TALIC conducts its business primarily in the annuity markets and to a lesser extent in the life insurance markets of the financial services industry. During 2009, the Company, in addition to not issuing life insurance products, ceased issuing variable annuity and market value adjusted annuity products. The Company offered the following guaranteed benefits within its variable annuity product suite: guaranteed minimum death benefits (“GMDB”), guaranteed minimum income benefits (“GMIB”) and guaranteed minimum withdrawal benefits (“GMWB”).
At December 31, 2010 and 2009, approximately $184.5 million (or 11%) and $161.4 million (or 12%), respectively, of the Company’s fixed maturity and equity securities portfolio consisted of non-publicly traded securities. Since significant judgment is required for the valuation of non-publicly traded securities, the estimated fair value of these securities may differ from amounts realized upon an immediate sale.
For AFS fixed maturity securities, an OTTI must be recognized in earnings when an entity either: a) has the intent to sell the debt security or b) more likely than not will be required to sell the debt security before its anticipated recovery. If the Company meets either of these criteria, the OTTI is recognized in earnings in an amount equal to the entire difference between the security’s amortized cost basis and its fair value at the balance sheet date. For AFS fixed maturity securities in unrealized loss positions that do not meet these criteria, the Company must analyze its ability to recover the amortized cost by comparing the net present value of projected future cash flows with the amortized cost of the security. The net present value is calculated by discounting the Company’s best estimate of projected future cash flows. If the net present value is less than the amortized cost of the investment, an OTTI is recorded. The OTTI is separated into two pieces: an amount representing the credit loss, where the present value of cash flows expected to be collected is less than the amortized cost basis of the security, and an amount related to all other factors (referred to as the non credit portion). The credit loss is recognized in earnings and the non credit loss is recognized in other comprehensive income (“OCI”), net of applicable taxes and value of business acquired. Management records subsequent changes in the estimated fair value (positive and negative) of AFS fixed maturity securities for which non credit OTTI was previously recognized in OCI in OCI-OTTI.
Mortgage loans on real estate are carried at unpaid principal balances adjusted for amortization of premiums and accretion of discounts and are net of valuation allowances and general reserves. The fair value for mortgage loans on real estate is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and/or similar remaining maturities. Interest income is accrued on the principal balance of the loan based on the loan’s contractual interest rate. Premiums and discounts are amortized using the effective yield method over the life of the loan. Interest income and amortization of premiums and discounts are reported in net investment income along with mortgage loan fees, which are recorded as they are incurred. Loans are considered impaired when it is probable that based upon current information and events, the Company will be unable to collect all amounts due under the contractual terms of the loan agreement. When the Company determines that a loan is impaired, a valuation allowance is established for the excess carrying value of the loan over its estimated collateral value. The Company does not accrue interest on loans ninety days past due. The Company also establishes a general reserve based on a percentage of the outstanding loan balance. At December 31, 2010 and 2009, there was $62.9 million and $70.9 million, respectively, in mortgage loans on real estate recorded on the Balance Sheets. A valuation allowance of $0.6 million was established for an impaired mortgage loan during 2010. In addition, during the fourth quarter 2010, a mortgage loan was impaired for $0.6 million and then sold. There were no impaired mortgage loans at December 31, 2009. The general reserve at December 31, 2010 and 2009 was less than $0.1 million. The change in the valuation allowance and the general reserve is reflected in net realized investment gains (losses), excluding OTTI losses on securities in the Statements of Income.
recorded as a realized investment gain (loss) in the Statements of Income. Variance swaps do not accrue interest, and typically, no cash is exchanged at initiation. At December 31, 2010, the Company had 360 outstanding short futures contracts with a notional amount of $112.8 million. At December 31, 2010, the Company had variance swaps with a notional value of $7.0 thousand and a fair value of ($0.3) million which is presented as a liability on the Balance Sheets. At December 31, 2009, the Company had 570 outstanding short futures contracts with a notional amount of $158.3 million. There were no variance swaps at December 31, 2009.
Financial assets that are lent to a third party or that are transferred subject to a repurchase agreement at a fixed price are not derecognized as the Company retains substantially all the risks and rewards of asset ownership. The lent securities are included in fixed maturity AFS securities in the Balance Sheets. A liability is recognized for cash collateral received, required initially at 102%, on which interest is accrued. If the fair value of the collateral is at any time less than 102% of the fair value of the loaned securities, the counterparty is mandated to deliver additional collateral, the fair value of which, together with the collateral already held in connection with the lending transaction, is at least equal to 102% of the fair value of the loaned securities. At December 31, 2010 and 2009, the payable for collateral under securities loaned was $160.4 million and $149.1 million, respectively.
