Industry analysts and observers generally agree that a sudden jump in interest rate levels would be harmful to life insurers with interest-sensitive products as it could provide an impetus for abnormal product surrenders and withdrawals at the same time fixed debt securities held by insurers declined in market value. The federal government's burgeoning deficit and the Federal Reserve's “easy money” stimulus threaten to push longer term interest rates higher by creating greater borrowing demand and fueling inflationary conditions, respectfully. Observers of credit markets increasingly predict an eventual rise in yields and speculate as to what may be the impetus to reverse the course on lower rates. It is uncertain what direction and at what pace interest rate movements may occur in the future and what impact, if any, such movements would have on the Company’s business, results of operations, cash flows or financial condition.
Deferred Policy Acquisition Costs (“DPAC”). The Company is required to defer certain policy acquisition costs and amortize them over future periods. These costs include commissions and certain other expenses that vary with and are directly associated with acquiring new business. The deferred costs are recorded as an asset commonly referred to as deferred policy acquisition costs. The DPAC asset balance is subsequently charged to income over the lives of the underlying contracts in relation to the anticipated emergence of revenue or profits. Actual revenue or profits can vary from Company estimates resulting in increases or decreases in the rate of amortization. The Company performs regular evaluations of its universal life and annuity contracts to determine if actual experience or other evidence suggests that earlier estimates should be revised. Assumptions considered significant include surrender and lapse rates, mortality, expense levels, investment performance, and estimated interest spread. Should actual experience dictate that the Company change its assumptions regarding the emergence of future revenues or profits (commonly referred to as “unlocking”), the Company would record a charge or credit to bring its DPAC balance to the level it would have been if using the new assumptions from the inception date of each policy.
Revenue Recognition. Premium income for the Company’s traditional life insurance contracts is generally recognized as the premium becomes due from policyholders. For annuity and universal life contracts, the amounts collected from policyholders are considered deposits and are not included in revenue. For these contracts, fee income consists of policy charges for policy administration, cost of insurance charges and surrender charges assessed against policyholders’ account balances which are recognized in the period the services are provided.
Universal life and annuity contract revenues - Revenues for universal life and annuity contract charges decreased slightly in 2013 compared to 2012 primarily due to lower surrender charge revenue from terminated policies. Revenues for universal life and annuity products consist of policy charges for the cost of insurance, administration charges, and surrender charges assessed against policyholder account balances, less reinsurance premiums as depicted in the following table.
Cost of insurance charges were $99.3 million in 2013 compared to $95.3 million in 2012 and $90.3 million in 2011. Cost of insurance charges typically trend with the size of the life insurance block in force. The increasing revenue from cost of insurance charges corresponds with the growth in life insurance in force. At December 31, 2013, the volume of life insurance in force increased to $22.4 billion from $21.6 billion as of the end of 2012. Administrative charges were $28.6 million, $32.6 million and $26.9 million for the years ended December 31, 2013, 2012 and 2011, respectively, and correlate with new life insurance business sales both in number of policies placed as well as the volume of insurance issued. During 2013, due to the substantial increase in the Company's single premium life insurance sales, the Company began deferring the premium load associated with this product causing a decrease in administrative charge revenue compared to 2012. This reduction was largely offset by corresponding changes to deferred policy acquisition costs and death benefit reserves. Surrender charges assessed against policyholder account balances upon withdrawal were $37.0 million in 2013 compared to $39.2 million in 2012 and $31.4 million in 2011. While the Company earns surrender charge income that is assessed upon policy terminations, the Company’s overall profitability is enhanced when policies remain in force and additional contract revenues are realized and the Company continues to make an interest rate spread equivalent to the difference it earns on its investment and the amounts that it credits to policyholders.
Gains and losses from index options are due to changes in equity market conditions. Index options are intended to act as hedges to match the returns on the product’s underlying reference index and the rise or decline in the index relative to the index level at the time of the option purchase which causes option values to likewise rise or decline. As income from index options fluctuates with the underlying index, the contract interest expense to policyholder accounts for the Company’s fixed-index products also fluctuates in a similar manner and direction. In 2013 and 2012, the reference indices increased and the Company recorded an overall gain from index options with a corresponding increase in contract interest expense in an amount relative to the gains recorded. In 2011, the opposite situation occurred as unrealized losses on unexpired options exceeded the realized gains on expiring options.
The Company records impairment write-downs when a decline in value is considered to be other-than-temporary and full recovery of the investment is not expected. Impairments due to credit factors are recorded in the Company’s consolidated statement of earnings while non-credit (liquidity) impairment losses are included in other comprehensive income (loss). Impairment and valuation write-downs reflected in the consolidated statements of earnings are summarized in the following table.
