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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D. C. 20549

FORM 10-K

For the fiscal year ended December 31, 2003.

For the transition period from                  to                 .

Commission file number 333-02491*.

KEMPER INVESTORS LIFE INSURANCE COMPANY

(Exact name of registrant as specified in charter)

Registrant’s telephone number, including area code: (206) 232-8400

Securities registered pursuant to Section 12(b) of the Act: none

Securities registered pursuant to Section 12(g) of the Act: none

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 and (2) has been subject to such filing requirements for the past 90 days.   Yes  ü   No     .

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes       No  ü .

The aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the last business day of the registrant’s most recently completed second fiscal quarter was $0. As of March 15, 2004, there were outstanding 250,000 shares of common stock, $10.00 par value per share, of the registrant.

Documents incorporated by reference: None.

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KEMPER INVESTORS LIFE INSURANCE COMPANY

FORM 10-K

For the Fiscal Year Ended December 31, 2003

INDEX

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PART I

Item 1. Business

Corporate structure

Kemper Investors Life Insurance Company (“KILICO”, “the Company”, “we”, “our” or “us”), founded in 1947, is incorporated under the insurance laws of the State of Illinois and is licensed in the District of Columbia and all states except New York. The Company’s Subsidiaries through September 3, 2003, (see “Sales and Reinsurance Ceded/Assumed” section below), included Investors Brokerage Services, Inc., Investors Brokerage Services Insurance Agency, Inc., Zurich Life Insurance Company of New York (“ZLICONY”), PMG Life Agency, Inc., PMG Marketing, Inc., PMG Securities Corporation and PMG Asset Management, Inc. (collectively “PMG”). ZLICONY is licensed to conduct business in the State of New York. KILICO is wholly-owned by Kemper Corporation (“Kemper”), a non-operating holding company. Kemper is an indirect wholly-owned subsidiary of Zurich Holding Company of America, Inc. (“ZHCA”), a holding company. ZHCA is an indirect wholly-owned subsidiary of Zurich Group Holding (“ZGH” or “Zurich”), a Swiss holding company. ZGH is wholly-owned by Zurich Financial Services (“ZFS” or “Parent”), a Swiss holding company.

Sales and Reinsurance Ceded/Assumed

FKLA

On September 3, 2003 (the “Closing Date” or the “Closing”), the Company transferred portions of its business through a one hundred percent coinsurance arrangement, as well as the capital stock of its wholly-owned subsidiaries, to its former affiliate, Federal Kemper Life Assurance Company (“FKLA”). Prior to the Closing Date, the Company, FKLA, Zurich Life Insurance Company of America (“ZLICA”) and Fidelity Life Association, a mutual legal reserve company (“FLA”) operated under the trade name “Zurich Life” and were all, except FLA, direct, wholly-owned subsidiaries of Kemper. Following the Closing Date, the Company remains a direct, wholly-owned subsidiary of Kemper.

These transfers were part of a larger transaction pursuant to a Stock and Asset Purchase Agreement, dated May 29, 2003 (the “Purchase Agreement”), among ZHCA, Kemper, the Company, ZFS, Banc One Insurance Holdings, Inc. (“BOIH”) and Bank One Corporation (“Bank One”). Under the Purchase Agreement, Kemper, an indirect subsidiary of ZFS, agreed to sell the capital stock of FKLA, ZLICA and Zurich Direct, Inc. to BOIH. BOIH also agreed to acquire indirect control of FLA via its acquisition of FKLA which, pursuant to a Management Agreement, directs the day-to-day operations of FLA. BOIH further agreed to acquire control of all the Company’s Subsidiaries.

Upon the Closing of the transactions contemplated by the Purchase Agreement, including the Coinsurance Agreement, effective as of the Closing (the “Coinsurance Agreement”), the Company ceded to FKLA, and FKLA assumed on a coinsurance basis, 100% of the General Account Liabilities. The “General Account Liabilities” included all of the Company’s gross liabilities and obligations, including benefits, claims, taxes, commissions and assessments for certain types of existing individual and group life insurance policies and annuity contracts (the “Reinsured Policies”), except for certain retained liabilities. The Reinsured Policies also included certain policies to be written by the Company for a period of twelve months subsequent to the Closing.

Upon the Closing, the Company also ceded to FKLA, and FKLA assumed on a modified coinsurance basis, a majority of the Separate Account Liabilities. The “Separate Account Liabilities” are all liabilities that were reflected in the Company’s separate accounts and that relate to the Reinsured Policies. Pursuant to the modified coinsurance framework under which Separate Account Liabilities are reinsured, ownership of the underlying separate account assets was not transferred to FKLA.

In consideration of FKLA’s assumption of the General Account Liabilities, the Company transferred to FKLA the Transferred Coinsurance Assets, less a Ceding Commission, as described below. “Transferred Coinsurance Assets,” as calculated on a statutory accounting basis, were defined as (a)(i) all of the issued and

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outstanding shares of the Company’s Subsidiaries and certain other assets (software, fixtures, equipment, etc.), (ii) certain investment assets and (iii) cash or cash equivalents, having an aggregate market value equal to the amount as of the Closing Date of the General Account Reserves, as defined in the Coinsurance Agreement, plus (b) the Company’s interest maintenance reserve as of the Closing Date (excluding interest maintenance reserve as a result of the realization of gain associated with transferring the Transferred Coinsurance Assets at market value rather than book value) minus (c) the aggregate amount of accruals with respect to the Reinsured Policies. Pursuant to the Coinsurance Agreement, FKLA established a trust account (the “Security Trust Account”) for the exclusive benefit of the Company funded with assets equal to one hundred percent of the general account reserves reinsured by FKLA, adjusted on a quarterly basis. FKLA is required to maintain the Security Trust Account in effect until the general account reserves are $400 million or less. At December 31, 2003, the general account reserves were $4.3 billion.

The Company also transferred to FKLA in consideration of FKLA’s reinsurance of future liabilities and obligations, in respect of the Reinsured Policies, future premiums, premiums receivable, policy loan receivables, reinsurance recoverables, separate account revenues, agents debit balances and all other fees, charges and amounts. In addition, pursuant to the Coinsurance Agreement, the administerial actions required of the Company with respect to the Bank Owned Life Insurance policies (the “BOLI Policies”) are performed by FKLA in exchange for an income stream of 8 to 12 basis points earned on the value of the invested assets of the BOLI Policies. The Company has also agreed that, for a period of three years following the Closing Date, it will not, except under limited circumstances, issue any new BOLI Policies going forward.

The “Ceding Commission”, discussed above, was $120 million, subject to a market value adjustment with respect to the Transferred Coinsurance Assets. The Ceding Commission was not transferred from FKLA to the Company, but rather was withheld from the investment assets transferred from the Company to FKLA as part of the Transferred Coinsurance Assets. Both the Company and FKLA finalized their settlement in February 2004. The resulting closing adjustment resulted in a decrease of $9.3 million in payable to reinsurers in the balance sheet as of February 2004.

The Company remains primarily responsible to its policyholders for all future claims and policyholder benefits related to the blocks of business ceded to FKLA and is not relieved of its obligations. Assets in support of the reserves for future policyholder benefits ceded to FKLA as part of the Coinsurance Agreement totaled $3.5 billion. Separate account assets that support the Separate Account Liabilities, but were not ceded to FKLA under the modified coinsurance arrangement totaled, $2.0 billion.

The following table is a summary of certain balance sheet and income statement line items affected by the accounting for the initial coinsurance transaction.

