1 See Item 1.2, Business of the Company and Note 3 to the accompanying consolidated financial statements for a discussion of the Company’s discontinued operations.
Management’s discussion and analysis of financial condition and results of operations of the Company for the three years ended December 31, 2009 follows. This management discussion and analysis should be read in conjunction with the financial data contained in Item 6, Selected Financial Data, and in Item 8, Financial Statements and Supplementary Data.
The Company and its subsidiaries are providers of insurance and other financial service products to a large spectrum of individual, corporate, institutional and governmental customers. The Company offers life insurance and annuities to individuals, while corporations and other institutions are offered retirement and savings products and services.
On April 1, 2008, the Company and certain of its subsidiaries completed the sale of substantially all of their healthcare insurance business to a subsidiary of CIGNA Corporation (“CIGNA”). The business that was sold, formerly reported as the Company’s Healthcare segment, was the vehicle through which it marketed and administered group life and health insurance to small, mid-sized and national employers. CIGNA acquired from the Company the stop loss, group life, group disability, group medical, group dental, group vision, group prescription drug coverage and group accidental death and dismemberment insurance business in the United States and the Company’s supporting information technology infrastructure through a combination of 100% indemnity reinsurance agreements, renewal rights, related administrative service agreements and the acquisition of certain of the Company’s subsidiaries. The Company retained a small portion of its Healthcare business and reports it within its Individual Markets segment. The statements of income and balance sheets of the disposed business activities are presented as discontinued operations for all periods presented in the accompanying consolidated financial statements.
The Company’s operations are organized into three business segments: Individual Markets, Retirement Services and Other. There is no legal separation of the three segments.
During 2008 and 2009, the Individual Markets segment focused on strengthening relationships with key distributors which translated into substantial sales growth. New relationships developed during 2008 and 2009 should contribute to continued sales growth in 2010.
The Company is committed to providing exceptional service and high value to life and annuity policyholders. It has a dedicated service unit to work in collaboration with its brokers and agents to ensure that policyholders continue to receive the information and service they need to make sound financial decisions with respect to their policies.
Variable asset-based fees received by the Company fluctuate with changes in participant account balances. Participant account balances change due to cash flow and unrealized market gains and losses associated with changes in the United States equities market. Fee income decreased by $43 million, or 10%, to $386 million for the year ended December 31, 2009 when compared to 2008. The decrease is primarily related to lower variable fee income as a result of lower average account balances due to the weak performance of the U.S. equities market.
The deterioration in the credit markets has not had a significant impact on the Company’s sources of liquidity. The Company has met its operating requirements by maintaining appropriate liquidity in its investment portfolio and utilizing cash flows from operations. The Company’s credit rating has remained stable. If necessary, the Company has continued access to a $50 million line of credit which currently has no amounts outstanding.
The Company classifies the majority of its fixed maturity and all of its equity investments as available-for-sale and records them at their estimated fair value with the related net unrealized gains or losses, net of policyholder related amounts and deferred taxes, being recorded in accumulated other comprehensive income (loss) in the stockholder’s equity section in its consolidated balance sheets.
The fair values for fixed maturity and equity securities are based upon a fair value hierarchy. Fair values of Level 1 investments are determined using quoted prices in active markets for identical assets. Level 2 investments have fair values determined from inputs that are observable, either directly or indirectly. Approximately 60% of all fixed maturity investments are priced from an external pricing service. The pricing service inputs include, but are not limited to, benchmark yields, reported trades, broker/dealer quotes, issuer spreads, two-sided markets, benchmark securities, offers and reference data. The inputs are considered observable and the valuations are classified as Level 2. Fixed maturity investments are also priced using a matrix which is based on credit quality and average life which are deemed Level 2 observable inputs. Other fixed maturity investments may be priced by other means such as broker quotes or internal models where the significant inputs are observable. Inputs used to derive fair values classified as Level 3 fixed maturity investments are unobservable and include situations where there is little, if any, market activity for the investment. In late 2007, broker/dealers largely discontinued their practice of holding securitized products in inventory, removing an important source of liquidity for the asset-backed security market. Based on this inactivity, the Company determined that internal models utilizing asset-backed securities index spreads rather than credit default swap spreads was a better measurement of fair value for certain asset-backed securities. The Company also prices fixed maturity investments utilizing broker quotes. If the broker’s inputs are largely unobservable, the valuation is classified as a Level 3. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts of the Company’s financial instruments.
One of the significant estimates related to the fair value of available-for-sale securities is the evaluation of investments for other-than-temporary impairments. The assessment of whether an other-than-temporary impairment has occurred on securities where management does not intend to sell the fixed maturity investment and it is not more likely than not the Company will be required to sell the fixed maturity investment before recovery of its amortized cost basis, is based upon management’s case-by-case evaluation of the underlying reasons for the decline in fair value. Management considers a wide range of factors, as described below, regarding the security issuer and uses its best judgment in evaluating the cause of the decline in its estimated fair value and in assessing the prospects for near-term recovery. Inherent in management’s evaluation of the security are assumptions and estimates about the issuer’s operations and ability to generate future cash flows. While all available information is taken into account, it is difficult to predict the ultimate recoverable amount from a distressed or impaired security.
Mortgage loans, which comprise 8% of the Company’s investments at both December 31, 2009 and 2008, respectively, are carried at their unpaid principal balances adjusted for any unamortized premiums or discounts and allowance for credit losses. The determination of the calculation and the adequacy of the mortgage loan allowance and mortgage impairments are subjective. Management’s periodic evaluation and assessment of the adequacy of the allowance for losses and the need for mortgage impairments is based on known and inherent risks in the portfolio, adverse situations that may affect the borrower’s ability to repay, the fair value of the underlying collateral, composition of the loan portfolio, current economic conditions, loss experience and other relevant factors. In determining the ultimate adequacy of the allowance for mortgage loans, greater consideration is given to the individual mortgage characteristics and related collateral.
The recognition of income on certain investments (e.g. loan-backed securities including mortgage-backed and asset-backed securities) is dependent upon market conditions, which could result in prepayments and changes in amounts to be earned.
The Company enters into limited derivative transactions which include the use of interest rate swaps, interest rate swaptions, foreign currency exchange contracts and exchange-traded United States government treasury futures. The Company uses these derivative instruments to manage various risks, including interest rate and foreign exchange risk associated with its invested assets and liabilities. Derivative instruments are not used for speculative reasons.
The Company controls the credit risk of its derivative contracts through credit approvals, limits, monitoring procedures and in some cases, requiring collateral. Risk of loss is generally limited to the portion of the fair value of derivative instruments which exceeds the value of the collateral held and not to the notional or contractual amounts of the derivatives. As the Company enters into derivative transactions only with high quality institutions, no losses associated with non-performance of derivative financial instruments have occurred.
The fair value of derivatives is determined by quoted market prices or through the use of pricing models. The determination of fair value, when quoted market values are not available, is based on valuation methodologies and assumptions deemed appropriate under the circumstances. Essential to the analysis of fair value is the risk of counterparty default. Counterparty credit risk was evaluated and fair values were adjusted accordingly at December 31, 2009 and 2008. Values can also be affected by changes in interest rates, foreign exchange rates, financial indices, credit spreads, market volatility and liquidity. Changes in the values of the derivatives are expected to be offset by changes in value of the hedged item.
· Fair value hedges - Interest rate futures are used to manage the risk of the change in the fair value of certain fixed rate maturity investments. Changes in the fair value of a derivative instrument that has been designated as a fair value hedge are recorded in current period net investment income.
· Policy and contract claims - Policy and contract liabilities for unpaid claims and claim expenses for life and health policies represent the amount estimated for claims that have been reported but not yet settled and claims incurred but not yet reported. Liabilities for unpaid claims are valued in accordance with the terms of the related policies and contracts. Liabilities for claims incurred but not yet reported are estimated based upon the Company’s historical experience and other actuarial assumptions that consider the effects of current developments, anticipated trends and risk management programs. The effects of changes in estimated liabilities are included in the results of operations in the period in which the changes occur.
