Our selected historical consolidated financial data as of and for each of the five years in the period ended December 31, 2011 follows. We derived the balance sheet data for the years ended December 31, 2011 and 2010 and the income statement data for the years ended December 31, 2011, 2010 and 2009 from our consolidated financial statements in this Annual Report on Form 10-K. We derived the balance sheet data for the years ended December 31, 2009, 2008 and 2007 and the income statement data for the years ended December 31, 2008 and 2007 from audited consolidated financial statements not in this Annual Report on Form 10-K. We have reclassified certain amounts for prior years to conform with our fiscal year 2011 presentation.
Management’s discussion and analysis reviews our consolidated financial condition at December 31, 2011 and 2010; our consolidated results of operations for the years 2011, 2010 and 2009; and, where appropriate, factors that may affect our future financial performance. This discussion should be read in conjunction with “Selected Financial Data” included in Item 6 and our consolidated financial statements in this Annual Report on Form 10-K.
Fees on life and annuity products. Fees consist primarily of (1) cost of insurance charges, which are based on the difference between policy face amounts and the account values (referred to as the net amount at risk); (2) 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; (3) premium-based fees to cover premium taxes and renewal commissions; and (4) surrender charges.
For fixed indexed annuities, policy benefits include the change in the liability associated with guaranteed minimum withdrawal benefits and the fair value of an embedded derivative liability. The assumptions used to calculate the guaranteed minimum withdrawal liability are consistent with those used for amortizing deferred policy acquisition costs. The fair value of the embedded derivative liability is calculated using significant management estimates, including (1) the expected value of index credits on the next policy anniversary dates, (2) the interest rate used to project the future growth in the contract liability, (3) the discount rate used to discount future benefit payments, which includes an adjustment for our credit worthiness; and (4) the expected costs of annual call options that will be purchased in the future to fund index credits beyond the next policy anniversary. These factors can vary significantly from period to period.
Interest margins. Interest margins consist of net investment income earned on universal life, fixed indexed annuities and other policyholder funds, gains on options purchased to fund index credits less the interest or index credits applied to policyholders on those funds. Interest margins also include investment income on assets supporting the Company’s surplus.
Net realized investment gains or losses related to investments and hedging programs include transaction gains and losses, OTTIs and changes in the value of certain derivatives. Certain of our variable annuity contracts include guaranteed minimum withdrawal and accumulation benefits. The change in fair value related to the embedded derivative is also included in net realized gains or losses.
Fees on life and annuity products. Prior to the impact of the deferred policy acquisition cost unlocking noted below, fees on our life and annuity products declined $4.1 million in 2011 compared to 2010. The decline in fees was primarily a result of lower surrenders and a decline in funds under management in universal life, variable universal life and variable annuity products. Offsetting these declines was an increase in non-asset based fees related to fixed indexed annuities. In addition, cost of insurance fees declined $23.3 million, primarily related to lower universal life insurance in force.
Net realized investment gains or losses on investments. Net realized investment losses increased $6.5 million to $16.4 million in 2011, compared to $9.9 million in 2010. The increase in net realized investment losses was primarily a result of a decline in net transaction gains of $28.3 million. In addition, realized losses related to fair value options were $0.6 million in 2011 compared to realized gains of $3.5 million in 2010. These declines were offset by $23.9 million of lower impairment losses for 2011 compared to 2010. Realized losses on derivative assets and liabilities improved $2.0 million during 2011. This improvement was primarily attributable to $17.2 million of lower realized losses on a surplus hedge, which utilizes futures and options to hedge against declines in equity markets and the resulting statutory capital and surplus impact. This improvement was offset by a $16.6 million increase in realized losses on embedded derivative liabilities and a $2.5 million decrease in realized gains on derivatives associated with variable annuity guarantees. Realized gains associated with variable annuity guarantees included a gain of $15.9 million for 2011 associated with the non-performance risk factor compared to a gain of $1.4 million for 2010.
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 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.
On September 14, 2011, we entered into a definitive agreement to sell Goodwin Capital Advisers, Inc. (“Goodwin”) to Conning Holdings Corp. (“Conning Holdings”). Also, on September 14, 2011, we entered into multi-year investment management agreements with Conning, Inc. (“Conning”) under which Conning will manage the Company’s publicly-traded fixed income assets. Because of the ongoing cash flows associated with the investment management agreements, results of these operations have been reflected within continuing operations. The transaction closed on November 18, 2011. A realized gain of $4.0 million was recognized on the sale during the fourth quarter of 2011.
Upon completion of these reviews, we revise our assumptions to reflect our current best estimate, thereby changing our estimate of EGPs in the deferred policy acquisition cost and unearned revenue amortization models, as well as projections within the death benefit and other insurance benefit reserving models. The deferred policy acquisition cost asset, the unearned revenue reserves and death benefit and other insurance benefit reserves are then adjusted with an offsetting benefit or charge to income to reflect such changes in the period of the revision, a process known as “unlocking.” Finally, an analysis is performed periodically to assess whether there are sufficient gross margins or gross profits to amortize the remaining deferred policy acquisition costs balances. If the estimates of gross profits or margins cannot support the continued amortization or recovery of deferred policy acquisition costs, the amortization of such costs is accelerated in the period in which the assumptions are changed, resulting in a charge to income.
Over the last several years, the Company has revised a number of assumptions, resulting in changes to expected future gross profits:
This average credit spread is recalculated 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, 2011 fair value of $41.9 million would increase to $44.7 million if the chosen spread were decreased by 50 basis points. If the chosen spread were increased by 50 basis points, the fair value would decrease to $39.3 million. The impact of the CSA at December 31, 2011 and 2010 was a reduction of $36.0 million and $19.9 million in the reserves associated with these riders, respectively.
In evaluating whether a decline in value is other than temporary, we consider several factors including, but not limited to, the following:
We employ a comprehensive process to determine whether or not a security in an unrealized loss position is other-than-temporarily impaired. This assessment is done on a security-by-security basis and involves significant management judgment. The assessment of whether impairments have occurred is based on management’s evaluation of the underlying reasons for the decline in estimated fair value. The Company’s review of its fixed maturity and equity securities for impairments includes an analysis of the total gross unrealized losses by three categories of severity and/or age of the gross unrealized loss, as summarized on pages 47,48 and 49, “Duration of Gross Unrealized Losses on Securities”. An extended and severe unrealized loss position on a fixed maturity security may not have any impact on the ability of the issuer to service all scheduled interest and principal payments and the Company’s evaluation of recoverability of all contractual cash flows or the ability to recover an amount at least equal to its amortized cost based on the present value of the expected future cash flows to be collected. In contrast, for certain equity securities, greater weight and consideration are given by the Company to a decline in market value and the likelihood such market value decline will recover.
See Note 8 to our consolidated financial statements under “Item 8: Financial Statements and Supplementary Data” and the “Debt and Equity Securities” and “Enterprise Risk Management” sections of “Item 7: Management’s Discussion and Analysis of Financial Condition and Results of Operations” in this Annual Report on Form 10-K for more information.
As of December 31, 2011, $314.1 million of net operating and capital loss carryover benefits were included in the deferred tax asset. Of this amount, $170.8 million related to $487.9 million of federal net operating losses that are scheduled to expire between the years 2021 and 2031. An additional $136.2 million related to $389.2 million of federal capital losses that are scheduled to expire between the years 2012 and 2016, with $18.8 million and $205.5 million expiring in 2012 and 2013, respectively. The remaining amount of $7.1 million is attributable to state income tax net operating losses.
As of December 31, 2011, we had deferred income tax assets of $2.0 million related to foreign tax credit carryovers, which are expected to expire between the 2015 and 2020 tax years. As of December 31, 2011, we had deferred income tax assets of $35.3 million related to general business tax credit carryovers, which are expected to expire between the years 2022 and 2031. Additionally, we had deferred income tax assets of $1.7 million related to AMT credit carryovers.
We have historically provided our employees with other post-employment benefits that include health care and life insurance. In December 2009, we announced the decision to eliminate retiree medical coverage for current employees whose age plus years of service did not equal at least 65 as of March 31, 2010. Employees who remain eligible must still meet all other plan requirements to receive benefits. In addition, the cap on the company’s contribution to pre-65 retiree medical costs per participant will be reduced beginning with the 2011 plan year.
Net income from continuing operations for 2011 was $30.1 million, or $0.26 per share, compared to a net loss from continuing operations of $24.6 million, or $(0.21) per share for 2010. The increase in results from continuing operations reflects lower policy acquisition cost amortization, lower operating expenses and improvement in net realized investment losses. These items were partially offset by lower premiums and fee income as well as higher income tax expense.
Fees on our life and annuity products declined as a result of lower surrenders and a decline in funds under management on universal life, variable universal life and variable annuity products. Offsetting these declines was an increase in non-asset based fees related to fixed indexed annuities. In addition, cost of insurance fees declined $23.3 million primarily related to lower net insurance in force in our universal life lines of business.
A net loss from discontinued operations of $22.0 million was recognized during 2011 which was primarily attributable to our discontinued group accident and health reinsurance operations as we strengthened reserves to reflect developments in the contracts underlying the block. See Note 21 to our consolidated financial statements in this Form 10-K for more information on discontinued operations.
