We have omitted this information from this report pursuant to General Instructions (I)(1)(a) and (b) of Form 10-K and are filing this Form 10-K with the reduced disclosure format permitted by that General Instruction.
Management’s narrative analysis of the results of operations is presented in lieu of Management’s Discussion and Analysis of Financial Condition and Results of Operations, pursuant to General Instruction (I)(2)(a) of Form 10-K.
The discussion in this Form 10-K may contain “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. We intend for these forward-looking statements to be covered by the safe harbor provisions of the federal securities laws relating to forward-looking statements. These forward-looking statements include statements relating to trends in, or representing management’s beliefs about our future transactions, strategies, operations and financial results and often contain words such as “will,” “anticipate,” “believe,” “plan,” “estimate,” “expect,” “intend,” “is targeting,” “may,” “should” and other similar words or expressions. Forward-looking statements are made based upon management’s current expectations and beliefs concerning trends and future developments and their potential effects on us. They are not guarantees of future performance. Our actual business, financial condition or results of operations may differ materially from those suggested by forward-looking statements as a result of risks and uncertainties which include, among others: (A) risks related to the Restatement, failure to file timely periodic reports with the SEC and our internal control over financial reporting, which include (i) the potential failure to remediate material weaknesses in our internal control over financial reporting and other material weaknesses may be identified in the future, which would adversely affect the accuracy and timing of our financial reporting; (ii) the extraordinary processes undertaken to effect the Restatement may not have been adequate to identify and correct all errors in our historical financial statements and, as a result, we may discover additional errors and our financial statements remain subject to the risk of future restatement; (iii) our failure to have current financial information available; (iv) the risk of failure to comply with the filing deadlines included in the SEC’s Cease-and-Desist Order, dated March 21, 2014, as amended by the Amended Cease-and-Desist Order, dated August 1, 2014, including that the SEC may seek sanctions against or deregister PNX and the Company; (v) the risk of PNX’s failure to file its delayed SEC filings and its 2014 Quarterly Reports on Form 10-Q by March 16, 2015, the extended deadline for providing these SEC filings to the bond trustee, as well as the risk associated with seeking additional consents from bondholders of its outstanding 7.45% Quarterly Interest Bonds Due 2032 regarding these SEC filings; (vi) the outcome of litigation and claims as well as regulatory examinations, investigations, proceedings and orders arising out of the Restatement and the failure by the Company and PNX to file SEC reports on a timely basis; (vii) further downgrades or withdrawals of our financial strength credit ratings, which could increase policy surrenders and withdrawals, adversely affect our relationships with distributors, reduce new sales, limit our ability to trade in derivatives and increase our costs of, or reduce our access to, future borrowings; (viii) our inability to hedge our positions due to our inability to replace hedges as a result of our credit rating; (ix) the incurrence of significant expenses related to the Restatement, the U.S. GAAP restatement undertaken by PNX, the remediation of weaknesses in our internal control over financial reporting and disclosure controls and procedures, and the preparation of this Form 10-K and our delayed SEC reports; (x) diversion of management and other human resources attention from the operation of our business; (xi) the risk that the Company’s and Phoenix Life’s restatements, the delay in our filing of periodic reports with the SEC and errors corrected in subsequent Statutory financial statement filings with state insurance regulators could result in regulatory investigations, examinations and/or inquiries, which may increase compliance costs and the potential for additional regulatory investigations, proceedings or other claims; and (xii) risks associated with our failure to file certain reports with state regulatory authorities; (B) risks related to our business, which include (i) unfavorable general economic developments including, but not limited to, specific related factors such as the performance of the debt and equity markets; (ii) the potential adverse effect of interest rate fluctuations on our business and results of operations; (iii) the potential adverse effect of legal actions and proceedings inherent in our business on our results of operations, financial position, business or reputation; (iv) the impact on our results of operations and financial condition of any required increase in our reserves for future policyholder benefits and claims if such reserves