The selected consolidated financial data set forth below for each of the five years in the period ended December 31, 2011 is not necessarily an indication of future operations. This data should be read in conjunction with our consolidated financial statements and notes thereto and Item 7, Management’s Discussion and Analysis of Operations and Financial Condition.
1Net investment income divided by average cash and total invested assets, based on book value (including accrued investment income).
We are engaged in the sale of insurance products, including individual annuities, individual life insurance and accident and health insurance. Our revenues are derived primarily from premiums received from the sale of annuity contracts and life, accident and health products, investment income and gains (net of losses) from our investment portfolio.
Under GAAP, our revenues from the sale of annuity contracts with life contingencies, life insurance products and accident and health products are treated differently from our revenues from the sale of annuity contracts without life contingencies, deferred annuities and universal life insurance products. Premiums from the sale of life insurance products and life contingent annuities are reported as premium income on our income statement. Premiums from the sale of deferred annuities, universal life insurance products and annuities without life contingencies are not reported as revenues, but rather are reported as additions to policyholders’ account balances on our balance sheet. For these products, earnings are recognized over time principally through the spread between interest income on invested assets and interest credited to policyholder’s accounts. Additional revenues are recognized over time in the form of policy fee income, surrender charges and mortality and other charges deducted from policyholders’ account balances.
The profitability of our life contingent annuities, individual life insurance and group accident and health products depends largely on the size of our in-force book of business, the adequacy of product pricing and underwriting discipline, and the efficiency of our claim and expense management.
As described under “Ratings” and “Regulation,” the Company’s business is substantially affected by capital ratios and their impact on the Company’s ratings. Insurance sales are being made with a greater selectivity based on increased profit level requirements for new business. We have determined that the level of competition in the sale of universal life insurance products has made it very difficult for smaller insurance companies to participate in that business in a profitable way. Accordingly, under the current market conditions, we are no longer engaged in the sale of universal life policies; however, we continue to service in-force contracts.
Unless specifically stated otherwise, all references to 2011, 2010 and 2009 refer to our fiscal years ended, or the dates, as the context requires, December 31, 2011, December 31, 2010 and December 31, 2009, respectively.
1. Interest Rate Risk. Our principal product is deferred annuities, which are interest rate sensitive instruments. In an interest rate environment of falling or stable rates, annuity holders are less likely to seek to surrender their annuities prior to maturity due to the absence of alternative, higher-yielding investments. However, in an environment of moderately or significantly increasing rates, such surrenders should be expected to increase. As of December 31, 2011, the existence of surrender fees on approximately 38.2% of the Insurance Company’s outstanding deferred annuities acts as a deterrent against surrenders. However, if interest rates climb sufficiently, such fees may not have a significant deterrent effect. Moreover, the surrender fees are only in effect typically for up to the first seven years of each annuity policy. In the event of a substantial increase in surrenders during a short period of time, we may have to sell longer-term assets to pay current surrender liabilities. We continually develop strategies to address the match between the timing of our assets and liabilities. To that end, in 2006 through 2008, a significant number of policies came off surrender charge and a significant portion of these policies were surrendered. We anticipated this event and maintained a significant level of cash equivalents to fund surrenders, avoiding the need to sell long-term assets at a loss. We believe that the heavy surrender activity associated with the 2006 through 2008 period is now largely behind us. Additionally, management has increased the incentive for agents to retain this business with us by paying full first year compensation on internal rollovers. Since 2008, a significantly smaller amount of business has been coming off surrender charge. The table below shows the in-force deferred annuities that are within the surrender charge period and the projected timing regarding the expiration of these surrender charges.
Management believes that we are able to offer our products at competitive prices to our targeted markets as a result of: (i) maintaining relatively low issuance costs by selling through the independent general agency system; (ii) minimizing home office administrative costs; and (iii) utilizing appropriate underwriting guidelines.
The following table summarizes our investment results for the periods indicated, as determined in accordance with GAAP.
