The following is a summary of selected consolidated financial information for the Company. The selected consolidated financial information for the years ended December 31, 2010, 2009 and 2008, and at December 31, 2010 and 2009 has been derived in part from the Company’s audited consolidated financial statements included in Item 8, Financial Statements and Supplementary Data. Note 1 to the consolidated financial statements discusses the significant accounting policies of the Company. The selected consolidated income statement data for the years ended December 31, 2007 and 2006 and the selected consolidated balance sheet data at December 31, 2008, 2007 and 2006 have been derived
The accompanying 2009 consolidated balance sheet, 2008 and 2009 consolidated statements of income and 2008 and 2009 consolidated statements of stockholder’s equity have been restated as a result of a previous misstatement of current and deferred income taxes and of deferred acquisition costs. The amounts in Item 6 are inclusive of the Company’s restatement of its consolidated financial statements. See Note 1 to the accompanying consolidated financial statements for further discussion.
(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, 2010 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 amounts in Item 7 are inclusive of the Company’s restatement of its consolidated financial statements. See Note 1 to the accompanying consolidated financial statements for further discussion.
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’s operations are organized into three business segments: Individual Markets, Retirement Services and Other. Management considers the ability to continue to expand its presence in the United States defined contribution and institutional insurance markets to be its primary points of focus. The life insurance, savings and investments marketplace is also highly competitive. Competitors include mutual fund companies, insurance companies, banks, investment advisors and certain service and professional organizations.
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 increased by $61 million, or 16%, to $447 million for the year ended December 31, 2010 when compared to 2009. The increase is primarily related to higher variable fee income as a result of higher average account balances due to the improved performance of the U.S. equities market.
During the year ended December 31, 2010, the Company recorded net other-than-temporary losses recognized in earnings of $79 million on its available-for-sale fixed maturity investments primarily related to asset-backed investments with home improvement loans and home equity loan collateral. A continued recovery in market liquidity, lower interest rates and tightening of credit spreads have resulted in improved market values for the Company’s fixed maturity and equity investments since December 31, 2009. The Company has recorded a decrease in gross unrealized losses of $362 million and an increase in gross unrealized gains of $392 million during the year ended December 31, 2010. This resulted in a $372 million increase to accumulated other comprehensive income (loss), net of policyholder related amounts and deferred taxes. See Notes 6 and 7 to the accompanying consolidated financial statements for a discussion of investments including impairment losses.
The instability in the credit markets since 2008 has not had a significant impact on the Company’s current 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 ratings have remained stable. In addition, the Company has continued access to a $50 million revolving credit facility which currently has no amounts outstanding.
stemming from such investment risks, are those associated with the determination of fair values and the recognition of impairments on investments.
The Company classifies substantially all 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 70% 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. These 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, such as reported trades, benchmark securities, bids and offers and market research publications. 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. Based on inactivity in certain sectors of the asset-backed securities market, 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.
Considerations used by the Company’s management in the impairment evaluation process include, but are not limited to, the following:
The Company recognizes in earnings an other-than-temporary impairment on a fixed maturity investment in an unrealized loss position when it either (a) has the intent to sell the fixed maturity investment or (b) more likely than not will be required to sell the fixed maturity investment before its anticipated recovery. The other-than-temporary impairment is the difference between the fixed maturity
Mortgage loans on real estate, which comprise 8% of the Company’s investments at both December 31, 2010 and 2009, 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 credit loss allowance and mortgage impairments involve judgments that incorporate qualitative and quantitative Company and industry mortgage performance data. Management’s periodic evaluation and assessment of the adequacy of the allowance for credit 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.
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, 2010 and 2009. 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.
DAC and VOBA associated with annuity and investment-type products are being amortized over the life of the contracts in proportion to the emergence of estimated gross profits. DAC and VOBA associated with traditional life insurance products are amortized over the premium-paying period of the related policies in proportion to the present value of estimated premium revenues recognized.
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. DAC and VOBA, for applicable products, are adjusted for the impact of unrealized gains or losses on investments as if these gains or losses had been realized, with corresponding credits or charges included in “Accumulated Other Comprehensive Income (Loss)”.
See Note 9 to the accompanying consolidated financial statements for more information regarding the Company’s recorded DAC and VOBA.