prove to be inadequate; (v) the possibility that mortality rates, persistency rates, funding levels or other factors may differ significantly from our assumptions used in pricing products; (vi) limited access to external sources of liquidity and financing; (vii) the effect of guaranteed benefits within our products; (viii) potential exposure to unidentified or unanticipated risk that could adversely affect our businesses or result in losses; (ix) the consequences related to variations in the amount of our statutory capital could adversely affect our business; (x) the possibility that we may not be successful in our efforts to implement a business plan focused on new market segments; (xi) changes in our investment valuations based on changes in our valuation methodologies, estimations and assumptions; (xii) the availability, pricing and terms of reinsurance coverage generally and the inability or unwillingness of our reinsurers to meet their obligations to us specifically; (xiii) our ability to attract and retain key personnel in a competitive environment and while delayed in our SEC reporting obligations; (xiv) our dependence on third parties to maintain critical business and administrative functions; (xv) the strong competition we face in our business from banks, insurance companies and other financial services firms; (xvi) changes in tax law and policy may affect us directly or indirectly through the cost of, the demand for or profitability of our products or services; (xvii) the possibility that federal and state regulation may increase our cost of doing business, impose additional reserve or capital requirements, levy financial assessments or constrain our operating and financial flexibility; (xvii) regulatory actions or examinations may harm our business; and (xviii) changes in accounting standards; and (C) other risks and uncertainties described herein or in any of our filings with the SEC. Certain other factors which may impact our business, financial condition or results of operations or which may cause actual results to differ from such forward-looking statements are discussed or included in our periodic reports filed with the SEC and are available on our website at www.phoenixwm.com under “Investor Relations.” You are urged to carefully consider all such factors. We do not undertake or plan to update or revise forward-looking statements to reflect actual results, changes in plans, assumptions, estimates or projections, or other circumstances occurring after the date of this Form 10-K, even if such results changes or circumstances make it clear that any forward-looking information will not be realized. If we make any future public statements or disclosures which modify or impact any of the forward-looking statements contained in or accompanying this Form 10-K, such statements or disclosures will be deemed to modify or supersede such statements in this Form 10-K.
We provide life insurance and annuity products through independent agents and financial advisors. Our policyholder base includes both affluent and middle market consumers, with our more recent business concentrated in the middle market. Most of our life insurance in force is permanent life insurance (universal life and variable universal life) insuring one or more lives. Our annuity products include fixed and variable annuities with a variety of death benefit and guaranteed living benefit options.
Fees on life and annuity products consist primarily of: (i) cost of insurance (“COI”) charges, which are based on the difference between policy face amounts and the account values (referred to as the NAR); (ii) asset-based fees (including mortality and expense charges for variable annuities) which are calculated as a percentage of assets under management within our separate accounts; (iii) premium-based fees to cover premium taxes and renewal commissions; and (iv) surrender charges.
Policy benefits include death claims net of reinsurance cash flows, including ceded premiums and recoverables, interest credited to policyholders and changes in policy liabilities and accruals. Certain universal life reserves are based on management’s assumptions about future COI fees and interest margins which, in turn, are affected by future premium payments, surrenders, lapses and mortality rates. Actual experience can vary significantly from these assumptions, resulting in greater or lesser changes in reserves. In addition, we regularly review and reset our assumptions in light of actual experience, which can result in material changes to these reserves.
Under U.S. GAAP, premiums and deposits for variable life, universal life and annuity products are not immediately recorded as revenues. For certain investment options of variable products, deposits are reflected on our balance sheets as an increase in separate account liabilities. Premiums and deposits for universal life, fixed annuities and certain investment options of variable annuities are reflected on our balance sheets as an increase in policyholder liabilities. Premiums and deposits for other products are reflected on our balance sheets as an increase in policy liabilities and accruals.
