The discussion in this Form 10-K may contain “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. We intend for these forward-looking statements to be covered by the safe harbor provisions of the federal securities laws relating to forward-looking statements. These forward-looking statements include statements relating to trends in, or representing management’s beliefs about our future transactions, strategies, operations and financial results and often contain words such as “will,” “anticipate,” “believe,” “plan,” “estimate,” “expect,” “intend,” “is targeting,” “may,” “should” and other similar words or expressions. Forward-looking statements are made based upon management’s current expectations and beliefs concerning trends and future developments and their potential effects on us. They are not guarantees of future performance. Our actual business, financial condition or results of operations may differ materially from those suggested by forward-looking statements as a result of risks and uncertainties which include, among others: (A) risks related to the restatement of our and Phoenix’s prior period financial statements and our internal control over financial reporting, which include (i) the presence of material weaknesses in our internal control over financial reporting, the potential failure to remediate material weaknesses in our internal control over financial reporting and that other material weaknesses may be identified in the future, which would adversely affect the accuracy and timing of our financial reporting; (ii) the extraordinary processes undertaken to effect the restatements by the Company and Phoenix may not have been adequate to identify and correct all errors in the historical financial statements and, as a result, we may discover additional errors and our financial statements remain subject to the risk of future restatement; (iii) the outcome of litigation and claims as well as regulatory examinations, investigations, proceedings and orders arising out of the restatement by the Company and Phoenix and the failure by the Company and Phoenix to have filed certain previously delayed SEC reports on a timely basis; (iv) our inability to hedge our positions due to our inability to replace hedges as a result of our credit rating; (v) the incurrence of significant restatement-related expenses; (vi) diversion of management and other human resources from the operation of our business; (vii) risks associated with the restatements by the Company and Phoenix and the Company’s ability to amend and update its existing registration statements, or file new registration statements, under the Securities Act and the Investment Company Act of 1940, as amended (the “Investment Company Act”), as well as risks associated with Phoenix Life’s ability to amend and update its existing registration statements, or file new registration statements, under the Securities Act and the Investment Company Act; (viii) risks associated with the ongoing compliance obligations of Phoenix and the Company under the SEC’s Cease-and-Desist Order, dated March 21, 2014, as amended by the Amended Cease-and-Desist Order, dated August 1, 2014; (ix) risk that the filing of single, multi-period comprehensive Annual Reports on Form 10-K to effect certain of the restatements by the Company and Phoenix did not satisfy our filing obligations and that we may be required to file additional reports to effect the restatements; (x) the risk that the Company’s, Phoenix’s and Phoenix Life’s restatements, the delay in filing of certain periodic reports with the SEC and errors corrected in subsequent statutory financial statement filings with state insurance regulators could result in regulatory investigations, examinations and/or inquiries, which may increase compliance costs and the potential for additional regulatory investigations, proceedings or other claims; and (xi) risks associated with our and Phoenix Life’s failure to file timely and accurate reports with state regulatory authorities; (B) risks related to our business, which include (i) unfavorable general economic developments including, but not limited to, specific related factors such as the performance of the debt and equity markets; (ii) the potential adverse effect of interest rate fluctuations on our business and results of operations; (iii) the potential adverse effect of legal actions and proceedings inherent in our business on our results of operations, financial position, business or reputation; (iv) further downgrades or withdrawals of our financial strength credit ratings, which could increase policy surrenders and withdrawals, adversely affect our relationships with distributors, reduce new sales, limit our ability to trade in derivatives and increase our costs of, or reduce our access to, future borrowings; (v)the impact on our results of operations and financial condition of any required increase in our reserves for future policyholder benefits and claims if such reserves prove to be inadequate; (vi) the possibility that mortality rates, persistency rates, funding levels or other factors may differ significantly from our assumptions used in pricing products; (vii) limited access to external sources of liquidity and financing; (viii) the effect of guaranteed benefits within our products; (ix) potential exposure to unidentified or unanticipated risk that could adversely affect our businesses or result in losses; (x) the consequences related to variations in the amount of our statutory capital could adversely affect our business; (xi) the possibility that we may not be successful in our efforts to implement a business plan focused on new market segments; (xii) changes in our investment valuations based on changes in our valuation methodologies, estimations and assumptions; (xiii) the availability, pricing and terms of reinsurance coverage generally and the inability or unwillingness of our reinsurers to meet their obligations to us specifically; (xiv) our ability to attract and retain key personnel in a competitive environment; (xv) our dependence on third parties to maintain critical business and administrative functions; (xvi) the strong competition we face in our business from banks, insurance companies and other financial services firms; (xvii) changes in tax law and policy may affect us directly or indirectly through the cost of, the demand for or profitability of our products or services; (xviii) the possibility that federal and state regulation may increase our cost of doing business, impose additional reserve or capital requirements, levy financial assessments or constrain our operating and financial flexibility; (xix) regulatory actions or examinations may harm our business; and (xx) changes in accounting standards; and (C) other risks and uncertainties described herein or in any of our filings with the SEC. Certain other factors which may impact our business, financial condition or results of operations or which may cause actual results to differ from such forward-looking statements are discussed or included in our periodic reports filed with the SEC and are available on our website at www.phoenixwm.com under “Investor Relations.” You are urged to carefully consider all such factors. We do not undertake or plan to update or revise forward-looking statements to reflect actual results, changes in plans, assumptions, estimates or projections, or other circumstances occurring after the date of this Form 10-K, even if such results changes or circumstances make it clear that any forward-looking information will not be realized. If we make any future public statements or disclosures which modify or impact any of the forward-looking statements contained in or accompanying this Form 10-K, such statements or disclosures will be deemed to modify or supersede such statements in this Form 10-K.
