18 )     (37 )
                

Net change in cash and cash equivalents

     427       (129 )

Cash and cash equivalents at beginning of period

     1,875       1,963  
                

Cash and cash equivalents at end of period

   $ 2,302     $ 1,834  
                

See Notes to Condensed Consolidated Financial Statements

 

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GENWORTH FINANCIAL, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

(1) Formation of Genworth and Basis of Presentation

Genworth Financial, Inc. (“Genworth”) was incorporated in Delaware on October 23, 2003 in preparation for the corporate reorganization of certain insurance and related subsidiaries of the General Electric Company (“GE”) and an initial public offering of Genworth common stock, which was completed on May 28, 2004 (“IPO”). In connection with the IPO, Genworth acquired substantially all of the assets and liabilities of GE Financial Assurance Holdings, Inc. (“GEFAHI”). Prior to its IPO, Genworth was a wholly-owned subsidiary of GEFAHI. GEFAHI is an indirect subsidiary of General Electric Capital Corporation (“GE Capital”), which in turn is an indirect subsidiary of GE. Prior to the corporate reorganization, GEFAHI was a holding company for a group of companies that provide life insurance, long-term care insurance, group life and health insurance, annuities, investment products and U.S. mortgage insurance. At the same time, Genworth also acquired certain other insurance businesses previously owned by other GE subsidiaries. These businesses included international mortgage insurance, payment protection insurance, a Bermuda reinsurer, and mortgage contract underwriting.

The accompanying condensed financial statements include on a consolidated basis the accounts of Genworth and our affiliate companies in which we hold a majority voting or economic interest, which we refer to as the “company,” “we,” “us,” or “our” unless the context otherwise requires. All intercompany accounts and transactions have been eliminated in consolidation.

We are a leading insurance company in the U.S., with an expanding international presence, serving the life and lifestyle protection, retirement income, investment and mortgage insurance needs of more than 15 million customers. We have leadership positions in key products that we expect will benefit from a number of significant demographic, governmental and market trends. We distribute our products and services through an extensive and diversified distribution network that includes financial intermediaries, independent producers and dedicated sales specialists. We conduct operations in 24 countries and have approximately 7,000 employees. We have the following four segments:

 

    Our Protection segment includes life insurance, long-term care insurance, linked benefit products, Medicare supplement insurance and, primarily for companies with fewer than 1,000 employees, group life and health insurance. Linked benefit products include life products with accelerated death benefits and annuity products with penalty-free withdrawals to pay long-term care benefits. Protection also includes consumer payment protection insurance, which helps consumers meet their payment obligations in the event of illness, involuntary unemployment, disability or death.

 

    Our Retirement Income and Investments segment includes fixed annuities, individual variable annuities, group variable annuities designed for 401(k) plans, single premium immediate annuities, variable life insurance, specialized products, including guaranteed investment contracts (“GICs”), funding agreements and funding agreements backing notes (“FABNs”), and asset management products and services.

 

    Our Mortgage Insurance segment includes mortgage insurance products and mortgage related services offered in the U.S., Canada, Australia, Europe, New Zealand, Mexico and Japan that facilitate homeownership by enabling borrowers to buy homes with low-down-payment mortgages.

 

    Our Corporate and Other segment includes debt financing expenses that are incurred at our holding company level, unallocated corporate income and expenses, and the results of a small, non-core business that is managed outside our operating segments.

On March 8, 2006, GEFAHI completed an offering (“Secondary Offering”) of 71.2 million shares of our Class B Common Stock. The 71.2 million shares were automatically converted to Class A Common Stock upon the sale of these shares to the public. We did not receive any proceeds in the Secondary Offering. Concurrently

 

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GENWORTH FINANCIAL, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

with the Secondary Offering, we repurchased 15.0 million shares of Class B Common Stock from our majority stockholder at a price of $31.93125 per share (the net proceeds per share received by the selling stockholder from the underwriters), which is recorded at cost as treasury stock in the unaudited condensed consolidated balance sheet. As a result of these transactions, GEFAHI no longer owns any of our outstanding common stock.

The accompanying condensed consolidated financial statements are unaudited and have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) and rules and regulations of the United States Securities and Exchange Commission (“SEC”). Preparing financial statements in conformity with GAAP requires us to make estimates and assumptions that affect reported amounts and related disclosures. Actual results could differ from those estimates. Certain prior year amounts have been reclassified to conform to the current year presentation. These condensed consolidated financial statements include all adjustments (consisting of normal recurring accruals) considered necessary by management to present a fair statement of the financial position, results of operations, and cash flow for the periods presented. The results reported in these condensed consolidated financial statements should not be regarded as necessarily indicative of results that may be expected for the entire year. The condensed consolidated financial statements included herein should be read in conjunction with the audited financial statements and related notes contained in our 2005 Annual Report on Form 10-K.

(2) Accounting Pronouncements

Recently adopted

On January 1, 2006, we adopted Financial Accounting Standards Board (“FASB”) Statement of Financial Accounting Standards (“SFAS”) No. 123R, Share-Based Payment, an amendment of SFAS No. 123, Accounting for Stock-Based Compensation. We adopted SFAS No. 123R under the modified prospective transition method. The statement requires companies to recognize the grant-date fair value of options and other equity-based awards within the income statement over the respective vesting period of the awards. We adopted SFAS No. 123 effective January 1, 2002 and, as permitted, we determined a grant date fair value using a Black-Scholes model (“Black-Scholes Model”) and recognized the related compensation expense through the income statement for all equity awards issued subsequent to January 1, 2002. As a result of the adoption of SFAS No. 123R, we will continue to recognize the remaining portion of the requisite service under previously granted unvested awards including those awards granted prior to January 1, 2002. Prior to the adoption of SFAS No. 123R, we adjusted compensation cost related to forfeiture of awards when the actual forfeiture occurred. SFAS No. 123R requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates and requires companies which previously accounted for forfeitures on an occurrence basis to include in income of the period of adoption a cumulative effect of a change in accounting principle for the adjustment to reflect estimated forfeitures for prior periods. On January 1, 2006, we recognized an increase to net income of $4 million related to the cumulative effect of a change in accounting principle for the adoption of SFAS No. 123R. See Note 5 for additional information.

As of January 1, 2006, we adopted SFAS No. 155, Accounting for Certain Hybrid Financial Instruments. SFAS No. 155 amends SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, and SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. SFAS No. 155 allows financial instruments that have embedded derivatives to be accounted for as a whole, eliminating the need to bifurcate the derivative from its host, if the holder elects to account for the whole instrument on a fair value basis. In addition, among other changes, SFAS No. 155 (i) clarifies which interest-only strips and principal-only strips are not subject to the requirements of SFAS No. 133; (ii) establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are

 

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GENWORTH FINANCIAL, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

hybrid financial instruments that contain an embedded derivative requiring bifurcation; (iii) clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives; and (iv) eliminates the prohibition on a qualifying special-purpose entity (“QSPE”) from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial interest. Adoption of SFAS No. 155 did not have a material impact on our condensed consolidated financial statements.

Not yet adopted

In September 2005, the American Institute of Certified Public Accountants (“AICPA”) issued Statement of Position (“SOP”) 05-1, Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection With Modifications or Exchanges of Insurance Contracts. This statement provides guidance on accounting for deferred acquisition costs and other balances on an internal replacement, defined broadly as a modification in product benefits, features, rights, or coverages that occurs by the exchange of an existing contract for a new contract, or by amendment, endorsement, or rider to an existing contract, or by the election of a benefit, feature, right, or coverage within an existing contract. SOP 05-1 is effective for internal replacements occurring in fiscal years beginning after December 15, 2006. The insurance industry has identified several implementation issues during their evaluation of SOP 05-1. An expert panel has been formed by the AICPA to evaluate certain of these interpretive issues that insurance companies are facing in their implementation. Based on our current interpretation, the adoption of SOP 05-1 will result in the shortening of the period over which our group life and health insurance business deferred acquisition costs are amortized. Transition to the shorter amortization period will occur throughout 2007 as each of our in-force contracts renew. Accordingly, under our current interpretation, we expect the transition in 2007 will result in additional amortization of deferred acquisition costs of approximately $60 to $65 million, net of tax. We do not expect any material financial statement impact from transition beyond 2007. Due to the nature of the interpretative issues being reviewed by the expert panel, we continue to evaluate the impact SOP 05-1 will have on our consolidated results of operations and financial position. Depending upon the outcome of the evaluation of these issues by the expert panel, we may refine our estimates of the associated impact related to our adoption of SOP 05-1.

In July 2006, FASB Interpretation (“FIN”) No. 48, Accounting for Uncertainty in Income Taxes, was issued. This guidance clarifies what criteria must be met prior to recognition of the financial statement benefit of a position taken in a tax return. Additionally, it applies to the recognition and measurement of income tax uncertainties resulting from a purchase business combination. This guidance is effective for fiscal years beginning after December 15, 2006. We are currently evaluating the impact FIN No. 48 will have on our consolidated results of operations and financial position.

In September 2006, FASB issued SFAS No. 157, Fair Value Measurements. This statement defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. SFAS No. 157 is effective prospectively with a limited form of retrospective application for fiscal years beginning after November 15, 2007 with early adoption encouraged. We are currently evaluating the impact that SFAS No. 157 will have on our consolidated results of operations and financial position.

In September 2006, FASB issued SFAS No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans. This statement requires an employer to recognize the overfunded or underfunded status of a defined benefit plan as an asset or liability in its statement of financial position and to recognize changes in that funded status in the year in which the changes occur through comprehensive income. SFAS No. 158 is effective prospectively for fiscal years ending after December 15, 2006. The adoption of SFAS No. 158 will not have a material impact on our consolidated results of operations and financial position.

 

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GENWORTH FINANCIAL, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

(3) Earnings per Common Share

Basic and diluted earnings per common share are calculated by dividing net income by the weighted average basic common shares outstanding and by the weighted average diluted common shares outstanding for the periods presented:

 

     Three months ended
September 30,
   Nine months ended
September 30,

(Amounts in millions except for per share data)

       2006            2005            2006            2005    

Basic earnings per common share:

           

Net income before accounting change

   $ 0.67    $ 0.65    $ 2.07    $ 1.92

Cumulative effect of accounting change, net of taxes

     —        —        0.01      —  
                           

Basic earnings per common share

   $ 0.67    $ 0.65    $ 2.08    $ 1.92
                           

Diluted earnings per common share:

           

Net income before accounting change

   $ 0.65    $ 0.64    $ 2.02    $ 1.88

Cumulative effect of accounting change, net of taxes

     —        —        0.01      —  
                           

Diluted earnings per common share

   $ 0.65    $ 0.64    $ 2.02    $ 1.88
                           

Weighted-average shares used in basic earnings per common share calculations

     453.8      470.7      458.8      476.7

Dilutive securities:

           

Stock purchase contracts underlying equity units

     8.1      6.4      7.7      4.9

Stock options and stock appreciation rights

     4.7      3.6      4.6      2.7

Restricted stock units

     0.6      0.4      0.6      0.4
                           

Weighted-average shares used in diluted earnings per common share calculations

     467.2      481.1      471.7      484.7
                           

(4) Acquisitions

On May 1, 2006, we completed the acquisition of Continental Life Insurance Company of Brentwood, Tennessee (“Continental Life”), for $145 million, plus contingent consideration of $5 million per year for two years based on attaining certain sales production thresholds. Continental Life’s business provides primarily Medicare supplement insurance and is a part of our Protection segment. This acquisition was accounted for using the purchase method. The excess purchase price over the estimated fair value of the net assets acquired of $29 million has been recorded as goodwill. In addition, $93 million of present value of future profits was recorded in connection with this transaction. The results of operations of Continental Life have been included in our consolidated results beginning May 1, 2006. We have reflected our initial allocation of the purchase price based on estimated fair value according to preliminary valuations. Such estimated values may change as additional information is obtained and the valuation is finalized.

On July 3, 2006, we completed the acquisition of Vero Lenders Mortgage Insurance Limited (“Vero LMI”), a subsidiary of Vero Insurance Limited, which had been a wholly owned by Promina Group Limited of Sydney, Australia, for $82 million, net of post-closing dividends to us. Vero LMI consists solely of a run-off mortgage insurance block and is part of our Mortgage Insurance segment. This acquisition was accounted for using the purchase method. Present value of future profits of $4 million and no goodwill was recorded in connection with this transaction. We have reflected our initial allocation of the purchase price based on estimated fair value according to preliminary valuations. Such estimated values may change as additional information is obtained and the valuation is finalized.

 

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GENWORTH FINANCIAL, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

On October 20, 2006, we acquired AssetMark Investment Services, Inc. (“AssetMark”) of Pleasant Hill, California, for approximately $230 million. AssetMark is an investment management and adviser company with more than $9 billion in third-party assets under management. Under terms of the agreement, we may pay additional performance-based payments of up to $100 million over three to five years. To fund this acquisition, we issued a total of $223 million of commercial paper at an interest rate of 5.29%. This transaction will be recorded in the fourth quarter of 2006.

(5) Stock-Based Compensation

On January 1, 2006, we adopted SFAS No. 123R under the modified prospective transition method. The statement requires the measurement and recognition of compensation expense for all share-based awards made to employees and directors, including stock options, stock appreciation rights (“SARs”), restricted stock units (“RSUs”) and deferred stock units (“DSUs”) under the 2004 Genworth Financial, Inc. Omnibus Incentive Plan (“Omnibus Incentive Plan”). We previously accounted for these awards under the fair value expense provisions of SFAS No. 123. Accordingly, on January 1, 2006, we recognized a $4 million after-tax increase to income related to our cumulative effect of adopting SFAS No. 123R.

We have recorded stock-based compensation expense related to the estimated value of the RSUs, DSUs, SARs and stock options for the periods presented:

 

    

Three months ended

September 30,

  

Nine months ended

September 30,

(Amounts in millions)

       2006            2005            2006            2005    

Stock-based compensation expense

   $ 11    $ 14    $ 36    $ 36
                           

For awards issued prior to January 1, 2006, stock-based compensation expense is recognized on a graded vesting attribution method over the awards’ respective vesting schedule. For awards issued after January 1, 2006, stock-based compensation expense is recognized evenly on a straight-line attribution method over the awards’ respective vesting period.

For purposes of determining the estimated fair value of stock-based payment awards on the date of grant we use the Black-Scholes Model. The Black-Scholes Model requires the input of certain assumptions that involve judgment. Management will continue to assess the assumptions and methodologies used to calculate estimated fair value of share-based compensation. Circumstances may change and additional data may become available over time, which could result in changes to these assumptions and methodologies.

The following table contains the stock option weighted-average grant-date fair value information and related valuation assumptions for the nine months ending September 30, 2006 and 2005. Fair value is estimated using the Black-Scholes Model.

 

     2006     2005  

Estimated fair value per option

   $ 11.60     $ 10.49  

Valuation Assumptions:

    

Expected term (years)

     6.0       6.0  

Expected volatility

     28.0 %     30.2 %

Expected dividend yield

     0.9 %     1.1 %

Risk-free interest rate

     4.8 %     4.0 %

Under the Omnibus Incentive Plan, we are authorized to grant 38 million equity awards.

 

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GENWORTH FINANCIAL, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

For the three months ended September 30, 2006 and 2005, we granted 1,705,410 and 1,700,439 stock options with exercise prices ranging from $33.27 to $34.13, and $30.79 to $32.27, respectively, which equaled the closing market prices on the date of grant and have an exercise term of 10 years. The stock options will vest in 20% annual increments commencing on the first anniversary of the date of grant. Additionally, during the three months ended September 30, 2006 and 2005 we issued 448,934 and 504,573 RSUs with restriction periods ranging from 3 to 5 years and a fair value of $34.13, and $32.08, respectively, which is measured at the market price of a share of our nonrestricted stock on the grant date. Additionally, during the three months ended September 30, 2006 and 2005, we granted 730,600 and 628,500 SARs with exercise prices of $34.13 and $32.10, respectively.

For the nine months ended September 30, 2006 and 2005, we granted 1,729,410 and 1,802,103 stock options with exercise prices ranging from $33.27 to $34.13 and $26.68 to $32.27, respectively, which equaled the closing market prices on the date of grant and have an exercise term of 10 years. The stock options will vest in 20% annual increments commencing on the first anniversary of the date of grant. Additionally, during the nine months ended September 30, 2006 and 2005 we issued 454,934 and 831,537 RSUs with restriction periods ranging from 3 to 5 years and a fair value of $34.11 and $30.11, respectively, which is measured at the market price of a share of our nonrestricted stock on the grant date. Additionally, during the nine months ended September 30, 2006 and 2005, we granted 730,600 and 628,500 SARs with exercise prices of $34.13 and $32.10, respectively. There were 15,161,276 and 16,054,088 stock options, 2,125,255 and 1,822,443 RSUs and 6,577,713 and 6,883,713 SARs outstanding as of September 30, 2006 and 2005, respectively.

