We believe our properties are adequate and suitable for our business as currently conducted and are adequately maintained. The above does not include properties we own for investment purposes only.
Our business, financial condition and results of operations are materially affected by economic and financial market conditions. The U.S. and global economies as well as the capital markets continue to show signs of improvement at a moderate pace; however, uncertainties in these environments continue to be a significant factor in the markets in which we operate. Factors such as consumer spending, business investment, the volatility of the capital markets, unemployment and the risk of inflation or deflation will affect the business and economic environment and, in turn, impact the demand for the type of financial and insurance products we offer. Adverse changes in the economy could have a material adverse effect on us. However, we believe those risks are somewhat mitigated by our financial strength, active enterprise risk management and disciplined underwriting for our products. Our diverse product mix across insurance segments is a strength that we expect will help us adapt to the volatile economic environment and give us the ability to serve the changing needs of our customers. Additionally, through our conservative business approach, we believe we remain financially strong, and we are committed to providing a steady and reliable source of financial protection for policyholders.
Low Interest Rates: In January 2014, the Federal Open Market Committee reaffirmed its plans to keep interest rates between 0 and 0.25 percent for as long as certain numerical metrics are met, such as the unemployment rate and long-term and short-term inflation rates. These actions were taken to support continued progress toward maximum employment and price stability. Consequently, the current low interest rate environment is expected to continue.
Increased Challenges of Talent Attraction and Retention: Despite the expected growth in the global population, the working-age population is expected to decline in many countries, including the U.S. Employers around the world may find it difficult to fill positions because of talent shortage in the markets. In addition, attracting individuals with the right skills and retaining employees remains a challenge. These challenges may become more difficult as the working population ages, the cost of higher education increases or if other industries develop a stronger appeal to job seekers. We are increasing our training and development resources to enhance the ability of our employees to meet customers’ needs. In addition, we are expanding the use of technology to broaden our candidate base when recruiting and to deliver targeted training to expand employees skills.
Effective management of invested assets and associated liabilities involving crediting rates and, where applicable, financial hedging instruments (which we use as economic hedges of equity-indexed life and annuity products), are important to the success of our life and annuity segments. Asset “disintermediation”, the risk of large outflows of cash at times when it is disadvantageous to us to dispose of invested assets, is a risk associated with this segment.
Competitive Pressures: In recent years, the competitive landscape of the U.S. life insurance industry has shifted. Established insurers are not only competing against each other but also against new market entrants that are developing products to attract the interest of the growing number of retirees. Competition exists not only in terms of retaining and/or acquiring consumers’ business, but also in terms of access to producers and distributors. Consolidation among distributors coupled with the aging sales force remains a challenge among insurers. In addition, the increased technological sophistication of consumers necessitates insurers and distributors to invest significant resources in technology to adapt to consumer expectations. We believe we possess sufficient scale, financial strength, resources and flexibility to effectively compete in this market.
The annuity market is also highly competitive. In addition to aggressive annuity rates and new product features on annuities, there is also a growing competition from other financial service firms. Insurers continue to evaluate their distribution channels and the way they deliver products to consumers. We have never provided guaranteed living benefits as a part of our variable annuity products. We believe these products were not adequately priced relative to the risk profile of the product. While this may have impeded our ability to sell variable annuities in the short term, we believe this strategy has given us an advantage in terms of profitability over the long-term.
We believe we will continue to be competitive in the life and annuity markets through our broad line of products, diverse distribution channels, and consistent high level of customer service. We modify our products to meet customer needs and to expand our reach where we believe we can obtain profitable growth. For example, traditional life insurance product sales increased in 2013 and 2012 primarily due to the new portfolio of term products introduced in 2012. Equity-indexed universal life insurance product sales also increased in 2013 and 2012.
Competition: The property and casualty insurance industry remains highly competitive. Despite the competitive environment, we expect to identify profitable opportunities through our strong distribution channels, expanding geographic coverage, marketing efforts, new product development and pricing sophistication.
On an ongoing basis, management reviews the estimates and assumptions used in the preparation of our financial statements. If management determines that modifications in estimates and assumptions are appropriate given current facts and circumstances, our financial position and results of operations as reported in the consolidated financial statements could change significantly.
Annuity Reserving Methodology-We determine the reserves for future amounts payable under annuity contracts, including fixed payout and deferred annuities. Reserves for payout annuities with more than insignificant amounts of mortality risk are calculated in accordance with the applicable accounting guidance for limited pay insurance contracts. Benefit and maintenance expense reserves are calculated by using assumptions reflecting our expectations, including an appropriate margin for adverse deviation. Payout annuity reserves are calculated using standard industry mortality tables specified for statutory reporting. If the resulting reserve would otherwise cause profits to be recognized at the issue date, additional reserves are recorded. The resulting recognition of profits would be gradual over the expected life of the contract.
The following assumptions reflect our best estimates and may impact our life and annuity reserves:
Recoverability-At least annually, we test the adequacy of the net benefit reserves (policy benefit reserves less DAC) recorded for life insurance and annuity products. This testing is referred to as “Loss Recognition” for traditional products and “Unlocking” for interest-sensitive products. To perform the tests, we use our current best estimate assumptions as to policyholder mortality, persistency, maintenance expenses and invested asset returns.
