With regard to the assets included in Level 3, the fixed maturity securities are made up primarily of asset-backed securities (“ABS”) including collateralized debt obligations, residential mortgage-backed securities (“RMBS”), commercial mortgage-backed securities (“CMBS”) and corporate securities. During the year ended December 31, 2010, the Company transferred approximately $156.4 million of net assets out of Level 3, primarily due to improvements in the level of observability of inputs used to price certain trading fixed maturity securities. Approximately $60.8 million of the market gains included in earnings for the twelve-month period ended December 31, 2010, were primarily related to ABS, RMBS, CMBS and corporate securities which were classified as held-for-trading and were measured using significant unobservable inputs.
The $111.2 million decrease in net derivative loss for the twelve-month period ended December 31, 2010 as compared to the same period in 2009 related to futures contracts, was primarily due to the Company’s short exposure to the change in equity markets. The Company’s derivative instruments portfolio includes short future positions to hedge guaranteed minimum benefits on certain variable annuity products against potential adverse movements in the stock market. An increase in equity markets decreases the value of these short positions. However, these positions comprise a combination of economic and macro hedges that offset funding gaps and other adverse movements in equity markets.
Of the net decrease of $350.5 million, $190.5 million was primarily due to a decrease in actual gross profits during the twelve-month period ended December 31, 2010 as compared to the twelve-month period ended December 31, 2009. The decrease in actual gross profits in 2010 relative to 2009 was primarily due to a lower increase in the fair value of the Company’s trading fixed maturity securities in 2010 as compared to 2009. The increase in the fair value of these securities was substantial in 2009 due to significant tightening on credit spreads and change in interest rates during the twelve-month ended December 31, 2009 as noted above. The decrease in actual gross profits also was due to a lower decrease in the liabilities held for guaranteed minimum benefits on certain variable annuity products in 2010 as compared to 2009.
The Group Protection segment sells group life insurance, group stop loss insurance, group dental and group short-term and long-term disability insurance products primarily to small and mid-size employers. This segment operates only in the State of New York through the Company’s subsidiary, SLNY.
The Company determines the fair value of its publicly traded fixed maturity securities using three primary pricing methods: third-party pricing services, non-binding broker quotes and pricing models. Prices are first sought from third party pricing services; the remaining unpriced securities are priced using one of the remaining two methods. Third-party pricing services derive the security prices through recently reported trades for identical or similar securities with adjustments for trading volumes and market observable information through the reporting date. In the event that there are no recent market trades, pricing services and brokers may use pricing models to develop a security price based on future expected cash flows discounted at an estimated market rate using collateral performance and vintages. The Company generally does not adjust quotes or prices obtained from brokers or pricing services.
The Company manages assets related to certain funds-withheld reinsurance agreements. These assets are primarily comprised of fixed maturity securities and mortgages and are accounted for consistent with the policies described above. Investment income on assets within funds-withheld reinsurance portfolios is included as a component of net investment income (loss) in the Company’s consolidated statements of operations.
DAC amortization is reviewed regularly and adjusted retrospectively when the Company calculates the actual profits or losses and revises its estimate of future gross profits to be realized from deposit-type contracts, including realized and unrealized gains and losses from investments. The Company also tests its DAC and SIA asset for loss recognition on a quarterly basis. The test is performed by comparing the GAAP liability, net of DAC and SIA, to the present value of future expected gross profits; an adjustment is required if the current GAAP liability, net of DAC and SIA, is higher than the present value of future expected gross profits. During the years ended December 31, 2010 and 2009, the Company wrote down DAC and the SIA by $126.0 million and $326.9 million, respectively, as a result of loss recognition related to certain annuity products. Please refer to Note 13 of the Company’s consolidated financial statements for the Company’s DAC and SIA roll-forward.
