Table of Contents

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D. C. 20549

 

FORM 10-Q

 

x      Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

 

For the quarterly period ended September 30, 2014

 

or

 

o         Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

 

For the transition period from                    to                    

 

Commission File Number 001-11339

 

PROTECTIVE LIFE CORPORATION

(Exact name of registrant as specified in its charter)

 

DELAWARE
(State or other jurisdiction of incorporation or organization)

 

95-2492236
(IRS Employer Identification Number)

 

2801 HIGHWAY 280 SOUTH

BIRMINGHAM, ALABAMA 35223

(Address of principal executive offices and zip code)

 

Registrant’s telephone number, including area code  (205) 268-1000

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes x  No o

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes x  No o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  x

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer, or a smaller reporting company. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer x

 

Accelerated Filer o

 

Non-accelerated filer o

 

Smaller Reporting Company o

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).  Yes o  No x

 

Number of shares of Common Stock, $0.50 Par Value, outstanding as of October 27, 2014:  79,288,518

 

 

 



Table of Contents

 

PROTECTIVE LIFE CORPORATION

QUARTERLY REPORT ON FORM 10-Q

FOR QUARTERLY PERIOD ENDED SEPTEMBER 30, 2014

 

TABLE OF CONTENTS

 

PART I

 

 

 

 

Page

Item 1.

Financial Statements (unaudited):

 

 

 

Consolidated Condensed Statements of Income For The Three and Nine Months Ended September 30, 2014 and 2013

 

3

 

Consolidated Condensed Statements of Comprehensive Income (Loss) For The Three and Nine Months Ended September 30, 2014 and 2013

 

4

 

Consolidated Condensed Balance Sheets as of September 30, 2014 and December 31, 2013

 

5

 

Consolidated Condensed Statements of Shareowners’ Equity For The Nine Months Ended September 30, 2014

 

7

 

Consolidated Condensed Statements of Cash Flows For The Nine Months Ended September 30, 2014 and 2013

 

8

 

Notes to Consolidated Condensed Financial Statements

 

9

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

68

Item 3.

Quantitative and Qualitative Disclosures About Market Risk

 

135

Item 4.

Controls and Procedures

 

135

 

 

 

 

PART II

 

 

 

 

Item 1.

Legal Proceedings

 

136

Item 1A.

Risk Factors and Cautionary Factors that may Affect Future Results

 

137

Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

 

147

Item 6.

Exhibits

 

148

 

Signature

 

149

 

2



Table of Contents

 

PROTECTIVE LIFE CORPORATION

CONSOLIDATED CONDENSED STATEMENTS OF INCOME

(Unaudited)

 

 

 

For The

 

For The

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

 

2014

 

2013

 

2014

 

2013

 

 

 

(Dollars In Thousands, Except Per Share Amounts)

 

Revenues

 

 

 

 

 

 

 

 

 

Premiums and policy fees

 

$

759,038

 

$

657,218

 

$

2,426,736

 

$

2,140,396

 

Reinsurance ceded

 

(277,136

)

(270,730

)

(947,817

)

(996,570

)

Net of reinsurance ceded

 

481,902

 

386,488

 

1,478,919

 

1,143,826

 

Net investment income

 

558,174

 

454,275

 

1,647,153

 

1,378,129

 

Realized investment gains (losses):

 

 

 

 

 

 

 

 

 

Derivative financial instruments

 

3,781

 

41,326

 

(191,495

)

192,592

 

All other investments

 

1,194

 

(19,508

)

153,456

 

(133,631

)

Other-than-temporary impairment losses

 

(1,142

)

(6,635

)

(2,026

)

(9,764

)

Portion recognized in other comprehensive income (before taxes)

 

(1,212

)

(2,046

)

(3,379

)

(7,501

)

Net impairment losses recognized in earnings

 

(2,354

)

(8,681

)

(5,405

)

(17,265

)

Other income

 

105,389

 

98,794

 

311,359

 

278,213

 

Total revenues

 

1,148,086

 

952,694

 

3,393,987

 

2,841,864

 

Benefits and expenses

 

 

 

 

 

 

 

 

 

Benefits and settlement expenses, net of reinsurance ceded: (three months: 2014 - $217,641; 2013 - $204,065; nine months: 2014 - $851,028; 2013 - $882,123)

 

630,285

 

624,577

 

2,106,620

 

1,764,323

 

Amortization of deferred policy acquisition costs and value of business acquired

 

134,918

 

22,446

 

242,031

 

149,631

 

Other operating expenses, net of reinsurance ceded: (three months: 2014 - $49,196; 2013 - $47,506; nine months: 2014 - $139,507; 2013 - $138,901)

 

198,000

 

163,550

 

573,038

 

511,149

 

Total benefits and expenses

 

963,203

 

810,573

 

2,921,689

 

2,425,103

 

Income before income tax

 

184,883

 

142,121

 

472,298

 

416,761

 

Income tax expense

 

65,974

 

49,060

 

161,773

 

142,210

 

Net income

 

$

118,909

 

$

93,061

 

$

310,525

 

$

274,551

 

 

 

 

 

 

 

 

 

 

 

Net income - basic

 

$

1.48

 

$

1.17

 

$

3.88

 

$

3.46

 

Net income - diluted

 

$

1.46

 

$

1.15

 

$

3.82

 

$

3.39

 

Cash dividends paid per share

 

$

0.24

 

$

0.20

 

$

0.68

 

$

0.58

 

 

 

 

 

 

 

 

 

 

 

Average shares outstanding - basic

 

80,231,591

 

79,492,274

 

79,942,018

 

79,346,771

 

Average shares outstanding - diluted

 

81,458,870

 

80,852,078

 

81,261,249

 

80,882,552

 

 

See Notes to Consolidated Condensed Financial Statements

 

3



Table of Contents

 

PROTECTIVE LIFE CORPORATION

CONSOLIDATED CONDENSED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

(Unaudited)

 

 

 

For The

 

For The

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

 

2014

 

2013

 

2014

 

2013

 

 

 

(Dollars In Thousands)

 

Net income

 

$

118,909

 

$

93,061

 

$

310,525

 

$

274,551

 

Other comprehensive income (loss):

 

 

 

 

 

 

 

 

 

Change in net unrealized gains (losses) on investments, net of income tax: (three months: 2014 - $(44,766); 2013 - $(145,224); nine months: 2014 - $431,299; 2013 - $(641,532))

 

(83,138

)

(269,703

)

800,982

 

(1,191,416

)

Reclassification adjustment for investment amounts included in net income, net of income tax: (three months: 2014 - $(7,446); 2013 - $(653); nine months: 2014 - $(16,027); 2013 - $(9,488))

 

(13,827

)

(1,212

)

(29,763

)

(17,621

)

Change in net unrealized gains (losses) relating to other-than-temporary impaired investments for which a portion has been recognized in earnings, net of income tax: (three months: 2014 - $561; 2013 - $(1,543) nine months: 2014 - $2,419; 2013 - $1,383)

 

1,044

 

(2,865

)

4,494

 

2,570

 

Change in accumulated (loss) gain - derivatives, net of income tax: (three months: 2014 - $(22); 2013 - $8; nine months: 2014 - $(31); 2013 - $(55))

 

(41

)

14

 

(58

)

(103

)

Reclassification adjustment for derivative amounts included in net income, net of income tax: (three months: 2014 - $103; 2013 - $200; nine months: 2014 - $552; 2013 - $577)

 

190

 

372

 

1,025

 

1,072

 

Change in postretirement benefits liability adjustment, net of income tax: (three months: 2014 - $631; 2013 - $(922); nine months: 2014 - $1,895; 2013 - $(2,766))

 

1,173

 

(1,712

)

3,520

 

(5,136

)

Total other comprehensive income (loss)

 

(94,599

)

(275,106

)

780,200

 

(1,210,634

)

Total comprehensive income (loss)

 

$

24,310

 

$

(182,045

)

$

1,090,725

 

$

(936,083

)

 

See Notes to Consolidated Condensed Financial Statements

 

4



Table of Contents

 

PROTECTIVE LIFE CORPORATION

CONSOLIDATED CONDENSED BALANCE SHEETS

(Unaudited)

 

 

 

As of

 

 

 

September 30, 2014

 

December 31, 2013

 

 

 

(Dollars In Thousands)

 

Assets

 

 

 

 

 

Fixed maturities, at fair value (amortized cost: 2014 - $34,222,620; 2013 - $33,668,770)

 

$

36,922,395

 

$

34,823,093

 

Fixed maturities, at amortized cost (fair value: 2014 - $453,741; 2013 - $335,676)

 

415,000

 

365,000

 

Equity securities, at fair value (cost: 2014 - $791,964; 2013 - $675,758)

 

809,648

 

646,027

 

Mortgage loans (2014 and 2013 includes $489,667 and $627,731 related to securitizations)

 

5,232,463

 

5,493,492

 

Investment real estate, net of accumulated depreciation (2014 - $376; 2013 - $1,066)

 

13,998

 

20,413

 

Policy loans

 

1,767,228

 

1,815,744

 

Other long-term investments

 

470,174

 

521,811

 

Short-term investments

 

183,411

 

134,146

 

Total investments

 

45,814,317

 

43,819,726

 

Cash

 

328,487

 

466,542

 

Accrued investment income

 

491,864

 

465,333

 

Accounts and premiums receivable, net of allowance for uncollectible amounts (2014 - $3,839; 2013 - $4,283)

 

123,136

 

101,039

 

Reinsurance receivables

 

6,132,550

 

6,175,115

 

Deferred policy acquisition costs and value of business acquired

 

3,263,299

 

3,570,215

 

Goodwill

 

103,139

 

105,463

 

Property and equipment, net of accumulated depreciation (2014 - $116,986; 2013 - $111,579)

 

52,939

 

52,403

 

Other assets

 

371,233

 

426,471

 

Income tax receivable

 

18,257

 

 

Assets related to separate accounts

 

 

 

 

 

Variable annuity

 

13,040,828

 

12,791,438

 

Variable universal life

 

813,178

 

783,618

 

Total assets

 

$

70,553,227

 

$

68,757,363

 

 

See Notes to Consolidated Condensed Financial Statements

 

5



Table of Contents

 

PROTECTIVE LIFE CORPORATION

CONSOLIDATED CONDENSED BALANCE SHEETS

(continued)

(Unaudited)

 

 

 

As of

 

 

 

September 30, 2014

 

December 31, 2013

 

 

 

(Dollars In Thousands)

 

Liabilities

 

 

 

 

 

Future policy benefits and claims

 

$

29,876,778

 

$

29,772,325

 

Unearned premiums

 

1,521,330

 

1,549,815

 

Total policy liabilities and accruals

 

31,398,108

 

31,322,140

 

Stable value product account balances

 

2,261,546

 

2,559,552

 

Annuity account balances

 

11,083,763

 

11,125,253

 

Other policyholders’ funds

 

1,377,504

 

1,214,380

 

Other liabilities

 

1,469,374

 

1,144,853

 

Income tax payable

 

 

12,761

 

Deferred income taxes

 

1,476,749

 

1,050,533

 

Non-recourse funding obligations

 

594,066

 

562,448

 

Repurchase program borrowings

 

359,804

 

350,000

 

Debt

 

1,380,000

 

1,585,000

 

Subordinated debt securities

 

540,593

 

540,593

 

Liabilities related to separate accounts

 

 

 

 

 

Variable annuity

 

13,040,828

 

12,791,438

 

Variable universal life

 

813,178

 

783,618

 

Total liabilities

 

65,795,513

 

65,042,569

 

Commitments and contingencies - Note 10

 

 

 

 

 

Shareowners’ equity

 

 

 

 

 

Preferred Stock; $1 par value, shares authorized: 4,000,000; Issued: None

 

 

 

 

 

Common Stock, $.50 par value, shares authorized: 2014 and 2013 - 160,000,000 shares issued: 2014 and 2013 - 88,776,960

 

$

44,388

 

$

44,388

 

Additional paid-in-capital

 

599,199

 

606,934

 

Treasury stock, at cost (2014 - 9,490,513; 2013 - 10,199,514)

 

(186,818

)

(200,416

)

Retained earnings

 

3,026,679

 

2,769,822

 

Accumulated other comprehensive income (loss):

 

 

 

 

 

Net unrealized gains (losses) on investments, net of income tax: (2014 - $705,180; 2013 - $289,908)

 

1,309,619

 

538,400

 

Net unrealized (losses) gains relating to other-than-temporary impaired investments for which a portion has been recognized in earnings, net of income tax: (2014 - $2,744; 2013 - $325)

 

5,097

 

603

 

Accumulated loss - derivatives, net of income tax: (2014 - $(145); 2013 - $(666))

 

(268

)

(1,235

)

Postretirement benefits liability adjustment, net of income tax: (2014 - $(21,637); 2013 - $(23,532))

 

(40,182

)

(43,702

)

Total shareowners’ equity

 

4,757,714

 

3,714,794

 

Total liabilities and shareowners’ equity

 

$

70,553,227

 

$

68,757,363

 

 

See Notes to Consolidated Condensed Financial Statements

 

6



Table of Contents

 

PROTECTIVE LIFE CORPORATION

CONSOLIDATED CONDENSED STATEMENTS OF SHAREOWNERS’ EQUITY

(Unaudited)

 

 

 

 

 

 

 

 

 

 

 

Accumulated

 

 

 

 

 

 

 

Additional

 

 

 

 

 

Other

 

Total

 

 

 

Common

 

Paid-In-

 

Treasury

 

Retained

 

Comprehensive

 

Shareowners’

 

 

 

Stock

 

Capital

 

Stock

 

Earnings

 

Income

 

Equity

 

 

 

(Dollars In Thousands)

 

Balance, December 31, 2013

 

$

44,388

 

$

606,934

 

$

(200,416

)

$

2,769,822

 

$

494,066

 

$

3,714,794

 

Net income for the nine months ended September 30, 2014

 

 

 

 

 

 

 

310,525

 

 

 

310,525

 

Other comprehensive income

 

 

 

 

 

 

 

 

 

780,200

 

780,200

 

Comprehensive income for the nine months ended September 30, 2014

 

 

 

 

 

 

 

 

 

 

 

1,090,725

 

Cash dividends ($0.68 per share)

 

 

 

 

 

 

 

(53,668

)

 

 

(53,668

)

Stock-based compensation

 

 

 

(7,735

)

13,598

 

 

 

 

 

5,863

 

Balance, September 30, 2014

 

$

44,388

 

$

599,199

 

$

(186,818

)

$

3,026,679

 

$

1,274,266

 

$

4,757,714

 

 

See Notes to Consolidated Condensed Financial Statements

 

7



Table of Contents

 

PROTECTIVE LIFE CORPORATION

CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS

(Unaudited)

 

 

 

For The Nine Months Ended September 30,

 

 

 

2014

 

2013

 

 

 

(Dollars In Thousands)

 

Cash flows from operating activities

 

 

 

 

 

Net income

 

$

310,525

 

$

274,551

 

Adjustments to reconcile net income to net cash provided by operating activities:

 

 

 

 

 

Realized investment losses (gains)

 

43,444

 

(41,696

)

Amortization of deferred policy acquisition costs and value of business acquired

 

242,031

 

149,631

 

Capitalization of deferred policy acquisition costs

 

(215,616

)

(240,398

)

Depreciation expense

 

5,687

 

6,731

 

Deferred income tax

 

8,390

 

154,457

 

Accrued income tax

 

(11,220

)

6,857

 

Interest credited to universal life and investment products

 

663,117

 

532,396

 

Policy fees assessed on universal life and investment products

 

(729,929

)

(659,058

)

Change in reinsurance receivables

 

42,565

 

60,600

 

Change in accrued investment income and other receivables

 

(28,297

)

7,370

 

Change in policy liabilities and other policyholders’ funds of traditional life and health products

 

12,184

 

261,691

 

Trading securities:

 

 

 

 

 

Maturities and principal reductions of investments

 

71,646

 

152,948

 

Sale of investments

 

187,829

 

220,711

 

Cost of investments acquired

 

(160,134

)

(297,558

)

Other net change in trading securities

 

(43,699

)

(9,069

)

Change in other liabilities

 

220,160

 

(48,694

)

Other income - gains on repurchase of non-recourse funding obligations

 

(4,587

)

(3,359

)

Other, net

 

(8,593

)

(85,008

)

Net cash provided by operating activities

 

605,503

 

443,103

 

Cash flows from investing activities

 

 

 

 

 

Maturities and principal reductions of investments, available-for-sale

 

941,989

 

752,754

 

Sale of investments, available-for-sale

 

1,465,632

 

1,718,810

 

Cost of investments acquired, available-for-sale

 

(3,056,904

)

(3,076,555

)

Change in investments, held-to-maturity

 

(50,000

)

(50,000

)

Mortgage loans:

 

 

 

 

 

New lendings

 

(649,125

)

(392,883

)

Repayments

 

908,364

 

543,297

 

Change in investment real estate, net

 

6,048

 

1,300

 

Change in policy loans, net

 

48,516

 

9,058

 

Change in other long-term investments, net

 

(69,778

)

(169,668

)

Change in short-term investments, net

 

(26,392

)

(10,912

)

Net unsettled security transactions

 

8,243

 

31,686

 

Purchase of property and equipment

 

(6,223

)

(17,983

)

Sales of property and equipment

 

 

86

 

Payments for business acquisitions

 

(906

)

 

Net cash used in investing activities

 

(480,536

)

(661,010

)

Cash flows from financing activities

 

 

 

 

 

Borrowings under line of credit arrangements and debt

 

190,000

 

430,000

 

Principal payments on line of credit arrangement and debt

 

(395,000

)

(380,000

)

Issuance (repayment) of non-recourse funding obligations

 

31,651

 

33,900

 

Repurchase program borrowings

 

9,804

 

(50,000

)

Dividends to shareowners

 

(53,668

)

(45,474

)

Investment product deposits and change in universal life deposits

 

2,415,424

 

2,413,676

 

Investment product withdrawals

 

(2,461,200

)

(2,198,547

)

Other financing activities, net

 

(33

)

 

Net cash (used in) provided by financing activities

 

(263,022

)

203,555

 

Change in cash

 

(138,055

)

(14,352

)

Cash at beginning of period

 

466,542

 

368,801

 

Cash at end of period

 

$

328,487

 

$

354,449

 

 

See Notes to Consolidated Condensed Financial Statements

 

8



Table of Contents

 

PROTECTIVE LIFE CORPORATION

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(Unaudited)

 

1.                                      BASIS OF PRESENTATION

 

Basis of Presentation

 

The accompanying unaudited consolidated condensed financial statements of Protective Life Corporation and subsidiaries (the “Company”) have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the disclosures required by GAAP for complete financial statements. In the opinion of management, the accompanying financial statements reflect all adjustments (consisting only of normal recurring items) necessary for a fair statement of the results for the interim periods presented. Operating results for the three and nine month periods ended September 30, 2014, are not necessarily indicative of the results that may be expected for the year ending December 31, 2014. The year-end consolidated condensed financial data was derived from audited financial statements but does not include all disclosures required by GAAP. For further information, refer to the consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2013.

 

The operating results of companies in the insurance industry have historically been subject to significant fluctuations due to changing competition, economic conditions, interest rates, investment performance, insurance ratings, claims, persistency, and other factors.

 

Reclassifications

 

Certain reclassifications have been made in the previously reported financial statements and accompanying notes to make the prior year amounts comparable to those of the current year. Such reclassifications had no effect on previously reported net income or shareowners’ equity.

 

Entities Included

 

The consolidated condensed financial statements include the accounts of Protective Life Corporation and subsidiaries and its affiliate companies in which the Company holds a majority voting or economic interest. Intercompany balances and transactions have been eliminated.

 

2.                                      SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

Significant Accounting Policies

 

For a full description of significant accounting policies, see Note 2 to consolidated financial statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2013. Although there were no significant changes to the Company’s accounting policies during the nine months ended September 30, 2014, the Company has clarified the disclosures related to its reinsurance accounting methodology as follows:

 

Reinsurance Accounting Methodology—Ceded premiums of the Company’s traditional life insurance products are treated as an offset to direct premium and policy fee revenue and are recognized when due to the assuming company. Ceded claims are treated as an offset to direct benefits and settlement expenses and are recognized when the claim is incurred on a direct basis. Ceded policy reserve changes are also treated as an offset to benefits and settlement expenses and are recognized during the applicable financial reporting period. Expense allowances paid by the assuming companies which are allocable to the current period are treated as an offset to other operating expenses. Since reinsurance treaties typically provide for allowance percentages that decrease over the lifetime of a policy, allowances in excess of the “ultimate” or final level allowance are capitalized. Amortization of capitalized reinsurance expense allowances representing recovery of acquisition costs is treated as an offset to direct amortization of DAC or VOBA.

 

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Amortization of deferred expense allowances is calculated as a level percentage of expected premiums in all durations given expected future lapses and mortality and accretion due to interest.

 

The Company utilizes reinsurance on certain short duration insurance contracts (primarily issued through the Asset Protection segment). As part of these reinsurance transactions the Company receives reinsurance allowances which reimburse the Company for acquisition costs such as commissions and premium taxes. A ceding fee is also collected to cover other administrative costs and profits for the Company. As a component of reinsurance costs, reinsurance allowances are accounted for in accordance with the relevant provisions of ASC Financial Services — Insurance Topic, which state that reinsurance costs should be amortized over the contract period of the reinsurance if the contract is short-duration.  Accordingly, reinsurance allowances received related to short-duration contracts are capitalized and charged to expense in proportion to premiums earned. Ceded unamortized acquisition costs are netted with direct unamortized acquisition costs in the balance sheet.

 

Ceded premiums and policy fees on the Company’s universal life (“UL”), VUL, bank-owned life insurance (“BOLI”), and annuity products reduce premiums and policy fees recognized by the Company. Ceded claims are treated as an offset to direct benefits and settlement expenses and are recognized when the claim is incurred on a direct basis. Ceded policy reserve changes are also treated as an offset to benefits and settlement expenses and are recognized during the applicable valuation period.

 

Since reinsurance treaties typically provide for allowance percentages that decrease over the lifetime of a policy, allowances in excess of the “ultimate” or final level allowance are capitalized. Amortization of capitalized reinsurance expense allowances are amortized based on future expected gross profits. Assumptions regarding mortality, lapses, and interest rates are continuously reviewed and may be periodically changed. These changes will result in “unlocking” that changes the balance in the ceded deferred acquisition cost and can affect the amortization of DAC and VOBA. Ceded unearned revenue liabilities are also amortized based on expected gross profits. Assumptions are based on the best current estimate of expected mortality, lapses and interest spread.

 

The Company has also assumed certain policy risks written by other insurance companies through reinsurance agreements. Premiums and policy fees as well as Benefits and settlement expenses include amounts assumed under reinsurance agreements and are net of reinsurance ceded. Assumed reinsurance is accounted for in accordance with ASC Financial Services—Insurance Topic.

 

Reinsurance Allowances — Long-Duration Contracts — Reinsurance allowances are intended to reimburse the ceding company for some portion of the ceding company’s commissions, expenses, and taxes. The amount and timing of reinsurance allowances (both first year and renewal allowances) are contractually determined by the applicable reinsurance contract and do not necessarily bear a relationship to the amount and incidence of expenses actually paid by the ceding company in any given year.

 

Ultimate reinsurance allowances are defined as the lowest allowance percentage paid by the reinsurer in any policy duration over the lifetime of a universal life policy (or through the end of the level term period for a traditional life policy). Ultimate reinsurance allowances are determined during the negotiation of each reinsurance agreement and will differ between agreements.

 

The Company determines its “cost of reinsurance” to include amounts paid to the reinsurer (ceded premiums) net of amounts reimbursed by the reinsurer (in the form of allowances).  As noted within ASC Financial Services—Insurance Topic, “The difference, if any, between amounts paid for a reinsurance contract and the amount of the liabilities for policy benefits relating to the underlying reinsured contracts is part of the estimated cost to be amortized.”  The Company’s policy is to amortize the cost of reinsurance over the life of the underlying reinsured contracts (for long-duration policies) in a manner consistent with the way in which benefits and expenses on the underlying contracts are recognized.  For the Company’s long-duration contracts, it is the Company’s practice to defer reinsurance allowances as a component of the cost of reinsurance and recognize the portion related to the recovery of acquisition costs as a reduction of applicable unamortized acquisition costs in such a manner that net acquisition costs are capitalized and charged to expense in proportion to net revenue recognized. The remaining balance of reinsurance allowances are included as a component of the cost of reinsurance and those allowances which are allocable to the current period are recorded as an offset to operating expenses in the current period consistent with the recognition of benefits and expenses on the underlying reinsured contracts. This practice is consistent with the Company’s practice of

 

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capitalizing direct expenses (e.g. commissions), and results in the recognition of reinsurance allowances on a systematic basis over the life of the reinsured policies on a basis consistent with the way in which acquisition costs on the underlying reinsured contracts would be recognized.  In some cases reinsurance allowances allocable to the current period may exceed non-deferred direct costs, which may cause net other operating expenses (related to specific contracts) to be negative.

 

Amortization of Reinsurance Allowances—Reinsurance allowances do not affect the methodology used to amortize DAC and VOBA, or the period over which such DAC and VOBA are amortized. Reinsurance allowances offset the direct expenses capitalized, reducing the net amount that is capitalized. DAC and VOBA on traditional life policies are amortized based on the pattern of estimated gross premiums of the policies in force. Reinsurance allowances do not affect the gross premiums, so therefore they do not impact traditional life amortization patterns. DAC and VOBA on universal life products are amortized based on the pattern of estimated gross profits of the policies in force. Reinsurance allowances are considered in the determination of estimated gross profits, and therefore do impact amortization patterns.

 

Reinsurance Liabilities—Claim liabilities and policy benefits are calculated consistently for all policies in accordance with GAAP, regardless of whether or not the policy is reinsured. Once the claim liabilities and policy benefits for the underlying policies are estimated, the amounts recoverable from the reinsurers are estimated based on a number of factors including the terms of the reinsurance contracts, historical payment patterns of reinsurance partners, and the financial strength and credit worthiness of reinsurance partners. Liabilities for unpaid reinsurance claims are produced from claims and reinsurance system records, which contain the relevant terms of the individual reinsurance contracts. The Company monitors claims due from reinsurers to ensure that balances are settled on a timely basis. Incurred but not reported claims are reviewed by the Company’s actuarial staff to ensure that appropriate amounts are ceded.

 

The Company analyzes and monitors the credit worthiness of each of its reinsurance partners to minimize collection issues. For newly executed reinsurance contracts with reinsurance companies that do not meet predetermined standards, the Company requires collateral such as assets held in trusts or letters of credit.

 

Components of Reinsurance Cost—The following income statement lines are affected by reinsurance cost:

 

Premiums and policy fees (“reinsurance ceded” on the Company’s financial statements) represent consideration paid to the assuming company for accepting the ceding company’s risks. Ceded premiums and policy fees increase reinsurance cost.

 

Benefits and settlement expenses include incurred claim amounts ceded and changes in ceded policy reserves. Ceded benefits and settlement expenses decrease reinsurance cost.

 

Amortization of deferred policy acquisition cost and VOBA reflects the amortization of capitalized reinsurance allowances representing recovery of acquisition costs. Ceded amortization decreases reinsurance cost.

 

Other expenses include reinsurance allowances paid by assuming companies to the Company less amounts representing recovery of acquisition costs. Reinsurance allowances decrease reinsurance cost.

 

The Company’s reinsurance programs do not materially impact the other income line of the Company’s income statement. In addition, net investment income generally has no direct impact on the Company’s reinsurance cost. However, it should be noted that by ceding business to the assuming companies, the Company forgoes investment income on the reserves ceded to the assuming companies. Conversely, the assuming companies will receive investment income on the reserves assumed which will increase the assuming companies’ profitability on business assumed from the Company.

 

Accounting Pronouncements Not Yet Adopted

 

Accounting Standards Update (“ASU”) No. 2014-08 — Reporting Discontinued Operations and Disclosure of Disposals of Components of an Entity. This Update changes the requirements for reporting discontinued operations and related disclosures. The Update limits the definition of a discontinued operation to

 

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disposals that represent “strategic shifts” that will have a major effect on an entity’s operation and financial results. Additionally, the Update requires enhanced disclosures about the components of discontinued operations and the financial effects of the disposal. The amendments in this Update are effective for annual and interim periods beginning after December 15, 2014. The Company is reviewing the additional disclosures required by the Update, and will apply the revised guidance to any disposals occurring after the effective date.

 

ASU No. 2014-09 — Revenue from Contracts with Customers (Topic 606). This Update provides for significant revisions to the recognition of revenue from contracts with customers across various industries. Under the new guidance, entities are required to apply a prescribed 5-step process 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 accounting for revenues associated with insurance products is not within the scope of this Update. The Update is effective for annual and interim periods beginning after December 15, 2016. The Company is reviewing its policies and processes to ensure compliance with the requirements in this Update, upon adoption.

 

ASU No. 2014-11 — Repurchase-to-Maturity Transactions, Repurchase Financings, and Disclosures. This Update changes the requirements for classification of certain repurchase agreements, and will expand the use of secured borrowing accounting for repurchase-to-maturity transactions. In addition, the Update requires additional disclosures for repurchase agreements accounted for both as sales and as secured borrowings. The amendments in this Update are effective for annual and interim periods beginning after December 15, 2014. The Update is not anticipated to impact the Company’s financial position or results of operations. The Company is reviewing its policies and processes to ensure compliance with the additional disclosure requirements in this Update.

 

ASU No. 2014-15 — Presentation of Financial Statements—Going Concern (Subtopic 205-40): Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern. This Update will require management to assess an entity’s ability to continue as a going concern, and will require footnote disclosures in certain circumstances. Under the updated guidance, management should consider relevant conditions and evaluate whether it is probable that the entity will be unable to meet its obligations within one year after the issuance date of the financial statements. The Update is effective for annual periods ending December 31, 2016 and interim periods thereafter, with early adoption is permitted. The amendments in this Update will not impact the Company’s financial position or results of operations. However, the new guidance will require a formal assessment of going concern by management based on criteria prescribed in the new guidance. The Company is reviewing its policies and processes to ensure compliance with the new guidance.

 

3.                                      SIGNIFICANT ACQUISITIONS

 

On October 1, 2013 Protective Life Insurance Company (“PLICO”) completed the acquisition contemplated by the master agreement (the “Master Agreement”) dated April 10, 2013. Pursuant to that Master Agreement with AXA Financial, Inc. (“AXA”) and AXA Equitable Financial Services, LLC (“AEFS”), PLICO acquired the stock of MONY Life Insurance Company (“MONY”) from AEFS and entered into a reinsurance agreement (the “Reinsurance Agreement”) pursuant to which it reinsured on a 100% indemnity reinsurance basis certain business (the “MLOA Business”) of MONY Life Insurance Company of America (“MLOA”). The final aggregate purchase price of MONY was $689 million. The ceding commission for the reinsurance of the MLOA Business was $370 million. Together, the purchase of MONY and reinsurance of the MLOA Business are hereto referred to as (the “MONY acquisition”). The MONY acquisition allowed the Company to invest its capital and increase the scale of its Acquisitions segment. The MONY acquisition business is comprised of traditional and universal life insurance policies and fixed and variable annuities, most of which were written prior to 2004.

 

The MONY acquisition was accounted for under the acquisition method of accounting under ASC Topic 805. In accordance with ASC 805-20-30, all identifiable assets acquired and liabilities assumed were measured at fair value as of the acquisition date. During the nine months ended September 30, 2014, as a result of new information obtained about facts and circumstances that existed as of the acquisition date, the Company recorded certain measurement period adjustments to fixed maturities, mortgage loans, cash, accounts and premiums receivable, VOBA, other assets, deferred income taxes, future policy benefits and claims, other policyholders’ funds, and other liabilities. These were customary adjustments that occurred during the normal course of reviewing and integrating the MONY acquisition. The net result on the amount of VOBA recorded by the Company in relation to the MONY acquisition was to decrease VOBA by approximately $14.0 million. This impact has been revised in the comparative consolidated balance sheet presented as

 

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of December 31, 2013. The Company has determined that the impact on amortization and other related amounts within the comparative interim and annual periods from that previously presented in the annual or interim consolidated condensed statements of income is immaterial. The amounts presented in the following table related to the MONY acquisition (presented as of the acquisition date of October 1, 2013) have been retrospectively revised for the aforementioned measurement period adjustments.

 

The following table summarizes the consideration paid for the acquisition and the determination of the fair value of assets acquired and liabilities assumed at the acquisition date:

 

 

 

Fair Value

 

 

 

As of

 

 

 

October 1, 2013

 

 

 

(Dollars In Thousands)

 

Assets

 

 

 

Fixed maturities, at fair value

 

$

6,557,853

 

Equity securities, at fair value

 

108,413

 

Mortgage loans

 

830,415

 

Policy loans

 

967,534

 

Short-term investments

 

130,963

 

Total investments

 

8,595,178

 

Cash

 

216,164

 

Accrued investment income

 

114,695

 

Accounts and premiums receivable, net of allowance for uncollectible amounts

 

26,055

 

Reinsurance receivable

 

422,692

 

Value of business acquired

 

205,767

 

Other assets

 

5,104

 

Income tax receivables

 

21,197

 

Deferred income taxes

 

188,142

 

Separate account assets

 

195,452

 

Total assets

 

$

9,990,446

 

Liabilities

 

 

 

Future policy benefits and claims

 

$

7,645,969

 

Unearned premiums

 

3,066

 

Total policy liabilities and accruals

 

7,649,035

 

Annuity account balances

 

752,163

 

Other policyholders’ funds

 

636,448

 

Other liabilities

 

66,124

 

Non-recourse funding obligation

 

2,548

 

Separate account liabilities

 

195,344

 

Total liabilities

 

9,301,662

 

Net assets acquired

 

$

688,784

 

 

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The following (unaudited) pro forma condensed consolidated results of operations assumes that the aforementioned acquisition was completed as of January 1, 2012:

 

 

 

Unaudited

 

 

 

For The

 

For The

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30, 2013

 

September 30, 2013

 

 

 

(Dollars In Thousands)

 

Revenue

 

$

1,166,516

 

$

3,482,582

 

Net income

 

$

128,036

 

$

333,552

 

EPS - basic

 

$

1.61

 

$

4.20

 

EPS - diluted

 

$

1.58

 

$

4.12

 

 

4.                                      MONY CLOSED BLOCK OF BUSINESS

 

In 1998, MONY converted from a mutual insurance company to a stock corporation (“demutualization”). In connection with its demutualization, an accounting mechanism known as a closed block (the “Closed Block”) was established for certain individuals’ participating policies in force as of the date of demutualization. Assets, liabilities, and earnings of the Closed Block are specifically identified to support its participating policyholders. The Company acquired the Closed Block in conjunction with the MONY acquisition as discussed in Note 3, Significant Acquisitions.

 

Assets allocated to the Closed Block inure solely to the benefit of each Closed Block’s policyholders and will not revert to the benefit of MONY or the Company. No reallocation, transfer, borrowing or lending of assets can be made between the Closed Block and other portions of MONY’s general account, any of MONY’s separate accounts or any affiliate of MONY without the approval of the Superintendent of The New York State Insurance Department (the “Superintendent”). Closed Block assets and liabilities are carried on the same basis as similar assets and liabilities held in the general account.

 

The excess of Closed Block liabilities over Closed Block assets (adjusted to exclude the impact of related amounts in accumulated other comprehensive income (loss) (“AOCI”)) at the acquisition date represented the estimated maximum future post-tax earnings from the Closed Block that would be recognized in income from continuing operations over the period the policies and contracts in the Closed Block remain in force. In connection with the acquisition of MONY, the Company has developed an actuarial calculation of the expected timing of MONY’s Closed Block’s earnings as of October 1, 2013.

 

If the actual cumulative earnings from the Closed Block are greater than the expected cumulative earnings, only the expected earnings will be recognized in the Company’s net income. Actual cumulative earnings in excess of expected cumulative earnings at any point in time are recorded as a policyholder dividend obligation because they will ultimately be paid to Closed Block policyholders as an additional policyholder dividend unless offset by future performance that is less favorable than originally expected. If a policyholder dividend obligation has been previously established and the actual Closed Block earnings in a subsequent period are less than the expected earnings for that period, the policyholder dividend obligation would be reduced (but not below zero). If, over the period the policies and contracts in the Closed Block remain in force, the actual cumulative earnings of the Closed Block are less than the expected cumulative earnings, only actual earnings would be recognized in income from continuing operations. If the Closed Block has insufficient funds to make guaranteed policy benefit payments, such payments will be made from assets outside the Closed Block.

 

Many expenses related to Closed Block operations, including amortization of VOBA, are charged to operations outside of the Closed Block; accordingly, net revenues of the Closed Block do not represent the actual profitability of the Closed Block operations. Operating costs and expenses outside of the Closed Block are, therefore, disproportionate to the business outside of the Closed Block.

 

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Summarized financial information for the Closed Block from December 31, 2013 through September 30, 2014 is as follows:

 

 

 

As of

 

 

 

September 30, 2014

 

December 31, 2013

 

 

 

(Dollars In Thousands)

 

Closed block liabilities

 

 

 

 

 

Future policy benefits, policyholders’ account balances and other

 

$

6,172,310

 

$

6,261,819

 

Policyholder dividend obligation

 

301,215

 

190,494

 

Other liabilities

 

28,102

 

1,259

 

Total closed block liabilities

 

6,501,627

 

6,453,572

 

Closed block assets

 

 

 

 

 

Fixed maturities, available-for-sale, at fair value

 

$

4,441,257

 

$

4,113,829

 

Equity securities, available-for-sale, at fair value

 

5,384

 

5,223

 

Mortgage loans on real estate

 

483,836

 

601,959

 

Policy loans

 

780,450

 

802,013

 

Cash and other invested assets

 

16,411

 

140,577

 

Other assets

 

214,785

 

206,938

 

Total closed block assets

 

5,942,123

 

5,870,539

 

Excess of reported closed block liabilities over closed block assets

 

559,504

 

583,033

 

Portion of above representing accumulated other comprehensive income:

 

 

 

 

 

Net unrealized investment gains (losses) net of deferred tax benefit of $0 and $1,074 net of policyholder dividend obligation of $69,409 and $12,720

 

 

(1,994

)

Future earnings to be recognized from closed block assets and closed block liabilities

 

$

559,504

 

$

581,039

 

 

Reconciliation of the policyholder dividend obligation from December 31, 2013 through September 30, 2014 is as follows:

 

 

 

For The

 

 

 

Nine Months Ended

 

 

 

September 30, 2014

 

 

 

(Dollars In Thousands)

 

Policyholder dividend obligation, at December 31, 2013

 

$

190,494

 

Applicable to net revenue (losses)

 

(8,781

)

Change in net unrealized investment gains (losses) allocated to the policyholder dividend obligation

 

119,502

 

Policyholder dividend obligation, end of period

 

$

301,215

 

 

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Closed Block revenues and expenses were as follows:

 

 

 

For The

 

For The

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30, 2014

 

September 30, 2014

 

 

 

(Dollars In Thousands)

 

Revenues

 

 

 

 

 

Premiums and other income

 

$

48,596

 

$

151,442

 

Net investment income

 

63,847

 

176,470

 

Net investment gains

 

223

 

6,328

 

Total revenues

 

112,666

 

334,240

 

Benefits and other deductions

 

 

 

 

 

Benefits and settlement expenses

 

101,200

 

300,735

 

Other operating expenses

 

286

 

376

 

Total benefits and other deductions

 

101,486

 

301,111

 

Net revenues before income taxes

 

11,180

 

33,129

 

Income tax expense

 

3,913

 

11,595

 

Net revenues

 

$

7,267

 

$

21,534

 

 

5.                                      PROPOSED DAI-ICHI MERGER

 

On June 3, 2014, the Company entered into an Agreement and Plan of Merger (the “Merger Agreement”) with The Dai-ichi Life Insurance Company, Limited, a kabushiki kaisha organized under the laws of Japan (“Dai-ichi”) and DL Investment (Delaware), Inc., a Delaware corporation and wholly owned subsidiary of Dai-ichi which provides for the merger of DL Investment (Delaware), Inc. with and into the Company (the “Merger”), with the Company surviving the Merger as a wholly owned subsidiary of Dai-ichi.

 

The Company’s Board of Directors unanimously (1) determined that the Merger and the other transactions contemplated by the Merger Agreement are fair to, advisable and in the best interests of, the Company and its shareowners, (2) approved the execution, delivery and performance of the Merger Agreement by the Company and the consummation of the Merger and the other transactions contemplated by the Merger Agreement, and (3) resolved to recommend the approval and adoption of the Merger Agreement and the transactions contemplated by the Merger Agreement by the shareowners of the Company. The Board of Directors received an opinion as to the fairness of the Merger consideration to be received by the shareowners of the Company from its financial advisor, Morgan Stanley & Co. LLC related to the terms of the Merger Agreement.

 

If the proposed Merger is completed, at the effective time of the Merger (the “Effective Time”), each share of the Company’s common stock, par value $0.50 per share, issued and outstanding immediately prior to the Effective Time, other than certain excluded shares, will be converted into the right to receive $70 in cash, without interest (the “Per Share Merger Consideration”). Shares of common stock held by Dai-ichi or the Company or their respective direct or indirect wholly-owned subsidiaries will not be entitled to receive the Merger Consideration. Stock appreciation rights, restricted stock units and performance shares issued under various benefit plans will be paid out as described below under “Treatment of Benefit Plans”.

 

Completion of the Merger is subject to various closing conditions, including, but not limited to, (1) adoption of the Merger Agreement by the affirmative vote of the holders of at least a majority of all outstanding shares of the Company’s common stock, which adoption was approved at a Special Meeting of Shareholders held on October 6, 2014, (2) requisite approval of the Japan Financial Services Agency of an application and notification filing by Dai-ichi and its affiliates, (3) the receipt of certain insurance regulatory approvals, (4) the absence of any laws that have been adopted or promulgated, or any order, injunction, decision or decree issued or remaining in effect, that would prohibit the Merger or make the Merger illegal, and (5) the expiration or termination of the applicable waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended, which waiting period terminated on July 25, 2014, pursuant to a grant of early termination by the Federal Trade Commission. Each party’s obligation to consummate the Merger also is subject to certain additional conditions that include the accuracy of the other party’s representations and warranties contained in the Merger Agreement (subject to certain materiality qualifiers) and the

 

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other party’s compliance with its covenants and agreements contained in the Merger Agreement in all material respects. The Merger Agreement does not contain a financing condition.

 

The Merger Agreement contains representations and warranties customary for transactions of this type. The Company has agreed to various customary covenants and agreements, including, among others, agreements to conduct its business in the ordinary course during the period between the execution of the Merger Agreement and the Effective Time, and not to engage in certain kinds of transactions during this period. In addition, and subject to certain limitations, either party may terminate the Merger Agreement if the Merger is not consummated by February 28, 2015, which date is extended until April 30, 2015 in the event of delays in obtaining regulatory approval.

 

Treatment of Benefit Plans

 

Pursuant to the Merger Agreement, at or immediately prior to the Effective Time, each stock appreciation right with respect to shares of Common Stock granted under any Stock Plan (each, a “SAR”) that is outstanding and unexercised immediately prior to the Effective Time and that has a base price per share of Common Stock underlying such SAR (the “Base Price”) that is less than the Per Share Merger Consideration (each such SAR, an “In-the-Money SAR”), whether or not exercisable or vested, will be cancelled and converted into the right to receive an amount in cash, without interest, determined by multiplying (i) the excess of the Per Share Merger Consideration over the Base Price of such In-the-Money SAR by (ii) the number of shares of Common Stock subject to such In-the-Money SAR (such amount, the “SAR Consideration”). At the Effective Time, each SAR that has a Base Price that is equal to or greater than the Per Share Merger Consideration, whether or not exercisable or vested, will be cancelled and the holder of such SAR will not be entitled to receive any payment in exchange for such cancellation.

 

Pursuant to the Merger Agreement, at or immediately prior to the Effective Time, each restricted share unit with respect to a share of Common Stock granted under any Stock Plan (each, a “RSU”) that is outstanding immediately prior to the Effective Time, whether or not vested, will be cancelled and converted into the right to receive an amount in cash, without interest, determined by multiplying (i) the Per Share Merger Consideration by (ii) the number of RSUs.

 

Pursuant to the Merger Agreement, at or immediately prior to the Effective Time, the number of performance shares earned for each award of performance shares granted under any Stock Plan will be calculated by determining the number of performance shares that would have been paid if the subject award period had ended on the December 31 immediately preceding the Effective Time (based on the conditions set for payment of performance share awards for the subject award period), provided that the number of performance shares earned for each award will not be less than the aggregate number of performance shares at the target performance level, and provided further that with respect to awards granted in the year in which the Effective Time occurs, performance shares will be earned at the same percentage as awards granted in the year preceding the year in which the Effective Time occurs. At or immediately prior to the Effective Time, each performance share so earned (each, a “Performance Share”) that is outstanding immediately prior to the Effective Time, whether or not vested, will be cancelled and converted into the right to receive an amount in cash, without interest, determined by multiplying (i) the Per Share Merger Consideration by (ii) the number of Performance Shares.

 

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6.                                      INVESTMENT OPERATIONS

 

Net realized gains (losses) for all other investments are summarized as follows:

 

 

 

For The

 

For The

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

 

2014

 

2013

 

2014

 

2013

 

 

 

(Dollars In Thousands)

 

Fixed maturities

 

$

22,329

 

$

10,546

 

$

49,897

 

$

42,007

 

Equity securities

 

1,298

 

 

1,298

 

2,367

 

Impairments on fixed maturity securities

 

(2,354

)

(7,421

)

(5,405

)

(13,918

)

Impairments on equity securities

 

 

(1,260

)

 

(3,347

)

Modco trading portfolio

 

(17,225

)

(25,960

)

110,067

 

(167,982

)

Other investments

 

(5,208

)

(4,094

)

(7,806

)

(10,023

)

Total realized gains (losses) - investments

 

$

(1,160

)

$

(28,189

)

$

148,051

 

$

(150,896

)

 

For the three and nine months ended September 30, 2014, gross realized gains on investments available-for-sale (fixed maturities, equity securities, and short-term investments) were $23.9 million and $51.9 million and gross realized losses were $2.5 million and $5.9 million, including $2.3 million and $5.1 million of impairment losses, respectively.

 

For the three and nine months ended September 30, 2013, gross realized gains on investments available-for-sale (fixed maturities, equity securities, and short-term investments) were $11.7 million and $48.5 million and gross realized losses were $9.6 million and $20.8 million, including $8.5 million and $16.7 million of impairment losses, respectively.

 

For the three and nine months ended September 30, 2014, the Company sold securities in an unrealized gain position with a fair value (proceeds) of $497.1 million and $1.1 billion, respectively. The gain realized on the sale of these securities was $23.9 million and $51.9 million, respectively.

 

For the three and nine months ended September 30, 2013, the Company sold securities in an unrealized gain position with a fair value (proceeds) of $332.1 million and $1.1 billion, respectively. The gain realized on the sale of these securities was $11.7 million and $48.5 million, respectively.

 

For the three and nine months ended September 30, 2014, the Company sold securities in an unrealized loss position with a fair value (proceeds) of $2.3 million and $6.7 million, respectively. The losses realized on the sale of these securities were $0.3 million and $0.8 million, respectively. These securities were sold in conjunction with the Company’s overall asset liability management process.

 

For the three and nine months ended September 30, 2013, the Company sold securities in an unrealized loss position with a fair value (proceeds) of $7.0 million and $64.2 million, respectively. The losses realized on the sale of these securities were $1.1 million and $4.1 million, respectively. These securities were sold in conjunction with the Company’s overall asset liability management process.

 

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Table of Contents

 

The amortized cost and fair value of the Company’s investments classified as available-for-sale as of September 30, 2014 and December 31, 2013, are as follows:

 

 

 

 

 

Gross

 

Gross

 

 

 

Total OTTI

 

 

 

Amortized

 

Unrealized

 

Unrealized

 

Fair

 

Recognized

 

 

 

Cost

 

Gains

 

Losses

 

Value

 

in OCI(1)

 

 

 

(Dollars In Thousands)

 

2014 

 

 

 

 

 

 

 

 

 

 

 

Fixed maturities:

 

 

 

 

 

 

 

 

 

 

 

Bonds

 

 

 

 

 

 

 

 

 

 

 

Residential mortgage-backed securities

 

$

1,405,720

 

$

51,253

 

$

(14,134

)

$

1,442,839

 

$

7,945

 

Commercial mortgage-backed securities

 

1,137,642

 

43,744

 

(5,863

)

1,175,523

 

 

Other asset-backed securities

 

869,175

 

13,437

 

(34,273

)

848,339

 

(105

)

U.S. government-related securities

 

1,563,337

 

43,178

 

(22,305

)

1,584,210

 

 

Other government-related securities

 

19,004

 

3,016

 

 

22,020

 

1

 

States, municipals, and political subdivisions

 

1,371,113

 

243,943

 

(2,349

)

1,612,707

 

 

Corporate bonds

 

25,026,858

 

2,497,515

 

(117,387

)

27,406,986

 

 

 

 

31,392,849

 

2,896,086

 

(196,311

)

34,092,624

 

7,841

 

Equity securities

 

767,889

 

34,209

 

(16,525

)

785,573

 

 

Short-term investments

 

108,088

 

 

 

108,088

 

 

 

 

$

32,268,826

 

$

2,930,295

 

$

(212,836

)

$

34,986,285

 

$

7,841

 

2013 

 

 

 

 

 

 

 

 

 

 

 

Fixed maturities:

 

 

 

 

 

 

 

 

 

 

 

Bonds

 

 

 

 

 

 

 

 

 

 

 

Residential mortgage-backed securities

 

$

1,435,477

 

$

34,155

 

$

(24,564

)

$

1,445,068

 

$

979

 

Commercial mortgage-backed securities

 

963,461

 

26,900

 

(19,705

)

970,656

 

 

Other asset-backed securities

 

926,396

 

15,135

 

(69,548

)

871,983

 

(51

)

U.S. government-related securities

 

1,529,818

 

32,150

 

(54,078

)

1,507,890

 

 

Other government-related securities

 

49,171

 

2,257

 

(1

)

51,427

 

 

States, municipals, and political subdivisions

 

1,315,457

 

103,663

 

(8,291

)

1,410,829

 

 

Corporate bonds

 

24,650,500

 

1,508,317

 

(392,067

)

25,766,750

 

 

 

 

30,870,280

 

1,722,577

 

(568,254

)

32,024,603

 

928

 

Equity securities

 

654,579

 

6,631

 

(36,362

)

624,848

 

 

Short-term investments

 

81,703

 

 

 

81,703

 

 

 

 

$

31,606,562

 

$

1,729,208

 

$

(604,616

)

$

32,731,154

 

$

928

 

 


(1)These amounts are included in the gross unrealized gains and gross unrealized losses columns above.

 

The amortized cost and fair value of the Company’s investments classified as held-to-maturity as of September 30, 2014 and December 31, 2013, are as follows:

 

 

 

 

 

Gross

 

Gross

 

 

 

Total OTTI

 

 

 

Amortized

 

Unrealized

 

Unrealized

 

Fair

 

Recognized

 

 

 

Cost

 

Gains

 

Losses

 

Value

 

in OCI

 

 

 

(Dollars In Thousands)

 

2014 

 

 

 

 

 

 

 

 

 

 

 

Fixed maturities:

 

 

 

 

 

 

 

 

 

 

 

Other

 

$

415,000

 

$

38,741

 

$

 

$

453,741

 

$

 

 

 

$

415,000

 

$

38,741

 

$

 

$

453,741

 

$

 

2013 

 

 

 

 

 

 

 

 

 

 

 

Fixed maturities:

 

 

 

 

 

 

 

 

 

 

 

Other

 

$

365,000

 

$

 

$

(29,324

)

$

335,676

 

$

 

 

 

$

365,000

 

$

 

$

(29,324

)

$

335,676

 

$

 

 

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Table of Contents

 

During the nine months ended September 30, 2014 and the year ended December 31, 2013, the Company did not record any other-than-temporary impairments on held-to-maturity securities. The Company’s held-to-maturity securities had no gross unrecognized holding losses for the period ended September 30, 2014 and $29.3 million for the year ended December 31, 2013. The Company does not consider these unrecognized holding losses to be other-than-temporary based on certain positive factors associated with the securities which include credit ratings, financial health of the issuer, continued access of the issuer to capital markets and other pertinent information.

 

As of September 30, 2014 and December 31, 2013, the Company had an additional $2.8 billion and $2.8 billion of fixed maturities, $24.1 million and $21.2 million of equity securities, and $75.3 million and $52.4 million of short-term investments classified as trading securities, respectively.

 

The amortized cost and fair value of available-for-sale and held-to-maturity fixed maturities as of September 30, 2014, by expected maturity, are shown below. Expected maturities of securities without a single maturity date are allocated based on estimated rates of prepayment that may differ from actual rates of prepayment.

 

 

 

Available-for-sale

 

Held-to-maturity

 

 

 

Amortized

 

Fair

 

Amortized

 

Fair

 

 

 

Cost

 

Value

 

Cost

 

Value

 

 

 

(Dollars In Thousands)

 

(Dollars In Thousands)

 

Due in one year or less

 

$

1,043,275

 

$

1,057,236

 

$

 

$

 

Due after one year through five years

 

4,538,893

 

4,831,128

 

 

 

Due after five years through ten years

 

8,886,075

 

9,347,371

 

 

 

Due after ten years

 

16,924,606

 

18,856,889

 

415,000

 

453,741

 

 

 

$

31,392,849

 

$

34,092,624

 

$

415,000

 

$

453,741

 

 

During the three and nine months ended September 30, 2014, the Company recorded pre-tax other-than-temporary impairments of investments of $1.1 million and $2.0 million, all of which related to fixed maturities, respectively. Credit impairments recorded in earnings during the three and nine months ended September 30, 2014 were $2.3 million and $5.4 million, respectively. During the three and nine months ended September 30, 2014, $1.2 million and $3.4 million of non-credit losses previously recorded in other comprehensive income were recorded in earnings as credit losses, respectively. For the three and nine months ended September 30, 2014, there were no other-than-temporary impairments related to fixed maturities or equity securities that the Company intended to sell or expected to be required to sell.

 

During the three and nine months ended September 30, 2013, the Company recorded pre-tax other-than-temporary impairments of investments of $6.7 million and $9.8 million, of which $5.4 million and $6.4 million related to fixed maturities and $1.3 million and $3.4 million related to equity securities, respectively. Credit impairments recorded in earnings during the three and nine months ended September 30, 2013 were $8.7 million and $17.3 million, respectively. During the three and nine months ended September 30, 2013, $2.0 million and $7.5 million of non-credit losses previously recorded in other comprehensive income were recorded in earnings as credit losses, respectively. For the three and nine months ended September 30, 2013, there were no other-than-temporary impairments related to fixed maturities or equity securities that the Company intended to sell or expected to be required to sell.