Overview-Total health net reserves of $146.5 million and $154.6 million were established using the following methods at December 31, 2013 and 2012, respectively.
Completion Factor Approach-This method assumes that the historical claim patterns will be an accurate representation of unpaid claim payments. An estimate of the unpaid claims is calculated by subtracting period-to-date paid claims from an estimate of the ultimate “complete” payment for all incurred claims in the period. Completion factors are calculated which “complete” the current period-to-date payment totals for each incurred month to estimate the ultimate expected payout.
Reserves for Claims and Claim Adjustment Expense (“CAE”)-Property and casualty reserves are established to provide for the estimated cost of paying for both reported as well as unreported claims. These reserves include estimates for both case and IBNR reserves. Included in these reserves are estimates of the expenses associated with settling claims, also known as CAE. The two major categories of CAE are defense and cost containment expense, and adjusting and other expense. The details of property and casualty reserves are shown below (in thousands):
IBNR-IBNR reserves are estimated based on many variables, including historical statistical information, inflation, legal developments, economic conditions, and general trends in claim severity, frequency and other factors that could affect the adequacy of claims reserves. Loss and premium data is aggregated by exposure class and by accident year. IBNR reserves are calculated by projecting ultimate losses on each class of business and subtracting paid losses and case reserves. Our overall reserve practice provides for ongoing claims evaluation and adjustment based on the development of related data and other relevant information pertaining to claims. Adjustments in aggregate reserves, if any, are included in the results of operations of the period during which such adjustments are made.
No significant change in the overall level of case reserve adequacy from period to period.
For non-credit lines of business, future inflation rates could vary from our assumption of relatively stable rates. Unexpected changes in future inflation rates could impact our financial position and liquidity, and thus we chose to measure the sensitivity of our reserve levels to unexpected changes in inflation. The impacts of future inflation for a 1.3% decrease and 2.7% increase over the implied inflation rate in the December 31, 2013 gross loss reserve balance are as follows (amounts in thousands):
Management believes our reserves at December 31, 2013 are adequate. New information, regulation, events or circumstances, unknown at the original valuation date, however, may result in future development resulting in our ultimate losses being significantly greater or less than the recorded reserves at December 31, 2013.
We had a DAC asset of approximately $1.28 billion and $1.25 billion at December 31, 2013 and 2012, respectively. Effective January 1, 2012, we retrospectively adopted new accounting guidance and implemented a new DAC capitalization policy. See Note 10, Deferred Policy Acquisition Cost of the Notes to the Consolidated Financial Statements for a detailed discussion regarding the impact of this pronouncement on us.
We believe the estimates used in our DAC calculations provide a representative example of how variations in assumptions and estimates would affect our business. The following table displays the sensitivity of reasonably likely changes in assumptions in the DAC amortization for our long-tail business at December 31, 2013 (in thousands):
The fair value of available-for-sale securities (equity and fixed maturity securities) is determined by management using one of the three primary sources of information: the quoted prices in active markets; third-party pricing services; or independent broker quotations. Estimated fair value of securities based on quoted prices in active markets is readily and regularly available; therefore, valuation of these securities generally does not involve management judgment. For securities without quoted prices, fair value measurement is determined using third-party pricing services’ proprietary pricing applications. The typical inputs used by the models are relevant market information, benchmark curves, benchmark pricing of like securities, sector groupings and matrix pricing. Any securities remaining unpriced after utilizing the first two pricing methods are submitted to the independent brokers for prices. We have analyzed the third-party pricing services and independent brokers’ valuation methodologies and related inputs, and have evaluated the various types of securities in our investment portfolio to determine an appropriate fair value hierarchy level based upon trading activity and the observability of market inputs. Management completes certain tests throughout the year and at year-end to determine that prices provided by our pricing services are reasonable.
We utilize over-the-counter equity options to hedge our exposure to equity-indexed universal life and equity-indexed deferred annuity benefits. Equity-indexed universal life and equity-indexed deferred annuity products include a fixed host contract and an embedded equity derivative. The embedded derivative portion of the contracts represent benefits in excess of fixed guarantees, and the host is associated with fixed or minimum interest credited rates. At inception, the value of the host contract equals the premium paid less the fair value of the embedded derivative. The initial host contract value is accreted to the fixed guaranteed value at the end of the contract indexing term. The fair value of the embedded derivative is recalculated at each reporting period using the current contract values and option pricing assumptions. Interest credited is generally comprised of interest accruals to policyholders’ account balances. In addition to the accrual of interest on the host contracts, the gain or loss on the embedded equity derivative is also recognized as interest credited. Embedded derivative gains and losses can cause material fluctuations in interest credited from one period to the next.
Management’s best estimate of future events and their impact is included in our accounting estimates. Certain changes or future events, such as changes in tax legislation, geographic mix of earnings and completion of tax audits could have an impact on our estimates and effective tax rate. For example, the dividends received deduction (“DRD”) reduces the amount of dividend income subject to tax and is a significant component of the difference between our actual tax expense and the expected amount determined using the U.S. federal statutory tax rate of 35%. The U.S. Department of the Treasury and the IRS have indicated that they intend to address, through regulations, the methodology to be followed in determining the DRD related to variable life insurance and annuity contracts. A change in the DRD, including the possible retroactive or prospective elimination of this deduction through regulations or legislation, could increase our actual tax expense and reduce our consolidated net income.