Prior to the Closing, the Company and FKLA shared common management and employees and FKLA performed the administration of the Company’s business through an administrative services arrangement. With the sale of FKLA to BOIH, the Company has established post-Closing Date service arrangements for the operation of its business on both a short-term and long-term basis. On a long-term basis, the overall corporate and business administration of the Company will be performed by its affiliate, Farmers New World Life Insurance Company (“FNWL”), subject to the oversight of our new officers, directors and employees. For an

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interim period of up to one year, pursuant to a transition services agreement, FKLA will provide transition services to the Company and FNWL with respect to the overall operations of the Company including legal support services, accounting and financial operations services and support, actuarial services and support, information technology services and support, policyholder and distributor services and support, distributor relationship management services, product management services, tax administration support services, disaster recovery, system conversion services and other services as required.

The transition services agreement is designed to facilitate the Company’s continued operations, in substantially the same manner as it operated prior to the Closing, while the Company transitions to a new management team and new employees. In addition, for a period of up to one year FKLA will provide administrative services with respect to the Company’s DESTINATIONS^SM business.

The Reinsured Policies and BOLI business will be administered by FKLA on a long-term basis subject to the oversight of the Company. As part of the Coinsurance Agreement, FKLA is responsible for providing certain administrative services with respect to the Reinsured Policies. This includes, but is not limited to, policy and policyholder administration, separate account administration, preparing accounting and actuarial information, and certain aspects of legal compliance.

On September 3, 2003, Kemper, the sole shareholder of the Company, elected a new Board of Directors and a new senior management team. None of the individuals serving on KILICO’s Board of Directors or in senior management positions prior to the Closing Date, except for the General Counsel, continue to serve in any capacity as directors or officers of the Company.

In the third quarter of 2003, the Company exchanged certain invested assets with FKLA, ZLICA and ZLICONY. These invested assets were to be excluded from the companies acquired by BOIH as outlined in the Purchase Agreement and substituted with different invested assets. The net difference between the excluded assets received by the Company and the substituted assets received by FKLA, ZLICA and ZLICONY was treated as a dividend to Kemper in the amount of approximately $10.0 million.

FNWL

The Company entered into a modified coinsurance treaty (“Modified Coinsurance Agreement”) on December 1, 2003 with an affiliate, FNWL. FNWL is a Washington domiciled stock life insurance company. Initially, the Company assumed all existing Non-Qualified Individual Flexible Payment Deferred (“NQ-FPDA”) and Non-Qualified Individual Single Premium Deferred (“NQ-SPDA”) annuities from FNWL. In exchange, the Company paid an initial ceding commission of $36.5 million. No portion of the assets constituting the consideration were transferred to the Company. Subsequent new issues by FNWL of NQ-FPDA and NQ-SPDA annuities will be assumed by the Company. In exchange, the Company will receive all reinsurance premiums and pay benefits to the policyholders relating to these contracts. The Company has a management and service agreement with FNWL to receive services reasonably necessary pursuant to this agreement.

Narrative description of business

As of the Closing, the Company ceased issuing new business with the exception of certain policies to be written and reinsured pursuant to the Coinsurance Agreement and certain BOLI policies which were in negotiation or active discussion at the time of the Closing. Up until that time, we offered both individual and group fixed-rate (general account) and variable (separate account) annuity contracts, as well as individual and group term life (general account) and group variable (separate account) life insurance products through various distribution channels. We offered investment-oriented products, guaranteed returns or a combination of both, to help policyholders meet multiple insurance and financial objectives. Financial institutions, securities brokerage firms, insurance agents and financial planners were important distribution channels for our products. Our sales mainly consisted of deposits received on certain long duration fixed and variable annuities and BOLI contracts.

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Our fixed and variable annuities generally have surrender charges that are a specified percentage of policy values or premiums which decline as the policy ages. General account annuity and interest-sensitive life policies are guaranteed to accumulate at specified interest rates but allow for periodic crediting rate changes.

Products

As of December 31, 2003, the Company is not selling any new business. We reinsured the majority of our business through the Coinsurance Agreement with FKLA. The Company is offering renewal business for the following products:

The DESTINATIONS^SM product was discontinued in the first quarter of 2003.

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Investors Brokerage Services, Inc. (“IBS”), a wholly-owned subsidiary through September 3, 2003, and BFP Securities, LLC, an affiliated broker-dealer, are the principal underwriters of our registered variable annuity and variable life products. BFP Securities, LLC is also the primary wholesaling distributor of our BOLI products.

A majority of our products are reinsured through the Coinsurance Agreement with FKLA discussed above, and we also have reinsurance agreements in place where we are the assuming party to the agreement. See “Sales and Reinsurance Ceded/Assumed” in Management’s Discussion and Analysis presented later in this Form 10-K.

Use of Non-GAAP Financial Measures

The Company’s consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). These financial statements and measures are used by management to assist in the analysis and management of the operations of the Company. In addition, the Company regularly reviews and reports non-GAAP financial measures called operating income (loss) and net operating income (loss), as well as monitors and reports a non-GAAP financial measure titled sales and a non-GAAP financial measure titled policyholder surrenders, withdrawals and death benefits.

Readers are encouraged to refer to Management’s Discussion and Analysis for detailed discussions of the components of these non-GAAP financial measures, how they differ from GAAP financial measures, how management uses this information and a reconciliation of these non-GAAP measures to the most directly comparable GAAP financial measures.

Business Segments

The Company has two primary operating segments, life insurance and annuities. These two operating segments reflect the way we manage our operations and make business decisions. Required financial information by business segment is set forth in the Management’s Discussion and Analysis and Note 13 of the Notes to Consolidated Financial Statements.

Ratings

Ratings are an important factor in establishing the competitive position of life insurance companies. Rating organizations continue to review the financial performance, and the condition of life insurers, and their investment portfolios. Any reductions in our claims-paying ability or financial strength ratings could result in our products or future products being less attractive to consumers. Any reductions in our parent’s ratings could also adversely impact our financial flexibility.

According to Best’s Insurance Reports, 2003, as of September 30, 2003, we ranked 52nd by admitted assets, and 137th by capital and surplus out of the top 250 life insurers. Our December 31, 2003 ratings were as follows:

We share our A.M. Best rating with ZFS. Our financial strength rating at December 31, 2003 was “A” (Excellent) and remains under review with negative implications.

We have a rating from Moody’s Investors Service (“Moody’s”) that is not considered a “group” rating. Our Moody’s rating was “A3” (Good) at December 31, 2003 and remains on CreditWatch for possible downgrade.

We receive a rating from Standard & Poor’s (“S&P”) that is not considered a “group” rating, thus our rating is not shared with ZFS. At December 31, 2003, our rating was “A-” (Strong) and given a stable outlook.

Each rating is subject to revision or withdrawal at any time by the assigning organization and should be evaluated independently of any other rating.

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Competition

We are in a highly competitive business. We compete with a large number of other stock and mutual life insurance companies, many of which are larger financially, although none is truly dominant in the industry. The Company, with its emphasis on annuity products, also competes for savings dollars with securities brokerage and investment advisory firms as well as other institutions that manage assets, produce financial products or market other types of investment products.

Employees

At December 31, 2003, we had 11 employees and, per the Coinsurance Agreement and transition services agreement, we will continue to use certain services of FKLA employees. Subsequent to the sale to BOIH, the Company utilized certain services of FNWL. During the majority of 2003 and the full years 2002 and 2001, the Company’s personnel were employees of FKLA. Expenses are allocated to the Company for the utilization of FNWL and FKLA employees and facilities.

