Back to GetFilings.com

Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D. C. 20549

FORM 10-Q

(Mark One)

For the quarterly period ended September 30, 2004.

For the transition period from              to             .

Commission file number 033-43462

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  x    No  ¨.

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

As of October 31, 2004, there were outstanding 250,000 shares of common stock, $10.00 par value per share, of the registrant.

Documents incorporated by reference: None.

Table of Contents

KEMPER INVESTORS LIFE INSURANCE COMPANY

FORM 10-Q

PART I. FINANCIAL STATEMENTS

Table of Contents

PART 1. FINANCIAL STATEMENTS

ITEM 1. Interim Financial Statements

Kemper Investors Life Insurance Company

Balance Sheets

(in thousands, except share data)

See accompanying notes to consolidated financial statements.

- 1 -

Table of Contents

Kemper Investors Life Insurance Company and Subsidiaries

Consolidated Statements of Operations

(in thousands)

(unaudited)

See accompanying notes to consolidated financial statements.

- 2 -

Table of Contents

Kemper Investors Life Insurance Company and Subsidiaries

Consolidated Statements of Comprehensive Income (Loss)

(in thousands)

(unaudited)

See accompanying notes to consolidated financial statements.

- 3 -

Table of Contents

Kemper Investors Life Insurance Company and Subsidiaries

Consolidated Statements of Cash Flows

(in thousands)

(unaudited)

See accompanying notes to consolidated financial statements.

- 4 -

Table of Contents

Kemper Investors Life Insurance Company and Subsidiaries

Notes to Consolidated Financial Statements (unaudited)

Kemper Investors Life Insurance Company, (the “Company” or “KILICO”) is licensed in the District of Columbia and all states, except New York. Zurich Life Insurance Company of New York (“ZLICONY”), a wholly-owned subsidiary through September 3, 2003, is licensed to conduct business in the State of New York. The Company also owned PMG Life Agency, Inc., PMG Marketing, Inc., PMG Securities Corporation and PMG Asset Management, Inc., collectively referred to as the PMG group of companies (“PMG”), Investors Brokerage Services, Inc., and Investors Brokerage Services Insurance Agency, Inc. through September 3, 2003. The Company is a wholly-owned subsidiary of 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”), a Swiss holding company.

We have prepared the accompanying consolidated financial statements pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”) for interim financial reporting. As used herein, the “Company,” “we,” “our” and similar terms include Kemper Investors Life Insurance Company and its wholly-owned subsidiaries through September 3, 2003, unless the context indicates otherwise. These consolidated financial statements are unaudited and, in our opinion, include all adjustments, consisting of normal recurring adjustments and accruals necessary for a fair presentation of the balance sheets, consolidated operating results, and consolidated cash flows for the periods presented. Operating results for the periods presented are not necessarily indicative of the results that may be expected for the year ending December 31, 2004. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States (“GAAP”) have been omitted in accordance with the rules and regulations of the SEC. These consolidated financial statements should be read in conjunction with the audited consolidated financial statements and accompanying notes included in our Annual Report on Form 10-K for the year ended December 31, 2003. Certain prior period amounts have been reclassified to conform to the current period presentation. The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries through September 3, 2003. Intercompany balances and transactions have been eliminated.

Use of Estimates

The preparation of financial statements in conformity with GAAP requires estimates and assumptions that affect the reported amounts of assets and liabilities, revenues and expenses, and related disclosures of contingent assets and liabilities in the consolidated financial statements and accompanying notes. Estimates are used for, but not limited to, deferred insurance acquisition costs, provisions for real estate-related losses and reserves, other temporary declines in values for fixed maturity and equity securities, the valuation allowance for deferred income taxes and future policy benefit reserves. Actual results could differ materially from those estimates.

BANK ONE. On September 3, 2003 (the “Closing Date”), 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.

- 5 -

Table of Contents

These transfers were part of a larger transaction pursuant to a Stock and Asset Purchase Agreement, dated as of May 29, 2003 (the “Purchase Agreement”), between ZHCA, Kemper, KILICO, 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 further agreed to acquire control of all the KILICO Subsidiaries.

