We undertake no obligation to publicly update or revise any forward-looking statements. Readers are cautioned not to place undue reliance on these forward-looking statements, which merely reflect Company expectations at the time of the writing. Actual results may differ materially from expectations conveyed in forward-looking statements due to changes caused by various risks and uncertainties. The reader should, however, consult any further disclosures TALIC may make in future filings of its Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, and Current Reports on Form 8-K.
During the preparation of the Company’s Annual Report on Form 10-K (“Form 10-K”) for the year ended December 31, 2014, an error in the tax valuation allowance was identified for the year ended December 31, 2013. The error principally relates to the scheduling of certain deferred tax liabilities in the Company’s analysis of the future ability to utilize net operating loss carryforwards in the tax expense calculations and the resulting amount of valuation allowance recognized. Following the identification of the tax-related error, Management initiated a comprehensive internal review of the Company’s historical financial information and determined the error materially impacted the audited financial statements for the year ended December 31, 2013 and the unaudited interim financial statements for March 31, 2014, June 30, 2014 and September 30, 2014. The Company filed a Current Report on Form 8-K with the Securities and Exchange Commission (“SEC”) on April 1, 2015 and a Current Report on Form 8-K/A on April 9, 2015 disclosing its conclusions that the audited financial statements of the Company for the year ended December 31, 2013 and the unaudited interim financial statements for March 31, 2014, June 30, 2014, and September 30, 2014 as contained in its historical Annual Report on Form 10-K and Quarterly Reports on Form 10-Q, respectively, should no longer be relied upon. Consequently, the Company has restated its financial statements for the year ended December 31, 2013 and the unaudited interim financial statements for March 31, 2014, June 30, 2014, and September 30, 2014. In addition, the Company identified, individually and in the aggregate, immaterial out-of-period errors which have been corrected in the periods to which they relate. The impact of the restatement of the Company’s financial statements is detailed in Note 1. “Restatement of Previously Reported Financial Information” and Note 14. “Quarterly Unaudited Financial Information” to the financial statements. The Company’s evaluation of the effectiveness of the Company’s disclosure controls and procedures and the Company’s remediation plans are described in “Item 9A. Controls and Procedures” in Part II of this 2014 Form 10-K.
The preparation of financial statements in conformity to GAAP requires management to make estimates and assumptions affecting the reported amounts of assets, liabilities, revenues and expenses and the disclosures of contingent assets and liabilities. Estimates, by their nature, are based on judgment and available information. Therefore, actual results could differ and could have a material impact on the financial statements.
The Company’s critical accounting policies and estimates are discussed below. See Note 2 to the Financial Statements for additional information regarding accounting policies.
The Company’s investments consist principally of fixed maturity and equity securities that are classified as available-for-sale (“AFS”) which are reported at estimated fair value. In addition, the Company held fixed maturity securities which contain a conversion to equity feature, which is considered an embedded derivative. These fixed maturity securities have been classified as trading and are reported at estimated fair value. During 2012, the last of these securities converted so the Company no longer holds any of these securities as of December 31, 2014 and 2013. The fair values of fixed maturity and equity securities are determined by management after taking into consideration several sources of data. When available, the Company uses quoted market prices in active markets to determine the fair value of its investments. The Company’s valuation policy utilizes a pricing hierarchy which dictates that publicly available prices are initially sought from indices and third-party pricing services. In the event that pricing is not available from these sources, those securities are submitted to brokers to obtain quotes. If broker quotes are not available, then securities are priced using internal cash flow modeling techniques. These valuation methodologies commonly use reported trades, bids, offers, issuer spreads, benchmark yields, estimated prepayment speeds, and/or estimated cash flows.
The Company’s portfolio of private placement securities is valued using a matrix pricing methodology. The pricing methodology is obtained from a third party service and indicates current spreads for securities based on weighted average life, credit rating and industry sector. Monthly the Company reviews the matrix to ensure the spreads are reasonable by comparing them to observed spreads for similar securities traded in the market. In order to account for the illiquid nature of these securities, illiquidity premiums are included in the valuation and are determined based upon the pricing of recent transactions in the private placement market as well as comparing the value of the privately offered security to a similar public security. The impact of the illiquidity premium to the overall valuation is less than 1% of the fair value. At December 31, 2014 and 2013, approximately $106.4 million (or 6%) and $72.5 million (or 4%), respectively, of the Company’s fixed maturity and equity securities portfolio consisted of private placement securities.