VOBA represents the portion of the purchase price that is allocated to the value of the right to receive future cash flows from the insurance and annuity contracts in force at the acquisition date. VOBA is based on actuarially determined projections, for each block of business, of future policy and contract charges, premiums, mortality, policyholder behavior, Separate Account performance, operating expenses, investment returns, and other factors. Actual experience on the purchased business may vary from these projections. Revisions in estimates result in changes to the amounts expensed in the reporting period in which the revisions are made and could result in the impairment of the asset and a charge to income if estimated future gross profits are less than the unamortized balance. At December 31, 2010 and 2009, the Company’s VOBA asset was $335.1 million and $374.7 million, respectively. For the years ended December 31, 2010, 2009 and 2008, the favorable (unfavorable) impact to pre-tax income related to VOBA unlocking was $24.6 million, ($79.4) million and ($40.4) million, respectively. In addition, for the years ended December 31, 2009 and 2008, there was an impairment charge of $63.9 million and $28.0 million, respectively. There was no impairment charge in 2010. See Note 4 to the Financial Statements for a further discussion.
The Company offers a sales inducement whereby the contract owner receives a bonus which increases the initial account balance by an amount equal to a specified percentage of the contract owner’s deposit. This amount may be subject to recapture under certain circumstances. Consistent with DAC, sales inducements for variable annuity contracts are deferred and amortized based on the estimated future gross profits for each group of contracts. These future gross profit estimates are subject to periodic evaluation
The short-term equity growth rate and the long-term growth rate for the amortization of VOBA, DAC and DSI were as follows:
Future policy benefits are actuarially determined liabilities, which are calculated to meet future obligations and are generally payable over an extended period of time. Principal assumptions used in the establishment of liabilities for future policy benefits are mortality, surrender rates, policy expenses, equity returns, interest rates, and inflation. These estimates and assumptions are influenced by historical experience, current developments and anticipated market trends. At December 31, 2010 and 2009, future policy benefits were $362.6 million and $439.6 million, respectively.
Future policy benefits also include liabilities, which can be either positive or negative, for contracts containing GMWB provisions and for the reinsurance of GMIB provisions (“GMIB reinsurance”) for variable annuities based on the fair value of the underlying benefit. GMWB and GMIB reinsurance are treated as embedded derivatives and are required to be reported separately from the host variable annuity contract. The fair value of these guarantees are calculated as the present value of future expected payments to policyholders less the present value of assessed rider fees attributable to the guarantees. Given the complexity and long-term nature of these guarantees, which are unlike instruments available in financial markets, their fair values are determined using stochastic techniques under a variety of market return scenarios. A variety of factors are considered, including expected market rates of return, equity and interest rate volatility, credit spread, correlations of market returns, discount rates and actuarial assumptions.
At December 31, 2010 and 2009, GMWB liability and GMIB reinsurance asset included within future policy benefits were as follows:
The valuation allowance for deferred tax assets at December 31, 2010 and 2009 was $93.0 million and $145.5 million, respectively. The valuation allowance is related to a net operating loss carryforward and other deferred tax assets that, in the judgment of management, is not more likely than not to be realized. In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that all or some of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets depends on generation of further taxable income during the periods in which those temporary differences are deductible. Management considers the scheduled reversal of deferred tax liabilities, projected taxable income, and tax-planning strategies in making the assessment.
The Company files a return in the U.S. federal tax jurisdiction and various state tax jurisdictions.
ASC 320, Investments-Debt and Equity Securities - guidance that makes OTTI guidance for debt securities more operational and improves the presentation and disclosure of OTTI on debt and equity securities in the financial statements. The revised guidance resulted in a net increase to retained earnings and decrease to accumulated other comprehensive income (loss) of $3.5 million at time of adoption - adopted June 30, 2009.
ASC 350, Intangibles-Goodwill and Other - guidance that amended the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset - adopted January 1, 2009.
Fundamentals remain somewhat weakened and some companies remain dependent on government support. However, funding concerns have largely abated as capital markets have reopened with the notable exception of those institutions most directly exposed to pressured governments. Also, deterioration in global asset quality has slowed significantly in all but the most stressed countries. Although the push for more capital is ongoing, the sector has raised a significant amount of capital since the start of the financial crisis, creating a larger buffer to absorb credit losses. Regulators have announced programs to strengthen capital requirements for the sector as a whole as well as implement additional regulatory controls and oversight, although certain provisions and rules are not yet finalized.