 

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Table of Contents

 

The following chart is a rollforward of available-for-sale credit losses on fixed maturities held by the Company for which a portion of other-than-temporary impairments were recognized in other comprehensive income (loss):

 

 

 

For The

 

For The

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

 

2014

 

2013

 

2014

 

2013

 

 

 

(Dollars In Thousands)

 

Beginning balance

 

$

17,985

 

$

51,832

 

$

41,692

 

$

122,121

 

Additions for newly impaired securities

 

 

1,663

 

 

3,278

 

Additions for previously impaired securities

 

626

 

4,840

 

1,653

 

7,894

 

Reductions for previously impaired securities due to a change in expected cash flows

 

(3,672

)

(6,537

)

(28,406

)

(74,007

)

Reductions for previously impaired securities that were sold in the current period

 

 

 

 

(7,488

)

Ending balance

 

$

14,939

 

$

51,798

 

$

14,939

 

$

51,798

 

 

The following table includes the gross unrealized losses and fair value of the Company’s investments that are not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position as of September 30, 2014:

 

 

 

Less Than 12 Months

 

12 Months or More

 

Total

 

 

 

Fair

 

Unrealized

 

Fair

 

Unrealized

 

Fair

 

Unrealized

 

 

 

Value

 

Loss

 

Value

 

Loss

 

Value

 

Loss

 

 

 

(Dollars In Thousands)

 

Residential mortgage-backed securities

 

$

149,282

 

$

(7,781

)

$

88,374

 

$

(6,353

)

$

237,656

 

$

(14,134

)

Commercial mortgage-backed securities

 

123,244

 

(1,534

)

124,578

 

(4,329

)

247,822

 

(5,863

)

Other asset-backed securities

 

109,657

 

(5,537

)

551,045

 

(28,736

)

660,702

 

(34,273

)

U.S. government-related securities

 

374,160

 

(7,835

)

348,900

 

(14,470

)

723,060

 

(22,305

)

Other government-related securities

 

 

 

 

 

 

 

States, municipalities, and political subdivisions

 

880

 

(6

)

40,936

 

(2,343

)

41,816

 

(2,349

)

Corporate bonds

 

2,218,594

 

(54,117

)

995,498

 

(63,270

)

3,214,092

 

(117,387

)

Equities

 

90,797

 

(1,305

)

128,465

 

(15,220

)

219,262

 

(16,525

)

 

 

$

3,066,614

 

$

(78,115

)

$

2,277,796

 

$

(134,721

)

$

5,344,410

 

$

(212,836

)

 

RMBS have a gross unrealized loss greater than twelve months of $6.4 million as of September 30, 2014. Factors such as the credit enhancement within the deal structure, the average life of the securities, and the performance of the underlying collateral support the recoverability of these investments.

 

CMBS have a gross unrealized loss greater than twelve months of $4.3 million as of September 30, 2014. Factors such as the credit enhancement within the deal structure, the average life of the securities, and the performance of the underlying collateral support the recoverability of these investments.

 

The other asset-backed securities have a gross unrealized loss greater than twelve months of $28.7 million as of September 30, 2014. This category predominately includes student-loan backed auction rate securities, the underlying collateral, of which is at least 97% guaranteed by the Federal Family Education Loan Program (“FFELP”). These unrealized losses have occurred within the Company’s auction rate securities (“ARS”) portfolio since the market collapse during 2008. At this time, the Company has no reason to believe that the U.S. Department of Education would not honor the FFELP guarantee, if it were necessary.

 

The U.S. government-related category has gross unrealized losses greater than twelve months of $14.5 million as of September 30, 2014. These declines were entirely related to changes in interest rates.

 

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Table of Contents

 

The corporate bonds category has gross unrealized losses greater than twelve months of $63.3 million as of September 30, 2014. These declines were primarily related to changes in interest rates during the period. The aggregate decline in market value of these securities was deemed temporary due to positive factors supporting the recoverability of the respective investments. Positive factors considered include credit ratings, the financial health of the issuer, the continued access of the issuer to capital markets, and other pertinent information.

 

The equities category has a gross unrealized loss greater than twelve months of $15.2 million as of September 30, 2014. The aggregate decline in market value of these securities was deemed temporary due to factors supporting the recoverability of the respective investments. Positive factors include credit ratings, the financial health of the issuer, the continued access of the issuer to the capital markets, and other pertinent information.

 

The Company does not consider these unrealized loss positions to be other-than-temporary, based on the factors discussed and because the Company has the ability and intent to hold these investments until the fair values recover, and does not intend to sell or expect to be required to sell the securities before recovering the Company’s amortized cost of the securities.

 

The following table includes the gross unrealized losses and fair value of the Company’s investments that are not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position as of December 31, 2013:

 

 

 

Less Than 12 Months

 

12 Months or More

 

Total

 

 

 

Fair

 

Unrealized

 

Fair

 

Unrealized

 

Fair

 

Unrealized

 

 

 

Value

 

Loss

 

Value

 

Loss

 

Value

 

Loss

 

 

 

(Dollars In Thousands)

 

Residential mortgage-backed securities

 

$

333,235

 

$

(14,051

)

$

210,486

 

$

(10,513

)

$

543,721

 

$

(24,564

)

Commercial mortgage-backed securities

 

429,228

 

(18,467

)

13,840

 

(1,238

)

443,068

 

(19,705

)

Other asset-backed securities

 

175,846

 

(14,555

)

497,512

 

(54,993

)

673,358

 

(69,548

)

U.S. government-related securities

 

891,698

 

(53,508

)

6,038

 

(570

)

897,736

 

(54,078

)

Other government-related securities

 

10,161

 

(1

)

 

 

10,161

 

(1

)

States, municipalities, and political subdivisions

 

172,157

 

(8,113

)

335

 

(178

)

172,492

 

(8,291

)

Corporate bonds

 

7,484,010

 

(353,211

)

272,423

 

(38,856

)

7,756,433

 

(392,067

)

Equities

 

376,776

 

(27,861

)

21,974

 

(8,501

)

398,750

 

(36,362

)

 

 

$

9,873,111

 

$

(489,767

)

$

1,022,608

 

$

(114,849

)

$

10,895,719

 

$

(604,616

)

 

RMBS had a gross unrealized loss greater than twelve months of $10.5 million as of December 31, 2013. Factors such as the credit enhancement within the deal structure, the average life of the securities, and the performance of the underlying collateral support the recoverability of these investments.

 

CMBS had a gross unrealized loss greater than twelve months of $1.2 million as of December 31, 2013. Factors such as the credit enhancement within the deal structure, the average life of the securities, and the performance of the underlying collateral support the recoverability of these investments.

 

The other asset-backed securities had a gross unrealized loss greater than twelve months of $55.0 million as of December 31, 2013. This category predominately includes student-loan backed auction rate securities, the underlying collateral, of which is at least 97% guaranteed by the FFELP. These unrealized losses have occurred within the Company’s ARS portfolio since the market collapse during 2008. At this time, the Company has no reason to believe that the U.S. Department of Education would not honor the FFELP guarantee, if it were necessary.

 

The corporate bonds category had gross unrealized losses greater than twelve months of $38.9 million as of December 31, 2013. The aggregate decline in market value of these securities was deemed temporary due to positive factors supporting the recoverability of the respective investments. Positive factors considered include credit ratings, the financial health of the issuer, the continued access of the issuer to capital markets, and other pertinent information.

 

The equities category had a gross unrealized loss greater than twelve months of $8.5 million as of December 31, 2013. The aggregate decline in market value of these securities was deemed temporary due to factors supporting the recoverability of the respective investments. Positive factors include credit ratings, the financial health of the issuer, the continued access of the issuer to the capital markets, and other pertinent information.

 

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Table of Contents

 

The Company does not consider these unrealized loss positions to be other-than-temporary, based on the factors discussed and because the Company has the ability and intent to hold these investments until the fair values recover, and does not intend to sell or expect to be required to sell the securities before recovering the Company’s amortized cost of the securities.

 

As of September 30, 2014, the Company had securities in its available-for-sale portfolio which were rated below investment grade of $1.7 billion and had an amortized cost of $1.6 billion. In addition, included in the Company’s trading portfolio, the Company held $322.6 million of securities which were rated below investment grade. Approximately $786.5 million of the below investment grade securities were not publicly traded.

 

The change in unrealized gains (losses), net of income tax, on fixed maturity and equity securities, classified as available-for-sale is summarized as follows:

 

 

 

For The

 

For The

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

 

2014

 

2013

 

2014

 

2013

 

 

 

(Dollars In Thousands)

 

Fixed maturities

 

$

(143,367

)

$

(156,636

)

$

1,004,990

 

$

(1,175,458

)

Equity securities

 

(2,184

)

(12,791

)

30,820

 

(17,393

)

 

Variable Interest Entities

 

The Company holds certain investments in entities in which its ownership interests could possibly be considered variable interests under Topic 810 of the FASB ASC (excluding debt and equity securities held as trading, available for sale, or held to maturity). The Company reviews the characteristics of each of these applicable entities and compares those characteristics to applicable criteria to determine whether the entity is a Variable Interest Entity (“VIE”). If the entity is determined to be a VIE, the Company then performs a detailed review to determine whether the interest would be considered a variable interest under the guidance. The Company then performs a qualitative review of all variable interests with the entity and determines whether the Company is the primary beneficiary. ASC 810 provides that an entity is the primary beneficiary of a VIE if the entity has 1) the power to direct the activities of the VIE that most significantly impact the VIE’s economic performance, and 2) the obligation to absorb losses of the VIE that could potentially be significant to the VIE or the right to receive benefits from the entity that could potentially be significant to the VIE.

 

Based on this analysis, the Company had an interest in one wholly owned subsidiary, Red Mountain, LLC (“Red Mountain”), that was continued to be classified as a VIE as of September 30, 2014 and December 31, 2013. The activity most significant to Red Mountain is the issuance of a note in connection with a financing transaction involving Golden Gate V Vermont Captive Insurance Company (“Golden Gate V”) and the Company in which Golden Gate V issued non-recourse funding obligations to Red Mountain and Red Mountain issued the note to Golden Gate V. Credit enhancement on the Red Mountain Note is provided by an unrelated third party. For details of this transaction, see Note 9, Debt and Other Obligations. The Company had the power, via its 100% ownership through an affiliate, to direct the activities of the VIE, but did not have the obligation to absorb losses related to the primary risks or sources of variability to the VIE. The variability of loss would be borne primarily by the third party in its function as provider of credit enhancement on the Red Mountain Note. Accordingly, it was determined that the Company is not the primary beneficiary of the VIE. The Company’s risk of loss related to the VIE is limited to its investment of $10,000. Additionally, the holding company (“PLC”) has guaranteed the VIE’s payment obligation for the credit enhancement fee to the unrelated third party provider. As of September 30, 2014, no payments have been made or required related to this guarantee.

 

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Table of Contents

 

7.                                      MORTGAGE LOANS

 

Mortgage Loans

 

The Company invests a portion of its investment portfolio in commercial mortgage loans. As of September 30, 2014, the Company’s mortgage loan holdings were approximately $5.2 billion. The Company has specialized in making loans on either credit-oriented commercial properties or credit-anchored strip shopping centers and apartments. The Company’s underwriting procedures relative to its commercial loan portfolio are based, in the Company’s view, on a conservative and disciplined approach. The Company concentrates on a small number of commercial real estate asset types associated with the necessities of life (retail, multi-family, professional office buildings, and warehouses). The Company believes these asset types tend to weather economic downturns better than other commercial asset classes in which it has chosen not to participate. The Company believes this disciplined approach has helped to maintain a relatively low delinquency and foreclosure rate throughout its history. The majority of the Company’s mortgage loans portfolio was underwritten and funded by the Company. From time to time, the Company may acquire loans in conjunction with an acquisition.

 

The Company’s commercial mortgage loans are stated at unpaid principal balance, adjusted for any unamortized premium or discount, and net of valuation allowances. Interest income is accrued on the principal amount of the loan based on the loan’s contractual interest rate. Amortization of premiums and discounts is recorded using the effective yield method. Interest income, amortization of premiums and discounts and prepayment fees are reported in net investment income.

 

Certain of the Company’s mortgage loans have call options or interest rate reset options between 3 and 10 years. However, if interest rates were to significantly increase, the Company may be unable to exercise the call options or increase the interest rates on its existing mortgage loans commensurate with the significantly increased market rates. Assuming the loans are with these options called at their next call dates, approximately $29.9 million would become due for the remainder of 2014, $1.1 billion in 2015 through 2019, $510.0 million in 2020 through 2024, and $129.3 million thereafter.

 

The Company offers a type of commercial mortgage loan under which the Company will permit a loan-to-value ratio of up to 85% in exchange for a participating interest in the cash flows from the underlying real estate. As of September 30, 2014 and December 31, 2013, approximately $583.4 million and $666.6 million, respectively, of the Company’s mortgage loans have this participation feature. Cash flows received as a result of this participation feature are recorded as interest income. During the three and nine month periods ended September 30, 2014 and 2013, the Company recognized $8.0 million, $13.8 million, $3.7 million and $12.9 million, respectively, of participating mortgage loan income.

 

As of September 30, 2014, approximately $34.0 million, or 0.07%, of invested assets consisted of nonperforming, restructured or mortgage loans that were foreclosed and were converted to real estate properties. The Company does not expect these investments to adversely affect its liquidity or ability to maintain proper matching of assets and liabilities. During the nine months ended September 30, 2014, certain mortgage loan transactions occurred that were accounted for as troubled debt restructurings under Topic 310 of the FASB ASC. For all mortgage loans, the impact of troubled debt restructurings is generally reflected in our investment balance and in the allowance for mortgage loan credit losses. Transactions accounted for as troubled debt restructurings during the quarter included either the acceptance of assets in satisfaction of principal at a future date or the recognition of permanent impairments to principal, and were the result of agreements between the creditor and the debtor. During the three and nine month periods ending September 30, 2014, the Company accepted or agreed to accept assets of $11.2 million and $26.3 million in satisfaction of $14.6 million and $30.6 million of principal, respectively. The Company also identified one loan whose principal of $12.6 million was permanently impaired to a value of $7.3 million. These transactions resulted in a $5.3 million and $6.2 million decrease in the Company’s investment in mortgage loans net of existing allowances for mortgage loans losses. Of the mortgage loan transactions accounted for as troubled debt restructurings, $21.8 million remain on the Company’s balance sheet as of September 30, 2014.

 

The Company’s mortgage loan portfolio consists of two categories of loans: (1) those not subject to a pooling and servicing agreement and (2) those subject to a contractual pooling and servicing agreement. As of September 30,

 

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2014, $34.0 million of mortgage loans not subject to a pooling and servicing agreement were nonperforming or restructured; $21.8 million of these nonperforming loans were restructured during the nine months ended September 30, 2014. The Company did not foreclose on any loans during the nine months ended September 30, 2014.

 

As of September 30, 2014, none of the loans subject to a pooling and servicing agreement were nonperforming. The Company did not foreclose on any nonperforming loans during the nine months ended September 30, 2014.

 

As of September 30, 2014 and December 31, 2013, the Company had an allowance for mortgage loan credit losses of $3.7 million and $3.1 million, respectively. Due to the Company’s loss experience and nature of the loan portfolio, the Company believes that a collectively evaluated allowance would be inappropriate. The Company believes an allowance calculated through an analysis of specific loans that are believed to have a higher risk of credit impairment provides a more accurate presentation of expected losses in the portfolio and is consistent with the applicable guidance for loan impairments in ASC Subtopic 310. Since the Company uses the specific identification method for calculating the allowance, it is necessary to review the economic situation of each borrower to determine those that have higher risk of credit impairment. The Company has a team of professionals that monitors borrower conditions such as payment practices, borrower credit, operating performance, and property conditions, as well as ensuring the timely payment of property taxes and insurance. Through this monitoring process, the Company assesses the risk of each loan. When issues are identified, the severity of the issues are assessed and reviewed for possible credit impairment. If a loss is probable, an expected loss calculation is performed and an allowance is established for that loan based on the expected loss. The expected loss is calculated as the excess carrying value of a loan over either the present value of expected future cash flows discounted at the loan’s original effective interest rate, or the current estimated fair value of the loan’s underlying collateral. A loan may be subsequently charged off at such point that the Company no longer expects to receive cash payments, the present value of future expected payments of the renegotiated loan is less than the current principal balance, or at such time that the Company is party to foreclosure or bankruptcy proceedings associated with the borrower and does not expect to recover the principal balance of the loan.

 

A charge off is recorded by eliminating the allowance against the mortgage loan and recording the renegotiated loan or the collateral property related to the loan as investment real estate on the balance sheet, which is carried at the lower of the appraised fair value of the property or the unpaid principal balance of the loan, less estimated selling costs associated with the property:

 

 

 

As of

 

 

 

September 30, 2014

 

December 31, 2013

 

 

 

(Dollars In Thousands)

 

Beginning balance

 

$

3,130

 

$

2,875

 

Charge offs

 

(416

)

(6,838

)

Recoveries

 

(2,600

)

(1,016

)

Provision

 

3,536

 

8,109

 

Ending balance

 

$

3,650

 

$

3,130

 

 

It is the Company’s policy to cease to carry accrued interest on loans that are over 90 days delinquent. For loans less than 90 days delinquent, interest is accrued unless it is determined that the accrued interest is not collectible. If a loan becomes over 90 days delinquent, it is the Company’s general policy to initiate foreclosure proceedings unless a workout arrangement to bring the loan current is in place. For loans subject to a pooling and servicing agreement, there are certain additional restrictions and/or requirements related to workout proceedings, and as such, these loans may have different attributes and/or circumstances affecting the status of delinquency or categorization of those in nonperforming status. An analysis of the delinquent loans is shown in the following chart as of September 30, 2014.

 

 

 

 

 

 

 

Greater

 

 

 

 

 

30-59 Days

 

60-89 Days

 

than 90 Days

 

Total

 

 

 

Delinquent

 

Delinquent

 

Delinquent

 

Delinquent

 

 

 

(Dollars In Thousands)

 

Commercial mortgage loans

 

$

15,104

 

$

1,659

 

$

10,502

 

$

27,265

 

Number of delinquent commercial mortgage loans

 

5

 

1

 

5

 

11

 

 

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The Company’s commercial mortgage loan portfolio consists of mortgage loans that are collateralized by real estate. Due to the collateralized nature of the loans, any assessment of impairment and ultimate loss given a default on the loans is based upon a consideration of the estimated fair value of the real estate. The Company limits accrued interest income on impaired loans to 90 days of interest. Once accrued interest on the impaired loan is received, interest income is recognized on a cash basis. For information regarding impaired loans, please refer to the following chart as of September 30, 2014 and December 31, 2013:

 

 

 

 

 

Unpaid

 

 

 

Average

 

Interest

 

Cash Basis

 

 

 

Recorded

 

Principal

 

Related

 

Recorded

 

Income

 

Interest

 

 

 

Investment

 

Balance

 

Allowance

 

Investment

 

Recognized

 

Income

 

 

 

(Dollars In Thousands)

 

2014 

 

 

 

 

 

 

 

 

 

 

 

 

 

Commercial mortgage loans:

 

 

 

 

 

 

 

 

 

 

 

 

 

With no related allowance recorded

 

$

6,045

 

$

7,558

 

$

 

$

1,511

 

$

 

$

 

With an allowance recorded

 

16,054

 

16,043

 

3,650

 

3,211

 

187

 

187

 

2013 

 

 

 

 

 

 

 

 

 

 

 

 

 

Commercial mortgage loans:

 

 

 

 

 

 

 

 

 

 

 

 

 

With no related allowance recorded

 

$

2,208

 

$

2,208

 

$

 

$

2,208

 

$

31

 

$

 

With an allowance recorded

 

21,288

 

21,281

 

3,130

 

5,322

 

304

 

304

 

 

Mortgage loans that were modified in a troubled debt restructuring were as follows:

 

 

 

 

 

 

 

Post-

 

 

 

 

 

Pre-Modification

 

Modification

 

 

 

 

 

Outstanding

 

Outstanding

 

 

 

Number of

 

Recorded

 

Recorded

 

 

 

Contracts

 

Investment

 

Investment

 

 

 

(Dollars In Thousands)

 

2014 

 

 

 

 

 

 

 

Troubled debt restructuring:

 

 

 

 

 

 

 

Commercial mortgage loans

 

5

 

$

27,164

 

$

21,848

 

 

8.                                      GOODWILL

 

During the nine months ended September 30, 2014, the Company decreased its goodwill balance by approximately $2.3 million. The decrease was due to an adjustment in the Acquisitions segment related to tax benefits realized during 2014 on the portion of tax goodwill in excess of GAAP basis goodwill. As of September 30, 2014, the Company had an aggregate goodwill balance of $103.1 million.

 

Accounting for goodwill requires an estimate of the future profitability of the associated lines of business to assess the recoverability of the capitalized acquisition goodwill. The Company evaluates the carrying value of goodwill at the segment (or reporting unit) level at least annually and between annual evaluations if events occur or circumstances change that would more likely than not reduce the fair value of the reporting unit below its carrying amount. Such circumstances could include, but are not limited to: 1) a significant adverse change in legal factors or in business climate, 2) unanticipated competition, or 3) an adverse action or assessment by a regulator. When evaluating whether goodwill is impaired, the Company first determines through qualitative analysis whether relevant events and circumstances indicate that it is more likely than not that segment goodwill balances are impaired as of the testing date. If it is determined that it is more likely than not that impairment exists, the Company compares its estimate of the fair value of the reporting unit to which the goodwill is assigned to the reporting unit’s carrying amount, including goodwill. The Company utilizes a fair value measurement (which includes a discounted cash flows analysis) to assess the carrying value of the reporting units in consideration of the recoverability of the goodwill balance assigned to each reporting unit as of the measurement date. The Company’s material goodwill balances are attributable to certain of its operating segments (which are each considered to be reporting units). The cash flows used to determine the fair value of the Company’s reporting units are dependent on a number of significant assumptions. The Company’s estimates, which

 

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consider a market participant view of fair value, are subject to change given the inherent uncertainty in predicting future results and cash flows, which are impacted by such things as policyholder behavior, competitor pricing, capital limitations, new product introductions, and specific industry and market conditions. Additionally, the discount rate used is based on the Company’s judgment of the appropriate rate for each reporting unit based on the relative risk associated with the projected cash flows. As of December 31, 2013, the Company performed its annual evaluation of goodwill and determined that no adjustment to impair goodwill was necessary. During the nine months ended September 30, 2014, no events occurred which indicate an impairment should be recorded or which would invalidate the previous results of the Company’s impairment assessment.

 

9.                                      DEBT AND OTHER OBLIGATIONS

 

The Company has access to a Credit Facility that provides the ability to borrow on an unsecured basis up to an aggregate principal amount of $750 million. The Company has the right in certain circumstances to request that the commitment under the Credit Facility be increased up to a maximum principal amount of $1.0 billion. Balances outstanding under the Credit Facility accrue interest at a rate equal to, at the option of the Borrowers, (i)  LIBOR plus a spread based on the ratings of the Company’s senior unsecured long-term debt (“Senior Debt”), or (ii) the sum of (A) a rate equal to the highest of (x) the Administrative Agent’s prime rate, (y) 0.50% above the Federal Funds rate, or (z) the one-month LIBOR plus 1.00% and (B) a spread based on the ratings of the Company’s Senior Debt. The Credit Facility also provides for a facility fee at a rate that varies with the ratings of the Company’s Senior Debt and that is calculated on the aggregate amount of commitments under the Credit Facility, whether used or unused. The maturity date on the Credit Facility is July 17, 2017. The Company is not aware of any non-compliance with the financial debt covenants of the Credit Facility as of September 30, 2014. There was an outstanding balance of $280.0 million at an interest rate of LIBOR plus 1.20% under the Credit Facility as of September 30, 2014.

 

Non-Recourse Funding Obligations

 

Golden Gate II Captive Insurance Company

 

Golden Gate II Captive Insurance Company (“Golden Gate II”), a South Carolina special purpose financial captive insurance company wholly owned by PLICO, had $575 million of outstanding non-recourse funding obligations as of September 30, 2014. These outstanding non-recourse funding obligations were issued to special purpose trusts, which in turn issued securities to third parties. Certain of our affiliates own a portion of these securities. As of September 30, 2014, securities related to $176.6 million of the outstanding balance of the non-recourse funding obligations were held by external parties and securities related to $398.4 million of the non-recourse funding obligations were held by our affiliates. The Company has entered into certain support agreements with Golden Gate II obligating the Company to make capital contributions or provide support related to certain of Golden Gate II’s expenses and in certain circumstances, to collateralize certain of the Company’s obligations to Golden Gate II. These support agreements provide that amounts would become payable by the Company to Golden Gate II if its annual general corporate expenses were higher than modeled amounts or if Golden Gate II’s investment income on certain investments or premium income was below certain actuarially determined amounts. As of September 30, 2014, no payments have been made under these agreements.

 

Golden Gate V Vermont Captive Insurance Company

 

On October 10, 2012, Golden Gate V, a Vermont special purpose financial insurance company, and Red Mountain, both wholly owned subsidiaries of PLICO, entered into a 20-year transaction to finance up to $945 million of “AXXX” reserves related to a block of universal life insurance policies with secondary guarantees issued by our direct wholly owned subsidiary PLICO and indirect wholly owned subsidiary, West Coast Life Insurance Company (“WCL”). Golden Gate V issued non-recourse funding obligations to Red Mountain, and Red Mountain issued a note with an initial principal amount of $275 million, increasing to a maximum of $945 million in 2027, to Golden Gate V for deposit to a reinsurance trust supporting Golden Gate V’s obligations under a reinsurance agreement with WCL, pursuant to which WCL cedes liabilities relating to the policies of WCL and retrocedes liabilities relating to the policies of PLICO. Through the structure, Hannover Life Reassurance Company of America (“Hannover Re”), the ultimate risk taker in the transaction, provides credit enhancement to the Red Mountain note for the 20-year term in exchange for a fee. The transaction is “non-recourse” to Golden Gate V, Red Mountain, WCL, PLICO and the Company, meaning that none of these companies are liable for the reimbursement of any credit enhancement payments required to be made. As

 

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of September 30, 2014, the principal balance of the Red Mountain note was $415 million. In connection with the transaction, the Company has entered into certain support agreements under which it guarantees or otherwise supports certain obligations of Golden Gate V or Red Mountain. Future scheduled capital contributions to prefund credit enhancement fees amount to approximately $144.3 million and will be paid in annual installments through 2031. The support agreements provide that amounts would become payable by the Company if Golden Gate V’s annual general corporate expenses were higher than modeled amounts or in the event write-downs due to other-than-temporary impairments on assets held in certain accounts exceed defined threshold levels. Additionally, the Company has entered into separate agreements to indemnify Golden Gate V with respect to material adverse changes in non-guaranteed elements of insurance policies reinsured by Golden Gate V, and to guarantee payment of certain fee amounts in connection with the credit enhancement of the Red Mountain note. As of September 30, 2014, no payments have been made under these agreements.

 

In connection with the transaction outlined above, Golden Gate V had a $415 million outstanding non-recourse funding obligation as of September 30, 2014. This non-recourse funding obligation matures in 2037, has scheduled increases in principal to a maximum of $945 million, and accrues interest at a fixed annual rate of 6.25%.

 

Non-recourse funding obligations outstanding as of September 30, 2014, on a consolidated basis, are shown in the following table:

 

 

 

 

 

 

 

Year-to-Date

 

 

 

 

 

Maturity

 

Weighted-Avg

 

Issuer

 

Balance

 

Year

 

Interest Rate

 

 

 

(Dollars In Thousands)

 

 

 

 

 

Golden Gate II Captive Insurance Company

 

$

176,551

 

2052

 

1.12

%

Golden Gate V Vermont Captive Insurance Company(1)

 

415,000

 

2037

 

6.25

%

MONY Life Insurance Company(1)

 

2,515

 

2024

 

6.63

%

Total

 

$

594,066

 

 

 

 

 

 


(1) Fixed rate obligations

 

During the nine months ended September 30, 2014, the Company repurchased $18.3 million of its outstanding non-recourse funding obligations, at a discount. These repurchases resulted in a $4.6 million pre-tax gain for the Company. During the nine months ended September 30, 2013, the Company repurchased $16.1 million of its outstanding non-recourse funding obligations, at a discount. These repurchases resulted in a $3.4 million pre-tax gain for the Company. These gains are recorded in other income in the consolidated statements of income.

 

Letters of Credit

 

Golden Gate III Vermont Captive Insurance Company (“Golden Gate III”), a Vermont special purpose financial insurance company and wholly owned subsidiary of PLICO, is party to a Reimbursement Agreement (the “Reimbursement Agreement”) with UBS AG, Stamford Branch (“UBS”), as issuing lender. Under the original Reimbursement Agreement, dated April 23, 2010, UBS issued a letter of credit (the “LOC”) in the initial amount of $505 million to a trust for the benefit of WCL. The Reimbursement Agreement was subsequently amended and restated effective November 21, 2011 (the “First Amended and Restated Reimbursement Agreement”), to replace the existing LOC with one or more letters of credit from UBS, and to extend the maturity date from April 1, 2018, to April 1, 2022. On August 7, 2013, the Company entered into a Second Amended and Restated Reimbursement Agreement with UBS (the “Second Amended and Restated Reimbursement Agreement”), which amended and restated the First Amended and Restated Reimbursement Agreement. Under the Second and Amended and Restated Reimbursement Agreement a new LOC in an initial amount of $710 million was issued by UBS in replacement of the existing LOC issued under the First Amended and Restated Reimbursement Agreement. The term of the LOC was extended from April 1, 2022 to October 1, 2023, subject to certain conditions being satisfied including scheduled capital contributions being made to Golden Gate III by one of its affiliates. The maximum stated amount of the LOC was increased from $610 million to $720 million in 2015 if certain conditions are met. On June 25, 2014, the Company entered into a Third Amended and Restated Reimbursement Agreement with UBS (the “Third Amended and Restated Reimbursement Agreement”), which amended and restated the Second Amended and Restated Reimbursement Agreement. Under the Third Amended and Restated Reimbursement Agreement, a new LOC in an initial amount of $915 million was issued by UBS in

 

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replacement of the existing LOC issued under the Second Amended and Restated Reimbursement Agreement. The term of the LOC was extended from October 1, 2023 to April 1, 2025, subject to certain conditions being satisfied including scheduled capital contributions being made to Golden Gate III by one of its affiliates. The maximum stated amount of the LOC was increased from $720 million to $935 million in 2015 if certain conditions are met. The LOC is held in trust for the benefit of WCL, and supports certain obligations of Golden Gate III to WCL under an indemnity reinsurance agreement originally effective April 1, 2010, as amended and restated on November 21, 2011, and as further amended and restated on August 7, 2013 and on June 25, 2014 to include additional blocks of policies, and pursuant to which WCL cedes liabilities relating to the policies of WCL and retrocedes liabilities relating to the policies of PLICO. The LOC balance was $925 million as of September 30, 2014. Subject to certain conditions, the amount of the LOC will be periodically increased up to a maximum of $935 million in 2015. The term of the LOC is expected to be approximately 15 years from the original issuance date. This transaction is “non-recourse” to WCL, PLICO, and the Company, meaning that none of these companies other than Golden Gate III are liable for reimbursement on a draw of the LOC. The Company has entered into certain support agreements with Golden Gate III obligating the Company to make capital contributions or provide support related to certain of Golden Gate III’s expenses and in certain circumstances, to collateralize certain of the Company’s obligations to Golden Gate III. Future scheduled capital contributions amount to approximately $122.5 million and will be paid in three installments with the last payment occurring in 2021, and these contributions may be subject to potential offset against dividend payments as permitted under the terms of the Third Amended and Restated Reimbursement Agreement. The support agreements provide that amounts would become payable by the Company to Golden Gate III if its annual general corporate expenses were higher than modeled amounts or if specified catastrophic losses occur during defined time periods with respect to the policies reinsured by Golden Gate III. Pursuant to the terms of an amended and restated letter agreement with UBS, the Company has continued to guarantee the payment of fees to UBS as specified in the Third Amended and Restated Reimbursement Agreement. As of September 30, 2014, no payments have been made under these agreements.

 

Golden Gate IV Vermont Captive Insurance Company (“Golden Gate IV”), a Vermont special purpose financial insurance company and wholly owned subsidiary of PLICO, is party to a Reimbursement Agreement with UBS AG, Stamford Branch, as issuing lender. Under the Reimbursement Agreement, dated December 10, 2010, UBS issued an LOC in the initial amount of $270 million to a trust for the benefit of WCL. The LOC balance increased, in accordance with the terms of the Reimbursement Agreement, during the third quarter of 2014 and was $740 million as of September 30, 2014. Subject to certain conditions, the amount of the LOC will be periodically increased up to a maximum of $790 million in 2016. The term of the LOC is expected to be 12 years from the original issuance date (stated maturity of December 30, 2022). The LOC was issued to support certain obligations of Golden Gate IV to WCL under an indemnity reinsurance agreement, pursuant to which WCL cedes liabilities relating to the policies of WCL and retrocedes liabilities relating to the policies of PLICO. This transaction is “non-recourse” to WCL, PLICO, and the Company, meaning that none of these companies other than Golden Gate IV are liable for reimbursement on a draw of the LOC. The Company has entered into certain support agreements with Golden Gate IV obligating the Company to make capital contributions or provide support related to certain of Golden Gate IV’s expenses and in certain circumstances, to collateralize certain of the Company’s obligations to Golden Gate IV. The support agreements provide that amounts would become payable by the Company to Golden Gate IV if its annual general corporate expenses were higher than modeled amounts or if specified catastrophic losses occur during defined time periods with respect to the policies reinsured by Golden Gate IV. The Company has also entered into a separate agreement to guarantee the payments of LOC fees under the terms of the Reimbursement Agreement. As of September 30, 2014, no payments have been made under these agreements.

 

Repurchase Program Borrowings

 

While the Company anticipates that the cash flows of its operating subsidiaries will be sufficient to meet its investment commitments and operating cash needs in a normal credit market environment, the Company recognizes that investment commitments scheduled to be funded may, from time to time, exceed the funds then available. Therefore, the Company has established repurchase agreement programs for certain of its insurance subsidiaries to provide liquidity when needed. The Company expects that the rate received on its investments will equal or exceed its borrowing rate. Under this program, the Company may, from time to time, sell an investment security at a specific price and agree to repurchase that security at another specified price at a later date. These borrowings are for a term less than 90 days. The market value of securities to be repurchased is monitored and collateral levels are adjusted where appropriate to protect the counterparty against credit exposure. Cash received is invested in fixed maturity securities, and the agreements provided for net settlement in the event of default or on termination of the agreements. As of

 

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September 30, 2014, the fair value of securities pledged under the repurchase program was $402.0 million and the repurchase obligation of $359.8 million was included in the Company’s consolidated condensed balance sheets (at an average borrowing rate of 8 basis points). During the nine months ended September 30, 2014, the maximum balance outstanding at any one point in time related to these programs was $633.7 million. The average daily balance was $511.3 million (at an average borrowing rate of 10 basis points) during the nine months ended September 30, 2014. As of December 31, 2013, the Company had a $350.0 million outstanding balance related to such borrowings. During 2013, the maximum balance outstanding at any one point in time related to these programs was $815.0 million. The average daily balance was $496.9 million (at an average borrowing rate of 11 basis points) during the year ended December 31, 2013.

 

10.                               COMMITMENTS AND CONTINGENCIES

 

The Company has entered into indemnity agreements with each of its current directors that provide, among other things and subject to certain limitations, a contractual right to indemnification to the fullest extent permissible under the law. The Company has agreements with certain of its officers providing up to $10 million in indemnification. These obligations are in addition to the customary obligation to indemnify officers and directors contained in the Company’s governance documents.

 

Under insurance guaranty fund laws, in most states insurance companies doing business therein can be assessed up to prescribed limits for policyholder losses incurred by insolvent companies. In addition, from time to time, companies may be asked to contribute amounts beyond prescribed limits. Most insurance guaranty fund laws provide that an assessment may be excused or deferred if it would threaten an insurer’s own financial strength. The Company does not believe its insurance guaranty fund assessments will be materially different from amounts already provided for in the financial statements.

 

A number of civil jury verdicts have been returned against insurers, broker dealers and other providers of financial services involving sales, refund or claims practices, alleged agent misconduct, failure to properly supervise representatives, relationships with agents or persons with whom the insurer does business, and other matters. Often these lawsuits have resulted in the award of substantial judgments that are disproportionate to the actual damages, including material amounts of punitive and non-economic compensatory damages. In some states, juries, judges, and arbitrators have substantial discretion in awarding punitive non-economic compensatory damages which creates the potential for unpredictable material adverse judgments or awards in any given lawsuit or arbitration. Arbitration awards are subject to very limited appellate review. In addition, in some class action and other lawsuits, companies have made material settlement payments. Publicly held companies in general and the financial services and insurance industries in particular are also sometimes the target of law enforcement and regulatory investigations relating to the numerous laws and regulations that govern such companies. Some companies have been the subject of law enforcement or regulatory actions or other actions resulting from such investigations. The Company, in the ordinary course of business, is involved in such matters.

 

The Company establishes liabilities for litigation and regulatory actions when it is probable that a loss has been incurred and the amount of the loss can be reasonably estimated. For matters where a loss is believed to be reasonably possible, but not probable, no liability is established. For such matters, the Company may provide an estimate of the possible loss or range of loss or a statement that such an estimate cannot be made. The Company reviews relevant information with respect to litigation and regulatory matters on a quarterly and annual basis and updates its established liabilities, disclosures and estimates of reasonably possible losses or range of loss based on such reviews.

 

Since the entry into the Merger Agreement on June 3, 2014, four lawsuits have been filed against the Company, our directors, Dai-ichi and DL Investment (Delaware), Inc. on behalf of alleged Company shareowners. On June 11, 2014, a putative class action lawsuit styled Edelman, et al. v. Protective Life Corporation, et al., Civil Action No. 01-CV-2014-902474.00, was filed in the Circuit Court of Jefferson County, Alabama. On July 30, 2014, the plaintiff in Edelman filed an amended complaint. Three putative class action lawsuits were filed in the Court of Chancery of the State of Delaware, Martin, et al. v. Protective Life Corporation, et al., Civil Action No. 9794-CB, filed June 19, 2014, Leyendecker, et al. v. Protective Life Corporation, et al., Civil Action No. 9931-CB, filed July 22, 2014 and Hilburn, et al. v. Protective Life Corporation, et al., Civil Action No. 9937-CB, filed July 23, 2014. The Delaware Court of Chancery consolidated the Martin, Leyendecker and Hilburn actions under the caption In

 

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re Protective Life Corp. Stockholders Litigation, Consolidated Civil Action No. 9794-CB, designated the Hilburn complaint as the operative consolidated complaint (the “Delaware Action”) and appointed Charlotte Martin, Samuel J. Leyendecker, Jr., and Deborah J. Hilburn to serve as co-lead plaintiffs. These lawsuits alleged that our Board of Directors breached its fiduciary duties to our shareowners, that the Merger involves an unfair price, an inadequate sales process, and unreasonable deal protection devices that purportedly preclude competing offers, and that the preliminary proxy statement filed with the SEC on July 10, 2014 failed to disclose purportedly material information. The complaints also alleged that the Company, Dai-ichi and DL Investment (Delaware), Inc. aided and abetted those alleged breaches of fiduciary duties. The complaints seek injunctive relief, including enjoining or rescinding the Merger, and attorneys’ and other fees and costs, in addition to other relief. The Delaware Action also seeks an award of unspecified damages.

 

With respect to the Edelman lawsuit, on September 5, 2014, the court held a hearing to address motions to dismiss the lawsuit filed on behalf of the Company, the members of the Company’s Board, and DL Investment (Delaware), Inc. On September 19, 2014, the court granted those motions and dismissed the Edelman lawsuit in its entirety and with prejudice, pending a possible appeal by the plaintiff. With respect to the Delaware Action, on September 24, 2014, the Company, each of the members of the Company’s Board, Dai-ichi, and DL Investment (Delaware), Inc. entered into a Memorandum of Understanding (the “MOU”) with the plaintiffs in that case, which sets forth the parties’ agreement in principle for a settlement of the Delaware Action. As set forth in the MOU, the Company, the members of the Company’s Board, Dai-ichi, and DL Investment (Delaware), Inc. agreed to the settlement solely to eliminate the burden, expense, distraction, and uncertainties inherent in further litigation, and without admitting any liability or wrongdoing. The MOU contemplates that the parties will seek to enter into a stipulation of settlement providing for the certification of a mandatory non opt-out class, for settlement purposes only, to include any and all record and beneficial owners of shares (excluding the members of the Company’s Board and their immediate family members, any entity in which any member of the Company’s Board has a controlling interest, and any successors in interest thereto) that held shares at any time during the period beginning on June 3, 2014, through the date of consummation or termination of the proposed Merger, including any and all of their respective successors in interest, successors, predecessors in interest, representatives, trustees, executors, administrators, heirs, assigns, or transferees, immediate and remote, and any person or entity acting for or on behalf of, or claiming under, any of them, together with their predecessors, successors and assigns, and a global release of claims relating to the Merger as set forth in the MOU. As part of the settlement, the Company agreed to make certain additional disclosures related to the Merger which are set forth in the Company’s Form 8-K filed on September 25, 2014 and which supplement the information contained in the Company’s definitive proxy statement filed with the SEC on August 25, 2014, as amended on August 27, 2014. Nothing in the Form 8-K or any stipulation of settlement shall be deemed an admission of the legal necessity or materiality of any of the disclosures set forth in the Form 8-K. The claims in the Delaware Action will not be released until the stipulation of settlement is approved by the Court of Chancery of the State of Delaware. The settlement will not affect the consideration to be received by the Company stockholders in connection with the Merger.

 

Although the Company cannot predict the outcome of any litigation or regulatory action or provide assurances as to the ultimate settlement of the Delaware Action, the Company does not believe that any such outcome will have an impact, either individually or in the aggregate, on its financial condition or results of operations that differs materially from the Company’s established liabilities. Given the inherent difficulty in predicting the outcome of such matters, however, it is possible that an adverse outcome in certain such matters could be material to the Company’s financial condition or results of operations for any particular reporting period.

 

The Company was audited by the IRS and the IRS proposed favorable and unfavorable adjustments to the Company’s 2003 through 2007 reported taxable income. The Company protested certain unfavorable adjustments and sought resolution at the IRS’ Appeals Division. The case has followed normal procedure and is now under review at Congress’ Joint Committee on Taxation. The Company believes the matter will conclude within the next twelve months. If the IRS prevails on every issue that it identified in this audit, and the Company does not litigate these issues, then the Company will make an income tax payment of approximately $26.6 million. However, this payment, if it were to occur, would not materially impact the Company or its effective tax rate.

 

Through the acquisition of MONY by PLICO certain income tax credit carryforwards, which arose in MONY’s pre-acquisition tax years, transferred to the Company. This transfer was in accordance with the applicable rules of the Internal Revenue Code and the related Regulations. In spite of this transfer, AXA, the former parent of the consolidated income tax return group in which MONY was a member, retains the right to utilize these credits in the

 

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future to offset future increases in its 2010 through 2013 tax liabilities. The Company had determined that, based on all information known as of the acquisition date and through the March 31, 2014 reporting date, it was probable that a loss of the utilization of these carryforwards had been incurred. Due to indemnification received from AXA during the quarter ending June 30, 2014, the probability of loss of these carryforwards has been eliminated. Accordingly, in the table summarizing the fair value of net assets acquired from the Acquisition, the amount of the deferred tax asset from the credit carryforwards is no longer offset by a liability.

 

The Company has received notice from two third party auditors that certain of the Company’s insurance subsidiaries, as well as certain other insurance companies for which the Company has coinsured blocks of life insurance and annuity policies, are under audit for compliance with the unclaimed property laws of a number of states. The audits are being conducted on behalf of the treasury departments or unclaimed property administrators in such states. The focus of the audits is on whether there have been unreported deaths, maturities, or policies that have exceeded limiting age with respect to which death benefits or other payments under life insurance or annuity policies should be treated as unclaimed property that should be escheated to the state. The Company is presently unable to estimate the reasonably possible loss or range of loss that may result from the audits due to a number of factors, including uncertainty as to the legal theory or theories that may give rise to liability, the early stages of the audits being conducted, and, with respect to one block of life insurance policies that is co-insured by a subsidiary of the Company, uncertainty as to whether the Company or other companies are responsible for the liabilities, if any, arising in connection with such policies. The Company will continue to monitor the matter for any developments that would make the loss contingency associated with the audits probable or reasonably estimable.

 

Certain of the Company’s subsidiaries have received notice that they are subject to a targeted multi-state examination with respect to their claims paying practices and their use of the U.S. Social Security Administration’s Death Master File or similar databases (a “Death Database”) to identify unreported deaths in their life insurance policies, annuity contracts and retained asset accounts. There is no clear basis in previously existing law for requiring a life insurer to search for unreported deaths in order to determine whether a benefit is owed, and substantial legal authority exists to support the position that the prevailing industry practice was lawful. A number of life insurers, however, have entered into settlement or consent agreements with state insurance regulators under which the life insurers agreed to implement procedures for periodically comparing their life insurance and annuity contracts and retained asset accounts against a Death Database, treating confirmed deaths as giving rise to a death benefit under their policies, locating beneficiaries and paying them the benefits and interest, and escheating the benefits and interest as well as penalties to the state if the beneficiary could not be found.  It has been publicly reported that the life insurers have paid substantial administrative and/or examination fees to the insurance regulators in connection with the settlement or consent agreements. The Company believes it is reasonably possible that insurance regulators could demand from the Company administrative and/or examination fees relating to the targeted multi-state examination. Based on publicly reported payments by other life insurers, the Company estimates the range of such fees to be from $0 to $3.5 million.

 

11.                               STOCK-BASED COMPENSATION

 

During the nine months ended September 30, 2014, 203,295 performance shares with an estimated fair value of $10.5 million were awarded. The criteria for payment of the 2014 performance awards is based primarily on the Company’s average operating return on average equity (“ROE”) over a three-year period. If the Company’s ROE is below 10.5%, no award is earned. If the Company’s ROE is at or above 12.0%, the award maximum is earned. Awards are paid in shares of the Company’s common stock.

 

Restricted stock units are awarded to participants and include certain restrictions relating to vesting periods. The Company issued 98,700 restricted stock units for the nine months ended September 30, 2014. These awards had a total fair value at grant date of $5.1 million. Approximately half of these restricted stock units vest after three years from the grant date and the remainder vest after four years.

 

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Stock appreciation right (“SARs”) have historically been granted to certain officers of the Company to provide long-term incentive compensation based solely on the performance of the Company’s common stock. The SARs are exercisable either five years after the date of grant or in three or four equal annual installments beginning one year after the date of grant (earlier upon the death, disability, or retirement of the officer, or in certain circumstances, of a change in control of the Company) and expire after ten years or upon termination of employment. The SARs activity as well as weighted-average base price is as follows:

 

 

 

Weighted-Average

 

 

 

 

 

Base Price per share

 

No. of SARs

 

Balance at December 31, 2013

 

$

23.08

 

1,305,101

 

SARs granted

 

 

 

SARs exercised / forfeited

 

21.94

 

(1,127,156

)

Balance at September 30, 2014

 

$

30.27

 

177,945

 

 

The Company will pay an amount in stock equal to the difference between the specified base price of the Company’s common stock and the market value at the exercise date for each SAR. There were no SARs issued for the nine months ended September 30, 2014.

 

For more information about the impact that the proposed merger with Dai-ichi will have on stock-based compensation, refer to Note 5, Proposed Dai-ichi Merger.

 

12.                               EMPLOYEE BENEFIT PLANS

 

Components of the net periodic benefit cost of the Company’s defined benefit pension plan and unfunded excess benefit plan are as follows:

 

 

 

For The

 

For The

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

 

2014

 

2013

 

2014

 

2013

 

 

 

(Dollars In Thousands)

 

Service cost — benefits earned during the period

 

$

2,453

 

$

2,708

 

$

7,359

 

$

8,124

 

Interest cost on projected benefit obligation

 

2,993

 

2,553

 

8,979

 

7,659

 

Expected return on plan assets

 

(3,065

)

(2,759

)

(9,195

)

(8,277

)

Amortization of prior service cost/(credit)

 

(95

)

(95

)

(285

)

(285

)

Amortization of actuarial losses

 

1,897

 

2,729

 

5,691

 

8,187

 

Total benefit cost

 

$

4,183

 

$

5,136

 

$

12,549

 

$

15,408

 

 

During the nine months ended September 30, 2014, the Company contributed $9.0 million to its defined benefit pension plan for the 2013 plan year and $6.3 million for the 2014 plan year. During October of 2014, the Company contributed $0.2 million to the defined benefit pension plan for the 2014 plan year. The Company will continue to make contributions in future periods as necessary to at least satisfy minimum funding requirements. The Company may also make additional contributions in future periods to maintain an adjusted funding target attainment percentage (“AFTAP”) of at least 80% and to avoid certain Pension Benefit Guaranty Corporation (“PBGC”) reporting triggers.

 

In addition to pension benefits, the Company provides life insurance benefits to eligible retirees and limited healthcare benefits to eligible retirees who are not yet eligible for Medicare. For a closed group of retirees over age 65, the Company provides a prescription drug benefit. The cost of these plans for the nine months ended September 30, 2014, was immaterial to the Company’s financial statements.

 

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13.                               ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS)

 

The following tables summarize the changes in the accumulated balances for each component of accumulated other comprehensive income (loss) (“AOCI”) as of September 30, 2014 and December 31, 2013.

 

Changes in Accumulated Other Comprehensive Income (Loss) by Component

 

 

 

 

 

 

 

 

 

Total

 

 

 

 

 

 

 

 

 

Accumulated

 

 

 

Unrealized

 

Accumulated

 

Minimum

 

Other

 

 

 

Gains and Losses

 

Gain and Loss

 

Pension Liability

 

Comprehensive

 

 

 

on Investments(2)

 

Derivatives

 

Adjustment

 

Income (Loss)

 

 

 

(Dollars In Thousands, Net of Tax)

 

Beginning Balance, December 31, 2013

 

$

539,003

 

$

(1,235

)

$

(43,702

)

$

494,066

 

Other comprehensive income (loss) before reclassifications

 

800,982

 

(58

)

 

800,924

 

Other comprehensive income (loss) relating to other- than-temporary impaired investments for which a portion has been recognized in earnings

 

4,494

 

 

 

4,494

 

Amounts reclassified from accumulated other comprehensive income (loss)(1)

 

(29,763

)

1,025

 

3,520

 

(25,218

)

Net current-period other comprehensive income (loss)

 

775,713

 

967

 

3,520

 

780,200

 

Ending Balance, September 30, 2014

 

$

1,314,716

 

$

(268

)

$

(40,182

)

$

1,274,266

 

 


(1) See Reclassification table below for details.

(2) These balances were offset by the impact of DAC and VOBA by $198.1 million and $380.4 million as of December 31, 2013 and September 30, 2014, respectively.

 

Changes in Accumulated Other Comprehensive Income (Loss) by Component

 

 

 

 

 

 

 

 

 

Total

 

 

 

 

 

 

 

 

 

Accumulated

 

 

 

Unrealized

 

Accumulated

 

Minimum

 

Other

 

 

 

Gains and Losses

 

Gain and Loss

 

Pension Liability

 

Comprehensive

 

 

 

on Investments(2)

 

Derivatives

 

Adjustment

 

Income (Loss)

 

 

 

(Dollars In Thousands, Net of Tax)

 

Beginning Balance, December 31, 2012

 

$

1,813,516

 

$

(3,496

)

$

(73,298

)

$

1,736,722

 

Other comprehensive income (loss) before reclassifications

 

(1,250,498

)

734

 

29,596

 

(1,220,168

)

Other comprehensive income (loss) relating to other- than-temporary impaired investments for which a portion has been recognized in earnings

 

4,591

 

 

 

4,591

 

Amounts reclassified from accumulated other comprehensive income (loss)(1)

 

(28,606

)

1,527

 

 

(27,079

)

Net current-period other comprehensive income (loss)

 

(1,274,513

)

2,261

 

29,596

 

(1,242,656

)

Ending Balance, December 31, 2013

 

$

539,003

 

$

(1,235

)

$

(43,702

)

$

494,066

 

 


(1) See Reclassification table below for details.

(2) These balances were offset by the impact of DAC and VOBA by $204.9 million and $198.1 million as of December 31, 2012 and December 31, 2013, respectively.

 

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The following tables summarize the reclassifications amounts out of AOCI for the three months ended September 30, 2014 and 2013.

 

Reclassifications Out of Accumulated Other Comprehensive Income (Loss)

 

 

 

Amount

 

 

 

 

 

Reclassified

 

 

 

 

 

from Accumulated

 

 

 

 

 

Other Comprehensive

 

Affected Line Item in the

 

 

 

Income (Loss)

 

Consolidated Condensed Statements of Income

 

 

 

(Dollars In Thousands)

 

 

 

 

 

 

 

 

 

Accumulated Other Comprehensive Income (Loss) Components

 

 

 

 

 

 

 

For The Three Months Ended September 30, 2014

 

 

 

 

 

Gains and losses on derivative instruments

 

 

 

 

 

Net settlement (expense)/benefit(1)

 

$

(293

)

Benefits and settlement expenses, net of reinsurance ceded

 

 

 

(293

)

Total before tax

 

 

 

103

 

Tax (expense) or benefit

 

 

 

$

(190

)

Net of tax

 

Unrealized gains and losses on available-for-sale securities

 

 

 

 

 

Net investment gains/losses

 

$

23,627

 

Realized investment gains (losses): All other investments

 

Impairments recognized in earnings

 

(2,354

)

Net impairment losses recognized in earnings

 

 

 

21,273

 

Total before tax

 

 

 

(7,446

)

Tax (expense) or benefit

 

 

 

$

13,827

 

Net of tax

 

 

 

 

 

 

 

Postretirement benefits liability adjustment

 

 

 

 

 

Amortization of net actuarial gain/(loss)

 

$

(1,900

)

Other operating expenses

 

Amortization of prior service credit/(cost)

 

95

 

Other operating expenses

 

 

 

(1,805

)

Total before tax

 

 

 

632

 

Tax (expense) or benefit

 

 

 

$

(1,173

)

Net of tax

 

 


(1) See Note 17, Derivative Financial Instruments for additional information.

 

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Reclassifications Out of Accumulated Other Comprehensive Income (Loss)

 

 

 

Amount

 

 

 

 

 

Reclassified

 

 

 

 

 

from Accumulated

 

 

 

 

 

Other Comprehensive

 

Affected Line Item in the

 

 

 

Income (Loss)

 

Consolidated Condensed Statements of Income

 

 

 

(Dollars In Thousands)

 

 

 

 

 

 

 

 

 

Accumulated Other Comprehensive Income (Loss) Components

 

 

 

 

 

 

 

For The Three Months Ended September 30, 2013

 

 

 

 

 

Gains and losses on derivative instruments

 

 

 

 

 

Net settlement (expense)/benefit(1)

 

$

(572

)

Benefits and settlement expenses, net of reinsurance ceded

 

 

 

(572

)

Total before tax

 

 

 

200

 

Tax (expense) or benefit

 

 

 

$

(372

)

Net of tax

 

Unrealized gains and losses on available-for-sale securities

 

 

 

 

 

Net investment gains/losses

 

$

10,546

 

Realized investment gains (losses): All other investments

 

Impairments recognized in earnings

 

(8,681

)

Net impairment losses recognized in earnings

 

 

 

1,865

 

Total before tax

 

 

 

(653

)

Tax (expense) or benefit

 

 

 

$

1,212

 

Net of tax

 

 


(1) See Note 17, Derivative Financial Instruments for additional information.

 

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The following tables summarize the reclassifications amounts out of AOCI for the nine months ended September 30, 2014 and 2013.