· Reinsurance - The Company enters into reinsurance transactions as both a provider and a purchaser of reinsurance. Policy benefits ceded to other insurance companies are presented as reinsurance receivables in the Company’s consolidated balance sheets. The cost of reinsurance related to long-duration contracts is accounted for over the life of the underlying reinsured policies using assumptions consistent with those used to account for the underlying policies. Ceded reinsurance contracts do not relieve the Company from its obligations to policyholders. Failure of reinsurers to honor their obligations under these contracts could result in losses to the Company. The Company evaluates the financial condition of its reinsurers and monitors concentrations of credit risk arising from similar geographic regions, activities or economic characteristics of the reinsurers to minimize its exposure to significant losses from reinsurer defaults.
Each reporting period, the Company updates the estimated present values of gross profits for that period. When the actual gross profits change from previous estimates, the cumulative DAC and VOBA amortization is re-estimated and adjusted by the cumulative charge or credit to current period earnings. When actual gross profits exceed those previously estimated, the DAC and VOBA amortization will increase, resulting in a current period charge to earnings. The opposite result occurs when the actual gross profits are below those previously estimated. These adjustments are made when the Company revises its estimates for such factors as investment yield, realized investment gains and losses and policyholder retention.
The amount of income taxes paid by the Company is subject to ongoing audits in the various jurisdictions in which it carries on business. The Company has executed closing agreements with the Internal Revenue Service (the ”IRS”) for all federal examinations on tax years 2004 and prior. The Company is currently under federal examination by the IRS for the 2005 tax year. The Company does not expect significant increases or decreases to the unrecognized tax benefits in 2010 as a result of the federal audit. Also, the Company does not expect significant increases or decreases relating to state and local audits.
Some of the more significant transactions impacting the Company’s results of operations are:
Premium income increased by $35 million, or 7%, to $560 million for the year ended December 31, 2009 when compared to 2008. This increase is primarily related to $102 million increase in sales of the single premium whole life product partially offset by a $51 million decrease in other insurance products, primarily term insurance products, in the Company’s Individual Markets segment further offset by a $16 million decrease of reinsurance activity in the Company’s Other segment.
Fee income decreased by $43 million, or 10%, to $386 million for the year ended December 31, 2009 when compared to 2008. The decrease is primarily related to lower variable fee income as a result of lower average account balances due to the weak performance of the U.S. equities market.
Policyholder benefit expenses include amounts paid or credited to policyholders, changes in policy liabilities, claims, surrenders and annuity and maturity payments. Excluding the impact of the aforementioned $306 million decrease in future policy benefits in 2008 related to the participating policy liabilities, benefits and expenses increased by $72 million, or 6%, to $1,326 million for the year ended December 31, 2009 when compared to 2008. The increase is primarily due to increased future policy benefits of $91 million related to the increase in the fixed single premium whole life product as mentioned above and an increase in interest credited to contractholders of $24 million in the Company’s Individual Markets segment.
Income tax expense decreased by $49 million to $47 million during the year ended December 31, 2009 when compared to 2008 due to the $164 million decrease in income from continuing operations, excluding the aforementioned $208 million gain in 2008 which was taxed in previous years.
Excluding the one-time recording of negative premium revenue in the amount of $1,387 million during the year ended December 31, 2007 resulting from the termination of the CLAC reinsurance agreement, premium revenues decreased by $5 million, or less than 1%, to $525 million during the year ended December 31, 2008 from $530 million in 2007. This decrease is primarily the result of a $20 million decrease in Other segment due to the July 2007 amended reinsurance agreement between Great-West Life & Annuity Insurance Company of South Carolina, a wholly-owned subsidiary of the Company, and CLAC as discussed in Note 5 to the consolidated financial statements. This decrease is partially offset by an $18 million premium increase in the Individual Markets segment primarily through improved sales of the single premium whole life product.
Excluding the one-time recording of $59 million of net investment income resulting from the termination of the CLAC reinsurance agreement, net investment income decreased by $2 million, or less than 1%, to $1,079 million during the year ended December 31, 2008 from $1,081 million in 2007. The decrease is primarily due to $43 million of net investment income in 2007 that is absent in 2008 as a result of the termination of the CLAC reinsurance agreement offset by higher policy loan interest income and an increase in the earned net investment income rate.
Operating expenses include general and administrative expenses, commissions, premium taxes, interest on long-term debt and amortization of deferred acquisition costs and value of business acquired. Total operating expenses decreased by $88 million, or 14%, to $522 million during the year ended December 31, 2008 from $610 million in 2007. The decrease is attributable to $92 million of expenses associated with the termination of the CLAC reinsurance agreement.
Although income from continuing operations before income taxes increased by $182 million during the year ended December 31, 2008 when compared to 2007, income tax expense decreased. This decrease is primarily because the income tax provision on the aforementioned $208 million gain resulting from the release of the liability associated with certain participating policies was recorded in previous years, as discussed in Note 4 to the consolidated financial statements.
Income from continuing operations for the Individual Markets segment decreased by $24 million, or 30%, to $55 million during the year ended December 31, 2009 when compared to 2008 primarily due to a decrease in fee income and an increase in realized losses on investments.
Premium income increased by $50 million, or 13%, to $428 million for the year ended December 31, 2009 when compared to 2008. The increase is primarily related to sales in the single premium whole life product marketed through banks which increased by $102 million partially offset by a $51 million decrease in other insurance products, primarily term insurance products.
Net investment income increased by $26 million, or 4%, to $718 million for the year ended December 31, 2009 when compared to 2008. The increase is primarily due to a $25 million increase in policy loan interest income as the result of higher interest rates charged.
Total benefits and expenses increased by $85 million, or 9%, to $1,084 million during the year ended December 31, 2009 when compared to 2008. The increase is attributable to an increase in future policy benefits related to the increased sales premium as mentioned above and higher interest credited to policyholders.
The following is a summary of the Individual Markets segment participant accounts at December 31, 2008 and 2007:
Fee income decreased by $13 million, or 19%, to $56 million during the year ended December 31, 2008 from $69 million in 2007. The decrease is primarily related to lower variable fee income due to the weak performance of the U.S. equities market in 2008, one time gains on the business owned life insurance block of business in 2007 due to surrender activity and $4 million of fee income in 2007 that is absent in 2008 as a result of the termination of the CLAC reinsurance agreement. Variable asset-based fees fluctuate with changes in participant account balances. Participant account balances change due to cash flow and unrealized market gains and losses associated with changes in the United States equities market.
Net investment income decreased by $67 million, or 9%, to $692 million during the year ended December 31, 2008 from $759 million in 2007. The decrease is primarily due to $58 million of net investment income recorded in connection with the 2007 termination of the reinsurance agreement with CLAC and $43 million of net investment income in 2007 that is absent in 2008 as a result of the termination of the CLAC reinsurance agreement. These decreases are partially offset by higher policy loan interest income.
Income tax expense decreased by $13 million to $28 million during the year ended December 31, 2009 when compared to 2008 is due to the $55 million decrease in income from continuing operations before income taxes.
Retirement participant accounts, including third-party administration and institutional accounts, increased by 462 thousand, or 12%, to 4,201 thousand at December 31, 2009 from 3,739 thousand at December 31, 2008 primarily due to the acquisition of an additional block of business from an existing institutional client and from the sale of a large plan in the public/non-profit government market. The following table provides information for the Retirement Services’ participant account values at December 31, 2009 and 2008:
Account values invested in the general account fixed investment options have increased by $400 million, or 6%, at December 31, 2009 compared to December 31, 2008 primarily due to transfers from variable investment options to the general account.
Year ended December 31, 2008 compared with the year ended December 31,
The following is a summary of certain financial data of the Retirement Services segment for the years ended December 31, 2008 and 2007:
The following is a summary of the Retirement Services segment participant accounts at December 31, 2008 and 2007:
Policyholder benefits remained stable, increasing by $5 million, or 2%, to $230 million during the year ended December 31, 2008 when compared to 2007.
Operating expenses decreased by $15 million, or 4%, to $324 million for the year ended December 31, 2008 when compared to 2007. The decrease is primarily due to expenses incurred in 2007 related to the acquisition of business from the Metropolitan Life Insurance Company (“MetLife”) and cost saving measures taken in 2008.
