Management considers certain non-GAAP financial measures to be useful to investors in evaluating our financial performance and condition. These have been reconciled to their most comparable GAAP financial measures. For a definition and further discussion of these non-GAAP measures, see “ - Use of non-GAAP Financial Measures.”
In addition, we have a fifth segment, referred to as the Other segment, which includes our operations that are not directly related to the operating segments. This includes small, non-insurance businesses that are managed outside our divisions; investment income related to unallocated surplus, private equity fund investments and tax credit investments; unallocated corporate expenses; interest expense on debt; and inter-segment elimination entries.
See Note 19 to the accompanying consolidated financial statements for the financial results of our segments.
Net income for 2013 increased to $220.7, from $205.4 in 2012, driven by higher pretax operating income and a favorable effective tax rate due to benefits from our tax credit investments. Significant developments include the following:
Retirement division: Favorable movements in interest rates and expanded bank distribution drove sales of $2.45 billion in 2013, led by strong sales of our FIA product. Earnings contributions from these sales in 2013 were offset
Achieve target loss ratio in our Benefits division, while maintaining our position as a leader in the medical stop-loss market and promoting growth in our group life & DI business;
Maintain stable interest spreads on our deferred and income annuity portfolios;
Increase sales of UL products through BGAs and expand our UL product portfolio, as well as growing sales of our variable COLI product.
We believe we have adequate capital to support strong organic growth through sales of fully-priced products, which remains our top priority for capital deployment. We are pleased with the increases in deferred annuity and individual life sales during the year and believe we are well positioned for a rising interest rate environment.
Refer to Item 1 - "Business - our strategies" for further discussion of these strategies. Our success may be affected by the factors discussed in Item 1A - “Risk Factors” and other factors as discussed herein.
While interest rates remain at historically low levels, we are encouraged by increases in the benchmark 10-year treasury rate seen during the second half of the year. Higher rates contributed to increased sales of our fixed deferred annuities. As interest rates rise over time, we expect to see increased sales.
Low interest rates have driven an increase in prepayments in our investment portfolio and related income that we receive (primarily make-whole payments on bonds). This income provides a boost to current period yields, but generates cash flows that must be reinvested at lower interest rates and may cause drag on yields in future periods.
Fixed maturities include bonds, mortgage-backed securities and redeemable preferred stock. We classify fixed maturities as available-for-sale and carry them at fair value. Net unrealized gains and losses related to these securities are calculated as the difference between the fair value and amortized cost. We report these unrealized gains and losses in AOCI in stockholders’ equity. Realized investment gains and losses are reported in the consolidated statements of income.
We determine the fair value of fixed maturities primarily by obtaining prices from third-party independent pricing services, which as of December 31, 2013 and 2012, priced 96.6% and 96.2%, respectively, of our fixed maturities. The pricing services we use have policies and processes to ensure that they are using objectively verifiable, observable market data, including documentation by major security type on the observable market inputs used to determine the prices. Securities are priced using evaluated pricing models that vary by asset class.
The standard inputs for security evaluations include benchmark yields, reported trades, broker-dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers and other reference data, including market research publications. Because many fixed income securities do not trade on a daily basis, evaluated pricing models apply available information through processes such as benchmark curves, benchmarking of like securities, sector groupings and matrix pricing. In addition, models are used to develop prepayment and interest rate scenarios, which take into account market convention. Our pricing services routinely review the inputs for the securities they cover; however, they do not provide an independent auditor’s report on controls over valuation.
We regularly evaluate our investments classified as available-for-sale for OTTI. The vast majority of these investments are fixed maturities. We record an OTTI on fixed maturities in an unrealized loss position when one of the following occurs:
we intend to sell a security; or it is more likely than not that we will be required to sell a security prior to recovery of its amortized cost basis.
the extent and duration of the decline in fair value below cost or amortized cost;
the financial condition and near-term prospects of the issuer of the security, including any specific events that may affect its operations, earnings potential or compliance with terms and covenants of the security;
our intent to sell or whether it is more likely than not we will be required to sell the security prior to recovery of its amortized cost, considering any regulatory developments, prepayment or call notifications and our liquidity needs.
For further discussion of our evaluation of investments for OTTI, see Note 4 to the consolidated financial statements.
We defer only costs that are directly related to the successful acquisition or renewal of insurance contracts, including:
Third-party underwriting costs related to contracts that are successfully acquired; and
The identification of internal costs directly related to the successful acquisition or renewal of a contract involves significant judgment and estimates. We estimate deferrable costs using time studies, internal surveys, and system-generated data about policy applications and issuances.
All other acquisition-related costs, including costs incurred for soliciting potential customers, managing distribution and underwriting functions, training, administration, unsuccessful acquisition or renewal efforts, market research and product development are not deferrable and are expensed in the period incurred. Further, certain costs associated with our wholesaler distribution model are not considered directly related to contract acquisition under the accounting standards, and we are not able to defer significant portions of our distribution costs related to our sales efforts. For example, sales of our FIA product increased during 2013, and the resulting increase in distribution expenses was not fully deferrable as a large portion of the expenses were not considered direct.
We amortize DAC and DSI over the premium paying period or over the lives of the policies in proportion to the future estimated gross profits (EGPs) of each of these product lines, as follows:
Deferred Annuities. The DAC amortization period is typically 20 years for deferred annuities, although most of the DAC amortization occurs within the first 10 years because the EGPs are highest during such period. To amortize DSI, we use the same methodology, assumptions and amortization period as used in amortizing DAC.
increases to interest margins in the current period from increased yields or decreased crediting rates;
increases to equity market returns and related changes in the FIA embedded derivative; and
if we increased our future lapse and withdrawal rate assumptions by a factor of 10%, the DAC asset balance would decrease approximately $6.8;
We adjust the unamortized DAC and DSI balances for the accumulated effect of net unrealized gains or losses on investments, which is recorded net of taxes in AOCI. This adjustment reflects the impact on estimated future gross profits as if the unrealized investment gains and losses had been realized as of the balance sheet date. Currently, our available-for-sale portfolio is in a net unrealized gain position, primarily due to the current interest rate environment, and the corresponding adjustment decreases our DAC and DSI balances and AOCI. In periods of rising interest rates, the fair value of our fixed maturities would generally decrease, and this may result in net unrealized investment losses. In such circumstances, the DAC and DSI adjustments would increase our DAC and DSI balances and increase AOCI. However, for DAC, this adjustment is limited to cumulative capitalized acquisition costs plus interest, which would be $222.3, net of taxes of $119.7, in our Deferred Annuities segment and $18.8, net of taxes of $10.2, in our Individual Life segment as of December 31, 2013. For DSI, this adjustment is limited to cumulative capitalized sales inducement costs plus interest, which would be $120.6, net of taxes of $64.9.
We periodically compare our actual experience with our estimates of actuarial liabilities for future policy benefits. To the extent that actual policy benefits differ from the reserves established for future policy benefits, such differences are recorded in the consolidated statements of income in the period in which the variances occur, which increases our total benefits and expenses.