For the year ended December 31, 2014, the Company recorded an OTTI in income of $0.1 million, with no associated value of business acquired amortization. For the years ended December 31, 2013 and 2012, the Company recorded an OTTI in income of $0.7 million and $0.3 million, respectively, net of value of business acquired amortization.
Put and call options have been utilized by the Company to create equity collars designed to have a zero cost at issue, which serve to hedge the risk of equity market declines by selling a portion of market upside above the Company’s long-term expected return. The equity collar was disposed of in the fourth quarter of 2013.
During the fourth quarter of 2014, the Company began writing credit default swaps enabling the Company to change the risk profile of the assets in the portfolio by enhancing the overall yield.
The Company enters into dollar roll repurchase agreement transactions whereby the Company takes delivery of mortgage-backed securities (“MBS”) pools and sells them to a counterparty along with an agreement to repurchase substantially the same pools at some point in the future, typically one month forward. These transactions are accounted for as collateralized borrowings, and the repurchase agreement liability is included in the Balance Sheets in payables for collateral under securities loaned and reverse repurchase agreements.
The following table provides a summary of the securities under reverse repurchase agreements for the years ended December 31:
VOBA 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. At December 31, 2014 and 2013, the Company’s VOBA asset was $268.1 million and $284.6 million, respectively. For the years ended December 31, 2014, 2013, and 2012, the favorable (unfavorable) impact to pre-tax net income related to VOBA unlocking was $6.6 million, $12.7 million, and ($0.7) million, respectively. There were no impairment charges in 2014, 2013, and 2012.
The costs of acquiring business, principally commissions, certain expenses related to policy issuance, and certain variable sales expenses that relate to and vary with the production of new and renewal business are deferred and amortized based on the estimated future gross profits for a group of contracts. DAC are subject to recoverability testing at the time of policy issuance and loss recognition testing at the end of each reporting period. At December 31, 2014 and 2013, variable annuities accounted for the Company’s entire DAC asset of $41.1 million and $34.9 million, respectively.
The long-term growth rate assumption for the amortization of VOBA, DAC and DSI was 8% at December 31, 2014 and 2013 and 9% at December 31, 2012.
Goodwill is the excess of the purchase price over the estimated fair value of net assets acquired. Goodwill and intangible assets with indefinite lives are not amortized, but are subject to impairment tests conducted at least annually. Impairment testing is to be performed using the fair value approach, which requires the use of estimates and judgment, at the “reporting unit” level. A reporting unit represents the operating segment which is the level at which the financial information is prepared and regularly reviewed by management. The entire asset amount has been allocated to annuities. Goodwill is reviewed for indications of value impairment, with consideration given to financial performance and other relevant factors. In addition, certain events including a significant adverse change in legal factors or the business climate, an adverse action or assessment by a regulator, or unanticipated competition would cause the Company to review the carrying amounts of goodwill for impairment. When considered impaired, the carrying amounts are written down to fair value based primarily on discounted cash flows. The Company performed annual tests of goodwill at December 31, 2014, 2013, and 2012 and determined there was no impairment of goodwill.
Future policy benefits are actuarially determined liabilities, which are calculated to meet future obligations and are generally payable over an extended period of time. Principal assumptions used in the establishment of liabilities for future policy benefits are mortality, surrender rates, policy expenses, equity returns, interest rates, and inflation. These estimates and assumptions are influenced by historical experience, current developments and anticipated market trends. At December 31, 2014 and 2013, future policy benefits were $425.2 million and $408.9 million, respectively.
At December 31, 2014 and 2013, GMWB liability and GMIB reinsurance asset included within future policy benefits were as follows:
At December 31, 2014 and 2013, the future policy benefits for the SALB liability was $0.5 million and less than $0.1 million, respectively.