A summary of stock option activity as of September 30, 2006 and changes during the nine months then ended is presented below:

 

     Shares subject to
option
    Weighted average
exercise price

Balance as of January 1, 2006

   15,770,646     $ 21.93

Granted

   1,729,410     $ 34.11

Exercised

   (1,761,127 )   $ 19.97

Forfeited

   (577,653 )   $ 21.99

Expired

   —      
        

Balance as of September 30, 2006

   15,161,276     $ 23.54
        

Exercisable as of September 30, 2006

   4,907,611     $ 23.38
        

A summary of the status of our other equity-based awards as of September 30, 2006 and the changes during the nine months then ended is presented below:

 

    Restricted stock units
(RSUs)
  Deferred stock units
(DSUs)
  Stock appreciation rights
(SARs)
    Number of
awards
    Weighted
average grant
date fair value
  Number of
awards
  Weighted
average fair value
  Number of
awards
    Weighted
average grant
date fair value

Balance as of January 1, 2006

  1,879,761     $ 24.74   16,868   $ 32.12   6,883,713     $ 7.02

Granted

  454,934     $ 34.11   21,143   $ 32.57   730,600     $ 11.60

Exercised

  (113,070 )   $ 19.51   —       (515,000 )   $ 6.65

Terminated

  (96,370 )   $ 27.40   —       (521,600 )   $ 7.43
                     

Balance as of September 30, 2006

  2,125,255     $ 26.90   38,011   $ 33.63   6,577,713     $ 7.48
                     

 

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GENWORTH FINANCIAL, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

As of September 30, 2006, there was $98 million of total unrecognized stock-based compensation expense related to non-vested awards not yet recognized. This expense is expected to be recognized over a weighted average period of two years.

Cash received from stock options exercised for the nine months ending September 30, 2006 was $32 million. New shares were issued to settle all exercised awards. The actual tax benefit realized for the tax deductions from the exercise of equity based awards was $6 million and $12 million for the three and nine month period ending September 30, 2006, respectively.

The following table summarizes information about stock options outstanding as of September 30, 2006:

 

     Outstanding    Exercisable

Exercise price range

   Shares in
thousands
   Average
life(1)
   Average
exercise
price
   Shares in
thousands
   Average
exercise
price

$14.11 – $18.51

   1,389,603    5.95    $ 17.28    1,037,627    $ 17.28

$19.45 – $22.67

   8,644,142    7.43    $ 19.76    1,818,316    $ 20.10

$23.20 – $27.95

   1,436,559    4.27    $ 27.00    1,387,044    $ 27.05

$28.00 – $36.62

   3,690,011    8.83    $ 33.40    663,663    $ 34.25

$37.89 – $39.60

   961    4.82    $ 38.77    961    $ 38.77
                  
   15,161,276    7.33    $ 23.54    4,907,611    $ 23.38
                  

(1) Average contractual life remaining in years

(6) Commitments and Contingencies

(a) Litigation

We face a significant risk of litigation and regulatory investigations and actions in the ordinary course of operating our businesses, including class action lawsuits. Our pending legal and regulatory actions include proceedings specific to us and others generally applicable to business practices in the industries in which we operate. Plaintiffs in class action and other lawsuits against us may seek very large or indeterminate amounts, including punitive and treble damages, which may remain unknown for substantial periods of time. A substantial legal liability or a significant regulatory action against us could have an adverse effect on our financial condition and results of operations. Moreover, even if we ultimately prevail in the litigation, regulatory action or investigation, we could suffer significant reputational harm, which could have an adverse effect on our business, financial condition or results of operations.

(b) Commitments

As of September 30, 2006, we were committed to fund $329 million in U.S. commercial mortgage loan investments and $191 million in limited partnership investments.

(7) Borrowings

Commercial Paper Facility

In March 2006, we issued $229 million of commercial paper and we used the proceeds from this issuance to finance a stock repurchase from GEFAHI concurrently with its secondary offering. The notes under the

 

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GENWORTH FINANCIAL, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

commercial paper program are offered pursuant to an exemption from registration under the Securities Act of 1933 and may have a maturity of up to 364 days from the date of issue. During the second quarter, we reduced the outstanding balance of our commercial paper by $85 million. As of September 30, 2006 and December 31, 2005, the weighted average interest rate on commercial paper outstanding was 5.26% and 3.29%, respectively, and the weighted average maturity was 28 and 53 days, respectively.

From October 19, 2006 to October 20, 2006, we issued a total of $223 million of commercial paper at an interest rate of 5.29%, to fund the AssetMark acquisition that closed on October 20, 2006, as further described in note 4 of these condensed consolidated financial statements.

Revolving Credit Facilities

On May 25, 2006 we entered into a $1.0 billion five-year revolving credit facility, which matures in May 2011, replacing our $1.0 billion five-year revolving credit facility, which was scheduled to mature in May 2009. We also have a $1.0 billion revolving credit facility that matures in April 2010. These facilities bear variable interest rates based on one-month LIBOR plus a margin. As of September 30, 2006, we had no borrowings under these facilities; however, we utilized $171 million of the commitment under these facilities for the issuance of a letter of credit for the benefit of one of our Mortgage Insurance subsidiaries.

Non-recourse Funding Obligations

On January 20, 2006, River Lake Insurance Company III (“River Lake III”), a special purpose financial captive insurance company wholly owned by First Colony Life Insurance Company (“First Colony”), our indirect wholly owned subsidiary, issued $750 million in aggregate principal amount of floating rate surplus notes due 2036 (the “RL III Notes”). River Lake III has received regulatory approval to issue additional series of its floating rate surplus notes up to an aggregate amount of $1.2 billion (including the RL III Notes), but is under no obligation to do so.

On September 22, 2006, River Lake Insurance Company (“River Lake I”), a special purpose captive insurance company wholly owned by First Colony, issued $300 million in aggregate principal amount of floating rate surplus notes due 2033 (the “RL I Notes”). River Lake I previously received approval from the Director of Insurance of the State of South Carolina (the “Director”) on July 23, 2003 to issue up to an aggregate amount of $1.2 billion of its floating rate surplus notes and has issued an aggregate of $1.1 billion to date (including the RL I Notes). Despite having additional capacity, River Lake I does not expect to issue any additional notes.

As of September 30, 2006 and December 31, 2005, the weighted average interest rate on our non-recourse funding obligations was 5.32% and 4.50%, respectively. The non-recourse funding obligations bear variable interest rates, and their carrying value approximates fair value as of September 30, 2006.

On October 24, 2006, Rivermont Life Insurance Company I (“Rivermont I”), a special purpose financial captive insurance company wholly owned by First Colony, issued $315 million in aggregate principal amount of floating rate surplus notes due 2050 (the “Rivermont I Notes”). Rivermont I has received regulatory approval to issue additional series of its floating rate surplus notes up to an aggregate principal amount of $475 million (including the Rivermont I Notes), but is under no obligation to do so. The Rivermont I Notes are direct financial obligations of Rivermont I and are not guaranteed by First Colony or Genworth.

The Rivermont I Notes were issued by Rivermont I to fund statutory reserves for policies subject to Valuation of Life Insurance Policies Regulation (more commonly known as “Regulation XXX”), as clarified by Actuarial Guideline 38 (more commonly known as “AXXX”) and its predecessor regulations. Rivermont I has

 

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GENWORTH FINANCIAL, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

reinsured from First Colony, on a combination coinsurance and modified coinsurance basis, certain universal life insurance policies with secondary guarantees written or reinsured by First Colony. Genworth has agreed to provide a limited guaranty to Rivermont I to mitigate certain interest rate risks associated with this reinsurance. Genworth has agreed to provide a limited guaranty to Rivermont I to mitigate certain interest rate risks associated with this reinsurance. First Colony has also agreed to indemnify Rivermont I for certain limited costs.

The Rivermont I Notes have been sold to a third-party for deposit into certain Delaware trusts (the “Trusts”) that will issue money market or term securities (the “Securities”). The holders of the Rivermont I Notes cannot require repayment from Genworth or any of its subsidiaries, other than Rivermont I, the direct issuer of the Rivermont I Notes. Genworth has also agreed, under certain circumstances, to provide to the Trusts a certain amount of liquidity in the event that the Trusts do not have sufficient funds available to fully redeem the Securities at the stated maturity date.

Rivermont I will pay interest on the principal amount of the Rivermont I Notes on a monthly basis, subject to regulatory approval. Any payment of principal of, including by redemption, or interest on the Rivermont I Notes may only be made with the prior approval of the Director of Insurance of the State of South Carolina in accordance with the terms of its licensing order and in accordance with applicable law. The holders of the Rivermont I Notes have no rights to accelerate payment of principal of the Rivermont I Notes under any circumstances, including without limitation, for nonpayment or breach of any covenant. Rivermont I reserves the right to repay the Rivermont I Notes at any time, subject to the terms of the Rivermont I Notes and prior regulatory approval.

(8) Securitization Entities

GE Capital, our former indirect majority stockholder, provides credit and liquidity support to a funding conduit it sponsored, which exposes it to a majority of the risks and rewards of the conduit’s activities and therefore makes GE Capital the primary beneficiary of the funding conduit. Upon adoption of FIN No. 46, Consolidation of Variable Interest Entities, GE Capital was required to consolidate the funding conduit because of this financial support. As a result, assets and liabilities of certain previously off-balance sheet securitization entities, for which we were the transferor, were required to be included in our condensed consolidated financial statements because the funding conduit no longer qualified as a third-party. Because these securitization entities lost their qualifying status, we were required to recognize $1.2 billion of securitized assets and $1.1 billion of associated liabilities in our condensed consolidated balance sheet in July 2003. The assets and liabilities associated with these securitization entities have been reported in the corresponding financial statement captions in our condensed consolidated balance sheet, and the assets are noted as restricted due to the lack of legal control we have over them. We apply the same accounting policies to these restricted assets and liabilities as we do to our unrestricted assets and liabilities.

As a result of GE Capital no longer having an ownership interest in us in March 2006, the respective funding conduit re-qualified as a third-party and these securitization entities regained their qualifying status under SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities. As a result, the assets were effectively re-securitized and the related assets and liabilities were derecognized from our condensed consolidated financial statements. This resulted in a reduction from December 31, 2005 balances of $685 million, $44 million, $660 million and $15 million of restricted investments held by securitization entities, other assets, borrowings related to securitization entities and other liabilities, respectively. We continue to hold a retained interest in the form of interest-only strips classified as fixed maturity securities available-for-sale on our condensed consolidated statements of financial position. We recognized an investment loss on sale of $11 million, net of tax, from this re-securitization transaction.

 

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GENWORTH FINANCIAL, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

(9) Operating Segment Information

We conduct our operations in four business segments: (1) Protection, which includes our life insurance, long-term care insurance, linked benefit products, Medicare supplement insurance, group life and health insurance and payment protection insurance; (2) Retirement Income and Investments, which includes our fixed annuities, individual variable annuities, group variable annuities designed for 401(k) plans, single premium immediate annuities, variable life insurance, specialized products, including GICs, funding agreements, and FABNs, and asset management products and services; (3) Mortgage Insurance, which includes our mortgage insurance products and mortgage related services that facilitate homeownership by enabling borrowers to buy homes with low-down-payment mortgages; and (4) Corporate and Other, which includes interest and other debt financing expenses and other corporate income and expenses not allocated to the segments, as well as the results of a small, non-core business managed outside our operating segments.

In 2006, we began to allocate net investment gains (losses) from our Corporate and Other segment to our Protection (except payment protection insurance) and Retirement Income and Investments segments using an approach based principally upon the investment portfolio established to support each of those segments’ products and targeted capital levels. We do not allocate net investment gains (losses) from our Corporate and Other segment to our Mortgage Insurance segment or to our payment protection insurance business within the Protection segment, because they have their own separate investment portfolios, and net investment gains (losses) from those portfolios are reflected in the Mortgage Insurance and Protection segment results, respectively.

Prior to 2006, all net investment gains (losses) were recorded in the Corporate and Other segment and were not reflected in the results of any of our other segments.

Effective January 1, 2006, GE Seguros (“Seguros”), a small Mexican-domiciled multi-line insurer, previously included in our Corporate and Other segment, is being managed within our Protection segment and whose results are now included as part of the payment protection insurance business. Segment information related to the Seguros move is reflected in all periods presented.

We use the same accounting policies and procedures to measure segment net operating income and assets as our consolidated net income and assets. Segment net operating income represents the basis on which the performance of our business is assessed by management. Segment net operating income excludes after-tax net investment gains (losses) (which can fluctuate significantly from period to period), and other adjustments, changes in accounting principles and infrequent or unusual non-operating items. There were no non-recurring, infrequent or unusual items excluded from net operating income for the periods presented.

 

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GENWORTH FINANCIAL, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

The following is a summary of revenues, segment net operating income and reconciliation to total company net income for the periods presented:

 

     Three months ended
September 30,
   

Nine months ended

September 30,

 

(Amounts in millions)

       2006             2005             2006             2005      

Revenues

        

Protection

   $ 1,654     $ 1,564     $ 4,845     $ 4,637  

Retirement Income and Investments

     762       705       2,201       2,175  

Mortgage Insurance

     356       303       1,055       897  

Corporate and Other

     32       56       82       140  
                                

Total revenues

   $ 2,804     $ 2,628     $ 8,183     $ 7,849  
                                

Segment net operating income (losses)

        

Protection

   $ 152     $ 145     $ 452     $ 417  

Retirement Income and Investments

     53       59       171       179  

Mortgage Insurance

     134       126       445       388  

Corporate and Other

     (32 )     (19 )     (77 )     (62 )
                                

Total segment net operating income

     307       311       991       922  

Net investment gains (losses), net of taxes and other adjustments

     (3 )     (4 )     (40 )     (8 )
                                

Net income before accounting change

     304       307       951       914  

Cumulative effect of accounting change, net of taxes

     —         —         4       —    
                                

Net income

   $ 304     $ 307     $ 955     $ 914  
                                

The following is a summary of total assets by operating segment as of:

 

(Amounts in millions)

   September 30,
2006
   December 31,
2005

Assets

     

Protection

   $ 37,793    $ 33,945

Retirement Income and Investments

     58,207      58,281

Mortgage Insurance

     8,000      7,118

Corporate and Other

     3,847      6,310
             

Total assets

   $ 107,847    $ 105,654
             

 

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our unaudited condensed consolidated financial statements and related notes included herein.

Cautionary note regarding forward-looking statements

This report contains certain “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements may be identified by words such as “expects,” “intends,” “anticipates,” “plans,” “believes,” “seeks,” “estimates,” “will,” or words of similar meaning and include, but are not limited to, statements regarding the outlook for our future business and financial performance. Forward-looking statements are based on management’s current expectations and assumptions, which are subject to inherent uncertainties, risks and changes in circumstances that are difficult to predict. Actual outcomes and results may differ materially due to global political, economic, business, competitive, market, regulatory and other factors and risks, including the following:

 

    Risks relating to our businesses, including interest rate fluctuations, downturns and volatility in equity markets, defaults in portfolio securities, downgrades in our financial strength and credit ratings, insufficiency of reserves, legal constraints on dividend distributions by subsidiaries, illiquidity of investments, competition, inability to attract or retain independent sales intermediaries and dedicated sales specialists, availability and adequacy of reinsurance, defaults by counterparties, foreign exchange rate fluctuations, regulatory restrictions on our operations and changes in applicable laws and regulations, legal or regulatory investigations or actions, political or economic instability, the failure or any compromise of the security of our computer systems and the occurrence of natural or man-made disasters or a pandemic disease;

 

    Risks relating to our Protection and Retirement Income and Investments segments, including unexpected changes in morbidity, mortality and unemployment rates, accelerated amortization of deferred acquisition costs and present value of future profits, goodwill impairments, reputational risks if we were to raise premiums on in-force long-term care insurance products, medical advances such as genetic mapping research, unexpected changes in persistency rates, increases in statutory reserve requirements, the failure of demand for long-term care insurance to increase as we expect and changes in tax and securities laws;

 

    Risks relating to our Mortgage Insurance segment, including the influence of Fannie Mae, Freddie Mac and a small number of large mortgage lenders and investors, increased regulatory scrutiny of Fannie Mae and Freddie Mac resulting in possible regulatory changes, decreases in the volume of high loan-to-value mortgage originations or increases in mortgage insurance cancellations, increases in the use of simultaneous second mortgages and other alternatives to private mortgage insurance and reductions by lenders in the level of coverage they select, unexpected increases in mortgage insurance default rates or severity of defaults, deterioration in economic conditions, insufficiency of premium rates to compensate us for risks associated with mortgage loans bearing high loan-to-value ratios, increases in the use of captive reinsurance or other risk sharing structures in the mortgage insurance market, changes in the demand for mortgage insurance that could arise as a result of efforts of large mortgage investors, legal or regulatory actions or investigations under applicable laws and regulations, including the Real Estate Settlement Practices Act and the Federal Fair Credit Reporting Act, competition with government-owned and government-sponsored entities, potential liabilities in connection with contract underwriting services and growth in the global mortgage insurance market that is lower than we expect; and

 

   

Risks relating to our separation from GE, including the possibility that we will not be able to replace certain services previously provided by GE on terms that are at least as favorable, the possibility that in certain circumstances we will be obligated to make payments to GE under our tax matters agreement even if our corresponding tax savings either are delayed or never materialize, the possibility that in the

 

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event of a change in control of our company we would have insufficient funds to meet accelerated obligations under the tax matters agreement, the possibility that certain service agreements with GE are not extended on favorable terms, and the significance of our distribution relationship with GE in our payment protection insurance business.

We undertake no obligation to publicly update any forward-looking statement, whether as a result of new information, future developments or otherwise.

Overview

Our business

We are a leading insurance company in the U.S., with an expanding international presence. We have three operating segments: Protection, Retirement Income and Investments, and Mortgage Insurance.