 

Reclassifications Out of Accumulated Other Comprehensive Income (Loss)

 

 

 

Amount

 

 

 

 

 

Reclassified

 

 

 

 

 

from Accumulated

 

 

 

 

 

Other Comprehensive

 

Affected Line Item in the

 

 

 

Income (Loss)

 

Consolidated Condensed Statements of Income

 

 

 

(Dollars In Thousands)

 

 

 

 

 

 

 

 

 

Accumulated Other Comprehensive Income (Loss) Components

 

 

 

 

 

 

 

For The Nine Months Ended September 30, 2014

 

 

 

 

 

Gains and losses on derivative instruments

 

 

 

 

 

Net settlement (expense)/benefit(1)

 

$

(1,577

)

Benefits and settlement expenses, net of reinsurance ceded

 

 

 

(1,577

)

Total before tax

 

 

 

552

 

Tax (expense) or benefit

 

 

 

$

(1,025

)

Net of tax

 

Unrealized gains and losses on available-for-sale securities

 

 

 

 

 

Net investment gains/losses

 

$

51,195

 

Realized investment gains (losses): All other investments

 

Impairments recognized in earnings

 

(5,405

)

Net impairment losses recognized in earnings

 

 

 

45,790

 

Total before tax

 

 

 

(16,027

)

Tax (expense) or benefit

 

 

 

$

29,763

 

Net of tax

 

 

 

 

 

 

 

Postretirement benefits liability adjustment

 

 

 

 

 

Amortization of net actuarial gain/(loss)

 

$

(5,700

)

Other operating expenses

 

Amortization of prior service credit/(cost)

 

285

 

Other operating expenses

 

 

 

(5,415

)

Total before tax

 

 

 

1,895

 

Tax (expense) or benefit

 

 

 

$

(3,520

)

Net of tax

 

 


(1) See Note 17, Derivative Financial Instruments for additional information.

 

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Reclassifications Out of Accumulated Other Comprehensive Income (Loss)

 

 

 

Amount

 

 

 

 

 

Reclassified

 

 

 

 

 

from Accumulated

 

 

 

 

 

Other Comprehensive

 

Affected Line Item in the

 

 

 

Income (Loss)

 

Consolidated Condensed Statements of Income

 

 

 

(Dollars In Thousands)

 

 

 

 

 

 

 

 

 

Accumulated Other Comprehensive Income (Loss) Components

 

 

 

For The Nine Months Ended September 30, 2013

 

 

 

 

 

Gains and losses on derivative instruments

 

 

 

 

 

Net settlement (expense)/benefit(1)

 

$

(1,649

)

Benefits and settlement expenses, net of reinsurance ceded

 

 

 

(1,649

)

Total before tax

 

 

 

577

 

Tax (expense) or benefit

 

 

 

$

(1,072

)

Net of tax

 

Unrealized gains and losses on available-for-sale securities

 

 

 

 

 

Net investment gains/losses

 

$

44,374

 

Realized investment gains (losses): All other investments

 

Impairments recognized in earnings

 

(17,265

)

Net impairment losses recognized in earnings

 

 

 

27,109

 

Total before tax

 

 

 

(9,488

)

Tax (expense) or benefit

 

 

 

$

17,621

 

Net of tax

 

 


(1) See Note 17, Derivative Financial Instruments for additional information.

 

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14.                               EARNINGS PER SHARE

 

Basic earnings per share is computed by dividing net income by the weighted-average number of common shares outstanding during the period, including shares issuable under various deferred compensation plans. Diluted earnings per share is computed by dividing net income by the weighted-average number of common shares and dilutive potential common shares outstanding during the period, assuming the shares were not anti-dilutive, including shares issuable under various stock-based compensation plans and stock purchase contracts.

 

A reconciliation of the numerators and denominators of the basic and diluted earnings per share is presented below:

 

 

 

For The

 

For The

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

 

2014

 

2013

 

2014

 

2013

 

 

 

(Dollars In Thousands, Except Per Share Amounts)

 

Calculation of basic earnings per share:

 

 

 

 

 

 

 

 

 

Net income

 

$

118,909

 

$

93,061

 

$

310,525

 

$

274,551

 

 

 

 

 

 

 

 

 

 

 

Average shares issued and outstanding

 

79,095,917

 

78,521,996

 

78,860,218

 

78,396,347

 

Issuable under various deferred compensation plans

 

1,135,674

 

970,278

 

1,081,800

 

950,424

 

Weighted shares outstanding - basic

 

80,231,591

 

79,492,274

 

79,942,018

 

79,346,771

 

 

 

 

 

 

 

 

 

 

 

Per share:

 

 

 

 

 

 

 

 

 

Net income - basic

 

$

1.48

 

$

1.17

 

$

3.88

 

$

3.46

 

 

 

 

 

 

 

 

 

 

 

Calculation of diluted earnings per share:

 

 

 

 

 

 

 

 

 

Net income

 

$

118,909

 

$

93,061

 

$

310,525

 

$

274,551

 

 

 

 

 

 

 

 

 

 

 

Weighted shares outstanding - basic

 

80,231,591

 

79,492,274

 

79,942,018

 

79,346,771

 

Stock appreciation rights (“SARs”)(1)

 

72,223

 

409,964

 

342,203

 

433,174

 

Issuable under various other stock-based compensation plans

 

869,320

 

592,580

 

718,215

 

758,976

 

Restricted stock units

 

285,736

 

357,260

 

258,813

 

343,631

 

Weighted shares outstanding - diluted

 

81,458,870

 

80,852,078

 

81,261,249

 

80,882,552

 

 

 

 

 

 

 

 

 

 

 

Per share:

 

 

 

 

 

 

 

 

 

Net income - diluted

 

$

1.46

 

$

1.15

 

$

3.82

 

$

3.39

 

 


(1)Excludes 454,925 SARs as of September 30, 2013, respectively, that are antidilutive. In the event the average market price exceeds the  issue price of the SARs, such rights would be dilutive to the Company’s earnings per share and will be included in the Company’s calculation of the  diluted average shares outstanding, for applicable periods.

 

15.                               INCOME TAXES

 

In the IRS audit that concluded in 2012, the IRS proposed favorable and unfavorable adjustments to the Company’s 2003 through 2007 reported taxable incomes. The Company protested certain unfavorable adjustments and is seeking resolution at the IRS’ Appeals Division. If the IRS prevails at Appeals, and the Company does not litigate these issues, then an acceleration of tax payments will occur. However, such accelerated payments would not materially impact the Company or its effective tax rate.

 

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A reconciliation of the beginning and ending amount of unrecognized tax benefits is as follows:

 

 

 

As of

 

 

 

September 30, 2014

 

December 31, 2013

 

 

 

(Dollars In Thousands)

 

Balance, beginning of period

 

$

105,881

 

$

75,292

 

Additions for tax positions of the current year

 

6,898

 

7,465

 

Additions for tax positions of prior years

 

41,109

 

26,386

 

Reductions of tax positions of prior years:

 

 

 

 

 

Changes in judgment

 

(9,294

)

(2,740

)

Settlements during the period

 

 

 

Lapses of applicable statue of limitations

 

 

(522

)

Balance, end of period

 

$

144,594

 

$

105,881

 

 

The Company believes that it is possible that in the next 12 months approximately $115.3 million of these unrecognized tax benefits will be reduced due to the expected closure of the aforementioned Appeals process and the lapsing of previous tax years’ statutes of limitations. In general, this closure would represent the Company’s possible successful negotiation of certain issues, coupled with its payment of the assessed taxes on the remaining issues. Regarding the amounts reported above for the nine months ended September 30, 2014 and the twelve months ended December 31, 2013, discussions with the IRS during these periods, which related to their ongoing examination of tax years 2008 through 2011, prompted the Company to contemporaneously revise upward its measurement of unrecognized tax benefits. These revisions included increasing prior determinations of amounts accrued for in earlier years as well as reducing some previously accrued amounts. These changes were almost entirely related to timing issues. Therefore, aside from the cost of interest, such changes did not result in any impact on the Company’s effective tax rate.

 

In July 2014, the IRS issued guidance related to the tax method of accounting for hedges of guaranteed benefits on variable annuity contracts. The Company has issued contracts that provide such benefits. It has treated the derivatives that economically hedge the risk associated with such contracts as tax hedges. There are several uncertainties regarding the provisions of this guidance. Examples include its effective date and its scope. Therefore, it is uncertain at this time whether this guidance will be applicable to the Company and whether it will adopt this guidance’s prescribed methodology. Consequently, the Company currently believes that the amounts of unrecognized tax benefits that relate to this issue and that are disclosed above are appropriate.

 

The Company used its estimate of its annual 2014 and 2013 income in computing its effective income tax rates for the three and nine months ended September 30, 2014 and 2013. The effective tax rates for the three and nine months ended September 30, 2014 were 35.7% and 34.3%, respectively, and 34.5% and 34.1% for the three and nine months ended September 30, 2013, respectively.

 

In general, the Company is no longer subject to U.S. federal, state, and local income tax examinations by taxing authorities for tax years that began before 2003.

 

Based on the Company’s current assessment of future taxable income, including available tax planning opportunities, the Company anticipates that it is more likely than not that it will generate sufficient taxable income to realize all of its material deferred tax assets. The Company did not record a valuation allowance against its material deferred tax assets as of September 30, 2014.

 

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16.                               FAIR VALUE OF FINANCIAL INSTRUMENTS

 

The Company determined the fair value of its financial instruments based on the fair value hierarchy established in FASB guidance referenced in the Fair Value Measurements and Disclosures Topic which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The Company has adopted the provisions from the FASB guidance that is referenced in the Fair Value Measurements and Disclosures Topic for non-financial assets and liabilities (such as property and equipment, goodwill, and other intangible assets) that are required to be measured at fair value on a periodic basis. The effect on the Company’s periodic fair value measurements for non-financial assets and liabilities was not material.

 

The Company has categorized its financial instruments, based on the priority of the inputs to the valuation technique, into a three level hierarchy. The fair value hierarchy gives the highest priority to quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). If the inputs used to measure fair value fall within different levels of the hierarchy, the category level is based on the lowest priority level input that is significant to the fair value measurement of the instrument.

 

Financial assets and liabilities recorded at fair value on the consolidated balance sheets are categorized as follows:

 

·                  Level 1: Unadjusted quoted prices for identical assets or liabilities in an active market.

 

·                  Level 2: Quoted prices in markets that are not active or significant inputs that are observable either directly or indirectly. Level 2 inputs include the following:

 

a)                                     Quoted prices for similar assets or liabilities in active markets

b)                                     Quoted prices for identical or similar assets or liabilities in non-active markets

c)                                      Inputs other than quoted market prices that are observable

d)                                     Inputs that are derived principally from or corroborated by observable market data through correlation or other means.

 

·                  Level 3: Prices or valuation techniques that require inputs that are both unobservable and significant to the overall fair value measurement. They reflect management’s own assumptions about the assumptions a market participant would use in pricing the asset or liability.

 

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The following table presents the Company’s hierarchy for its assets and liabilities measured at fair value on a recurring basis as of September 30, 2014:

 

 

 

Level 1

 

Level 2

 

Level 3

 

Total

 

 

 

(Dollars In Thousands)

 

Assets:

 

 

 

 

 

 

 

 

 

Fixed maturity securities - available-for-sale

 

 

 

 

 

 

 

 

 

Residential mortgage-backed securities

 

$

 

$

1,442,834

 

$

5

 

$

1,442,839

 

Commercial mortgage-backed securities

 

 

1,175,523

 

 

1,175,523

 

Other asset-backed securities

 

 

282,971

 

565,368

 

848,339

 

U.S. government-related securities

 

1,316,839

 

267,371

 

 

1,584,210

 

State, municipalities, and political subdivisions

 

 

1,609,032

 

3,675

 

1,612,707

 

Other government-related securities

 

 

22,020

 

 

22,020

 

Corporate bonds

 

132

 

26,029,048

 

1,377,806

 

27,406,986

 

Total fixed maturity securities - available-for-sale

 

1,316,971

 

30,828,799

 

1,946,854

 

34,092,624

 

 

 

 

 

 

 

 

 

 

 

Fixed maturity securities - trading

 

 

 

 

 

 

 

 

 

Residential mortgage-backed securities

 

 

290,862

 

 

290,862

 

Commercial mortgage-backed securities

 

 

151,870

 

 

151,870

 

Other asset-backed securities

 

 

101,523

 

170,676

 

272,199

 

U.S. government-related securities

 

229,222

 

4,889

 

 

234,111

 

State, municipalities, and political subdivisions

 

 

284,132

 

 

284,132

 

Other government-related securities

 

 

55,901

 

 

55,901

 

Corporate bonds

 

 

1,517,519

 

23,177

 

1,540,696

 

Total fixed maturity securities - trading

 

229,222

 

2,406,696

 

193,853

 

2,829,771

 

Total fixed maturity securities

 

1,546,193

 

33,235,495

 

2,140,707

 

36,922,395

 

Equity securities

 

637,708

 

98,882

 

73,058

 

809,648

 

Other long-term investments(1)

 

99,961

 

71,316

 

105,417

 

276,694

 

Short-term investments

 

146,557

 

36,854

 

 

183,411

 

Total investments

 

2,430,419

 

33,442,547

 

2,319,182

 

38,192,148

 

Cash

 

328,487

 

 

 

328,487

 

Other assets

 

11,692

 

 

 

11,692

 

Assets related to separate accounts

 

 

 

 

 

 

 

 

 

Variable annuity

 

13,040,828

 

 

 

13,040,828

 

Variable universal life

 

813,178

 

 

 

813,178

 

Total assets measured at fair value on a recurring basis

 

$

16,624,604

 

$

33,442,547

 

$

2,319,182

 

$

52,386,333

 

 

 

 

 

 

 

 

 

 

 

Liabilities:

 

 

 

 

 

 

 

 

 

Annuity account balances(2)

 

$

 

$

 

$

98,129

 

$

98,129

 

Other liabilities (1)

 

39,510

 

46,155

 

533,746

 

619,411

 

Total liabilities measured at fair value on a recurring basis

 

$

39,510

 

$

46,155

 

$

631,875

 

$

717,540

 

 


(1)Includes certain freestanding and embedded derivatives.

(2)Represents liabilities related to fixed indexed annuities.

 

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The following table presents the Company’s hierarchy for its assets and liabilities measured at fair value on a recurring basis as of December 31, 2013:

 

 

 

Level 1

 

Level 2

 

Level 3

 

Total

 

 

 

(Dollars In Thousands)

 

Assets:

 

 

 

 

 

 

 

 

 

Fixed maturity securities - available-for-sale

 

 

 

 

 

 

 

 

 

Residential mortgage-backed securities

 

$

 

$

1,445,040

 

$

28

 

$

1,445,068

 

Commercial mortgage-backed securities

 

 

970,656

 

 

970,656

 

Other asset-backed securities

 

 

326,175

 

545,808

 

871,983

 

U.S. government-related securities

 

1,211,141

 

296,749

 

 

1,507,890

 

State, municipalities, and political subdivisions

 

 

1,407,154

 

3,675

 

1,410,829

 

Other government-related securities

 

 

51,427

 

 

51,427

 

Corporate bonds

 

107

 

24,216,703

 

1,549,940

 

25,766,750

 

Total fixed maturity securities - available-for-sale

 

1,211,248

 

28,713,904

 

2,099,451

 

32,024,603

 

 

 

 

 

 

 

 

 

 

 

Fixed maturity securities - trading

 

 

 

 

 

 

 

 

 

Residential mortgage-backed securities

 

 

310,877

 

 

310,877

 

Commercial mortgage-backed securities

 

 

158,570

 

 

158,570

 

Other asset-backed securities

 

 

93,278

 

194,977

 

288,255

 

U.S. government-related securities

 

191,332

 

4,906

 

 

196,238

 

State, municipalities, and political subdivisions

 

 

260,892

 

 

260,892

 

Other government-related securities

 

 

57,097

 

 

57,097

 

Corporate bonds

 

 

1,497,362

 

29,199

 

1,526,561

 

Total fixed maturity securities - trading

 

191,332

 

2,382,982

 

224,176

 

2,798,490

 

Total fixed maturity securities

 

1,402,580

 

31,096,886

 

2,323,627

 

34,823,093

 

Equity securities

 

523,219

 

50,927

 

71,881

 

646,027

 

Other long-term investments (1)

 

56,469

 

54,965

 

196,133

 

307,567

 

Short-term investments

 

132,544

 

1,602

 

 

134,146

 

Total investments

 

2,114,812

 

31,204,380

 

2,591,641

 

35,910,833

 

Cash

 

466,542

 

 

 

466,542

 

Other assets

 

10,979

 

 

 

10,979

 

Assets related to separate accounts

 

 

 

 

 

 

 

 

 

Variable annuity

 

12,791,438

 

 

 

12,791,438

 

Variable universal life

 

783,618

 

 

 

783,618

 

Total assets measured at fair value on a recurring basis

 

$

16,167,389

 

$

31,204,380

 

$

2,591,641

 

$

49,963,410

 

 

 

 

 

 

 

 

 

 

 

Liabilities:

 

 

 

 

 

 

 

 

 

Annuity account balances (2)

 

$

 

$

 

$

107,000

 

$

107,000

 

Other liabilities (1)

 

30,241

 

156,931

 

270,630

 

457,802

 

Total liabilities measured at fair value on a recurring basis

 

$

30,241

 

$

156,931

 

$

377,630

 

$

564,802

 

 


(1)Includes certain freestanding and embedded derivatives.

(2)Represents liabilities related to fixed indexed annuities.

 

Determination of fair values

 

The valuation methodologies used to determine the fair values of assets and liabilities reflect market participant assumptions and are based on the application of the fair value hierarchy that prioritizes observable market inputs over unobservable inputs. The Company determines the fair values of certain financial assets and financial liabilities based on quoted market prices, where available. The Company also determines certain fair values based on future cash flows discounted at the appropriate current market rate. Fair values reflect adjustments for counterparty credit quality, the Company’s credit standing, liquidity, and where appropriate, risk margins on unobservable parameters. The following is a discussion of the methodologies used to determine fair values for the financial instruments as listed in the above table.

 

The fair value of fixed maturity, short-term, and equity securities is determined by management after considering one of three primary sources of information: third party pricing services, non-binding independent broker quotations, or pricing matrices. Security pricing is applied using a ‘‘waterfall’’ approach whereby publicly available

 

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prices are first sought from third party pricing services, the remaining unpriced securities are submitted to independent brokers for non-binding prices, or lastly, securities are priced using a pricing matrix. Typical inputs used by these three pricing methods include, but are not limited to: benchmark yields, reported trades, broker/dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers, and reference data including market research publications. Third party pricing services price approximately 90% of the Company’s available-for-sale and trading fixed maturity securities. Based on the typical trading volumes and the lack of quoted market prices for available-for-sale and trading fixed maturities, third party pricing services derive the majority of security prices from observable market inputs such as recent reported trades for identical or similar securities making adjustments through the reporting date based upon available market observable information outlined above. If there are no recent reported trades, the third party pricing services and brokers may use matrix or model processes to develop a security price where future cash flow expectations are developed based upon collateral performance and discounted at an estimated market rate. Certain securities are priced via independent non-binding broker quotations, which are considered to have no significant unobservable inputs. When using non-binding independent broker quotations, the Company obtains one quote per security, typically from the broker from which we purchased the security. A pricing matrix is used to price securities for which the Company is unable to obtain or effectively rely on either a price from a third party pricing service or an independent broker quotation.

 

The pricing matrix used by the Company begins with current spread levels to determine the market price for the security. The credit spreads, assigned by brokers, incorporate the issuer’s credit rating, liquidity discounts, weighted-average of contracted cash flows, risk premium, if warranted, due to the issuer’s industry, and the security’s time to maturity. The Company uses credit ratings provided by nationally recognized rating agencies.

 

For securities that are priced via non-binding independent broker quotations, the Company assesses whether prices received from independent brokers represent a reasonable estimate of fair value through an analysis using internal and external cash flow models developed based on spreads and, when available, market indices. The Company uses a market-based cash flow analysis to validate the reasonableness of prices received from independent brokers. These analytics, which are updated daily, incorporate various metrics (yield curves, credit spreads, prepayment rates, etc.) to determine the valuation of such holdings. As a result of this analysis, if the Company determines there is a more appropriate fair value based upon the analytics, the price received from the independent broker is adjusted accordingly. The Company did not adjust any quotes or prices received from brokers during the nine months ended September 30, 2014.

 

The Company has analyzed the third party pricing services’ valuation methodologies and related inputs and has also evaluated the various types of securities in its investment portfolio to determine an appropriate fair value hierarchy level based upon trading activity and the observability of market inputs that is in accordance with the Fair Value Measurements and Disclosures Topic of the ASC. Based on this evaluation and investment class analysis, each price was classified into Level 1, 2, or 3. Most prices provided by third party pricing services are classified into Level 2 because the significant inputs used in pricing the securities are market observable and the observable inputs are corroborated by the Company. Since the matrix pricing of certain debt securities includes significant non-observable inputs, they are classified as Level 3.

 

Asset-Backed Securities

 

This category mainly consists of residential mortgage-backed securities, commercial mortgage-backed securities, and other asset-backed securities (collectively referred to as asset-backed securities or “ABS”). As of September 30, 2014, the Company held $3.4 billion of ABS classified as Level 2. These securities are priced from information provided by a third party pricing service and independent broker quotes. The third party pricing services and brokers mainly value securities using both a market and income approach to valuation. As part of this valuation process they consider the following characteristics of the item being measured to be relevant inputs: 1) weighted-average coupon rate, 2) weighted-average years to maturity, 3) types of underlying assets, 4) weighted-average coupon rate of the underlying assets, 5) weighted-average years to maturity of the underlying assets, 6) seniority level of the tranches owned, and 7) credit ratings of the securities.

 

After reviewing these characteristics of the ABS, the third party pricing service and brokers use certain inputs to determine the value of the security. For ABS classified as Level 2, the valuation would consist of predominantly market observable inputs such as, but not limited to: 1) monthly principal and interest payments on the underlying

 

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assets, 2) average life of the security, 3) prepayment speeds, 4) credit spreads, 5) treasury and swap yield curves, and 6) discount margin. The Company reviews the methodologies and valuation techniques (including the ability to observe inputs) in assessing the information received from external pricing services and in consideration of the fair value presentation.

 

As of September 30, 2014, the Company held $736.1 million of Level 3 ABS, which included $565.4 million of other asset-backed securities classified as available-for-sale and $170.7 million of other asset-backed securities classified as trading. These securities are predominantly ARS whose underlying collateral is at least 97% guaranteed by the FFELP. As a result of the ARS market collapse during 2008, the Company prices its ARS using an income approach valuation model. As part of the valuation process the Company reviews the following characteristics of the ARS in determining the relevant inputs: 1) weighted-average coupon rate, 2) weighted-average years to maturity, 3) types of underlying assets, 4) weighted-average coupon rate of the underlying assets, 5) weighted-average years to maturity of the underlying assets, 6) seniority level of the tranches owned, 7) credit ratings of the securities, 8) liquidity premium, and 9) paydown rate.

 

Corporate bonds, U.S. Government-related securities, States, municipals, and political subdivisions, and Other government related securities

 

As of September 30, 2014, the Company classified approximately $29.8 billion of corporate bonds, U.S. government-related securities, states, municipals, and political subdivisions, and other government-related securities as Level 2. The fair value of the Level 2 bonds and securities is predominantly priced by broker quotes and a third party pricing service. The Company has reviewed the valuation techniques of the brokers and third party pricing service and has determined that such techniques used Level 2 market observable inputs. The following characteristics of the bonds and securities are considered to be the primary relevant inputs to the valuation: 1) weighted- average coupon rate, 2) weighted-average years to maturity, 3) seniority, and 4) credit ratings. The Company reviews the methodologies and valuation techniques (including the ability to observe inputs) in assessing the information received from external pricing services and in consideration of the fair value presentation.

 

The brokers and third party pricing service utilize valuation models that consist of a hybrid income and market approach to valuation. The pricing models utilize the following inputs: 1) principal and interest payments, 2) treasury yield curve, 3) credit spreads from new issue and secondary trading markets, 4) dealer quotes with adjustments for issues with early redemption features, 5) liquidity premiums present on private placements, and 6) discount margins from dealers in the new issue market.

 

As of September 30, 2014, the Company classified approximately $1.4 billion of bonds and securities as Level 3 valuations. Level 3 bonds and securities primarily represent investments in illiquid bonds for which no price is readily available. To determine a price, the Company uses a discounted cash flow model with both observable and unobservable inputs. These inputs are entered into an industry standard pricing model to determine the final price of the security. These inputs include: 1) principal and interest payments, 2) coupon rate, 3) sector and issuer level spread over treasury, 4) underlying collateral, 5) credit ratings, 6) maturity, 7) embedded options, 8) recent new issuance, 9) comparative bond analysis, and 10) an illiquidity premium.

 

Equities

 

As of September 30, 2014, the Company held approximately $171.9 million of equity securities classified as Level 2 and Level 3. Of this total, $66.0 million represents Federal Home Loan Bank (“FHLB”) stock. The Company believes that the cost of the FHLB stock approximates fair value. The remainder of these equity securities is primarily investments in preferred stock.

 

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Other long-term investments and Other liabilities

 

Other long-term investments and other liabilities consist entirely of free-standing and embedded derivative financial instruments. Refer to Note 17, Derivative Financial Instruments for additional information related to derivatives. Derivative financial instruments are valued using exchange prices, independent broker quotations, or pricing valuation models, which utilize market data inputs. Excluding embedded derivatives, as of September 30, 2014, 98.2% of derivatives based upon notional values were priced using exchange prices or independent broker quotations. The remaining derivatives were priced by pricing valuation models, which predominantly utilize observable market data inputs. Inputs used to value derivatives include, but are not limited to, interest swap rates, credit spreads, interest rate and equity market volatility indices, equity index levels, and treasury rates. The Company performs monthly analysis on derivative valuations that includes both quantitative and qualitative analyses.

 

Derivative instruments classified as Level 1 generally include futures and puts, which are traded on active exchange markets.

 

Derivative instruments classified as Level 2 primarily include interest rate and inflation swaps, options, and swaptions. These derivative valuations are determined using independent broker quotations, which are corroborated with observable market inputs.

 

Derivative instruments classified as Level 3 were embedded derivatives and include at least one significant non-observable input. A derivative instrument containing Level 1 and Level 2 inputs will be classified as a Level 3 financial instrument in its entirety if it has at least one significant Level 3 input.

 

The Company utilizes derivative instruments to manage the risk associated with certain assets and liabilities. However, the derivative instruments may not be classified within the same fair value hierarchy level as the associated assets and liabilities. Therefore, the changes in fair value on derivatives reported in Level 3 may not reflect the offsetting impact of the changes in fair value of the associated assets and liabilities.

 

The embedded derivatives are carried at fair value in “other long-term investments” and “other liabilities” on the Company’s consolidated balance sheet. The changes in fair value are recorded in earnings as “Realized investment gains (losses) — Derivative financial instruments”. Refer to Note 17, Derivative Financial Instruments for more information related to each embedded derivatives gains and losses.

 

The fair value of the guaranteed minimum withdrawal benefits (“GMWB”) embedded derivative is derived through the income method of valuation using a valuation model that projects future cash flows using multiple risk neutral stochastic equity scenarios and policyholder behavior assumptions. The risk neutral scenarios are generated using the current swap curve and projected equity volatilities and correlations. The projected equity volatilities are based on a blend of historical volatility and near- term equity market implied volatilities. The equity correlations are based on historical price observations. For policyholder behavior assumptions, expected lapse and utilization assumptions are used and updated for actual experience, as necessary. The Company assumes age-based mortality from the National Association of Insurance Commissioners 1994 Variable Annuity MGDB Mortality Table for company experience, with attained age factors varying from 49% - 80%. The present value of the cash flows is determined using the discount rate curve, which is based upon LIBOR plus a credit spread (to represent the Company’s non-performance risk). As a result of using significant unobservable inputs, the GMWB embedded derivative is categorized as Level 3. These assumptions are reviewed on a quarterly basis.

 

The balance of the fixed indexed annuities (“FIA”) embedded derivative is impacted by policyholder cash flows associated with the FIA product that are allocated to the embedded derivative in addition to changes in the fair value of the embedded derivative during the reporting period.  The fair value of the FIA embedded derivative is derived through the income method of valuation using a valuation model that projects future cash flows using current index values and volatility, the hedge budget used to price the product, and policyholder assumptions (both elective and non-elective). For policyholder behavior assumptions, expected lapse and withdrawal assumptions are used and updated for actual experience, as necessary. The Company assumes age-based mortality from the 1994 Variable Annuity MGDB mortality table modified for company experience, with attained age factors varying from 49% - 80%. The present value of the cash flows is determined using the discount rate curve, which is based upon LIBOR up to one year and constant maturity treasury rates plus a credit spread (to represent the Company’s non-performance risk) thereafter. Policyholder

 

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assumptions are reviewed on an annual basis. As a result of using significant unobservable inputs, the FIA embedded derivative is categorized as Level 3.

 

The balance of the indexed universal life (“IUL”) embedded derivative is impacted by policyholder cash flows associated with the IUL product that are allocated to the embedded derivative in addition to changes in the fair value of the embedded derivative during the reporting period. The fair value of the IUL embedded derivative is derived through the income method of valuation using a valuation model that projects future cash flows using current index values and volatility, the hedge budget used to price the product, and policyholder assumptions (both elective and non-elective). For policyholder behavior assumptions, expected lapse and withdrawal assumptions are used and updated for actual experience, as necessary. The Company assumes age-based mortality from the SOA 2008 VBT Primary Tables modified for company experience, with attained age factors varying from 37% - 74%. The present value of the cash flows is determined using the discount rate curve, which is based upon LIBOR up to one year and constant maturity treasury rates plus a credit spread (to represent the Company’s non-performance risk) thereafter. Policyholder assumptions are reviewed on an annual basis. As a result of using significant unobservable inputs, the IUL embedded derivative is categorized as Level 3.

 

The Company has assumed and ceded certain blocks of policies under modified coinsurance agreements in which the investment results of the underlying portfolios inure directly to the reinsurers. As a result, these agreements contain embedded derivatives that are reported at fair value. Changes in their fair value are reported in earnings. The investments supporting these agreements are designated as “trading securities”; therefore changes in their fair value are also reported in earnings. The fair value of the embedded derivative is the difference between the statutory policy liabilities (net of policy loans) of $2.6 billion and the fair value of the trading securities of $2.9 billion. As a result, changes in the fair value of the embedded derivatives are largely offset by the changes in fair value of the related investments and each are reported in earnings. The fair value of the embedded derivative is considered a Level 3 valuation due to the unobservable nature of the policy liabilities.

 

Annuity account balances

 

The Company records certain of its FIA reserves at fair value. The fair value is considered a Level 3 valuation. The FIA valuation model calculates the present value of future benefit cash flows less the projected future profits to quantify the net liability that is held as a reserve. This calculation is done using multiple risk neutral stochastic equity scenarios. The cash flows are discounted using LIBOR plus a credit spread. Best estimate assumptions are used for partial withdrawals, lapses, expenses and asset earned rate with a risk margin applied to each. These assumptions are reviewed at least annually as a part of the formal unlocking process. If an event were to occur within a quarter that would make the assumptions unreasonable, the assumptions would be reviewed within the quarter.

 

The discount rate for the fixed indexed annuities is based on an upward sloping rate curve which is updated each quarter. The discount rates for September 30, 2014, ranged from a one month rate of 0.29%, a 5 year rate of 2.58%, and a 30 year rate of 4.21%. A credit spread component is also included in the calculation to accommodate non-performance risk.

 

Separate Accounts

 

Separate account assets are invested in open-ended mutual funds and are included in Level 1.

 

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Valuation of Level 3 Financial Instruments

 

The following table presents the valuation method for material financial instruments included in Level 3, as well as the unobservable inputs used in the valuation of those financial instruments:

 

 

 

Fair Value

 

 

 

 

 

 

 

 

 

As of

 

Valuation

 

Unobservable

 

Range

 

 

 

September 30, 2014

 

Technique

 

Input

 

(Weighted Average)

 

 

 

(Dollars In Thousands)

 

 

 

 

 

 

 

Assets:

 

 

 

 

 

 

 

 

 

Other asset-backed securities

 

$

564,877

 

Discounted cash flow

 

Liquidity premium

 

0.59% - 1.49% (0.82%)

 

 

 

 

 

 

 

Paydown rate

 

9.29% - 15.18% (12.42%)

 

Corporate bonds

 

1,312,780

 

Discounted cash flow

 

Spread over treasury

 

0.51% - 5.75% (1.86%)

 

Liabilities:

 

 

 

 

 

 

 

 

 

Embedded derivatives - GMWB(1)

 

$

24,854

 

Actuarial cash flow model

 

Mortality

 

49% to 80% of 1994 MGDB table

 

 

 

 

 

 

 

Lapse

 

0% - 24%, depending on product/duration/funded status of guarantee

 

 

 

 

 

 

 

Utilization

 

97% - 103%

 

 

 

 

 

 

 

Nonperformance risk

 

0.13% - 1.02%

 

Annuity account balances(2)

 

98,129

 

Actuarial cash flow model

 

Asset earned rate

 

3.86% - 5.92%

 

 

 

 

 

 

 

Expenses

 

$88 - $102 per policy

 

 

 

 

 

 

 

Withdrawal rate

 

2.20%

 

 

 

 

 

 

 

Mortality

 

49% to 80% of 1994 MGDB table

 

 

 

 

 

 

 

Lapse

 

2.2% - 33.0%, depending on duration/surrender charge period

 

 

 

 

 

 

 

Return on assets

 

1.50% - 1.85% depending on

 

 

 

 

 

 

 

 

 

surrender charge period

 

 

 

 

 

 

 

Nonperformance risk

 

0.13% - 1.02%

 

Embedded derivative - FIA

 

103,497

 

Actuarial cash flow model

 

Expenses

 

$83 - $97 per policy

 

 

 

 

 

 

 

Withdrawal rate

 

1.1% - 4.5% depending on duration and tax qualification

 

 

 

 

 

 

 

Mortality

 

49% to 80% of 1994 MGDB table

 

 

 

 

 

 

 

Lapse

 

2.5% - 40.0%, depending on duration/surrender charge period

 

 

 

 

 

 

 

Nonperformance risk

 

0.13% - 1.02%

 

Embedded derivative - IUL

 

2,609

 

Actuarial cash flow model

 

Mortality

 

37% - 74% of 2008

VBT Primary Tables

 

 

 

 

 

 

 

Lapse

 

0.5% - 10.0%, depending on duration/distribution channel and smoking class

 

 

 

 

 

 

 

Nonperformance risk

 

0.13% - 1.02%

 

 


(1)The fair value for the GMWB embedded derivative is presented as a net liability for the purposes of this chart. Excludes modified coinsurance arrangements.

(2)Represents account balance liabilities related to fixed indexed annuities.

 

The chart above excludes Level 3 financial instruments that are valued using broker quotes and those which book value approximates fair value.

 

The Company has considered all reasonably available quantitative inputs as of September 30, 2014, but the valuation techniques and inputs used by some brokers in pricing certain financial instruments are not shared with the Company. This resulted in $248.4 million of financial instruments being classified as Level 3 as of September 30, 2014. Of the $248.4 million, $171.2 million are other asset backed securities, $74.2 million are corporate bonds, and $3.0 million are equity securities.

 

48



Table of Contents

 

In certain cases the Company has determined that book value materially approximates fair value. As of September 30, 2014, the Company held $87.7 million of financial instruments where book value approximates fair value. Of the $87.7 million, $70.0 million represents equity securities, which are predominantly FHLB stock, $14.0 million are corporate bonds, and $3.7 million are other fixed maturity securities.

 

The following table presents the valuation method for material financial instruments included in Level 3, as well as the unobservable inputs used in the valuation of those financial instruments:

 

 

 

Fair Value

 

 

 

 

 

 

 

 

 

As of

 

Valuation

 

Unobservable

 

Range

 

 

 

December 31, 2013

 

Technique

 

Input

 

(Weighted Average)

 

 

 

(Dollars In Thousands)

 

 

 

 

 

 

 

Assets:

 

 

 

 

 

 

 

 

 

Other asset-backed securities

 

$

545,808

 

Discounted cash flow

 

Liquidity premium

 

1.00% - 1.68% (1.08%)

 

 

 

 

 

 

 

Paydown rate

 

8.57% - 16.87% (12.05%)

 

Corporate bonds

 

1,555,898

 

Discounted cash flow

 

Spread over treasury

 

0.11% - 6.75% (2.06%)

 

Embedded derivatives - GMWB(1)

 

156,287

 

Actuarial cash flow model

 

Mortality

 

49% to 80% of 1994 MGDB table

 

 

 

 

 

 

 

Lapse

 

0% - 24%, depending on product/duration/funded status of guarantee

 

 

 

 

 

 

 

Utilization

 

97% - 103%

 

 

 

 

 

 

 

Nonperformance risk

 

0.15% - 1.06%

 

Liabilities:

 

 

 

 

 

 

 

 

 

Annuity account balances(2)

 

$

107,000

 

Actuarial cash flow model

 

Asset earned rate

 

5.37%

 

 

 

 

 

 

 

Expenses

 

$88 - $102 per policy

 

 

 

 

 

 

 

Withdrawal rate

 

2.20%

 

 

 

 

 

 

 

Mortality

 

49% to 80% of 1994 MGDB table

 

 

 

 

 

 

 

Lapse

 

2.2% - 33.0%, depending on duration/surrender charge period

 

 

 

 

 

 

 

Return on assets

 

1.50% - 1.85% depending on surrender charge period

 

 

 

 

 

 

 

Nonperformance risk

 

0.15% - 1.06%

 

Embedded derivative - FIA

 

25,324

 

Actuarial cash flow model

 

Expenses

 

$83 - $97 per policy

 

 

 

 

 

 

 

Withdrawal rate

 

1.1% - 4.5% depending on duration and tax qualification

 

 

 

 

 

 

 

Mortality

 

49% to 80% of 1994 MGDB table

 

 

 

 

 

 

 

Lapse

 

2.2% - 45.0%, depending on duration/surrender charge period

 

 

 

 

 

 

 

Nonperformance risk

 

0.15% - 1.06%

 

 


(1)The fair value for the GMWB embedded derivative is presented as a net asset for the purposes of this chart. Excludes modified coinsurance arrangements.

(2)Represents liabilities related to fixed indexed annuities.

 

49



Table of Contents

 

The chart above excludes Level 3 financial instruments that are valued using broker quotes and those which book value approximates fair value.

 

The Company has considered all reasonably available quantitative inputs as of December 31, 2013, but the valuation techniques and inputs used by some brokers in pricing certain financial instruments are not shared with the Company. This resulted in $216.6 million of financial instruments being classified as Level 3 as of December 31, 2013. Of the $216.6 million, $195.0 million are other asset backed securities, $21.0 million are corporate bonds, and $0.6 million are equity securities.

 

In certain cases the Company has determined that book value materially approximates fair value. As of December 31, 2013, the Company held $77.2 million of financial instruments where book value approximates fair value. Of the $77.2 million, $71.3 million represents equity securities, which are predominantly FHLB stock, $2.2 million of other corporate bonds, and $3.7 million of other fixed maturity securities.

 

The asset-backed securities classified as Level 3 are predominantly ARS. A change in the paydown rate (the projected annual rate of principal reduction) of the ARS can significantly impact the fair value of these securities. A decrease in the paydown rate would increase the projected weighted average life of the ARS and increase the sensitivity of the ARS’ fair value to changes in interest rates. An increase in the liquidity premium would result in a decrease in the fair value of the securities, while a decrease in the liquidity premium would increase the fair value of these securities.

 

The fair value of corporate bonds classified as Level 3 is sensitive to changes in the interest rate spread over the corresponding U.S. Treasury rate. This spread represents a risk premium that is impacted by company specific and market factors. An increase in the spread can be caused by a perceived increase in credit risk of a specific issuer and/or an increase in the overall market risk premium associated with similar securities. The fair values of corporate bonds are sensitive to changes in spread. When holding the treasury rate constant, the fair value of corporate bonds increase when spreads decrease, and decrease when spreads increase.

 

The fair value of the GMWB embedded derivative is sensitive to changes in the discount rate which includes the Company’s nonperformance risk, volatility, lapse, and mortality assumptions. The volatility assumption is an observable input as it is based on market inputs. The Company’s nonperformance risk, lapse, and mortality are unobservable. An increase in the three unobservable assumptions would result in a decrease in the fair value and conversely, if there is a decrease in the assumptions the fair value would increase. The fair value is also dependent on the assumed policyholder utilization of the GMWB where an increase in assumed utilization would result in an increase in the fair value and conversely, if there is a decrease in the assumption, the fair value would decrease.

 

The fair value of the FIA account balance liability is predominantly impacted by observable inputs such as discount rates and equity returns. However, the fair value of the FIA account balance liability is sensitive to the asset earned rate and required return on assets, which are unobservable. The value of the liability increases with an increase in required return on assets and a decrease in the asset earned rate and conversely, the value of the liability decreases with a decrease in required return on assets and an increase in the asset earned rate.

 

The fair value of the FIA embedded derivative is predominantly impacted by observable inputs such as discount rates and equity returns. However, the fair value of the FIA embedded derivative is sensitive to non-performance risk, which is unobservable. The value of the liability increases with decreases in the discount rate and non-performance risk and decreases with increases in the discount rate and nonperformance risk. The value of the liability increases with increases in equity returns and the liability decreases with a decrease in equity returns.

 

The fair value of the IUL embedded derivative is predominantly impacted by observable inputs such as discount rates and equity returns. However, the fair value of the IUL embedded derivative is sensitive to non-performance risk. The value of the liability increases with decreases in the discount rate and non-performance risk and decreases with increases in the discount rate and nonperformance risk, which is unobservable. The value of the liability increases with increases in equity returns and the liability decreases with a decrease in equity returns.

 

50



Table of Contents

 

The following table presents a reconciliation of the beginning and ending balances for fair value measurements for the three months ended September 30, 2014, for which the Company has used significant unobservable inputs (Level 3):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Gains (losses)

 

 

 

 

 

Total

 

Total

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

included in

 

 

 

 

 

Realized and Unrealized

 

Realized and Unrealized

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Earnings

 

 

 

 

 

Gains

 

Losses

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

related to

 

 

 

 

 

 

 

Included in

 

 

 

Included in

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Instruments

 

 

 

 

 

 

 

Other

 

 

 

Other

 

 

 

 

 

 

 

 

 

Transfers

 

 

 

 

 

still held at

 

 

 

Beginning

 

Included in

 

Comprehensive

 

Included in

 

Comprehensive

 

 

 

 

 

 

 

 

 

in/out of

 

 

 

Ending

 

the Reporting

 

 

 

Balance

 

Earnings

 

Income

 

Earnings

 

Income

 

Purchases

 

Sales

 

Issuances

 

Settlements

 

Level 3

 

Other

 

Balance

 

Date

 

 

 

(Dollars In Thousands)

 

Assets:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Fixed maturity securities available-for-sale

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Residential mortgage-backed securities

 

$

10

 

$

 

$

 

$

 

$

(1

)

$

 

$

(5

)

$

 

$

 

$

 

$

1

 

$

5

 

$

 

Commercial mortgage-backed securities

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Other asset-backed securities

 

568,097

 

 

2,161

 

(71

)

(4,299

)

 

(140

)

 

 

 

(380

)

565,368

 

 

U.S. government-related securities

 

 

 

 

 

 

 

 

 

 

 

 

 

 

States, municipals, and political subdivisions

 

3,675

 

 

 

 

 

 

 

 

 

 

 

3,675

 

 

Other government-related securities

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Corporate bonds

 

1,524,297

 

201

 

8,435

 

 

(9,452

)

11,797

 

(59,352

)

 

 

(96,565

)

(1,555

)

1,377,806

 

 

Total fixed maturity securities - available-for-sale

 

2,096,079

 

201

 

10,596

 

(71

)

(13,752

)

11,797

 

(59,497

)

 

 

(96,565

)

(1,934

)

1,946,854

 

 

Fixed maturity securities - trading

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Residential mortgage-backed securities

 

842

 

11

 

 

 

 

 

 

 

 

(853

)

 

 

 

Commercial mortgage-backed securities

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Other asset-backed securities

 

176,386

 

1,834

 

 

(837

)

 

 

(7,137

)

 

 

 

430

 

170,676

 

1,287

 

U.S. government-related securities

 

 

 

 

 

 

 

 

 

 

 

 

 

 

States, municipals and political subdivisions

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Other government-related securities

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Corporate bonds

 

31,520

 

182

 

 

(676

)

 

 

(5,583

)

 

 

(2,518

)

252

 

23,177

 

234

 

Total fixed maturity securities - trading

 

208,748

 

2,027

 

 

(1,513

)

 

 

(12,720

)

 

 

(3,371

)

682

 

193,853

 

1,521

 

Total fixed maturity securities

 

2,304,827

 

2,228

 

10,596

 

(1,584

)

(13,752

)

11,797

 

(72,217

)

 

 

(99,936

)

(1,252

)

2,140,707

 

1,521

 

Equity securities

 

81,784

 

1,298

 

2,461

 

 

(91

)

(1,742

)

 

 

 

(10,651

)

(1

)

73,058

 

 

Other long-term investments(1)

 

123,301

 

233

 

 

(18,117

)

 

 

 

 

 

 

 

105,417

 

(17,884

)

Short-term investments

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total investments

 

2,509,912

 

3,759

 

13,057

 

(19,701

)

(13,843

)

10,055

 

(72,217

)

 

 

(110,587

)

(1,253

)

2,319,182

 

(16,363

)

Total assets measured at fair value on a recurring basis

 

$

2,509,912

 

$

3,759

 

$

13,057

 

$

(19,701

)

$

(13,843

)

$

10,055

 

$

(72,217

)

$

 

$

 

$

(110,587

)

$

(1,253

)

$

2,319,182

 

$

(16,363

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Liabilities:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Annuity account balances(2)

 

$

102,456

 

$

862

 

$

 

$

 

$

 

$

 

$

 

$

125

 

$

3,590

 

$

 

$

 

$

98,129

 

$

 

Other liabilities(1)

 

484,747

 

22,317

 

 

(71,316

)

 

 

 

 

 

 

 

533,746

 

(48,999

)

Total liabilities measured at fair value on a recurring basis

 

$

587,203

 

$

23,179

 

$

 

$

(71,316

)

$

 

$

 

$

 

$

125

 

$

3,590

 

$

 

$

 

$

631,875

 

$

(48,999

)

 


(1)Represents certain freestanding and embedded derivatives.

(2)Represents liabilities related to fixed indexed annuities.

 

For the three months ended September 30, 2014, there were no transfers into Level 3.

 

For the three months ended September 30, 2014, there were $110.6 million of securities transferred out of Level 3. This amount was transferred to Level 2. These transfers resulted from securities that were priced using significant unobservable inputs in previous periods, but are now priced by independent pricing services or brokers, using no significant unobservable inputs as of September 30, 2014.

 

For the three months ended September 30, 2014, there were no transfers from Level 2 to Level 1.

 

For the three months ended September 30, 2014, there were no transfers from Level 1.

 

51



Table of Contents

 

The following table presents a reconciliation of the beginning and ending balances for fair value measurements for the three months ended September 30, 2013, for which the Company has used significant unobservable inputs (Level 3):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Gains (losses)

 

 

 

 

 

Total

 

Total

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

included in

 

 

 

 

 

Realized and Unrealized

 

Realized and Unrealized

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Earnings

 

 

 

 

 

Gains

 

Losses

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

related to

 

 

 

 

 

 

 

Included in

 

 

 

Included in

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Instruments

 

 

 

 

 

 

 

Other

 

 

 

Other

 

 

 

 

 

 

 

 

 

Transfers

 

 

 

 

 

still held at

 

 

 

Beginning

 

Included in

 

Comprehensive

 

Included in

 

Comprehensive

 

 

 

 

 

 

 

 

 

in/out of

 

 

 

Ending

 

the Reporting

 

 

 

Balance

 

Earnings

 

Income

 

Earnings

 

Income

 

Purchases

 

Sales

 

Issuances

 

Settlements

 

Level 3

 

Other

 

Balance

 

Date

 

 

 

(Dollars In Thousands)

 

Assets:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Fixed maturity securities available-for-sale

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Residential mortgage-backed securities

 

$

14,062

 

$

 

$

1,310

 

$

 

$

 

$

 

$

(12

)

$

 

$

 

$

(15,333

)

$

11

 

$

38

 

$

 

Commercial mortgage-backed securities

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Other asset-backed securities

 

576,396

 

 

52

 

 

(26,969

)

11,769

 

(12,085

)

 

 

 

(392

)

548,771

 

 

U.S. government-related securities

 

 

 

 

 

 

 

 

 

 

 

 

 

 

States, municipals, and political subdivisions

 

4,330

 

 

 

 

 

 

 

 

 

 

 

4,330

 

 

Other government-related securities

 

20,000

 

 

1

 

 

 

 

(20,000

)

 

 

 

(1

)

 

 

Corporate bonds

 

194,895

 

 

1,662

 

 

(3,513

)

11,002

 

(13,558

)

 

 

(3,385

)

385

 

187,488

 

 

Total fixed maturity securities - available-for-sale

 

809,683

 

 

3,025

 

 

(30,482

)

22,771

 

(45,655

)

 

 

(18,718

)

3

 

740,627

 

 

Fixed maturity securities - trading

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Residential mortgage-backed securities

 

1,582

 

 

 

(1

)

 

 

(72

)

 

 

(1,494

)

(15

)

 

 

Commercial mortgage-backed securities

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Other asset-backed securities

 

168,851

 

3,167

 

 

(1,080

)

 

16,394

 

(16,568

)

 

 

 

203

 

170,967

 

1,596

 

U.S. government-related securities

 

 

 

 

 

 

 

 

 

 

 

 

 

 

States, municipals and political subdivisions

 

3,500

 

 

 

(123

)

 

 

 

 

 

(3,377

)

 

 

 

Other government-related securities

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Corporate bonds

 

5,092

 

 

 

(4

)

 

 

 

 

 

 

4

 

5,092

 

(4

)

Total fixed maturity securities - trading

 

179,025

 

3,167

 

 

(1,208

)

 

16,394

 

(16,640

)

 

 

(4,871

)

192

 

176,059

 

1,592

 

Total fixed maturity securities

 

988,708

 

3,167

 

3,025

 

(1,208

)

(30,482

)

39,165

 

(62,295

)

 

 

(23,589

)

195

 

916,686

 

1,592

 

Equity securities

 

69,418

 

 

 

 

 

 

 

 

 

 

 

69,418

 

 

Other long-term investments(1)

 

100,072

 

53,791

 

 

(300

)

 

 

 

 

 

 

 

153,563

 

53,491

 

Short-term investments

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total investments

 

1,158,198

 

56,958

 

3,025

 

(1,508

)

(30,482

)

39,165

 

(62,295

)

 

 

(23,589

)

195

 

1,139,667

 

55,083

 

Total assets measured at fair value on a recurring basis

 

$

1,158,198

 

$

56,958

 

$

3,025

 

$

(1,508

)

$

(30,482

)

$

39,165

 

$

(62,295

)

$

 

$

 

$

(23,589

)

$

195

 

$

1,139,667

 

$

55,083

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Liabilities:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Annuity account balances(2)

 

$

114,614

 

$

 

$

 

$

(2,472

)

$

 

$

 

$

 

$

46

 

$

6,542

 

$

 

$

 

$

110,590

 

$

 

Other liabilities(1)

 

335,581

 

72,905

 

 

(23,854

)

 

 

 

 

 

 

 

286,530

 

49,051

 

Total liabilities measured at fair value on a recurring basis

 

$

450,195

 

$

72,905

 

$

 

$

(26,326

)

$

 

$

 

$

 

$

46

 

$

6,542

 

$

 

$

 

$

397,120

 

$

49,051

 

 


(1)Represents certain freestanding and embedded derivatives.

(2)Represents liabilities related to fixed indexed annuities.

 

For the three months ended September 30, 2013, $1.3 million of securities were transferred into Level 3. This amount was transferred from Level 2. These transfers resulted from securities that were priced by independent pricing services or brokers in previous periods, using no significant unobservable inputs, but were priced internally using significant unobservable inputs where market observable inputs were no longer available as of September 31, 2013.

 

For the three months ended September 30, 2013, there were $24.9 million of securities transferred out of Level 3. This amount was transferred into Level 2. These transfers resulted from securities that were priced using significant unobservable inputs in previous periods, but are now priced by independent pricing services or brokers, using no significant unobservable inputs as of September 30, 2013.

 

For the three months ended September 30, 2013, there were no transfers from Level 2 to Level 1.

 

For the three months ended September 30, 2013, there were no transfers from Level 1.

 

52



Table of Contents

 

The following table presents a reconciliation of the beginning and ending balances for fair value measurements for the nine months ended September 30, 2014, for which the Company has used significant unobservable inputs (Level 3):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Gains (losses)

 

 

 

 

 

Total

 

Total

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

included in

 

 

 

 

 

Realized and Unrealized

 

Realized and Unrealized

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Earnings

 

 

 

 

 

Gains

 

Losses

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

related to

 

 

 

 

 

 

 

Included in

 

 

 

Included in

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Instruments

 

 

 

 

 

 

 

Other

 

 

 

Other

 

 

 

 

 

 

 

 

 

Transfers

 

 

 

 

 

still held at

 

 

 

Beginning

 

Included in

 

Comprehensive

 

Included in

 

Comprehensive

 

 

 

 

 

 

 

 

 

in/out of

 

 

 

Ending

 

the Reporting

 

 

 

Balance

 

Earnings

 

Income

 

Earnings

 

Income

 

Purchases

 

Sales

 

Issuances

 

Settlements

 

Level 3

 

Other

 

Balance

 

Date

 

 

 

(Dollars In Thousands)

 

Assets:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Fixed maturity securities available-for-sale

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Residential mortgage-backed securities

 

$

28

 

$

 

$

 

$

 

$

(1

)

$

 

$

(23

)

$

 

$

 

$

 

$

1

 

$

5

 

$

 

Commercial mortgage-backed securities

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Other asset-backed securities

 

545,808

 

 

36,227

 

(71

)

(5,532

)

 

(9,934

)

 

 

 

(1,130

)

565,368

 

 

U.S. government-related securities

 

 

 

 

 

 

 

 

 

 

 

 

 

 

States, municipals, and political subdivisions

 

3,675

 

 

 

 

 

 

 

 

 

 

 

3,675

 

 

Other government-related securities

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Corporate bonds

 

1,549,940

 

1,170

 

62,723

 

 

(16,717

)

102,029

 

(162,391

)

 

 

(151,858

)

(7,090

)

1,377,806

 

 

Total fixed maturity securities - available-for-sale

 

2,099,451

 

1,170

 

98,950

 

(71

)

(22,250

)

102,029

 

(172,348

)

 

 

(151,858

)

(8,219

)

1,946,854

 

 

Fixed maturity securities - trading

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Residential mortgage-backed securities

 

 

11

 

 

 

 

842

 

 

 

 

(853

)

 

 

 

Commercial mortgage-backed securities

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Other asset-backed securities

 

194,977

 

8,685

 

 

(3,951

)

 

 

(29,832

)

 

 

 

797

 

170,676

 

1,959

 

U.S. government-related securities

 

 

 

 

 

 

 

 

 

 

 

 

 

 

States, municipals and political subdivisions

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Other government-related securities

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Corporate bonds

 

29,199

 

1,060

 

 

(729

)

 

4,059

 

(10,693

)

 

 

4

 

277

 

23,177

 

(1

)

Total fixed maturity securities - trading

 

224,176

 

9,756

 

 

(4,680

)

 

4,901

 

(40,525

)

 

 

(849

)

1,074

 

193,853

 

1,958

 

Total fixed maturity securities

 

2,323,627

 

10,926

 

98,950

 

(4,751

)

(22,250

)

106,930

 

(212,873

)

 

 

(152,707

)

(7,145

)

2,140,707

 

1,958

 

Equity securities

 

71,881

 

1,298

 

3,653

 

 

(257

)

9,551

 

(2,416

)

 

 

(10,651

)

(1

)

73,058

 

 

Other long-term investments(1)

 

196,133

 

478

 

 

(91,194

)

 

 

 

 

 

 

 

105,417

 

(90,716

)

Short-term investments

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total investments

 

2,591,641

 

12,702

 

102,603

 

(95,945

)

(22,507

)

116,481

 

(215,289

)

 

 

(163,358

)

(7,146

)

2,319,182

 

(88,758

)

Total assets measured at fair value on a recurring basis

 

$

2,591,641

 

$

12,702

 

$

102,603

 

$

(95,945

)

$

(22,507

)

$

116,481

 

$

(215,289

)

$

 

$

 

$

(163,358

)

$

(7,146

)

$

2,319,182

 

$

(88,758

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Liabilities:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Annuity account balances(2)

 

$

107,000

 

$

 

$

 

$

(2,261

)

$

 

$

 

$

 

$

300

 

$

11,432

 

$

 

$

 

$

98,129

 

$

 

Other liabilities(1)

 

270,630

 

22,342

 

 

(285,458

)

 

 

 

 

 

 

 

533,746

 

(263,116

)

Total liabilities measured at fair value on a recurring basis

 

$

377,630

 

$

22,342

 

$

 

$

(287,719

)

$

 

$

 

$

 

$

300

 

$

11,432

 

$

 

$

 

$

631,875

 

$

(263,116

)

 


(1)Represents certain freestanding and embedded derivatives.

(2)Represents liabilities related to fixed indexed annuities.

 

For the nine months ended September 30, 2014, $31.0 million of securities were transferred into Level 3. This amount was transferred from Level 2. These transfers resulted from securities that were priced by independent pricing services or brokers in previous periods, using no significant unobservable inputs, but were priced internally using significant unobservable inputs where market observable inputs were no longer available as of September 30, 2014. All transfers are recognized as of the end of the period.

 

For the nine months ended September 30, 2014, there were $194.4 million of securities transferred into Level 2. This amount was transferred from Level 3. These transfers resulted from securities that were previously priced using significant unobservable inputs, now priced by independent pricing services or brokers.

 

For the nine months ended September 30, 2014, there were no transfers from Level 2 to Level 1.

 

For the nine months ended September 30, 2014, there were no transfers out of Level 1.

 

53



Table of Contents

 

The following table presents a reconciliation of the beginning and ending balances for fair value measurements for the nine months ended September 30, 2013, for which the Company has used significant unobservable inputs (Level 3):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Gains (losses)

 

 

 

 

 

Total

 

Total

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

included in

 

 

 

 

 

Realized and Unrealized

 

Realized and Unrealized

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Earnings

 

 

 

 

 

Gains

 

Losses

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

related to

 

 

 

 

 

 

 

Included in

 

 

 

Included in

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Instruments

 

 

 

 

 

 

 

Other

 

 

 

Other

 

 

 

 

 

 

 

 

 

Transfers

 

 

 

 

 

still held at

 

 

 

Beginning

 

Included in

 

Comprehensive

 

Included in

 

Comprehensive

 

 

 

 

 

 

 

 

 

in/out of

 

 

 

Ending

 

the Reporting

 

 

 

Balance

 

Earnings

 

Income

 

Earnings

 

Income

 

Purchases

 

Sales

 

Issuances

 

Settlements

 

Level 3

 

Other

 

Balance

 

Date

 

 

 

(Dollars In Thousands)

 

Assets:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Fixed maturity securities available-for-sale

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Residential mortgage-backed securities

 

$

4

 

$

 

$

1,310

 

$

 

$

(337

)

$

14,349

 

$

(12

)

$

 

$

 

$

(15,287

)

$

11

 

$

38

 

$

 

Commercial mortgage-backed securities

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Other asset-backed securities

 

596,143

 

 

43,808

 

 

(54,517

)

24,931

 

(62,471

)

 

 

1,227

 

(350

)

548,771

 

 

U.S. government-related securities

 

 

 

 

 

 

 

 

 

 

 

 

 

 

States, municipals, and political subdivisions

 

4,335

 

 

 

 

 

 

(5

)

 

 

 

 

4,330

 

 

Other government-related securities

 

20,011

 

 

2

 

 

(3

)

 

(20,000

)

 

 

 

(10

)

 

 

Corporate bonds

 

167,892

 

116

 

2,673

 

 

(13,559

)

29,277

 

(58,742

)

 

 

58,945

 

886

 

187,488

 

 

Total fixed maturity securities - available-for-sale

 

788,385

 

116

 

47,793

 

 

(68,416

)

68,557

 

(141,230

)

 

 

44,885

 

537

 

740,627

 

 

Fixed maturity securities - trading

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Residential mortgage-backed securities

 

 

 

 

(1

)

 

1,582

 

(72

)

 

 

(1,494

)

(15

)

 

 

Commercial mortgage-backed securities

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Other asset-backed securities

 

70,535

 

7,964

 

 

(3,949

)

 

122,224

 

(29,344

)

 

 

2,210

 

1,327

 

170,967

 

4,814

 

U.S. government-related securities

 

 

 

 

 

 

 

 

 

 

 

 

 

 

States, municipals and political subdivisions

 

 

 

 

(123

)

 

3,500

 

 

 

 

(3,377

)

 

 

 

Other government-related securities

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Corporate bonds

 

115

 

1

 

 

(27

)

 

 

(17

)

 

 

5,013

 

7

 

5,092

 

(4

)

Total fixed maturity securities - trading

 

70,650

 

7,965

 

 

(4,100

)

 

127,306

 

(29,433

)

 

 

2,352

 

1,319

 

176,059

 

4,810

 

Total fixed maturity securities

 

859,035

 

8,081

 

47,793

 

(4,100

)

(68,416

)

195,863

 

(170,663

)

 

 

47,237

 

1,856

 

916,686

 

4,810

 

Equity securities

 

69,418

 

 

 

 

 

 

 

 

 

 

 

69,418

 

 

Other long-term investments(1)

 

31,591

 

122,643

 

 

(671

)

 

 

 

 

 

 

 

153,563

 

121,972

 

Short-term investments

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total investments

 

960,044

 

130,724

 

47,793

 

(4,771

)

(68,416

)

195,863

 

(170,663

)

 

 

47,237

 

1,856

 

1,139,667

 

126,782

 

Total assets measured at fair value on a recurring basis

 

$

960,044

 

$

130,724

 

$

47,793

 

$

(4,771

)

$

(68,416

)

$

195,863

 

$

(170,663

)

$

 

$

 

$

47,237

 

$

1,856

 

$

1,139,667

 

$

126,782

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Liabilities:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Annuity account balances(2)

 

$

129,468

 

$

 

$

 

$

(6,159

)

$

 

$

 

$

 

$

247

 

$

25,284

 

$

 

$

 

$

110,590

 

$

 

Other liabilities(1)

 

611,437

 

377,398

 

 

(52,491

)

 

 

 

 

 

 

 

286,530

 

(324,907

)

Total liabilities measured at fair value on a recurring basis

 

$

740,905

 

$

377,398

 

$

 

$

(58,650

)

$

 

$

 

$

 

$

247

 

$

25,284

 

$

 

$

 

$

397,120

 

$

(324,907

)

 


(1)Represents certain freestanding and embedded derivatives.

(2)Represents liabilities related to fixed indexed annuities.

 

For the nine months ended September 30, 2013, $72.1 million of securities were transferred into Level 3. This amount was transferred from Level 2. These transfers resulted from securities that were priced by independent pricing services or brokers in previous periods, using no significant unobservable inputs, but were priced internally using significant unobservable inputs where market observable inputs were no longer available as of September 30, 2013. All transfers are recognized as of the end of the period.

 

For the nine months ended September 30, 2013, there were $24.9 million of securities transferred out of Level 3. This amount was transferred to Level 2. These transfers resulted from securities that were priced using significant unobservable inputs in previous periods, but are now priced by independent pricing services or brokers, using no significant unobservable inputs as of September 30, 2013.

 

For the nine months ended September 30, 2013, there were no transfers from Level 2 to Level 1.

 

For the nine months ended September 30, 2013, there were no transfers out of Level 1.

 

54



Table of Contents

 

Total realized and unrealized gains (losses) on Level 3 assets and liabilities are primarily reported in either realized investment gains (losses) within the consolidated statements of income (loss) or other comprehensive income (loss) within shareowners’ equity based on the appropriate accounting treatment for the item.

 

Purchases, sales, issuances, and settlements, net, represent the activity that occurred during the period that results in a change of the asset or liability but does not represent changes in fair value for the instruments held at the beginning of the period. Such activity primarily relates to purchases and sales of fixed maturity securities and issuances and settlements of fixed indexed annuities.

 

The Company reviews the fair value hierarchy classifications each reporting period. Changes in the observability of the valuation attributes may result in a reclassification of certain financial assets or liabilities. Such reclassifications are reported as transfers in and out of Level 3 at the beginning fair value for the reporting period in which the changes occur.

 

The amount of total gains (losses) for assets and liabilities still held as of the reporting date primarily represents changes in fair value of trading securities and certain derivatives that exist as of the reporting date and the change in fair value of fixed indexed annuities.

 

Estimated Fair Value of Financial Instruments

 

The carrying amounts and estimated fair values of the Company’s financial instruments as of the periods shown below are as follows:

 

 

 

 

 

As of

 

 

 

 

 

September 30, 2014

 

December 31, 2013

 

 

 

Fair Value

 

Carrying

 

 

 

Carrying

 

 

 

 

 

Level

 

Amounts

 

Fair Values

 

Amounts

 

Fair Values

 

 

 

 

 

(Dollars In Thousands)

 

Assets:

 

 

 

 

 

 

 

 

 

 

 

Mortgage loans on real estate

 

3

 

$

5,232,463

 

$

5,727,368

 

$

5,493,492

 

$

5,956,133

 

Policy loans

 

3

 

1,767,228

 

1,767,228

 

1,815,744

 

1,815,744

 

Fixed maturities, held-to-maturity(1)

 

3

 

415,000

 

453,741

 

365,000

 

335,676

 

 

 

 

 

 

 

 

 

 

 

 

 

Liabilities:

 

 

 

 

 

 

 

 

 

 

 

Stable value product account balances

 

3

 

$

2,261,546

 

$

2,278,155

 

$

2,559,552

 

$

2,566,209

 

Annuity account balances

 

3

 

11,083,763

 

10,667,467

 

11,125,253

 

10,639,637

 

 

 

 

 

 

 

 

 

 

 

 

 

Debt:

 

 

 

 

 

 

 

 

 

 

 

Bank borrowings

 

3

 

$

280,000

 

$

280,000

 

$

485,000

 

$

485,000

 

Senior Notes

 

2

 

1,100,000

 

1,356,020

 

1,100,000

 

1,294,675

 

Subordinated debt securities

 

2

 

540,593

 

548,783

 

540,593

 

473,503

 

Non-recourse funding obligations(2)

 

3

 

594,066

 

575,532

 

562,448

 

470,709

 

 

Except as noted below, fair values were estimated using quoted market prices.

 


(1)         Security purchased from unconsolidated subsidiary, Red Mountain LLC.

(2)         Of this carrying amount, $415.0 million, fair value of $431.1 million, as of September 30, 2014, and $365.0 million, fair value of $321.5 million as of December 31, 2013, relates to non-recourse funding obligations issued by Golden Gate V.

 

Fair Value Measurements

 

Mortgage loans on real estate

 

The Company estimates the fair value of mortgage loans using an internally developed model. This model includes inputs derived by the Company based on assumed discount rates relative to the Company’s current mortgage

 

55



Table of Contents

 

loan lending rate and an expected cash flow analysis based on a review of the mortgage loan terms. The model also contains the Company’s determined representative risk adjustment assumptions related to credit and liquidity risks.

 

Policy loans

 

The Company believes the fair value of policy loans approximates book value. Policy loans are funds provided to policy holders in return for a claim on the policy. The funds provided are limited to the cash surrender value of the underlying policy. The nature of policy loans is to have a negligible default risk as the loans are fully collateralized by the value of the policy. Policy loans do not have a stated maturity and the balances and accrued interest are repaid either by the policyholder or with proceeds from the policy. Due to the collateralized nature of policy loans and unpredictable timing of repayments, the Company believes the fair value of policy loans approximates carrying value.

 

Fixed maturities, held-to-maturity

 

The Company estimates the fair value of its fixed maturity, held-to-maturity securities using internal discounted cash flow models. The discount rates used in the model were based on a current market yield for similar financial instruments.

 

Stable value product and Annuity account balances

 

The Company estimates the fair value of stable value product account balances and annuity account balances using models based on discounted expected cash flows. The discount rates used in the models were based on a current market rate for similar financial instruments.

 

Debt

 

Bank borrowings

 

The Company believes the carrying value of its bank borrowings approximates fair value as the borrowings pay a floating interest rate plus a spread based on the rating of the Company’s senior debt which the Company believes approximates a market interest rate.

 

Non-recourse funding obligations

 

The Company estimates the fair value of its non-recourse funding obligations using internal discounted cash flow models. The discount rates used in the model were based on a current market yield for similar financial instruments.

 

17.                               DERIVATIVE FINANCIAL INSTRUMENTS

 

Types of Derivative Instruments and Derivative Strategies

 

The Company utilizes a risk management strategy that incorporates the use of derivative financial instruments to reduce exposure to certain risks, including but not limited to, interest rate risk, inflation risk, currency exchange risk, volatility risk, and equity market risk. These strategies are developed through the Company’s analysis of data from financial simulation models and other internal and industry sources, and are then incorporated into the Company’s risk management program.

 

Derivative instruments expose the Company to credit and market risk and could result in material changes from period to period. The Company attempts to minimize its credit risk by entering into transactions with highly rated counterparties. The Company manages the market risk by establishing and monitoring limits as to the types and degrees of risk that may be undertaken. The Company monitors its use of derivatives in connection with its overall asset/liability management programs and risk management strategies. In addition, all derivative programs are monitored by our risk management department.

 

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Table of Contents

 

Derivatives Related to Interest Rate Risk Management

 

Derivative instruments that are used as part of the Company’s interest rate risk management strategy include interest rate swaps, interest rate futures, interest rate caps, and interest rate swaptions. The Company’s inflation risk management strategy involves the use of swaps that requires the Company to pay a fixed rate and receive a floating rate that is based on changes in the Consumer Price Index (“CPI”).

 

Derivatives Related to Risk Mitigation of Variable Annuity Contracts

 

The Company may use the following types of derivative contracts to mitigate its exposure to certain guaranteed benefits related to variable annuity contracts and fixed indexed annuities:

 

·                  Foreign Currency Futures

·                  Variance Swaps

·                  Interest Rate Futures

·                  Equity Options

·                  Equity Futures

·                  Credit Derivatives

·                  Interest Rate Swaps

·                  Interest Rate Swaptions

·                  Volatility Futures

·                  Volatility Options

·                  Total Return Swaps

 

Accounting for Derivative Instruments

 

The Company records its derivative financial instruments in the consolidated condensed balance sheet in “other long-term investments” and “other liabilities” in accordance with GAAP, which requires that all derivative instruments be recognized in the balance sheet at fair value. The change in the fair value of derivative financial instruments is reported either in the statement of income or in other comprehensive income (loss), depending upon whether it qualified for and also has been properly identified as being part of a hedging relationship, and also on the type of hedging relationship that exists.

 

For a derivative financial instrument to be accounted for as an accounting hedge, it must be identified and documented as such on the date of designation. For cash flow hedges, the effective portion of their realized gain or loss is reported as a component of other comprehensive income and reclassified into earnings in the same period during which the hedged item impacts earnings. Any remaining gain or loss, the ineffective portion, is recognized in current earnings. For fair value hedge derivatives, their gain or loss, as well as the offsetting loss or gain attributable to the hedged risk of the hedged item is recognized in current earnings. Effectiveness of the Company’s hedge relationships is assessed on a quarterly basis.

 

The Company reports changes in fair values of derivatives that are not part of a qualifying hedge relationship through earnings in the period of change. Changes in the fair value of derivatives that are recognized in current earnings are reported in “Realized investment gains (losses) - Derivative financial instruments”.

 

Derivative Instruments Designated and Qualifying as Hedging Instruments

 

Cash-Flow Hedges

 

·                  In connection with the issuance of inflation-adjusted funding agreements, the Company has entered into swaps to convert the floating CPI-linked interest rate on these agreements to a fixed rate. The Company pays a fixed rate on the swap and receives a floating rate primarily determined by the period’s change in the CPI. The amounts that are received on the swaps are equal to the amounts that are paid on the agreements.

 

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Table of Contents

 

Derivative Instruments Not Designated and Not Qualifying as Hedging Instruments

 

The Company uses various other derivative instruments for risk management purposes that do not qualify for hedge accounting treatment. Changes in the fair value of these derivatives are recognized in earnings during the period of change.

 

Derivatives Related to Variable Annuity Contracts

 

·                  The Company uses equity, interest rate, currency, and volatility futures to mitigate the risk related to certain guaranteed minimum benefits, including GMWB, within its VA products. In general, the cost of such benefits varies with the level of equity and interest rate markets, foreign currency levels, and overall volatility. No volatility future positions were held as of September 30, 2014.

 

·                  The Company uses equity options, variance swaps, and volatility options to mitigate the risk related to certain guaranteed minimum benefits, including GMWB, within its VA products. In general, the cost of such benefits varies with the level of equity markets and overall volatility. No volatility option positions were held as of September 30, 2014.

 

·                  The Company uses interest rate swaps and interest rate swaptions to mitigate the risk related to certain guaranteed minimum benefits, including GMWB, within its VA products.

 

·                  The Company markets certain VA products with a GMWB rider. The GMWB component is considered an embedded derivative, not considered to be clearly and closely related to the host contract.

 

Derivatives Related to Fixed Annuity Contracts

 

·                  The Company uses equity and volatility futures to mitigate the risk within its fixed indexed annuity products. In general, the cost of such benefits varies with the level of equity and overall volatility.

 

·                  The Company used equity options to mitigate the risk within its fixed indexed annuity products. In general, the cost of such benefits varies with the level of equity markets.

 

·                  The Company markets certain fixed indexed annuity products. The FIA component is considered an embedded derivative, not considered to be clearly and closely related to the host contract.

 

Other Derivatives

 

·                  The Company uses certain interest rate swaps to mitigate the price volatility of fixed maturities. None of these positions were held as of September 30, 2014.

 

·                  The Company purchased interest rate caps to mitigate its risk with respect to the Company’s LIBOR exposure and the potential impact of European financial market distress. None of these positions were held as of September 30, 2014.

 

·                  The Company uses various swaps and other types of derivatives to manage risk related to other exposures.

 

·                  The Company markets certain IUL products. The IUL component is considered an embedded derivative, not considered to be clearly and closely related to the host contract.

 

·                  The Company is involved in various modified coinsurance and funds withheld arrangements which contain embedded derivatives. Changes in their fair value are recorded in current period earnings. The investment portfolios that support the related modified coinsurance reserves and funds withheld arrangements had fair value changes which substantially offset the gains or losses on these embedded derivatives.

 

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Table of Contents

 

The following table sets forth realized investments gains and losses for the periods shown:

 

Realized investment gains (losses) - derivative financial instruments

 

 

 

For The

 

For The

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

 

2014

 

2013

 

2014

 

2013

 

 

 

(Dollars In Thousands)

 

Derivatives related to variable annuity contracts:

 

 

 

 

 

 

 

 

 

Interest rate futures - VA

 

$

1,979

 

$

(2,255

)

$

12,777

 

$

(26,393

)

Equity futures - VA

 

861

 

(12,568

)

(9,049

)

(39,829

)

Currency futures - VA

 

10,185

 

(6,531

)

6,020

 

1,440

 

Variance swaps - VA

 

1,570

 

(1,347

)

(1,103

)

(9,566

)

Equity options - VA

 

2,050

 

(29,094

)

(31,240

)

(65,631

)

Interest rate swaptions - VA

 

(2,812

)

1,725

 

(17,213

)

(738

)

Interest rate swaps - VA

 

22,011

 

(19,224

)

124,548

 

(125,502

)

Embedded derivative - GMWB

 

(51,429

)

80,541

 

(181,105

)

264,231

 

Total derivatives related to variable annuity contracts

 

(15,585

)

11,247

 

(96,365

)

(1,988

)

Derivatives related to FIA contracts:

 

 

 

 

 

 

 

 

 

Embedded derivative - FIA

 

(2,462

)

(104

)

(9,036

)

(145

)

Equity futures - FIA

 

117

 

(42

)

1,067

 

(42

)

Volatility futures - FIA

 

(4

)

 

4

 

 

Equity options - FIA

 

1,099

 

104

 

5,077

 

85

 

Total derivatives related to FIA contracts

 

(1,250

)

(42

)

(2,888

)

(102

)

Derivatives related to IUL contracts:

 

 

 

 

 

 

 

 

 

Embedded derivative - IUL

 

347

 

 

62

 

 

Equity futures - IUL

 

16

 

 

16

 

 

Equity options - IUL

 

(24

)

 

(24

)

 

Total derivatives related to IUL contracts

 

339

 

 

54

 

 

Embedded derivative - Modco reinsurance treaties

 

20,426

 

30,074

 

(91,945

)

191,847

 

Interest rate swaps

 

 

72

 

 

2,984

 

Other derivatives

 

(149

)

(25

)

(351

)

(149

)

Total realized gains (losses) - derivatives

 

$

3,781

 

$

41,326

 

$

(191,495

)

$

192,592

 

 

The following table sets forth realized investments gains and losses for Modco trading portfolio that is included in realized investment gains (losses) — all other investments:

 

Realized investment gains (losses) - all other investments

 

 

 

For The

 

For The

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

 

2014

 

2013

 

2014

 

2013

 

 

 

(Dollars In Thousands)

 

Modco trading portfolio(1)

 

$

(17,225

)

$

(25,960

)

$

110,067

 

$

(167,982

)

 


(1)The Company elected to include the use of alternate disclosures for trading activities.

 

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Table of Contents

 

The following tables present the components of the gain or loss on derivatives that qualify as a cash flow hedging relationship:

 

Gain (Loss) on Derivatives in Cash Flow Relationship

 

 

 

 

 

Amount and Location of

 

 

 

 

 

Amount of Gains (Losses)

 

Gains (Losses)

 

 

 

 

 

Deferred in

 

Reclassified from

 

Amount and Location of

 

 

 

Accumulated Other

 

Accumulated Other

 

(Losses) Recognized in

 

 

 

Comprehensive Income

 

Comprehensive Income

 

Income (Loss) on

 

 

 

(Loss) on Derivatives

 

(Loss) into Income (Loss)

 

Derivatives

 

 

 

(Effective Portion)

 

(Effective Portion)

 

(Ineffective Portion)

 

 

 

 

 

Benefits and settlement

 

Realized investment

 

 

 

 

 

expenses

 

gains (losses)

 

 

 

(Dollars In Thousands)

 

For The Three Months Ended September 30, 2014

 

 

 

 

 

 

 

Inflation

 

$

(64

)

$

(293

)

$

(79

)

Total

 

$

(64

)

$

(293

)

$

(79

)

 

 

 

 

 

 

 

 

For The Nine Months Ended September 30, 2014

 

 

 

 

 

 

 

Inflation

 

$

(90

)

$

(1,577

)

$

(205

)

Total

 

$

(90

)

$

(1,577

)

$

(205

)

 

Gain (Loss) on Derivatives in Cash Flow Relationship

 

 

 

 

 

Amount and Location of

 

 

 

 

 

Amount of Gains (Losses)

 

Gains (Losses)

 

 

 

 

 

Deferred in

 

Reclassified from

 

Amount and Location of

 

 

 

Accumulated Other

 

Accumulated Other

 

(Losses) Recognized in

 

 

 

Comprehensive Income

 

Comprehensive Income

 

Income (Loss) on

 

 

 

(Loss) on Derivatives

 

(Loss) into Income (Loss)

 

Derivatives

 

 

 

(Effective Portion)

 

(Effective Portion)

 

(Ineffective Portion)

 

 

 

 

 

Benefits and settlement

 

Realized investment

 

 

 

 

 

expenses

 

gains (losses)

 

 

 

(Dollars In Thousands)

 

For The Three Months Ended September 30, 2013

 

 

 

 

 

 

 

Inflation

 

$

22

 

$

(572

)

$

(62

)

Total

 

$

22

 

$

(572

)

$

(62

)

 

 

 

 

 

 

 

 

For The Nine Months Ended September 30, 2013

 

 

 

 

 

 

 

Inflation

 

$

(157

)

$

(1,649

)

$

(253

)

Total

 

$

(157

)

$

(1,649

)

$

(253

)

 

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Table of Contents

 

The tables below present information about the nature and accounting treatment of the Company’s primary derivative financial instruments and the location in and effect on the consolidated condensed financial statements for the periods presented below:

 

 

 

As of September 30, 2014

 

As of December 31, 2013

 

 

 

Notional

 

Fair

 

Notional

 

Fair

 

 

 

Amount

 

Value

 

Amount

 

Value

 

 

 

(Dollars In Thousands)

 

Other long-term investments

 

 

 

 

 

 

 

 

 

Derivatives not designated as hedging instruments:

 

 

 

 

 

 

 

 

 

Interest rate swaps

 

$

345,000

 

$

6,426

 

$

200,000

 

$

1,961

 

Embedded derivative - Modco reinsurance treaties

 

65,241

 

1,381

 

80,376

 

1,517

 

Embedded derivative - GMWB

 

4,637,095

 

104,036

 

6,113,017

 

194,616

 

Equity futures

 

291,062

 

5,451

 

3,387

 

111

 

Currency futures

 

87,061

 

1,963

 

14,338

 

321

 

Equity options

 

2,212,459

 

144,029

 

1,376,205

 

78,277

 

Interest rate swaptions

 

625,000

 

13,078

 

625,000

 

30,291

 

Other

 

592

 

330

 

425

 

473

 

 

 

$

8,263,510

 

$

276,694

 

$

8,412,748

 

$

307,567

 

Other liabilities

 

 

 

 

 

 

 

 

 

Cash flow hedges:

 

 

 

 

 

 

 

 

 

Inflation

 

$

105,786

 

$

433

 

$

182,965

 

$

1,865

 

Derivatives not designated as hedging instruments:

 

 

 

 

 

 

 

 

 

Interest rate swaps

 

1,130,000

 

43,470

 

1,230,000

 

153,322

 

Variance swaps

 

1,000

 

2,252

 

1,500

 

1,744

 

Embedded derivative - Modco reinsurance treaties

 

2,539,004

 

298,728

 

2,578,590

 

206,918

 

Embedded derivative - GMWB

 

5,109,066

 

128,912

 

2,494,142

 

38,388

 

Embedded derivative - FIA

 

689,543

 

103,497

 

244,424

 

25,324

 

Embedded derivative - IUL

 

5,232

 

2,609

 

 

 

Interest rate futures

 

337,015

 

1,949

 

322,902

 

5,221

 

Equity futures

 

57,615

 

604

 

164,595

 

6,595

 

Currency futures

 

81,945

 

124

 

118,008

 

840

 

Equity options

 

587,303

 

36,811

 

257,065

 

17,558

 

Other

 

358

 

22

 

230

 

27

 

 

 

$

10,643,867

 

$

619,411

 

$

7,594,421

 

$

457,802

 

 

Based on the expected cash flows of the underlying hedged items, the Company expects to reclassify $0.3 million out of accumulated other comprehensive income (loss) into earnings during the next twelve months.

 

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Table of Contents

 

18.                     OFFSETTING OF ASSETS AND LIABILITIES

 

Certain of the Company’s derivative instruments are subject to enforceable master netting arrangements that provide for the net settlement of all derivative contracts between the Company and a counterparty in the event of default or upon the occurrence of certain termination events. Collateral support agreements associated with each master netting arrangement provide that the Company will receive or pledge financial collateral in the event either minimum thresholds, or in certain cases ratings levels, have been reached. Additionally, certain of the Company’s repurchase agreements provide for net settlement on termination of the agreement. Refer to Note 9, Debt and Other Obligations for details of the Company’s repurchase agreement programs.

 

The tables below present the derivative instruments by assets and liabilities for the Company as of September 30, 2014:

 

 

 

 

 

 

 

Net Amounts

 

 

 

 

 

 

 

 

 

 

 

Gross

 

of Assets

 

Gross Amounts Not Offset

 

 

 

 

 

 

 

Amounts

 

Presented in

 

in the Statement of

 

 

 

 

 

Gross

 

Offset in the

 

the

 

Financial Position

 

 

 

 

 

Amounts of

 

Statement of

 

Statement of

 

 

 

Cash

 

 

 

 

 

Recognized

 

Financial 

 

Financial

 

Financial

 

Collateral

 

 

 

 

 

Assets

 

Position

 

Position

 

Instruments

 

Received

 

Net Amount

 

 

 

(Dollars In Thousands)

 

Offsetting of Derivative Assets

 

 

 

 

 

 

 

 

 

 

 

 

 

Derivatives:

 

 

 

 

 

 

 

 

 

 

 

 

 

Free-Standing derivatives

 

$

170,970

 

$

 

$

170,970

 

$

58,156

 

$

34,311

 

$

78,503

 

Embedded derivative - Modco reinsurance treaties

 

1,381

 

 

1,381

 

 

 

1,381

 

Embedded derivative - GMWB

 

104,036

 

 

104,036

 

 

 

104,036

 

Total derivatives, subject to a master netting arrangement or similar arrangement

 

276,387

 

 

276,387

 

58,156

 

34,311

 

183,920

 

Total derivatives, not subject to a master netting arrangement or similar arrangement

 

307

 

 

307

 

 

 

307

 

Total derivatives

 

276,694

 

 

276,694

 

58,156

 

34,311

 

184,227

 

Total Assets

 

$

276,694

 

$

 

$

276,694

 

$

58,156

 

$

34,311

 

$

184,227

 

 

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Table of Contents

 

 

 

 

 

 

 

Net Amounts

 

 

 

 

 

 

 

 

 

 

 

Gross

 

of Liabilities

 

Gross Amounts Not Offset

 

 

 

 

 

 

 

Amounts

 

Presented in

 

in the Statement of

 

 

 

 

 

Gross

 

Offset in the

 

the

 

Financial Position

 

 

 

 

 

Amounts of

 

Statement of

 

Statement of

 

 

 

Cash

 

 

 

 

 

Recognized

 

Financial

 

Financial

 

Financial

 

Collateral

 

 

 

 

 

Liabilities

 

Position

 

Position

 

Instruments

 

Paid

 

Net Amount

 

 

 

(Dollars In Thousands)

 

Offsetting of Derivative Liabilities

 

 

 

 

 

 

 

 

 

 

 

 

 

Derivatives:

 

 

 

 

 

 

 

 

 

 

 

 

 

Free-Standing derivatives

 

$

85,665

 

$

 

$

85,665

 

$

58,156

 

$

25,961

 

$

1,548

 

Embedded derivative - Modco reinsurance treaties

 

298,728

 

 

298,728

 

 

 

298,728

 

Embedded derivative - GMWB

 

128,912

 

 

128,912

 

 

 

128,912

 

Embedded derivative - FIA

 

103,497

 

 

103,497

 

 

 

103,497

 

Embedded derivative - IUL

 

2,609

 

 

2,609

 

 

 

2,609

 

Total derivatives, subject to a master netting arrangement or similar arrangement

 

619,411

 

 

619,411

 

58,156

 

25,961

 

535,294

 

Total derivatives, not subject to a master netting arrangement or similar arrangement

 

 

 

 

 

 

 

Total derivatives

 

619,411

 

 

619,411

 

58,156

 

25,961

 

535,294

 

Repurchase agreements(1)

 

359,804

 

 

359,804

 

 

 

359,804

 

Total Liabilities

 

$

979,215

 

$

 

$

979,215

 

$

58,156

 

$

25,961

 

$

895,098

 

 


(1) Borrowings under repurchase agreements are for a term less than 90 days.

 

The tables below present the derivative instruments by assets and liabilities for the Company as of December 31, 2013:

 

 

 

 

 

 

 

Net Amounts

 

 

 

 

 

 

 

 

 

 

 

Gross

 

of Assets

 

Gross Amounts Not Offset

 

 

 

 

 

 

 

Amounts

 

Presented in

 

in the Statement of

 

 

 

 

 

Gross

 

Offset in the

 

the

 

Financial Position

 

 

 

 

 

Amounts of

 

Statement of

 

Statement of

 

 

 

Cash

 

 

 

 

 

Recognized

 

Financial

 

Financial

 

Financial

 

Collateral

 

 

 

 

 

Assets

 

Position

 

Position

 

Instruments

 

Received

 

Net Amount

 

 

 

(Dollars In Thousands)

 

Offsetting of Derivative Assets

 

 

 

 

 

 

 

 

 

 

 

 

 

Derivatives:

 

 

 

 

 

 

 

 

 

 

 

 

 

Free-Standing derivatives

 

$

110,983

 

$

 

$

110,983

 

$

52,487

 

$

10,700

 

$

47,796

 

Embedded derivative - Modco reinsurance treaties

 

1,517

 

 

1,517

 

 

 

1,517

 

Embedded derivative - GMWB

 

194,616

 

 

194,616

 

 

 

194,616

 

Total derivatives, subject to a master netting arrangement or similar arrangement

 

307,116

 

 

307,116

 

52,487

 

10,700

 

243,929

 

Total derivatives, not subject to a master netting arrangement or similar arrangement

 

451

 

 

451

 

 

 

451

 

Total derivatives

 

307,567

 

 

307,567

 

52,487

 

10,700

 

244,380

 

Total Assets

 

$

307,567

 

$

 

$

307,567

 

$

52,487

 

$

10,700

 

$

244,380

 

 

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Table of Contents

 

 

 

 

 

 

 

Net Amounts

 

 

 

 

 

 

 

 

 

 

 

Gross

 

of Liabilities

 

Gross Amounts Not Offset

 

 

 

 

 

 

 

Amounts

 

Presented in

 

in the Statement of

 

 

 

 

 

Gross

 

Offset in the

 

the

 

Financial Position

 

 

 

 

 

Amounts of

 

Statement of

 

Statement of

 

 

 

Cash

 

 

 

 

 

Recognized

 

Financial

 

Financial

 

Financial

 

Collateral

 

 

 

 

 

Liabilities

 

Position

 

Position

 

Instruments

 

Paid

 

Net Amount

 

 

 

(Dollars In Thousands)

 

Offsetting of Derivative Liabilities

 

 

 

 

 

 

 

 

 

 

 

 

 

Derivatives:

 

 

 

 

 

 

 

 

 

 

 

 

 

Free-Standing derivatives

 

$

187,172

 

$

 

$

187,172

 

$

52,487

 

$

98,359

 

$

36,326

 

Embedded derivative - Modco reinsurance treaties

 

206,918

 

 

206,918

 

 

 

206,918

 

Embedded derivative - GMWB

 

38,388

 

 

38,388

 

 

 

 

38,388

 

Embedded derivative - FIA

 

25,324

 

 

25,324

 

 

 

25,324

 

Total derivatives, subject to a master netting arrangement or similar arrangement

 

457,802

 

 

457,802

 

52,487

 

98,359

 

306,956

 

Total derivatives, not subject to a master netting arrangement or similar arrangement

 

 

 

 

 

 

 

Total derivatives

 

457,802

 

 

457,802

 

52,487

 

98,359

 

306,956

 

Repurchase agreements(1)

 

350,000

 

 

350,000

 

 

 

350,000

 

Total Liabilities

 

$

807,802

 

$

 

$

807,802

 

$

52,487

 

$

98,359

 

$

656,956

 

 


(1) Borrowings under repurchase agreements are for a term less than 90 days.

 

19.                               OPERATING SEGMENTS

 

The Company has several operating segments each having a strategic focus. An operating segment is distinguished by products, channels of distribution, and/or other strategic distinctions. The Company periodically evaluates its operating segments, as prescribed in the ASC Segment Reporting Topic, and makes adjustments to its segment reporting as needed. A brief description of each segment follows.

 

·                  The Life Marketing segment markets fixed universal life (“UL”), variable universal life (“VUL”), bank-owned life insurance (“BOLI”), and level premium term insurance (“traditional”) products on a national basis primarily through networks of independent insurance agents and brokers, broker-dealers, financial institutions, and independent marketing organizations.

 

·                  The Acquisitions segment focuses on acquiring, converting, and servicing policies from other companies. The segment’s primary focus is on life insurance policies and annuity products that were sold to individuals. The level of the segment’s acquisition activity is predicated upon many factors, including available capital, operating capacity, potential return on capital, and market dynamics. Policies acquired through the Acquisitions segment are typically blocks of business where no new policies are being marketed. Therefore earnings and account values are expected to decline as the result of lapses, deaths, and other terminations of coverage unless new acquisitions are made.

 

·                  The Annuities segment markets fixed and variable annuity products. These products are primarily sold through broker-dealers, financial institutions, and independent agents and brokers.

 

·                  The Stable Value Products segment sells fixed and floating rate funding agreements directly to the trustees of municipal bond proceeds, money market funds, bank trust departments, and other institutional investors. The segment also issues funding agreements to the FHLB, and markets guaranteed investment contracts (“GICs”) to 401(k) and other qualified retirement savings plans.  Additionally, the Company has contracts outstanding pursuant to a funding agreement-backed notes program registered with the United States Securities and Exchange Commission (the “SEC”) which offered notes to both institutional and retail investors.

 

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·                  The Asset Protection segment markets extended service contracts and credit life and disability insurance to protect consumers’ investments in automobiles, watercraft, and recreational vehicles. In addition, the segment markets a guaranteed asset protection (“GAP”) product. GAP coverage covers the difference between the loan pay-off amount and an asset’s actual cash value in the case of a total loss.

 

·                  The Corporate and Other segment primarily consists of net investment income not assigned to the segments above (including the impact of carrying liquidity), expenses not attributable to the segments above (including interest on certain corporate debt). This segment includes earnings from several non-strategic or runoff lines of business, various investment-related transactions, the operations of several small subsidiaries, and the repurchase of non-recourse funding obligations.

 

The Company uses the same accounting policies and procedures to measure segment operating income (loss) and assets as it uses to measure consolidated net income and assets. Segment operating income (loss) is income before income tax, excluding realized gains and losses on investments and derivatives net of the amortization related to deferred acquisition costs (“DAC”) value of business acquired (“VOBA”), and benefits and settlement expenses. Operating earnings exclude changes in the GMWB embedded derivatives (excluding the portion attributed to economic cost), realized and unrealized gains (losses) on derivatives used to hedge the VA product, actual GMWB incurred claims and the related amortization of DAC attributed to each of these items.

 

Segment operating income (loss) represents the basis on which the performance of the Company’s business is internally assessed by management. Premiums and policy fees, other income, benefits and settlement expenses, and amortization of DAC/VOBA are attributed directly to each operating segment. Net investment income is allocated based on directly related assets required for transacting the business of that segment. Realized investment gains (losses) and other operating expenses are allocated to the segments in a manner that most appropriately reflects the operations of that segment. Investments and other assets are allocated based on statutory policy liabilities net of associated statutory policy assets, while DAC/VOBA and goodwill are shown in the segments to which they are attributable.

 

There were no significant intersegment transactions during the three or nine months ended September 30, 2014 and 2013.

 

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The following tables summarize financial information for the Company’s segments:

 

 

 

For The

 

For The

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

 

2014

 

2013

 

2014

 

2013

 

 

 

(Dollars In Thousands)

 

Revenues

 

 

 

 

 

 

 

 

 

Life Marketing

 

$

400,706

 

$

377,416

 

$

1,192,504

 

$

1,092,063

 

Acquisitions

 

408,522

 

240,067

 

1,273,714

 

752,247

 

Annuities

 

182,239

 

196,305

 

482,313

 

547,259

 

Stable Value Products

 

38,713

 

25,208

 

93,641

 

91,596

 

Asset Protection

 

70,584

 

71,495

 

207,837

 

210,879

 

Corporate and Other

 

47,322

 

42,203

 

143,978

 

147,820

 

Total revenues

 

$

1,148,086

 

$

952,694

 

$

3,393,987

 

$

2,841,864

 

Segment Operating Income (Loss)

 

 

 

 

 

 

 

 

 

Life Marketing

 

$

32,820

 

$

29,218

 

$

82,654

 

$

77,598

 

Acquisitions

 

72,929

 

29,429

 

198,807

 

93,241

 

Annuities

 

49,335

 

50,866

 

156,236

 

130,646

 

Stable Value Products

 

19,506

 

19,206

 

54,190

 

59,514

 

Asset Protection

 

8,530

 

6,827

 

23,433

 

20,292

 

Corporate and Other

 

(15,110

)

(14,251

)

(42,520

)

(35,066

)

Total segment operating income

 

168,010

 

121,295

 

472,800

 

346,225

 

Realized investment (losses) gains - investments(1)

 

(4,836

)

(36,282

)

138,617

 

(165,349

)

Realized investment (losses) gains - derivatives

 

21,709

 

57,108

 

(139,119

)

235,885

 

Income tax expense

 

(65,974

)

(49,060

)

(161,773

)

(142,210

)

Net income

 

$

118,909

 

$

93,061

 

$

310,525

 

$

274,551

 

 

 

 

 

 

 

 

 

 

 

Investment gains (losses)(2)

 

$

(1,160

)

$

(28,189

)

$

148,051

 

$

(150,896

)

Less: amortization related to DAC/VOBA and benefits and settlement expenses

 

3,676

 

8,093

 

9,434

 

14,453

 

Realized investment gains (losses) - investments

 

$

(4,836

)

$

(36,282

)

$

138,617

 

$

(165,349

)

 

 

 

 

 

 

 

 

 

 

Derivative gains (losses)(3)

 

$

3,781

 

$

41,326

 

$

(191,495

)

$

192,592

 

Less: VA GMWB economic cost

 

(17,928

)

(15,782

)

(52,376

)

(43,293

)

Realized investment gains (losses) - derivatives

 

$

21,709

 

$

57,108

 

$

(139,119

)

$

235,885

 

 


(1) Includes credit related other-than-temporary impairments of $2.3 million and $5.4 million for the three and nine months ended September 30, 2014, respectively, as compared to $8.7 million and $17.3 million for the three and nine months ended September 30, 2013, respectively.

(2)Includes realized investment gains (losses) before related amortization.

(3)Includes realized gains (losses) on derivatives before the VA GMWB economic cost.

 

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Operating Segment Assets

 

 

 

As of September 30, 2014

 

 

 

(Dollars In Thousands)

 

 

 

Life

 

 

 

 

 

Stable Value

 

 

 

Marketing

 

Acquisitions

 

Annuities

 

Products

 

Investments and other assets

 

$

13,699,580

 

$

19,895,240

 

$

20,595,599

 

$

2,260,840

 

Deferred policy acquisition costs and value of business acquired

 

1,950,507

 

635,336

 

637,752

 

706

 

Goodwill

 

10,192

 

30,194

 

 

 

Total assets

 

$

15,660,279

 

$

20,560,770

 

$

21,233,351

 

$

2,261,546

 

 

 

 

Asset

 

Corporate

 

 

 

Total

 

 

 

Protection

 

and Other

 

Adjustments

 

Consolidated

 

Investments and other assets

 

$

917,926

 

$

9,802,176

 

$

15,428

 

$

67,186,789

 

Deferred policy acquisition costs and value of business acquired

 

38,596

 

402

 

 

3,263,299

 

Goodwill

 

62,670

 

83

 

 

103,139

 

Total assets

 

$

1,019,192

 

$

9,802,661

 

$

15,428

 

$

70,553,227

 

 

 

 

Operating Segment Assets

 

 

 

As of December 31, 2013

 

 

 

(Dollars In Thousands)

 

 

 

Life

 

 

 

 

 

Stable Value

 

 

 

Marketing

 

Acquisitions

 

Annuities

 

Products

 

Investments and other assets

 

$

13,135,914

 

$

20,188,321

 

$

19,974,246

 

$

2,558,551

 

Deferred policy acquisition costs and value of business acquired

 

2,071,470

 

799,255

 

647,485

 

1,001

 

Goodwill

 

10,192

 

32,517

 

 

 

Total assets

 

$

15,217,576

 

$

21,020,093

 

$

20,621,731

 

$

2,559,552

 

 

 

 

Asset

 

Corporate

 

 

 

Total

 

 

 

Protection

 

and Other

 

Adjustments

 

Consolidated

 

Investments and other assets

 

$

852,273

 

$

8,355,618

 

$

16,762

 

$

65,081,685

 

Deferred policy acquisition costs and value of business acquired

 

50,358

 

646

 

 

3,570,215

 

Goodwill

 

62,671

 

83

 

 

105,463

 

Total assets

 

$

965,302

 

$

8,356,347

 

$

16,762

 

$

68,757,363

 

 

20.                               SUBSEQUENT EVENTS

 

The Company has evaluated the effects of events subsequent to September 30, 2014, and through the date we filed our consolidated condensed financial statements with the United States Securities and Exchange Commission. All accounting and disclosure requirements related to subsequent events are included in our consolidated condensed financial statements.

 

On September 15, 2014, the Company announced that it had issued notice to redeem the entire $100,000,000 outstanding principal amount of the Company’s 8.00% Senior Notes issued on October 9, 2009. The payment in respect of the redemption of the Senior Notes was made on October 15, 2014.

 

The Company held a Special Meeting of Shareholders on October 6, 2014. At the meeting, the Company’s shareowners voted upon and approved a proposal to adopt the Merger Agreement.

 

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Item 2.         Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

The following Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) should be read in conjunction with our consolidated condensed financial statements included under Part I, Item 1, Financial Statements (Unaudited), of this Quarterly Report on Form 10-Q and our audited consolidated financial statements for the year ended December 31, 2013, included in our Annual Report on Form 10-K.

 

For a more complete understanding of our business and current period results, please read the following MD&A in conjunction with our latest Annual Report on Form 10-K and other filings with the United States Securities and Exchange Commission (the “SEC”).

 

Certain reclassifications have been made in the previously reported financial statements and accompanying notes to make the prior period amounts comparable to those of the current period. Such reclassifications had no effect on previously reported net income or shareowners’ equity.

 

FORWARD-LOOKING STATEMENTS — CAUTIONARY LANGUAGE

 

This report reviews our financial condition and results of operations including our liquidity and capital resources. Historical information is presented and discussed, and where appropriate, factors that may affect future financial performance are also identified and discussed. Certain statements made in this report include “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements include any statement that may predict, forecast, indicate, or imply future results, performance, or achievements instead of historical facts and may contain words like “believe,” “expect,” “estimate,” “project,” “budget,” “forecast,” “anticipate,” “plan,” “will,” “shall,” “may,” and other words, phrases, or expressions with similar meaning. Forward-looking statements involve risks and uncertainties, which may cause actual results to differ materially from the results contained in the forward-looking statements, and we cannot give assurances that such statements will prove to be correct. Given these risks and uncertainties, investors should not place undue reliance on forward-looking statements as a prediction of actual results. We undertake no obligation to publicly update any forward-looking statements, whether as a result of new information, future developments or otherwise. For more information about the risks, uncertainties, and other factors that could affect our future results, please refer to Part I, Item 2, Management’s Discussion and Analysis of Financial Condition and Results of Operations, “Risks and Uncertainties,” and Part II, Item 1A, Risk Factors and Cautionary Factors that may Affect Future Results, of this report, as well as Part I, Item 1A, Risk Factors and Cautionary Factors that may Affect Future Results, of our Annual Report on Form 10-K for the fiscal year ended December 31, 2013.

 

OVERVIEW

 

Our business

 

We are a holding company headquartered in Birmingham, Alabama, with subsidiaries that provide financial services through the production, distribution, and administration of insurance and investment products. Founded in 1907, Protective Life Insurance Company (“PLICO”) is our largest operating subsidiary. Unless the context otherwise requires, the “Company,” “we,” “us,” or “our” refers to the consolidated group of Protective Life Corporation and our subsidiaries.

 

We have several operating segments, each having a strategic focus. An operating segment is distinguished by products, channels of distribution, and/or other strategic distinctions. We periodically evaluate our operating segments as prescribed in the Accounting Standards Codification (“ASC”) Segment Reporting Topic, and make adjustments to our segment reporting as needed.

 

Our operating segments are Life Marketing, Acquisitions, Annuities, Stable Value Products, Asset Protection, and Corporate and Other.

 

·                  Life Marketing - We market fixed universal life (“UL”), variable universal life (“VUL”), bank-owned life insurance (“BOLI”), and level premium term insurance (“traditional”) products on a national basis

 

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primarily through networks of independent insurance agents and brokers, broker-dealers, financial institutions, and independent marketing organizations.

 

·                  Acquisitions - We focus on acquiring, converting, and servicing policies from other companies. The segment’s primary focus is on life insurance policies and annuity products that were sold to individuals. The level of the segment’s acquisition activity is predicated upon many factors, including available capital, operating capacity, potential return on capital, and market dynamics. Policies acquired through the Acquisition segment are typically blocks of business where no new policies are being marketed. Therefore earnings and account values are expected to decline as the result of lapses, deaths, and other terminations of coverage unless new acquisitions are made.

 

·                  Annuities - We market fixed and variable annuity (“VA”) products. These products are primarily sold through broker-dealers, financial institutions, and independent agents and brokers.

 

·                  Stable Value Products - We sell fixed and floating rate funding agreements directly to the trustees of municipal bond proceeds, money market funds, bank trust departments, and other institutional investors. The segment also issues funding agreements to the Federal Home Loan Bank (“FHLB”), and markets guaranteed investment contracts (“GICs”) to 401(k) and other qualified retirement savings plans. Additionally, we have contracts outstanding pursuant to a funding agreement-backed notes program registered with the SEC which offered notes to both institutional and retail investors.

 

·                  Asset Protection - We market extended service contracts and credit life and disability insurance to protect consumers’ investments in automobiles, watercraft, and recreational vehicles. In addition, the segment markets a guaranteed asset protection (“GAP”) product. GAP coverage covers the difference between the loan pay-off amount and an asset’s actual cash value in the case of a total loss.

 

·                  Corporate and Other - This segment primarily consists of net investment income not assigned to the segments above (including the impact of carrying liquidity) and expenses not attributable to the segments above (including interest on certain corporate debt). This segment includes earnings from several non-strategic or runoff lines of business, various investment-related transactions, the operations of several small subsidiaries, and the repurchase of non-recourse funding obligations.

 

EXECUTIVE SUMMARY

 

Net income for the three months ended September 30, 2014 was $118.9 million or $1.46 per average diluted share.  After-tax operating income for the three months ended September 30, 2014 was $107.9 million or $1.33 per average diluted share.

 

We reported strong financial results for the first nine months of 2014 and we remain confident in our ability to execute on our plans for the remainder of the year.

 

Significant financial information related to each of our segments is included in “Results of Operations”.

 

RECENT DEVELOPMENTS — PROPOSED DAI-ICHI MERGER

 

As described in Note 5, Proposed Dai-ichi Merger, to the consolidated condensed financial statements, on June 3, 2014, we entered into an Agreement and Plan of Merger (the “Merger Agreement”) with The Dai-ichi Life Insurance Company, Limited, a kabushiki kaisha organized under the laws of Japan (“Dai-ichi”) and DL Investment (Delaware), Inc., a Delaware corporation and wholly owned subsidiary of Dai-ichi, which provides for the merger of DL Investment (Delaware), Inc. with and into the Company (the “Merger”), with the Company surviving the Merger as a wholly owned subsidiary of Dai-ichi. If the proposed Merger is completed, at the effective time of the Merger (the “Effective Time”), each share of our common stock, par value $0.50 per share, issued and outstanding immediately prior to the Effective Time, other than certain excluded shares, will be converted into the right to receive $70 in cash, without interest (the “Per Share Merger Consideration”). Shares of common stock held by Dai-ichi or the Company or their respective direct or indirect wholly-owned subsidiaries will not be entitled to receive the Merger Consideration. Stock appreciation rights, restricted stock units and performance shares issued under various benefit plans will be paid

 

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out as described in Note 5, Proposed Dai-ichi Merger, to the consolidated condensed financial statements included in this report, under the heading “Treatment of Benefit Plans”.

 

Completion of the Merger is subject to various closing conditions, including, but not limited to, (1) adoption of the Merger Agreement by the affirmative vote of the holders of at least a majority of all outstanding shares of common stock, which adoption was approved at a Special Meeting of Shareholders held on October 6, 2014, (2) requisite approval of the Japan Financial Services Agency of an application and notification filing by Dai-ichi and its affiliates, (3) the receipt of certain insurance regulatory approvals, (4) the absence of any laws that have been adopted or promulgated, or any order, injunction, decision or decree issued or remaining in effect, that would prohibit the Merger or make the Merger illegal, and (5) the expiration or termination of the applicable waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended, which waiting period terminated on July 25, 2014, pursuant to a grant of early termination by the Federal Trade Commission. Each party’s obligation to consummate the Merger also is subject to certain additional conditions that include the accuracy of the other party’s representations and warranties contained in the Merger Agreement (subject to certain materiality qualifiers) and the other party’s compliance with its covenants and agreements contained in the Merger Agreement in all material respects. The Merger Agreement does not contain a financing condition.  Subject to certain limitations, either party may terminate the Merger Agreement if the Merger is not consummated by February 28, 2015, which date is extended until April 30, 2015 in the event of delays in obtaining regulatory approval.

 

For additional information regarding the Merger and related matters, including the treatment of benefit plans, please refer to our Current Reports on Form 8-K filed with the SEC on June 4, 2014 and September 25, 2014, our definitive proxy statement filed with the SEC on August 25, 2014, as amended on August 27, 2014, and Note 5, Proposed Dai-ichi Merger, to the consolidated condensed financial statements included in this report.

 

RISKS AND UNCERTAINTIES

 

The factors which could affect our future results include, but are not limited to, general economic conditions and the following risks and uncertainties:

 

Risks Related to the Proposed Dai-ichi Merger

 

·                  the Merger is subject to various closing conditions, including regulatory and third party approvals;

·                  failure to timely complete the Merger could adversely impact our stock price, business, financial condition, and results of operations;

·                  the pendency of the Merger and operating restrictions contained in the Merger Agreement could adversely affect our business and operations;

·                  shareowner litigation against the Company, our directors and/or Dai-ichi could delay or prevent the Merger and cause us to incur significant costs and expenses; and;

·                  our debt ratings and the financial strength ratings of our insurance subsidiaries may be adversely affected by the transactions contemplated by the Merger Agreement;

 

General

 

·                  exposure to the risks of natural and man-made disasters and catastrophes, diseases, epidemics, pandemics, malicious acts, terrorist acts and climate change, which could adversely affect our operations and results;

·                  a disruption affecting the electronic systems of the Company or those on whom the Company relies could adversely affect our business, financial condition and results of operations;

·                  confidential information maintained in our systems could be compromised or misappropriated, damaging our business and reputation and adversely affecting our financial condition and results of operations;

·                  our results and financial condition may be negatively affected should actual experience differ from management’s assumptions and estimates;

·                  we may not realize our anticipated financial results from our acquisitions strategy;

·                  we may not be able to achieve the expected results from our recent acquisition;

 

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·                  assets allocated to the MONY Closed Block benefit only the holders of certain policies; adverse performance of Closed Block assets or adverse experience of Closed Block liabilities may negatively affect us;

·                  we are dependent on the performance of others;

·                  our risk management policies, practices, and procedures could leave us exposed to unidentified or unanticipated risks, which could negatively affect our business or result in losses;

·                  our strategies for mitigating risks arising from our day-to-day operations may prove ineffective resulting in a material adverse effect on our results of operations and financial condition;

 

Financial environment

 

·                  interest rate fluctuations and sustained periods of low interest rates could negatively affect our interest earnings and spread income, or otherwise impact our business;

·                  our investments are subject to market and credit risks, which could be heightened during periods of extreme volatility or disruption in financial and credit markets;

·                  equity market volatility could negatively impact our business;

·                  our use of derivative financial instruments within our risk management strategy may not be effective or sufficient;

·                  credit market volatility or disruption could adversely impact our financial condition or results from operations;

·                  our ability to grow depends in large part upon the continued availability of capital;

·                  we could be adversely affected by a ratings downgrade or other negative action by a ratings organization;

·                  we could be forced to sell investments at a loss to cover policyholder withdrawals;

·                  disruption of the capital and credit markets could negatively affect our ability to meet our liquidity and financing needs;

·                  difficult general economic conditions could materially adversely affect our business and results of operations;

·                  we may be required to establish a valuation allowance against our deferred tax assets, which could materially adversely affect our results of operations, financial condition, and capital position;

·                  we could be adversely affected by an inability to access our credit facility;

·                  we could be adversely affected by an inability to access FHLB lending;

·                  our financial condition or results of operations could be adversely impacted if our assumptions regarding the fair value and future performance of our investments differ from actual experience;

·                  the amount of statutory capital that we have and the amount of statutory capital that we must hold to maintain our financial strength and credit ratings and meet other requirements can vary significantly from time to time and is sensitive to a number of factors outside of our control;

·                  we operate as a holding company and depend on the ability of our subsidiaries to transfer funds to us to meet our obligations and pay dividends;

 

Industry

 

·                  we are highly regulated, are subject to routine audits, examinations and actions by regulators, law enforcement agencies, and self-regulatory organizations;

·                  changes to tax law or interpretations of existing tax law could adversely affect our ability to compete with non-insurance products or reduce the demand for certain insurance products;

·                  financial services companies are frequently the targets of legal proceedings, including class action litigation, which could result in substantial judgments;

·                  publicly held companies in general and the financial services industry in particular are sometimes the target of law enforcement investigations and the focus of increased regulatory scrutiny;

·                  new accounting rules, changes to existing accounting rules, or the grant of permitted accounting practices to competitors could negatively impact us;

·                  use of reinsurance introduces variability in our statements of income;

·                  our reinsurers could fail to meet assumed obligations, increase rates, or be subject to adverse developments that could affect us;

·                  our policy claims fluctuate from period to period resulting in earnings volatility;

 

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Competition

 

·                  we operate in a mature, highly competitive industry, which could limit our ability to gain or maintain our position in the industry and negatively affect profitability;

·                  our ability to maintain competitive unit costs is dependent upon the level of new sales and persistency of existing business; and

·                  we may not be able to protect our intellectual property and may be subject to infringement claims.

 

For more information about the risks, uncertainties, and other factors that could affect our future results, please see Part II, Item 1A of this report and our Annual Report on Form 10-K.

 

CRITICAL ACCOUNTING POLICIES

 

Our accounting policies require the use of judgments relating to a variety of assumptions and estimates, including, but not limited to expectations of current and future mortality, morbidity, persistency, expenses, and interest rates, as well as expectations around the valuations of securities. Because of the inherent uncertainty when using the assumptions and estimates, the effect of certain accounting policies under different conditions or assumptions could be materially different from those reported in the consolidated condensed financial statements. For a complete listing of our critical accounting policies, refer to our Annual Report on Form 10-K for the year ended December 31, 2013.

 

Deferred Policy Acquisition Costs

 

Based on the Accounting Standards Codification (“ASC” or “Codification”) Financial Services — Insurance Topic, we make certain assumptions regarding the mortality, persistency, expenses, and interest rates we expect to experience in future periods. These assumptions are to be best estimates and are periodically updated whenever actual experience and/or expectations for the future change from that assumed. Additionally, using guidance from ASC Investments-Debt and Equity Securities Topic, these costs have been adjusted by an amount equal to the amortization that would have been recorded if unrealized gains or losses on investments associated with our universal life an investment products had been realized. Acquisition costs for stable value contracts are amortized over the term of the contracts using the effective yield method.

 

RESULTS OF OPERATIONS

 

We use the same accounting policies and procedures to measure segment operating income (loss) and assets as we use to measure consolidated net income and assets. Segment operating income (loss) is income before income tax, excluding realized gains and losses on investments and derivatives net of the amortization related to deferred acquisition costs (“DAC”), value of business acquired (“VOBA”), and benefits and settlement expenses. Operating earnings exclude changes in the guaranteed minimum withdrawal benefits (“GMWB”) embedded derivatives (excluding the portion attributed to economic cost), realized and unrealized gains (losses) on derivatives used to hedge the VA product, actual GMWB incurred claims, and the related amortization of DAC attributed to each of these items.

 

Segment operating income (loss) represents the basis on which the performance of our business is internally assessed by management. Premiums and policy fees, other income, benefits and settlement expenses, and amortization of DAC/VOBA are attributed directly to each operating segment. Net investment income is allocated based on directly related assets required for transacting the business of that segment. Realized investment gains (losses) and other operating expenses are allocated to the segments in a manner that most appropriately reflects the operations of that segment. Investments and other assets are allocated based on statutory policy liabilities net of associated statutory policy assets, while DAC/VOBA and goodwill are shown in the segments to which they are attributable.

 

However, segment operating income (loss) should not be viewed as a substitute for accounting principles generally accepted in the United States of America (“GAAP”) net income. In addition, our segment operating income (loss) measures may not be comparable to similarly titled measures reported by other companies.

 

We periodically review and update as appropriate our key assumptions on products using the ASC Financial Services-Insurance Topic, including future mortality, expenses, lapses, premium persistency, benefit utilization, investment yields, interest spreads, and equity market returns. Changes to these assumptions result in adjustments which increase or decrease DAC amortization and/or benefits and expenses. The periodic review and updating of assumptions is referred to as “unlocking”. When referring to DAC amortization or unlocking on products covered under the ASC Financial Services-Insurance Topic, the reference is to changes in all balance sheet components amortized over estimated gross profits.

 

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The following table presents a summary of results and reconciles segment operating income (loss) to consolidated net income:

 

 

 

For The

 

 

 

For The

 

 

 

 

 

Three Months Ended

 

 

 

Nine Months Ended

 

 

 

 

 

September 30,

 

 

 

September 30,

 

 

 

 

 

2014

 

2013

 

Change

 

2014

 

2013

 

Change

 

 

 

(Dollars In Thousands)

 

 

 

(Dollars In Thousands)

 

 

 

Segment Operating Income (Loss)

 

 

 

 

 

 

 

 

 

 

 

 

 

Life Marketing

 

$

32,820

 

$

29,218

 

12.3

%

$

82,654

 

$

77,598

 

6.5

%

Acquisitions

 

72,929

 

29,429

 

n/m

 

198,807

 

93,241

 

n/m

 

Annuities

 

49,335

 

50,866

 

(3.0

)

156,236

 

130,646

 

19.6

 

Stable Value Products

 

19,506

 

19,206

 

1.6

 

54,190

 

59,514

 

(8.9

)

Asset Protection

 

8,530

 

6,827

 

24.9

 

23,433

 

20,292

 

15.5

 

Corporate and Other

 

(15,110

)

(14,251

)

(6.0

)

(42,520

)

(35,066

)

(21.3

)

Total segment operating income

 

168,010

 

121,295

 

38.5

 

472,800

 

346,225

 

36.6

 

Realized investment gains (losses) - investments(1)

 

(4,836

)

(36,282

)

 

 

138,617

 

(165,349

)

 

 

Realized investment gains (losses) - derivatives

 

21,709

 

57,108

 

 

 

(139,119

)

235,885

 

 

 

Income tax expense

 

(65,974

)

(49,060

)

 

 

(161,773

)

(142,210

)

 

 

Net income

 

$

118,909

 

$

93,061

 

27.8

 

$

310,525

 

$

274,551

 

13.1

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Investment gains (losses)(2)

 

$

(1,160

)

$

(28,189

)

 

 

$

148,051

 

$

(150,896

)

 

 

Less: amortization related to DAC/VOBA and benefits and settlement expenses

 

3,676

 

8,093

 

 

 

9,434

 

14,453

 

 

 

Realized investment gains (losses) - investments

 

$

(4,836

)

$

(36,282

)

 

 

$

138,617

 

$

(165,349

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Derivative gains (losses) (3)

 

$

3,781

 

$

41,326

 

 

 

$

(191,495

)

$

192,592

 

 

 

Less: VA GMWB economic cost

 

(17,928

)

(15,782

)

 

 

(52,376

)

(43,293

)

 

 

Realized investment gains (losses) - derivatives

 

$

21,709

 

$

57,108

 

 

 

$

(139,119

)

$

235,885

 

 

 

 


(1)         Includes credit related other-than-temporary impairments of $2.3 million and $5.4 million for the three and nine months ended September 30, 2014, respectively, as compared to $8.7 million and $17.3 million for the three and nine months ended September 30, 2013, respectively.

(2)         Includes realized investment gains (losses) before related amortization.

(3)         Includes realized gains (losses) on derivatives before the VA GMWB economic cost.

 

For The Three Months Ended September 30, 2014 as compared to The Three Months Ended September 30, 2013

 

Net income for the three months ended September 30, 2014, included a $46.7 million, or 38.5%, increase in segment operating income. The increase consisted of a $3.6 million increase in the Life Marketing segment, a $43.5 million increase in the Acquisitions segment, a $0.3 million increase in the Stable Value Products segment, and a $1.7 million increase in the Asset Protection segment. These increases were partially offset by a $1.5 million decrease in the Annuities segment and a $0.9 million decrease in the Corporate and Other segment.

 

We experienced net realized gains of $2.6 million for the three months ended September 30, 2014, as compared to net realized gains of $13.1 million for the three months ended September 30, 2013. The gains realized for the three months ended September 30, 2014, were primarily related to $23.6 million of gains related to investment securities sale activity, $3.2 million of gains related to the net activity of the modified coinsurance portfolio, and net gains of $0.3 million of derivatives related to indexed universal life (“IUL”) contracts. Partially offsetting these gains were $2.3 million of other-than-temporary impairment credit-related losses, $5.4 million of losses related to other investment and derivative activity, $15.6 million of losses on derivatives related to variable annuity contracts, and net losses of $1.3 million of derivatives related to fixed indexed annuity (“FIA”) contracts.

 

·                  Life Marketing segment operating income was $32.8 million for the three months ended September 30, 2014, representing an increase of $3.6 million, or 12.3%, from the three months ended September 30, 2013. The

 

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increase was primarily due to higher universal life premiums and policy fees, favorable traditional mortality, and higher investment income due to an increase in reserves. These items were largely offset by the impact of prospective unlocking and an increase in non-deferred expenses. The segment recorded an unfavorable $2.6 million of prospective unlocking for the three months ended September 30, 2014, as compared to a favorable $2.4 million of prospective unlocking for the three months ended September 30, 2013.

 

·                  Acquisitions segment operating income was $72.9 million for the three months ended September 30, 2014, an increase of $43.5 million as compared to the three months ended September 30, 2013, primarily due to the impact of the MONY acquisition which occurred in the fourth quarter of 2013. MONY operating income was $29.3 million for the three months ended September 30, 2014. In addition, the increase was driven by a $15.9 million favorable variance related to prospective unlocking.  For the three months ended September 30, 2014, the segment recorded favorable prospective unlocking of $11.7 million as compared to an unfavorable $4.2 million of prospective unlocking for the three months ended September 30, 2013.

 

·                  Annuities segment operating income was $49.3 million for the three months ended September 30, 2014, as compared to $50.9 million for the three months ended September 30, 2013, a decrease of $1.5 million or 3.0%. This variance included an unfavorable change in unlocking and other operating expenses partially offset by higher net policy fees and other income in the VA line and lower credited interest. The segment recorded an unfavorable $3.4 million of unlocking for the three months ended September 30, 2014, as compared to favorable unlocking of $4.9 million for the three months ended September 30, 2013.

 

·                  Stable Value Products segment operating income was $19.5 million and increased $0.3 million, or 1.6%, for the three months ended September 30, 2014, as compared to the three months ended September 30, 2013. The increase in operating earnings resulted from an increase in participating mortgage income offset by lower adjusted operating spreads and a decline in average account values. Participating mortgage income for the three months ended September 30, 2014 was $3.9 million compared to $2.4 million for the three months ended September 30, 2013. The adjusted operating spread, which excludes participating income, decreased by 5 basis points for the three months ended September 30, 2014 over the prior year.

 

·                  Asset Protection segment operating income was $8.5 million, representing an increase of $1.7 million, or 24.9%, for the three months ended September 30, 2014, as compared to the three months ended September 30, 2013. Service contract earnings increased $1.6 million, primarily due to lower losses. Credit insurance earnings increased $0.1 million, primarily resulting from lower expenses. Earnings from the GAP product were consistent with the prior year.

 

·                  Corporate & Other segment operating loss was $15.1 million for the three months ended September 30, 2014, as compared to an operating loss of $14.3 million for the three months ended September 30, 2013.  The change was primarily due to higher overhead expenses partially offset by a $7.5 million favorable investment income variance related to called securities compared to the three months ended September 30, 2013.

 

For The Nine Months Ended September 30, 2014 as compared to The Nine Months Ended September 30, 2013

 

Net income for the nine months ended September 30, 2014, included a $126.6 million, or 36.6%, increase in segment operating income. The increase consisted of a $5.1 million increase in the Life Marketing segment, a $105.6 million increase in the Acquisitions segment, a $25.6 million increase in the Annuities segment, and a $3.1 million increase in the Asset Protection segment. These increases were partially offset by a $5.3 million decrease in the Stable Value Products segment and a $7.5 million decrease in the Corporate and Other segment.

 

We experienced net realized losses of $43.4 million for the nine months ended September 30, 2014, as compared to net realized gains of $41.7 million for the nine months ended September 30, 2013. The losses realized for the nine months ended September 30, 2014, were primarily related to $96.4 million of losses on derivatives related to variable annuity contracts, $5.4 million of other-than-temporary impairment credit-related losses, net losses of $2.9 million of derivatives related to FIA contracts, and $8.2 million of losses related to other investment and derivative activity. Partially offsetting these losses were gains of $51.2 million related to investment securities sale activity, $18.1

 

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million of gains related to the net activity of the modified coinsurance portfolio, and net gains of $0.1 million of derivatives related to IUL contracts.

 

·                  Life Marketing segment operating income was $82.7 million for the nine months ended September 30, 2014, representing an increase of $5.1 million, or 6.5%, from the nine months ended September 30, 2013. The increase was primarily due to higher universal life premiums and policy fees, higher investment income due to an increase in reserves, and favorable traditional mortality. This increase was largely offset by less favorable universal life mortality and unfavorable prospective unlocking compared to 2013. The segment recorded an unfavorable $2.6 million of prospective unlocking for the nine months ended September 30, 2014, as compared to a favorable $2.4 million for the nine months ended September 30, 2013.

 

·                  Acquisitions segment operating income was $198.8 million for the nine months ended September 30, 2014, an increase of $105.6 million as compared to the nine months ended September 30, 2013. This was primarily due to the impact of the MONY acquisition which occurred in the fourth quarter of 2013. MONY operating income was $86.3 million for the nine months ended September 30, 2014. In addition, the increase was driven by a $15.9 million favorable variance related to prospective unlocking.  For the nine months ended September 30, 2014, the segment recorded favorable prospective unlocking of $11.7 million as compared to an unfavorable $4.2 million of prospective unlocking for the nine months ended September 30, 2013.

 

·                  Annuities segment operating income was $156.2 million for the nine months ended September 30, 2014, as compared to $130.6 million for the nine months ended September 30, 2013, an increase of $25.6 million, or 19.6%. This variance was a result of higher net policy fees and other income in the VA line and lower credited interest. These favorable variances were partially offet by an unfavorable change in unlocking and other operating expenses. The segment recorded a favorable $0.1 million of unlocking for the nine months ended September 30, 2014, as compared to favorable unlocking of $8.5 million for the three months ended September 30, 2013.

 

·                  Stable Value Products segment operating income was $54.2 million and decreased $5.3 million, or 8.9%, for the nine months ended September 30, 2014, as compared to the nine months ended September 30, 2013. The decrease in operating earnings resulted from a decrease in participating mortgage income and a decline in average account values. Participating mortgage income for the nine months ended September 30, 2014 was $4.9 million compared to $9.5 million for the nine months ended September 30, 2013.

 

·                  Asset Protection segment operating income was $23.4 million, representing an increase of $3.1 million, or 15.5%, for the nine months ended September 30, 2014, as compared to the nine months ended September 30, 2013. Service contract earnings increased $3.1 million primarily due to lower loss ratios and higher volume. Credit insurance earnings increased $0.8 million primarily due to lower losses and lower expenses in 2014. Earnings from the GAP product line decreased $0.8 million primarily resulting from higher losses.

 

·                  Corporate and Other segment operating loss was $42.5 million for the nine months ended September 30, 2014, as compared to an operating loss of $35.1 million for the nine months ended September 30, 2013. The change resulted from an $11.9 million unfavorable variance in other operating expenses partially offset by a $2.6 million increase in net investment income and a $1.2 million increase in other income as compared to the nine months ended September 30, 2013.

 

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Table of Contents

 

Life Marketing

 

Segment results of operations

 

Segment results were as follows:

 

 

 

For The

 

 

 

For The

 

 

 

 

 

Three Months Ended

 

 

 

Nine Months Ended

 

 

 

 

 

September 30,

 

 

 

September 30,

 

 

 

 

 

2014

 

2013

 

Change

 

2014

 

2013

 

Change

 

 

 

(Dollars In Thousands)

 

 

 

(Dollars In Thousands)

 

 

 

REVENUES

 

 

 

 

 

 

 

 

 

 

 

 

 

Gross premiums and policy fees

 

$

377,014

 

$

356,809

 

5.7

%

$

1,226,218

 

$

1,217,852

 

0.7

%

Reinsurance ceded

 

(150,586

)

(145,075

)

(3.8

)

(550,661

)

(607,917

)

9.4

 

Net premiums and policy fees

 

226,428

 

211,734

 

6.9

 

675,557

 

609,935

 

10.8

 

Net investment income

 

139,818

 

129,935

 

7.6

 

410,550

 

387,237

 

6.0

 

Other income

 

31,435

 

32,144

 

(2.2

)

94,537

 

91,288

 

3.6

 

Total operating revenues

 

397,681

 

373,813

 

6.4

 

1,180,644

 

1,088,460

 

8.5

 

Realized gains (losses) - investments

 

2,686

 

3,603

 

(25.5

)

11,806

 

3,603

 

n/m

 

Realized gains (losses) - derivatives

 

339

 

 

n/m

 

54

 

 

n/m

 

Total revenues

 

400,706

 

377,416

 

6.2

 

1,192,504

 

1,092,063

 

9.2

 

BENEFITS AND EXPENSES

 

 

 

 

 

 

 

 

 

 

 

 

 

Benefits and settlement expenses

 

215,949

 

330,156

 

(34.6

)

819,615

 

866,995

 

(5.5

)

Amortization of deferred policy acquisition costs

 

106,737

 

(24,284

)

n/m

 

148,179

 

16,804

 

n/m

 

Other operating expenses

 

42,175

 

38,723

 

8.9

 

130,196

 

127,063

 

2.5

 

Operating benefits and expenses

 

364,861

 

344,595

 

5.9

 

1,097,990

 

1,010,862

 

8.6

 

Amortization related to benefits and settlement expenses

 

29

 

483

 

(94.0

)

1,740

 

483

 

n/m

 

Amortization of DAC related to realized gains (losses) - investments

 

200

 

819

 

(75.6

)

3,555

 

819

 

n/m

 

Total benefits and expenses

 

365,090

 

345,897

 

5.5

 

1,103,285

 

1,012,164

 

9.0

 

INCOME BEFORE INCOME TAX

 

35,616

 

31,519

 

13.0

 

89,219

 

79,899

 

11.7

 

Less: realized gains (losses)

 

3,025

 

3,603

 

 

 

11,860

 

3,603

 

 

 

Less: amortization related to benefits and settlement expenses

 

(29

)

(483

)

 

 

(1,740

)

(483

)

 

 

Less: related amortization of DAC

 

(200

)

(819

)

 

 

(3,555

)

(819

)

 

 

OPERATING INCOME

 

$

32,820

 

$

29,218

 

12.3

 

$

82,654

 

$

77,598

 

6.5

 

 

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Table of Contents

 

The following table summarizes key data for the Life Marketing segment:

 

 

 

For The

 

 

 

For The

 

 

 

 

 

Three Months Ended

 

 

 

Nine Months Ended

 

 

 

 

 

September 30,

 

 

 

September 30,

 

 

 

 

 

2014

 

2013

 

Change

 

2014

 

2013

 

Change

 

 

 

(Dollars In Thousands)

 

 

 

(Dollars In Thousands)

 

 

 

Sales By Product

 

 

 

 

 

 

 

 

 

 

 

 

 

Traditional

 

$

183

 

$

390

 

(53.1

)%

$

433

 

$

1,091

 

(60.3

)%

Universal life

 

33,058

 

32,261

 

2.5

 

93,942

 

123,437

 

(23.9

)

BOLI

 

 

 

n/m

 

22

 

 

n/m

 

 

 

$

33,241

 

$

32,651

 

1.8

 

$

94,397

 

$

124,528

 

(24.2

)

Sales By Distribution Channel

 

 

 

 

 

 

 

 

 

 

 

 

 

Independent agents

 

$

24,587

 

$

23,395

 

5.1

 

$

70,945

 

$

86,040

 

(17.5

)

Stockbrokers / banks

 

7,923

 

8,608

 

(8.0

)

21,409

 

36,831

 

(41.9

)

BOLI / other

 

731

 

648

 

12.8

 

2,043

 

1,657

 

23.3

 

 

 

$

33,241

 

$

32,651

 

1.8

 

$

94,397

 

$

124,528

 

(24.2

)

Average Life Insurance In-force(1)

 

 

 

 

 

 

 

 

 

 

 

 

 

Traditional

 

$

399,961,084

 

$

423,831,748

 

(5.6

)

$

405,583,949

 

$

430,538,542

 

(5.8

)

Universal life

 

139,804,885

 

109,933,560

 

27.2

 

132,052,762

 

100,813,147

 

31.0

 

 

 

$

539,765,969

 

$

533,765,308

 

1.1

 

$

537,636,711

 

$

531,351,689

 

1.2

 

Average Account Values

 

 

 

 

 

 

 

 

 

 

 

 

 

Universal life

 

$

7,175,792

 

$

7,003,612

 

2.5

 

$

7,142,767

 

$

6,865,081

 

4.0

 

Variable universal life

 

561,709

 

468,595

 

19.9

 

545,762

 

440,238

 

24.0

 

 

 

$

7,737,501

 

$

7,472,207

 

3.6

 

$

7,688,529

 

$

7,305,319

 

5.2

 

 


(1)         Amounts are not adjusted for reinsurance ceded.

 

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Table of Contents

 

Operating expenses detail

 

Other operating expenses for the segment were as follows:

 

 

 

For The

 

 

 

For The

 

 

 

 

 

Three Months Ended

 

 

 

Nine Months Ended

 

 

 

 

 

September 30,

 

 

 

September 30,

 

 

 

 

 

2014

 

2013

 

Change

 

2014

 

2013

 

Change

 

 

 

(Dollars In Thousands)

 

 

 

(Dollars In Thousands)

 

 

 

Insurance companies:

 

 

 

 

 

 

 

 

 

 

 

 

 

First year commissions

 

$

38,881

 

$

39,168

 

(0.7

)%

$

111,925

 

$

135,332

 

(17.3

)%

Renewal commissions

 

7,653

 

8,238

 

(7.1

)

22,319

 

25,426

 

(12.2

)

First year ceding allowances

 

(663

)

(939

)

29.4

 

(1,556

)

(3,035

)

48.7

 

Renewal ceding allowances

 

(37,755

)

(40,322

)

6.4

 

(100,571

)

(120,393

)

16.5

 

General & administrative

 

44,849

 

41,005

 

9.4

 

132,415

 

130,001

 

1.9

 

Taxes, licenses, and fees

 

7,235

 

8,153

 

(11.3

)

20,401

 

28,666

 

(28.8

)

Other operating expenses incurred

 

60,200

 

55,303

 

8.9

 

184,933

 

195,997

 

(5.6

)

Less: commissions, allowances & expenses capitalized

 

(47,700

)

(46,636

)

(2.3

)

(144,728

)

(156,364

)

7.4

 

Other insurance company operating expenses

 

12,500

 

8,667

 

44.2

 

40,205

 

39,633

 

1.4

 

Marketing companies:

 

 

 

 

 

 

 

 

 

 

 

 

 

Commissions

 

21,801

 

22,298

 

(2.2

)

66,450

 

64,610

 

2.8

 

Other operating expenses

 

7,874

 

7,758

 

1.5

 

23,541

 

22,820

 

3.2

 

Other marketing company operating expenses

 

29,675

 

30,056

 

(1.3

)

89,991

 

87,430

 

2.9

 

Other operating expenses

 

$

42,175

 

$

38,723

 

8.9

 

$

130,196

 

$

127,063

 

2.5

 

 

For The Three Months Ended September 30, 2014 as compared to The Three Months Ended September 30, 2013

 

Segment operating income

 

Operating income was $32.8 million for the three months ended September 30, 2014, representing an increase of $3.6 million, or 12.3%, from the three months ended September 30, 2013. The increase was primarily due to higher universal life premiums and policy fees, favorable traditional mortality, and higher investment income due to an increase in reserves. These items were largely offset by the impact of prospective unlocking and an increase in non-deferred expenses. The segment recorded an unfavorable $2.6 million of prospective unlocking for the three months ended September 30, 2014, as compared to a favorable $2.4 million of prospective unlocking for the three months ended September 30, 2013.

 

Operating revenues

 

Total operating revenues for the three months ended September 30, 2014, increased $23.9 million, or 6.4%, as compared to the three months ended September 30, 2013. This increase was driven by higher net premiums and policy fees due to continued growth in the universal life block and higher investment income due to increases in net in force reserves.

 

Net premiums and policy fees

 

Net premiums and policy fees increased by $14.7 million, or 6.9%, for the three months ended September 30, 2014, as compared to the three months ended September 30, 2013, due to continued growth in the universal life block, partially offset by decreases in traditional life premiums.

 

Net investment income

 

Net investment income in the segment increased $9.9 million, or 7.6%, for the three months ended September 30, 2014, as compared to the three months ended September 30, 2013. Of the increase in net investment income, $4.7

 

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million was attributable to a net increase in universal life reserves. Additionally, traditional life investment income increased $4.5 million primarily due to higher reserve balances.

 

Other income

 

Other income decreased $0.7 million, or 2.2%, for the three months ended September 30, 2014, as compared to the three months ended September 30, 2013, primarily due to lower revenue in the segment’s non-insurance operations.

 

Benefits and settlement expenses

 

Benefits and settlement expenses decreased by $114.2 million, or 34.6%, for the three months ended September 30, 2014, as compared to the three months ended September 30, 2013, due primarily to the impact of unlocking and favorable traditional and universal life mortality, which was partially offset by growth in retained universal life insurance in-force. For the three months ended September 30, 2014, universal life and BOLI unlocking decreased policy benefits and settlement expenses $78.7 million as compared to an increase of $41.2 million in the three months ended September 30, 2013. Unlocking in 2014 was largely driven by assumption changes to mortality, reinsurance and yields. Reinsurance, lapses, yields, and credited interest contributed to the unlocking in 2013.

 

Amortization of DAC

 

DAC amortization increased $131.0 million for the three months ended September 30, 2014, as compared to the three months ended September 30, 2013, primarily due to the impact of unlocking. For the three months ended September 30, 2014, universal life and BOLI unlocking increased amortization by $90.6 million, largely driven by assumption changes to mortality, reinsurance and yields. For the three months ended September 30, 2013, universal life and BOLI unlocking decreased amortization $40.3 million.

 

Other operating expenses

 

Other operating expenses increased $3.5 million for the three months ended September 30, 2014, as compared to the three months ended September 30, 2013. This increase reflects higher new business acquisition costs associated with slightly higher sales and higher general administrative expenses of $3.8 million.

 

Sales

 

Sales for the segment increased $0.6 million for the three months ended September 30, 2014, as compared to the three months ended September 30, 2013.

 

For The Nine Months Ended September 30, 2014 as compared to The Nine Months Ended September 30, 2013

 

Segment operating income

 

Operating income was $82.7 million for the nine months ended September 30, 2014, representing an increase of $5.1 million, or 6.5%, from the nine months ended September 30, 2013. The increase was primarily due to higher universal life premiums and policy fees, higher investment income due to an increase in reserves, and favorable traditional life mortality. This increase was largely offset by less favorable universal life mortality and unfavorable prospective unlocking compared to 2013. The segment recorded an unfavorable $2.6 million of prospective unlocking for the nine months ended September 30, 2014, as compared to a favorable $2.4 million for the nine months ended September 30, 2013.

 

Operating revenues

 

Total operating revenues for the nine months ended September 30, 2014, increased $92.2 million, or 8.5%, as compared to the nine months ended September 30, 2013. This increase was driven by higher net premiums and policy fees due to continued growth in the universal life block and higher investment income due to increases in net in force reserves.

 

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Net premiums and policy fees

 

Net premiums and policy fees increased by $65.6 million, or 10.8%, for the nine months ended September 30, 2014, as compared to the nine months ended September 30, 2013, due to an increase in premiums and policy fees associated with growth of the universal life block of business, and the impact of unlocking on ceded premiums, which was almost entirely offset in benefit and settlement expense in the second quarter of 2014. The increase was partially offset by decreases in traditional life premiums.

 

Net investment income

 

Net investment income in the segment increased $23.3 million, or 6.0%, for the nine months ended September 30, 2014, as compared to the nine months ended September 30, 2013. Of the increase in net investment income, $14.9 million was the result of a net increase in universal life reserves. Additionally, traditional life investment income increased $6.8 million due to higher reserves, higher tax benefits and lower funding costs.

 

Other income

 

Other income increased $3.2 million, or 3.6%, for the nine months ended September 30, 2014, as compared to the nine months ended September 30, 2013, primarily due to higher revenue in the segment’s non-insurance operations.

 

Benefits and settlement expenses

 

Benefits and settlement expenses decreased by $47.4 million, or 5.5%, for the nine months ended September 30, 2014, as compared to the nine months ended September 30, 2013, due to the impact of unlocking and favorable traditional life mortality, partially offset by growth in retained universal life insurance in-force and less favorable mortality in the universal life block. For the nine months ended September 30, 2014, universal life and BOLI unlocking decreased policy benefits and settlement expenses $57.5 million as compared to an increase of $42.8 million for the nine months ended September 30, 2013. Unlocking in 2014 was largely driven by assumption changes to mortality, reinsurance, and yields. Of the total impact due to unlocking, $23.5 million is offset within the decline in ceded premiums in the second quarter of 2014. Reinsurance, lapses, yields, and credited interest contributed to the unlocking in 2013.

 

Amortization of DAC

 

DAC amortization increased $131.4 million for the nine months ended September 30, 2014, as compared to the nine months ended September 30, 2013, primarily due to differing impacts of unlocking. In 2014, universal life and BOLI unlocking increased amortization $95.8 million, as compared to a decrease of $42.6 million in 2013.

 

Other operating expenses

 

Other operating expenses increased $3.1 million for the nine months ended September 30, 2014, as compared to the nine months ended September 30, 2013. This increase reflects higher marketing company expenses of $2.6 million and higher general administrative expenses, offset by reduced new business acquisition costs associated with lower sales.

 

Sales

 

Sales for the segment decreased $30.1 million for the nine months ended September 30, 2014, as compared to the nine months ended September 30, 2013. Universal life sales decreased $29.5 million due to sales in 2013 of a product we are no longer marketing.

 

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Reinsurance

 

Currently, the Life Marketing segment reinsures significant amounts of its life insurance in-force. Pursuant to the underlying reinsurance contracts, reinsurers pay allowances to the segment as a percentage of both first year and renewal premiums. Reinsurance allowances represent the amount the reinsurer is willing to pay for reimbursement of acquisition costs incurred by the direct writer of the business. A portion of reinsurance allowances received is deferred as part of DAC and a portion is recognized immediately as a reduction of other operating expenses. As the non-deferred portion of allowances reduces operating expenses in the period received, these amounts represent a net increase to operating income during that period.

 

Reinsurance allowances do not affect the methodology used to amortize DAC or the period over which such DAC is amortized. However, they do affect the amounts recognized as DAC amortization. DAC on universal life-type, limited-payment long duration, and investment contracts business is amortized based on the estimated gross profits of the policies in-force. Reinsurance allowances are considered in the determination of estimated gross profits, and therefore, impact DAC amortization on these lines of business. Deferred reinsurance allowances on level term business are recorded as ceded DAC, which is amortized over estimated ceded premiums of the policies in-force. Thus, deferred reinsurance allowances may impact DAC amortization. A more detailed discussion of the components of reinsurance can be found in the Reinsurance section of Note 2, Summary of Significant Accounting Policies of our Annual Report on Form 10-K for the fiscal year ended December 31, 2013.

 

Impact of reinsurance

 

Reinsurance impacted the Life Marketing segment line items as shown in the following table:

 

Life Marketing Segment

Line Item Impact of Reinsurance

 

 

 

For The

 

For The

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

 

2014

 

2013

 

2014

 

2013

 

 

 

(Dollars In Thousands)

 

REVENUES

 

 

 

 

 

 

 

 

 

Reinsurance ceded

 

$

(150,586

)

$

(145,075

)

$

(550,661

)

$

(607,917

)

BENEFITS AND EXPENSES

 

 

 

 

 

 

 

 

 

Benefits and settlement expenses

 

(131,579

)

(121,278

)

(558,976

)

(596,141

)

Amortization of deferred policy acquisition costs

 

(26,144

)

(9,279

)

(45,333

)

(33,717

)

Other operating expenses (1)

 

(36,119

)

(35,227

)

(101,763

)

(101,592

)

Total benefits and expenses

 

(193,842

)

(165,784

)

(706,072

)

(731,450

)

 

 

 

 

 

 

 

 

 

 

NET IMPACT OF REINSURANCE (2)

 

$

43,256

 

$

20,709

 

$

155,411

 

$

123,533

 

 

 

 

 

 

 

 

 

 

 

Allowances received

 

$

(38,418

)

$

(41,261

)

$

(102,127

)

$

(120,427

)

Less: Amount deferred

 

2,299

 

6,034

 

364

 

18,835

 

Allowances recognized

 

 

 

 

 

 

 

 

 

(ceded other operating expenses) (1)

 

$

(36,119

)

$

(35,227

)

$

(101,763

)

$

(101,592

)

 


(1)         Other operating expenses ceded per the income statement are equal to reinsurance allowances recognized after capitalization.

(2)         Assumes no investment income on reinsurance. Foregone investment income would substantially reduce the favorable impact of reinsurance. The Company estimates that the impact of foregone investment income would reduce the net impact of reinsurance by 90% to 160%.

 

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The table above does not reflect the impact of reinsurance on our net investment income. By ceding business to the assuming companies, we forgo investment income on the reserves ceded. Conversely, the assuming companies will receive investment income on the reserves assumed, which will increase the assuming companies’ profitability on the business we cede. The net investment income impact to us and the assuming companies has not been quantified. The impact of including foregone investment income would be to substantially reduce the favorable net impact of reinsurance reflected above. We estimate that the impact of foregone investment income would be to reduce the net impact of reinsurance presented in the table above by 90% to 160%. The Life Marketing segment’s reinsurance programs do not materially impact the “other income” line of our income statement.

 

As shown above, reinsurance had a favorable impact on the Life Marketing segment’s operating income for the periods presented above. The impact of reinsurance is largely due to our quota share coinsurance program in place prior to mid-2005. Under that program, generally 90% of the segment’s traditional new business was ceded to reinsurers. Since mid-2005, a much smaller percentage of overall term business has been ceded due to a change in reinsurance strategy on traditional business. In addition, since 2012, a much smaller percentage of the segment’s new universal life business has been ceded.  As a result of that change, the relative impact of reinsurance on the Life Marketing segment’s overall results is expected to decrease over time. While the significance of reinsurance is expected to decline over time, the overall impact of reinsurance for a given period may fluctuate due to variations in mortality, unlocking of balances, and variations from term business during the post level premium period.

 

For The Three Months Ended September 30, 2014 as compared to The Three Months Ended September 30, 2013

 

The higher ceded premiums for 2014 as compared to 2013 were caused primarily by higher universal life premiums and policy fees of $4.4 million. Ceded universal life premiums increased with the increase in the direct universal life premiums and policy fees.

 

Ceded benefits and settlement expenses were higher for the three months ended September 30, 2014, as compared to the three months ended September 30, 2013, due to higher universal life ceded claims, partially offset by decreases in ceded reserves. Traditional ceded benefits decreased $4.3 million for the three months ended September 30, 2014, as compared to the three months ended September 30, 2013, due to lower ceded claims, slightly offset by an increase in ceded reserves. Universal life ceded benefits increased $14.7 million for the three months ended September 30, 2014, as compared to the three months ended September 30, 2013, due to higher ceded claims partially offset by a decrease in change in ceded reserves. Ceded universal life claims were $19.0 million higher for the three months ended September 30, 2014, as compared to the three months ended September 30, 2013.

 

Ceded amortization of deferred policy acquisitions costs increased for the three months ended September 30, 2014, as compared to the three months ended September 30, 2013, primarily due to the differences in unlocking between the two periods.

 

Ceded other operating expenses reflect the impact of reinsurance allowances on net income. Allowances decreased in the traditional life block, reflecting runoff of business and increased in the universal life block reflecting the impact of unlocking on reinsurance.

 

For The Nine Months Ended September 30, 2014 as compared to The Nine Months Ended September 30, 2013

 

The lower ceded premiums for 2014 as compared to 2013 were caused primarily by lower universal life premiums and policy fees of $11.5 million and lower traditional life premiums of $46.5 million. Ceded traditional premium for the nine months ended September 30, 2014 decreased from the nine months ended September 30, 2013, primarily due to fluctuations in the number of policies entering their post level period. Ceded universal life premiums for the nine months ended September 30, 2014 decreased from the nine months ended September 30, 2013 primarily due to the second quarter 2014 impact of unlocking on ceded premiums, almost entirely offset in benefit and settlement expenses.

 

Ceded benefits and settlement expenses were lower for the nine months ended September 30, 2014, as compared to the nine months ended September 30, 2013, due to a decrease in change in ceded reserves, partially offset by higher ceded claims. Traditional ceded benefits decreased $47.5 million for the nine months ended September 30, 2014, as compared to the nine months ended September 30, 2013, due to a decrease in change in ceded reserves and a

 

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decrease in ceded death benefits. Universal life ceded benefits increased $11.0 million for the nine months ended September 30, 2014, as compared to the nine months ended September 30, 2013, due to an increase in ceded claims, partially offset by a decrease in ceded reserves due to the impact of unlocking on ceded premium. Ceded universal life claims were $68.2 million higher for the nine months ended September 30, 2014, as compared to the nine months ended September 30, 2013.

 

Ceded amortization of deferred policy acquisitions costs increased for the nine months ended September 30, 2014, as compared to the nine months ended September 30, 2013, primarily due to the differences in unlocking between the two periods.

 

Ceded other operating expenses reflect the impact of reinsurance allowances on net income. Allowances decreased in the traditional line reflecting runoff of business, and increased in the universal life line reflecting the allowance pattern on older business, changes in the mix of business, and the impact of unlocking on reinsurance.

 

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Acquisitions

 

Segment results of operations

 

Segment results were as follows:

 

 

 

For The

 

 

 

For The

 

 

 

 

 

Three Months Ended

 

 

 

Nine Months Ended

 

 

 

 

 

September 30,

 

 

 

September 30,

 

 

 

 

 

2014

 

2013

 

Change

 

2014

 

2013

 

Change

 

 

 

(Dollars In Thousands)

 

 

 

(Dollars In Thousands)

 

 

 

REVENUES

 

 

 

 

 

 

 

 

 

 

 

 

 

Gross premiums and policy fees

 

$

270,959

 

$

194,379

 

39.4

%

$

872,356

 

$

611,299

 

42.7

%

Reinsurance ceded

 

(90,744

)

(92,970

)

2.4

 

(293,459

)

(292,229

)

(0.4

)

Net premiums and policy fees

 

180,215

 

101,409

 

77.7

 

578,897

 

319,070

 

81.4

 

Net investment income

 

219,453

 

133,695

 

64.1

 

656,113

 

403,050

 

62.8

 

Other income

 

3,036

 

1,004

 

n/m

 

10,386

 

3,033

 

n/m

 

Total operating revenues

 

402,704

 

236,108

 

70.6

 

1,245,396

 

725,153

 

71.7

 

Realized gains (losses) - investments

 

(14,718

)

(24,992

)

41.1

 

119,927

 

(163,726

)

n/m

 

Realized gains (losses) - derivatives

 

20,536

 

28,951

 

(29.1

)

(91,609

)

190,820

 

n/m

 

Total revenues

 

408,522

 

240,067

 

70.2

 

1,273,714

 

752,247

 

69.3

 

BENEFITS AND EXPENSES

 

 

 

 

 

 

 

 

 

 

 

 

 

Benefits and settlement expenses

 

295,252

 

173,423

 

70.2

 

919,849

 

530,773

 

73.3

 

Amortization of value of business acquired

 

2,703

 

18,030

 

(85.0

)

37,106

 

54,904

 

(32.4

)

Other operating expenses

 

31,820

 

15,226

 

n/m

 

89,634

 

46,235

 

93.9

 

Operating benefits and expenses

 

329,775

 

206,679

 

59.6

 

1,046,589

 

631,912

 

65.6

 

Amortization related to benefits and settlement expenses

 

2,564

 

104

 

n/m

 

13,595

 

104

 

n/m

 

Amortization of VOBA related to realized gains (losses) - investments

 

612

 

398

 

53.8

 

1,393

 

1,514

 

(8.0

)

Total benefits and expenses

 

332,951

 

207,181

 

60.7

 

1,061,577

 

633,530

 

67.6

 

INCOME BEFORE INCOME TAX

 

75,571

 

32,886

 

n/m

 

212,137

 

118,717

 

78.7

 

Less: realized gains (losses)

 

5,818

 

3,959

 

 

 

28,318

 

27,094

 

 

 

Less: amortization related to benefits and settlement expenses

 

(2,564

)

(104

)

 

 

(13,595

)

(104

)

 

 

Less: related amortization of VOBA

 

(612

)

(398

)

 

 

(1,393

)

(1,514

)

 

 

OPERATING INCOME

 

$

72,929

 

$

29,429

 

n/m

 

$

198,807

 

$

93,241

 

n/m

 

 

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The following table summarizes key data for the Acquisitions segment:

 

 

 

For The

 

 

 

For The

 

 

 

 

 

Three Months Ended

 

 

 

Nine Months Ended

 

 

 

 

 

September 30,

 

 

 

September 30,

 

 

 

 

 

2014

 

2013

 

Change

 

2014

 

2013

 

Change

 

 

 

(Dollars In Thousands)

 

 

 

(Dollars In Thousands)

 

 

 

Average Life Insurance In-Force(1)

 

 

 

 

 

 

 

 

 

 

 

 

 

Traditional

 

$

186,577,010

 

$

166,134,343

 

12.3

%

$

190,139,888

 

$

169,083,110

 

12.5

%

Universal life

 

34,619,902

 

27,475,762

 

26.0

 

35,366,654

 

28,050,853

 

26.1

 

 

 

$

221,196,912

 

$

193,610,105

 

14.2

 

$

225,506,542

 

$

197,133,963

 

14.4

 

Average Account Values

 

 

 

 

 

 

 

 

 

 

 

 

 

Universal life

 

$

4,540,271

 

$

3,318,872

 

36.8

 

$

4,573,397

 

$

3,338,832

 

37.0

 

Fixed annuity(2)

 

3,765,858

 

3,018,382

 

24.8

 

3,795,553

 

3,048,919

 

24.5

 

Variable annuity

 

1,462,919

 

577,578

 

n/m

 

1,492,537

 

576,569

 

n/m

 

 

 

$

9,769,048

 

$

6,914,832

 

41.3

 

$

9,861,487

 

$

6,964,320

 

41.6

 

Interest Spread - UL & Fixed Annuities

 

 

 

 

 

 

 

 

 

 

 

 

 

Net investment income yield(3)

 

5.66

%

5.73

%

 

 

5.67

%

5.70

%

 

 

Interest credited to policyholders

 

3.97

 

4.02

 

 

 

3.98

 

3.99

 

 

 

Interest spread

 

1.69

%

1.71

%

 

 

1.69

%

1.71

%

 

 

 


 (1)      Amounts are not adjusted for reinsurance ceded.

 (2)      Includes general account balances held within variable annuity products and is net of coinsurance ceded.

 (3)      Earned rates exclude portfolios supporting modified coinsurance and crediting rates exclude 100% cessions.

 

For The Three Months Ended September 30, 2014 as compared to The Three Months Ended September 30, 2013

 

Segment operating income

 

Operating income was $72.9 million for the three months ended September 30, 2014, an increase of $43.5 million as compared to the three months ended September 30, 2013, primarily due to the impact of the MONY acquisition which occurred in the fourth quarter of 2013. MONY operating income was $29.3 million for the three months ended September 30, 2014. In addition, the increase was driven by a $15.9 million favorable variance related to prospective unlocking.  For the three months ended September 30, 2014, the segment recorded favorable prospective unlocking of $11.7 million as compared to an unfavorable $4.2 million of prospective unlocking for the three months ended September 30, 2013.

 

Operating revenues

 

Net premiums and policy fees increased $78.8 million, or 77.7%, for the three months ended September 30, 2014, as compared to the three months ended September 30, 2013, primarily due to the impact of the MONY acquisition which occurred in the fourth quarter of 2013. MONY net premiums for the three months ended September 30, 2014 were $79.1 million, and were partly offset by runoff of other business. Net investment income increased $85.8 million, or 64.1%, for the three months ended September 30, 2014, as compared to the three months ended September 30, 2013, due to the $94.0 million impact of MONY partly offset by expected runoff of business.

 

Total benefits and expenses

 

Total benefits and expenses increased $125.8 million, or 60.7%, for the three months ended September 30, 2014, as compared to the three months ended September 30, 2013. The increase was primarily due to the MONY acquisition increasing operating benefits and expenses $145.7 million, partly offset by runoff and the impact of favorable unlocking of $9.7 million for the three months ended September 30, 2014 as compared to an unfavorable $1.7 million for three months ended September 30, 2013.

 

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For The Nine Months Ended September 30, 2014 as compared to The Nine Months Ended September 30, 2013

 

Segment operating income

 

Operating income was $198.8 million for the nine months ended September 30, 2014, an increase of $105.6 million as compared to the nine months ended September 30, 2013. This was primarily due to the impact of the MONY acquisition which occurred in the fourth quarter of 2013. MONY operating income was $86.3 million for the nine months ended September 30, 2014. In addition, the increase was driven by a $15.9 million favorable variance related to prospective unlocking.  For the nine months ended September 30, 2014, the segment recorded favorable prospective unlocking of $11.7 million as compared to an unfavorable $4.2 million of prospective unlocking for the nine months ended September 30, 2013.

 

Operating revenues

 

Net premiums and policy fees increased $259.8 million, or 81.4%, for the nine months ended September 30, 2014, as compared to the nine months ended September 30, 2013, primarily due to the impact of the MONY acquisition which occurred in the fourth quarter of 2013. MONY net premiums for the nine months ended September 30, 2014 were $282.5 million, and were partly offset by runoff of other business. Net investment income increased $253.1 million, or 62.8%, for the nine months ended September 30, 2014, as compared to the nine months ended September 30, 2013, due to the $272.9 million impact of MONY, partly offset by expected runoff of business.

 

Total benefits and expenses

 

Total benefits and expenses increased $428.0 million, or 67.6%, for the nine months ended September 30, 2014, as compared to the nine months ended September 30, 2013. The increase was primarily due to the MONY acquisition, partly offset by the impact of favorable unlocking of $6.3 million for the nine months ended September 30, 2014 as compared to an unfavorable $2.4 million for the nine months ended September 30, 2013. The MONY acquisition increased operating benefits and expenses $475.9 million.

 

Reinsurance

 

The Acquisitions segment currently reinsures portions of both its life and annuity in-force. The cost of reinsurance to the segment is reflected in the chart shown below. A more detailed discussion of the components of reinsurance can be found in the Reinsurance section of Note 2, Summary of Significant Accounting Policies of our Annual Report on Form 10-K for the fiscal year ended December 31, 2013.

 

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Impact of reinsurance

 

Reinsurance impacted the Acquisitions segment line items as shown in the following table:

 

Acquisitions Segment

Line Item Impact of Reinsurance

 

 

 

For The

 

For The

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

 

2014

 

2013

 

2014

 

2013

 

 

 

(Dollars In Thousands)

 

REVENUES

 

 

 

 

 

 

 

 

 

Reinsurance ceded

 

$

(90,744

)

$

(92,970

)

$

(293,459

)

$

(292,229

)

BENEFITS AND EXPENSES

 

 

 

 

 

 

 

 

 

Benefits and settlement expenses

 

(69,300

)

(65,336

)

(240,838

)

(238,789

)

Amortization of deferred policy acquisition costs

 

(3,544

)

(2,718

)

(9,703

)

(7,307

)

Other operating expenses

 

(12,027

)

(12,014

)

(34,972

)

(36,460

)

Total benefits and expenses

 

(84,871

)

(80,068

)

(285,513

)

(282,556

)

 

 

 

 

 

 

 

 

 

 

NET IMPACT OF REINSURANCE (1)

 

$

(5,873

)

$

(12,902

)

$

(7,946

)

$

(9,673

)

 


(1) Assumes no investment income on reinsurance. Foregone investment income would substantially reduce the favorable impact of reinsurance.

 

The segment’s reinsurance programs do not materially impact the other income line of the income statement. In addition, net investment income generally has no direct impact on reinsurance cost. However, by ceding business to the assuming companies, we forgo investment income on the reserves ceded to the assuming companies. Conversely, the assuming companies will receive investment income on the reserves assumed which will increase the assuming companies’ profitability on business assumed from the Company. For business ceded under modified coinsurance arrangements, the amount of investment income attributable to the assuming company is included as part of the overall change in policy reserves and, as such, is reflected in benefit and settlement expenses. The net investment income impact to us and the assuming companies has not been quantified as it is not fully reflected in our consolidated financial statements.

 

The net impact of reinsurance was more favorable by $7.0 million for the three months ended September 30, 2014, as compared to the three months ended September 30, 2013, primarily due to a favorable impact from the MONY acquisition. In the three months ended September 30, 2014, ceded revenues increased by $2.2 million and ceded benefits and expenses increased by $4.8 million as the impact of the MONY acquisition more than offset runoff in other blocks.

 

The net impact of reinsurance was more favorable by $1.7 million for the nine months ended September 30, 2014, as compared to the nine months ended September 30, 2013, primarily due to a favorable impact from the MONY acquisition. In the nine months ended September 30, 2014, ceded revenues increased by $1.2 million and ceded benefits and expenses increased by $3.0 million as the impact of the MONY acquisition more than offset runoff in other blocks.

 

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Table of Contents

 

Annuities

 

Segment results of operations

 

Segment results were as follows:

 

 

 

For The

 

 

 

For The

 

 

 

 

 

Three Months Ended

 

 

 

Nine Months Ended

 

 

 

 

 

September 30,

 

 

 

September 30,

 

 

 

 

 

2014

 

2013

 

Change

 

2014

 

2013

 

Change

 

 

 

(Dollars In Thousands)

 

 

 

(Dollars In Thousands)

 

 

 

REVENUES

 

 

 

 

 

 

 

 

 

 

 

 

 

Gross premiums and policy fees

 

$

38,614

 

$

34,870

 

10.7

%

$

112,445

 

$

96,387

 

16.7

%

Reinsurance ceded

 

 

 

n/m

 

 

 

n/m

 

Net premiums and policy fees

 

38,614

 

34,870

 

10.7

 

112,445

 

96,387

 

16.7

 

Net investment income

 

117,646

 

116,699

 

0.8

 

351,943

 

352,045

 

n/m

 

Realized gains (losses) - derivatives

 

(17,928

)

(15,782

)

(13.6

)

(52,376

)

(43,293

)

(21.0

)

Other income

 

38,027

 

33,295

 

14.2

 

109,444

 

90,690

 

20.7

 

Total operating revenues

 

176,359

 

169,082

 

4.3

 

521,456

 

495,829

 

5.2

 

Realized gains (losses) - investments

 

4,787

 

236

 

n/m

 

7,734

 

10,227

 

(24.4

)

Realized gains (losses) - derivatives, net of economic cost

 

1,093

 

26,987

 

(95.9

)

(46,877

)

41,203

 

n/m

 

Total revenues

 

182,239

 

196,305

 

(7.2

)

482,313

 

547,259

 

(11.9

)

BENEFITS AND EXPENSES

 

 

 

 

 

 

 

 

 

 

 

 

 

Benefits and settlement expenses

 

78,031

 

80,963

 

(3.6

)

232,864

 

243,804

 

(4.5

)

Amortization of deferred policy acquisition costs and value of business acquired

 

18,336

 

11,246

 

63.0

 

44,504

 

37,663

 

18.2

 

Other operating expenses

 

30,657

 

26,007

 

17.9

 

87,852

 

83,716

 

4.9

 

Operating benefits and expenses

 

127,024

 

118,216

 

7.5

 

365,220

 

365,183

 

n/m

 

Amortization related to benefits and settlement expenses

 

290

 

(2,276

)

n/m

 

2,297

 

(3,132

)

n/m

 

Amortization of DAC related to realized gains (losses) - investments

 

(19

)

8,565

 

n/m

 

(13,146

)

14,665

 

n/m

 

Total benefits and expenses

 

127,295

 

124,505

 

2.2

 

354,371

 

376,716

 

(5.9

)

INCOME BEFORE INCOME TAX

 

54,944

 

71,800

 

(23.5

)

127,942

 

170,543

 

(25.0

)

Less: realized gains (losses) - investments

 

4,787

 

236

 

 

 

7,734

 

10,227

 

 

 

Less: realized gains (losses) - derivatives, net of economic cost

 

1,093

 

26,987

 

 

 

(46,877

)

41,203

 

 

 

Less: amortization related to benefits and settlement expenses

 

(290

)

2,276

 

 

 

(2,297

)

3,132

 

 

 

Less: related amortization of DAC

 

19

 

(8,565

)

 

 

13,146

 

(14,665

)

 

 

OPERATING INCOME

 

$

49,335

 

$

50,866

 

(3.0

)

$

156,236

 

$

130,646

 

19.6

 

 

88



Table of Contents

 

The following table summarizes key data for the Annuities segment:

 

 

 

For The

 

 

 

For The

 

 

 

 

 

Three Months Ended

 

 

 

Nine Months Ended

 

 

 

 

 

September 30,

 

 

 

September 30,

 

 

 

 

 

2014

 

2013

 

Change

 

2014

 

2013

 

Change

 

 

 

(Dollars In Thousands)

 

 

 

(Dollars In Thousands)

 

 

 

Sales

 

 

 

 

 

 

 

 

 

 

 

 

 

Fixed annuity

 

$

267,604

 

$

180,714

 

48.1

%

$

717,359

 

$

434,165

 

65.2

%

Variable annuity

 

279,458

 

357,484

 

(21.8

)

686,966

 

1,656,066

 

(58.5

)

 

 

$

547,062

 

$

538,198

 

1.6

 

$

1,404,325

 

$

2,090,231

 

(32.8

)

Average Account Values

 

 

 

 

 

 

 

 

 

 

 

 

 

Fixed annuity(1)

 

$

8,243,541

 

$

8,214,702

 

0.4

 

$

8,212,895

 

$

8,251,504

 

(0.5

)

Variable annuity

 

12,456,974

 

10,989,161

 

13.4

 

12,268,923

 

10,354,702

 

18.5

 

 

 

$

20,700,515

 

$

19,203,863

 

7.8

 

$

20,481,818

 

$

18,606,206

 

10.1

 

Interest Spread - Fixed Annuities(2)

 

 

 

 

 

 

 

 

 

 

 

 

 

Net investment income yield

 

5.47

%

5.50

%

 

 

5.48

%

5.51

%

 

 

Interest credited to policyholders

 

3.33

 

3.50

 

 

 

3.34

 

3.54

 

 

 

Interest spread

 

2.14

%

2.00

%

 

 

2.14

%

1.97

%

 

 

 


(1) Includes general account balances held within variable annuity products.