Account values invested in the general account fixed investment options have increased by $573 million, or 10% at December 31, 2008 compared to December 31, 2007 primarily due to transfers from variable investment options to the general account.
Year ended December 31, 2009 compared with the year ended December 31,
The distribution of the Company’s fixed maturity portfolio by the Company’s internal credit rating at December 31, 2009 and 2008 is summarized as follows:
The change in the percentage of assets rated AAA was related to decreases in the fair value, decreases in credit ratings and dispositions during the year. The majority of the decreases in credit ratings were related to assets in the mortgage-backed and asset-backed securities class. The increase in the percentage of assets rated AA and BBB was primarily related to purchases of assets since the beginning of the year. The increase in the percentage of assets rated BB and below was related to decreases in credit ratings.
The Company holds fixed maturity investments guaranteed by monoline insurers. Monoline insurers provide guarantees on debt for issuers, often in the form of credit wraps, which enhance the credit of the issuer. Monoline insurers guarantee the timely repayment of bond principal and interest when a bond issuer defaults and generally provide credit enhancement for certain securities. During 2009, FGIC, a monoline insurer, was ordered to suspend all claims payments. The financial health of several other monoline insurers has been in question recently and several insurers have experienced ratings downgrades.
At December 31, 2009 and 2008, the Company had $624 million and $611 million of asset-backed securities insured by monolines other than FGIC. At December 31, 2009 and 2008, the overall credit quality of the Company’s monoline-insured asset-backed securities, including the benefits of monoline insurance was BBB+ and AA-, respectively, and excluding the benefits of monoline insurance, the overall credit quality was BB+ and A-. The Company has other insured securities with a fair value of $161 million primarily exposed to state/municipal bond authorities and utilities and financial services companies.
The Company has exposure to the subprime market in the form of home equity loan asset-backed securities in the amount of $889 million, or 4% of total investments of $20,376 million as of December 31, 2009 and $873 million, or 5% of total investments of $18,082 million as of December 31, 2008. The majority of these securities are investment grade rated, 91% of which have a rating of AAA. The weighted average credit enhancement level for these securities is 33% (excluding any monoline guarantees) as of December 31, 2009.
Fair Value Measurement and Impairment of Fixed Maturity and Equity Investments Classified as Available-for-Sale
Security valuation methods can be subjective. Each fixed maturity and equity investment is categorized in a hierarchy based on the observability of inputs into the valuation methodology with Level 3 being the least observable. Total assets and liabilities measured using significant unobservable inputs (Level 3) decreased by $151 million from December 31, 2008. Total Level 3 assets and liabilities at December 31, 2009 and 2008 were $648 million and $799 million, respectively, or 2% of total assets and liabilities. The decrease is primarily due to transfers out of Level 3 during 2009 due to the availability of observable prices as a result of the return of market liquidity in some sectors. Due to market conditions during 2008 which continued in 2009, the Company used internal models to determine fair value for asset-backed securities backed by prime home improvement loans. Using these internal models instead of an external source resulted in a decrease to unrealized losses in the amount of $99 million. The internal models utilized asset-backed index spread assumptions versus credit default spread assumptions used by the external source. The change in Level 3 assets did not affect the Company’s operations, liquidity or capital resources during the period.
The Company classifies the majority of its fixed maturity and all of its equity investments as available-for-sale and records them at fair value with the related net gain or loss, net of policyholder related amounts and deferred taxes, being recorded in accumulated other comprehensive income in the stockholder’s equity section in the accompanying consolidated balance sheets. All available-for-sale securities with gross unrealized losses at the balance sheet date are subjected to the Company’s process for identification and evaluation of other-than-temporary impairments.
The following tables summarize the fair values and gross unrealized losses on fixed maturity investments where the estimated fair value has declined and remained below amortized cost by 20% or more at December 31, 2009 and 2008:
The Company holds approximately $5,246 million in various mortgage-backed and asset-backed collateralized mortgage securities including securities backed by U.S. agencies, of which $3,178 million are experiencing unrealized losses of approximately $509 million at December 31, 2009. Included in this amount is $308 million which has declined and remained below amortized cost by 20% or more. Of the $509 million in unrealized losses, approximately $189 million is related to securities on which there had been a credit rating downgrade since December 31, 2008. Of the $189 million, $72 million are rated investment grade and $117 million are rated non-investment grade at December 31, 2009. The non-investment grade rated securities are primarily asset-backed securities with home improvement and home equity loan collateral. Future changes in the fair value of these securities will be dependent upon market liquidity and general market conditions.
During the year ended December 31, 2009, the Company recorded other-than-temporary impairments of $99 million on its fixed maturity investments. Write-downs in the amount of $11 million were primarily related to assets the Company sold at a loss. The Company recognized $88 million of losses related to credit impairment on asset-backed securities with home improvement loan collateral guaranteed by FGIC. FGIC, a monoline insurer, was ordered to suspend all claims payments by the New York Insurance Department. The impact of the order to suspend all claims payable has resulted in a shortfall of the payments on $216 million of par value of the Company’s holdings with a FGIC monoline guarantee. These securities are now carried at $113 million with an estimated realizable value of $127 million. The estimated realizable value was determined using pricing cashflow models with an exclusion of the adjustment for illiquidity.
At December 31, 2009, the Company had nine fixed maturities, other than asset-backed securities discussed above, which had missed either a principal or interest payment, compared to 1 fixed maturity at December 31, 2008. These securities had carrying values in the amounts of $17 million (0.12% of the total fixed maturity investment portfolio) and $4 million (0.03% of the total fixed maturity investment portfolio) at December 31, 2009 and 2008, respectively.
The Company’s mortgage loans on real estate are comprised exclusively of commercial loans and are carried at their unpaid principal balances, net of allowances for credit losses. The Company does not originate any single family residential mortgage loans. The Company follows a comprehensive approach with the management of mortgage loans that includes ongoing analysis of key mortgage characteristics such as debt service coverage, property condition, loan-to-value ratios and market conditions. Collateral valuations are performed for all mortgages to identify possible risks and exposures. These valuations are then incorporated into the determination of the Company’s allowance for credit losses.
Occasionally, the Company elects to restructure certain mortgage loans if the economic benefits to it are believed to be more advantageous than those achieved by acquiring the collateral through foreclosure. At December 31, 2009 and 2008, there were no restructured loans. The Company anticipates moderate but disciplined participation in the real estate market during 2010.
Other investments consist primarily of equity investments, policy loans, short-term investments, limited partnerships and investment in real estate. The Company anticipates limited participation in equity markets during 2010.
The Company uses certain derivatives, such as futures, swaps and interest rate swaptions for purposes of managing interest rate and foreign currency exchange risks. These derivatives, when taken alone, may subject the Company to varying degrees of market and credit risk; however, when used for hedging purposes, these instruments typically reduce risk. The Company controls the credit risk of its derivative contracts through credit approvals, limits, monitoring procedures and in some cases, requiring collateral.
The Company makes commitments to fund limited partnership interests in the normal course of its business. The amounts of these unfunded commitments at December 31, 2009 and 2008 were $27 million and $33 million, respectively. The precise timing of the fulfillment of the commitment cannot be predicted, however, these amounts are due within one year of the dates indicated. There are no other obligations or liabilities arising from such arrangements that are reasonably likely to become material.
The Company makes commitments to lend funds for mortgage loan investments in the normal course of its business. The amounts of mortgage loan commitments at December 31, 2009 and 2008 were $30 million and $5 million, respectively. There are no other obligations or liabilities arising from such arrangements that are reasonably likely to become material.
The Company maintains a corporate credit facility agreement in the amount of $50 million for general corporate purposes. The Company had no borrowings under the credit facility at either December 31, 2009 or 2008. See Note 20 to the accompanying consolidated financial statements for a further discussion of the credit facility.
The following table summarizes the Company’s major contractual obligations at December 31, 2009:
Estimated future policyholder obligations have been developed in accordance with industry accepted actuarial standards based upon the estimated timing of cash flows related to the policies or contracts, the Company’s historical experience and its expectation of future payment patterns. Management has incorporated significant assumptions in developing these estimates, many of which are outside of the Company’s control and include assumptions relating to mortality, morbidity, policy renewals and terminations, retirement, inflation, disability recovery rates, investment returns, future interest crediting levels, policy loans, future premium receipts on current policies in-force and other contingent events as may be appropriate to the respective product type. Due to the significance of the assumptions used, the amounts presented could materially differ from actual results.