Regulatory Environment

General Regulation

We are generally subject to regulation and supervision by the insurance departments of Illinois and other jurisdictions where we are licensed to do business. These departments enforce laws and regulations designed to ensure that insurance companies maintain adequate capital and surplus; manage investments according to prescribed character, standards and limitations; and comply with a variety of operational standards. The departments also make periodic examinations of individual companies and review annual and other reports on the financial condition of each company operating within their respective jurisdictions. Regulations, which often vary from state to state, cover most aspects of the life insurance business including market practices, policy forms, and accounting and financial reporting procedures.

Insurance holding company laws enacted in many states grant additional powers to state insurance commissioners to regulate acquisitions of and by domestic insurance companies, to require periodic disclosure of relevant information and to regulate certain transactions with related companies. These laws also impose prior approval requirements for certain transactions with affiliates and generally regulate dividend distributions by an insurance subsidiary to its holding company parent. In addition, certain of our variable life insurance and variable annuity products, and the related separate accounts, are subject to regulation by the Securities and Exchange Commission (the “SEC”).

National Association of Insurance Commissioners

Insurance companies are required to file detailed annual and quarterly statutory financial statements with state insurance regulators in each of the states in which they do business. Additionally their business and accounts are subject to examination by such agencies at any time. Insurance regulators periodically examine an insurer’s financial condition, adherence to statutory accounting practices and compliance with insurance department rules and regulations. Applicable state insurance laws, rather than federal bankruptcy laws, apply to the liquidation or the restructuring of insurance companies. As part of their routine regulatory oversight process, state insurance departments periodically conduct detailed examinations of the books, records and accounts of insurance companies domiciled in their states. Such examinations are generally conducted in cooperation with the insurance departments of two or three other states under guidelines promulgated by the National Association of Insurance Commissioners (“NAIC”). The most recently completed examination of the Company was conducted by the Illinois, Delaware, Kentucky, and Nevada insurance departments for the five-year periods ended December 31, 2000. The final report of this examination did not result in any significant issues or adjustments.

The NAIC annually calculates certain statutory financial ratios for most insurance companies in the United States. These calculations are known as the Insurance Regulatory Information System (“IRIS”) ratios. Currently,

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thirteen IRIS ratios are calculated. The primary purpose of the ratios is to provide an early warning of potential negative developments. The NAIC reports a company’s ratios to state regulators who may then contact the company if three or more ratios fall outside the NAIC’s “usual ranges.”

Based on statutory financial data as of December 31, 2003, we had three ratios outside the usual ranges: the net income to total income (including realized capital gains and losses) ratio, the change in premium ratio and the change in reserving ratio. The net income to total income (including realized capital gains and losses) ratio was outside the usual range due to our net loss in 2003. The change in premium and change in reserving ratios were outside the usual ranges primarily due to the amounts ceded and assumed under the FLKA and FNWL reinsurance agreements, respectively.

Based on statutory financial data as of December 31, 2002, we had six ratios outside the usual ranges: the net change in capital and surplus ratio, the net income to total income (including realized capital gains and losses) ratio, the adequacy of investment income ratio, the change in premium ratio, the change in product mix ratio and the change in reserving ratio. The results for the net change in capital and surplus ratio and the net income to total income ratio were primarily caused by the $84.9 million statutory net loss reported that was caused by the significant downturn in the stock market during 2002. The result for the adequacy of investment income ratio was primarily due to compressed spread income due to the current low interest rate environment and the use of conservative tabular interest rates. The result for the change in premium ratio and the change in the product mix ratio was primarily caused by a decrease in sales of our DESTINATIONS^SM product in 2002 due to the discontinuation of the GRIB option in November 2001. The result for the change in the reserving ratio was primarily due to the level of individual variable universal life premiums, which carry marginal reserves in the general account, versus the change in reserves which primarily reflects a matured block of universal life policies with minimal premium volume.

Other than certain states requesting routine quarterly financial reporting or explanations of the underlying causes for certain ratios, no state regulators have taken any action due to our IRIS ratios for 2003 or earlier years.

Regulation of Dividends and Other Payments

Dividend distributions from us to our sole stockholder are restricted by state insurance laws. In Illinois, where we are domiciled, if a proposed dividend, together with other distributions during the 12 preceding months, would exceed the greater of (a) ten percent of our statutory surplus as regards policyholders as of the preceding December 31, or (b) our statutorily adjusted net income for the preceding calendar year, then the proposed dividend must be reported to the director of insurance at least 30 days prior to the proposed payment date. The dividend then may be paid only if not disapproved. The Illinois insurance laws also permit payment of dividends only out of earned surplus, exclusive of most unrealized capital gains. A $10.0 million dividend was paid to Kemper in the third quarter of 2003 in conjunction with the asset transfer pursuant to the Purchase Agreement which was approved by the Illinois Department of Insurance. In 2002, the Company did not pay any dividends. The Company cannot pay any dividends in 2004 without the Illinois Department of Insurance approval.

In connection with the Purchase Agreement, the Company is restricted from paying dividends or making any other distributions of capital or surplus for a period of four years from the closing date.

Risk-based Capital and Asset Adequacy

Under Illinois’s asset adequacy and risk-based capital rules, state regulators may mandate remedial action for inadequately reserved or capitalized companies. The asset adequacy rules are designed to ensure that assets supporting reserves are adequate to cover liabilities under a variety of economic scenarios. The focus of risk-based capital rules is a risk-based formula that applies prescribed factors to various risk elements in an insurer’s business and investments to develop a minimum capital requirement designed to be proportional to the amount of

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risk assumed by the insurer. At December 31, 2003 our risk-based capital ratio was 353% compared to 226% at December 31, 2002. Our capital levels exceed minimum risk-based capital requirements, and are in compliance with applicable asset adequacy rules.

To our knowledge, we are in compliance, in all material respects, with all applicable regulations.

Available Information

The Company’s financial results are available through the Internet and mail. The Company files Current Reports on Form 8-K, Quarterly Reports on Form 10-Q, Annual Reports on Form 10-K and other reports electronically with the SEC, which are available on the SEC’s web site (http://www.sec.gov). At your request, we will mail you our Annual Report on Form 10-K, our Quarterly Reports on Form 10-Q and Current Reports on Form 8-K. To request a copy of any of these SEC filings, or to request other information, please contact:

Kemper Investors Life Insurance Company

Financial Reporting

3003 77^th Avenue SE

Mercer Island, WA 98040

Item 2. Properties

We currently maintain an administrative office with an affiliated company, Zurich North America, in Schaumburg, Illinois. From January until September 2003, the Company shared 307,804 square feet of office space leased by Zurich North America from Wells Real Estate Funds, located in Schaumburg, Illinois. During this term, we made payments for our share of lease expenses per the terms of our agreement with Zurich North America. We also share space with an affiliated company, FNWL, in Mercer Island, Washington. We make payments for our share of rent and lease expenses based on a general allocation from FNWL.

Item 3. Legal Proceedings

We have been named as defendant in certain lawsuits incidental to our insurance business. Our management believes that the resolution of these various lawsuits will not result in any material adverse effect on our consolidated financial position or results of operations.

Item 4. Submission of Matters to a Vote of Security Holders

No matters were submitted for a vote of our stockholder during the fourth quarter of 2003.

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PART II

Item 5. Market for Registrant’s Common Stock and Related Stockholder Matters

On September 20, 2002, Kemper contributed $30 million of capital to the Company. In addition, on December 31, 2002, Kemper forgave a $7.3 million tax receivable from the Company, which was recorded as a capital contribution on our books.

Item 6. Selected Financial Data

The following selected financial information should be read in conjunction with our consolidated financial statements and notes thereto, included in Item 8, “Financial Statements and Supplementary Data,” and information contained in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” Historical results are not necessarily indicative of future results. The following amounts are shown in millions.