The overall exposure to the banking sub-sector in the Company’s portfolio is of high quality. The unrealized losses in the banking sub-sector primarily reflect low floating rate coupons on some securities, and credit spread widening on deeply subordinated securities. After a very challenging period for credit fundamentals during the financial crisis, the banking industry in the United States continues to recover, with a return to profitability, stabilization in asset quality and improved capital and liquidity. Most of the U.S. banks have either returned the government aid or hope to do so in the near future. Going forward, normalized returns for the industry are likely to be lower due partly to regulatory reform, but higher capital requirements are intended to reduce overall risk. The near-term outlook is somewhat constrained by tepid loan demand as well as litigation and other related costs. Included in the Company’s banking exposure are hybrid securities, which typically have an original maturity of more than 30 years, may be perpetual and were designed to receive enhanced equity credit from rating agencies. In addition, they have other features that may not be consistent across issues such as a cumulative or non-cumulative coupon, capital replacement language and an alternative payment mechanism. The Company’s exposure to hybrid securities in an unrealized loss is all rated investment grade and there is little risk of payment interruption. The Company evaluated the near-term prospects of the issuers in relation to the severity and duration of the unrealized loss and does not consider those investments to be impaired at December 31, 2010.
Fundamentals in the gaming industry remain weak due to increased debt and related interest costs due to leveraged buyout activity and a material reduction in discretionary consumer spending. A deteriorating weak homebuilding environment and a material drop-off in consumer confidence, coupled with concerns over unemployment resulted in declining demand. Recent supply additions have come at a very difficult time and have added to the supply/demand imbalance. Discounted rooms have been offered to entice demand, which will have a negative effect on margins. Recently, the industry has seen some positive momentum in occupancy rates and convention traffic, but a recovery is still a ways off.
The Company evaluated the near-term prospects of the issuers in relation to the severity and duration of the unrealized loss and does not consider those investments to be impaired at December 31, 2010.
The Company’s $0.5 million of gross unrealized losses within the utility sector has a fair value of $10.0 million. The majority of the unrealized loss in the utility sector relates to the electrical sub-sector which has just under $0.4 million of gross unrealized losses on securities with a fair value of $6.1 million.
The electrical sub-sector is generally viewed as a defensive sub-sector during weak economic environments. The economic slowdown has resulted in declining revenue trends, which have been most pronounced in the large industrial customer base. Companies in the sub-sector have responded to the declining revenue trends with cost cutting initiatives and reduced capital expenditure programs. Liquidity remains adequate for most companies in the electrical utility sub-sector and significant debt refinancing has been completed which further enhanced liquidity profiles. Other headwinds continue to affect the industry including ongoing capital expenditure requirements, the possibility of CO2 legislation, declining unregulated generation margins, and increasingly uncertain state regulatory environments during a time of economic stress. Even with these headwinds, most balance sheets have been maintained and cash flow has been sufficient to support credit fundamentals. Industrial demand has shown improvement through 2010 which has also contributed to stable credit profiles. The Company evaluated the near-term prospects of the issuers in relation to the severity and duration of the unrealized loss and does not consider those investments to be impaired at December 31, 2010.
All ABS - housing securities are monitored and reviewed on a monthly basis. Detailed cash flow models using the current collateral pool and capital structure on the portfolio are performed quarterly. Model output is generated under base and several stress-case scenarios. Our internal ABS - housing asset specialists utilize widely recognized industry modeling software to perform a loan-by-loan, bottom-up approach to modeling. Key assumptions used in the models are projected defaults, loss severities, and prepayments. Each of these key assumptions varies greatly based on the significantly diverse characteristics of the current collateral pool for each security. Loan-to-value, loan size, and borrower credit history are some of the key characteristics used to determine the level of assumption that is utilized. Defaults were estimated by identifying the loans that
There is one individual issuer rated below investment grade in the ABS - housing sector which has an unrealized loss position greater than $2.5 million:
RMBS are securitizations of underlying pools of non-commercial mortgages on real estate. The underlying residential mortgages have varying credit ratings and are pooled together and sold in tranches. The Company’s RMBS includes government sponsored enterprise (“GSE”) guaranteed passthroughs, whole loan passthroughs and negative amortization mortgage-backed securities.
RMBS of the Company are monitored and reviewed on a monthly basis. Detailed cash flow models using the current collateral pool and capital structure on the portfolio are performed quarterly. Model output is generated under base and several stress-case scenarios. Our internal RMBS asset specialists utilize widely recognized industry modeling software to perform a loan-by-loan, bottom-up approach to modeling. Key assumptions used in the models are projected defaults, loss severities, and prepayments. Each of these key assumptions varies greatly based on the significantly diverse characteristics of the current collateral pool for each security. Loan-to-value, loan size, and borrower credit history are some of the key characteristics used to determine the level of assumption that is utilized. Defaults were estimated by identifying the loans that are in various delinquency buckets and defaulting a certain percentage of them over the near-term and long-term. Assumed defaults on delinquent loans are dependent on the specific security’s collateral attributes and historical performance.
The Company’s $3.5 million of gross unrealized losses within the RMBS sector has a fair value of $24.9 million. The pace of deterioration in the housing market began to stabilize in late 2009 and continued in 2010. Even with the stabilization, fundamentals in RMBS continue to be weak, which impacts the magnitude of the unrealized loss. Delinquencies and severities in property liquidations remain at an elevated level, while prepayments remain at historically low levels. Due to the weak fundamental situation, reduced liquidity, and the requirement for higher yields due to market uncertainty, credit spreads remain elevated across the asset class. In addition, a high percentage of the Company’s RMBS portfolio is comprised of floating rate securities, which has resulted in higher unrealized losses relative to fixed rate securities but not necessarily higher default losses.
The Company’s RMBS portfolio also includes securities issued by a GSE. The Company’s $0.2 million of gross unrealized losses within this RMBS sub-sector has a fair value of $6.5 million.
There are no individual issuers rated below investment grade in the RMBS sector which have unrealized loss positions greater than $2.5 million.
The Company defines investment grade securities as unsecured debt obligations that have a rating equivalent to S&P’s BBB- or higher (or similar rating agency). At December 31, 2010 and 2009, approximately $55.8 million (or 3%) and $38.9 million (or 3%), respectively, of fixed maturity securities were rated BBB-, which is the lowest investment grade rating given by Standard and Poor’s. Below investment grade securities are speculative and are subject to significantly greater risks related to the creditworthiness of the issuers and the liquidity of the market for such securities. The Company closely monitors such investments.
The majority of assets depressed over 20% as well as over 40% and greater than one year are primarily related to subprime ABS - housing related, CMBS and RMBS. As there has been no impact to expected future cash flows, the Company does not consider the underlying investments to be impaired at December 31, 2010.
Subprime mortgages are loans to homebuyers who have weak or impaired credit histories. Through 2008, the market for these loans has expanded rapidly. During that time, however, lending practices and credit assessment standards grew steadily weaker. As a result, the market is experiencing a sharp increase in the number of loan defaults. Investors in subprime mortgage assets include not only mortgage lenders, but also brokers, hedge funds, and insurance companies. The Company does not currently invest in or originate whole loan residential mortgages. The Company categorizes ABS issued by a securitization trust as having subprime mortgage exposure when the average credit score of the underlying mortgage borrowers in a securitization trust is below 660 at issuance. The Company also categorizes ABS issued by a securitization trust with second lien mortgages as subprime mortgage exposure, even though a significant percentage of second lien mortgage borrowers may not necessarily have credit scores below 660 at issuance.
For the year ended December 31, 2009, the Company’s impairment losses were $9.9 million, net of VOBA amortization. During 2009, the Company impaired its holdings of CIT Group, Inc. and Lear Corporation for $1.6 million and $1.1 million, respectively, due to bankruptcy filings of the issuers. Additionally, the Company recorded a $2.0 million gross impairment on an upper tier 2 capital security of Lloyds Banking Group due to the intent to sell the security during the year. Twenty-two unique issuers accounted for the remaining gross impairment losses of $9.5 million with no single issuer accounting for more than $1.0 million.
The cumulative effect adjustment was calculated for all AFS securities held at April 1, 2009, for which an OTTI was previously recognized, but at April 1, 2009, the Company did not intend to sell the security and it was not more likely than not that the Company would be required to sell the security before recovery of its amortized cost, by comparing the present value of cash flows expected to be received at April 1, 2009, to the amortized cost basis of the AFS securities. The discount rate used to calculate the present value of the cash flows expected to be collected was the rate for each respective AFS security in effect before recognizing any OTTI. In addition, because the carrying amount of VOBA is adjusted for the effects of realized and unrealized gains and losses on AFS securities, the Company recognized a true-up to the VOBA balances for this cumulative effect adjustment.
