Changes in laws and regulations, particularly those affecting our operations or our products;
The political, monetary, economic and operational impacts of the Brexit referendum held on June 23, 2016 in which the U.K. electorate voted to withdraw from the E.U.
the net earnings from investments of fixed rate life insurance and annuity contract owner deposits less interest credited to contract owners, commonly known as interest spread.
The investment performances of the underlying U.S. equity-based mutual funds supporting the Company’s variable products do not replicate the returns of any specific U.S. equity market index. However, investment performance will generally increase or decrease with corresponding increases or decreases in the overall U.S. equity market. There are several standard indices published on a daily basis that measure performance of selected components of the U.S. equity market. Examples include the Dow Jones Industrial Average (“Dow”), the NASDAQ Composite Index (“NASDAQ”) and the Standard & Poor’s 500 Composite Stock Price Index (“S&P”). The Dow, NASDAQ and S&P ended 2016 with increases of 13%, 9% and 10%, from 2015, respectively. The Dow, NASDAQ and S&P ended 2015 with increases (decreases) of (2%), 6% and (1%), from 2014, respectively.
(b) Represents the increase (decrease) between current year and prior year (in basis points).
See Item 1 Business, for further management discussion of the Company’s business operations.
The Company’s portfolio of private placement securities is valued using a matrix pricing methodology. The pricing methodology is implemented in a third party service and indicates current spreads for securities based on weighted average life, credit rating and industry sector. On a monthly basis, the Company reviews the matrix to ensure the spreads are reasonable by comparing them to observed spreads for similar securities traded in the market. In order to account for the illiquid nature of these securities, illiquidity premiums are included in the valuation and are determined based upon the pricing of recent transactions in the private placement market as well as comparing the value of the privately offered security to a similar public security. The impact of the illiquidity premium to the overall valuation is less than 2% of the fair value. The Company’s portfolio consists primarily of publicly traded securities with only a minor portion comprised of private placement securities. At December 31, 2016 and 2015, approximately $107.0 million (or 7.0%) and $110.9 million (or 7.0%), respectively, of fixed maturity and equity securities portfolio consisted of private placement securities.
For equity securities, once management determines that a decline in the value of an AFS security is other-than-temporary, the cost basis of the equity security is reduced to its fair value, with a corresponding charge to earnings.
Objective evidence of impairment of an investment in an equity instrument classified as AFS includes information about significant changes with an adverse effect that have taken place in the technological, market, economic or legal environment in which the issuer operates, that indicates that the cost of the investment in the equity instrument may not be recovered. As part of an ongoing process, the equity analysts actively monitor earnings releases, company fundamentals, new developments and industry trends for any signs of possible impairment. If an AFS equity security is impaired based upon the Company’s qualitative or quantitative impairment criteria, any further declines in the fair value at subsequent reporting dates are recognized as impairments. Therefore, at each reporting period, for an equity security that is determined to be impaired based upon the Company’s impairment criteria, an impairment is recognized for the difference between the fair value and the original cost basis, less any previously recognized impairments.
For fixed maturity AFS securities, an OTTI must be recognized in earnings when an entity either a) has the intent to sell the debt security, or b) is more likely than not to be required to sell the debt security before its anticipated recovery. If the Company meets either of these criteria, the OTTI is recognized in earnings in an amount equal to the entire difference between the security’s amortized cost basis and its fair value at the balance sheet date. For fixed maturity AFS securities in unrealized loss positions that do not meet these criteria, the Company must analyze its ability to recover the amortized cost by comparing the net present value of projected future cash flows with the amortized cost of the security. The net present value is calculated by discounting the Company’s best estimate of projected future cash flows. If the net present value is less than the amortized cost of the investment, an OTTI is recorded.
For the year ended December 31, 2016, the Company recorded an OTTI in income of $5.2 million, excluding VOBA. For the years ended December 31, 2015 and 2014, the Company recorded an OTTI in income of $1.9 million and $0.1 million, respectively, excluding VOBA.
See Notes to Financial Statements, Note 3 Investments, for further discussion.
The Company uses several types of derivatives to manage the capital market risk associated with the GMWB. Derivatives are primarily used by the Company to manage risk associated with interest rate or equity market risk or volatility. Freestanding derivatives are carried on the Balance Sheets at fair value. If a derivative is not designated as an accounting hedge or its use in managing risk does not qualify for hedge accounting, changes in the fair value of the derivatives are reported in net derivative gains (losses) in the Statements of Income (Loss).
The Company uses variance swaps to hedge equity risk. The Company also enters into total return swaps that are based on the S&P. The Company recognizes gains (losses) from the change in fair value of the variance swaps and total return swaps in net derivative gains (losses) in the Statements of Income (Loss).
The Company also writes credit default swaps enabling the Company to change the risk profile of the assets in the portfolio by enhancing the overall yield. As a writer of credit default swaps, the Company actively monitors the underlying asset, being careful to note any events (default or similar credit event) that would require the Company to perform on the credit default swap. If such events would take place, the Company has recourse provisions from the proceeds of the bankruptcy settlement of the underlying entity or by the sale of the underlying bond. In the event the representative issuer defaults on its debt obligation referenced in the contract, a payment equal to the notional amount of the contract will be made by the Company and recognized in net derivative gains (losses) in the Statement of Income.