The Company sponsors pension and other post retirement benefit plans in various forms covering employees who meet specified eligibility requirements. The obligations and expenses associated with these plans require an extensive use of estimates and assumptions, such as the discount rate applied to pension obligations, expected rate of return on plan assets, rate of future compensation increases, healthcare cost trend rates, as well as assumptions regarding participant demographics such as rate and age of retirements, withdrawal rates and mortality. Management, in consultation with its independent consulting actuarial firm, determines these assumptions based upon a variety of factors such as historical performance of the plan and its assets, currently available market and industry data and expected benefit payout streams. The assumptions used will differ, and may differ materially, from actual results due to, among other factors, changing market and economic conditions, higher or lower withdrawal rates and changes in participant demographics. These assumptions are subjective in many cases and have an important effect on the Company’s pension and post retirement benefit obligations.
Accounting and tax regulations require that items be included in income tax returns at different times from when they are reflected in financial statements. These timing differences give rise to deferred tax assets and liabilities. A deferred tax liability is recognized for temporary differences that will result in taxable amounts or nondeductible expenses in future years. A deferred tax asset is recognized for temporary differences that will result in tax deductible amounts or nontaxable income in future years, including loss carryforwards.
The amount of income taxes paid by the Company is subject to ongoing audits in the various jurisdictions in which it carries on business. With few exceptions, the Company is no longer subject to U.S. federal, state and local income tax examinations by tax authorities for years 2005 and prior. Tax year 2006 is subject to a limited scope federal examination by the Internal Revenue Service (the “I.R.S.”) in regards to an immaterial matter. Tax years 2007, 2008 and 2009 are open to federal examination by the I.R.S. The Company does not expect significant increases or decreases to unrecognized tax benefits relating to federal, state or local audits.
The following is a summary of certain financial data of the Company for the years ended December 31, 2010 and 2009:
Net realized investment losses decreased by $43 million, or 64%, to a loss of $24 million for the year ended December 31, 2010 when compared to 2009. The $24 million loss in 2010 is primarily due to $81 million of write-downs primarily on fixed maturity securities guaranteed by Ambac Financial Group, Inc. (“Ambac”) (See discussion under Item 7.7 Investment Operations, Fixed Maturity Investments below) offset by $57 million of net realized gains on the sale of investments. The $67 million loss in 2009 is due to $99 million of write-downs primarily on fixed maturity securities guaranteed by Financial Guaranty Insurance Company (“FGIC”) (See discussion under Item 7.7 Investment Operations, Fixed Maturity Investments below) offset by $32 million of net realized gains on the sale of investments.
Net investment income increased by $70 million, or 6%, to $1,149 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 in the Individual Markets segment and a $31 million increase in net investment income in 2009 due to increases in general account assets in the Company’s Retirement Services segment.
Income tax expense decreased by $41 million to $42 million during the year ended December 31, 2009 when compared to 2008 due to the $161 million decrease in income from continuing operations, excluding the aforementioned $208 million gain in 2008 which was taxed in previous years.
Fee income increased by $6 million, or 12%, to $56 million for the year ended December 31, 2010 when compared to 2009. The increase is primarily related to higher fees as a result of higher sales of the BOLI product.
Net realized investment losses decreased by $37 million, or 97%, to a loss of $1 million for the year ended December 31, 2010 when compared to 2009. The $1 million loss in 2010 is due to $34 million of write-downs primarily on fixed maturity securities guaranteed by Ambac offset by $33 million of net realized gains on the sale of investments. The $38 million loss in 2009 is due to $47 million of write-downs primarily on fixed maturity securities guaranteed by FGIC partially offset by $9 million of net realized gains on the sale of investments.
Income from continuing operations for the Individual Markets segment decreased by $26 million, or 31%, to $57 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.
Net realized losses on investments increased by $26 million to $38 million for the year ended December 31, 2009 when compared to 2008. The $38 million loss in 2009 is due to $47 million of write-downs primarily on fixed maturity securities guaranteed by FGIC partially offset by $9 million of net realized gains on the sale of investments. The $12 million loss in 2008 is due to $49 million of write-downs primarily on a fixed maturity security backed by Lehman Brothers Holdings Inc. and on securities backed by General Motors Corporation. These write-downs are partially offset by $37 million of net realized gains on the sale of investments.
The slight decrease in participant accounts is primarily the result of policy maturities and policy surrenders.
