Our selected historical consolidated financial data as of and for each of the five years in the period ended December 31, 2012 is reflected in the schedule that follows. We obtained the balance sheet data for the years ended December 31, 2012 and 2011 and the income statement data for the years ended December 31, 2012, 2011 and 2010 from our amended and restated audited consolidated financial statements in this Annual Report on Form 10-K. The selected consolidated financial data as of and for the years ended December 31, 2009 and 2008 has been obtained from our restated unaudited consolidated financial statements which are not contained in this report. The financial information as of and for the years ended December 31, 2009 and 2008 has been restated to reflect adjustments to our financial statements as discussed in “Explanatory Note” in the forepart of this report, in “
Management’s discussion and analysis reviews our consolidated financial condition at December 31, 2012 and 2011; our consolidated results of operations for the years 2012, 2011 and 2010; and, where appropriate, factors that may affect our future financial performance. This discussion should be read in conjunction with “Item 6: Selected Financial Data” and our consolidated financial statements in this Annual Report on Form 10-K.
During the preparation of the Company’s Form 10-Q for the period ended September 30, 2012, certain errors were identified in the Company’s consolidated statement of cash flows for the nine months ended September 30, 2012, as well as for previously reported periods. The Company filed a Current Report on Form 8-K with the SEC on November 8, 2012 (as was amended by Forms 8-K/A filed by the Company on March 15, 2013 and April 24, 2013, respectively) disclosing its conclusion that certain of its previously issued annual audited and interim unaudited financial statements contained in its historical Annual Reports on Form 10-K and Quarterly Reports on Form 10-Q should no longer be relied upon and should be restated. During the restatement process, the Company identified and corrected material errors, made certain reclassifications and adjustments to correct previously identified non-material out of period errors and corrected errors in retrospectively adopted amended accounting guidance. The impact of the restatement on the Company’s consolidated financial statements is detailed in Note 2 “Restatement and Amendment of Previously Reported Financial Information” to our consolidated financial statements and under “Item 8: Financial Statements and Supplementary Data” in this 2012 Form 10-K. As a result of the errors identified during the restatement, management identified material weaknesses in our internal control over financial reporting and concluded that the Company’s disclosure controls and procedures were not effective as of December 31, 2012. These weaknesses, an evaluation of the effectiveness of the Company’s disclosure controls and procedures and the Company’s remediation plans are more fully described in “Item 9A: Controls and Procedures” in Part II of this 2012 Form 10-K.
Our Life and Annuity segment’s profitability is driven by interaction of the following elements:
Income tax expense/benefit consists of both current and deferred tax provisions. The computation of these amounts is a function of pre-tax income and the application of relevant tax law and U.S. GAAP accounting guidance. In assessing the realizability of our deferred tax assets, we make significant judgments with respect to projections of future taxable income, the identification of prudent and feasible tax planning strategies and the reversal pattern of the Company’s book-to-tax differences that are temporary in nature. We also consider the expiration dates and amounts of carryforwards related to net operating losses, capital losses, foreign tax credits and general business tax credits. Based on our assessment, we have recorded a valuation allowance against a significant portion of our deferred tax assets based upon our conclusion that there is insufficient objective positive evidence to overcome the significant negative evidence from our cumulative losses in recent years. This assessment could change in the future, resulting in a release of the valuation allowance and a benefit to income.
Under U.S. GAAP, premiums and deposits for variable life, universal life and annuity products are not immediately recorded as revenues. For certain investment options of variable products, deposits are reflected on our consolidated balance sheets as an increase in separate account liabilities. Premiums and deposits for universal life, fixed annuities and certain investment options of variable annuities are reflected on our consolidated balance sheets as an increase in policyholder deposit funds. Premiums and deposits for other products are reflected on our consolidated balance sheets as an increase in policy liabilities and accruals.
Net realized investment gains or losses on investments. Net realized investment losses of $10.5 million were recognized in 2012 compared to a net realized investment loss of $32.1 million in 2011. Net realized gains on sales of long-term debt securities accounted for $31.0 million of the total realized gains over the year as interest rates reached historically low levels in 2012. Common and preferred equity investments and other alternative investments accounted for gains of $13.3 million due to strong performance in global equity markets during 2012. These gains were partially offset by impairments of $28.8 million on long-term debt securities and common stock and losses of $38.3 million on derivative assets and embedded derivative liabilities. These derivative losses were primarily attributable to a loss of $34.2 million on derivative contracts which hedge the variable annuity and fixed indexed annuity guarantees, offset by $12.1 million in gains on embedded derivative liabilities associated with fixed and variable annuity guarantees. Included in the net derivative loss were gains of $9.8 million associated with the non-performance risk factor. In addition, realized losses of $15.9 million related to our surplus hedge, which utilizes futures and options to hedge against declines in equity markets and the resulting statutory capital and surplus impact.
Since its formation in the fourth quarter of 2009, Saybrus’ results of operations have steadily improved as revenue has increased and expenses have declined. Inclusive of intercompany transactions, revenue in 2012 was $22.9 million, compared with $18.2 million in 2011. Of these amounts, revenue of $11.4 million and $11.3 million was earned from the sales of Phoenix life and annuity products in 2012 and 2011, respectively. Operating expenses increased to $20.4 million in 2012 from $19.5 million in 2011. The increase was primarily driven by an increase in compensation related expenses.
We believe this strategy has produced a firm foundation and positioned us for continued growth, even as our business remains sensitive to general economic conditions and capital market trends including equity markets and interest rates.
Each year we perform a comprehensive assumption review or an unlocking where we revise our assumptions to reflect the results of recent experience studies, thereby changing our estimate of estimated gross profits (“ EGPs”) in the deferred policy acquisition cost and unearned revenue amortization models, as well as projections within the death benefit and other insurance benefit reserving models as described more fully in Note 3 to our consolidated financial statements under “Item 8: Financial Statements and Supplementary Data” in this Annual Report on Form 10-K. While the final impact of the 2013 annual comprehensive assumption review is not yet complete, preliminary indications suggest an overall improvement in mortality experience and an increase in interest rates, both of which are significant assumptions and a driver of results. However, the ultimate impact of this experience on the annual unlock and on our consolidated results of operations has not yet been determined.