Policy benefits. Policy benefits decreased $110.3 million for the twelve months ended December 31, 2013 compared with the twelve months ended December 31, 2012. The decrease in policy benefit expenses is primarily due to gains on guaranteed insurance benefit liabilities and reserves for profits followed by losses of $84.1 million as a result of assumption changes made during the annual comprehensive review of assumptions in the fourth quarter of 2013. The most significant driver of the positive 2013 unlock results was the incorporation of a mortality improvement assumption in the overall mortality table, which resulted in improved expected mortality on universal life and variable universal life products.
Income taxes. The effective tax rate for 2013 and 2012 was (63.8%) and (13.3%) respectively. The principal cause of the difference between the effective rate and the U.S. statutory rate of 35% in 2013 was the dividend deduction and a decrease in the valuation allowance on the pre-tax income. The principal cause of the difference between the effective rate and the U.S. statutory rate of 35% in 2012 was the dividend received deduction and an increase in the valuation allowance on the pre-tax loss.
We believe there is significant demand for our products among middle market households seeking to accumulate assets and secure lifetime income during retirement. The current low interest rate environment provides limited opportunities for consumers to protect principal and generate predictable income. Our indexed annuity products are positioned favorably vis-à-vis traditional investments such as bank certificates of deposits.
Recent trends in the life insurance industry may affect our mortality, policy persistency and premium persistency. The evolution of the financial needs of policyholders, the emergence of a secondary market for life insurance, and increased availability and subsequent contraction of premium financing suggest that the reasons for purchasing our products have changed. Deviations in experience from our assumptions have had, and could continue to have, an adverse effect on the profitability of certain universal life products. Most of our current products permit us to increase charges and adjust crediting rates during the life of the policy or contract (subject to guarantees in the policies and contracts). We have made, and may in the future make, such adjustments.
The discussion and analysis of our financial condition and results of operations are based upon our financial statements, which have been prepared in accordance with U.S. GAAP. U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Critical accounting estimates are reflective of significant judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain.
Deferred policy acquisition costs are adjusted through other comprehensive income (“OCI”) each period as a result of unrealized gains or losses on securities classified as available-for-sale in a process commonly referred to as shadow accounting. This adjustment is required in order to reflect the impact of these unrealized amounts as if these unrealized amounts had been realized.
Policy persistency assumptions vary by product and policy year and are updated based on recently observed experience. Policyholders are generally assumed to behave rationally; hence rates are typically lower when surrender penalties are in effect or when policy benefits are more valuable.
We expect that our universal life block of business will generate profits followed by losses and, therefore, we establish an additional liability to accrue for the expected losses over the period of expected profits. The assumptions used in estimating these liabilities are consistent with those used for amortizing deferred policy acquisition costs and are subject to the same variability and risk.
See Note 2 to our financial statements under “Item 8: Financial Statements and Supplementary Data” and the “Enterprise Risk Management” section of “Item 7: Management’s Discussion and Analysis of Financial Condition and Results of Operations” in this Form 10-K for more information.
The CSA is updated every quarter and, therefore, the fair value will change with the passage of time even in the absence of any other changes that would affect the valuation. For example, the December 31, 2013 fair value of $74.8 million would increase to $79.7 million if the spread were decreased by 50 basis points. If the spread were increased by 50 basis points, the fair value would decrease to $70.2 million.
We recognize realized investment losses when declines in fair value of debt securities are considered to be an OTTI.
On a quarterly basis, we evaluate securities in an unrealized loss position for potential recognition of an OTTI. In addition, we maintain a watch list of securities in default, near default or otherwise considered by our investment professionals as being distressed, potentially distressed or requiring a heightened level of scrutiny. We also identify securities whose fair value has been below amortized cost on a continuous basis for zero to six months, six months to 12 months and greater than 12 months.
We account for income taxes in accordance with ASC 740, Accounting for Income Taxes.