All mortgage loans that are impaired have an established allowance for loss. Changing economic conditions impact our valuation of mortgage loans. Changing vacancies and rents are incorporated into the discounted cash flow analysis that the Company performs for monitored loans and may contribute to the establishment of (or an increase or decrease in) an allowance for losses. In addition, the Company continues to monitor the entire commercial mortgage loan portfolio to identify risk. Areas of emphasis are properties that have deteriorating credits or have experienced debt coverage reduction. Where warranted, the Company has established or increased loss reserves based upon this analysis. There was one impaired mortgage loan at December 31, 2010 for $0.6 million and no impaired mortgage loans at December 31, 2009. At December 31, 2010 and 2009, there were no commercial mortgage loans that were two or more payments delinquent. See Note 3 to the Financial Statements for further discussion.
During 2010, average variable account balances increased $0.4 billion (or 5%) to $8.0 billion as compared to the same period in 2009. The increase in average variable account balances contributed $6.5 million to the increase in asset-based policy charge revenue during 2010 as compared to 2009.
costs as compared to assumptions. If the Company determines that it needs to increase its estimated long term cost of guaranteed benefits, it will result in establishing greater guaranteed benefit liabilities as compared to current practice.
At December 31, 2010 and 2009, the Company had 14,140 and 15,498 life insurance and annuity contracts inforce with interest rate guarantees, respectively. The estimated average rate of interest credited on behalf of contract owners was 3.76% and 3.49% during 2010 and 2009, respectively. Total invested assets supporting these liabilities with interest rate guarantees had an estimated average effective yield of 4.50% and 2.49% during 2010 and 2009, respectively. In 2010 the number of life insurance and annuity contracts inforce with interest rate guarantees decreased 1,358 (or 9%) as compared to 2009.
The National Association of Insurance Commissioners utilizes the RBC adequacy monitoring system. The RBC calculates the amount of adjusted capital that a life insurance company should have based upon that company’s risk profile. At December 31, 2010 and 2009, based on the RBC formula, the Company’s total adjusted capital levels were above the minimum amount of capital required to avoid regulatory action.
Amortization of VOBA was $20.4 million for the year ended December 31, 2010, which included favorable unlocking of $24.6 million. Amortization and impairment of VOBA was $155.5 million for the year ended December 31, 2009, which included unfavorable unlocking of $79.4 million. Favorable unlocking during 2010 was primarily driven by the favorable equity market in the latter half of the year, while in 2009 poor equity market performance during the first quarter resulted in unfavorable unlocking. In addition, during 2009, an impairment charge $63.9 million was recorded as estimated future gross profits were less than the unamortized balance at March 31, 2009.
Insurance expenses and taxes decreased $21.7 million (or 29%) in 2010 as compared to 2009. The following table provides the changes in insurance expenses and taxes for each respective period:
(b) The decrease in interest related losses during 2009 was primarily due to impairments taken in 2008.
(b) The decrease in annuity benefit expense was primarily driven by the change in reserve for the embedded derivatives as compared to the same period in 2008. This was primarily a result of the positive equity markets relative to the same period in 2008.
Amortization and impairment of VOBA was $155.5 million and $37.7 million for 2009 and 2008, respectively. During 2009 and 2008, there was an impairment charge of $63.9 million and $28.0 million, respectively as estimated future gross profits were less than the unamortized balance. In addition, for 2009 and 2008, there was unfavorable unlocking of $79.4 million and $40.5 million, respectively. During 2009, the unfavorable unlocking was primarily driven by equity market volatility and revisions to policyholder behavior assumptions.
At December 31, 2008, an impairment charge was taken for the entire unamortized other intangibles balance which included the distribution agreement, the trade name and the non-compete agreement acquired at the acquisition date. Amortization expense for 2008 was $3.8 million. Impairment charges were recorded in the fourth quarter of 2008 for other intangibles and goodwill of $76.1 million and $139.3 million, respectively.
Insurance expenses and taxes increased $6.9 million (or 10%) in 2009 as compared to 2008. The following table provides the changes in insurance expenses and taxes for each respective period:
(a) The decrease in commissions is primarily due to the Company no longer issuing variable annuity products during the latter part of 2009, as well as a decline in trail commissions as a result of decreased average variable account balances in 2009 as compared to 2008.
The Company’s operating results are categorized into two business segments: Annuity and Life Insurance. The Company’s Annuity segment consists of variable annuity and interest-sensitive annuity contracts. The Company’s Life Insurance segment consists of variable life insurance and interest-sensitive life insurance contracts. The accounting policies of the business segments are the same as those described in the summary of significant accounting policies. All revenue and expense transactions are recorded at the contract level and accumulated at the business segment level for review by management.