Management’s Discussion and Analysis of Financial Condition and Results of Operations for the three years ended December 31, 2012 is intended to provide in narrative form the perspective of the management of Kansas City Life Insurance Company (the Company) on its financial condition, results of operations, liquidity, and certain other factors that may affect its future results. This discussion should be read in conjunction with the consolidated financial statements and accompanying notes included in this document.
Kansas City Life markets individual insurance products, including traditional, interest sensitive, and variable products through a nationwide sales force of independent general agents and third-party marketing arrangements. Kansas City Life also markets group insurance products, which include life, dental, vision, and disability products through its sales force of independent general agents, group brokers, and third-party marketing arrangements. Kansas City Life operates in 48 states and the District of Columbia.
The Company earns revenues primarily from premiums received from the sale of life insurance, immediate annuities, and accident and health policies; from earnings on its investment portfolio; and from the sale of investment assets. Insurance revenues from the sale of traditional life insurance, immediate annuity products, and accident and health products are reported as premium income for financial statement purposes. Considerations for supplementary contracts with life contingencies are reported as other revenues. However, deposits received from the sale of interest sensitive products, namely universal life insurance products, fixed deferred annuities, variable universal life, variable annuities, and supplementary contracts without life contingencies, are not reported as premium revenues. These are instead reported as additions to the policyholders’ account balances and are reflected as deposits in Financing Activities section of the Consolidated Statements of Cash Flows. Accordingly, insurance revenues on these products are recognized over time in the form of contract charges assessed against policyholder account balances, charges assessed on the early surrender of policyholder account balances, and other charges deducted from policyholder balances.
General economic conditions may affect future results. Market fluctuations, often extreme in nature, have significantly impacted the financial markets and the Company’s investments, revenues, and policyholder benefits in recent periods. The sustained low interest rate environment and volatile equity markets have presented significant challenges to the financial markets as a whole and specifically to companies invested in fixed maturity and equity securities. These conditions may continue and the stressed economic and market environment may persist into the future, affecting the Company’s revenue, net income, and financial position.
Increasing competition and changes in consumer behavior, which may affect the Company’s ability to sell its products and retain business;
Customer and agent response to new products, distribution channels, and marketing initiatives;
Fluctuations in experience regarding current mortality, morbidity, persistency, and interest rates relative to expected amounts used in pricing the Company’s products;
Regulatory, accounting, or tax changes that may affect the cost of, or the demand for, the Company’s products or services; and
Mortgage loans are stated at cost, net of an allowance for potential future losses. Loans in foreclosure, loans considered impaired, or loans past due 90 days or more are placed on a non-accrual status. If a mortgage loan is determined to be in non-accrual status, the Company does not accrue interest income. The loan is independently monitored and evaluated as to potential impairment or foreclosure. This evaluation includes assessing the probability of receiving future cash flows, along with consideration of many of the factors described in Note 6 - Financing Receivables. If delinquent payments are made and the loan is brought current, then the Company returns the loan to active status and accrues income accordingly.
To the extent the Company's review and valuation determines a loan is impaired, that amount is charged to the allowance for loss and the loan balance is reduced. In the event that a property is foreclosed upon, the carrying value is written down to the lesser of the current fair value or book value of the property with a charge to the allowance for potential future losses and a corresponding reduction to the mortgage loan asset.
For additional information pertaining to DAC and VOBA, please see Note 1.
A 10 basis point reduction in future interest rate spreads would result in a reduction in DAC and an increase in current period amortization expense of $2.6 million.
The following table reflects the estimated pre-tax impact to VOBA on universal life and fixed deferred annuity products that could occur in a twelve-month period for an unlocking adjustment due to reasonably likely changes in significant assumptions. Changes in assumptions of the same magnitude in the opposite direction would have an impact of a similar magnitude but opposite direction of the examples provided.
A 10% increase in expected surrender rates for all future years would result in a reduction in VOBA and an increase in current period amortization expense of $0.7 million.
Liabilities for reinsurance are calculated on an actuarial present value method consistent with the risks being transferred.
Policyholder account balances include universal life insurance, fixed deferred annuity contracts, and investment-type contracts. Liabilities for these policyholder account balances are included without reduction for potential surrender charges and deferred front-end contract charges. The account balances for these types of contracts are equal to cumulative deposits, less contract charges and withdrawals, plus interest credited. Front-end contract charges are deferred and amortized over the term of the policies. Policyholder benefits incurred in excess of related policyholder account balances are charged to policyholder benefits expense. Interest on policyholder account balances is credited as earned.
Premiums for traditional life insurance products are reported as revenue when due. Premiums on accident and health, disability, vision, and dental insurance are reported as earned ratably over the contract period in proportion to the amount of insurance protection provided. A reserve is provided for the portion of premiums written which relates to unexpired terms of coverage.
The Company measures its sales or new business production with two components: new premiums recorded and new deposits received. Premiums and deposits are also identified by general product type. New premiums and new deposits are considered to be first year and single receipts. Premiums and deposits are subdivided into two categories: new and renewal. New premiums and deposits are measures of sales or new business production. Renewal premiums and deposits occur as continuing business from existing customers.