The Company executed two significant coinsurance agreements during 2003 which are discussed in the Reinsurance section of Management’s Discussion and Analysis as well as Note 3 of the Notes to Consolidated Financial Statements. Comparison between 2003 and prior years is impacted by these coinsurance agreements.

As further discussed in Management’s Discussion and Analysis, we wrote down our goodwill asset as of January 1, 2002, in accordance with Statement of Financial Accounting Standard (“SFAS”) No. 142, Goodwill and Other Intangible Assets, issued in July 2001. The 2002 write-down totaled $178.4 million. We had no goodwill impairment in 2003 and there was no remaining goodwill at December 31, 2003.

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Forward-looking statements

All statements, trend analyses and other information contained in this report and elsewhere (such as in other filings by the Company with the SEC, press releases, presentations by the Company or its management or oral statements) about markets for our products and trends in our operations or financial results, as well as other statements including, but not limited to, such words as “anticipate,” “believe,” “include,” “plan,” “estimate,” “assume,” “expect,” “project,” “intend,” and other similar expressions, constitute forward-looking statements under the Private Securities Litigation Reform Act of 1995. These forward-looking statements are subject to known and unknown risks, uncertainties and other factors which may cause actual results to be materially different from those contemplated by the forward-looking statements. These factors include, among other things:

All forward-looking statements included in this document are based on information available to the Company on the date hereof, and the Company assumes no obligation to update any forward looking statements. The Company undertakes no obligation to publicly update or revise any forward-looking statement, whether as a result of new information, future results or otherwise.

Critical Accounting Policies

The preparation of financial statements in conformity with GAAP requires estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, expenses, and related disclosures of contingent assets and liabilities in the consolidated financial statements and accompanying notes. The SEC has defined a company’s critical accounting policies as the ones that are most important to the portrayal of the company’s financial condition and results of operations which require the company to make its most difficult and subjective judgments, often as a result of the need to make estimates of matters that are inherently uncertain. Based on this

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definition, we have identified the critical accounting policies and judgments addressed below. We also have other key accounting policies which involve the use of estimates, judgments and assumptions that are significant to understanding our results. For additional information see Note 1 of the Notes to Consolidated Financial Statements. Although we believe that our estimates, assumptions, and judgments are reasonable, they are based upon information currently available. Actual results may differ significantly from these estimates under different assumptions, judgments or conditions.

Deferred Insurance Acquisition Costs

The costs of acquiring new business, principally commission expense and certain policy issuance and underwriting expenses, have been deferred to the extent they are recoverable from estimated future gross profits (“EGPs”) on the related contracts and policies. The deferred insurance acquisition costs (“DAC”) for annuities, separate account business and interest-sensitive life insurance products are amortized over the estimated contract life in relation to the present value of EGPs, arising principally from projected investment margins, mortality and expense margins and surrender charges. DAC related to such interest-sensitive products also reflect the estimated impact of unrealized gains or losses on fixed maturity securities held as available-for-sale in the investment portfolio, through a charge or credit to accumulated other comprehensive income, net of income tax. The DAC for term life insurance products are amortized over the premium paying period of the policies.

Actual gross profits can vary from management’s estimates, resulting in increases or decreases in the rate of amortization. The Company regularly evaluates its EGPs to determine if actual experience or other evidence suggests that earlier estimates should be revised. In the event that the Company were to revise its EGPs, the cumulative DAC amortization would be adjusted to reflect such revised EGPs in the period the revision was determined to be necessary. Several assumptions considered to be significant in the development of EGPs include separate account fund performance, surrender and lapse rates, estimated interest spread and estimated mortality. The separate account fund performance assumption is critical to the development of the EGPs related to the Company’s variable annuity and to a lesser extent, variable universal life insurance business.

Additionally, the Company continues to perform analyses with respect to the potential impact of a revision to future EGPs. If such a revision to EGPs were deemed necessary, the Company would adjust, as appropriate, the assumptions for products accounted for in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 97, “Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments”, and reproject its future EGPs based on current account values at the end of the quarter in which a revision is deemed to be necessary.

The overall recoverability of the DAC asset is dependant on the future profitability of the business. The Company monitors the aggregate recoverability of the DAC asset by comparing the amounts deferred to the present value of total EGPs. In addition, the Company routinely monitors its DAC asset for recoverability against severe declines in its separate account assets, which could occur if the equity markets experienced another significant sell-off, as the majority of policyholders’ funds in the separate accounts are invested in the equity market.

Future Policy Benefits

Liabilities for future policy benefits related to annuities and interest-sensitive life contracts reflect net premiums received plus interest credited during the contract accumulation period and the present value of future payments for contracts that have annuitized. A liability has been established for GMDB in excess of account values. GRIB reserves have been established to cover the present value of future benefits for policies that were deemed to have elected annuitization. In accordance with current GAAP guidance, no additional liabilities for future policy benefits related to guaranteed living benefits have been established.

Current interest rates credited during the contract accumulation period range from 0.5% to 7.4%. Future minimum guaranteed interest rates vary from 2.0% to 4.5%. For contracts that have annuitized, interest rates used in determining the present value of future payments range principally from 2.5% to 12.0%.

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Liabilities for future term life policy benefits have been computed principally by a net level premium method. Anticipated rates of mortality are based on the 1975-1980 Select and Ultimate Table modified by Company experience, including withdrawals. Assumed investment yields are by policy duration and range from 4.2% to 4.6% over 20 years.

Impairment Losses on Investments

Management regularly reviews its fixed maturity and equity securities portfolio to evaluate the necessity of recording impairment losses for other-than-temporary declines in the fair value of investments. A number of criteria are considered during this process including, but not limited to, the current fair value as compared to cost or amortized cost, as appropriate, of the security, the length of time the security’s fair value has been below cost or amortized cost, and by how much, specific credit issues related to the issuer and current economic conditions. Also, the Company estimates the cash flows over the life of purchased beneficial interests in securitized financial assets. Based on current information and events, if the Company estimates that the fair value of its beneficial interests is not greater than or equal to its carrying value and if there has been a decrease in the estimated cash flows since the last revised estimate, considering both timing and amount, then an other-than-temporary impairment is recognized and the purchased beneficial interest is written down to fair value. Other-than-temporary impairment losses result in a permanent reduction of the cost basis of the underlying investment.

Significant changes in the factors the Company considers when evaluating investments for impairment losses could result in a significant change in impairment losses reported in the consolidated financial statements.

Valuation Allowances on Mortgage Loans on Real Estate

The Company provides valuation allowances for impairments of mortgage loans on real estate based on a review by portfolio managers and its investment committee. Mortgage loans on real estate are considered impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. When the Company determines that a loan is impaired, a provision for loss is established equal to the difference between the carrying value and the estimated value of the mortgage loan. Estimated value is based on the present value of expected future cash flows discounted at the loan’s effective interest rate, or the fair value of the collateral if the loan is collateral dependent. Loans in foreclosure and loans considered impaired are placed on nonaccrual status. Interest received on nonaccrual status mortgage loans on real estate is included in net investment income in the period received.

The valuation allowance account for mortgage loans on real estate is maintained at a level believed adequate by the Company to absorb estimated credit losses. The Company’s periodic evaluation of the adequacy of the allowance for losses is based on past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower’s ability to repay, the estimated value of the underlying collateral, composition of the loan portfolio, current economic conditions and other relevant factors. Significant changes in the factors the Company considers in determining the valuation allowance on mortgage loans on real estate could result in a significant change in the valuation allowance reported in the consolidated financial statements.

Federal Income Taxes

Beginning with the year ended December 31, 2002, the Company files a consolidated federal income tax return with ZHCA. Deferred taxes are provided on the temporary differences between the tax and financial statement basis of assets and liabilities.