On September 3, 2003 the Company transferred most of the general account liabilities through a one hundred percent coinsurance arrangement, ceded 100% of all direct individual life insurance renewal premiums and ceded a majority of the separate account liabilities on a modified coinsurance basis to FKLA. Reinsured policies also included certain policies to be written by the Company through September 3, 2004. Ownership of the underlying separate account assets was not transferred to FKLA. The Company remains 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

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 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 September 30, 2004, the reinsurance recoverable from FKLA was approximately $3.5 billion compared to approximately $3.6 billion at December 31, 2003.

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 Business 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 $120.0 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 closing adjustment resulted in a $9.3 million decrease in payable to reinsurers on the balance sheet as of February 2004.

The Company previously assumed from FKLA $100.0 million in premiums related to a Funding Agreement. Funding Agreements are insurance contracts similar to structured settlements, immediate annuities and guaranteed investment contracts (“GICs”). The contracts qualify as insurance under state laws and are sold as non-surrenderable immediate annuities to a trust established by a securities firm. The securities firm sold interests in the trust to institutional investors. This Funding Agreement has a variable rate of interest based upon LIBOR, is an obligation of the Company’s general account, is recorded as a future policy benefit, and will expire in November 2004. At September 30, 2004, the Funding Agreement balance was $100.7 million compared to $100.2 million at December 31, 2003.

- 6 -

Table of Contents

FNWL. The Company entered into a modified coinsurance treaty (the “Modified Coinsurance Agreement”) on December 1, 2003 with an affiliate, Farmers New World Life Insurance Company (“FNWL”). FNWL is a stock life insurance company domiciled in the state of Washington. 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. No portion of the assets constituting the consideration was 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. The Modified Coinsurance Agreement requires the separate recording of an embedded derivative in the financial statements of the Company per SFAS 133, Implementation Issue B36, Embedded Derivatives: Modified Coinsurance Arrangements and Debt Instruments That Incorporate Credit Risk Exposures That Are Unrelated or Only Partially Related to the Creditworthiness of the Obligor under Those Instruments (“DIG B36”) and was valued at $28.9 million at September 30, 2004. The modified coinsurance receivable from FNWL was $797.0 million and $762.5 million at September 30, 2004 and December 31, 2003, respectively. The modified coinsurance payable to FNWL was $786.9 million and $758.9 million, at September 30, 2004 and December 31, 2003, respectively.

FLA. The Company’s ceded future policy benefits reflect coinsurance (indemnity reinsurance) transactions where the Company insured liabilities in 1991 and 1992 with FLA. The reinsurance recoverables were approximately $200.8 million and approximately $207.7 million at September 30, 2004 and December 31, 2003, respectively.

TRANSAMERICA RE. The net amount at risk of the guaranteed minimum death benefits (“GMDB”) and guaranteed retirement income benefits (“GRIB”) on certain variable annuity contracts issued between March 1, 1997 and April 30, 2000 were ceded to outside reinsurers. As of September 30, 2004 and December 31, 2003, the reinsurance recoverable related to reinsuring the net amount at risk on these contracts with Transamerica Re amounted to approximately $67.1 million and approximately $26.3 million, respectively.

ZICBB. The Company is also a party to a reinsurance agreement with an affiliated company, Zurich Insurance Company, Bermuda Branch (“ZICBB”). Under the terms of this agreement, the Company cedes, on a yearly renewable term basis, approximately 98% of the net amount at risk (death benefit payable to the insured less the insured’s separate account cash surrender value) related to separate account BOLI. As consideration for this reinsurance coverage, the Company cedes separate account fees (cost of insurance charges) to ZICBB. At September 30, 2004 and December 31, 2003, reinsurance recoverables totaling approximately $230.8 million and approximately $206.2 million, respectively, were secured by a trust agreement, which was supported by cash and invested assets with a fair value of approximately $255.0 million and $235.4 million at September 30, 2004 and December 31, 2003, respectively.

