In addition during 2009, personnel performing services for the Registrant occupied office space in Jacksonville, Florida, which was owned by ML&Co. An allocable share of the cost of the above mentioned premise was paid by the Registrant through a transition services agreement between AUSA and ML&Co.
¡ The effects of corporate bankruptcies and/or accounting restatements on the financial markets and the resulting decline in the value of equity and debt securities we hold;
Lowering of one or more of the financial strength ratings and the adverse impact such action may have on the premium writings, policy retention, profitability and liquidity;
The impact of product withdrawals, restructurings and other unusual items; and
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 2011, approximately $1.8 million (or 1%) of the Company’s fixed maturity and equity securities portfolio consisted of private placement securities. The Company did not have any private placement securities at December 31, 2010.
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.
For fixed maturity AFS securities, an OTTI must be recognized in earnings when an entity either a) has the intent to sell the debt security or b) more likely than not will be required to sell the debt security before its anticipated recovery. If the Company meets either of these criteria, the OTTI is recognized in earnings in an amount equal to the entire difference between the security’s amortized cost basis and its fair value at the balance sheet date. For fixed maturity AFS securities in unrealized loss positions that do not meet these criteria, the Company must analyze its ability to recover the amortized cost by comparing the net present value of projected future cash flows with the amortized cost of the security. The net present value is calculated by discounting the Company’s best estimate of projected future cash flows. If the net present value is less than the amortized cost of the investment, an OTTI is recorded. The OTTI is separated into two pieces: an amount representing the credit loss, where the present value of cash flows expected to be collected is less than the amortized cost basis of the security, and an amount related to all other factors (referred to as the non credit portion). The credit loss is recognized in earnings and the non credit loss is recognized in other comprehensive income (“OCI”), net of applicable taxes and value of business acquired. Management records subsequent changes in the estimated fair value (positive and negative) of fixed maturity AFS securities for which non credit OTTI was previously recognized in OCI in OCI-OTTI.
For the years ended December 31, 2011, 2010 and 2009, the Company recorded an OTTI in income, with no value of business acquired amortization, of less than $0.1 million, $0.1 million and $0.9 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, 2011 and 2010, the Company’s VOBA asset was $27.6 million and $29.6 million, respectively. For the years ended December 31, 2011, 2010 and 2009, the favorable (unfavorable) impact to pre-tax net income related to VOBA unlocking was ($0.7) million, $0.6 million and ($0.5) million, respectively. For the year ended December 31, 2009, there was an impairment charge on variable annuities of $7.2 million. There were no impairment charges in 2011 and 2010. 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, 2011 and 2010, variable annuities accounted for the Company’s entire DAC asset of $0.5 million and $0.4 million, respectively.
DAC for variable annuities is amortized with interest over the anticipated lives of the insurance contracts in relation to the present values of estimated future gross profits from asset-based fees, guaranteed benefit rider fees, contract fees, and surrender charges, less a provision for guaranteed death and living benefit expenses, policy maintenance expenses, and non-capitalized commissions. Future gross profit estimates are subject to periodic evaluation with necessary revisions applied against amortization to date. The impact of revisions and assumptions to estimates on cumulative amortization is recorded as a charge or benefit to current operations, commonly referred to as “unlocking”. Changes in assumptions can have a significant impact on the amount of DAC reported and the related amortization patterns. In general, increases in the estimated Separate Accounts return and decreases in surrender or mortality assumptions increase the expected future profitability of the underlying business and may lower the rate of DAC amortization. Conversely, decreases in the estimated Separate Accounts returns and increases in surrender or mortality assumptions reduce the expected future profitability of the underlying business and may increase the rate of DAC amortization. For the year ended December 31, 2011, the unfavorable impact to pre-tax net income related to DAC unlocking was less than $0.1 million. For the years ended December 31, 2010 and 2009, there was relatively no impact to pre-tax income related to DAC unlocking. See Note 4 to the Financial Statements for a further discussion.
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, 2011 and 2010, future policy benefits were $19.1 million and $17.4 million, respectively.
ASC 944, Financial Services-Insurance - ASU 2010-15, How Investments Held Through Separate Accounts Affect an Insurer’s Consolidation Analysis of Those Investments - clarifies that an insurance entity should not consider any separate account interest held for the benefit of policyholders in an investment to be the insurer’s interest and should not combine those interests with its general account interest in the same investment when assessing the investment for consolidation - adopted January 1, 2011.
ASC 820, Fair Value Measurements and Disclosure - ASU 2010-06, Improving Disclosures about Fair Value Measurements - guidance on new disclosures and clarifications of existing disclosures about fair value measurements - adopted January 1, 2010.
ASC 820, Fair Value Measurements and Disclosures - ASU 2011-04, Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS - amends current guidance to achieve common fair value measurement and disclosure requirements in U.S. GAAP and International Financial Reporting Standards - will be adopted January 1, 2012.
Total direct deposits (including internal exchanges) were $0.9 million, $1.0 million and $2.9 million for the years ended December 31, 2011, 2010 and 2009, respectively. The decrease in deposits was primarily due to the Company ceasing to issue new variable annuity and market value adjusted annuity products in 2009. Internal exchanges during 2011 and 2010 were $0.2 million and $0.4 million, respectively. There were no internal exchanges during 2009.
Hybrid securities are included in the Company’s banking exposure, which typically have an original maturity of more than 30 years, may be perpetual and were designed to receive enhanced equity credit from rating agencies. In addition, they have other features that may not be consistent across issues such as a cumulative or non-cumulative coupon, capital replacement language and an alternative payment mechanism. The Company’s exposure to hybrid securities in an unrealized loss position is all rated investment grade and there is little risk of payment interruption.
RMBS are securitizations of underlying pools of residential mortgages on real estate. The underlying residential mortgages have varying credit characteristics and are pooled together and sold in tranches. The Company’s RMBS portfolio includes government sponsored enterprise (“GSE”) guaranteed passthroughs and whole loan collateralized mortgage obligations (“CMO”). The majority of the Company’s RMBS unrealized losses relate to whole loan CMOs.
All RMBS securities of the Company 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 stress-case scenarios. Our RMBS 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 Company’s $0.2 million of gross unrealized losses within the RMBS sector has a fair value of $0.7 million. The unrealized loss in the sector is primarily a result of the housing downturn the United States has experienced since 2007. Even with the stabilization over the past two years, fundamentals in RMBS continue to be weak, which impacts the magnitude of the unrealized loss. Delinquencies and severities in property liquidations remain at an elevated level, while prepayments remain at historically low levels. Due to the weak fundamental situation, reduced liquidity, and the requirement for higher yields due to market uncertainty, credit spreads remain elevated across the asset class.
The Company defines investment grade securities as unsecured debt obligations that have a rating equivalent to S&P’s BBB- or higher (or similar rating agency). At December 31, 2011 and 2010 approximately $4.1 million (or 3%) and $11.2 million (or 8%), respectively, of fixed maturity securities were rated BBB-, which is the lowest investment grade rating given by S&P. Below investment grade securities are speculative and are subject to significantly greater risks related to the creditworthiness of the issuers and the liquidity of the market for such securities. The Company closely monitors such investments.
Gross unrealized losses and OTTI on below investment grade AFS securities represented 25% and 33% of total gross unrealized losses and OTTI on all AFS securities at December 31, 2011 and 2010, 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, 2011.
During 2011, 2010 and 2009, there was less than $0.1 million, $0.1 million, and $0.1 million, respectively, of investment income on fixed maturity trading securities recorded in net investment income in the Statements of Income. During 2011 and 2010, there was less than $0.1 million and less than $0.1 million, respectively, of loss recognized from the change in the fair value on fixed maturity trading securities recorded in net investment income in the Statements of Income. The Company recognized gains of less than $0.1 million during 2011 on the conversion of fixed maturity trading securities to preferred stock. There were no conversions of fixed maturity trading securities to preferred stock in 2010 or 2009.
Subprime mortgages are loans to homebuyers who have weak or impaired credit histories. Through 2008, the market for these loans had expanded rapidly. During that time, however, lending practices and credit assessment standards grew steadily weaker. As a result, the market is now experiencing a sharp increase in the number of loan defaults. Investors in subprime mortgage assets include not only mortgage lenders, but also brokers, hedge funds, and insurance companies. The Company does not currently invest in or originate whole loan residential mortgages. The Company categorizes ABS issued by a securitization trust as having subprime mortgage exposure when the average credit score of the underlying mortgage borrowers in a securitization trust is below 660 at issuance. The Company also categorizes ABS issued by a securitization trust with second lien mortgages as subprime mortgage exposure, even though a significant percentage of second lien mortgage borrowers may not necessarily have credit scores below 660 at issuance. The estimated fair value of the subprime mortgage investments at December 31, 2011 and 2010 was $1.6 million and $2.0 million, respectively, entirely in first lien - fixed rate, AAA quality and vintages prior to 2004.
Changes in the U.S. equity market directly affect the values of the underlying U.S. equity-based mutual funds supporting Separate Accounts assets and, accordingly, the values of variable contract owner account balances. Approximately 68% of Separate Accounts assets were invested in equity-based mutual funds at December 31, 2011. Since asset-based fees collected on in force variable contracts represent a significant source of revenue, the Company’s financial condition will be impacted by fluctuations in investment performance of equity-based Separate Accounts assets. During 2011, average variable account balances decreased $28.4 million (or 4.6%) to $593.4 million as compared to the same period in 2010.
Credit spreads represent the credit risk premiums required by market participants for a given credit quality, i.e., the additional yield that a debt instrument issued by an AA-rated entity must produce over a risk-free alternative (e.g., U.S. Treasury instruments). Changes in credit spreads have an inverse relationship to the value of interest sensitive investments.
At December 31, 2011 and 2010, the Company had 994 and 1,069 life insurance and annuity contracts inforce with interest rate guarantees, respectively. The estimated average rate of interest credited on behalf of contract owners was 4.1% and 4.0% during 2011 and 2010, respectively. Total invested assets supporting these liabilities with interest rate guarantees had an estimated average effective yield of 4.3% and 6.3% during 2011 and 2010, respectively.
The Company’s liquidity requirements include the payment of sales commissions and other underwriting expenses and the funding of its contractual obligations for the life insurance and annuity contracts it has in force. The Company has developed and utilizes a cash flow projection system and regularly performs asset/liability duration matching in the management of its asset and liability portfolios. The Company anticipates funding its cash requirements utilizing cash from operations, normal investment maturities and anticipated calls and repayments, consistent with prior years. At December 31, 2011 and 2010, the Company’s assets included $174.1 million and $170.6 million, respectively, of cash, short-term investments and investment grade publicly traded AFS securities that could be liquidated if funds were required.
During 2011 and 2010, the Company did not receive a capital contribution from AUSA. In 2011, the Company paid a cash dividend of $25.0 million to AUSA. In 2010, the Company did not pay a dividend to AUSA.
The following table summarizes the Company’s ratings at March 29, 2012:
For the years ended December 31, 2011 and 2010, the Company recorded net income of $6.2 million and $12.1 million, respectively. The decline in income during 2011 as compared to 2010 was primarily due to higher policy benefits and a higher effective tax rate.
Policy charge revenue decreased $0.6 million (or 4.2%) to $14.0 million during 2011, as compared to $14.6 million in 2010. The following table provides the changes in policy charge revenue by type for each respective period:
(b) The decrease in annuity benefit expense in 2011 as compared to 2010 was primarily driven by a reduction in risk neutral rates and lower equity market performance which favorably impacted the GMIB Reinsurance reserves.