The Company provides for federal income taxes based on amounts the Company believes it will ultimately owe. Inherent in the provision for federal income taxes are estimates regarding the deductibility of certain expenses and the realization of certain tax credits. In the event the ultimate deductibility of certain expenses or the realization of certain tax credits differs from its estimates, the Company may be required to significantly change the provision for federal income taxes recorded in the consolidated financial statements.

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A written agreement provides the method of allocating tax between the Company and ZHCA. In general, allocation is based upon a separate return calculation with no immediate benefit for a taxable loss which is utilized in the current year consolidated return. Intercompany tax balances are settled within thirty days after: the filing of the consolidated federal income tax return, the payment of an estimated payment, an additional assessment of the consolidated tax liability, a refund of the consolidated tax liability or any other reduction to the Company’s apportioned tax liability in accordance with the tax sharing agreement.

NON-GAAP FINANCIAL MEASURES

We analyze operating performance using non-GAAP financial measures titled operating income (loss) and net operating income (loss). For our reporting segments, operating income (loss) and net operating income (loss) are the basis by which management evaluates segment operating results. Operating income (loss) is calculated by excluding amortization of goodwill and intangibles, goodwill impairment, and cumulative effect of accounting changes in addition to the removal of net realized gains and losses on investments, after tax, from net income. We calculate net operating income (loss) by adjusting net income (loss) to exclude net realized gains and losses on investments, after tax. Operating income (loss) and net operating income (loss), or similar measures are commonly used in the insurance industry as measures of ongoing earnings performance. Other non-GAAP financial measures used by management include Sales (see “Premium Income” section) and Policyholder surrenders, withdrawals and death benefits (see “Claims Incurred and Other Benefits” section).

The excluded items are important in understanding our overall results of operations. It is important to note that operating income (loss) and net operating income (loss) should not be viewed as substitutes for net income (loss) from continuing operations or net income (loss) determined in accordance with GAAP, rather they are considered supplementary measures we believe are useful in analyzing our results of operations. Also, our definitions of these non-GAAP financial measures may differ from those used by other companies.

We exclude net realized gains and losses on investments, after tax, from these non-GAAP financial measures because such items are often the result of specific events, which may vary significantly in magnitude from period-to-period and may or may not be at management’s discretion. We believe that analyzing data excluding the potentially fluctuating effects of these transactions helps depict trends in the underlying revenues and profitability drivers of our business without consideration of these items.

The following tables reconcile our reported net income (loss) to net operating income (loss) and net income (loss) to operating income (loss) for each of the last three years.

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RESULTS OF OPERATIONS

We recorded a net loss of $9.2 million in 2003, compared with a net loss of $169.0 million in 2002 and net income of $51.6 million in 2001. The net loss in 2003 was significantly impacted by fully amortizing the insurance acquisition costs as a result of the Purchase Agreement. Deferral of insurance acquisition costs and amortization of insurance acquisition costs were $163.6 million higher in 2003 than 2002. These increased expenses were offset in part by an increase in realized investment gains in 2003, compared to 2002. The net loss in 2002 was primarily attributable to the impairment of the goodwill asset and lower operating earnings for 2002, compared with 2001.

Net income (loss)

The following table reflects the components of net income (loss) during the past three years:

The decrease in amortization of goodwill and other intangibles was due to the implementation of SFAS 142, Goodwill and Other Intangible Assets, issued in July 2001. SFAS 142 primarily addresses the accounting that must be applied to goodwill and other intangible assets subsequent to their acquisition. Effective January 1, 2002, SFAS 142 required that goodwill and indefinite-lived intangible assets no longer be amortized, but be tested annually for impairment at the reporting unit level.

As a result of the implementation of SFAS 142, we recorded an impairment of $21.9 million in the second quarter of 2002. In the following quarter, we wrote off the remaining balance of our goodwill asset, $156.5 million, under the direction of our indirect, 100% shareholder, ZFS’ Board of Directors.

We recorded an operating loss of $63.7 million in 2003, compared with operating income of $10.7 million in 2002, primarily due to:

offset by

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Operating income decreased to $10.7 million in 2002, compared with $51.9 million in 2001, primarily due to:

offset by

REVENUE

Net Investment Income

Pre-tax net investment income totaled $162.7 million in 2003, compared with $228.3 million in 2002, and $269.4 million in 2001. This includes our share of the operating results from equity investments in real estate consisting of other income less other expenses. The decrease in investment income in 2003 was primarily due to the transfer of invested assets to FKLA from the coinsurance agreement and the reinvestment of 2002 and 2003 sales proceeds, maturities and prepayments of fixed maturity securities into lower yielding securities due to the lower interest rate environment. Spread revenue decreased in 2003, compared with 2002, due to a larger decrease in investment income than the decrease in interest credited. Invested assets were transferred in September 2003, per the purchase agreement, which decreased average invested assets and contributed to lower investment income in 2003 than the prior year.

Spread revenue decreased in 2002, compared with 2001, due to a larger decrease in investment income than the decrease in interest credited. The decrease in investment income was primarily due to the non-recurrence of the positive impact during 2001 of placing certain mortgage loans on accrual status in the fourth quarter of 2001 (see Investments—Real Estate-Related Investments for further discussion) and the loss of investment income earned on the BOLI funds withheld account (“FWA”) during 2002. During the first quarter of 2002, we amended our BOLI reinsurance agreement with a ZFS affiliated company, Zurich Insurance Company, Bermuda Branch (“ZICBB”). Under the amended agreement, the balance in the FWA was transferred to a trust account that acts as security for the reinsurance agreement. On January 25, 2002, approximately $222.5 million in cash was transferred to the trust account. The trust account is not reflected in our consolidated financial statements but is included in ZICBB’s financial statements.

Investment income was positively impacted by $15.7 million in 2001 by the inclusion of three years of interest on loans previously carried on nonaccrual status and negatively impacted in 2002 and 2001 by purchase accounting adjustments. Under purchase accounting, the fair value of the fixed maturity investments as of January 4, 1996, the date Kemper was acquired by ZFS, became the new cost basis in those investments. The difference between the new cost basis and original par is then amortized against investment income over the remaining effective lives of the fixed maturity investments. As a result of the interest rate environment since

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January 4, 1996, the market value of the fixed maturity investments was approximately $133.9 million greater than original par. Premium amortization decreased investment income by approximately $0.9 million in 2003, compared with $1.9 million in 2002 and $2.8 million in 2001.

Foregone Investment Income

Foregone investment income is the result of fixed maturity securities that are in default and certain real estate-related investments that have been placed on nonaccrual status. Any increase in nonperforming securities, and either worsening or stagnant real estate conditions, would increase the expected adverse effect on future investment income and realized investment results. Total foregone investment income before tax on both nonaccrual real estate-related investments and nonperforming fixed maturity investments was as follows:

Net Realized Investment Gains (Losses)

The following table provides the breakdown by type of investment sold for net realized investment gains (losses), net of tax.

Net realized investment gains and (losses), net of tax

(in millions)

Net income reflects after-tax realized investment gains of $55.0 million in 2003, after-tax realized losses of $0.5 million in 2002 and after-tax realized gains of $13.4 million in 2001. Net realized investment gains were primarily due to the transfer of assets under the Coinsurance Agreement with FKLA, as described earlier in the Sales and Reinsurance Ceded/Assumed section and Note 3 of the Notes to Consolidated Financial Statements.