Consolidated total premiums decreased $9.8 million or 5% in 2011 compared to 2010, as total new premiums decreased $14.7 million or 27% and total renewal premiums increased $4.9 million or 3%. The decrease in new premiums was due to a $15.5 million or 69% decline in immediate annuity sales. This decrease was largely the result of elevated sales of this product in 2010 due to the heightened preference of guaranteed benefits by consumers at that time. In addition to the sizeable fluctuations mentioned above, the decrease in new immediate annuity sales can also be attributed to lower interest rates during 2011 and increased competition from alternative products. Partially offsetting the decrease in immediate annuities, new individual life insurance premiums increased, largely from the Old American segment. The increase in renewal premiums reflected a $2.1 million or 2% increase in individual life insurance renewal premiums and a $2.5 million or 7% increase in group accident and health renewal premiums. The increase in individual life insurance renewal premiums largely resulted from the Old American segment. The increase in group accident and health renewal premiums reflected growth in short-term disability and dental premiums.
Total new deposits decreased from the prior year by $2.6 million or 3% in 2012, following a $10.0 million or 10% decrease in 2011. The decrease in 2012 was largely due to a $5.3 million decrease in new fixed deferred annuity deposits. This was partially offset by a $1.7 million or 11% increase in new variable annuity deposits and a $1.2 million or 11% increase in new universal life deposits. The decline in 2011 was largely due to a decrease in new fixed deferred annuities, as well as declines in new universal life and variable annuity deposits.
Total renewal deposits decreased from the prior year by $3.6 million or 2% in 2012 following a $5.8 million or 4% increase in 2011. The decline in 2012 was largely attributable to a decrease in fixed deferred annuity renewal deposits. The improvement in 2011 was due to an increase in renewal fixed deferred annuity deposits.
Contract charges consist of cost of insurance, expense loads, amortization of unearned revenues, and surrender charges on policyholder account balances. The cost of insurance and expense loads are earned over time by the continued persistency of these products. Surrender charges result from charges levied for withdrawals of policies during time frames defined in the policy contract. Finally, a component of contract charges is the recognition over time of the deferred revenue liability (DRL) from certain fixed and variable universal life policies. This liability arises from front-end loads on such policies and is recognized in concert with the future expected gross profits, similar to the amortization of DAC. Unlocking or other events may also have an impact on future expected gross profits on products and policies. If it is determined that it is appropriate to change the assumptions of future experience, then an unlocking adjustment is recognized for the block of business being evaluated. Certain assumptions, such as interest spreads and surrender rates, may be interrelated. As such, unlocking adjustments often reflect revisions to multiple assumptions. In addition, the Company may also consider refinements in estimates for other unusual or one-time occurrences for events such as administrative or actuarial system upgrades. These items are applied to the appropriate financial statement line items similar to unlocking adjustments.
Total contract charges charges declined $1.2 million or 1% in 2012 and $5.0 million or 5% in 2011, relative to the same periods one year earlier. The decline in 2012 was due to several factors including a decrease in cost of insurance charges, largely due to the runoff of closed blocks; a decrease in expense loads that resulted from increased sales of products with lower expense loads in 2012 relative to the prior year; and a decline in surrender charges, reflecting lower surrenders on universal life products. Partially offsetting these, the amortization of deferred revenue increased due to improved reinsurance modeling capabilities resulting from a system upgrade during 2011. The decline in 2011 primarily resulted from factors including lower amortization of deferred revenue due to unlocking, as discussed below; a decline in cost of insurance charges, largely due to the runoff of closed blocks; and a decline in surrender charges, reflecting reduced surrenders of universal life and variable universal life products in the ongoing blocks of business.
Included in total contract charges are groups of policies and companies that the Company considers to be closed blocks. Total contract charges on these closed blocks equaled 35% of total consolidated contract charges during 2012, compared to 36% in 2011. Total contract charges on closed blocks declined 3% from $35.9 million in 2011 to $34.8 million in 2012, reflecting the runoff of this business. Total contract charges on open blocks of business were essentially flat in 2012 compared to 2011.
Gross investment income is largely composed of interest, dividends and other earnings on fixed maturity securities, equity securities, short-term investments, mortgage loans, real estate, and policy loans. Gross investment income decreased $1.1 million or 1% in 2012 compared to 2011, as an increase in average invested assets was more than offset by lower yields earned. Gross investment income increased $1.7 million or 1% in 2011 compared to 2010, as an increase in average invested assets was partially offset by lower yields.
The Company has significantly increased its holdings in commercial mortgage loans in recent periods. The Company owned $674.0 million in mortgage loans at December 31, 2012, up from $601.9 million at December 31, 2011 and $559.2 million at December 31, 2010. Over this time, mortgage loan investment income increased from 17% of gross investment income to 20% in 2012. It is anticipated that the increased allocation to mortgage loans will provide a favorable impact on investment portfolio yields.
Investment income from real estate properties provided $9.5 million or 5% of gross investment income in 2012 compared to $7.7 million or 4% in 2011. This increase was largely the result of a change in the mix of real estate investments and improved occupancy in certain properties.