The Company also utilizes put and call options which serve to hedge the risk of equity market declines. The Company recognizes gains (losses) from the change in fair value of the options in net derivative gains (losses) in the Statements of Income (Loss).
assumptions utilized in measuring insurance liabilities and expected gross profits used in amortizing VOBA. The assumptions include, but are not necessarily limited to, inputs such as mortality, policyholder behavior and expected future rates of returns on investments. As part of this review, the Company considers emerging experience, future expectations and other data, including any observable market data. These assumptions are updated and implemented in the third quarter of each year, unless a material change in experience, indicative of a long term trend, is observed during an interim period. For VOBA, the impact of revisions and assumptions to estimates on cumulative amortization is recorded as a charge or credit to current operations, commonly referred to as “unlocking.”
The long-term growth rate assumption for the amortization of VOBA was 8% at December 31, 2016 and 2015. At December 31, 2016 and 2015, the Company’s VOBA asset was $222.3 million and $259.5 million, respectively. For the years ended December 31, 2016, 2015, and 2014, the favorable (unfavorable) impact to pre-tax net income related to VOBA unlocking was ($12.9) million, $0.1 million, and $6.6 million, respectively. There was a $0.5 million VOBA impairment in 2016. There were no impairment charges in 2015 and 2014.
See Notes to Financial Statements, Note 4 VOBA and DAC, for further discussion.
The Company’s liability for future policy benefits consists of liabilities for immediate annuities and liabilities for certain guaranteed benefits contained in the variable insurance products the Company manufactures. Liabilities for immediate annuities are equal to the present value of estimated future payments to or on behalf of policyholders, where the timing and amount of payment generally depends on policyholder mortality. Interest rates used in establishing such liabilities were in the range of 0.01% to 8.8% during 2016 and 2015. See Notes to Financial Statements, Note 5 Variable Contracts Containing Guaranteed Benefits, for further discussion.
The Company uses the asset and liability method in providing income taxes on all transactions that have been recognized in the financial statements. The asset and liability method requires that deferred taxes be adjusted to reflect the tax rates at which future taxable amounts will be settled or realized. The Company provides for income taxes based on amounts that it believes it will ultimately owe. Inherent in the provision for income taxes are estimates regarding the realization of certain tax deductions and credits.
Specific estimates include the realization of dividend-received deductions (“DRD”) and foreign tax credits (“FTC”). A portion of the Company’s investment income related to Separate Accounts business qualifies for the DRD and FTC. Information necessary to calculate these tax adjustments is typically not available until the following year. However, within the current year’s provision, management makes estimates regarding the future tax deductibility of these items. These estimates are primarily based on recent historic experience. See Notes to Financial Statements, Note 6 Income Taxes, for further discussion.
The valuation allowance for deferred tax assets at December 31, 2016 and December 31, 2015 was $154.4 million and $130.9 million, respectively (this included losses that are anticipated to be used in the consolidated group to reflect the income statement impact of the losses that would not be used if filing separately). The valuation allowance is related to the loss carry forwards, tax credits, and other deferred tax assets that, in the current judgment of management, are not more likely than not to be realized. In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that all or some of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets depends on future generation of future taxable income during the periods in which those temporary differences are deductible. Management considers the scheduled reversal of deferred tax liabilities, projected taxable income, and tax-planning strategies in making the assessment. The amount of deferred tax asset considered realizable, however, could be increased in the near term if estimates of future taxable income during the carry forward period are increased.
At December 31, 2016, the Company’s total assets were $8.7 billion or $0.5 billion less than the $9.2 billion in assets at December 31, 2015. Assets excluding Separate Accounts assets decreased $215.0 million to $3.0 billion during 2016. The change in total assets was due to a decline in Separate Accounts assets and general fund investments assets supporting policyholder liabilities and reserves as business continues to run-off.
Deposits are currently limited to additions to existing policies, which will result in fluctuations period over period.
The Company’s liability for policyholder account balances represents the contract value that has accrued to the benefit of policyholders as of the Balance Sheet date. The liability is generally equal to the accumulated account deposits plus interest credited less policyholders’ withdrawals and other charges assessed against the account balance. Policyholder account balances decreased from 2015 to 2016 by $58.2 million due to an increase in death benefits, withdrawals and surrenders, offset by interest credited to policyholders.
Future policy benefits includes reserves established to cover insurance risk associated with the Company’s benefit guarantee provisions for GMDB and GMIB products and liabilities related to the Company’s GMWB and SALB contract provisions recorded at fair value.
The amortized cost/cost, gross unrealized gains and losses/OTTI, estimated fair value and percentage of estimated fair value of investments in fixed maturity and equity AFS securities at December 31, 2016 and 2015 were:
Only two issuers represent more than 5% of the total unrealized loss position. Of the two, one is a High Yield Corp Non-Convertible holding with $0.6 million of unrealized loss and the other is an Investment Grade MBS (PT) holding with $0.6 million of unrealized loss.