The valuation allowance for federal deferred tax assets at December 31, 2014 and 2013 (As Restated) was $113.4 million and $139.3 million, respectively (this includes losses that are anticipated to be used in the consolidated group to reflect the income statement impact of the losses that would not be used if filing separately). The valuation allowance is related to loss carryforwards and other deferred tax assets that, in the judgment of management, are not more likely than not to be realized. In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that all or some of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets depends on generation of future taxable income during the periods in which those temporary differences are deductible. Management considers the scheduled reversal of deferred tax liabilities, projected taxable income, and tax-planning strategies in making the assessment. The error that was identified during the preparation of the Company’s 2014 financial statements, which required a restatement of the Company’s financial statements as of the year ended December 31, 2013 and the three quarters of 2014 relate to the complexity of the tax valuation allowance calculation.
The following outlines the adoption of recent accounting guidance in 2013. See Note 2 to the Financial Statements for a further discussion.
ASC 210, Balance Sheet - Accounting Standards Update (“ASU”) 2011-11, Disclosures about Offsetting Assets and Liabilities - enhances disclosures about financial instruments and derivative instruments that are either offset on the statement of financial position or subject to an enforceable master netting arrangement - adopted January 1, 2013.
ASC 740, Income Taxes - ASU 2013-11, Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists, requires that the liability related to certain unrecognized tax benefits should be offset against a deferred tax asset for a net operating loss carryforward, a similar tax loss or a tax credit carryfoward if such settlement is required or expected in the event the uncertain tax position is disallowed - early adopted September 30, 2013.
During 2014, 2013 and 2012, fixed contract owner deposits were $0.2 million. During 2014, 2013 and 2012, fixed contract owner withdrawals were $71.8 million, $92.1 million, and $104.7 million, respectively.
The amortized cost/cost and estimated fair value of investments in fixed maturity and equity securities at December 31, 2014 and 2013 were:
(1) Subsequent unrealized gains (losses) on OTTI securities are included in OCI-OTTI.
The Company’s $2.3 million of gross unrealized losses within the financial services sector has a fair value of $37.7 million at December 31, 2014. The majority of the unrealized loss in the financial services sector relates to one below investment grade security, Genworth Financial, which can be found within the insurance sub-sector. The $1.9 million of unrealized losses for Genworth Financial relates to the decline in value of its long term care product.
The Company’s $5.2 million of gross unrealized losses within the industrial sector has a fair value of $70.9 million at December 31, 2014. The industrial sector is further subdivided into various sub-sectors with a majority of its gross unrealized loss made up of issuers within the energy and consumer cyclical sub-sectors. Issuers within the energy sub-sector had total unrealized losses of $2.3 million, which relates to declining oil prices during 2014. Within the consumer cyclical sub-sector, there was one issuer that had a $1.6 million unrealized loss. This issuer previously defaulted and just recently restructured its debt.
The Company’s $0.5 million of gross unrealized losses classified as equity have a fair value of $9.7 million at December 31, 2014. All of the unrealized loss relates to holdings in the banking sub-sector.
Gross unrealized losses and OTTI on below investment grade AFS securities represented 63% and 6% of total gross unrealized losses and OTTI on all AFS securities at December 31, 2014 and 2013, respectively. Generally, below investment grade securities are more likely than investment grade securities to develop credit concerns. The ratios of estimated fair value to amortized cost reflected in the table below were not necessarily indicative of the market value to amortized cost relationships for the securities throughout the entire time that the securities have been in an unrealized loss position nor are they necessarily indicative of these ratios subsequent to December 31, 2014.
Details underlying AFS securities below investment grade and in an unrealized loss were as follows:
The following tables provide the ABS subprime mortgage exposure by rating and estimated fair value by vintage at December 31, 2014 and 2013:
The fair value for mortgage loans on real estate is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and/or similar remaining maturities. The estimated fair value of the mortgage loans on real estate at December 31, 2014 and 2013 was $71.4 million and $51.5 million, respectively.
