Our executive headquarters consist of our main office building at One American Row in Hartford, Connecticut, which we own and occupy. We also lease space in two garages in Hartford, Connecticut for employee parking. Property is also leased for our home office in East Greenbush, New York.
The discussion in this Annual Report on 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, including that the SEC may seek sanctions against or deregister the Company and PHLVIC; (v) the risk of failure to file our delayed SEC filings by March 16, 2015, the extended deadline for providing these delayed SEC filings to the bond trustee, as well as the risk associated with seeking additional consents from bondholders of our outstanding 7.45% Quarterly Interest Bonds Due 2032 regarding these delayed filings; (vi) the risk that the delay in filing our annual report and any failure to satisfy other NYSE listing requirements could cause the NYSE to commence suspension or delisting procedures with respect to our securities, including our common stock; (vii) 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 PHLVIC to file SEC reports on a timely basis; (viii) further downgrades or withdrawals of our debt or 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; (ix) our inability to hedge our positions due to our inability to replace hedges as a result of our credit rating; (x) the incurrence of significant Restatement-related expenses; (xi) diversion of management and other human resources attention from the operation of our business; (xii) our inability to access alternate financing arrangements to fund our ongoing operations and our inability to register securities for offer and sale with the SEC under the Securities Act until we have filed the delayed SEC filings and are otherwise current with our relevant SEC filing obligations; (xiii) risks associated with our insurance company subsidiaries’ delay in completing their respective U.S. GAAP financial statement restatements and PHLVIC’s delay in its SEC reporting obligations; and (xiv) risks associated with our insurance company subsidiaries’ 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) the effect of guaranteed benefits within our products; (vii) potential exposure to unidentified or unanticipated risk that could adversely affect our businesses or result in losses; (viii) the consequences related to variations in the amount of our statutory capital could adversely affect our business; (ix) the possibility that we may not be successful in our efforts to implement a business plan focused on new market segments; (x) changes in our investment valuations based on changes in our valuation methodologies, estimations and assumptions; (xi) the availability, pricing and terms of reinsurance coverage generally and the inability or unwillingness of our reinsurers to meet their obligations to us specifically; (xii) our ability to attract and retain key personnel in a competitive environment and while delayed in our SEC reporting obligations; (xiii) our dependence on third parties to maintain critical business and administrative functions; (xiv) the strong competition we face in our business from banks, insurance companies and other financial services firms; (xv) our reliance, as a holding company, on dividends and other payments from our subsidiaries to meet our financial obligations and pay future dividends, particularly since our insurance subsidiaries’ ability to pay dividends is subject to regulatory restrictions; (xvi) the potential need to fund deficiencies in our closed block; (xvii) 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; (xviii) 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; (xix) regulatory actions or examinations may harm our business; (xx) potential future material losses from our discontinued reinsurance business; and (xxi) 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.
In 2012, 99% of Phoenix product sales, as defined by total annuity deposits and total life premium, were annuities, and 90% of those sales were fixed indexed annuities. In addition, we have expanded sales of other insurance companies’ policies through our distribution subsidiary, Saybrus Partners, Inc. (“Saybrus”).
We operate two businesses segments: Life and Annuity and Saybrus. The Life and Annuity segment includes individual life insurance and annuity products, including our closed block. Saybrus provides dedicated life insurance and other consulting services to financial advisors in partner companies, as well as support for sales of Phoenix’s product line through independent distribution organizations.
A substantial but gradually declining amount of our Life and Annuity segment earnings derive from the closed block, which consists primarily of participating life insurance policies sold prior to our demutualization and initial public offering in 2001. We do not expect the net income contribution from the closed block to deviate materially from its actuarially projected path as long as actual cumulative earnings meet or exceed expected cumulative earnings. See Note 5 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 the closed block.
Policy benefits include death claims net of reinsurance cash flows, including ceded premiums and recoverables, interest credited to policyholders and changes in reserves for future claims payments. 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.
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: (i) the expected value of index credits on the next policy anniversary dates; (ii) the interest rate used to project the future growth in the contract liability; (iii) the discount rate used to discount future benefit payments, which includes an adjustment for our credit worthiness; and (iv) 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.
Certain of our variable annuity contracts include guaranteed minimum death and income benefits. The change in the liability associated with these guarantees is included in policy benefits. The value of these liabilities is sensitive to changes in equity markets, equity market volatility and interest rates, as well as subject to management assumptions regarding future surrenders, rider utilization rates and mortality.
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 and embedded derivatives.
Saybrus is a fee-based business driven by the commission revenue earned on consultation services provided to partner companies as well as on sales of Phoenix Life and PHLVIC product lines. These fees are offset by compensation-related expenses attributable to our sales force.
Fees on life and annuity products. Fees on our life and annuity products decreased $40.6 million in the twelve months ended December 31, 2012 compared with the twelve months ended December 31, 2011. Lower fees were primarily a result of COI charges which decreased $39.6 million related to declining universal life and variable universal life insurance in force. In addition, investment fees decreased during 2012 compare with 2011 due to the sale of Goodwin during the fourth quarter of 2011. Partially offsetting these declines were higher fees related to an increase in outstanding annuity policies.
Policy benefits. Policy benefits increased $29.1 million in 2012 compared to 2011. The increase in policy benefit expense was a result of higher death benefits for universal life and traditional whole life products as a result of negative mortality experience during 2012, primarily in the third quarter. Annuity benefits increased largely due to changes in reserves on fixed indexed annuities associated with minimum death and income benefit guarantees which were driven by increased sales during the year. Policy benefit expenses of $36.3 million were incurred during 2012 due to reserve unlocking adjustments as a result of our annual comprehensive review of actuarial assumptions in the third quarter of 2012. These expenses were partially offset by lower policy benefits within the closed block due to positive mortality during 2012 and a decrease in outstanding policies in force as the block ages.
Deferred policy acquisition cost amortization. Policy acquisition cost amortization increased $42.1 million in 2012 compared to 2011. This increase in amortization was attributable to the unlocking of assumptions as a result the annual comprehensive review of assumptions in the third quarter of 2012. The unlocking resulted in amortization of $55.2 million in 2012, which included amortization of $46.2 million for traditional life policies from lower projected net yields related to investment income returns and amortization of $6.0 million for universal life policies primarily due to lower spreads due to the low interest rate environment. Excluding the impact of the unlocking, amortization related to universal life decreased as a result of negative mortality experience during the year. Amortization related to annuities decreased primarily as a result of improved market performance.
Income taxes. The effective tax rate for 2012 and 2011 was 2.4% and 455.5% respectively. 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, expired tax attribute carryforwards and an increase in the valuation allowance on the pre-tax loss. The principal cause of the difference between the effective rate and the U.S. statutory rate of 35% in 2011 was the dividend received deduction and an increase in the valuation allowance on the pre-tax income.
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 Company incurred $63.0 million in 2013 for audit, financial and actuarial consulting, legal and bond consent solicitation expenses related to the restatement process and preparation of restated financial statements.
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.
Certain of our policies may be surrendered for value or exchanged for a different one of our products (internal replacement). The deferred policy acquisition costs balance associated with the replaced or surrendered policies is adjusted to reflect these surrenders.
Separate account return assumptions are derived from the long-term returns observed in the asset classes in which the separate accounts are invested. Short-term deviations from the long-term expectations are expected to revert to the long-term assumption over five years.
Investment returns are based on the current yields and maturities of our fixed income portfolio combined with expected reinvestment rates given current market interest rates. Reinvestment rates are assumed to revert to long-term rates implied by the forward yield curve and long-term default rates. Contractually permitted future changes in credited rates are assumed to help support investment margins.
All assumption changes, whether resulting from the annual comprehensive review or from other periodic assessments, are considered an unlock in the period of revision. An unlock adjusts the deferred policy acquisition cost, SIA and URR balances as well as additional death benefit reserves and COI balances in the consolidated balance sheets. An unlock that results in an after-tax benefit generally occurs as a result of actual experience or future expectations of product profitability being favorable compared to previous estimates. An unlock that results in an after-tax charge generally occurs as a result of actual experience or future expectations of product profitability being unfavorable compared to previous estimates.
Separate account returns: Trends in equity markets have been reflected in the separate account return assumptions for variable annuities and variable universal life business. Our sensitivity analysis of the impact of this assumption indicates that at December 31, 2012, had we reprojected EGPs using a 100 basis point lower separate account return assumption (after fund fees and mortality and expense charges) 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 $5.7 million, before taxes. Conversely, a 100 basis point increase in the separate account return assumption would have decreased amortization and increased net income by approximately $7.1 million, before taxes.
Interest rates and default rates: Changes in estimates of future interest rates result in changes in the amortization of deferred policy acquisition costs associated with certain products because future EGPs include interest margins. The impacts of such a change depend on a variety of factors including the period over which the change is expected, the relative change between short-term and long-term interest rates, and management’s ability and preparedness to change policy credited rates.
Generally, future policy benefits are payable over an extended period of time and related liabilities are calculated recognizing future expected benefits, expenses and premiums. Such liabilities are established based on methods and underlying assumptions in accordance with U.S. GAAP and applicable actuarial standards. Principal assumptions used in the establishment of liabilities for future policy benefits are mortality, morbidity, policyholder behavior, investment returns, inflation, expenses and other contingent events as appropriate. These assumptions are intended to estimate the experience for the period the policy benefits are payable. Utilizing these assumptions, liabilities are established on a cohort basis, as appropriate. If experience is less favorable than assumed, additional liabilities may be established, resulting in a charge to policyholder benefits and claims.
See Note 3 to our consolidated 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 Annual Report on Form 10-K for more information.
Our fair value calculation of embedded derivative liabilities includes a credit standing adjustment (the “CSA”). The CSA represents the adjustment that market participants would make to reflect the risk that guaranteed benefit obligations may not be fulfilled (“non-performance risk”). We estimate our CSA using the credit spread (based on publicly available credit spread indices) for financial services companies similar to the Company’s life insurance subsidiaries.
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, 2012 fair value of $27.6 million would increase to $29.8 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 $25.5 million. The impact of the CSA related to variable annuity GMAB and GMWB embedded derivatives at December 31, 2012 and 2011 was a reduction of $17.1 million and $38.0 million in the reserves associated with these riders, respectively.
We classify our debt and equity securities as available-for-sale and report them in our consolidated balance sheets at fair value. Fair value is based on quoted market price or external third party information, where available. When quoted market prices are not available, we estimate fair value by discounting debt security cash flows to reflect interest rates currently being offered on similar terms to borrowers of similar credit quality, by quoted market prices of comparable instruments and by independent pricing sources or internally developed pricing models.
As of December 31, 2012, we concluded that our estimates of future taxable income, certain tax planning strategies and other sources of income did not constitute sufficient positive evidence to assert that it is more likely than not that certain deferred tax assets would be realizable. Accordingly, a valuation allowance of $523.3 million has been recorded on net deferred tax assets of $572.7 million. The remaining deferred tax asset of $49.4 million attributable to available-for-sale debt securities with gross unrealized losses does not require a valuation allowance due to our ability and intent to hold these securities until recovery of principal value through sale or contractual maturity, thereby avoiding the realization of taxable losses. This conclusion is consistent with prior periods. The impact of the valuation allowance on the allocation of tax to the components of the financial statements included an increase of $48.4 million in continuing operations, an increase of $55.1 million in OCI-related deferred tax balances and an increase of $6.0 million recorded to discontinued operations.
We have three defined benefit pension plans covering our employees. The employee pension plan provides benefits up to the amount allowed under the Internal Revenue Code. The two supplemental plans provide benefits in excess of the primary plan. Retirement benefits under the plans are a function of years of service and compensation. Effective March 31, 2010, all benefit accruals under all of our funded and unfunded defined benefit plans were frozen. This change was announced in 2009 and a curtailment was recognized at that time for the reduction in the expected years of future service.
Year ended December 31, 2012 compared to year ended December 31, 2011
Net investment income increased by $6.4 million to $829.3 million for the twelve months ended December 31, 2012 compared to $822.9 million for the twelve months ended December 31, 2011. The increase was due to higher investment income on long-term debt securities as a result of additional purchases during the year and higher returns on private equity investments. These increases were partially offset by lower interest income on policy loans due to the declining balance of policy loans outstanding.
Net realized investment losses of $10.5 million were recognized for the twelve months ended December 31, 2012 compared to net realized investment losses of $32.1 million for the twelve months ended December 31, 2011. Net realized gains on sales of long-term debt securities accounted for $31.0 million of the total realized gains over the year as interest rates reached historically low levels in 2012. Common and preferred equity investments and other alternative investments accounted for gains of $13.3 million due to strong performance in global equity markets during 2012. These gains were partially offset by impairments of $28.8 million on long-term debt securities and common stock and losses of $38.3 million on derivative assets and embedded derivative liabilities. These derivative losses were primarily attributable to a loss of $34.2 million on derivative contracts which hedge the variable annuity and fixed indexed annuity guarantees, offset by $12.1 million in gains on embedded derivative liabilities associated with fixed and variable annuity guarantees. Included in the net derivative loss were gains of $9.8 million associated with the non-performance risk factor. In addition, realized losses of $15.9 million related to our surplus hedge, which utilizes futures and options to hedge against declines in equity markets and the resulting statutory capital and surplus impact.
The Company recorded an income tax benefit of $3.7 million to continuing operations in 2012, compared to an income tax expense of $12.3 million to continuing operations in 2011. A current tax expense of $15.6 million was recognized related to the accrual of regular taxes, offset by available credits up to the alternative minimum tax liability. This current tax expense was offset by a deferred tax benefit of $19.3 million that results from the application of ASC 740 intraperiod allocation rules. These rules allow for the benefitting of current year losses in continuing operations when an increase to the valuation allowance is avoided due to the existence of current year income elsewhere reported in the financial statements (e.g., discontinued operations, other comprehensive income). In 2011, a current tax expense of $12.3 million was recognized related to alternative minimum tax.
Net realized investment losses of $32.1 million were recognized for the twelve months ended December 31, 2011 compared to net realized investment losses of $11.2 million for the twelve months ended December 31, 2010. Net realized gains on sales of long-term debt securities accounted for $8.6 million of the total realized gains over the year. Common equity investments accounted for gains of $3.8 million. These gains were partially offset by impairments of $26.8 million on long-term debt securities and common stock and losses of $20.0 million on derivative assets and embedded derivative liabilities. The Company recognized a realized capital gain of $4.0 million from the sale of Goodwin.
Policy acquisition cost amortization decreased $110.3 million for the twelve months ended December 31, 2011 compared to the twelve months ended December 31, 2010. This decrease in amortization was attributable to the unlocking of assumptions as a result of annual comprehensive reviews of assumptions in the third quarters of 2011 and 2010. The unlocking resulted in an overall decrease in amortization of $2.8 million in 2011, compared to an acceleration of amortization of $58.1 million in 2010. In 2010, the unlocking was primarily driven by increased lapses in portions of our universal life business which resulted in $36.6 million of additional amortization. Excluding the impact of the unlocking, amortization was lower by $52.3 million as a result of less favorable mortality experience during 2011 primarily within the universal life product line.
Operating expenses decreased $40.7 million to $247.9 million in the twelve months ended December 31, 2011, compared to $288.6 million in the twelve months ended December 31, 2010. The decrease in operating expenses was a result of lower professional fees and outside services as well as lower compensation related expenses.
The Company recorded an income tax expense of $12.3 million to continuing operations in 2011, compared to an income tax benefit of $10.3 million to continuing operations in 2010. A current tax expense of $12.3 million was recognized related to alternative minimum tax. In 2010, as a result of the application of the same intraperiod allocation rules that were applicable and described above in relation to 2012, a $14.4 million tax benefit was recorded to continuing operations, which was offset by current tax expense of $4.1 million.
The Company recorded a net loss from continuing operations for the three months ended March 31, 2012 of $13.1 million, or $(2.25) per share, compared with a net loss from continuing operations of $9.7 million, or $(1.67) per share for the three months ended March 31, 2011. The decrease in results from continuing operations reflects lower premiums and fee income and a higher income tax expense. These items were partially offset by higher net investment income and lower policy benefits.
Fees on our life and annuity products decreased $8.0 million in the three months ended March 31, 2012 compared with the three months ended March 31, 2011. Lower fees were primarily a result of COI charges which decreased $7.9 million related to declining universal life and variable universal life insurance in force.
For the three months ended March 31, 2012 and 2011, the net losses from discontinued operations of $0.5 million and $1.5 million, respectively, primarily consisted of legal expenses associated with litigation related to our indemnification of Tiptree in accordance with the definitive sales agreement.
The Company’s net loss from continuing operations for the three months ended June 30, 2012 was $30.0 million, or ($5.16) per share, compared with a net loss from continuing operations of $7.3 million, or ($1.26) per share for the three months ended June 30, 2011. The increase in the net loss reflects declines in fee income and net investment income and an increase in net realized investment losses. These declines in results were partially offset by lower policy benefits.
Net realized investment losses of $17.3 million were recognized for the three months ended June 30, 2012, compared with a net realized investment gain of $1.6 million for the three months ended June 30, 2011. Realized investment losses for the quarter were due to an impairment loss of $5.1 million on common stock and long-term debt securities and a net loss of $13.7 million on derivative assets and embedded derivative liabilities. These losses were partially offset by net realized gains on $3.2 million on long-term debt securities. The derivative loss was attributable to a loss of $24.3 million on our embedded derivative liabilities associated with variable and fixed indexed annuity guarantees and a $7.0 million loss on derivative contracts associated with our fixed indexed annuity guarantees. These losses were offset by derivative gains of $15.5 million on derivative contracts related to variable annuity guarantees and a gain of $1.6 million related to our surplus hedge which utilizes futures and options to hedge against declines in equity markets and the resulting statutory capital and surplus impact. A loss of $3.5 million related to the non-performance risk factor was included in the total derivative loss.
The Company recorded an income tax benefit of $7.4 million to continuing operations for the quarter ended June 30, 2012 compared with income tax expense of $8.6 million as of June 30, 2011. The decrease was driven by a $13.0 million benefit that results from the application of ASC 740 intraperiod allocation rules. These rules allow for the benefitting of current year losses in continuing operations when an increase to the valuation allowance is avoided due to the existence of current year income elsewhere reported in the financial statements (e.g., discontinued operations, other comprehensive income). This benefit was offset by a decrease of $5.6 million of current tax accrued.
Net investment income increased by $1.6 million to $205.1 million for the three months ended September 30, 2012 compared to $203.5 million for the three months ended September 30, 2011. The increase was due to higher investment income on long-term debt securities as a result of additional purchase over the period which was partially offset by lower interest income on policy loans due to the declining balance of loans outstanding.
Gain on debt repurchase increased by $11.9 million for the three months ended September 30, 2012 compared with the three months ended September 30, 2011. The Company repurchased $48.3 million par value of surplus notes during 2012.
Policy acquisition cost amortization increased $36.6 million for the three months ended September 30, 2012 compared with the three months ended September 30, 2011. This increase in amortization was attributable to the unlocking of assumptions as a result the annual comprehensive review of assumptions in the third quarter of 2012. The unlocking resulted in an overall increase in amortization of $46.3 million in the third quarter of 2012, which included an increase of $37.0 million for traditional life policies from lower projected net yields related to investment income returns and an increase of $6.7 million for universal life policies from lower spreads due to low interest rate environment. Excluding the impact of the unlocking, amortization decreased related to variable and universal life as a result of poor mortality experience during the current quarter. Amortization related to annuities decreased primarily as a result of improved market performance.
A net loss from discontinued operations of $6.0 million was recognized for the three months ended September 30, 2012, primarily due to outside legal expenses associated with litigation related to our indemnification of Tiptree in accordance with the definitive sales agreement.
Three months ended December 31, 2012 compared with three months ended December 31, 2011
The Company recorded a net loss from continuing operations for the three months ended December 31, 2012 of $17.2 million, or $(3.02) per share, compared with a net loss from continuing operations of $4.2 million, or $(0.72) per share for the three months ended December 31, 2011. The decrease in results from continuing operations reflects lower premiums and fee income. These declines in results were partially offset by higher net investment income.
Premium revenue decreased $13.4 million in the three months ended December 31, 2012 compared with the three months ended December 31, 2011 as a result of lower renewal premiums in the closed block, as well as lower paid up additions on policies within the closed block due to a change in the dividend scale in 2011.
Fees on our life and annuity products decreased $7.9 million in the three months ended December 31, 2012 compared with the three months ended December 31, 2011. Lower fees were primarily a result of COI charges which decreased $13.2 million primarily related to declining universal life insurance in force. These decreases were partially offset by a $2.6 increase in administrative fees on annuity products and a $3.0 million increase in Saybrus commissions as a result of product sales during the quarter.
Net investment income increased by $11.2 million to $206.0 million for the three months ended December 31, 2012 compared to $194.8 million for the three months ended December 31, 2011. The increase was due to higher returns on private equity and infrastructure funds, which were partially offset by lower interest income on policy loans due to the declining balance of policy loans outstanding.
Net realized investment losses of $12.1 million were recognized for the three months ended December 31, 2012 compared to net realized investment losses of $14.1 million for the three months ended December 31, 2011. Net realized gains of $5.3 million on long-term bonds and common stock gains of $3.3 million were offset by an impairment loss of $9.5 million on long-term debt securities and losses on derivative assets and embedded derivative liabilities totaling $11.8 million. This derivative loss was primarily attributable to a loss of $13.2 million on derivatives associated with variable fixed indexed annuity guarantees, offset by $5.2 million in gains on embedded derivatives liabilities associated with variable and fixed indexed annuity guarantees. Included in the net derivative loss were gains of $3.0 million associated with the non-performance risk factor. In addition, realized losses of $3.5 million related to our surplus hedge, which utilizes futures and options to hedge against declines in equity markets and the resulting statutory capital and surplus impact.
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, 2012, 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.
We also manage interest rate risk by emphasizing the purchase of securities that feature prepayment restrictions and call protection. Our product design and pricing strategies include the use of surrender charges or restrictions on withdrawals in some products. The Company’s exposure to interest rate risk has been consistent from year to year.
The selection of a 100 basis point immediate increase or decrease in interest rates at all points on the yield curve is a hypothetical rate scenario used to demonstrate potential risk. While a 100 basis point immediate increase or decrease of this type does not represent our view of future market changes, it is a hypothetical near-term change that illustrates the potential effect of such events. Although these fair value measurements provide a representation of interest rate sensitivity, they are based on our portfolio exposures at a point in time and may not be representative of future market results. These exposures will change as a result of ongoing portfolio transactions in response to new business, management’s assessment of changing market conditions and available investment opportunities.
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 $34.8 and $35.7 million in available-for-sale equity securities on our consolidated balance sheets as of December 31, 2012 and 2011, respectively.
As part of our analysis of separate account returns, we perform two sensitivity tests. If at December 31, 2012 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 $5.7 million, before taxes.
If, instead, at December 31, 2012 we had reprojected EGPs using a 100 basis points higher separate account return assumption (after fund fees and mortality and expense charges) for both the variable annuity and variable life businesses and used our current best estimate assumptions for all other assumptions, the estimated decrease to amortization and increase to net income would have been approximately $7.1 million, before taxes.
Effective March 31, 2010, all benefit accruals under all of our funded and unfunded defined benefit plans were frozen. This change was announced in 2009 and a curtailment was recognized at that time for the reduction in the expected years of future service.
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 fixed maturity 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.
See Note 14 to our consolidated financial statements under “Item 8: Financial Statements and Supplementary Data” in this Annual Report on Form 10-K for additional information regarding the estimated fair value of investments.
Individual categories may not agree with the Debt Securities by Type table on previous page due to nature of underlying collateral. In addition, RMBS holdings in this exhibit include $30.6 million classified as fair value investments on the consolidated balance sheets. For these fair value investments, there is no impact to OCI as carrying value is equal to market value.
Includes commercial mortgage-backed CDOs with amortized cost and market values of $34.2 million and $24.7 million, respectively.
In addition to these credit-related impairments recognized through earnings, we impaired securities to fair value through other comprehensive loss for any impairments related to non-credit related factors. These types of impairments were driven primarily by market or sector credit spread widening or by a lack of liquidity in the securities. The amount of impairments recognized as an adjustment to other comprehensive loss due to these factors was $22.9 million in 2012, $38.5 million in 2011 and $58.7 million in 2010.
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 comprehensive income.
The following tables present certain information with respect to our gross unrealized gains and losses related to our investments in debt securities as of December 31, 2012. We separately present information that is applicable to unrealized losses both outside and inside the closed block. See Note 9 to our consolidated financial statements under “Item 8: Financial Statements and Supplementary Data” in this Annual Report on Form 10-K for more information regarding the closed block. Applicable deferred policy acquisition costs and deferred income taxes further reduce the effect of unrealized gains and losses on our comprehensive income.
For debt securities inside the closed block with gross unrealized losses, there were no unrealized losses after offsets at December 31, 2012.
Cash used for operating activities decreased by $184.8 million during the year ended December 31, 2011 compared to the year ended December 31, 2010. This was primarily attributable to a decrease in policyholder benefits consistent with favorable persistency and mortality. While operating cash flows remain negative for the year ended December 31, 2011, this was primarily driven by cash surrenders of deposit-type contracts for which funds were readily available in segregated separate accounts or liquid general account assets.
Cash used for operating activities increased by $21.4 million during the three months ended March 31, 2012 compared with the three months ended March 31, 2011. This was primarily attributable to lower renewal premiums on our legacy blocks of business due to a declining in force population. Offsetting this is the reduced base compensation cost due to the sale of Goodwin during the third quarter of 2011.
Cash used for operating activities increased by $13.6 million during the six months ended June 30, 2012 compared with the six months ended June 30, 2011. This was primarily attributable to lower death benefit payments on variable universal life policies as compared to June 30, 2011 and reduced base compensation cost due to the sale of Goodwin during the third quarter of 2011. Offsetting these impacts were lower renewal premiums on our legacy blocks of business due to a declining in force population.
Cash flows used for operating activities increased by $36.9 million as a result of reduced commissions paid related to lower sales of our fixed indexed annuity product and the reduced base compensation cost due to the sale of Goodwin during the third quarter of 2011. Offsetting this impact was unfavorable mortality in the third quarter of 2012 on our universal life block of business and lower renewal premiums on our legacy blocks of business due to a declining in force population.
Cash flows provided by financing activities decreased by $166.9 million as a result of a decrease in fixed indexed annuity deposits and an increase in fixed indexed annuity withdrawals as compared to September 30, 2011. Further, the Company repurchased and retired $48.3 million par amount of its outstanding 7.15% surplus notes for aggregate consideration of $36.2 million during 2012.
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 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 $78.3 million in 2013. During the year ended December 31, 2012, Phoenix Life declared $71.8 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. Phoenix Life may have less flexibility to pay dividends to the parent company if we experience declines in either statutory capital or RBC in the future. As of December 31, 2012, we had $922.5 million of statutory capital, surplus and asset valuation reserve (“AVR”). Our estimated RBC ratio was in excess of 250% at Phoenix Life. See Notes 22 and 28 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, regulatory matters and dividends to the parent.
The increase in cash used for operating activities for the year ended December 31, 2011, compared to the year ended December 31, 2010, was primarily attributable to a $3.3 million payment by the parent company to Phoenix Life in December 2011 to cover operating expenses of Goodwin, which was sold in November 2011.
The increase in cash provided by investing activities was due mainly to $25.5 million lower capital contributions to subsidiaries and a $39.8 million increase in dividends from Phoenix Life offset by a $7.3 million reduction in proceeds from the sale of a subsidiary.
The cash values 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, 2012, our Life Companies had approximately $10.7 billion 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, 2012 were $2.4 billion.
Aggregate life surrenders in 2012 were 5.8% of related reserves, compared with 6.6% in 2011. Cash, treasuries and agency mortgage-backed securities accounted for 10.6% of fixed income investments at year end 2012, as compared to 8.7% at year end 2011. 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.
On September 20, 2012, the Board authorized a program to repurchase up to an aggregate amount of $25,000,000 (not including fees and expenses) of the Company’s outstanding common stock shares. Under the stock repurchase program, purchases may be made from time to time in the open market, in accelerated stock buyback arrangements, in privately negotiated transactions or otherwise, subject to market prices and other conditions. No time limit was placed on the duration of the program, which may be modified, extended or terminated by the Board at any time. The Board also terminated the Company’s previously existing stock repurchase program. No shares were repurchased in 2012.
The financial strength and debt ratings as of March 28, 2014 were as follows:
PHLVIC is also rated by A.M. Best Company, Inc. and Standard & Poor’s. Phoenix Life and Annuity Company and American Phoenix Life and Reassurance Company are only rated by A.M. Best Company, Inc. All subsidiaries have the same rating as Phoenix Life.
Deferred policy acquisition costs decreased primarily related to universal life and traditional whole life as a result of amortization during the year ended December 31, 2012. The deferred policy acquisition cost balance associated with fixed annuities increased related to the deferral of commissions on sales of our fixed indexed annuities, partially offset by amortization of previously deferred expenses. The table below presents deferred policy acquisition cost by product.
The decrease in the deferred income tax assets recorded is attributable to the current period reduction of unrealized losses on the Company’s available-for-sale debt securities for which a deferred tax asset has been recorded.
The majority of the decrease in discontinued assets and liabilities during the year ended December 31, 2012 was a result of the commutation of certain contracts during the second quarter of 2012.
Deferred policy acquisition costs decreased primarily related to universal life as a result of amortization during the quarter ended March 31, 2012. The deferred policy acquisition cost balance associated with the fixed annuities increased related to the deferral of commissions on sales of our fixed indexed annuities, partially offset by amortization. The table below presents deferred policy acquisition cost by product.
The decrease in deferred tax assets recorded is attributable to the current period reduction of unrealized losses on the Company’s available-for-sale debt securities for which a deferred tax asset has been recorded.
The decline in other assets at March 31, 2012 as compared with December 31, 2011 was primarily a result of a decrease in investment receivables attributable to a lower volume of unsettled investment sales, a decrease in the current tax receivable and a decrease in premises and equipment related to amortization.
Separate accounts increased as a result of favorable market performance during the quarter and positive variable universal life net flows, partially offset by variable annuity surrenders.
Policyholder deposit funds increased primarily as a result of continued sales growth of fixed indexed annuities.
Dividend obligations increased during the three months ended March 31, 2012 primarily resulting from an increase in unrealized gains on the closed block assets related to a decline in interest rates in the first three months of 2012.
Deferred policy acquisition costs decreased primarily related to universal life as a result of amortization during the six months ended June 30, 2012. The table below presents deferred policy acquisition cost by product.
Dividend obligations increased during the six months ended June 30, 2012 primarily resulting from an increase in unrealized gains on the closed block assets related to a decline in interest rates in the first six months of 2012.
The increase in total investments was the result of purchases of securities associated with positive cash flow generated by our annuity business as sales continue to increase. In addition, the value of available-for-sale debt securities improved as a result of favorable impacts on fixed income securities as treasury rates declined during the first three quarters of 2012. Partially offsetting these increases was a decline in policy loans outstanding.
Policyholder deposit funds increased during the nine months ended September 30, 2012 primarily as a result of continued sales growth of fixed indexed annuities.
During the third quarter of 2012, $48.3 million of surplus notes were repurchased from the open market.
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 3 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 consolidated balance sheets 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, 2012 consolidated balance sheets 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.
The definitive agreement contains a provision requiring us to indemnify Tiptree for any losses due to actions resulting from certain specified acts or omissions associated with the divested business prior to closing. There has been litigation filed that falls within this provision of the agreement but does not name the Company as a party to the litigation. We intend to defend these matters vigorously based on our indemnity commitment.
Included within the January 4, 2010 agreement with Tiptree was a provision for the purchase of PLARNY pending regulatory approval. On September 24, 2010, approval was obtained from the NYDFS for Tiptree and PFG Holdings Acquisition Corporation to acquire PLARNY. The transaction closed on October 6, 2010. Because of the divestiture, these operations are reflected as discontinued operations.
We provide our employees with post-employment benefits that include retirement benefits, through pension and savings plans, and other benefits, including health care and life insurance. Employee benefit expense related to these plans totaled $15.5 million, $16.5 million and $22.4 million for 2012, 2011 and 2010, respectively.
The employee pension plan is a qualified plan that is funded with assets held in a trust. It is the Company’s practice to make contributions to the qualified pension plan at least sufficient to avoid benefit restrictions under funding requirements of the Pension Protection Act of 2006. This generally requires the Company to maintain assets that are at least 80% of the plan’s liabilities as calculated under the applicable regulations at the end of the prior year. Under these regulations, the qualified pension plan is currently funded above 80% of the funding target liabilities as of December 31, 2012.
The funded status of the qualified pension plan based on the projected benefit obligations for the years ended December 31, 2012 and 2011 are summarized in the following table:
The changes in the projected benefit obligations of the employee plan at December 31, 2012 as compared to December 31, 2011 were principally the result of accrued interest cost and actuarial losses due to assumption changes.
The changes in the projected benefit obligations of the supplemental plans at December 31, 2012 as compared to December 31, 2011 were principally the result of accrued interest cost and actuarial losses due to assumption changes.
We also have a postretirement benefit plan, which is unfunded and had projected benefit obligations of $40.6 million and $59.6 million as of December 31, 2012 and 2011, respectively. We fund periodic benefit payments under this plan from cash flows from operations as they become due.
We have entered into agreements with certain key executives of the Company that will, in certain circumstances, 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 on our pension and other post-employment benefits.
Effective October 1, 2011, Phoenix Life entered into an agreement that provides modified coinsurance for approximately one-third of the closed block policies. This contract did not meet the requirements of risk transfer in accordance with U.S. GAAP, and therefore, deposit accounting is applied.
See Note 22 to our consolidated financial statements under “Item 8: Financial Statements and Supplementary Data” in this Annual Report on Form 10-K regarding the Life Companies’ statutory financial information and regulatory matters.