The Company derives its revenues principally from 1) premiums earned for insurance coverages provided to insureds; 2) net investment income; and 3) net realized capital gains and losses.
Profitability of our insurance operations depends heavily upon the Company’s underwriting discipline, as we seek to manage exposure to loss through favorable risk selection and diversification, management of claims, use of reinsurance, the size of our in force block, actual mortality and morbidity experience, and our ability to manage our expense ratio, which we accomplish through economies of scale and management of acquisition costs and other underwriting expenses.
The 2013 financial results are driven by our conservative business management and traditional life product sales. The low interest rate environment continues to impact our results and our industry as investment yields are an integral component of our business operations.
Our assets grew $41 million in 2013 and totaled $1.2 billion as of December 31, 2013.
Realized net investment losses during 2013 of $0.3 million were recognized as $0.4 million of losses was recorded on sales of two equity mutual fund issuers, offset by gains of $0.1 million on calls of bond securities. In 2012 and 2011 gains resulted primarily from sales of securities that had been previously impaired due to declines in market values. These gains were partially offset by other-than-temporary impairments on investment securities and other long-term assets that were recorded in 2012 and 2011 of $1,319,000 and $631,000, respectively, reported as realized losses.
2013 changes in reserves resulted in liability increases resulting from increased sales of endowment products that build up reserves at a faster pace than whole life longer term mortality based products. Additionally, the sustained low interest rate environment also results in a higher reserve development due to the lower interest yield assumptions over the past several years.
It is predicted that the interest rate environment will remain low for the foreseeable future, which translates into lower profit margins for insurers. We have been impacted by the historically low interest rate environment over the past several years as our fixed income investment portfolio, primarily invested in callable securities, has been reinvested at lower yields. The Company’s conservative investment strategy has not changed but we have focused new purchases into holding of state municipalities and essential service issuers compared to our historical investment in U.S. government holdings. Our investment earnings also impact the reserve and Deferred Acquisition Costs (“DAC”) balances, as assumptions are used in the development of the balances. Due to the recent decline in investment yields on our portfolio, our projection of long-term investment returns has declined. This has resulted in increasing the reserves on policies issued in the current year, as well as reducing the DAC asset.
As an increasing percentage of the world population reaches retirement age, we believe we will benefit from increased demand for living benefit products rather than death products, as aging baby boomers will require cash accumulation to pay expenses to meet their lifetime income needs. Our ordinary life products are designed to accumulate cash values to provide for living expenses in a policy owner's later years, while continuously providing a death benefit.
On October 7, 2013, the Company entered into a purchase agreement with Magnolia Guaranty Life Insurance Company ("MGLIC") in the amount of $5.2 million. MGLIC is a Mississippi Company that began writing business in 1992 and issues primarily industrial life policies through independent funeral homes in the state of Mississippi. MGLIC had approximately $8.6 million of admitted assets as of December 31, 2013. This transaction was finalized on March 7, 2014 and will add a Mississippi domiciled company to our home service segment.
Premium Income. Premium income derived from life, accident and health, and property insurance sales, increased 3.7% during 2013. The increase resulted primarily from renewal premiums, which totaled $148.3 million, $142.2 million and $135.1 million in 2013, 2012 and 2011, respectively. New sales, termed as first year premiums, increased 4.0%, 6.1%, and 6.6% in the life segment in 2013, 2012 and 2011. Endowment sales represent a significant portion of new business sales internationally with the 20 year endowment and endowment to age 65 as our top products. In addition, most of our life insurance policies contain a policy loan provision, which allows the policyholder to use cash value of a policy to pay premiums. The policy loan asset balance increased 13.7% and 10.0% in 2013 and 2012, year over year.
Investment income from fixed maturity securities accounted for approximately 84.8% of total investment income for the year ended December 31, 2013. We have reduced investment holdings in bonds of U.S. Government-sponsored enterprises, such as Federal National Mortgage Association (“FNMA”) and Federal Home Loan Mortgage Corporation (“FHLMC”), which comprised 7.6% of the total fixed maturity portfolio based on amortized cost at December 31, 2013. We have increased our investment purchases of corporate and municipal securities over the past several years, focusing on utility service sectors in these security categories. In addition, we currently have $35.0 million invested in equity securities related to bond mutual funds as these securities offer a competitive yield with a shorter duration.
Included in net realized investment gains and losses are OTTI on investments. We recorded an OTTI write-down in 2012 of $1,319,000 related to one coal powered energy issuer debt security holding which has a maturity date in 2017. In 2011 we recorded an OTTI of $70,000 related to one American Airlines (“AMR”) debt security holding that had a maturity date in 2012. AMR declared bankruptcy in November of 2011. We also recorded an impairment in 2011 of $0.6 million related to an investment property that was acquired as part of the ONLIC acquisition in 2008.
Decrease in Fair Value of Warrants. In 2012, all of the remaining warrants outstanding were either exercised or converted into our Class A common stock, due to an election by the warrant holders, or expiration. We recognized a gain on the decrease in fair value of warrants of $0.5 million and $1.1 million in 2012 and 2011, respectively. The 2012 and 2011 gain was the result of the significant decrease in the number of warrants outstanding due to expirations and exercises. The warrant liability was calculated using the Black-Scholes option pricing model, which projects the future value of the warrants when they expire. Current accounting standards require the change in the value of the warrant liability be recorded as a component of revenues. When the liability increased we incurred a loss, and when the liability decreased we recognized income. There were no warrants outstanding during 2013.
Policy surrenders increased in 2013, 2012 and 2011, but remained at a level that represents approximately 0.5% of direct ordinary whole life insurance inforce. The increase in surrender expense is primarily related to our international business and is expected to increase over time due to the aging of this block of business. A significant portion of surrenders relates to policies that have been in force over fifteen years and no longer have a surrender charge associated with them. Total direct insurance inforce reported in 2013 was $4.7 billion compared to $4.6 billion in and 2012 and 2011.
Endowment benefits increased in 2012 and decreased slightly in 2013. We have a series of international policies that carry an immediate endowment benefit of an amount selected by the policy owner. These benefits have been popular in the Pacific Rim and Latin America, where the Company has experienced increased interest in our guaranteed products in recent years. Like policy dividends, annual guaranteed endowments are factored into the premium and, as such, the increase has no impact on profitability. The Company expects these benefits to continue to increase as this block of business increases and persists.
Reserves. The change in future policy benefit reserves has increased 11.3% and 14.4% in 2013 and 2012 due primarily to the current low interest rate environment necessitating higher reserves for policies issued in the last few years due to lower long term yield projections compared to prior assumptions. In addition, we continue to experience growth in new sales of endowment products, which require higher initial reserve levels, than whole life products. Endowment sales totaled approximately $14.3 million, $14.3 million and $12.3 million in 2013, 2012 and 2011, respectively.
Commissions. Commission expense fluctuates in a direct relationship to new and renewal insurance premiums and has increased 2.7% in 2013 compared to 2012 as premium revenues have increased.
Deferred Policy Acquisition Costs. Capitalized deferred policy acquisition costs ("DAC") were $29.4 million, $29.1 million and $27.8 million in 2013, 2012 and 2011. These costs will vary based upon successful efforts related to newly issued policies and renewal business. Significantly lower amounts are capitalized related to renewal business in correlation with the lower commissions paid on that business compared to first year business which have higher commission rates.
Amortization of deferred policy acquisition costs is impacted by persistency and may fluctuate from year to year. Amortization in 2013 increased as we experienced lower persistency in both the life and home service segment. Amortization costs increased in 2012 compared to 2011 as a result of the asset balance growth. Policy persistency was comparable in the life segment for 2012 and 2011 periods presented, but declined in the Home Service segment in 2012 and 2011, resulting in higher amortization. In addition, the prolonged low interest rate environment impacted the assumptions used in the development of the DAC asset for new policies issued and resulted in a lower DAC balance and decreased amortization by approximately $0.2 million and increased amortization by $0.4 million and $1.4 million in 2013, 2012 and 2011, respectively.
Premiums. Premium revenues increased for 2013 compared to 2012 and 2011, due to higher international renewal premiums, which have experienced strong persistency as this block of insurance ages. First year premiums increased in the current year, reflecting improved new business production in all products internationally. Sales from Colombia, Ecuador, Taiwan and Venezuela represented the majority of the first year premium increase.
Endowment sales represent a significant portion of new business sales internationally, as these products continue to exceed our whole life sales in the current markets. In addition, most of our life insurance policies contain a policy loan provision, which allows the policyholder to use cash value of a policy to pay premiums. The policy loan asset balance increased 13.7% year over year.
We continue to report strong first year and renewal premiums in our top producing countries as noted above. Our international business and premium collections could be impacted by future changes relative to laws, regulations or economic events in the countries from which we accept applications. Currently Venezuela is experiencing civil unrest due to local demonstrations against crime, corruption and soaring inflation. In addition, there were recent law changes in Colombia that may impact activities of our independent consultants. See "Item 1A. Risk Factors" on pages 7 and 13 for additional information.
A number of domestic life insurance companies we acquired had blocks of accident and health insurance policies. We have ceded this business to Puritan Life Insurance Company ("Puritan"), an unaffiliated insurance company under a coinsurance agreement, under which it assumes substantially all of our accident and health policies. The premium amounts ceded under the coinsurance agreement in the years ended December 31, 2013, 2012, and 2011 were $56 thousand, $3.9 million and $4.5 million, respectively. The coinsurance agreement allows for full assumption by Puritan of this business upon approval by state insurance authorities. The decrease in premiums ceded for 2013 was due to the fact that Puritan received state approval in many states and has obtained over 95% assumption of all policies during 2013.
Realized Investment Gains, Net. Realized losses of $0.2 million and gains of $0.5 million and $1.3 million were recognized in 2013, 2012 and 2011, due to the sale of two bond mutual fund holdings in 2013 and due to disposals in 2012 and 2011 of previously impaired equity mutual funds.
Increase in Future Policy Benefit Reserves. Policy benefit reserves in 2013 increased compared to the same period in 2012, primarily from the effect of the current low interest rate environment on reserve development for policies issued in the last few years which have higher reserve build up compared to prior issue years. The accounting guidance of long duration contracts we sell requires the Company to “lock in” the original assumptions such as mortality, interest, surrenders and expenses at the time the initial policies are written, therefore gains or losses attributable to actual experience that differs from the original assumptions flows through the income statement in the period where in the differences occur.
Policyholder Dividends. Policyholder dividends have risen at a rate that corresponds with the growth rate in new international life insurance premiums. The Company issues long duration participating policies to foreign residents that are expected to pay dividends to policyholders based upon actual experience. Policyholder dividends are factored into the premiums and have no impact on profitability.
Our Home Service Insurance segment provides pre-need and final expense ordinary life insurance and annuities to middle and lower income individuals primarily in Louisiana, Mississippi and Arkansas. Our policies in this segment are sold and serviced through funeral homes and a home service marketing distribution system utilizing over 350 employees and independent agents.
Net Investment Income. Net investment income has increased as our overall portfolio yield has increased 13 basis points from 2012 yield as discussed in the Consolidated Results of Operations above.
Increase in Future Policy Benefit Reserves. The current year change in reserves was minimal as premiums were relatively flat and lapse experience was comparable to 2012. We noted increased lapse experience in 2012 compared to 2011. We believe the increase in lapses was due to economic pressures including increased unemployment.
Policyholders' dividends. The increase in 2012 compared to prior and subsequent years resulted from a manual adjustment that was properly set up in 2012 in the policy administration system to appropriately reflect increasing policy values from annual paid up additions. This one time increase in dividends paid and single premium revenue of approximately $180,000 had no impact on the overall segment earnings for the year 2012. The reserve liability had been previously set up relative to this policy feature and was decreased by $35,000 based upon the system calculated value.
Capitalization and Amortization of Deferred Policy Acquisition Costs ("DAC"). DAC capitalization is directly correlated to fluctuations in first year commissions. Amortization was relatively level as we experienced comparable lapse rates in the three years presented in this segment. We monitor lapse rates as a key component of our insurance operations. Amortization in 2011 includes an adjustment that resulted in an increase of $0.3 million due to a refinement in an estimate using system generated information related to SPLIC assumptions.
This segment represents the administrative support entities to the insurance operations whose revenues are primarily intercompany and have been eliminated in consolidation under GAAP, which typically results in a segment loss. In 2012 and 2011 the fair value adjustment related to the Company's warrants to purchase Class A common stock were recorded which resulted in a gain of $0.4 million and $1.1 million. These amounts fluctuate due to the movement in our Class A common stock price and fair value calculation for warrants using the Black-Scholes valuation model. There were no warrants outstanding during 2013.
Financial stability and the prevention of capital erosion are important investment considerations for the Company. A primary investment goal is the conservation of assets due to the long-term nature of a significant portion of our liabilities. The administration of our investment portfolios is handled internally, pursuant to board-approved investment guidelines, with all trading activity approved by a committee of each entity’s respective board of directors. The guidelines used require that bonds, both government and corporate, are of high quality, investment grade and comprise a majority of the investment portfolio. State insurance statutes prescribe the quality and percentage of the various types of investments that may be made by insurance companies and generally permit investment in qualified state, municipal, federal and foreign government obligations, high quality corporate bonds, preferred and common stock, mortgage loans and real estate within certain specified percentages. The assets selected are intended to mature in accordance with the average maturity of the insurance products and to provide the cash flow for our insurance company subsidiaries to meet their respective policyholder obligations.
(1) Includes $3.8 million and $6.1 million of U.S. Government agencies and government-sponsored enterprise for the years ended December 31, 2013 and 2012, respectively.
At December 31, 2013, investments in fixed maturity and equity securities were 88.7% of our total cash, and cash equivalents and investments. All of our fixed maturities were classified as either available-for-sale or held-to-maturity securities at December 31, 2013 and 2012. We had no fixed maturity or equity securities that were classified as trading securities at December 31, 2013 or 2012.
Credit ratings reported for the periods indicated are assigned by a Nationally Recognized Statistical Rating Organization ("NRSRO") such as Moody’s Investors Service, Standard & Poor’s and Fitch Ratings. A credit rating assigned by a NRSRO is a quality based rating, with AAA representing the highest quality and D the lowest, with BBB and above being considered investment grade. In addition, the Company may use credit ratings of the National Association of Insurance Commissioners ("NAIC") Securities Valuation Office ("SVO") as assigned, if there is no NRSRO rating. Securities rated by the SVO are grouped in the equivalent NRSRO category as stated by the SVO and securities that are not rated by a NRSRO are included in the "other" category.
The Company was not exposed to holding investments in any category under special revenue bond that were greater than 10% based upon activity as of December 31, 2013.
Gross unrealized losses on fixed maturities available-for-sale amounted to $13.1 million as of December 31, 2013 and $1.1 million as of December 31, 2012. This increase in gross unrealized losses was due to an increase in the interest rate environment. There were $0.4 million and $0.2 million of gross unrealized losses on equity securities as of December 31, 2013 and 2012. In 2012 and 2011, the Company sold equity mutual fund holdings from the Life and Home Service segments and recorded realized gains of $0.6 million and $1.3 million due to market recovery since impairment at December 31, 2008. Information on unrealized gains and losses by category is set forth in our consolidated financial statements, Note 2 - Investments, in the "Notes to the Consolidated Financial Statements."
Our liquidity requirements are met primarily by funds provided from operations. Premium deposits and revenues, investment income and investment maturities are the primary sources of funds, while investment purchases, policy benefits, and operating expenses are the primary uses of funds. We historically have not had to liquidate investments to provide cash flow, and there were no liquidity issues in 2013 or 2012. Our investments consist of 88.8% of marketable debt securities and 6.0% of equity securities classified as available-for-sale that could be readily converted to cash for liquidity needs.
Cash flows from our insurance operations historically have been sufficient to meet current needs. Cash flows from operating activities were $81.4 million, $69.3 million and $64.3 million for the years ended December 31, 2013, 2012 and 2011, respectively. We have traditionally also had significant cash flows from both scheduled and unscheduled fixed maturity security calls, maturities, redemptions, and prepayments, which totaled $92.7 million, $326.7 million and $283.3 million in 2013, 2012 and 2011. These cash flows, for the most part, are reinvested in fixed income securities. Net cash outflows from investment activity totaled $84.9 million, $50.0 million and $85.1 million for the years ended December 31, 2013, 2012 and 2011, respectively. The outflows from investing activities for the year ended December 31, 2013, primarily related to the investment of excess cash and cash equivalents generated from operations during 2013. The Company's cash flows from financing activities were $1.7 million in 2013, $3.8 million in 2012 and $4.3 million in 2011.
At December 31, 2013, all of our insurance subsidiaries were above the required minimum RBC levels.
In 2013 and 2011, CICA contributed 50,000 and 150,000 shares of Citizens, Inc. Class A common stock to CNLIC as a capital contribution due to minimum capital and surplus considerations. The contributed shares had a fair market contributed value of $443 thousand and $1.2 million. These shares were subsequently purchased by Citizens, Inc., the ultimate parent, for $440 thousand and $1.1 million cash in 2013 and 2011, respectively. Citizens, Inc. also purchased Class A Common shares in 2012 from CTI with an approximate fair value of $0.5 million. These transactions have been eliminated under consolidation accounting rules.
The Company does not have off-balance sheet arrangements at December 31, 2013 and, therefore, does not expect any future effects on the Company's financial condition related to any such arrangements. We do not utilize special purpose entities as investment vehicles, nor are there any such entities in which we have an investment that engages in speculative activities of any nature, and we do not use such investments to hedge our investment positions.
Citizens is a holding company and has had minimal operations of its own. Our assets consist of the capital stock of our subsidiaries, cash, fixed income securities, mutual funds and investment real estate. Our cash flows depend primarily upon the availability of statutorily permissible payments, primarily payments under management agreements from our two primary life insurance subsidiaries, CICA and SPLIC. The ability to make payments is limited by applicable laws and regulations of Colorado, CICA's state of domicile, and Louisiana, SPLIC's state of domicile, which subject insurance operations to significant regulatory restrictions. These laws and regulations require, among other things, that these insurance subsidiaries maintain minimum solvency requirements and limit the amount of dividends these subsidiaries can pay to the holding company. We historically have not relied upon dividends from subsidiaries for our cash flow needs. However, CICA and SPLIC both dividend available funds from time to time in relation to new acquisition target strategies. CICA has contributed amounts in the form of dividends to Citizens totaling $5.4 million and $6.8 million in 2012 and 2011, respectively.
Management has discussed the development and selection of its critical accounting estimates with the Audit Committee of the Board of Directors, and the Audit Committee has reviewed the disclosure presented below relating to them. See Footnote No. 1, “Summary of Significant Accounting Policies,” of the Notes to our Financial Statements for further information on our critical accounting policies.
A recoverability test that considers, among other things, actual experience and projected future experience is performed at least annually. These annual recoverability tests initially calculate the available premium (gross premium less benefit and expense portion of premium) for the next 30 years. The available premium per policy and the deferred policy acquisition costs per policy are then calculated. The deferred policy acquisition costs are then evaluated over two methods utilizing reasonable assumptions and two other methods using pessimistic assumptions. The two methods using reasonable assumptions illustrate an early-deferred policy acquisition recoverability period. The two methods utilizing pessimistic assumptions still support early recoverability of our aggregate deferred policy acquisition costs. Management believes that our deferred policy acquisition costs and related amortization for the years ended December 31, 2013, 2012 and 2011 limits the amount of deferred costs to its estimated realizable value. This belief is based upon the analysis performed on capitalized expenses that vary with and are primarily related to the acquisition of new and renewal insurance business, utilization of the factor method and annual recoverability testing.
A recoverability test that considers, among other things, actual experience and projected future experience is performed at least annually. These annual recoverability tests initially calculate the available premium (gross premium less benefit and expense portion of premium) for the next thirty years. The CCRA is then evaluated utilizing reasonable assumptions. Management believes our CCRA and related amortization is recoverable for the years ended December 31, 2013, 2012 and 2011. This belief is based upon the analysis performed on estimated future results of the block and our annual recoverability testing.
If management determines that an investment experienced an OTTI, management must then determine the amount of OTTI to be recognized in earnings. If management does not intend to sell the security and it is more likely than not that the Company will not be required to sell the security before recovery of its amortized cost basis less any current period loss, the OTTI will be separated into the amount representing the credit loss and the amount related to all other factors. The amount of OTTI related to the credit loss is determined based on the present value of cash flows expected to be collected and is recognized in earnings. The amount of OTTI related to other factors will be recognized in other comprehensive income, net of applicable taxes. The previous amortized cost basis less the OTTI recognized in earnings will become the new amortized cost basis of the investment. If management intends to sell the security or more likely than not will be required to sell the security before recovery of its amortized cost basis less any current period credit loss, the OTTI will be recognized in earnings equal to the entire difference between the investment's amortized cost basis and its fair value at the balance sheet date. Any recoveries related to the value of these securities are recorded as an unrealized gain (as other comprehensive income (loss) in shareholders' equity) and not recognized in income until the security is ultimately sold.
A deferred tax asset or deferred tax liability is recorded only if a determination is made that it is more-likely-than-not that the tax treatment on which the deferred tax item depends will be sustained in the event of an audit. These determinations inherently involve management's judgment. In addition, the Company must record a tax valuation allowance with respect to deferred tax assets if it is more-likely-than-not that the tax benefit will not be realized. This valuation allowance is in essence a contra account to the deferred tax asset. Management must determine the portion of the deferred tax asset and resulting tax benefit that may not be realized based upon judgment of expected outcomes. Due to significant estimates utilized in establishing the valuation allowance and the potential for changes in facts and circumstances, it is reasonably possible that we will be required to record a valuation allowance in future reporting periods. Such a charge could have a material adverse effect on our results of operations, financial condition and capital position.