The following selected financial data, except for non-GAAP financial measures, have been derived from our consolidated financial statements. The consolidated income statement data for the years ended December 31, 2011, 2010 and 2009 and the consolidated balance sheet data as of December 31, 2011 and 2010, except for the non-GAAP financial measures, have been derived from our consolidated financial statements included elsewhere herein. The consolidated income statement data for the years ended December 31, 2008 and 2007 and the consolidated balance sheet data as of December 31, 2009, 2008 and 2007, except for the non-GAAP financial measures, have been derived from the consolidated financial statements not included herein. The selected financial data presented below should be read in conjunction with
See Note 19 to the Consolidated Financial Statements for financial results of our segments, including our operating revenues, for each of the last three fiscal years.
As we continue to lay the groundwork for future growth, we, and the life insurance industry as a whole, face a difficult environment in managing both capital and risk. The ongoing concerns over European sovereign debt and credit markets, the prolonged low-interest rate environment, the United States’ growing deficit, prolonged high-levels of unemployment and the slow economic recovery continue to put pressure on financial services companies. We remain proactive in maintaining our spreads and capital levels in 2012 to continue creating stockholder value.
To improve our asset yield in this environment, we have been and plan to continue increasing our investments in commercial mortgage loans we underwrite. While interest rates on recently written loans have decreased consistent with the overall level of interest rates, they continue to be an attractive investment opportunity. During 2011, we originated mortgage loans of $956.9 with an average yield of approximately 5.6%. This asset class comprised 9.6% of our invested assets as of December 31, 2011, up from 7.3% as of December 31, 2010.
Filled key leadership positions and began infrastructure development to expand our presence in the group life and disability income marketplace;
Started product and infrastructure development to offer a new variable annuity product; and
Our 2012 focus is to continue executing on our Grow & Diversify initiatives, while at the same time remaining focused on our core businesses and maintaining our financial strength ratings. We believe the Grow & Diversify initiatives will help us expand into less interest sensitive products and markets. In 2012, we are targeting the following:
We believe we have adequate levels of capital to support our current business and to fund organic and transactional growth. We continue to look for acquisition opportunities that fit our strategies and help us drive improved earnings. However, the success of these and other strategies may be affected by the factors discussed in Item 1A - “Risk Factors” and other factors as discussed herein.
Making the determinations as to whether one or more of these conditions exist often requires judgment. As part of this process, we analyze investments in an unrealized loss position to determine whether the decline in value is other-than-temporary. The impairment review involves the investment management team, including our portfolio asset managers. To make this determination, we consider both quantitative and qualitative criteria including:
any reduction or elimination of dividends or nonpayment of scheduled interest;
value and the amortized cost basis of the security in the period of determination. In determining our intent to sell a security or whether it is more likely than not that we will be required to sell a security, we evaluate facts and circumstances such as decisions to reposition our security portfolio, sales of securities to meet cash flow needs and sales of securities to capitalize on favorable pricing.
If we do not intend to sell a security, but believe we will not recover all the security’s contractual cash flows, the amortized cost is written down to our estimated recovery value and recorded as a realized loss in our consolidated statements of income, as this is determined to be a credit loss. The remainder of the decline in fair value is recorded as OTTI on fixed maturities not related to credit losses in OCI as this is determined to be a noncredit or recoverable loss. We determine the estimated recovery values by using discounted cash flow models that consider estimated cash flows under current and expected future economic conditions with various assumptions regarding the timing and amount of principal and interest payments. The recovery value is based on our best estimate of expected future cash flows discounted at the security’s effective yield prior to impairment. Our best estimate of future cash flows is based on assumptions, including various performance indicators, such as historical default and recovery rates, credit ratings, current delinquency rates and the structure of the issuer/security. These assumptions require the use of significant judgment and include the probability of issuer default and estimates regarding timing and amount of expected recoveries. In addition, projections of expected future fixed maturity security cash flows may change based upon new information regarding the performance of the issuer and/or underlying collateral. Future impairments may develop if actual results underperform current cash flow modeling assumptions, which may be the result of macroeconomic factors, changes in assumptions used and specific deterioration in certain industry sectors or company failures.
For further discussion of our evaluation of investments for OTTI, see Note 6 to the Consolidated Financial Statements.
Fixed maturities include bonds, mortgage-backed securities and redeemable preferred stock. We classify all fixed maturities as available-for-sale and carry them at fair value. We report net unrealized investment gains and
losses related to our available-for-sale securities, which is equal to the difference between the fair value and the amortized cost, in AOCI in stockholders’ equity. We report net realized investment gains and losses 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, 2011 and 2010, priced 95.9% and 95.6%, respectively, of our fixed maturities. The third-party independent pricing services we use have policies and processes to ensure that they are using objectively verifiable, observable market data, including documentation on the observable market inputs used to determine the prices, by major security type. 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 to prepare evaluations. 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 analyze the prices received from the pricing services to ensure they represent a reasonable estimate of fair value, as well as the overall reasonableness and consistent use of inputs. We perform analytical reviews of changes in prices between reporting periods, periodic deep-dive analyses into pricing of selected securities, and back-testing of selected sales activity to determine whether there are any significant differences between the market price used to value the security prior to sale and the actual sales price. Annually, we review documentation of the pricing methodologies and inputs used, by asset class, and participate in due diligence procedures, including walkthroughs of security pricing procedures and corroboration of prices with multiple pricing services for selected securities. Based upon our procedures, we believe that the values provided by our pricing services are accurate and determined in accordance with U.S. GAAP. We have engaged our pricing services in discussion regarding the valuation of a security; however, it has not been our practice to adjust their prices.
As of December 31, 2011 and 2010, $936.4, or 4.1%, and $892.9, or 4.2%, respectively, of our fixed maturities portfolio was invested in private placement securities, a significant portion of which are not actively traded. The fair values of these assets are typically determined using a discounted cash flow approach. The valuation model requires the use of inputs that are not market-observable and involves significant judgment. The discount rate is based on the current Treasury curve adjusted for credit and liquidity factors. The appropriate illiquidity adjustment is estimated based on illiquidity spreads observed in transactions involving other similar securities. In limited situations, private placement securities are valued through the use of a single broker quote because the security is very thinly traded. In such situations, we consider the fair value a Level 3 measurement.
Fixed maturities categorized as Level 3 investments were $921.0 and $926.9 as of December 31, 2011 and 2010, respectively. As of December 31, 2011 and 2010, we had net unrealized gains of $75.2 and $57.9, respectively, on our Level 3 fixed maturities. For the year ended December 31, 2011 and 2010, we reported net realized losses of $4.5 and $5.0, respectively, on our Level 3 fixed maturities.
We defer as assets certain policy acquisition costs, including commissions, distribution costs and other underwriting costs, that vary with, and are primarily related to, the production of new and renewal business. We limit our deferral to acquisition expenses contained in our product pricing assumptions. When our DAC asset is amortized, it reduces income. We also defer as assets certain sales inducements, including inducement interest, which are included within other assets on our Consolidated Balance Sheets. When our DSI asset is amortized it increases interest credited and reduces income. The following table summarizes our DAC asset balances by segment:
In our Deferred Annuities, Income Annuities and Life segments, 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, or 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. It is common for deferred annuity policies to lapse after the surrender charge period expires. To amortize DSI, we use the same methodology, assumptions and amortization period as used in amortizing DAC.
We regularly conduct DAC and DSI recoverability analyses, where we compare the current DAC asset balances with the estimated present value of future profitability of the underlying business. The DAC and DSI asset balances are considered recoverable if the present value of future profits is greater than the current DAC and DSI asset balances.