Net realized investment gains on fixed maturity securities in 2003 were primarily due to the transfer of assets under the Coinsurance Agreement with FKLA. The $1.6 million of after-tax write-downs are related to other-than-temporary declines in value of certain securities, primarily certain airline issues. Net realized investment gains on fixed maturity securities in both 2002 and 2001 were primarily due to the sale of securities in a decreasing interest rate environment that resulted in higher market values in fixed maturity investments. Significantly offsetting these realized gains in 2002 and 2001 were other-than-temporary declines in value of certain securities due to credit-related concerns about a number of issuers and collateralized bond obligation impairment losses related to Emerging Issues Task Force Issue No. 99-20, Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets. (See “Investments” section). These write-downs totaled $12.0 million and $10.1 million in 2002 and 2001, respectively.

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Unrealized gains and losses on fixed maturity investments that are available-for-sale are not reflected in net income. These changes in unrealized value are recorded as a component of accumulated other comprehensive income, net of any applicable income taxes. If, and to the extent, a fixed maturity investment suffers an other-than-temporary decline in value, the security is written down to net realizable value, and the write-down adversely impacts net income.

The real estate-related gains in 2001 were primarily due to the release of reserve allowances originally recorded against certain mortgage loans. (See “Investments” section).

The other gains, net, for 2003 are primarily due to the transfer of assets under the Coinsurance Agreement with FKLA. The other losses, net, for 2002 consisted primarily of a write-down on a leveraged lease that covered two aircraft. The aircraft are leased by United Airlines (“UAL”) and were written down to zero subsequent to UAL filing Chapter 11 bankruptcy in the fourth quarter of 2002. The pre-tax write-down totaled $17.5 million.

We regularly monitor our investment portfolio and as part of this process review the assets for possible impairments of carrying value. Because the review process includes estimates involving changing economic conditions and other factors, there can be no assurance that current estimates will prove accurate over time.

Premium Income

During 2003, we primarily received premiums from renewal business and a lesser proportion from new business. We discontinued all new sales of our products during the year and, as of December 31, 2003, we do not offer any products for new business but, continue to receive premium income from renewal business.

The Company regularly monitors and reports a non-GAAP financial measure titled sales. Sales or similar measures are commonly used in the insurance industry as a measure of business generated in the period. Sales should not be viewed as a substitute for revenues or premium income determined in accordance with GAAP, and the Company’s definition of sales might differ from that used by other companies. Sales generate customer funds managed and administered, which ultimately drive revenues and premium income. Sales are primarily comprised of statutory premiums and deposits on individual and group annuities and life insurance products sold to a diverse customer base. Statutory premiums and deposits are calculated in accordance with accounting practices prescribed or permitted by regulatory authorities and then adjusted to arrive at sales. Premium income is generated from both current and previous sales that are in-force during part of the reporting period and are reported as policy charges, life insurance premiums, net investment income and other revenues. Premium income is generated primarily based on charges against the in-force or surrendering contracts based on a fraction of the value of the contract while sales relate primarily to the amount of premiums and deposits received in a period.

The Company believes that the presentation of sales as measured for management purposes enhances the understanding of the Company’s business and helps depict trends that may not be apparent in the results of operations due to differences between the timing of sales and revenue recognition.

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The following table reflects our sales and reinsurance assumed:

Sales and reinsurance assumed

(in millions)

Sales of annuity products consist of total deposits received, which are not recorded as revenue within the consolidated statements of operations. Variable annuity deposits, including deposits under the fixed account option, decreased $497.9 million in 2003, compared with 2002, and decreased $1.6 billion in 2002, compared with 2001. The decrease in the variable annuity deposits over both years was primarily due to lower sales of our DESTINATIONS^SM product. In the fourth quarter of 2001, we discontinued offering the GRIB option with the DESTINATIONS^SM product due to the continued decline in the stock market and, in the first quarter of 2003, we discontinued all sales of DESTINATIONS^SM. We continue to receive additional deposits on existing contracts.

Fixed annuity deposits decreased $153.3 million in 2003, compared with 2002 while fixed annuity deposits increased $228.3 million in 2002 when compared with 2001. This fluctuation was primarily due to the successful promotion of our Zurich Classic II fixed annuity product in the second half of 2002 through the first quarter of 2003.

In 2003, we entered into a modified coinsurance treaty with an affiliate, FNWL, in which we reinsure all of FNWL’s existing and subsequent new issues of certain fixed annuities. (See “Reinsurance” section and Note 3 of the Notes to Consolidated Financial Statements) In exchange, we receive all reinsurance premiums and pay benefits to the policyholders relating to these contracts. In 2003, we assumed $743.7 million in fixed annuity premiums.

Sales of BOLI decreased $580.8 million to $282.9 million in 2003, compared with $863.7 million in 2002. In 2003, as part of the Coinsurance Agreement with FKLA we have agreed not to issue any new BOLI policies, with certain exceptions, which resulted in the decrease in sales. The majority of the BOLI sales were attributable to renewal premiums. Due to the nature of the BOLI product—high dollar volume per sale, low frequency of sales, the level of BOLI sales has fluctuated, sometimes significantly, between periods. We anticipate there will be limited issuance of BOLI policies going forward.

Sales of BOLI increased $348.4 million to $863.7 million in 2002, compared with $515.3 million in 2001, the majority of which was attributable to renewal premiums. Due to the nature of the product – high dollar volume per sale, low frequency of sales, the level of BOLI sales fluctuated, sometimes significantly, between periods. Continued maturation of the BOLI market and our ratings as a company also affected the level of BOLI sales.

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Sales of separate account variable universal life insurance decreased $5.4 million to $12.3 million in 2003, compared with $17.7 million in 2002 as we exited this product line in 2002 due to lack of scale and profitability.

Sales of individual variable universal life insurance decreased $11.9 million to $17.7 million in 2002, compared with $29.6 million in 2001 as we exited this product line in 2002 due to lack of scale and profitability. Sales of these separate account variable products pose minimal investment risk as policyholders also direct their premium to one or more subaccounts that invest in underlying investment funds which invest in stocks and bonds.

We receive premium tax and DAC tax expense loads from certain policyholders, as well as administrative fees and cost of insurance charges. These fees and charges are compensation for providing life insurance coverage to the policyholders potentially in excess of their cash surrender values.

The face amount of new variable universal life insurance business issued amounted to $0.1 billion in 2002, compared with $2.2 billion in 2001. The decrease in face amount issued in 2002, compared with 2001, was primarily due to the decrease in first year sales of BOLI.

The following table reconciles our sales with premium income, as reported in our Consolidated Statements of Operations:

Separate Account Fees and Charges

Separate account fees and charges are generated by both BOLI and non-BOLI variable life insurance and annuity products. Separate accounts generally pose minimal investment risk to the Company as policyholders direct their premium to one or more subaccounts that invest in underlying investment funds which invest in stocks and bonds. The customer bears the investment risk on these stocks or bonds; however, the risk is subject to any underlying guaranties provided in the contract. We receive premium tax and DAC tax expense loads from certain policyholders, as well as administrative fees and cost of insurance charges. These fees and charges are compensation for providing life insurance coverage to the policyholders potentially in excess of their cash surrender values. Additional fees are charged to cover specific benefit options elected by the policyholders, such as the GRIB option.

Separate account fees and charges

(in millions)

Included in direct separate account fees and charges are administrative and other fees received from the separate account products of $77.4 million in 2003, compared with $79.0 million in 2002 and $66.7 million in 2001. The decrease in administrative and other fee revenue in 2003, compared with 2002, was due to reinsurance

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agreements decreasing non-BOLI fees and also certain policyholders’ account values that have increased above $50,000 due mainly to the increase in the equity markets. Records maintenance charges on contracts above $50,000 are waived. Administrative and other fee revenue increased in 2002, compared with 2001, mainly due to growth in average separate account assets, somewhat offset by the decline in the stock market, as the fees are primarily asset-based.

