The Company’s investments consist principally of fixed maturity and equity securities that are classified as available-for-sale (“AFS”) which are reported at estimated fair value. In addition, the Company held fixed maturity securities which contain a conversion to equity feature, which is considered an embedded derivative. These fixed maturity securities have been classified as trading and are reported at estimated fair value. During 2012, the last of these securities converted so the Company no longer holds any of these securities as of December 31, 2013 and 2012. The fair values of fixed maturity and equity securities are determined by management after taking into consideration several sources of data. When available, the Company uses quoted market prices in active markets to determine the fair value of its investments. The Company’s valuation policy utilizes a pricing hierarchy which dictates that publicly available prices are initially sought from indices and third-party pricing services. In the event that pricing is not available from these sources, those securities are submitted to brokers to obtain quotes. If broker quotes are not available, then securities are priced using internal cash flow modeling techniques. These valuation methodologies commonly use reported trades, bids, offers, issuer spreads, benchmark yields, estimated prepayment speeds, and/or estimated cash flows.
The Company’s portfolio of private placement securities is valued using a matrix pricing methodology. The pricing methodology is obtained from a third party service and indicates current spreads for securities based on weighted average life, credit rating and industry sector. Monthly the Company reviews the matrix to ensure the spreads are reasonable by comparing them to observed spreads for similar securities traded in the market. In order to account for the illiquid nature of these securities, illiquidity premiums are included in the valuation and are determined based upon the pricing of recent transactions in the private placement market as well as comparing the value of the privately offered security to a similar public security. The impact of the illiquidity premium to the overall valuation is less than 1% of the value. At December 31, 2013 and 2012, approximately $72.5 million (or 4%) and $63.6 million (or 4%), respectively, of the Company’s fixed maturity and equity securities portfolio consisted of private placement securities.
Changes in the fair value of fixed maturity and equity securities deemed AFS are reported as a component of accumulated other comprehensive income (loss), net of taxes on the Balance Sheets and are not reflected in the Statements of Income until a sale transaction occurs or when credit-related declines in estimated fair value are deemed other-than-temporary. Changes in fair value of fixed maturity securities deemed trading are reported as a component of net investment income.
The Company regularly reviews each investment in its fixed maturity and equity AFS securities portfolio to evaluate the necessity of recording impairment losses for other-than-temporary declines in the fair value of investments. Management makes this determination through a series of discussions with the Company’s portfolio managers and credit analysts, and information obtained from external sources (i.e.; company announcements, ratings agency announcements, or news wire services). For fixed maturity AFS securities, the Company also considers whether it is more likely than not that it will not be required to sell the debt security before its anticipated recovery. The factors that may give rise to a potential OTTI include, but are not limited to, i) certain credit-related events such as default of principal or interest payments by the issuer, ii) bankruptcy of issuer, iii) certain security restructurings, and iv) fair market value less than cost or amortized cost for an extended period of time. In the absence of a readily ascertainable market value, the estimated fair value on these securities represents management’s best estimate and is based on comparable securities and other assumptions as appropriate. Management bases this determination on the most recent information available.
At December 31, 2013 and 2012, there was $46.4 million and $52.6 million, respectively, in mortgage loans on real estate recorded on the Balance Sheets. The estimated fair value of the mortgage loans on real estate at December 31, 2013 and 2012 was $51.5 million and $59.5 million, respectively. There were no impaired mortgage loans at December 31, 2013 or 2012. The general reserve at December 31, 2013 and 2012 was less than $0.1 million. The change in the valuation allowance and the general reserve is reflected in net realized investment gains (losses), excluding OTTI losses on securities in the Statements of Income. At December 31, 2013 and 2012, there were no mortgage loans that were two or more payments delinquent. See Note 3 to the Financial Statements for further discussion.
During 2013, the Company entered into cash flow hedging transactions on Treasury Inflation Protected Securities (“TIPS”) utilizing interest rate swaps to lengthen portfolio duration and to hedge the variability of cash flows due to changes in inflation.
102%, on which interest is accrued. If the fair value of the collateral is at any time less than 102% of the fair value of the loaned securities, the counterparty is mandated to deliver additional collateral, the fair value of which, together with the collateral already held in connection with the lending transaction, is at least equal to 102% of the fair value of the loaned securities. At December 31, 2013 and 2012, the payable for collateral under securities loaned was $260.5 million and $216.3 million, respectively. The amortized cost of securities out on loan at December 31, 2013 and 2012 was $251.2 million and $187.2 million, respectively. The estimated fair value of securities out on loan at December 31, 2013 and 2012 was $247.2 million and $206.2 million, respectively.
