Interest Rate Risk: One of the Insurance Company’s principal products is deferred annuities, which are interest rate sensitive instruments. In an interest rate environment of falling or stable rates the Insurance Company’s annuity holders are less likely to seek to surrender their annuities prior to maturity to seek alternative, higher-yielding investments. However, in an environment of moderately or significantly increasing rates, such surrenders should be expected to increase. As of December 31, 2009, the existence of surrender fees on approximately 43.7% of the Insurance Company’s outstanding deferred annuities acts as a deterrent against surrenders. However, if interest rates climb sufficiently, such fees may not have a significant deterrent effect. Moreover, the surrender fees are only in effect, primarily for up to the first 7 years of each annuity policy and, therefore, disappear over time (see table below). In the event of a substantial increase in surrenders during a short period of time, the Insurance Company may have to sell off longer-term assets to pay current surrender liabilities. The Insurance Company continually develops strategies to address the match between the timing of its assets and liabilities. To that end, in 2006, 2007 and 2008, a significant number of policies came off surrender charge and a significant portion of this business did surrender. This can be seen in the surrender ratio in the table on page 3. The Company anticipated this and maintained a significant level of cash equivalents to fund surrenders avoiding the need to sell long-term assets at a loss. The Company believes that the heavy surrender activity is now largely behind us. Additionally, management has increased the incentive for agents to retain this business with the Company by paying full first year compensation on internal rollovers. Since 2008, a significantly smaller amount of business has been coming off surrender charge, as shown in the table below. Consequently, we expect a continuation of the markedly lower surrender ratio in the next twelve months, when compared to those in prior years.
The primary market risks in the Insurance Company’s investment portfolio are interest rate risk (discussed above), credit risk and, to a lesser degree, equity price risk. Changes in credit risk are generally measured by changes in corporate yields in relation to the underlying Treasuries (“corporate spreads”) as well as changes in the Credit Default Swap (“CDS”) market, although the Company is a cash investor and does not buy or sell credit default swaps. The Insurance Company's exposure to foreign exchange risk is insignificant. The Insurance Company has no direct commodity risk. Changes in interest rates can potentially impact the Corporation’s profitability. In certain scenarios where interest rates are volatile, the Insurance Company could be exposed to disintermediation risk (asset/liability mismatch) and reduction in net interest rate spread or profit margin. See “Interest Rate Risk” above.
At December 31, 2009, preferred stock losses of duration longer than 12-months totaled $15.5 million on a cost basis of $61.4 million. Four of the positions represent holdings of preference shares in the Royal Bank of Scotland which continue to pay dividends. Although non-cumulative, Royal Bank of Scotland has asserted that it has a contractual obligation to continue to pay these dividends under the indenture of each issue or risk a default of an associated bond issue. It has asserted that it will continue to pay these dividends unless prohibited by its financial regulators. The Royal Bank preference shares represent a combined loss of approximately $9 million on a cost basis of $21.3 million. The remaining top 5 loss position represents a holding in Duke Realty Corp. totaling $849,000.
In evaluating a company's statutory financial and operating performance, A.M. Best reviews the Company's profitability, leverage and liquidity, as well as the company's book of business, the adequacy and soundness of its reinsurance, the quality and estimated market value of its assets, the adequacy of its reserves and the experience and competency of its management.
If the Insurance Company does not have the financial flexibility to upstream a dividend to the Corporation and the Corporation is restricted in its ability to raise capital, the Board of Directors may decide to reduce or suspend the payment of dividends to shareholders until capital conditions improve.
The Insurance Company is continually assessing its Swaption portfolio to determine if sufficient protection is provided to cover projected realized losses in the event of a liquidation of assets to satisfy annuity surrenders under a 300 basis points increase in interest rates. As part of this process, the Insurance Company may consider purchasing additional Swaptions as well as extending the maturity of its Swaption portfolio. Future consideration of these transactions or other asset/liability management strategies is dependent upon periodic testing based on updated asset and liability data.
(2) The difference between the recorded liability of $3,177.8 million, and the total payment obligation amount of $4,659.8 million, is $1,482.0 million and is comprised of (i) future interest to be credited; (ii) the effect of mortality discount for those payments that are life contingent; and (iii) the impact of surrender charges on those contracts that have such charges.
Of the total payment of $4,659.8 million, $3,011.2 million, or 64.6%, is from the Company’s deferred annuity, life, and accident and health business. Determining the timing of these payments involves significant uncertainties, including mortality, morbidity, persistency, investment returns, and the timing of policyholder surrender. Notwithstanding these uncertainties, the table reflects an estimate of the timing of such payments.