TALIC conducts its business primarily in the annuity markets and to a lesser extent in the life insurance markets of the financial services industry. The Company offered the following guaranteed benefits within its variable annuity product suite: guaranteed minimum death benefits (“GMDB”), guaranteed minimum income benefits (“GMIB”) and guaranteed minimum withdrawal benefits (“GMWB”). In addition, the Company sells a fixed contingent annuity (also sometimes referred to as a contingent deferred annuity (“CDA”)), which includes a stand-alone living benefit (“SALB”).
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 value. At December 31, 2012 and December 31, 2011, approximately $63.6 million (or 4%) and $56.7 million (or 3%), respectively, of the Company’s fixed maturity and equity securities portfolio consisted of private placement securities.
For the year ended December 31, 2012, the Company recorded an OTTI in income of $0.3 million, net of value of business acquired amortization. For the year ended December 31, 2011, the Company recorded an OTTI in income of $1.2 million, with no associated value of business acquired amortization. For the year ended December 31, 2010, the Company recorded an OTTI in income of $1.6 million, 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. This program does not hedge any specific product group, but rather provides protection against a portion of the total remaining equity tail risk after existing hedge programs across all products in extreme market decline scenarios.
At December 31, 2012 and 2011, the Company had 412 and 630 outstanding short futures contracts with a notional amount of $145.7 million and $197.3 million, respectively.
At December 31, 2012 and 2011, the Company had variance swaps with a notional value of $11 thousand and $5 thousand, respectively, and a net fair value of ($1.9) million and ($1.3) million, respectively, which is presented as a liability on the Balance Sheets. The Company recognized $0.6 million and $1.0 million of losses from the change in fair value of the variance swaps in net investment income in the Statements of Income during the years ended December 31, 2012 and 2011, respectively.
The Company can also receive or pledge collateral related to derivative transactions. The credit support agreement contains a fair value threshold of $1.0 million over which collateral needs to be pledged by the Company or its counterparty. At December 31, 2012, the Company has pledged securities in the amount of $4.9 million to counterparties. At December 31, 2011, there was no cash collateral pledged or received on derivative transactions in accordance with the credit support agreement.
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 Sheet in payables for collateral under securities loaned and reverse repurchase agreements. At December 31, 2012, the payable for reverse repurchase agreements was $26.4 million. At December 31, 2012 the estimated fair value and amortized cost of the securities that were pledged to the counterparty to support the initial dollar roll was $26.2 million and $26.0 million, respectively. There were no reverse repurchase agreements at December 31, 2011.
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. Revisions in estimates result in changes to the amounts expensed in the reporting period in which the revisions are made and could result in the impairment of the asset and a charge to income if estimated future gross profits are less than the unamortized balance. At December 31, 2012 and 2011, the Company’s VOBA asset was $271.3 million and $309.6 million, respectively. For the years ended December 31, 2012, 2011, and 2010, the favorable (unfavorable) impact to pre-tax income related to VOBA unlocking was $4.3 million, ($11.6) million, and $24.6 million, respectively. There were no impairment charges in 2012, 2011, and 2010. See Note 4 to the Financial Statements for a further discussion.
DAC for variable annuities is amortized with interest over the anticipated lives of the insurance contracts in relation to the present values of estimated future gross profits from asset-based fees, guaranteed benefit rider fees, contract fees, and surrender charges, less a provision for guaranteed death and living benefit expenses, policy maintenance expenses, and non-capitalized commissions. Future gross profit estimates are subject to periodic evaluation with necessary revisions applied against amortization to date. 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”. Changes in assumptions can have a significant impact on the amount of DAC reported and the related amortization patterns. In general, increases in the estimated Separate Accounts return and decreases in surrender or mortality assumptions increase the expected future profitability of the underlying business and may lower the rate of DAC amortization. Conversely, decreases in the estimated Separate Accounts returns and increases in surrender or mortality assumptions reduce the expected future profitability of the underlying business and may increase the rate of DAC amortization. For the years ended December 31, 2012, 2011, and 2010, there was a favorable (unfavorable) impact to pre-tax income related to DAC unlocking of $1.8 million, ($3.0) million, and $1.1 million, respectively. See Note 4 to the Financial Statements for a further discussion.