The Company recorded net realized investment gains of $18.4 million in 2012, $3.1 million in 2011, and $0.5 million in 2010. During 2012, investment losses of $1.7 million were due to write-downs of investment securities that were considered other-than-temporarily impaired. In addition the Company recorded impairment losses of $0.8 million on the Company's real estate investments. Partially offsetting these were $2.7 million in gains resulting from sales of investment securities and $3.8 million in gains from securities called and other. In the above table, investment securities called and other includes, but is not limited to, principal pay downs and sinking funds.
During 2011, investment losses of $2.0 million were due to write-downs of investment securities that were considered other-than-temporarily impaired. These were partially offset by $3.9 million in gains on the sale of investment securities and $3.6 million of investment gains realized on securities called and other.
During 2012, two securities were written down through earnings that were equal to or exceeded $0.5 million on a consolidated basis. The first was a collateralized debt obligation that was written down by $0.5 million due to an increase in projected future losses on the underlying collateral. The second was a corporate security that was written down by $0.6 million due to the expected settlement value after the issuer filed for bankruptcy. The Company did not have any individual investment securities that were written down through earnings during 2011 that exceeded $0.5 million on a consolidated basis. During 2010, two securities were written down through earnings that exceeded $0.5 million on a consolidated basis. The first was a securitization of U.S. government guaranteed student loans that was written down by $1.0 million due to the liquidation of the security by the trustees at the direction of a majority of bondholders. The second was a mortgage-backed security that was written down $0.6 million due to a decline in the subprime and non-conforming mortgage markets and the specific performance of the underlying collateral caused cash flow projections to be less than the amortized cost of the security.
The primary sources of investment risk to which the Company is exposed include credit risk, interest rate risk, and liquidity risk. The Company’s ability to manage these risks is essential to the success of the organization. In particular, the Company devotes considerable resources to both the credit analysis of each new investment and to ongoing credit positions. A default by an issuer usually involves some loss of principal to the investor. Losses can be mitigated by timely sales of affected securities or by active involvement in a restructuring process. However, there can be no assurance that the efforts of an investor will lead to favorable outcomes in a bankruptcy or restructuring. Credit risk is managed primarily through industry, issuer, and structure diversification.
Equity securities available for sale, at fair value (cost: 2012 - $18,195; 2011 - $34,951)
Treasury stock, at cost (2012 - 7,463,823 shares; 2011 - 7,187,315 shares)
Cost of 107,511 shares acquired (2011 - 158,694 shares; 2010 - 99,012 shares)
Cost of 19,624 shares sold (2011 - 954 shares; 2010 - 1,026 shares)
The preparation of the consolidated financial statements requires management of the Company to make estimates and assumptions relating to the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the consolidated financial statements, and the reported amounts of revenue and expenses during the period. These estimates are inherently subject to change and actual results could differ from these estimates. Included among the material (or potentially material) reported amounts and disclosures that require extensive use of estimates are the fair value of certain invested assets, DAC, VOBA, future policy benefits, policy and contract claim liabilities, pension and other postretirement benefits, and the valuation allowance on deferred income tax assets.
The Company’s principal investments are in fixed maturity securities, mortgage loans, and real estate; all of which are exposed to three primary sources of investment risk: credit, interest rate, and liquidity. The fixed maturity securities, which are all classified as available for sale, are carried at fair value in the Company’s Consolidated Balance Sheets, with unrealized gains or losses recorded in accumulated other comprehensive income. The unrealized gains or losses are recorded net of the adjustment to policyholder account balances, future policy benefits, and DAC to reflect what would have been earned had those gains or losses been realized and the proceeds reinvested. For additional information, please see Note 5 - Fair Value Measurements.
Real estate consists of directly owned investments and real estate joint ventures. Real estate that is directly owned is carried at depreciated cost. Real estate joint ventures consist primarily of office buildings, industrial warehouses, unimproved land for future development, and low income housing tax credit (LIHTC) investments. Real estate joint ventures are consolidated when required or are valued at cost, adjusted for the Company’s equity in earnings.
The Company has a policy and process in place to identify securities and other assets that could potentially have an impairment that is other-than-temporary. This process involves monitoring market events and other items that could impact issuers’ credit ratings, business climate, management changes, litigation and government actions, and other similar factors. This process also involves monitoring late payments, downgrades by rating agencies, key financial ratios, financial statements, revenue forecasts, asset quality, and cash flow projections as indicators of credit issues. For additional information, please see Note 4 - Investments.
Crediting rates for universal life insurance and fixed deferred annuity products ranged from 1.00% to 5.50% in 2012 (2011 - 1.50% to 5.50%; 2010 - 2.00% to 5.50%).