7 Related party long-term debt interest - One long-term surplus note bears interest at a fixed rate through maturity. The second surplus note bears interest initially at a fixed rate that will change in the future based upon the then current three-month London Interbank Offering Rate. The interest payments shown in this table are calculated based upon the contractual rates in effect on December 31, 2009 and do not consider the impact of future interest rate changes.
8 Repurchase agreements and commercial paper - The Company’s obligations under its commercial paper and repurchase agreement programs are short-term in nature. The amounts presented represent the amounts due upon maturity of the instrument. The obligations related to these liabilities are presented in the table above in the less than one year category as presented in the Company’s consolidated balance sheet.
Expected benefit payments to the Company’s defined benefit pension and post-retirement medical plans through 2019.
In June 2009, the Financial Accounting Standards Board (the “FASB”) issued Statement of Financial Accounting Standards No. 168, “The FASB Accounting Standards CodificationTM and the Hierarchy of Generally Accepted Accounting Principles - a replacement of FASB Statement No. 162” (“SFAS No. 168”). SFAS No. 168 establishes the FASB Accounting Standards CodificationTM (the “ASC”) as the single source of authoritative accounting principles recognized by the FASB to be applied in the preparation of financial statements in conformity with generally accepted accounting principles in the United States (“GAAP”) applied by nongovernmental entities. All previously issued GAAP authoritative pronouncements are superseded and replaced by the ASC and are considered non-authoritative. The ASC also established that rules and interpretative releases of the Securities and Exchange Commission (the “SEC”) under authority of federal securities laws are also sources of GAAP for SEC registrants. SFAS No. 168 and the ASC are effective for interim or annual financial periods ending after September 15, 2009. The Company adopted SFAS No. 168 and the ASC for its fiscal quarter ended September 30, 2009.
In May 2009, the FASB issued Statement of Financial Accounting Standards No. 165, “Subsequent Events” (“SFAS No. 165”). Effective July 1, 2009, SFAS No.165 was superseded and replaced by certain provisions of ASC topic 855, “Subsequent Events” (“ASC topic 855”). These provisions of ASC topic 855 require companies to establish principles and requirements for subsequent events. Specifically, these provisions of ASC topic 855 require the disclosure of the period after the balance sheet date through which management has evaluated events and transactions that may occur for potential recognition or disclosure in a company’s financial statements. In addition, these provisions of ASC topic 855 provide the circumstances under which the disclosures are required of an entity regarding events and circumstances that have occurred after the balance sheet date but before financial statements are issued or are available to be issued. These provisions of ASC topic 855 are effective for interim or annual financial periods ending after June 15, 2009. The Company adopted these provisions of ASC topic 855 for its fiscal quarter ended June 30, 2009. The adoption of these provisions of ASC topic 855 did not have an impact on the Company’s consolidated financial position or the results of its operations.
In June 2009, the FASB issued Statement of Financial Accounting Standards No. 166 “Accounting for Transfers of Financial Assets - an amendment of FASB Statement No. 140” (“SFAS No. 166”). Effective July 1, 2009, SFAS No.166 was superseded and replaced by certain provisions of ASC topic 860, “Transfers and Servicing” (“ASC topic 860”). Among other things, provisions of ASC topic 860 improve the relevance, representational faithfulness and comparability of the information that a reporting entity provides in its financial statements about a transfer of financial assets, the effects of a transfer on its financial position, financial performance and cash flows, and a transferor’s continuing involvement, if any, in transferred financial assets. The ASC topic 860 has been further amended relating to derecognition guidance and eliminating the exemption from consolidation for qualifying special-purpose entities. These amendments to ASC topic 860 are effective as of the beginning of interim and annual reporting periods that begin after November 15, 2009. The Company adopted the amended provisions of ASC topic 860 for its fiscal year beginning January 1, 2010. The adoption of these provisions of ASC topic 860 did not have a material impact on the Company’s consolidated financial position or the results of its operations.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Great-West Life & Annuity Insurance Company and subsidiaries as of December 31, 2009 and 2008, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2009, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
As discussed in Note 2, the Company changed its accounting for the recognition and presentation of other-than-temporary impairments for certain investments, as required by accounting guidance adopted on April 1, 2009.
Organization - Great-West Life & Annuity Insurance Company (“GWLA”) and its subsidiaries (collectively, the “Company”) is a direct wholly-owned subsidiary of GWL&A Financial Inc. (“GWL&A Financial”), a holding company formed in 1998. GWL&A Financial is a wholly-owned subsidiary of Great-West Lifeco U.S. Inc. (“Lifeco U.S.”) and an indirect wholly-owned subsidiary of Great-West Lifeco Inc. (“Lifeco”). The Company offers a wide range of life insurance, retirement and investment products to individuals, businesses and other private and public organizations throughout the United States. The Company is an insurance company domiciled in the State of Colorado and is subject to regulation by the Colorado Division of Insurance.
Basis of presentation - The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America (“GAAP”) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Significant estimates are required to account for valuation of investments and other-than-temporary impairments, recognition of income on certain investments, valuation and accounting for derivative instruments, goodwill, deferred acquisition costs and value of business acquired, policy and contract benefits and claims, employee benefits plans and taxes on income. Actual results could differ from those estimates.
The Company classifies the majority of its fixed maturity and all of its equity investments as available-for-sale and records them at fair value with the related net unrealized gain or loss, net of policyholder related amounts and deferred taxes, in accumulated other comprehensive income (loss) in the stockholder’s equity section of the consolidated balance sheets. Net unrealized gains and losses related to participating contract policies that cannot be distributed are recorded as undistributed earnings on participating business in the Company’s consolidated balance sheets. The Company recognizes the acquisition of its fixed maturity and equity investments on a trade date basis.
Premiums and discounts are recognized as a component of net investment income using the scientific interest method. Realized gains and losses are included in net realized investment gains (losses). Declines in value determined to be other-than-temporary are included in total other-than-temporary impairment losses recognized.
Gains and losses realized on disposal of investments are determined on a specific identification basis. See item 10 below for a description of realization of other-than-temporary impairments.
The Company may employ a trading strategy that involves the sale of securities with a simultaneous agreement to repurchase similar securities at a future date at an agreed-upon price. Proceeds of the sale are reinvested in other securities and may enhance the current yield and total return. The difference between the sales price and the future repurchase price is recorded as an adjustment to net investment income. During the period between the sale and repurchase, the Company will not be entitled to receive interest and principal payments on the securities sold. Losses may arise from changes in the value of the securities or if the counterparty enters bankruptcy proceedings or becomes insolvent. In such cases, the Company’s right to repurchase the security may be restricted. Amounts owed to brokers under these arrangements are included in repurchase agreements in the accompanying consolidated balance sheets. The liability is collateralized by securities with approximately the same fair value.
The Company receives collateral for lending securities that are held as part of its investment portfolio. The Company requires collateral in an amount greater than or equal to 102% of the market value of domestic securities loaned and 105% of foreign securities loaned. Such collateral is used to replace the securities loaned in event of default by the borrower. The Company’s securities lending transactions are accounted for as collateralized borrowings. Collateral is defined as government securities, letters of credit and/or cash collateral. The borrower can return and the Company can request the loaned securities at any time. The Company maintains ownership of the loaned securities at all times and is entitled to receive from the borrower any payments for interest or dividends received on such securities during the loan term.
Derivative financial instruments - All derivatives, whether designated in hedging relationships or not, are recorded on the consolidated balance sheets in other assets and other liabilities at fair value. Accounting for the ongoing changes in the fair value of a derivative depends upon the intended use of the derivative and its designation as determined when the derivative contract is entered into. If the derivative is designated as a fair value hedge, the changes in its fair value and of the fair value of the hedged item attributable to the hedged risk are recognized in earnings in net investment income. If the derivative is designated as a cash flow hedge, the effective portions of the changes in the fair value of the derivative are recorded in accumulated other comprehensive income (loss) in the Company’s consolidated balance sheets and are recognized in the consolidated income statements when the hedged item affects earnings. Changes in the fair value of derivatives not qualifying for hedge accounting and the over effective portion of cash flow hedges are recognized in net investment income in the period of the change. Certain derivatives in a net asset position have cash pledged as collateral to the Company in accordance with the collateral support agreements with the counterparty. This collateral is held directly by the Company. This unrestricted cash collateral is included in other assets and the obligation to return is included in other liabilities.