1Average of cash and aggregate invested amounts at the beginning and end of period.
2Net investment income is gross investment income net of investment expenses and excludes capital gains and losses and provision for income taxes.
4Net realized investment gains (losses) include provisions for impairment in value that are considered other than temporary and exclude provisions for income taxes.
We derive a predominant portion of our total revenues from investment income. We manage most of our investments internally. All investments made on our behalf are governed by the Statement of Investment Policy established and approved by the Finance and Investment Committee and the Board of Directors of the Insurance Company and Presidential Life Corporation and by qualitative and quantitative limits prescribed by applicable insurance laws and regulations. The Finance and Investment Committee meets regularly to set and review investment policy and to approve current investment plans. The actions of the Finance and Investment Committees are subject to review and approval by the Board of Directors of the Insurance Company and Presidential Life Corporation. Our Statement of Investment Policy must comply with NYDFS regulations and the regulations of other applicable regulatory bodies.
Our investment philosophy generally focuses on purchasing investment grade securities with the intention of holding such securities to maturity. However, as market opportunities, liquidity or regulatory considerations may dictate, securities may be sold prior to maturity. We have categorized all fixed maturity securities as available for sale and carry such investments at market value.
We seek to manage our investment portfolio in part to reduce its exposure to interest rate fluctuations. In general, the market value of our fixed maturity portfolio increases or decreases in an inverse relationship with fluctuations in interest rates, and our net investment income increases or decreases in direct relationship with interest rate changes. For example, if interest rates decline, our fixed maturity investments generally will increase in market value, while net investment income will decrease as fixed income investments mature or are sold and proceeds are reinvested at the declining rates, and vice versa. Management is aware that prevailing market interest rates frequently shift and, accordingly, has adopted strategies that are designed to address either an increase or decrease in prevailing rates.
Our principal investments are in fixed maturities, all of which are exposed to at least one of three primary sources of investment risk: credit, interest rate and market valuation. The financial statement risks are those associated with the recognition of impairments and income, as well as the determination of fair values. When assessing our intent to sell a fixed maturity security or if it is more likely that we will be required to sell a fixed maturity security before recovery of its cost basis, we evaluate facts and circumstances such as, but not limited to, decisions to reposition our security portfolio and sale of securities to meet cash flow needs. In order to determine the amount of the credit loss for a fixed maturity security, we calculate the recovery value by performing a discounted cash flow analysis based on the current cash flows and future cash flows we expect to recover. The discount rate is the effective interest rate implicit in the underlying fixed maturity security. The effective interest rate is the original yield or the coupon if the fixed maturity security was previously impaired. If an other than temporary impairment, or OTTI, exists and we have the intent to sell the security, we conclude that the entire OTTI is credit-related and the amortized cost for the security is written down to current fair value with a corresponding charge to realized loss on our consolidated statements of income. If we do not intend to sell a fixed maturity security or it is not more likely than not we will be required to sell a fixed maturity security before recovery of its amortized cost basis but the present value of the cash flows expected to be collected is less than the amortized cost of the fixed maturity security (referred to as the credit loss), we conclude that an OTTI has occurred and the amortized cost is written down to the estimated recovery value with a corresponding charge to realized loss on our consolidated statements of income, as this is also deemed the credit portion of the OTTI. The remainder of the decline to fair value is recorded to other comprehensive income, or OCI, as an unrealized OTTI loss on our consolidated balance sheets, as this is considered a noncredit (i.e., recoverable) impairment. For a further discussion regarding our accounting policy and related judgments involved in OTTI assessments, refer to “Critical Accounting Policies and Estimates” below.
Securities or obligations of entities involved in or emerging from reorganization proceedings under U. S. Bankruptcy laws are often available at prices that may represent significant discounts to underlying collateral values or enterprise values. Investment strategies in this segment include investments in secured debt of distressed companies where the general partner believes it can significantly influence the outcome of events by acquiring a controlling or blocking interest in order to maximize recoveries and returns. Control-focused strategies can provide for the ability to mitigate risk by influencing not only the timing of a re-organization but also the structure of a company’s reorganized balance sheet.