Other policy revenues include mortality charges, earned policy service fees and surrender charges on interest-sensitive life insurance policies. These charges increased during 2013 compared to 2012, and 2012 compared to 2011 primarily due to the growing block of interest-sensitive life policies.
(1) These are weighted amounts representing 10% of single and excess premiums and 15% of credit life premuims.
Policyholder benefits increased during 2013 compared to 2012 primarily due to an increase in claims and the accrual of interest related to claims identified upon the application of the modified claims settlement procedure described below. Policyholder benefits also increased due to a block of limited pay contracts, which were evaluated as requiring additional reserves in 2013. Policyholder benefits decreased slightly during 2012 compared to 2011 primarily due to a lower IBNR accrual in 2012.
Acquisition costs capitalized increased during 2013 compared to 2012, and during 2012 compared to 2011 primarily due to an increase in commissions from higher production.
We use reinsurance to mitigate excessive risk to the Life segment. During 2013, our retention limits were $2,350,000 for issue ages 65 and under, and $1,550,000 for issue ages 66 and older for traditional and universal life, unchanged from 2012. Accidental death and premium waiver benefits are mostly retained on new business. Increases in reserves and premium amounts ceded primarily reflect increased use of reinsurance in conjunction with treaties related to universal life products. Decreases in assumed reserves and premium were primarily due to the cancellation of reinsurance agreements, which are now in run-off, and our writing of this business on a direct basis with two credit life reinsurers.
Earnings remained relatively unchanged during 2013 compared to 2012, and increased during 2012 compared to 2011 primarily due to lower operating expenses. In addition, the increase in the interest spread between net investment income and interest credited to policyholders’ account balances was higher in 2012 compared to 2011, which contributed to the improvement in earnings during 2012.
Variable deferred annuity net inflows increased for all years presented. These products have no guaranteed minimum withdrawal benefits. Our total direct exposure on the guaranteed minimum death benefits associated with these products was $1.5 million and $2.4 million as of December 31, 2013 and 2012 respectively. After reinsurance, which is with reinsurers rated “A” or higher by A.M. Best, the net exposure was $0.3 million and $0.6 million, as of December 31, 2013 and 2012, respectively.
During 2013, net investment income without option return decreased compared to 2012 primarily due to lower aggregate account values and portfolio yield. Interest credited to policyholders’ account balances without embedded derivative decreased during 2013 compared to 2012 due to a decrease in crediting rates and the $6 million non-recurring credited interest relating to settled litigation during 2012. Net investment income without option return increased during 2012 compared to 2011, primarily due to increases in aggregate annuity account values. Interest credited to policyholders’ account balances without equity-indexed return decreased during 2012 compared to 2011 due to a decrease in crediting rates.
Earnings increased during 2013 compared to 2012 driven primarily by a decrease in claims incurred, partially offset by a decrease in premiums. Earnings increased 5.3% for 2012 compared to 2011.
For the medical expense business, we use reinsurance on an excess of loss basis. We retain the first $500,000 per claim and amounts in excess of $2,000,000. We cede or retrocede the majority of the risk associated with our stop loss and other MGU programs. We maintain reinsurance on a quota share basis for our long-term care and disability income business.
Net Premiums written increased during 2013 compared to 2012 due to continued rate adequacy improvements in our homeowners and commercial lines, especially in our agricultural business. Net premiums earned decreased during 2013 compared to 2012 primarily due to decreases in our personal auto business. Net premiums written and earned decreased during 2012 compared to 2011 resulting from a decline of policies in-force due to attrition and risk mitigation actions in our Personal lines, in addition to product alterations in our credit business.
Claims incurred decreased during 2013 compared to 2012, and during 2012 compared to 2011 as a result of decreases in both catastrophe and non-catastrophe weather-related losses. We continue to reduce our exposure in high catastrophe, high concentration areas which has contributed to a decrease in losses. The loss ratio decreased for all periods presented as a result of the decreases in catastrophe losses, improved rate adequacy and reduced claims frequency.
Gross catastrophes for the year ended December 31, 2013 were $83.9 million compared to $135.6 million for 2012. Although there was an increase in the number of catastrophe events, we experienced a significant decrease in catastrophe losses due primarily to a decrease in the severity of catastrophes in 2013 as compared to 2012. In 2013, there were 30 catastrophe events compared to 26 in 2012, and 31 in 2011. Hurricane Sandy accounted for $46.6 million in gross catastrophe losses and $11.1 million in net catastrophe losses in 2012. The catastrophe activity during 2011 included a record number of tornados, including two events which impacted primarily Alabama in late April 2011 and Joplin, Missouri in May 2011, accounting for $102.6 million in gross catastrophe losses and $30.5 million in net catastrophe losses.
Expenses attributable to the change in DAC increased during 2013 compared to 2012, and during 2012 compared to 2011. The capitalized costs being amortized on credit-related property products written in prior years exceeded the costs being capitalized on the newer credit-related products sold. We regularly review the recoverability of DAC, and if the actual emergence of future profitability were to be substantially lower than estimated, we would accelerate DAC amortization to account for any recoverability issues or premium deficiency. We have not historically experienced these issues with our DAC balances.