(2) Interest spread on average general account values.

 

 

 

For The

 

 

 

For The

 

 

 

 

 

Three Months Ended

 

 

 

Nine Months Ended

 

 

 

 

 

September 30,

 

 

 

September 30,

 

 

 

 

 

2014

 

2013

 

Change

 

2014

 

2013

 

Change

 

 

 

(Dollars In Thousands)

 

 

 

(Dollars In Thousands)

 

 

 

Derivatives related to variable annuity contracts:

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest rate futures - VA

 

$

1,979

 

$

(2,255

)

$

4,234

 

$

12,777

 

$

(26,393

)

$

39,170

 

Equity futures - VA

 

861

 

(12,568

)

13,429

 

(9,049

)

(39,829

)

30,780

 

Currency futures - VA

 

10,185

 

(6,531

)

16,716

 

6,020

 

1,440

 

4,580

 

Variance swaps - VA

 

1,570

 

(1,347

)

2,917

 

(1,103

)

(9,566

)

8,463

 

Equity options - VA

 

2,050

 

(29,094

)

31,144

 

(31,240

)

(65,631

)

34,391

 

Interest rate swaptions - VA

 

(2,812

)

1,725

 

(4,537

)

(17,213

)

(738

)

(16,475

)

Interest rate swaps - VA

 

22,011

 

(19,224

)

41,235

 

124,548

 

(125,502

)

250,050

 

Embedded derivative - GMWB(1)

 

(51,429

)

80,541

 

(131,970

)

(181,105

)

264,231

 

(445,336

)

Total derivatives related to variable annuity contracts

 

 

(15,585

)

 

11,247

 

 

(26,832

)

 

(96,365

)

 

(1,988

)

 

(94,377

)

Derivatives related to FIA contracts:

 

 

 

 

 

 

 

 

 

 

 

 

 

Embedded derivative - FIA

 

(2,462

)

(104

)

(2,358

)

(9,036

)

(145

)

(8,891

)

Equity futures - FIA

 

117

 

(42

)

159

 

1,067

 

(42

)

1,109

 

Volatility futures - FIA

 

(4

)

 

(4

)

4

 

 

4

 

Equity options - FIA

 

1,099

 

104

 

995

 

5,077

 

85

 

4,992

 

Total derivatives related to FIA contracts

 

 

(1,250

)

 

(42

)

 

(1,208

)

 

(2,888

)

 

(102

)

 

(2,786

)

Economic cost - VA GMWB(2)

 

17,928

 

15,782

 

2,146

 

52,376

 

43,293

 

9,083

 

Realized gains (losses) - derivatives, net of economic cost

 

$

1,093

 

$

26,987

 

$

(25,894

)

$

(46,877

)

$

41,203

 

$

(88,080

)

 


(1) Includes impact of nonperformance risk of $10.0 million for the three months ended September 30, 2014 and a net zero impact for the nine months ended September 30, 2014 and $(10.5) million and $(3.1) million for the three and nine months ended September 30, 3013, respectively.

(2) Economic cost is the long-term expected average cost of providing the product benefit over the life of the policy based on product pricing assumptions. These include assumptions about the economic/market environment, and elective and non-elective policy owner behavior (e.g. lapses, withdrawal timing, mortality, etc.).

 

89



Table of Contents

 

 

 

As of

 

 

 

 

 

September 30, 2014

 

December 31, 2013

 

Change

 

 

 

(Dollars In Thousands)

 

 

 

GMDB - Net amount at risk(1)

 

$

98,901

 

$

90,021

 

9.9

%

GMDB Reserves

 

20,526

 

16,001

 

28.3

 

GMWB and GMAB Reserves

 

24,891

 

(156,228

)

n/m

 

Account value subject to GMWB rider

 

9,711,404

 

9,513,847

 

2.1

 

GMWB Benefit Base

 

9,741,126

 

9,162,797

 

6.3

 

GMAB Benefit Base

 

5,035

 

5,441

 

(7.5

)

S&P 500® Index

 

1,972

 

1,848

 

6.7

 

 


(1) Guaranteed benefits in excess of contract holder account balance.

 

For The Three Months Ended September 30, 2014 as compared to The Three Months Ended September 30, 2013

 

Segment operating income

 

Segment operating income was $49.3 million for the three months ended September 30, 2014, as compared to $50.9 million for the three months ended September 30, 2013, a decrease of $1.5 million or 3.0%. This variance included an unfavorable change in unlocking and other operating expenses partially offset by higher net policy fees and other income in the VA line and lower credited interest. The segment recorded an unfavorable $3.4 million of unlocking for the three months ended September 30, 2014, as compared to favorable unlocking of $4.9 million for the three months ended September 30, 2013.

 

Operating revenues

 

Segment operating revenues increased $7.3 million, or 4.3%, for the three months ended September 30, 2014, as compared to the three months ended September 30, 2013, primarily due to increases in net policy fees and other income from the VA line of business. Those increases were partially offset by increased GMWB economic cost in the VA line of business. Average fixed account balances increased 0.4% and average variable account balances grew 13.4% for the three months ended September 30, 2014, as compared to the three months ended September 30, 2013.

 

Benefits and settlement expenses

 

Benefits and settlement expenses decreased $2.9 million, or 3.6%, for the three months ended September 30, 2014, as compared to the three months ended September 30, 2013. This decrease was primarily the result of lower credited interest and a $1.0 million favorable change in unlocking. Partially offsetting these favorable changes was an unfavorable change of $1.4 million in guaranteed benefit reserves.

 

Amortization of DAC

 

DAC amortization increased $7.1 million, or 63.0%, for the three months ended September 30, 2014, as compared to the three months ended September 30, 2013, primarily due to an unfavorable change in unlocking. DAC unlocking for the three months ended September 30, 2014 was $3.5 million unfavorable as compared to $5.8 million favorable unlocking for the three months ended September 30, 2013.

 

Other operating expenses

 

Other operating expenses increased $4.7 million, or 17.9%, for the three months ended September 30, 2014, as compared to the three months ended September 30, 2013. The increase is primarily due to higher renewal commissions.

 

Sales

 

Total sales increased $8.9 million, or 1.6%, for the three months ended September 30, 2014, as compared to the three months ended September 30, 2013. Sales of variable annuities decreased $78.0 million, or 21.8% for the three

 

90



Table of Contents

 

months ended September 30, 2014, as compared to the three months ended September 30, 2013. Sales of fixed annuities increased by $86.9 million, or 48.1% for the three months ended September 30, 2014, as compared to the three months ended September 30, 2013, driven by an increase in fixed indexed annuities (“FIA”) sales.

 

For The Nine Months Ended September 30, 2014 as compared to The Nine Months Ended September 30, 2013

 

Segment operating income

 

Segment operating income was $156.2 million for the nine months ended September 30, 2014, as compared to $130.6 million for the nine months ended September 30, 2013, an increase of $25.6 million, or 19.6%. This variance was a result of higher net policy fees and other income in the VA line and lower credited interest. These favorable variances were partially offet by an unfavorable change in unlocking and other operating expenses. The segment recorded a favorable $0.1 million of unlocking for the nine months ended September 30, 2014, as compared to favorable unlocking of $8.5 million for the nine months ended September 30, 2013.

 

Operating revenues

 

Segment operating revenues increased $25.6 million, or 5.2%, for the nine months ended September 30, 2014, as compared to the nine months ended September 30, 2013, primarily due to increases in policy fees and other income from the VA line of business. Those increases were partially offset by increased GMWB economic cost in the VA line of business. Average fixed account balances decreased 0.5% while average variable account balances grew 18.5% for the nine months ended September 30, 2014, as compared to the nine months ended September 30, 2013.

 

Benefits and settlement expenses

 

Benefits and settlement expenses decreased $10.9 million, or 4.5%, for the nine months ended September 30, 2014, as compared to the nine months ended September 30, 2013. This decrease was primarily the result of lower credited interest, lower realized losses in the MVA annuities line and a $0.5 million favorable change in unlocking. These favorable changes were partially offset by unfavorable changes in guaranteed benefit reserves and the SPIA mortality variance.

 

Amortization of DAC

 

DAC amortization increased $6.8 million, or 18.2%, for the nine months ended September 30, 2014, as compared to the nine months ended September 30, 2013, primarily due to an unfavorable change in unlocking. DAC unlocking for the nine months ended September 30, 2014, was $1.0 million favorable as compared to $9.9 million favorable unlocking for the nine months ended September 30, 2013.

 

Other operating expenses

 

Other operating expenses increased $4.1 million, or 4.9%, for the nine months ended September 30, 2014, as compared to the nine months ended September 30, 2013. The increase is due to higher renewal commissions partially offset by lower acquisition expenses and lower guaranty fund allocations.

 

Sales

 

Total sales decreased $685.9 million, or 32.8%, for the nine months ended September 30, 2014, as compared to the nine months ended September 30, 2013. Sales of variable annuities decreased $969.1 million, or 58.5% for the nine months ended September 30, 2014, as compared to the nine months ended September 30, 2013. Sales of fixed annuities increased by $283.2 million, or 65.2% for the nine months ended September 30, 2014, as compared to the nine months ended September 30, 2013, driven by an increase in FIA sales.

 

91



Table of Contents

 

Stable Value Products

 

Segment results of operations

 

Segment results were as follows:

 

 

 

For The

 

 

 

For The

 

 

 

 

 

Three Months Ended

 

 

 

Nine Months Ended

 

 

 

 

 

September 30,

 

 

 

September 30,

 

 

 

 

 

2014

 

2013

 

Change

 

2014

 

2013

 

Change

 

 

 

(Dollars In Thousands)

 

 

 

(Dollars In Thousands)

 

 

 

REVENUES

 

 

 

 

 

 

 

 

 

 

 

 

 

Net investment income

 

$

28,781

 

$

29,478

 

(2.4

)%

$

83,737

 

$

93,203

 

(10.2

)%

Other income

 

 

 

n/m

 

1

 

 

n/m

 

Total operating revenues

 

28,781

 

29,478

 

(2.4

)

83,738

 

93,203

 

(10.2

)

Realized gains (losses)

 

9,932

 

(4,270

)

n/m

 

9,903

 

(1,607

)

n/m

 

Total revenues

 

38,713

 

25,208

 

53.6

 

93,641

 

91,596

 

2.2

 

BENEFITS AND EXPENSES

 

 

 

 

 

 

 

 

 

 

 

 

 

Benefits and settlement expenses

 

8,793

 

9,639

 

(8.8

)

28,126

 

31,925

 

(11.9

)

Amortization of deferred policy acquisition costs

 

96

 

110

 

(12.7

)

295

 

287

 

2.8

 

Other operating expenses

 

386

 

523

 

(26.2

)

1,127

 

1,477

 

(23.7

)

Total benefits and expenses

 

9,275

 

10,272

 

(9.7

)

29,548

 

33,689

 

(12.3

)

INCOME BEFORE INCOME TAX

 

29,438

 

14,936

 

97.1

 

64,093

 

57,907

 

10.7

 

Less: realized gains (losses)

 

9,932

 

(4,270

)

 

 

9,903

 

(1,607

)

 

 

OPERATING INCOME

 

$

19,506

 

$

19,206

 

1.6

 

$

54,190

 

$

59,514

 

(8.9

)

 

92



Table of Contents

 

The following table summarizes key data for the Stable Value Products segment:

 

 

 

For The

 

 

 

For The

 

 

 

 

 

Three Months Ended

 

 

 

Nine Months Ended

 

 

 

 

 

September 30,

 

 

 

September 30,

 

 

 

 

 

2014

 

2013

 

Change

 

2014

 

2013

 

Change

 

 

 

(Dollars In Thousands)

 

 

 

(Dollars In Thousands)

 

 

 

Sales

 

 

 

 

 

 

 

 

 

 

 

 

 

GIC

 

$

15,000

 

$

80,200

 

(81.3

)%

$

40,850

 

$

397,504

 

(89.7

)%

GFA - Direct Institutional

 

 

 

n/m

 

50,000

 

 

n/m

 

 

 

$

15,000

 

$

80,200

 

(81.3

)

$

90,850

 

$

397,504

 

(77.1

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Average Account Values

 

$

2,358,842

 

$

2,503,294

 

(5.8

)%

$

2,478,224

 

$

2,529,382

 

(2.0

)%

Ending Account Values

 

$

2,261,546

 

$

2,531,262

 

(10.7

)%

$

2,261,546

 

$

2,531,262

 

(10.7

)%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Operating Spread

 

 

 

 

 

 

 

 

 

 

 

 

 

Net investment income yield

 

4.88

%

4.71

%

 

 

4.51

%

4.91

%

 

 

Interest credited

 

1.49

 

1.54

 

 

 

1.51

 

1.68

 

 

 

Operating expenses

 

0.08

 

0.10

 

 

 

0.08

 

0.09

 

 

 

Operating spread

 

3.31

%

3.07

%

 

 

2.92

%

3.14

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Adjusted operating spread(1)

 

2.64

%

2.69

%

 

 

2.65

%

2.64

%

 

 

 


 (1) Excludes participating mortgage loan income and other income.

 

For The Three Months Ended September 30, 2014 as compared to The Three Months Ended September 30, 2013

 

Segment operating income

 

Operating income was $19.5 million and increased $0.3 million, or 1.6%, for the three months ended September 30, 2014, as compared to the three months ended September 30, 2013. The increase in operating earnings resulted from an increase in participating mortgage income offset by lower adjusted operating spreads and a decline in average account values. Participating mortgage income for the three months ended September 30, 2014 was $3.9 million compared to $2.4 million for the three months ended September 30, 2013. The adjusted operating spread, which excludes participating income, decreased by 5 basis points for the three months ended September 30, 2014 over the prior year.

 

For The Nine Months Ended September 30, 2014 as compared to The Nine Months Ended September 30, 2013

 

Segment operating income

 

Operating income was $54.2 million and decreased $5.3 million, or 8.9%, for the nine months ended September 30, 2014, as compared to the nine months ended September 30, 2013. The decrease in operating earnings resulted from a decrease in participating mortgage income and a decline in average account values. Participating mortgage income for the nine months ended September 30, 2014 was $4.9 million compared to $9.5 million for the nine months ended September 30, 2013.

 

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Asset Protection

 

Segment results of operations

 

Segment results were as follows:

 

 

 

For The

 

 

 

For The

 

 

 

 

 

Three Months Ended

 

 

 

Nine Months Ended

 

 

 

 

 

September 30,

 

 

 

September 30,

 

 

 

 

 

2014

 

2013

 

Change

 

2014

 

2013

 

Change

 

 

 

(Dollars In Thousands)

 

 

 

(Dollars In Thousands)

 

 

 

REVENUES

 

 

 

 

 

 

 

 

 

 

 

 

 

Gross premiums and policy fees

 

$

68,340

 

$

66,604

 

2.6

%

$

203,052

 

$

200,993

 

1.0

%

Reinsurance ceded

 

(35,804

)

(32,681

)

(9.6

)

(103,689

)

(96,416

)

(7.5

)

Net premiums and policy fees

 

32,536

 

33,923

 

(4.1

)

99,363

 

104,577

 

(5.0

)

Net investment income

 

5,589

 

5,804

 

(3.7

)

17,043

 

17,440

 

(2.3

)

Other income

 

32,459

 

31,768

 

2.2

 

91,431

 

88,862

 

2.9

 

Total operating revenues

 

70,584

 

71,495

 

(1.3

)

207,837

 

210,879

 

(1.4

)

BENEFITS AND EXPENSES

 

 

 

 

 

 

 

 

 

 

 

 

 

Benefits and settlement expenses

 

24,745

 

26,384

 

(6.2

)

73,813

 

77,006

 

(4.1

)

Amortization of deferred policy acquisition costs

 

6,133

 

7,402

 

(17.1

)

19,782

 

22,471

 

(12.0

)

Other operating expenses

 

31,176

 

30,882

 

1.0

 

90,809

 

91,110

 

(0.3

)

Total benefits and expenses

 

62,054

 

64,668

 

(4.0

)

184,404

 

190,587

 

(3.2

)

INCOME BEFORE INCOME TAX

 

8,530

 

6,827

 

24.9

 

23,433

 

20,292

 

15.5

 

OPERATING INCOME

 

$

8,530

 

$

6,827

 

24.9

 

$

23,433

 

$

20,292

 

15.5

 

 

The following table summarizes key data for the Asset Protection segment:

 

 

 

For The

 

 

 

For The

 

 

 

 

 

Three Months Ended

 

 

 

Nine Months Ended

 

 

 

 

 

September 30,

 

 

 

September 30,

 

 

 

 

 

2014

 

2013

 

Change

 

2014

 

2013

 

Change

 

 

 

(Dollars In Thousands)

 

 

 

(Dollars In Thousands)

 

 

 

Sales

 

 

 

 

 

 

 

 

 

 

 

 

 

Credit insurance

 

$

7,754

 

$

9,105

 

(14.8

)%

$

22,812

 

$

26,291

 

(13.2

)%

Service contracts

 

104,821

 

102,796

 

2.0

 

289,068

 

283,984

 

1.8

 

GAP

 

19,193

 

18,140

 

5.8

 

54,951

 

50,359

 

9.1

 

 

 

$

131,768

 

$

130,041

 

1.3

 

$

366,831

 

$

360,634

 

1.7

 

Loss Ratios(1)

 

 

 

 

 

 

 

 

 

 

 

 

 

Credit insurance

 

30.5

%

20.7

%

 

 

29.2

%

34.8

%

 

 

Service contracts

 

92.5

 

99.0

 

 

 

88.8

 

92.0

 

 

 

GAP

 

53.2

 

46.0

 

 

 

56.5

 

41.7

 

 

 

 


(1) Incurred claims as a percentage of earned premiums

 

For The Three Months Ended September 30, 2014 as compared to The Three Months Ended September 30, 2013

 

Segment operating income

 

Operating income was $8.5 million, representing an increase of $1.7 million, or 24.9%, for the three months ended September 30, 2014, as compared to the three months ended September 30, 2013.

 

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Service contract earnings increased $1.6 million, primarily due to lower losses.  Credit insurance earnings increased $0.1 million, primarily resulting from lower expenses.  Earnings from the GAP product were consistent with the prior year.

 

Net premiums and policy fees

 

Net premiums and policy fees decreased $1.4 million, or 4.1%, for the three months ended September 30, 2014, as compared to the three months ended September 30, 2013. Service contract premiums decreased $1.0 million and GAP premiums decreased $0.5 million primarily due to higher ceded premiums.  Credit insurance premiums increased $0.1 million.

 

Other income

 

Other income increased $0.7 million, or 2.2%, for the three months ended September 30, 2014, as compared to the three months ended September 30, 2013 due primarily to higher volume in the service contract and GAP product lines.

 

Benefits and settlement expenses

 

Benefits and settlement expenses decreased $1.6 million, or 6.2%, for the three months ended September 30, 2014, as compared to the three months ended September 30, 2013. Service contract claims decreased $2.4 million resulting from lower loss ratios and higher ceded losses. The decrease was partially offset by an increase in GAP claims of $0.3 million and credit insurance claims of $0.4 million due to higher loss ratios.

 

Amortization of DAC and Other operating expenses

 

Amortization of DAC was $1.3 million, or 17.1%, lower for the three months ended September 30, 2014, as compared to the three months ended September 30, 2013, primarily due to lower DAC balances and a change in the mix of business in the GAP product line. Other operating expenses increased $0.3 million, or 1.0%, for the three months ended September 30, 2014.

 

Sales

 

Total segment sales increased $1.7 million, or 1.3%, for the three months ended September 30, 2014, as compared to the three months ended September 30, 2013. Higher auto sales helped drive increased service contract sales of $2.0 million and GAP product sales of $1.1 million. Credit insurance sales decreased $1.4 million due to the decreasing demand for this product.

 

For The Nine Months Ended September 30, 2014 as compared to The Nine Months Ended September 30, 2013

 

Segment operating income

 

Operating income was $23.4 million, representing an increase of $3.1 million, or 15.5%, for the nine months ended September 30, 2014, as compared to the nine months ended September 30, 2013. Service contract earnings increased $3.1 million primarily due lower loss ratios and higher volume. Credit insurance earnings increased $0.8 million primarily due to lower losses and lower expenses in 2014. Earnings from the GAP product line decreased $0.8 million primarily resulting from higher losses.

 

Net premiums and policy fees

 

Net premiums and policy fees decreased $5.2 million, or 5.0%, for the nine months ended September 30, 2014, as compared to the nine months ended September 30, 2013. Service contract premiums decreased $3.4 million and GAP premiums decreased $2.3 million primarily due to higher ceded premiums.  Credit insurance premiums increased $0.5 million.

 

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Other income

 

Other income increased $2.6 million, or 2.9%, for the nine months ended September 30, 2014, as compared to the nine months ended September 30, 2013 due primarily to higher volume in the service contract and GAP product lines.

 

Benefits and settlement expenses

 

Benefits and settlement expenses decreased $3.2 million, or 4.1%, for the nine months ended September 30, 2014, as compared to the nine months ended September 30, 2013.  Service contract claims decreased $5.2 million due to higher ceded losses and lower loss ratios. Credit insurance claims decreased $0.5 million, primarily due to lower loss ratios. The decreases were partially offset by an increase of $2.5 million in GAP claims due to higher loss ratios.

 

Amortization of DAC and Other operating expenses

 

Amortization of DAC was $2.7 million, or 12.0%, lower for the nine months ended September 30, 2014, as compared to the nine months ended September 30, 2013, primarily due to lower DAC balances and a change in the mix of business in the GAP product line. Other operating expenses decreased $0.3 million for the nine months ended September 30, 2014.

 

Sales

 

Total segment sales increased $6.2 million, or 1.7%, for the nine months ended September 30, 2014, as compared to the nine months ended September 30, 2013. Higher auto sales in 2014 helped drive increased service contract sales of $5.1 million and GAP product sales of $4.6 million. The increase was partly offset by a decrease in credit insurance sales of $3.5 million due to the decreasing demand for this product.

 

Reinsurance

 

The majority of the Asset Protection segment’s reinsurance activity relates to the cession of single premium credit life and credit accident and health insurance, vehicle service contracts, and guaranteed asset protection insurance to producer affiliated reinsurance companies (“PARCs”). These arrangements are coinsurance contracts ceding the business on a first dollar quota share basis at 100% to limit our exposure and allow the PARCs to share in the underwriting income of the product. Reinsurance contracts do not relieve us from our obligations to our policyholders. A more detailed discussion of the components of reinsurance can be found in the Reinsurance section of Note 2, Summary of Significant Accounting Policies to our Annual Report on Form 10-K for the fiscal year ended December 31, 2013.

 

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Reinsurance impacted the Asset Protection segment line items as shown in the following table:

 

Asset Protection Segment

Line Item Impact of Reinsurance

 

 

 

For The

 

For The

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

 

2014

 

2013

 

2014

 

2013

 

 

 

(Dollars In Thousands)

 

REVENUES

 

 

 

 

 

 

 

 

 

Reinsurance ceded

 

$

(35,804

)

$

(32,681

)

$

(103,689

)

$

(96,416

)

BENEFITS AND EXPENSES

 

 

 

 

 

 

 

 

 

Benefits and settlement expenses

 

(15,462

)

(14,993

)

(46,222

)

(42,894

)

Amortization of deferred policy acquisition costs

 

(1,595

)

(1,770

)

(4,633

)

(5,192

)

Other operating expenses

 

(1,762

)

(1,530

)

(5,434

)

(4,494

)

Total benefits and expenses

 

(18,819

)

(18,293

)

(56,289

)

(52,580

)

 

 

 

 

 

 

 

 

 

 

NET IMPACT OF REINSURANCE (1)

 

$

(16,985

)

$

(14,388

)

$

(47,400

)

$

(43,836

)

 


(1)    Assumes no investment income on reinsurance. Foregone investment income would substantially change the impact of reinsurance.

 

For The Three Months Ended September 30, 2014 as compared to The Three Months Ended September 30, 2013

 

Reinsurance premiums ceded increased $3.1 million, or 9.6%, for the three months ended September 30, 2014, as compared to the three months ended September 30, 2013. The increase was primarily due to an increase in ceded GAP and service contract premiums, somewhat offset by a decline in ceded dealer credit insurance premiums due to lower sales.

 

Benefits and settlement expenses ceded increased $0.5 million, or 3.1%, for the three months ended September 30, 2014, as compared to the three months ended September 30, 2013. The increase was primarily due to higher ceded losses in the service contract and GAP lines, somewhat offset by lower ceded losses in the dealer credit line.

 

Amortization of DAC ceded decreased $0.2 million while other operating expenses increased $0.2 million for the three months ended September 30, 2014 as compared to the three months ended September 30, 2013.

 

Net investment income has no direct impact on reinsurance cost. However, by ceding business to the assuming companies, we forgo investment income on the reserves ceded. Conversely, the assuming companies will receive investment income on the reserves assumed which generally will increase the assuming companies’ profitability on business we cede. The net investment income impact to us and the assuming companies has not been quantified as it is not reflected in our consolidated financial statements.

 

For The Nine Months Ended September 30, 2014 as compared to The Nine Months Ended September 30, 2013

 

Reinsurance premiums ceded increased $7.3 million, or 7.5%, for the nine months ended September 30, 2014, as compared to the nine months ended September 30, 2013. The increase was primarily due to an increase in ceded GAP and service contract premiums, somewhat offset by a decline in ceded dealer credit insurance premiums due to lower sales.

 

Benefits and settlement expenses ceded increased $3.3 million, or 7.8%, for the nine months ended September 30, 2014, as compared to the nine months ended September 30, 2013. The increase was primarily due to higher ceded losses in the service contract line.

 

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Amortization of DAC ceded decreased $0.6 million, or 10.8%, for the nine months ended September 30, 2014, as compared to the nine months ended September 30, 2013, primarily as the result of a decrease in ceded activity in the dealer credit line and a change in the mix of business in the GAP product line. Other operating expenses increased $0.9 million for the nine months ended September 30, 2014, as compared to the nine months ended September 30, 2013 mainly due to increased ceded activity in the GAP line.

 

Net investment income has no direct impact on reinsurance cost. However, by ceding business to the assuming companies, we forgo investment income on the reserves ceded. Conversely, the assuming companies will receive investment income on the reserves assumed which generally will increase the assuming companies’ profitability on business we cede. The net investment income impact to us and the assuming companies has not been quantified as it is not reflected in our consolidated financial statements.

 

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Corporate and Other

 

Segment results of operations

 

Segment results were as follows:

 

 

 

For The

 

 

 

For The

 

 

 

 

 

Three Months Ended

 

 

 

Nine Months Ended

 

 

 

 

 

September 30,

 

 

 

September 30,

 

 

 

 

 

2014

 

2013

 

Change

 

2014

 

2013

 

Change

 

 

 

(Dollars In Thousands)

 

 

 

(Dollars In Thousands)

 

 

 

REVENUES

 

 

 

 

 

 

 

 

 

 

 

 

 

Gross premiums and policy fees

 

$

4,111

 

$

4,556

 

(9.8

)%

$

12,665

 

$

13,865

 

(8.7

)%

Reinsurance ceded

 

(2

)

(4

)

50.0

 

(8

)

(8

)

n/m

 

Net premiums and policy fees

 

4,109

 

4,552

 

(9.7

)

12,657

 

13,857

 

(8.7

)

Net investment income

 

46,887

 

38,664

 

21.3

 

127,767

 

125,154

 

2.1

 

Other income

 

432

 

583

 

(25.9

)

5,560

 

4,340

 

28.1

 

Total operating revenues

 

51,428

 

43,799

 

17.4

 

145,984

 

143,351

 

1.8

 

Realized gains (losses) - investments

 

(3,926

)

(2,829

)

(38.8

)

(1,524

)

354

 

n/m

 

Realized gains (losses) - derivatives

 

(180

)

1,233

 

n/m

 

(482

)

4,115

 

n/m

 

Total revenues

 

47,322

 

42,203

 

12.1

 

143,978

 

147,820

 

(2.6

)

BENEFITS AND EXPENSES

 

 

 

 

 

 

 

 

 

 

 

 

 

Benefits and settlement expenses

 

4,632

 

5,701

 

(18.8

)

14,721

 

16,365

 

(10.0

)

Amortization of deferred policy acquisition costs

 

120

 

160

 

(25.0

)

363

 

504

 

(28.0

)

Other operating expenses

 

61,786

 

52,189

 

18.4

 

173,420

 

161,548

 

7.3

 

Total benefits and expenses

 

66,538

 

58,050

 

14.6

 

188,504

 

178,417

 

5.7

 

INCOME (LOSS) BEFORE INCOME TAX

 

(19,216

)

(15,847

)

(21.3

)

(44,526

)

(30,597

)

(45.5

)

Less: realized gains (losses) - investments

 

(3,926

)

(2,829

)

 

 

(1,524

)

354

 

 

 

Less: realized gains (losses) - derivatives

 

(180

)

1,233

 

 

 

(482

)

4,115

 

 

 

OPERATING INCOME (LOSS)

 

$

(15,110

)

$

(14,251

)

(6.0

)

$

(42,520

)

$

(35,066

)

(21.3

)

 

For The Three Months Ended September 30, 2014 as compared to The Three Months Ended September 30, 2013

 

Segment operating income (loss)

 

Corporate & Other segment operating loss was $15.1 million for the three months ended September 30, 2014, as compared to an operating loss of $14.3 million for the three months ended September 30, 2013.  The change was primarily due to higher overhead expenses partially offset by a $7.5 million favorable investment income variance related to called securities compared to the three months ended September 30, 2013.

 

Operating revenues

 

Net investment income for the segment increased $8.2 million, or 21.3%, for the three months ended September 30, 2014, as compared to the three months ended September 30, 2013. The increase in net investment income was primarily due to a $7.5 million favorable variance related to called securities and a $0.9 million increase related to a portfolio of securities designated for trading as compared to the three months ended September 30, 2013. Net premiums and policy fees decreased $0.4 million, or 9.7%, for the three months ended September 30, 2014, as compared to the three months ended September 30, 2013 and other income decreased $0.2 million.

 

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Table of Contents

 

Total benefits and expenses

 

Total benefits and expenses increased $8.5 million for the three months ended September 30, 2014, as compared to the three months ended September 30, 2013, primarily due to higher overhead expenses for the three months ended September 30, 2014.

 

For The Nine Months Ended September 30, 2014 as compared to The Nine Months Ended September 30, 2013

 

Segment operating income (loss)

 

Corporate and Other segment operating loss was $42.5 million for the nine months ended September 30, 2014, as compared to an operating loss of $35.1 million for the nine months ended September 30, 2013. The change resulted from an $11.9 million unfavorable variance in other operating expenses partially offset by a $2.6 million increase in net investment income and a $1.2 million increase in other income as compared to the nine months ended September 30, 2013.

 

Operating revenues

 

Net investment income for the segment increased $2.6 million, or 2.1%, for the nine months ended September 30, 2014, as compared to the nine months ended September 30, 2013, and net premiums and policy fees decreased $1.2  million, or 8.7%. The increase in net investment income included a $5.5 million favorable variance related to called securities and a $1.8 million increase related to a portfolio of securities designated for trading as compared to the nine months ended September 30, 2013.  Partially offsetting these increases was a $2.0 million unfavorable variance related to mortgage loan prepayment fee income as compared to the nine months ended September 30, 2013 and lower core net investment income. Other income increased $1.2 million for the nine months ended September 30, 2014 as compared to the nine months ended September 30, 2013, primarily due to a $1.2 million favorable variance related to gains generated on the repurchase of non-recourse funding obligations.

 

Total benefits and expenses

 

Total benefits and expenses increased $10.1 million for the nine months ended September 30, 2014, as compared to the nine months ended September 30, 2013, primarily due to higher overhead expenses.

 

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CONSOLIDATED INVESTMENTS

 

Certain reclassifications have been made in the previously reported financial statements and accompanying tables to make the prior year amounts comparable to those of the current year. Such reclassifications had no effect on previously reported net income, shareowners’ equity, or the totals reflected in the accompanying tables.

 

Portfolio Description

 

As of September 30, 2014, our investment portfolio was approximately $45.8 billion. The types of assets in which we may invest are influenced by various state insurance laws which prescribe qualified investment assets. Within the parameters of these laws, we invest in assets giving consideration to such factors as liquidity and capital needs, investment quality, investment return, matching of assets and liabilities, and the overall composition of the investment portfolio by asset type and credit exposure.

 

The following table presents the reported values of our invested assets:

 

 

 

As of

 

 

 

September 30, 2014

 

December 31, 2013

 

 

 

(Dollars In Thousands)

 

Publicly issued bonds (amortized cost: 2014 - $26,810,505; 2013 - $26,112,290)

 

$

28,997,046

 

63.3

%

$

27,069,262

 

61.8

%

Privately issued bonds (amortized cost: 2014 - $7,827,115; 2013 - $7,921,480)

 

8,340,349

 

18.2

 

8,118,831

 

18.5

 

Fixed maturities

 

37,337,395

 

81.5

 

35,188,093

 

80.3

 

Equity securities (cost: 2014 - $791,964; 2013 - $675,758)

 

809,648

 

1.8

 

646,027

 

1.5

 

Mortgage loans

 

5,232,463

 

11.4

 

5,493,492

 

12.5

 

Investment real estate

 

13,998

 

 

20,413

 

 

Policy loans

 

1,767,228

 

3.9

 

1,815,744

 

4.1

 

Other long-term investments

 

470,174

 

1.0

 

521,811

 

1.2

 

Short-term investments

 

183,411

 

0.4

 

134,146

 

0.4

 

Total investments

 

$

45,814,317

 

100.0

%

$

43,819,726

 

100.0

%

 

Included in the preceding table are $2.8 billion and $2.8 billion of fixed maturities and $75.3 million and $52.4 million of short-term investments classified as trading securities as of September 30, 2014 and December 31, 2013, respectively. The trading portfolio includes invested assets of $2.8 billion and $2.8 billion as of September 30, 2014 and December 31, 2013, respectively, held pursuant to modified coinsurance (“Modco”) arrangements under which the economic risks and benefits of the investments are passed to third party reinsurers. Also included above are $415.0 million and $365.0 million of securities classified as held-to-maturity as of September 30, 2014 and December 31, 2013, respectively.

 

Fixed Maturity Investments

 

As of September 30, 2014, our fixed maturity investment holdings were approximately $37.3 billion. The approximate percentage distribution of our fixed maturity investments by quality rating is as follows:

 

 

 

As of

 

Rating

 

September 30, 2014

 

December 31, 2013

 

AAA

 

12.5

%

12.5

%

AA

 

7.1

 

7.0

 

A

 

32.3

 

32.2

 

BBB

 

41.5

 

41.7

 

Below investment grade

 

5.5

 

5.6

 

Not rated

 

1.1

 

1.0

 

 

 

100.0

%

100.0

%

 

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Table of Contents

 

We use various Nationally Recognized Statistical Rating Organizations’ (“NRSRO”) ratings when classifying securities by quality ratings. When the various NRSRO ratings are not consistent for a security, we use the second-highest convention in assigning the rating. When there are no such published ratings, we assign a rating based on the statutory accounting rating system if such ratings are available.

 

We do not have material exposure to financial guarantee insurance companies with respect to our investment portfolio. As of September 30, 2014, based upon amortized cost, $35.5 million of our securities were guaranteed either directly or indirectly by third parties out of a total of $34.3 billion fixed maturity securities held by us (0.1% of total fixed maturity securities).

 

Changes in fair value for our available-for-sale portfolio, net of related DAC, VOBA, and policyholder dividend obligation are charged or credited directly to shareowners’ equity, net of tax. Declines in fair value that are other-than-temporary are recorded as realized losses in the consolidated statements of income, net of any applicable non-credit component of the loss, which is recorded as an adjustment to other comprehensive income (loss).

 

The distribution of our fixed maturity investments by type is as follows:

 

 

 

As of

 

Type

 

September 30, 2014

 

December 31, 2013

 

 

 

(Dollars In Millions)

 

Corporate bonds

 

$

28,947.7

 

$

27,293.4

 

Residential mortgage-backed securities

 

1,733.7

 

1,756.0

 

Commercial mortgage-backed securities

 

1,327.4

 

1,129.2

 

Other asset-backed securities

 

1,120.5

 

1,160.2

 

U.S. government-related securities

 

1,818.3

 

1,704.1

 

Other government-related securities

 

77.9

 

108.5

 

States, municipals, and political subdivisions

 

1,896.9

 

1,671.7

 

Other

 

415.0

 

365.0

 

Total fixed income portfolio

 

$

37,337.4

 

$

35,188.1

 

 

Within our fixed maturity investments, we maintain portfolios classified as “available-for-sale”, “trading”, and “held-to-maturity”. We purchase our available-for-sale investments with the intent to hold to maturity by purchasing investments that match future cash flow needs. However, we may sell any of our available-for-sale and trading investments to maintain proper matching of assets and liabilities. Accordingly, we classified $34.1 billion, or 91.3%, of our fixed maturities as “available-for-sale” as of September 30, 2014. These securities are carried at fair value on our consolidated condensed balance sheets.

 

Fixed maturities that we have both the positive intent and ability to hold to maturity are classified as “held-to-maturity”. We classified $415.0 million, or 1.1% of our fixed maturities as “held-to-maturity” as of September 30, 2014. These securities are carried at amortized cost on our consolidated condensed balance sheets.

 

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Trading securities are carried at fair value and changes in fair value are recorded on the income statement as they occur. Our trading portfolio accounts for $2.8 billion, or 7.6%, of our fixed maturities and $75.3 million of short-term investments as of September 30, 2014. Changes in fair value on the trading portfolio, including gains and losses from sales, are passed to the reinsurers through the contractual terms of the reinsurance arrangements. Partially offsetting these amounts are corresponding changes in the fair value of the embedded derivative associated with the underlying reinsurance arrangement. The total Modco trading portfolio fixed maturities by rating is as follows:

 

 

 

As of

 

Rating

 

September 30, 2014

 

December 31, 2013

 

 

 

(Dollars In Thousands)

 

AAA

 

$

446,609

 

$

419,866

 

AA

 

270,741

 

266,173

 

A

 

896,117

 

854,020

 

BBB

 

893,708

 

924,554

 

Below investment grade

 

319,453

 

324,453

 

Total Modco trading fixed maturities

 

$

2,826,628

 

$

2,789,066

 

 

A portion of our bond portfolio is invested in residential mortgage-backed securities (“RMBS”), commercial mortgage-backed securities (“CMBS”), and other asset-backed securities (collectively referred to as asset-backed securities or “ABS”). ABS are securities that are backed by a pool of assets. These holdings as of September 30, 2014, were approximately $4.2 billion. Mortgage-backed securities (“MBS”) are constructed from pools of mortgages and may have cash flow volatility as a result of changes in the rate at which prepayments of principal occur with respect to the underlying loans. Excluding limitations on access to lending and other extraordinary economic conditions, prepayments of principal on the underlying loans can be expected to accelerate with decreases in market interest rates and diminish with increases in interest rates.

 

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Residential mortgage-backed securities - As of September 30, 2014, our RMBS portfolio was approximately $1.7 billion. Sequential securities receive payments in order until each class is paid off. Planned amortization class securities (“PACs”) pay down according to a schedule. Pass through securities receive principal as principal of the underlying mortgages is received.

 

The tables below include a breakdown of these holdings by type and rating as of September 30, 2014.

 

 

 

Percentage of

 

 

 

Residential

 

 

 

Mortgage-

 

 

 

Backed

 

Type

 

Securities

 

Sequential

 

27.7

%

PAC

 

36.9

 

Pass Through

 

10.4

 

Other

 

25.0

 

 

 

100.0

%

 

 

 

Percentage of

 

 

 

Residential

 

 

 

Mortgage-Backed

 

Rating

 

Securities

 

AAA

 

64.0

%

AA

 

0.1

 

A

 

0.9

 

BBB

 

0.4

 

Below investment grade

 

34.6

 

 

 

100.0

%

 

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Table of Contents

 

Alt-A Collateralized Holdings

 

As of September 30, 2014, we held securities with a fair value of $377.4 million, or 0.8% of invested assets, supported by collateral classified as Alt-A. As of December 31, 2013, we held securities with a fair value of $395.0 million supported by collateral classified as Alt-A. We included in this classification certain whole loan securities where such securities had underlying mortgages with a high level of limited loan documentation. As of September 30, 2014, these securities had a fair value of $135.9 million and an unrealized gain of $34.0 million.

 

The following table includes the percentage of our collateral classified as Alt-A, grouped by rating category, as of September 30, 2014:

 

 

 

Percentage of

 

 

 

Alt-A

 

Rating

 

Securities

 

A

 

1.3

%

BBB

 

0.3

 

Below investment grade

 

98.4

 

 

 

100.0

%

 

The following tables categorize the estimated fair value and unrealized gain/(loss) of our mortgage-backed securities collateralized by Alt-A mortgage loans by rating as of September 30, 2014:

 

Alt-A Collateralized Holdings

 

 

 

Estimated Fair Value of Security by Year of Security Origination

 

 

 

2010 and

 

 

 

 

 

 

 

 

 

 

 

Rating

 

Prior

 

2011

 

2012

 

2013

 

2014

 

Total

 

 

 

(Dollars In Millions)

 

A

 

$

5.1

 

$

 

$

 

$

 

$

 

$

5.1

 

BBB

 

1.2

 

 

 

 

 

1.2

 

Below investment grade

 

371.1

 

 

 

 

 

371.1

 

Total mortgage-backed securities collateralized by Alt-A mortgage loans

 

$

377.4

 

$

 

$

 

$

 

$

 

$

377.4

 

 

 

 

Estimated Unrealized Gain (Loss) of Security by Year of Security Origination

 

 

 

2010 and

 

 

 

 

 

 

 

 

 

 

 

Rating

 

Prior

 

2011

 

2012

 

2013

 

2014

 

Total

 

 

 

(Dollars In Millions)

 

A

 

$

0.1

 

$

 

$

 

$

 

$

 

$

0.1

 

BBB

 

0.1

 

 

 

 

 

0.1

 

Below investment grade

 

44.2

 

 

 

 

 

44.2

 

Total mortgage-backed securities collateralized by Alt-A mortgage loans

 

$

44.4

 

$

 

$

 

$

 

$

 

$

44.4

 

 

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Sub-prime Collateralized Holdings

 

As of September 30, 2014, we held securities with a total fair value of $1.8 million that were supported by collateral classified as sub-prime. As of December 31, 2013, we held securities with a fair value of $2.0 million that were supported by collateral classified as sub-prime.

 

Prime Collateralized Holdings

 

As of September 30, 2014, we had RMBS collateralized by prime mortgage loans (including agency mortgages) with a total fair value of $1.4 billion, or 3.0%, of total invested assets. As of December 31, 2013, we held securities with a fair value of $1.4 billion of RMBS collateralized by prime mortgage loans (including agency mortgages).

 

The following table includes the percentage of our collateral classified as prime, grouped by rating category, as of September 30, 2014:

 

 

 

Percentage of

 

 

 

Prime

 

Rating

 

Securities

 

AAA

 

82.0

%

AA

 

0.2

 

A

 

0.7

 

BBB

 

0.4

 

Below investment grade

 

16.7

 

 

 

100.0

%

 

The following tables categorize the estimated fair value and unrealized gain/(loss) of our mortgage-backed securities collateralized by prime mortgage loans (including agency mortgages) by rating as of September 30, 2014:

 

Prime Collateralized Holdings

 

 

 

Estimated Fair Value of Security by Year of Security Origination

 

 

 

2010 and

 

 

 

 

 

 

 

 

 

 

 

Rating

 

Prior

 

2011

 

2012

 

2013

 

2014

 

Total

 

 

 

(Dollars In Millions)

 

AAA

 

$

509.4

 

$

316.6

 

$

26.9

 

$

152.1

 

$

105.4

 

$

1,110.4

 

AA

 

0.2

 

 

 

 

2.3

 

2.5

 

A

 

9.8

 

 

 

 

 

9.8

 

BBB

 

5.4

 

 

 

 

 

5.4

 

Below investment grade

 

226.4

 

 

 

 

 

226.4

 

Total mortgage-backed securities collateralized by prime mortgage loans

 

$

751.2

 

$

316.6

 

$

26.9

 

$

152.1

 

$

107.7

 

$

1,354.5

 

 

 

 

Estimated Unrealized Gain (Loss) of Security by Year of Security Origination

 

 

 

2010 and

 

 

 

 

 

 

 

 

 

 

 

Rating

 

Prior

 

2011

 

2012

 

2013

 

2014

 

Total

 

 

 

(Dollars In Millions)

 

AAA

 

$

24.0

 

$

11.5

 

$

0.1

 

$

0.4

 

$

(0.4

)

$

35.6

 

AA

 

 

 

 

 

 

 

A

 

0.5

 

 

 

 

 

0.5

 

BBB

 

0.5

 

 

 

 

 

0.5

 

Below investment grade

 

10.8

 

 

 

 

 

10.8

 

Total mortgage-backed securities collateralized by prime mortgage loans

 

$

35.8

 

$

11.5

 

$

0.1

 

$

0.4

 

$

(0.4

)

$

47.4

 

 

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Commercial mortgage-backed securities - Our CMBS portfolio consists of commercial mortgage-backed securities issued in securitization transactions. As of September 30, 2014, the CMBS holdings were approximately $1.3 billion. As of December 31, 2013, the CMBS holdings were approximately $1.1 billion.

 

The following table includes the percentages of our CMBS holdings, grouped by rating category, as of September 30, 2014:

 

 

 

Percentage of

 

 

 

Commercial

 

 

 

Mortgage-Backed

 

Rating

 

Securities

 

AAA

 

70.6

%

AA

 

15.3

 

A

 

12.4

 

BBB

 

1.7

 

 

 

100.0

%

 

The following tables categorize the estimated fair value and unrealized gain/(loss) of our CMBS as of September 30, 2014:

 

Commercial Mortgage-Backed Securities

 

 

 

Estimated Fair Value of Security by Year of Security Origination

 

 

 

2010 and

 

 

 

 

 

 

 

 

 

 

 

Rating

 

Prior

 

2011

 

2012

 

2013

 

2014

 

Total

 

 

 

(Dollars In Millions)

 

AAA

 

$

149.8

 

$

211.9

 

$

308.0

 

$

147.9

 

$

119.1

 

$

936.7

 

AA

 

32.9

 

38.1

 

42.5

 

29.9

 

59.3

 

202.7

 

A

 

79.9

 

52.0

 

13.6

 

19.6

 

 

165.1

 

BBB

 

22.9

 

 

 

 

 

22.9

 

Total commercial mortgage- backed securities

 

$

285.5

 

$

302.0

 

$

364.1

 

$

197.4

 

$

178.4

 

$

1,327.4

 

 

 

 

Estimated Unrealized Gain (Loss) of Security by Year of Security Origination

 

 

 

2010 and

 

 

 

 

 

 

 

 

 

 

 

Rating

 

Prior

 

2011

 

2012

 

2013

 

2014

 

Total

 

 

 

(Dollars In Millions)

 

AAA

 

$

8.3

 

$

18.9

 

$

2.9

 

$

0.5

 

$

0.4

 

$

31.0

 

AA

 

2.1

 

3.1

 

(1.4

)

(0.3

)

0.2

 

3.7

 

A

 

3.2

 

0.6

 

(0.8

)

(0.8

)

 

2.2

 

BBB

 

0.4

 

 

 

 

 

0.4

 

Total commercial mortgage- backed securities

 

$

14.0

 

$

22.6

 

$

0.7

 

$

(0.6

)

$

0.6

 

$

37.3

 

 

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Other asset-backed securities — Other asset-backed securities pay down based on cash flow received from the underlying pool of assets, such as receivables on auto loans, student loans, credit cards, etc. As of September 30, 2014, these holdings were approximately $1.1 billion. As of December 31, 2013, these holdings were approximately $1.2 billion.

 

The following table includes the percentages of our other asset-backed holdings, grouped by rating category, as of September 30, 2014:

 

 

 

Percentage of

 

 

 

Other Asset-

 

 

 

Backed

 

Rating

 

Securities

 

AAA

 

51.3

%

AA

 

19.0

 

A

 

17.4

 

BBB

 

0.6

 

Below investment grade

 

11.7

 

 

 

100.0

%

 

The following tables categorize the estimated fair value and unrealized gain/(loss) of our asset-backed securities as of September 30, 2014:

 

Other Asset-Backed Securities

 

 

 

Estimated Fair Value of Security by Year of Security Origination

 

 

 

2010 and

 

 

 

 

 

 

 

 

 

 

 

Rating

 

Prior

 

2011

 

2012

 

2013

 

2014

 

Total

 

 

 

(Dollars In Millions)

 

AAA

 

$

490.9

 

$

13.2

 

$

31.8

 

$

19.1

 

$

20.1

 

$

575.1

 

AA

 

156.2

 

 

56.5

 

 

 

212.7

 

A

 

43.5

 

51.5

 

56.0

 

34.5

 

10.0

 

195.5

 

BBB

 

6.4

 

 

 

 

 

6.4

 

Below investment grade

 

130.8

 

 

 

 

 

130.8

 

Total other asset-backed securities

 

$

827.8

 

$

64.7

 

$

144.3

 

$

53.6

 

$

30.1

 

$

1,120.5

 

 

 

 

Estimated Unrealized Gain (Loss) of Security by Year of Security Origination

 

 

 

2010 and

 

 

 

 

 

 

 

 

 

 

 

Rating

 

Prior

 

2011

 

2012

 

2013

 

2014

 

Total

 

 

 

(Dollars In Millions)

 

AAA

 

$

(16.7

)

$

1.2

 

$

0.5

 

$

0.6

 

$

0.2

 

$

(14.2

)

AA

 

(10.0

)

 

(0.9

)

 

 

(10.9

)

A

 

4.0

 

4.6

 

(0.6

)

2.0

 

 

10.0

 

BBB

 

0.3

 

 

 

 

 

0.3

 

Below investment grade

 

12.1

 

 

 

 

 

12.1

 

Total other asset-backed securities

 

$

(10.3

)

$

5.8

 

$

(1.0

)

$

2.6

 

$

0.2

 

$

(2.7

)

 

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Table of Contents

 

We obtained ratings of our fixed maturities from Moody’s Investors Service, Inc. (“Moody’s”), Standard & Poor’s Corporation (“S&P”), and/or Fitch Ratings (“Fitch”). If a fixed maturity is not rated by Moody’s, S&P, or Fitch, we use ratings from the National Association of Insurance Commissioners (“NAIC”), or we rate the fixed maturity based upon a comparison of the unrated issue to rated issues of the same issuer or rated issues of other issuers with similar risk characteristics. As of September 30, 2014, 98.9% of our fixed maturities were rated by Moody’s, S&P, Fitch, and/or the NAIC.

 

The industry segment composition of our fixed maturity securities is presented in the following table:

 

 

 

As of

 

% Fair

 

As of

 

% Fair

 

 

 

September 30, 2014

 

Value

 

December 31, 2013

 

Value

 

 

 

(Dollars In Thousands)

 

Banking

 

$

2,857,662

 

7.7

%

$

2,664,495

 

7.6

%

Other finance

 

669,372

 

1.8

 

620,544

 

1.8

 

Electric

 

3,916,855

 

10.5

 

3,752,261

 

10.7

 

Natural gas

 

2,722,243

 

7.3

 

2,369,185

 

6.7

 

Insurance

 

2,927,633

 

7.8

 

2,634,325

 

7.5

 

Energy

 

2,097,747

 

5.6

 

1,947,154

 

5.5

 

Communications

 

1,506,470

 

4.0

 

1,500,544

 

4.3

 

Basic industrial

 

1,861,834

 

5.0

 

1,674,169

 

4.8

 

Consumer noncyclical

 

3,201,955

 

8.6

 

3,040,080

 

8.6

 

Consumer cyclical

 

2,082,199

 

5.6

 

2,141,961

 

6.1

 

Finance companies

 

237,263

 

0.6

 

261,871

 

0.7

 

Capital goods

 

1,353,734

 

3.6

 

1,300,671

 

3.7

 

Transportation

 

974,658

 

2.6

 

909,574

 

2.6

 

Other industrial

 

360,121

 

1.0

 

390,766

 

1.1

 

Brokerage

 

619,523

 

1.7

 

627,630

 

1.8

 

Technology

 

1,075,231

 

2.9

 

1,009,357

 

2.9

 

Real estate

 

250,985

 

0.7

 

269,378

 

0.8

 

Other utility

 

232,198

 

0.6

 

179,346

 

0.5

 

Commercial mortgage-backed securities

 

1,327,393

 

3.6

 

1,129,226

 

3.2

 

Other asset-backed securities

 

1,120,538

 

3.0

 

1,160,238

 

3.3

 

Residential mortgage-backed non-agency securities

 

807,126

 

2.2

 

800,154

 

2.3

 

Residential mortgage-backed agency securities

 

926,575

 

2.5

 

955,791

 

2.7

 

U.S. government-related securities

 

1,818,321

 

4.9

 

1,704,128

 

4.8

 

Other government-related securities

 

77,920

 

0.2

 

108,524

 

0.3

 

State, municipals, and political divisions

 

1,896,839

 

5.1

 

1,671,721

 

4.8

 

Other

 

415,000

 

0.9

 

365,000

 

0.9

 

Total

 

$

37,337,395

 

100.0

%

$

35,188,093

 

100.0

%

 

Our investments classified as available-for-sale and trading in debt and equity securities are reported at fair value. Our investments classified as held-to-maturity are reported at amortized cost. As of September 30, 2014, our fixed maturity investments (bonds and redeemable preferred stocks) had a market value of $37.3 billion, which was 8.7% above amortized cost of $34.3 billion. These assets are invested for terms approximately corresponding to anticipated future benefit payments. Thus, market fluctuations are not expected to adversely affect liquidity.

 

Market values for private, non-traded securities are determined as follows: 1) we obtain estimates from independent pricing services and 2) we estimate market value based upon a comparison to quoted issues of the same issuer or issues of other issuers with similar terms and risk characteristics. We analyze the independent pricing services valuation methodologies and related inputs, including an assessment of the observability of market inputs. Upon obtaining this information related to market value, management makes a determination as to the appropriate valuation amount.

