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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D. C. 20549

FORM 10-K

(Mark One)

For the fiscal year ended December 31, 2004.

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  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.

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 30, 2005, 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, 2004

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. 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. 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.

Sales and Reinsurance Ceded/Assumed

BANK ONE

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.

Effective July 1, 2004, Bank One Corporation (“Bank One”) merged with and into JPMorgan Chase & Co., with JPMorgan Chase & Co. being the surviving entity. On November 1, 2004, FKLA changed its name to Chase Insurance Life and Annuity Company, ZLICA changed its name to Chase Insurance Life Company and ZLICONY changed its name to Chase Insurance Life Company of New York. These entities will be referred to in this Form 10K as FKLA, ZLICA and ZLICONY.

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 (solely for purposes of certain sections), Banc One Insurance Holdings, Inc. (“BOIH”) and Bank One Corporation (solely for purposes of certain sections). 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, administers 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 that have been 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

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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 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, 2004 and 2003, the general account reserves, as defined by the Coinsurance Agreement, were $3.5 billion and $3.6 billion, respectively.

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.

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 Company’s 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 $3.4 billion for 2004 and $3.5 for 2003. Separate account assets that support the Separate Account Liabilities, but were not ceded to FKLA under the modified coinsurance arrangement, totaled $3.9 billion in 2004 and $3.6 billion in 2003.

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 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 has been and will continue to 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 interim period of one year, pursuant to a transition services agreement, FKLA provided 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

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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. Subsequent to the expiration of the transition services agreement, the Company and FNWL have performed such services. In addition to providing transition services, FKLA also provided administrative services with respect to the Company’s DESTINATIONS^SM business. In September 2004, the administration of the DESTINATIONS^SM business was transferred to a third party administrator.

The Reinsured Policies and BOLI business have been and will continue to 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 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 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 was transferred to the Company. Subsequent new issues by FNWL of NQ-FPDA and NQ-SPDA annuities are 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.

Our fixed and variable annuities generally have surrender charges that are a specified percentage of policy values or premiums which decline as the policy or premium ages. Several of our variable annuities offer a Market Value Adjustment Option (“MVA Option”) which provides fixed accumulations that are adjusted up or down if a withdrawal (including a transfer or annuitization) occurs before the maturity of the Guarantee Period. The Market Value Adjustment (“MVA”) generally reflects the relationship between current interest rates at the

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time of withdrawal and the interest rate guaranteed for the term of the Guarantee Period. General account annuity and interest-sensitive life policies are guaranteed to accumulate at specified interest rates but allow for periodic crediting rate changes.

Products

With the exception of certain policies to be written under the Coinsurance Agreement, as of December 31, 2003, the Company ceased selling any new business Effective as of the Closing, we reinsured the majority of our business through the Coinsurance Agreement with FKLA. The Company is continuing to receive premium on the following products:

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Investors Brokerage Services, Inc., 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 “Reinsurance” in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of this Form 10-K).

Currently, interests under contracts relating to the MVA Option have been registered under the Securities Act of 1933, as amended (the “1933 Act”). The Company is contemplating revising its MVA Options by putting a “floor” on the MVA feature and increasing the guaranteed interest rate to 3% on those Guarantee Period Values currently crediting less than 3%. The “floor” will ensure that, regardless of any changes in interest rates, the return on Guarantee Period Value on and after the effective date of the revision (before any deductions for contract charges) will not be less than the contract’s new minimum guaranteed interest rate of 3% per annum. The specific terms of this change would be described in an MVA Endorsement that would be issued on all applicable annuities. As a result of the issuance of an MVA Endorsement, interests under the contracts relating to the MVA Option would no longer be registered under the 1933 Act, as amended. The Company anticipates that a revision to the MVA option may be effected as early as April 1, 2005. In connection with the revision of the MVA Option, the Company intends to file a Form 15 with the Securities and Exchange Commission (the “SEC”) to notify the SEC that it no longer has a duty to file reports under Section 15(d) of the Securities Exchange Act of 1934.

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 Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” 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 Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and in Item 8, Note 14 of the “Notes to Consolidated Financial Statements” of this Form 10-K.

Ratings

Ratings are an important factor in establishing the competitive position of life insurance companies. Rating organizations continue to review the financial performance, 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.