The following two tables present the gross unrealized losses for fixed maturities where the estimated fair value had declined and remained below amortized cost and the number of issuers with total gross unrealized losses in excess of 12 months for fixed maturities and common stock at December 31, 2011:
Total unrealized losses decreased from $44.1 million at December 31, 2010 to $26.1 million at December 31, 2011. This decrease in the unrealized losses resulted from the significant decline in U.S. Treasury yields from the 5-year maturity out to 30-years. Five-year Treasuries declined in yield to .83% at year-end 2011 as compared to 2.00% at year-end 2010. Ten-year Treasuries declined to 1.88% at year-end 2011 from 3.29% at year-end 2010 and 30-year Treasuries declined to 2.89% at year-end 2011 from 4.34% at year-end 2010. We carefully examine each issue where the market value has fallen below 80% of book value to determine if the bonds are not-other-than-temporarily impaired. Consistent with our OTTI Policy, we will recognize a write-down of book value to current market value, if warranted. Six securities were written down during 2011, producing an OTTI charge of $5.4 million.
Dresdner Funding Trust is a junior subordinated debt issue of Dresdner Bank, a German bank that has recently been impacted by the European debt crisis, particularly with its holdings of Greek sovereign debt. The American General Institutional Capital Trust and the Nationwide Mutual Life holdings are large holdings (book value of $ 9.58 million and $ 11.95 million, respectively) of insurance company fixed income securities. Sears Roebuck Acceptance was recently impacted by the decline in Sears Roebuck and K-Mart sales and earnings. These bonds are now rated Caa1 by Moody’s and CCC+ by Standard and Poor’s. Countrywide Capital Trust, guaranteed by Bank of America upon the purchase of Countrywide Financial in 2008, has been recently impacted by the downgrade of certain Bank of America securities to below investment-grade. Currently, these securities are rated Ba1 by Moody’s and BB+ by Standard and Poor’s.
At December 31, 2011, preferred stock losses totaled $7.3 million on a cost basis of $41.4 million. The largest loss of $2.8 million is an $8.33 million book value position in a National Westminster Bank 7.763% preferred. National Westminster Bank is owned by the Royal Bank of Scotland. Although non-cumulative, Royal Bank of Scotland has asserted that it has a contractual obligation to continue paying the dividends under the indenture of this issue or risk a default of an associated bond issue. It has asserted that it will continue to pay these dividends unless prohibited by its financial regulators. The next four loss positions include a $1.3 million loss in a Royal Bank of Scotland 5.75% preferred (book value of $ 7.23 million), also with a “must-pay” provision; a $0.534 million loss position ($ 2 million book value) in a Santander Finance 6.41% preferred series A; a $0.499 million loss ($ 1.48 million book value) in a “must-pay” preferred of the Royal Bank of Scotland (7.65% series F); and a $0.475 million loss ( $ 2.6 million book value) in a Morgan Stanley Capital Trust, 6.25% 3/01/33 series.
The rating upgrade of Presidential Life reflects its favorable risk-adjusted capitalization, positive earnings over a five-year period and no financial leverage. The stable outlook reflects our continued profitable operating posture and favorable capitalization ratios. However, A.M. Best believes lower investment yields due to the current interest rate environment may result in further spread compression and lead to lower earnings.
A.M. Best's rating is based on factors which primarily are relevant to policyholders, agents and intermediaries and is not directed towards the protection of investors, nor is it intended to allow investors to rely on such a rating in evaluating our financial condition.
Results of Operations - Comparison of Fiscal Year 2011 to Fiscal Year 2010 and Fiscal Year 2010 to Fiscal Year 2009.