 

    Protection. We offer U.S. customers life insurance, long-term care insurance, linked benefit products, Medicare supplement insurance and, primarily for companies with fewer than 1,000 employees, group life and health insurance. Through our European operations, we offer payment protection insurance, which helps consumers meet their payment obligations in the event of illness, involuntary unemployment, disability or death. Effective January 1, 2006, GE Seguros (“Seguros”), a small Mexican-domiciled multi-line insurer, previously included in our Corporate and Other segment, is being managed within our Protection segment and whose results are now included as part of the payment protection insurance business. For the three months ended September 30, 2006 and 2005, our Protection segment had segment net operating income of $152 million and $145 million, respectively. For the nine months ended September 30, 2006 and 2005, our Protection segment had segment net operating income of $452 million and $417 million, respectively.

 

    Retirement Income and Investments. We offer U.S. customers fixed annuities, individual variable annuities, group variable annuities designed for 401(k) plans, single premium immediate annuities, variable life insurance, specialized products, including guaranteed investment contracts (“GICs”), funding agreements and funding agreements backing notes (“FABNs”), and asset management products and services. For the three months ended September 30, 2006 and 2005, our Retirement Income and Investments segment had segment net operating income of $53 million and $59 million, respectively. For the nine months ended September 30, 2006 and 2005, our Retirement Income and Investments segment had segment net operating income of $171 million and $179 million, respectively.

 

    Mortgage Insurance. In the U.S., Canada, Australia, Europe, New Zealand, Mexico and Japan, we offer mortgage insurance products that facilitate homeownership by enabling borrowers to buy homes with low-down-payment mortgages and mortgage related services for our financial services customers. For the three months ended September 30, 2006 and 2005, our Mortgage Insurance segment had segment net operating income of $134 million and $126 million, respectively. For the nine months ended September 30, 2006 and 2005, our Mortgage Insurance segment had segment net operating income of $445 million and $388 million, respectively.

We also have a Corporate and Other segment, which consists primarily of unallocated corporate income and expenses, the results of a small, non-core business that is managed outside our operating segments, and most of our interest and other financing expenses. For the three months ended September 30, 2006 and 2005, our Corporate and Other segment had segment net operating losses of $32 million and $19 million, respectively. For the nine months ended September 30, 2006 and 2005, our Corporate and Other segment had segment net operating losses of $77 million and $62 million, respectively.

Our financial information

The financial information presented herein has been derived from our condensed consolidated financial statements.

 

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Revenues and expenses

Our revenues consist primarily of the following:

 

    Protection. The revenues in our Protection segment consist primarily of:

 

    net premiums earned on individual life, individual long-term care, group life and health, and payment protection insurance policies;

 

    net investment income and net investment gains (losses) on the separate investment portfolio held by our payment protection insurance business, and net investment income and net investment gains (losses) allocated to this segment’s other lines of business; and

 

    policy fees and other income, including fees for mortality and surrender charges primarily from universal life insurance policies, and other administrative charges.

 

    Retirement Income and Investments. The revenues in our Retirement Income and Investments segment consist primarily of:

 

    net premiums earned on single premium immediate annuities and structured settlements with life contingencies;

 

    net investment income and net investment gains (losses) allocated to this segment; and

 

    policy fees and other income, including surrender charges, mortality and expense charges, investment management fees and commissions.

 

    Mortgage Insurance. The revenues in our Mortgage Insurance segment consist primarily of:

 

    net premiums earned on mortgage insurance policies;

 

    net investment income and net investment gains (losses) on the segment’s separate investment portfolio; and

 

    policy fees and other income, including fees from contract underwriting services.

 

    Corporate and Other. The revenues in our Corporate and Other segment consist primarily of:

 

    net premiums, policy fees and other income from a small non-core insurance business in this segment; and

 

    unallocated net investment income and net investment gains (losses).

In 2006, we began to allocate net investment gains (losses) from our Corporate and Other segment to our Protection (except payment protection insurance) and Retirement Income and Investments segments using an approach based principally upon the investment portfolios established to support each of those segments’ products and targeted capital levels. We do not allocate net investment gains (losses) from our Corporate and Other segment to our Mortgage Insurance segment or to our payment protection insurance business within the Protection segment because they have their own separate investment portfolios, and net investment gains (losses) from those portfolios are reflected in the Mortgage Insurance and Protection segment results, respectively.

Prior to 2006, all net investment gains (losses) were recorded in the Corporate and Other segment and were not reflected in the results of any of our other segments.

Our expenses consist primarily of the following:

 

    benefits provided to policyholders and contractholders and changes in reserves;

 

    interest credited on general account balances;

 

    operating expenses, including commissions, marketing expenses, policy and contract servicing costs, overhead and other general expenses that are not capitalized (shown net of deferrals);

 

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    amortization of deferred policy acquisition costs and other intangible assets;

 

    interest and other financing expenses; and

 

    income taxes.

We allocate corporate expenses to each of our operating segments based on the amount of capital allocated to that segment.

Critical accounting policies

The accounting policies discussed in this section are those that we consider to be particularly critical to an understanding of our financial statements because their application places the most significant demands on our ability to judge the effect of inherently uncertain matters on our financial results. For all of these policies, we caution that future events rarely develop exactly as forecast, and our management’s best estimates may require adjustment.

Valuation of investment securities. We obtain values for actively traded securities from external pricing services. For infrequently traded securities, we obtain quotes from brokers or we estimate values using internally developed pricing models. These models are based upon common valuation techniques and require us to make assumptions regarding credit quality, liquidity and other factors that affect estimated values. We regularly review investment securities for impairment in accordance with our impairment policy, which includes both quantitative and qualitative criteria. Quantitative criteria include length of time and amount that each security position is in an unrealized loss position, and for fixed maturities, whether the issuer is in compliance with terms and covenants of the security. Qualitative criteria include the financial strength and specific prospects for the issuer as well as our intent to hold the security until recovery. Our impairment reviews involve our finance, risk and asset management teams, as well as the portfolio management and research capabilities of GEAM (“GE Asset Management”) and other third-party managers, as required. We actively perform comprehensive market research, monitor market conditions and segment our investments by credit risk in order to minimize impairment risks.

Deferred acquisition costs. Deferred acquisition costs, or DAC, represent costs which vary with and are primarily related to the sale and issuance of our insurance policies and investment contracts that are deferred and amortized over the estimated life of the related insurance policies. These costs include commissions in excess of ultimate renewal commissions, solicitation and printing costs, sales material and some support costs, such as underwriting and contract and policy issuance expenses. DAC is subsequently amortized to expense, over the lives of the underlying contracts, in relation to the anticipated recognition of premiums or gross profits.

The amortization of DAC for traditional long-duration insurance products (including guaranteed renewable term life, life-contingent structured settlements and immediate annuities and long-term care insurance) is determined as a level proportion of premium based on commonly accepted actuarial methods and reasonable assumptions, established when the contract or policy is issued, about mortality, morbidity, lapse rates, expenses, and future yield on related investments. GAAP requires that assumptions for these types of products not be modified (or unlocked) unless recoverability testing deems them to be inadequate or a re-pricing event occurs. Amortization is adjusted each period to reflect policy lapse or termination rates as compared to anticipated experience. Accordingly, we could experience accelerated amortization of DAC if policies terminate earlier than originally assumed.

Amortization of DAC for annuity contracts without significant mortality risk and investment and universal life products is based on expected gross profits. Expected gross profits are adjusted quarterly to reflect actual experience to-date or for the unlocking of underlying key assumptions based on experience studies such as

mortality, withdrawal or lapse rates, investment margin or maintenance expenses. The estimation of expected

gross profits is subject to change given the inherent uncertainty as to the underlying key assumptions employed and the long duration of our policy or contract liabilities. Changes in expected gross profits reflecting the

 

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unlocking of key assumptions could result in a material increase or decrease in the amortization of DAC

depending on the magnitude of the change in underlying assumptions. Significant factors that could result in a material increase or decrease in DAC amortization for these products include material changes in withdrawal or lapse rates, investment spreads or mortality assumptions. For the nine-months ended September 30, 2006 and 2005, key assumptions were unlocked in our Protection and Retirement Income and Investments segments to reflect our current expectation of future investment spreads and mortality.

The amortization of DAC for mortgage insurance is based on expected gross margins. Expected gross margins, defined as premiums less losses, are set based on assumptions for future persistency and loss development of the business. These assumptions are updated quarterly for actual experience to-date or as our expectations of future experience are revised based on experience studies. Due to the inherent uncertainties in making assumptions about future events, materially different experience from expected results in persistency or loss development could result in a material increase or decrease to DAC amortization for this business. For the nine months ended September 30, 2006 and 2005, key assumptions were unlocked in our Mortgage Insurance segment to reflect our current expectation of future persistency.

The following table sets forth the increase (decrease) on amortization of DAC related to unlocking of key assumptions by segment for the periods indicated:

 

     Three months ended
September 30,

(Amounts in millions)

       2006             2005    

Protection

   $ (7 )   $ 2

Retirement Income and Investments

     4       —  

Mortgage insurance

     (2 )     4
              

Total

   $ (5 )   $ 6
              

The following discussion includes disclosure of variations from current estimates of DAC amortization and recoverability due to reasonably likely adverse changes in certain key assumptions. The impact of reasonably likely adverse changes described below is estimated individually, without consideration for any correlation among key assumptions or among lines of business. The estimated adverse variation in the amortization and recoverability of our DAC due to changes in key assumptions is an estimate of possible variation that may occur in the future, likely over a period of several calendar years.

The DAC amortization methodology for our variable products (variable annuities and variable universal life insurance) includes a long-term equity market average appreciation assumption of 8.5%. When actual returns vary from the expected 8.5% we assume a reversion to this mean over a 3- to 5-year period, subject to the imposition of ceilings and floors. The assumed returns over this reversion period are limited to the 85th percentile of historical market performance. Variation in equity market returns that could be considered reasonably likely would not have a material effect on the amortization of DAC.

We regularly review DAC to determine if it is recoverable from future income. For deposit products, if the current present value of estimated future gross profits is less than the unamortized DAC for a line of business, a charge to income is recorded for additional DAC amortization or for increased benefit reserves. For other products, if the benefit reserves plus anticipated future premiums and interest earnings for a line of business are less than the current estimate of future benefits and expenses (including any unamortized DAC), a charge to income is recorded for additional DAC amortization or for increased benefit reserves.

Continued low interest rates and lower than expected termination rates on older issued long-term care insurance policies have reduced our margins on this business. As of December 31, 2005, additional adverse variations in morbidity, mortality, termination rates or interest rates that could be considered reasonably likely to occur in the future would result in our long-term care insurance DAC being no longer fully recoverable. As of

 

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December 31, 2005, adverse variation that we consider reasonably likely would result in additional amortization of DAC of up to $11 million assuming there is no increase in future premiums. However, more adverse variation could result in additional amortization of DAC or the establishment of additional benefit reserves, while any favorable variation would result in additional margin in our DAC recoverability analysis and would result in higher earnings recognition over the remaining duration of the in-force block. We expect future sales of profitable long-term care insurance will improve margins, which would reduce the likelihood that adverse variation in key assumptions would result in our DAC being no longer fully recoverable. As of December 31, 2005, we had $1.6 billion of DAC related to our long-term care insurance business. As of December 31, 2005, we believe all of our other businesses have sufficient future income, where the related DAC would be recoverable under adverse variations in morbidity, mortality, withdrawal or lapse rate, maintenance expense or interest rates that could be considered reasonably likely to occur.

As of September 30, 2006, we believe all of our businesses, including our long-term care business, have sufficient future income, where the related DAC would be recoverable under adverse variations in morbidity, mortality, withdrawal or lapse rate, maintenance expense or interest rates that could be considered reasonably likely to occur. For the nine months ended September 30, 2006 and 2005, there were no material charges to earnings as a result of our DAC recoverability testing.

Present value of future profits. In conjunction with the acquisition of a block of insurance policies or investment contracts, a portion of the purchase price is assigned to the right to receive future gross profits arising from existing insurance and investment contracts. This intangible asset, called the present value of future profits, or PVFP, represents the actuarially estimated present value of future cash flows from the acquired policies. PVFP is amortized, net of accreted interest, in a manner similar to the amortization of DAC.

The following discussion includes disclosure of variations from current estimates of PVFP recoverability due to reasonably likely adverse changes in certain key assumptions. The impact of reasonably likely adverse changes described below is estimated individually, without consideration for any correlation among key assumptions or among lines of business. The estimated adverse variation in the recoverability of our PVFP due to changes in key assumptions is an estimate of possible variation that may occur in the future, likely over a period of several calendar years.

We regularly review our assumptions and periodically test PVFP for recoverability in a manner similar to our treatment of DAC.

Continued low interest rates and lower than expected termination rates on long-term care insurance policies have reduced our margins for this acquired business. Additional adverse variations in morbidity, mortality, termination rates or interest rates that could be considered reasonably likely to occur in the future would result in our long-term care insurance PVFP being no longer fully recoverable. As of December 31, 2005, adverse variation that we consider reasonably likely would result in additional amortization of PVFP of up to $33 million assuming there is no increase in future premiums. However, more adverse variation could result in additional amortization of PVFP or the establishment of additional benefit reserves, while any favorable variation would result in additional margin in our PVFP recoverability analysis and would result in higher earnings recognition over the remaining duration of the in-force block. As of December 31, 2005, we had $100 million of PVFP related to our long-term care insurance business. As of December 31, 2005, we believe all of our other businesses have sufficient future income, where the related PVFP would be recoverable under adverse variations in morbidity, mortality, withdrawal or lapse rate, maintenance expense or interest rates that could be considered reasonably likely to occur.

As of September 30, 2006, we believe all of our businesses, including our long-term care business, have sufficient future income, where the related PVFP would be recoverable under adverse variations in morbidity, mortality, withdrawal or lapse rate, maintenance expense or interest rates that could be considered reasonably likely to occur. For the nine months ended September 30, 2006 and 2005, there were no material charges to earnings as a result of our PVFP recoverability testing.

 

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Valuation of goodwill. Goodwill represents the excess of the amount paid to acquire our subsidiaries and other businesses over the fair value of their net assets at the date of acquisition. Under GAAP, we test the carrying value of goodwill for impairment annually at the “reporting unit” level, which is either an operating segment or a business one level below the operating segment. Under certain circumstances, interim impairment tests may be required if events occur or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. Goodwill is impaired if the fair value of the reporting unit as a whole is less than the fair value of the identifiable assets and liabilities of the reporting unit, plus the carrying value of goodwill, at the date of the test. The carrying amount of each reporting unit is determined based on the capital required to support the reporting unit’s activities including tangible and intangible assets. The determination of a reporting unit’s capital allocation requires management judgment and considers many factors including required regulatory capital.

The initial recognition of goodwill and subsequent testing for impairment require management to make assumptions concerning estimates of how the reporting unit will perform in the future using valuation methods including discounted cash flow analysis. These assumptions are based on our historical experience and our expectations of future performance. Our estimates are subject to change given the inherent uncertainty in predicting future performance and cash flows, which are impacted by such as things as policyholder behavior, competitor pricing, new product introductions and specific industry and market conditions. For the nine months ended September 30, 2006 and 2005 there were no material charges to earnings as a result of our impairment testing.

Insurance liabilities and reserves. We calculate and maintain reserves for the estimated future payment of claims to our policyholders and contractholders based on actuarial assumptions and in accordance with industry practice and GAAP. Many factors can affect these reserves, including economic and social conditions, inflation, healthcare costs, changes in doctrines of legal liability and damage awards in litigation. Therefore, the reserves we establish are necessarily based on estimates, assumptions and our analysis of historical experience. Our results depend significantly upon the extent to which our actual claims experience is consistent with the assumptions we used in determining our reserves and pricing our products. Our reserve assumptions and estimates require significant judgment and, therefore, are inherently uncertain. We cannot determine with precision the ultimate amounts that we will pay for actual claims or the timing of those payments.

Insurance reserves differ for long- and short-duration insurance policies and annuity contracts. Measurement of long-duration insurance reserves (such as guaranteed renewable term life, whole life and long-term care insurance policies) is based on approved actuarial methods, but necessarily includes assumptions about expenses, mortality, morbidity, lapse rates and future yield on related investments. Short-duration contracts (such as payment protection insurance) are accounted for based on actuarial estimates of the amount of loss inherent in that period’s claims, including losses incurred for which claims have not been reported. Short-duration contract loss estimates rely on actuarial observations of ultimate loss experience for similar historical events.

Estimates of mortgage insurance reserves for losses and loss adjustment expenses are based on notices of mortgage loan defaults and estimates of defaults that have been incurred but have not been reported by loan servicers, using assumptions of claim rates for loans in default and the average amount paid for loans that result in a claim. As is common accounting practice in the mortgage insurance industry and in accordance with GAAP, loss reserves are not established for future claims on insured loans that are not currently in default.

Unearned premiums. For single premium insurance contracts, we recognize premiums over the policy life in accordance with the estimated expiration of risk. We recognize a portion of the revenue in premiums earned in the current period, while the remaining portion is deferred as unearned premiums and earned over time in accordance with the estimated expiration of risk. If single premium policies are canceled and the premium is non-refundable, then the remaining unearned premium related to each cancelled policy is recognized to earned premiums upon notification of the cancellation. Estimation of risk expiration on which we base premium recognition is inherently judgmental and is based on actuarial analysis of historical experience.