Premiums for traditional individual life products are considered earned revenue when due. Premiums related to group life, group stop loss, group dental and group disability insurance are recognized as earned revenue pro-rata over the contract period. The unexpired portion of these premiums is recorded as unearned premiums. Revenue from universal life-type products and investment-related products includes charges for the cost of insurance (mortality), initiation and administration of the policy, and surrender charges. Revenue is recognized when the charges are assessed except that any portion of an assessment that relates to services to be provided in future years is deferred and recognized over the period during which the services are provided.
SLNY has a series of agreements with SLHIC, through which substantially all of the New York issued business of SLHIC was transferred to SLNY. As part of these agreements, SLNY received certain intangible assets totaling $31.3 million. These assets included the value of distribution acquired, VOBA, and VOCRA. The value of distribution acquired of $7.5 million is being amortized on a straight-line basis over its projected economic life of 25 years. The amortization expense for the value of distribution acquired was $0.3 million for each of the years ended December 31, 2010, 2009 and 2008.
The amortized cost and fair value of fixed maturity securities held at December 31, 2009, were as follows:
The following table shows the fair value and gross unrealized losses, which includes temporary unrealized losses and the portion of non-credit OTTI losses recognized in AOCI, of the Company’s available-for-sale fixed maturity investments, aggregated by investment category and length of time that the individual securities had been in an unrealized loss position at December 31, 2010.
The Company individually evaluates all its mortgage loans for impairment and records a specific provision for those deemed impaired. The Company also collectively evaluates most of its mortgage loans (excluding those for which a specific allowance was recorded) for impairment. At December 31, 2010, the Company individually and collectively evaluated loans with a gross carrying value of $1,791.3 million and $1,706.0 million, respectively.
At December 31, 2009, the Company determined that the VOCRA asset was impaired and recorded an impairment charge of $2.6 million. The impairment charge was allocated to the Group Protection segment. The fair value of VOCRA was calculated as the sum of the undiscounted cash flows the Company expects to realize, based on the segment’s anticipated long-term profit margins.
Mortgage loans: The fair values of mortgage and other loans are estimated by discounting future cash flows using current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities.
A brief discussion of the Company’s significant reinsurance agreements by business segment follows. (See Note 16 for additional information on the Company’s business segments.)
Reinsurance payable includes a funds-withheld liability of $326.9 million and $307.8 million at December 31, 2010 and 2009, respectively, and a deferred gain of $105.3 million and $118.9 million at December 31, 2010 and 2009, respectively. The funds-withheld assets are comprised of bonds, policy loans, and cash and cash equivalents that are managed by the Company. The funds-withheld coinsurance agreement gives rise to an embedded derivative which is required to be separated from the host reinsurance contract. At December 31, 2010 and 2009, the fair value of the embedded derivative increased contractholder deposit funds and other policy liabilities by $24.1 million and $26.3 million, respectively.
Effective December 31, 2009, the Company transferred all of its employees to an affiliate, Sun Life Services, with the exception of 28 employees who were transferred to SLFD, another affiliate. As a result of this transaction, the Company transferred pension and other employee benefit liabilities, accumulated other comprehensive income related to pension and other postretirement plans, and cash to Sun Life Services. Concurrent with this transaction, Sun Life Services became the sponsor of the retirement plans described below. The employee transfer did not change the provisions of the related retirement plans. The annual cost of these benefits to the Company is allocated and charged to the Company in a manner consistent with the allocation of employee compensation expenses.
The Company will file a consolidated federal income tax return with SLC - U.S. Ops Holdings for the year ended December 31, 2010, as the Company did for the years ended December 31, 2009 and 2008.
In the normal course of its business, the Company has entered into agreements that include indemnities in favor of third parties, such as contracts with advisors and consultants, outsourcing agreements, underwriting and agency agreements, information technology agreements, distribution agreements and service agreements. The Company has also agreed to indemnify its directors and certain of its officers and employees in accordance with the Company’s By-laws. The Company believes any potential liability under these agreements is neither probable nor estimatable. Therefore, the Company has not recorded any associated liability.