the charges imposed on variable annuity, CDA and variable life insurance contracts, and
Each month, the Company performs an analysis of the information obtained from third-party services and brokers to ensure that the information is reasonable and produces a reasonable estimate of fair value. The Company considers both qualitative and quantitative factors as part of this analysis, including but not limited to, recent transactional activity for similar fixed maturities, review of pricing statistics and trends, and consideration of recent relevant market events. Other controls and procedures over pricing received from indices, third-party pricing services, or brokers include validation checks such as exception reports which highlight significant price changes, stale prices or un-priced securities. In addition, the Company performs back testing on a sample basis. Back testing involves selecting a sample of securities trades and comparing the prices in those transactions to prices used for financial reporting. Significant variances between the price used for financial reporting and the transaction price are investigated to explain the cause of the difference.
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, 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.
Loans are considered impaired when it is probable that based upon current information and events, the Company will be unable to collect all amounts due under the contractual terms of the loan agreement. When the Company determines that a loan is impaired, a valuation allowance is established for the excess carrying value of the loan over its estimated collateral value. Changing economic conditions impact the valuation of mortgage loans. Changing vacancies and rents are incorporated into the discounted cash flow analysis that the Company performs for monitored loans and may contribute to the establishment of (or an increase or decrease in) an allowance for losses. In addition, the Company continues to monitor the entire commercial mortgage loan portfolio to identify risk. Areas of emphasis are properties that have deteriorating credits or have experienced debt coverage reduction. Where warranted, the Company has established or increased loss reserves based upon this analysis. The Company does not accrue interest on loans ninety days past due. The Company also establishes a general reserve which is calculated by applying a percentage, based on risk rating and maturity, to the outstanding loan balance.
At December 31, 2014 and 2013, there was $66.7 million and $46.4 million, respectively, in mortgage loans on real estate recorded on the Balance Sheets. The estimated fair value of the mortgage loans on real estate at December 31, 2014 and 2013 was $71.4 million and $51.5 million, respectively. There was one impaired mortgage loan during the first quarter of 2014 which was subsequently sold during the third quarter of 2014 for a ($2.0) million realized loss. There were no impaired mortgage loans at December 31, 2014 or 2013. The general reserve at December 31, 2014 and 2013 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, 2014 and 2013, there were no mortgage loans that were two or more payments delinquent. See Note 4 to the Financial Statements for further discussion.
Derivatives are financial instruments in which the value changes in response to an underlying variable that require little or no net initial investment and are settled at a future date. The Company has entered into derivatives, such as futures, options, total return swaps, and variance swaps to hedge minimum guarantees on variable annuity contracts. These derivatives are recognized on the Balance Sheet and are carried at fair value with changes in fair value recognized as a component of net derivative gains (losses) in the Statements of Income.
The Company has entered into variance swaps to hedge the costs of the volatility of the Standard and Poor’s 500 Composite Stock Price Index (“S&P”). These variance swaps are similar to volatility options where the underlying index provides for the market value movements. Variance swaps do not accrue interest, and typically, no cash is exchanged at initiation.
For further discussion of the Company’s use of derivatives, see the Results of Operations and Note 4 to the Financial Statements.
Financial assets that are lent to a third party or that are transferred subject to a repurchase agreement at a fixed price are not derecognized as the Company retains substantially all the risks and rewards of asset ownership. The loaned securities are included in fixed maturity AFS securities in the Balance Sheets. A liability is recognized for cash collateral received, required initially at 102%, on which interest is accrued. If the fair value of the collateral is at any time less than 102% of the fair value of the loaned securities, the counterparty is mandated to deliver additional collateral, the fair value of which, together with the collateral already held in connection with the lending transaction, is at least equal to 102% of the fair value of the loaned securities.
The following table provides a summary of the securities under securities lending agreements for the years ended December 31:
For acquired annuity and variable life insurance contracts, VOBA is amortized in proportion to 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 5 to the Financial Statements for further discussion.
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 credit 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 years ended December 31, 2014, 2013, and 2012, there was a favorable (unfavorable) impact to pre-tax net income related to DAC unlocking of $2.4 million, ($2.2) million, and $0.5 million, respectively. See Note 5 to the Financial Statements for further discussion.
The expense and the subsequent capitalization and amortization (accretion) are recorded as a component of policy benefits in the Statements of Income. At December 31, 2014 and 2013, variable annuities accounted for the Company’s entire DSI asset of $9.4
million and $7.5 million, respectively. For the years ended December 31, 2014, 2013, and 2012, there was a favorable (unfavorable) impact to pre-tax income related to unlocking of $0.9 million, ($0.3) million, and $0.5 million, respectively. See Note 5 to the Financial Statements for a further discussion.
At December 31, 2014 and 2013, GMDB and GMIB liabilities included within future policy benefits were as follows:
The Company regularly evaluates the assumptions used to establish these liabilities, as well as actual experience, and adjusts GMDB and GMIB liabilities with a related charge or credit to earnings (“unlocking”) if actual experience or evidence suggests that the assumptions should be revised. For the years ended December 31, 2014, 2013 and 2012, the favorable impact to pre-tax income related to GMDB and GMIB unlocking was $16.7 million, $35.9 million, and $41.9 million, respectively.
Future policy benefits also include liabilities, which can be either positive or negative, 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 Company filed a separate federal income tax return for the years 2008 through 2012. A consolidated tax return was filed for 2013. An examination by the Internal Revenue Service is in progress for the years 2011 and 2012. 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 2014.