 

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As of September 30, 2006 and December 31, 2005, we had $4.2 billion and $3.6 billion, respectively of unearned premiums of which $2.3 billion and $1.8 billion, respectively, related to our international mortgage insurance business. We recognize international mortgage insurance unearned premiums over a period of up to 25 years, most of which are recognized between 3 and 7 years from issue date. The recognition of earned premiums for our international mortgage insurance business involves significant estimates and assumptions as to future loss development and policy cancellations. These assumptions are based on our historical experience and our expectations of future performance, which are highly dependent on assumptions as to long-term macroeconomic conditions including interest rates, home price appreciation and the rate of unemployment. We periodically review our estimate of risk expiration and adjust this estimate based on actual experience and changes in our expectation of future performance with any adjustments reflected in current period earnings. For the nine months ended September 30, 2006 and 2005, increases to international mortgage insurance earned premiums as a result of adjustments made to our estimation of risk expiration were $14 million and $19 million, respectively.

The following discussion includes disclosure of variations from current estimates of risk expiration due to reasonably likely changes in certain key assumptions. The estimated variation of our expiration of risk due to changes in key assumptions is an estimate of possible variation that may occur in the future, likely over a period of several calendar years.

Our estimate of risk expiration for our international mortgage insurance business is subject to change given the inherent uncertainty as to the underlying loss development and policy cancellation assumptions and the long duration of our international mortgage insurance policy contracts. Actual experience that is different than assumed for loss development or policy cancellations could result in a material increase or decrease in the recognition of earned premiums depending on the magnitude of the difference between actual and assumed experience. Loss development and policy cancellation variations that could be considered reasonably likely to occur in the future would result in accelerated or decelerated recognition of earned premiums that would result in an increase in net earnings of up to $40 million or a decrease in net earnings of up to $20 million, depending on the magnitude of variation experienced. It is important to note that the variation discussed above is not meant to be a best-case or worst-case scenario, and therefore, it is possible that future variation may exceed the amounts discussed above.

The remaining portion of our unearned premiums relates to our payment protection insurance and long-term care insurance businesses where the underlying assumptions as to risk expiration are not subject to significant uncertainty. Accordingly, changes in underlying assumptions as to premium recognition we consider being reasonably likely for these businesses would not result in a material impact on net earnings.

Derivatives. We enter into freestanding derivative transactions primarily to manage the risk associated with variability in cash flows or changes in fair values related to our financial assets and liabilities. We also use derivative instruments to hedge our currency exposure associated with certain foreign operations. We also purchase investment securities, issue certain insurance policies and engage in certain reinsurance contracts that have embedded derivatives. The associated financial statement risk is the volatility in net income which can result from (1) changes in fair value of derivatives not qualifying as accounting hedges; (2) ineffectiveness of designated hedges; and (3) counterparty default. Accounting for derivatives is complex, as evidenced by significant authoritative interpretations of the primary accounting standards which continue to evolve, as well as the significant judgments and estimates involved in determining fair value in the absence of quoted market values. These estimates are based on valuation methodologies and assumptions deemed appropriate in the circumstances. Such assumptions include estimated volatility and interest rates used in the determination of fair value where quoted market values are not available. The use of different assumptions may have a material effect on the estimated fair value amounts.

Contingent liabilities. A liability is contingent if the amount is not presently known, but may become known in the future as a result of the occurrence of some uncertain future event. We estimate our contingent liabilities based on management’s estimates about the probability of outcomes and their ability to estimate the range of

 

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exposure. Accounting standards require that a liability be recorded if management determines that it is probable

that a loss has occurred and the loss can be reasonably estimated. In addition, it must be probable that the loss will be confirmed by some future event. As part of the estimation process, management is required to make assumptions about matters that are by their nature highly uncertain.

The assessment of contingent liabilities, including legal contingencies and income tax liabilities, involves the use of critical estimates, assumptions and judgments. Management’s estimates are based on their belief that future events will validate the current assumptions regarding the ultimate outcome of these exposures. However, there can be no assurance that future events, such as court decisions or Internal Revenue Service positions, will not differ from management’s assessments. Whenever practicable, management consults with third-party experts (including attorneys, accountants and claims administrators) to assist with the gathering and evaluation of information related to contingent liabilities. Based on internally and/or externally prepared evaluations, management makes a determination whether the potential exposure requires accrual in the financial statements.

Recent business trends and conditions

The following business trends and conditions have had a significant impact on our products during the periods covered by this report:

Life insurance. Results in our life insurance business are impacted by sales, mortality, persistency, investment yields, and statutory reserve requirements. Additionally, sales of our products are dependent on competitive product features and pricing, distribution expansion and penetration, and consistent customer service. Regulation XXX requires insurers to establish additional statutory reserves for term and universal life insurance policies with long-term premium guarantees, which increases the capital required to write these products. For term life insurance, we have implemented capital management actions that improve our new business returns and have enabled us to decrease our premium rates. Several competitors have executed similar capital management actions and lowered their term prices accordingly, which has made the market more competitive and could affect our future sales levels. In addition, valuation of Life Insurance Policies Regulation as clarified by Actuarial Guideline 38 (more commonly known as “Regulation AXXX”) requires insurers to establish additional statutory reserves for certain universal life policies with secondary guarantees. On October 24, 2006, our wholly-owned subsidiary, Rivermont Life Insurance Company I, issued $315 million of non-recourse funding obligations to fund statutory reserves required by Regulation AXXX for certain blocks of our universal life business. Rivermont has received regulatory approval to issue up to an aggregate of $475 million of non-recourse funding obligations.

Long-term care insurance. Results of our long-term care insurance business are influenced by morbidity, persistency, investment yields, new product sales, expenses and reinsurance. Industry-wide first-year annualized premiums of individual long-term care insurance decreased approximately 11% for the six months ended June 30, 2006 compared to the six months ended June 30, 2005 according to the most recently published data by LIMRA International. Our sales growth in a challenging market reflects the breadth of our distribution and progress across multiple growth initiatives with an emphasis on broadening our product offerings, although, sales growth has been slower than anticipated over the last couple of years. However, the continued low interest rate environment and the impact of lower termination rates on older issued policies, some with expiring reinsurance coverage, are causing higher benefits and other changes in policy reserves, resulting in lower net operating income. In response to these trends, we will continue to pursue multiple growth initiatives, continue investing in claims process improvements, execute investment strategies and, if appropriate, consider rate increases to improve loss ratios.

In addition, during the second quarter of 2006, we completed the acquisition of Continental Life Insurance Company of Brentwood, Tennessee, a provider of Medicare supplement insurance, for approximately $145 million. This acquisition enhances our presence in the senior supplemental insurance market by more than doubling our existing annualized premiums for this product and giving us access to approximately 4,200 independent agents.

 

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Payment protection insurance. Growth of our payment protection insurance business is dependent on economic conditions including consumer lending levels, client account penetration and the number of countries and markets we enter. Additionally, the types and mix of our products will vary based on regulatory and consumer acceptance of our products. Our payment protection insurance business continues to show strong growth from increased penetration of existing relationships, and the addition of new distribution relationships in existing and new countries.

Retirement products. Retirement Income and Investments segment results are affected by investment performance, interest rate levels, slope of the interest rate yield curve, net interest spreads, equity market fluctuations, mortality and the impact of new product sales and lapses. In addition, our competitive position within many of our distribution channels, as well as our ability to retain business, depends significantly upon product features, including current and minimum crediting rates on spread-based products relative to our competitors, surrender charge periods in fixed annuities as well as guaranteed features we offer in variable products. We continually evaluate our competitive position based upon each of those features, and we make adjustments as appropriate to meet our target return thresholds.

The attractiveness of certain fixed annuities has declined as a result of continued low long-term interest rates, a relatively flat yield curve and short-term investment alternatives, such as certificates of deposit. These trends are having an adverse impact on both sales and retention of fixed annuities with the latter resulting in an acceleration of DAC amortization. In recent quarters, we have experienced improved spreads in fixed annuities primarily due to run-off of and crediting rate resets of historically higher crediting rate business. We expect this trend to continue.

We continue to focus on our Income Distribution Series of variable annuity products and riders. We have witnessed a decline in defined benefit retirement plans in favor of defined contribution plans with more of the responsibility for retirement income planning falling on the individual. Additionally, U.S. savings rates are at historical lows. We believe these factors support demand for individual and group retirement income products that provide various forms of guaranteed benefits with the opportunity to realize market performance upside. Our Income Distribution Series provides the contractholder with the ability to receive a guaranteed minimum income stream that they cannot outlive, along with an opportunity to participate in market appreciation. However, through various techniques, these products are designed to reduce some of our risks that generally accompany traditional products with guaranteed living benefits. We are targeting individuals who are focused on building a personal portable retirement plan or are moving from the accumulation to the distribution phase of their retirement planning.

We offer asset management products to individual investors and support services for independent broker-dealers. The industry is witnessing rapid increases of independent broker-dealers as registered representatives are leaving large national firms to form their own small firms. These new small firms need client and back office support services and access to technology. Further, individuals are increasingly transferring their money to managed products from mutual funds. We expect these trends to continue and possibly accelerate in the future. As a result of these trends, we are expanding our presence in this market and have completed the acquisition of AssetMark Investment Services, Inc., a leading provider of open architecture asset management solutions to independent financial advisors, with more than $9 billion in assets under management. Our products consist of separately managed accounts and managed mutual fund accounts. We receive a management fee based upon the amount of assets under management. The results of our asset management business are a function of net flows and investment performance of assets under management, which are influenced by the relative performance of our product’s underlying investments and the overall equity market environment.

Mortgage insurance. The results of our Mortgage Insurance segment are affected by employment and other economic and housing markets trends, including interest rate trends, home price appreciation, mortgage origination volume and levels of mortgage delinquencies (including seasonal effects). In addition, movements in foreign currency exchange rates affect our international mortgage insurance results.

 

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We believe the U.S. economy overall remains relatively strong based on continued gross domestic product growth and low levels of unemployment. However, we believe that the U.S. housing market is slowing. In particular, certain areas of the Great Lakes region have experienced an economic slowdown and have seen a more pronounced weakness in their housing market as well as a decline in home prices. While our portfolio concentration in the impacted areas is limited to less than 10% of our total risk in-force, these areas of weakness may cause our U.S. losses and loss ratio to increase.

The recent rise in interest rates and lower home price appreciation in the U.S. have contributed to rising persistency rates. Our U.S. flow persistency was 72% and 64% for the nine months ended September 30, 2006 and September 30, 2005, respectively. We believe that sustained higher interest rates and increased persistency will lead to stable to growing levels of insurance in-force. Primary insurance in-force increased from $102 billion as of June 30, 2006 to $104 billion as of September 30, 2006. This increase in primary insurance-in-force reflected the second sequential quarter increase in flow insurance in-force after nearly five years of decline.

The demand for flow private mortgage insurance declined in the six months ended June 30, 2006 as compared to the same period in 2005, according to data published by Inside Mortgage Finance. We believe this was driven principally by the significant use of simultaneous second mortgages as an alternative to private mortgage insurance, the origination of mortgages that did not meet the eligibility requirements of Fannie Mae and Freddie Mac and mortgages that were securitized in mortgage-backed securities that did not use private mortgage insurance.

The bulk mortgage insurance market is increasing as a percentage of the overall primary mortgage insurance market, which we believe is driven in part, by an increase in non-prime mortgage-backed security issuances. We have increased our participation in selected segments of the bulk market and continue to evaluate additional opportunities this market presents.

Our international mortgage insurance business has continued to expand with favorable operating results. We expect that the growth of our established international mortgage insurance business and our entry into new international markets will continue to contribute an increasing portion of this segment’s total revenues and profits.

As a result of the significant U.S. refinancing activity since 2002 and the expansion of our international business in recent years, as of September 30, 2006, approximately 63% of our U.S. risk in-force and 61% of our international risk in-force have not yet reached its anticipated highest claim frequency years, which are generally between the third and seventh year of the loan. We expect our loss experience on these loans will increase as these books of business continue to mature.

In the second quarter of 2006, the Canadian government expanded its authority to guarantee mortgage insurance to cover any approved mortgage insurer in addition to us and can now do this without further legislation. The overall cap on guaranteed policies was also increased to CDN $200 billion. These changes facilitate our ongoing ability to offer mortgage insurance products under the guarantee but may also enable potential new competitors to do the same.

See “—Results of Operations by Segment” and selected operating performance measures contained herein for additional discussion of business trends and conditions.

 

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Results of Operations

“Net operating income” is a non-GAAP financial measure that we define as net income, excluding after-tax net investment gains (losses) (which can fluctuate significantly from period to period), and other adjustments, changes in accounting principles and infrequent or unusual non-operating items. There were no non-recurring, infrequent or unusual items excluded from net operating income in the three and nine months ended September 30, 2006 and 2005.

Management believes that analysis of “net operating income” enhances understanding and comparability of performance by highlighting underlying business activity and profitability drivers. However, “net operating income” should not be viewed as a substitute for net income in accordance with GAAP. In addition, our definition of “net operating income” may differ from the definitions used by other companies.

 

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Three Months Ended September 30, 2006 Compared to Three Months Ended September 30, 2005

The following table provides a reconciliation of net income to “net operating income” (as defined above) for the three months ended September 30, 2006 and 2005:

 

     Three months ended
September 30,
    Increase (decrease) and
percentage change
 

(Amounts in millions, except per share amounts)

       2006             2005                 2006 vs. 2005          

Revenues:

        

Premiums

   $ 1,680     $ 1,547     $ 133     9 %

Net investment income

     944       902       42     5 %

Net investment gains (losses)

     (6 )     (7 )     1     14 %

Policy fees and other income

     186       186       —       0 %
                          

Total revenues

     2,804       2,628       176     7 %
                          

Benefits and expenses:

        

Benefits and other changes in policy reserves

     1,183       1,026       157     15 %

Interest credited

     383       364       19     5 %

Acquisition and operating expenses, net of deferrals

     533       506       27     5 %

Amortization of deferred acquisition costs and intangibles

     170       217       (47 )   (22 )%

Interest expense

     87       72       15     21 %
                          

Total benefits and expenses

     2,356       2,185       171     8 %
                          

Income before income taxes and accounting change

     448       443       5     1 %

Provision for income taxes

     144       136       8     6 %
                          

Net income before accounting change

     304       307       (3 )   (1 )%

Cumulative effect of accounting change, net of taxes

     —         —         —       —   %
                          

Net income

     304       307       (3 )   (1 )%

Adjustments to net income:

        

Net investment (gains) losses, net of taxes and other adjustments

     3       4       (1 )   (25 )%

Cumulative effect of accounting change, net of taxes

     —         —         —       —   %
                          

Net operating income

   $ 307     $ 311     $ (4 )   (1 )%
                          

Net earnings per common share:

        

Basic

   $ 0.67     $ 0.65      
                    

Diluted

   $ 0.65     $ 0.64      
                    

Net operating earnings per common share:

        

Basic

   $ 0.68     $ 0.66      
                    

Diluted

   $ 0.66     $ 0.65      
                    

Weighted-average common shares outstanding:

        

Basic

     453.8       470.7      
                    

Diluted

     467.2       481.1      
                    

Premiums. Premiums consist primarily of premiums earned on insurance products for individual life, long-term care, Medicare supplement, group life and health, payment protection, single premium immediate annuities and structured settlements with life contingencies and mortgage insurance policies. Premiums increased $66 million in our Protection segment primarily due to a $73 million increase in our long-term care business mainly from growth in the in-force block and the Continental Life acquisition. Additionally, our Protection segment increased $26 million primarily from growth in the in-force of our term life insurance and group business. Partially offsetting these increases in the Protection segment was a $33 million decrease from our

 

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payment protection business as a result of a decrease in the U.K. run-off block. Premiums in our Mortgage Insurance segment increased $44 million reflecting growth and seasoning of our of our international mortgage insurance in-force block. Our Retirement Income and Investments segment increased $21 million attributable to higher sales of our life-contingent single premium immediate annuities, partially offset by a reduction in our life-contingent structured settlement annuities.

Net investment income. Net investment income increased primarily as a result of an increase in average invested assets in our Protection and Retirement Income and Investments segments. The increase in our Protection segment was attributable to growth of our long-term care in-force block and an increase related to assets purchased using proceeds from our issuance of non-recourse funding obligations supporting certain term life insurance policies. The increase in our Retirement Income and Investments segment was largely driven by new production in institutional products. Our Mortgage segment also increased due to growth in assets in the mortgage international business. Weighted average investment yields were 5.7% for the three months ended September 30, 2006 and 2005. Higher yields on floating rate investments for the three months ended September 30, 2006 were offset primarily by lower investment income from bond calls, commercial mortgage loan prepayments and limited partnership investments. Net investment income for the three months ended September 30, 2006 included $13 million of investment income from bond calls, commercial mortgage loan prepayments and limited partnership investments as compared to $40 million in investment income from bond calls, mortgage loan prepayments and limited partnership investments in the prior year.

Net investment gains (losses). For the three months ended September 30, 2006, gross investment gains were $14 million and gross investment (losses) were ($20) million, including ($1) million of impairments. Gross investment gains for the three months ended September 30, 2006 were primarily attributable to $11 million in gains on the sale of available-for-sale fixed maturities and equity securities. Gross investment losses include $19 million of interest rate related losses as a result of the disposition of available-for-sale securities primarily from portfolio repositioning activities. For the three months ended September 30, 2005, gross investment gains on available-for-sale securities were $35 million and gross investment (losses) on available-for-sale securities were ($42) million, including ($32) million of impairments. The available-for-sale securities impairments related primarily to fixed maturity securities issued by companies in the finance and insurance, retail, timber and transportation industries ($10 million, $9 million, $5 million and $4 million, respectively).

Policy fees and other income. Policy fees and other income consist primarily of cost of insurance and surrender charges assessed on universal life insurance policies, fees assessed against policyholder and contractholder account values, and commission income. Policy fees and other income remained flat for the period. Higher sales and growth in assets under management in Retirement Income and Investments’ fee-based products resulted in a $22 million increase in policy fees and other income. This was offset by a $20 million reduction in our life business as a result of unfavorable unearned revenue adjustments and a $4 million reduction in our mortgage insurance business largely driven by the recent elimination of Canadian application fees.

Benefits and other changes in policy reserves. Benefits and other changes in policy reserves consist primarily of benefits paid and reserve activity related to current claims and future policy benefits on insurance and investment products for life, long-term care, Medicare supplement, group life and health, payment protection, structured settlements and single premium immediate annuities with life contingencies and claim costs incurred related to mortgage insurance products. The increase in benefits and other changes in policy reserves was primarily driven by a $79 million increase in our long-term care business as a result of higher incurred claims driven by aging and growth in the in-force block, continued low termination rates on older issued policies as well as the Continental Life acquisition. Adding to this increase was a $40 million increase in our Mortgage Insurance segment primarily driven by higher losses from portfolio seasoning in our international mortgage insurance business, increased losses from a limited number of Australian distribution relationships and $9 million of favorable adjustments in the prior year that did not recur. Additionally, our U.S. mortgage insurance business increased attributable to higher losses associated with a smaller decline in our average reserve per delinquency than in the prior year. Our Retirement Income and Investments segment also increased as a

 

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result of higher sales of life-contingent single premium immediate annuities, which was partially offset by a decrease in sales of life-contingent structured settlement annuities.

Interest credited. Interest credited represents interest credited on behalf of policyholder and contractholder general account balances. The increase in interest credited from our Retirement Income and Investments segment was primarily due to a $28 million increase related to spread-based institutional products as a result of higher crediting rates on floating rate products and higher assets under management. This increase was partially offset by a $16 million decrease in interest credited related to spread-based retail products, primarily due to fixed annuities crediting rates being reset to current, lower rates as the fixed annuities reach the end of their initial crediting rate guarantee period. In addition, interest credited increased $7 million from universal life products in our Protection segment primarily from higher crediting rates and higher account values.

Acquisition and operating expenses, net of deferrals. Acquisition and operating expenses, net of deferrals, represent costs and expenses related to the acquisition and ongoing maintenance of insurance and investment contracts, including commissions, policy issuance expenses and other underwriting and general operating costs. These costs and expenses are net of amounts that are capitalized and deferred, which are primarily costs and expenses that vary with and are primarily related to the sale and issuance of our insurance policies and investment contracts, such as first-year commissions in excess of ultimate renewal commissions and other policy issuance expenses. Acquisition and operating expenses, net of deferrals, increased primarily from an $11 million increase in our payment protection business as a result of growth in continental Europe and Ireland and changes in foreign exchange rates, which was partially offset by a decrease associated with our U.K. run-off block. In addition, our long-term care business increased $7 million primarily from the Continental acquisition. Also, our Retirement Income and Investments’ fee-based products increased $13 million associated with higher sales and growth in assets under management.

Amortization of deferred acquisition costs and intangibles. Amortization of deferred acquisition costs and intangibles consists primarily of the amortization of acquisition costs that are capitalized, PVFP and capitalized software. Amortization of deferred acquisition costs and intangibles decreased as a result of a $57 million decrease in our Protection segment primarily attributable to a $32 million decrease from our life insurance business, as further described in the Protection segment results, a $28 million decrease from our payment protection insurance business, partially offset by a $4 million increase in our long-term care business. The decrease in our payment protection insurance business was largely driven by the continued decline of our run-off block within the U.K. and was partially offset by an increase attributable to changes in foreign exchange rates. These decreases were offset by an $11 million increase in our Retirement Income and Investments segment primarily from our spread-based retail products due to continued lapses in our fixed annuities.

Interest expense. Interest expense increased primarily as a result of the issuances of additional non-recourse funding obligations and an increase in average variable rates paid on those obligations. This was partially offset by a decrease in interest expense associated with the derecognition of borrowings related to securitization entities in the first quarter of 2006.

Provision for income taxes. The effective tax rate increased to 32.1% for the three months ended September 30, 2006 from 30.7% for the three months ended September 30, 2005. The increase in effective tax rate was primarily attributable to nonrecurring favorable examination developments in 2005, offset in part by the increase in lower taxed foreign earnings in 2006.

Net operating income. The decrease in net operating income reflects decreases in our Retirement Income and Investments and Corporate and Other segments segment net operating income, offset by increases in our Protection and Mortgage Insurance segments net operating income, as discussed in the “—Results of Operations by Segment.” Included in net operating income is a $6 million, net of tax, increase attributable to changes in foreign exchange rates.

 

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Nine Months Ended September 30, 2006 Compared to Nine Months Ended September 30, 2005

The following table provides a reconciliation of net income to “net operating income” (as defined above) for the nine months ended September 30, 2006 and 2005.

 

     Nine months ended
September 30,
    Increase (decrease) and
percentage change
 

(Amounts in millions, except per share amounts)

       2006             2005                   2006 vs. 2005            

Revenues:

        

Premiums

   $ 4,867     $ 4,766     $ 101     2 %

Net investment income

     2,821       2,595       226     9 %

Net investment gains (losses)

     (77 )     (13 )     (64 )   NM (1)

Policy fees and other income

     572       501       71     14 %
                          

Total revenues

     8,183       7,849       334     4 %
                          

Benefits and expenses:

        

Benefits and other changes in policy reserves

     3,314       3,152       162     5 %

Interest credited

     1,134       1,051       83     8 %

Acquisition and operating expenses, net of deferrals

     1,529       1,476       53     4 %

Amortization of deferred acquisition costs and intangibles

     551       618       (67 )   (11 )%

Interest expense

     257       213       44     21 %
                          

Total benefits and expenses

     6,785       6,510       275     4 %
                          

Income before income taxes and accounting change

     1,398       1,339       59     4 %

Provision for income taxes

     447       425       22     5 %
                          

Net income before accounting change

     951       914       37     4 %

Cumulative effect of accounting change, net of taxes

     4       —         4     NM (1)
                          

Net income

     955       914       41     4 %

Adjustments to net income:

        

Net investment (gains) losses, net of taxes and other adjustments

     40       8       32     NM (1)

Cumulative effect of accounting change, net of taxes

     (4 )     —         (4 )   NM (1)
                          

Net operating income

   $ 991     $ 922     $ 69     7 %
                          

Net earnings per common share:

        

Basic

   $ 2.08     $ 1.92      
                    

Diluted

   $ 2.02     $ 1.88      
                    

Net operating earnings per common share:

        

Basic

   $ 2.16     $ 1.93      
                    

Diluted

   $ 2.10     $ 1.90      
                    

Weighted-average common shares outstanding:

        

Basic

     458.8       476.7      
                    

Diluted

     471.7       484.7      
                    

(1) Not meaningful

Premiums. The increase in premiums is primarily driven by an increase of $66 million in our Protection segment primarily driven by a $117 million increase in our long-term care business mainly from growth in the in-force block and $70 million from the Continental Life acquisition. Additionally, our Protection segment increased $88 million primarily from growth in the in-force blocks of our term life insurance and group insurance businesses. Our payment protection business decreased $139 million driven by the run-off block within the U.K. and changes in foreign exchange rates. Partially offsetting these decreases in our payment protection business

 

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was premium growth in continental Europe and Ireland. Premiums in our Mortgage Insurance segment increased $123 million largely driven by growth and seasoning of our international mortgage insurance in-force block. The decrease in Retirement Income and Investments premiums was primarily the result of a $141 million reduction in our life-contingent structured settlement annuities, which was partially offset by a $59 million increase from higher sales of our life-contingent single premium immediate annuities.

Net investment income. Net investment income increased primarily as a result of an increase in average invested assets in our Protection segment attributable to growth of our long-term care in-force block and an increase related to assets purchased using proceeds from our issuance of non-recourse funding obligations supporting certain term life insurance policies. Additionally, our Retirement Income and Investments segment was principally due to increased yields on floating rate investments and higher assets under management. Our Mortgage insurance segment also increased due to an increase in assets associated with the growth of our international mortgage business. The increase in net investment income was also due to an increase in weighted average investment yields to 5.7% for the nine months ended September 30, 2006 from 5.5% for the nine months ended September 30, 2005. The increase in weighted average investment yields was primarily attributable to increased yields on floating rate investments. Net investment income for the nine months ended September 30, 2006 included $67 million of investment income related to a reduction in bond calls, commercial mortgage loan prepayments, limited partnership investments and the release of commercial mortgage loan loss reserves as compared to $69 million in the prior year.

Net investment gains (losses). For the nine months ended September 30, 2006, gross investment gains were $42 million and gross investment (losses) were ($119) million, including ($6) million of impairments. These impairments were attributable to available-for-sale equity securities, fixed maturities and limited partnership investments ($4 million, $1 million and $1 million, respectively). Gross investment gains for the nine months ended September 30, 2006 were associated with $41 million in gains on the sale of available-for-sale fixed maturities and equity securities. Gross investment losses for the nine months ended September 30, 2006 include $95 million of interest rate related losses as a result of the disposition of available-for-sale securities primarily from portfolio repositioning activities, $17 million on the derecognition of assets and liabilities associated with certain securitization entities, and $6 million of impairment charges. For the nine months ended September 30, 2005, gross investment gains were $86 million and gross investment (losses) were ($99) million, including ($68) million of impairments. These impairments were attributable to available-for-sale fixed maturities, equity investments and limited partnership investments ($62 million, $5 million and $1 million, respectively). The fixed maturities impairments related primarily to securities issued by companies in the automotive, transportation finance and insurance and retail industries ($17 million, $16 million, $10 million and $9 million, respectively).

Policy fees and other income. The increase in policy fees and other income was primarily due to a $58 million increase in Retirement Income and Investments’ fee-based products driven by higher sales and growth in assets under management. In addition, our Protection segment increased $13 million primarily due to growth of our universal life insurance in-force block in our life insurance business and a reclassification from premiums and interest credited in our long-term care business.

Benefits and other changes in policy reserves. The increase in benefits and other changes in policy reserves was primarily driven by a $152 million increase in our Protection segment principally from our long-term care insurance business as a result of higher incurred claims driven by aging and growth in the in-force block, expiring reinsurance coverage, continued low termination rates on older issued policies and the Continental Life acquisition. Adding to this increase was a $76 million increase in our Mortgage Insurance segment largely driven by higher losses in Australia from portfolio seasoning and increased losses from a limited number of distribution relationships. Additionally, our U.S. mortgage insurance business increased attributable to an increase in our average reserve per delinquency. These increases were partially offset by a decrease in our Retirement Income and Investments segment of $64 million primarily attributable to the decline in life-contingent structured settlement annuity sales.

Interest credited. The increase in interest credited was primarily due to a $97 million increase related to spread-based institutional products as a result of increased crediting rates on floating rate products and higher

 

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assets under management, partially offset by a $33 million decrease largely from fixed annuities in our spread-based retail products associated with crediting rates being reset to current, lower rates as the fixed annuities reach their initial crediting rate guarantee period. Our Protection segment also experienced a $17 million increase principally from $13 million in our long-term care business driven by growth in the cash surrender value of our corporate owned life insurance block of business and reclassification from policy fees and other income in the prior year.

Acquisition and operating expenses, net of deferrals. Acquisition and operating expenses, net of deferrals, increased primarily due to higher expenses of $37 million in our Retirement Income and Investments segment largely from higher sales and growth in assets under management in fee-based products, partially offset by $6 million of lower expenses associated with our spread-based retail products. Additionally, our long-term care business increased $43 million largely due to growth from the in-force-block and the Continental acquisition. These increases were partially offset by a $30 million decrease in our payment protection insurance business primarily driven by our run-off block within the U.K. and changes in foreign exchange rates.

Amortization of deferred acquisition costs and intangibles. Amortization of deferred acquisition cost and intangibles decreased primarily due to a $95 million decrease in our Protection segment largely driven by our payment protection insurance business run-off block within the U.K. This decrease was partially offset by a $30 million increase in our Retirement Income and Investments segment from higher lapses and more favorable gross profit margins in spread-based retail products.

Interest expense. Interest expense increased primarily as a result of the issuances of additional non-recourse funding obligations and an increase in average variable rates paid on those obligations. This was partially offset by a decrease in interest expense associated with the first quarter 2006 derecognition of borrowings related to securitization entities.

Provision for income taxes. The effective tax rate increased to 32.0% for the nine months ended September 30, 2006 from 31.7% for the nine months ended September 30, 2005. The increase in effective tax rate was primarily attributable to nonrecurring favorable examination developments in 2005, offset in part by the increase in lower taxed foreign earnings in 2006.

Net operating income. The increase in net operating income reflects increases in segment net operating income in our Protection and Mortgage Insurance segments, offset by decreases in our Retirement Income and Investments and Corporate and Other segments, as discussed in the “—Results of Operations by Segment.” Included in net operating income is a $6 million, net of tax, increase attributable to changes in foreign exchange rates.

Results of Operations by Segment

Management regularly reviews the performance of each of our operating segments (Protection, Retirement Income and Investments and Mortgage Insurance) based on after-tax segment net operating income (loss), which excludes: (1) cumulative effect of accounting changes, and (2) infrequent or unusual non-operating items. Certain other items, including most of our interest and other financing expenses and advertising, marketing and other corporate expenses, are included in our Corporate and Other segment. Although these excluded items are significant to our consolidated financial performance, we believe that the presentation of segment net operating income (loss) enhances our understanding and assessment of the results of operations of our operating segments by highlighting net income (loss) attributable to the normal, recurring operations of our business. However, segment net operating income (loss) is not a substitute for net income determined in accordance with GAAP.

Protection segment

We offer U.S. customers life insurance, long-term care insurance, linked benefits products, Medicare supplement insurance and, primarily for companies with fewer than 1,000 employees, group life and health insurance. In Europe, we offer payment protection insurance in 18 countries, which helps consumers meet their

 

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payment obligations in the event of illness, involuntary unemployment, disability or death. Effective January 1, 2006, Seguros, a small Mexican-domiciled multi-line insurer, previously included in our Corporate and Other segment, is now being managed within our Protection segment and whose results are now included as part of the payment protection insurance business.

Three Months Ended September 30, 2006 Compared to Three Months Ended September 30, 2005

The following table sets forth the results of operations relating to our Protection segment for the three months ended September 30, 2006 and 2005:

 

     Three months ended
September 30,
   Increase (decrease) and
percentage change
 

(Amounts in millions)

       2006             2005                  2006 vs. 2005            

Revenues:

         

Premiums

   $ 1,199     $ 1,133    $ 66     6 %

Net investment income

     363       321      42     13 %

Net investment gains (losses)

     2       —        2     NM (1)

Policy fees and other income

     90       110      (20 )   (18 )%
                         

Total revenues

     1,654       1,564      90     6 %
                         

Benefits and expenses:

         

Benefits and other changes in policy reserves

     822       740      82     11 %

Interest credited

     97       90      7     8 %

Acquisition and operating expenses, net of deferrals

     356       332      24     7 %

Amortization of deferred acquisition costs and intangibles

     106       163      (57 )   (35 )%

Interest expense

     34       13      21     162 %
                         

Total benefits and expenses

     1,415       1,338      77     6 %
                         

Income before income taxes

     239       226      13     6 %

Provision for income taxes

     85       81      4     5 %
                         

Segment net income

     154       145      9     6 %

Adjustments to segment net income:

         

Net investment (gains) losses, net of taxes and other adjustments

     (2 )     —        (2 )   NM (1)
                         

Segment net operating income

   $ 152     $ 145    $ 7     5 %
                         

(1) Not meaningful

The following table sets forth net operating income for the products included in our Protection segment for the three months ended September 30, 2006 and 2005:

 

     Three months ended
September 30,
  

Increase (decrease) and

percentage change

 

(Amounts in millions)

       2006            2005                2006 vs. 2005          

Protection segment net operating income:

          

Life insurance

   $ 79    $ 73    $ 6     8 %

Long-term care insurance

     38      41      (3 )   (7 )%

Payment protection insurance

     26      23      3     13 %

Group life and health insurance

     9      8      1     13 %
                        

Total segment net operating income

   $ 152    $ 145    $ 7     5 %
                        

 

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Segment net operating income

Segment net operating income in our life insurance business increased primarily due to growth in term life insurance in-force and continued favorable mortality experience. The increase in our payment protection insurance business was primarily associated with growth in continental Europe and Ireland in-force, partially offset by lower U.K. income and included a $1 million increase, net of tax, attributable to changes in foreign exchange rates. The decrease in our long-term care insurance business was principally the result of higher incurred claims and lower investment yield as net insurance cash flows continue to be invested at new money rates lower than our portfolio yield.

Revenues

Premiums increased $66 million driven by $73 million in our long-term care business, $16 million in our life business and $10 million in our group business, offset by a decrease of $33 million in our payment protection business. The increase in our long-term care insurance business was attributable to growth in long-term care insurance in-force and included a $43 million increase from the Continental acquisition. The increase in our life insurance business was mainly due to growth in the in-force block of term life insurance. The increase in our group insurance business was principally from growth in our non-medical products, partially offset by lower premiums from our medical and individual voluntary products. Our payment protection insurance business decrease is largely driven by $71 million from the U.K. market. The decrease from the U.K. market was the result of the continued run-off of low return blocks of business and the exit from the travel insurance business. Partially offsetting the decrease from the U.K. market was growth in continental Europe and Ireland and an $11 million increase attributable to changes in foreign exchange rates. The increase in continental Europe and Ireland relates to growth from new distribution relationships and an increase in consumer lending in those markets.

