This Management's Narrative Analysis of Results of Operations should be read in conjunction with the Financial Statements and Notes to Financial Statements included herein.
Changes affecting mortality, morbidity, persistence and other factors that may impact the profitability of our insurance products;
Changes in laws and regulations, particularly those affecting our operations or our products
The adverse impact of any lowering of one or more of our credit ratings on policy retention, profitability and liquidity;
Competitive, legal, regulatory or tax changes that affect the distribution cost of or demand for our products;
The investment performances of the underlying U.S. equity-based mutual funds supporting the Company’s variable products do not replicate the returns of any specific U.S. equity market index. However, investment performance will generally increase or decrease with corresponding increases or decreases in the overall U.S. equity market. There are several standard indices published on a daily basis that measure performance of selected components of the U.S. equity market. Examples include the Dow Jones Industrial Average (“Dow”), the NASDAQ Composite Index (“NASDAQ”) and the Standard & Poor’s 500 Composite Stock Price Index (“S&P”). The Dow, NASDAQ and S&P ended 2017 with increases of 25%, 27% and 19% from 2016, respectively. The Dow, NASDAQ and S&P ended 2016 with increases of 13%, 9% and 10% from 2015, respectively.
Changes in the U.S. equity market directly affect the values of the underlying U.S. equity-based mutual funds supporting Separate Accounts assets and, accordingly, the values of variable contract owner account balances. Approximately 72% of Separate Accounts assets were invested in equity-based mutual funds at December 31, 2017. Since asset-based fees collected on in-force contracts represent a significant source of revenue, the Company’s financial condition will be impacted by fluctuations in investment performance of equity-based Separate Accounts assets. During 2017, average variable Separate Account balances increased $0.07 billion (or 1.2%) to $5.7 billion as compared to the same period in 2016, due to strong equity market performance, offset by continued run-off of the closed block, resulting in an increase in related fees of $1.1 million.
Fluctuations in the U.S. equity market also directly impact the Company’s exposure to guaranteed benefit provisions contained in the contracts it enters into. Minimal or negative investment performance generally results in greater exposure to guarantee provisions. Prolonged periods of minimal or negative investment performance will result in greater guaranteed benefit costs as compared to assumptions. If the Company determines that it needs to increase its estimated long-term cost of guaranteed benefits, it will need to establish higher guaranteed benefit liabilities than it has established in the past.
The impact of changes in medium-term interest rates, corporate credit and credit spreads on market valuations were as follows:
The Company defines medium-term interest rates as the average interest rate on U.S. Treasury securities with terms of one to five years.
The increase in unrealized market valuations in the current year is driven primarily by credit spreads tightening.
Each month, the Company performs an analysis of the information obtained from third-party services and brokers to ensure that the information is reasonable and produces a reasonable estimate of fair value. The Company considers both qualitative and quantitative factors as part of this analysis, including but not limited to, recent transactional activity for similar fixed maturities, review of pricing statistics and trends, and consideration of recent relevant market events. Other controls and procedures over pricing received from indices, third-party pricing services, or brokers include validation checks, such as the review of exception reports that highlight significant price changes, stale prices or un-priced securities. In addition, the Company performs back testing on a sample basis. Back testing involves selecting a sample of securities trades and comparing the prices in those transactions to prices used for financial reporting. Significant variances between the price used for financial reporting and the transaction price are investigated to explain the cause of the difference.
Changes in the fair value of fixed maturity and equity securities deemed AFS are reported as a component of accumulated other comprehensive income (loss) (“AOCI”), net of taxes on the Balance Sheets and are not reflected in the Statements of Income (Loss) until a sale transaction occurs or when credit-related declines in estimated fair value are deemed other-than-temporary.