The Company is a party to legal actions and is involved in regulatory investigations. Given the inherent unpredictability of these matters, it is difficult to estimate the impact on our financial position. Liabilities are established when it is probable that a loss has been incurred and the amount of the loss can be reasonably estimated. On a quarterly and annual basis, the Company reviews relevant information with respect to liabilities for litigation, regulatory investigations, and litigation-related contingencies to be reflected in the Company’s financial statements. It is possible that an adverse outcome in certain of the Company’s litigation or the use of different assumptions in the determination of amounts recorded could have a material effect upon the Company’s net income or cash flows in particular quarterly or annual periods.
The Company recorded net income of $55.7 million for the twelve months ended December 31, 2013 as compared with a net loss of $137.7 million for the twelve months ended December 31, 2012. The increase in net income is primarily due to the following items:
Net realized investment gains, excluding OTTI, of $5.4 million were recognized for the twelve months ended December 31, 2013 compared to net realized investment losses, excluding OTTI, of $19.5 million for the twelve months ended December 31, 2012. The change in the net realized investment gains is primarily attributable to a decrease in realized losses on derivatives that are used to hedge the risks associated with variable annuity guarantees and the fixed indexed annuity liabilities. For the twelve months ended December 31, 2013 there were losses on derivative investments of $23.1 million, while there were losses of $49.0 million for the twelve months ended December 31, 2012. The continued improvement in the equity markets results in losses on the derivatives that are used to hedge the risk associated with the variable annuity guarantees, that are offset by gains on the derivatives that are used to hedge the risks associated with the fixed indexed annuities. The fixed indexed annuity hedging gains were more significant in 2013 due to more significant increases in the equity market in 2013 than in 2012, as well as additional derivatives purchased due to continued sales of fixed indexed annuities.
Policy benefits decreased $110.3 million for the twelve months ended December 31, 2013 compared with the twelve months ended December 31, 2012. The decrease in policy benefit expenses is primarily due to gains on guaranteed insurance benefit liabilities and reserves for profits followed by losses of $84.1 million as a result of assumption changes made during the annual comprehensive review of assumptions in the fourth quarter of 2013. The most significant driver of the positive 2013 unlock results was the incorporation of a mortality improvement assumption in the overall mortality table, which resulted in improved expected mortality on universal life and variable universal life products.
Partially offsetting the increase in net income were the following items:
Operating expenses increased by $13.2 million for the twelve months ended December 31, 2013 compared with the twelve months ended December 31, 2012. The increase in operating expenses was a result of higher professional fees and outside consulting services primarily as a result of the restatement.
For the years 2013, 2012 and 2011, inflation did not have a material effect on our results of operations.
Our ultimate parent company, PNX, has an enterprise-wide risk management program under which PHL Variable operations are covered. Our Chief Risk Officer reports to the Chief Executive Officer and monitors our risk management activities. The Chief Risk Officer provides regular reports to the Board without the presence of other members of management. Our risk management governance consists of several management committees to oversee and address issues pertaining to all our major risks-operational, market and product-as well as capital management. In all cases, these committees include one or more of our Chief Executive Officer, Chief Financial Officer, Chief Investment Officer and Chief Risk Officer.
PNX has established an Operational Risk Committee, chaired by the Chief Risk Officer, to develop an enterprise-wide framework for managing operational risks. This committee meets periodically and includes membership that represents all significant operating, financial and staff departments of PNX. Among the risks the committee reviews and manages and for which it provides general oversight are business continuity risk, disaster recovery risk and risks related to the Company’s information technology systems.
One of the key measures we use to quantify our interest rate exposure is duration, a measure of the sensitivity of the fair value of assets and liabilities to changes in interest rates. For example, if interest rates increase by 100 basis points, or 1%, the fair value of an asset or liability with a duration of five is expected to decrease by 5%. We believe that as of December 31, 2013, our asset and liability portfolio durations were reasonably matched.
Includes debt securities where the fair value option has been elected.
Equity futures fair value includes margin account cash balance of $12.5 million.