The following depicts the sensitivities for our DSI asset balance: if we changed our future lapse and withdrawal rate assumptions by a factor of 10%, the effect on the DSI asset balance is approximately $2.3; if we changed our future expense assumptions by a factor of 10%, the effect on the DSI asset balance is $0.2. Subsequent to the January 1, 2012 restatement of our DAC balance (discussed below), we expect the DAC and DSI asset balance to grow during 2012 as we write new business, and as this occurs, we expect the sensitivities discussed above to grow accordingly. In addition, depending on the amount and the type of new business written in the future, we may determine that other assumptions may produce significant variations in our financial results.
(1) The reductions in book value and adjusted book value are presented net of taxes of $(10.3) and $(17.8), respectively.
(2) Amounts are presented net of the accumulated effect of net unrealized investment gains of $(203.6), $(182.3) and $21.3, respectively.
The adoption of this standard in 2012 will not impact our deferral of commissions, premium taxes or premium-based assessments, as they are considered incremental direct costs and continue to be deferrable under the new guidance. For the year ended December 31, 2011, $89.9, or approximately 75%, of our total $118.8 deferred acquisition costs was related to commissions, premium taxes and premium-based assessments.
The most significant reduction in deferrals relates to costs for our wholesaler distribution structure. For the year ended December 31, 2011, these accounted for $13.0, or 11%, of total deferred acquisition costs. A significant portion of our wholesaler distribution expense is related to relationship management with key distributors such as financial institutions or BGAs. While we considered these activities critical to our distribution model, they do not meet the accounting standard criteria for direct contract selling activities and are not deferrable under the new standard. Upon adoption, we expect these deferrals will decrease by approximately 80%, which was $10.4 for the year ended December 31, 2011.
We compute liabilities for future policy benefits under traditional individual life and group life insurance policies on the level premium method, which uses a level premium assumption to fund reserves. We select the level of premiums at issuance so that the actuarial present value of future benefits equals the actuarial present value of future premiums. We set the interest, mortality and persistency assumptions in the year of issue and include provisions for adverse deviations. These liabilities are contingent upon the death of the insured while the policy is in force. We derive mortality assumptions from both company-specific and industry statistics. We discount future benefits at interest rates that vary by year of policy issue. These interest rates are set initially at a rate consistent with portfolio rates at the time of issue, and grade to a lower rate, such as the statutory valuation interest rate, over time. Assumptions are made at the time each policy is issued, and do not change over time unless the liability amount is determined to be inadequate to cover future policy benefits. The provisions for adverse deviations are intended to provide coverage for the risk that actual experience may be worse than locked-in best-estimate assumptions.
Our primary sources of revenues from our insurance operations are premiums, net investment income and policy fees and contract charges. Our primary sources of expenses from our insurance operations are policyholder benefits and claims, interest credited to policyholder reserves and account balances, and general
business and operating expenses, net of DAC. We allocate shared service operating expenses to each segment using multiple factors, including employee headcount, allocated investments, account values and time study results. We also generate net realized investment gains (losses) on sales or impairment of our investments and changes in fair value on our equity trading portfolio.
Each of our four operating 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.
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 fund limited partnerships and interest expense from amortization of tax credit investments.
In the following paragraphs, we provide definitions of our non-GAAP measures. For a reconciliation of these non-GAAP measures to their most directly comparable GAAP measures, see Item 6 - “Selected Financial Data”.
Pre-tax adjusted operating income is adjusted operating income on a pre-tax basis. It also represents the cumulative total of segment pre-tax adjusted operating income, which at the segment level is a GAAP measure. Income from operations before income taxes is the most directly comparable GAAP measure to pre-tax adjusted operating income.
Adjusted Operating Income per Common Share - Basic and Adjusted Operating Income per Common Share - Diluted
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 outstanding warrants because the warrant holders only participate in dividends and would not be entitled to proceeds in the event of a liquidation or winding down of our company should such event precede the exercise of the outstanding warrants.
We believe investors find it useful to review the results 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.
The following discussion should be read in conjunction with our consolidated financial statements and related Notes.
(1) Represents a non-GAAP measure. For a definition of this measure, see - “Use of non-GAAP Financial Measures.”
Net income decreased $1.3 as a result of lower net realized investment gains partially offset by higher pre-tax adjusted operating income. In addition, the provision for income taxes decreased $8.8 primarily due to lower pre-tax income and an increase in tax credits, which drove a lower effective tax rate, 28.5% for the year ended December 31, 2011 compared to 30.5% for 2010.
Pre-tax adjusted operating income increased on higher profitability in three of our four operating segments. Included in our 2011 segment results is $23.0 of net investment income, received mainly in the fourth quarter of 2011, related to investment prepayments (primarily bond make-whole premiums from investments in our Deferred Annuities and Life segments, and our prepayment speed adjustment), offset by related DAC and DSI unlocking expenses totaling $4.8. This compares to $14.5 of prepayment related income in 2010. In addition, other underwriting and operating expenses increased $39.4 over prior year levels, primarily due to higher employee-related expenses and professional services expenses, including costs related to our Grow and Diversity initiatives, as well as operational expenses related to the American United Life (AUL) business (discussed further below).
Our Benefits segment’s profitability increased $7.6 due to an improved stop-loss loss ratio on a larger block of medical stop-loss business. On July 1, 2011, we assumed medical stop-loss policies from AUL and acquired the renewal rights for their stop-loss business. The AUL transaction accounts for the majority of the increase in premiums and policyholder benefits and claims. For the full year 2011, the loss ratio decreased to 63.1%, from 64.9%, in 2010.
Our Life segment’s profitability decreased $10.0 primarily due to the favorable impact of a $7.4 reserve release in the first quarter of 2010 and a $3.6 increase in individual claims. These items were partially offset by increased income on higher BOLI account values and $5.0 of investment prepayment related income.
Net income increased $72.6 as a result of net realized investment gains and higher pre-tax adjusted operating income, which also led to an increase in our tax provision. Pre-tax adjusted operating income increased on higher profitability in three of our four operating segments as discussed below in more detail.
Our Deferred Annuities segment’s profitability increased $22.7 as the investment margin increased $38.2 on a $1.6 billion increase in our fixed account values, driven by strong sales for the three years ended 2010. Partially offsetting the increase in the investment margin was a $16.0 increase in DAC amortization also related to the increase in fixed account values as our DAC balances grew from increased sales.
Our Income Annuities segment’s results decreased $9.2 due primarily to unfavorable mortality with mortality losses of $2.6 for 2010, compared to mortality gains of $5.1 for 2009. Slightly offsetting this was an improved interest spread on reserves, which increased to 0.57% for the year ended December 31, 2010 compared to 0.53% for the same period of 2009. This improvement was driven by increased originations of mortgage loans and a reduction in interest credited.
Our Life segment’s profitability increased $8.6 on impacts related to decreased individual insurance claims. Life’s results for the year ended December 31, 2010 also included a $7.4 benefit related to the release of bonus interest reserves and decreased amortization of deferred acquisition costs as the credited interest rate on our universal life products was adjusted downward to the guaranteed minimum over 2010. This was partially offset by a decrease in the BOLI return on assets (ROA) driven by a decrease in the PGAAP reserve amortization, and an increase in BOLI general account claims.
The increase in other underwriting and operating expenses of $27.2 was primarily related to the AUL transaction. Also contributing to the increase were higher employee related costs, increased commissions and $3.0 of expenses related to the expansion of our group life and disability operations as part of the Grow & Diversify strategy.
(2) 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, net of any related deferred sales inducement unlocking, and the MBS prepayment speed adjustment.
Interest credited increased $28.9, primarily due to a $1.4 billion increase in fixed annuities account values. The higher account values also led to a $13.4 increase in DAC amortization. Included in the interest credited and DAC amortization increases is $4.8 of DAC and DSI unlocking expense recorded in the fourth quarter of 2011 related to the investment prepayment income, offset by a $2.5 benefit from DAC unlocking in the third quarter of 2011.
Segment pre-tax adjusted operating income increased $22.7 driven by an increase in fixed account values and $4.9 of additional investment prepayment related income received in 2010, resulting in an increased investment margin. This was partially offset by an increase in DAC amortization which is also related to an increase in account value driven by higher sales.
Policy fees, contract charges, and other increased $2.5 primarily due to higher in force account values. Fees from our variable annuities increased $1.5 due to improved market conditions resulting in an increase in our variable annuities account values. The remaining increase is primarily due to an increase in surrender charges on higher withdrawals, which was expected given the growth in account values.
(1) 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 credited decreased $13.3 due to favorable changes in mortality experience, increased funding services activity and lower reserves. We experienced mortality gains of $0.3 for 2011, compared to losses of $2.6 for 2010. Funding services increased $5.9 during 2011 driven by an increase in the number of cases factored.
The following table sets forth the results of operations relating to our Life segment:
(2) Individual claims represents incurred claims, net of reinsurance, on our term and universal life policies.
(4) UL account value and BOLI account value represent our liabilities to our policyholders.
(5) UL 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 in the general account attributed to UL policies. The credited rate is the approximate rate credited on UL policyholder fixed account values. Interest credited is subject to contractual terms, including minimum guarantees. The UL interest spread is decreasing as the SPL product becomes a larger portion of the total UL account value. The SPL product’s cost of insurance and mortality and expense fee revenue is not reflected in the interest spread. The credited rate to
(6) Individual sales represents annualized first year premiums for recurring premium products, and 10% of new single premium deposits net of first year policy lapses and/or surrenders.
Segment pre-tax adjusted operating income decreased $10.0 primarily due to a $7.4 reserve release in the first quarter of 2010 causing a reduction in benefits and expenses. In addition, year-over-year individual claims were higher and we recorded unfavorable reserve modifications in 2011. Also contributing to the decrease was an increase in other underwriting and operating expenses due primarily to expenses related to our Grow & Diversify initiative and employee-related expenses. These items were partially offset by increased income on higher BOLI account values and investment prepayment related income.
Benefits and expenses increased $32.6 partially due to a bonus reserve decrease in 2010, which reduced total benefits and expenses by $7.4, which included the impact on DAC amortization.
Segment pre-tax adjusted operating income increased $8.6 primarily due to a $2.8 reduction in individual insurance claims, and a $7.4 benefit related to a 2010 first quarter credited rate reduction, discussed in further detail below.
Due to the low interest rate environment, the credited interest rate on a universal life product was adjusted downward beginning first quarter 2010 to the guaranteed minimum rate. For this product, bonus interest is not earned if the credited rate is equal to the guaranteed minimum. As a result, during the first quarter of 2010, we released bonus interest reserves of $6.0 recorded in policyholder benefits and claims, benefited from a $1.7 reduction in DAC amortization due to the unlocking of future assumptions and recorded a $(0.3) adjustment to policy fees, contract charges and other. In addition, policyholder benefits and claims decreased due to individual insurance claims, decreasing $2.8.
Interest credited increased $7.4 primarily due to growth in BOLI account value as a result of strong persistency and new sales in 2010.
Our Other segment’s pre-tax adjusted operating loss of $(10.7) for the year ended December 31, 2011 improved $0.7 from a loss of $(11.4) for the same period in 2010. Policy fees, contract charges, and other increased $4.2 due to higher broker-dealer concession revenue and advisory fees, which were partially offset by a $3.2 increase in related commissions.
Our investment portfolio is structured with the objective of supporting the expected cash flows of our liabilities and producing stable returns over the long term. The composition of our portfolio reflects our asset management philosophy of protecting principal and receiving appropriate reward for risk. Our investment portfolio mix as of December 31, 2011 consisted in large part of high quality fixed maturities and commercial mortgage loans we originated, as well as a smaller allocation of high yield fixed maturities, marketable equity securities, investments in limited partnerships (primarily tax credit investments and private equity funds) and other investments. Our marked-to-market portfolio of equity securities, also referred to as our equity investments, support investment strategies, as well as asset and liability matching strategies for certain long-duration insurance products. The equity investments include common stock, investments in REITs, and convertible bonds. We believe that prudent levels of equity investments offer enhanced long term, after-tax total returns to support a portion of our longest duration liabilities.
(3) Investments in private equity funds are carried at fair value, while our limited partnership interests related to tax credit investments are carried at amortized cost.
The increase in invested assets during the year ended December 31, 2011 is primarily due to portfolio growth generated by sales of fixed deferred annuities and a net increase in the fair value of our fixed maturities. As of December 31, 2011 we had net unrealized gains of $1.8 billion on our fixed maturities compared with $865.3 of net unrealized gains as of December 31, 2010. Contributing to the increase in net unrealized gains is a rise in market prices on older, higher-yielding fixed maturities in the current lower yield environment.
(2) The negative yield from affordable housing investments is offset by U.S. federal income tax benefits. The total impact to net income was $6.2, $4.6 and $3.7 for the years ended December 31, 2011, 2010 and 2009, respectively.
For the year ended December 31, 2011 net investment income increased 6.0% compared to 2010. This increase was driven by higher invested assets on strong sales of our fixed deferred annuities in 2009 through 2011. The income increase driven by growth in invested assets was partially offset by a decrease in the total net investment yields, which decreased to 5.30% in 2011 from 5.49% in 2010. The reduction in yields is the effect of the prolonged low interest rate environment as we have experienced lower yields on purchases and reinvestment of fixed maturities. Overall yields on fixed maturity purchases in 2011 were 198 basis points (bps) lower than the average yield on existing fixed maturities. Our yields would have been lower without the impact of prepayment related income. Included in our fixed maturity yields is the impact of bond prepayments and corporate action activity, such as make-whole and consent fees on early calls of fixed maturities. During 2011, these generated 8 bps of yield, compared to 4 bps in 2010. To improve our overall yields, we continued to increase our underwriting of commercial mortgage loans throughout 2011 and 2010.
For the year ended December 31, 2010, our portfolio produced net realized gains of $39.8, compared to losses of $(29.3) for the same period in 2009. This improvement was driven by a $65.6 decline impairments, which were $20.9 in 2010 compared to $86.5 in 2009.
(2) This primarily consists of changes in fair value on derivatives instruments, gains (losses) on calls and redemptions, and the impact of net realized investment gains (losses) on DAC and DSI.
The Securities Valuation Office, or SVO, of the 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. NAIC designations of “3” through “6” are referred to as below investment grade, which generally include securities rated BB+ or lower by Standard & Poor’s. In recent years, the NAIC adopted a modeling approach to determine the NAIC designation for RMBS and CMBS securities.
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 6.6% and 5.9% of our fixed maturities portfolio as of December 31, 2011 and 2010, respectively. To enhance our overall net investment yields, we strategically increased purchases of higher yield, S&P equivalent B and BB rated fixed maturities. We held NAIC 5 and 6 designated securities with gross unrealized losses of $30.7 as of December 31, 2011, of which $26.2, or 82.1%, related to six issuers. These issuers are current on their contractual payments and our analysis supports the recoverability of amortized cost.
The following table sets forth the fair value of our fixed maturities by sector, as well as the associated gross unrealized gains and losses and the percentage of total fixed maturities that each sector comprises as of the dates indicated:
Our fixed maturities holdings are diversified by industry and issuer. As of December 31, 2011, there was $93.3 of gross unrealized losses in financial sector securities, which were primarily associated with long dated
The portfolio does not have significant exposure to any single issuer. As of December 31, 2011 and 2010, the fair value of our ten largest corporate securities holdings was $1,505.0 and $1,276.9, or 9.3% and 8.8% of the portfolio, respectively. The fair value of our largest exposure to a single issuer of corporate securities was $221.5, or 1.4% of the portfolio, as of December 31, 2011. All of the securities related to this issuer have an NAIC rating of 2 or higher. As of December 31, 2010, the fair value of our largest exposure to a single issuer of corporate securities was $140.4, or 1.0%, all of which had an NAIC rating of 2 or higher.
As of December 31, 2011, the fair value of our fixed maturities in European Union countries was $1,391.2, or 6.1% of our total fixed maturities portfolio. These fixed maturities had gross unrealized losses of $32.9 as of December 31, 2011. The fair value of our ten largest European Union country holdings was $836.1, or 3.7% of the fixed maturities portfolio. The fair value of our largest single issuer exposure to a European Union country was $116.0, or 0.5% of the portfolio.
All of our RMBS and CMBS securities have prepayment options. Prepayments that vary in amount or timing from our estimates cause fluctuations in our yields due to an acceleration or deceleration of unamortized
The following table sets forth the fair value of the Company’s investment in agency, prime, and Alt-A RMBS and the percentage of total invested assets they represent:
On a fair value basis as of December 31, 2011, our Alt-A portfolio was 88.5% fixed rate collateral and 11.5% hybrid adjustable rate mortgages, or ARMs, with no exposure to option ARMs. Generally, fixed rate mortgages have performed better with lower delinquencies and defaults on the underlying collateral than both option ARMs and hybrid ARMs in the current economic environment. As of December 31, 2011 and 2010, respectively, $47.8, or 53.4%, and $62.6, or 56.2%, of the total Alt-A portfolio had an S&P equivalent credit rating of AAA.
There have been various government initiatives through the Obama administration’s Making Home Affordable program that may increase prepayment risk on our RMBS portfolio. Recent changes to HARP (Home
Affordable Refinance Program), which targets borrowers whose mortgages are owned or guaranteed by Freddie Mac or Fannie Mae, are current on their mortgages, and have loan-to-values exceeding 80% among other qualifying requirements, increases the risk of prepayment on our agency RMBS. Also, recent changes to HAMP (Home Affordable Modification Program) which targets employed borrowers facing financial hardship to reduce their mortgage payments may increase prepayments. Finally, President Obama’s State of the Union address included new initiatives aimed at helping qualified homeowners refinance. Increased policy risk from housing related initiatives such as these may result in higher than expected prepayments on our MBS in the future. We are monitoring the underlying collateral in our RMBS to determine the impact of these programs.
The following table sets forth the total fair value, and amortized cost of our non-agency CMBS by credit quality and year of origination (vintage). There were 12 securities having a fair value of $278.4 and an amortized cost of $306.3 that were rated A by S&P, while Moody’s and/or Fitch rated them AAA.
U.S. CMBS have historically utilized a senior/subordinate credit structure to allocate cash flows and losses. The structure was changed in late 2004 and was in transition into early 2005 when fully implemented to include super-senior, mezzanine and junior AAA tranches. This change resulted in increasing the credit enhancement (subordination) on the most senior tranche (super-senior) to 30%. The mezzanine AAAs were structured to typically have 20% credit enhancement and the junior AAAs 14% credit enhancement. Credit enhancement refers to the weighted-average percentage of outstanding capital structure that is subordinate in the priority of cash flows and absorbs losses first. Credit enhancement does not include any equity interest or property value in excess of outstanding debt. The super 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. Since 2010, new issues of U.S. CMBS (referred to as “CMBS 2.0”) have simpler structures. The CMBS 2.0 AAA credit enhancement averages approximately 17%, and the division of the AAA class into super-senior, mezzanine, and junior tranches is no longer present.
Prospector Partners, LLC, or Prospector, manages our portfolio of equity and equity-like investments, the majority of which are publicly traded common stock and convertible securities. 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. These securities are recorded at fair value, with changes in fair value recorded in net realized investment gains (losses). The common stock securities are included in trading marketable equity securities and the convertible securities are included in fixed maturities on our consolidated balance sheets.
The following table compares our total gross return on the equity component of our Prospector portfolio to the benchmark S&P 500 Total Return Index for the years ended December 31, 2011, 2010 and 2009.
Beginning in the second quarter of 2011, we implemented a new investment strategy focusing on real estate-related investments to enhance funding of the long duration liabilities in our Income Annuities segment. The investments for this strategy primarily consist of investments in REITs, which are included in trading marketable equity securities on our consolidated balance sheets. As of December 31, 2011, the real estate-related investments had a fair value of $147.7 and a total gross return of 2.7%.
Our mortgage loan department originates commercial mortgages and manages our existing commercial mortgage loan portfolio. The commercial mortgage loan holdings are secured by first-mortgage liens on income-producing commercial real estate, primarily in the retail, industrial and office building sectors. All loans are underwritten consistently to our standards based on loan-to-value (LTV) ratios and debt service coverage ratios (DSCR) based on income and detailed market, property and borrower analysis using our long-term experience in commercial mortgage lending. A large majority of our loans have personal guarantees and all loans are inspected and evaluated annually. We diversify our mortgage loans by geographic region, loan size and scheduled maturities. On our consolidated balance sheets, mortgage loans are reported net of an allowance for losses, deferred loan origination costs, unearned mortgage loan fees and a purchase accounting adjustment; however, the following tables exclude these items.
The stress experienced in the U.S. financial markets during the economic downturn and unfavorable credit market conditions led to a decrease in overall liquidity and availability of capital in the commercial mortgage loan market, which has led to greater opportunities for more selective loan originations, especially those loans in our range of specialization, $1.0 to $5.0. We believe a disciplined increase in our mortgage loan portfolio will help maintain the overall quality of our investment portfolio and obtain appropriate yields to match our policyholder liabilities. We continue to increase our investments in mortgage loans to improve our overall investment yields. This strategy has resulted in increased net investment yields when compared to fixed maturity investments. We originated $956.9 of mortgage loans during the year ended December 31, 2011 and expect to continue this pace of originations during 2012.
We use the LTV and DSCR ratios as our primary metrics to assess mortgage loan quality. The following table sets forth the LTV ratios for our gross mortgage loan portfolio:
The following table sets forth the DSCR for our gross mortgage loan portfolio:
The DSCR compares the amount of rental income a property is generating to the amount of the mortgage payments due on the property. DSCRs are calculated using the most current annual operating history for the collateral. As of December 31, 2011 and 2010, the mortgage loan portfolio had weighted-average DSCRs of 1.72
and 1.73, respectively. For loans originated during the years ended December 31, 2011 and 2010, 56.0% and 58.4%, respectively, had a DSCR of 1.60 or more. As of December 31, 2011, there were 70 loans with an aggregate carrying value of $120.8 that had a DSCR of less than 1.00. The average outstanding principal balance of these loans was $1.7 and these borrowers were current with respect to their loan payments.
The following table sets forth the gross carrying value of our investments in mortgage loans by geographic region:
The following table sets forth the gross carrying value of our investments in mortgage loans by property type:
The following table sets forth our gross carrying value of our investments in mortgage loans by contractual maturity date:
For more information and further discussion of our allowance of mortgage loans, see Note 5 to our consolidated financial statements.
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 sources of cash to pay dividends and meet its obligations, including payments of principal and interest on notes payable and tax obligations.
We have and intend to pay quarterly cash dividends on our common stock and warrants. During 2011, we declared and paid cash dividends of $0.23 per common share. The declaration and payment of future dividends to holders of our common stock will be at the discretion of our board of directors. See “- Dividends” below for further discussion.
Lingering effects of the credit market crisis that began in 2008 are still impacting the economy. During 2011, the pace of the economic growth continued to be slow with ongoing concerns over the United States’ growing deficit, European sovereign debt markets and continued high levels of unemployment. The credit
markets remain tight and interest rates have fallen to historic low levels with no indicators of increasing in the near future, as evidenced by the announcement of the United States Federal Reserve that it expects rates to continue at this low level through late 2014. In managing our business under the challenging market conditions over the past few years, we benefitted from our strong financial fundamentals. We actively manage our liquidity in light of changing market, economic and business conditions and we believe that our liquidity levels are more than adequate to cover our exposures, as evidenced by the following:
We continued to generate strong cash inflows on our deposit contracts (annuities and universal life policies) for the year ended December 31, 2011 despite the low interest rate environment, which has reduced the market demand for fixed annuities.
While certain lapses and surrenders occur in the normal course of business, these lapses and surrenders have not deviated materially from management expectations.
As of December 31, 2011, we had the ability to borrow, on an unsecured basis, up to a maximum principal amount of $300.0 under a revolving line of credit arrangement.
We continued to generate strong cash flows from operations, which were $987.5 for 2011, $925.7 for 2010 and $798.4 for 2009.
The amount of AOCI, net of taxes, on our balance sheet increased to $1,013.5 as of December 31, 2011 from $432.5 as of December 31, 2010. The primary driver was an increase in the fair value of our available-for-sale securities, due to the low interest rate environment.
(2) In a liquidity crisis situation, we could invoke the five-year payout provision so that the contract value with interest is paid out ratably over five years.
(3) The surrender value on these contracts is generally zero. Represents incurred but not reported claim liabilities.
(4) The biggest deterrent to surrender is the taxation on the gain within these contracts, which includes a 10% non-deductible penalty tax. Banks can exchange certain of these contracts with other carriers, tax-free. However, a significant portion of this business does not qualify for this tax-free treatment due to the employment status of the original covered employees and charges may be applicable.
(5) 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, which range from 1.0 - 1.5%. Given the current low interest rate environment, we do not expect significant changes in the persistency of this business.
Symetra’s insurance 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 subsidiaries hold highly liquid, high quality, shorter-term investment securities and other liquid investment-grade fixed maturities and cash equivalents to fund anticipated operating expenses, surrenders and withdrawals.
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 liquidity requirements, including under foreseeable stress scenarios.
Our capitalization increased $753.6 as of December 31, 2011, as compared to December 31, 2010 due to an increase in stockholders’ equity from our net income of $199.6 and a $581.0 increase in AOCI, primarily driven by an improvement in the fair value of our available-for-sale securities. We believe our capital level positions us well to capitalize on organic growth as well as pursue any potentially favorable acquisition opportunities.
The senior notes do not contain any financial covenants or any provisions restricting us from purchasing or redeeming capital stock, paying dividends or entering into a highly leveraged transaction, reorganization, restructuring, merger or similar transaction. In addition, we are not required to repurchase, redeem or modify the terms of any of the senior notes upon a change of control or other event involving Symetra.
Effective December 14, 2011, concurrently with the $300.0 senior unsecured revolving credit agreement discussed above, the prior $200.0 credit agreement, dated August 16, 2007 was terminated. This credit facility was set to mature in August 2012.
For a description of additional terms of this facility, see Note 12 to the Consolidated Financial Statements.
The payment of dividends and other distributions to Symetra by its insurance subsidiaries is controlled by insurance laws and regulations. In general, dividends in excess of prescribed limits are deemed “extraordinary” and require insurance regulatory approval. During the year ended December 31, 2011, Symetra received dividends of $52.0 from its insurance subsidiaries. Symetra received dividends of $40.0 from its insurance subsidiaries in 2010. Symetra received no dividends from its insurance subsidiaries in 2009.
Based on our statutory results, as of December 31, 2011, Symetra’s insurance subsidiaries may pay it dividends of up to $182.3 during 2012 without needing to obtain regulatory approval.
Years Ended December 31, 2011 and 2010. Net cash used in investing activities for 2011 was $1,647.9, an $808.9 decrease over the same period in 2010. This decrease was primarily the result of decreased purchases of fixed maturities, partially offset by increased mortgage loans originations. In addition, we strategically sold certain CMO securities during 2011 due to prepayment volatility and lower yielding fixed maturities, and increased our investments in mortgage loans to improve overall yields.
Years Ended December 31, 2010 and 2009. Net cash used in investing activities for 2010 was $2,456.8, a $314.5 increase over the same period in 2009. This increase was primarily the result of increased purchases of fixed maturities and higher originations of mortgage loans, as we deployed cash generated from sales of fixed deferred annuities and BOLI, as well as net proceeds from our IPO. These were partially offset by an increase in cash received from prepayments, maturities and calls on fixed maturities, and strategic sales of fixed maturities.
Cash flows from our financing activities are primarily driven by the amounts and timing of cash received from deposits into certain life insurance and annuity policies and proceeds from our issuances of common stock, as well as the amounts and timing of cash disbursed to fund withdrawals from certain life insurance and annuity policies, and dividend distributions to our stock and warrant holders. The following discussion highlights key drivers in the level of cash flows generated from our financing activities:
Years Ended December 31, 2011 and 2010. Net cash provided by financing activities for 2011 was $628.1, a $919.8 decrease over the same period in 2010. This was primarily driven by lower policyholder deposits as there were no BOLI deposits in 2011, compared to $461.0 in 2010, and higher deferred annuity policyholder withdrawals, which we anticipate as polices on a growing block of business move out of the surrender charge period. In addition, we received net IPO proceeds of $282.5 during the first quarter of 2010.
Years Ended December 31, 2010 and 2009. Net cash provided by financing activities for 2010 was $1,547.9, a $414.2 increase over the same period in 2009. This was primarily due to net IPO proceeds of $282.5 received during the first quarter of 2010 and an increase in policyholder deposits, primarily related to increased BOLI deposits offset by decreased fixed annuity deposits.
We enter into obligations with third parties in the ordinary course of our operations. The estimated cash payments related to these obligations as of December 31, 2011 are set forth in the table below. The estimated payments reflected in this table are based on management’s estimates and assumptions, which are necessarily subjective. Actual cash out flows in future periods will vary, possibly materially. Further, we do not believe that our cash flow requirements can be assessed based upon an analysis of these obligations as the funding of these future cash obligations will be from future cash flows from premiums, deposits, fees and investment income that are not reflected in the table below. In addition, our operations involve significant expenditures that are not based upon commitments, including expenditures for payroll and income taxes.
(4) Primarily comprised of unfunded mortgage loan commitments of $105.1, as of December 31, 2011.
(5) Includes minimum rental commitments on leases for office space and certain equipment. For more information, see Note 14 to the Consolidated Financial Statements.
We have audited the accompanying consolidated balance sheets of Symetra Financial Corporation as of December 31, 2011 and 2010, and the related consolidated statements of income, changes in stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2011. 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.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Symetra Financial Corporation at December 31, 2011 and 2010, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2011, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.
The consolidated financial statements have been prepared in conformity with U.S. generally accepted accounting principles (GAAP), including the rules and regulations of the Securities and Exchange Commission (SEC). The preparation of financial statements in conformity with GAAP requires the Company to make estimates and assumptions that may affect the amounts reported in the consolidated financial statements.
The Company’s group life and health insurance policies are short duration contracts. Premiums from these products are recognized as revenue when earned over the life of the policy and a liability for the portion of premiums unearned is reported on the consolidated balance sheets. Benefit claims are charged to operations as incurred.
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. Marketable equity securities classified as available-for-sale primarily include nonredeemable preferred stock. See Note 6 for information about the valuation of securities and additional disclosures about fair value measurements.
In the normal course of business the Company makes passive investments in structured securities issued by variable interest entities (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.
The Company carries its mortgage loans at outstanding principal balances, adjusted for unamortized deferred fees and costs, net of an allowance for loan losses. Loan origination fees and costs are deferred and amortized over the life of the loan. Interest income, including amortization of deferred fees and expenses, is recorded in net investment income. See Note 5 for further discussion of the Company’s allowance for loan losses.
are included in other invested assets at fair value on the Company’s consolidated balance sheets. We do not believe our derivative instruments expose the Company to significant risk.
Cash and cash equivalents consist of demand bank deposits and short-term highly liquid investments with maturities of three months or less at the time of purchase. Cash equivalents are reported at cost, which approximates fair value.
The Company amortizes acquisition costs for deferred annuity contracts and universal life insurance policies over the lives of the contracts or policies in proportion to the estimated future gross profits of each of these product lines. To do this, the Company makes assumptions as to surrender rates, mortality experience, maintenance expenses, and investment performance. Actual profits can vary from the estimates and can thereby result in increases or decreases to DAC amortization rates. The Company regularly evaluates its assumptions and, when necessary, revises the estimated gross profits of these contracts, resulting in adjustments to DAC amortization. When such estimates are revised, they are recorded in current earnings. The Company adjusts the unamortized balance of DAC for the impact on estimated future gross profits as if net unrealized investment gains and losses on securities had been realized as of the balance sheet date. The Company includes the impact of this adjustment, net of tax, in AOCI.
The Company conducts regular recoverability analyses for DAC asset balances associated with deferred and immediate annuity contracts, universal life contracts, and traditional life contracts. The Company compares the current DAC asset balances with the estimated present value of future profitability of the underlying business. The DAC asset balances are considered recoverable if the present value of future profits is greater than the current DAC asset balance. As of December 31, 2011 and 2010, all of the DAC asset balances were considered recoverable.
For some products, policyholders can elect to modify product benefits, features, rights or coverage by exchanging a contract for a new contract; by amendment, endorsement or rider to a contract; or by election of a
feature or coverage within a contract. These transactions are known as internal replacements. If the modification substantially changes the original contract, the DAC is immediately written off through income and any eligible costs associated with the replacement contract are deferred. If the modification does not substantially change the contract, the DAC is retained and amortized over the life of the modified contract and any acquisition costs associated with the related modification are expensed.
The Company offers sales inducements on certain deferred annuity contracts and universal life policies. For certain deferred annuity contracts, the inducement interest entitles the contract holder to an incremental amount of interest to be 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 reported as other assets and amortized into interest credited using the same methodology and assumptions used to amortize DAC. Deferred sales inducement balances are subject to regular recoverability testing to ensure that capitalized amounts do not exceed the present value of anticipated gross profits.
Certain operating leases of the Company provide for minimum annual payments that change over the life of the lease. The aggregate minimum annual payments are expensed on the straight-line basis over the minimum lease term. Rent holidays, rent incentives, and tenant improvement allowances are amortized on the straight-line basis over the initial term of the lease and any option period that is reasonably assured.
Separate account assets are reported at fair value and represent funds that are invested on behalf of the Company’s variable annuity, life, and universal life 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 primarily represent the policyholder’s account balance in the separate account. Fees charged to policyholders include mortality, policy administration, and surrender charges and are included in policy fees, contract charges, and other on the consolidated statements of income.
Liabilities for fixed deferred annuity contracts and universal life policies, including BOLI, are computed as deposits net of withdrawals made by the policyholder, plus amounts credited based on contract specifications, less contract fees and charges assessed.
For single premium immediate annuities (SPIAs), including structured settlements, liabilities are based on discounted amounts of estimated future benefits. Future benefits are either fully guaranteed or are contingent on the survivorship of the annuitant. Contingent future benefits are discounted with pricing mortality assumptions, which include provisions for longer life spans over time. The interest rate pattern used to calculate the reserves for SPIAs is set at issue. The interest rates within the pattern vary over time and start with interest rates that prevailed at contract issue. As of December 31, 2011, the weighted-average implied interest rate on the existing book of business was 6.0% and is expected to grade to 6.6% during the next 20 years.
Liabilities for policy and contract claims primarily represent liabilities for claims under group medical stop-loss and limited benefit medical insurance policies and are established on the basis of reported losses (case basis method). The Company also provides for claims incurred but not reported (IBNR), based on expected loss ratios, claims paying completion patterns and historical experience. The Company reviews estimates for reported but unpaid claims and IBNR quarterly. Any necessary adjustments are reflected in current operating results. If expected loss ratios increase or expected claims paying completion patterns extend, the IBNR claim liability increases.
Income taxes have been determined using the liability method. The provision for income taxes has two components: amounts currently payable or receivable and deferred income taxes. The deferred income taxes are calculated as the difference between the book and tax bases of the appropriate assets and liabilities and are measured using enacted tax rates. Deferred tax assets are recognized only to the extent that it is more likely than not that future taxable profits will be available. A valuation allowance is established where deferred tax assets cannot be recognized.
In January 2010, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2010-06, Fair Value Measurements and Disclosures (Topic 820) - Improving Disclosures about Fair Value Measurement. This ASU requires additional disclosures about an entity’s fair value measurements, including information about inputs to Level 2 measurements, gross transfers into and out of Levels 1 and 2, and information about activity for Level 3 measurements on a gross basis. It also clarifies the level of disaggregation required for existing fair value disclosures. The Company adopted this standard on January 1, 2010, except for the provisions regarding activity for Level 3 measurements presented on a gross basis, which was adopted on January 1, 2011, as provided for in the standard. See Note 6 for the Company’s disclosures related to fair value measurements.
ASU 2011-02, A Creditor’s Determination of Whether a Restructuring is a Troubled Debt Restructuring
In September 2011, the FASB issued ASU 2011-08, Intangibles - Goodwill and Other (Topic 350) - Testing Goodwill for Impairment. This ASU allows companies to assess qualitative factors to determine if it is more-likely-than-not that goodwill might be impaired and whether it is necessary to perform the two-step goodwill impairment test required under current accounting standards. The standard is effective for fiscal years beginning after December 15, 2011. The Company elected to early adopt this ASU on July 1, 2011, which did not have a material impact on the financial statements.
In May 2011, the FASB issued ASU 2011-04, Fair Value Measurements (Topic 820) - Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in US GAAP and IFRSs. This ASU establishes common definitions of fair value and requirements for measurement and disclosure between U.S. GAAP and International Financial Reporting Standards (IFRS). Enhanced disclosures include quantitative information about unobservable inputs to Level 3 measurements, when available; qualitative information about the sensitivity of Level 3 measurements to alternative inputs; and classification within the fair value hierarchy of all fair value measurements disclosed. The standard is effective for interim and annual periods beginning after December 15, 2011, and the Company prospectively adopted this standard on January 1, 2012. Effective with the first quarter 2012, the Company will provide the additional disclosures but does not expect any material changes to its fair value measurements.
For the years ended December 31, 2011 and 2010, 2.950 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 antidilutive. There were no antidilutive awards outstanding as of December 31, 2009. Also, performance units granted during 2010 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. Refer to Note 15 for discussion of the performance units.
The following table presents information relating to the Company’s calculations of basic and diluted earnings per share:
Based on National Association of Insurance Commissioners (NAIC) ratings, as of December 31, 2011 and 2010, the Company held below-investment-grade fixed maturities with fair values of $1,508.1 and $1,257.5, respectively, and amortized costs of $1,583.7 and $1,321.2, respectively. These holdings amounted to 6.6% and 5.9% of the Company’s investments in fixed maturities at fair value as of December 31, 2011 and 2010, respectively.
As of December 31, 2011 and 2010, $3,783.8, or 69.3%, and $3,968.0, or 69.7%, respectively, of the Company’s mortgage-backed securities were agency securities. Of the remaining non-agency securities, $1,274.9, or 76.0%, and $1,240.1, or 72.1%, respectively, were AAA-rated commercial mortgage-backed securities, and $272.8, or 16.3%, and $329.7, or 19.2%, were residential mortgage-backed securities classified as prime. Based on a review of underlying mortgage loan pool characteristics, such as credit scores and financial ratios, the Company classified $89.4 and $111.3, of its non-agency residential mortgage-backed securities as Alt-A as of December 31, 2011 and 2010, respectively, as each has overall collateral credit quality between prime and subprime. Of the securities classified as Alt-A, 59.1% and 88.1% had an NAIC rating of 1 as of December 31, 2011 and 2010, respectively. As of December 31, 2011 and 2010, the Company had no mortgage-backed securities classified as subprime.
(1) This includes net gains (losses) on calls and redemptions, and changes in the fair value of the Company’s convertible fixed maturities held as of period end totaling $(10.2), $5.4 and $10.1 for the years ended December 31, 2011, 2010 and 2009, respectively. As of December 31, 2011 and 2010, the Company’s convertible fixed maturities totaled $85.4 and $83.0, respectively.
During 2011, the Company recorded OTTI charges in earnings on fixed maturities totaling $14.1. The largest write-downs were from investments in the materials sector, totaling $4.9, or 34.8%; the financial sector, totaling $3.5, or 24.8%; and the industrial sector, totaling $2.7, or 19.1%. During 2010, the Company recorded OTTI charges in earnings on fixed maturities totaling $20.9. The largest write-downs were from investments in the financial sector, totaling $8.3, or 39.7%; the industrial sector, totaling $6.7, or 32.1%; and the utilities sector, totaling $2.2, or 10.5%. During 2009, the Company recorded OTTI charges on fixed maturities totaling $86.5. The largest write-downs were from investments in the financial sector, totaling $43.8, or 50.6%; the consumer discretionary sector, totaling $21.2, or 24.5%; and the materials sector, totaling $12.0, or 13.9%.
Extent and duration of the decline in fair value below cost or amortized cost;
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 and the Company’s liquidity needs.
To determine the recovery value, credit loss for a corporate security, the Company performs an analysis related to the underlying issuer including, but not limited to, the following:
Fundamentals of the issuer to determine what the Company would recover if the issuer were to file for bankruptcy, compared to the price at which the market is trading;
The Company reviewed its available-for-sale investments with unrealized losses as of December 31, 2011 and 2010 in accordance with its impairment policy and determined, after the recognition of other-than-temporary impairments, 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. 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.
Higher Risk Loans - All loans with an LTV ratio greater than 80%, or loans which have an LTV ratio between 65% and 80%, and a DSCR of less than 1.50.
(2) Other includes the allowance for loan losses, deferred fees and costs, and a 2004 purchase accounting adjustment.
In developing its portfolio reserve for incurred but not specifically identified losses, the Company evaluates loans by risk category as well as its past loan experience, commercial real estate market conditions, and third party data for expected losses on loans with similar LTV ratios and DSCRs. Each loan’s LTV ratio and DSCR is updated during the third quarter of each year.
The Company determines the fair value of its financial instruments based on the fair value hierarchy, which requires an entity to maximize its use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The Company has categorized its financial instruments, based on the priority of the inputs to the valuation technique, 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 within which a fair value measurement falls is determined based on the lowest-level input that is significant to the fair value measurement. The Company’s financial assets recorded at fair value on the consolidated balance sheets are categorized as follows:
Level 3 - Instruments whose significant value drivers are unobservable. This comprises financial instruments for which fair value is estimated based on industry-standard pricing methodologies and internally developed models utilizing significant inputs not based on or corroborated by readily available market information. In limited circumstances, this category may also utilize non-binding
broker quotes. This category primarily consists of certain less-liquid fixed maturities, including certain corporate private placement securities, and investments in private equity funds.
The following tables present the financial assets accounted for at fair value on a recurring basis, classified by the valuation hierarchy described above. The Company has no financial liabilities accounted for at fair value on a recurring basis.
The Company analyzes the prices received from the pricing services to ensure they represent a reasonable estimate of fair value, including analytical reviews of prices between reporting periods. The Company also performs procedures to gain assurance on the overall reasonableness and consistent use of inputs, valuation methodologies and compliance with fair value accounting standards. This includes an annual review of pricing methodologies and inputs by asset class and performing annual due diligence procedures, including deep-dive analyses, back-testing of selected sales activity to determine whether there were significant differences between the market price used to value the security prior to sale and the actual sales price, and corroboration of prices by obtaining multiple pricing quotes for selected securities. Based upon its analyses, the Company has not adjusted prices obtained from the pricing services.
As of December 31, 2011 and 2010, the fair value of the Company’s corporate securities classified as Level 2 measurements was $15,450.3 and $13,786.8, respectively. The following table presents additional information about the composition of the Level 2 corporate securities:
Corporate securities classified as Level 2 measurements are priced by independent pricing services utilizing evaluated pricing models. 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. Because many corporate securities do not trade on a daily basis, evaluated pricing applications apply available information through processes such as benchmark curves, benchmarking of like securities, sector groupings and matrix pricing to prepare valuations.
As of December 31, 2010, 94.7% of corporate securities classified as Level 3 were privately placed securities. These securities were issued by entities primarily in the industrial sector, 21.6%, the financial sector, 21.2%, and the consumer discretionary sector, 15.9%.
The following table presents additional information about the composition of the Level 3 privately placed corporate securities:
Level 2 RMBS securities are priced by independent pricing services that utilize evaluated pricing models. The significant observable 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 RMBS do not trade on a daily basis, evaluated pricing applications apply available information through processes such as benchmark curves, benchmarking of like securities, sector groupings and matrix pricing to prepare evaluations. In addition, the pricing services use models and processes to develop prepayment and interest rate scenarios. The pricing services monitor market indicators, industry and economic events, and their models take into account market convention.
Level 2 CMBS securities are priced by independent pricing services that utilize evaluated pricing models. The significant observable inputs for security evaluations include benchmark yields, reported trades, broker-dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers, new issues, monthly payment information and other reference data, including market research publications. Because many CMBS do not trade on a daily basis, evaluated pricing applications apply available information through processes, such as benchmark curves, benchmarking of like securities, sector groupings and matrix pricing to prepare evaluations.
The fair value for the Company’s investments in private equity funds is approximated based upon the Company’s proportionate interest in the underlying partnership or fund’s net asset value (NAV). The Company is generally unable to liquidate these investments during the term of the partnership or fund, which range from five to twelve years. As such, the Company classifies these securities as Level 3 measurements.
(1) Transfers into and/or out of Level 3 are reported at the value as of the beginning of the period in which the transfer occurs. Gross transfers into Level 3 were $1.6 for the year ended December 31, 2011. Gross transfers out of Level 3 were $34.5 for the year ended December 31, 2011.
The following table presents additional information about assets measured at fair value on a recurring basis and for which the Company has utilized significant unobservable inputs (Level 3) to determine fair value for the year ended December 31, 2010:
(1) Transfers into and/or out of Level 3 are reported at the value as of the beginning of the period in which the transfer occurs. Gross transfers into Level 3 were $14.9 for the year ended December 31, 2010. Gross transfers out of Level 3 were $257.3 for the year ended December 31, 2010, of which $250.5 were related to reverse mortgages that are now priced by the Company’s pricing service, as public market information on certain of the Company’s RMBS securities became available. Such securities are now classified as Level 2.
The Company estimates the fair values of funds held under deposit contracts related to investment-type contracts using an income approach, 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. The carrying value of this balance excludes $5,685.8 and $5,487.1 of liabilities related to insurance contracts as of December 31, 2011 and 2010, respectively.
(2) Net of taxes of $(5.3), $(17.3) and $13.4 for the years ended December 31, 2011, 2010 and 2009, respectively.
(3) Net of taxes of $(38.5), $(30.7) and $(44.2) for the years ended December 31, 2011, 2010 and 2009, respectively.
(4) Net of taxes of $6.6, $2.0 and $(20.2) for the years ended December 31, 2011, 2010 and 2009, respectively. For the years ended December 31, 2011, 2010 and 2009, $11.7 (net of taxes of $6.3), $24.8 (net of taxes of $13.3) and $30.5 (net of taxes of $16.4), respectively, of losses previously classified as OTTI not related to credit losses were reclassified into net income.
As of December 31, 2011, the Company had two stock-based compensation plans: the Symetra Financial Corporation Equity Plan, amended and restated on August 11, 2010, (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 shares are authorized for issuance under the Equity Plan, and 4.305 equity instruments are available for future issuance as of December 31, 2011. 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 0.870 shares are authorized for issuance under this plan. As of December 31, 2011, 0.713 shares are available for future issuance under the Stock Purchase Plan.
The total fair value of restricted stock vested during the years ended December 31, 2011 and 2010 was $0.2 and $1.6, respectively. No restricted stock vested during the year ended December 31, 2009.
The expected term of stock options is the period that options are expected to be outstanding. The risk-free rate is based on the U.S. Treasury yield curve over the expected term of the option that is in effect at the grant date. The dividend yield curve is calculated based on historical dividends. Expected volatility is calculated based on daily historical prices and implied volatility.
Outstanding options have a remaining contractual term of 6.5 years and no intrinsic value as of December 31, 2011. As of December 31, 2011, unrecognized compensation cost for stock options was $5.7 and is expected to be recognized over the next 5.5 years.
Under the Company’s Stock Purchase Plan, eligible employees may purchase shares of the Company’s stock on quarterly purchase dates at an amount equal to 85% of the closing market price of the common stock.
Compensation cost for employees is recognized for each three-month period between purchase dates, and is equal to the fair value of the discount received on the purchase of shares. Compensation cost recognized for employees under the Company’s Stock Purchase Plan for the years ended December 31, 2011 and 2010 was $0.2 and $0.1, respectively. The Company did not issue any shares pursuant to the Stock Purchase Plan in 2009.
The Company reinsures nearly all of its group long-term disability income business. The reinsurer is responsible for paying all claims. The Company reinsures 100% of its exposure to group medical stop loss claims in excess of $1.1.
Ceded reinsurance reduced policyholder benefits and claims by $55.6, $51.0 and $54.1 for the years ended December 31, 2011, 2010 and 2009, respectively.
The following table provides a reconciliation of the beginning and ending reserve balances for policy and contract claims:
Effective December 14, 2011, concurrently with entry into the unsecured revolving credit agreement referenced above, the Company terminated its prior $200.0 credit agreement, dated August 16, 2007, which was set to mature in August 2012. At termination, the Company had no borrowings outstanding under the credit agreement and was in compliance with all covenants.
The Company files income tax returns in the U.S. federal and various state jurisdictions. The Company’s federal income tax returns have been examined and closing agreements have been executed with the Internal Revenue Service, or the statute of limitations has expired for all tax periods through December 31, 2007. The Company is not currently subject to any state income tax exams.
Because of the nature of the business, the Company is subject to legal actions filed or threatened in the ordinary course of its business operations. The Company does not expect that any such litigation, pending or threatened, as of December 31, 2011, will have a material adverse effect on its consolidated financial condition, future operating results or liquidity.
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 $12.3, $12.0 and $13.1 for the years ended December 31, 2011, 2010 and 2009, respectively, which included the fixed fee as well as a variable fee based on usage.
As of December 31, 2011 and 2010, unfunded mortgage loan commitments were $105.1 and $39.2, respectively. The Company had no other material commitments or contingencies as of December 31, 2011 and 2010.
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. Prior to 2010, incentives were provided as performance share grants under the Performance Share Plan (see below).
Prior to 2010, the Company issued incentive awards in the form of performance shares to selected members of management under a performance share plan program (the “Performance Share Plan”). The value of each performance share was determined at the discretion of the Company’s Board of Directors, based on achievement of a specified growth target over a three-year period, and paid in cash. The expense recorded for awards under the Performance Share Plan was $(4.3) and $8.3 for the years ended December 31, 2010 and 2009, respectively. Due to management turnover during 2010, the Company reduced its Performance Share Plan accrual to reflect forfeitures from management turnover and recorded a net benefit. The Company also incurred related severance expenses of $5.4 during the year ended December 31, 2010.
The Company’s insurance subsidiaries are restricted by state regulations as to the aggregate amount of dividends they may pay to their parent company in any consecutive 12-month period without regulatory approval. Accordingly, based on statutory limits as of December 31, 2010, the Company was eligible to receive dividends from its insurance subsidiaries during 2011 without obtaining regulatory approval as long as the aggregate dividends paid over the twelve months preceding any dividend payment date in 2011 did not exceed $194.0. The total amount of dividends received by the Company from its insurance subsidiaries during 2011 was $52.0. Based on state regulations as of December 31, 2011, the Company is eligible to receive dividends from its insurance subsidiaries during 2012 without obtaining regulatory approval as long as the aggregate dividends paid over the 12 months preceding any dividend payment date in 2012 do not exceed $182.3.
Statutory capital and surplus for Symetra Life Insurance Company was $1,822.8 and $1,752.3 for the years ended December 31, 2011 and 2010, respectively.
The Company has an Investment Management Agreement, with White Mountains Advisors, LLC (WMA), a subsidiary of White Mountains Insurance Group, Ltd., amended and restated on June 1, 2011. White Mountains Insurance Group, Ltd. is a related party who beneficially owns 26.888 shares of the Company’s common stock, including warrants exercisable for 9.488 shares. This agreement, as amended, provides for investment advisory services related to the Company’s invested assets and portfolio management services. Expenses amounted to $15.5, $14.1, and $14.0 for the years ended December 31, 2011, 2010 and 2009, respectively. As of December 31, 2011 and 2010, amounts due to WMA were $4.0, and $3.4, respectively.
The primary segment profitability measure that management uses is segment pre-tax adjusted operating income (loss), which is calculated by adjusting income (loss) before federal income taxes to exclude net realized investment gains (losses), and for the Deferred Annuities’ segment, to include the net investment gains (losses) on fixed indexed annuity (FIA) options.
When evaluating segment pre-tax adjusted operating income (loss) in the Deferred Annuities’ segment, management includes the net investment gains (losses) from options related to an FIA hedging program. This program consists of buying S&P 500 Index call options to hedge the equity return component of FIA products. These options do not qualify for hedge accounting treatment, and net gains (losses) from the options are recorded in net realized investment gains (losses). Since the interest incurred on the Company’s FIA products is included as a component of interest credited, it is more meaningful to evaluate results inclusive of the results of this hedge program.
Life. Life offers a wide array of insurance products such as term and universal life insurance including single-premium life insurance, as well as BOLI.
The accounting policies of the segments are the same as those described in Note 2, except for the method of capital allocation. The Company has an internally developed risk-based capital model, the purpose of which is to
The following tables present selected financial information by segment and reconcile segment pre-tax adjusted operating income (loss) to amounts reported in the consolidated statements of income.
The unaudited quarterly results of operations for years ended December 31, 2011 and 2010 are summarized in the table below.