SOP 03-1

In July 2003, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants (“AcSEC”) issued a final Statement of Position 03-1, “Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts” (the “SOP” or “SOP 03-1”). The SOP was adopted effective January 1, 2004. The SOP addresses a wide variety of topics, some of which have a significant impact on the Company. The major provisions of the SOP require the Company to:

- 7 -

Table of Contents

On January 1, 2004, the Company recorded a $157.9 million cumulative effect adjustment to earnings. The cumulative adjustments to earnings and other comprehensive income were recorded net of amortization of deferred acquisition costs and income taxes. At January 1, 2004, the date of initial application, the cumulative effect of the adoption of the SOP was comprised of the following individual impacts:

Cumulative Effect of Adoption

(in millions)

GMDB and GRIB Reserves for Annuity Contracts. The Company sold variable annuity contracts with guaranteed minimum death benefits (“GMDB”) and guaranteed retirement income benefits (“GRIB”) equal to the greater of (1) the account value; (2) the sum of all premium payments less prior withdrawals accumulated at 5%; or (3) the maximum anniversary value of the contract, plus any premium payments since the contract anniversary, minus any withdrawals following the contract anniversary. The GMDB is payable upon death. For policies with GRIB, the guarantee applies to the funds available to purchase an annuity after seven years. The Company currently reinsures approximately 31% of the benefit guarantees associated with its in-force block of business. As of December 31, 2003, prior to the adoption of SOP 03-1, the Company had recorded a liability for GMDB and GRIB benefits sold with variable annuity products of approximately $46.6 million. Subsequent to the adoption of the SOP, the Company recorded an additional liability for GMDB and GRIB benefits of approximately $6.4 million. For the nine month period ended September 30, 2004, $36.5 million of additional future policyholder liabilities related to the GMDB and GRIB benefits were recorded due to SOP 03-1. The determination of the GMDB and GRIB liability and related reinsurance recoverable is based on models that involve a range of scenarios and assumptions, including those regarding expected market rates of return and volatility, contract surrender rates, annuitization elections and mortality experience. The models use 1,000 stochastic equity scenarios selected from the American Academy of Actuaries’ C3 Phase 2 Report. The assumptions used are consistent with those used in determining estimated gross profits for purposes of amortizing deferred acquisition costs. SOP 03-1 modified how liability reserves are calculated for the variable annuity contracts issued by the Company. Prior to SOP 03-1, a GMDB reserve was established for all contracts and a GRIB reserve was established only for contracts deemed to have annuitized. These reserves reflected the present value of future benefits with no offset against future revenues. Under SOP 03-1, a reserve is established for all contracts, resulting in additional recognition of future policy benefits. However, the reserve is reduced by a percentage of future revenues, resulting in a relatively small reserve increase at implementation.

- 8 -

Table of Contents

Amortization of Deferred Insurance Acquisition Costs. The Company has deferred certain acquisition costs (“DAC”) in accordance with SFAS 97 “Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments,” and amortizes those costs over the term of the policies. With the initial adoption of the SOP, $236.5 million of DAC was amortized to reflect the reduction in future estimated gross profits (EGPs) in the amount by which future revenues offset future benefits in the reserve calculation.

Gross Exposure or Net Amount at Risk

(in millions)

At both December 31, 2003 and September 30, 2004, the Company held approximately $3.8 billion of variable annuities that contained GMDB and GRIB benefits. The Company’s total gross exposure (i.e. before reinsurance), or net amount at risk (the amount by which current account values in the variable annuity contracts are not sufficient to meet its GMDB and GRIB commitments), related to these guaranteed death and annuitization benefits was approximately $947.1 million at September 30, 2004 and was approximately $739.5 million at December 31, 2003. After reinsurance, the Company’s net exposure was approximately $629.1 million and $462.7 million at September 31, 2004 and December 31, 2003, respectively.

Summary of Liabilities for Guarantees

(in millions)

Separate Account Presentation. The Company had recorded certain market value adjusted (“MVA”) fixed annuity products as separate account assets and liabilities through December 31, 2003. Notwithstanding the MVA feature in this product, all of the investment performance of the separate account assets is not being passed to the contractholder, and it therefore does not meet the conditions for separate account reporting under the SOP.