For the years ended December 31, 2011, 2010 and 2009, approximately 47.8%, 36.3% and 51.4%, respectively, of premiums from traditional life, annuity, universal life and investment-type contracts received by us were attributable to sales to annuitants and policyholders residing in the State of New York.
Earnings (losses) from limited partnerships that are accounted for under the equity method, amounted to approximately $2.2 million, ($5.5) million and ($.1) million for 2011, 2010 and 2009, respectively. Because equity in earnings or losses from limited partnerships accounted for under the equity method are based on changes in fair value, which is the basis for carrying value, and fair value of the underlying investments can fluctuate greatly from period-to-period, there is inherent volatility to income. With respect to limited partnerships accounted for under the fair value method, fair value is also the basis for carrying value but such changes are unrealized and reflected in other comprehensive income until distributed to us. Income included within distributions of the limited partnerships accounted for under the fair value method are classified as realized gains and losses and therefore excluded from net investment income (see below in the paragraph following the table on realized gains).
Our ratios of net investment income to average cash and invested assets (based on book value and excluding equity in earnings of the limited partnerships) was 5.89%, 6.01% and 5.95% for 2011, 2010 and 2009, respectively.
Realized investment gains, including OTTI losses, amounted to $35.3 million, $26.9 million, and $(10.9) in 2011, 2010 and 2009, respectively. The table below details the components of these amounts:
A significant contributor to our profitability depends, in large part, on the investment returns generated on our portfolio, or the ratio of net investment income to book value mean assets excluding our limited partnerships, less what we are contractually obligated to credit to our policyholders. This is referred to as “investment spread”. The crediting rate on investments and reserves and the resulting investment spread for 2011, 2010 and 2009 are summarized below:
The interest expense on our notes payable amounted to approximately $0.8 million in 2009. In 2009, our 7 7/8% Senior Notes were paid in full. We did not incur any interest expense in 2010 or 2011 as we had no debt.
Commissions to agents, net were $4.3 million, $7.2 million and $10.7 million in 2011, 2010 and 2009, respectively. Commission expense declined in 2011 and 2010 due to lower annuity sales relative to the previous year.
General Expenses and Taxes and Costs Related to Consent Revocation and Proxy Solicitation
General expenses, taxes, and costs related to consent revocation and proxy solicitation totaled $22.5 million, $20.1 million and $19.8 million in 2011, 2010 and 2009, respectively. This represents an increase of 11.7% comparing 2011 to 2010 and an increase of 1.3% comparing 2010 to 2009. The increase in general expenses and taxes during 2011 is primarily due to an increase in severance costs, the cost of the New York State triennial examination, and legal and accounting expenses associated with our financial restatements.
For the reasons discussed above, income before income taxes amounted to $55.9 million, $34.8 million and $1.0 million in 2011, 2010 and 2009, respectively.
The following information summarizes the components of the unrealized investment gains:
Given the Insurance Company’s historical cash flow and current financial results, management believes that, for the reasonably foreseeable future, the Insurance Company’s cash flow from operating activities will provide sufficient liquidity for the operations of the Insurance Company.
The Insurance Company’s inability to upstream a dividend could have an adverse material impact on us. With no debt on the balance sheet, currently our biggest cash outlay is to our shareholders in the form of cash dividends, which at the current level of $.25 per share annually, total approximately $7.4 million per year. The Insurance Company’s current capital and surplus level does not trigger an urgent need for capital raising. However, from time to time, we explore capital raising options for various reasons, including, but not limited to, the following:
· Possible additional restrictions by the NYDFS on dividends that could be up streamed from the Insurance Company.
If the Insurance Company does not have the financial flexibility to upstream a dividend to us and we are restricted in our ability to raise capital, the Board of Directors may decide to reduce or suspend the payment of dividends to shareholders until capital conditions improve. The Board of Directors may also decide to reduce or suspend the payment of dividends if the implementation of our strategy so dictates.