 

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Table of Contents

 

Mortgage Loans

 

We invest a portion of our investment portfolio in commercial mortgage loans. As of September 30, 2014, our mortgage loan holdings were approximately $5.2 billion. We have specialized in making loans on either credit-oriented commercial properties or credit-anchored strip shopping centers and apartments. Our underwriting procedures relative to our commercial loan portfolio are based, in our view, on a conservative and disciplined approach. We concentrate on a small number of commercial real estate asset types associated with the necessities of life (retail, multi-family, professional office buildings, and warehouses). We believe these asset types tend to weather economic downturns better than other commercial asset classes in which it has chosen not to participate. We believe this disciplined approach has helped to maintain a relatively low delinquency and foreclosure rate throughout its history. The majority of our mortgage loans portfolio was underwritten and funded by us. From time to time, we may acquire loans in conjunction with an acquisition.

 

Our commercial mortgage loans are stated at unpaid principal balance, adjusted for any unamortized premium or discount, and net of valuation allowances. Interest income is accrued on the principal amount of the loan based on the loan’s contractual interest rate. Amortization of premiums and discounts is recorded using the effective yield method. Interest income, amortization of premiums and discounts, and prepayment fees are reported in net investment income.

 

Certain of our mortgage loans have call options or interest rate reset options between 3 and 10 years. However, if interest rates were to significantly increase, we may be unable to exercise the call options or increase the interest rates on our existing mortgage loans commensurate with the significantly increased market rates. Assuming the loans are called at their next call dates, approximately $29.9 million will become due in the remainder of 2014, $1.1 billion in 2015 through 2019, $510.0 million in 2020 through 2024, and $129.3 million thereafter.

 

We also offer a type of commercial mortgage loan under which we will permit a loan-to-value ratio of up to 85% in exchange for a participating interest in the cash flows from the underlying real estate. As of September 30, 2014 and December 31, 2013, approximately $583.4 million and $666.6 million, respectively, of our mortgage loans had this participation feature. Cash flows received as a result of this participation feature are recorded as interest income. During the three and nine month period ended September 30, 2014 and 2013, we recognized $8.0 million and $13.8 million and $3.7 million and $12.9 million, respectively, of participating mortgage loan income.

 

We record mortgage loans net of an allowance for credit losses. This allowance is calculated through analysis of specific loans that have indicators of potential impairment based on current information and events. As of September 30, 2014 and December 31, 2013, our allowance for mortgage loan credit losses was $3.7 million and $3.1 million, respectively. While our mortgage loans do not have quoted market values, as of September 30, 2014, we estimated the fair value of our mortgage loans to be $5.7 billion (using discounted cash flows from the next call date), which was approximately 8.9% greater than the amortized cost, less any related loan loss reserve.

 

At the time of origination, our mortgage lending criteria targets that the loan-to-value ratio on each mortgage is 75% or less. We target projected rental payments from credit anchors (i.e., excluding rental payments from smaller local tenants) of 70% of the property’s projected operating expenses and debt service.

 

As of September 30, 2014, approximately $34.0 million, or 0.07%, of invested assets consisted of nonperforming, restructured or mortgage loans that were foreclosed and were converted to real estate properties. We do not expect these investments to adversely affect its liquidity or ability to maintain proper matching of assets and liabilities. During the nine months ended September 30, 2014, certain mortgage loan transactions occurred that were accounted for as troubled debt restructurings under Topic 310 of the FASB ASC. For all mortgage loans, the impact of troubled debt restructurings is generally reflected in our investment balance and in the allowance for mortgage loan credit losses. Transactions accounted for as troubled debt restructurings during the quarter included either the acceptance of assets in satisfaction of principal at a future date or the recognition of permanent impairments to principal, and were the result of agreements between the creditor and the debtor. During the three and nine month periods ending September 30, 2014, we accepted or agreed to accept at a date prior to year end 2014, assets of $11.2 million and $26.3 million in satisfaction of $14.6 million and $30.6 million of principal. We also identified one $12.6 million loan whose principal was permanently impaired to a value of $7.3 million. These transactions resulted in a $5.3 million and $6.2 million decrease in our investment in mortgage loans net of existing allowances for mortgage loans

 

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losses. Of the mortgage loan transactions accounted for as troubled debt restructurings, $21.8 million remain on our balance sheet as of September 30, 2014.

 

Our mortgage loan portfolio consists of two categories of loans: (1) those not subject to a pooling and servicing agreement and (2) those subject to a contractual pooling and servicing agreement. As of September 30, 2014, $34.0 million of mortgage loans not subject to a pooling and servicing agreement were nonperforming or restructured. $21.8 million of these nonperforming loans were restructured during the nine months ended September 30, 2014. We did not foreclose on any loans during the nine months ended September 30, 2014.

 

As of September 30, 2014, none of the loans subject to a pooling and servicing agreement were nonperforming. We did not foreclose on any nonperforming loans during the nine months ended September 30, 2014.

 

We do not expect these investments to adversely affect our liquidity or ability to maintain proper matching of assets and liabilities.

 

It is our policy to cease to carry accrued interest on loans that are over 90 days delinquent. For loans less than 90 days delinquent, interest is accrued unless it is determined that the accrued interest is not collectible. If a loan becomes over 90 days delinquent, it is our general policy to initiate foreclosure proceedings unless a workout arrangement to bring the loan current is in place. For loans subject to a pooling and servicing agreement, there are certain additional restrictions and/or requirements related to workout proceedings, and as such, these loans may have different attributes and/or circumstances affecting the status of delinquency or categorization of those in nonperforming status.

 

Risk Management and Impairment Review

 

We monitor the overall credit quality of our portfolio within established guidelines. The following table includes our available-for-sale fixed maturities by credit rating as of September 30, 2014:

 

 

 

 

 

Percent of

 

Rating

 

Fair Value

 

Fair Value

 

 

 

(Dollars In Thousands)

 

 

 

AAA

 

$

4,225,854

 

12.4

%

AA

 

2,389,486

 

7.0

 

A

 

11,179,642

 

32.8

 

BBB

 

14,618,108

 

42.9

 

Investment grade

 

32,413,090

 

95.1

 

BB

 

1,076,734

 

3.2

 

B

 

176,328

 

0.5

 

CCC or lower

 

426,472

 

1.2

 

Below investment grade

 

1,679,534

 

4.9

 

Total

 

$

34,092,624

 

100.0

%

 

Not included in the table above are $2.5 billion of investment grade and $322.6 million of below investment grade fixed maturities classified as trading securities and $415.0 million of fixed maturities classified as held-to-maturity.

 

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Limiting bond exposure to any creditor group is another way we manage credit risk. We held no credit default swaps on the positions listed below as of September 30, 2014. The following table summarizes our ten largest maturity exposures to an individual creditor group as of September 30, 2014:

 

 

 

Fair Value of

 

 

 

 

 

Funded

 

Unfunded

 

Total

 

Creditor

 

Securities

 

Exposures

 

Fair Value

 

 

 

(Dollars In Millions)

 

Berkshire Hathaway Inc.

 

$

214.6

 

$

 

$

214.6

 

Bank of America Corp.

 

186.7

 

0.3

 

187.0

 

General Electric

 

185.0

 

 

185.0

 

Duke Energy Corp.

 

183.4

 

 

183.4

 

Wells Fargo & Co.

 

178.4

 

 

178.4

 

Comcast Corp.

 

178.2

 

 

178.2

 

Nextera Energy Inc.

 

174.3

 

 

174.3

 

Exelon Corp.

 

172.6

 

 

172.6

 

JP Morgan Chase and Company

 

152.3

 

19.0

 

171.3

 

Rio Tinto PLC

 

162.3

 

 

162.3

 

 

Determining whether a decline in the current fair value of invested assets is an other-than-temporary decline in value is both objective and subjective, and can involve a variety of assumptions and estimates, particularly for investments that are not actively traded in established markets. We review our positions on a monthly basis for possible credit concerns and review our current exposure, credit enhancement, and delinquency experience.

 

Management considers a number of factors when determining the impairment status of individual securities. These include the economic condition of various industry segments and geographic locations and other areas of identified risks. Since it is possible for the impairment of one investment to affect other investments, we engage in ongoing risk management to safeguard against and limit any further risk to our investment portfolio. Special attention is given to correlative risks within specific industries, related parties, and business markets.

 

For certain securitized financial assets with contractual cash flows, including RMBS, CMBS, and other asset-backed securities (collectively referred to as asset-backed securities or “ABS”), GAAP requires us to periodically update our best estimate of cash flows over the life of the security. If the fair value of a securitized financial asset is less than its cost or amortized cost and there has been a decrease in the present value of the expected cash flows since the last revised estimate, considering both timing and amount, an other-than-temporary impairment charge is recognized. Estimating future cash flows is a quantitative and qualitative process that incorporates information received from third party sources along with certain internal assumptions and judgments regarding the future performance of the underlying collateral. Projections of expected future cash flows may change based upon new information regarding the performance of the underlying collateral. In addition, we consider our intent and ability to retain a temporarily depressed security until recovery.

 

Securities in an unrealized loss position are reviewed at least quarterly to determine if an other-than-temporary impairment is present based on certain quantitative and qualitative factors. We consider a number of factors in determining whether the impairment is other-than-temporary. These include, but are not limited to: 1) actions taken by rating agencies, 2) default by the issuer, 3) the significance of the decline, 4) an assessment of our intent to sell the security (including a more likely than not assessment of whether we will be required to sell the security) before recovering the security’s amortized cost, 5) the duration of the decline, 6) an economic analysis of the issuer’s industry, and 7) the financial strength, liquidity, and recoverability of the issuer. Management performs a security-by-security review each quarter in evaluating the need for any other-than-temporary impairments. Although no set formula is used in this process, the investment performance, collateral position, and continued viability of the issuer are significant measures considered, along with an analysis regarding our expectations for recovery of the security’s entire amortized cost basis through the receipt of future cash flows. Based on our analysis, for the three and nine months ended September 30, 2014, we concluded that approximately $2.3 million and $5.4 million, respectively, of investment securities in an unrealized loss position was other-than-temporarily impaired, due to credit-related factors, resulting in a charge to earnings. Additionally, we recognized $1.2 million and $3.4 million, respectively, of non-credit losses

 

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previously recorded in other comprehensive income (loss) that were recorded in earnings. These non-credit gains were caused by recognizing, in the current quarter, credit losses in earnings that had previously been recognized as non-credit losses in other comprehensive income.

 

There are certain risks and uncertainties associated with determining whether declines in market values are other-than-temporary. These include significant changes in general economic conditions and business markets, trends in certain industry segments, interest rate fluctuations, rating agency actions, changes in significant accounting estimates and assumptions, commission of fraud, and legislative actions. We continuously monitor these factors as they relate to the investment portfolio in determining the status of each investment.

 

We have deposits with certain financial institutions which exceed federally insured limits. We have reviewed the creditworthiness of these financial institutions and believe there is minimal risk of a material loss.

 

Certain European countries have experienced varying degrees of financial stress. Risks from the continued debt crisis in Europe could continue to disrupt the financial markets which could have a detrimental impact on global economic conditions and on sovereign and non-sovereign obligations. There remains considerable uncertainty as to future developments in the European debt crisis and the impact on financial markets.

 

The chart shown below includes our non-sovereign fair value exposures in these countries as of September 30, 2014. As September 30, 2014, we had no unfunded exposure and had no direct sovereign fair value exposure.

 

 

 

 

 

 

 

Total Gross

 

 

 

Non-sovereign Debt

 

Funded

 

Financial Instrument and Country

 

Financial

 

Non-financial

 

Exposure

 

 

 

(Dollars In Millions)

 

Securities:

 

 

 

 

 

 

 

United Kingdom

 

$

537.1

 

$

803.9

 

$

1,341.0

 

Netherlands

 

159.1

 

203.8

 

362.9

 

France

 

104.6

 

236.8

 

341.4

 

Switzerland

 

150.3

 

159.3

 

309.6

 

Germany

 

97.0

 

136.4

 

233.4

 

Spain

 

42.7

 

148.6

 

191.3

 

Sweden

 

125.9

 

38.1

 

164.0

 

Belgium

 

 

109.9

 

109.9

 

Norway

 

12.4

 

91.5

 

103.9

 

Italy

 

 

101.9

 

101.9

 

Ireland

 

11.5

 

69.9

 

81.4

 

Luxembourg

 

 

67.7

 

67.7

 

Portugal

 

 

15.5

 

15.5

 

Denmark

 

13.9

 

 

13.9

 

Total securities

 

1,254.5

 

2,183.3

 

3,437.8

 

Derivatives:

 

 

 

 

 

 

 

United Kingdom

 

16.4

 

 

16.4

 

Germany

 

10.1

 

 

10.1

 

Switzerland

 

8.7

 

 

8.7

 

Total derivatives

 

35.2

 

 

35.2

 

Total securities

 

$

1,289.7

 

$

2,183.3

 

$

3,473.0

 

 

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Realized Gains and Losses

 

The following table sets forth realized investment gains and losses for the periods shown:

 

 

 

For The

 

 

 

For The

 

 

 

 

 

Three Months Ended

 

 

 

Nine Months Ended

 

 

 

 

 

September 30,

 

 

 

September 30,

 

 

 

 

 

2014

 

2013

 

Change

 

2014

 

2013

 

Change

 

 

 

(Dollars In Thousands)

 

Fixed maturity gains - sales

 

$

22,586

 

$

11,666

 

$

10,920

 

$

50,650

 

$

46,110

 

$

4,540

 

Fixed maturity losses - sales

 

(257

)

(1,120

)

863

 

(753

)

(4,103

)

3,350

 

Equity gains - sales

 

1,298

 

 

1,298

 

1,298

 

2,367

 

(1,069

)

Equity losses - sales

 

 

 

 

 

 

 

Impairments on fixed maturity securities

 

(2,354

)

(7,421

)

5,067

 

(5,405

)

(13,918

)

8,513

 

Impairments on equity securities

 

 

(1,260

)

1,260

 

 

(3,347

)

3,347

 

Modco trading portfolio

 

(17,225

)

(25,960

)

8,735

 

110,067

 

(167,982

)

278,049

 

Other

 

(5,208

)

(4,094

)

(1,114

)

(7,806

)

(10,023

)

2,217

 

Total realized gains (losses) - investments

 

$

(1,160

)

$

(28,189

)

$

27,029

 

$

148,051

 

$

(150,896

)

$

298,947

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Derivatives related to variable annuity contracts:

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest rate futures - VA

 

$

1,979

 

$

(2,255

)

$

4,234

 

$

12,777

 

$

(26,393

)

$

39,170

 

Equity futures - VA

 

861

 

(12,568

)

13,429

 

(9,049

)

(39,829

)

30,780

 

Currency futures - VA

 

10,185

 

(6,531

)

16,716

 

6,020

 

1,440

 

4,580

 

Variance swaps - VA

 

1,570

 

(1,347

)

2,917

 

(1,103

)

(9,566

)

8,463

 

Equity options - VA

 

2,050

 

(29,094

)

31,144

 

(31,240

)

(65,631

)

34,391

 

Interest rate swaptions - VA

 

(2,812

)

1,725

 

(4,537

)

(17,213

)

(738

)

(16,475

)

Interest rate swaps - VA

 

22,011

 

(19,224

)

41,235

 

124,548

 

(125,502

)

250,050

 

Embedded derivative - GMWB

 

(51,429

)

80,541

 

(131,970

)

(181,105

)

264,231

 

(445,336

)

Total derivatives related to variable annuity contracts

 

(15,585

)

11,247

 

(26,832

)

(96,365

)

(1,988

)

(94,377

)

Derivatives related to FIA contracts:

 

 

 

 

 

 

 

 

 

 

 

 

 

Embedded derivative - FIA

 

(2,462

)

(104

)

(2,358

)

(9,036

)

(145

)

(8,891

)

Equity futures - FIA

 

117

 

(42

)

159

 

1,067

 

(42

)

1,109

 

Volatility futures - FIA

 

(4

)

 

(4

)

4

 

 

4

 

Equity options - FIA

 

1,099

 

104

 

995

 

5,077

 

85

 

4,992

 

Total derivatives related to FIA contracts

 

(1,250

)

(42

)

(1,208

)

(2,888

)

(102

)

(2,786

)

Derivatives related to IUL contracts:

 

 

 

 

 

 

 

 

 

 

 

 

 

Embedded derivative - IUL

 

347

 

 

347

 

62

 

 

62

 

Equity futures - IUL

 

16

 

 

16

 

16

 

 

16

 

Equity options - IUL

 

(24

)

 

(24

)

(24

)

 

(24

)

Total derivatives related to IUL contracts

 

339

 

 

339

 

54

 

 

54

 

Embedded derivative - Modco reinsurance treaties

 

20,426

 

30,074

 

(9,648

)

(91,945

)

191,847

 

(283,792

)

Interest rate swaps

 

 

72

 

(72

)

 

2,984

 

(2,984

)

Other derivatives

 

(149

)

(25

)

(124

)

(351

)

(149

)

(202

)

Total realized gains (losses) - derivatives

 

$

3,781

 

$

41,326

 

$

(37,545

)

$

(191,495

)

$

192,592

 

$

(384,087

)

 

Realized gains and losses on investments reflect portfolio management activities designed to maintain proper matching of assets and liabilities and to enhance long-term investment portfolio performance. The change in net realized investment gains (losses), excluding impairments and Modco trading portfolio activity during the nine months ended September 30, 2014, primarily reflects the normal operation of our asset/liability program within the context of the changing interest rate and spread environment, as well as tax planning strategies designed to utilize capital loss carryforwards.

 

Realized losses are comprised of both write-downs of other-than-temporary impairments and actual sales of investments. For the three and nine months ended September 30, 2014, we recognized pre-tax other-than-temporary impairments of $2.3 million and $5.4 million, respectively, due to credit-related factors, resulting in a charge to earnings. Additionally, we recognized $1.2 million and $3.4 million, respectively, of non-credit losses previously

 

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recorded in other comprehensive income in earnings as credit losses. For the three and nine months ended September 30, 2013, we recognized pre-tax other-than-temporary impairments of $8.7 million and $17.3 million, respectively. These other-than-temporary impairments resulted from our analysis of circumstances and our belief that credit events, loss severity, changes in credit enhancement, and/or other adverse conditions of the respective issuers have caused, or will lead to, a deficiency in the contractual cash flows related to these investments. These other-than-temporary impairments, net of Modco recoveries, are presented in the chart below:

 

 

 

For The

 

For The

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

 

2014

 

2013

 

2014

 

2013

 

 

 

(Dollars In Millions)

 

Alt-A MBS

 

$

0.8

 

$

1.5

 

$

2.8

 

$

4.5

 

Other MBS

 

0.7

 

1.6

 

1.8

 

5.1

 

Corporate bonds

 

 

4.3

 

 

4.3

 

Equities

 

 

1.3

 

 

3.4

 

Other

 

0.8

 

 

0.8

 

 

Total

 

$

2.3

 

$

8.7

 

$

5.4

 

$

17.3

 

 

As previously discussed, management considers several factors when determining other-than-temporary impairments. Although we purchase securities with the intent to hold them until maturity, we may change our position as a result of a change in circumstances. Any such decision is consistent with our classification of all but a specific portion of our investment portfolio as available-for-sale. For the nine months ended September 30, 2014, we sold securities in an unrealized loss position with a fair value of $6.7 million. For such securities, the proceeds, realized loss, and total time period that the security had been in an unrealized loss position are presented in the table below:

 

 

 

Proceeds

 

% Proceeds

 

Realized Loss

 

% Realized Loss

 

 

 

(Dollars In Thousands)

 

<= 90 days

 

$

4,077

 

60.6

%

$

(247

)

32.9

%

>90 days but <= 180 days

 

630

 

9.4

 

(99

)

13.1

 

>180 days but <= 270 days

 

210

 

3.1

 

(16

)

2.1

 

>270 days but <= 1 year

 

135

 

2.0

 

(20

)

2.7

 

>1 year

 

1,675

 

24.9

 

(371

)

49.2

 

Total

 

$

6,727

 

100.0

%

$

(753

)

100.0

%

 

For the three and nine months ended September 30, 2014, we sold or otherwise disposed of securities in an unrealized loss position with a fair value (proceeds) of $2.3 million and $6.7 million, respectively. The loss realized on the sale of these securities was $0.3 million and $0.8 million, respectively. We made the decision to exit these holdings in conjunction with our overall asset liability management process.

 

For the three and nine months ended September 30, 2014, we sold securities in an unrealized gain position with a fair value of $497.1 million and $1.1 billion, respectively. The gain realized on the sale of these securities was $23.9 million and $51.9 million, respectively.

 

The $5.2 million of other realized losses recognized for the three months ended September 30, 2014, consists of the decrease in the mortgage loan reserves of $0.6 million, mortgage loan losses of $5.9 million, and partnership gains of $0.1 million. The $7.8 million of other realized losses recognized for the nine months ended September 30, 2014, consists of the increase in the mortgage loan reserves of $0.6 million, mortgage loan losses of $6.9 million, and real estate losses of $0.3 million.

 

For the three and nine months ended September 30, 2014, net losses of $17.2 million and net gains of $110.1 million primarily related to changes in fair value on our Modco trading portfolios were included in realized gains and losses, respectively. Of this amount, approximately $4.7 million and $16.4 million, respectively, of gains were realized through the sale of certain securities, which will be reimbursed to our reinsurance partners over time through the

 

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reinsurance settlement process for this block of business. The Modco embedded derivative associated with the trading portfolios had realized pre-tax gains of $20.4 million and losses of $91.9 million during the three and nine months ended September 30, 2014, respectively. These gains for the three months ended September 30, 2014, were due to the credit spreads widening slightly and the nine months ended September 30, 2014 losses were primarily the result of credit spreads modestly retightening and lower treasury yields.

 

Realized investment gains and losses related to derivatives represent changes in their fair value during the period and termination gains/(losses) on those derivatives that were closed during the period.

 

We use equity, interest rate, currency, and volatility futures to mitigate the risk related to certain guaranteed minimum benefits, including GMWB, within our VA products. In general, the cost of such benefits varies with the level of equity and interest rate markets, foreign currency levels, and overall volatility. The equity futures resulted in net pre-tax gains of $0.9 million and losses of $9.0 million, interest rate futures resulted in pre-tax gains of $2.0 million and $12.8 million, currency futures resulted in net pre-tax gains of $10.2 million and $6.0 million, and volatility futures resulted in no pre-tax gains or losses for the three and nine months ended September 30, 2014, respectively. No volatility future positions were held as of September 30, 2014.

 

We also use equity options, variance swaps, and volatility options to mitigate the risk related to certain guaranteed minimum benefits, including GMWB, within our VA products. In general, the cost of such benefits varies with the level of equity markets and overall volatility. The equity options resulted in net pre-tax gains of $2.1 million and losses of $31.2 million, the variance swaps resulted in a net pre-tax gain of $1.6 million and a loss of $1.1 million, and the volatility options resulted in no pre-tax gains or losses, respectively, for three and nine months ended September 30, 2014. No volatility options positions were held as of September 30, 2014.

 

We use interest rate swaps and interest rate swaptions to mitigate the risk related to certain guaranteed minimum benefits, including GMWB, within our VA products. The interest rate swaps resulted in net pre-tax gains of $22.0 million and $124.5 million and interest rate swaptions resulted in a net pre-tax loss of $2.8 million and $17.2 million for the three and nine months ended September 30, 2014, respectively.

 

The GMWB rider embedded derivative on variable deferred annuities, with a GMWB rider, had net realized losses of $51.4 million and $181.1 million for the three and nine months ended September 30, 2014, respectively. The loss was primarily the result of a change in interest rates during 2014.

 

We use certain interest rate swaps to mitigate the price volatility of fixed maturities. These positions resulted in no pre-tax gains or losses for the three and nine months ended September 30, 2014. None of these positions were held as of September 30, 2014.

 

We purchased interest rate caps during 2011, to mitigate our credit risk with respect to our LIBOR exposure and the potential impact of European financial market distress. These caps resulted in no pre-tax gains or losses for the three and nine months ended September 30, 2014. No interest rate caps were held as of September 30, 2014.

 

We also use various swaps and other types of derivatives to mitigate risk related to other exposures. These contracts generated net pre-tax losses of $0.1 million and $0.4 million for the three and nine months ended September 30, 2014, respectively.

 

We recognized pre-tax losses of $2.5 million and $9.0 million, respectively, for the three and nine months ended September 30, 2014 related to the embedded derivative on the FIA product. We use certain equity options as well as equity and volatility futures to mitigate certain equity market risks associated with the FIA. For the three and nine months ended September 30, 2014, we recognized pre-tax gains of $1.2 million and $6.1 million related to these derivatives, respectively.

 

We recognized pre-tax gains of $0.3 million and $0.1 million, respectively, for the three and nine months ended September 30, 2014 related to the embedded derivative on the indexed universal life (“IUL”) product. We use certain equity options as well as equity futures to mitigate certain equity market risks associated with the IUL.

 

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Unrealized Gains and Losses — Available-for-Sale Securities

 

The information presented below relates to investments at a certain point in time and is not necessarily indicative of the status of the portfolio at any time after September 30, 2014. Information about unrealized gains and losses is subject to rapidly changing conditions, including volatility of financial markets and changes in interest rates. Management considers a number of factors in determining if an unrealized loss is other-than-temporary, including the expected cash to be collected and the intent, likelihood, and/or ability to hold the security until recovery. Consistent with our long-standing practice, we do not utilize a “bright line test” to determine other-than-temporary impairments. On a quarterly basis, we perform an analysis on every security with an unrealized loss to determine if an other-than-temporary impairment has occurred. This analysis includes reviewing several metrics including collateral, expected cash flows, ratings, and liquidity. Furthermore, since the timing of recognizing realized gains and losses is largely based on management’s decisions as to the timing and selection of investments to be sold, the tables and information provided below should be considered within the context of the overall unrealized gain/(loss) position of the portfolio. We had an overall net unrealized gain of $2.7 billion, prior to tax and DAC offsets, as of September 30, 2014, and an overall net unrealized gain of $1.1 billion as of December 31, 2013.

 

For fixed maturity and equity securities held that are in an unrealized loss position as of September 30, 2014, the fair value, amortized cost, unrealized loss, and total time period that the security has been in an unrealized loss position are presented in the table below:

 

 

 

Fair

 

% Fair

 

Amortized

 

% Amortized

 

Unrealized

 

% Unrealized

 

 

 

Value

 

Value

 

Cost

 

Cost

 

Loss

 

Loss

 

 

 

(Dollars In Thousands)

 

<= 90 days

 

$

2,962,129

 

55.4

%

$

3,036,237

 

54.6

%

$

(74,108

)

34.8

%

>90 days but <= 180 days

 

37,685

 

0.7

 

39,509

 

0.7

 

(1,824

)

0.9

 

>180 days but <= 270 days

 

35,436

 

0.7

 

36,216

 

0.7

 

(780

)

0.4

 

>270 days but <= 1 year

 

31,363

 

0.6

 

32,766

 

0.6

 

(1,403

)

0.7

 

>1 year but <= 2 years

 

1,588,804

 

29.7

 

1,671,210

 

30.1

 

(82,406

)

38.7

 

>2 years but <= 3 years

 

388,448

 

7.3

 

414,446

 

7.5

 

(25,998

)

12.2

 

>3 years but <= 4 years

 

32,022

 

0.6

 

34,032

 

0.6

 

(2,010

)

0.9

 

>4 years but <= 5 years

 

12,973

 

0.2

 

15,637

 

0.3

 

(2,664

)

1.3

 

>5 years

 

255,549

 

4.8

 

277,192

 

4.9

 

(21,643

)

10.1

 

Total

 

$

5,344,409

 

100.0

%

$

5,557,245

 

100.0

%

$

(212,836

)

100.0

%

 

The majority of the unrealized loss as of September 30, 2014 for both investment grade and below investment grade securities is attributable to fluctuations in credit and mortgage spreads for certain securities. The negative impact of spread levels for certain securities was partially offset by lower treasury yield levels and the associated positive effect on security prices. Spread levels have improved since December 31, 2013. However, certain types of securities, including tranches of RMBS and ABS, continue to be priced at a level which has caused the unrealized losses noted above. We believe spread levels on these RMBS and ABS are largely due to uncertainties regarding future performance of the underlying mortgage loans and/or assets.

 

As of September 30, 2014, the Barclays Investment Grade Index was priced at 111.2 bps versus a 10 year average of 165.0 bps. Similarly, the Barclays High Yield Index was priced at 463.9 bps versus a 10 year average of 602.2 bps. As of September 30, 2014, the five, ten, and thirty-year U.S. Treasury obligations were trading at levels of 1.757%, 2.490%, and 3.197%, as compared to 10 year averages of 2.564%, 3.368%, and 4.094%, respectively.

 

As of September 30, 2014, 80.1% of the unrealized loss was associated with securities that were rated investment grade. We have examined the performance of the underlying collateral and cash flows and expect that our investments will continue to perform in accordance with their contractual terms. Factors such as credit enhancements within the deal structures and the underlying collateral performance/characteristics support the recoverability of the investments. Based on the factors discussed, we do not consider these unrealized loss positions to be other-than-temporary. However, from time to time, we may sell securities in the ordinary course of managing our portfolio to meet diversification, credit quality, yield enhancement, asset/liability management, and liquidity requirements.

 

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Expectations that investments in mortgage-backed and asset-backed securities will continue to perform in accordance with their contractual terms are based on assumptions a market participant would use in determining the current fair value. It is reasonably possible that the underlying collateral of these investments will perform worse than current market expectations and that such an event may lead to adverse changes in the cash flows on our holdings of these types of securities. This could lead to potential future write-downs within our portfolio of mortgage-backed and asset-backed securities. Expectations that our investments in corporate securities and/or debt obligations will continue to perform in accordance with their contractual terms are based on evidence gathered through our normal credit surveillance process. Although we do not anticipate such events, it is reasonably possible that issuers of our investments in corporate securities will perform worse than current expectations. Such events may lead us to recognize potential future write-downs within our portfolio of corporate securities. It is also possible that such unanticipated events would lead us to dispose of those certain holdings and recognize the effects of any such market movements in our financial statements.

 

As of September 30, 2014, there were estimated gross unrealized losses of $7.6 million related to our mortgage-backed securities collateralized by Alt-A mortgage loans. Gross unrealized losses in our securities collateralized by Alt-A residential mortgage loans as of September 30, 2014, were primarily the result of continued widening spreads, representing marketplace uncertainty arising from higher defaults in Alt-A residential mortgage loans and rating agency downgrades of securities collateralized by Alt-A residential mortgage loans. As of September 30, 2014, we reviewed the performance of the underlying collateral supporting these securities and determined that the expected cash flows were in line with the valuation. As such, we believe unrealized losses as of September 30, 2014 were temporary in nature.

 

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We have no material concentrations of issuers or guarantors of fixed maturity securities. The industry segment composition of all securities in an unrealized loss position held as of September 30, 2014, is presented in the following table:

 

 

 

Fair

 

% Fair

 

Amortized

 

% Amortized

 

Unrealized

 

% Unrealized

 

 

 

Value

 

Value

 

Cost

 

Cost

 

Loss

 

Loss

 

 

 

(Dollars In Thousands)

 

Banking

 

$

491,912

 

9.2

%

$

514,676

 

9.3

%

$

(22,764

)

10.7

%

Other finance

 

137,490

 

2.6

 

141,164

 

2.5

 

(3,674

)

1.7

 

Electric

 

170,406

 

3.2

 

174,691

 

3.1

 

(4,285

)

2.0

 

Natural gas

 

172,506

 

3.2

 

175,175

 

3.2

 

(2,669

)

1.3

 

Insurance

 

318,328

 

6.0

 

326,396

 

5.9

 

(8,068

)

3.8

 

Energy

 

231,992

 

4.3

 

241,769

 

4.4

 

(9,777

)

4.6

 

Communications

 

229,853

 

4.3

 

239,186

 

4.3

 

(9,333

)

4.4

 

Basic industrial

 

322,829

 

6.0

 

345,516

 

6.2

 

(22,687

)

10.7

 

Consumer noncyclical

 

529,133

 

9.9

 

553,385

 

10.0

 

(24,252

)

11.4

 

Consumer cyclical

 

263,020

 

4.9

 

272,503

 

4.9

 

(9,483

)

4.5

 

Finance companies

 

2,460

 

 

2,993

 

0.1

 

(533

)

0.3

 

Capital goods

 

126,972

 

2.4

 

130,816

 

2.4

 

(3,844

)

1.8

 

Transportation

 

90,972

 

1.7

 

93,772

 

1.7

 

(2,800

)

1.3

 

Other industrial

 

90,602

 

1.7

 

92,936

 

1.7

 

(2,334

)

1.1

 

Brokerage

 

34,903

 

0.7

 

34,982

 

0.6

 

(79

)

 

Technology

 

215,012

 

4.0

 

222,315

 

4.0

 

(7,303

)

3.4

 

Real estate

 

 

 

 

 

 

 

Other utility

 

4,964

 

0.1

 

4,991

 

0.1

 

(27

)

 

Commercial mortgage-backed securities

 

247,821

 

4.6

 

253,684

 

4.6

 

(5,863

)

2.8

 

Other asset-backed securities

 

660,703

 

12.4

 

694,976

 

12.5

 

(34,273

)

16.1

 

Residential mortgage-backed non-agency

 

 

 

 

 

 

 

 

 

 

 

 

 

securities

 

199,676

 

3.7

 

211,164

 

3.8

 

(11,488

)

5.4

 

Residential mortgage-backed agency

 

 

 

 

 

 

 

 

 

 

 

 

 

securities

 

37,980

 

0.7

 

40,626

 

0.7

 

(2,646

)

1.2

 

U.S. government-related securities

 

723,059

 

13.5

 

745,364

 

13.4

 

(22,305

)

10.5

 

Other government-related securities

 

 

 

 

 

 

 

States, municipals, and political divisions

 

41,816

 

0.9

 

44,165

 

0.6

 

(2,349

)

1.0

 

Total

 

$

5,344,409

 

100.0

%

$

5,557,245

 

100.0

%

$

(212,836

)

100.0

%

 

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The percentage of our unrealized loss positions, segregated by industry segment, is presented in the following table:

 

 

 

As of

 

 

 

September 30, 2014

 

December 31, 2013

 

 

 

 

 

 

 

Banking

 

10.7

%

8.1

%

Other finance

 

1.7

 

2.3

 

Electric

 

2.0

 

7.0

 

Natural gas

 

1.3

 

5.1

 

Insurance

 

3.8

 

4.2

 

Energy

 

4.6

 

2.4

 

Communications

 

4.4

 

5.6

 

Basic industrial

 

10.7

 

5.1

 

Consumer noncyclical

 

11.4

 

12.1

 

Consumer cyclical

 

4.5

 

6.1

 

Finance companies

 

0.3

 

0.2

 

Capital goods

 

1.8

 

2.8

 

Transportation

 

1.3

 

2.4

 

Other industrial

 

1.1

 

1.6

 

Brokerage

 

 

0.7

 

Technology

 

3.4

 

3.9

 

Real estate

 

 

0.6

 

Other utility

 

 

0.7

 

Commercial mortgage-backed securities

 

2.8

 

3.3

 

Other asset-backed securities

 

16.1

 

11.5

 

Residential mortgage-backed non-agency securities

 

5.4

 

2.5

 

Residential mortgage-backed agency securities

 

1.2

 

1.6

 

U.S. government-related securities

 

10.5

 

8.9

 

Other government-related securities

 

 

 

States, municipals, and political divisions

 

1.0

 

1.3

 

Total

 

100.0

%

100.0

%

 

The range of maturity dates for securities in an unrealized loss position as of September 30, 2014, varies, with 5.7% maturing in less than 5 years, 31.6% maturing between 5 and 10 years, and 62.7% maturing after 10 years. The following table shows the credit rating of securities in an unrealized loss position as of September 30, 2014:

 

S&P or Equivalent

 

Fair

 

% Fair

 

Amortized

 

% Amortized

 

Unrealized

 

% Unrealized

 

Designation

 

Value

 

Value

 

Cost

 

Cost

 

Loss

 

Loss

 

 

 

(Dollars In Thousands)

 

AAA/AA/A

 

$

2,780,736

 

52.0

%

$

2,882,679

 

51.9

%

$

(101,943

)

47.9

%

BBB

 

2,060,227

 

38.5

 

2,128,760

 

38.3

 

(68,533

)

32.2

 

Investment grade

 

4,840,963

 

90.5

 

5,011,439

 

90.2

 

(170,476

)

80.1

 

BB

 

251,434

 

4.7

 

277,815

 

5.0

 

(26,381

)

12.4

 

B

 

55,484

 

1.1

 

57,302

 

1.0

 

(1,818

)

0.8

 

CCC or lower

 

196,528

 

3.7

 

210,689

 

3.8

 

(14,161

)

6.7

 

Below investment grade

 

503,446

 

9.5

 

545,806

 

9.8

 

(42,360

)

19.9

 

Total

 

$

5,344,409

 

100.0

%

$

5,557,245

 

100.0

%

$

(212,836

)

100.0

%

 

As of September 30, 2014, we held a total of 471 positions that were in an unrealized loss position. Included in that amount were 92 positions of below investment grade securities with a fair value of $503.4 million that were in an unrealized loss position. Total unrealized losses related to below investment grade securities were $42.4 million, of

 

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which $29.0 million had been in an unrealized loss position for more than twelve months. Below investment grade securities in an unrealized loss position were 1.1% of invested assets.

 

As of September 30, 2014, securities in an unrealized loss position that were rated as below investment grade represented 9.5% of the total fair value and 19.9% of the total unrealized loss. After a review of each security and its expected cash flows, we believe the decline in market value to be temporary. We have the ability and intent to hold these securities to maturity. As of September 30, 2014, total unrealized losses for all securities in an unrealized loss position for more than twelve months were $134.7 million. A widening of credit spreads is estimated to account for unrealized losses of $453.2 million, with changes in treasury rates offsetting this loss by an estimated $318.5 million.

 

The majority of our RMBS holdings as of September 30, 2014, were super senior or senior bonds in the capital structure. Our total non-agency portfolio has a weighted-average life of 6.29 years. The following table categorizes the weighted-average life for our non-agency portfolio, by category of material holdings, as of September 30, 2014:

 

 

 

Weighted-Average

 

Non-agency portfolio

 

Life

 

 

 

 

 

Prime

 

7.43

 

Alt-A

 

4.58

 

 

The following table includes the fair value, amortized cost, unrealized loss, and total time period that the security has been in an unrealized loss position for all below investment grade securities as of September 30, 2014:

 

 

 

Fair

 

% Fair

 

Amortized

 

% Amortized

 

Unrealized

 

% Unrealized

 

 

 

Value

 

Value

 

Cost

 

Cost

 

Loss

 

Loss

 

 

 

(Dollars In Thousands)

 

<= 90 days

 

$

227,236

 

45.1

%

$

238,286

 

43.7

%

$

(11,050

)

26.1

%

>90 days but <= 180 days

 

29,665

 

5.9

 

31,380

 

5.7

 

(1,715

)

4.0

 

>180 days but <= 270 days

 

7,588

 

1.5

 

8,055

 

1.5

 

(467

)

1.1

 

>270 days but <= 1 year

 

5,475

 

1.1

 

5,615

 

1.0

 

(140

)

0.3

 

>1 year but <= 2 years

 

95,047

 

18.9

 

105,924

 

19.4

 

(10,877

)

25.7

 

>2 years but <= 3 years

 

19,589

 

3.9

 

26,092

 

4.8

 

(6,503

)

15.4

 

>3 years but <= 4 years

 

16,580

 

3.3

 

17,093

 

3.1

 

(513

)

1.2

 

>4 years but <= 5 years

 

564

 

0.1

 

637

 

0.1

 

(73

)

0.2

 

>5 years

 

101,702

 

20.2

 

112,724

 

20.7

 

(11,022

)

26.0

 

Total

 

$

503,446

 

100.0

%

$

545,806

 

100.0

%

$

(42,360

)

100.0

%

 

LIQUIDITY AND CAPITAL RESOURCES

 

Liquidity

 

Liquidity refers to a company’s ability to generate adequate amounts of cash to meet its needs. We meet our liquidity requirements primarily through positive cash flows from our operating subsidiaries. Primary sources of cash from the operating subsidiaries are premiums, deposits for policyholder accounts, investment sales and maturities, and investment income. Primary uses of cash include benefit payments, withdrawals from policyholder accounts, investment purchases, policy acquisition costs, interest payments, and other operating expenses. We believe that we have sufficient liquidity to fund our cash needs under normal operating scenarios.

 

In the event of significant unanticipated cash requirements beyond our normal liquidity needs, we have additional sources of liquidity available depending on market conditions and the amount and timing of the liquidity need. These additional sources of liquidity include cash flows from operations, the sale of liquid assets, accessing our credit facility, and other sources described herein.

 

Our decision to sell investment assets could be impacted by accounting rules, including rules relating to the likelihood of a requirement to sell securities before recovery of our cost basis. Under stressful market and economic

 

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conditions, liquidity may broadly deteriorate which could negatively impact our ability to sell investment assets. If we require on short notice significant amounts of cash in excess of normal requirements, we may have difficulty selling investment assets in a timely manner, be forced to sell them for less than we otherwise would have been able to realize, or both.

 

While we anticipate that the cash flows of our operating subsidiaries will be sufficient to meet our investment commitments and operating cash needs in a normal credit market environment, we recognize that investment commitments scheduled to be funded may, from time to time, exceed the funds then available. Therefore, we have established repurchase agreement programs for certain of our insurance subsidiaries to provide liquidity when needed. We expect that the rate received on our investments will equal or exceed our borrowing rate. Under this program, we may, from time to time, sell an investment security at a specific price and agree to repurchase that security at another specified price at a later date. These borrowings are for a term less than 90 days. The market value of securities to be repurchased is monitored and collateral levels are adjusted where appropriate to protect the counterparty against credit exposure. The agreements provide for net settlement in the event of default or on termination of the agreements. As of September 30, 2014, the fair value of securities pledged under the repurchase program was $402.0 million and the repurchase obligation of $359.8 million was included in our consolidated condensed balance sheets (at an average borrowing rate of 8 basis points). During the nine months ended September 30, 2014, the maximum balance outstanding at any one point in time related to these programs was $633.7 million. The average daily balance was $511.3 million (at an average borrowing rate of 10 basis points) during the nine months ended September 30, 2014. As of December 31, 2013, we had a $350.0 million outstanding balance related to such borrowings. During 2013, the maximum balance outstanding at any one point in time related to these programs was $815.0 million. The average daily balance was $496.9 million (at an average borrowing rate of 11 basis points) during the year ended December 31, 2013.

 

Additionally, we may, from time to time, sell short-duration stable value products to complement our cash management practices. Depending on market conditions, we may also use securitization transactions involving our commercial mortgage loans to increase liquidity for the operating subsidiaries.

 

Credit Facility

 

We have access to a Credit Facility that provides the ability to borrow on an unsecured basis up to an aggregate principal amount of $750 million. We have the right in certain circumstances to request that the commitment under the Credit Facility be increased up to a maximum principal amount of $1.0 billion. Balances outstanding under the Credit Facility accrue interest at a rate equal to, at the option of the Borrowers, (i) LIBOR plus a spread based on the ratings of our senior unsecured long-term debt (“Senior Debt”), or (ii) the sum of (A) a rate equal to the highest of (x) the Administrative Agent’s prime rate, (y) 0.50% above the Federal Funds rate, or (z) the one-month LIBOR plus 1.00% and (B) a spread based on the ratings of our Senior Debt. The Credit Facility also provides for a facility fee at a rate, currently 0.175%, that varies with the ratings of our Senior Debt and that is calculated on the aggregate amount of commitments under the Credit Facility, whether used or unused. The maturity date on the Credit Facility is July 17, 2017. We were not aware of any non-compliance with the financial debt covenants of the Credit Facility as of September 30, 2014. There was an outstanding balance of $280.0 million at an interest rate of LIBOR plus 1.20% under the Credit Facility as of September 30, 2014.

 

Sources and Use of Cash

 

Our primary sources of funding are dividends from our operating subsidiaries; revenues from investments, data processing, legal, and management services rendered to subsidiaries; investment income; and external financing. These sources of cash support our general corporate needs including our common stock dividends and debt service. The states in which our insurance subsidiaries are domiciled impose certain restrictions on the insurance subsidiaries’ ability to pay us dividends. These restrictions are based in part on the prior year’s statutory income and/or surplus. Generally, these restrictions pose no short-term liquidity concerns. We plan to retain portions of the earnings of our insurance subsidiaries in those companies primarily to support their future growth.

 

We are a member of the FHLB of Cincinnati. FHLB advances provide an attractive funding source for short-term borrowing and for the sale of funding agreements. Membership in the FHLB requires that we purchase FHLB capital stock based on a minimum requirement and a percentage of the dollar amount of advances outstanding. Our borrowing capacity is determined by the following factors: 1) total advance capacity is limited to the lower of 50% of

 

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total assets or 100% of mortgage-related assets of Protective Life Insurance Company, our largest insurance subsidiary, 2) ownership of appropriate capital and activity stock to support continued membership in the FHLB and current and future advances, and 3) the availability of adequate eligible mortgage or treasury/agency collateral to back current and future advances.

 

We held $66.0 million of FHLB common stock as of September 30, 2014, which is included in equity securities. In addition, our obligations under the advances must be collateralized. We maintain control over any such pledged assets, including the right of substitution. As of September 30, 2014, we had $771.9 million of funding agreement-related advances and accrued interest outstanding under the FHLB program.

 

As of September 30, 2014, we reported approximately $614.7 million (fair value) of Auction Rate Securities (“ARS”) in non-Modco portfolios. As of September 30, 2014, 100% of these ARS were rated Aaa/AA+. While the auction rate market has experienced liquidity constraints, we believe that based on our current liquidity position and our operating cash flows, any lack of liquidity in the ARS market will not have a material impact on our liquidity, financial condition, or cash flows.

 

All of the auction rate securities held, on a consolidated basis, in non-Modco portfolios as of September 30, 2014, were student loan-backed auction rate securities, for which the underlying collateral is at least 97% guaranteed by the Federal Family Education Loan Program (“FFELP”). As there is no active market for these auction rate securities, we use a valuation model, which incorporates, among other inputs, the contractual terms of each indenture and current valuation information from actively-traded asset-backed securities with comparable underlying assets (i.e. FFELP-backed student loans) and vintage.

 

We use an income approach valuation model to determine the fair value of our student loan-backed auction rate securities. Specifically, a discounted cash flow method is used. The expected yield on the auction rate securities is estimated for each coupon date, based on the contractual terms on each indenture. The estimated market yield is based on comparable securities with observable yields and an additional yield spread for illiquidity of auction rate securities in the current market.

 

The auction rate securities held in non-Modco portfolios are classified as a Level 2 or Level 3 valuation. An unrealized loss of $27.8 million and $57.2 million was recorded as of September 30, 2014 and December 31, 2013, respectively, and we have not recorded any other-than-temporary impairment because the underlying collateral for each of the auction rate securities is at least 97% guaranteed by the FFELP and there are subordinate tranches within each of these auction rate security issuances that would support the senior tranches in the event of default. In the event of a complete and total default by all underlying student loans, the principal shortfall, in excess of the 97% FFELP guarantee, would be absorbed by the subordinate tranches. Our credit exposure is to the FFELP guarantee, not the underlying student loans. At this time, we have no reason to believe that the U.S. Department of Education would not honor the FFELP guarantee, if it were necessary. In addition, we do not intend to sell or expect to be required to sell the securities before recovering our amortized cost of these securities. Therefore, we believe that no other-than-temporary impairment has been experienced.

 

The liquidity requirements of our regulated insurance subsidiaries primarily relate to the liabilities associated with their various insurance and investment products, operating expenses, and income taxes. Liabilities arising from insurance and investment products include the payment of policyholder benefits, as well as cash payments in connection with policy surrenders and withdrawals, policy loans, and obligations to redeem funding agreements.

 

Our insurance subsidiaries maintain investment strategies intended to provide adequate funds to pay benefits and expected surrenders, withdrawals, loans, and redemption obligations without forced sales of investments. In addition, our insurance subsidiaries hold highly liquid, high-quality short-term investment securities and other liquid investment grade fixed maturity securities to fund our expected operating expenses, surrenders, and withdrawals. As of September 30, 2014, our total cash and invested assets were $46.1 billion. The life insurance subsidiaries were committed as of September 30, 2014, to fund mortgage loans in the amount of $407.0 million.

 

Our positive cash flows from operations are used to fund an investment portfolio that provides for future benefit payments. We employ a formal asset/liability program to manage the cash flows of our investment portfolio relative to our long-term benefit obligations. Our insurance subsidiaries held approximately $388.2 million in cash and

 

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short-term investments as of September 30, 2014, and we held $57.6 million in cash available for general corporate purposes.

 

The following chart includes the cash flows provided by or used in operating, investing, and financing activities for the following periods:

 

 

 

For The

 

 

 

Nine Months Ended

 

 

 

September 30,

 

 

 

2014

 

2013

 

 

 

(Dollars In Thousands)

 

Net cash provided by operating activities

 

$

605,503

 

$

443,103

 

Net cash used in investing activities

 

(480,536

)

(661,010

)

Net cash (used in) provided by financing activities

 

(263,022

)

203,555

 

Total

 

$

(138,055

)

$

(14,352

)

 

For The Nine Months Ended September 30, 2014 as compared to The Nine Months Ended September 30, 2013

 

Net cash provided by operating activities - Cash flows from operating activities are affected by the timing of premiums received, fees received, investment income, and expenses paid. Principal sources of cash include sales of our products and services. We typically generate positive cash flows from operating activities, as premiums and deposits collected from our insurance and investment products exceed benefit payments and redemptions, and we invest the excess. Accordingly, in analyzing our cash flows we focus on the change in the amount of cash available and used in investing activities.

 

Net cash used in investing activities - Changes in cash from investing activities primarily related to the activity in our investment portfolio.

 

Net cash (used in) provided by financing activities - Changes in cash from financing activities included $9.8 million inflows from repurchase program borrowings for the nine months ended September 30, 2014 as compared to outflows of $50.0 million for the nine months ended September 30, 2013 and $45.8 million outflows of investment product and universal life net activity for the nine months ended September 30, 2014, as compared to $215.1 million of inflows in the prior year. Net activity related to credit facility borrowings resulted in outflows of $205.0 million for the nine months ended September 30, 2014, as compared to net inflows of $50.0 million for the nine months ended September 30, 2013. Net issuance of non-recourse funding obligations equaled $31.7 million during the nine months ended September 30, 2014, as compared to issuance of $33.9 million during the nine months ended September 30, 2013.

 

Capital Resources

 

To give us flexibility in connection with future acquisitions and other funding needs, we have debt securities, preferred and common stock, and additional preferred securities of special purpose finance subsidiaries registered under the Securities Act of 1933 on a delayed (or shelf) basis. Additionally, we have access to the Credit Facility previously mentioned.

 

Captive Reinsurance Companies

 

Golden Gate Captive Insurance Company (“Golden Gate”), a South Carolina special purpose financial captive insurance company and wholly owned subsidiary of PLICO, had three series of Surplus Notes with a total outstanding balance of $800 million as of September 30, 2014. We hold the entire outstanding balance of Surplus Notes. The Series A1 Surplus Notes have a balance of $400 million and accrue interest at 7.375%, the Series A2 Surplus Notes have a balance of $100 million and accrue interest at 8%, and the Series A3 Surplus Notes have a balance of $300 million and accrue interest at 8.45%.

 

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Golden Gate II Captive Insurance Company (“Golden Gate II”), a special purpose financial captive insurance company wholly owned by PLICO, had $575 million of outstanding non-recourse funding obligations as of September 30, 2014. These outstanding non-recourse funding obligations were issued to special purpose trusts, which in turn issued securities to third parties. Certain of our affiliates own a portion of these securities. As of September 30, 2014, securities related to $176.6 million of the outstanding balance of the non-recourse funding obligations were held by external parties and securities related to $398.4 million of the non-recourse funding obligations were held by our affiliates. These non-recourse funding obligations mature in 2052. $275 million of this amount is currently accruing interest at a rate of LIBOR plus 30 basis points. We have experienced higher borrowing costs than were originally expected associated with $300 million of our non-recourse funding obligations supporting the business reinsured to Golden Gate II. These higher costs are the result of a higher spread component of interest expense associated with the illiquidity of the current market for auction rate securities, as well as a rating downgrade of our guarantor by certain rating agencies. The current rate associated with these obligations is LIBOR plus 200 basis points, which is the maximum rate we can be required to pay under these obligations. We have contingent approval to issue an additional $100 million of obligations. Under the terms of the non-recourse funding obligations, the special purpose trusts, as holders of the non-recourse funding obligations, cannot require repayment from us or any of our subsidiaries, other than Golden Gate II, the direct issuer of the non-recourse funding obligations, although we have agreed to indemnify Golden Gate II for certain costs and obligations (which obligations do not include payment of principal and interest on the surplus notes). In addition, we have entered into certain support agreements with Golden Gate II obligating us to make capital contributions or provide support related to certain of Golden Gate II’s expenses and in certain circumstances, to collateralize certain of our obligations to Golden Gate II. These support agreements provide that amounts would become payable by us to Golden Gate II if its annual general corporate expenses were higher than modeled amounts or if Golden Gate II’s investment income on certain investments or premium income was below certain actuarially determined amounts. As of September 30, 2014, no payments have been made under these agreements.

 

On October 10, 2012, Golden Gate V Vermont Captive Insurance Company (“Golden Gate V”), a Vermont special purpose financial insurance company, and Red Mountain, LLC (“Red Mountain”), both wholly owned subsidiaries of PLICO, entered into a 20-year transaction to finance up to $945 million of “AXXX” reserves related to a block of universal life insurance policies with secondary guarantees issued by our direct wholly owned subsidiary PLICO and indirect wholly owned subsidiary, WCL. Golden Gate V issued non-recourse funding obligations to Red Mountain, and Red Mountain issued a note with an initial principal amount of $275 million, increasing to a maximum of $945 million in 2027, to Golden Gate V for deposit to a reinsurance trust supporting Golden Gate V’s obligations under a reinsurance agreement with WCL, pursuant to which WCL cedes liabilities relating to the policies of WCL and retrocedes liabilities relating to the policies of PLICO. Through the structure, Hannover Life Reassurance Company of America (“Hannover Re”), the ultimate risk taker in the transaction, provides credit enhancement to the Red Mountain note for the 20-year term in exchange for a fee. The transaction is “non-recourse” to Golden Gate V, Red Mountain, WCL, PLICO and the Company, meaning that none of these companies are liable for the reimbursement of any credit enhancement payments required to be made. As of September 30, 2014, the principal balance of the Red Mountain note was $415 million. In connection with the transaction, we have entered into certain support agreements under which we guarantee or otherwise support certain obligations of Golden Gate V or Red Mountain. Future scheduled capital contributions to prefund credit enhancement fees amount to approximately $144.3 million and will be paid in annual installments through 2031. The support agreements provide that amounts would become payable by us if Golden Gate V’s annual general corporate expenses were higher than modeled amounts or in the event write-downs due to other-than-temporary impairments on assets held in certain accounts exceed defined threshold levels. Additionally, we have entered into separate agreements to indemnify Golden Gate V with respect to material adverse changes in non-guaranteed elements of insurance policies reinsured by Golden Gate V, and to guarantee payment of certain fee amounts in connection with the credit enhancement of the Red Mountain note. As of September 30, 2014, no payments have been made under these agreements.