The following table provides detail about policyholder account balances at December 31,
DAC, principally agent commissions and other selling, selection, and issue costs, which are related directly to the successful acquisition of new or renewal insurance contracts, are capitalized as incurred. At least annually, the Company reviews its DAC capitalization policy and the specific items which are capitalized with existing guidance. See Note 3 for discussion of the implementation of new accounting guidance adopted during 2012 related to the costs capitalized. These deferred costs for life insurance products are generally deferred and amortized over the premium paying period. Policy acquisition costs that relate to interest sensitive and variable insurance products are deferred and amortized in relation to the estimated gross profits to be realized over the lives of the contracts.
emerging trends within the industry. Short-term deviations in experience affect the amortization of DAC, deferred revenue liability (DRL), and VOBA in the period, but do not necessarily indicate that a change to the long-term assumptions of future experience is warranted. If it is determined that it is appropriate to change the assumptions related to future experience, then an unlocking adjustment is recognized retrospectively for the block of business being evaluated. Certain assumptions, such as interest spreads and surrender rates, may be interrelated. As such, unlocking adjustments often reflect revisions to multiple assumptions. The DAC, DRL, or VOBA balance is immediately impacted by any assumption changes, with the change reflected through the income statement as an unlocking adjustment. These adjustments can be positive or negative with adjustments reducing amortization limited to amounts previously deferred plus interest accrued through the date of the adjustment.
The following table summarizes the effects of the refinements in estimates on all products and unlocking of assumptions on interest sensitive products in the Consolidated Statements of Comprehensive Income for the years ended December 31.
Premiums for traditional life insurance products are reported as revenue when due. Premiums on accident and health, disability, and dental insurance are reported as earned ratably over the contract period in proportion to the amount of insurance protection provided.
Comprehensive income is comprised of net income and other comprehensive income. Other comprehensive income includes the unrealized investment gains or losses on securities available for sale (net of reclassification adjustments) net of adjustments to DAC, VOBA, policyholder account balances, and future policy benefits. In addition, other comprehensive income includes the change in the liability for benefit plan obligations. Other comprehensive income reflects these items net of tax. For additional information, please see Note 16 - Comprehensive Income.
The Company prospectively adopted Accounting Standards Update (ASU) No. 2010-26, “Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts,” effective January 1, 2012. This guidance modifies the types of costs incurred by insurance entities that can be capitalized when issuing or renewing insurance contracts. The guidance defines allowable deferred acquisition costs as incremental or directly related to the successful acquisition of new or renewal contracts. In addition, certain costs related directly to acquisition activities performed by the insurer, such as underwriting and policy issuance, are also deferrable. This guidance also defines the considerations for the deferral of direct-response advertising costs.
The amount of acquisition costs capitalized during 2012 was $36.9 million. The acquisition costs that would have been capitalized during 2012 if the Company's previous policy had been applied during that period was $34.0 million. Thus, the adoption of this guidance resulted in an increase of $2.9 million in the amount of acquisition costs capitalized during 2012. After consideration of amortization, the net result of the adoption of ASU No. 2010-26 was an increase of $2.6 million in pretax earnings in 2012.
During the third quarter of 2012, the Company completed a change in accounting estimate related to a long-lived asset. This asset concluded its initial depreciation schedule in the third quarter of 2012. The Company reassessed this asset and its ongoing use of it and determined that it has a useful life greater than estimated at the time of initial implementation. The Company has the ability and the intent to hold and use this asset over the reassessed useful life. The Company also established an updated residual value, consistent with longer use of the asset. The Company recalculated the depreciation that would have been recognized to date using the reevaluated useful life and residual value resulting in additional depreciation of $3.7 million being recorded as an operating
The following table provides amortized cost and fair value of securities by asset class at December 31, 2011.
As part of the required accounting for unrealized gains and losses, the Company also adjusts the deferred acquisition costs (DAC) and value of business acquired (VOBA) assets to recognize the adjustment to those assets as if the unrealized gains and losses from securities classified as available for sale actually had been realized.
The following table provides information regarding fixed maturity and equity security investments available for sale with unrealized losses by length of time at December 31, 2012.
The following table provides information regarding fixed maturity and equity security investments available for sale with unrealized losses by length of time at December 31, 2011.
The following table provides the distribution of maturities for fixed maturity securities available for sale with unrealized losses at December 31. Expected maturities may differ from these contractual maturities since borrowers may have the right to call or prepay obligations.
The Company held one non-income producing security with a carrying value of $1.9 million million at December 31, 2012 (2011 - two securities with a carrying value of $3.2 million). This security was previously written down due to other-than-temporary impairments and placed on non-accrual status.
The Company did not hold securities of any corporation and its affiliates that exceeded 10% of stockholders' equity at December 31, 2012 or December 31, 2011.
Credit losses on securities held at beginning of year in accumulated other comprehensive income
The following table provides the net unrealized gains (losses) reported in accumulated other comprehensive income (loss) on the Company's investments in securities available for sale, at December 31.
The following table provides realized investment gains (losses) by major category for the years ended December 31.
Investments in mortgage loans totaled $674.0 million at December 31, 2012 ($601.9 million - December 31, 2011). The Company's mortgage loans are mostly secured by commercial real estate and are stated at cost, adjusted for amortization of premium and accrual of discount, less an allowance for potential future losses. This allowance is maintained at a level believed by management to be adequate to absorb estimated credit losses and was $3.3 million at December 31, 2012 ($2.8 million - December 31, 2011). Management's periodic evaluation and assessment of the adequacy of the allowance is based on known and inherent risks in the portfolio, historical experience, industry data, current economic conditions, and other relevant factors. Please see Note 6 - Financing Receivables for additional information. Four mortgage loans have been foreclosed upon and transferred to real estate investments during the past three years. Two of the foreclosed loans resulted in recognition of impairment losses to the Company, as their fair values were less than the carrying values. Also, there were three delinquent mortgage loans at December 31, 2012 (three at December 31, 2011), although payment was subsequently received on one loan in January 2013 to bring this loan current. A fifth mortgage default occurred in the third quarter of 2012, and this loan is in the process of foreclosure. The Company does not hold mortgage loans to any single borrower that exceed 5% of stockholders' equity.