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According to Best’s Insurance Reports, 2004, as of September 30, 2004, we ranked 55th by admitted assets and 151st by capital and surplus out of the top 250 life insurers.

As of December 31, 2004, our A.M. Best Company (“A.M. Best”) rating was “A-” (Excellent), with a stable outlook, and our rating from Moody’s Investors Service was “A3” (Good), with a stable outlook. Our Standard & Poor’s rating was “A-” (Strong) with a stable outlook.

Competition

We ceased selling new products in 2003, and therefore, no longer face the highly competitive pressures typically encountered in the insurance industry.

Employees

At December 31, 2004, we had 11 employees and we also used certain services of FNWL. Previously, per the Coinsurance Agreement and transition services agreement, we used certain services of FKLA employees. During the majority of 2003 and all of 2002, the Company’s personnel were employees of FKLA. Expenses were 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 SEC.

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, respectively, 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.

In addition to the above, ZFS, the parent of the Company, has received subpoenas from the SEC and the Office of the New York Attorney General requesting information regarding non-traditional products. These subpoenas, while not addressed directly to the Company, cover any such products that may have been purchased or sold by the Company. ZFS is cooperating with the authorities in providing documents and information. Other companies in the industry have also received such subpoenas.

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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, 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, 2004, we had two ratios outside the usual ranges: the adequacy of investment income ratio and the change in premium ratio. The adequacy of investment income ratio was outside the usual range primarily due to interest on supplemental contracts under coinsurance agreements. If the ratio were adjusted for the coinsured interest, it would have fallen within the expected range. The change in premium ratio was outside the usual range primarily due to the amounts ceded and assumed under the FKLA and FNWL reinsurance agreements, respectively.

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.

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 2004 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. In 2004, the Company did not pay any dividends. 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. The Company cannot pay any dividends in 2005 without the approval of the Illinois Department of Insurance.

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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 date of the Purchase Agreement.

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 risk assumed by the insurer. At December 31, 2004 our risk-based capital ratio was 373% compared to 353% at December 31, 2003. Our capital levels exceed minimum risk-based capital requirements, and reserves are in compliance with applicable asset adequacy rules.

Guaranty Fund Assessments

Each state has insurance guaranty association laws under which life and property and casualty insurers doing business in the state are members and may be assessed by state insurance guaranty associations for certain obligations of insolvent insurance companies to policyholders and claimants. Typically, states assess each member insurer in an amount related to the member insurer’s proportionate share of the business written by all member insurers in the state. At December 31, 2004 and 2003, our accrued liability related to state insurance guaranty association laws was approximately $3.3 million and $3.4 million, respectively. While we cannot predict the amount and timing of any future assessments on our insurance companies under these laws, we have established reserves that we believe are adequate for assessments relating to insurance companies that are currently subject to insolvency proceedings.

The Gramm-Leach-Bliley Act

The Gramm-Leach-Bliley Act of 1999 (“GLBA”) permits mergers that combine commercial banks, insurers and securities firms under one holding company, a “financial holding company.” Until passage of the GLBA, the Glass-Steagall Act of 1933, as amended, had limited the ability of banks to engage in securities-related businesses, and the Bank Holding Company Act of 1956, as amended, had restricted banks from being affiliated with insurers. As a result of GLBA, the ability of banks to affiliate with insurers may affect the Company by substantially increasing the number, size and financial strength of potential competitors. Privacy provisions of GLBA became fully effective in 2001. These provisions established consumer protections regarding the security and confidentiality of nonpublic personal information and require full disclosure of the privacy policies of financial institutions, including U.S. insurers, to their consumer customers.

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

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Item 2. Properties

We currently share office space with an affiliated company, FNWL, in Mercer Island, Washington. We make payments for our share of rent and overhead 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 Holder

No matters were submitted for a vote of our stockholder during the fourth quarter of 2004.

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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 had no long-term debt obligations at December 31st in any of the years presented in the table above.

As is fully described in this Item under the caption “Effects of New Accounting Pronouncements” and in Item 8, Note 15 of the “Notes to Consolidated Financial Statements”, with the initial adoption of the Accounting

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Standards Executive Committee of the American Institute of Certified Public Accountants’ (“AcSEC”) 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”). Effective January 1, 2004, we have adopted SOP 03-1 which resulted a cumulative effect of accounting change of $(157.9) million.