Bank overdrafts - The Company’s cash management system provides for the reimbursement of all major bank disbursement accounts on a daily basis. Checks issued but not yet presented to banks for payment can result in overdraft balances for accounting purposes and are included in other liabilities in the accompanying consolidated balance sheets. At December 31, 2009 and 2008, these liabilities were $28,674 and $8,817, respectively.
Internal use software - Purchased software costs, as well as certain internal and external costs incurred to develop internal use computer software during the application development stage are capitalized. Capitalized internal use software development costs, net of accumulated amortization, in the amounts of $20,590 and $14,944, are included in other assets at December 31, 2009 and 2008, respectively. The Company capitalized $8,014, $2,324 and $3,504 of internal use software development costs during the years ended December 31, 2009, 2008 and 2007, respectively.
Deferred acquisition costs and value of business acquired - Deferred acquisition costs (“DAC”), which primarily consists of sales commissions and costs associated with the Company’s sales representatives related to the production of new business or through the acquisition of insurance or annuity contracts through indemnity reinsurance transactions, have been deferred to the extent recoverable. The value of business acquired (“VOBA”) represents the estimated fair value of insurance or annuity contracts acquired either directly through the acquisition of another insurance company or through the acquisition of insurance or annuity contracts through assumption reinsurance transactions. The recoverability of such costs is dependent upon the future profitability of the related business. DAC and VOBA associated with the annuity products and flexible premium universal life insurance products are being amortized over the life of the contracts in proportion to the emergence of gross profits. Retrospective adjustments of these amounts are made when the Company revises its estimates of current or future gross profits. DAC and VOBA associated with traditional life insurance are amortized over the premium-paying period of the related policies in proportion to premium revenues recognized. See Note 9 for additional information regarding deferred acquisition costs and the value of business acquired.
Separate accounts - Separate account assets and related liabilities are carried at fair value in the accompanying consolidated balance sheets. The Company’s separate accounts invest in shares of Maxim Series Fund, Inc. and Putnam Funds, open-end management investment companies, which are affiliates of the Company, and shares of other non-affiliated mutual funds and government and corporate bonds. Investment income and realized capital gains and losses of the separate accounts accrue directly to the contractholders and, therefore, are not included in the Company’s consolidated statements of income. Revenues to the Company from the separate accounts consist of contract maintenance fees, administrative fees and mortality and expense risk charges. The Company’s separate accounts include mutual funds or other investment options that purchase guaranteed interest annuity contracts issued by the Company. During the years ended December 31, 2009 and 2008, these purchases totaled $149,302 and $64,723, respectively. As the general account investment contracts are also included in the separate account balances in the accompanying consolidated balance sheets, the Company has reduced the separate account assets and liabilities by $364,233 and $265,299 at December 31, 2009 and 2008, respectively, to eliminate these amounts in its consolidated balance sheets at those dates.
Life insurance and annuity future benefits - Life insurance and annuity future benefits with life contingencies in the amounts of $11,807,570 and $11,322,866 at December 31, 2009 and 2008, respectively, are computed on the basis of estimated mortality, investment yield, withdrawals, future maintenance and settlement expenses and retrospective experience rating premium refunds. Annuity contract benefits without life contingencies in the amounts of $7,117,591 and $6,736,101 at December 31, 2009 and 2008, respectively, are established at the contractholder’s account value.
Reinsurance - The Company enters into reinsurance transactions as both a provider and purchaser of reinsurance. In the normal course of its business, the Company seeks to limit its exposure to loss on any single insured and to recover a portion of benefits paid by ceding risks to other insurance enterprises under excess coverage and coinsurance contracts. For each of its reinsurance agreements, the Company determines if the agreement provides indemnification against loss or liability relating to insurance risk in accordance with applicable accounting standards. If the Company determines that a reinsurance agreement does not provide indemnification against loss or liability relating to insurance risk, the Company records the agreement using the deposit method of accounting. The Company reviews all contractual features, particularly those that may limit the amount of insurance risk to which the reinsurer is subject or features that delay the timely reimbursement of claims.
Participating business - The Company has participating policies in which the policyholder shares in the Company’s earnings through policyholder dividends that reflect the difference between the assumptions used in the premium charged and the actual experience on those policies. The amount of dividends to be paid is determined by the Board of Directors.
Participating life and annuity policy benefits are $6,354,261 and $6,155,890 at December 31, 2009 and 2008, respectively. Participating business approximates 9% of the Company’s individual life insurance in-force at December 31, 2009 and 2008 and 19%, 24% and 32% of individual life insurance premium income for the years ended December 31, 2009, 2008 and 2007, respectively. The policyholder’s share of net income on participating policies that cannot be distributed is excluded from stockholder’s equity by a charge to operations and a credit to a liability.
Net realized gains and losses on investments and derivative financial instruments - Net realized gains and losses from investment sales are reported as a component of revenues and are determined on a specific identification basis. Net realized gains and losses also result from the termination of derivative contracts prior to expiration that are not designated as hedges for accounting purposes and certain fair-value hedge relationships. Impairments are recognized as other-than-temporary impairment losses when investment losses in value are deemed other-than-temporary. Non-credit impairments are reclassified to accumulated other comprehensive income (loss).
Regulatory requirements - In accordance with the requirements of the Colorado Division of Insurance, GWLA must demonstrate that it maintains adequate capital. At December 31, 2009 and 2008, GWLA was in compliance with the requirement. See Note 12.
In February 2006, the FASB issued Statement of Financial Accounting Standards No. 155, “Accounting for Certain Hybrid Financial Instruments” (“SFAS No. 155”). Effective July 1, 2009, SFAS No. 155 was superseded and replaced by certain provisions of ASC topic 815, “Derivatives and Hedging” (“ASC topic 815”). These provisions of ASC topic 815 permit any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation to be carried at fair value in its entirety, with changes in fair value recognized in earnings. In addition, these provisions of ASC topic 815 require that beneficial interests in securitized financial assets be analyzed to determine whether they are freestanding derivatives or contain an embedded derivative. These provisions of ASC topic 815 are applicable to new or modified financial instruments in fiscal years beginning after September 15, 2006, however they may be applied to instruments that an entity holds at the date of adoption on an instrument-by-instrument basis. The Company adopted these provisions on January 1, 2007. The adoption increased stockholder’s equity by $115.
In June 2006, the FASB issued Financial Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”). Effective July 1, 2009, FIN 48 was superseded and replaced by certain provisions of ASC topic 740, “Income Taxes” (“ASC topic 740”). These provisions of ASC topic 740 clarify the accounting for uncertainty in income taxes. In addition, they prescribe a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken in a tax return. They also provide guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. These provisions of ASC topic 740 are effective for fiscal years beginning after December 15, 2006. The Company adopted these provisions on January 1, 2007. The adoption decreased stockholder’s equity by $6,195.
In April 2009, the FASB issued Staff Position No. FAS 115-2 and FAS 124-2, “Recognition and Presentation of Other-Than-Temporary Impairments” (“FSP No. FAS 115-2 and FAS 124-2”). Effective July 1, 2009, FSP No. FAS 115-2 and FAS 124-2 was superseded and replaced by certain provisions of ASC topic 320, “Investments - Debt and Equity Securities” (“ASC topic 320”). These provisions of ASC topic 320 require companies, among other things, to bring greater consistency to the timing of impairment recognition and provide for greater clarity about the credit and non-credit components of impaired debt securities that are not expected to be sold. These provisions of ASC topic 320 also require increased and timelier disclosures regarding expected cash flows, credit losses and an aging of securities with unrealized losses. These provisions of ASC topic 320 are effective for interim and annual periods ending after June 15, 2009. The Company adopted these provisions of ASC topic 320 for its fiscal quarter ended June 30, 2009 and recognized the effect of applying them as a change in accounting principle. The Company recognized an $8,528, net of income taxes, cumulative effect adjustment upon initially applying these provisions of ASC topic 320 as an increase to retained earnings with a corresponding decrease to accumulated other comprehensive income (loss).