At December 31, 2012, the Company had 18% of its invested assets in commercial mortgage loans, up from 17% at December 31, 2011. New commercial loans were $178.7 million, $132.9 million and $140.8 million for 2012, 2011 and 2010, respectively. The level of new commercial mortgage loans in any year is influenced by market conditions, as the Company responds to changes in interest rates, available spreads, and borrower demand.
In addition to the subject collateral underlying the mortgage, the Company typically requires some amount of recourse from borrowers as another potential source of repayment. The recourse requirement is determined as part of the underwriting requirements of each loan. The Company added 92 new loans to the portfolio during 2012 and 76 or 83% of these loans had some amount of recourse requirement. A total of 40 new loans or $122.4 million were purchased from institutional lenders during 2012. At December 31, 2012, 35% of the Company's commercial mortgage portfolio had been acquired rather than originated by the Company. The purchased loans are generally seasoned performing loans having characteristics of property type, geographical diversification, term, underwriting and cash flows that are similar to the Company's portfolio of originated loans. The average loan to value ratio for the overall portfolio was 47% at December 31, 2012, up from 46% at December 31, 2011. These ratios are based upon the current balance of loans relative to the appraisal of value at the time the loan was originated or acquired. The average loan balance was approximately $1.6 million at December 31, 2012 and December 31, 2011. The Company has certain mortgage loans that had an unamortized premium balance of $3.6 million, as of December 31, 2012 ($0.8 million - December 31, 2011).
At December 31, 2012, the Company had a construction-to-permanent loan commitment in the amount of $2.8 million, and $2.5 million had been disbursed on this loan. At completion and fulfillment of occupancy requirements, the construction loan will convert to a long-term, fixed-rate permanent loan.
Investments in real estate totaled $124.7 million at December 31, 2012 ($128.0 million at December 31, 2011). The table below provides information concerning the Company's real estate investments by major category at December 31.
Investment real estate is depreciated on a straight-line basis over periods ranging from 3 to 60 years. The Company had $53.5 million in real estate sales during 2012.
Short-term financial assets include cash and other short-term investments. Cash is categorized as Level 1. Other short-term assets are invested in institutional money market funds. These assets are categorized as Level 2, as the valuation is based upon the net asset value (NAV) of the fund.
Fair values of mortgage loans on real estate properties are calculated by discounting contractual cash flows, using discount rates based on current industry pricing or the Company’s estimate of an appropriate risk-adjusted discount rate for loans of similar size, type, remaining maturity, likelihood of prepayment, and repricing characteristics. Mortgage loans are categorized as Level 3 in the fair value hierarchy.
Fair values for liabilities under investment-type insurance contracts are based upon account value. The fair values of investment-type insurance contracts included with policyholder account balances for fixed deferred annuities are estimated to be their cash surrender values. The fair values of supplementary contracts without life contingencies are estimated to be the present value of payments at a market yield. The fair values of deposits with no stated maturity are estimated to be the amount payable on demand at the measurement date. These liabilities are categorized as Level 3.
Fair values for short-term notes payable approximate their carrying value. The carrying amount is a reasonable estimate of the fair value because of the relatively short time between the origination of the loan and its expected repayment.
The Company utilizes external independent third-party pricing services to determine the majority of its fair values on investment securities available for sale. At December 31, 2012, approximately 96% of the carrying value of these investments was from external pricing services, 2% was from brokers, and 2% was derived from internal matrices and calculations. In the event that the primary pricing service does not provide a price, the Company utilizes the price provided by a second pricing service. The Company reviews prices received from service providers for reasonableness and unusual fluctuations but generally accepts the price identified from the primary pricing service. In the event a price is not available from either third-party pricing service, the Company pursues external pricing from brokers. Generally, the Company pursues and utilizes only one broker quote per security. In doing so, the Company solicits only brokers which have previously demonstrated knowledge and experience of the subject security. If a broker price is not available, the Company determines a fair value through various valuation techniques that may include discounted cash flows, spread-based models, or similar techniques, depending upon the specific security to be priced. These techniques are primarily applied to private placement securities. The Company utilizes available market information, wherever possible, to identify inputs into the fair value determination, primarily including prices and spreads on comparable securities. At December 31, 2012, the Company obtained prices for five securities from brokers and internally determined the prices for 19 securities. At December 31, 2011, the Company obtained prices for five securities from brokers and internally determined prices for 15 securities.