The Company executed two significant coinsurance agreements during 2003 which are discussed in the Reinsurance section in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” as well as in Item 8, Note 3 of the “Notes to Consolidated Financial Statements”. Comparison of 2004 and 2003 to prior years is impacted by these coinsurance agreements.

As further discussed in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, 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 (“SFAS 142”). The 2002 write-down totaled $178.4 million. As of December 31, 2002, there was no goodwill remaining on the books of the Company.

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:

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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 definition, we have identified the critical accounting policies and judgments, which are 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 Item 8, Note 1 of the “Notes to Consolidated Financial Statements” of this Form 10-K. 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 accounts 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.

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 was 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 business.

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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 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. As a result of the adoption of SOP 03-1, $ 236.5 million of DAC was amortized to reflect the reduction in EGPs in the amount by which future revenues offset future benefits in the reserve calculation.

The overall recoverability of the DAC asset is dependent 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. In July 2003, the AcSEC issued SOP 03-1, which the Company adopted effective January 1, 2004. In accordance with the provisions of SOP 03-1, a liability has been established for GMDB and GRIB benefits in excess of account values. 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. (Refer to “Cumulative Effect of Accounting Change, Net of Tax” and “Effects of New Accounting Pronouncements” in this Item and Item 8, Note 15 to the “Notes to Consolidated Financial Statements”.)

Current interest rates credited during the contract accumulation period range from 0.3% 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%.

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.

Our liability for unpaid claims and claim adjustment expenses, which is included in “Other accounts payable and liabilities”, is less than 1% of total liabilities as of December 31, 2004 and 2003. Unpaid claims and claim adjustment expenses includes estimates of claims that we believe have been incurred, but have not yet been reported (“IBNR”) as of December 31, 2004 and 2003. These IBNR estimates, which are based on our historical experience, are regularly adjusted to reflect actual claims experience. When actual experience differs from our previous estimate, the resulting difference will be included in our reported results for the current period in the “Claims incurred and other policyholder benefits” caption in our consolidated statements of operations. On an ongoing basis, trends in actual experience are a significant factor in the determination of claim reserve levels.

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Policy Loans

Many policies that accumulate cash value contain provisions that allow the policy owner to “borrow” against or to use the cash value. When a loan balance is present on a policy, annual interest is charged on the policy anniversary. If a payment is not made, the interest amount is added to the loan balance. Interest may be charged in advance or arrears depending on the plan and interest rates also vary by plan. An overloan situation may occur if the value of the policy is less than the amount of the loan. Overloans usually occur when a premium is not paid and the automatic premium loan provision is applied or when the annual loan interest is charged and not paid and the maximum available cash value has been used. In the case of an overloan situation, the policy owner is notified of the requirements to continue coverage prior to policy termination. Policies that terminate because of an overloan may be considered for reinstatement. Normal reinstatement guidelines are followed and the amount of money requested for reinstatement includes the loan interest. Policy loans are carried at unpaid balances and reduce liabilities for future policy benefits.

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 or real estate could result in a significant change in the valuation allowance reported in the consolidated financial statements.

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Federal Income Taxes

Beginning with the year ended December 31, 2002, the Company has filed 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 or receive. 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.

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 an immediate benefit for a taxable loss. 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 Policyholder 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.

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The following tables reconcile our reported net (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

Components of Net Loss

The following table reflects the components of our net loss during the past three years:

We recorded a net loss of $145.3 million in 2004, compared with a net loss of $9.2 million in 2003 and a net loss of $169.0 million in 2002. The net loss in 2004 resulted primarily from a $157.9 million cumulative effect adjustment to earnings. The adjustment resulted from our adoption of SOP 03-1 and is more fully discussed below in “Effects of New Accounting Pronouncements” in this Item. Net income in 2004 before the $157.9 million cumulative effect of accounting change, net of tax, was $12.1 million compared to a net loss in 2003 of $24.5 million. Revenue in 2004 decreased by $202.5 million compared to 2003, while benefits and expenses decreased by $239.1 million due to a significantly different structure of the Company following the closing of the Purchase and Coinsurance Agreements.