In June 2009, the FASB issued Statement of Financial Accounting Standards No. 167 “Amendments to FASB Interpretation No. 46(R)” (“SFAS No. 167”). Effective July 1, 2009, SFAS No.167 was superseded and replaced by certain provisions of ASC topic 810. These provisions of ASC topic 810 require reconsideration of whether an enterprise was the primary beneficiary of a variable interest entity (“VIE”) only when specific events had occurred. The amended provisions of ASC topic 810 change the consolidation guidance applicable to a VIE. They also amend the guidance governing the determination of whether an entity is the primary beneficiary of a VIE, and is, therefore, required to consolidate the VIE. The amended provisions of ASC topic 810 also requires enhanced disclosures about an entity’s involvement with a VIE. The amended provisions of ASC topic 810 are effective as of the beginning of interim and annual reporting periods that begin after November 15, 2009. The Company adopted the amended provisions of ASC topic 810 for its fiscal year beginning January 1, 2010. The adoption of these provisions of ASC topic 810 did not have a material impact on the Company’s consolidated financial position or the results of its operations. In January 2010, the FASB moved to finalize an Accounting Standards Update (“ASU”) to defer the effective date of ASC topic 810 as it relates to a reporting enterprise’s interest in certain entities and for certain money market mutual funds.
On April 1, 2008, the Company and certain of its subsidiaries completed the sale of substantially all of their healthcare insurance business to a subsidiary of CIGNA Corporation (“CIGNA”) for $1.5 billion in cash. During the year ended December 31, 2008, the Company recognized a gain in the amount of $681,528, net of income taxes, upon completion of the transaction. Income from discontinued operations for the year ended December 31, 2008 includes charges in the amount of $63,739, net of income taxes, related to costs associated with the sale. The business that was sold, formerly reported as the Company’s Healthcare segment, was the vehicle through which it marketed and administered group life and health insurance to small, mid-sized and national employers. CIGNA acquired from the Company the stop loss, group life, group disability, group medical, group dental, group vision, group prescription drug coverage and group accidental death and dismemberment insurance business in the United States and the Company’s supporting information technology infrastructure through a combination of 100% indemnity reinsurance agreements, renewal rights, related administrative service agreements and the acquisition of certain of the Company’s subsidiaries. The Company retained a small portion of its healthcare business and reports it within its Individual Markets segment. As discussed in Note 17, the Company’s business is now comprised of its Individual Markets, Retirement Services and Other segments. The statements of income and balance sheets of the disposed business activities are presented as discontinued operations for all periods presented in the consolidated financial statements.
The following table summarizes the classifications of assets and liabilities of discontinued operations at December 31, 2009 and 2008:
The following table summarizes selected financial information included in income from discontinued operations in the consolidated statements of income for the years ended December 31, 2009, 2008 and 2007:
The Company adopted a restructuring plan in connection with the sale of its Healthcare segment. The restructuring plan consisted of a structural reorganization which will enable the Company to operate effectively in its present business environment. The liability is included in other liabilities in the consolidated balance sheets. The amounts incurred during the period and adjustments to original estimates during the period have been charged (credited) to income from discontinued operations in the consolidated statement of income for the year ended December 31, 2008. At December 31, 2009, the restructuring plan was substantially complete.
During the first quarter of 2008, the liability for undistributed earnings on participating business decreased by $207,785 in connection with a long-standing assumption reinsurance agreement under which the Company had reinsured a block of participating policies. In addition, the agreement also required the Company to perform an analysis as of March 31, 2008, to determine whether the policyholders were eligible for a special dividend. Based on the Company’s analysis, it was determined that a special dividend was not required and, accordingly, the liability was released. An income tax provision was recorded on the undistributed earnings when those earnings occurred. Accordingly, there was no income tax provision recorded at the time of the liability release. On January 1, 2008, the Company began recognizing the net earnings on these policies in its net income. A liability for undistributed earnings on participating business remains for those participating policies that are not subject to this reinsurance agreement.
Included in the consolidated balance sheets at December 31, 2009 and 2008 are the following related party amounts:
¹ A note payable to GWL&A Financial was issued as a surplus note on November 15, 2004, with a face amount of $195,000 and carrying amounts of $194,218 and $194,206 at December 31, 2009 and 2008, respectively. The surplus note bears interest at the rate of 6.675% per annum, payable in arrears on each May 14 and November 14. The note matures on November 14, 2034.
The Company’s wholly owned subsidiary, Great-West Life & Annuity Insurance Company of South Carolina (“GWSC”) and CLAC are parties to a reinsurance agreement pursuant to which GWSC assumes term life insurance from CLAC. GWL&A Financial obtained two letters of credit for the benefit of the Company as collateral under the GWSC and CLAC reinsurance agreement for policy liabilities and capital support. The first letter of credit is for $1,006,200 and renews annually until it expires on December 31, 2025. The second letter of credit is for $70,000 and renews annually for an indefinite period of time. At December 31, 2009 and 2008 there were no outstanding amounts related to the letters of credit.
Included within reinsurance receivable in the consolidated balance sheets are $407,154 and $376,378 of funds withheld assets as of December 31, 2009 and 2008, respectively. CLAC pays the Company interest on the funds withheld balance at a rate of 4.55% per annum.
A subsidiary of the Company, GW Capital Management, LLC, serves as a Registered Investment Advisor to Maxim Series Fund, Inc. an affiliated open-end management investment company and to several affiliated insurance company separate accounts. Included in fee income on the consolidated statements of income is $52,540, $61,403 and $73,495 of advisory and management fee income from these affiliated entities for the years ended December 31, 2009, 2008 and 2007, respectively.
The Company’s separate accounts invest in shares of Maxim Series Fund, Inc. and Putnam Funds which are affiliates of the Company, and shares of other non-affiliated mutual funds and government and corporate bonds. The Company’s separate accounts include mutual funds or other investment options that purchase guaranteed interest annuity contracts issued by the Company. During the years ended December 31, 2009 and 2008, these purchases totaled $149,302 and $64,723 respectively. As the general account investment contracts are also included in the separate account balances in the accompanying consolidated balance sheets, the Company has reduced the separate account assets and liabilities by $364,233 and $265,299 at December 31, 2009 and 2008, respectively, to eliminate these amounts in its consolidated balance sheets at those dates.
The amortized cost and estimated fair value of fixed maturity investments classified as available-for-sale at December 31, 2009, by contractual maturity date, are shown in the table below. Actual maturities will likely differ from these projections because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
Mortgage-backed and asset-backed securities include collateralized mortgage obligations that consist primarily of sequential and planned amortization classes with final stated maturities up to thirty years and expected average lives of up to fifteen years.
The following table summarizes information regarding the sales of fixed maturity investments classified as available-for-sale for the years ended December 31, 2009, 2008 and 2007:
The Company controls the credit risk of its derivative contracts through credit approvals, limits, monitoring procedures and in some cases, requiring collateral. The Company’s exposure is limited to the portion of the fair value of derivative instruments which exceeds the value of the collateral held and not to the notional or contractual amounts of the derivatives. Counterparty credit risk was evaluated and fair values were adjusted accordingly at December 31, 2009 and 2008. As the Company enters into derivative transactions only with high quality institutions, no realized losses associated with non-performance of derivative financial instruments have occurred. The Company had no derivatives with credit-risk-related contingent features at either December 31, 2009 or 2008.
Fair value hedges - Interest rate futures are used to manage the risk of the change in the fair value of certain fixed rate maturity investments. The Company’s derivatives treated as fair value hedges are eligible for hedge accounting. Changes in the fair value of the hedging derivative, including amounts measured as ineffective, and changes in the fair value of the hedged item are reported within net investment income. Hedges closed are reported in realized investment gains (losses).