The determination of the value of the Company's liabilities that are reported at fair value in the financial statements is the responsibility of the Company's valuation actuary group, which reports to the Company's Senior Vice President and Actuary. This group manages and creates the policies and processes used to determine the fair value for these liabilities. Methodologies used include internal assumptions and third-party inputs to derive a value, including a risk-neutral option pricing model that incorporates a third-party-developed index that is consistent with the attributes of the product and provides for an approximate match of the volatility measure with the expected life of the underlying contracts. The fair value methodologies and the fair values are reviewed by the Senior Vice President and Actuary, the Principal Accounting Officer, and the Chief Financial Officer. The results of these reviews are made known to the Company's Disclosure Committee and to the Company's Audit Committee. In addition, any significant policy or process changes made are also discussed with the Company's Audit Committee.
The Company's primary category of Level 3 fair values is fixed maturity securities, totaling $46.1 million as of December 31, 2012. These assets are valued using comparable security valuations through the unobservable input of estimated discount spreads. Specifically, the Company reviews the values and discount spreads on similar securities for which such information is observable in the market. Estimates of increased discount spreads are then determined based upon the characteristics of the securities being evaluated. The Company estimates that an increased spread of 10 basis points on each of the Level 3 securities would reduce the reported fair value by $0.2 million as of December 31, 2012.
Agent specific loans. At December 31, 2012, these loans totaled $1.1 million with an allowance for doubtful accounts of $0.3 million. As of December 31, 2011, agent specific loans totaled $0.8 million with an allowance for doubtful accounts of $0.2 million.
The Company considers its mortgage loan portfolio to be long-term financing receivables. Mortgage loans are stated at cost, adjusted for amortization of premium and accrual of discount, less of an allowance for potential future losses. Mortgage loan interest income is recognized on an accrual basis with any premium or discount amortized over the life of the loan. Prepayment and late fees are recorded on the date of collection. Loans in foreclosure, loans considered impaired, or loans past due 90 days or more are placed on a non-accrual status.
As of December 31, 2012, there were three mortgage loans that were 30 days or more past due, including one 90 days past due and one 120 days past due. The loan that was 120 days past due is in the process of foreclosure. Subsequently, payment was received on two of the three delinquent loans and one was brought current in January 2013. At December 31, 2011, there were three mortgage loans that were 30 days past due. Subsequently, payment was received on all of these loans and they were brought current in January 2012.
The allowance for potential future losses on mortgage loans is maintained at a level believed by management to be adequate to absorb estimated credit losses. Management's periodic evaluation and assessment of the adequacy of the reserve is based on known and inherent risks in the portfolio, historical and industry data, current economic conditions, and other relevant factors. The Company assesses the amount it maintains in the mortgage loan allowance through an assessment of what the Company believes are relevant factors at both the macro-environmental level and specific loan basis. A loan is considered impaired if it is probable that contractual amounts due will not be collected. The Company's allowance for credit losses was $3.3 million at December 31, 2012 and $2.8 million at December 31, 2011.
potential future losses on loans that contain elevated risk profiles. If the Company determines through its evaluation that a loan has an elevated specific risk profile, it then individually assesses the loan’s risk profile and assigns a specific allowance value based on many factors, including those identified below.
Analysis of the Company’s loan portfolio based on loan size concentrations, geographic concentrations, property type concentrations, maturity concentrations, origination loan-to-value concentrations, and borrower concentrations.
The risk that the performance of the underlying property could deteriorate in the future;
The risk that fraudulent, inaccurate, or misleading information could be provided to the Company;
The allowance for potential future losses increased $0.5 million during 2012 due to the Company's evaluation of the portfolio's risk profile and expected ongoing performance.
To the extent the Company's review and valuation determines a loan is impaired, that amount is charged to the allowance for potential future losses and the loan balance is reduced. In the event that a property is foreclosed upon, the carrying value is written down to the lesser of the current fair value, less selling costs, or book value of the property with a charge to the allowance and a corresponding reduction to the mortgage loan asset.
The following table presents the carrying amount and maximum exposure to loss relating to VIEs for which the Company holds a variable interest, but is not the primary beneficiary, and which had not been consolidated at December 31, 2012 and December 31, 2011. The table includes investments in seven real estate joint ventures and 26 affordable housing real estate joint ventures at December 31, 2012 and investments in eleven real estate joint ventures and 27 affordable housing real estate joint ventures at December 31, 2011.
At December 31, 2012 and 2011, the Company had unfunded commitments of $1.3 million and $7.0 million, respectively. In 2012, there were $0.3 million of mortgage loan commitments outstanding to the real estate joint venture VIEs and $0.6 million in 2011. Unfunded equity commitments for the development of properties owned were $1.0 million and $6.4 million in 2012 and 2011, respectively. The loan commitments are included in Note 21 to Consolidated Financial Statements. The Company also has contingent commitments to fund additional equity contributions for operating support to certain real estate joint venture VIEs, which could result in additional exposure to loss. However, the Company is not able to quantify the amount of these contingent commitments.
During 2012, the Company completed a change in accounting estimate related to a long-lived asset. This asset concluded its initial depreciation schedule in the third quarter of 2012. The Company reassessed this asset and its ongoing use and determined that it has a useful life greater than estimated at the time of its initial implementation. The Company also established an updated residual value, consistent with a longer use of the asset. Please see Note 3 - Change in Accounting Principle and Change in Accounting Estimate for additional information. Depreciation expense totaled $5.1 million in 2012 (2011 - $1.5 million; 2010 - $1.5 million).