The following is a summary of certain financial data of the Retirement Services segment for the years ended December 31, 2010 and 2009:
Net income for the Retirement Services segment increased by $42 million, or 55%, to $118 million during the year ended December 31, 2010 when compared to 2009. The increase is primarily related to a $56 million increase in fee income, $17 million lower amortization of DAC and an improvement in net interest margins partially offset by a $46 million increase in general insurance expenses due to increased participants.
Income tax expense increased by $13 million, or 52%, to $38 million during the year ended December 31, 2010 when compared to 2009. The increase is primarily due to a $55 million increase in income before income taxes in 2010.
The following is a summary of certain financial data of the Retirement Services segment for the years ended December 31, 2009 and 2008:
Net investment income increased by $31 million, or 9%, to $383 million for the year ended December 31, 2009 when compared to 2008. The increase is primarily due to an increase in the average account value of the general accounts during 2009 when compared to 2008. This average asset increase is primarily due to transfers from variable investment options to the general account.
Operating expenses increased by $33 million, or 10%, to $362 million for the year ended December 31, 2009 when compared to 2008. The increase is primarily related to a $20 million increase in amortization of DAC, value of business acquired and other intangibles due to lower estimated future gross profits in 2009 compared to the estimated future gross profits in 2008 due to a decrease in projected fee income. In addition, pension and post-retirement expenses increased $5 million and state assessments increased $2 million.
Income tax expense decreased by $9 million to $25 million during the year ended December 31, 2009 when compared to 2008 is due to the $52 million decrease in income from continuing operations before income taxes.
Participant account values invested in unaffiliated retail investment options and participant account values where only administrative services and record-keeping functions are provided have increased by $27,145 million, or 36%, at December 31, 2009 compared to December 31, 2008. The increase is primarily due to new sales and the higher U.S. equity markets at December 31, 2009 compared to December 31, 2008.
The following is a summary of certain financial data of the Company’s Other segment for the years ended December 31, 2010 and 2009:
The results of operations of the Company’s Other segment is substantially comprised of activity under the assumption reinsurance agreement between GWSC and CLAC and corporate items not directly allocated to the other business segments. Net income for the Company’s Other segment increased by $15 million from a loss of $8 million during the year ended December 31, 2009 to a gain of $7 during the year ended December 31, 2010. The increase of $15 million is due to an $8 million increase from reinsurance which is primarily attributable to a decrease in future policy benefits.
Loss from continuing operations for the Company’s Other segment was $8 million for the year ended December 31, 2009 compared to net income of $251 million for 2008. The decrease is primarily related to a $208 million gain as a result of the release of the liability associated with certain participating policies on January 1, 2008 and a $98 million ($64 million net of income taxes) liability release on these policies in 2008. See Note 3 to the accompanying consolidated financial statements. These decreases are partially offset by a $13 million increase in investment income.
The National Association of Insurance Commissioners (the “NAIC”) adopted a rating methodology for non-agency residential mortgage-backed securities (“RMBS”) that became effective December 31, 2009 and commercial mortgage-backed securities (“CMBS”) that became effective December 31, 2010. The NAIC’s objective with the rating methodology for non-agency RMBS and CMBS was to increase the accuracy in assessing expected losses, and to use the improved assessment to determine a more appropriate capital requirement for non-agency RMBS and CMBS. The revised methodology reduces regulatory reliance on rating agencies and allows for greater regulatory input into the assumptions used to estimate expected losses from non-agency RMBS and CMBS.
The Company does not have any direct bond holdings of the actual monoline insurers. Excluding FGIC and Ambac holdings where the insurer has been ordered to suspend claims as discussed above, the Company’s insured holdings at December 31, 2010 are as follows:
The Company has no exposure to sub-prime collateralized debt obligations, asset-backed commercial paper or structured investment vehicles. The Company’s exposure to Alt A mortgage-backed securities is $1 million. The underlying mortgages of Alt A securities have a risk potential that is greater than prime but less than sub-prime. The borrowers behind these mortgages typically have clean credit histories, but the mortgage itself will generally have some issues that increase its risk profile. These issues may include higher loan-to-value and debt-to-income ratios or inadequate documentation of the borrower’s income.