ASC 860, Transfers and Servicing - ASU 2014-11, Repurchase-to-Maturity Transactions, Repurchase Financings, and Disclosure - requires repurchase-to-maturity transactions to be accounted for as secured borrowings and amends accounting for repurchase financings. It also requires disclosure for (1) repurchase agreements, securities lending transactions, and repurchase-to-maturity transactions accounted for as secured borrowings and (2) certain transactions
accounted for as a sale. The guidance will be effective for the Company on January 1, 2015, except for disclosure requirements for certain transactions accounted for as secured borrowings which will be effective on April 1, 2015. The Company is evaluating the impact that adoption will have on the Company’s disclosures.
ASC 606, Revenue from Contracts with Customers - ASU 2014-09, Revenue from Contracts with Customers: Topic 606 (ASU 2014-09) - requires that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The guidance establishes a five-step process to achieve this core principle. ASU 2014-09 will be effective for the Company on January 1, 2017, using either of two methods: retrospective to each prior reporting period presented with certain practical expedients, or retrospective with the cumulative effect of initial application recognized at the date of initial application subject to certain additional disclosures. The Company has not yet selected a transition method and are evaluating the impact that adoption of this update is expected to have on the Company’s financial statements.
Total direct deposits (including internal exchanges) were $21.6 million, $30.4 million, and $35.3 million for the years ended December 31, 2014, 2013 and 2012, respectively. Deposits are currently limited to additions to existing policies which will result in fluctuations period over period. Internal exchanges during 2014, 2013 and 2012 were $6.8 million, $3.8 million, and $6.5 million, respectively.
At December 31, 2014, the Company’s assets were $10.1 billion or $448.0 million less than the $10.6 billion in assets at December 31, 2013. Assets excluding Separate Accounts assets increased $122.8 million. Separate Accounts assets, which represent 67% of total assets, decreased $570.8 million to $6.8 billion. Changes in Separate Accounts assets were as follows:
Four issuers represent more than 5% of the total unrealized loss position, comprised of below investment grade corporate bonds with $4.9 million of unrealized losses at December 31, 2014.
The amortized cost and estimated fair value of fixed maturity AFS securities at December 31, 2014 and 2013 by rating agency equivalent were:
During the fourth quarter of 2014, the Company changed its methodology for determining credit ratings for its fixed maturity AFS securities. The Company changed the rating hierarchy to align more closely with the Credit Name Limit Policy (“CNLP”) as maintained internally by AEGON NV. In previous years the disclosure of ratings followed a hierarchy of S&P, Moody’s, Fitch, Internal and National Association of Insurance Commissioners (“NAIC”). Under the CNLP, a composite rating is used, which is based on a combination of the ratings of the constituents mentioned. The rating used is the lower of the external rating and the internal rating. This change in methodology did not impact net income, total assets or total liabilities.
The investment performance of the underlying U.S. equity-based mutual funds supporting the Company’s variable products do not replicate the returns of any specific U.S. equity market index. However, investment performance will generally increase or decrease with corresponding increases or decreases of the overall U.S. equity market. There are several standard indices published on a daily basis that measure performance of selected components of the U.S. equity market. Examples include the Dow Jones Industrial Average (“Dow”), the NASDAQ Composite Index (“NASDAQ”) and the S&P. The Dow, NASDAQ and S&P ended 2014 with increases of 8%, 13% and 11%, respectively, from 2013. The Dow, NASDAQ and S&P ended 2013 with increases of 27%, 38% and 30%, respectively, from 2012.
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 75% of Separate Accounts assets were invested in equity-based mutual funds at December 31, 2014. 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 2014, the total average variable account balances decreased $0.1 billion (or 1%) to $7.0 billion as compared to the same period in 2013.
The following table summarizes the Company’s policyholders’ obligations at December 31, 2014:
Policy benefits increased $31.0 million during 2014 as compared to 2013. The following table provides the changes in policy benefits by type:
Amortization (accretion) of DAC was ($6.1) million and $12.9 million for 2014 and 2013, respectively, which included favorable (unfavorable) unlocking of $2.4 million and ($2.2) million, respectively. The change in 2014 was primarily driven by updated policyholder assumptions and underperforming Separate Accounts during the year which resulted in accretion and favorable unlocking as compared to 2013.
(a) The decrease in general insurance expense is primarily related to a change in guaranty fund assessments when compared to 2013.
For the years ended December 31, 2013 (As Restated) and 2012, the Company recorded net income (loss) of ($214.3) million and $164.3 million, respectively. The decrease in income during 2013 as compared to 2012 was primarily due to realized derivative losses related to the equity collar hedge, the addition of a tax valuation allowance, higher policy benefits expense offset by lower VOBA amortization expense in 2013.
Net realized derivative losses increased $211.5 million to $259.9 million during 2013 as compared to $48.4 million in 2012. The following table provides the changes in net realized derivative losses by type:
(b) The total return swaps were entered into during 2013 and are based on the return of the S&P.
Amortization of DAC was $12.9 million and $4.9 million for 2013 and 2012, respectively, which included favorable (unfavorable) unlocking of ($2.2) million and $0.5 million, respectively. The increase in 2013 was primarily driven by positive gross profits resulting in increased amortization as compared to 2012.
Amortization of VOBA was $4.8 million and $27.8 million for the years ended December 31, 2013 and 2012, respectively, which included favorable (unfavorable) unlocking of $12.7 million and ($0.7) million, respectively. 2013 was impacted by favorable equity markets and positive gross profits as compared to 2012.
Insurance expenses and taxes increased $1.2 million in 2013 as compared to 2012. The following table provides the changes in insurance expenses and taxes for each respective period:
(a) The increase in general insurance expense is primarily related to a change in guaranty fund assessments when compared to 2012.