Separate account assets and liabilities arise from the sale of variable universal life insurance and variable annuity products. The separate account represents funds segregated for the benefit of certain policyholders who bear the investment risk. The assets are legally segregated and are not subject to claims which may arise from any other business of the Company. The separate account assets and liabilities, which are equal, are recorded at fair value based upon net asset value (NAV). Policyholder account deposits and withdrawals, investment income, and realized investment gains and losses are excluded from the amounts reported in the Consolidated Statements of Comprehensive Income. Revenues to the Company from separate accounts consist principally of contract charges, which include maintenance charges, administrative fees, and mortality and risk charges.
The Company has a guaranteed minimum withdrawal benefit (GMWB) rider that can be added to new or existing variable annuity contracts. The rider provides an enhanced withdrawal benefit that guarantees a stream of income payments to an owner or annuitant, regardless of the contract account value. The value of variable annuity separate accounts with the GMWB rider was $102.5 million at December 31, 2012 (2011 - $86.6 million) and the guarantee liability was $(1.1) million at December 31, 2012 (2011 - $(0.2)
The total separate account assets were $340.1 million at December 31, 2012 (2011 - $316.6 million). Variable universal life and variable annuity assets comprised 29% and 71% of this amount, respectively in both 2012 and 2011.
At December 31, 2012, separate account balances for variable annuity contracts were $243.1 million. The total reserve held for variable annuity GMDB was $0.1 million (December 31, 2011 - $0.2 million). Additional information related to the GMDB and related separate account balances and net amount at risk (the amount by which the GMDB exceeds the account balance) as of December 31, 2012 and 2011 is provided below:
Return of the greater of net deposits accumulated annually at 5% or the highest anniversary contract value
As a member of the FHLB with a capital investment of $4.7 million, the Company has the ability to borrow on a collateralized basis from the FHLB. The Company received dividends on the capital investment in the FHLB equal to $0.1 million during 2012 (2011 - $0.1 million; 2010 - $0.1 million).
The Company and its subsidiaries file income tax returns in the U.S. federal jurisdiction and various state jurisdictions. In general, the Company is no longer subject to U.S. federal, state or local income tax examinations by tax authorities for years prior to 2009. The Company is not currently under examination by the Internal Revenue Service.
The Company recognizes interest and penalties accrued related to unrecognized tax benefits in income tax expense (benefit). In 2012 and 2011, the Company did not recognize any expense (benefit) related to interest and penalties. During the year ended December 31, 2010, the Company recognized expense (benefit) of approximately ($0.7) million in interest and penalties. The Company did not have any accrued interest and penalties at December 31, 2012 or December 31, 2011.
Certain of the Company's pension plan assets consist of investments in pooled separate accounts offered by the Plan. Net asset value (NAV) of the separate accounts is calculated in a manner consistent with GAAP for investment companies and is determinative of their fair value. Several of the separate accounts invest in publicly quoted mutual funds or actively managed stocks. The fair value of the underlying mutual funds or stock is used to determine the NAV of the separate account, which is not publicly quoted. Some of the separate accounts also invest in fixed income securities. The fair value of the underlying securities is based on quoted prices of similar assets and used to determine the NAV of the separate account. Sale of plan assets may be at values less than
The current assumption for the expected long-term rate of return on plan assets is 8.0%. This assumption is determined by analyzing: 1) historical average returns achieved by asset allocation and active management; 2) historical data on the volatility of returns; 3) current yields available in the marketplace; 4) actual returns on plan assets; and 5) current and anticipated future allocation among asset classes. The asset classes used for this analysis are domestic and international equities, investment grade corporate bonds, alternative assets, and cash. The overall rate is derived as a weighted average of the estimated long-term returns on the asset classes represented in the investment portfolio of the plan. Effective January 1, 2013, the Company decreased the assumption for the expected long-term rate of return on plan assets to be 7.7%
Non-contributory defined contribution retirement plans for eligible general agents and sales agents provide supplemental payments based upon earned agency first year individual life and annuity commissions. Contributions to these plans in 2012 were $0.1 million (2011 - $0.1 million; 2010 - $0.1 million). Non-contributory deferred compensation plans for eligible agents based upon earned first year commissions are also offered. Contributions to these plans in 2012 were $0.5 million (2011 - $0.5 million; 2010 - $0.3 million).
Other changes in plan assets and benefit obligations recognized in other comprehensive income:
Weighted average assumptions used to determine benefit obligations at December 31:
The following table provides the components of net periodic benefit cost for the years ended December 31.
For measurement purposes, the annual increase in the per capita cost of covered health care benefits was assumed to be 8.5%, decreasing gradually to 5.5% in 2025 and thereafter.
During the first quarter of 2012, the Company identified an error related to the amortization period for unrecognized actuarial gains and losses for its pension plan. The Company determined that upon curtailment of the plan on January 1, 2011, the status
of the plan participants should have changed from active to inactive. The amortization period was corrected from the average remaining service period of plan participants, approximately ten years, to the average remaining life expectancy of plan participants, approximately 26 years. The Company has recognized a $2.0 million pre-tax benefit during 2012 related to the reversal of amortization recorded during 2011.