Also included in separate account fees and charges are cost of insurance (“COI”) charges related to variable universal life insurance, primarily BOLI, of $184.8 million, $163.1 million, and $162.1 million in 2003, 2002, and 2001, respectively. Of these COI charges, $177.8 million, $156.5 million, and $168.1 million, in 2003, 2002 and 2001, respectively, were ceded to ZICBB.

Net BOLI cost of insurance charges and fees increased $1.8 million in 2003 compared with 2002, primarily due to an amended agreement with ZICBB to change the cost of insurance charges base to increase mortality reserves. Net BOLI cost of insurance charges and fees increased $12.8 million in 2002, compared with 2001, primarily related to the transfer of the assets supporting the FWA to a trust. Prior to the 2001 transfer, we ceded additional cost of insurance charges due to appreciation of the FWA, resulting in ceded COI charges in excess of 100% of direct COI charges received.

Broker-dealer Commission Revenue

Broker-dealer commission revenue decreased $9.8 million in 2003 compared with 2002 due in large part to the sale of subsidiaries that generated these revenues in September 2003 per the Purchase Agreement. The 2003 decrease was in line with a $9.3 million decrease in broker-dealer expenses. Broker-dealer commission revenue increased $2.5 million in 2002, compared with 2001. This increase was substantially offset by an increase in broker-dealer commission expense in 2002.

Other Income

Other income decreased $5.8 million in 2003, compared with 2002. The decrease was due to the write-off of fixed assets, policy loan balances, and other assets that were deemed either uncollectible or non-recoverable during 2003. Additionally, surrender charge revenues declined from $10.1 million, in 2002, to $7.6 million, in 2003. The reduction in surrender charge revenue in 2003 was due to decreased policyholder surrender and withdrawal activity.

Other income increased $3.0 million in 2002, compared with 2001, primarily due to surrender charge revenues. Surrender charge revenue totaled $10.1 million in 2002, compared to $6.5 million in 2001. The 2002 increase in surrender charge revenue reflects the increased policyholder surrender and withdrawal activity, excluding BOLI, during the same period.

BENEFITS AND EXPENSES

Interest credited to policyholders

Interest credited to policyholders decreased $38.1 million in 2003 compared to 2002 and decreased $6.2 million in 2002 compared to 2001. The decrease in interest credited in 2003 was due to the Coinsurance Agreement with FKLA and to lower average interest crediting rates reflecting the declining interest rate environment and by lower average policyholder account balances. The decrease in interest credited in 2002, compared to 2001, was due to lower average interest crediting rates reflecting the declining interest rate environment offset by higher average policyholder account balances.

Claims Incurred and Other Benefits

Claims incurred and other policyholder benefits decreased $49.0 million in 2003, compared with 2002, primarily due to the coinsurance agreement with FKLA and to reduced policyholder reserves for GMDB on certain of our variable annuity contracts due to an improved stock market in 2003. The decrease was partially

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offset by an increase in GRIB reserves in 2003. Since the GRIB reserve is based on present value calculations, it will continue to increase as the payment date nears. Claims incurred and other policyholder benefits increased $40.7 million in 2002, compared with 2001, primarily due to an increase in policyholder reserves for GMDB and GRIB due to increasing variable annuity business in-force and a lower stock market. We reserve for death benefit guaranties in our variable annuities. For policies that were deemed to have elected annuitization, GRIB reserves have been established to cover the present value of future benefits. A decline in the stock market would have the impact of increasing these GMDB and GRIB reserves.

Reflecting the current interest rate environment and other competitive market factors, we adjust crediting rates on interest-sensitive products over time in order to manage spread revenue and policyholder surrender and withdrawal activity. Spread revenue can also be improved over time by increasing investment income.

Policyholder surrenders, withdrawals and death benefits

(in millions)

General account surrenders, withdrawals and death benefits decreased $132.8 million in 2003, compared with 2002, due to a decrease in both death benefits and surrenders and withdrawals. General account surrenders, withdrawals and death benefits decreased $92.3 million in 2002, compared with 2001, due to a decrease in overall surrenders and withdrawals as equity markets were volatile.

Surrenders, withdrawals and death benefits on separate account products decreased $55.3 million in 2003, compared with 2002. The decrease reflects lower surrenders and withdrawals as equity markets increased during 2003, generally increasing the market value of separate account assets. The decrease was offset in part by increased death benefits in 2003 compared to 2002. Surrenders, withdrawals and death benefits on separate account products increased $28.3 million in 2002, compared with 2001. Excluding surrenders of $92.4 million on BOLI contracts in 2001, the majority of which was a contract with an affiliate, surrenders, withdrawals and death benefits on separate account products increased $120.7 million in 2002, compared with 2001. The increase was primarily due to investors’ seeking more stable returns during a period of equity market uncertainty.

The following table reconciles our policyholder surrenders, withdrawals and death benefits with claims incurred and other policyholder benefits, as reported in our Consolidated Statements of Operations:

Premiums paid by and benefits paid to policyholders related to annuity and certain life insurance products are treated as investment contract deposits and payments, respectively, per GAAP. Premiums are treated as deposits (increases) to policyholders’ account balances and benefits are treated as payments (decreases) from policyholders’ account balances. The increase (decrease) in reserves primarily represents estimated future guaranteed policyholder benefits. Interest on benefits and other is primarily interest that accrues on annuity benefits and death benefits before pending claims are settled.

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Pursuant to GAAP, no additional liabilities for future policy benefits related to GMDB and GRIB have been established as of December 31, 2003. However, starting in January, 2004, the recognition of future policy benefits for GMDB and GRIB and its impact on the Company’s financial statements will vary from the amounts reported as of December 31, 2003 and 2002 due to the implementation of a new accounting pronouncement, Statement of Position 03-1 “Accounting and Reporting by Insurance Enterprises for Certain Non Traditional Long Duration Contracts and for Separate Accounts.” (See the Future Adoption of New Accounting Standards section and Note 14 of the Notes to Consolidated Financial Statements.)

Taxes, Licenses & Fees

Taxes, licenses and fees primarily reflect taxes assessed on premiums related to BOLI. Taxes, licenses and fees decreased $21.1 million in 2003 compared to 2002 and increased $8.5 million in 2002 compared to 2001. The decrease in 2003 was due to a decrease in BOLI renewal premiums. The increase in 2002 was primarily due to an increase in BOLI renewal premiums during the year.

Commissions and Operating Expenses, Net of the Deferral of Insurance Acquisition Costs

Commissions and operating expenses, net of the deferral of insurance acquisition costs, decreased $28.0 million to $26.7 million in 2003, compared with $54.5 million in 2002. The decrease was primarily due to the coinsurance to FKLA in 2003. Commissions and operating expenses, net of the deferral of insurance acquisition costs were virtually unchanged in 2002 compared with 2001 at $54.5 million and $54.2 million, respectively.

Amortization of Insurance Acquisition Costs

Amortization of insurance acquisition costs increased $116.8 million in 2003, compared with 2002, primarily due to the write-off of deferred insurance acquisition costs related to the blocks of business ceded to FKLA. Amortization of insurance acquisition costs increased $16.9 million in 2002, compared with 2001. This net increase was attributable to lower future estimated gross profits (EGPs) due to the continued decline in the stock market, realized capital gains on investments and a lower yielding investment portfolio.

