This Management’s Narrative Analysis of Results of Operations should be read in conjunction with the Financial Statements and Notes to Financial Statements included herein.
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, and the reported amounts of revenues and expenses. 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, and it is possible that such changes could occur in the near term.
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 exchange traded derivatives, such as futures, options and variance swaps to hedge minimum guarantees on variable annuity contracts.
Futures contracts are used to hedge the liability risk associated with products providing the policyholder a return based on various global equity market indices. Net settlements on the futures occur daily.
All derivatives recognized on the Balance Sheets are carried at fair value with changes in fair value recognized in the Statements of Income. The Company does not seek hedge accounting on these hedges because, in most cases, the derivatives’ change in value will create a natural offset in the Statements of Income with the change in reserves. The fair value for exchange traded derivatives, such as futures, are calculated net of the interest accrued to date and is based on quoted market prices. Fair value for the equity collar’s put and call options is calculated using the Black-Scholes model using market observable inputs for the underlying market price and volatility surface. The fair value of variance swaps is calculated as the difference between the estimated volatility of the underlying S&P index at maturity to the actual volatility of the underlying S&P index at initiation (i.e.; strike) multiplied by the notional value of the swap. At termination, the final fair value is recorded as a realized investment gain (loss) in the Statements of Income.
At December 31, 2012, the Company had equity collars with a notional value of $1.5 billion and a net fair value of ($9.8) million. These collars were acquired in the fourth quarter of 2012 and the Company recognized $9.8 million of losses from the change in fair value of these derivatives during the year ended December 31, 2012, which was recorded as a component of net investment income.
In addition, in order to trade futures, the Company is required to post collateral to an exchange (sometimes referred to as margin). The fair value of collateral posted in relation to the futures margin was $9.9 million and $16.9 million as of December 31, 2012 and 2011, respectively.
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 lent 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. At December 31, 2012 and 2011, the payable for collateral under securities loaned was $216.3 million and $244.0 million, respectively.
Value of Business Acquired (“VOBA”), Deferred Policy Acquisition Costs (“DAC”), and Deferred Sales Inducements (“DSI”)
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, 2012 and 2011, variable annuities accounted for the Company’s entire DSI asset of $10.0 million and $10.4 million, respectively. For the years ended December 31, 2012, 2011, and 2010, there was a favorable (unfavorable) impact to pre-tax income related to unlocking of $0.5 million, ($0.6) million, and $0.3 million, respectively. See Note 4 to the Financial Statements for a further discussion.
The long-term and short term growth rate assumption for the amortization of VOBA, DAC and DSI was 9% at December 31, 2012, 2011, and 2010.
Goodwill is the excess of the purchase price over the estimated fair value of net assets acquired. Goodwill and intangible assets with indefinite lives are not amortized, but are subject to impairment tests conducted at least annually. Impairment testing is to be performed using the fair value approach, which requires the use of estimates and judgment, at the “reporting unit” level. A reporting unit represents the operating segment which is the level at which the financial information is prepared and regularly reviewed by management. The entire asset amount has been allocated to annuities. Goodwill is reviewed for indications of value impairment, with consideration given to financial performance and other relevant factors. In addition, certain events including a significant adverse change in legal factors or the business climate, an adverse action or assessment by a regulator, or unanticipated competition would cause the Company to review the carrying amounts of goodwill for impairment. When considered impaired, the carrying amounts are written down to fair value based primarily on discounted cash flows. The Company performed tests of goodwill at December 31, 2012, 2011, and 2010 and determined there was no impairment of goodwill.
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, 2012, 2011 and 2010, the favorable (unfavorable) impact to pre-tax income related to GMDB and GMIB unlocking was $36.2 million, ($70.0) million, and $41.0 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 value 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.
Specific estimates include the realization of dividend-received deductions (“DRD”) and foreign tax credits (“FTC”). A portion of the Company’s investment income related to Separate Accounts business qualifies for the DRD and FTC. Information necessary to calculate these tax adjustments is typically not available until the following year. However, within the current year’s provision, management makes estimates regarding the future tax deductibility of these items. These estimates are primarily based on recent historic experience. See Note 6 to the Financial Statements for a further discussion.
ASC 310, Receivables - ASU 2011-02, A Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring - clarifies when a loan modification or restructuring is considered a troubled debt restructuring - adopted April 1, 2011, applied retrospectively to January 1, 2011.
ASC 220, Comprehensive Income - ASU 2013-02, Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income, requires an entity to provide information about significant items reclassified out of accumulated other comprehensive income (“AOCI”) by component - will be adopted January 1, 2013.
Total direct deposits (including internal exchanges) were $35.3 million, $33.5 million, and $46.0 million for the years ended December 31, 2012, 2011 and 2010, respectively. Deposits are currently limited to additions to existing policies which will result in fluctuations period over period. Internal exchanges during 2012, 2011 and 2010 were $6.5 million, $5.9 million, and $5.2 million, respectively.
During 2012, 2011 and 2010, fixed contract owner deposits were $0.2 million, $0.2 million, and $0.2 million, respectively. During 2012, 2011 and 2010, fixed contract owner withdrawals were $104.7 million, $114.2 million, and $114.8 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”), 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, 2012.