For fixed maturity AFS securities, an OTTI must be recognized in earnings when an entity either a) has the intent to sell the debt security, or b) is more likely than not to be required to sell the debt security before its anticipated recovery. If the Company meets either of these criteria, the OTTI is recognized in earnings in an amount equal to the entire difference between the security’s amortized cost basis and its fair value at the balance sheet date. For fixed maturity AFS securities in unrealized loss positions that do not meet these criteria, the Company must analyze its ability to recover the amortized cost by comparing the net present value of projected future cash flows with the amortized cost of the security. The net present value is calculated by discounting the Company’s best estimate of projected future cash flows. If the net present value is less than the amortized cost of the investment, an OTTI is recorded. The OTTI is separated into two pieces: an amount representing the credit loss, where the present value of cash flows expected to be collected is less than the amortized cost basis of the security, and an amount related to all other factors (referred to as the non-credit portion). The credit loss is recognized in earnings and the non-credit loss is recognized in Other Comprehensive Income (“OCI”), net of applicable taxes and VOBA. Management records subsequent changes in the estimated fair value (positive and negative) of fixed maturity AFS securities for which non-credit OTTI was previously recognized in OCI in “Net unrealized other-than-temporary impairments on securities.”
For the year ended December 31, 2017, the Company did not record OTTI in income. For the years ended December 31, 2016 and 2015, the Company recorded an OTTI in income of $5.2 million and $1.9 million, respectively, excluding VOBA.
The Company uses several types of derivatives to manage the capital market risk associated with the GMWB. Derivatives are primarily used by the Company to manage risk associated with interest rate or equity market risk or volatility. Freestanding derivatives are carried in the Balance Sheets at fair value. If a derivative is not designated as an accounting hedge or its use in managing risk does not qualify for hedge accounting, changes in the fair value of the derivatives are reported in net derivative gains (losses) in the Statements of Income (Loss).
To qualify for hedge accounting, the hedge relationship is designated and formally documented at inception, detailing the particular risk management objective and strategy for the hedge (which includes the item and risk that is being hedged), the derivative that is being used and how hedge effectiveness is being assessed. For hedge accounting purposes, a distinction is made between fair value hedges, cash flow hedges and hedges of a net investment in a foreign operation. Currently and during the periods covered by the accompanying Financial Statements, the Company has only had cash flow hedges.
A cash flow hedge is the hedge of the exposure to variability of cash flows to be received or paid related to a recognized asset or liability. For derivatives that are designated and qualify as cash flow hedges, the effective portion of the gain or loss on the derivative is reported as a component of OCI and reclassified into the Statements of Income (Loss) when the Company’s earnings are affected by the variability of the hedged item. Any hedge ineffectiveness is recognized as a component of net derivative gains (losses) in the Statements of Income (Loss).
The Company has entered into cash flow hedging transactions on Treasury Inflation Protected Securities (“TIPS”) utilizing interest rate swaps to lengthen portfolio duration and to hedge the variability of cash flows due to changes in inflation. The Company recognizes hedge ineffectiveness gains (losses) from the difference of the change in fair value of the swap and the change in fair value of the underlying Treasury in net derivative gains (losses) in the Statements of Income (Loss).
Equity futures contracts and interest rate futures contracts are used to hedge the equity risk and interest rate risk, respectively, associated with these types of variable guaranteed products, in particular the claim and/or revenue risks of the liability portfolio. Net settlements on the futures occur daily. The realized gains (losses) on settlement of these futures are recorded in net derivative gains (losses) in the Statements of Income (Loss).
The Company also writes credit default swaps (“CDS”) enabling the Company to change the risk profile of the assets in the portfolio by enhancing the overall yield. As a writer of CDS, the Company actively monitors the underlying asset, being careful to note any events (default or similar credit event) that would require the Company to perform on the CDS. If such events would take place, a payment equal to the notional amount of the contract, less any potential recoveries as determined by the underlying agreement, will be made by the Company to the counterparty to the swap, and recognized in net derivative gains (losses) in the Statements of Income (Loss).
The Company enters into fixed-to-float and float-to-fixed interest rate swaps in order to hedge the interest rate risk on the underlying liability. The Company holds these contracts at fair value, and recognizes gains (losses) related to changes in fair value in net derivative gains (losses) in the Statements of Income (Loss).
VOBA reflects the estimated fair value of in force contracts acquired and represents the portion of the purchase price that is allocated to the value of the right to receive future cash flows from the insurance and annuity contracts in force at the acquisition date. VOBA is based on actuarially determined projections, for each block of business, of future policy and contract charges, premiums, mortality, policyholder behavior, Separate Account performance, operating expenses, investment returns, and other factors. Actual experience on the purchased business may vary from these projections. Annually, the Company performs a comprehensive review of actuarial assumptions utilized in measuring insurance liabilities and expected gross profits used in amortizing VOBA. The assumptions include, but are not necessarily limited to, inputs such as mortality, policyholder behavior and expected future rates of returns on investments. As part of this review, the Company considers emerging experience, future expectations and other data, including any observable market data. These assumptions are updated and implemented in the third quarter of each year, unless a material change in experience, indicative of a long-term trend, is observed during an interim period. For VOBA, the impact of revisions and assumptions to estimates on cumulative amortization is recorded as a charge or credit to current operations, commonly referred to as “unlocking.”
See Notes to Financial Statements, Note 4 VOBA, DAC and DSI, for further discussion.
Included within future policy benefits are liabilities for GMDB and GMIB provisions contained in the variable products that the Company has issued. The Company regularly evaluates the assumptions used to establish these liabilities, as well as actual experience, and adjusts GMDB and GMIB liabilities with a related charge or credit to earnings (“unlocking”) if actual experience or evidence suggests that the assumptions should be revised.
Future policy benefits also include liabilities, which can be either positive or negative, for contracts containing GMWB and SALB provisions based on the fair value of the underlying benefit. GMWB and GMIB reinsurance are treated as embedded derivatives and are required to be reported separately from the host contract. The fair values of these guarantees are calculated as the present value of future expected payments to policyholders less the present value of assessed fees attributable to the guarantees. Given the complexity and long-term nature of these guarantees, which are unlike instruments available in financial markets, their fair values are determined using stochastic techniques under a variety of market return scenarios. A variety of factors are considered, including expected market rates of return, equity and interest rate volatility, credit spread, correlations of market returns, discount rates and actuarial assumptions. Currently, the Company does not hedge the risks associated with the SALB.
The Company uses the asset and liability method in providing income taxes on all transactions that have been recognized in the Financial Statements. The asset and liability method requires that deferred taxes be adjusted to reflect the tax rates at which future taxable amounts will be settled or realized. The Company provides for income taxes based on amounts that it believes it will ultimately owe. Inherent in the provision for income taxes are estimates regarding the realization of certain tax deductions and credits.
At December 31, 2017, the Company’s assets were $8.63 billion or $0.04 billion less than the $8.67 billion in assets at December 31, 2016. Assets excluding Separate Accounts assets decreased $176.3 million from $3.0 billion at December 31, 2016 to $2.8 billion at December 31, 2017. The change in total assets was due to a decrease in general fund investments assets supporting policyholder liabilities and reserves, along with a decrease in VOBA as business continues to run-off, offset by an increase in Separate Accounts assets.
The Company’s liability for policyholder account balances represents the contract value that has accrued to the benefit of policyholders as of the Balance Sheet date. The liability is generally equal to the accumulated policyholder deposits plus interest credited less policyholders’ withdrawals and other charges assessed against the account balance. Policyholder account balances decreased from 2016 to 2017 by $54.8 million due to death benefits, withdrawals and surrenders of $99.5 million, offset by interest credited to policyholders of $44.8 million.
During 2017, future policy benefits decreased $75.2 million from $486.8 million to $411.6 million at December 31, 2016 and 2017, respectively, primarily driven by unlocking adjustments of $71.5 million resulting from higher market performance and favorable mortality assumption updates.