Cash flow hedges - Interest rate swap agreements are used to convert the interest rate on certain debt securities from a floating rate to a fixed rate. Foreign currency exchange contracts are used to manage the foreign exchange rate risk associated with bonds denominated in other than U.S. dollars. Interest rate futures are used to manage the interest rate risks of forecasted acquisitions of fixed rate maturity investments. Unrealized derivative gains and losses from the effective portion of cash flow hedges are included in accumulated other comprehensive income (loss) and are reclassified into earnings at the time interest income is recognized on the hedged item.
Derivatives not designated as hedging instruments - The Company attempts to match the timing of when interest rates are committed on insurance products with other new investments. However, timing differences may occur and can expose the Company to fluctuating interest rates. To offset this risk, the Company uses U.S. Treasury futures contracts. The Company also utilizes U.S. Treasury futures as a method of adjusting the duration of the overall portfolio. Interest rate swaptions are used to manage the potential variability in future interest payments on certain insurance products due to a change in credited interest rates and the related change in cash flows due to increased surrenders. Although management believes the above-mentioned derivatives are effective hedges from an economic standpoint, they do not meet the requirements for hedge accounting treatment. Changes in the fair value of a derivative instrument that has not been designated as a hedging instrument are recorded in current period net investment income and total realized investment gains (losses).
During the years ended December 31, 2009, 2008 and 2007, decreases in the amounts of $2,627, $0 and $75, respectively, were recognized in net income from market value changes of derivatives not receiving hedge accounting treatment.
The following tables present derivative instruments in the consolidated balance sheet at December 31, 2009:
Impairment of fixed maturity and equity investments classified as available-for-sale - The Company classifies the majority of its fixed maturity investments and all of its equity investments as available-for-sale and records them at fair value with the related net unrealized gain or loss, net of policyholder related amounts and deferred taxes, in accumulated other comprehensive income (loss) in the stockholder’s equity section in the accompanying consolidated balance sheets. All available-for-sale securities with gross unrealized losses at the balance sheet date are subjected to the Company’s process for the identification and evaluation of other-than-temporary impairments.
The payment structure of the fixed maturity investment and the likelihood of the issuer being able to make payments that increase in the future.
Fixed maturity investments - Total unrealized losses decreased by $840,160 and the total number of securities in an unrealized loss position decreased by 2,010, or 80%, from December 31, 2008 to December 31, 2009. This significant decrease in unrealized losses was across most asset classes and reflects overall recovery in market liquidity and tightening of credit spreads, although the economic uncertainty in these markets still remains.
All sectors across the corporate fixed maturity investment class had a decrease in unrealized losses. While the proportionate percentage in the finance sector increased, the actual unrealized losses decreased by $146,978. The finance sector has recovered more slowly than the other sectors in 2009. At December 31, 2009, 57% of total unrealized losses on corporate debt securities (approximately $122,795 of the $216,886), were related to securities on which there has been a ratings downgrade since December 31, 2008. Of the downgraded securities, 47% (approximately $57,135 of the $122,795) continue to be rated BBB or above.
Unrealized losses on asset-backed, residential and commercial mortgage-backed securities decreased by $283,041, $51,145, and $75,127 respectively, since December 31, 2008, generally due to tightening of credit spreads and increased market liquidity. Although markets have improved, the continued market disruption has influenced valuations at December 31, 2009. Unless otherwise noted below in the other-than-temporary impairment recognition section, the underlying collateral on the securities within the portfolio along with credit enhancement and/or guarantees is sufficient to expect full repayment of the principal. See Note 7 for additional discussion regarding fair value measurements.
The credit loss portion on fixed maturities was determined as the difference between the securities’ amortized cost and the present value of expected future cash flows. These expected cash flows were determined using judgment and the best information available to the Company and were discounted at the securities’ original effective interest rate. Inputs used to derive expected cash flows included default rates, credit ratings, collateral characteristics and current levels of subordination.
Included in net investment income and net realized gains (losses) on investments are amounts allocable to the participating fund account. This allocation is based upon the activity in a specific block of invested assets that are segmented for the benefit of the participating fund account. The amounts of net investment income allocated to the participating fund account were $4,799, $4,823 and $373,244 for the years ended December 31, 2009, 2008 and 2007, respectively. The amounts of net realized gains (losses) allocated to the participating fund account were $234, $177 and ($4,669) for the years ended December 31, 2009, 2008 and 2007, respectively.
The following tables summarize the carrying amounts and estimated fair values of the Company’s financial instruments at December 31, 2009 and 2008:
The fair values for public fixed maturity and equity securities are based upon quoted market prices or estimates from independent pricing services. However, in cases where quoted market prices are not readily available, such as for private fixed maturity investments, fair values are estimated. To determine estimated fair value for these instruments, the Company generally utilizes discounted cash flows calculated at current market rates on investments of similar quality and term. Fair value estimates are made at a specific point in time, based on available market information and judgments about financial instruments, including estimates of the timing and amounts of expected future cash flows and the credit standing of the issuer or counterparty. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts of the Company’s financial instruments.
Mortgage loan fair value estimates are generally based on discounted cash flows. A discount rate matrix is incorporated whereby the discount rate used in valuing a specific mortgage generally corresponds to that mortgage’s remaining term and credit quality. The rates selected for inclusion in the discount rate matrix reflect rates that the Company would quote if placing loans representative in size and quality to those currently in its portfolio.
Included in other assets at December 31, 2009 and 2008 are derivative financial instruments in the amounts of $23,150 and $92,713, respectively. Included in other liabilities at December 31, 2009 and 2008 are derivative financial instruments in the amounts of $3,317 and $0, respectively. The estimated fair values of over-the-counter derivatives, primarily consisting of interest rate swaps and interest rate swaptions which are held for other than trading purposes, are the estimated amounts the Company would receive or pay to terminate the agreements at the end of each reporting period, taking into consideration current interest rates, counterparty credit risk and other relevant factors. Counterparty credit risk was evaluated and adjusted accordingly at both December 31, 2009 and 2008.
The estimated fair values of annuity contract benefits without life contingencies are estimated by discounting the projected expected cash flows to the maturity of the contracts utilizing risk-free spot interest rates plus a provision for credit risk.
· Level 2 inputs utilize other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. Level 2 inputs include quoted prices for similar assets and liabilities in active markets, and inputs other than quoted prices that are observable for the asset or liability, such as interest rates and yield curves that are observable at commonly quoted intervals. The fair values for some Level 2 securities were obtained from a pricing service. The list of inputs used by the pricing service is reviewed on a quarterly basis. The pricing service inputs include, but are not limited to, benchmark yields, reported trades, broker/dealer quotes, issuer spreads, two-sided markets, benchmark securities, offers and reference data. Level 2 securities include those priced using a matrix which are based on credit quality and average life, U.S. government and agency securities, restricted stock, some private equities, certain fixed maturity investments and some over-the-counter derivatives. See Note 6 for further discussions of derivatives and their impact on the Company’s consolidated financial statements.
In the normal course of its business, the Company seeks to limit its exposure to loss on any single insured and to recover a portion of benefits paid by ceding risks to other insurance enterprises under excess coverage and coinsurance contracts. The Company retains a maximum liability in the amount of $3,500 of coverage per individual life.
Amortization expense for other intangible assets included in general insurance expenses was $4,192, $4,725 and $4,699 for the years ended December 31, 2009, 2008 and 2007, respectively. Except for goodwill, the Company has no intangible assets with indefinite lives.
The estimated future amortization of other intangible assets using current assumptions, which are subject to change, for the years ended December 31, 2010 through December 31, 2014 is as follows:
At December 31, 2009 and 2008, the Company had 50,000,000 shares of $1 par value preferred stock authorized, none of which were issued or outstanding at either date. In addition, the Company has 50,000,000 shares of $1 par value common stock authorized, 7,032,000 of which were issued and outstanding at both December 31, 2009 and 2008.
GWLA’s net income and capital and surplus, as determined in accordance with statutory accounting principles and practices as prescribed by the National Association of Insurance Commissioners, for the years ended December 31, 2009, 2008 and 2007 are as follows:
The following table summarizes the components of general insurance expenses for the years ended December 31, 2009, 2008 and 2007:
The Company also provides supplemental executive retirement plans to certain key executives. These plans provide key executives with certain benefits upon retirement, disability or death based upon total compensation. The Company has purchased individual life insurance policies with respect to each employee covered by this plan. The Company is the owner and beneficiary of the insurance contracts.