All mortgage loans that are impaired have an established allowance for loss. Changing economic conditions impact our valuation of mortgage loans. Changing vacancies and rents are incorporated into the discounted cash flow analysis that the Company performs for monitored loans and may contribute to the establishment of (or an increase or decrease in) an allowance for losses. In addition, the Company continues to monitor the entire commercial mortgage loan portfolio to identify risk. Areas of emphasis are properties that have deteriorating credits or have experienced debt coverage reduction. Where warranted, the Company has established or increased loss reserves based upon this analysis. There was one impaired mortgage loan during the first quarter of 2014 which was subsequently sold during the third quarter of 2014 for a ($2.0) million realized loss. There were no impaired mortgage loans at December 31, 2014 and 2013. At December 31, 2014 and 2013, there were no commercial mortgage loans that were two or more payments delinquent. See Note 4 to the Financial Statements for further discussion.
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 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, 2014 and 2013, the Company’s assets included $2.2 billion and $2.1 billion, respectively, of cash, short-term investments and investment grade publicly traded AFS securities that could be liquidated if funds were required.
In order to continue 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. Statutory accounting principles differ from GAAP in multiple major respects. Under statutory accounting principles, the acquisition costs of new business are charged to expense, while under GAAP they are amortized over a period of time. Under statutory accounting principles, the required additions to statutory reserves are calculated under different rules than under GAAP. In addition, the valuation of investments and accounting for deferred taxes differs between the two bases of accounting.
The National Association of Insurance Commissioners 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, 2014 and 2013, 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 ratings at April 15, 2015:
The Company has utilized public information to estimate the future assessments it will incur as a result of life insurance company insolvencies. At December 31, 2014 and 2013, the Company’s estimated liability for future guaranty fund assessments was $0.1 million and $0.2 million, respectively. In addition, the Company has a receivable for future premium tax deductions of $4.5 million and $4.6 million at December 31, 2014 and 2013, respectively. The Company regularly monitors public information regarding insurer insolvencies and adjusts its estimated liability as appropriate.
For the years ended December 31, 2014 and 2013 (As Restated), the Company recorded net income (loss) of $33.5 million and ($214.3) million, respectively. The change in net income during 2014 as compared to 2013 was primarily due to higher realized derivative losses related to the equity collar hedge and the addition of a tax valuation allowance in 2013.
Net derivative losses decreased $183.8 million to $76.1 million during 2014 as compared to $259.9 million in 2013. The following table provides the changes in net derivative gains (losses) by type:
(a) The equity collar was disposed of in the fourth quarter of 2013 which is driving the decrease in losses. The 2013 losses were driven by the increase in the S&P index. This was a zero cost at inception macro equity hedge to protect against a portion of the unhedged equity tail risk by selling a portion of the market upside above the Company’s long term expected return and buying protection against extreme market declines. As a result, when equity markets increase, the equity collar declines in value. When markets decrease, the equity collar increases in value.
(b) The Company had a large notional amount of short positions in total return swaps in 2014, and the increase in the S&P gave rise to losses. The total return swap gains in 2013 were the result of long exposure to the S&P.
(c) Short futures result in losses when equity markets increase and long futures result in gains as equity markets increase. The Company no longer holds long futures. Short futures performance was driven by the 11% and 30% increases in the S&P for the periods ended December 31, 2014 and 2013, respectively.
Amortization of VOBA was $10.8 million and $4.8 million for the years ended December 31, 2014 and 2013, respectively, which included favorable unlocking of $6.6 million and $12.7 million, respectively. The change in 2014 was impacted by lower equity market performance and updated policyholder assumptions resulting in increased amortization and favorable unlocking as compared to 2013.
(c) Short futures result in losses when equity markets increase and long futures result in gains as equity markets increase. The 2013 performance from these futures positions was driven by the increase in the S&P.
Policy benefits increased $27.9 million during 2013 as compared to 2012. The following table provides the changes in policy benefits by type:
The Company is not dependent upon any single customer, and no single customer accounted for more than 10% of its revenues during 2014, 2013, or 2012.