The Company’s liability for policyholder account balances represents the contract value that has accrued to the benefit of policyholders at the Balance Sheet date. The liability is generally equal to the accumulated account deposits plus interest credited less policyholders’ withdrawals and other charges assessed against the account balance. Policyholder account balances at December 31, 2012 and 2011 were $1.4 billion and $1.5 billion, respectively.
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, 2012 and 2011, future policy benefits were $418.7 million and $475.9 million, respectively.
At December 31, 2012 and 2011, GMDB and GMIB liabilities included within future policy benefits were as follows:
At December 31, 2012 and 2011, GMWB liability and GMIB reinsurance asset included within future policy benefits were as follows:
At December 31, 2012, the future policy benefits for the SALB liability was less than $0.1 million.
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 federal income taxes based on amounts it believes it will ultimately owe. Inherent in the provision for federal income taxes are estimates regarding the realization of certain tax deductions and credits.
At December 31, 2012, the Company did not have a tax valuation allowance for deferred tax assets. The valuation allowance for deferred tax assets at December 31, 2011 was $90.4 million. The valuation allowance is related to a net operating loss carryforward and other deferred tax assets that, in the judgment of management, is 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.
Accounting Standards Codification (“ASC”) 944, Financial Services-Insurance - Accounting Standards Update (“ASU”) 2010-26, Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts - modifies the definition of the types of costs incurred by insurance entities that can be capitalized in the acquisition of new and renewal contracts - adopted January 1, 2012.
ASC 820, Fair Value Measurements and Disclosures - ASU 2011-04, Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS - amends current guidance to achieve common fair value measurement and disclosure requirements in U.S. GAAP and International Financial Reporting Standards (“IFRS”) - adopted January 1, 2012.
ASU 2011-12, Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05 - defers the amendments in ASU 2011-05 that relate to presentation of reclassifications out of accumulated other comprehensive income - adopted January 1, 2012.
ASC 820, Fair Value Measurements and Disclosure - Accounting Standards Update (“ASU”) 2010-06, Improving Disclosures about Fair Value Measurement - requires separate presentation of information about purchases, sales, issuances, and settlements in the Level 3 reconciliation for fair value measurements using significant unobservable inputs - adopted January 1, 2011.
At December 31, 2012, the Company’s assets were $10.5 billion or $18.9 million higher than the $10.5 billion in assets at December 31, 2011. Assets excluding Separate Accounts assets increased $57.5 million. Separate Accounts assets, which represent 66% of total assets, decreased $38.7 million to $7.0 billion. Changes in Separate Accounts assets were as follows:
The following schedule identifies the Company’s general account invested assets by type at December 31:
loss on one RMBS holding of $0.3 million relates to a securitized portfolio of prime 2005 hybrid mortgages that contain fixed income positions where our holding is rated below investment grade and was previously impaired to discounted cash flows. The company owns four investment grade corporate non-convertible securities with an unrealized loss of $0.9 million.
The overall exposure to the banking sub-sector in the Company’s portfolio is of high quality. The unrealized losses in the banking sub-sector primarily reflect the size of our holdings, low floating rate coupons on some securities, and credit spread widening in the sector due to the European Sovereign Debt Crisis as well as residual impact from both the U.S. financial crisis and concerns over the U.S. Fiscal Cliff. As a whole, the sub-sector improved in the second half of 2012, following a volatile first half. Decisive steps by EU leaders and world central banks to stabilize the euro and improve funding conditions calmed investor concerns that a euro breakup was imminent. Credit spreads continue to reflect some uncertainty over new efforts by regulators to impose “burden sharing” on creditors in order to quickly stabilize or wind up troubled banks. While these measures have made securities more volatile in the near-term, new, more stringent global legislation on bank capital and liquidity requirements is intended to reduce overall risk in the sector going forward and decouple troubled banks from the Sovereign. Furthermore, central banks appear committed to providing liquidity to the market, while asset write-downs and credit losses have diminished substantially in all but the most troubled countries.
