TALIC conducts its business primarily in the annuity markets and to a lesser extent in the life insurance markets of the financial services industry. Currently, the Company is not issuing new life insurance, variable annuity and market value adjusted annuity products. 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 2012, the Company began selling a fixed contingent annuity (also sometimes referred to as a contingent deferred annuity (“CDA”)) that includes a stand-alone living benefit (“SALB”). A SALB is essentially a guaranteed lifetime withdrawal benefit which exists independently and is applied to mutual funds and exchange traded funds.
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 holds 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. 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. Lastly, 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.
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 years ended December 31, 2010 and 2009, the Company recorded an OTTI in income of $0.6 million and $9.9 million, respectively, net of value of business acquired amortization.
Derivatives are financial instruments in which the value changes in response to an underlying variable, that require little or no net initial investment and are settled at a future date. The Company has entered into short futures contracts to hedge minimum guarantees on variable annuity contracts. The Company has also entered into variance swaps to hedge the costs of the volatility of the Standard & Poor’s 500 Composite Stock Price Index (“S&P”) market. These variance swaps are similar to volatility options where the underlying index provides for the market value movements. All derivatives recognized on the Balance Sheets are carried at fair value with changes in fair value recognized in the Statements of Income. The fair value for exchange traded derivatives, such as futures, are calculated net of the interest accrued to date and is based on quoted market prices. Net settlements on the futures occur daily. The fair value of variance swaps is calculated as the difference between the estimated volatility of the underlying S&P index at maturity to the actual volatility of the underlying S&P index at initiation (i.e.; strike) multiplied by the notional value of the swap. At termination the final fair value is recorded as a realized investment gain (loss) in the Statements of Income. Variance swaps do not accrue interest, and typically, no cash is exchanged at initiation.
The Company can also receive collateral related to derivative transactions that it enters into. 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, 2011 and 2010, the Company did not pledge or receive collateral on derivative transactions.
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, 2011 and 2010, the Company’s VOBA asset was $309.6 million and $335.1 million, respectively. For the years ended December 31, 2011, 2010 and 2009, the favorable (unfavorable) impact to pre-tax income related to VOBA unlocking was ($11.6) million, $24.6 million and ($79.4) million, respectively. In addition, for the year ended December 31, 2009, there was an impairment charge on variable annuities of $63.9 million. There were no impairment charges in 2011 and 2010. See Note 4 to the Financial Statements for a further discussion.
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, 2011 and 2010, variable annuities accounted for the Company’s entire DAC asset of $45.0 million and $31.4 million, respectively.
The long-term growth rate assumption for the amortization of VOBA, DAC and DSI was 9% at December 31, 2011, 2010 and 2009. The short-term growth rate assumption for the amortization of VOBA, DAC and DSI was 9% at December 31, 2011 and 2010 and 7.25% at December 31, 2009.
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 the annual test of goodwill at December 31, 2011, 2010 and 2009 and determined there was no impairment of the 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, 2011 and 2010, future policy benefits were $475.9 million and $362.6 million, respectively.
At December 31, 2011 and 2010, GMDB and GMIB liabilities included within future policy benefits were as follows:
At December 31, 2011 and 2010, GMWB liability and GMIB reinsurance asset included within future policy benefits were as follows:
The following outlines the adoption of accounting guidance in 2010. See Note 1 to the Financial Statements for a further discussion.
ASC 310, Receivables - ASU 2010-20, Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses - guidance requires new and expanded disclosures about the allowance for credit losses, credit quality, impaired loans, modifications, and nonaccrual and past due financing receivables - adopted December 31, 2010.
ASC 944, Financial Services-Insurance - 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 - will be 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 - will be adopted January 1, 2012.
During 2011, 2010 and 2009, fixed contract owner deposits were $0.2 million, $0.2 million and $1.9 million, respectively. During 2011, 2010 and 2009, fixed contract owner withdrawals were $114.2 million, $114.8 million and $162.0 million, respectively.
The Company maintains a general account investment portfolio comprised primarily of investment grade fixed maturity securities, policy loans, cash and cash equivalents and mortgage loans on real estate.