This section reviews our financial condition at December 31, 2014 and 2013; our results of operations for the years 2014, 2013 and 2012; and, where appropriate, factors that may affect our future financial performance. This discussion should be read in conjunction with our financial statements in this Form 10-K. We define increases or decreases greater than or equal to 200% as “NM” or not meaningful.
In 2014, 99% of PHL Variable product sales, as defined by total annuity deposits and total life premium, were annuities, and 94% of those sales were fixed indexed annuities.
Net realized investment gains or losses. Net realized investment gains, excluding OTTI, have been driven primarily by realized gains or losses on both the embedded policy derivatives associated with the fixed indexed annuity and variable annuity guarantees, and the derivative instruments that are used to hedge these businesses. The changes in the fair value of the policy embedded derivatives and the derivative instruments are driven by changes in the equity markets, including interest rates, market volatility, and overall market levels, as well as changes in actual and projected policyholder behavior. In 2014, there were realized losses on the embedded derivatives, while there were gains on the variable annuity embedded derivatives and losses on the fixed indexed annuity embedded derivative in 2013. In 2014, the losses on the embedded derivatives were primarily driven by the continued decline of interest rates and increased volatility in the equity markets.
As part of the annual assumption review and unlock, assumptions used in the calculation of the liability for PFBL are updated. In both 2013 and 2014, updates were made to long-term mortality assumptions that impacted expected future gross profits favorably. These updates resulted in an unlock benefit of $4.5 million for the year ended December 31, 2014 and a benefit of $86.2 million for the year ended December 31, 2013.
Overall, mortality improved in 2013 and has stayed consistent between 2013 and 2014. As a result, policy benefit expenses associated with incurred claims has remained consistent between the periods.
Other operating expenses. Other operating expenses have remained at elevated levels and continued to impact our earnings. These expenses are driven primarily by professional fees, including audit, outside consulting and legal services due to the preparation of financial statements and remediation efforts. Audit, other professional fees and outside consulting and legal services continue to be a driver of other operating expenses for the Company.
Since 2009, we have pursued a strategy focused on balance sheet strength, policyholder service, operational efficiency and profitable growth. Within the growth portion of the strategy, we shifted our target market to middle market and mass affluent families and individuals planning for or living in retirement and focused the majority of our efforts on building and distributing a competitive portfolio of fixed indexed annuity products. On a smaller scale, we developed life insurance products for the same target market. Our ultimate parent company established a distribution company to sell Phoenix products through independent marketing organizations and producers and provide consulting services to partner firms in support of policies written by companies other than Phoenix. These efforts have produced a firm foundation for continued growth, even as our business remains sensitive to general economic conditions and capital market trends including equity markets and interest rates.
For a discussion of accounting standards and changes in accounting, see Note 3 to our financial statements under “Item 8: Financial Statements and Supplementary Data” in this Form 10-K.
The discussion and analysis of our financial condition and results of operations are based upon our financial statements, which have been prepared in accordance with U.S. GAAP. In preparing these financial statements in conformity with U.S. GAAP, we are required to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Significant estimates and assumptions are made in the determination of EGPs used in the valuation and amortization of assets and liabilities associated with universal life and annuity contracts; policyholder liabilities and accruals; valuation of investments in debt and equity securities; limited partnerships and other investments; valuation of deferred tax assets; and accruals for contingent liabilities. Actual results could differ from these estimates.