Our Property and Casualty segment consists of: (i) Personal products, which we market primarily to individuals, represent 61.4% of net premiums written, (ii) Commercial products, which focus primarily on agricultural and other commercial markets, represent 30.4% of net premiums written, and (iii) Credit-related property insurance products, which are marketed to and through financial institutions and retailers, represent 8.2% of net premiums written.
Personal Automobile: Net premiums written and earned decreased in our personal automobile line during 2013 compared to 2012, and 2012 compared to 2011, primarily due to a decline in policies in-force. The loss and combined ratios remained substantially unchanged during 2013 compared to 2012. The loss and combined ratios increased slightly during 2012 compared to 2011 consistent with our expectations.
The combined industry ratios per A.M. Best’s “U.S. Property/Casualty-Review and Preview” for 2013 (estimated), 2012 and 2011 are 100.8%, 102.1%, and 102.0%, respectively.
Homeowners: Net premiums written and earned increased during 2013 compared to 2012 primarily due to increasing premium rates over the time period. The loss and combined ratios decreased during 2013 compared to 2012 due to a decline in both catastrophe and non-catastrophe weather-related losses and improved rate adequacy. Net premiums written and earned decreased during 2012 compared to 2011 primarily due to fewer policies in-force. The decrease in homeowner policies in-force was primarily driven by improved rate adequacy and our catastrophe risk mitigation actions. The loss and combined ratios decreased during 2012 compared to 2011 primarily due to improved catastrophe experience and rate adequacy.
The combined ratios for the industry per A.M. Best for 2013 (estimated), 2012 and 2011 were 94.0%, 103.9%, and 122.1%, respectively.
Other Personal: These products include watercraft, rental-owner and umbrella coverages for individuals seeking to protect their personal property and liability not covered within their homeowner and auto policies. The loss and combined ratios remained substantially unchanged during 2013 compared to 2012, and decreased during 2012 compared to 2011. As this is currently the smallest line of business in our Personal Products, minor fluctuations in results can cause greater volatility in these ratios.
Agricultural Business: Our agricultural business product allows policyholders to customize and cover their agriculture exposure using a package policy which includes coverage for residences and household contents, farm buildings and building contents, personal and commercial liability and personal property. Net premiums written and earned increased during 2013 compared to 2012 primarily as a result of rate increases and an increase in new business writings, offset by a slight decrease in policies in force. Net premiums written were substantially unchanged in 2012 as compared to 2011, and net premiums earned increased during 2012 as compared to 2011, primarily as a result of a decrease in reinsurance reinstatement premiums. The loss and combined ratios decreased for all periods presented, primarily as the result of a reduction in net catastrophe losses, as well as a combination of rate and underwriting actions. The frequency and severity of storms and weather related events continue to cause variability in this line of business.
Credit-related property products for the periods indicated were as follows (in thousands, except percentages):
We reinsure a portion of the risks that we underwrite to manage our loss exposure and protect capital resources. In return for a premium, reinsurers assume a portion of the claims incurred. In addition to our reinsurance coverage, we are partially protected by the Terrorism Risk Insurance Act of 2002, which was modified and extended through December 31, 2014 by the Terrorism Risk Insurance Program Reauthorization Act of 2007.
• 75% of multiple peril losses in each of the following separate regions
All states excluding hurricane losses in coastal states (covered by previous coverage) with insuring protection from other regional coverage a. through d.
We also purchased a Stretch & Aggregate coverage which consists of a $35 million annual limit available either wholly or in part across two layers. The first layer is 8.75% of $400 million excess of $100 million on an occurrence basis. The second layer provides aggregate protection. Qualifying loss to the second layer is $35 million excess of $5 million of aggregated catastrophes losses. Recoveries follow satisfaction of a $45 million annual aggregate deductible. This coverage was placed at 71.43% in 2014.
(1) A.M.Best rating as of the most current information available February 4, 2014.
For 2013, the net favorable prior year claims and CAE development was $38.9 million, compared to approximately $47.6 million of net favorable prior year development in 2012, as a result of better than expected paid and incurred loss emergence across several lines of business.
Net favorable reserve development during 2013 and 2012 was primarily driven by personal and commercial auto and commercial liability lines. Net and gross reserve calculations have shown favorable development as a result of loss emergence compared to what was implied by the loss development patterns used in the original estimation of losses. For additional information regarding claims and CAE, refer to Note 12, Liability for Unpaid Claims and Claim Adjustment Expenses, of the Notes to the Consolidated Financial Statements.
Earnings increased during 2013 compared to 2012 primarily due to increases in realized gains and net investment income. The increase in realized gains was driven by sales of investment real estate properties as well as a reduction in other-than-temporary impairments related to investment securities. Earnings decreased during 2012 compared to 2011 due to the lower realized gains, primarily as a result of the $22.5 million other-than-temporary impairments related to investment securities. In addition, other operating expenses increased during the same period as a result of share-based compensation costs under the stock and incentive plan and an increase in allocated costs to this segment during 2012.
Mortgage Loans-We invest in commercial mortgage loans that are diversified by property-type and geography to support our insurance business. Generally, mortgage loans are secured by first liens on income-producing real estate with a loan-to-value ratio of up to 75%. Mortgage loans held-for-investment are carried at outstanding principal balances, adjusted for any unamortized premium or discount, deferred fees or expenses, and net of allowances. The weighted average coupon yield on the principal funded for mortgage loans was 5.2% and 5.5% at December 31, 2013 and 2012, respectively. It is likely that the weighted average yield on funded mortgage loans will decline as loans mature and new loans are originated with lower rates in the current interest rate environment.