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 adoption of SFAS 142, Goodwill and Other Intangible Assets, which generated a $21.9 million loss upon adoption of the new accounting standard. In addition, in September 2002 the Board of Directors of the Company’s indirect 100% shareholder, ZFS, approved a plan to improve the profitability of ZFS and its subsidiaries. Under this plan, ZFS considered a number of strategic options, many of which would impact the recoverability of the carrying value of certain assets. Among the assets affected by the plan was the goodwill associated with the 1996 acquisition of the Zurich Life companies by ZFS. As a result, the Company recorded a complete write-off of the remaining goodwill related to the acquisition of $156.5 million in 2002.

We recorded operating income of $12.1 million in 2004, compared with an operating loss of $63.7 million in 2003, an increase of $75.8 million, or 119%. This was primarily due to a decrease in amortization of DAC and value of business acquired (“VOBA”) by $139.8 and $56.8 million, respectively, resulting from blocks of business that were ceded to Bank One in the third quarter of 2003 and implementation of SOP 03-1. These were offset by a $135.3 million decrease in investment income resulting from the transfer of invested assets to FKLA as discussed below in “REVENUE-Net Investment Income”.

We recorded an operating loss of $63.7 million in 2003, compared with operating income of $10.7 million in 2002, a decrease of $74.4 million, or 695%. The decrease was primarily due to a $65.7 million decline in investment income resulting from lower yielding securities due to a lower interest rate environment and increased amortization of DAC and VOBA by $116.8 million and $36.0 million, respectively, offset by a decline in the DAC, claims incurred and commission expenses of $46.8 million, $49.0 million and $38.5 million, respectively.

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REVENUE

Net Investment Income

Pre-tax net investment income totaled $26.8 million in 2004, compared with $162.1 million in 2003, and $227.8 million in 2002. This represents a decrease in 2004 of $135.3 million, or 83.5% as compared with 2003, and a decrease in 2003 of $65.7 million, or 28.8%, compared to 2002. This includes our share of the operating results from equity investments in real estate. The decrease in investment income in 2004 compared to 2003 was primarily due to the Coinsurance Agreement with FKLA, which resulted in the transfer of invested assets, with an aggregate fair value of approximately $3.2 billion in September 2003. This decline in invested assets along with the decline in yields on our investment portfolio resulted in lower investment income in 2004 as compared to prior years. Included in the 2004 pre-tax investment income is $2.7 million of income that is allocable to policyholders and separate accounts, in accordance with SOP 03-1. Income allocable to policyholders and separate accounts was not included in investment income in prior years since the provisions of SOP 03-1 did not become effective for the Company until January 1, 2004. The decrease in pre-tax net investment income in 2003 was largely due to the transfer of $3.2 billion of invested assets to FKLA pursuant with the Coinsurance Agreement.

Spread revenue decreased in 2004 and 2003, compared with 2002, due to a larger decrease in investment income than the decrease in interest credited to policyholders.

Investment income for the past three years has been negatively impacted 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 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 $0.2 million, $0.9 million, and $1.9 million in 2004, 2003, and 2002, respectively.

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:

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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 after-tax realized investment gains decreased $54.5 million, or 99.1% to $0.5 million in 2004 as compared to after-tax realized gains of $55.0 million in 2003. Net realized investment gains in 2003 represent an increase of $55.5 million, or 11100% as compared to the net after-tax realized loss of $0.5 million in 2002. Net realized investment gains in 2004 were primarily due to the sales of certain fixed maturity securities during the first quarter of 2004, which were sold to fund settlement of the Purchase Agreement, as well as release of reserves held for certain real estate investments of $2.7 million. In addition, the Company realized a $0.2 million after tax gain on the settlement of an outstanding mortgage loan in August 2004. The principal received totaled approximately $7.0 million and generated an additional $0.2 million of realized after-tax gains from the payoff. On September 30, 2004, the Company satisfied its obligation to provide a financial guaranty in the form of an extended standby credit enhancement to a third party letter of credit for property development in Texas (see “Off-Balance Sheet Transactions” in this Item). The realized gains were partially offset by after-tax impairment losses of $4.0 million on a fixed maturity security and $1.0 million on a preferred stock due to other-than-temporary impairment. Management has reviewed and performed testing on the assessment of impairment for both the fixed maturity security and the preferred stock. As a result, the Company has concluded that the decline in value was not recoverable. The fixed maturity security and preferred stock were subsequently sold in October and September 2004, respectively.