The projection of EGPs requires the extensive use of actuarial assumptions, estimates and judgments about the future. Future EGPs are generally projected for the estimated lives of the contracts. Assumptions are set separately for each product and are reviewed at least annually based on our current best estimates of future events.
The Company has updated a number of assumptions that have resulted in changes to expected future gross profits. The most significant assumption updates made over the last several years resulting in a change to future gross profits and the amortization of DAC, SIA and URR are related to changes in expected premium persistency, the incorporation of a mortality improvement assumption and other updates to mortality based on updated experience. Other of the more significant drivers of changes to expected gross profits over the last several years include changes in expected separate account investment returns due to changes in equity markets; changes in expected future interest rates and default rates based on continued experience and expected interest rate changes; changes in mortality, lapses and other policyholder behavior assumptions that are updated to reflect more recent policyholder and industry experience; and changes in expected policy administration expenses.
See Note 3 to our financial statements under “Item 8: Financial Statements and Supplementary Data” and the “Enterprise Risk Management” section of “Item 7: Management’s Discussion and Analysis of Financial Condition and Results of Operations” in this Form 10-K for additional information.
The CSA is updated every quarter and, therefore, the fair value will change with the passage of time even in the absence of any other changes that would affect the valuation. For example, the December 31, 2014 fair value of $160.3 million would increase to $170.0 million if the spread were decreased by 50 basis points. If the spread were increased by 50 basis points, the fair value would decrease to $151.4 million.
We classify our debt and equity securities as available-for-sale and report them in our balance sheets at fair value. Fair value is based on quoted market price or external third-party information, where available. When quoted market prices are not available, we estimate fair value by discounting debt security cash flows to reflect interest rates currently being offered on similar terms to borrowers of similar credit quality, by quoted market prices of comparable instruments and by independent pricing sources or internally developed pricing models.
We recognize realized investment losses when declines in fair value of debt and equity securities are considered to be an OTTI.
An impairment of a debt security, or certain equity securities with debt-like characteristics, is deemed other-than-temporary if:
We are included in the consolidated federal income tax return filed by Phoenix and are party to a tax sharing agreement by and among Phoenix and its subsidiaries. In accordance with this agreement, federal income taxes are allocated as if they had been calculated on a separate company basis, except that benefits for any net operating losses or other tax credits generated by the Company will be provided at the earlier of when such loss or credit is utilized in the consolidated federal tax return and when the tax attribute would have otherwise expired.
Year ended December 31, 2014 compared to year ended December 31, 2013
The decrease in net income of $173.7 million for the year ended December 31, 2014 compared to the year ended December 31, 2013 is primarily due to the following items:
A decrease of $87.0 million in the unlock benefit in 2014, which was a benefit of $95.3 million in 2013 and a benefit of $8.3 million in 2014. The unlock benefit in the current year is driven primarily by changes in policyholder behavior assumptions in the universal life business, most significantly mortality and lapses. The benefit in 2013 was driven primarily by the incorporation of a mortality improvement assumption in the universal life business.
Realized losses increased by $62.0 million for the year ended December 31, 2014 compared to the year ended December 31, 2013. In 2014, there were realized losses on the embedded derivatives both in the fixed indexed annuity business and the variable annuity business, while there were gains on the variable annuity embedded derivatives and losses on the fixed indexed annuity embedded derivatives in 2013. In 2014, the losses on the embedded derivatives were primarily driven by the continued decline of interest rates and increased volatility in the equity markets. In 2013, the gains were driven primarily by strong equity market performance decreasing the liability associated with the variable annuity guarantees.
The income tax expense increased $28.5 million from a benefit of $24.7 million for the year ended December 31, 2013 to an expense of $3.8 million for the year ended December 31, 2014. The increase in 2014 was primarily driven by an increase in current tax expense accrued.
Net investment income increased $31.1 million for the year ended December 31, 2014 compared to the year ended December 31, 2013. The increase in net investment income is driven primarily by continued sales of the fixed indexed annuity business and overall higher asset levels while the yield has remained relatively stable.
Phoenix has established an Operational Risk Committee, chaired by the Chief Risk Officer, to develop an enterprise-wide framework for managing operational risks. This committee meets periodically and includes membership that represents all significant operating, financial and staff departments of Phoenix. Among the risks the committee reviews and manages and for which it provides general oversight are business continuity risk, disaster recovery risk and risks related to the Company’s information technology systems.