Our primary sources of revenues from our insurance operations are premiums, net investment income and policy fees and contract charges. We also generate net realized investment gains (losses), primarily on sales or impairment of our investments, and changes in fair value on our equity trading portfolio and derivative financial instruments. Our primary sources of expenses from our insurance operations are policyholder benefits and claims, interest credited to policyholder reserves and account
Each of our four business segments maintains its own portfolio of invested assets, which are managed in accordance with specific guidelines. The net investment income and realized investment gains (losses) are reported in the segment in which they occur. We also allocate surplus net investment income to each segment using a risk-based capital formula. The unallocated portion of net investment income is reported in the Other segment. Investment expenses, which are recorded as a reduction of net investment income, are allocated to each segment based on its portfolio of invested assets. We allocate shared service operating expenses to each segment using multiple factors, including employee headcount and time study results.
Premiums consist primarily of premiums from our group insurance products, primarily medical stop-loss, limited benefit medical, group life and DI, individual term and whole life insurance products.
Net investment income represents the income earned on our investments, net of investment expenses, including prepayment-related income such as bond make-whole payments. Net investment income also includes gains or losses from changes in the fair value of our investments in private equity funds and expense from amortization of tax credit investments.
Policy fees, contract charges and other includes cost of insurance (COI) charges primarily on our UL and BOLI policies, mortality expense, surrender and other administrative charges to policyholders, revenues from our non-insurance businesses, and reinsurance allowance fees.
Policyholder benefits and claims consist of benefits paid and reserve activity on group insurance, individual life and BOLI products.
Interest expense primarily includes interest on corporate debt, the impact of interest rate hedging activities on the debt and amortization of debt issuance costs.
Adjusted Operating Income, Pre-tax Adjusted Operating Income, Adjusted Operating Income per Common Share - Basic, and Adjusted Operating Income per Common Share - Diluted
Net income is the most directly comparable GAAP measure to adjusted operating income. Net income for any period presents the results of our insurance operations, as well as our net realized investment gains (losses). We consider investment income generated by our invested assets to be part of the results of our insurance operations because they are acquired and generally held to maturity to generate income that we use to meet our obligations. Conversely, we do not consider many of the activities reported through net realized investment gains (losses) as part of the results of our insurance operations. The timing and amount of these gains (losses) are driven by investment decisions and external economic developments unrelated to our management of the insurance and underwriting aspects of our business.
Adjusted operating income per common share - basic, and adjusted operating income per common share - diluted, consist of adjusted operating income, divided by the GAAP-basis weighted average basic and diluted shares outstanding, respectively. Net income per common share - basic, and net income per common share - diluted, are the most directly comparable GAAP measures. See “Adjusted operating income” above, for an explanation of the differences between net income, which is the numerator for the GAAP measures, and adjusted operating income, the numerator for these non-GAAP measures.
In addition to using adjusted operating income per common share - basic, and adjusted operating income per common share - diluted, to evaluate our insurance operations, our management and board of directors have other uses for this measure, including assessing achievement of our financial plan.
Adjusted book value consists of stockholders’ equity, less AOCI. Adjusted book value per common share is calculated as adjusted book value, divided by outstanding common shares. This measure does not include shares subject to warrants in the periods they were outstanding because the warrant holders only participated in dividends and would not have been entitled to proceeds in the event of a liquidation or winding down of our company should such event have preceded the exercise of the outstanding warrants.
We believe investors find it useful if we present them with a financial measure excluding these temporary and unrealized changes in the fair values of our investments, and the related effects on AOCI. By evaluating our adjusted book value, an investor can assess our financial condition based on our general practice of holding our fixed maturities to maturity. Additionally, by translating this measure into adjusted book value per common share, we allow the investor to assess its proportionate stake in our adjusted book value as of the dates presented, and the change in such measures over time.
Adjusted book value, as converted consists of adjusted book value, plus the assumed proceeds from the exercise of outstanding warrants. This measure is used to calculate adjusted book value per common share, as converted which gives effect to the exercise of outstanding warrants. The warrants were net-share settled on June 20, 2013, resulting in the issuance of 5,297,758 shares of common stock. As of June 30, 2013 and all subsequent periods, this measure is equivalent to adjusted book value per common share and is no longer reviewed by management. It is provided for comparative purposes only.
We believe investors find it useful to review the returns of our insurance operations separate from the gain and loss activity attributable to most of our investment portfolio because it highlights trends in the performance of our insurance operations. In addition, we believe investors find it useful if we present them with a financial measure that removes from stockholders’ equity the temporary and unrealized changes in the fair values of our investments, and the related effects on AOCI, because we do not expect to realize the unrealized gains (losses) that are included in our AOCI balance as of any particular date. By referring to operating ROAE, an investor can form a judgment as to how effectively our management uses funds invested by our stockholders to generate adjusted operating income growth. Thus, we present operating ROAE for a period to measure the rate of return produced by our adjusted operating income in such period based on our average adjusted book value for such period.
Set forth below is a summary of our consolidated financial results. The variances noted in the total company and segment tables should be interpreted as increases or (decreases), respectively.
Net income increased $15.3 primarily as a result of higher pre-tax adjusted operating income and a decrease in the provision for income taxes due to a lower effective tax rate. Pre-tax adjusted operating income increased $4.5 from the year ended December 31, 2012.
Pre-tax earnings contributions from our Deferred Annuities, Individual Life, and Other segments improved, partially offset by a decline in earnings in our Benefits and Income Annuities segments. Excluding non-deferrable incentive compensation and expenses related to higher sales, we held our underwriting and operating expenses flat with 2012 levels.
Pre-tax adjusted operating income declined $25.5 from 2011. Our earnings results reflect a $42.6 increase in other underwriting and operating expenses over 2011 expense levels. This is primarily due to higher employee-related and professional services expenses related to our strategic growth initiatives. Also included in our 2012 segment results, discussed further below, is $24.7 of net investment income related to investment prepayments, less $2.5 of related DAC and DSI amortization. This compares to $23.0 of prepayment-related income received in 2011, net of related DAC and DSI amortization.
The provision for income taxes decreased $12.7 on lower pre-tax earnings and a lower effective tax rate, which was 24.0% for the year ended December 31, 2012 compared to 28.3% for the same period in 2011. The effective tax rate decreased due to an increase in tax credit investments and the related benefits.
The following table sets forth pre-tax adjusted operating income, by segment:
Represents a non-GAAP measure. For a definition of this measure, see - “Use of non-GAAP Financial Measures.”
The results of operations and selected operating metrics for our five segments (Benefits, Deferred Annuities, Income Annuities, Individual Life and Other) for the years ended December 31, 2013, 2012 and 2011 are set forth in the following sections.
Expense ratio is equal to other underwriting and operating expenses of our insurance operations divided by premiums earned.
Combined ratio is equal to the sum of the loss ratio and the expense ratio.
In addition to the drivers discussed above, we consider the following information useful in understanding our results.
