Management’s discussion and analysis reviews our financial condition at December 31, 2013 and 2012; our results of operations for the years 2013, 2012 and 2011; and, where appropriate, factors that may affect our future financial performance. This discussion should be read in conjunction with our financial statements in this Form 10-K.
Saybrus Partners, Inc. (“Saybrus”), an affiliate, provides dedicated life insurance and other consulting services to financial advisors in partner companies, as well as support for sales of Phoenix’s product line through independent distribution organizations.
Net realized investment gains (losses). Net realized investment gains, excluding OTTI, of $5.4 million were recognized for the twelve months ended December 31, 2013 compared to net realized investment losses, excluding OTTI, of $19.5 million for the twelve months ended December 31, 2012. The change in the net realized investment gains is primarily attributable to a decrease in realized losses on derivatives that are used to hedge the risks associated with variable annuity guarantees and the fixed indexed annuity liabilities. For the twelve months ended December 31, 2013 there were losses on derivative investments of $23.1 million, while there were losses of $49.0 million for the twelve months ended December 31, 2012. The continued improvement in the equity markets results in losses on the derivatives that are used to hedge the risk associated with the variable annuity guarantees, that are offset by gains on the derivatives that are used to hedge the risks associated with the fixed indexed annuities. The fixed indexed annuity hedging gains were more significant in 2013 due to more significant increases in the equity market in 2013 than in 2012, as well as additional derivatives purchased due to continued sales of fixed indexed annuities.
For a discussion of accounting standards and changes in accounting, see Note 2 to our financial statements under “Item 8: Financial Statements and Supplementary Data” in this Form 10-K.
We amortize deferred policy acquisition costs (“DAC”) based on the related policy’s classification. For universal life, variable universal life and deferred annuities, deferred policy acquisition costs are amortized in proportion to estimated gross profits (“EGPs”) discussed more fully below. EGPs are also used to amortize other assets and liabilities in the Company’s 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. EGPs are based on historical and anticipated future experience which is updated periodically.
Mortality assumptions are based on Company experience over a rolling five-year period plus supplemental data from industry sources and trends. A mortality improvement assumption is also incorporated into the overall mortality table. These assumptions can vary by issue age, gender, underwriting class and policy duration.
Future premiums and related fees are projected based on contractual terms, product illustrations at the time of sale and expected policy lapses without value. Assumptions are updated based on recently observed experience and include anticipated changes in behavior based on changes in policy charges if the Company has a high degree of confidence that such changes will be implemented (e.g., change in COI charges).
Annually, we complete a comprehensive assumption review where management makes a determination of best estimate assumptions based on a comprehensive review of recent experience and industry trends. Assumption changes resulting from this review may change our estimates of EGPs in the DAC, SIA, and URR models, as well as projections within the death benefit and other insurance benefit reserving models, the profits followed by losses reserve models, and cost of reinsurance models. Throughout the year, we may also update the assumptions and adjust these balances if emerging data indicates a change is warranted. All assumption changes, whether resulting from the annual comprehensive review or from other periodic assessments, are considered an unlock in the period of revision and adjust the DAC, SIA, URR, death and other insurance benefit reserves, profits followed by losses reserve, and cost of reinsurance balances in the balance sheets with an offsetting benefit or charge to income to reflect such changes in the period of the revision. An unlock that results in an after-tax benefit generally occurs as a result of actual experience or future expectations of product profitability being more favorable than previous estimates. An unlock that results in an after-tax charge generally occurs as a result of actual experience or future expectations of product profitability being less favorable than previous estimates.
We make guarantees on certain variable annuity contracts, including GMAB, GMWB and COMBO as well as provide credits based on the performance of certain indices (“index credits”) on our fixed indexed annuity contracts that meet the definition of an embedded derivative. The GMAB, GMWB and COMBO embedded derivative liabilities associated with our variable annuity contracts are accounted for at fair value, using a risk neutral stochastic valuation methodology with changes in fair value recorded in realized investment gains. The inputs to our fair value methodology include estimates derived from the asset derivatives market, including the equity volatility and the swap curve. Several additional inputs are not obtained from independent sources, but instead reflect our internally developed assumptions related to mortality rates, lapse rates and policyholder behavior. The fair value of the embedded derivative liabilities associated with the index credits on our fixed indexed annuity contracts is calculated using the budget method with changes in fair value recorded in realized investment gains. The initial value under the budget method is established based on the fair value of the options used to hedge the liabilities. The value of the index credits in future years is estimated to be the budgeted amount. The budget amount is based on the impact of projected interest rates on the discounted liabilities. Several additional inputs reflect our internally developed assumptions related to lapse rates and policyholder behavior. As there are significant unobservable inputs included in our fair value methodology for these embedded derivative liabilities, we consider the above-described methodology as a whole to be Level 3 within the fair value hierarchy.