The percentage increase in the S&P 500 for the year ended December 31, 2003, was 26.4% while 2002 and 2001 had reductions of (23.4)%, and (13.0)%, respectively. Appreciation in the stock market in 2003 resulted in increases in separate account assets, which also increased asset-based separate account fees and future EGPs. This slowed amortization in the current period. Depreciation in the stock market in 2002 and 2001 resulted in decreases in separate account assets, which reduced asset-based separate account fees and future EGPs. This accelerated amortization in 2002 and 2001. Realized capital gains on investments increased current gross profits, decreasing future EGPs, and accelerated amortization in the current period. The lower yielding investment portfolio compresses future interest margins (spread income) which reduces future EGPs and also accelerates current year amortization.

Amortization of Value of Business Acquired

Deferred insurance acquisition costs, for policies sold prior to the Company’s acquisition were replaced under purchase accounting by the value of business acquired (“VOBA”). The VOBA reflects the present value of the right to receive future cash flows from insurance contracts existing at the date of acquisition. The amortization of the VOBA is calculated assuming an interest rate equal to the liability or contract rate on the business acquired. Deferred insurance acquisition costs are established on all new policies sold after this acquisition.

In 2003, the underlying acquired business which we had been amortizing was transferred to FKLA as part of the Purchase Agreement, resulting in amortization of $56.8 million, and a zero balance at December 31, 2003. For 2002 and 2001, depreciation in the stock market continued to decrease the separate account assets and the related asset-based separate account fees over the past few years. The continued reduction in the asset-based

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separate account fees decreased the current and future EGPs in 2002 and 2001. The amortization of the VOBA over the past several years reflects the net impact that the decline in the stock market has had on the current and future EGPs of the pre-acquisition annuity contracts. A lower yielding investment portfolio also impacted VOBA amortization in 2002. The lower yielding investment portfolio compressed future interest margins (spread income) which reduced future EGPs and accelerated current year amortization.

Goodwill Impairment and Amortization of Goodwill and Other Intangibles

As previously discussed, during 2002, we wrote off the remaining goodwill asset that was on the books at December 31, 2001. In accordance with SFAS 142, no amortization was recorded in 2002 related to the goodwill asset. Other intangible assets related to the purchase of PMG continued to be amortized on a straight-line basis through August 2003, until PMG was sold to Bank One in accordance with the Purchase Agreement.

Income Tax Expense (Benefit)

Income tax benefit for 2003 increased by $12.9 million, compared with 2002, primarily due to a $55.0 million deferred tax expense incurred in 2002 as a result of goodwill impairment and amortization of other intangible expense. Tax expense for 2002 decreased by $30.5 million, compared with 2001, primarily due to lower operating earnings in 2002, compared to 2001 and realized capital losses in 2002, compared to realized capital gains in 2001. The prior year’s provision to return adjustments created a tax benefit of $2.2 million during 2002. There were no such adjustments during 2001. Tax expense also decreased by $3.6 million in 2002 related to a tax settlement with the Internal Revenue Service.

ASSETS UNDER MANAGEMENT

The following table reflects our assets under management:

Assets under management

(in millions)

Total assets under management decreased in 2003, compared with 2002, primarily reflecting the transfer of assets as part of the Coinsurance Agreement with FKLA. Total assets under management were also affected by equity market and interest rate fluctuations. The level of policyholder surrenders, withdrawals and death benefits also directly impacts the level of assets under management from year to year.

Investments

Our principal investment strategy is to maintain a balanced, well-diversified portfolio supporting the insurance contracts written. We make shifts in our investment portfolio depending on, among other factors:

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A changing marketplace has affected the life insurance industry. To accommodate customers’ increased preference for safety over higher yields, we have systematically reduced our investment risk. During 2003, the portfolio decreased $3.2 billion due to asset sales and transfers resulting from the Purchase Agreement with Bank One. We continue to invest in higher quality, lower risk investments. During 2002, because of continued poor economic conditions, which resulted in both write-downs and credit-related losses in our fixed income portfolio, we repositioned this portfolio. The losses in 2002 were largely offset by realized gains on sales in the portfolio and the proceeds were primarily reinvested in higher quality, less risky investments at the expense of reducing our portfolio yield. This should result in less volatility in our fixed income portfolio in the future.

Our cash flow is carefully monitored and our investment program is regularly and systematically planned to provide funds to meet all obligations and to optimize investment return. For the majority of investment securities, portfolio management is handled by Deutsche Investment Management Americas, Inc. (“DIM”). DIM provides investment services including purchases and sales of securities, under the supervision of the Investment Committee of the Company.

Invested assets and cash

(in millions)

Fixed Maturity Securities

We carry our fixed maturity investment portfolio, which is considered available-for-sale, at estimated fair value. The aggregate unrealized appreciation or depreciation is recorded as a component of accumulated other comprehensive income, net of deferred taxes. The change in unrealized gains and losses on fixed maturity securities at December 31, 2003 was a decrease of $115.6 million. The change in unrealized gains and losses on fixed maturity securities at December 31, 2002 was an increase of $69.4 million.

At December 31, 2003, investment-grade fixed maturity securities, cash and short-term investments accounted for 90.1% of invested assets and cash, compared with 85.7% at December 31, 2002. Approximately 55.6% of our NAIC Class 1 bonds were rated AAA or equivalent at year-end 2003, compared with 48.0% at December 31, 2002.

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Approximately 14.4% of the investment-grade fixed maturity securities at December 31, 2003 were residential mortgage-backed securities, down from 16.2% at December 31, 2002. Approximately 8.6% of the investment-grade fixed maturity securities at December 31, 2003 were commercial mortgage-backed securities, compared with 6.3% at December 31, 2002. The residential mortgage-backed securities consist primarily of marketable mortgage pass-through securities issued by the Government National Mortgage Association, the Federal National Mortgage Association or the Federal Home Loan Mortgage Corporation and other investment-grade securities collateralized by mortgage pass-through securities issued by these entities. We have not made any investments in interest-only or other similarly volatile tranches of mortgage-backed securities. Our mortgage-backed investments are generally of AAA credit quality, and the markets for these investments have been and are expected to remain liquid.

Approximately 14.2% and 7.3% of the investment-grade fixed maturity securities consisted of asset-backed securities at December 31, 2003 and 2002, respectively. At December 31, 2003, the majority of investments in asset-backed securities were backed by automobile loans (22.7%), credit card loans (21.9%), collateralized loan and bond obligations (19.4%), and manufactured housing loans (18.4%). At December 31, 2002, the majority of investments in asset-backed securities were backed by home equity loans (34.7%), manufactured housing loans (17.7%), collateralized loan and bond obligations (15.4%) and automobile loans (13.1%).

Future investment income from mortgage-backed securities and other asset-backed securities may be affected by the timing of principal payments and the yields on reinvestment alternatives available at the time of such payments. Prepayment activity resulting from a decline in interest rates on such securities purchased at a premium would accelerate the amortization of the premiums. Accelerated amortization would result in reductions of investment income related to such securities.

At December 31, 2003 and 2002, unamortized premiums and discounts related to mortgage-backed and asset-backed securities were as follows (in millions):

Amortization of the discount or premium from mortgage-backed and asset-backed securities is recognized using a level, effective yield method. This method considers the estimated timing and amount of prepayments of the underlying loans and is adjusted to reflect differences between the prepayments originally anticipated and the actual prepayments received and currently anticipated. To the extent that the estimated lives of these securities change as a result of changes in prepayment rates, the adjustment is also included in net investment income.

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The table below provides information about the mortgage-backed and asset-backed securities that are sensitive to changes in interest rates. The expected maturity dates have been calculated on a security by security basis for asset-backed securities and collateralized mortgage obligations. Mortgage pass-through expected maturities are calculated on expected cash flow given certain prepayment assumptions. An iterative process is used to determine the implied rate embedded in the current market price and is consistent with the current interest rate and economic environment.