The Company’s $0.5 million of gross unrealized losses within the financial services sector relates to securities with a fair value of $15.6 million. $0.1 million of this relates specifically to one high yield issuer.
The Company’s $2.7 million of gross unrealized losses within the industrial sector relates to securities with a fair value of $64.4 million. The industrial sector is further subdivided into various sub-sectors with a majority of its gross unrealized loss made up of issuers within the energy and consumer non-cyclical sub-sectors. Issuers within the energy sub-sector had total unrealized losses of $1.0 million, which relates to lower natural gas and oil prices. Issuers within the consumer non-cyclical sub-sector had total unrealized losses of $0.8 million, with the majority of the impact relating to issuers within the pharmaceutical industry, as there are elevated concerns regarding potential pricing reform.
Details underlying securities in a continuous gross unrealized loss and OTTI position for below investment grade AFS securities were as follows:
In 2016, the Company entered into dollar roll repurchase agreement transactions in order to earn a qualified yield while maintaining a strong liquidity position. Dollar roll balances increased through September 30, 2016 as excess cash was available within the Company, while waiting for improved investment yields on longer term instruments. In the final quarter of 2016, the dollar roll balance decreased to $46.6 at December 31, 2016, as the significant rise in rates and higher equity markets led to derivative outflows.
The NAIC utilizes the RBC adequacy monitoring system. The RBC calculates the amount of adjusted capital that a life insurance company should have based upon that company’s risk profile. At December 31, 2016 and 2015, based on the RBC formula, the Company’s total adjusted capital levels were well in excess of the minimum amount of capital required to avoid regulatory action.
The financial strength rating scales of S&P Global Rating Services (“S&P”), A.M. Best Company (“A.M. Best”), and Fitch Ratings (“Fitch”) are characterized as follows:
On April 15, 2016, A.M. Best affirmed the Company’s rating at A+, and maintained the stable outlook. On August 23, 2016, Fitch downgraded the Company’s rating from AA- to A+, and changed the outlook from negative to stable. On February 10, 2017, S&P affirmed the Company’s rating at AA-, and changed the outlook from stable to negative.
The following table summarizes the Company’s ratings at March 30, 2017.
(a) The policyholder liabilities include benefit and claim liabilities of which a significant portion represents policies and contracts that do not have a stated contractual maturity. The projected cash benefit payments in the table above are based on management’s best estimates of the expected gross benefits and expenses, partially offset by the expected gross premiums, fees and charges relating to the existing business in force. Estimated cash benefit payments are based on mortality and lapse assumptions comparable with the Company’s historical experience, modified for recently observed trends. Actual payment obligations may differ if experience varies from these assumptions. The cash benefit payments are presented on an undiscounted basis and are before a deduction of taxes and before reinsurance. The liability amounts in the Company’s financial statements reflect the discounting for interest as well as adjustments for the timing of other factors as described above. As a result, the sum of the cash benefit payments shown for all years in the table above exceeds the corresponding policyholder liability amounts.
The Company has utilized public information to estimate the future assessments it will incur as a result of insolvencies of life insurance companies that are members of a life insurance guaranty association in which the Company is also a member. When a member becomes insolvent, the guaranty association assesses the remaining members of the association an amount sufficient to
For the years ended December 31, 2016 and 2015, the Company recorded net income (loss) of (20.5) million and $13.7 million, respectively. The decrease in net earnings during 2016 as compared to 2015 was driven by lower policy charge revenue and higher derivative losses offset by lower policy benefits expense.
Net derivative losses increased $52.7 million from $37.5 million in 2015 driven by the impact of improving equity market performance on short positions in equity-linked total return swaps and futures. The following table provides the changes in net derivative gains (losses) by type:
(b) Long positions on bond futures contracts produced realized losses of $1.4 million for the year as a result of the upward shift of the rate curve, which subsequently decreased the value of the underlying bonds.
(g) The Company saw unrealized gains of $2.7 million on credit default swaps as corporate and sovereign spreads tightened during the year.
Amortization of VOBA increased $10.1 million from $22.4 million at December 31, 2015 to $32.5 million at December 31, 2016. The increase was primarily driven by the unfavorable impact from unlocking adjustments of $12.9 million arising from the annual review and update of valuation model assumptions, offset by a decrease in amortization of $2.9 million, related to the decline in gross profits during 2016. See Notes to Financial Statements, Note 4 VOBA and DAC, for further discussion.
Amortization and (accretion) of DAC was $3.8 million and ($6.1) million for the years ended December 31, 2015 and 2014, respectively, which included favorable (unfavorable) unlocking of ($1.5) million and $2.4 million, respectively. The decrease in DAC in 2015 was primarily driven by amortization from positive gross profits. The increase in DAC in 2014 was driven by negative gross profits from the increase in fair value reserves.
The Company is not dependent upon any single customer, and no single customer accounted for more than 10% of its revenues during 2016, 2015 and 2014.