Private placement and limited partnership portfolios previously managed under Goodwin continue to be managed by Phoenix under its subsidiary, Phoenix Life.
The definitive agreement contains a provision requiring us to indemnify Tiptree for any losses due to actions resulting from certain specified acts or omissions associated with the divested business prior to closing. There has been litigation filed that falls within this provision of the agreement but does not name the Company as a party to the litigation. We intend to defend these matters vigorously based on our indemnity commitment. See Note 24 to our consolidated financial statements under “Item 8: Financial Statements and Supplementary Data” in this Annual Report on Form 10-K for additional information.
Included within the January 4, 2010 agreement with Tiptree was a provision for the purchase of PLARNY pending regulatory approval. On September 24, 2010, approval was obtained from the NYDFS for Tiptree and PFG Holdings Acquisition Corporation to acquire PLARNY. The transaction closed on October 6, 2010. Because of the divestiture, these operations are reflected as discontinued operations. We have reclassified prior period financial statements to conform to this change.
For a discussion of accounting standards and change in accounting, see Note 3 to our consolidated financial statements under “Item 8: Financial Statements and Supplementary Data” in this Annual Report on Form 10-K.
The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with U.S. GAAP. U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Critical accounting estimates are reflective of significant judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain.
We amortize deferred policy acquisition costs based on the related policy’s classification. For individual participating life insurance policies, deferred policy acquisition costs are amortized in proportion to estimated gross margins (“EGMs”) arising principally from investment results, mortality, dividends to policyholders and expense margins. For universal life, variable universal life and deferred annuities, deferred policy acquisition costs are amortized in proportion to EGPs discussed more fully below. EGPs are also used to amortize other assets and liabilities in the Company’s consolidated balance sheets, such as sales inducement assets (“SIA”) and unearned revenue reserves (“URR”). Components of EGPs are used to determine reserves for universal life and fixed, indexed and variable annuity contracts with death and other insurance benefits such as guaranteed minimum death and guaranteed minimum income benefits. Both EGMs and EGPs are based on historical and anticipated future experience which is updated periodically.
The projection of EGPs and EGMs requires the extensive use of actuarial assumptions, estimates and judgments about the future. Future EGPs and EGMs are generally projected for the estimated lives of the contracts. Assumptions are set separately for each product and are reviewed at least annually based on our current best estimates of future events. The following table summarizes the most significant assumptions used in the categories set forth below:
Mortality assumptions are based on Company experience over a rolling five-year period plus supplemental data from industry sources and trends. These assumptions vary by issue age, gender, underwriting class and policy duration.
See Note 14 to our consolidated financial statements under “Item 8: Financial Statements and Supplementary Data” in this Annual Report on Form 10-K for additional disclosures of our fair value methodologies.
our intent to sell the security, or whether it is more likely than not that we will be required to sell it before recovery; and
Impairments due to deterioration in credit that result in a conclusion that the present value of cash flows expected to be collected will not be sufficient to recover the amortized cost basis of the security are considered other-than-temporary. Other declines in fair value (for example, due to interest rate changes, sector credit rating changes or company-specific rating changes) that result in a conclusion that the present value of cash flows expected to be collected will not be sufficient to recover the amortized cost basis of the security may also result in a conclusion that an OTTI has occurred.
the security has traded at a significant discount to cost for an extended period of time; or
Equity securities are determined to be other-than-temporarily impaired based on management judgment and the consideration of the issuer’s financial condition along with other relevant facts and circumstances. Those securities which have been in a continuous decline for over a twelve month period are generally considered impaired. Additionally, declines in value that are severe and rapid are considered for reasonability of whether the impairment would be temporary.
We employ a comprehensive process to determine whether or not a security in an unrealized loss position is other-than-temporarily impaired. This assessment is done on a security-by-security basis and involves significant management judgment. The assessment of whether impairments have occurred is based on management’s evaluation of the underlying reasons for the decline in estimated fair value. The Company’s review of its fixed maturity and equity securities for impairments includes an analysis of the total gross unrealized losses by severity and/or age of the gross unrealized loss, as summarized on pages 71 and 72, “Duration of Gross Unrealized Losses on Securities.” An extended and severe unrealized loss position on a fixed maturity security may not have any impact on the ability of the issuer to service all scheduled interest and principal payments and the Company’s evaluation of recoverability of all contractual cash flows or the ability to recover an amount at least equal to its amortized cost based on the present value of the expected future cash flows to be collected. In contrast, for certain equity securities, greater weight and consideration are given by the Company to a decline in market value and the likelihood such market value decline will recover.
See Note 9 to our consolidated financial statements under “Item 8: Financial Statements and Supplementary Data” and the “Debt and Equity Securities” and “Enterprise Risk Management” sections of “Item 7: Management’s Discussion and Analysis of Financial Condition and Results of Operations” in this Annual Report on Form 10-K for more information.
The net periodic costs for the plans consider an assumed discount (interest) rate, an expected rate of return on plan assets and trends in health care costs. Of these assumptions, our expected rate of return assumptions, and to a lesser extent our discount rate assumptions, have historically had the most significant effect on our net period costs associated with these plans. The Company uses a building block approach in estimating the long-term rate of return for plan assets by asset class. The historical relationships between equities, fixed income and other asset classes are reviewed. We apply long-term asset return estimates to the plan’s target asset allocation to determine the weighted-average long-term return. Our long-term asset allocation was determined through modeling long-term returns and asset return volatilities. Our assumed long-term rate of return for 2012 was 8.0% for our pension plan. Given the amount of plan assets as of December 31, 2011, the beginning of the measurement year, if we had assumed an expected rate of return for our pension that was 100 basis points higher or 100 basis points lower than the rates we assumed, the change in our net periodic costs would have been a decrease of $4.3 million and an increase of $4.3 million, respectively. These amounts consider only changes in our assumed long term rate of return given the level and mix of invested assets at the beginning of the measurement year, without consideration of possible changes in any of the other assumptions described above that could ultimately accompany any changes in our assumed long-term rate of return.
We determine our discount rate, used to value the pension and postretirement benefit obligations, based upon rates commensurate with current yields on high quality corporate bonds. Our assumed discount rate for 2012 was 4.53% for our pension plan, 4.39% for the supplemental retirement plan and 4.11%/3.35% for our other postretirement benefit plan (the discount rate for our other postretirement benefit plan was changed from 4.11% to 3.35% on October 1, 2012 due to amendments to the plan). Given the amount of pension and postretirement obligations as of December 31, 2011, the beginning of the measurement year, if we had assumed a discount rate for our pension plans and our other postretirement benefit plan that was 100 basis points higher or 100 basis points lower than the rates we assumed, the change in our net periodic costs would have been as shown in the table below. These amounts consider only changes in our assumed discount rate without consideration of possible changes in any of the other assumptions described above that could ultimately accompany any changes in our assumed discount rate.
As of December 31, 2012, the projected benefit obligation for the Company’s pension plan, supplemental plan and other postretirement plan were $694.8 million, $150.9 million and $40.6 million, respectively.
The sensitivity of the projected benefit obligations for each of these plans to a 100 basis point change in the discount rate is presented in the table below.
The assumptions used may differ materially from actual results due to, among other factors, changing market and economic conditions and changes in participant demographics. These differences may have a significant effect on the Company’s consolidated financial statements and liquidity. See Note 17 to our consolidated financial statements under “Item 8: Financial Statements and Supplementary Data” in this Annual Report on Form 10-K information on these and other assumptions used in measuring liabilities relating to the Company’s pension and other postretirement benefits.
In addition, the cap on the Company’s contribution to pre-65 retiree medical costs per participant was reduced beginning with the 2011 plan year. In October 2012, we announced that effective January 1, 2013, the Company's contribution for pre-65 retiree medical and for post-65 retiree medical was reduced per covered member. These decisions affected retiree medical contributions for both past service and active employees. Curtailments were recognized as a result of the plan changes. The net effect was a reduction of our projected benefit obligation.
The Company recorded a net loss from continuing operations for the twelve months ended December 31, 2012 of $152.3 million, or $(26.40) per share, compared with a net loss from continuing operations of $9.6 million, or $(1.65) per share for the twelve months ended December 31, 2011. The decrease in results from continuing operations reflects higher policy benefits and policy acquisition cost amortization and lower premium revenue and fee income. These declines in results were partially offset by higher net investment income and realized investment gains.
Premium revenue decreased $46.4 million in the twelve months ended December 31, 2012 compared with the twelve months ended December 31, 2011 as a result of lower renewal premiums within the closed block and lower paid up additions on policies within the closed block due to a change in the dividend scale in 2011.
Policy benefits increased $29.1 million for the twelve months ended December 31, 2012 compared with the twelve months ended December 31, 2011. The increase in policy benefit expense was a result of higher death benefits for universal life and traditional whole life products as a result of negative mortality experience during 2012, primarily in the third quarter. Annuity benefits increased largely due to changes in reserves on fixed indexed annuities associated with minimum death and income benefit guarantees which were driven by increased sales during the year. Policy benefit expenses of $36.3 million were incurred during 2012 due to reserve unlocking adjustments as a result of our annual comprehensive review of actuarial assumptions in the third quarter of 2012. These expenses were partially offset by lower policy benefits within the closed block.
Policy acquisition cost amortization increased $42.1 million in the twelve months ended December 31, 2012 compared with the twelve months ended December 31, 2011. This increase in amortization was attributable to the unlocking of assumptions as a result the annual comprehensive review of assumptions in the third quarter of 2012. The unlocking resulted in amortization of $55.2 million in 2012, which included amortization of $46.2 million for traditional life policies from lower projected net yields related to investment income returns and amortization of $6.0 million for universal life policies primarily due to lower spreads due to the low interest rate environment. Excluding the impact of the unlocking, amortization related to universal life decreased as a result of negative mortality experience during the year. Amortization related to annuities decreased primarily as a result of improved market performance.
The effective tax rate for 2012 and 2011 was 2.4% and 455.5% respectively. The principal cause of the difference between the effective rate and the U.S. statutory rate of 35% in 2012 was an increase in the valuation allowance on the pre-tax loss, expired tax attribute carryforwards and the dividend received deduction. The principal cause of the difference between the effective rate and the U.S. statutory rate of 35% in 2011 was an increase in the valuation allowance on the pre-tax income and the dividend received deduction.
The Company recorded a net loss from continuing operations for the twelve months ended December 31, 2011 of $9.6 million, or $(1.65) per share, compared with a net loss from continuing operations of $31.3 million, or $(5.39) per share for the twelve months ended December 31, 2010. The increase in results from continuing operations reflects lower policy acquisition cost amortization and other operating expenses. These increases in results were partially offset by lower premium revenue, fee income and net investment income and higher net realized investment losses.
Premium revenue decreased $58.8 million in the twelve months ended December 31, 2011 compared with the twelve months ended December 31, 2010 as a result of lower renewal premiums and lower paid up additions on policies within the closed block as a result of the change in the 2011 dividend scale. These decreases were partially offset by increases in premium revenue within the traditional life lines of business.
Fees on our life and annuity products declined as a result of lower surrenders and a decline in funds under management on universal life, variable universal life and variable annuity products. In addition, cost of insurance fees declined $23.3 million primarily related to lower insurance in force in our universal life lines of business. Offsetting these declines was an increase in non-asset based fees related to fixed indexed annuities.
A net loss from discontinued operations of $21.6 million was recognized during 2011 which was primarily attributable to our discontinued group accident and health reinsurance operations as we strengthened reserves to reflect developments in the contracts underlying the block. See Note 21 to our consolidated financial statements in this Annual Report on Form 10-K for more information on discontinued operations.
The effective tax rate for 2011 and 2010 was 455.5% and 24.8%, respectively. The principal cause of the difference between the effective rate and the U.S. statutory rate of 35% in 2011 was an increase in the valuation allowance on the pre-tax income and the dividend received deduction. The principal cause of the difference between the effective rate and the U.S. statutory rate of 35% in 2010 was the dividend received deduction, an increase in the valuation allowance on the pre-tax loss and the expiration of tax credits.
Net investment income increased by $3.9 million to $217.9 million for the three months ended March 31, 2012 compared to $214.0 million for the three months ended March 31, 2011. The increase was due to higher investment income on long-term debt securities as a result of additional purchases during the year and higher returns on mezzanine and direct equity investments.
Net realized investment losses of $8.6 million were recognized for the three months ended March 31, 2012, compared with $9.5 million for the three months ended March 31, 2011. Realized investment losses for the quarter were due to an impairment loss of $6.8 million on long-term debt securities and a net loss of $5.6 million on derivative assets and embedded derivative liabilities. The derivative loss was primarily attributable to a $23.4 million loss associated with derivatives related to variable and fixed indexed annuity guarantees and realized losses of $6.0 million related to our surplus hedge, which utilizes futures and options to hedge against declines in equity markets and the resulting statutory capital and surplus impact. Partially offsetting these losses were gains of $24.1 million related to embedded derivative liabilities associated with variable and fixed indexed annuity guarantees and a realized gain of $7.0 million associated with the non-performance risk factor.
Policy benefits decreased $8.3 million for the three months ended March 31, 2012 compared with the three months ended March 31, 2011. The decrease in policy benefit expense was primarily a result of lower variable universal life and closed block death benefits due to positive mortality during the first quarter. These decreases were partially offset by higher benefits on tradition life policies due to negative mortality and higher annuity benefits due to changes in reserves on fixed indexed annuities associated with minimum death and income benefit guarantees which were driven by increased sales during the period.
The Company recorded income tax expense of $11.3 million and $7.7 million to continuing operations for the three months ended March 31, 2012 and 2011, respectively. The income tax expense relates primarily to the alternative minimum tax of $11.9 million. The expected deferred tax offset related to the alternative minimum tax credit carryforward was eliminated by an increase in the valuation allowance. Additionally, this alternative minimum tax impact was offset by a deferred tax benefit of $0.6 million that results from the application of ASC 740 intraperiod allocation rules. These rules allow for the benefitting of current year losses in continuing operations when an increase to the valuation allowance is avoided due to the existence of current year income elsewhere reported in the financial statements (e.g., discontinued operations, other comprehensive income).
Fees on our life and annuity products decreased $17.0 million in the three months ended June 30, 2012 compared with the three months ended June 30, 2011. Lower fees were primarily a result of a decrease of $9.6 million in COI charges related to declining universal life and variable universal life insurance in force and a decrease of $2.6 million in surrender charges consistent with lower policy surrenders. Other fee income decreased $5.1 million in the quarter ended June 30, 2012 compared with the quarter ended June 30, 2011, primarily attributable to a decrease in investment management fees subsequent to the sale of Goodwin in the fourth quarter of 2011.
Policy benefits decreased $10.8 million for the three months ended June 30, 2012 compared with the three months ended June 30, 2011. The decrease in policy benefit expenses was primarily a result of lower universal life and closed block death benefits due to positive mortality over the quarter. These decreases were partially offset by increases in loss recognition related to traditional life policies and higher annuity benefits due to changes in reserves on fixed indexed annuities associated with minimum death and income benefit guarantees, which were driven by increased sales during the period.
Other operating expenses decreased $4.2 million to $59.8 million for the quarter ended June 30, 2012, compared with $64.0 million for the quarter ended June 30, 2011. The decrease in operating expenses was a result of lower sales incentives and compensation expenses, which were partially offset by higher professional fees.
A net loss from discontinued operations of $5.5 million was recognized for the quarter ended June 30, 2012, primarily due to the commutation of certain contracts.
Three months ended September 30, 2012 compared with three months ended September 30, 2011
The Company recorded a net loss from continuing operations for the three months ended September 30, 2012 of $92.0 million, or $(16.00) per share, compared with net income from continuing operations of $11.6 million, or $1.99 per share for the three months ended September 30, 2011. The decrease in results from continuing operations reflects higher policy benefits and policy acquisition cost amortization, and lower premium revenue and fee income. These declines in results were partially offset by higher realized investment gains.
Premium revenue decreased $17.1 million in the quarter ended September 30, 2012 compared with the quarter ended September 30, 2011 as a result of lower renewal premiums on traditional life lines of business, as well as lower paid up additions on policies within the closed block due to a change in the dividend scale in 2011.
Fees on our life and annuity products decreased $7.7 million in the quarter ended September 30, 2012 compared with the quarter ended September 30, 2011. Lower fees were primarily a result of COI charges which decreased $8.3 million related to declining universal life insurance in force.
Net realized investment gains of $27.5 million were recognized for the three months ended September 30, 2012 compared to net realized investment losses of $10.1 million for the three months ended September 30, 2011. Net realized gains on sales of long-term debt securities accounted for $22.6 million of the total realized gains as interest rates reached historically low levels during the quarter. In addition, net realized gains of $10.7 million were related to sales of preferred and common equity investments. Offsetting these gains were impairment losses of $7.4 million on long-term debt securities and $7.1 million in losses on derivative assets and embedded derivative liabilities. The derivative losses were due to a loss of $6.2 million on derivative contracts associated with variable annuity and fixed indexed annuity guarantees and losses of $7.9 million related to the surplus hedge which utilizes futures and options to hedge against declines in equity markets and the resulting statutory capital and surplus impact. Partially offsetting these losses were gains of $7.1 million on embedded derivative liabilities associated with variable and fixed indexed annuity guarantees and a gain of $3.4 million associated with the nonperformance risk factor.
Policy benefits increased $59.4 million for the three months ended September 30, 2012 compared to the three months ended September 30, 2011. The increase in policy benefit expense was driven by adverse mortality and significant claim expenses, primarily related to universal life. Fluctuations in mortality are inherent in our lines of business. Annuity benefits increased due to changes in reserves on fixed indexed annuities associated with minimum death and income benefit guarantees, which were driven by increased sales during the period. In addition, our annual comprehensive review of actuarial assumptions in the third quarter of 2012 increased benefits $36.3 million as a result of unlocking adjustments. These increases in expenses were partially offset by lower policy benefits within the closed block.
Policyholder dividends increased $27.5 million for the three months ended September 30, 2012 compared to the three months ended September 30, 2011 due to lower policy benefits from favorable mortality within the closed block and from the portion of the net investment gains attributable to the closed block.
The Company recorded income tax benefit of $4.9 million to continuing operations for the quarter ended September 30, 2012 compared with $6.8 million as of September 30, 2011. The decrease was driven by a $10.8 million benefit that results from the application of ASC 740 intraperiod allocation rules. These rules allow for the benefitting of current year losses in continuing operations when an increase to the valuation allowance is avoided due to the existence of current year income elsewhere reported in the financial statements (e.g., discontinued operations, other comprehensive income). This benefit was offset by an additional $5.9 million of current tax accrued.
Policyholder dividends increased $12.3 million for the three months ended December 31, 2012 primarily due to favorable mortality experience within the closed block compared to the three months ended December 31, 2011 which experienced negative mortality.
The Company recorded income tax benefit of $2.7 million to continuing operations for the quarter ended December 31, 2012 compared with income tax expense of $2.8 million as of December 31, 2011. The decrease was driven by a $5.1 million expense recorded due to the exception to the intraperiod allocation rules in accordance with ASC 740-20, Accounting for Income Taxes - Intraperiod Tax Allocation, offset by a decrease of $7.8 million of current tax accrued.
For the years 2012, 2011 and 2010, inflation did not have a material effect on our consolidated results of operations.
Operational risk is the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. As reported in “Item 9A: Controls and Procedures” of this Annual Report on Form 10-K, the Company has concluded that there are material weaknesses in its internal control over financial reporting, which have materially adversely affected its ability to timely and accurately report its results of operations and financial condition, and that its disclosure controls and procedures are ineffective as of December 31, 2012. These material weaknesses have not been fully remediated as of the filing date of this report and the Company cannot assure that other material weaknesses will not be identified in the future. It is necessary for the Company to maintain effective internal control over financial reporting to prevent fraud and errors, and to maintain effective disclosure controls and procedures so that it can provide timely and reliable financial and other information. If the Company fails to maintain an effective system of internal controls, the accuracy and timing of its financial reporting may be adversely affected. Further, the absence of timely and reliable financial and other information about the Company’s business operations may inhibit the Company’s ability to identify operational risk. A failure to correct material weaknesses in our internal controls could result in further restatements of financial statements and correction of other information filed with the SEC. See “Item 1A: Risk Factors” in Part I of this Annual Report on Form 10-K for a description of these and other risks that may impact the Company’s operations. Also see “Item 9A: Controls and Procedures” in Part II of this Annual Report on Form 10-K for more information regarding these weaknesses, an evaluation of the effectiveness of the Company’s disclosure controls and procedures, and the Company’s remediation plans.
We measure, manage and monitor market risk associated with our insurance and annuity business as part of our ongoing commitment to fund insurance liabilities. We have developed an integrated process for managing the interaction between product features and market risk. This process involves our Corporate Finance, Corporate Portfolio Management and Life and Annuity Product Development departments. These areas coordinate with each other and report results and make recommendations to our Asset-Liability Management Committee (“ALCO”) chaired by the Chief Financial Officer.
Interest rate risk is the risk that we will incur economic losses due to adverse changes in interest rates. Our exposure to interest rate changes results primarily from our interest-sensitive insurance liabilities and from our significant holdings of fixed rate investments. Our insurance liabilities largely comprise dividend-paying individual whole life and universal life policies and annuity contracts. Our fixed maturity investments include U.S. and foreign government bonds, securities issued by government agencies, corporate bonds, asset-backed securities and mortgage-backed securities, most of which are exposed to changes in medium-term and long-term U.S. Treasury rates.
To calculate duration for liabilities, we project liability cash flows under a number of stochastically generated interest rate scenarios and discount them to a net present value using a risk-free market rate increased for our own credit risk. For interest-sensitive liabilities the projected cash flows reflect the impact of the specific scenarios on policyholder behavior as well as the effect of minimum guarantees. Duration is calculated by revaluing these cash flows at an alternative level of interest rates and by determining the percentage change in fair value from the base case.
Equity futures fair value includes margin account cash balance of $15.9 million.
We manage credit risk through the fundamental analysis of the underlying obligors, issuers and transaction structures. Through internal staff and an outsource relationship, we employ experienced credit analysts who review obligors’ management, competitive position, cash flow, coverage ratios, liquidity and other key financial and non-financial information. These analysts recommend the investments needed to fund our liabilities while adhering to diversification and credit rating guidelines. In addition, when investing in private debt securities, we rely upon broad access to management information, negotiated protective covenants, call protection features and collateral protection. We review our debt security portfolio regularly to monitor the performance of obligors and assess the stability of their current credit ratings.
Certain variable annuity products sold by our Life Companies contain GMDBs. The GMDB feature provides annuity contract owners with a guarantee that the benefit received at death will be no less than a prescribed amount. This minimum amount is based on the net deposits paid into the contract, the net deposits accumulated at a specified rate, the highest historical account value on a contract anniversary or, if a contract has more than one of these features, the greatest of these values. To the extent that the GMDB is higher than the current account value at the time of death, the Company incurs a cost. This typically results in an increase in annuity policy benefits in periods of declining financial markets and in periods of stable financial markets following a decline. As of December 31, 2012 and 2011, the difference between the GMDB and the current account value (NAR) for all existing contracts was $39.5 million and $130.8 million, respectively. This was our exposure to loss had all contract owners died on either December 31, 2012 or 2011. See Note 12 to our consolidated financial statements under “Item 8: Financial Statements and Supplementary Data” in this Annual Report on Form 10-K for more information.
Certain variable annuity products sold by our Life Companies contain guaranteed minimum living benefits. These include guaranteed minimum accumulation, withdrawal, income and payout annuity floor benefits. The GMAB guarantees a return of deposit to a policyholder after 10 years regardless of market performance. The GMWB guarantees that a policyholder can withdraw a certain percentage for life regardless of market performance. The GMIB guarantees that a policyholder can convert his or her account value into a guaranteed payout annuity at a guaranteed minimum interest rate and a guaranteed mortality basis, while also assuming a certain level of growth in the initial deposit. We also offer a combination rider that offers both GMAB and GMDB benefits. We have established a hedging program for managing the risk associated with our guaranteed minimum accumulation and withdrawal benefit features. We continue to analyze and refine our strategies for managing risk exposures associated with all our separate account guarantees. The liabilities related to these benefits totaled $51.2 million and $66.4 million at December 31, 2012 and 2011, respectively.
See Note 7 to our consolidated financial statements under “Item 8: Financial Statements and Supplementary Data” in this Annual Report on Form 10-K for more information regarding deferred policy acquisition costs.
We sponsor defined benefit pension plans for our employees. For U.S. GAAP accounting purposes, we assumed an 8.0% long-term rate of return on plan assets in the most recent valuations, performed as of December 31, 2012. To the extent there are deviations in actual returns, there will be changes in our projected expense and funding requirements. As of December 31, 2012, the projected benefit obligation for our funded and unfunded defined benefit plans was in excess of plan assets by $219.0 million and $150.9 million, respectively. We made contributions totaling $18.2 million and $17.4 million to the pension plans during 2012 and 2011, respectively. Over the next 12 months, we expect to make contributions of approximately $11.4 million.
Our debt securities portfolio consists primarily of investment grade publicly traded and privately placed corporate bonds, residential mortgage-backed securities (“RMBS”), commercial mortgage-backed securities (“CMBS”) and other asset-backed securities. As of December 31, 2012, our debt securities, with a fair value of $12,656.0 million, represented 79.2% of total investments.
We manage credit risk through industry and issuer diversification. Maximum exposure to an issuer is defined by quality ratings, with higher quality issuers having larger exposure limits. Our investment approach emphasizes a high level of industry diversification. The top five industry holdings as of December 31, 2012 in our debt securities portfolio were banking (6.7%), electrical utilities (5.6%), oil (4.1%), insurance (3.8%) and diversified financial services (3.5%).
Most of our RMBS portfolio is highly rated. At December 31, 2012, 94.3% of the total residential portfolio was rated investment grade. We hold $321.3 million of RMBS investments backed by prime rated mortgages, $268.6 million backed by Alt-A mortgages and $136.3 million backed by sub-prime mortgages, which combined amount to 4.5% of our total investments. The majority of our prime, Alt-A and sub-prime exposure is investment grade, with 59.7% being rated NAIC-1 and 26.1% rated NAIC-2. We have employed a disciplined approach in the analysis and monitoring of our mortgage-backed securities. Our approach involves a monthly review of each security. Underlying mortgage data is obtained from the security’s trustee and analyzed for performance trends. A security-specific stress analysis is performed using the most recent trustee information. This analysis forms the basis for our determination of whether the security will pay in accordance with the contractual cash flows. RMBS impairments during the year ended December 31, 2012 totaled $10.3 million. These impairments consist of $1.9 million from prime, $6.0 million from Alt-A and $2.4 million from sub-prime.
Percentages based on Market Value. CMBS holdings in this exhibit include $10.6 million classified as fair value investments on the consolidated balance sheets. For these fair value investments, there is no impact to OCI as carrying value is equal to market value.
Includes the change in fair value of embedded derivatives associated with variable annuity GMWB, GMAB and COMBO riders. See Note 12 to our consolidated financial statements under “Item 8: Financial Statements and Supplementary Data” in this Annual Report on Form 10-K for additional disclosures.
Fixed income OTTIs recorded in 2012 were primarily concentrated in structured securities. These impairments were driven primarily by increased collateral default rates. In our judgment, these credit events and other adverse conditions of the collateral have caused, or will most likely lead to, a deficiency in the contractual cash flows related to the investment. Therefore, based upon these credit events, we have determined that OTTIs exist. Total debt impairments recognized through earnings related to such credit-related circumstances were $22.8 million in 2012, $26.0 million in 2011 and $48.3 million in 2010. There were equity security OTTIs of $5.7 million in 2012, $0.8 in 2011 and $0.2 million in 2010. There were limited partnerships and other investment OTTIs of $0.3 million in 2012, $0.0 in 2011 and $0.1 million in 2010.
For debt securities outside of the closed block with gross unrealized losses, 36.3% of the unrealized losses after offsets pertain to investment grade securities and 63.7% of the unrealized losses after offsets pertain to below-investment-grade securities at December 31, 2012.
Cash used for operating activities increased by $83.0 million during the year ended December 31, 2012 compared to the year ended December 31, 2011. This was driven by unfavorable mortality in the third and fourth quarters of 2012 on our universal life block of business and lower renewal premiums on our legacy blocks of business due to a declining in force population. Partially offsetting these items was reduced commissions paid related to lower sales of our fixed indexed annuity product and reduced base compensation cost due to the sale of Goodwin during the third quarter of 2011. Further, cash paid for income taxes increased $12.2 million as a result of recent continued taxable income from our insurance entities and the exhaustion of net operating losses that had been utilized in previous years.
Cash flows used for investing activities decreased $363.0 million during the year ended December 31, 2012 compared to the year ended December 31, 2011 as a result of a greater increase in sales and maturities relative to purchases. This is primarily driven by less cash being provided by financing and operating activities, namely due to a reduction in deposits and an increase in withdrawals of fixed index annuities. Purchasing activity was also down due to less cash being generated from our investment portfolio due to a low interest rate environment, while investment sales activity was higher in an effort to produce capital gains to offset previous capital losses.
Cash flows provided by financing activities decreased $277.7 million during the year ended December 31, 2012. This decline was primarily a result of a decrease in policyholder deposits exceeding a decrease in withdrawals and lower sales of fixed indexed annuities when compared to 2011. Further, the Company repurchased $48.3 million par amount of its outstanding 7.15% surplus notes for aggregate consideration of $36.2 million during 2012. See Note 10 to our consolidated financial statements under “Item 8: Financial Statements and Supplementary Data” in this Annual Report on Form 10-K for additional information on financing activities.
Cash used for investing activities decreased $38.9 million during the three months ended March 31, 2012 compared with the three months ended March 31, 2011. The primary driver of this fluctuation was a decrease in purchases of available-for-sale debt securities attributable to the low interest rate environment.
Cash provided by financing activities increased $15.9 million during the three months ended March 31, 2012 compared with the three months ended March 31, 2011. This inflow is attributable to increased policyholder deposits related to improved sales of fixed indexed annuities as compared with the three months ended March 31, 2011.
Six months ended June 30, 2012 compared with six months ended June 30, 2011
Cash used for investing activities decreased $88.4 million during the six months ended June 30, 2012 compared with the six months ended June 30, 2011. The primary driver of this fluctuation was decreased purchases of available-for-sale debt securities resulting from comparable fixed index annuity deposits and less cash being generated from our investment portfolio due to low interest rate environment.
Cash provided by financing activities decreased $41.2 million during the six months ended June 30, 2012 compared with the six months ended June 30, 2011. This decrease is attributable to lower fixed indexed annuity deposits resulting from lower sales of fixed indexed annuities as compared the June 30, 2011.
Nine months ended September 30, 2012 compared with nine months ended September 30, 2011
Cash flows used for investing activities decreased by $283.6 million as a result of decreased cash provided by financing and operating activities resulting from sales maturities of available-for-sale debt exceeding purchases of available for sales debt. The fluctuation in purchasing activity was primarily driven by a reduction in deposits from sales of fixed index annuities as compared to September 30, 2011 while sales increased due to an effort to produce capital gains to offset previous capital losses.
In 2012, 2011 and 2010, the Company did not pay any stockholder dividends.
During 2011, financing cash activities totaling $0.7 million related to the repurchase of senior unsecured bonds were recorded compared to no financing transactions being recorded for the year ended December 31, 2010.
The Company effected a 1-for-20 reverse stock split of its common stock following market close on August 10, 2012. No fractional shares were issuable in connection with the reverse stock split. Instead, shareholders were entitled to receive cash in lieu of fractional shares, based on the closing price of the Company’s common stock on August 10, 2012. As a result of the reverse stock split, an aggregate of $2.9 million was payable to shareholders for such fractional shares. See Note 11 to our consolidated financial statements under “Item 8: Financial Statements and Supplementary Data” in this Annual Report on Form 10-K for additional information on the reverse stock split.
Rating agencies assign Phoenix Life financial strength ratings and assign the holding company debt ratings based in each case on their opinions of the relevant company’s ability to meet its financial obligations. A downgrade or withdrawal of any of our credit ratings could negatively impact our liquidity. For additional information regarding certain risks associated with our credit ratings, please see the risk factors under “Risks Related to the Restatement, Failure to File Timely Periodic Reports with the SEC and our Internal Control Over Financial Reporting.” contained in “Item 1A: Risk Factors” in Part I of this 2012 Form 10-K.
On August 28, 2013, A.M. Best Company, Inc. downgraded our financial strength rating from B+ to B and our senior debt rating from b+ to b. The financial strength rating was removed from under review with negative implications and assigned a stable outlook. The senior debt rating was removed from under review with negative implications and assigned a negative outlook. On April 9, 2013, A.M. Best Company, Inc. maintained under review with negative implications on our financial strength rating of B+ and lowered our senior debt rating from bb- to b+. On December 7, 2012, A.M. Best Company, Inc. placed under review with negative implications our financial strength rating of B+ and our senior debt rating of bb-. On January 13, 2012, A.M. Best Company, Inc. affirmed our financial strength rating of B+ and our senior debt rating of bb-. They changed their outlook on our ratings from stable to positive. On February 8, 2011, A.M. Best Company, Inc. affirmed our financial strength rating of B+ and our senior debt rating of bb-. They changed their outlook on our ratings from negative to stable.
On January 14, 2014, Moody’s Investor Services withdrew all ratings of The Phoenix Companies, Inc. including the Caa1 senior debt rating of Phoenix and the Ba2 financial strength rating of the company's life insurance subsidiaries and the B1 (hyb) debt rating of Phoenix Life's surplus notes. On September 25, 2013, Moody’s Investor Services maintained the review for downgrade for our Ba2 financial strength rating and Caa1 senior debt rating. On June 21, 2013, Moody’s Investor Services maintained the review for downgrade for our Ba2 financial strength rating and Caa1 senior debt rating. On March 20, 2013, Moody’s Investor Services maintained the review for downgrade for our financial strength rating of Ba2 and downgraded our senior debt rating B3 to Caa1. On December 12, 2012, Moody’s Investor Services placed our Ba2 financial strength rating and B3 senior debt rating under review for downgrade. On December 16, 2011, Moody’s Investor Services affirmed our financial strength rating of Ba2 and our senior debt rating of B3. They changed their outlook on our ratings from stable to positive.
On May 22, 2013, Standard & Poor’s affirmed our financial strength rating of BB- and senior debt rating of B-. All ratings were removed from CreditWatch with Negative Implications and placed on negative outlook. On March 8, 2013, Standard & Poor’s placed our financial strength rating of BB- and our senior debt rating of B- on CreditWatch Negative. On January 16, 2013, Standard & Poor’s affirmed our financial strength rating of BB- and our senior debt rating of B-. They also removed the ratings from CreditWatch Negative and returned the outlook to stable. On December 7, 2012, Standard & Poor’s affirmed our financial strength rating of BB- and our senior debt rating of B- and placed the ratings on CreditWatch Negative. On April 5, 2012, Standard & Poor’s affirmed our financial strength rating of BB- and raised our senior debt rating to B- from CCC+. They maintained their stable outlook on our ratings. On March 24, 2011, Standard & Poor’s affirmed our financial strength rating of BB- and our senior debt rating of CCC+. They changed their outlook on our ratings from negative to stable.
The increase in total investments was the result of purchases of securities associated with positive cash flow generated by our annuity business as sales continue to increase. In addition, the value of available-for-sale debt securities improved as a result of favorable impacts on fixed income securities as treasury rates have declined during 2012.
Dividend obligations increased during the 12 months ended December 31, 2012 primarily resulting from an increase in unrealized gains on the closed block assets related to a decline in interest rates.