Segment pre-tax adjusted operating income decreased $8.6, primarily the result of increased operating expenses related to the expansion of our group life and DI operations. Also contributing to the decline was a less favorable loss ratio on a larger block of medical stop-loss business. The loss ratio increased to 65.1% for the year ended December 31, 2012, compared to 63.1% for 2011. Growth in our block of medical stop-loss business was a result of strong sales and premium related to the block of business acquired in July 2011.
Total sales represent deposits for new policies net of first year policy lapses and/or surrenders.
Deferred Annuities’ sales nearly doubled, reaching $2,243.5 for 2013 compared to $1,146.6 for 2012. This was primarily the result of higher sales of our FIA product, which totaled $1,298.0 in 2013 compared with $292.6 in 2012. FIA sales benefited from a more favorable interest rate environment and ongoing expansion of our retirement products on bank distribution platforms. Expanded bank distribution also helped to diversify our deferred annuity sales with more key partners.
Net investment income increased $19.6, driven by a $0.85 billion increase in average invested assets due to higher fixed annuities account values. This growth was partially offset by lower portfolio yields, which was the result of lower yields on recent fixed maturity purchases and commercial mortgage loan originations, and prepayments of higher yielding assets. We received prepayment-related income of $14.4, compared to $9.2 in 2011.
The following table sets forth the results of operations relating to our Income Annuities segment:
Reserves represent the present value of future income annuity benefits and assumed expenses, discounted by the assumed interest rate. This metric represents the amount of our in-force book of business.
Interest spread is the difference between the net investment yield and the credited rate to policyholders. The net investment yield is the approximate yield on invested assets, excluding equities, attributed to the segment. The credited rate is the approximate rate credited on policyholder reserves.
Base interest spread is the interest spread adjusted to exclude items that can vary significantly from period to period due to a number of factors and, therefore, may contribute to yields that are not indicative of the underlying trends. This is primarily the impact of asset prepayments, such as bond make-whole premiums and the MBS prepayment speed adjustment.
Interest credited decreased $3.0 driven by lower crediting rates on lower reserves, which was partially offset by lower mortality gains. Mortality experience is volatile and can fluctuate significantly from period to period.
Net investment income decreased $3.2, due to lower average invested assets and lower yields. Policy fees, contract charges, and other increased $5.0, primarily from fee revenue earned on increased sales of third-party structured settlements.
Sales increased to $258.2 for 2012, compared to $221.9 for 2011, due to the effectiveness of shorter-duration SPIA sales strategies to help customers maximize retirement income.
The following table sets forth the results of operations relating to our Individual Life segment:
Individual claims represents incurred claims, net of reinsurance, on our term and universal life policies.
Segment pre-tax adjusted operating income increased $8.3, driven by lower individual claims, a favorable impact of annual unlocking, and higher prepayment-related income. These sources of earnings were partially offset by a lower BOLI base ROA, due to higher BOLI claims, and lower earnings contributions from our decreasing block of term life business.
Benefit-related expenses (policyholder benefits and claims, and interest credited) decreased $4.6, driven by lower claims on our UL business and lower crediting rates on our BOLI business. These were partially offset by higher BOLI claims and growth in account value.
Sales of individual life products increased to $18.6 for 2013, compared to $9.1 in 2012. An expanded BGA distribution network contributed to higher sales of our Classic UL product, which were partially offset by lower sales of SPL policies.
The Other segment reported pre-tax adjusted operating losses of $26.1 for 2012, compared with losses of $10.7 for 2011. This decline in results was due to lower net investment income, mainly related to tax credit and private equity fund investments, and higher operating expenses primarily related to our exploration of acquisition opportunities.
Amortization of tax credit investments, which is recorded as a reduction to net investment income, increased $7.4 over 2011 due to higher levels of investments in these assets. Tax credit investments reduce investment income, but provide tax benefits that reduce our provision for income taxes and decrease our effective tax rate. See “Investments - Investments in Limited Partnerships - Tax Credit Investments” for further information.
Investments in private equity funds are carried at fair value, and our tax credit investments are carried at amortized cost.
The return on invested assets is an important element of our financial results. The following table sets forth the income yield and net investment income, excluding realized investment gains (losses), for each major investment category:
Other income producing assets includes other invested assets, short-term investments and cash and cash equivalents.
Although prepayment-related income increased overall yields in the periods received, this increase was partially offset by lower investment yields as a result of the interest rate environment. Excluding the impacts from prepayment-related income, yields on our entire investment portfolio decreased to 4.75% for the year ended December 31, 2013 from 4.98% for the same period in 2012. In an attempt to mitigate this impact, we continued to focus on our underwriting of commercial mortgage loans, which generally provide higher yields than fixed maturities. We also strategically increased our investment in high-quality foreign corporate securities with a focus on investment grade securities which is discussed further in “- Exposure to European Fixed Maturity Securities.”
For the year ended December 31, 2012, net investment income was essentially flat compared to 2011. This was driven by an increase in invested assets on sales of fixed annuities, partially offset by a decrease in the total net investment yield, which decreased to 5.08% in 2012 from 5.30% in 2011. The reduction reflected the prolonged low interest rate environment, as yields on fixed maturity purchases in the year ended December 31, 2012 were approximately 275 bps lower than the average yield on existing fixed maturity investments. Yields on fixed maturity purchases in the year ended December 31, 2011 were approximately 198 bps lower than the average yield on existing investments in 2011.
In an attempt to mitigate the effects of the low interest rate environment, we continued to increase our underwriting of commercial mortgage loans. For the year ended December 31, 2012, we originated loans at a spread over U.S. Treasuries of approximately 345 bps, compared with an approximate 325 bps spread over U.S. Treasuries for 2011. In addition, we received prepayment-related income that generated approximately 10 bps of yield in both 2012 and 2011.
The Securities Valuation Office (SVO) of the National Association of Insurance Commissioners (NAIC) evaluates the investments of insurers for regulatory reporting purposes and assigns fixed maturities to one of the six categories called “NAIC Designations.” NAIC designations of “1” or “2” include fixed maturities considered investment grade, which generally include securities rated BBB- or higher by Standard & Poor’s (S&P). NAIC designations of “3” through “6” are referred to as below investment grade, which generally include securities rated BB+ or lower by S&P. In recent years, the SVO adopted a modeling approach to determine the NAIC designation for non-agency RMBS and CMBS securities. As a result, the NAIC designation for such securities may not correspond to the S&P designations described.
The following table presents our fixed maturities by NAIC designation and S&P equivalent credit ratings, as well as the percentage of total fixed maturities, based upon fair value, that each designation comprises:
Below investment grade securities comprised 5.5% and 5.4% of our fixed maturities portfolio as of December 31, 2013 and 2012, respectively. As of December 31, 2013, our NAIC 5 and 6 designated securities had gross unrealized losses of $13.8. Our analysis of these securities, including management’s estimates of future cash flows, where appropriate, supports the recoverability of amortized cost.
As of December 31, 2013, there was $276.2 of gross unrealized losses in our portfolio, compared to $56.7 as of December 31, 2012. Gross unrealized gains also decreased by $1,149.7, to $1,352.6 as of December 31, 2013 from $2,502.3 as of December 31, 2012. These changes were primarily due to gradually rising interest rates in 2013. The benchmark 10-year U.S. Treasury rate increased from 1.78% as of December 31, 2012 to 3.04% as of December 31, 2013. If interest rates continue to increase, we would expect continued reductions in net unrealized gains for our portfolio.
As of December 31, 2013 and 2012, the fair value of our state and political subdivision securities included $34.2 and $35.1 of municipal general obligation bonds and $717.3 and $741.4 of municipal revenue bonds, respectively. We have municipal holdings of $5.4 in Illinois as of both December 31, 2013 and 2012, and no exposure to holdings in Michigan or Puerto Rico.
The following tables summarize our exposure to European fixed maturity holdings separated between sovereign debt, financial industry and other corporate debt exposures. The country designation is based on the issuer’s country of incorporation. The majority of these holdings are denominated in U.S. dollars. As of December 31, 2013 and 2012, we held $530.6 and $156.1, respectively, of fixed maturities denominated in a foreign currency and reported in U.S. dollars based on period-end exchange rates. As part of our strategy to improve portfolio yields, we invest in high-quality foreign corporate securities with a focus on investment grade securities. We utilize foreign currency swaps and forwards to hedge our exposure to foreign currency.
The fair value of our ten largest European security holdings was $973.9, or 4.2% of the fixed maturities portfolio as of December 31, 2013, and $920.7, or 3.9% as of 2012. All of the issuers of our ten largest European security holdings had an S&P rating above BBB+ and a Moody's rating above Baa1. The fair value of our largest single European issuer exposure was $150.6, or 0.6%, and $125.0, or 0.5%, of the portfolio as of December 31, 2013 and 2012, respectively, and had an S&P rating of BBB+ and a Moody's rating of Baa1.
We classify our investments in RMBS as agency, prime, Alt-A, and subprime. Agency RMBS are guaranteed or otherwise supported by the Federal National Mortgage Association, the Federal Home Loan Mortgage Corporation, or the Government National Mortgage Association. Prime RMBS have underlying loans to customers with good quality credit profiles. Subprime RMBS have underlying loans to customers with a greater risk of default. Alt-A RMBS have overall credit quality between prime and subprime, based on a review of their underlying mortgage loans and factors such as credit scores and financial ratios. The Company had no exposure to subprime loans as of December 31, 2013 or 2012.
As of December 31, 2013, our Alt-A portfolio was collateralized with 94.3% fixed rate mortgages and 5.7% hybrid adjustable rate mortgages (ARMs) with no exposure to option ARMs. Generally, fixed rate mortgages have had better credit performance than ARMs, with lower delinquencies and defaults on the underlying collateral.
As of December 31, 2013, our Alt-A, prime and total non-agency RMBS had an estimated weighted-average credit enhancement of 12.9%, 7.6% and 8.8%, respectively. Credit enhancement refers to the weighted-average percentage of the outstanding capital structure that is subordinate in the priority of cash flows and absorbs losses first. We believe that our credit enhancement will help mitigate our exposure to losses on these securities.
As of December 31, 2013, our RMBS had total gross unamortized discount and premium of $65.5 and $46.2, respectively. Changes in prepayment speeds, which are based on prepayment activity of the underlying mortgages, may create volatility in our net investment income because they accelerate or decelerate our amortization of the unamortized premiums and discounts. The impact to net investment income is dependent on whether the securities are at a discount or premium and whether the prepayment speeds increase or decrease.
As of December 31, 2013, our CMBS portfolio was highly concentrated in the most senior tranches, with 99.6% of our AAA-rated securities in the most senior tranche, based on amortized cost. The senior class has priority over the mezzanine and junior classes to all principal and interest cash flows and will not experience any loss of principal until both the entire mezzanine and junior tranches are written down to zero. As of December 31, 2013, our CMBS had total gross unamortized discount and premium of $18.7 and $16.0, respectively.
The weighted-average credit enhancement of our CMBS, adjusted to remove defeased loans, was 32.1% as of December 31, 2013. We believe this additional credit enhancement is significant, especially in the event of a deep real estate downturn during which losses would be expected to increase substantially.
Our equity investments consist primarily of publicly traded common stock. We believe that these investments are suitable for funding certain long duration liabilities in our Income Annuities segment and, on a limited basis, in our surplus portfolio. The majority of these securities are included in trading marketable equity securities on our consolidated balance sheets and are recorded at fair value, with changes in fair value recorded in net realized investment gains (losses). In the latter half of 2013, we began classifying purchases of common stock securities as available-for-sale securities. Available-for-sale securities are carried at fair value on our consolidated balance sheets, with changes in fair value recorded in other comprehensive income. We expect to continue to designate purchases of common stock securities as available-for-sale.
The following table compares our total gross return on our common stock to the S&P 500. The gross return includes both the impact of changes in fair value and dividend income.
A portion of our equity investments are in real estate-related investments to enhance the funding of the long duration liabilities in our Income Annuities segment. These primarily consist of investments in real-estate investment trusts (REITs), which are included in trading marketable equity securities on our consolidated balance sheets.
We continue to increase our investments in mortgage loans, as this strategy has resulted in increased net investment yields when compared to fixed maturity investments. We believe a disciplined increase in commercial mortgage loan investments will help maintain the overall quality of our investment portfolio and obtain appropriate yields to match our policyholder liabilities. We originated $697.4 of mortgage loans during the year ended December 31, 2013, and expect to continue similar originations during 2014.
We use the LTV ratio and DSCR as our primary metrics to assess mortgage loan quality. These factors are also considered in evaluation of our allowance for mortgage loan losses. For more information and further discussion of the allowance for mortgage loan losses, see Note 5 to our consolidated financial statements. As of December 31, 2013, no loans were considered nonperforming.
As of December 31, 2013, loans with an aggregate carrying value of $115.3 had a DSCR of less than 1.00. The average outstanding principal balance of these loans was $1.8 with a weighted average LTV of 76.6%.
The following table sets forth our investments in mortgage loans by contractual maturity date as of December 31, 2013:
Symetra conducts its operations through its operating subsidiaries, and our liquidity requirements primarily have been and will continue to be met by funds from such subsidiaries. Dividends from its subsidiaries are Symetra’s principal source of cash to pay dividends to stockholders, fund the stock repurchase program and meet its obligations, including payments of principal and interest on notes payable.
We continued to generate strong cash flows from operations, which were $1,019.6 for 2013, $1,011.2 for 2012 and $987.5 for 2011.
We ended the year with positive net cash flows of $405.0 on deferred annuities, as deposits increased from strong sales in 2013.
In managing the liquidity of our insurance operations, we consider the risk of policyholder and contract holder withdrawals of funds earlier than assumed when selecting assets to support these contractual obligations. We use surrender charges and other contract provisions to mitigate the extent, timing and profitability impact of such withdrawals. The following table sets forth liquidity characteristics of our general account policyholder liabilities, composed of annuity reserves, deposit liabilities and policy and contract claim liabilities, net of reinsurance recoverables:
Approximately half of the account value has been with us for many years, due to guaranteed minimum interest rates of 4.0 - 4.5% that are significantly higher than those currently offered on new business. Given the current interest rate environment, we do not expect significant changes in the persistency of this business.
Other represents the sum of the following: (a) our term life insurance policyholder liabilities, net of reinsurance recoverables. There is no surrender value related to these contracts; (b) incurred but not reported claim liabilities mainly related to our medical stop-loss business. The precise timing and amount of payment is unknown; and (c) reported claim liabilities for BOLI, term life insurance, medical stop-loss and group life policies.
Represents the sum of funds held under deposit contracts, future policy benefits and policy and contract claims in the consolidated balance sheets, excluding other policyholder related liabilities and reinsurance recoverables of $231.5 and $231.4 as of December 31, 2013 and 2012, respectively.
Symetra’s insurance company subsidiaries maintain investment strategies intended to provide adequate funds to pay benefits without forced sales of investments. Products having liabilities with longer durations, such as certain life insurance policies and structured settlement annuities, are matched with investments having similar estimated lives such as long-term fixed maturities, mortgage loans and marketable equity securities. Shorter-term liabilities are matched with fixed maturities that have short- and medium-terms. In addition, our insurance company subsidiaries hold sufficient levels of highly liquid, high quality assets to fund anticipated operating expenses, surrenders and withdrawals.
We define liquid assets to include cash, cash equivalents, short-term investments, publicly traded fixed maturities and public equity securities. As of December 31, 2013 and 2012, our insurance company subsidiaries had liquid assets of $23.17 billion and $23.29 billion, respectively, and Symetra had liquid assets of $162.6 and $77.6, respectively. The portion of total company liquid assets comprised of cash and cash equivalents and short-term investments was $76.6 and $136.7 as of December 31, 2013 and 2012, respectively.
We consider attributes of the various categories of liquid assets (for example, type of asset and credit quality) in evaluating the adequacy of our insurance operations’ liquidity under a variety of stress scenarios. We believe that the liquidity profile of our assets is sufficient to satisfy our liquidity requirements, including under foreseeable stress scenarios.
For further description and additional terms of our debt facilities, see Note 12 to the consolidated financial statements.
We declared and paid a quarterly dividend of $0.08 per common share, including outstanding warrants, during the first and second quarters of 2013 and $0.09 per common share during the third and fourth quarters of 2013 for a total payout of $43.2.
Cash flows from our operating activities are primarily driven by the amount and timing of cash received for income on our investments, including dividends and interest, and premiums on our group insurance and term life insurance products, as well as the amount and timing of cash disbursed for our payment of policyholder benefits and claims, underwriting and operating expenses and income taxes. The following discussion highlights key drivers in the level of cash flows generated from our operating activities:
Years Ended December 31, 2013 compared with 2012. Net cash used in investing activities for the year ended December 31, 2013 increased $801.7 over the same period in 2012. This was primarily the result of an increase in purchases of fixed maturities as a result of increased FIA deposits referred to below in "- Financing Activities," partially offset by higher sales of equity securities due to the liquidation of our mutual funds and lower mortgage loan originations.
Years Ended December 31, 2013 compared with 2012. Net cash provided by financing activities for the year ended December 31, 2013 was $596.6, in comparison to cash used in financing activities of $253.4 during the same period in 2012. This change was driven by higher policyholder deposits, mainly from higher FIA sales, offset by shares repurchased as part of the Company’s common stock repurchase program.
We have investments in limited partnership interests related to tax credit investments and private equity partnerships. We will provide capital contributions to our private equity partnerships through 2016 with a remaining committed amount of $14.9 at the discretion of the general partner, subject to certain contribution limits. Since the timing of payment is uncertain, the unfunded amount has been included in the payment due in less than one year. Amounts recorded on the balance sheets are included in “other liabilities.”
Primarily comprised of unfunded mortgage loan commitments of $50.5, as of December 31, 2013.
We have derivative instruments with off-balance-sheet risks whose notional or contractual amounts exceed their fair value. For further information on our derivative instruments, see Note 4 in the consolidated financial statements. We also have commitments or off-balance sheet arrangements primarily related to unfunded mortgage loans, leases, and our revolving credit facility. For further information on these items, see Notes 14 and 12 in the consolidated financial statements.
We have audited the accompanying consolidated balance sheets of Symetra Financial Corporation as of December 31, 2013 and 2012, and the related consolidated statements of income, comprehensive income (loss), changes in stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2013. Our audits also included the financial statement schedules listed in the Index at Item 15(a). These financial statements and schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Symetra Financial Corporation’s internal control over financial reporting as of December 31, 2013, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (1992 framework) and our report dated February 25, 2014 expressed an unqualified opinion thereon.
The most significant estimates include those used to determine the following: valuation of investments carried at fair value; the identification and measurement of other-than-temporary impairments (OTTI) of investments; the balance, recoverability and amortization of deferred policy acquisition costs (DAC) and deferred sales inducements (DSI); and the liabilities for funds held under deposit contracts, future policy benefits, and policy and contract claims. The recorded amounts reflect management’s best estimates, though actual results could differ from those estimates.
The Company classifies its investments in fixed maturities and certain marketable equity securities as available-for-sale and carries them at fair value. Fixed maturities primarily include bonds, mortgage-backed securities and redeemable preferred stock. See Note 6 for information on the valuation of these securities and additional disclosures regarding fair value measurements.
The Company reports interest and dividends earned, including prepayment fees or interest-related make whole payments in net investment income. Interest income for fixed maturities is recognized using the effective yield method. When the collectability of interest income for fixed maturities is considered doubtful, any accrued but uncollectible interest is deducted from investment income in the current period. The Company then places the securities on nonaccrual status, and they are not restored to accrual status until all delinquent interest and principal are paid.
For mortgage-backed securities, the Company recognizes income using a constant effective yield based on anticipated prepayments and the estimated economic life of the securities. Quarterly, the Company compares actual prepayments to anticipated prepayments and recalculates the effective yield to reflect actual payments plus anticipated future payments. The Company includes any resulting adjustment in net investment income in the current period.
In the normal course of business, the Company makes passive investments in structured securities issued by VIEs. These structured securities primarily include residential and commercial mortgage-backed securities. Because the Company lacks the ability to direct the activities that most significantly impact the economic performance of the VIEs, it is not considered the primary beneficiary and therefore does not consolidate them. The Company’s maximum exposure to loss with respect to these investments is limited to the amortized cost of the Company’s investment, which is $4,571.5 and $4,708.1 as of December 31, 2013 and 2012, respectively.
The Company is invested in common stock that is classified as trading. Changes in the fair value of the Company’s trading portfolio are recorded in net realized investment gains (losses) in the consolidated statements of income. Dividends earned on trading securities are reported in net investment income.
Investments in limited partnerships also include investments in private equity funds recorded at fair value. The impact of changes in the fair value of private equity funds is recorded in net investment income. The Company elected the fair value option for these investments, regardless of ownership percentage, to standardize the related accounting and reporting.