Short-term investments are valued at amortized cost, which approximates fair value.
the reasons for the decline in value (credit event, interest related or market fluctuations);
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 debt securities for impairments includes an analysis of the total gross unrealized losses by severity and/or age of the gross unrealized loss, as summarized in the, “Duration of Gross Unrealized Losses on Securities” section. An extended and severe unrealized loss position on a debt 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 an extended decline in market value and the likelihood such market value decline will recover.
See Note 6 to our financial statements under “Item 8: Financial Statements and Supplementary Data” and the “Debt Securities” and “Enterprise Risk Management” sections of “Item 7: Management’s Discussion and Analysis of Financial Condition and Results of Operations” in this Form 10-K for more information.
As of December 31, 2013, we concluded that our estimates of future taxable income, certain tax planning strategies and other sources of income did not constitute sufficient positive evidence to assert that it is more likely than not that certain deferred tax assets would be realizable. Accordingly, a valuation allowance of $74.2 million has been recorded on net deferred tax assets of $102.2 million. The valuation allowance recorded constitutes a full valuation allowance on the net deferred tax assets that require future taxable income in order to be realized. The remaining deferred tax asset of $28.0 million attributable to available-for-sale debt securities with gross unrealized losses do not require a valuation allowance due to our ability and intent to hold these securities until recovery of fair or principal value through sale or contractual maturity, thereby avoiding the realization of taxable losses. This conclusion is consistent with prior periods. The impact of the valuation allowance on the allocation of tax to the components of the financial statements included a decrease of $31.7 million in net loss and an increase of $0.5 million in OCI-related deferred tax balances.
See Note 10 to our financial statements under “Item 8: Financial Statements and Supplementary Data” in this Form 10-K for more information related to income taxes.
See Note 9 to our financial statements under “Item 8: Financial Statements and Supplementary Data” in this Form 10-K for more information on fair value instruments.
The table below shows the interest rate sensitivity of our derivatives measured in terms of fair value, excluding derivative liabilities embedded in products. These exposures will change as our insurance liabilities are created and discharged and as a result of portfolio and risk management activities.
Equity risk is the risk that we will incur economic losses due to adverse changes in equity prices. At December 31, 2013, we held certain financial instruments that are sensitive to equity market movements, primarily related to our holdings of common stock and mutual funds, private equity partnership interests and other equities, as well as fair value equity instruments, equity options and other investments. We manage equity price risk through industry and issuer diversification and asset allocation techniques.
See Note 9 to our financial statements under “Item 8: Financial Statements and Supplementary Data” in this Form 10-K for additional information regarding the estimated fair value of investments.
Our available-for-sale 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, 2013, our available-for-sale debt securities, with a fair value of $3,426.3 million, represented 88.5% 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, 2013 in our available-for-sale debt and short-term investment portfolio were banking (6.5%), electrical utilities (5.8%), diversified financial services (5.1%), oil (4.1%), and real estate investment trusts (3.2%).
Most of our RMBS portfolio is highly rated. At December 31, 2013, 97.9% of the total residential portfolio was rated investment grade. We hold $58.2 million of RMBS investments backed by prime rated mortgages, $73.9 million backed by Alt-A mortgages and $45.8 million backed by sub-prime mortgages, which combined amount to 4.3% of our total investments. The majority of our prime, Alt-A, and sub-prime exposure is investment grade, with 94% being rated NAIC-1 and another 4% 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, 2013 totaled $1.5 million. These impairments consist of $0.1 million from prime, $1.0 million from Alt-A and $0.4 million from sub-prime.
Individual categories may not agree with the Debt Securities by Type table on previous page due to nature of underlying collateral. In addition, RMBS holdings in this exhibit include $19.0 million classified as fair value investments on the balance sheets. For these fair value investments, there is no impact to OCI as carrying value is equal to market value.
OTTIs recorded on available-for-sale debt securities in 2013 were primarily concentrated in structured securities. These impairments were driven primarily by increased collateral default rates. In our judgment, these credit events or 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 were $2.0 million in 2013, $2.8 million in 2012 and $2.8 million in 2011. There were equity security OTTIs of $0 in 2013, $0 in 2012 and $0.4 million in 2011. There were no limited partnerships and other investment OTTIs in 2013, 2012 and 2011.