We recorded a net loss from continuing operations of $24.6 million, or $(0.21) per share, for 2010 compared to a net loss from continuing operations of $196.0 million, or $(1.68) per share, for 2009. The improvement in results from continuing operations reflects increased net investment income, lower net realized investment losses, lower policy benefits and lower income tax expense. These improvements were partially offset by lower premiums, higher policyholder dividends, and higher policy acquisition cost amortization.
Net realized investment losses improved $92.3 million to $9.9 million for 2010, compared to $102.2 million for 2009. The improvement in realized losses was a result of a significant decline in OTTIs. In addition, realized losses on derivative assets and liabilities improved to $7.9 million in 2010 compared to $31.0 million in 2009. This was primarily attributable to embedded derivatives associated with variable and fixed indexed annuity guarantees which had a gain of $11.1 million in 2010 versus a loss of $31.0 million in 2009. Of this improvement in embedded derivatives, $29.7 million was associated with the non-performance risk factor. This was partially offset by losses of $19.0 million on our surplus hedge that was entered into during 2010.
Policy benefits decreased $89.6 million to $1,090.0 million for 2010 from $1,179.6 million for 2009. Unlocking adjustments of $7.7 million and $18.7 million in 2010 and 2009, respectively, decreased overall death benefit and other insurance benefit reserves. Excluding the impact of unlocking, policyholder benefits decreased primarily as a result of the decrease in policyholder dividend obligations in the closed block as a result of the change in the 2011 dividend scale and improved mortality for universal life.
For the years 2011, 2010 and 2009, inflation did not have a material effect on our consolidated results of operations.
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, 2011, our asset and liability portfolio durations were approximately matched but reflected somewhat lower asset durations because of our continued emphasis on liquidity. We regularly undertake a sensitivity analysis that calculates liability durations under various cash flow scenarios. We also calculate key rate durations for assets and liabilities that show the impact of interest rate changes at specific points on the yield curve. In addition, we monitor the short- and medium-term asset and liability cash flows profiles by portfolio to manage our liquidity needs.
See Note 13 to our consolidated financial statements under “Item 8: Financial Statements and Supplementary Data” in this Annual Report on Form 10-K for more information on derivative instruments.
Equity risk is the risk that we will incur economic losses due to adverse changes in equity prices. Our exposure to changes in equity prices primarily results from our variable annuity and variable life products, as well as from our holdings of common stocks, mutual funds, private equity partnership interests and other equities. We manage our insurance liability risks on an integrated basis with other risks through our liability and risk management and capital and other asset allocation strategies. We also manage equity price risk through industry and issuer diversification and asset allocation techniques. We held $35.7 and $47.5 million in available-for-sale equity securities on our balance sheet as of December 31, 2011 and 2010, respectively.
Certain annuity products sold by our Life Companies 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, 2011 and 2010, the difference between the GMDB and the current account value (net amount at risk) for all existing contracts was $151.2 million and $116.7 million, respectively. This was our exposure to loss had all contract owners died on either December 31, 2011 or 2010. See Note 11 to our consolidated financial statements under “Item 8: Financial Statements and Supplementary Data” in this Annual Report on Form 10-K for more information.
Certain life and annuity products sold by our Life Companies contain guaranteed minimum living benefits. These include guaranteed minimum accumulation, withdrawal, income and payout annuity floor benefits. The GMAB guarantees a return of deposit to a policyholder after 10 years regardless of market performance. The GMWB guarantees that a policyholder can withdraw a certain percentage for life regardless of market performance. The GMIB guarantees that a policyholder can convert his or her account value into a guaranteed payout annuity at a guaranteed minimum interest rate and a guaranteed mortality basis, while also assuming a certain level of growth in the initial deposit. The guaranteed payout annuity floor benefit (“GPAF”) guarantees that the variable annuity payment will not fall below the dollar amount of the initial payment. We also offer a combination rider that offers both GMAB and GMDB benefits. We have established a hedging program for managing the risk associated with our guaranteed minimum accumulation and withdrawal benefit features. We continue to analyze and refine our strategies for managing risk exposures associated with all our separate account guarantees. The liabilities related to these benefits totaled $62.0 million and $32.1 million at December 31, 2011 and 2010, respectively.
As part of our analysis of separate account returns, we perform two sensitivity tests. If at December 31, 2011 we had reprojected EGPs using a 100 basis points lower separate account return assumption (after fund fees and mortality and expense charges) for both the variable annuity and the variable life businesses and used our current best estimate assumptions for all other assumptions, the estimated increase to amortization and decrease to net income would have been approximately $6.1 million, before taxes.
Our debt securities portfolio consists primarily of investment grade publicly traded and privately placed corporate bonds, residential mortgage-backed securities (“RMBS”), commercial mortgage-backed securities (“CMBS”) and other asset-backed securities. As of December 31, 2011, our debt securities, with a fair value of $11,890.0 million, represented 78.4% of total investments.
We manage credit risk through industry and issuer diversification. Maximum exposure to an issuer is defined by quality ratings, with higher quality issuers having larger exposure limits. Our investment approach emphasizes a high level of industry diversification. The top five industry holdings as of December 31, 2011 in our debt securities portfolio were banking (6.0%), electrical utilities (5.3%), insurance (3.6%), oil (3.6%) and diversified financial services (2.7%).
We invest directly in CMBS. To the extent these assets deteriorate in credit quality and decline in value for an extended period, we may realize impairment losses. When making investment decisions, we have been focused on identifying those securities that could withstand significant increases in delinquencies and foreclosures in the underlying mortgage pools before incurring a loss of principal.
Includes the change in fair value of embedded derivatives associated with variable annuity GMWB, GMAB, GPAF and COMBO riders. See Note 11 to our consolidated financial statements under “Item 8: Financial Statements and Supplementary Data” in this Annual Report on Form 10-K for additional disclosures.
Additional credit losses on securities for which a portion of the OTTI loss was recognized in AOCI are included within net OTTI losses recognized in earnings on the statements of income and comprehensive income.
Cash used for operating activities decreased by $447.8 million for the year ended December 31, 2010 compared to the year ended December 31, 2009. This was primarily the result of a decrease in policyholder benefits of $415.5 million consistent with favorable mortality and lower surrenders as compared with prior year.
Net cash flows provided by discontinued operations were positive for the year ended December 31, 2010, an increase of $62.8 million compared to the year ended December 31, 2009. This was primarily a result of a decrease in available-for-sale assets related to the discontinued reinsurance operations business consistent with the net decline in policyholder benefits and accruals during 2010. This compared to an increase in available-for-sale assets consistent with the net increase in policyholder benefits and accruals during 2009.
In addition to existing cash and securities, our primary source of liquidity consists of dividends from Phoenix Life. Under New York Insurance Law, Phoenix Life is permitted to pay stockholder dividends to the holding company in any calendar year without prior approval from the New York Department of Financial Services (“NYDFS”) in the amount of the lesser of 10% of Phoenix Life’s surplus to policyholders as of the immediately preceding calendar year or Phoenix Life’s statutory net gain from operations for the immediately preceding calendar year, not including realized capital gains. Based on this calculation, Phoenix Life would be able to pay a dividend of $71.8 million in 2012. During the year ended December 31, 2011, Phoenix Life paid $64.8 million in dividends. In assessing our ability to pay dividends from Phoenix Life, we also consider the level of statutory capital and RBC of that entity. Our capitalization increased in the current and in the prior year; however, Phoenix Life may have less flexibility to pay dividends to the parent company if we experience future declines. As of December 31, 2011, we had $853.0 million of statutory capital, surplus and AVR. Our estimated RBC ratio was in excess of 200% at Phoenix Life. See Note 22 to our consolidated financial statements under “Item 8: Financial Statements and Supplementary Data” in this Annual Report on Form 10-K for more information on Phoenix Life statutory financial information and regulatory matters.
In 2011, 2010 and 2009, the Company did not pay any stockholder dividends.
Our principal needs at the holding company level are debt service (net of amounts due on bonds repurchased), income taxes and operating expenses. Interest expense on senior unsecured bonds for the years ended December 31, 2011, 2010 and 2009 was $19.3 million, $19.3 million and $20.6 million, respectively. As of December 31, 2011, future minimum annual principal payments on senior unsecured bonds are $252.8 million in 2032.
The increase in cash provided by operating activities for the year ended December 31, 2011, compared to the year ended December 31, 2010, was primarily attributable to a $39.8 million increase in dividends from Phoenix Life.
Outflows used for investing activities decreased with lower capital contributions to subsidiaries. Additional inflows were recognized from debt security redemptions.
Individual life insurance policies, other than term life insurance policies, increase in cash values over their lives. Policyholders have the right to borrow an amount up to a certain percentage of the cash value of their policies at any time. As of December 31, 2011, our Life Companies had approximately $10.9 billion in cash values with respect to which policyholders had rights to take policy loans. The majority of cash values eligible for policy loans are at variable interest rates that are reset annually on the policy anniversary. Policy loans at December 31, 2011 were $2.4 billion.