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 $294 million at December 31, 2010 from December 31, 2009. Net Level 3 assets and liabilities at December 31, 2010 were $353 million or 1% of total assets and liabilities compared to net Level 3 assets and liabilities of $648 million or 2% at December 31, 2009. This decrease is due to improved market observability of inputs into valuation methodologies. The use of internal models for Level 3 assets did not affect the Company’s operations, liquidity or capital resources during the period.
Due to market conditions beginning in 2008, which have continued through 2010, the Company used internal models to determine fair value for asset-backed securities backed by home improvement loans. Using these models instead of an external source resulted in a decrease to unrealized losses of $58 million. The internal models utilized asset-backed index spread assumptions versus credit default spread assumptions used by the external source.
The Company classifies substantially all 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 (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 identification and evaluation of other-than-temporary impairments.
During the year ended December 31, 2010, the Company recorded net other-than-temporary losses recognized in earnings of $79 million on its fixed maturity investments. These losses were primarily related to credit impairment on asset-backed securities with home improvement loan, home equity loan and Alt A loan collateral guaranteed by Ambac. These securities are now carried at $63 million. During the year ended December 31, 2009, the Company recorded net other-than-temporary losses recognized in earnings of $99 million on its fixed maturity investments. (See Note 6 to the accompanying consolidated financial statements).
All collateral received from derivative counterparties is in the form of cash and is included as an asset in the consolidated balance sheet, with an offsetting liability for the obligation to return the collateral. The Company received unrestricted cash of $8 million and $4 million as of December 31, 2010 and 2009, respectively. The cash collateral is reinvested in a government money market fund.
The weighted average loan-to-value ratio for the Company’s mortgage loans on real estate was 53% and 50% at December 31, 2010 and 2009, respectively. The debt service coverage ratio was 2.00 and 1.92 times at December 31, 2010 and 2009, respectively. During 2010 and 2009, the Company originated 29 and 23 new loans, respectively. At origination, the weighted average loan-to-value ratio was 50% and 46% and debt service coverage ratio was 2.43 and 2.14 times in 2010 and 2009, respectively.
The Company originates interest only and amortizing commercial mortgage loans. During 2010 and 2009, the Company originated mortgage loans structured with an interest only component in the amount of $212 million and $222 million, respectively, compared to a total mortgage loan portfolio at December 31, 2010 and 2009 of $1,722 million and $1,554 million, respectively. The weighted average loan-to-value ratio of the interest only loans originated in 2010 and 2009 was 48% and 47%, respectively.
As noted in the Executive Summary above, the Company introduced a GMWB product, Great-West® SecureFoundationSM, into the 401(k) markets in 2010. In the past, the Company had limited use of derivatives; however, with the introduction of the GMWB product combined with the interest rate risk hedging program introduced during the fourth quarter of 2009, the Company’s use of derivatives has increased with additional usage expected. The Company uses certain derivatives, such as futures, swaps and interest rate swaptions for purposes of managing interest rate, equity 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 over-the-counter derivative contracts through credit approvals, limits, monitoring procedures and in most 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. The Company enters into derivative transactions only with high quality institutions.
Notes 1 and 6 to the consolidated financial statements contain a discussion of the Company’s derivative position.
The yield on average invested assets decreased in 2010 compared to 2009 primarily due to the Company charging lower interest rates on policy loans and achieving lower yields on new investments as credit markets stabilized, spreads across asset classes narrowed and the U.S. treasury yield curve shifted lower through the year. The yield on average invested assets increased in 2009 compared to 2008 primarily due to the Company charging higher interest rates on policy loans and taking advantage of higher yielding investment opportunities attributable to dislocations in the credit markets.
The Company continues to be well capitalized, with sufficient borrowing capacity to meet the anticipated needs of its business. The Company’s financial strength provides the capacity and flexibility to enable it to raise funds in the capital markets through the issuance of commercial paper. The Company had $92 million and $98 million of commercial paper outstanding at December 31, 2010 and 2009, respectively. The commercial paper has been given a rating of A-1+ by Standard & Poor’s Ratings Services and a rating of P-1 by Moody’s Investors Service, each being the highest rating available. Through the recent financial market volatility, the Company continued to have the ability to access the capital markets for funds. The loss of this access in the future would not have a significant impact to the Company’s liquidity as the commercial paper is not used to fund daily operations and is an insignificant amount in relation to total invested assets.