Our liquidity requirements principally relate to the liabilities associated with various life insurance and annuity products and operating expenses. Liabilities arising from life insurance and annuity products include the payment of benefits, as well as cash payments in connection with policy surrenders, withdrawals, and loans.
Historically, we have used cash flow from operations, investing activities and capital contributions from our shareholder to fund liquidity requirements. Our principal cash inflows from life insurance and annuities activities come from premiums, annuity deposits, and charges on insurance policies and annuity contracts. Principal cash inflows from investing activities result from repayments of principal, proceeds from maturities, sales of invested assets, and investment income.
Cash used for operating activities decreased by $34.9 million during the year ended December 31, 2013 compared to the year ended December 31, 2012. This decrease was driven by lower death benefits paid for universal life during 2013 in conjunction with reduced commissions paid related to lower sales of our fixed indexed annuity product. Partially offsetting this increase were increased audit and consulting fees related to the Restatement.
Cash flows used for investing activities decreased $139.9 million during the year ended December 31, 2013 compared to the year ended December 31, 2012 as a result of an decrease in purchases of short term investments. 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, combined with significantly increased holdings of cash and cash equivalents in lieu of reinvestment.
On August 28, 2013, A.M. Best Company, Inc. downgraded our financial strength rating from B+ to B. The rating was also removed from under review with negative implications and assigned a stable outlook. On April 9, 2013, A.M. Best Company, Inc. maintained their under review with negative implications outlook on our financial strength rating of B+. On December 7, 2012, A.M. Best Company, Inc. placed our B+ financial strength rating under review with negative implications. On January 13, 2012, A.M. Best Company, Inc. affirmed our financial strength rating of B+. They changed their outlook from stable to positive. On February 8, 2011, A.M. Best Company, Inc. affirmed our financial strength rating of B+ and changed their outlook from negative to stable.
December 12, 2012, Moody’s Investor Services placed our financial strength rating of Ba2 under review for downgrade. On December 16, 2011, Moody’s Investor Services affirmed our financial strength rating of Ba2 and changed their outlook from stable to positive.
On August 12, 2014, Standard & Poor's lowered its financial strength ratings on Phoenix Life and PHL Variable to B+ from BB- and affirmed its B- long-term counterparty credit rating on The Phoenix Companies, Inc. They removed the ratings from CreditWatch and assigned a negative outlook. They also affirmed The Phoenix Companies, Inc.'s long-term counterparty credit rating. On May 20, 2014, Standard & Poor’s placed our financial strength rating of BB- and senior debt rating of B- on CreditWatch with negative implications. On May 22, 2013, Standard & Poor’s affirmed our financial strength rating of BB-. 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- on CreditWatch Negative. On January 16, 2013, Standard & Poor’s affirmed our financial strength rating of BB-. 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 placed it on CreditWatch Negative. On April 5, 2012, Standard & Poor’s affirmed our financial strength rating of BB- and maintained their stable outlook on our ratings.
The financial strength ratings as of August 21, 2014 were as follows:
The increase in reinsurance recoverables is primarily due to large claims at the end of 2013 that were not yet reimbursed by third-party reinsurers.
The Company issued $30 million of surplus notes on December 30, 2013 which were purchased by PNX. The notes are due on December 30, 2043 and interest is paid annually at a rate of 10.5%.
Future obligations are based on our estimate of future investment earnings, mortality and surrenders. Actual obligations in any single year, or ultimate total obligations, may vary materially from these estimates as actual experience emerges. As described in Note 2 to our financial statements under “Item 8: Financial Statements and Supplementary Data” in this Form 10-K, policy liabilities and accruals are recorded on the balance sheets in amounts adequate to meet the estimated future obligations of the policies in force. The policyholder obligations reflected in the table above exceed the policy liabilities, policyholder deposit fund liabilities and separate account liabilities reported on our December 31, 2013 balance sheets because the above amounts do not reflect future investment earnings and future premiums and deposits on those policies. Separate account obligations will be funded by the cash flows from separate account assets, while the remaining obligations will be funded by cash flows from investment earnings on general account assets and premiums and deposits on contracts in force.
As of December 31, 2013, we did not have any significant off-balance sheet arrangements as defined by Item 303(a)(4)(ii) of SEC Regulation S-K.
See Note 15 to our financial statements under “Item 8: Financial Statements and Supplementary Data” in this Form 10-K for more information.