The limited partnerships that the Company invests in meet the definition of a VIE. Because the Company, as a limited partner, lacks the ability to direct the activities of any of these partnerships, it is not considered the primary beneficiary and therefore has not consolidated them. The maximum exposure to loss in these VIEs was $316.4 and $261.8 as of December 31, 2013 and 2012, respectively. The maximum exposure to loss includes unconditional commitments to provide future capital contributions.
The Company adjusts the unamortized DAC balance for the effect of net unrealized gains and losses on securities and embedded derivatives as if they had been realized as of the balance sheet date. The Company includes the impact of this adjustment, net of tax, in AOCI. The Company also adjusts its unamortized DAC balance for the effect of realized gains and losses. These adjustments are recognized in net realized investment gains (losses) in the consolidated statements of income.
The Company offers sales inducements on certain deferred annuity contracts and universal life policies. For certain deferred annuity contracts, the inducement entitles the contract holder to an incremental amount of interest that is credited to the account value over a 12- to 60-month period following the initial deposit, depending on the product. The incremental interest causes the initial credited rate to be higher than the contract’s expected ongoing crediting rates for periods after the inducement. For certain universal life policies, the inducement provides an immediate increment to the policyholder’s account value at the issue date or time of deposit. Deferred sales inducements are included in receivables and other assets and amortized into interest credited using the same methodology and assumptions used to amortize DAC. Deferred sales inducement balances
Separate account assets are reported at fair value and represent funds that are invested on behalf of the Company’s variable product policyholders. The assets of each separate account are legally segregated and are not subject to claims that arise out of the Company’s other business activities. Investment risks associated with market value changes are borne by the policyholder, except to the extent of guaranteed minimum death benefits (GMDB) made by the Company with respect to certain accounts. Net investment income and realized investment gains and losses accrue directly to the policyholders and are not included in the Company’s revenues. Separate account liabilities represent the policyholder’s account balance in the separate account. Fees charged to policyholders reduce the account value and the Company includes these fees as revenue in the consolidated statements of income.
The Company estimates liabilities for future policy benefits for its traditional individual life policies as the present value of expected future policy benefits less future net premiums. The Company selects the net premiums so that the actuarial present value of future benefits equals the actuarial present value of future premiums. The Company sets the interest, mortality, and persistency assumptions in the year of issue and includes a provision for adverse deviation. The provision for adverse deviation is intended to provide coverage for the risk that actual experience may be worse than locked-in best-estimate assumptions. These liabilities are contingent upon the death or disability of the insured while the policy is in force. The Company derives mortality assumptions from both company-specific and industry statistics. Future benefits are discounted at interest rates that vary by year of policy issue. These rates are initially set to be consistent with portfolio rates at the time of issue, and are graded to a lower rate over time. Assumptions are set at the time each product is introduced and are not updated for actual experience unless the total product liability amount is determined to be inadequate to cover future policy benefits.
In December 2011, the FASB issued ASU 2011-11, Balance Sheet (Topic 210) - Disclosures about Offsetting Assets and Liabilities. This ASU requires the Company to disclose information about financial assets and liabilities that are offset or have the potential to be offset, along with the related contractual arrangements, to enable users to understand the effect of such arrangements on its balance sheets. The ASU requires the Company to disclose information on both a gross and net basis about instruments and transactions within the scope of this standard.
ASU 2013-02, Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income
In February 2013, the FASB issued ASU 2013-02, Comprehensive Income (Topic 220) - Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income. This ASU supersedes the presentation requirements in ASU 2011-05, Presentation of Comprehensive Income, and ASU 2011-12, Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05. This ASU requires the Company to present, either on the face of the financial statements or in the notes to the consolidated financial statements, the effect of significant reclassifications out of AOCI by the respective line item on the statements of income. This ASU does not change the requirement to present other comprehensive income by component in the consolidated financial statements. The Company prospectively adopted this standard on January 1, 2013 and included the disclosures in Note 8.
The Company has issued equity instruments to employees that are considered in the computation of earnings per share, including restricted stock and stock options. Refer to Note 9 for discussion of these instruments. The restricted stock is considered a participating security because the holders are entitled to receive any dividends declared on the common stock concurrently with the holders of outstanding shares of common stock, on a one-to-one basis. Participating restricted stock is included in basic and diluted earnings per share based on the application of the two-class method.
For the years ended December 31, 2013, 2012 and 2011, 2,650,000, 2,650,000 and 2,950,000, respectively, of stock options were excluded from the computation of diluted earnings per share, based on the application of the treasury stock method, because they were anti-dilutive. Also, performance units granted during 2011 had the option to settle in cash or shares at the Company’s discretion. These units were excluded from the computation of diluted earnings per share because the Company has a historical practice of and intent to settle these awards in cash. Beginning in 2012, performance units granted are required to be settled in cash. Refer to Note 15 for further discussion of the performance units.
This includes net gains (losses) on changes in the fair value of trading securities held as of period end totaling $41.1, $37.7 and $(7.5) for the years ended December 31, 2013, 2012 and 2011, respectively.
This includes net gains (losses) on derivatives not designated for hedge accounting and other instruments.
(All amounts in millions, except share and per share data, unless otherwise stated)
Nonpayment of scheduled interest, or the reduction or elimination of dividends;
For fixed maturities, the Company’s intent to sell or whether it is more likely than not the Company will be required to sell the fixed maturity prior to recovery of its amortized cost, considering any regulatory developments, prepayment or call notifications and the Company’s liquidity needs.
For fixed maturities, the Company concludes that an OTTI has occurred if a security is underwater and there is an intent to sell the security or if the present value of expected cash flows is less than the amortized cost of the security (i.e., a credit loss exists). In order to determine the amount of the credit loss, the Company calculates the recovery value by discounting its estimate of future cash flows from the security. The discount rate is the original effective yield for corporate securities or current effective yield for mortgage-backed and other structured securities.
Changes to the rating of the security by a rating agency;
Susceptibility to prepayment and anti-selection due to changes in the interest rate environment.
The Company records OTTI charges in the consolidated statements of income on fixed maturities. The largest write-downs were from investments in the following sectors:
There were no marketable equity securities recorded as available-for-sale that were underwater by 20% or more as of December 31, 2013 and 2012.
The Company reviewed its available-for-sale investments with unrealized losses as of December 31, 2013 and 2012 in accordance with its impairment policy and determined, after the recognition of OTTI, that the remaining declines in fair value were temporary. The Company did not intend to sell its underwater securities, and it was not more likely than not that the Company will be required to sell the securities before recovery of cost or amortized cost, which may be maturity. For fixed maturities, this conclusion is supported by the Company’s spread analyses, cash flow modeling and expected continuation of contractually required principal and interest payments.
As of December 31, 2013 and 2012, the Company has evaluated the near-term prospects of its available-for-sale equity securities in relation to the severity and duration of the impairment. Based on that evaluation, the Company concluded that it had the ability and intent to hold these investments until a recovery of fair value.
Represents circumstances where the Company determined in the period that it intended to sell the security prior to recovery of its amortized cost.
Derivatives are instruments whose values are derived from underlying instruments, indexes or rates; have a notional amount; and can be net settled. This includes derivatives that are embedded in other financial instruments or in certain existing assets or liabilities. The Company is exposed to various risks relating to its ongoing business operations, primarily equity market risk, interest rate risk, and foreign currency exchange risk. The Company uses derivative instruments as one of its strategies to manage these risks. These derivative instruments primarily consist of equity index options, interest rate swaps, foreign currency swaps and foreign currency forwards. The Company has established policies for managing its derivatives, including prohibitions on derivatives market-making and other speculative derivatives activities.
The Company uses call options based on the S&P 500 or a commodities-based index as part of its equity market risk management strategy. The Company offers a fixed indexed annuity (FIA) contract that permits the contract holder to allocate a portion of their account value to an equity market component, where interest credited to the contract is linked to the performance of the S&P 500 or a commodities-based index, subject to caps set by the Company. The contract holders may elect to rebalance index options at renewal dates annually. As of each renewal date, the Company has the opportunity to re-price the indexed component by establishing cap rates, subject to minimum guarantees.
The index-based crediting feature in these contracts is an embedded derivative instrument that is bifurcated from the host contract for measurement purposes, because it possesses economic characteristics that are not clearly and closely related to the economic characteristics of the host contract. The embedded derivative, which is reported with the host instrument as funds held under deposit contracts in the consolidated balance sheets, is carried at fair value with changes in fair value recognized in net realized investment gains (losses).
The Company uses foreign currency swaps and forwards as part of its foreign currency risk management strategy. The Company uses foreign currency swaps to reduce risks from changes in currency exchange rates with respect to the Company's investments denominated in foreign currencies. In a foreign currency swap transaction, the Company agrees with other parties to exchange, at specified intervals, one currency for another at a specified rate of exchange. Generally, the notional amount of each currency is exchanged at the maturity of the currency swap by each party. These derivatives qualify and are designated as cash flow hedges.
The following tables present the potential effect of netting arrangements by counterparty on the Company’s consolidated balance sheets:
As of December 31, 2013, the maximum term over which the Company is hedging its exposure to the variability in future cash flows is approximately eleven years. The Company recorded no ineffectiveness for cash flow hedging relationships for the years ended December 31, 2013, 2012 or 2011.
The following table shows the effect of non-designated derivatives in the consolidated statements of income, which is recorded in net realized investment gains (losses):
As of December 31, 2013 and 2012, reserve amounts of $0.2 and $0.0, respectively, were held for loans specifically evaluated for impairment.
The Company determines the fair value of its financial instruments based on the fair value hierarchy, which favors the use of observable inputs over the use of unobservable inputs when measuring fair value. The Company has categorized its financial instruments into the three-level hierarchy, which gives the highest priority to quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). The level to which a fair value measurement falls is assigned based on the lowest-level input that is significant to the measurement. The fair value measurements for the Company’s financial instruments are categorized as follows:
Level 2 - Quoted prices for similar instruments in active markets and model-derived valuations whose inputs are observable. This category includes those financial instruments that are valued using industry-standard pricing methodologies or models. All significant inputs are observable or derived from observable information in the marketplace. Financial instruments in this category primarily include corporate fixed maturities and mortgage-backed securities.
The pricing services provide prices where observable inputs are available, utilizing evaluated pricing models that vary by asset class. If sufficient objectively verifiable information about a security’s valuation is not available, the pricing services will not provide a valuation for the security. In these situations, the security’s fair value is determined using internal pricing models.
As of December 31, 2013 and 2012, the fair value of the Company’s corporate securities classified as Level 2 measurements was $17,324.4 and $17,162.7, respectively. The following table presents additional information about the composition of the Level 2 corporate securities:
The majority of corporate securities classified as Level 2 measurements are priced by independent pricing services utilizing evaluated pricing models. Because many corporate securities do not trade on a daily basis, evaluated pricing models apply available information through processes such as benchmark curves, benchmarking of like securities, sector groupings and matrix pricing to prepare valuations. The significant inputs for security evaluations include benchmark yields, reported trades, broker-dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers and other reference data, including market research publications.
As of December 31, 2013 and 2012, the fair value of the Company’s commercial mortgage-backed securities (CMBS) classified as Level 2 measurements was $1,512.6 and $1,688.9, respectively. The weighted-average coupon rate on these securities was 4.82% and 5.03% as of December 31, 2013 and 2012, respectively.
The fair values of funds held under deposit contracts related to investment-type contracts are estimated based on the present value of the discounted cash flows. Cash flows were projected using best estimates for lapses, mortality and expenses, and discounted at a risk-free rate plus a nonperformance risk spread.
As of December 31, 2013, the fair value of the Company’s notes payable is determined by an independent pricing service utilizing evaluated pricing models, consistent with how fair value was determined for the majority of its corporate securities. The use of observable inputs resulted in a Level 2 measurement. The Company's previous method utilized nonbinding third party broker quotes, which had resulted in a Level 3 measurement as of December 31, 2012.
Issues and settlements are related to the Company’s embedded derivative liabilities.
Other is comprised of transactions such as pay downs, calls, amortization and redemptions.
The following table provides a reconciliation of the beginning and ending balance for DSI, which is included in receivables and other assets in the consolidated balance sheets. DSI amortization is included in interest credited in the consolidated statements of income.
Other comprehensive income (loss) before reclassifications is net of taxes of $(481.1), $(0.9), $59.2, $(9.4) and $(432.2), respectively, for the year ended December 31, 2013, net of taxes of $201.1, $(2.8), $(24.4), $(0.1) and $173.8, respectively, for the year ended December 31, 2012, and net of taxes of $353.9, $0.3, $(35.3), $3.3 and $322.2, respectively, for the year ended December 31, 2011.
On February 1, 2013, the Company’s board of directors authorized the repurchase, at management’s discretion, of up to 10,000,000 shares of the Company’s outstanding common stock. The authorization was increased to 16,000,000 shares on May 21, 2013. The Company has repurchased 6,952,266 shares under the program as of December 31, 2013. This includes 6,089,999 shares purchased on May 17, 2013 from a related party in a privately negotiated transaction for a total of $81.8.
As of December 31, 2013, the Company had two stock-based compensation plans: the Symetra Financial Corporation Equity Plan, amended and restated on November 8, 2011, (the “Equity Plan”) and the Symetra Financial Corporation Employee Stock Purchase Plan, amended and restated on May 11, 2010, (the “Stock Purchase Plan”). Under the Equity Plan, the Company is authorized to issue various types of stock-based compensation to employees, directors and consultants. A total of 7,830,000 shares are authorized for issuance under the Equity Plan, and 4,134,471 shares are available for future issuance as of December 31, 2013. The Stock Purchase Plan allows eligible employees to purchase shares of the Company’s common stock at a 15% discount from the market price. A total of 870,000 shares are authorized for issuance under this plan. As of December 31, 2013, 438,880 shares are available for future issuance under the Stock Purchase Plan.
Stock-based compensation expense for restricted shares, recognized in other underwriting and operating expenses in the consolidated statements of income, was $3.5, $3.5, and $2.1 for the years ended December 31, 2013, 2012 and 2011, respectively. The related income tax benefit for the years ended December 31, 2013, 2012 and 2011 was $1.2, $1.2 and $0.7, respectively.
The Company reinsures portions of its insurance risk with reinsurance and other insurance companies in order to diversify risk and manage loss exposure, primarily in the Individual Life and Benefits segments.
In the Benefits segment, the Company reinsures portions of risk associated with its group life and disability income and medical stop-loss businesses. The Company reinsured its group life risk and capped its liability at $0.25 per individual, per line of coverage. The Company reinsured 40% of its short-term disability risk prior to June 2013, and 20% thereafter. The Company reinsured 90% of its long-term disability risk. The Company reinsured its exposure to medical stop loss claims in excess of $1.0 for aggregate policies and $1.1 per individual for policies issued prior to October 2013, and increased its retention to $1.5 per individual thereafter. The Company also has catastrophic coverage for its group life policies based on geographic location.
The Company evaluates the financial condition of its reinsurers to monitor its exposure to losses from reinsurer insolvencies. As of December 31, 2013, $121.1 or 39.0%, of the reinsurance recoverable was related to one reinsurer. The Company analyzes reinsurance recoverables according to the credit ratings of its reinsurers and is not aware of its major reinsurers currently experiencing financial difficulties. Of the total amount due from reinsurers as of both December 31, 2013 and 2012, 99.6% were with reinsurers rated A- or higher by A.M. Best. The Company had no write-offs or reserve for uncollectible reinsurance in 2013, 2012 or 2011.
The following table sets forth the effect of reinsurance on premiums and policy fees and contract charges. It is disaggregated by accident and health and life insurance products, which are short- and long-duration contracts, respectively.
The decrease in assumed accident and health premiums and the percentage of assumed to total premiums and other amounts assessed to policyholders in 2012 and 2013 is related to the indemnity reinsurance agreement and acquired renewal rights for medical stop-loss insurance policies issued by American United Life Insurance Company (AUL) on July 1, 2011.
Ceded reinsurance reduced policyholder benefits and claims by $65.2, $63.9 and $55.6 for the years ended December 31, 2013, 2012 and 2011, respectively.
The following table provides a reconciliation of the beginning and ending liability balances for unpaid claims and claims adjustment expenses. These reserves include policy and contract claims and certain amounts recorded in future policy benefits on the consolidated balance sheets.
The Company includes penalties and interest accrued related to unrecognized tax benefits in the calculation of income tax expense. As of December 31, 2013, the Company has no unrecognized tax benefits and does not expect significant changes within the next year.
The Company has a service agreement with a third party service provider to outsource the majority of its information technology infrastructure. The initial term of the service agreement expires in July 2014, subject to early termination in certain cases, with two one-year extensions at the Company’s election. Under the terms of the service agreement, the Company agreed to pay an annual fixed service fee ranging from $10.6 to $11.4 for five years. The Company incurred service fee expenses of $13.4, $13.6 and $12.3 for the years ended December 31, 2013, 2012 and 2011, respectively, which included the fixed fee as well as a variable fee based on usage.
As of December 31, 2013 and 2012, unfunded mortgage loan commitments were $50.5 and $64.4, respectively. The Company had no other material commitments or contingencies as of December 31, 2013 and 2012.
Under the Equity Plan, the Company has the ability to issue various types of awards, including restricted stock, stock options, stock appreciation rights, restricted stock units, performance shares, performance units and other types of awards at the discretion of the board of directors.
During 2013, 2012 and 2011, the Company granted performance units to various members of management under the Equity Plan. The value of each performance unit is determined at the discretion of the Company’s board of directors based on the success of the Company over a three-year period. These are accounted for as liability awards, as the Company intends or is required to settle such awards in cash. The Company recognized $6.4, $4.7 and $2.5 in expense related to performance units granted under the Equity Plan for the years ended December 31, 2013, 2012 and 2011, respectively. The Company also granted restricted stock and stock options under the Equity Plan, as discussed in Note 9.
The Company’s insurance company subsidiaries are required to prepare statutory financial statements in accordance with statutory accounting practices prescribed or permitted by the insurance department of the state of domicile. Statutory accounting practices primarily differ from GAAP by charging policy acquisition costs to expense as incurred and establishing future policy benefit liabilities using different actuarial assumptions, as well as accounting for investments, certain assets and deferred taxes on a different basis. Permitted statutory accounting practices encompass all accounting practices not so prescribed, which have been specifically allowed by state insurance authorities. The Company’s insurance company subsidiaries have no material permitted accounting practices.
The statutory net income (loss) and statutory capital and surplus for the Company’s insurance company subsidiaries are as follows:
The Company has an Investment Management Agreement, amended and restated on June 1, 2011, with White Mountains Advisors, LLC (WMA), a subsidiary of White Mountains Insurance Group, Ltd. White Mountains Insurance Group, Ltd. is a related party who beneficially owns 20,048,879 shares of the Company’s common stock. This agreement, as amended, provides for investment advisory services related to the Company’s invested assets and portfolio management services. Expenses amounted to $16.9, $16.0 and $15.5 for the years ended December 31, 2013, 2012 and 2011, respectively. As of December 31, 2013 and 2012, amounts due to WMA were $4.3 and $3.9, respectively.
The primary profitability measure that management uses to manage segment results is pre-tax adjusted operating income (loss). Pre-tax adjusted operating income is defined as net income, excluding after-tax net realized investment gains (losses) that are not reflective of the performance of the Company's insurance operations. Excluded gains (losses) are associated with investment sales or disposal, other-than-temporary investment impairments, changes in the fair value of mark-to-market investments and derivative investments (except for certain S&P 500 options) and changes in the fair value of embedded derivatives related to our fixed indexed annuity product.
In the Deferred Annuities segment, certain net investment gains (losses) related to the FIA product sold in the late 1990s are considered related to the performance of insurance operations and included in the pre-tax adjusted operating income. This business credits interest to policyholder accounts based on equity market performance, which is recorded in interest credited. The Company purchases S&P 500 options to economically hedge exposure to this block of business, which are not designated for hedge accounting. The realized gains from these are used to meet these obligations.
Benefits. Benefits offers products and services related to medical stop-loss insurance, limited benefit medical insurance, group life insurance, accidental death and dismemberment insurance and disability income insurance, mainly to employer groups.
Deferred Annuities. Deferred Annuities offers fixed and variable deferred annuities, including fixed indexed annuities, to consumers who want to accumulate tax-deferred assets for retirement.
Income Annuities. Income Annuities offers single premium immediate annuities, or SPIAs, to customers seeking a reliable source of retirement income or to protect against outliving their assets during retirement. In addition, Income Annuities services a block of structured settlement policies sold to fund third party personal injury settlements. Income Annuities also offers funding services options to existing structured settlement clients.