ABS - housing related securities are secured by pools of residential mortgage loans primarily those which are categorized as subprime. The unrealized loss is primarily due to decreased liquidity and increased credit spreads in the market combined with significant increases in expected losses on loans within the underlying pools. The Company’s $1.4 million of gross unrealized losses within the ABS - housing sector has a fair value of $22.4 million.
software to perform a loan-by-loan, bottom-up approach to modeling. Key assumptions used in the models are projected defaults, loss severities, and prepayments. Each of these key assumptions varies greatly based on the significantly diverse characteristics of the current collateral pool for each security. Loan-to-value, loan size, and borrower credit history are some of the key characteristics used to determine the level of assumption that is utilized. Defaults were estimated by identifying the loans that are in various delinquency buckets and defaulting a certain percentage of them over the near-term and long-term. Assumed defaults on delinquent loans are dependent on the specific security’s collateral attributes and historical performance.
RMBS of the Company are monitored and reviewed on a monthly basis. Detailed cash flow models using the current collateral pool and capital structure on the portfolio are updated and reviewed quarterly. Model output is generated under base and stress-case scenarios. Our RMBS asset specialists utilize widely recognized industry modeling software to perform a loan-by-loan, bottom-up approach to modeling. Key assumptions used in the models are projected defaults, loss severities, and prepayments. Each of these key assumptions varies greatly based on the significantly diverse characteristics of the current collateral pool for each security. Loan-to value, loan size, and borrower credit history are some of the key characteristics used to determine the level of assumption that is utilized. Defaults were estimated by identifying the loans that are in various delinquency buckets and defaulting a certain percentage of them over the near-term and long-term. Assumed defaults on delinquent loans are dependent on the specific security’s collateral attributes and historical performance.
Loss severity assumptions were determined by obtaining historical rates from broader market data and by adjusting those rates for vintage, specific pool performance, collateral type, mortgage insurance and estimated loan modifications. Prepayments were estimated by examining historical averages of prepayment activity on the underlying collateral. Once the entire pool is modeled, the results are closely analyzed by our asset specialists to determine whether or not our particular tranche or holding is at risk for not collecting all contractual cash flows taking into account the seniority and other terms of the tranches held.
The Company’s $0.2 million of gross unrealized losses within the RMBS sector has a fair value of $10.7 million. The unrealized loss in the sector is primarily a result of the housing downturn the United States has experienced since 2007. Even with the stabilization over the past two years, fundamentals in RMBS continue to be weak, which impacts the magnitude of the unrealized loss. Delinquencies and severities in property liquidations remain at an elevated level, while prepayments remain at historically low levels. Due to the weak fundamental situation, reduced liquidity, and the requirement for higher yields due to market uncertainty, credit spreads remain elevated across the asset class.
There are no individual issues rated below investment grade in the RMBS sector which have unrealized loss positions greater than $2.5 million.
Securities are impaired to the net present value of projected future cash flows where holdings are not projected to pay principal and interest in full. As the remaining unrealized losses in the RMBS portfolio relate to holdings where the Company expects to receive full principal and interest, the Company does not consider the underlying investments to be impaired as of December 31, 2012.
The Company defines investment grade securities as unsecured debt obligations that have a rating equivalent to S&P’s BBB- or higher (or similar rating agency). At December 31, 2012 and 2011, approximately $96.1 million (or 5%) and $61.8 million (or 3%), respectively, of fixed maturity securities were rated BBB-, which is the lowest investment grade rating given by S&P. Below investment grade securities are speculative and are subject to significantly greater risks related to the creditworthiness of the issuers and the liquidity of the market for such securities. The Company closely monitors such investments.
Unrealized gains (losses) incurred during 2012 and 2011 were primarily due to price fluctuations resulting from changes in interest rates and credit spreads. If the Company has the intent to sell or it is more likely than not that the Company will be required to sell these securities prior to the anticipated recovery of the amortized cost, securities are written down to fair value. If cash flow models indicate a credit event will impact future cash flows, the security is impaired to discounted cash flows. As the remaining unrealized losses in the portfolio relate to holdings where the Company expects to receive full principal and interest, the Company does not consider the underlying investments to be impaired.
Gross unrealized losses and OTTI on below investment grade AFS securities represented 83% and 68% of total gross unrealized losses and OTTI on all AFS securities at December 31, 2012 and 2011, 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, 2012.
The asset depressed over 20% and greater than one year at December 31, 2012 is related to a preferred stock (ABN AMRO) with exposure to the banking sector. The drop in price for the ABN AMRO preferred stock was primarily due to high illiquidity in the markets in general due to the European debt crisis. There were no assets depressed over 40% at December 31, 2012.
During 2012, 2011 and 2010, there was $0.1 million, $0.6 million, and $1.7 million, respectively, of investment income on fixed maturity trading securities recorded in net investment income in the Statements of Income. During 2012, 2011, and 2010 there was $1.1 million, $0.4 million, and ($1.5) million, respectively, of income (loss) recognized from the change in the fair value on fixed maturity trading securities recorded in net investment income in the Statements of Income. The Company recognized losses of $0.9 million and $0.1 million during 2012 and 2011, respectively on the conversion of fixed maturity trading securities to preferred stock. There were no conversions of fixed maturity trading securities to preferred stock in 2010.
The following tables provide the ABS subprime mortgage exposure by rating and estimated fair value by vintage at December 31, 2012 and 2011:
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, 2012 and December 31, 2011 was $59.5 million and $61.8 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 were no impaired mortgage loans at December 31, 2012 and 2011. At December 31, 2012 and 2011, there were no commercial mortgage loans that were two or more payments delinquent. See Note 3 to the Financial Statements for further discussion.
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 70% of Separate Accounts assets were invested in equity-based mutual funds at December 31, 2012. Since asset-based fees collected on in force variable 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 2012, average variable account balances decreased $0.6 billion (or 7%) to $7.1 billion as compared to the same period in 2011.
(a) 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 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, 2012 and 2011, the Company’s assets included $2.4 billion and $2.3 billion, respectively, of cash, short-term investments and investment grade publicly traded AFS securities that could be liquidated if funds were required.
Ratings are an important factor in establishing the competitive position in the insurance and financial services marketplace. Rating agencies rate insurance companies based on financial strength and the ability to pay claims, factors more relevant to contract holders than investors.
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, 2012 and 2011, the Company’s estimated liability for future guaranty fund assessments was $0.6 million and $0.6 million, respectively. In addition, the Company has a receivable for future premium tax deductions of $4.0 million and $3.8 million at December 31, 2012 and 2011, respectively. The Company regularly monitors public information regarding insurer insolvencies and adjusts its estimated liability as appropriate.
Amortization (accretion) of DAC was $0.8 million and ($13.1) million for 2012 and 2011, respectively, which included favorable (unfavorable) unlocking of $1.9 million and ($3.0) million, respectively. The change in 2012 as compared to 2011 was principally driven by favorable equity markets resulting in amortization and favorable unlocking.
Amortization of VOBA was $19.9 million and $12.2 million for the years ended December 31, 2012 and 2011, respectively, which included favorable (unfavorable) unlocking of $4.3 million and ($11.6) million. 2012 was impacted by favorable equity markets and positive gross profits in the fourth quarter as compared to 2011.
(b) The increase in non-asset based policy charge revenue is primarily due to the recapture of an indemnity reinsurance agreement in 2011.
(b) The change in equity related gains (losses) principally relates to the decrease in net losses on futures contracts during 2011 as compared to 2010. Short futures contracts fluctuate relative to the volatility in the S&P.
(b) The increase in annuity benefit expense was primarily due to the reduction in risk neutral rates and lower equity market performance which resulted in an increase in guaranteed benefits in 2011 as compared to 2010.
Insurance expenses and taxes decreased $4.8 million (or 9%) in 2011 as compared to 2010. The following table provides the changes in insurance expenses and taxes for each respective period: