Our executive headquarters consist of our main office building at One American Row in Hartford, Connecticut, which we own and occupy. As of December 31, 2014, we also leased space in one garage in Hartford, Connecticut for employee parking. Property is also leased for our home office in East Greenbush, New York.
Fees on life and annuity products consist primarily of: (i) COI charges, which are based on the difference between policy face amounts and the account values (referred to as the net amount at risk or “NAR”); (ii) asset-based fees (including mortality and expense charges for variable annuities) which are calculated as a percentage of assets under management within our separate accounts; (iii) premium-based fees to cover premium taxes and renewal commissions; and (iv) surrender charges.
Policy benefits include death claims net of reinsurance cash flows, including ceded premiums and recoverables, interest credited to policyholders and changes in policy liabilities and accruals. 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. 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.
Non-deferred operating expenses are expenses related to servicing policies, premium taxes, reinsurance allowances, non-deferrable acquisition expenses and commissions and general overhead, including professional fees and outside consulting and legal services. They also include pension and other benefit costs which involve significant estimates and assumptions.
Under U.S. GAAP, premiums and deposits for variable life, universal life and annuity products are not immediately recorded as revenues. For certain investment options of variable products, deposits are reflected on our balance sheets as an increase in liabilities. Premiums and deposits for universal life, fixed annuities and certain investment options of variable annuities are reflected on our balance sheets as an increase in policyholder deposit funds. Premiums and deposits for other products are reflected on our balance sheets as an increase in policy liabilities and accruals.
Changes in the liabilities associated with guaranteed benefits are impacted by changes in actual policyholder behavior and expected policyholder behavior, as well as market changes and investment results. The most significant driver of changes in liabilities associated with guaranteed benefits is the fixed indexed annuity business. As a result of realized losses on the investments that are used to hedge this business, the liability accrual for the year ended December 31, 2014 was less than that for the year ended December 31, 2013. Generally, realized losses on the derivatives used to hedge this business will be offset by a benefit to the guaranteed benefit liabilities.
Income taxes. The effective tax rate for 2014 and 2013 was (3.6%) and (62.2%), respectively. The primary drivers of the differences between the effective tax rate and the U.S. statutory rate of 35% in 2014 is the increase in the valuation allowance on the pre-tax loss and the dividends received deduction. The primary drivers of the differences between the effective tax rate and the U.S. statutory rate in 2013 is the decrease in the valuation allowance on the pre-tax income and the dividends received deduction.
We amortize DAC based on the related policy’s classification. For universal life, variable universal life and deferred annuities, deferred policy acquisition costs are amortized in proportion to EGPs discussed more fully below. EGPs are also used to amortize other assets and liabilities in the Company’s balance sheets, such as sales inducement assets (“SIA”) and unearned revenue reserves (“URR”). Components of EGPs are used to determine reserves for universal life and fixed indexed and variable annuity contracts with death and other insurance benefits such as guaranteed minimum death and guaranteed minimum income benefits. EGPs are based on historical and anticipated future experience which is updated periodically.
DAC is adjusted through other comprehensive income (“OCI”) each period as a result of unrealized gains or losses on securities classified as available-for-sale in a process commonly referred to as shadow accounting. This adjustment is required in order to reflect the impact of these unrealized amounts as if these unrealized amounts had been realized.
See Note 3 to our financial statements under “Item 8: Financial Statements and Supplementary Data” in this Form 10-K for additional information related to DAC.
Future policy benefits are generally 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.
We expect that our universal life block of business will generate profits followed by losses and, therefore, we establish an additional liability (“PFBL”) to accrue for the expected losses over the period of expected profits. The assumptions used in estimating these liabilities are consistent with those used for amortizing deferred policy acquisition costs and are subject to the same variability and risk.
We make guarantees on certain variable annuity contracts, including GMAB, GMWB and combination rider (“COMBO”) as well as provide credits based on the performance of certain indices (“index credits”) on our fixed indexed annuity contracts that meet the definition of an embedded derivative. The GMAB, GMWB and COMBO embedded derivative liabilities associated with our variable annuity contracts are accounted for at fair value, using a risk neutral stochastic valuation methodology with changes in fair value recorded in realized investment gains. The inputs to our fair value methodology include estimates derived from the asset derivatives market, including the equity volatility and the swap curve. Several additional inputs are not obtained from independent sources, but instead reflect our internally developed assumptions related to mortality rates, lapse rates and policyholder behavior. The fair value of the embedded derivative liabilities associated with the index credits on our fixed indexed annuity contracts is calculated using the budget method with changes in fair value recorded in realized investment gains. The initial value under the budget method is established based on the fair value of the options used to hedge the liabilities. The value of the index credits in future years is estimated to be the budgeted amount. The budget amount is based on the impact of projected interest rates on the discounted liabilities. Several additional inputs reflect our internally developed assumptions related to lapse rates and policyholder behavior. As there are significant unobservable inputs included in our fair value methodology for these embedded derivative liabilities, we consider the above-described methodology as a whole to be Level 3 within the fair value hierarchy.
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 and its insurance company affiliates.
See Note 10 to our financial statements under “Item 8: Financial Statements and Supplementary Data” in this Form 10-K for additional disclosures of our fair value methodologies.
we determined we may not realize the full recovery on our investment.
See Note 3 and Note 7 to our financial statements under “Item 8: Financial Statements and Supplementary Data” and the “Debt and Equity Securities” and “Enterprise Risk Management” sections of “Item 7: Management’s Discussion and Analysis of Financial Condition and Results of Operations” in this Form 10-K for more information.
Deferred tax assets and/or liabilities are determined by multiplying the differences between the financial reporting and tax reporting bases for assets and liabilities by the enacted tax rates expected to be in effect when such differences are recovered or settled. U.S. GAAP requires an assessment of the realizability of deferred tax assets in order to determine whether a valuation allowance should be recorded. The total deferred tax asset, net of any valuation allowance, represents the deferred tax asset that management estimates to be realizable. The assessment of the realizability of deferred tax assets involves management making assumptions and judgments about all available positive and negative evidence including the reversal of gross deferred tax liabilities, projected future taxable income, prudent and feasible tax planning strategies and recent operating results, including the existence of cumulative income (loss) incurred over the three-year period ended December 31, 2014.
As of December 31, 2014, 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 $127.9 million has been recorded on net deferred tax assets of $141.0 million. The valuation allowance recorded constitutes a full valuation allowance on the net deferred tax assets that require future taxable income in order to be realized. The remaining deferred tax asset of $13.1 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 $43.1 million in net loss and an increase of $14.9 million in OCI-related deferred tax balances.
The Company has minimal uncertain tax positions and accordingly, the liability for uncertain tax positions is not material to the financial statements.
See Note 11 to our financial statements under “Item 8: Financial Statements and Supplementary Data” in this Form 10-K for more information related to income taxes.
The increase in policy benefits expense of $120.1 million for the year ended December 31, 2014 compared to the year ended December 31, 2013 is primarily driven by the following:
An increase of $40.0 million in PFBL, excluding unlock, in 2014 compared to 2013. The increase in PFBL was primarily driven by a decrease in the new money yield for the year and the slope of the forward curve, which indicates the market expectation of future changes in interest rates which reduces expected future profitability and increases the liability.
Premium revenue decreased $1.5 million for the year ended December 31, 2014 compared with the year ended December 31, 2013 as a result of lower renewal premiums due to declining policies in force.
Other operating expenses decreased $17.5 million for the year ended December 31, 2014 compared to the year ended December 31, 2013. The decrease in other operating expenses is driven primarily by a decrease in the amount of audit fees and other professional services fees that are being allocated to the Company.
For the years 2014, 2013 and 2012, inflation did not have a material effect on our results of operations.
Our ultimate parent company, Phoenix, has an enterprise-wide risk management program under which PHL Variable operations are covered. Our Chief Risk Officer reports to the Chief Executive Officer and monitors our risk management activities. The Chief Risk Officer provides regular reports to the Board without the presence of other members of management. Our risk management governance consists of several management committees to oversee and address issues pertaining to all our major risks-operational, market and product-as well as capital management. In all cases, these committees include one or more of our Chief Executive Officer, Chief Financial Officer, Chief Investment Officer and Chief Risk Officer.
Operational risk is the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. As reported in “Item 9A: Controls and Procedures” of this Form 10-K, the Company has concluded that there are material weaknesses in its internal control over financial reporting, which have materially adversely affected its ability to timely and accurately report its results of operations and financial condition, and that its disclosure controls and procedures are ineffective as of December 31, 2014. These material weaknesses have not been fully remediated as of the filing date of this report and the Company cannot assure that other material weaknesses will not be identified in the future. It is necessary for the Company to maintain effective internal control over financial reporting to prevent fraud and errors, and to maintain effective disclosure controls and procedures so that it can provide timely and reliable financial and other information. If the Company fails to maintain an effective system of internal controls, the accuracy and timing of its financial reporting may be adversely affected. Further, the absence of timely and reliable financial and other information about the Company’s business operations may inhibit the Company’s ability to identify operational risk. A failure to correct material weaknesses in our internal controls could result in further restatements of financial statements and correction of other information filed with the SEC. See “Item 1A: Risk Factors” in Part I of this Form 10-K for a description of these and other risks that may impact the Company’s operations. Also see “Item 9A: Controls and Procedures” in Part II of this Form 10-K for more information regarding these weaknesses, an evaluation of the effectiveness of the Company’s disclosure controls and procedures, and the Company’s remediation plans.
credit risk, which relates to the uncertainty associated with the ongoing ability of an obligor to make timely payments of principal and interest; and
We measure, manage and monitor market risk associated with our insurance and annuity business, as part of our ongoing commitment to fund insurance liabilities. We have developed an integrated process for managing the interaction between product features and market risk. This process involves our Corporate Finance, Corporate Portfolio Management and Life and Annuity Product Development departments. These areas coordinate with each other and report results and make recommendations to our Asset-Liability Management Committee (“ALCO”) chaired by the Chief Risk Officer.
See Note 10 to our financial statements under “Item 8: Financial Statements and Supplementary Data” in this Form 10-K for additional information on fair value instruments.
See Note 9 to our financial statements under “Item 8: Financial Statements and Supplementary Data” in this Form 10-K for additional information on derivative instruments.
See the “Critical Accounting Estimates” section above for more information on DAC and policy liabilities and accruals.
The values below represent changes to balances before adjustment for unrealized gains/losses.
The primary potential risk to our operations related to guaranteed minimum interest crediting rates could arise mainly in our universal life product since the account values with higher guarantees, primarily 4.0%, are concentrated in this product. Our other annuity products also contain guaranteed minimum interest rates but the aggregate account values or the guaranteed minimum rates are relatively lower compared to universal life. At December 31, 2014, we have approximately $5.4 billion of policyholder insurance liabilities and policyholder deposit funds. Of this amount, approximately $4.1 billion represents contracts with crediting rates that may be adjusted over the life of the contract, subject to certain guaranteed minimums. The table below summarizes the related account values of policies with guaranteed minimum interest rates using ranges indicating the percentage of account values at the guaranteed minimum interest rate range. Our products that do not have an account value with a guaranteed minimum crediting rate are not included in the table below, even though most of our products to some degree are sensitive to interest rates. The table below focuses on products with both an account value and a guaranteed minimum interest rate. See the “Low Interest Rate Environment” section below for further discussion.
The table below shows the sensitivity of our investments that are sensitive to public equity market movements measured in terms of their fair value.
Certain variable annuity products sold by us contain GMDBs. The GMDB feature provides annuity contract owners with a guarantee that the benefit received at death will be no less than a prescribed amount. This minimum amount is based on the net deposits paid into the contract, the net deposits accumulated at a specified rate, the highest historical account value on a contract anniversary or, if a contract has more than one of these features, the greatest of these values. To the extent that the GMDB is higher than the current account value at the time of death, the Company incurs a cost. This typically results in an increase in annuity policy benefits in periods of declining financial markets and in periods of stable financial markets following a decline. As of December 31, 2014, the difference between the GMDB and the current account value (NAR) for all existing contracts was $16.8 million. This was our exposure to loss had all contract owners died on December 31, 2014. See Note 8 to our financial statements under “Item 8: Financial Statements and Supplementary Data” in this Form 10-K for additional information.
While fixed indexed annuities comprise a larger balance of policies with guaranteed minimum interest rates to protect the initial investment, the crediting/guarantee rates on these products adjust more consistently with interest rates so there is a less significant impact to our results of operations.
The low interest rate environment discussion immediately above does not include the additional and interrelated impacts to earnings from the amortization of deferred policy acquisition costs and profits followed by losses which occurs in response to changing estimated gross profits. (See “Enterprise Risk Management - Market Risk - Interest Rate Sensitivity of DAC and Policy Liabilities” discussion above.)
See Note 10 to our financial statements under “Item 8: Financial Statements and Supplementary Data” in this Form 10-K for additional information regarding the estimated fair value of investments.
Management assessed all securities in an unrealized loss position in determining whether impairments were temporary or other-than-temporary. In reaching its conclusions, management exercised significant judgment and used a number of issuer-specific quantitative indicators and qualitative judgments to assess the probability of receiving a given security’s contractual cash flows. This included the issue’s implied yield to maturity, cumulative default rate based on rating, comparisons of issue-specific spreads to industry or sector spreads, specific trading activity in the issue and other market data, such as recent debt tenders and upcoming refinancing requirements. Management also reviewed fundamentals such as issuer credit and liquidity metrics, business outlook and industry conditions. Management maintains a watch list of securities that is reviewed for impairments. Each security on the watch list was evaluated, analyzed and discussed, with the positive and negative factors weighed in the ultimate determination of whether or not the security was other-than-temporarily impaired. For securities for which no OTTI was ultimately indicated at December 31, 2014, management does not have the intention to sell, nor does it expect to be required to sell, these securities prior to their recovery. OTTIs recorded in 2014 were immaterial.
Available-for-Sale Debt Securities Non-Credit OTTI Losses in AOCI, by Security Type: [1]
For available-for-sale debt securities with gross unrealized losses, 86.5% of the unrealized losses after offsets pertain to investment grade securities and 13.5% of the unrealized losses after offsets pertain to below-investment-grade securities at December 31, 2014.
Historically, we have used cash flows from operations, investing activities and capital contributions from our shareholder to fund liquidity requirements. Our principal cash inflows from life insurance and annuities activities come from premiums, annuity deposits and charges on insurance policies and annuity contracts. Principal cash inflows from investing activities result from repayments of principal, proceeds from maturities, sales of invested assets and investment income.
Individual life insurance policies are less susceptible to withdrawals than annuity contracts because policyholders may incur surrender charges and be required to undergo a new underwriting process in order to obtain a new insurance policy. As indicated in the table above, most of our annuity contract reserves and deposit fund liabilities are subject to withdrawals at market value.
We believe that our current and anticipated sources of liquidity are adequate to meet our current and anticipated needs.
Rating agencies assign financial strength ratings to Phoenix Life and its subsidiaries based on their opinions of the Companies’ ability to meet their respective financial obligations. A downgrade or withdrawal of any of our credit ratings could negatively impact our liquidity. For additional information regarding certain risks associated with our credit ratings, please see the risk factors under “Risks Related to the Restatement of Prior Period Financial Statements and our Internal Control Over Financial Reporting.” contained in “Item 1A: Risk Factors” in Part I of this Form 10-K.
The financial strength ratings as of April 6, 2015 were as follows:
On January 14, 2014, Moody’s Investor Services withdrew all ratings of The Phoenix Companies, Inc. including the Ba2 financial strength rating of the Company’s life insurance subsidiaries and the B1 debt rating of Phoenix Life’s surplus notes.
An increase in available-for-sale debt and equity securities of $823.2 million, which is primarily driven by continued purchases of fixed indexed annuities, for which there were deposits of $713.7 million for the year, and an increase in market value of $136.6 million for the year due to decreases in interest rates.
The increase in available-for-sale debt and equity securities is offset by a decrease in derivative assets of $67.8 million for the period, primarily due to the expiration of some of the swaptions and call options in the first quarter of 2014. The decrease is partially offset by a corresponding decrease in derivative liabilities, which are recorded within other liabilities.
A decrease in the DAC asset of $39.2 million, which is driven primarily by a decrease of $38.0 million in the shadow component from unrealized gains on investments as well as continued amortization of previously deferred costs.
A decrease in other assets of $45.8 million, which is driven primarily by a decrease in the current tax receivable due to the Company’s tax sharing agreement, which was a receivable of $26.6 million at December 31, 2013 and was a payable of $22.8 million at December 31, 2014 and is recorded within other liabilities.
An increase in policy liabilities and accruals of $184.1 million, which is driven primarily by continued increases in the reserves associated with guaranteed benefit liabilities of $88.3 million, as well as an increase in the profits followed by losses reserve on the universal life business of $96.3 million.
The increase in liabilities was partially offset by a decrease in separate account liabilities of $295.2 million. The decrease in separate account liabilities was primarily due to policyholder withdrawals and other fund withdrawals, and was partially offset by continued deposits on current business inforce and positive market performance during the year.
We do not anticipate any increases to unrecognized tax benefits that would have a significant impact on the financial position of the Company. Therefore, no unrecognized tax benefits have been excluded from this table. See Note 11 to our financial statements under “Item 8: Financial Statements and Supplementary Data” in this Form 10-K for additional information on unrecognized tax benefits.
Our ultimate parent company provides employees with post-employment benefits that include retirement benefits, through pension and savings plans, and other benefits, including health care and life insurance. This includes three defined benefit pension plans. We incur applicable employee benefit expenses through the process of cost allocation by Phoenix.
See Note 14 to our financial statements under “Item 8: Financial Statements and Supplementary Data” in this Form 10-K for more information.
The RBC of PHL Variable as of December 31, 2014 was in excess of 200% of the Company Action Level.