The Company enters into dollar roll repurchase agreement transactions whereby the Company takes delivery of mortgage-backed securities (“MBS”) pools and sells them to a counterparty along with an agreement to repurchase substantially the same pools at some point in the future, typically one month forward. These transactions are accounted for as collateralized borrowings, and the repurchase agreement liability is included in the Balance Sheet in payables for collateral under securities loaned and reverse repurchase agreements. At December 31, 2013 there were no reverse repurchase agreements. At December 31, 2012, the payable for reverse repurchase agreements was $26.4 million. At December 31, 2012 the estimated fair value and amortized cost of the securities that were pledged to the counterparty to support the initial dollar roll was $26.2 million and $26.0 million, respectively.
VOBA represents the portion of the purchase price that is allocated to the value of the right to receive future cash flows from the insurance and annuity contracts in force at the acquisition date. VOBA is based on actuarially determined projections, for each block of business, of future policy and contract charges, premiums, mortality, policyholder behavior, Separate Account performance, operating expenses, investment returns, and other factors. Actual experience on the purchased business may vary from these projections. Revisions in estimates result in changes to the amounts expensed in the reporting period in which the revisions are made and could result in the impairment of the asset and a charge to income if estimated future gross profits are less than the unamortized balance. At December 31, 2013 and 2012, the Company’s VOBA asset was $286.7 million and $271.3 million, respectively. For the years ended December 31, 2013, 2012, and 2011, the favorable (unfavorable) impact to pre-tax net income related to VOBA unlocking was $12.7 million, $4.3 million, and ($11.6) million, respectively. There were no impairment charges in 2013, 2012, and 2011. See Note 4 to the Financial Statements for a further discussion.
The costs of acquiring business, principally commissions, certain expenses related to policy issuance, and certain variable sales expenses that relate to and vary with the production of new and renewal business are deferred and amortized based on the estimated future gross profits for a group of contracts. DAC are subject to recoverability testing at the time of policy issuance and loss recognition testing at the end of each reporting period. At December 31, 2013 and 2012, variable annuities accounted for the Company’s entire DAC asset of $33.1 million and $44.7 million, respectively.
The long-term growth rate assumption for the amortization of VOBA, DAC and DSI was 8% at December 31, 2013 and 9% at December 31, 2012 and 2011.
Future policy benefits are actuarially determined liabilities, which are calculated to meet future obligations and are generally payable over an extended period of time. Principal assumptions used in the establishment of liabilities for future policy benefits are mortality, surrender rates, policy expenses, equity returns, interest rates, and inflation. These estimates and assumptions are influenced by historical experience, current developments and anticipated market trends. At December 31, 2013 and 2012, future policy benefits were $384.8 million and $418.7 million, respectively.
At December 31, 2013 and 2012, GMDB and GMIB liabilities included within future policy benefits were as follows:
The Company regularly evaluates the assumptions used to establish these liabilities, as well as actual experience, and adjusts GMDB and GMIB liabilities with a related charge or credit to earnings (“unlocking”) if actual experience or evidence suggests that the assumptions should be revised. For the years ended December 31, 2013, 2012 and 2011, the favorable (unfavorable) impact to pre-tax income related to GMDB and GMIB unlocking was $38.6 million, $36.2 million, and ($70.0) million, respectively.
At December 31, 2013 and 2012, the future policy benefits for the SALB liability was less than $0.1 million.
The Company filed a separate federal income tax return for the years 2008 through 2012, but no examination by the Internal Revenue Service has commenced. Effective January 1, 2013 for federal income tax purposes, the Company joined in a consolidated income tax return filing with its direct parent, AUSA, and its indirect parent, Transamerica Corporation, and other affiliated companies. A tax return has not yet been filed for 2013.
ASC 860, Transfers and Servicing - ASU 2011-03, Reconsideration of Effective Control for Repurchase Agreements - modifies the criteria for determining when a repurchase transaction should be accounted for as a secured borrowing or as a sale - adopted January 1, 2012.
The amortized cost/cost and estimated fair value of investments in fixed maturity and equity securities at December 31, 2013 and 2012 were:
The Company’s $2.7 million of gross unrealized losses within the financial services sector has a fair value of $50.6 million. The majority of the unrealized loss in the financial services sector relates to one investment grade Real Estate Investment Trust (“REIT”) security. The unrealized loss on this position is primarily driven by interest rate increases during 2013. There are no individual issuers rated below investment grade in this sector which have an unrealized loss position greater than $2.5 million.
The Company’s $5.9 million of gross unrealized losses within the industrial sector has a fair value of $94.8 million. The industrial sector is further subdivided into various sub-sectors with a majority of its gross unrealized loss in the consumer non-cyclical and technology sub-sectors. The unrealized loss in these sub-sectors is primarily driven by interest rates increasing during 2013.
All ABS - housing related securities are monitored and reviewed on a monthly basis. Detailed cash flow models using the current collateral pool and capital structure on the portfolio are updated and reviewed quarterly. Model output is generated under base and several stress-case scenarios. Our internal ABS - housing related asset specialists utilize widely recognized industry modeling software to perform a loan-by-loan, bottom-up approach to modeling. Key assumptions used in the models are projected defaults, loss severities, and prepayments. Each of these key assumptions varies greatly based on the significantly diverse characteristics of the current collateral pool for each security. Loan-to-value, loan size, and borrower credit history are some of the key characteristics used to determine the level of assumption that is utilized. Defaults were estimated by identifying the loans that are in various delinquency buckets and defaulting a certain percentage of them over the near-term and long-term. Assumed defaults on delinquent loans are dependent on the specific security’s collateral attributes and historical performance.
The commercial real estate market previously experienced a deterioration in property level fundamentals over 2008-2010, which led to an increase in CMBS loan-level delinquencies. The introduction of 30% credit enhanced tranches within the 2005-2008 vintage deals provide some offset to these negative fundamentals. Over the last year, the CMBS market experienced several positive factors as commercial real estate fundamentals have begun to display some signs of stabilization. The pace of credit deterioration appears to be moderating as property transactions have increased and there is greater availability of financing for commercial real estate. Liquidity has improved within the CMBS market, but a broad re-pricing of risk has kept credit spreads on legacy subordinate CMBS tranches at wide levels.
Gross unrealized losses and OTTI on below investment grade AFS securities represented 6% and 79% of total gross unrealized losses and OTTI on all AFS securities at December 31, 2013 and 2012, respectively. Generally, below investment grade securities are more likely than investment grade securities to develop credit concerns. The ratios of estimated fair value to amortized cost reflected in the table below were not necessarily indicative of the market value to amortized cost relationships for the securities throughout the entire time that the securities have been in an unrealized loss position nor are they necessarily indicative of these ratios subsequent to December 31, 2013.
At December 31, 2013 and 2012, the Company had 10,926 and 11,855 life insurance and annuity contracts in force with interest rate guarantees, respectively. The estimated average rate of interest credited on behalf of contract owners was 3.18% and 3.68% during 2013 and 2012, respectively. Total invested assets supporting these liabilities with interest rate guarantees had an estimated average effective yield of 5.1% and 5.4% during 2013 and 2012, respectively.
During 2013 and 2012, the Company did not receive a capital contribution from AUSA nor did the Company pay a cash dividend to AUSA.
The National Association of Insurance Commissioners utilizes the RBC adequacy monitoring system. The RBC calculates the amount of adjusted capital that a life insurance company should have based upon that company’s risk profile. At December 31, 2013 and 2012, based on the RBC formula, the Company’s total adjusted capital levels were well in excess of the minimum amount of capital required to avoid regulatory action.
A downgrade of our financial strength rating could affect our competitive position in the insurance industry as customers may select companies with higher financial strength ratings. These ratings are not a recommendation to buy or hold any of the Company’s securities and they may be revised or revoked at any time at the sole discretion of the rating organization.
The Company has utilized public information to estimate the future assessments it will incur as a result of life insurance company insolvencies. At December 31, 2013 and 2012, the Company’s estimated liability for future guaranty fund assessments was $0.2 million and $0.6 million, respectively. In addition, the Company has a receivable for future premium tax deductions of $4.6 million and $4.0 million at December 31, 2013 and 2012, respectively. The Company regularly monitors public information regarding insurer insolvencies and adjusts its estimated liability as appropriate.
Policy charge revenue decreased $2.1 million to $185.6 million during 2013, as compared to $187.7 million in 2012. The following table provides the changes in policy charge revenue by type for each respective period:
(b) The increase in annuity benefit expense was primarily due to benefits paid exceeding the release of fair value reserves in 2013 as compared to 2012.
(b) The decrease in non-asset based policy charge revenue is primarily due to the run-off of the life business as well as less paid up additions.
Net realized derivative losses increased $29.1 million to $48.4 million during 2012 as compared to $19.3 million in 2011. The following table provides the changes in net realized derivative losses by type:
(a) The equity collar losses were driven by the increase in the S&P index which grew 13% for the period ended December 31, 2012. This is a zero cost at inception macro equity hedge to protect against a portion of the unhedged equity tail risk by selling a portion of the market upside above the Company’s long term expected return and buying protection against extreme market declines. As a result, when equity markets increase, these equity collars will decline in value. When equity markets decrease, they will increase in value.
(b) The variance swaps are based on market performance of the S&P during the period ended December 31, 2012 when compared to the same period in 2011.
Amortization (accretion) of DAC was $0.8 million and ($13.1) million for 2012 and 2011, respectively, which included favorable (unfavorable) unlocking of $1.8 million and ($3.0) million, respectively. The change in 2012 as compared to 2011 was principally driven by favorable equity markets resulting in amortization and favorable unlocking.
Insurance expenses and taxes increased $0.5 million in 2012 as compared to 2011. The following table provides the changes in insurance expenses and taxes for each respective period:
The Company is not dependent upon any single customer, and no single customer accounted for more than 10% of its revenues during 2013, 2012, or 2011.