Prior to the adoption of the measurement provisions of ASC topic 715 for its year ended December 31, 2008, the Company utilized a November 30 measurement date for the Defined Benefit Pension and Post-Retirement Medical plans. Upon adoption of the measurement provision of ASC topic 715, the Company changed the measurement date to correspond to the end of its fiscal year, December 31. The impact of adopting the measurement date provisions of ASC 715 was a decrease to stockholder’s equity of $206. Prepaid benefit costs and intangible assets are included in other assets and accrued benefit costs and unfunded status amounts are included in other liabilities in the accompanying consolidated balance sheets.
The following table presents amounts recognized in the consolidated balance sheets at December 31, 2009 and 2008 for the Company’s Defined Benefit Pension, Post-retirement Medical and Supplemental Executive Retirement plans:
The following table provides information regarding amounts in accumulated other comprehensive income that are expected to be recognized as components of net periodic benefit costs during the year ended December 31, 2010:
Net periodic (benefit) cost of the Defined Benefit Pension, Post-Retirement Medical and Supplemental Executive Retirement plans included in general insurance expenses in the accompanying consolidated statements of income for the years ended December 31, 2009, 2008 and 2007 includes the following components:
Assumed healthcare cost trend rates have a significant effect on the amounts reported for the Post- Retirement Medical Plan. For measurement purposes, an 8.00% annual rate of increase in the per capita cost of covered healthcare benefits was assumed and that the rate would gradually decrease to a level of 5.25% by 2016.
The following table presents how the Company’s Defined Benefit Pension Plan assets are invested at December 31, 2009 and 2008:
The following table presents information about the Defined Benefit Retirement Plan’s assets measured at fair value on a recurring basis as of December 31, 2009 and indicates the fair value hierarchy of the valuation techniques utilized to determine such fair value. See Note 7 for a description of Level 1, Level 2 and Level 3 hierarchies and for valuation methods applied.
The following tables present additional information about assets and liabilities of the Defined Benefit Retirement Plan measured at fair value on a recurring basis and for which the Company has utilized Level 3 inputs to determine fair value:
The investment objective of the Defined Benefit Pension Plan is to provide a risk-adjusted return that will ensure the payment of benefits while protecting against the risk of substantial investment losses. Correlations among the asset classes are used to identify an asset mix that the Company believes will provide the most attractive returns. Long-term return forecasts for each asset class using historical data and other qualitative considerations to adjust for projected economic forecasts are used to set the expected rate of return for the entire portfolio.
The following table presents the ranges the Company targets for the allocation of invested Defined Benefit Pension Plan assets at December 31, 2010:
The following table presents a reconciliation between the statutory federal income tax rate and the Company’s effective federal income tax rate from continuing operations for the years ended December 31, 2009, 2008 and 2007:
The Company adopted the income tax contingency provisions contained in ASC topic 740 on January 1, 2007. As a result of the adoption of these provisions, the Company recognized an $87,427 increase in the liability for unrecognized tax benefits, of which $6,195 was accounted for as a reduction to the January 1, 2007 balance of retained earnings. The Company recognized increases in unrecognized tax benefits of $24,843 and $6,600 during the tax years ended December 31, 2009 and 2008, respectively. During the twelve months ended December 31, 2009, the Company recognized an increase of $21,268 in the current period unrecognized tax benefits relating to changes in the composition of the consolidated tax group. Because of the impact of deferred tax accounting, the increase in the unrecognized tax benefit does not effect the effective tax rate. The Company anticipates additional increases in its unrecognized tax benefits of $18,000 to $20,000, in the next twelve months, due to changes in the composition of the consolidated group. The Company does not anticipate that this increase in its unrecognized tax benefit will impact the effective tax rate.
The Company recognizes accrued interest and penalties related to unrecognized tax benefits in current income tax expense. The Company recognized approximately $2,430, $6,916 and $1,300 in interest and penalties related to the uncertain tax positions during the years ended December 31, 2009, 2008 and 2007, respectively. The Company had approximately $14,978 and $12,548 accrued for the payment of interest and penalties at December 31, 2009 and 2008, respectively.
Amounts presented for investment assets above include $58,348 and $400,339 related to the net unrealized losses (gains) on the Company’s fixed maturity and equity investments, which are classified as available-for-sale at December 31, 2009 and 2008, respectively.
Included in due from parent and affiliates at December 31, 2009 and 2008 is $177,716 and $37,097, respectively, of income taxes receivable from Lifeco U.S. related to the consolidated income tax return filed by the Company and certain subsidiaries. Included in the consolidated balance sheets at December 31, 2009 and 2008 is $34,905 and $31,205 of income taxes receivable in other assets related to the separate federal income tax returns filed by certain subsidiaries, state income tax returns and unrecognized tax benefits.
The accounting policies of each of the reportable segments are the same as those described in Note 1. The Company evaluates performance of its reportable segments based on their profitability from operations after income taxes. Inter-segment transactions and balances have been eliminated in consolidation. The Company’s operations are not materially dependent on one or a few customers, brokers or agents.
The following tables summarize segment financial information for the year ended and as of December 31, 2009:
The following table presents information regarding the share-based compensation expense the Company recognized during the years ended December 31, 2009, 2008 and 2007. Share-based compensation expense of continuing operations is included in general insurance expenses in the consolidated statements of income. Share-based compensation expense of discontinued operations is included in income from discontinued operations in the consolidated statements of income.
The following table summarizes the status of, and changes in, the Lifeco plan options granted to Company employees which are outstanding at December 31, 2009. The options granted relate to underlining stock traded in Canadian dollars on the Toronto Stock Exchange, therefore, the amounts, which are presented in United States dollars, will fluctuate as a result of exchange rate fluctuations.
¹ The aggregate intrinsic value is calculated as the difference between the market price of Lifeco common shares on December 31, 2009 and the exercise price of the option (only if the result is positive) multiplied by the number of options.
¹ The intrinsic value of options exercised is calculated as the difference between the market price of Lifeco common shares on the date of exercise and the exercise price of the option multiplied by the number of options exercised.
The Company enters into operating leases primarily for the rental of office space. The following table shows, as of December 31, 2009, scheduled related party debt principal repayments and minimum annual rental commitments for operating leases having initial or remaining non-cancelable lease terms in excess of one year during the years ended December 31, 2010 through 2014 and thereafter:
The Company is one of two defendants in an action filed in the Colorado District Court for Arapahoe County, Colorado by a disease management vendor in an action relating to its healthcare business (which was sold to Connecticut General Life Insurance Company in a transaction that closed on April 1, 2008). The plaintiff alleges that the Company breached a contract with it and engaged in tortious conduct, for which the plaintiff seeks both compensatory and punitive damages. The Company believes it has meritorious defenses against the plaintiff’s claims and is vigorously contesting them. The Company’s motion for partial summary judgment is pending. The lawsuit is scheduled for trial commencing March 1, 2010.
The extent of the losses beyond any amounts that may be accrued is not readily determinable at this time. However, based on facts and circumstances presently known, in the opinion of management, an unfavorable outcome will not materially affect the equity of the Company, although its results of discontinued operations may be adversely affected.
The Company has entered into a corporate credit facility agreement in the amount of $50,000 for general corporate purposes. The credit facility matures on May 26, 2010. Interest accrues at a rate dependent upon various conditions and terms of borrowings. The agreement requires, among other things, the Company to maintain a minimum adjusted statutory net worth of $900,000 plus 50% of its statutory net income, if positive, for each quarter ending after June 30, 2008. The Company had no borrowings under the credit facility at either December 31, 2009 or 2008 and was in compliance with all covenants.
Management has evaluated subsequent events for potential recognition or disclosure in the Company’s consolidated financial statements through February 19, 2010, the date on which the Company’s consolidated financial statements were issued. No subsequent event has occurred requiring its recognition or disclosure in the Company’s consolidated financial statements.
On February 8, 2010, the Company’s Board of Directors declared a dividend in the amount of $66,000 to be paid during the first quarter of 2010.
(1) A reclassification of $29,500 was made from unearned premium reserves to future policy benefits, losses, claims and expenses for consistency with the presentation as of December 31, 2009.