Aggregate life surrenders in 2011 were 6.5% of related reserves, compared with 8.0% in 2010. Cash, treasuries and agency mortgage-backed securities accounted for 8.7% of fixed income investments at year end 2011, as compared to 8.5% at year end 2010. A strong liquidity profile remains a priority for the Company, but as financial markets and the economy continue to improve the size and composition of this liquid asset portfolio will change to better meet the needs of the Company. These actions, along with resources the Company devotes to monitoring and managing surrender activity, are key components of liquidity management within the Company.
Rating agencies assign Phoenix Life financial strength ratings and assign the holding company debt ratings based in each case on their opinions of the relevant company’s ability to meet its financial obligations.
On January 13, 2012, A.M. Best Company, Inc. affirmed our financial strength rating of B+ and our senior debt rating of bb-. They changed their outlook on our ratings from stable to positive. On February 8, 2011, A.M. Best Company, Inc. affirmed our financial strength rating of B+ and our senior debt rating of bb-. They changed their outlook on our ratings from negative to stable.
On December 16, 2011, Moody’s Investor Services affirmed our financial strength rating of Ba2 and our senior debt rating of B3. They changed their outlook on our ratings from stable to positive.
On March 24, 2011, Standard & Poor’s affirmed our financial strength rating of BB- and our senior debt rating of CCC+. They changed their outlook on our ratings from negative to stable.
The decline in other assets was a result of a decrease in investment receivables attributable to a lower volume of investment sales and a decrease in premises and equipment related to amortization.
Policyholder deposit funds increased primarily as a result of continued sales growth of fixed indexed annuities as illustrated in the table below entitled “Annuity Funds on Deposit”.
Annuity funds on deposit increased during each of the years ended December 31, 2010 and 2009. Funds on deposit increased $104.9 million more during 2009 than during 2010. While positive market performance contributed to the increase in both years, the market recovery during 2009 resulted in a larger increase of funds. Partially offsetting lower market performance was an increase in deposits over prior year, reflecting new sales of our fixed indexed annuities and lower surrenders in 2010 compared to 2009.
Future obligations are based on our estimate of future investment earnings, mortality, surrenders and applicable policyholder dividends. Included in the amounts above are policyholder dividends generated by estimated favorable future investment and mortality, in excess of guaranteed amounts for our closed block. Actual obligations in any single year, or ultimate total obligations, may vary materially from these estimates as actual experience emerges. As described in Note 2 to our consolidated financial statements under “Item 8: Financial Statements and Supplementary Data” in this Annual Report on Form 10-K, policy liabilities and accruals are recorded on the balance sheet in amounts adequate to meet the estimated future obligations of the policies in force. The policyholder obligations reflected in the table above exceed the policy liabilities, policyholder deposit fund liabilities and separate account liabilities reported on our December 31, 2011 consolidated balance sheet because the above amounts do not reflect future investment earnings and future premiums and deposits on those policies. Separate account obligations will be funded by the cash flows from separate account assets, while the remaining obligations will be funded by cash flows from investment earnings on general account assets and premiums and deposits on contracts in force.
Other commercial commitments relate to agreements to fund limited partnerships. These commitments can be drawn down by private equity funds as necessary to fund their portfolio investments through the end of the funding period as stated in each agreement.
On September 14, 2011, we entered into a definitive agreement to sell Goodwin Capital Advisers, Inc. (“Goodwin”) to Conning Holdings. Also, on September 14, 2011, we entered into multi-year investment management agreements with Conning under which Conning will manage the Company’s publicly-traded fixed income assets. Because of the ongoing cash flows associated with the investment management agreements, results of these operations have been reflected within continuing operations. The transaction closed on November 18, 2011. A realized gain of $4.0 million was recognized on the sale during the fourth quarter of 2011.
The changes in the projected benefit obligations of the employee plan at December 31, 2011 as compared to December 31, 2010 were principally the result of accrued interest cost and actuarial losses due to assumption changes.
We have entered into agreements with certain key executives of the Company that will, under a change in control, provide separation benefits upon the termination of the executive’s employment by the Company for reasons other than death, disability, cause or retirement, or by the executive for “good reason,” as defined in the agreements. The agreements provide this protection only if the termination occurs following (or is effectively connected with) the occurrence of a change of control, as defined in the agreements. As soon as reasonably possible upon a change in control, as so defined, we are required to make an irrevocable contribution to a trust in an amount sufficient to pay benefits due under these agreements.
See Note 17 to our consolidated financial statements under “Item 8: Financial Statements and Supplementary Data” in this Annual Report on Form 10-K for more information.
The Financial Statements and Supplementary Data required by this item are presented beginning on page.