Equity Securities-Our equity portfolio is in companies publicly traded on a national U.S. stock exchange; the cost and estimated fair value of the equity securities are as follows (in thousands):
Policy Loans-For certain life insurance products, policyholders may borrow funds using the policy’s cash value as collateral. The maximum amount of the policy loan depends upon the policy’s surrender value and the number of years since policy origination. As of December 31, 2013, we had $397.4 million in policy loans with a loan to surrender value of 67.9%, and at December 31, 2012, we had $395.3 million in policy loans with a loan to surrender value of 59.5%. Interest rates on policy loans primarily range from 3.0% to 12.0% per annum. Policy loans may be repaid at any time by the policyholder and have priority to any claims on the policy. If the policyholder fails to repay the policy loan, funds are withdrawn from the policy’s benefits.
Net investment income increased $31.4 million and $17.2 million during 2013 and 2012, respectively, primarily due to increases in net investment income from options and mortgage loans. Net investment income from options increased $64.4 million during 2013 and $21.7 million during 2012 primarily due to increases in the underlying equity markets. Net investment income from mortgage loans increased $16.7 million and $7.0 million during 2013 and 2012, respectively, primarily due to increases in mortgage loan investments. These increases were offset by a decrease in net investment income from bonds as bonds with lower interest yields made up a larger percentage of our portfolio as older bonds, which were purchased when interest rates were higher, matured.
The net unrealized gains on available-for-sale securities at December 31, 2013 and 2012 were $812.8 and $736.0 million, respectively. Unrealized gains or losses on available-for-sale securities have no impact on earnings. Rather, they are recognized as other comprehensive income or loss, which directly impacts equity. The gross unrealized gains of available-for-sale securities increased $127.1 million to $884.5 million during 2013 primarily resulting from increases in the value of equity securities. The gross unrealized losses of available-for-sale securities increased to $71.6 million from $21.4 million. The increase in gross unrealized losses during 2013 is primarily attributable to corporate debt securities and the impact changes in interest rates have on fixed income securities.
The fair value of our investment securities is affected by various factors, including volatility of financial markets, changes in interest rates and fluctuations in credit spread. We have the ability and intent to hold those securities in unrealized loss positions, until a market price recovery or maturity. Further, it is unlikely that we will be required to sell them prior to recovery, and recovery is expected in a reasonable period of time.
Changes in interest rates during 2013 and market expectations for potentially higher rates through 2014 will likely lead to increases in the volume of annuity contracts, which may be partially offset by increases in surrenders. Freezing our defined benefit pension plans will lessen the impact of changes in interest rates on our contributions to these plans and future contributions to our defined benefit plans may be smaller than historical contributions. A portion of the contributions will be used for the employer matching contributions to defined contribution retirement plans, which will provide employees with the potential to accumulate assets for retirement. There are no other known trends or uncertainties regarding product pricing, changes in product lines or rising costs, which would have a significant impact to cash flows from operations. Additionally, we have paid dividends to stockholders for over 100 consecutive years and expect to continue this trend. No unusually large capital expenditures are expected in the next 12-24 months.
We have notes payable relating to borrowings by real estate joint ventures that we consolidate into our financial statements that are not part of our capital resources. During 2012, one real estate joint venture, which the company consolidates, borrowed $100.0 million from a third party using the real estate owned by the joint venture as collateral. The debt service on the ten year loan is intended to be met by the earnings and cash flow of the joint venture. The lenders for the notes payable have no recourse against us in the event of default by the joint ventures. Therefore, the liability we have for these notes payable is limited to our investment in the respective ventures, which totaled $12.8 million and $18.1 million at December 31, 2013 and 2012, respectively.
During 2013, our capital resources increased substantially compared to 2012 primarily due to higher earnings, increases in unrealized gains from our equity investment portfolio partially offset by lower unrealized gains from the effect of interest rates on our fixed income investments and the defined benefit pension plan adjustment. The pension plan adjustment is attributable to a lower liability measurement due to increases in the discount rate and plan amendments.
Statutory capital and surplus is the capital of our insurance companies reported in accordance with accounting practices prescribed or permitted by the applicable state insurance departments. RBC is a measure of an insurer’s solvency calculated using formulas and instructions from the NAIC. State laws specify regulatory actions if an insurer’s ratio of statutory capital and surplus to RBC, falls below certain levels. The RBC formula for life companies establishes capital requirements for asset, interest rate, market, insurance and business risks. The RBC formula for property and casualty companies establishes capital requirements for asset and underwriting risks including reserve risk.
The achievement of long-term growth will require growth in American National Insurance Company’s and our insurance subsidiaries’ statutory capital and surplus. Our subsidiaries may obtain additional statutory capital through various sources, such as retained statutory earnings or equity contributions from us. As of December 31, 2013, the levels of our and our insurance subsidiaries’ capital and surplus exceeded the minimum RBC requirements.
The following summarizes our contractual obligations as of December 31, 2013 (in thousands):
(2) Includes case reserves for reported claims and reserves for IBNR with the timing of future payments based on our historical payment patterns. The timing of these payments may vary significantly from the pattern shown in the preceding table. The ultimate losses may vary materially from the recorded amounts, which are our best estimates.
(3) Reflects estimated future claim payments for claims incurred based on mortality and morbidity assumptions that are consistent with historical claims experience. These are not discounted with interest and will exceed the liabilities recorded in reserves for future claim payment, which are discounted with interest. Due to the significance of the assumptions used, the amounts presented could materially differ from actual payments. Effective December 31, 2013, amounts are presented before reinsurance as management believes this provides a better representation of the Company’s cash requirements.
Consolidated Statements of Comprehensive Income (Loss) for the years ended December 31, 2013, 2012, and
Consolidated Statements of Changes in Stockholders’ Equity for the years ended December 31, 2013, 2012, and 2011
As discussed in note 10 to the consolidated financial statements, the Company adopted Financial Accounting Standards Board Accounting Standards Update 2010-26, Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts, effective January 1, 2012, and applied the retrospective method of adoption to all period periods presented in the consolidated financial statements.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company’s internal control over financial reporting as of December 31, 2013, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated February 28, 2014 expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.
We have audited American National Insurance Company’s (the Company) internal control over financial reporting as of December 31, 2013, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Managements’ Annual Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.
Mortgage loans on real estate are stated at unpaid principal balance, adjusted for any unamortized discount, deferred expenses, and allowances. Accretion of discounts is recorded using the effective yield method. Interest income, prepayment fees and accretion of discounts and origination fees are reported in “Net investment income” in the consolidated statements of operations. Interest income earned on impaired and non-impaired loans is accrued on the principal amount of the loan based on contractual interest rate. However, interest ceases to accrue for loans on which interest is more than 90 days past due, when the collection of interest is not probable or when a loan is in foreclosure. Income on past due loans is reported on a cash basis. When a loan becomes current, it is placed back into accrual status. Cash receipts on impaired loans are recorded as a reduction of principal, interest income, expense reimbursement or other manner in accordance with the loan agreement. Gains and losses from the sale of loans and changes in allowances are reported in “Realized investment gains (losses)” in the consolidated statements of operations.
Investment real estate including related improvements, are stated at cost less accumulated depreciation. Depreciation is provided on a straight-line basis over the estimated useful life of the asset (typically 15 to 50 years). Rental income is recognized on a straight-line basis over the term of the respective lease. American National classifies a property as held-for-sale if it commits to a plan to sell a property within one year and actively markets the property in its current condition for a price that is reasonable in comparison to its estimated fair value. Real estate held-for-sale is stated at the lower of depreciated cost or estimated fair value less expected disposition costs, and is not depreciated while it is classified as held-for-sale. American National periodically reviews its investment real estate for impairment and tests properties for recoverability whenever events or changes in circumstances indicate the carrying amount of the asset may not be recoverable and the carrying value of the property exceeds its estimated fair value. Properties whose carrying values are greater than their undiscounted cash flows are written down to their estimated fair value, with the impairment loss included in “Realized investment gains (losses)” in the consolidated statements of operations. Impairment losses are based upon the estimated fair value of real estate, which is generally computed using the present value of expected future cash flows from the real estate discounted at a rate commensurate with the underlying risks as well as other appraisal methods. Real estate acquired upon foreclosure is recorded at the lower of its cost, or its estimated fair value at the date of foreclosure.
Real Estate Joint Ventures and Other Limited Partnership Interests-American National uses the equity method of accounting for its investments in real estate joint ventures and other limited partnership interests in which it has more than a minor interest or influence over the investee’s operations, but it does not have a controlling interest and is not the primary beneficiary. These investments are reported as “Investments in unconsolidated affiliates” in the consolidated statements of financial position. For certain joint ventures, American National records its share of earnings using a lag methodology of one to three months for all instances where timely financial information is not available and the contractual right does not exist to receive such financial information. In addition to the investees’ regular impairment analysis of its underlying investments, American National routinely evaluates its investments in those investees for impairments. American National considers financial and other information provided by the investee, other known information and inherent risks in the underlying investments, as well as future capital commitments, in determining whether impairment has occurred. When an impairment is deemed to have occurred at the joint venture level, American National recognizes its share within “Equity in earnings (losses) of unconsolidated affiliates” to record the investment at its fair value. When an impairment results from American National’s separate analysis, an adjustment is made through “Realized investment gains (losses)” to record the investment at its fair value.
American National evaluates all equity securities in unrealized loss positions on a quarterly basis and recognizes an OTTI loss on those where a market price recovery is not expected in a reasonable period of time. All equity securities with unrealized losses are also evaluated for credit quality. OTTI is recognized if management believes the carrying value of securities will not be realized, regardless of the length of time that they have had an unrealized loss.
Deferred policy acquisition costs (“DAC”) are the capitalized costs related directly to the successful acquisition of new or renewal insurance contracts. Significant costs are incurred to acquire insurance and annuity contracts, including commissions and certain underwriting, policy issuance and processing expenses.
Policyholders’ account balances represent the contract value that has accrued to the benefit of the policyholders related to universal-life, limited-pay and investments-type contracts. These are generally equal to the accumulated deposits, plus interest credited, reduced by withdrawals, payouts, and accumulated policyholder assessments.
Reinsurance-Reinsurance recoverables are estimated amounts due to American National from reinsurers related to paid and unpaid ceded claims and CAE and are presented net of a reserve for non-recoverability. Recoveries on our gross ultimate losses are generally determined by a review of individual large claims as well as by estimating the ceded portion of IBNR using assumed distribution of loss by percentage retained. The most significant assumption used is the average size of the individual losses for those claims that have occurred but have not yet been recorded. The ultimate amount of the reinsurance ceded recoverable is unknown until all losses are settled.
Universal life and single premium whole life revenues represent amounts assessed to policyholders. Included in revenue are mortality charges, surrender charges actually paid and earned policy service fees. Amounts included in expenses are benefits in excess of account balances returned to policyholders.
American National Insurance Company and its eligible subsidiaries file a consolidated life and non-life federal income tax return. Certain subsidiaries that are consolidated for financial reporting are not eligible to be included in the consolidated federal income tax return; accordingly, they file separate returns.
Restricted Stock Units-Effective December 31, 2012, American National’s Board Compensation Committee modified the settlement provision within the outstanding restricted stock units (“RSU”) providing the recipients of the awards option to settle vested RSUs in either cash or American National common stock. The modification in the settlement provision changed the RSU classification from an equity to a liability award. After the modification, the liability has been remeasured each reporting period through the vesting date and will be adjusted for the changes in fair value. The compensation liability related to the RSUs is included in “Other Liabilities” in the consolidated statement of financial position.
Separate account assets and liabilities are funds intended to meet the investment objectives of contract holders who bear the investment risk. Investment income and investment gains and losses from these separate funds accrue to the benefit of the contract holders. Separate accounts are established in conformity with insurance laws and are not chargeable with liabilities that arise from any other business of American National. American National reports separately, as assets and liabilities, investments held in separate accounts and liabilities of the separate accounts if (i) such separate accounts are legally recognized; (ii) assets supporting the contract liabilities are legally insulated from American National’s general account liabilities; (iii) investments are directed by the contract holder; and (iv) all investment performance, net of contract fees and assessments, is passed through to the contract holder. The assets of these accounts are carried at fair value. Deposits, net investment income and realized investment gains and losses for these accounts are excluded from revenues, and related liability increases are excluded from benefits and expenses in the consolidated financial statements.
Amended guidance for derecognition of an in substance real estate subsidiary. The amendment clarifies that when a reporting entity ceases to have a controlling financial interest in a subsidiary that is in substance real estate because of a default on the subsidiary’s nonrecourse debt secured by the real estate, the reporting entity should apply the guidance for real estate sales when evaluating the subsidiary for deconsolidation.
Guidance that amends the disclosures about offsetting assets and liabilities. The new guidance requires disclosures of both gross and net information about offsetting and related arrangements. Subsequently, amendments were issued to clarify the scope of this guidance covering only those derivatives that are either offsets in accordance with the right of setoff conditions, the balance sheet netting criteria or subject to an enforceable master netting arrangement or similar agreement.
The amortized cost at fair value, by contractual maturity, of fixed maturity securities are shown below (in thousands):
Total mortgage loans are net of unamortized discounts of $852,000 and $4,346,000 and unamortized origination fees of $15,709,000 and $14,076,000 at December 31, 2013 and 2012, respectively. No unearned income is included in these amounts.
Loans not evaluated individually for collectibility are segregated by property-type and location, and allowance factors are applied. These factors are developed annually and reviewed quarterly based on our historical loss experience adjusted for the expected trend in the rate of foreclosure losses. Allowance factors are higher for loans of certain property types and in certain regions based on loss experience or a blended historical loss factor.
American National has granted concessions to mortgage loan borrowers related to their ability to pay the loans which are classified as troubled debt restructurings. Concessions are generally one of, or a combination of, a delay in payment of principal or interest, a reduction of the contractual interest rate or an extension of the maturity date. American National considers the amount, timing and extent of concessions in determining any impairment or changes in the specific allowance for loan losses recorded in connection with a troubled debt restructuring. The carrying value after specific allowance, before and after modification in a troubled debt restructuring, may not change significantly, or may increase if the expected recovery is higher than the pre-modification recovery assessment.
The number of mortgage loans and recorded investment in troubled debt restructuring are as follows:
American National and its wholly-owned subsidiaries regularly invest in real estate partnerships and joint ventures. American National frequently participates in the design of these entities with the sponsor, but in most cases, its involvement is limited to financing. Through analysis performed by American National, some of these partnerships and joint ventures have been determined to be variable interest entities (“VIEs”). In certain instances, in addition to an economic interest in the entity, American National holds the power to direct the most significant activities of the entity and is deemed the primary beneficiary or consolidator of the entity. The assets of the consolidated VIEs are restricted and must first be used to settle their liabilities. Creditors or beneficial interest holders of these VIEs have no recourse to the general credit of American National, as American National’s obligation is limited to the amount of its committed investment. American National has not provided financial or other support to the VIEs in the form of liquidity arrangements, guarantees, or other commitments to third parties that may affect the fair value or risk of its variable interest in the VIEs in 2013 or 2012.
The notes payable in the consolidated statements of financial position pertain to the borrowings of the consolidated VIEs. The liability of American National Insurance Company relating to notes payable of the consolidated VIEs is limited to the amount of its direct or indirect investment in the respective ventures, which totaled $12,782,000 and $18,063,000 at December 31, 2013 and 2012, respectively. The current portion of notes payable was $3,199,000 and $50,884,000 at December 31, 2013 and 2012, respectively. The average interest rate on the current portion of the notes payable was 4.25% during 2013. The total long-term portion of notes payable consists of three notes with the following interest rates: 4.0%, and adjusted LIBOR plus LIBOR margin. Of the long-term notes payable, $9,375,000 will mature in 2016, with the remainder maturing beyond 5 years.
As of December 31, 2013, a real estate investment with a carrying value of $15,086,000 was classified as held for sale as of after an offer to purchase the property was received and it is likely the transaction will occur in 2014. The property is carried at fair value less estimated selling cost, which resulted in a $300,000 loss.
American National purchases over-the-counter equity-indexed options as economic hedges against fluctuations in the equity markets to which equity-indexed products are exposed. Equity-indexed contracts include a fixed host universal-life insurance or annuity contract and an equity-indexed embedded derivative. The detail of derivative instruments is shown below (in thousands, except the number of instruments):
The pricing of certain commercial mortgage-backed securities use discounted cash flow models, and these securities are classified as Level 3 measurements. These models include significant non-observable inputs including an internally determined credit rating of the security and an externally provided credit spread. At December 31, 2013 and 2012, the modeled discount rate ranges from 5.9% to 6.0%.
Mortgage Loans-The fair value of mortgage loans is estimated using discounted cash flow analyses on a loan by loan basis by applying a discount rate to expected cash flows from future installment and balloon payments. The discount rate takes into account general market trends and specific credit risk trends for the individual loan. Factors used to arrive at the discount rate include inputs from spreads based on U.S. Treasury notes and the loan’s credit quality, region, property type, lien priority, payment type and current status.
Within the net gain (loss) for derivatives included in net investment income were an unrealized gain/loss of $72,071,000, $8,710,000 and of ($12,613,000) relating to assets still held at December 31, 2013, 2012, and 2011, respectively.
The net and gross reserve calculations have shown favorable development for the last several years as a result of favorable loss emergence compared to what was implied by the loss development patterns used in the original estimation of losses in prior years. Estimates for ultimate incurred claims attributable to insured events of prior years decreased by approximately $46,872,000 in 2013, $48,688,000 in 2012, and $82,523,000 in 2011.
Effective December 31, 2012, the settlement provision within outstanding RSU awards was modified to allow the recipient of the awards to settle the vested RSUs in either cash or American National’s common stock. This change in the settlement provision is expected to apply to all future issuance of RSU awards. Prior to the modification, vested RSUs were converted to American National’s common stock on a one-for-one basis. This modification changes the award classification from an equity to a liability award. At the date of modification, American National recorded a liability of $7,974,000 with a corresponding reduction in additional paid-in capital. The liability will be remeasured and adjusted for changes in the fair value each reporting period through the vesting date. RSUs generally vest after a three-year graded vesting requirement. Certain awards vest over a shorter period as a result of retirement provisions. The modification, which was applied consistently to all participants, resulted in an incremental cost of $5,232,000 and $0 for the years ended December 31, 2013 and 2012, respectively.
The statutory capital and surplus and net income (loss) of our life and property and casualty insurance entities in accordance with statutory accounting practices are shown below (in thousands):
American National Insurance Company’s payment of dividends to stockholders is restricted by statutory regulations. The restrictions require life insurance companies to maintain minimum amounts of capital and surplus, and in the absence of special approval, limit the payment of dividends to the greater of prior year statutory net income from operations on an annual, non-cumulative basis, or 10% of prior year statutory surplus. Under Texas insurance law, American National Insurance Company is permitted to pay total dividends of $266,786,000 during 2014, without prior approval of the Texas Department of Insurance. Similar restrictions on amounts that can transfer in the form of dividends, loans, or advances to American National Insurance Company apply to its insurance subsidiaries.
The accounting policies of the segments are the same as those described in Note 2. All revenue and expense amounts specifically attributable to policy transactions are recorded directly to the appropriate operating segment. Revenues and expenses not specifically attributable to policy transactions are allocated to each segment as follows:
The following summarizes results of operations by operating segments (in thousands):
The components of net periodic benefit cost for the defined benefit pension plans are shown below (in thousands):
American National provides certain health and dental benefits to a closed block of retirees and their dependents who met certain age and length of service requirements as of December 31, 1993. The primary retiree health benefit plan provides Medicare Supplemental and prescription drug benefits. The plan is contributory, with American National’s contribution limited to $40 per month for retirees and spouses with any additional contributions necessary, being made by the retirees.
American National has guaranteed bank loans for customers of a third-party marketing operation. The bank loans are used to fund premium payments on life insurance policies issued by American National. The loans are secured by the cash values of the life insurance policies. If the customer were to default on the bank loan, American National would be obligated to pay off the loans. As the cash values of the life insurance policies always equal or exceed the balance of the loans, management does not foresee any loss on these guarantees. The total amount of the guarantees outstanding as of December 31, 2013, was approximately $206,376,000, while the total cash values of the related life insurance policies was approximately $210,050,000.