For purposes of our consolidated statements of cash flows, financing activities relate primarily to sales and surrenders of the Insurance Company's annuity and universal life insurance products. The payment of dividends by us to our stockholders is also considered to be a financing activity. Net cash used in our financing activities amounted to approximately $84.8 million, $52.6 million and $62.1 million in 2011, 2010 and 2009, respectively. These fluctuations primarily are attributable to changes in policyholder account balances as a result of surrenders, sales and interest earned by the policyholders. The repayment of our debt was also a primarily use of cash in 2009.
In order to maintain consistency in our portfolio, our deferred annuity products incorporate surrender charges to discourage surrenders or withdrawals. Annuitants may not terminate or withdraw funds from their annuity contracts for a significant initial period (generally seven years) without incurring penalties in the form of surrender charges. These surrender charges generally range from 1% to 9% of the investment. Approximately 61.8%, 57.5% and 56.3% of the Insurance Company's deferred annuity contracts in force (measured by reserves) as of December 31, 2011, 2010 and 2009 were beyond the surrender period and therefore could be surrendered without charge.
The market value of our fixed maturity portfolio changes as interest rates change. In general, rate decreases cause asset prices to rise, while rate increases cause asset prices to fall. Based on market values and prevailing interest rates as of December 31, 2011, a hypothetical instantaneous increase in interest rates of 100 basis points would produce a loss in fair value of our fixed maturity assets of approximately $204.1 million. Conversely, a hypothetical instantaneous decrease in interest rates of 100 basis points would produce a gain in fair value of our fixed maturity assets of approximately $222.3 million. Our risk of loss during a period of rising interest rates generally relates to the potential need to sell fixed maturity investments in the event net cash outflows from surrenders and partial withdrawals exceed net cash inflows plus excess cash and short-term investments on hand. Such risk is mitigated by surrender charges that both discourage early surrenders and partial withdrawals and reduce proceeds paid to an annuitant that surrenders a contract. At December 31, 2011, approximately 61.8% of the Insurance Company's deferred annuity contracts in force (measured by reserves) were beyond the surrender period and therefore could be surrendered without charge. To mitigate the risk of loss from large surrender and withdrawal activity from these deferred annuities during a period of rising interest rates, we enter into payor swaptions. When interest rates rise, the value of these derivatives rise and may be sold to partially offset losses from the sale of fixed maturity investments prior to maturity. If interest rates were to rise by 100 basis points, the fair value of payor swaptions held at December 31, 2011 would increase by approximately $4.9 million.
We neither transact business nor hold investments denominated in currencies other than the U.S. dollar. We do hold corporate debt securities issued by sponsors outside the United States for which valuation potentially could be subject to foreign currency risk and/or credit exposure to foreign sovereign debt. At December 31, 2011, we held $239.5 million of fixed maturity investments issued by foreign entities, of which $68.6 million related to European issuers. Of the $68.6 million, $30.4 million involved issuers in countries whose currency is the Euro.
A persistent focus of our management is maintaining the appropriate balance between the duration of invested assets and the duration of contractual liabilities to our annuity holders. Towards this end, at least quarterly, our investment department determines the duration of our invested assets in coordination with our actuaries, who are responsible for calculating the liability duration. In the event it is determined that the duration gap between its assets and liabilities exceeds a one year target level, we may re-position our assets through the sale of invested assets or the purchase of new investments. We manage the investment portfolio focusing on duration management to support our current and future liabilities. Through periodic monitoring of the effective duration of our assets and liabilities, we seek to maintain the degree of duration mismatch within the guidelines of our policy, which provides for a mismatch of up to one year. As of December 31, 2011 and December 31, 2010, the effective duration of our fixed income portfolio was approximately 5.9 and 5.6 years, respectively. The effective duration of our liabilities for the same periods was approximately 6.6 and 5.8 years.
Another element of the asset liability management strategy is to hedge against the risks posed by a rapid and sustained rise in interest rates by entering into a form of derivative transaction known as a payor swaption. The effect of this transaction would be to lessen the negative impact on us of a significant increase in interest rates. With payor swaptions, we should be able to maintain more competitive crediting rates to policyholders when interest rates rise.