The increase in net investment income was primarily the result of growth of our long-term care in-force block, an increase in assets purchased using proceeds from our issuance of non-recourse funding obligations supporting certain term life insurance policies, and a $1 million increase attributable to changes in foreign exchange rates in our payment protection insurance business.

For a discussion of net investment gains (losses), see the comparison for this line item under “—Results of Operations.”

Policy fees and other income decreased $20 million principally driven by our life insurance business. The decrease was primarily in our universal life insurance products and resulted from an unfavorable $13 million adjustment in unearned revenue in the current year and a $9 million favorable adjustment to unearned revenue on a closed block of non-standard business in the prior year.

Benefits and expenses

Benefits and other changes in policy reserves increased $82 million attributable to a $79 million increase in our long-term care business, a $15 million increase in our life insurance business and a $7 million increase in our group business, partially offset by a decrease of $19 million in our payment protection business. The increase in our long-term care insurance business was the result of higher incurred claims driven by the aging and growth in the in-force block and continued low termination rates on older issued policies, and a $35 million increase from the Continental acquisition. The increase in our life insurance business was due to growth of our term and universal life in-force block. The increase in our group insurance business was principally driven by growth of the in-force and higher claims in the non-medical insurance products. The decrease in our payment protection insurance business was primarily related to lower claims in our run-off block of business within the U.K. which was partially offset by an $1 million increase attributable to changes in foreign exchange rates.

Acquisition and operating expenses, net of deferrals increased $24 million driven by $11 million from our payment protection insurance business, $8 million from our long-term care insurance business, $3 million from our life insurance business and $2 million from our group insurance business. The increase in our payment

 

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protection business was principally related to growth of in-force production in continental Europe and Ireland and an $8 million increase attributable to changes in foreign exchange rates. These increases were partially offset by a decrease in expenses resulting from lower production associated with the U.K. run-off block. The increase in our long-term care insurance business was largely the result of $7 million of expenses from the Continental acquisition.

Amortization of deferred acquisition costs and intangibles decreased $57 million primarily attributable to $32 million from our life insurance business, $28 million from our payment protection insurance business, partially offset by a $4 million increase in our long-term care insurance business. The decrease in our payment protection insurance business was largely driven by our run-off block and was partially offset by a $2 million increase attributable to changes in foreign exchange rates.

Current year amortization in our life business included decreases in our universal life insurance products of $7 million due to an unearned revenue adjustment and $7 million associated with revisions to estimated gross profit assumptions. Prior year amortization also included a $10 million unfavorable adjustment in our universal life amortization.

Interest expense increased $21 million from the issuance of additional non-recourse funding obligations and an increase in average variable rates paid those obligations.

Provision for income taxes

The effective tax rate decreased to 35.6% for the three months ended September 30, 2006 from 35.8% for the three months ended September 30, 2005. The decrease in effective tax rate was primarily attributable to the increase in lower taxed foreign earnings and a reduction in excess foreign tax credits, offset by nonrecurring favorable examination developments in 2005.

 

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Nine Months Ended September 30, 2006 Compared to Nine Months Ended September 30, 2005

The following table sets forth the results of operations relating to our Protection segment for the nine months ended September 30, 2006 and 2005:

 

     Nine months ended
September 30,
   Increase (decrease) and
percentage change
 

(Amounts in millions)

       2006             2005                  2006 vs. 2005            

Revenues:

         

Premiums

   $ 3,478     $ 3,412    $ 66     2 %

Net investment income

     1,073       948      125     13 %

Net investment gains (losses)

     4       —        4     NM (1)

Policy fees and other income

     290       277      13     5 %
                         

Total revenues

     4,845       4,637      208     4 %
                         

Benefits and expenses:

         

Benefits and other changes in policy reserves

     2,347       2,195      152     7 %

Interest credited

     288       271      17     6 %

Acquisition and operating expenses, net of deferrals

     1,036       1,014      22     2 %

Amortization of deferred acquisition costs and intangibles

     381       476      (95 )   (20 )%

Interest expense

     93       33      60     182 %
                         

Total benefits and expenses

     4,145       3,989      156     4 %
                         

Income before income taxes

     700       648      52     8 %

Provision for income taxes

     245       231      14     6 %
                         

Segment net income

     455       417      38     9 %

Adjustments to segment net income:

         

Net investment (gains) losses net of taxes and other adjustments

     (3 )     —        (3 )   NM (1)
                         

Segment net operating income

   $ 452     $ 417    $ 35     8 %
                         

(1) Not meaningful

The following table sets forth net operating income for the products included in our Protection segment for the nine months ended September 30, 2006 and 2005:

 

     Nine months ended
September 30,
  

Increase (decrease) and

percentage change

 

(Amounts in millions)

       2006            2005              2006 vs. 2005        

Segment net operating income:

          

Life insurance

   $ 230    $ 196    $ 34     17 %

Long-term care insurance

     118      129      (11 )   (9 )%

Payment protection insurance

     80      69      11     16 %

Group life and health insurance

     24      23      1     4 %
                        

Total segment net operating income

   $ 452    $ 417    $ 35     8 %
                        

Segment net operating income

Segment net operating income in our life insurance business increased primarily due to in-force growth in term life insurance and continued favorable mortality. The increase in our payment protection insurance business net operating earnings was primarily associated with growth in continental Europe and Ireland production, partially offset by lower income in the U.K. and included a $3 million decrease, net of tax, attributable to changes in foreign exchange rates. The decrease in our long-term care insurance business was principally the result of higher incurred claims and lower investment yields as net insurance cash flows continue to be invested at new money rates lower than our portfolio yield.

 

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Our current year long-term care business segment net operating income benefited from $17 million, net of tax, reserve adjustments, partially offset by $7 million, net of tax, of reinsurance adjustments. The prior year benefited from a $7 million, net of tax, favorable experience on a reinsured block. Prior year net operating income in our life insurance business was reduced by an $8 million unfavorable adjustment, net of tax, on reinsured term life insurance policies.

Revenues

Premiums increased $66 million driven by $117 million in our long-term care insurance business, $69 million in our life business and $19 million in our group business, offset by a decrease of $139 million in our payment protection business. The increase in our long-term care insurance business was attributable to growth in the long-term care insurance in-force block and included a $70 million increase in Medicare supplement attributable to the Continental acquisition. The increase in our life insurance business was due to in-force growth of term life insurance. The increase in our group insurance business was principally from growth in our non-medical products, partially offset by decreases in medical and individual voluntary products. Our payment protection insurance business decreased largely from the U.K. market including a $28 million decrease attributable to changes in foreign exchange rates. The decrease from the U.K. market was the result of continued run-off of low return blocks of business and the exit from the travel insurance business. Partially offsetting these decreases was growth in continental Europe and Ireland from new distribution relationships and an increase in consumer lending in those markets.

The prior year included $19 million of favorable items in our long-term care business that did not recur in the current year. Our long-term care business also decreased as a result of a $6 million classification to policy fees and other income in the current year.

The increase in net investment income was primarily the result of growth of our long-term care in-force block and an increase in assets purchased using proceeds from our issuance of non-recourse funding obligations supporting certain term life insurance policies, partially offset by a $2 million decrease attributable to changes in foreign exchange rates in our payment protection insurance business.

For a discussion of net investment gains (losses), see the comparison for this line item under “—Results of Operations.”

Policy fees and other income increased $13 million attributable to $10 million in our long-term care insurance business and $6 million in our life insurance business, offset by a $3 million decrease in our group business. The decrease in our group insurance business was related to an expected drop in lives from the planned migration to outside third-party administrators.

The increase in our life insurance business was largely due to growth of our universal life insurance products. Partially offsetting this was a $13 million decrease related to an adjustment in unearned revenue in the current year, a $9 million increase related to an adjustment to unearned revenue on a closed block of non-standard business in the prior year, and a $12 million decrease related to an adjustment on a reinsured block of term life insurance policies in the prior year. The current year increase in our long-term care insurance business is the result of a $6 million classification from premiums and $4 million reclassification from interest credited.

Benefits and expense

Benefits and other changes in policy reserves increased $152 million attributable to a $151 million increase in our long-term care insurance business, a $32 million increase in our life insurance business and a $20 million increase in our group insurance business, partially offset by a decrease of $51 million in our payment protection business. The increase in our long-term care insurance business was the result of aging and growth of the in-force block, continued low termination rates on older issued policies, some with expiring reinsurance coverage, and

 

40


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also included a $52 million increase from the Continental acquisition. The increase in our life insurance business was due mainly to growth of our term and universal life in-force that was partially offset by favorable current year mortality. The increase in our group insurance business was principally driven by growth and higher claims in our non-medical insurance products. The decrease in our payment protection insurance business was primarily related to a reduction of claims in our run-off block of business within the U.K. and a $4 million decrease attributable to changes in foreign exchange rates.

Our long-term care business benefits and other changes in policy reserves also included reserve adjustments in both years. The prior year included $17 million of net favorable reserve adjustments including a favorable correction of a long-term care policy rider and a reserve adjustment on a closed block of business, partially offset by strengthening of claim reserves. The current year includes a $27 million decrease due to a favorable adjustment related to group long-term care policies.

Interest credited increased $17 million principally from $13 million in our long-term care insurance business driven by growth in cash surrender value of our corporate owned life insurance block of business.

Acquisition and operating expenses, net of deferrals increased $22 million from a $43 million increase from our long-term care insurance business and a $12 million increase from our life insurance business, offset by decreases of $30 million in our payment protection insurance business and $3 million in our group insurance business. The increase in our long-term care insurance business was largely the result of growth of in-force, $12 million from the Continental acquisition and $8 million increase related to a reinsurance adjustment in the current year. The increase in our life insurance business was primarily due to prior year expense favorability that did not recur in the current year. The decrease in our payment protection insurance business was principally from our run-off block and included a $15 million decrease attributable to changes in foreign exchange rates.

Amortization of deferred acquisition costs and intangibles decreased $95 million largely the result of a $70 million decrease in our payment protection insurance business and a $19 million decrease in our life insurance business. The decrease in our payment protection insurance business was primarily due to lower amortization from our run-off block and was partially offset by a $7 million increase attributable to changes in foreign exchange rates. Our long-term care insurance business decreased $4 million as a result of a $27 million unfavorable correction of a long-term care policy rider in the prior year. This decrease was partially offset by higher amortization from growth of the in-force block of long-term care insurance and higher terminations in our Medicare supplement product.

Current year amortization in our life insurance business included decreases in our universal life insurance products of $7 million due to an unearned revenue adjustment and $7 million associated with revisions to estimated gross profit assumptions. Prior year amortization also included a $10 million amortization adjustment in our universal life amortization.

Interest expense increased $60 million in our life insurance business from the issuance of additional non-recourse funding obligations and an increase in average variable rates paid on those obligations.

Provision for income taxes

The effective tax rate decreased to 35.0% for the nine months ended September 30, 2006 from 35.6% for the nine months ended September 30, 2005. The decrease in effective tax rate was primarily attributable to the increase in lower taxed foreign earnings and a reduction in excess foreign tax credits, offset by nonrecurring favorable examination developments in 2005.

 

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Protection selected operating performance measures

Life insurance

The following tables set forth selected operating performance measures regarding our life insurance products as of or for the three and nine months ended September 30, 2006 and 2005:

 

     Three months
ended September 30,
   Percentage
change
    Nine months
ended September 30,
   Percentage
change
 

(Amounts in millions)

       2006            2005        2006 vs. 2005         2006            2005        2006 vs. 2005  

Term life insurance

                

Net earned premiums

   $ 224    $ 205    9 %   $ 658    $ 582    13 %

Annualized first-year premiums

     36      38    (5 )%     107      101    6 %

Revenues

     282      241    17 %     827      674    23 %

Universal and whole life insurance

                

Net earned premiums and deposits

   $ 112    $ 104    8 %   $ 352    $ 304    16 %

Annualized first-year deposits

     9      7    29 %     28      20    40 %

Excess deposits

     24      12    100 %     65      26    150 %

Revenues

     163      187    (13 )%     517      528    (2 )%

Total life insurance

                

Net earned premiums and deposits

   $ 336    $ 309    9 %   $ 1,010    $ 886    14 %

Annualized first-year premiums

     36      38    (5 )%     107      101    6 %

Annualized first-year deposits

     9      7    29 %     28      20    40 %

Excess deposits

     24      12    100 %     65      26    150 %

Revenues

     445      428    4 %     1,344      1,202    12 %

 

     As of September 30,    Percentage
change
 

(Amounts in millions)

   2006    2005    2006 vs. 2005  

Term life insurance

        

Life insurance in-force, net of reinsurance

   $ 422,163    $ 366,131    15 %

Life insurance in-force before reinsurance

     583,780      525,264    11 %

Universal and whole life insurance

        

Life insurance in-force, net of reinsurance

   $ 41,595    $ 41,722    —   %

Life insurance in-force before reinsurance

     49,337      49,613    (1 )%

Total life insurance

        

Life insurance in-force, net of reinsurance

   $ 463,758    $ 407,853    14 %

Life insurance in-force before reinsurance

     633,117      574,877    10 %

Term life insurance. Term life insurance annualized first-year premiums decreased primarily as a result of an increasingly competitive pricing environment. The increase in term life insurance net earned premiums and insurance in-force was primarily due to growth of the in-force block of business as a result of new and renewal premiums. Term life insurance revenues also increased due to higher net investment income related to an increase in invested assets related to securities purchased using the proceeds from our issuance of non-recourse funding obligations supporting our term life insurance capital management strategy.

Universal and whole life insurance. Universal life annualized first-year deposits increased primarily from new product offerings gaining momentum in the market. The decrease in our in-force block was largely the result of the continued run-off on our closed block of whole life insurance.

 

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Table of Contents

Long-term care insurance

The following tables set forth selected operating performance measures regarding our long-term care insurance business, which includes individual and group long-term care insurance, Medicare supplement insurance, as well as several run-off blocks of accident and health insurance and corporate-owned life insurance for the three and nine months ended September 30, 2006 and 2005:

 

    Three months
ended September 30,
  Percentage
change
    Nine months
ended September 30,
  Percentage
change
 

(Amounts in millions)

      2006           2005       2006 vs. 2005         2006           2005       2006 vs. 2005  

Net earned premiums

  $ 485   $ 412   18 %   $ 1,368   $ 1,251   9 %

Annualized first-year premiums:

           

Long-term care

    44     38   16 %     127     115   11 %

Medicare supplement and other A&H

    7     3   133 %     23     9   130 %

Revenues

    679     583   16 %     1,936     1,742   11 %

The increase in annualized first-year premiums was primarily due to an increase in individual long-term care products, including $6 million on new product sales in California in the third quarter of 2006 ahead of a price increase and the broadening of our product offering in Medicare supplement, including $5 million and $9 million in the three and nine months ended September 30, 2006, respectively, from the Continental Life acquisition. The increase in net earned premium and revenue, was largely the result of the additional layer of 2005 annualized first-year premiums. The increase in revenue was also to the result of an higher net investment income principally from an increase in average invested assets backing growth of our long-term care business, partially offset by lower investment yields as a result of a continued low interest rate environment.

Payment protection insurance

The following table sets forth selected operating performance measures regarding our payment protection insurance and other related consumer protection insurance products for the three and nine months ended September 30, 2006 and 2005:

 

     Three months
ended September 30,
   Percentage
change
    Nine months
ended September 30,
   Percentage
change
 

(Amounts in millions)

       2006            2005        2006 vs. 2005         2006            2005        2006 vs. 2005  

Payment protection insurance gross written premiums, premium equivalents and deposits

   $ 552    $ 454    22 %   $ 1,471    $ 1,408    4 %

Mexico operations gross written premiums

     18      14    29 %     49      38    29 %

Net earned premiums

     310      343    (10 )%     923      1,062    (13 )%

Revenues

     340      373    (9 )%     1,011      1,157    (13 )%

Gross written premiums, premium equivalents and deposits, gross of ceded reinsurance and cancellations, for the three and nine months ended September 30, 2006 includes $96 million and $128 million, respectively, of gross deposits on reciprocal reinsurance transactions, which we accounted for under the deposit method of accounting, and growth from continental Europe and Ireland. The three and nine months ended September 30, 2006 included an increase of $23 million and a decrease of $36 million, respectively, attributable to changes in foreign exchange rates. The remainder of the decrease compared to the respective prior year periods was largely driven by a decline of gross written premiums in the U.K., partially offset by growth in the continental Europe and Ireland market.

Net earned premiums and revenues for the three and nine months ended September 30, 2006 compared to the three and nine months ended September 30, 2005 decreased primarily due to continued run-off of low return blocks of business in the U.K. market, the exit from our travel insurance business and a decrease attributable to changes in foreign exchange rates, partially offset by growth in the continental Europe and Ireland markets.

 

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Table of Contents

Group life and health insurance

The following table sets forth selected operating performance measures regarding our group products for the three and nine months ended September 30, 2006 and 2005:

 

     Three months
ended September 30,
   Percentage
change
    Nine months
ended September 30,
   Percentage
change
 

(Amounts in millions)

       2006            2005        2006 vs. 2005         2006            2005        2006 vs. 2005  

Net earned premiums

   $ 176    $ 166    6 %   $ 512    $ 493    4 %

Annualized first-year premiums

     41      37    11 %     119      105    13 %

Revenues

     190      180    6 %     554      536    3 %

The increase in annualized first-year premiums was the result of growth in sales in non-medical products, partially offset by lower sales of medical products due to competitive pricing in that market. Growth in net earned premiums is the result of sales growth in recent periods, predominantly in the non-medical and individual products, partially offset by lapses primarily in medical products.

Retirement Income and Investments segment

We offer U.S. customers fixed annuities, individual variable annuities, group variable annuities designed for 401(k) plans, single premium immediate annuities, variable life insurance, specialized products, including GICs, funding agreements and FABNs, and asset management products and services.

Three Months Ended September 30, 2006 Compared to Three Months Ended September 30, 2005

The following table sets forth the results of operations relating to our Retirement Income and Investments segment for the three months ended September 30, 2006 and 2005:

 

    

Three month ended

September 30,

   Increase (decrease) and
percentage change
 

(Amounts in millions)

       2006             2005                2006 vs. 2005          

Revenues:

         

Premiums

   $ 210     $ 189    $ 21     11 %

Net investment income

     475       455      20     4 %

Net investment gains (losses)

     (8 )     —        (8 )   NM (1)

Policy fees and other income

     85       61      24     39 %
                         

Total revenues

     762       705      57     8 %
                         

Benefits and expenses:

         

Benefits and other changes in policy reserves

     284       247      37     15 %

Interest credited

     286       274      12     4 %

Acquisition and operating expenses, net of deferrals

     76       66      10     15 %

Amortization of deferred acquisition costs and intangibles

     46       33      13     39 %

Interest expense

     2       1      1     100 %
                         

Total benefits and expenses

     694       621      73     12 %
                         

Income before income taxes

     68       84      (16 )   (19 )%

Provision for income taxes

     20       25      (5 )   (20 )%
                         

Segment net income

     48       59      (11 )   (19 )%

Adjustments to segment net income:

         

Net investment (gains) losses, net of taxes and other adjustments

     5       —        5     NM (1)
                         

Segment net operating income

   $ 53     $ 59    $ (6 )   (10 )%
                         

(1) Not meaningful

 

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Table of Contents

The following tables set forth net operating income for the products included in our Retirement Income and Investments segment for the three months ended September 30, 2006 and 2005:

 

     Three months ended
September 30,
   Increase (decrease) and
percentage change
 

(Amounts in millions)

       2006            2005                2006 vs. 2005          

Segment net operating income:

          

Spread-based retail

   $ 23    $ 39    $ (16 )   (41 )%

Spread-based institutional

     9      6      3     50 %

Fee-based

     21      14      7     50 %
                        

Total segment net operating income

   $ 53    $ 59    $ (6 )   (10 )%
                        

Segment net operating income

Segment net operating income from spread-based retail products decreased $16 million primarily due to lower investment income from bond calls and mortgage loan prepayments in the current year, an increase in DAC amortization resulting from higher lapses on fixed annuities and lower assets under management from withdrawals outpacing new deposits. Additionally, the prior year included income tax favorability that did not recur in the current year.

Segment net operating income from spread-based institutional products increased $3 million largely from higher spreads and growth in assets under management related to our FABNs.

Segment net operating income on fee-based products increased $7 million principally as a result of income tax benefits from dividends received deductions including a change in a prior year estimate and growth in assets under management driven by distribution expansion, favorable equity markets and continued product introduction and enhancements.

Revenues

The increase in premiums was primarily the result of a $53 million increase in our life-contingent single premium immediate annuities driven by higher sales. This increase was partially offset by a $28 million reduction in our life-contingent structured settlement annuities due to our continued pricing discipline in the low long-term interest rate environment and our decision in the third quarter of 2006 to discontinue sales of this product.

The increase in net investment income was principally a result of higher yields on floating rate investments backing spread-based institutional products and higher assets under management. Partially offsetting these increases were lower bond calls and commercial mortgage loan prepayment fees of $13 million as compared to prior year.

For a discussion of net investment gains (losses), see the comparison for this line item under “—Results of Operations.”

The increase in policy fees and other income was primarily attributable to a $22 million increase in the fee-based segment as a result of increased sales and growth in assets under management from distribution expansion, favorable equity markets and continued product introduction and enhancements.

Benefits and expenses

Benefits and other changes in policy reserves increased primarily as a result of a $57 million increase in life-contingent single premium immediate annuities driven by higher sales, which was partially offset by a $21 million decrease in life-contingent structured settlement annuities due to our pricing discipline in the continuing low long-term interest rate environment and our decision in the third quarter of 2006 to discontinue sales of this product.

 

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The increase in interest credited was principally due to a $28 million increase related to spread-based institutional products as a result of higher crediting rates on floating rate products and higher assets under management. This increase was partially offset by a $16 million decrease in interest credited on fixed annuities associated with crediting rates being reset to lower rates as the fixed annuities reach their initial crediting rate guarantee period.

The increase in acquisition and operating expenses, net of deferrals, was primarily from $13 million of expenses associated with higher sales and growth in assets under management in fee-based products.

The increase in amortization of deferred acquisition costs and intangibles was largely the result of an $11 million increase in spread-based retail products primarily due to higher lapses of fixed annuities.

Provision for income taxes

The effective tax rate decreased to 29.4% for the three months ended September 30, 2006 from 29.8% for the three months ended September 30, 2005. This decrease in the effective tax rate was primarily attributable to an increase in benefits from dividends received deductions including a change in prior year estimate, partially offset by nonrecurring favorable IRS examination developments in 2005.

Nine Months Ended September 30, 2006 Compared to Nine Months Ended September 30, 2005

The following table sets forth the results of operations relating to our Retirement Income and Investments segment for the nine months ended September 30, 2006 and 2005:

 

    

Nine months ended

September 30,

   Increase (decrease) and
percentage change
 

(Amounts in millions)

       2006             2005                2006 vs. 2005          

Revenues:

         

Premiums

   $ 590     $ 674    $ (84 )   (12 )%

Net investment income

     1,427       1,320      107     8 %

Net investment gains (losses)

     (62 )     —        (62 )   NM (1)

Policy fees and other income

     246       181      65     36 %
                         

Total revenues

     2,201       2,175      26     1 %
                         

Benefits and expenses:

         

Benefits and other changes in policy reserves

     792       856      (64 )   (7 )%

Interest credited

     846       780      66     8 %

Acquisition and operating expenses, net of deferrals

     228       191      37     19 %

Amortization of deferred acquisition costs and intangibles

     122       92      30     33 %

Interest expense

     4       2      2     100 %
                         

Total benefits and expenses

     1,992       1,921      71     4 %
                         

Income before income taxes

     209       254      (45 )   (18 )%

Provision for income taxes

     69       75      (6 )   (8 )%
                         

Segment net income

     140       179      (39 )   (22 )%

Adjustments to segment net income:

         

Net investment (gains) losses, net of taxes and other adjustments

     31       —        31     NM (1)
                         

Segment net operating income

   $ 171     $ 179    $ (8 )   (4 )%
                         

(1) Not meaningful

 

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The following table sets forth net operating income for the products included in our Retirement Income and Investments segment for the nine months ended September 30, 2006 and 2005:

 

     Nine months ended
September 30,
   Increase (decrease) and
percentage change
 

(Amounts in millions)

       2006            2005                2006 vs. 2005          

Segment net operating income:

          

Spread-based retail

   $ 88    $ 108    $ (20 )   (19 )%

Spread-based institutional

     32      26      6     23 %

Fee-based

     51      45      6     13 %
                        

Total segment net operating income

   $ 171    $ 179    $ (8 )   (4 )%
                        

Segment net operating income

Segment net operating income from spread-based retail products decreased $20 million primarily due to income tax favorability that did not recur in the current year, an increase in DAC amortization resulting from higher lapses on fixed annuities, lower net investment income related to bond calls and mortgage prepayments in the current year, unfavorable mortality on life-contingent annuities and lower assets under management from withdrawals outpacing new deposits.

Segment net operating income on fee-based products increased $6 million principally as a result of income tax benefits from dividends received deductions including a change in a prior year estimate and growth in assets under management driven by our distribution expansion, favorable equity markets and continued product introduction and enhancements.

Segment net operating earnings from spread-based institutional products increased $6 million primarily due to higher spreads and growth in assets under management related to our FABNs.

Revenues

The decrease in premiums was primarily the result of a $141 million reduction in our life-contingent structured settlement annuities due to our continued pricing discipline in the low long-term interest rate environment and our decision in the third quarter of 2006 to discontinue sales of this product. This decrease was partially offset by a $59 million increase in our life-contingent single premium immediate annuities driven by higher sales.

The increase in net investment income was principally due to increased yields on floating rate investments backing spread-based institutional products and higher assets under management. Partially offsetting this increase was lower net investment income related to bond calls and mortgage prepayment of $14 million in the current year.

For a discussion of net investment gains (losses), see the comparison for this line item under “—Results of Operations.”

The increase in policy fees and other income was primarily attributable to a $58 million increase in the fee-based segment as a result of increased sales and growth in assets under management from distribution expansion, favorable equity markets and continued product introduction and enhancements. In addition, surrender fees in our spread-based retail products increased $7 million.

Benefits and expenses

Benefits and other changes in policy reserves decreased primarily as a result of a $126 million decrease in life-contingent structured settlement annuities due to our continued pricing discipline in the continuing low long-

 

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term interest rate environment and our decision in the third quarter of 2006 to discontinue sales of this product. This decrease was partially offset by a $67 million increase in life-contingent single premium immediate annuities driven largely by higher sales.

The increase in interest credited was principally due to a $97 million increase related to spread-based institutional products as a result of higher crediting rates on floating rate products and higher assets under management. This increase was partially offset by a $33 million decrease in interest credited on fixed annuities associated with crediting rates being reset to current, lower rates as the fixed annuities reach their initial crediting rate guarantee period.

The increase in acquisition and operating expenses, net of deferrals, was primarily from increased expenses of $44 million associated with higher sales and growth in assets under management in fee-based products. This was partially offset by $5 million of lower expenses associated with our deferred annuities.

The increase in amortization of deferred acquisition costs and intangibles was largely the result of a $24 million increase in spread-based retail products primarily due to higher lapses and more favorable gross profit margins. Additionally, fee-based products increased by $5 million attributable to growth in assets under management.

Provision for income taxes

The effective tax rate increased to 33.0% for the nine months ended September 30, 2006 from 29.5% for the nine months ended September 30, 2005. This increase in the effective tax rate was primarily attributable to a nonrecurring favorable IRS examination development in 2005, offset by an increase in benefits from dividends received deductions including a change in prior year estimate.

 

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Retirement Income and Investments selected operating performance measures

Spread-based retail products

The following table sets forth selected operating performance measures regarding our spread-based retail products as of or for the three and nine months ended September 30, 2006 and 2005:

 

    As of or for the three months
ended September 30,
    Percentage
change
    As of or for the nine months
ended September 30,
    Percentage
change
 

(Amounts in millions)

          2006                     2005             2006 vs. 2005             2006                     2005             2006 vs. 2005  

Fixed annuities

           

Account value, net of reinsurance, beginning of period

  $ 14,835     $ 15,540     (5 )%   $ 15,547     $ 15,113     3 %

Deposits

    424       530     (20 )%     1,017       1,514     (33 )%

Interest credited

    137       154     (11 )%     421       454     (7 )%

Surrenders, benefits and product charges

    (947 )     (548 )   73 %     (2,536 )     (1,405 )   80 %
                                   

Account value, net of reinsurance, end of period

  $ 14,449     $ 15,676     (8 )%   $ 14,449     $ 15,676     (8 )%
                                   

Single premium immediate annuities

           

Account value, net of reinsurance, beginning of period

  $ 5,888     $ 5,488     7 %   $ 5,680     $ 5,344     6 %

Net earned premiums and deposits

    294       230     28 %     834       657     27 %

Interest credited

    82       77     7 %     240       234     3 %

Surrenders, benefits and product charges

    (200 )     (217 )   (8 )%     (690 )     (657 )   5 %
                                   

Account value, net of reinsurance, end of period

  $ 6,064     $ 5,578     9 %   $ 6,064     $ 5,578     9 %
                                   

Structured settlements

           

Account value, net of reinsurance, beginning of period

  $ 966     $ 765     26 %   $ 871     $ 533     63 %

Net earned premiums and deposits

    37       69     (46 )%     140       309     (55 )%

Interest credited

    14       11     27 %     39       33     18 %

Surrenders, benefits and product charges

    (14 )     (14 )   —   %     (47 )     (44 )   7 %
                                   

Account value, net of reinsurance, end of period

  $ 1,003     $ 831     21 %   $ 1,003     $ 831     21 %
                                   

Total premiums from spread-based retail products

  $ 210     $ 189     11 %   $ 590     $ 674     (12 )%
                                   

Total deposits on spread-based retail products

  $ 545     $ 640     (15 )%   $ 1,401     $ 1,806     (22 )%
                                   

 

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Fixed annuities. The account value, net of reinsurance, decreased primarily due to lapses being greater than deposits throughout 2006. The attractiveness of certain fixed annuities has declined as a result of continued low long-term interest rates, a flat yield curve and competitiveness of short-term investment alternatives, such as certificates of deposit. These trends are having an adverse impact on both sales and retention of fixed annuities. In recent quarters, we have experienced improved spreads in fixed annuities principally from run-off of and crediting rate resets of historically higher crediting rate business. The continued low long-term interest rate environment and a relatively flat yield curve, along with our pricing discipline of selling business that meets our profitability objectives, have adversely affected sales and retention of our fixed annuities. We expect this trend to continue.

Single premium immediate annuities. The account value, net of reinsurance, increased primarily due to the positive net impact of new product sales, lower lapse percentages and higher interest credited on account values in 2005 and 2006.

Structured settlements. Our continued pricing discipline in a challenging and competitive long-term interest rate environment was the primary cause for lower sales of these products during 2006. As a result, and upon completion of a strategic review of our structured settlement annuities, we decided in the third quarter of 2006 to discontinue sales of this product based on relative profitability in this market compared to our other product lines. This exit is not expected to have a material impact on current or future earnings. We will, however, continue to service our current blocks of business.

Spread-based institutional products

The following table sets forth selected operating performance measures regarding our spread-based institutional products as of the three and nine months ended September 30, 2006 and 2005:

 

     As of or for the three
months ended
September 30,
    Percentage
change
    As of or for the nine
months ended
September 30,
    Percentage
change
 

(Amounts in millions)

         2006                 2005           2006 vs. 2005     2006     2005     2006 vs. 2005  

GICs, funding agreements and FABNs

            

Account value, net of reinsurance, beginning of period

   $ 9,886     $ 9,162     8 %   $ 9,777     $ 9,541     2 %

Deposits(1)

     676       1,402     (52 )%     2,154       3,114     (31 )%

Interest credited

     128       101     27 %     365       269     36 %

Surrenders and benefits(1)

     (878 )     (667 )   32 %     (2,484 )     (2,926 )   (15 )%
                                    

Account value, net of reinsurance, end of period

   $ 9,812     $ 9,998     (2 )%   $ 9,812     $ 9,998     (2 )%
                                    

(1) “Surrenders and benefits” include contracts that have matured but are redeposited with us and are reflected as deposits. In the three months ended September 30, 2006 and 2005, surrenders and deposits included $105 million and $320 million, respectively, and in the nine months ended September 30, 2006 and 2005, surrenders and deposits included $415 million and $1,328 million, respectively, that were redeposited and reflected under “Deposits.”

Despite a slight decrease in account values due to GIC maturities, spread-based institutional account values benefited from the launch of our registered notes program in the fourth quarter of 2005. This program resulted in an issuance of $300 million of FABNs in 2005 and $1,450 million during 2006. The increase in interest credited was driven by higher crediting rates on our floating rate products largely due to an increase in short-term interest rates.

 

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Fee-based products

The following table sets forth selected operating performance measures regarding our fee-based products as of the nine months ended September 30, 2006 and 2005:

 

    As of or for the three
months ended
September 30,
    Percentage
change
    As of or for the nine
months ended
September 30,
    Percentage
change
 

(Amounts in millions)

        2006                 2005           2006 vs. 2005         2006             2005         2006 vs. 2005  

Income Distribution Series(2)

           

Account value, net of reinsurance, beginning of period

  $ 1,555     $ 634     145 %   $ 911     $ 462     97 %

Deposits

    334       109     NM (1)     965       286     NM (1)

Interest credited and investment performance

    68       13     NM (1)     122       17     NM (1)

Surrenders, benefits and product charges

    (28 )     (9 )   NM (1)     (69 )     (18 )   NM (1)
                                   

Account value, net of reinsurance, end of period

  $ 1,929     $ 747     158 %   $ 1,929     $ 747     158 %
                                   

Traditional variable annuities

           

Account value, net of reinsurance, beginning of period

  $ 1,458     $ 902     62 %   $ 1,182     $ 632     87 %

Deposits

    105       137     (23 )%     384       425     (10 )%

Interest credited and investment performance

    54       35     54 %     113       51     122 %

Surrenders, benefits and product charges

    (32 )     (26 )   23 %     (94 )     (60 )   57 %
                                   

Account value, net of reinsurance, end of period

  $ 1,585     $ 1,048     51 %   $ 1,585     $ 1,048     51 %
                                   

Variable life insurance

           

Account value, beginning of period

  $ 367     $ 347     6 %   $ 363     $ 345     5 %

Deposits

    7       7     —   %     23       26     (12 )%

Interest credited and investment performance

    10       13     (23 )%     23       13     77 %

Surrenders, benefits and product charges

    (13 )     (12 )   8 %     (38 )     (29 )   31 %
                                   

Account value, end of period

  $ 371     $ 355     5 %   $ 371     $ 355     5 %
                                   

Third-party assets

           

Account value, beginning of period

  $ 6,143     $ 4,335     42 %   $ 5,180     $ 3,973     30 %

Deposits

    602       429     40 %     1,827       1,112     64 %

Interest credited and investment performance

    154       160     (4 )%     249       122     104 %

Surrenders, benefits and product charges

    (133 )     (147 )   (10 )%     (490 )     (430 )   14 %
                                   

Account value, end of period

  $ 6,766     $ 4,777     42 %   $ 6,766     $ 4,777     42 %
                                   

(1) Not meaningful
(2) The Income Distribution Series offers variable annuity products and four riders that provide the contractholder with a guaranteed minimum income stream that they cannot outlive, along with an opportunity to participate in market appreciation.

 

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Income Distribution Series. We experienced an increase in assets under management attributable to the launch of our guaranteed minimum withdrawal for life benefit rider in the fourth quarter of 2005. Sales of this product remained strong during 2006, achieving the highest production to date in the third quarter of 2006.

Traditional variable annuities. The increase in assets under management was principally the result of ongoing sales of our core income series variable annuity products and favorable equity markets for the first nine months of 2006. In addition, the introduction of our group variable annuity product in the fourth quarter of 2005 has contributed to the growth in our assets under management.

Third-party assets. Third-party assets include assets managed by our Genworth Financial Asset Management and Genworth Financial Advisor groups. The increase in third-party assets was primarily due to growth in managed money accounts from new and existing clients, as well as favorable equity markets. Significant contributors to the growth in deposits were the result of expansion of our distribution network, growth in our sales force, and changes in our fee structure. On October 20, 2006, we acquired AssetMark Investment Services, Inc., an investment management and advisor company with more than $9 billion in third-party assets under management.

Mortgage Insurance segment

In the U.S., Canada, Australia, Europe, New Zealand, Mexico and Japan, we offer mortgage insurance products that facilitate homeownership by enabling borrowers to buy homes with low-down-payment mortgages and mortgage related services for our financial services customers. These products generally also aid financial institutions in managing their capital efficiently by reducing the capital required for low-down-payment mortgages.

Three Months Ended September 30, 2006 Compared to Three Months Ended September 30, 2005

The following table sets forth the results of operations relating to our Mortgage Insurance segment for the three months ended September 30, 2006 and 2005:

 

     Three months ended
September 30,
   Increase (decrease) and
percentage change
 

(Amounts in millions)

       2006            2005                2006 vs. 2005          

Revenues:

          

Premiums

   $ 262    $ 218    $ 44     20 %

Net investment income

     86      73      13     18 %

Net investment gains (losses)

     —        —        —       —   %

Policy fees and other income

     8      12      (4 )   (33 )%
                        

Total revenues

     356      303      53     17 %
                        

Benefits and expenses:

          

Benefits and other changes in policy reserves

     76      36      40     111 %

Acquisition and operating expenses, net of deferrals

     76      81      (5 )   (6 )%

Amortization of deferred acquisition costs and intangibles

     17      18      (1 )   (6 )%
                        

Total benefits and expenses

     169      135      34     25 %
                        

Income before income taxes

     187      168      19     11 %

Provision for income taxes

     53      42      11     26 %
                        

Segment net income

     134      126      8     6 %

Adjustments to segment net income:

          

Net investment (gains) losses, net of taxes and other adjustments

     —        —        —       —   %
                        

Segment net operating income

   $ 134    $ 126    $ 8     6 %
                        

 

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The following table sets forth net operating income for the products included in our Mortgage Insurance segment for the three months ended September 30, 2006 and 2005:

 

     Three months ended
September 30,
   Increase (decrease) and
percentage change
 

(Amounts in millions)

       2006            2005                2006 vs. 2005          

Segment net operating income:

          

U.S. mortgage insurance

   $ 53    $ 58    $ (5 )   (9 )%

International mortgage insurance

     81      68      13     19 %
                        

Total segment net operating income

   $ 134    $ 126    $ 8     6 %
                        

Segment net operating income

Our U.S. mortgage insurance business segment net operating income remained flat compared to the prior year excluding $5 million, net of tax, of favorable net adjustments to losses, expenses and taxes in the prior year that did not recur. Higher losses and a higher effective tax rate were partially offset by lower expenses, growth in premiums and an increase in earnings from our intra-segment reinsurance and capital maintenance agreements with our international mortgage insurance business.

Our international mortgage insurance business segment net operating income increase includes an increase of $5 million, net of tax, attributable to changes in foreign exchange rates and favorable adjustments to losses of $6 million, net of tax, in the prior year that did not recur. Growth of the business and seasoning of our insurance in-force were partially offset by an increase in losses from portfolio seasoning and higher losses from a limited number of Australian distribution relationships, as well as continued investments in our global expansion.

Revenues

Our international mortgage insurance premiums increased by $37 million, $8 million of which was attributable to changes in foreign exchange rates, driven by the growth and aging of our international in-force block of business. The increase in our U.S. mortgage insurance business of $7 million was primarily driven by increased flow premiums resulting from higher average price per policy, increased reinsurance premiums assumed from our international mortgage insurance business and higher bulk premiums.

The increase in net investment income of $13 million, which included a $3 million increase attributable to changes in foreign exchange rates, was largely the result of an increase in invested assets associated with the growth of our international mortgage insurance business.

Policy fees and other income decreased by $4 million primarily due to the recent elimination of Canadian application fees in our international mortgage insurance business.

Benefits and Expenses

Our international mortgage insurance benefits and other changes in policy reserves increased $23 million, including a $1 million increase attributable to changes in foreign exchange rates. This increase was primarily driven by higher losses from seasoning of more recent in-force blocks of business, increased losses from a limited number of Australian distribution relationships and $9 million of favorable adjustments in the prior year that did not recur. The increase in our U.S. mortgage insurance business of $17 million was primarily attributable to the increase in losses associated with a smaller decline in our average reserve per delinquency than the prior year and a $5 million favorable adjustment to reserves on our prime bulk business in the prior year that did not recur.

 

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Acquisition and operating expenses, net of deferrals decreased in our U.S. mortgage insurance business primarily driven by continued productivity initiatives and other expense reductions, lower contract underwriting volume and $4 million of non-recurring expenses in the prior year quarter. Acquisition and operating expenses, net of deferrals in our international mortgage insurance business increased as a result of continued investment in our existing international mortgage insurance platforms and potential new international platforms as well as a $2 million increase attributable to changes in foreign exchange rates.

Our U.S. mortgage insurance business amortization of deferred acquisition costs and intangibles decreased $4 million primarily due to an acceleration of amortization of deferred acquisition costs in the prior year related to low persistency rates. The increase in our international mortgage insurance business amortization of deferred acquisition costs was mainly due to the growth and seasoning of our insurance in-force in our international business.

Provision for income taxes

Provision for income taxes increased $11 million, which includes a $2 million increase attributable to changes in foreign exchange rates. The effective tax rate increased to 28.3% for the three months ended September 30, 2006 from 25.0% for the three months ended September 30, 2005. This increase in effective tax rate was primarily attributable to nonrecurring favorable IRS examination developments in 2005, offset by the increase in lower taxed foreign earnings and a reduction in excess foreign tax credits. Our Mortgage Insurance segment’s effective tax rate is below the statutory rate primarily as a result of tax-exempt investment income and lower taxed foreign earnings.

Nine Months Ended September 30, 2006 Compared to Nine Months Ended September 30, 2005

The following table sets forth the results of operations relating to our Mortgage Insurance segment for the nine months ended September 30, 2006 and 2005:

 

     Nine months ended
September 30,
   Increase (decrease) and
percentage change
 

(Amounts in millions)

       2006             2005                2006 vs. 2005          

Revenues:

         

Premiums

   $ 776     $ 653    $ 123     19 %

Net investment income

     251       210      41     20 %

Net investment gains (losses)

     2       —        2     NM (1)

Policy fees and other income

     26       34      (8 )   (24 )%
                         

Total revenues

     1,055       897      158     18 %
                         

Benefits and expenses:

         

Benefits and other changes in policy reserves

     172       96      76     79 %

Acquisition and operating expenses, net of deferrals

     220       215      5     2 %

Amortization of deferred acquisition costs and intangibles

     45       42      3     7 %
                         

Total benefits and expenses

     437       353      84     24 %
                         

Income before income taxes

     618       544      74     14 %

Provision for income taxes

     172       156      16     10 %
                         

Segment net income

     446       388      58     15 %

Adjustments to segment net income:

         

Net investment (gains) losses, net of taxes and other adjustments

     (1 )     —        (1 )   NM (1)
                         

Segment net operating income

   $ 445     $ 388    $ 57     15 %
                         

(1) Not meaningful

 

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The following table sets forth net operating income for the products included in our Mortgage Insurance segment for the nine months ended September 30, 2006 and 2005:

 

     Nine months ended
September 30,
   Increase (decrease) and
percentage change
 

(Amounts in millions)

       2006            2005                2006 vs. 2005          

Segment net operating income:

           

U.S. mortgage insurance

   $ 197    $ 191    $ 6    3 %

International mortgage insurance

     248      197      51    26 %
                       

Total segment net operating income

   $ 445    $ 388    $ 57    15 %
                       

Segment net operating income

Our U.S. mortgage insurance business segment net operating earnings increased as a result of lower expenses, an increase in earnings from our intra-segment reinsurance and capital maintenance agreements with our international mortgage insurance business and higher investment income. These were partially offset by an increase in losses and a higher effective tax rate. The current year includes a $2 million, net of tax, favorable adjustment to losses. The prior year includes $5 million, net of tax, favorable net adjustments to losses, expenses and taxes.

Our international mortgage insurance business segment net operating earnings increased by $51 million, including $9 million, net of tax, attributable to changes in foreign exchange rates, driven by growth of the business, seasoning of our insurance in-force and a decrease in effective tax rate. These were partially offset by an increase in losses from portfolio seasoning and higher losses from a limited number of Australian distribution relationships, as well as continued investments in our global expansion. The current year includes $5 million, net of tax, of favorable adjustments to premiums. The prior year includes $12 million, net of tax, of favorable adjustments to premiums and losses.

Revenues

Our international mortgage insurance premiums increased by $108 million, which included an increase of $11 million attributable to changes in foreign exchange rates, driven by the growth and aging of our international in-force block, which resulted in increased earned premiums from prior-year new insurance written. The year-over-year increase was impacted by a $10 million release of unearned premium reserves on our single premium product in the first quarter of 2005 due to the completion of a European cancellation study and was partially offset by an $8 million favorable adjustment of unearned premium reserves in Australia in the second quarter of 2006. The increase in premiums of $15 million in our U.S. mortgage insurance business was primarily due to increased reinsurance premiums assumed from our international mortgage insurance business, increased bulk premiums and increased flow premiums resulting from increased average price.

The increase in net investment income, which included an increase of $4 million attributable to changes in foreign exchange rates, was largely the result of an increase in invested assets associated with the growth of our international mortgage insurance and increased yield in the investment portfolio of our U.S. mortgage insurance business.

The decrease in policy fees and other income was primarily from lower fees for contract underwriting services in our U.S. mortgage insurance business and the recent elimination of Canadian application fees in our international mortgage insurance business.

Benefits and Expenses

Our U.S. mortgage insurance benefits and other changes in policy reserves increased $20 million primarily driven by an increase in losses associated with an increase in our average reserve per delinquency and an

 

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increase of $5 million related to a prime bulk reserve adjustment in the prior year that did not recur. This was partially offset by claims paid favorability and a $3 million decrease in reserves for severely impacted areas associated with Hurricanes Katrina and Rita. Our international mortgage insurance benefits and other changes in policy reserves increased $56 million primarily driven by higher losses in Australia reflecting the seasoning of more recent in-force blocks of business, increased losses from a limited number of distribution relationships in Australia and an increase of $9 million related to loss adjustments in the prior year that did not recur.

The increase in acquisition and operating expenses, net of deferrals, was primarily due to an increase in costs from our existing international platforms and continued investment in potential new international mortgage insurance platforms as well as a $2 million increase attributable to changes in foreign exchange rates. This increase was partially offset in our U.S. mortgage insurance business as a result of continued productivity improvements and other expense reductions, lower contract underwriting volume and an increase in indemnity reserves related to our U.S. contract services offerings in the prior year that did not recur.

Amortization of deferred acquisition costs and intangibles increased as a result of the growth and seasoning in our international mortgage insurance business which was partially offset by $6 million of accelerated amortization of deferred acquisition costs as a result of low persistency in the prior year that did not recur.

Provision for income taxes

Provision for income taxes increased $16 million, which includes a $5 million increase attributable to changes in foreign exchange rates. The effective tax rate decreased to 27.8% for the nine months ended September 30, 2006 from 28.7% for the nine months ended September 30, 2005. This decrease in effective tax rate was primarily attributable to the increase in lower taxed foreign earnings and a reduction in excess foreign tax credits, offset by nonrecurring favorable IRS examination developments in 2005. Our Mortgage Insurance segment’s effective tax rate is below the statutory rate primarily as a result of tax-exempt investment income and lower taxed foreign earnings.

Mortgage Insurance selected operating performance measures

The following tables set forth selected operating performance measures regarding our U.S. and international mortgage businesses as of or for the dates indicated:

 

     Three months
ended September 30,
   Percentage
change
    Nine months
ended September 30,
   Percentage
change
 

(Amounts in millions)

   2006    2005    2006 vs. 2005     2006    2005    2006 vs. 2005  

Net premiums written:

                

U.S. mortgage insurance

   $ 121    $ 112    8 %   $ 355    $ 332    7 %

International mortgage insurance

     311      204    52 %     759      509    49 %
                                

Total net premiums written

   $ 432    $ 316    37 %   $ 1,114    $ 841    32 %
                                

Net premiums earned:

                

U.S. mortgage insurance

   $ 118    $ 111    6 %   $ 350    $ 335    4 %

International mortgage insurance

     144      107    35 %     426      318    34 %
                                

Total net premium earned

   $ 262    $ 218    20 %   $ 776    $ 653    19 %
                                

New insurance written:

                

U.S. mortgage insurance

   $ 8,200    $ 7,200    14 %   $ 23,200    $ 20,100    15 %

International mortgage insurance

     28,700      21,000    37 %     70,800      56,600    25 %
                                

Total new insurance written

   $ 36,900    $ 28,200    31 %   $ 94,000    $ 76,700    23 %
                                

 

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Net premiums written

For the three months ended September 30, 2006, the increase in net premiums written was primarily driven by increases in new insurance written in our international mortgage insurance business. The increase in our international mortgage insurance business of $107 million, which included an increase of $17 million attributable to changes in foreign exchange rates, was primarily the result of an increase in flow new insurance written. The increase in net premiums written in our U.S. mortgage insurance business of $9 million was primarily due to higher flow average price per policy, more sales of our single premium product and increased reinsurance premiums assumed from our international mortgage insurance business.

For the nine months ended September 30, 2006, the increase in net premiums written was primarily due to increases in new insurance written in our international mortgage insurance business. The increase in our international business of $250 million, which included an increase of $19 million attributable to changes in foreign exchange rates, was the result of an increase in new insurance written. Included in the international increase was the impact of a catch-up of sales reported to us due to a delay in timing of customer reporting in Australia. The increase in net premiums written in our U.S. mortgage insurance business of $23 million was principally from higher flow average price per policy, higher sales of our single premium product and increased reinsurance premiums assumed from our international mortgage insurance business.

Most of our international mortgage insurance policies provide for single premiums at the time that loan proceeds are advanced. We initially record the single premiums to unearned premium reserves and recognize the premiums earned over time in accordance with the estimated expiration of risk. As of September 30, 2006, our unearned premium reserves in our international mortgage insurance business increased to $2.3 billion from $1.7 billion as of September 30, 2005.

New insurance written

For the three months ended September 30, 2006, the increase in new insurance written was primarily driven by our international mortgage insurance business. International new insurance written increased $7.7 billion, which included an increase of $1.1 billion attributable to changes in foreign exchange rates. The increase in international new insurance written was largely due to growth in international flow and bulk products, which was primarily the result of ongoing expansion of our customer base in Europe and continued account penetration in Canada. U.S. new insurance written increased $1.0 billion associated with an increase in our bulk product writings.

For the nine months ended September 30, 2006, the increase in new insurance written was driven by both our U.S. and international mortgage insurance businesses. International new insurance written increased $14.2 billion, which included an increase of $0.3 billion attributable to changes in foreign exchange rates. The increase in international new insurance written was primarily due to growth in international flow insurance which is the result of the ongoing expansion of our customer base in Europe, continued account penetration in Canada, strong sales by key customers in Australia and a catch-up of sales reported to us caused by a delay in timing of customer reporting in Australia. U.S. new insurance written increased $3.1 billion primarily due to an increase in our bulk product writings and a modest increase in flow new insurance written.

 

     As of September 30,    Percentage change  

(Amounts in millions)

   2006    2005    2006 vs. 2005  

Primary insurance in-force:

        

U.S. mortgage insurance

   $ 104,000    $ 101,900    2 %

International mortgage insurance

     319,600      231,000   <