Debt security impairments in 2013, 2012 and 2011 primarily pertain to write-downs on asset-backed securities whose cash flows and fair values did not support the amortized cost basis at which the instruments were recorded in the financial statements.
Life and other policy benefits - Life and other policy benefits include death claims of $36.9 million, $31.8 million and $29.8 million for 2013, 2012 and 2011, respectively. While death claim amounts are subject to variation from period to period, the Company’s mortality experience has generally been consistent with or better than its product pricing assumptions. Although not utilized previously, the Company initiated a project during 2012 to identify unreported death claims by researching the Social Security Administration master data base for deceased individuals matching with insureds under in force policies of the Company. The Company identified death claims of $2.5 million in 2012 through this initiative for deaths incurred over the past decade and prior in some cases. Going forward, new state regulations require the Company to continue this program as frequently as quarterly in order to identify unreported death claims. Given the efforts undertaken in 2012 the amounts uncovered will be lesser in scope as search results will be more current.
The Company implemented new actuarial reserving systems beginning with specific blocks of business in 2009 and completed the final blocks of business in the fourth quarter of 2011. These new reserving systems enhance the Company's ability to provide estimates used in establishing future policy liabilities, monitor deferred acquisition costs and deferred sales inducement assets, and support other actuarial processes within the Company. The vendor system provides actuarial formula calculations producing refined estimates of reserves in accordance with GAAP while the previous reserving system produced estimated liabilities on state regulated actuarial formulas which were supplemented with adjustments in order to produce GAAP reserve estimates. The Company elected to purchase and install the new reserving system as growth in its lines of businesses created a need for more refined and controlled actuarial reserve computations and analysis in accordance with GAAP. During the conversion process, current reserving assumptions were reviewed and updated as appropriate with adjustments periodically recorded in the financial statements during this time frame.
Amortization of deferred policy acquisition costs - Life insurance companies are required to defer certain expenses that vary with, and are primarily related to, the cost of acquiring new business. The majority of these acquisition expenses consist of commissions paid to agents, underwriting costs, and certain marketing expenses. Recognition of these deferred policy acquisition costs (“DPAC”) as an expense in the consolidated financial statements occurs over future periods in relation to the expected emergence of profits priced into the products sold. This emergence of profits is based upon assumptions regarding premium payment patterns, mortality, persistency, investment performance, and expense patterns. Companies are required to review universal life and annuity contract assumptions periodically to ascertain whether actual experience has deviated significantly from that assumed. If it is determined that a significant deviation has occurred, the emergence of profit patterns is to be "unlocked" and reset based upon the actual experience. DPAC balances are also adjusted each period to reflect current policy lapse or termination rates, expense levels and credited rates on policies as compared to anticipated experience (“true-up”) with the adjustment reflected in current period amortization expense. In accordance with GAAP guidance the Company must also write off deferred acquisition costs and unearned revenue liabilities upon internal replacement of certain contracts as well as annuitizations of deferred annuities.
The following table identifies the effects of unlocking and true-up adjustments on DPAC balances recorded through amortization expense for 2013, 2012 and 2011.
General insurance expenses include amounts provided for various legal matters and outstanding litigation. As more fully described in Item 3. Legal Proceedings of this report, the Company entered into a settlement agreement pertaining to a class action lawsuit which was approved by the U.S. District Court in February 2014. Included in general insurance expense for 2013 is an accrual of $6.5 million related to this settlement.
A summary of segment earnings from continuing operations for the years ended December 31, 2013, 2012 and 2011 is provided below. The segment earnings exclude realized gains and losses on investments, net of taxes.
International universal life revenues also include surrender charges assessed upon surrender of contracts by policyholders. In the midst of the financial crisis the past few years, the Company’s international policyholders in particular exhibited concern regarding the developments in U.S. financial markets. This evidenced itself in the Company’s termination activity in its international life policies in force. During 2009, the Company incurred higher termination experience than is typical which resulted in recognition of increased surrender charge fee income. This level of termination activity subsequently subsided in 2011 although the termination activity in 2012 and 2013 picked up somewhat over the pace incurred in 2011. The following table illustrates the Company’s international life termination experience over the past five years.
As described previously, premiums collected on universal life products are not reflected as revenues in the Company's consolidated statements of earnings in accordance with GAAP. Actual international universal life premiums collected are detailed below.
As indicated in the discussion concerning net investment income, contract interest expense includes fluctuations that are the result of the performance of underlying equity indices associated with fixed-index universal life products. The derivative gain (loss) realized on purchased call options is included in the amounts the Company credits to policyholders. For more details about the Company’s use of index options to hedge the performance of equity indices refer to the derivative gain (loss) discussion in the Consolidated Operations section of this Item 7.
Premiums and contract charges primarily consist of surrender charge income recognized on terminated policies. The amount of surrender charge income recognized is determined by the volume of surrendered contracts as well as the duration of each contract at the time of surrender given the pattern of declining surrender charge rates over time that is common to most annuity contracts. The Company's lapse rate for annuity contracts during 2013 was 6.5%, a slight increase from a rate of 6.1% in 2012 and 5.9% in 2011.
Fixed-index products are more attractive for consumers when interest rate levels remain low and equity markets produce positive returns. Since the Company does not offer variable products or mutual funds, fixed-index products provide an important alternative to the Company's existing fixed interest rate annuity products. Fixed-index annuity deposits as a percentage of total annuity deposits were 88%, 79% and 65% for the years ended December 31, 2013, 2012 and 2011, respectively. The increasing percentage of fixed-index products to total annuity deposits reflects the low interest rate environment and the current bull market in equities.
Derivatives, index options, are call options purchased to hedge the interest crediting mechanism associated with the Company's fixed-index universal life and annuity policies. These options are reported on the balance sheet at fair value in accordance with GAAP. As previously discussed in the Results of Operations section of this Item 7, the unrealized gain position of options held at December 31, 2013 of $106.5 million was approximately $69.9 million larger than the unrealized gain position at December 31, 2012 of $36.6 million as a result of rising equity markets during 2013.
Substantially all of the Company’s investable cash flows are directed toward the purchase of debt securities. The Company’s investment policy calls for investing in debt securities that are investment grade, meet quality and yield objectives, and provide adequate liquidity for obligations to policyholders. Debt securities with intermediate maturities are targeted by the Company as they more closely match the intermediate nature of the Company’s policy liabilities and provide an appropriate strategy for managing cash flows. With the advent of the Federal Reserve's low interest rate environment, the percentage of mortgage-backed securities in the Company's investment portfolio has declined over the past few years reflecting increased prepayment activity. The Company holds minimal levels of U.S. Treasury securities due to their low yields and deposits most of these holdings with various state insurance departments in order to meet security deposit on hand requirements in these states.
The Company's investment guidelines do not allow for the purchase of below investment grade securities. The investments held in debt securities below investment grade are the result of subsequent downgrades of the securities. These holdings are further summarized below.
The Company's percentage of below investment grade securities compared to total invested assets at December 31, 2013 was relatively consistent with that of year-end 2012 although the dollar amount increased due to certain issues held being downgraded to below-investment grade levels during the year. The Company's holdings of below investment grade securities are relatively small and as a percentage of total invested assets low compared to industry averages.
However, the Company does have exposure to the debt of non-financial companies in certain of these countries. The following table shows bond holdings at December 31, 2013 of non-financial companies that are domiciled in Portugal, Ireland, Italy, Greece or Spain held in the available for sale and held to maturity debt security portfolios.
During the year ended December 31, 2013, the Company recorded other-than-temporary impairment ("OTTI") credit related write-downs on debt securities totaling $0.2 million and a separate $0.1 million on equity securities. The debt security impairments all pertained to asset-backed securities whose fair value and present value of future cash flows fell below the amortized cost of the security. See Note 3, Investments Debt and Equity Securities, of the accompanying consolidated financial statements for further discussion.
Since the Company's adoption of the GAAP guidance and accounting for other-than-temporary impairments due to credit loss versus non-credit loss, the Company recognized a total of $6.4 million of other-than-temporary impairments of which $2.5 million was deemed credit related and recognized as realized investment losses in earnings, and $3.9 million was deemed a non-credit related impairment and recognized in other comprehensive income.
As of December 31, 2013, 2 of the subprime securities were rated AA, 4 were rated BBB, 2 were rated B, and 2 were rated CC.
The Company's direct investments in real estate are not a significant portion of its total investment portfolio as most of these investments were acquired through mortgage loan foreclosures. For the year ended December 31, 2012, one property was acquired through mortgage loan foreclosure while for the years ended December 31, 2013 and 2011, no real estate properties were acquired through mortgage loan foreclosure. The Company also participates in several real estate joint ventures and limited partnerships that invest primarily in income-producing retail properties.
The Company held net investments in mortgage loans totaling $132.8 million and $142.2 million at December 31, 2013 and 2012, respectively. The diversification of the portfolio by geographic region, property type, and loan-to-value ratio was as follows:
The contractual maturities of mortgage loan principal balances at December 31, 2013 and 2012 were as follows:
The Company's real estate investments total approximately $18.2 million at December 31, 2013 and $18.8 million at December 31, 2012, and consist primarily of income-producing properties which are being operated by a wholly-owned subsidiary of the Company. The Company recognized operating income on these properties of approximately $1.7 million, $1.6 million and $1.6 million for the years ended December 31, 2013, 2012 and 2011, respectively. The Company monitors the conditions and market values of these properties on a regular basis and makes repairs and capital improvements to keep the properties in good condition. The Company recorded net realized investment gains and losses of $0.3 million, $2.6 million and $(0.1) million associated with these properties in the years ended December 31, 2013, 2012 and 2011, respectively.
The Company’s design of its fixed-index products incorporates a budget for the purchase of over-the-counter call options to fund the index credits due to policyholders. Management monitors current prices of these call options and manages the cost of purchases through the terms of the policy contracts. These terms permit the Company to change caps, participation rates, and asset fees, subject to guaranteed minimums, thus managing the cost of the call options quoted by counterparties. In addition, the Company's product terms allow for the Company to withdraw from offering a particular index option at any time effective on the next policy anniversary date.
Debt securities held to maturity are recorded at their amortized cost basis. Accordingly, the unrealized gain amounts shown in the table above are not incorporated into the Company's consolidated financial statements at December 31, 2013 and 2012, respectively.
The following table profiles the Company’s insurance liabilities at December 31, 2013 for annuities, deposit-type contracts and supplementary contracts with life contingencies by surrender and discretionary withdrawal characteristics.
Mortgage and other loans were modeled by discounting scheduled cash flows through the scheduled maturities of the loans, starting with interest rates currently being offered for similar loans to borrowers with similar credit ratings. Policy loans were modeled by discounting estimated cash flows using U.S. Treasury Bill interest rates as the base rates at December 31, 2013. The estimated cash flows include assumptions as to whether such loans will be repaid by the policyholders or settled upon payment of death or surrender benefits on the underlying insurance contracts and incorporate both Company experience and mortality assumptions associated with such contracts.
The above described scenarios produce estimated changes in cash flows as well as cash flow reinvestment projections. Estimated cash flows in the Company's model assume cash flow reinvestments, which are representative of the Company's current investment strategy. Calls and prepayments include scheduled maturities and those expected to occur which would benefit the security issuers. Assumed policy surrenders consider differences and relationships between credited interest rates and market interest rates as well as surrender charges on individual policies. The impact to earnings also includes the expected effects on amortization of deferred policy acquisition costs. The model considers only annuity and supplemental contracts in force at December 31, 2013, and does not consider new product sales or the possible impact of interest rate changes on sales.
The Company’s net exposure to loss due to credit risk if the option counterparties failed to completely perform according to the terms of the one-year contracts is as follows at December 31, 2013 and 2012.
In the past, cash flows from the Company's insurance operations have been sufficient to meet current needs. Cash flows from operating activities were $253.6 million, $290.3 million, and $244.8 million in 2013, 2012, and 2011, respectively. The Company also has significant cash flows from both scheduled and unscheduled investment security maturities, redemptions, and prepayments. These cash flows totaled $1.5 billion, $1.8 billion, and $0.8 billion in 2013, 2012, and 2011, respectively. Cash flows from security maturities, redemptions, and prepayments were amplified over the last three years due to the decline in interest rates. These cash flow items could be reduced if interest rates rise in 2014. Net cash flows from the Company's universal life and annuity deposit product operations totaled $106.6 million, $144.2 million, and $662.9 million in 2013, 2012, and 2011, respectively.
During October 2010, the FASB issued new guidance affecting insurance companies that incur costs in the acquisition of new and renewal insurance contracts. The guidance addresses the diversity in practice regarding the interpretation for which costs relating to the acquisition of new or renewal business qualifies for deferral. The new guidance specified the acquisition costs which are capitalizable and those which must be expensed. The effective date was for interim and annual periods ending after December 15, 2011. The adoption of this guidance for the Company was effective January 1, 2012. See Note 1, Summary of Significant Accounting Policies, of the accompanying consolidated financial statements for additional disclosures.
During January 2011, the FASB issued new guidance which defers the effective date of disclosures about troubled debt restructurings in Accounting Standards Update No. 2010-20. The effective date is for interim and annual periods ending after June 15, 2011. The adoption of this guidance did not have a significant impact on the consolidated financial statements.