During the 2005 to 2010 period, we established and implemented a program of payor swaptions designed to lessen the impact of a 300 basis point rise in interest rates. We established International Swaps and Derivatives Association “ISDA” Credit Support Agreements with various counterparties, which are six money center banks with credit ratings exceeding Aa3 by Moody’s and A+ by Standard and Poor’s. The final contract expired on June 21, 2010 with no residual value. From year-end 2009 to expiration, the change in market value was a loss of $389,970.
Future consideration of these transactions or other asset/liability management strategies is dependent upon periodic testing based on updated asset and liability data.
The table below summarizes the credit quality of our fixed maturity securities, excluding preferred stocks, as of December 31, 2011 and December 31, 2010 as rated by Standard and Poor’s.
The following presents a summary of our significant contractual obligations as of December 31, 2011.
1The difference between the recorded liability of $3,062.2 million, and the total payment obligation amount of $4,425.0 million, is $1,362.8 million and is comprised of (i) future interest to be credited; (ii) the effect of mortality discount for those payments that are life contingent; and (iii) the impact of surrender charges on those contracts that have such charges. Of the total payment of $4,425.0 million, $2,887.6 million, or 65.3% is from our deferred annuity, life, and accident and health business. Determining the timing of these payments involves significant uncertainties, including mortality, morbidity, persistency, investment returns, and the timing of policyholder surrender. Notwithstanding these uncertainties, the table reflects an estimate of the timing of such payments.
2See Note 1D “Summary of Significant Accounting Policies, Investments”, to the consolidated financial statements.
3Purchase obligations include contracts where we have a non-cancelable commitment to purchase goods and services.
In a declining interest rate environment, our cost of funds would be expected to decrease over time, reflecting lower interest crediting rates on its fixed annuities. Conversely, in an increasing interest rate environment, the cost of funds would be expected to increase, reflecting higher interest crediting rates. Should increased liquidity be required for withdrawals in such an interest rate environment, management believes that the portion of our investments that are designated as available for sale in our consolidated balance sheet could be sold without materially adverse consequences in light of the general strengthening in market prices that would be expected in the fixed maturity security market.
See Note 1, Item N, “Notes to the Consolidated Financial Statements” for a full description of new accounting pronouncements, including the respective dates of adoption and the effects on our results of operations and financial condition.
The preparation of financial statements in conformity with GAAP requires the application of accounting policies that require judgment involving estimates and assumptions affecting amounts reported in the consolidated financial statements. The critical accounting policies, estimates and related judgments underlying our consolidated financial statements are summarized below. In applying these accounting policies, management makes subjective and complex judgments that frequently require estimates about matters that are inherently uncertain. Many of these policies, estimates and related judgments are common in the insurance and financial services industries; others are specific to our business operations.
Unadjusted quoted prices in active markets for identical assets or liabilities. We define active markets based on average trading volume for equity securities. The size of the bid/ask spread is used as an indicator of market activity for fixed maturity securities.
Our investments in fixed maturity and equity securities, investments in trading securities and certain short-term investments are reported at their estimated fair value. In determining the estimated fair value of these investments, various methodologies, assumptions and inputs are utilized, as described further below.
Fair value is the carrying value for both limited partnerships accounted for under the fair value and equity methods. We initially estimate the fair value of investments in certain limited partnerships by reference to the transaction price. Subsequently, we generally obtain the fair value of these investments from net asset value information provided by the general partner or manager of the investments, the financial statements of which are generally audited annually. We consider observable market data and perform diligence procedures in validating the reasonableness of the fair value of assets held by a limited partnership and thus the appropriateness of using the net asset value as a fair value measurement. The carrying value for limited partnership interests accounted for using the equity method do not meet the definition of financial instruments for which fair value is required to be disclosed.