The Company maintains a general account investment portfolio comprised primarily of investment grade fixed maturity securities, policy loans and cash and cash equivalents. To align with a change in the Company’s investment strategy, during the latter half of the year, the Company reduced its investment in hedge funds, decreasing the limited partnerships on the Balance Sheets by $69.5 million. In addition, the sale of $122.1 million in mortgage loan investments to affiliates and the net purchase of $120.7 million of investment grade securities from affiliates drove the change in balances for mortgage loans on real estate and fixed maturity AFS securities on the Balance Sheets by ($91.3) million and $61.6 million, respectively.
Subsequent unrealized gains (losses) on OTTI securities are included in Net unrealized OTTI on securities in the Statements of Comprehensive Income (Loss).
There were no individual issuers rated below investment grade in the industrial sector that had an unrealized loss position greater than $2.5 million.
The Company's $0.4 million of gross unrealized losses within the CMBS sector relates to securities with a fair value of $30.0 million, as fundamentals remain supportive with commercial property prices above their prior peak. Commercial real estate valuation increases have slowed. The delinquency rate has started to fall as loan resolution outpace new defaults and positive net supply increases the total outstanding balance. Liquidity remains reasonable for the CMBS market; however, credit spreads on legacy subordinate CMBS tranches remain at wide levels.
The amortized cost and estimated fair value of fixed maturity AFS securities at December 31, 2017 and 2016 by rating agency equivalent were:
Mortgage loans on real estate consist entirely of mortgages on commercial real estate. The Company does not accrue interest on loans ninety days past due. At December 31, 2017 and 2016, there were no commercial mortgage loans that had two or more payments delinquent. Mortgage loans by property type and geographic region changed significantly from 2016 to 2017 due to the sale of mortgage loans to affiliates during in the third quarter of 2017.
The Company’s liquidity requirements include the payment of sales commissions and other underwriting expenses and the funding of its contractual obligations for the life insurance and annuity contracts that it has in force. The Company has developed and utilizes a cash flow projection system and regularly performs asset/liability duration matching in the management of its asset and liability portfolios. The Company anticipates funding its cash requirements utilizing cash from operations, normal investment maturities and anticipated calls and repayments, consistent with prior years. At December 31, 2017 and 2016, the Company’s assets included $1.7 billion and $1.6 billion, respectively, of cash, short-term investments and investment grade publicly-traded AFS securities that could be liquidated if funds were required.
During 2017, the Company paid a $140.0 million dividend and $47.5 million return of capital to TA Corp. During 2016, the Company paid a $75.0 million dividend to TA Corp and $88.3 million return of capital to TA Corp.
To maintain the ability to issue annuity products, the Company must meet or exceed the statutory capital and surplus requirements of the insurance departments of the states in which it conducts business. The Company’s application of SAP differ from GAAP in the following major respects: under SAP, the acquisition costs of new business are charged to expense, while under GAAP they are amortized over a period of time; under SAP, the required additions to statutory reserves are calculated under different rules than under GAAP; and, the valuation of investments and accounting for deferred taxes differs between the two bases of accounting.
The NAIC utilizes the RBC adequacy monitoring system. The RBC calculates the amount of adjusted capital that a life insurance company should have based upon that company's risk profile. At December 31, 2017 and 2016, based on the RBC formula, the Company’s total adjusted capital levels were well in excess of the minimum amount of capital required to avoid regulatory action.
The following table summarizes the Company’s obligations to policyholders at December 31, 2017 related to the indicated accounts:
During 2017, short positions in equity-linked futures produced losses of $1.4 million due to the steadily improving equity market performance.
Short positions on equity-linked total return swaps resulted in losses of $16.2 million during 2017, as a reflection of improving equity market performance relative to periodic payment and reset dates.
The Company is not dependent upon any single customer, and no single customer accounted for more than 10% of its revenues during 2017, 2016 and 2015.
The Financials Statements of Registrant are set forth in Part IV hereof and are incorporated herein by reference.