See Note 8 to our financial statements under “Item 8: Financial Statements and Supplementary Data” in this Form 10-K for more information on derivative instruments.
Includes term life and payout annuity products subject to loss recognition.
Includes private equity funds. The value of private equity investments are not highly correlated to public equity markets, because of their liquidity and valuation methodologies. Direct private equity investments have been included in the sensitivity because they have equity exposure for the Company.
Certain variable annuity products sold by us contain GMDBs. The GMDB feature provides annuity contract owners with a guarantee that the benefit received at death will be no less than a prescribed amount. This minimum amount is based on the net deposits paid into the contract, the net deposits accumulated at a specified rate, the highest historical account value on a contract anniversary or, if a contract has more than one of these features, the greatest of these values. To the extent that the GMDB is higher than the current account value at the time of death, the Company incurs a cost. This typically results in an increase in annuity policy benefits in periods of declining financial markets and in periods of stable financial markets following a decline. As of December 31, 2013, the difference between the GMDB and the current account value (NAR) for all existing contracts was $13.7 million. This was our exposure to loss had all contract owners died on December 31, 2013. See Note 7 to our financial statements under “Item 8: Financial Statements and Supplementary Data” in this Form 10-K for more information.
See Note 4 to our financial statements under “Item 8: Financial Statements and Supplementary Data” in this Form 10-K for more information regarding deferred policy acquisition costs.
Using professional judgment and experience, we evaluate and weigh the relevance and significance of all readily available market information to determine the best estimate of fair value. The fair values investments with unobservable inputs are determined by management after considering prices from our pricing vendors. Fair values for debt securities are primarily based on yield curve analysis along with ratings and spread data. Other inputs may be considered for fair value calculations including published indexed data, sector specific performance, comparable price sources and similar traded securities.
We invest in a variety of debt securities. We classify these investments into various sectors using industry conventions; however, our classifications may differ from similarly titled classifications of other companies. We classify debt securities into investment grade and below-investment-grade securities based on ratings prescribed by the National Association of Insurance Commissioners (“NAIC”). In a majority of cases, these classifications will coincide with ratings assigned by one or more Nationally Recognized Statistical Rating Organizations (“NRSROs”); however, for certain structured securities, the NAIC designations may differ from NRSRO designations based on the amortized cost of the securities in our portfolio.
Includes commercial mortgage-backed CDOs with amortized cost and market values of $2.0 million and $2.3 million, respectively. CMBS holdings in this exhibit include $4.5 million classified as fair value investments on the balance sheets. For these fair value investments, there is no impact to OCI as carrying value is equal to market value.
Includes the change in fair value of embedded derivatives associated with fixed index annuity indexed crediting feature and variable annuity GMWB, GMAB and COMBO riders. See Note 8 to our financial statements under “Item 8: Financial Statements and Supplementary Data” in this Form 10-K for additional disclosures.
which a Portion of the OTTI Loss was Recognized in OCI:
Less: Credit losses on securities impaired due to intent to sell
For available-for-sale debt securities with gross unrealized losses, 95.6% of the unrealized losses after offsets pertain to investment grade securities and 4.4% of the unrealized losses after offsets pertain to below-investment-grade securities at December 31, 2013.
In the normal course of business, we enter into transactions involving various types of financial instruments such as debt securities. These instruments have credit risk and also may be subject to risk of loss due to interest rate and market fluctuations.
Cash flows provided by financing activities decreased $110.5 million during the year ended December 31, 2013. This decline was primarily a result of a decrease in policyholder deposits of fixed indexed annuities when compared to 2012. Offsetting this decline was the issuance of $30.0 million of debt during 2013, which were purchased by PNX. See Note 11 to our financial statements under “Indebtedness due to affiliate” under "Item 8. Financial Statements and Supplementary Data" in this Form 10-K for additional information on this transaction.
The cash value of certain individual life insurance policies increase over the lives of the policies. Policyholders have the right to borrow an amount up to a certain percentage of the cash value on those policies. As of December 31, 2013, we had approximately $689.8 million in cash values with respect to which policyholders had rights to take policy loans. For eligible policies, the majority of policy loans are at variable interest rates that are reset annually on the policy anniversary. Policy loans at December 31, 2013 were $66.1 million.
The primary liquidity risks regarding cash inflows from the investing activities are the risks of default by debtors, interest rate and other market volatility, and potential illiquidity of investments. We closely monitor and manage these risks.
We believe that the existing and expected sources of liquidity are adequate to meet both current and anticipated needs.
The increase in total investments was primarily the result of purchases of new securities due to new deposits in the annuity business. Partially offsetting this were declines in the market value of available-for-sale debt securities resulting from increases in interest rates during 2013 and decreases in cash and short-term investments.
The increase in derivative instruments is primarily due to gains on the call options that are used to hedge the fixed indexed annuity business. This increase in derivative assets is offset by increases in derivative liabilities, which are recorded within other liabilities. The net derivative position of $127.0 million as of December 31, 2013 has not fluctuated significantly from the net derivative position of $103.7 million as of December 31, 2012.
The increase in other assets is primarily due to an increase in the current tax asset recoverable from PNX, due to the existing tax sharing agreement.
The increase in other liabilities is due to additional accrued expenses related to audit and consulting services, and an increase in the fair value of derivative liabilities. The increase in the fair value of the derivative liabilities is offset by increases in derivative assets, which are recorded within investments. The net derivative position of $127.0 million as of December 31, 2013 has not fluctuated significantly from the net derivative position of $103.7 million as of December 31, 2012.
The increase in total stockholder’s equity was primarily a result of the net income recognized for the twelve months ended December 31, 2013 and capital contributions of $45.0 million during 2013. Partially offsetting these increases were additional accumulated other comprehensive losses associated with unrealized losses on available-for-sale debt securities due to the rise in interest rates during 2013.
We do not anticipate any increases to unrecognized tax benefits that would have a significant impact on the financial position of the Company. Therefore, no unrecognized tax benefits have been excluded from this table. See Note 10 to our financial statements under “Item 8: Financial Statements and Supplementary Data” in this Form 10-K for additional information on unrecognized tax benefits.
Employee benefit expense allocated to us for these benefits totaled $3.2 million, $4.6 million and $7.6 million for 2013, 2012 and 2011, respectively. Over the next 12 months, Phoenix Life expects to make contributions to the pension plan of which approximately $6.4 million will be allocated to us. On July 6, 2012, the Surface Transportation Extension Act of 2012, Part II, was enacted into law and was effective immediately. The law includes certain pension funding stabilization provisions, which the Company has taken advantage of in 2012.
We use reinsurance agreements to limit potential losses, reduce exposure to larger risks and provide capital relief with regard to certain reserves. We remain liable to the extent that reinsuring companies may not be able to meet their obligations under reinsurance agreements in effect. Failure of the reinsurers to honor their obligations could result in losses to the Company. Since we bear the risk of nonpayment, on a quarterly basis we evaluate the financial condition of our reinsurers and monitor concentrations of credit risk. Based on our review of their financial statements, reputation in the reinsurance marketplace and other relevant information, we believe that we have no material exposure to uncollectible life reinsurance. At December 31, 2013, five major reinsurance companies account for approximately 73% of the reinsurance recoverable.
Our statutory basis capital and surplus including asset valuation reserve (“AVR”) decreased from $321.0 million at December 31, 2012 to $235.2 million at December 31, 2013. The principal factor resulting in this decrease was $123.1 million of reserve strengthening, including consideration of results from asset adequacy analysis. This was partially offset by $45.0 million of capital contributions received from PM Holdings, Inc. and $30 million relating to the issuance of surplus notes issued by PHL Variable and purchased by PNX.
The estimated RBC of PHL Variable as of December 31, 2013 was in excess of 250% of the Company Action Level.