A review of all investments for impairment is performed quarterly. Investments, including fixed maturities, common stocks and limited partnerships, are added to an OTTI “Watch List” if: (1) the market value has declined below 80% of the cost basis; and (2) the decline has persisted for more than six months. Whenever an investment is added to the OTTI “Watch List”, our Investment Department prepares a memorandum outlining the potential impairment rationale, including relevant positive and negative qualitative and quantitative factors. When assessing impairments, there is a rebuttable presumption that a credit impairment of an investment has occurred when: (1) the market value has declined below 80% of the cost basis; and (2) the decline persisted for an extended period; and/or (3) a perceived material event has occurred potentially affecting the investment. To overcome this presumption, we must prepare a persuasive qualitative and quantitative analysis supporting that an other-than-temporary credit impairment has not occurred. OTTI memos are approved by the Chief Financial Officer, Chief Investment Officer, the Finance and Investment Committee and the Audit Committee.
In order to determine the amount of the impairment loss from credit, as opposed to interest rate fluctuations, for a fixed maturity security, we calculate the recovery value by performing a discounted cash flow analysis based on the current cash flows and future cash flows we expect to recover. The discount rate is the effective interest rate implicit in the underlying fixed maturity security. The effective interest rate is the original yield or the coupon if the fixed maturity security was previously impaired. If an OTTI exists and we have the intent to sell the security, we conclude that the entire OTTI is credit-related and the amortized cost for the security is written down to current fair value with a corresponding charge to realized loss on our consolidated statements of income. If we do not intend to sell a fixed maturity security or it is not more likely than not we will be required to sell a fixed maturity security before recovery of its amortized cost basis but the present value of the cash flows expected to be collected is less than the amortized cost of the fixed maturity security (referred to as the credit loss), we conclude that an OTTI has occurred and the amortized cost is written down to the estimated recovery value with a corresponding charge to realized loss on our consolidated statements of income, as this is also deemed the credit portion of the OTTI. The remainder of the decline to fair value is recorded to other comprehensive income (“OCI”), as an unrealized OTTI loss on our consolidated balance sheets, as this is considered a noncredit (i.e., recoverable) impairment.
¨ Adverse conditions specifically related to the security or to specific conditions in an industry or geographic area;
For all fixed maturities securities evaluated for OTTI, we consider the timing and amount of the cash flows. In assessing corporate fixed maturities securities for OTTI, we evaluate the ability of the issuer to meet its debt obligations and the value of the company or specific collateral securing the debt position including the fundamentals of the issuer to determine what we would recover if they were to file bankruptcy versus the price at which the market is trading; fundamentals of the industry in which the issuer operates; expectations regarding defaults and recovery rates; and changes to the rating of the security by a rating agency.
For our investments in limited partnerships, we determine whether to apply the equity method of accounting or the fair value accounting method. The determination to apply the equity method of accounting requires judgment, particularly the extent of influence necessary to apply that accounting method. Further, the timing of earnings recognition, including reporting partnership interests on a one quarter lag and OTTI write-downs and classification of earnings requires judgment that is stipulated in our accounting policy for limited partnerships.
The Insurance Company incurs significant costs in connection with acquiring new business. Under applicable accounting rules, these costs, which vary, are deferred. The recovery of such costs is dependent upon the future profitability of the related product, which in turn is dependent mainly on investment returns in excess of interest credited, as well as policy persistency, mortality and expenses. Changes in estimates could result in the impairment of the DAC asset and a charge to income if the present values of estimated future gross profits are less than the unamortized DAC. Judgments in connection with estimating future profitability include, but are not limited to, product groupings and segmentation of the investment portfolio. Historically, we have assessed recoverability in the aggregate, consistent with our segment reporting. If a premium deficiency were to exist, we would reduce the DAC balance by the amount of the deficiency or to zero through a charge to current period earnings. If the deficiency were to be greater than the DAC balance for those products involving life, mortality or morbidity, we then increase policy reserves by the excess, by means of a charge to current period earnings. Each year we conduct testing to confirm that the unamortized DAC asset is recoverable and that DAC balance write-down or premium deficiency reserves are deemed necessary.