The Company also has available a revolving credit facility agreement, which expires on May 26, 2013, in the amount of $50 million for general corporate purposes. The Company had no borrowings under this credit facility at December 31, 2010. The Company does not anticipate the need for borrowings under this facility and the loss of its availability would not significantly impact its liquidity. This credit facility replaced a similar $50 million credit facility which expired on May 26, 2010. The Company had no borrowings under the expired credit facility at December 31, 2009 or through its expiration.
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, 2010 and 2009 were $32 million and $30 million, respectively. There are no other obligations or liabilities arising from such arrangements that are reasonably likely to become material.
The Company, as lessee, has entered into various lease and sublease agreements primarily for the rental of office space. See Note 19 to the accompanying consolidated financial statements for a further discussion of operating leases.
GWL&A Financial obtained two letters of credit for the benefit of the Company as collateral under a reinsurance agreement for policy liabilities and capital support. The first letter of credit is for $1,068 million and renews annually until it expires on December 31, 2025. The second letter of credit is for $70 million and renews annually for an indefinite period of time. See Note 5 to the accompanying consolidated financial statements for a further discussion of the letters of credit and the reinsurance agreement.
(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.
(9) Payable under securities lending agreements - The Company accepts both cash and non-cash collateral in connection with its securities lending program. Since the securities lending transactions generally expire within one year or the timing of the return of the collateral is uncertain, the obligations related to these liabilities are presented in the table above in the less than one year category in the amounts of the liabilities presented in the Company’s consolidated balance sheet.
(11) Operating leases - The Company is obligated under various non-cancelable operating leases, primarily for office space. Contractual provisions exist that could increase the lease obligations presented, including operating expense escalation clauses. Management does not consider the impact of any such clauses to be material to the Company’s operating lease obligations.
See Note 2 to the accompanying consolidated financial statements for a further discussion of the application of recent accounting pronouncements.
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, 2010 and 2009, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2010, 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.
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 direct 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, valuation and accounting for derivative instruments, policy and contract benefits and claims, deferred acquisition costs and value of business acquired, goodwill, employee benefits plans and taxes on income. Actual results could differ from those estimates.
Restatement of the December 31, 2009 and 2008 consolidated financial statements - The accompanying consolidated financial statements as of and for the years ended December 31, 2009 and 2008 have been restated to reflect the following:
· Current and deferred income taxes for continuing and discontinued operations were each overstated due to errors in the current and deferred tax accounts. These errors are primarily the result of an omitted deferred tax asset related to pensions and other less significant items in the current and deferred tax accounts. As a result of these tax errors, stockholder’s equity was understated by $33,313 and $29,551 for the years ended December 31, 2009 and 2008, respectively.
· Deferred acquisition costs were overstated due to the inclusion of certain expenses related to service contracts that were not associated with annuity contracts. The deferred acquisition costs have been reduced for these service contracts and their expenses are included as part of general insurance expenses. As a result of the error in deferred acquisition costs, stockholder’s equity was overstated by $23,262 and $21,564 for the years ended December 31, 2009 and 2008, respectively.
· Adjustments were made to correct the consolidated statement of cash flows to reflect the adjustments above in addition to adjustments for a misclassification of cash flows from in process trades. As a result of the corrections to the statement of cash flows, net cash flows from operations (decreased) increased by ($31,845) and $11,228 and net cash flows from investing activities increased by $5,213 and $2,827 and net cash flows from financing activities increased (decreased) by $26,632 and $14,055 for the year ended December 31,2009 and 2008 respectively.
The following table summarizes the effect of the adjustments the Company made to its consolidated financial statements as a result of these adjustments:
4. Limited partnership and other corporation interests are accounted for using either the cost or equity method of accounting. The Company uses the cost method on investments where it has a minor equity interest and no significant influence over the entity’s operations. The Company uses the equity method on investments in which it has a partnership interest in excess of 5%, although the Company has no significant influence over the entity’s operations. Also included in limited partnership interests are limited partnerships established for the purpose of investing in low-income housing that qualify for federal and state tax credits. These interests are carried at amortized cost as determined using the effective yield method.
6. Short-term investments include securities purchased with initial maturities of one year or less and are carried at amortized cost, which approximates fair value. The Company classifies its short-term investments as available-for-sale.
8. 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.