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 debt crisis as well as residual impact from the U.S. financial crisis. As a whole, the sub-sector remained volatile in 2011 as financial bail-outs in Greece, Ireland, and Portugal led to fears that Italy and Spain may require similar International bail-outs. European banks hold a significant amount of Government debt on their balance sheets. Subordinated securities, specifically, have become a target for liability management exercises by some European banks as they attempt to raise core Tier 1 ratios to 9% by June 2012 as required by the European Banking Authority. Deeply subordinated securities became more volatile following successful attempts by the European Commission to impose “burden sharing” on the subordinated securities of those banks receiving significant state-aid as a result of the 2008 financial crisis. Furthermore, proposed legislation in the US and Europe could give governments wide discretion to impose “burden sharing” on both senior and subordinated bondholders in order to quickly stabilize or wind-up troubled banks. While these measures have made existing subordinated 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. Furthermore, central banks appear committed to providing liquidity to the market and, as a result, asset write-downs and credit losses have diminished substantially in all but the most troubled countries.
The Company’s $1.8 million of gross unrealized losses within the industrial sector has a fair value of $19.6 million. The unrealized loss in the industrial sector primarily relates to two sub-sectors, communications and consumer cyclical. The communications sub-sector has $1.0 million of gross unrealized losses with a fair value of $11.4 million. The consumer cyclical sub-sector has $0.5 million of gross unrealized losses with a fair value of $4.9 million.
The communications sub-sector includes the wirelines industry where the economic uncertainty in Europe weighed on investment grade telecom providers. The Company evaluated the near-term prospects of the issuers in relation to the severity and duration of the unrealized loss and does not consider those investments to be impaired at December 31, 2011.
All the unrealized losses within the consumer cyclical sub-sector relate to the gaming industry. Fundamentals in the gaming industry remain weak due to high debt balances and related interest costs due to leveraged buyout activity and a material reduction in discretionary consumer spending. A weak homebuilding environment and a material drop-off in consumer confidence, coupled with concerns over unemployment resulted in weak demand. While the gaming industry has seen some positive momentum in occupancy rates and convention traffic, the rate and extent of a future recovery are uncertain at this time. The Company evaluated the near-term prospects of the issuers in relation to the severity and duration of the unrealized loss and does not consider those investments to be impaired at December 31, 2011.
There are no individual issuers rated below investment grade in the consumer cyclical sub-sector which have unrealized loss positions greater than $2.5 million.
ABS - housing related securities are secured by pools of residential mortgage loans which are primarily 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. Expected losses within the underlying pools are generally higher than original expectations, primarily in certain later-vintage adjustable rate mortgage loan pools, which has led to some rating downgrades in these securities. The Company’s $7.2 million of gross unrealized losses within the ABS - housing related sector has a fair value of $25.8 million.
The Company does not currently invest in or originate whole loan residential mortgages. The Company categorizes mortgage backed securities issued by a securitization trust as having subprime mortgage exposure when the average credit score of the underlying mortgage borrowers in a securitization trust is below 660 at issuance. The Company also categorizes mortgage backed securities issued by a securitization trust with second lien mortgages as subprime mortgage exposure, even though a significant percentage of second lien mortgage borrowers may not necessarily have credit scores below 660 at issuance.
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 ABS - housing related 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 at December 31, 2011.
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.
There is one individual issuer rated below investment grade in the RMBS sector which has an unrealized loss position greater than $2.5 million.
* Ratings based on a hierarchy of S&P, Moody’s, Fitch, Internal, NAIC
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 at December 31, 2011.
The Company’s $5.3 million of gross unrealized losses classified as equity have a fair value of $31.0 million. The majority of the unrealized loss relates to preferred non-convertible holdings in the banking sub-sector which have $5.2 million of gross unrealized losses with a fair value of $25.0 million. Objective evidence of impairment of an investment in an equity instrument classified as available-for-sale includes information about significant changes with an adverse effect that have taken place in the technological, market, economic or legal environment in which the issuer operates, and indicates that the cost of the investment in the equity instrument may not be recovered. As part of an ongoing process, the equity analysts actively monitor earnings releases, company fundamentals, new developments and industry trends for any signs of possible impairment. If an available-for-sale equity security is impaired based upon the Company’s qualitative or quantitative impairment criteria, any further declines in the fair value at subsequent reporting dates are recognized as impairments. Therefore, at each reporting period, for an equity security that is determined to be impaired based upon the Company’s impairment criteria, an impairment is recognized for the difference between the fair value and the original cost basis, less any previously recognized impairments.
The amortized cost and estimated fair value of fixed maturity AFS securities at December 31, 2011 and 2010 by rating agency equivalent were:
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, 2011 and 2010, approximately $61.8 million (or 3%) and $55.8 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 2011 and 2010 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.