Interest rate risk is the risk that we will incur economic losses due to adverse changes in interest rates. Our debt security investments include U.S. and foreign government bonds, securities issued by government agencies, corporate bonds, asset-backed securities and mortgage-backed securities, most of which are exposed to changes in medium-term and long-term U.S. Treasury rates. Our exposure to interest rate changes results primarily from our significant holdings of fixed rate investments and our interest-sensitive insurance liabilities. Our insurance liabilities largely comprise dividend-paying universal life policies and annuity contracts.
Liabilities in excess of the policyholder account balance for universal life contracts, some of which contain secondary guarantees, are generally determined by estimating the expected value of benefits and expenses when claims are triggered and recognizing those benefits and expenses over the accumulation period based on total expected assessments. The assumptions used in estimating these liabilities are consistent with those used for amortizing DAC. The universal life block of business has experience which produces profits in earlier periods followed by losses in later periods for which a liability is required to be held in addition to the policy liabilities recorded.
The table below shows the interest rate sensitivity of our deferred policy acquisition costs and policy liabilities.
Of the $2.8 billion, $2.7 billion represents account value in fixed indexed annuity products. Most of these contracts have guaranteed minimum interest crediting rates of 0%, or close to 0%.
Certain liabilities are sensitive to equity market movements. Our exposure to changes in equity prices primarily results from our variable annuity and variable life products. We manage our insurance liability risks on an integrated basis with other risks through our liability and risk management and capital and other asset allocation strategies.
See Note 5 to our financial statements under “Item 8: Financial Statements and Supplementary Data” in this Form 10-K for additional information regarding DAC.
The values above represent changes to balances before adjustment for unrealized gains/losses.
As a result of the continuing low interest rate environment, the Company’s current reinvestment yields are generally lower than the current investment portfolio yield, primarily for our investments in fixed income securities. We expect our portfolio income yields to continue to gradually decline in future periods if interest rates remain low. Approximately 80% of the Company’s $5.4 billion total policy liabilities and deposit funds have account values that contain certain guaranteed minimum interest rates, principally universal life, fixed indexed annuities, and the fixed return portion of variable annuities.
For certain products, we guarantee interest rates to our policyholders and primarily invest in fixed rate securities to fund those guaranteed rates. Interest rate spread management could impact the Company most significantly in its universal life policies, since guaranteed interest rates, in some cases, are near or approaching our current reinvestment rate on our related fixed income securities. However, universal life account values represent less than 20.0% of our total policy liabilities, accruals, and deposit funds. The current book yield of the investment portfolio backing our universal life policies was approximately 4.6% for the year ended December 31, 2014 while the guaranteed minimum policyholder crediting rate for these policies was primarily at 4.0%.
Our available-for-sale debt securities portfolio consists primarily of investment grade publicly traded and privately placed corporate bonds, residential mortgage-backed securities (“RMBS”), commercial mortgage-backed securities (“CMBS”) and other asset-backed securities (“ABS”). As of December 31, 2014, available-for-sale equity securities include $28.7 million of perpetual preferred securities, of which $6.9 million was below-investment-grade. As of December 31, 2014, our available-for-sale debt securities, with a fair value of $4,221.8 million, represented 91.5% of total investments.
Most of our RMBS portfolio is highly rated. At December 31, 2014, 98.1% of the total residential portfolio was rated investment grade. We hold $48.8 million of RMBS investments backed by prime rated mortgages, $64.7 million backed by Alt-A mortgages and $43.3 million backed by sub-prime mortgages, which combined amount to 3.2% of our total investments. The majority of our prime, Alt-A, and sub-prime exposure is investment grade, with 79% rated NAIC-1 and 13% rated NAIC-2. We have employed a disciplined approach in the analysis and monitoring of our mortgage-backed securities. Our approach involves a monthly review of each security. Underlying mortgage data is obtained from the security’s trustee and analyzed for performance trends. A security-specific stress analysis is performed using the most recent trustee information. This analysis forms the basis for our determination of whether the security will pay in accordance with the contractual cash flows. There were no RMBS impairments for the year ended December 31, 2014.
Individual categories may not agree with the Available-for-Sale Debt Securities by Type table on previous page due to nature of underlying collateral. In addition, RMBS holdings in this exhibit include $18.1 million classified as fair value investments on the balance sheets. For these fair value investments, there is no impact to OCI as carrying value is equal to fair value.
Includes commercial mortgage-backed CDOs with amortized cost and fair values of $2.1 million and $2.2 million, respectively. CMBS holdings in this exhibit include $3.1 million classified as fair value investments on the balance sheets. For these fair value investments, there is no impact to OCI as carrying value is equal to fair value.