On January 1, 2004, market value reserves of approximately $64.1 million included in separate account liabilities were revalued at their current account value to the general account, and the related separate account assets were also reclassified to the general account. Fixed maturities and equity securities were reclassified to the general account, as available for sale securities, and will continue to be recorded at fair value; however, subsequent changes in fair value, net of amortization of deferred acquisition costs and income taxes, are recorded in other comprehensive income rather than net income. Net investment income was increased by those investments reclassified to the general account and change in claims and other policyholder benefits were increased due to changes in reserves, with a corresponding decrease in separate account fees.

- 9 -

Table of Contents

EITF 03-01

In March 2004, the Emerging Issues Task Force (“EITF”) reached a final consensus on Issue 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” (“EITF 03-1”). EITF 03-1 adopted a three-step impairment model for securities within its scope. The three-step model must be applied on a security-by-security basis as follows:

Step 1: Determine whether an investment is impaired. An investment is impaired if the fair value of the investment is less than its cost basis.

Step 2: Evaluate whether an impairment is other-than-temporary. For debt securities that cannot be contractually prepaid or otherwise settled in such a way that the investor would not recover substantially all of its cost, an impairment is deemed other-than-temporary if the investor does not have the ability and intent to hold the investment until a forecasted market price recovery or it is probable that the investor will be unable to collect all amounts due according to the contractual terms of the debt security.

Step 3: If the impairment is other-than-temporary, recognize an impairment loss equal to the difference between the investment’s cost basis and its fair value.

Subsequent to an other-than-temporary impairment loss, a debt security should be accounted for in accordance with Statement of Position (“SOP”) 03-03, “Accounting for Loans and Certain Debt Securities Acquired in a Transfer.” EITF 03-1 does replace the impairment guidance for investments accounted for under EITF Issue 99-20, “Recognition of Interest Income and Impairments on Purchased and Retained Beneficial Interests in Securitized Financial Assets” (“EITF 99-20”); however, investors will be required to determine if a security is other-than-temporarily impaired under EITF 03-1 if the security is determined not to be impaired under EITF 99-20. The disclosure provisions of EITF 03-1 were adopted by the Company effective December 31, 2003 and were included in Note 4 of the Notes to Consolidated Financial Statements incorporated in the Company’s 2003 Form 10-K Annual Report.

On September 30 2004, the Financial Accounting Standards Board (“FASB”) issued a final FASB Staff Position (“FSP”), FSP EITF Issue 03-1-1 that delays the effective date for the measurement and recognition guidance included in paragraphs 10 through 20 of EITF 03-1. The deferral is expected to last for one quarter. The disclosure requirements required by EITF 03-1 have not been deferred. In addition, during September 2004 the FASB issued a proposed FSP EITF Issue 03-1-a, which proposes guidance on the application of paragraph 16 of EITF 03-1 to debt securities that are impaired because of interest rate and/or sector spread increases. The comment period for the proposed FSP runs until October 29, 2004.

The Company is still assessing the impact of adoption of this standard on the Company’s financial condition and results of operations.

The Company has a security lending agreement with a lending agent. The agreement authorizes the agent to lend securities held in the Company’s portfolio to a list of authorized borrowers. Concurrent with delivery of the securities, the borrower provides the Company with cash collateral equal to at least 102% of the market value of the loaned securities.

The securities are marked-to-market on a daily basis, and the collateral is adjusted on the next business day. The collateral is invested in highly liquid, fixed income investments with a maturity of less than one year. Income earned from the security lending arrangement is shared 25% and 75% between the agent and the Company, respectively. Income earned by the Company was approximately $6,000 in the third quarter of 2004 and was approximately $72,000 in the third quarter of 2003. For the first nine months of 2004 and 2003, respectively, the Company earned approximately $23,000 and $271,000 from securities lending activity. The Company’s securities on loan at September 30, 2004 consisted of U.S. Treasury bonds and a corporate bond and had an estimated fair value of approximately $49.9 million. There were not any securities on loan at December 31, 2003.

- 10 -

Table of Contents

On September 30, 2004, the Company satisfied its obligation to provide a financial guarantee in the form of an extended standby credit enhancement to a third party letter of credit by funding $25.1 million to the issuer of the letter of credit. This standby credit enhancement was in support of bonds issued to finance the development of a certain retirement property in Texas, with an original expiration date of March 22, 2004. On March 15, 2004, the agreement was extended to September 30, 2004 in exchange for a nominal fee.