Eight issuers represent more than 5% of the total unrealized loss position, comprised of three subprime ABS housing holdings, one RMBS holding, and four corporate non-convertible bonds. The three subprime ABS holdings have been impaired to discounted cash flows and have a remaining unrealized loss in OCI-OTTI of $1.4 million. These subprime mortgage ABS holdings are below investment grade deals whereby the collateral is comprised of 2006-2007 fixed rate, first lien subprime mortgages. The unrealized
The Company’s $0.3 million of gross unrealized losses within the financial services sector has a fair value of $18.5 million. The majority of the unrealized loss in the financial services sector relates to the banking sub-sector which has $0.3 million of gross unrealized losses on securities with a fair value of $15.4 million. Companies within the Company’s financial services sector are high in credit quality and, as a whole, represent a large portion of the corporate debt market. In spite of weak global economic growth, market sentiment improved in the second half of 2012 following important steps towards addressing the European Sovereign Debt Crisis coupled with large-scale interventions by central banks. Beginning with the EU Summit in June, EU leaders have committed to decisive steps to strengthen the common currency, including steps to create a stronger Banking Union and Fiscal Union for the euro area. The creation of the European Stability Mechanism (ESM) and a Single Supervisory Mechanism to regulate banks in the Eurozone has helped calm concerns that the euro currency is not strong enough to survive a funding crisis or banking crisis in a member state. Furthermore the European Central Bank has committed to stabilize the common currency by purchasing government bonds under its new Outright Monetary Purchase (OMT) program. In the U.S. economic conditions appear to be improving, the Federal Reserve has committed to ongoing quantitative easing until labor market conditions improve, and the Fiscal Cliff agreement provided near-term relief.
Included in the Company’s banking exposure are hybrid securities, which typically have an original maturity of more than 30 years, may be perpetual and were designed to receive enhanced equity credit from rating agencies. In addition, they have other features that may not be consistent across issues such as a cumulative or non-cumulative coupon, capital replacement language and an alternative payment mechanism. The Company’s exposure to hybrid securities in an unrealized loss is all rated investment grade and there is little risk of payment interruption. The Company evaluated the near-term prospects of the issuers in relation to the severity and duration of the unrealized loss and does not consider those investments to be impaired at December 31, 2012.
All ABS - housing related securities are monitored and reviewed on a monthly basis. Detailed cash flow models using the current collateral pool and capital structure on the portfolio are updated and reviewed quarterly. Model output is generated under base and several stress-case scenarios. Our internal ABS - housing related asset specialists utilize widely recognized industry modeling
Securities are impaired to the net present value of projected future cash flows where holdings are not projected to pay principal and interest in full. As the remaining unrealized losses in the ABS - housing related 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 at December 31, 2012.
The Company’s $1.3 million of gross unrealized losses classified as equity have a fair value of $34.2 million. All of the unrealized loss relates to preferred non-convertible holdings in the banking sub-sector. 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.
These factors typically require significant management judgment. The impairment review process has resulted in no other than temporary impairment charges for the year ended December 31, 2012 for the Company.
For the year ended December 31, 2012, the Company recorded an OTTI in income of $0.3 million, net of associated value of business acquired amortization. For the year ended December 31, 2011, the Company recorded an OTTI in income of $1.2 million, with no associated value of business acquired amortization. For the year ended December 31, 2010, the Company recorded an OTTI in income of $1.6 million, net of associated value of business acquired amortization.
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 2012 with increases of 7%, 16% and 13%, respectively, from 2011. The Dow, NASDAQ and S&P ended 2011 with increases (decreases) of 6%, (2%) and less than (0.1%), respectively, from 2010.
At December 31, 2012 and 2011, the Company had 11,855 and 12,939 life insurance and annuity contracts inforce with interest rate guarantees, respectively. The estimated average rate of interest credited on behalf of contract owners was 3.68% and 3.74% during 2012 and 2011, respectively. Total invested assets supporting these liabilities with interest rate guarantees had an estimated average effective yield of 5.4% and 5.2% during 2012 and 2011, respectively.
During 2012 and 2011, the Company did not receive a capital contribution from AUSA nor did the Company pay a dividend to AUSA.
The National Association of Insurance Commissioners utilizes the RBC adequacy monitoring system. The RBC calculates the amount of adjusted capital that a life insurance company should have based upon that company’s risk profile. At December 31, 2012 and 2011, based on the RBC formula, the Company’s total adjusted capital levels were well in excess of the minimum amount of capital required to avoid regulatory action.
The following table summarizes the Company’s policyholders’ obligations at December 31, 2012:
For the years ended December 31, 2012 and 2011, the Company recorded net income of $165.9 million and $18.7 million, respectively. The increase in income during 2012 as compared to 2011 was primarily due to higher income tax benefit, specifically the elimination of a tax valuation allowance in first quarter 2012 and negative annuity benefit unlocking from separate accounts outperforming expectations in 2012.
(a) The change in equity related losses principally relates to the increase in net losses on futures contracts during 2012 as compared to 2011. Short futures contracts fluctuate relative to the volatility in the S&P.
(b) The decrease in annuity benefit expense was primarily due to the increase in risk neutral rates and higher equity market performance which resulted in a decrease in the fair value reserves in 2012 as compared to 2011.
Insurance expenses and taxes increased $0.5 million (or 1%) in 2012 as compared to 2011. The following table provides the changes in insurance expenses and taxes for each respective period:
For the years ended December 31, 2011 and 2010, the Company recorded net income of $18.7 million and $137.9 million, respectively. The decrease in income during 2011 as compared to 2010 was primarily due to higher policy benefits and a lower income tax benefit, partially offset by a decrease in VOBA and DAC amortization, a decrease in insurance expenses and taxes and lower net realized investment losses.