Includes the change in fair value of embedded derivatives associated with fixed index annuity indexed crediting feature and variable annuity riders. See Note 8 to our financial statements under “Item 8: Financial Statements and Supplementary Data” in this Form 10-K for additional disclosures.
for which a Portion of the OTTI Loss was Recognized in OCI:
Represents the amount of non-credit OTTI losses recognized in AOCI excluding net unrealized gains or losses subsequent to the date of impairment.
Cash flows provided by financing activities increased $6.3 million during the year ended December 31, 2014. This was primarily a result of an increase in policyholder deposits of fixed indexed annuity products during 2014. Offsetting this increase were reductions of inflows related to capital contributions and debt issuances.
The cash values of certain individual life insurance policies increase over the lives of the policies. Policyholders have the right to borrow an amount up to a certain percentage of the cash value on those policies. As of December 31, 2014, we had approximately $737.7 million in cash values with respect to which policyholders had rights to take policy loans. For eligible policies, the majority of policy loans are at variable interest rates that are reset annually on the policy anniversary. Policy loans at December 31, 2014 were $68.1 million.
Management targets a minimum risk based capital of 225% at the Company. In 2014 and 2013, The Phoenix Companies, Inc. made capital contributions of $15.0 million and $45.0 million, respectively for our benefit. In 2013, we issued a $30.0 million surplus note which was purchased by The Phoenix Companies, Inc.
Total assets increased $321.8 million from December 31, 2013 to December 31, 2014. The increase is primarily attributable to the following:
A decrease in deferred income taxes, net, of $14.7 million driven primarily by a decrease in unrealized losses on available-for-sale debt securities during the period.
An increase in policyholder deposit funds of $531.7 million, which is driven primarily by continued sales of the fixed indexed annuity products, for which there were deposits of approximately $713.7 million during the period.
Total stockholder’s equity decreased $77.6 million from December 31, 2013 to December 31, 2014. The decrease is primarily attributable to the following:
A net loss for 2014 that increased the accumulated deficit by $109.3 million.
Future obligations are based on our estimate of future investment earnings, mortality and surrenders. Actual obligations in any single year, or ultimate total obligations, may vary materially from these estimates as actual experience emerges. As described in Note 3 to our financial statements under “Item 8: Financial Statements and Supplementary Data” in this Form 10-K, policy liabilities and accruals are recorded on the balance sheets in amounts adequate to meet the estimated future obligations of the policies in force. The policyholder obligations reflected in the table above exceed the policy liabilities, policyholder deposit fund liabilities and separate account liabilities reported on our December 31, 2014 balance sheets because the above amounts do not reflect future investment earnings and future premiums and deposits on those policies. Separate account obligations will be funded by the cash flows from separate account assets, while the remaining obligations will be funded by cash flows from investment earnings on general account assets and premiums and deposits on contracts in force.
Other long-term liabilities relate to agreements to fund venture capital partnerships. The venture capital commitments can be drawn down by private equity funds as necessary to fund their portfolio investments through the end of the funding period as stated in each agreement.
Employee benefit expense allocated to us for these benefits totaled $3.8 million, $3.2 million and $4.6 million for 2014, 2013 and 2012, respectively. On August 8, 2014, the Highway and Transportation Funding Act of 2014 was enacted into law, effective immediately. The law extends certain pension funding provisions originally included in the Moving Ahead for Progress in the 21st Century Act (MAP-21). Phoenix Life took advantage of this in the third quarter of 2014 which resulted in no further contributions to the pension plan for the remainder of 2014. Over the next 12 months, Phoenix Life does not expect to make any contributions to the pension plan.
As of December 31, 2014, we did not have any significant off-balance sheet arrangements as defined by Item 303(a)(4)(ii) of SEC Regulation S-K.
Our statutory basis capital and surplus including asset valuation reserve (“AVR”) decreased from $235.2 million at December 31, 2013 to $213.7 million at December 31, 2014. The principal factor resulting in this decrease was $41.1 million of net losses. This was partially offset by $15.0 million of capital contributions received from PM Holdings, Inc.
Connecticut Insurance Law requires that Connecticut life insurers report their RBC. RBC is based on a formula calculated by applying factors to various asset, premium and statutory reserve items. The formula takes into account the risk characteristics of the insurer, including asset risk, insurance risk, interest rate risk and business risk. The Connecticut Insurance Department has regulatory authority to require various actions by, or take various actions against, insurers whose Total Adjusted Capital (capital and surplus plus AVR) does not exceed certain RBC levels.
The levels of regulatory action, the trigger point and the corrective actions required are summarized below: