The Registrant’s home office is located in Little Rock, Arkansas. Personnel performing services for the Registrant operate in Transamerica Corporation office space in Cedar Rapids, Iowa and St. Petersburg, Florida. An allocable share of the cost of each of the above mentioned premises was paid by the Registrant through the common cost allocation service agreement. We believe that our existing offices are adequate to meet our current requirements and we anticipate that suitable additional or substitute space will be available, as necessary, upon favorable terms.
TALIC conducts its business primarily in the annuity markets and to a lesser extent in the life insurance and fixed contingent annuity markets of the financial services industry. The Company offered the following guaranteed benefits within its variable annuity product suite: guaranteed minimum death benefits (“GMDB”) guaranteed minimum income benefits (“GMIB”) and guaranteed minimum withdrawal benefits (“GMWB”). In addition, the Company’s fixed contingent annuity (also sometimes referred to as a contingent deferred annuity (“CDA”)), includes a stand-alone living benefit (“SALB”).
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions affecting the reported amounts of assets, liabilities, revenues and expenses and the disclosures of contingent assets and liabilities. Estimates, by their nature, are based on judgment and available information. Therefore, actual results could differ and could have a material impact on the financial statements.
The Company’s portfolio of private placement securities is valued using a matrix pricing methodology. The pricing methodology is obtained from a third party service and indicates current spreads for securities based on weighted average life, credit rating and industry sector. Monthly the Company reviews the matrix to ensure the spreads are reasonable by comparing them to observed spreads for similar securities traded in the market. In order to account for the illiquid nature of these securities, illiquidity premiums are included in the valuation and are determined based upon the pricing of recent transactions in the private placement market as well as comparing the value of the privately offered security to a similar public security. The impact of the illiquidity premium to the overall valuation is less than 2% of the fair value. At December 31, 2015 and 2014, approximately $110.9 million (or 7%) and $106.4 million (or 6%), respectively, of the Company’s fixed maturity and equity securities portfolio consisted of private placement securities.
Changes in the fair value of fixed maturity and equity securities deemed AFS are reported as a component of accumulated other comprehensive income (loss), net of taxes on the Balance Sheets and are not reflected in the Statements of Income until a sale transaction occurs or when credit-related declines in estimated fair value are deemed other-than-temporary.
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 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, 1) certain credit-related events such as default of principal or interest payments by the issuer, 2) bankruptcy of issuer, 3) certain security restructurings, and 4) 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 equity securities, once management determines a decline in the value of an AFS security is other-than-temporary, the cost basis of the equity security is reduced to its fair value, with a corresponding charge to earnings. Objective evidence of impairment of an investment in an equity instrument classified as available-for-sale includes information about significant changes with an adverse effect that have taken place in the technological, market, economic or legal environment in which the issuer operates, and indicates that the cost of the investment in the equity instrument may not be recovered. As part of an ongoing process, the equity analysts actively monitor earnings releases, company fundamentals, new developments and industry trends for any signs of possible impairment. If an available-for-sale equity security is impaired based upon the Company’s qualitative or quantitative impairment criteria, any further declines in the fair value at subsequent reporting dates are recognized as impairments. Therefore, at each reporting period, for an equity security that is determined to be impaired based upon the Company’s impairment criteria, an impairment is recognized for the difference between the fair value and the original cost basis, less any previously recognized impairments.
(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.
Debt securities are monitored individually for impairments based on our asset specialists expectations of payment interruption in the next 12-18 months. The probability of interruption is based on assessments of capital markets, funding needs and the liquidity profile of the issuer. Specific to energy holdings as of the balance sheet date, our expectations are in line with the markets assuming a gradual migration to an oil price per barrel of $40 to $45 by year end 2016. Considering this, it was determined that the probability of default of our energy holdings was not significant enough to warrant impairment.
Standard and Poor’s (S&P) futures contracts and interest rate futures contracts are used to hedge the equity risk and interest rate risk, respectively, associated with these types of variable guaranteed products, in particular the claim and/or revenue risks of the liability portfolio. Net settlements on the futures occur daily. The realized gains (losses) on settlement of these futures are recorded in net derivative gains (losses) in the Statements of Income.
During the third quarter of 2013, the Company entered into cash flow hedging transactions on Treasury Inflation Protected Securities (“TIPS”) utilizing interest rate swaps to lengthen portfolio duration and to hedge the variability of cash flows due to changes in inflation. The Company recognizes hedge ineffectiveness gains (losses) from the difference of the change in fair value of the swap and the change in fair value of the underlying Treasury in net derivative gains (losses) in the Statements of Income.
During the fourth quarter of 2015, the Company entered into fixed-to-float and float-to-fixed interest rate swaps in order to hedge the interest rate risk on the underlying liability. The Company holds these contracts at fair market value, and gains (losses) related to changes in fair value are recognized in net derivative gains (losses) in the Statements of Income.
The Company also uses an option strategy to hedge equity risk. These derivatives were purchased in the second quarter of 2015 as part of a hedging program which hedges a specific range of equity market decline. The strategy has limited profitability but also limited risk characteristics due to the structure of the package of put options. The Company recognizes gains (losses) from the change in fair value of the options in net derivative gains (losses) in the Statements of Income.
For acquired annuity and variable life insurance contracts, VOBA is amortized in proportion to estimated gross profits arising principally from investment margins, mortality and expense margins, rider margins, and surrender charges, based on historical and anticipated future experience, which is updated periodically. Revisions in estimates result in changes to the amounts amortized 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. See Note 4 to the financial statements for 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 the group of acquired contracts. DAC are subject to recoverability testing at the time of the policy issuance and loss recognition testing at the end of each reporting period. At December 31, 2015 and 2014, variable annuities accounted for the Company’s entire DAC asset of $37.5 million and $41.1 million, respectively.
The Company offers a sales inducement whereby the contract owner receives a bonus that increases the initial account balance by an amount equal to a specified percentage of the contract owner’s deposit. This amount may be subject to recapture under certain circumstances. Consistent with DAC, sales inducements for variable annuity contracts are deferred and amortized based on the estimated future gross profits for each group of contracts. The long-term equity growth rate assumption for the amortization of DSI was 8% at December 31, 2015 and 2014. These future gross profit estimates are subject to periodic evaluation by the Company, with necessary revisions applied against amortization (accretion) to date. The impact of these revisions on cumulative amortization (accretion) is recorded as a charge or credit to current operations, commonly referred to as “unlocking”. It is reasonably possible that estimates of future gross profits could be reduced in the future, resulting in a material reduction in the carrying amount of the DSI asset.
Future policy benefits also include liabilities, for contracts containing GMWB and SALB provisions and for the reinsurance of GMIB provisions (“GMIB reinsurance”) for contracts based on the fair value of the underlying benefit. GMWB and GMIB reinsurance are treated as embedded derivatives and are required to be reported separately from the host contract. The fair values of these guarantees are calculated as the present value of future expected payments to policyholders less the present value of assessed fees attributable to the guarantees. Given the complexity and long-term nature of these guarantees, which are unlike instruments available in financial markets, their fair values are determined using stochastic techniques under a variety of market return scenarios. A variety of factors are considered, including expected market rates of return, equity and interest rate volatility, credit spread, correlations of market returns, discount rates and actuarial assumptions. Currently, the Company does not hedge the risks associated with the SALB.
The valuation allowance for deferred tax assets at December 31, 2015 and 2014 was $130.9 million and $113.4 million, respectively (this includes losses that are anticipated to be used in the consolidated group to reflect the income statement impact of the losses that would not be used if filing separately). The valuation allowance is related to loss carryforwards and other deferred tax assets that, in the judgment of management, are not more likely than not to be realized on a separate return basis. In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that all or some of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets depends on generation of future taxable income during the periods in which those temporary differences are deductible. Management considers the scheduled reversal of deferred tax liabilities, projected taxable income, and tax-planning strategies in making the assessment.
The Company filed a separate federal income tax return for the years 2008 through 2012. A consolidated tax return was filed for 2013 and 2014. An examination by the Internal Revenue Service is in progress for the years 2011 through 2013. The company believes that there are adequate defenses against or sufficient provisions established related to any open or contested tax positions. A consolidated tax return has not yet been filed for 2015.
Total direct deposits (including internal exchanges from fixed to variable annuities or vice versa) were $22.4 million, $21.6 million, and $30.4 million for the years ended December 31, 2015, 2014 and 2013, respectively. Deposits are currently limited to additions to existing policies which will result in fluctuations period over period. Internal exchanges during 2015, 2014 and 2013 were $6.8 million, $6.8 million, and $3.8 million, respectively.
The Company monitors industry sectors and individual debt securities for evidence of impairment. This evidence may include one or more of the following: 1) deteriorating market to book ratio, 2) increasing industry risk factors, 3) deteriorating financial condition of the issuer, 4) covenant violations of the issuer, 5) high probability of bankruptcy of the issuer, 6) nationally recognized credit rating agency downgrades, and/or 7) intent or requirement to sell before a debt security’s anticipated recovery. Additionally, for structured securities (asset-backed securities (“ABS”), residential mortgage-backed securities (“RMBS”), and commercial mortgage-backed securities (“CMBS”)), cash flow trends and underlying levels of collateral are monitored. A security is impaired if there is objective evidence that a loss event has occurred after the initial recognition of the asset that has a negative impact on the estimated future cash flows. A specific security is considered to be impaired when it is determined that it is probable that not all amounts due (both principal and interest) will be collected as scheduled. For debt 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 debt 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 Company has evaluated the near-term prospects of the issuers in relation to the severity and duration of the unrealized loss, and unless otherwise noted, does not consider these investments to be impaired at December 31, 2015.
The Company’s $0.9 million of gross unrealized losses within the financial services sector has a fair value of $39.9 million. $0.3 million of this total specifically relates to three high yield issuers.
There was one individual issuer rated below investment grade in the industrial sector that had an unrealized loss position greater than $2.5 million. Breitburn Energy Partners had $3.3 million of gross unrealized losses within the energy sub-sector, which was due to low oil and natural gas prices.
The Company’s $1.1 million of gross unrealized losses classified as equity have a fair value of $9.2 million. All of the unrealized loss relates to preferred non-convertible holdings in the banking sub-sector. The impairment review process has resulted in no OTTI charges for the year ended December 31, 2015 for the Company.
Unrealized gains (losses) incurred during 2015 and 2014 were primarily due to price fluctuations resulting from changes in interest rates and credit spreads. If the Company has the intent to sell or it is more likely than not that the Company will be required to sell these securities prior to the anticipated recovery of the amortized cost, securities are written down to fair value. If cash flow models indicate a credit event will impact future cash flows, the security is impaired to discounted cash flows. As the remaining unrealized losses in the portfolio relate to holdings where the Company expects to receive full principal and interest, the Company does not consider the underlying investments to be impaired.
Gross unrealized losses and OTTI on below investment grade AFS securities represented 45% and 63% of total gross unrealized losses and OTTI on all AFS securities at December 31, 2015 and 2014, 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, 2015.
Details underlying AFS securities below investment grade and in an unrealized loss position were as follows:
The following tables provide the ABS subprime mortgage exposure by rating and estimated fair value by vintage at December 31, 2015 and 2014:
The fair value for mortgage loans on real estate is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and or similar remaining maturities. The estimated fair value of the mortgage loans on real estate at December 31, 2015 and 2014 was $92.9 million and $71.4 million, respectively. There were 14 new mortgage loans in 2015 which drove the increase in fair value from 2014. There was one impaired mortgage loan during 2014 which was subsequently sold during the period for a ($2.0) million realized loss. There were no impaired mortgage loans at December 31, 2015 or 2014. The general reserve at December 31, 2015 and 2014 was less than $0.1 million. The change in the valuation allowance and the general reserve is reflected in net realized investment gains (losses), excluding OTTI losses on securities in the Statements of Income. At December 31, 2015 and 2014, there were no mortgage loans that were two or more payments delinquent. See Note 3 to the Financial Statements for further discussion.
The following table provides a summary of the securities under securities lending agreements for the years ended at December 31:
The decrease in the payables for collateral under securities loaned was due to a decline in demand for the Company’s securities by borrowers in the market.
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 42% of Separate Accounts assets were invested in equity-based mutual funds at December 31, 2015. 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 2015, the total average variable account balances decreased $0.6 billion (or 9 %) to $6.4 billion as compared to the same period in 2014.
The following table summarizes the Company’s ratings at March 30, 2016:
The Company has utilized public information to estimate the future assessments it will incur as a result of life insurance company insolvencies. At December 31, 2015 and 2014, the Company’s estimated liability for future guaranty fund assessments was $0.1 million. In addition, the Company has a receivable for future premium tax deductions of $4.2 million and $4.5 million at December 31, 2015 and 2014, respectively. The Company regularly monitors public information regarding insurer insolvencies and adjusts its estimated liability as appropriate.
Policy charge revenue decreased $11.1 million to $166.8 million during 2015, as compared to $177.9 million in 2014. The following table provides the changes in policy charge revenue by type for each respective period:
(a) Lower Separate Account Balances during 2015 due to the declining block of business results in lower asset-based policy charge revenue.
(c) Options short the equity total return market which declined during 2015 driving the gains during the year.
(c) During 2015 there was an increase in gross profits resulting in increased amortization compared with 2014 which saw a decrease in gross profits leading to accretion.
(d) The decrease in life insurance mortality expense relates to a decrease in claims activity in 2015 compared to 2014.
For the years ended December 31, 2014 and 2013, the Company recorded net income (loss) of $33.5 million and ($214.3) million, respectively. The change in net earnings during 2014 as compared to 2013 was primarily due to higher realized derivative losses related to the equity collar hedge and the addition of a tax valuation allowance in 2013.
(a) The equity collar was disposed of in the fourth quarter of 2013 which is driving the decrease in losses. The 2013 losses were driven by the increase in the S&P index. This was a zero cost at inception macro equity hedge to protect against a portion of the unhedged equity tail risk by selling a portion of the market upside above the Company’s long term expected return and buying protection against extreme market declines. As a result, when equity markets increase, the equity collars decline in value. When markets decrease, they increase in value.
(c) During 2014 there was a decrease in gross profits resulting in accretion compared with 2013 which saw an increase in gross profits leading to increased amortization.