During 2012, $48.3 million of surplus notes were repurchased and retired from the open market.
The decrease in total stockholders’ equity was primarily a result of the net loss recognized for the 12 months ended December 31, 2012. The net loss was partially offset by a decrease in accumulated other comprehensive loss related to appreciation of investments.
The increase in total investments was the result of purchases of securities associated with positive cash flow generated by our annuity business as sales continue to increase. In addition, limited partnerships and other investments increased primarily as a result of mezzanine funds.
The decrease in total stockholders’ equity was primarily a result of a decrease in accumulated other comprehensive loss related to appreciation of investments, which were partially offset by the net loss recognized for the quarter.
The increase in total investments was the result of purchases of securities associated with positive cash flow generated by our annuity business as sales continue to increase. In addition, the value of available-for-sale debt securities improved as a result of favorable impacts on fixed income securities as treasury rates have declined during the first half of 2012.
Separate accounts decreased as a result of the transfer of pension assets from a Phoenix separate account to the direct control of the plan’s trustee. Variable annuity surrenders and lower market performance also contributed to the decline.
Policyholder deposit funds increased during the six months ended June 30, 2012 primarily as a result of continued sales growth of fixed indexed annuities.
The decrease in total stockholders’ equity was primarily a result of the net loss recognized for the quarter. The net loss was partially offset by a decrease in accumulated other comprehensive loss related to appreciation of investments.
The increase in accrued investment income was attributable to the higher amount of available for sale debt securities and higher policyholder loan accrued interest.
The increase in receivables was attributable to a higher amount of claims to reinsurers as a result of negative mortality experience in the third quarter of 2012, resulting in higher outstanding reinsurance recoverables.
Deferred policy acquisition costs decreased primarily related to universal life as a result of amortization during the nine months ended September 30, 2012. The deferred policy acquisition cost balance associated with fixed annuities increased related to the deferral of commissions on sales of our fixed indexed annuities, partially offset by amortization of previously deferred expenses. The table below presents deferred policy acquisition cost by product.
Discontinued assets and liabilities declined as a result of the commutation of certain contracts during the second quarter of 2012.
Separate accounts decreased primarily as a result of the transfer of pension assets from a Phoenix separate account to the direct control of the plan’s trustee during the second quarter of 2012.
Dividend obligations increased during the nine months ended September 30, 2012 primarily resulting from an increase in unrealized gains on the closed block assets related to a decline in interest rates in the first nine months of 2012.
The decrease in total stockholders’ equity was primarily a result of the net loss recognized for quarter. The net loss was partially offset by a decrease in accumulated other comprehensive loss related to appreciation of investments.
Annuity funds on deposit increased $412.1 million during the year ended December 31, 2011 compared to an increase of $79.4 million during the year ended December 31, 2010. The higher increase in 2011 was driven by deposits related to the growth in sales of the fixed indexed annuity product partially offset by lower fund performance and larger surrenders related to variable annuity products.
Variable universal life funds on deposit decreased $132.5 million during the year ended December 31, 2011 compared to a decrease of $16.9 million during the year ended December 31, 2010. The larger decline in 2011 was primarily driven by lower market performance partially offset by lower surrenders.
Other purchase liabilities relate to open purchase orders and other contractual obligations. This amount does not include our expected pension contribution of approximately $11.4 million in 2013. See Note 17 to our consolidated financial statements under “Item 8: Financial Statements and Supplementary Data” in this Annual Report on Form 10-K for additional information on pension and other postretirement benefits.
We do not anticipate any increases to unrecognized tax benefits that would have a significant impact on the financial position of the Company. Therefore, no unrecognized tax benefits have been excluded from this table. See Note 15 to our consolidated financial statements under “Item 8: Financial Statements and Supplementary Data” in this Annual Report on Form 10-K for additional information on unrecognized tax benefits.
On January 4, 2010, we signed a definitive agreement to sell PFG and its subsidiaries, including AGL Life Assurance Company, to Tiptree. Because of the divestiture, these operations are reflected as discontinued operations. On June 23, 2010, we completed the divestiture of PFG and closed the transaction.
We have three defined benefit pension plans covering our employees. The employee pension plan provides benefits up to the amount allowed under the Internal Revenue Code. The two supplemental plans provide benefits to certain executives in excess of the primary plan. Retirement benefits under the plans are a function of years of service and compensation. Effective March 31, 2010, all benefit accruals under all of our funded and unfunded defined benefit plans were frozen. This change was announced in 2009 and a curtailment was recognized at that time for the reduction in the expected years of future service.
To meet the above funding objectives, we made contributions to the pension plan totaling $18.2 million and $17.4 million during 2012 and 2011, respectively. Over the next 12 months, we expect to make contributions of approximately $11.4 million from the Company’s operating cash flow. On July 6, 2012, the Surface Transportation Extension Act of 2012, Part II, was enacted into law and is effective immediately. The law includes certain pension funding stabilization provisions, which the Company has taken advantage of in 2012.
The Company also has two supplemental plans that provide benefits to certain executives in excess of the primary plan. These plans are unfunded and represent general obligations of the Company. We fund periodic benefit payments to retirees as they become due under these plans from cash-flow from operations. The projected benefit obligations for the years ended December 31, 2012 and 2011 were $150.9 million and $141.9 million, respectively.
We do not have any off-balance sheet arrangements that are reasonably likely to have a material effect on the financial condition, results of operations, liquidity, or capital resources of the Company. The Company does have unfunded commitments to purchase investments in limited partnerships and private placements and a commitment for infrastructure services which are disclosed in Note 25 to our consolidated financial statements under “Item 8: Financial Statements and Supplementary Data” in this Annual Report on Form 10-K.
Phoenix Life’s statutory basis capital and surplus (including AVR) increased from $845.7 million at December 31, 2011 to $922.5 million at December 31, 2012. The principal factors resulting in this increase were net income of $208.7 million offset by dividends paid to PNX of $71.8 million and the $48.3 million surplus note redemption.
Authorized Control Level - results when Total Adjusted Capital falls below 50% of Company Action Level RBC as defined by the NAIC where in addition to the above, the insurance regulators are permitted but not required to place the Company under regulatory control; and