In the first week of October 2004, the third party fulfilled its obligation to the Company by relinquishing its rights to the collateral pool assets, valued at approximately $18.0 million, and paying the Company $7.1 million in cash. In conjunction with the transaction, the United States Treasury bond valued at $28.4 million previously deposited with the issuer of the letter of credit has been released.

In April 2003, the FASB released Statement 133 (“SFAS 133”) Implementation Issue B36, Embedded Derivatives: Modified Coinsurance Arrangements and Debt Instruments That Incorporate Credit Risk Exposures That Are Unrelated or Only Partially Related to the Creditworthiness of the Obligor under Those Instruments (“DIG B36”). DIG B36 addresses the need to separately account for an embedded derivative within a reinsurer’s receivable and ceding company’s payable arising from modified coinsurance or similar arrangements. SFAS 133 indicates that an embedded derivative must be separated from the host contract (bifurcated) if the economic characteristics and risks of the embedded derivative instrument are not clearly and closely related to the economic characteristics and risks of the host contract. DIG B36 concludes that bifurcation is necessary in a modified coinsurance arrangement because the yield on the receivable and payable is based on a specified proportion of the ceding company’s return on either its general account assets or a specified block of those assets, rather than the overall creditworthiness of the ceding company. The effective date of implementation was the first day of the first fiscal quarter beginning after September 15, 2003 (October 1, 2003 for the Company), with earlier application as of the beginning of a fiscal quarter permitted. The Company adopted DIG B36 on October 1, 2003.

On December 1, 2003, the Company entered into a Modified Coinsurance Agreement with FNWL, which was impacted by the provisions of DIG B36. The Modified Coinsurance Agreement requires the separate recording of an embedded derivative. At September 30, 2004 and December 31, 2003, the Company had an embedded derivative valued at $28.9 million and $25.9 million, respectively, recorded in modified coinsurance receivable — related party with the corresponding income and expenses recorded in modified coinsurance income (expense) — related party during the respective reporting periods.

A floating rate funding agreement was reinsured in 2000 and the Company subsequently entered into an interest rate swap agreement with a notional value of $100.0 million, which expires in November 2004 with Zurich Capital Markets, Inc., an affiliated counterparty. The interest swap is a cash flow hedge of the floating rate funding agreement. Each period, gains and losses resulting from changes in the fair value of the swap contract are recorded to accumulated other comprehensive income (loss). The terms of the swap contract have been structured to match the terms of the hedged item. No net gains or losses, resulting from hedge ineffectiveness, were recognized in results of operations, during the quarter ended September 30, 2004 or year ended December 31, 2003.

At September 30, 2004 and December 31, 2003, the swap agreement had a negative market value of approximately $ 2.2 million and approximately $4.5 million, respectively. The negative market value was included as a component of other accounts payable and liabilities in the accompanying balance sheets. A single net payment is made by one counterparty at each due date. The Company paid approximately $ 2.4 million and approximately $4.6 million year to date through September 30, 2004, and December 31, 2003, respectively, as settlement for the difference between the fixed-rate and floating-rate interest.

- 11 -

Table of Contents

The Company has two primary operating segments, life insurance and annuities. In the following table, the Company uses the captions “net operating income (loss)” and “operating income (loss)” as operating measures of segment performance. Net operating income (loss) is calculated by deducting net realized investment gains (losses) on investments after tax, from net income (loss). Operating income (loss) is calculated by excluding amortization of intangibles and cumulative effect of accounting changes in addition to the removal of net realized gains (losses) on investments, after tax, from net income (loss). Net realized investment gains or (losses) are excluded from net operating income (loss) because they can, in part, be discretionary and are not indicative of operational trends.

It is important to note that operating income (loss) and net operating income (loss) should not be viewed as substitutes for income from continuing operations before federal income taxes or net income (loss) determined in accordance with GAAP, rather they are considered supplementary measures the Company believes are useful in analyzing its results of operations. Also, the Company’s definitions of these non-GAAP financial measures may differ from those used by other companies.

- 12 -

Table of Contents

Nonaccrual loans are real estate-related investments, or mortgage loans, for which the likelihood of collection of principal or interest is doubtful. Interest does not accrue on real estate-related investments when it is judged that the likelihood of interest collection is doubtful. Troubled real estate-related investments consisted of loans on nonaccrual status primarily related to mortgage loans on properties located in Hawaii. The Hawaii property loans were paid in full in August 2004. The principal received totaled approximately $6.9 million and generated approximately $2.1 million of realized gains from the release of the reserve plus $0.3 million of realized gains from the payoff. There were no loans or reserves for loans on nonaccrual status at September 30, 2004, while $2.1 million was reserved on approximately $7.1 million of mortgage loans at December 31, 2003.

We have been named as a defendant in certain lawsuits incidental to our insurance business. 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.

In connection with a recent industry-wide probe, the Company, along with other insurers, received inquiries on November 1 and 8, 2004 from the North Carolina and Illinois departments of insurance related to compensation and marketing arrangements. Such inquiries were made in the form of a subpoena and demand for production of information. The Company is complying with the inquiries and responding in due course. The Company is currently evaluating these inquiries and has not yet determined the impact, if any, to the Company. The Company may receive similar inquiries from other state insurance departments.

- 13 -

Table of Contents

ITEM 2. 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.

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

Our Management’s Discussion and Analysis is based upon our consolidated financial statements that have been prepared in conformity with GAAP. The preparation of these 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. As a result, actual results reported as revenue and expense could differ from the estimates reported in the financial statements under different assumptions, judgments or conditions. For additional information regarding our accounting policies, refer to our December 31, 2003 Form 10-K. Although we believe that our estimates, assumptions, and judgments are reasonable, they are based upon information currently available.

Business Description

On September 3, 2003 (the “Closing Date”), 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 as of May 29, 2003 (the “Purchase Agreement”), between ZHCA, Kemper, KILICO, 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 further agreed to acquire control of all the KILICO Subsidiaries.

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.

- 14 -

Table of Contents

While the majority of our business is coinsured, we retain the majority of our DESTINATIONS^SM business. The DESTINATIONS^SM product is a registered individual and group variable, fixed and market value adjusted deferred annuity product that offers approximately 40 variable subaccount investment options with various investment managers, ten guarantee periods, a fixed account option, dollar cost averaging, Guaranteed Minimum Death Benefit (“GMDB”) and Guaranteed Retirement Income Benefit (“GRIB”) options. The GRIB was an optional benefit to the DESTINATIONS^SM variable annuity for an additional asset-based fee. It allows for a proxy account value, called the GRIB Base, to be applied to the guaranteed annuity factors (settlement option purchase rates) in the contract. The GRIB and GMDB Base prior to attained age 80 is the greatest of:

The DESTINATIONS^SM product was discontinued in the first quarter of 2003; however, we continue to receive renewal premiums for this product.

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.

Non-GAAP Financial Measures

We quantify segment operating performance using non-GAAP financial measures titled operating income (loss) and net operating income (loss). Net operating income (loss) is calculated by adjusting net income (loss) to exclude net realized gains (losses) on investments, after tax. Operating income (loss) is calculated by excluding amortization of intangibles and cumulative effect of accounting changes in addition to the removal of net realized gains (losses) on investments, after tax, from net income (loss). 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 Policyholder surrenders, withdrawals and death benefits (see “Claims Incurred and Other Policyholder Benefits” section).

The excluded items are important in understanding the Company’s 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 income from continuing operations before federal income taxes or net income (loss) determined in accordance with GAAP, rather they are considered supplementary measures the Company believes are useful in analyzing its results of operations. Also, the Company’s definitions of these non-GAAP financial measures may differ from those used by other companies.

We exclude net realized gains (losses) on investments, after tax, from these non-GAAP financial measures because such items are often the result of specific events, and may or may not be at management’s discretion. We believe that analyzing data excluding these transactions helps depict trends in the underlying revenues and profitability drivers of our business.

- 15 -

Table of Contents

The following tables reconcile our reported net income (loss) to net operating income (loss) and net income (loss) to operating income (loss) for the first three and nine months of 2004 and 2003, respectively.

Reconciliation of Net Income (Loss) to Net Operating Income (Loss)

and Net Income ( Loss) to Operating Income (Loss)

(in millions)