9. One of the significant estimates inherent in the valuation of investments is the evaluation of fixed maturity for other-than-temporary impairments. The evaluation of impairments is a quantitative and qualitative process, which is subject to risks and uncertainties and is intended to determine whether declines in the fair value of investments should be recognized in current period earnings. The risks and uncertainties include changes in general economic conditions, the issuer’s financial condition or near term recovery prospects, the effects of changes in interest rates or credit spreads and the recovery period. The Company’s accounting policy requires that a decline in the value of a security below its cost or amortized cost basis be assessed to determine if the decline is other-than-temporary.
If management either (a) has the intent to sell a fixed maturity investment or (b) it is more likely than not the Company will be required to sell a fixed maturity investment before its anticipated recovery, a charge is recorded in net realized investment losses equal to the difference between the fair value and cost or amortized cost basis of the security. If management does not intend to sell the security 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, but the present value of the cash flows expected to be collected (discounted at the effective interest rate implicit in the fixed maturity investment prior to impairment) is less than the amortized cost basis of the fixed maturity investment (referred to as the credit loss portion), an other-than-temporary impairment is considered to have occurred. In this instance, total other-than-temporary impairment is bifurcated into two components: the amount related to the credit loss, which is recognized in current period earnings; and the amount attributed to other factors (referred to as the non-credit portion), which is recognized as a separate component in accumulated other comprehensive income (loss). After the recognition of an other-than-temporary impairment, a fixed maturity investment is accounted for as if it had been purchased on the measurement date of the other-than-temporary impairment, with an amortized cost basis equal to the previous amortized cost basis less the other-than-temporary impairment recognized in earnings.
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 $24,196 and $20,590, are included in other assets at December 31, 2010 and 2009, respectively. The Company capitalized $9,816, $8,014 and $2,324 of internal use software development costs during the years ended December 31, 2010, 2009 and 2008, 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. DAC and VOBA, for applicable products, are adjusted for the impact of unrealized gains or losses on investments as if these gains or losses had been realized, with corresponding credits or charges included in “Accumulated Other Comprehensive Income (Loss)”. See Note 9 for additional information regarding deferred acquisition costs and the value of business acquired.
Goodwill and other intangible assets - Goodwill is the excess of cost over the fair value of assets acquired and liabilities assumed in connection with an acquisition and is considered an indefinite lived asset and therefore is not amortized. The Company tests goodwill for impairment annually or more frequently if events or circumstances indicate that there may be justification for conducting an interim test. If the carrying value of goodwill exceeds its fair value, the excess is recognized as an impairment and recorded as a charge against net income in the period in which the impairment is identified. There were no impairments of goodwill recognized during the years ended December 31, 2010, 2009 or 2008.
Separate accounts - Separate account assets and related liabilities are carried at fair value in the accompanying consolidated balance sheets. The Company issues variable annuity contracts through separate accounts for which investment income and investment gains and losses accrue directly to, and investment risk is borne by, the contractholder and therefore, are not included in the Company’s consolidated statements of income.
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. See footnote 5 for a further discussion of separate accounts.
Life insurance and annuity future benefits - Life insurance and annuity future benefits with life contingencies in the amounts of $12,395,926 and $11,807,570 at December 31, 2010 and 2009, 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 $7,976,954 and $7,117,591 at December 31, 2010 and 2009, respectively, are established at the contractholder’s account value.
Recognition of premium and fee income and benefits and expenses - Life insurance premiums are recognized when due. Annuity contract premiums with life contingencies are recognized as received. Revenues for annuity and other contracts without significant life contingencies consist of contract charges for the cost of insurance and contract administration and surrender fees that have been assessed against the contract account balance during the period and are recognized when earned. Fees from assets under management, which consist of contract maintenance fees, administration fees and mortality and expense risk charges, are recognized when due. Benefits and expenses on policies with life contingencies are associated with earned premiums so as to result in recognition of profits over the life of the contracts. Premiums and policyholder benefits and expenses are presented net of reinsurance.
Net investment income - Interest income from fixed maturities and mortgage loans on real estate is recognized when earned. Net investment income on equity securities is primarily comprised of dividend income and is recognized on ex-dividend date.
Realized investment gains (losses) and derivative financial instruments - Realized investment gains and losses are reported as a component of revenues and are determined on a specific identification basis. Realized investment 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. See