The following table provides information about the outstanding three-year intervals at December 31, 2012.
No payments were made during 2012, 2011, or 2010 for the three-year intervals ended December 31, 2011, 2010, and 2009, respectively. The cost of compensation charged as an operating expense during 2012 was $2.2 million, net of tax. The cost of compensation charged as an operating expense during both 2011 and 2010 was $0.3 million, net of tax.
The following table reflects the Company’s reinsurance partners whose reinsurance recoverable was 5% or greater of the Company's total reinsurance recoverable at December 31, 2012, along with their A. M. Best credit rating.
A contingent liability exists with respect to reinsurance, which may become a liability of the Company in the unlikely event that the reinsurers should be unable to meet obligations assumed under reinsurance contracts. The solvency of reinsurers is reviewed annually.
Insurance revenues, as shown in the Consolidated Statements of Comprehensive Income, consist of premiums and contract charges, less reinsurance ceded. Insurance revenues are defined as “customer revenues” for segment reporting purposes. Other revenues consist primarily of supplementary contract considerations, policyholder dividends left with the Company to accumulate, income received on the sale of low income housing tax credits by a subsidiary of the Company, and fees charged on products and sales from the Company's broker-dealer subsidiary. Customer revenues are added to other revenues, net investment income, and realized investment gains (losses) to reconcile to the Company's total revenues. Benefits and expenses are specifically and directly identified and recorded by segment. Certain expenses may also be allocated as necessary.
The unaudited quarterly results of operations for the years ended December 31, 2012 and 2011 are summarized in the table below.
For Kansas City Life, the maximum stockholder dividends payable without prior approval in 2013 is $32.7 million, 10% of 2012 capital and surplus. For Old American and Sunset Life, the maximum stockholder dividends payable without prior approval in 2013 is $2.4 million and $6.5 million, respectively, which is the statutory net gain from operations for the preceding year for each company. Each of the individual insurance enterprises believes that the statutory limitations impose no practical restrictions on any of its dividend payment plans.
In the normal course of business, the Company has open purchase and sale commitments. At December 31, 2012, the Company had purchase commitments to fund mortgage loans and affordable housing projects of $8.6 million and one construction-to-permanent loan of $0.3 million that is subject to the borrower’s performance, and $5.3 million for the development of real estate investments.
The Company's broker-dealer and investment advisor subsidiary is involved in a business that involves a substantial risk of liability. Legal and other proceedings involving financial services firms, including the Company's subsidiary, continue to have a significant impact on the industry. Significant matters over the last few years have included registered representative activity and certain types of securities products (particularly private placements and real estate investment products).
In accordance with applicable accounting guidelines, the Company establishes an accrued liability for litigation and regulatory matters when those matters present loss contingencies that are both probable and estimable. As a litigation or regulatory matter develops, it is evaluated on an ongoing basis, often in conjunction with outside counsel, as to whether the matter presents a loss contingency that meets conditions indicating the need for accrual and/or disclosure. If and when a loss contingency related to litigation or regulatory matters is deemed to be both probable and estimable, the Company establishes an accrued liability. This accrued liability is then monitored for further developments that may affect the amount of the accrued liability.
The Company is subject to various indemnification obligations issued in conjunction with certain transactions, primarily assumption reinsurance agreements, stock purchase agreements, mortgage servicing agreements, tax credit assignment agreements, construction and lease guarantees, and borrowing agreements whose terms range in duration and often are not explicitly defined. Generally, a maximum obligation is not explicitly stated. Therefore, the overall maximum amount of the obligation under the indemnifications cannot be reasonably estimated. The Company is unable to estimate with certainty the ultimate legal and financial liability with respect to these indemnifications. The Company believes that the likelihood is remote that material payments would be required under such indemnifications and therefore such indemnifications would not result in a material adverse effect on the financial position or results of operations.
All other information required by this Schedule is shown in Note 15 - Reinsurance in the Notes to Consolidated Financial Statements.
We have audited the accompanying consolidated balance sheets of Kansas City Life Insurance Company and subsidiaries (the Company) as of December 31, 2012 and 2011, and the related consolidated statements of comprehensive income, stockholders' equity, and cash flows for each of the years in the three-year period ended December 31, 2012. In connection with our audits of the consolidated financial statements, we also have audited financial statement schedules I to V. We also have audited the Company's internal control over financial reporting as of December 31, 2012, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company's management is responsible for these consolidated financial statements and financial statement schedules, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management's Assessment of Internal Control Over Financial Reporting. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules and an opinion on the Company's internal control over financial reporting based on our audits.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Kansas City Life Insurance Company and subsidiaries as of December 31, 2012 and 2011, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2012, in conformity with U.S. generally accepted accounting principles. Also in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. Also in our opinion, Kansas City Life Insurance Company and subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2012, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
As discussed in Note 3 to the consolidated financial statements, effective January 1, 2012, the Company modified the types of costs incurred that can be capitalized when issuing or renewing insurance contracts due to the prospective adoption of Financial Accounting Standards Board Accounting Standards Update (ASU) No. 2010-26, Accounting for Costs associated with Acquiring or Renewing Insurance Contracts.