In addition to affecting our assessment of recoverability, future profitability enters into management’s estimate of future gross profits, which are used to amortize deferred acquisition costs for our investment-type products, including deferred annuities and universal life. Changes in these estimates result in changes to the amounts expensed in the reporting period in which the revisions are made. To demonstrate the sensitivity of our net DAC balance ($41.7 million as of December 31, 2011) relative to our future spreads and expenses for deferred annuities and universal life, the information below indicates how much the net DAC balance would have changed if the future spread assumption decreased by 30% and if the future expense assumption increased by 30%. We believe that any variation in our expense or spread estimate is likely to fall within these ranges.
Effective January 1, 2012, we adopted the FASB’s new guidance for DAC on a prospective basis. Refer to Note 1N in the Notes to the Consolidated Financial Statements.
The reserves of single premium life and limited pay life products reflected in our consolidated financial statements are based upon our best estimates of mortality, persistency, expenses and investment income, with appropriate provisions for adverse statistical deviation as of the policies issue date. We use the net level premium method for all noninterest sensitive products. The assumptions are locked in at policy issuance, unless a premium deficiency position has to be recognized wherein a revised assumption would be used. For all investment type products such as deferred annuities and universal life, the policy account value is reported as its policy benefit reserve. This is equal to the accumulation of gross premiums plus interest credited less mortality and expense charges and withdrawals. In determining reserves for its insurance and annuity products, the Insurance Company performs periodic studies to compare current experience for mortality, interest and lapse rates with expected experience in the reserve assumptions. Differences are reflected currently in earnings for each period.
For those annuities and supplementary contracts with life contingencies that comprise a portion of future policy benefits ($665 million of reserves), an increase in mortality experience of 1% per year for individual contracts would increase the present value of future benefits by approximately $37 million. Conversely, a decrease in mortality experience of 1% per year would decrease the present value of future benefits by approximately $34 million. We believe that any variation of our mortality estimates is likely to fall within this range.
For traditional life insurance business ($51.7 million of reserves), establishing reserves requires the use of many assumptions. Due to the number of independent variables inherent in the calculation of these reserves, and because this business is not material to our overall results, it is not practical to perform a quantitative analysis on the impact of changes in underlying assumptions. However, the Insurance Company historically has not experienced significant adverse deviations from its assumptions and believes that its assumptions are realistic and produce reserves that are fairly stated in accordance with GAAP.
We account for income taxes under FASB Codification Topic 740-10-25 - Income Taxes. Accordingly, we use the asset and liability method to record deferred income taxes. Accordingly, deferred income tax assets and liabilities are recognized that reflect the net tax effect of the temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes, using enacted tax rates. Such temporary differences are primarily due to the tax basis of reserves for future policy benefits, deferred acquisition costs, and net operating loss carry forwards. A valuation allowance is applied to deferred tax assets if it is more likely than not that all, or some portion, of the benefits related to the deferred tax assets will not be realized. Our effective tax rate is principally based on income, non-taxable and non-deductible items, changes in liabilities for tax uncertainties, true-ups of deferred and current tax provisions for new information, and statutory tax rates.
Uncertain Tax Liabilities - We have open tax years, 2006 and 2007, in the United States that are currently under examination by the applicable taxing authorities, and certain later tax years that may in the future be subject to examination. We periodically evaluate the adequacy of our uncertain tax liabilities and tax reserves, taking into account our open tax return positions, tax assessments received and tax law changes. The process of evaluating uncertain tax liabilities and tax reserves involves the use of estimates and a high degree of management judgment. The final determination of tax audits could affect our tax reserves. During 2011, we reduced our liability for tax uncertainties by $1.0 million, primarily due to the close of prior tax years, thereby favorably affecting our effective tax rate.