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 airline issues. Net realized investment gains on fixed maturity securities in 2002 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 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” (“EITF 99-20”). These write-downs totaled $12.0 million after tax in 2002. The other gains, net, for 2003 were primarily due to the transfer of assets under the Coinsurance Agreement with FKLA. The other realized losses 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 after-tax write-down totaled $11.4 million.

Unrealized gains and losses on fixed maturity investments that are available-for-sale are not reflected in net income. Such changes in unrealized value are recorded as a component of accumulated other comprehensive

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income (loss), 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 (loss).

We regularly monitor our investment portfolio and as part of this process review the assets for possible impairments of carrying value according to Emerging Issues Task Force Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” (“EITF 03-1”), which replaced “EITF 99-20” in March 2004 (see “Investments” section). 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. See further discussion of EITF 03-1 at “Effects of New Accounting Pronouncements” in this item.

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 2003 and, as of December 31, 2004, 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. As a result of the discontinuance of new sales of our products during 2003, premium income currently is generated from renewal business and is reported as policy charges, life insurance premiums, net investment income and other revenues.

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.

The following table reflects our sales and reinsurance assumed:

Sales and reinsurance assumed

(in millions)

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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 $125.8 million, or 26%, in 2004, compared with 2003, and decreased $497.9 million, or 51%, in 2003, compared with 2002. 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 $193.6 million, or 89%, in 2004, compared with 2003, and decreased $153.3 million, or 41%, in 2003, compared with 2002. The decrease in 2004, compared to 2003, resulted from the discontinuance of sales of new products. The decrease in 2003, compared with 2002 was primarily due to the successful promotion of our Zurich Classic II fixed annuity product, which had a significant impact in the second half of 2002, but only a minimal impact in 2003.

On December 1, 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” in this Item and in Item 8, 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. We assumed $70.8 million and $743.7 million in fixed annuity premiums in 2004 and 2003, respectively. The decrease is primarily due to an initial premium of $736.5 million assumed in 2003.

BOLI deposits decreased $148.0 million, or 52%, to $135.5 million in 2004, compared with $283.5 million in 2003, and decreased $580.2 million, or 67%, in 2003 compared with 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 contributed in part to the decrease in sales. 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.

Sales of separate account variable universal life insurance decreased $1.5 million, or 12%, to $10.8 million in 2004, compared with $12.3 million in 2003, and decreased $5.4 million, or 31%, in 2003 compared with 2002 as we exited this product line in 2002 due to lack of scale and profitability.

Sales of term life insurance decreased $3.0 million or 86%, to $0.5 million in 2004 compared with $3.5 million, in 2003, and decreased $0.2 million, or 5%, in 2003 compared with 2002. The decreases result from discontinued term life product as of September 2003.

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

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direct their premium to one or more subaccounts that invest in underlying investment funds, which invest in stocks and bonds. The policyholder bears the investment risk on these stocks or bonds; however, the risk is subject to any underlying guarantees 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)

Separate account fees on non-BOLI variable life and annuities decreased $7.2 million, or 10%, in 2004 compared to 2003 due to greater amounts ceded to FKLA on non-BOLI policies amounting to approximately $16.8 million, offset by a $9.6 million increase in separate account fees and charges. Separate account fees on non-BOLI variable life and annuities decreased $14.9 million, or 18%, in 2003 compared to 2002 primarily due to greater amounts ceded to FKLA in 2003 on non-BOLI policies and a decrease in separate account fees in 2003.

Net BOLI cost of insurance (“COI”) charges and fees decreased $8.3 million in 2004 compared to 2003, primarily due to the ceding of BOLI Administrative fees to FKLA in the amount of $11.0 million, offset by a $2.7 million increase in DAC tax loads and separate account fees. Net BOLI COI charges and fees increased $1.9 million in 2003 compared with 2002, primarily due to an amended agreement with a ZFS affiliated company, Zurich Insurance Company, Bermuda Branch (“ZICBB”), which changed the COI charges base to increase mortality reserves.

BOLI premium tax expense loads, which are based upon a percentage of premiums, decreased $2.5 million, or 54% in 2004 compared to 2003, due to a decrease in BOLI premiums in 2004. The decrease of $11.6 million, or 72%, in 2003 compared to 2002 was the result of a decrease in BOLI premiums in 2003.

Broker-dealer commission revenue

Broker-dealer commission revenue decreased $18.7 million, or 100%, to $0 in 2004 compared with 2003. We no longer receive broker-dealer revenues as the subsidiaries that generated these revenues were sold in September 2003 in connection with the Purchase Agreement. The 2004 decrease was in line with the $18.6 million, or 100%, decrease to $0 in broker-dealer expenses.

Broker-dealer commission revenue decreased $9.8 million in 2003 compared with 2002 due primarily to the sale in September 2003 of the subsidiaries as noted in the preceding paragraph. The 2003 decrease was in line with the $9.3 million decrease in broker dealer expenses.

Modified coinsurance income—related party

Modified coinsurance income—related party was approximately $11.2 million and $4.1 million in 2004 and 2003 respectively, an increase in 2004 of $7.1 million, or 173%. This increase was primarily due to income from

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policy activity being received for the full year for 2004 versus only one month in 2003. The Modified Coinsurance Agreement was entered into on December 1, 2003; therefore, there was no modified coinsurance income in 2002.

Other Income

Other income increased $45.2 million, or 154%, in 2004, compared with 2003 and increased $14.5 million, or 98%, in 2003 compared with 2002. The increase in 2004, compared to 2003, was due primarily to the Coinsurance Agreement with FKLA, which resulted in the reclassification to Other income of interest credited to policyholders on the coinsured investment contracts which were previously recorded as an offset to Interest credited to policyholders. The reclassification was for a full year in 2004 compared to a four-month period in 2003. The increase was offset by a decline in surrender charge revenue from $7.6 million, in 2003, to $3.7 million, in 2004. The reduction in surrender charge revenue in 2004 was due to decreased policyholder surrender and withdrawal activity. The increase in 2003, compared to 2002, was also due primarily to the reclassification of certain expenses related to the Coinsurance Agreement with FKLA and of Modified Coinsurance Agreement with FNWL.

BENEFITS AND EXPENSES

Interest credited to policyholders

Interest credited to policyholders decreased $60.0 million, or 43%, in 2004 compared to 2003 and decreased $11.8 million, or 8%, in 2003 compared to 2002. The decrease in interest credited in 2004, compared to 2003, was due primarily to the Coinsurance Agreement with FKLA, which resulted in the reclassification to Other income of interest credited to policyholders on the coinsured investment contracts which were previously reflected as an offset to Interest credited to policyholders. The reclassification was for a full year in 2004 compared to a four-month period in 2003. The decrease in 2003, compared with 2002, was due to lower average interest crediting rates reflecting the declining interest rate environment and lower average policyholder account balances, offset by the reclassification of certain expenses related to the Coinsurance Agreement with FKLA.

Claims incurred and other policyholder benefits

Claims incurred and other policyholder benefits increased $21.7 million, or 159%, in 2004, compared with 2003, primarily due to implementation of SOP 03-1 increasing reserves and reclassification of the separate account market value adjustment accounts. Claims incurred and other policyholder benefits decreased by $49.0 million, or 78%, 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 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. For the years ending December 31, 2003 and 2002, which was prior to the implementation of SOP 03-1, a GMDB reserve had been established for all contracts and a GRIB reserve had been established for only those contracts deemed to have annuitized.

Commencing January 1, 2004, additional liabilities for future policy benefits related to GMDB and GRIB were recorded with the implementation of SOP 03-1. In 2004, the liability for future policy benefits related to GMDB and GRIB increased by $1.2 million and $23.7 million, respectively.

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. Changes in reserves primarily represent estimated future guaranteed

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policyholder benefits. Interest that accrues on annuity benefits and death benefits before pending claims are settled comprises the majority of the other policyholder benefits.

Policyholder surrenders, withdrawals and death benefits

(in millions)

General account surrenders, withdrawals and death benefits decreased $208.7 million, or 92%, in 2004, compared with 2003, due primarily to the ceding of these benefits in accordance with the Coinsurance Agreement with FKLA. General account surrenders, withdrawals and death benefits decreased $132.6 million, or 37%, in 2003, compared with 2002, due to a decrease in both death benefits and surrenders and withdrawals.

Surrenders, withdrawals and death benefits on separate account products decreased $47.4 million in 2004, compared with 2003. 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 2004 and 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.

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:

Taxes, Licenses & Fees

Taxes, licenses and fees primarily reflect taxes assessed on premiums related to BOLI. Taxes, licenses and fees were $3.0 million in 2004 compared to $(1.8) million in 2003 and $19.2 million in 2002. The $4.8 million, or 267%, increase in 2004 compared to 2003 was primarily due to tax expenses during 2004, compared to tax credits in 2003 resulting from premium tax overpayments. The $21.0 million, or 109%, decrease in 2003 compared to 2002 was primarily due to a decrease in BOLI renewal premiums resulting in lower premium taxes.

Commissions

Commissions were $20.4 million in 2004 compared to $45.0 million in 2003 and $83.5 million in 2002. The $24.6 million, or 55%, decrease in 2004 compared to 2003 and the $38.5 million decrease, or 46%, in 2003 compared to 2002 were primarily due to the Coinsurance Agreement with FKLA.

Operating Expenses

Operating expenses were $16.1 million in 2004 compared to $31.1 million in 2003 and $67.5 million in 2002. The $15.0 million, or 48%, decrease in 2004 compared to 2003 was primarily attributable to lower salaries

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and benefits, overheads and sales and distribution expenses due in large part to the businesses sold and transferred in the Purchase Agreement in September 2003. The $36.4 million, or 54% decrease in 2003 compared to 2002 was primarily attributable to the Coinsurance Agreement with FKLA in 2003.

Deferral of Insurance Acquisition Costs

The Company did not sell any new policies in 2004; therefore, there were not any insurance acquisition costs to be deferred in 2004. Deferral of insurance acquisition costs in 2003 was $49.7 million compared to $96.5 million in 2002. The $46.8 million, or 48%, decrease in 2003 was attributable to the Company’s discontinuing sales of new policies in 2003.

Amortization of Deferred Insurance Acquisition Costs

Amortization of insurance acquisition costs decreased $139.8 million, or 92%, in 2004, compared with 2003 and increased $116.8 million, or 334%, in 2003, compared with 2002, primarily due to the write-off in 2003 of deferred insurance acquisition costs related to the blocks of business ceded to FKLA and implementation of SOP 03-1 in 2004. In addition, since the Company has ceased selling any new business, no new acquisition costs were incurred in 2004 to defer and amortize.

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 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 the entire $56.8 million balance in our Consolidated Financial Statements at December 31, 2003. In 2002, depreciation in the stock market continued to decrease the separate account assets and the related asset-based separate account fees. The continued reduction in the asset-based separate account fees decreased the current and future EGPs in 2002. 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 compressed future interest margins (spread income) which reduced future EGPs and accelerated current year amortization.

Goodwill Impairment and Amortization of Goodwill and Other Intangibles

We recorded no goodwill impairment or amortization of goodwill and other intangibles in 2004.

Goodwill impairment and amortization of goodwill and other intangibles was $0.5 million in 2003 compared with $157.3 million in 2002. The $156.8 million, or 99%, decrease in amortization of goodwill and other intangibles in 2003 compared to 2002 was primarily attributable to the adoption of SFAS 142, Goodwill and Other Intangible Assets, which generated a $21.9 million loss recorded as a cumulative effect accounting change. In September 2002, the Board of Directors of the Company’s indirect 100% shareholder, ZFS, approved a plan to improve the profitability of ZFS and its subsidiaries. Under this plan, ZFS considered a number of strategic options, many of which would impact the recoverability of the carrying value of certain assets. Among the assets affected by the plan was the goodwill associated with the 1996 acquisition of the Zurich Life companies by ZFS. As a result, the Company recorded a complete write-off of the remaining goodwill related to the acquisition of $156.5 million in 2002.

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Income Tax Expense (Benefit)

Income tax benefit for 2004 decreased by $14.9 million, or 97%, compared with 2003, primarily due to higher operating earnings in 2004 as compared to 2003. Income tax benefit for 2003 increased by $12.9 million or 537%, compared to 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.

Cumulative Effect of Accounting Change, Net of Tax

On January 1, 2004, the Company recorded a $(157.9) million cumulative effect adjustment to earnings equal to the revaluation of its GMDB and GRIB liabilities in accordance with SOP 03-1 (see “Effects of new accounting pronouncements” in this Item and in Item 8, Note 15 in the “Notes to Consolidated Financial Statements”).

ASSETS UNDER MANAGEMENT

The following table reflects our assets under management:

Assets under management

(in millions)

Total assets under management are 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. Total assets under management increased approximately $789.4 million, or 5%, at December 31, 2004 to $16.7 billion, compared with $15.9 billion December 31, 2003. General account assets decreased approximately $5.0 million largely due to settlement of the funding agreement and related interest rate swap in November 2004. The net interest payment for the swap agreement was $4.5 million and the funding agreement payoff was $101.1 million. Partially offsetting the settlement payments were proceeds from the disposition of the underlying asset portfolio of $81.3 million, market or fair value appreciation on the securitized portfolio of $17.5 million, and a $58.2 million SOP 03-1 reclassification during 2004. In addition, policy loans increased by $18.5 million and investment interest income was reinvested in the securitized portfolio, accounting for the remainder of the variance. The SOP 03-1 reclassification correspondingly decreased total separate accounts, with DESTINATIONS^SM decreasing approximately $18.1 million, and other separate account assets decreasing approximately $40.1 million due to the reclassification. DESTINATIONS^SM separate account assets increased by $325.2 million, largely attributable to favorable market performance offset by the $18.1 million SOP 03-1 reclassification. Other separate account assets decreased approximately $0.8 million due to net redemptions and the $40.1 million SOP 03-1 reclassification partially offset by favorable market performance. BOLI separate account assets increased approximately $469.9 million, largely attributable to favorable market performance in the BOLI funds.

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 various factors, including:

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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 2004, approximately $65.7 million of joint venture mortgage loans, third-party mortgage loans, and other real estate-related investments were paid in full or sold. This represents a 99.6% decrease in these asset classes. A majority of the proceeds were reinvested in longer duration fixed maturity securities. These transactions generated a pre-tax net realized gain of $4.1 million from the release of related reserves and a $0.3 million pre-tax realized gain on the sale. Total investment assets plus cash and cash equivalents decreased approximately $5.0 million, or 0.7% in 2004, as compared to 2003.

During 2003, the portfolio decreased $3.2 billion due to asset sales and transfers resulting from the Coinsurance Agreement with FKLA. 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. We continue to invest in higher quality, lower risk investments.

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. The investment securities portfolio is primarily managed 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)

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Fixed Maturity Securities

We carry our fixed maturity securities portfolio, which is considered available-for-sale, at estimated fair value. Fair values are sensitive to movements in interest rates and other economic developments and can be expected to fluctuate, at times significantly, from period to period. The aggregate unrealized appreciation or depreciation is recorded as a component of accumulated other comprehensive income, net of deferred taxes. In 2004, the aggregate unrealized after-tax gain of the fixed maturity portfolio was $5.2 million, an increase of $10.9 million, or 191.2%, compared to 2003. In 2003, the aggregate unrealized after-tax loss of $5.7 million on the fixed maturity portfolio represents a decrease of $73.8 million, or 108.2%, compared to 2002, largely due to the $3.2 billion decrease in invested fixed maturity securities due to asset sales and transfers resulting from the Coinsurance Agreement with FKLA.

At December 31, 2004, investment-grade fixed maturity securities, cash and short-term investments accounted for 96.3% of invested assets and cash, compared with 90.1% at December 31, 2003. Approximately 44.2% of our NAIC Class 1 bonds were rated AAA or equivalent at December 31, 2004, compared with 55.6% at December 31, 2003. The decrease in AAA rated holdings is primarily due to the maturity of approximately $11.2 million of U.S. Government securities and the sale of a $45.0 million U.S. Treasury security, which supported a funding agreement, upon termination of the agreement in November 2004.

Approximately 6.1% of the investment-grade fixed maturity securities at December 31, 2004 were residential mortgage-backed securities, down from 9.6% at December 31, 2003. Approximately 20.8% of the investment-grade fixed maturity securities at December 31, 2004 were commercial mortgage-backed securities, compared with 12.3% at December 31, 2003. 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 15.6% and 15.4% of the investment-grade fixed maturity securities consisted of asset-backed securities at December 31, 2004 and 2003, respectively. At December 31, 2004 and 2003, the majority of investments in asset-backed securities were backed by:

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.

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At December 31, 2004 and 2003, 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. The increase in unamortized premiums and discounts in 2004 is largely due to the 24.1% increase in the asset-backed and mortgage-backed securities in our portfolio as compared to 2003 holdings.

The following table 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.