Details underlying securities in a continuous gross unrealized loss and OTTI position for AFS investment grade securities were as follows:
Subprime mortgages are loans to homebuyers who have weak or impaired credit histories. Through 2008, the market for these loans had expanded rapidly. During that time, however, lending practices and credit assessment standards grew steadily weaker. As a result, the market experienced a sharp increase in the number of loan defaults. Investors in subprime mortgage assets include not only mortgage lenders, but also brokers, hedge funds, and insurance companies. The Company does not currently invest in or originate whole loan residential mortgages. The Company categorizes ABS issued by a securitization trust as having subprime mortgage exposure when the average credit score of the underlying mortgage borrowers in a securitization trust is below 660 at issuance. The Company also categorizes ABS issued by a securitization trust with second lien mortgages as subprime mortgage exposure, even though a significant percentage of second lien mortgage borrowers may not necessarily have credit scores below 660 at issuance.
For the year ended December 31, 2011, the Company’s impairment losses were $1.2 million, with no associated VOBA amortization. During 2011, the Company impaired its holdings of 2007 vintage subprime mortgage ABS for $0.7 million due to an adverse change in cash flows, a 2006 vintage subprime mortgage ABS for $0.1 million, a corporate bond for $0.3 million due to adverse changes in cash flows and a corporate non-convertible security for $0.1 million due to a pre-packaged bankruptcy.
For the year ended December 31, 2010, the Company’s impairment losses were $0.6 million, net of associated VOBA amortization. The gross impairment losses recognized in the Statements of Income were primarily driven by the impairment of a 2005 vintage RMBS for $0.7 million and a 2007 vintage ABS subprime mortgage for $0.3 million due to adverse changes in cash flows. A corporate bond was also impaired for $0.4 million due to the intent to sell or being more likely than not required to sell. In addition, the Company impaired its holding of a 2007 vintage subprime mortgage ABS for $0.4 million.
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, 2011. There was one impaired mortgage loan at 2010 for $0.6 million. At December 31, 2011 and 2010, 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 69% of Separate Accounts assets were invested in equity-based mutual funds at December 31, 2011. 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 2011, average variable account balances decreased $0.4 billion (or 4%) to $7.7 billion as compared to the same period in 2010.
Credit spreads represent the credit risk premiums required by market participants for a given credit quality, i.e., the additional yield that a debt instrument issued by a AA-rated entity must produce over a risk-free alternative (e.g., U.S. Treasury instruments). Changes in credit spreads have an inverse relationship to the value of interest sensitive investments.
The impact of changes in medium term interest rates, corporate credit and credit spreads on market valuations were as follows:
At December 31, 2011 and 2010, the Company had 12,939 and 14,140 life insurance and annuity contracts inforce with interest rate guarantees, respectively. The estimated average rate of interest credited on behalf of contract owners was 3.74% and 3.76% during 2011 and 2010, respectively. Total invested assets supporting these liabilities with interest rate guarantees had an estimated average effective yield of 5.2% and 4.5% during 2011 and 2010, respectively.
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, 2011 and 2010, 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.
On August 19, 2011, S&P upgraded the Company’s outlook from negative to stable. The Company’s financial strength rating remained the same.
Policy benefits increased $150.7 million during 2011 as compared to 2010. The following table provides the changes in policy benefits by type:
Amortization of VOBA was $12.2 million and $20.4 million for the years ended December 31, 2011 and 2010, respectively, which included favorable (unfavorable) unlocking of ($11.6) million and $24.6 million. 2011 was impacted by unfavorable equity markets and long term interest rate assumption changes during the third quarter resulting in lower amortization and unfavorable unlocking as compared to 2010.
(b) The change in equity related gains (losses) principally relates to the decrease in the net losses on futures contracts during 2010. Short futures contracts fluctuate relative to the volatility in the S&P 500.
Amortization (accretion) of DAC was ($3.7) million and $10.6 million for 2010 and 2009, respectively. For 2010 and 2009, there was a favorable (unfavorable) impact to pre-tax income related to DAC unlocking of $1.1 million and ($2.6) million, respectively. The decrease in amortization during 2010 as compared to 2009 was primarily due to the decline in the guaranteed benefit reserves.
Amortization of VOBA was $20.4 million for the year ended December 31, 2010, which included favorable unlocking of $24.6 million. Amortization and impairment of VOBA was $155.5 million for the year ended December 31, 2009, which included
unfavorable unlocking of $79.4 million. Favorable unlocking during 2010 was primarily driven by the favorable equity market in the latter half of the year, while in 2009 poor equity market performance during the first quarter resulted in unfavorable unlocking. In addition, during 2009, an impairment charge of $63.9 million was recorded as estimated future gross profits were less than the unamortized balance at March 31, 2009.