 

Letters of Credit

 

Golden Gate III Vermont Captive Insurance Company (“Golden Gate III”), a Vermont special purpose financial insurance company and wholly owned subsidiary of PLICO, is party to a Reimbursement Agreement (the “Reimbursement Agreement”) with UBS AG, Stamford Branch (“UBS”), as issuing lender. Under the original Reimbursement Agreement, dated April 23, 2010, UBS issued a letter of credit (the “LOC”) in the initial amount of $505 million to a trust for the benefit of WCL. The Reimbursement Agreement was subsequently amended and restated effective November 21, 2011 (the “First Amended and Restated Reimbursement Agreement”), to replace the existing

 

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LOC with one or more letters of credit from UBS, and to extend the maturity date from April 1, 2018, to April 1, 2022. On August 7, 2013, we entered into a Second Amended and Restated Reimbursement Agreement with UBS (the “Second Amended and Restated Reimbursement Agreement”), which amended and restated the First Amended and Restated Reimbursement Agreement. Under the Second and Amended and Restated Reimbursement Agreement a new LOC in an initial amount of $710 million was issued by UBS in replacement of the existing LOC issued under the First Amended and Restated Reimbursement Agreement. The term of the LOC was extended from April 1, 2022 to October 1, 2023, subject to certain conditions being satisfied including scheduled capital contributions being made to Golden Gate III by one of its affiliates. The maximum stated amount of the LOC was increased from $610 million to $720 million in 2015 if certain conditions are met. On June 25, 2014, we entered into a Third Amended and Restated Reimbursement Agreement with UBS (the “Third Amended and Restated Reimbursement Agreement”), which amended and restated the Second Amended and Restated Reimbursement Agreement. Under the Third Amended and Restated Reimbursement Agreement, a new LOC in an initial amount of $915 million was issued by UBS in replacement of the existing LOC issued under the Second Amended and Restated Reimbursement Agreement. The term of the LOC was extended from October 1, 2023 to April 1, 2025, subject to certain conditions being satisfied including scheduled capital contributions being made to Golden Gate III by one of its affiliates. The maximum stated amount of the LOC was increased from $720 million to $935 million in 2015 if certain conditions are met. The LOC is held in trust for the benefit of WCL, and supports certain obligations of Golden Gate III to WCL under an indemnity reinsurance agreement originally effective April 1, 2010, as amended and restated on November 21, 2011, and as further amended and restated on August 7, 2013 and on June 25, 2014 to include additional blocks of policies, and pursuant to which WCL cedes liabilities relating to the policies of WCL and retrocedes liabilities relating to the policies of PLICO. The LOC balance was $925 million as of September 30, 2014. Subject to certain conditions, the amount of the LOC will be periodically increased up to a maximum of $935 million in 2015. The term of the LOC is expected to be approximately 15 years from the original issuance date. This transaction is “non-recourse” to WCL, PLICO, and the Company, meaning that none of these companies other than Golden Gate III are liable for reimbursement on a draw of the LOC. We have entered into certain support agreements with Golden Gate III obligating us to make capital contributions or provide support related to certain of Golden Gate III’s expenses and in certain circumstances, to collateralize certain of our obligations to Golden Gate III. Future scheduled capital contributions amount to approximately $122.5 million and will be paid in three installments with the last payment occurring in 2021, and these contributions may be subject to potential offset against dividend payments as permitted under the terms of the Third Amended and Restated Reimbursement Agreement. The support agreements provide that amounts would become payable by us to Golden Gate III if its annual general corporate expenses were higher than modeled amounts or if specified catastrophic losses occur during defined time periods with respect to the policies reinsured by Golden Gate III. Pursuant to the terms of an amended and restated letter agreement with UBS, we have continued to guarantee the payment of fees to UBS as specified in the Third Amended and Restated Reimbursement Agreement. As of September 30, 2014, no payments have been made under these agreements.

 

Golden Gate IV Vermont Captive Insurance Company (“Golden Gate IV”), a Vermont special purpose financial insurance company and wholly owned subsidiary of PLICO, is party to a Reimbursement Agreement with UBS AG, Stamford Branch, as issuing lender. Under the Reimbursement Agreement, dated December 10, 2010, UBS issued an LOC in the initial amount of $270 million to a trust for the benefit of WCL. The LOC balance increased, in accordance with the terms of the Reimbursement Agreement, during the third quarter of 2014 and was $740 million as of September 30, 2014. Subject to certain conditions, the amount of the LOC will be periodically increased up to a maximum of $790 million in 2016. The term of the LOC is expected to be 12 years from the original issuance date (stated maturity of December 30, 2022). The LOC was issued to support certain obligations of Golden Gate IV to WCL under an indemnity reinsurance agreement, pursuant to which WCL cedes liabilities related to the policies of WCL and retrocedes liabilities relating to the policies of PLICO. This transaction is “non-recourse” to WCL, PLICO, and the Company, meaning that none of these companies other than Golden Gate IV are liable for reimbursement on a draw of the LOC. We have entered into certain support agreements with Golden Gate IV obligating us to make capital contributions or provide support related to certain of Golden Gate IV’s expenses and in certain circumstances, to collateralize certain of our obligations to Golden Gate IV. The support agreements provide that amounts would become payable by us to Golden Gate IV if its annual general corporate expenses were higher than modeled amounts or if specified catastrophic losses occur during defined time periods with respect to the policies reinsured by Golden Gate IV. We have also entered into a separate agreement to guarantee the payments of LOC fees under the terms of the Reimbursement Agreement. As of September 30, 2014, no payments have been made under these agreements.

 

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A life insurance company’s statutory capital is computed according to rules prescribed by the NAIC, as modified by state law. Generally speaking, other states in which a company does business defer to the interpretation of the domiciliary state with respect to NAIC rules, unless inconsistent with the other state’s regulations. Statutory accounting rules are different from GAAP and are intended to reflect a more conservative view, for example, requiring immediate expensing of policy acquisition costs. The NAIC’s risk-based capital requirements require insurance companies to calculate and report information under a risk-based capital formula. The achievement of long-term growth will require growth in the statutory capital of our insurance subsidiaries. The subsidiaries may secure additional statutory capital through various sources, such as retained statutory earnings or our equity contributions. In general, dividends up to specified levels are considered ordinary and may be paid 30 days after written notice to the insurance commissioner of the state of domicile unless such commissioner objects to the dividend prior to the expiration of such period. Dividends in larger amounts are considered extraordinary and are subject to affirmative prior approval by such commissioner. The maximum amount that would qualify as an ordinary dividend to us from our insurance subsidiaries in 2014 is estimated to be $305.1 million.

 

State insurance regulators and the NAIC have adopted risk-based capital (“RBC”) requirements for life insurance companies to evaluate the adequacy of statutory capital and surplus in relation to investment and insurance risks. The requirements provide a means of measuring the minimum amount of statutory surplus appropriate for an insurance company to support its overall business operations based on its size and risk profile. A company’s risk-based statutory surplus is calculated by applying factors and performing calculations relating to various asset, premium, claim, expense, and reserve items. Regulators can then measure the adequacy of a company’s statutory surplus by comparing it to the RBC. We manage our capital consumption by using the ratio of our total adjusted capital, as defined by the insurance regulators, to our company action level RBC (known as the RBC ratio), also as defined by insurance regulators.

 

Statutory reserves established for VA contracts are sensitive to changes in the equity markets and are affected by the level of account values relative to the level of any guarantees and product design. As a result, the relationship between reserve changes and equity market performance may be non-linear during any given reporting period. Market conditions greatly influence the capital required due to their impact on the valuation of reserves and derivative investments mitigating the risk in these reserves. Risk mitigation activities may result in material and sometimes counterintuitive impacts on statutory surplus and RBC ratio. Notably, as changes in these market and non-market factors occur, both our potential obligation and the related statutory reserves and/or required capital can vary at a non-linear rate.

 

In an effort to mitigate the equity market risks discussed above relative to PLICO’s RBC ratio, PLICO has reinsured GMWB and GMDB riders related to its variable annuity contracts to Shades Creek Captive Insurance Company (“Shades Creek”), a Vermont captive insurance company, a wholly owned insurance subsidiary of the Company. The purpose of Shades Creek is to reduce the volatility in RBC due to non-economic variables included within the RBC calculation.

 

We have an intercompany capital support agreement with Shades Creek. The agreement provides through a guarantee that we will contribute assets or purchase surplus notes (or cause an affiliate or third party to contribute assets or purchase surplus notes) in amounts necessary for Shades Creek’s regulatory capital levels to equal or exceed minimum thresholds as defined by the agreement. As of September 30, 2014, Shades Creek maintained capital levels in excess of the required minimum thresholds. The maximum potential future payment amount which could be required under the capital support agreement will be dependent on numerous factors, including the performance of equity markets, the level of interest rates, performance of associated hedges, and related policyholder behavior.

 

We cede material amounts of insurance and transfer related assets to other insurance companies through reinsurance. However, notwithstanding the transfer of related assets, we remain liable with respect to ceded insurance should any reinsurer fail to meet the obligations that it assumed. We evaluate the financial condition of our reinsurers and monitor the associated concentration of credit risk. For the three and nine months ended September 30, 2014, we ceded premiums to unaffiliated third party reinsurers amounting to $277.1 million and $947.8 million, respectively. In addition, we had receivables from unaffiliated reinsurers amounting to $6.1 billion as of September 30, 2014. We review reinsurance receivable amounts for collectability and establish bad debt reserves if deemed appropriate.

 

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Ratings

 

Various Nationally Recognized Statistical Rating Organizations (“rating organizations”) review the financial performance and condition of insurers, including our insurance subsidiaries, and publish their financial strength ratings as indicators of an insurer’s ability to meet policyholder and contract holder obligations. These ratings are important to maintaining public confidence in an insurer’s products, its ability to market its products and its competitive position. The following table summarizes the financial strength ratings of our significant member companies from the major independent rating organizations as of September 30, 2014:

 

 

 

 

 

 

 

Standard &

 

 

 

Ratings

 

A.M. Best

 

Fitch

 

Poor’s

 

Moody’s

 

 

 

 

 

 

 

 

 

 

 

Insurance company financial strength rating:

 

 

 

 

 

 

 

 

 

Protective Life Insurance Company

 

A+

 

A

 

AA-

 

A2

 

West Coast Life Insurance Company

 

A+

 

A

 

AA-

 

A2

 

Protective Life and Annuity Insurance Company

 

A+

 

A

 

AA-

 

 

Lyndon Property Insurance Company

 

A-

 

 

 

 

MONY Life Insurance Company

 

A+

 

A

 

A+

 

A2

 

 

Our ratings are subject to review and change by the rating organizations at any time and without notice. A downgrade or other negative action by a ratings organization with respect to the financial strength ratings of our insurance subsidiaries could adversely affect sales, relationships with distributors, the level of policy surrenders and withdrawals, competitive position in the marketplace, and the cost or availability of reinsurance. With the announcement of the Dai-ichi transaction, each rating agency has undertaken a review of our insurance company subsidiaries’ financial strength ratings in light of the transaction. The rating agencies may take various actions, positive or negative, and their actions may not be known until the Merger closes.

 

Rating organizations also publish credit ratings for the issuers of debt securities, including the Company. Credit ratings are indicators of a debt issuer’s ability to meet the terms of debt obligations in a timely manner. These ratings are important in the debt issuer’s overall ability to access credit markets and other types of liquidity. Ratings are not recommendations to buy our securities or products. A downgrade or other negative action by a ratings organization with respect to our credit rating could limit our access to capital markets, increase the cost of issuing debt, and a downgrade of sufficient magnitude, combined with other negative factors, could require us to post collateral. As is the case with the financial strength ratings of our insurance subsidiaries, the rating agencies have undertaken a review of our debt ratings in light of the Dai-ichi transaction.

 

LIABILITIES

 

Many of our products contain surrender charges and other features that are designed to reward persistency and penalize the early withdrawal of funds. Certain stable value and annuity contracts have market-value adjustments that protect us against investment losses if interest rates are higher at the time of surrender than at the time of issue.

 

As of September 30, 2014, we had policy liabilities and accruals of approximately $31.4 billion. Our interest-sensitive life insurance policies have a weighted average minimum credited interest rate of approximately 3.51%.

 

Contractual Obligations

 

We enter into various obligations to third parties in the ordinary course of our operations. However, we do not believe that our cash flow requirements can be assessed solely based upon an analysis of these obligations. The most significant factors affecting our future cash flows are our ability to earn and collect cash from our customers, and the cash flows arising from our investment program. Future cash outflows, whether they are contractual obligations or not, will also vary based upon our future needs. Although some outflows are fixed, others depend on future events. Examples of fixed obligations include our obligations to pay principal and interest on fixed-rate borrowings. Examples of obligations that will vary include obligations to pay interest on variable-rate borrowings and insurance liabilities that

 

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depend on future interest rates, market performance, or surrender provisions. Many of our obligations are linked to cash-generating contracts. In addition, our operations involve significant expenditures that are not based upon contractual obligations. These include expenditures for income taxes and payroll.

 

As of September 30, 2014, we carried a $142.1 million liability for uncertain tax positions, including interest on unrecognized tax benefits. These amounts are not included in the long-term contractual obligations table because of the difficulty in making reasonably reliable estimates of the occurrence or timing of cash settlements with the respective taxing authorities.

 

The table below sets forth future maturities of our contractual obligations:

 

 

 

 

 

Payments due by period

 

 

 

 

 

Less than

 

 

 

 

 

More than

 

 

 

Total

 

1 year

 

1-3 years

 

3-5 years

 

5 years

 

 

 

(Dollars In Thousands)

 

Debt(1)

 

$

2,206,678

 

$

319,190

 

$

415,703

 

$

262,500

 

$

1,209,285

 

Non-recourse funding obligations(2)

 

2,107,689

 

30,178

 

73,115

 

86,964

 

1,917,432

 

Subordinated debt securities(3)

 

1,410,309

 

33,283

 

66,566

 

66,566

 

1,243,894

 

Stable value products(4)

 

2,333,243

 

856,555

 

938,283

 

463,462

 

74,943

 

Operating leases(5)

 

17,409

 

6,136

 

7,108

 

2,041

 

2,124

 

Home office lease(6)

 

80,206

 

1,226

 

2,455

 

76,525

 

 

Mortgage loan and investment commitments

 

415,067

 

415,067

 

 

 

 

Repurchase program borrowings(7)

 

359,805

 

359,805

 

 

 

 

Policyholder obligations(8)

 

42,481,870

 

1,314,009

 

2,931,811

 

3,135,158

 

35,100,892

 

Total(9)

 

$

51,412,276

 

$

3,335,449

 

$

4,435,041

 

$

4,093,216

 

$

39,548,570

 

 


(1)         Debt includes all principal amounts owed on note agreements and expected interest payments due over the term of the notes.

(2)         Non-recourse funding obligations include all undiscounted principal amounts owed and expected future interest payments due over the term of the notes. Of the total undiscounted cash flows, $1.9 billion relates to the Golden Gate V transaction. These cash out flows are matched and predominantly offset by the cash inflows Golden Gate V receives from notes issued by a nonconsolidated variable interest entity. The remaining amounts are associated with the Golden Gate II notes outstanding and held by third parties as well as certain obligations assumed with the acquisition of MONY Life Insurance Company.

(3)         Subordinated debt securities includes all principal amounts and interest payments due over the term of the obligations.

(4)         Anticipated stable value products cash flows including interest.

(5)         Includes all lease payments required under operating lease agreements.

(6)         The lease payments shown assume we exercise our option to purchase the building at the end of the lease term. Additionally, the payments due by the periods above were computed based on the terms of the renegotiated lease agreement, which was entered in December 2013.

(7)         Represents secured borrowings as part of our repurchase program as well as related interest.

(8)         Estimated contractual policyholder obligations are based on mortality, morbidity, and lapse assumptions comparable to our historical experience, modified for recent observed trends. These obligations are based on current balance sheet values and do not incorporate an expectation of future sales. Due to the significance of the assumptions used, the amounts presented could materially differ from actual results. Separate account obligations are excluded from the chart as variable separate account obligations are legally insulated from general account obligations and will be fully funded by cash flows from variable separate account assets. We expect to fully fund the general account obligations from cash flows from general account assets.

(9)         Excluded from this table are certain pension obligations.

 

FAIR VALUE OF FINANCIAL INSTRUMENTS

 

FASB guidance defines fair value for GAAP and establishes a framework for measuring fair value as well as a fair value hierarchy based on the quality of inputs used to measure fair value and enhances disclosure requirements for fair value measurements. The term “fair value” in this document is defined in accordance with GAAP. The standard describes three levels of inputs that may be used to measure fair value. For more information, see Note 2, Summary of Significant Accounting Policies and Note 16, Fair Value of Financial Instruments.

 

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Available-for-sale securities and trading account securities are recorded at fair value, which is primarily based on actively traded markets where prices are based on either direct market quotes or observed transactions. Liquidity is a significant factor in the determination of the fair value for these securities. Market price quotes may not be readily available for some positions or for some positions within a market sector where trading activity has slowed significantly or ceased. These situations are generally triggered by the market’s perception of credit uncertainty regarding a single company or a specific market sector. In these instances, fair value is determined based on limited available market information and other factors, principally from reviewing the issuer’s financial position, changes in credit ratings, and cash flows on the investments. As of September 30, 2014, $2.2 billion of available-for-sale and trading account assets, excluding other long-term investments, were classified as Level 3 fair value assets.

 

The fair values of derivative assets and liabilities include adjustments for market liquidity, counterparty credit quality, and other deal specific factors, where appropriate. The fair values of derivative assets and liabilities traded in the over-the-counter market are determined using quantitative models that require the use of multiple market inputs including interest rates, prices, and indices to generate continuous yield or pricing curves and volatility factors. The predominance of market inputs are actively quoted and can be validated through external sources. Estimation risk is greater for derivative financial instruments that are either option-based or have longer maturity dates where observable market inputs are less readily available or are unobservable, in which case quantitative based extrapolations of rate, price, or index scenarios are used in determining fair values. As of September 30, 2014, the Level 3 fair values of derivative assets and liabilities determined by these quantitative models were $105.4 million and $533.7 million, respectively.

 

The liabilities of certain of our annuity account balances are calculated at fair value using actuarial valuation models. These models use various observable and unobservable inputs including projected future cash flows, policyholder behavior, our credit rating, and other market conditions. As of September 30, 2014, the Level 3 fair value of these liabilities was $98.1 million.

 

For securities that are priced via non-binding independent broker quotations, we assess whether prices received from independent brokers represent a reasonable estimate of fair value through an analysis using internal and external cash flow models developed based on spreads and, when available, market indices. We use a market-based cash flow analysis to validate the reasonableness of prices received from independent brokers. These analytics, which are updated daily, incorporate various metrics (yield curves, credit spreads, prepayment rates, etc.) to determine the valuation of such holdings. As a result of this analysis, if we determine there is a more appropriate fair value based upon the analytics, the price received from the independent broker is adjusted accordingly. We did not adjust any quotes or prices received from brokers during the nine months ended September 30, 2014.

 

Of our $2.3 billion, or 4.4%, of total assets (measured at fair value on a recurring basis) classified as Level 3 assets, $736.1 million were ABS. Of this amount, $574.1 million were student loan related ABS and $162.0 million were non-student loan related ABS. The years of issuance of the ABS are as follows:

 

Year of Issuance

 

Amount

 

 

 

(In Millions)

 

2002

 

$

292.4

 

2003

 

96.9

 

2004

 

117.4

 

2006

 

13.1

 

2007

 

93.8

 

2012

 

97.2

 

2013

 

25.3

 

Total

 

$

736.1

 

 

The ABS was rated as follows: $477.9 million were AAA rated, $162.7 million were AA rated, $92.6 million were A rated, $2.4 million were BBB rated, and $0.5 million were less than investment grade. We do not expect any credit losses on these securities related to student loans since the majority of the underlying collateral of the student loan asset-backed securities is guaranteed by the U.S. Department of Education.

 

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MARKET RISK EXPOSURES AND OFF-BALANCE SHEET ARRANGEMENTS

 

Our financial position and earnings are subject to various market risks including changes in interest rates, the yield curve, spreads between risk-adjusted and risk-free interest rates, foreign currency rates, used vehicle prices, and equity price risks and issuer defaults. We analyze and manage the risks arising from market exposures of financial instruments, as well as other risks, through an integrated asset/liability management process. Our asset/liability management programs and procedures involve the monitoring of asset and liability durations for various product lines; cash flow testing under various interest rate scenarios; and the continuous rebalancing of assets and liabilities with respect to yield, credit and market risk, and cash flow characteristics. These programs also incorporate the use of derivative financial instruments primarily to reduce our exposure to interest rate risk, inflation risk, currency exchange risk, volatility risk, and equity market risk. See Note 17, Derivative Financial Instruments for additional information on our financial instruments.

 

The primary focus of our asset/liability program is the management of interest rate risk within the insurance operations. This includes monitoring the duration of both investments and insurance liabilities to maintain an appropriate balance between risk and profitability for each product category, and for us as a whole. It is our policy to maintain asset and liability durations within one year of one another, although, from time to time, a broader interval may be allowed.

 

We are exposed to credit risk within our investment portfolio and through derivative counterparties. Credit risk relates to the uncertainty of an obligor’s continued ability to make timely payments in accordance with the contractual terms of the instrument or contract. We manage credit risk through established investment policies which attempt to address quality of obligors and counterparties, credit concentration limits, diversification requirements, and acceptable risk levels under expected and stressed scenarios. Derivative counterparty credit risk is measured as the amount owed to us, net of collateral held, based upon current market conditions. In addition, we periodically assess exposure related to potential payment obligations between us and our counterparties. We minimize the credit risk in derivative financial instruments by entering into transactions with high quality counterparties, (A-rated or higher at the time we enter into the contract) and we maintain credit support annexes with certain of those counterparties.

 

We utilize a risk management strategy that includes the use of derivative financial instruments. Derivative instruments expose us to credit market and basis risk. Such instruments can change materially in value from period-to-period. We minimize our credit risk by entering into transactions with highly rated counterparties. We manage the market and basis risks by establishing and monitoring limits as to the types and degrees of risk that may be undertaken. We monitor our use of derivatives in connection with our overall asset/liability management programs and procedures. In addition, all derivative programs are monitored by our risk management department.

 

Derivative instruments that are used as part of our interest rate risk management strategy include interest rate swaps, interest rate futures, interest rate caps, and interest rate options. Our inflation risk management strategy involves the use of swaps that require us to pay a fixed rate and receive a floating rate that is based on changes in the Consumer Price Index (“CPI”).

 

We may use the following types of derivative contracts to mitigate our exposure to certain guaranteed benefits related to variable annuity contracts and fixed indexed annuities:

 

·                  Foreign Currency Futures

·                  Variance Swaps

·                  Interest Rate Futures

·                  Equity Options

·                  Equity Futures

·                  Credit Derivatives

·                  Interest Rate Swaps

·                  Interest Rate Swaptions

·                  Volatility Futures

·                  Volatility Options

·                  Total Return Swaps

 

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We believe our asset/liability management programs and procedures and certain product features provide protection against the effects of changes in interest rates under various scenarios. Additionally, we believe our asset/liability management programs and procedures provide sufficient liquidity to enable us to fulfill our obligation to pay benefits under our various insurance and deposit contracts. However, our asset/liability management programs and procedures incorporate assumptions about the relationship between short-term and long-term interest rates (i.e., the slope of the yield curve), relationships between risk-adjusted and risk-free interest rates, market liquidity, spread movements, implied volatility, policyholder behavior, and other factors, and the effectiveness of our asset/liability management programs and procedures may be negatively affected whenever actual results differ from those assumptions.

 

In the ordinary course of our commercial mortgage lending operations, we may commit to provide a mortgage loan before the property to be mortgaged has been built or acquired. The mortgage loan commitment is a contractual obligation to fund a mortgage loan when called upon by the borrower. The commitment is not recognized in our financial statements until the commitment is actually funded. The mortgage loan commitment contains terms, including the rate of interest, which may be different than prevailing interest rates. As of September 30, 2014, we had outstanding mortgage loan commitments of $407.0 million at an average rate of 4.79%.

 

Impact of continued low interest rate environment

 

Significant changes in interest rates expose us to the risk of not realizing anticipated spreads between the interest rate earned on investments and the interest rate credited to in-force policies and contracts. In addition, certain of our insurance and investment products guarantee a minimum credited interest rate (“MGIR”). In periods of prolonged low interest rates, the interest spread earned may be negatively impacted to the extent our ability to reduce policyholder crediting rates is limited by the guaranteed minimum credited interest rates. Additionally, those policies without account values may exhibit lower profitability in periods of prolonged low interest rates due to reduced investment income.

 

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The table below presents account values by range of current minimum guaranteed interest rates and current crediting rates for our universal life and deferred fixed annuity products:

 

Credited Rate Summary

As of September 30, 2014

 

 

 

 

 

1-50 bps

 

More than

 

 

 

Minimum Guaranteed Interest Rate

 

At

 

above

 

50 bps

 

 

 

Account Value

 

MGIR

 

MGIR

 

above MGIR

 

Total

 

 

 

(Dollars In Millions)

 

Universal Life Insurance

 

 

 

 

 

 

 

 

 

>2% - 3%

 

$

186

 

$

941

 

$

2,005

 

$

3,132

 

>3% - 4%

 

3,515

 

1,684

 

137

 

5,336

 

>4% - 5%

 

2,049

 

15

 

 

2,064

 

>5% - 6%

 

225

 

 

 

225

 

Subtotal

 

5,975

 

2,640

 

2,142

 

10,757

 

 

 

 

 

 

 

 

 

 

 

Fixed Annuities

 

 

 

 

 

 

 

 

 

1%

 

$

564

 

$

186

 

$

285

 

$

1,035

 

>1% - 2%

 

609

 

518

 

207

 

1,334

 

>2% - 3%

 

1,992

 

113

 

539

 

2,644

 

>3% - 4%

 

296

 

 

 

296

 

>4% - 5%

 

303

 

 

 

303

 

Subtotal

 

3,764

 

817

 

1,031

 

5,612

 

Total

 

$

9,739

 

$

3,457

 

$

3,173

 

$

16,369

 

 

 

 

 

 

 

 

 

 

 

Percentage of Total

 

59

%

21

%

20

%

100

%

 

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The table below presents account values by range of current minimum guaranteed interest rates and current crediting rates for our universal life and deferred fixed annuity products:

 

Credited Rate Summary

As of December 31, 2013

 

 

 

 

 

1-50 bps

 

More than

 

 

 

Minimum Guaranteed Interest Rate

 

At

 

above

 

50 bps

 

 

 

Account Value

 

MGIR

 

MGIR

 

above MGIR

 

Total

 

 

 

(Dollars In Millions)

 

Universal Life Insurance

 

 

 

 

 

 

 

 

 

>2% - 3%

 

$

43

 

$

1,024

 

$

1,984

 

$

3,051

 

>3% - 4%

 

3,109

 

2,099

 

150

 

5,358

 

>4% - 5%

 

2,110

 

15

 

 

2,125

 

>5% - 6%

 

232

 

 

 

232

 

Subtotal

 

5,494

 

3,138

 

2,134

 

10,766

 

 

 

 

 

 

 

 

 

 

 

Fixed Annuities

 

 

 

 

 

 

 

 

 

1%

 

$

422

 

$

173

 

$

461

 

$

1,056

 

>1% - 2%

 

612

 

518

 

279

 

1,409

 

>2% - 3%

 

1,846

 

308

 

632

 

2,786

 

>3% - 4%

 

309

 

 

 

309

 

>4% - 5%

 

313

 

 

 

313

 

Subtotal

 

3,502

 

999

 

1,372

 

5,873

 

Total

 

$

8,996

 

$

4,137

 

$

3,506

 

$

16,639

 

 

 

 

 

 

 

 

 

 

 

Percentage of Total

 

54

%

25

%

21

%

100

%

 

We are active in mitigating the impact of a continued low interest rate environment through product design, as well as adjusting crediting rates on current in-force policies and contracts. We also manage interest rate and reinvestment risks through our asset/liability management process. Our asset/liability management programs and procedures involve the monitoring of asset and liability durations; cash flow testing under various interest rate scenarios; and the regular rebalancing of assets and liabilities with respect to yield, credit and market risk, and cash flow characteristics. These programs also incorporate the use of derivative financial instruments primarily to reduce our exposure to interest rate risk, inflation risk, currency exchange risk, volatility risk, and equity market risk.

 

IMPACT OF INFLATION

 

Inflation increases the need for life insurance. Many policyholders who once had adequate insurance programs may increase their life insurance coverage to provide the same relative financial benefit and protection. Higher interest rates may result in higher sales of certain of our investment products.

 

The higher interest rates that have traditionally accompanied inflation could also affect our operations. Policy loans increase as policy loan interest rates become relatively more attractive. As interest rates increase, disintermediation of stable value and annuity account balances and individual life policy cash values may increase. The market value of our fixed-rate, long-term investments may decrease, we may be unable to implement fully the interest rate reset and call provisions of our mortgage loans, and our ability to make attractive mortgage loans, including participating mortgage loans, may decrease. In addition, participating mortgage loan income may decrease. The difference between the interest rate earned on investments and the interest rate credited to life insurance and investment products may also be adversely affected by rising interest rates.

 

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RECENTLY ISSUED ACCOUNTING STANDARDS

 

See Note 2, Summary of Significant Accounting Policies, to the consolidated condensed financial statements for information regarding recently issued accounting standards.

 

Item 3.                                 Quantitative and Qualitative Disclosures about Market Risk

 

See Part I, Item 2, Management’s Discussion and Analysis of Financial Condition and Results of Operations, “Executive Summary” and “Liquidity and Capital Resources”, and Part II, Item 1A, Risk Factors of this Report for market risk disclosures in light of the current conditions in the financial and credit markets, and the economy generally.

 

Item 4.                     Controls and Procedures

 

(a)                                 Disclosure controls and procedures

 

In order to ensure that the information the Company must disclose in its filings with the Securities and Exchange Commission is recorded, processed, summarized, and reported on a timely basis, the Company’s management, with the participation of its Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of the design and operation of its disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)), except as otherwise noted below. Based on their evaluation as of the end of the period covered by this Form 10-Q, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that the Company’s disclosure controls and procedures were effective. It should be noted that any system of controls, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. Further, the design of any control system is based in part upon certain judgments, including the costs and benefits of controls and the likelihood of future events. Because of these and other inherent limitations of control systems, no evaluation of controls can provide absolute assurance that all control issues, if any, within the Company have been detected.

 

In conducting our evaluation of the effectiveness of internal control over financial reporting as of September 30, 2014, the Company has excluded the internal controls relating to the administrative systems and processes being provided by third parties for MONY Life Insurance Company (“MONY”) and the blocks of life and health business reinsured from MONY Life Insurance Company of America (“MLOA Business”). As of September 30, 2014, the Company is in the process of, but has not completed its own evaluation of the design and operation of the internal controls relating to the administrative systems and processes, including those currently being provided by third parties, for MONY and the MLOA business. For the three and nine months ended September 30, 2014, MONY and the MLOA Business represented revenues and pre-tax income of $175.8 million and $569.7 million and $27.4 million and $79.9 million, respectively, of the Company’s consolidated income before income tax.

 

(b)                                 Changes in internal control over financial reporting

 

During the second quarter of 2014, the Company began the conversion and integration of administrative processing into its internal controls over financial reporting for the MONY and MLOA blocks of business. The conversion to the Company’s operating environment was substantially complete as of September 30, 2014.

 

There have been no changes in the Company’s internal control over financial reporting during the nine months ended September 30, 2014, that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting. The Company’s internal controls exist within a dynamic environment and the Company continually strives to improve its internal controls and procedures to enhance the quality of its financial reporting.

 

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PART II

 

Item 1.  Legal Proceedings

 

Since the entry into the Merger Agreement on June 3, 2014, four lawsuits have been filed against the Company, our directors, Dai-ichi and DL Investment (Delaware), Inc. on behalf of alleged Company shareowners. On June 11, 2014, a putative class action lawsuit styled Edelman, et al. v. Protective Life Corporation, et al., Civil Action No. 01-CV-2014-902474.00, was filed in the Circuit Court of Jefferson County, Alabama.  On July 30, 2014, the plaintiff in Edelman filed an amended complaint. Three putative class action lawsuits were filed in the Court of Chancery of the State of Delaware, Martin, et al. v. Protective Life Corporation, et al., Civil Action No. 9794-CB, filed June 19, 2014, Leyendecker, et al. v. Protective Life Corporation, et al., Civil Action No. 9931-CB, filed July 22, 2014 and Hilburn, et al. v. Protective Life Corporation, et al., Civil Action No. 9937-CB, filed July 23, 2014.  The Delaware Court of Chancery consolidated the Martin, Leyendecker, and Hilburn actions under the caption In re Protective Life Corp. Stockholders Litigation, Consolidated Civil Action No. 9794-CB, designated the Hilburn complaint as the operative consolidated complaint (the “Delaware Action”) and appointed Charlotte Martin, Samuel J. Leyendecker, Jr., and Deborah J. Hilburn to serve as co-lead plaintiffs. These lawsuits allege that our Board of Directors breached its fiduciary duties to our shareowners, that the Merger involves an unfair price, an inadequate sales process, and unreasonable deal protection devices that purportedly preclude competing offers, and that the preliminary proxy statement filed with the SEC on July 10, 2014 failed to disclose purportedly material information. The complaints also alleged that the Company, Dai-ichi and DL Investment (Delaware), Inc. aided and abetted those alleged breaches of fiduciary duties. The complaints seek injunctive relief, including enjoining or rescinding the Merger, and attorneys’ and other fees and costs, in addition to other relief. The Delaware Action also seeks an award of unspecified damages.

 

With respect to the Edelman lawsuit, on September 5, 2014, the court held a hearing to address motions to dismiss the lawsuit filed on behalf of the Company, the members of the Company’s Board, and DL Investment (Delaware), Inc.  On September 19, 2014, the court granted those motions and dismissed the Edelman lawsuit in its entirety and with prejudice, pending a possible appeal by the plaintiff. With respect to the Delaware Action, on September 24, 2014, the Company, each of the members of the Company’s Board, Dai-ichi, and DL Investment (Delaware), Inc. entered into a Memorandum of Understanding (the “MOU”) with the plaintiffs in that case, which sets forth the parties’ agreement in principle for a settlement of the Delaware Action. As set forth in the MOU, the Company, the members of the Company’s Board, Dai-ichi, and DL Investment (Delaware), Inc. agreed to the settlement solely to eliminate the burden, expense, distraction, and uncertainties inherent in further litigation, and without admitting any liability or wrongdoing.  The MOU contemplates that the parties will seek to enter into a stipulation of settlement providing for the certification of a mandatory non opt-out class, for settlement purposes only, to include any and all record and beneficial owners of shares (excluding the members of the Company’s Board and their immediate family members, any entity in which any member of the Company’s Board has a controlling interest, and any successors in interest thereto) that held shares at any time during the period beginning on June 3, 2014, through the date of consummation or termination of the proposed Merger, including any and all of their respective successors in interest, successors, predecessors in interest, representatives, trustees, executors, administrators, heirs, assigns, or transferees, immediate and remote, and any person or entity acting for or on behalf of, or claiming under, any of them, together with their predecessors, successors and assigns, and a global release of claims relating to the Merger as set forth in the MOU.  As part of the settlement, the Company agreed to make certain additional disclosures related to the Merger which are set forth in the Company’s Form 8-K filed on September 25, 2014 and which supplement the information contained in the Company’s definitive proxy statement filed with the SEC on August 25, 2014, as amended on August 27, 2014.  Nothing in the Form 8-K or any stipulation of settlement shall be deemed an admission of the legal necessity or materiality of any of the disclosures set forth in the Form 8-K. The claims in the Delaware Action will not be released until the stipulation of settlement is approved by the Court of Chancery of the State of Delaware.  The settlement will not affect the consideration to be received by the Company stockholders in connection with the Merger. There can be no assurance that the parties to the Delaware Action will ultimately enter into a stipulation of settlement or that the court will approve such settlement even if the parties were to enter into such stipulation, or the extent to which attorneys’ fees and expenses will be awarded to the plaintiffs’ counsel. The Company cannot provide assurances as to the ultimate settlement of the Delaware Action or with respect to any lawsuits regarding the Merger that may be filed in the future.

 

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Except as set forth above, to the knowledge and in the opinion of management, there are no material pending legal proceedings, other than ordinary routine litigation incidental to the business of the Company, to which the Company or any of its subsidiaries is a party or of which any of our properties is the subject. For additional information regarding legal proceedings, see Part II, Item 1A, Risk Factors and Cautionary Factors that may Affect Future Results, of this report and Note 10, Commitments and Contingencies, to the consolidated condensed financial statements.

 

Item 1A.  Risk Factors and Cautionary Factors that may Affect Future Results

 

The operating results of companies in the insurance industry have historically been subject to significant fluctuations. The factors which could affect the Company’s future results include, but are not limited to, general economic conditions and known trends and uncertainties. In addition to other information set forth in this report, you should carefully consider the factors discussed in Part I, Item 1A, Risk Factors and Cautionary Factors that may Affect Future Results in the Company’s Annual Report on Form 10-K for the year ended December 31, 2013, and the factors discussed in Part II, Item 1A, Risk Factors and Cautionary Factors that may Affect Future Results in the Company’s Quarterly Reports on Form 10-Q for the quarters ended March 31, 2014 and June 30, 2014, which could materially affect the Company’s business, financial condition, or future results of operations.

 

Risks Related to the Proposed Dai-ichi Merger

 

The Merger is subject to various closing conditions, including regulatory and third party approvals.

 

As discussed above, on June 3, 2014, the Company entered into the Merger Agreement pursuant to which it would become a wholly owned subsidiary of Dai-ichi. Completion of the Merger is subject to certain closing conditions, including, without limitation, approval of the Company’s shareowners, which approval was received at a Special Meeting of Shareholders held on October 6, 2014, the receipt of required third party consents and regulatory approvals, including those of the Financial Services Agency of Japan and domestic insurance regulators, the expiration or termination of the applicable waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, which waiting period terminated on July 25, 2014, pursuant to a grant of early termination by the Federal Trade Commission, the absence of legal impediments or a material adverse effect with respect to the Company preventing the consummation of the Merger, as well as other conditions to closing as are customary in transactions such as the Merger. A number of the closing conditions are outside of our control and we cannot predict with certainty whether all of the required closing conditions will be satisfied or waived or if other uncertainties may arise. In addition, regulators could impose additional requirements or obligations as conditions for their approvals, which may be burdensome. Despite our best efforts, we may not be able to satisfy the various closing conditions or obtain the necessary waivers or approvals in a timely fashion or at all, in which case the Merger would be prevented or delayed.

 

Failure to timely complete the Merger could adversely impact our stock price, business, financial condition and results of operations.

 

There is no assurance that the conditions to the Merger will be satisfied in a timely manner, or that the Merger will occur. A failure to consummate the Merger on a timely basis or at all could result in negative publicity and cause the price of our common stock to decline, to the extent our current stock price reflects a market assumption that the Merger will occur. In addition, as a result of the announcement of the Merger Agreement, trading in our stock has increased substantially. If the Merger is not consummated, the investment goals of our shareowners may be materially different than those of our shareowners on a pre-Merger announcement basis.  In addition, we will remain liable for significant transaction costs that will be payable even if the Merger is not completed and could also be required to pay a termination fee to Dai-ichi in certain specific circumstances. For these and other reasons, failure to timely consummate the Merger could adversely impact our stock price and perceived acquisition value, business, financial condition and results of operations.

 

The pendency of the Merger and operating restrictions contained in the Merger Agreement could adversely affect our business and operations.

 

The proposed Merger could cause disruptions to the Company’s business and business relationships, which could have an adverse impact on the Company’s results of operations, liquidity and financial condition. For example, the attention of the Company’s management may be directed to Merger related considerations, the Company’s current

 

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and prospective employees may experience uncertainty about their future roles with the Company which may adversely affect our ability to retain and hire key personnel, and parties with which the Company has business relationships, including customers, potential customers and distributors, may experience uncertainty as to the future of such relationships and seek alternative relationships with third parties or seek to alter their present business relationships with us in a manner that negatively impacts the Company. In addition, the Company has incurred, and will continue to incur, significant transaction costs in connection with the Merger, and many of these fees and costs are payable regardless of whether the Merger is consummated.

 

Shareowner litigation against the Company, our directors and/or Dai-ichi could delay or prevent the Merger and cause us to incur significant costs and expenses.

 

Transactions such as the Merger are often subject to lawsuits by shareowners. To date, multiple purported class action lawsuits have been filed by shareowners seeking injunctive relief, including enjoining or rescinding the Merger, an award of unspecified damages, attorneys’ and other fees and costs, and other relief. Conditions to the closing of the Merger require that no laws or legal restraints must have been adopted or in effect, and that no restraining order, injunction or other order, judgment, decision, opinion or decree must have been issued, in each case having the effect of making the Merger illegal or otherwise prohibiting the consummation of the Merger. While one lawsuit filed in Alabama has been dismissed with prejudice and the parties have reached a Memorandum of Understanding to settle all outstanding claims in the consolidated Delaware Action, we cannot assure you that other actions will not be filed or as to the outcome of any pending or similar future lawsuits, including the costs associated with defending the claims or any other liabilities that may be incurred in connection with the litigation or settlement of these lawsuits. If the plaintiffs in any action are successful in obtaining an injunction prohibiting the parties from completing the Merger on the agreed-upon terms, such an injunction may prevent the completion of the Merger in the expected time frame or altogether.

 

Our debt ratings and the financial strength ratings of our insurance subsidiaries may be adversely affected by the transactions contemplated by the Merger Agreement.

 

Following the announcement of the Dai-ichi transaction, the rating agencies have undertaken a review of our debt ratings and our insurance company subsidiaries’ financial strength ratings. See Item 2, Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources - Ratings, for additional information regarding the rating agencies and our ratings. The rating agencies may take various actions, positive or negative, and the result may not be known until the Merger closes.  Any negative action by a ratings agency could have a material adverse impact on the Company’s financial condition or results of operations.

 

General Risk Factors

 

The Company is exposed to risks related to natural and man-made disasters and catastrophes, diseases, epidemics pandemics, malicious acts, terrorist acts and climate change, which could adversely affect the Company’s operations and results.

 

While the Company has obtained insurance, implemented risk management and contingency plans, and taken preventive measures and other precautions, no predictions of specific scenarios can be made nor can assurance be given that there are not scenarios that could have an adverse effect on the Company. A natural or man-made disaster or catastrophe, including a severe weather or geological event such as a storm, tornado, fire, flood, or earthquake, disease, epidemic, pandemic, malicious act, terrorist act, or the occurrence of climate change, could cause the Company’s workforce to be unable to engage in operations at one or more of its facilities or result in short or long-term interruptions in the Company’s business operations, any of which could be material to the Company’s operating results for a particular period. In addition, such events could adversely affect the mortality, morbidity, or other experience of the Company or its reinsurers and have a significant negative impact on the Company. In addition, claims arising from the occurrence of such events or conditions could have a material adverse effect on the Company’s financial condition and results of operations. Such events or conditions could also have an adverse effect on lapses and surrenders of existing policies, as well as sales of new policies. The Company’s risk management efforts and other precautionary plans and activities may not adequately predict the impact on the Company from such events.

 

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In addition, such events or conditions could result in a decrease or halt in economic activity in large geographic areas, adversely affecting the marketing or administration of the Company’s business within such geographic areas and/or the general economic climate, which in turn could have an adverse effect on the Company. Such events or conditions could also result in additional regulation or restrictions on the Company in the conduct of its business. The possible macroeconomic effects of such events or conditions could also adversely affect the Company’s asset portfolio, as well as many other aspects of the Company’s business, financial condition, and results of operations.

 

The Company may not realize its anticipated financial results from its acquisitions strategy.

 

The Company’s acquisitions of companies and acquisitions or coinsurance of blocks of insurance business have increased its earnings in part by allowing the Company to position itself to realize certain operating efficiencies. However, there can be no assurance that the Company will have future suitable opportunities for, or sufficient capital available to fund, such transactions. If our competitors have access to capital on more favorable terms or at a lower cost, our ability to compete for acquisitions may be diminished. In addition, there can be no assurance that the Company will realize the anticipated financial results from such transactions.

 

The Company may be unable to complete an acquisition transaction. Completion of an acquisition transaction may be more costly or take longer than expected, or may have a different or more costly financing structure than initially contemplated. In addition, the Company may not be able to complete or manage multiple acquisition transactions at the same time, or the completion of such transactions may be delayed or be more costly than initially contemplated. The Company or other parties to the transaction may be unable to obtain regulatory approvals required to complete an acquisition transaction. If the Company identifies and completes suitable acquisitions, it may not be able to successfully integrate the business in a timely or cost-effective manner. In addition, there may be unforeseen liabilities that arise in connection with businesses or blocks of insurance business that the Company acquires.

 

Additionally, in connection with its acquisition transactions that involve reinsurance, the Company assumes, or otherwise becomes responsible for, the obligations of policies and other liabilities of other insurers. Any regulatory, legal, financial, or other adverse development affecting the other insurer could also have an adverse effect on the Company.

 

Risks Related to the Financial Environment

 

The Company’s investments are subject to market and credit risks. These risks could be heightened during periods of extreme volatility or disruption in financial and credit markets.

 

The Company’s invested assets and derivative financial instruments are subject to risks of credit defaults and changes in market values. These risks could be heightened during periods of extreme volatility or disruption in the financial and credit markets, including as a result of social or political unrest or instability domestically or abroad. A widening of credit spreads will increase the unrealized losses in the Company’s investment portfolio. The factors affecting the financial and credit markets could lead to other-than-temporary impairments of assets in the Company’s investment portfolio.

 

The value of the Company’s commercial mortgage loan portfolio depends in part on the financial condition of the tenants occupying the properties that the Company has financed. The value of the Company’s investment portfolio, including its portfolio of government debt obligations, debt obligations of those entities with an express or implied governmental guarantee and debt obligations of other issuers holding a large amount of such obligations, depends in part on the ability of the issuers or guarantors of such debt to maintain their credit ratings and meet their contractual obligations. Factors that may affect the overall default rate on, and market value of, the Company’s invested assets, derivative financial instruments, and mortgage loans include interest rate levels, financial market performance, and general economic conditions as well as particular circumstances affecting the individual tenants, borrowers, issuers and guarantors.

 

Significant continued financial and credit market volatility, changes in interest rates and credit spreads, credit defaults, real estate values, market illiquidity, declines in equity prices, acts of corporate malfeasance, ratings downgrades of the issuers or guarantors of these investments, and declines in general economic conditions, either alone or in combination, could have a material adverse impact on the Company’s results of operations, financial condition, or

 

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cash flows through realized losses, impairments, changes in unrealized loss positions, and increased demands on capital, including obligations to post additional capital and collateral. In addition, market volatility can make it difficult for the Company to value certain of its assets, especially if trading becomes less frequent. Valuations may include assumptions or estimates that may have significant period-to-period changes that could have an adverse impact on the Company’s results of operations or financial condition.

 

Credit market volatility or disruption could adversely impact the Company’s financial condition or results from operations.

 

Significant volatility or disruption in domestic or foreign credit markets, including as a result of social or political unrest or instability, could have an adverse impact in several ways on either the Company’s financial condition or results from operations. Changes in interest rates and credit spreads could cause market price and cash flow variability in the fixed income instruments in the Company’s investment portfolio. Significant volatility and lack of liquidity in the credit markets could cause issuers of the fixed-income securities in the Company’s investment portfolio to default on either principal or interest payments on these securities. Additionally, market price valuations may not accurately reflect the underlying expected cash flows of securities within the Company’s investment portfolio.

 

The Company’s statutory surplus is also impacted by widening credit spreads as a result of the accounting for the assets and liabilities on its fixed market value adjusted (“MVA”) annuities. Statutory separate account assets supporting the fixed MVA annuities are recorded at fair value. In determining the statutory reserve for the fixed MVA annuities, the Company is required to use current crediting rates based on U.S. Treasuries. In many capital market scenarios, current crediting rates based on U.S. Treasuries are highly correlated with market rates implicit in the fair value of statutory separate account assets. As a result, the change in the statutory reserve from period to period will likely substantially offset the change in the fair value of the statutory separate account assets. However, in periods of volatile credit markets, actual credit spreads on investment assets may increase sharply for certain sub-sectors of the overall credit market, resulting in statutory separate account asset market value losses. Credit spreads are not consistently fully reflected in crediting rates based on U.S. Treasuries, and the calculation of statutory reserves will not substantially offset the change in fair value of the statutory separate account assets resulting in reductions in statutory surplus. This situation would result in the need to devote significant additional capital to support fixed MVA annuity products.

 

Volatility or disruption in the credit markets could also impact the Company’s ability to efficiently access financial solutions for purposes of issuing long-term debt for financing purposes, its ability to obtain financial solutions for purposes of supporting certain traditional and universal life insurance products for capital management purposes, or result in an increase in the cost of existing securitization structures.

 

The ability of the Company to implement financing solutions designed to fund a portion of statutory reserves on both the traditional and universal life blocks of business is dependent upon factors such as the ratings of the Company, the size of the blocks of business affected, the mortality experience of the Company, the credit markets, and other factors. The Company cannot predict the continued availability of such solutions or the form that the market may dictate. To the extent that such financing solutions were desired but are not available, the Company’s financial position could be adversely affected through impacts including, but not limited to, higher borrowing costs, surplus strain, lower sales capacity, and possible reduced earnings expectations.

 

The Company could be adversely affected by an inability to access FHLB lending.

 

The Company is a member of the Federal Home Loan Bank (the “FHLB”) of Cincinnati, which provides the Company with access to FHLB financial services, including advances that provide an attractive funding source for short-term borrowing and for the sale of funding agreements. In recent years, the Federal Housing Finance Agency (“FHFA”) has released proposed rules, which include revised member participation standards, and advisory bulletins addressing concerns associated with insurance company (as opposed to federally-backed bank) access to FHLB financial services, the state insurance regulatory framework and FHLB creditor status in the event of member insurer insolvency. In response to FHFA actions, FHLB members, the NAIC and trade groups developed model legislation that would enable insurers to access FHLB funding on similar collateral terms as federally insured depository institutions.  While members of the FHLB and NAIC were not able to agree on certain points, legislation based on this model has been introduced in several states and is not being opposed by the NAIC. It is unclear at this time whether or to what

 

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extent additional or new legislation or regulatory action regarding continued membership in and access to FHLB financial services will be enacted or adopted. Any developments that limit access to FHLB financial services or eliminate the Company’s eligibility for continued FHLB membership could have a material adverse effect on the Company.

 

Industry Related Risks

 

The business of the Company is highly regulated and is subject to routine audits, examinations and actions by regulators, law enforcement agencies and self-regulatory organizations.

 

The Company is subject to government regulation in each of the states in which it conducts business. In many instances, the regulatory models emanate from the National Association of Insurance Commissioners (“NAIC”). Such regulation is vested in state agencies having broad administrative and in some instances discretionary power dealing with many aspects of the Company’s business, which may include, among other things, premium rates and increases thereto, underwriting practices, reserve requirements, marketing practices, advertising, privacy, policy forms, reinsurance reserve requirements, insurer use of captive reinsurance companies, acquisitions, mergers, capital adequacy, claims practices and the remittance of unclaimed property. In addition, some state insurance departments may enact rules or regulations with extra-territorial application, effectively extending their jurisdiction to areas such as permitted insurance company investments that are normally the province of an insurance company’s domiciliary state regulator.

 

At any given time, a number of financial, market conduct, or other examinations or audits of the Company’s subsidiaries may be ongoing. It is possible that any examination or audit may result in payments of fines and penalties, payments to customers, or both, as well as changes in systems or procedures, any of which could have a material adverse effect on the Company’s financial condition or results of operations.

 

The Company’s insurance subsidiaries are required to obtain state regulatory approval for rate increases for certain health insurance products. The Company’s profits may be adversely affected if the requested rate increases are not approved in full by regulators in a timely fashion.

 

State insurance regulators and the NAIC regularly re-examine existing laws and regulations applicable to insurance companies and their products. Changes in these laws and regulations, or in interpretations thereof, are often made for the benefit of the consumer and may lead to additional expense for the insurer and, thus, could have a material adverse effect on the Company’s financial condition and results of operations. The NAIC may also be influenced by the initiatives and regulatory structures or schemes of international regulatory bodies, and those initiatives or regulatory structures or schemes may not translate readily into the regulatory structures or schemes or the legal system (including the interpretation or application of standards by juries) under which U.S. insurers must operate. In August 2013, the Financial Stability Board (“FSB”) released a report encouraging the U.S. to move toward a federal regulatory system for insurance. The International Association of Insurance Supervisors (“IAIS”) is developing group-wide supervision requirements, including a global capital standard, to be applied to large, internationally active insurance groups (“IAIGs”), as well as standards for companies posing systemic risk to be applied to global systemically important insurers (“G-SII’s”). These are only a few examples of international developments impacting the global insurance market. At this time, FSB reports, IAIS Insurance Core Principles, and other international work products are not directly binding on the Company, and the Company has not been identified as either an IAIG or G-SII. However, there is increasing pressure to conform to international standards due to the globalization of the business of insurance and the recent financial crisis. Any international reports, standards or mandates that directly impact, or indirectly influence, the nature of U.S. regulation or industry operations, or become applicable to the Company, directly or indirectly, as a result of the Merger, could impact the Company and its reserve and capital requirements, financial condition or results of operations.

 

Although some NAIC pronouncements, particularly as they affect accounting, reserving and risk based capital issues, may take effect automatically without affirmative action taken by the states, the NAIC is not a governmental entity and its processes and procedures do not comport with those to which governmental entities typically adhere. Therefore, it is possible that actions could be taken by the NAIC that become effective without the procedural safeguards that would be present if governmental action was required. In addition, with respect to some financial regulations and guidelines, states sometimes defer to the interpretation of the insurance department of a non-domiciliary

 

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state. Neither the action of the domiciliary state nor the action of the NAIC is binding on a state. Accordingly, a state could choose to follow a different interpretation. The Company is also subject to the risk that compliance with any particular regulator’s interpretation of a legal, accounting or actuarial issue may result in non-compliance with another regulator’s interpretation of the same issue, particularly when compliance is judged in hindsight. There is an additional risk that any particular regulator’s interpretation of a legal, accounting or actuarial issue may change over time to the Company’s detriment, or that changes to the overall legal or market environment may cause the Company to change its practices in ways that may, in some cases, limit its growth or profitability. Statutes, regulations, interpretations, and instructions may be applied with retroactive impact, particularly in areas such as accounting, reserve and risk based capital requirements. Also, regulatory actions with prospective impact can potentially have a significant impact on currently sold products.

 

The NAIC has announced more focused inquiries on certain matters that could have an impact on the Company’s financial condition and results of operations. Such inquiries concern, for example, examination of statutory accounting disclosures for separate accounts, insurer use of captive reinsurance companies, certain aspects of insurance holding company reporting and disclosure, reserving for universal life products with secondary guarantees, reinsurance, and risk based capital calculations. In addition, the NAIC continues to consider various initiatives to change and modernize its financial and solvency requirements and regulations. It is considering changing to, or has considered and passed, a principles-based reserving method for life insurance and annuity reserves, changes to the accounting and risk-based capital regulations, changes to the governance practices of insurers, and other items. Some of these proposed changes, including implementing a principles-based reserving methodology, would require the approval of state legislatures. The Company cannot provide any estimate as to what impact these more focused inquiries or proposed changes, if they occur, will have on its product mix, product profitability, reserve and capital requirements, financial condition or results of operations.

 

With respect to reserving requirements for universal life policies with secondary guarantees (“ULSG”), in 2012 the NAIC adopted revisions to Actuarial Guideline XXXVIII (“AG38”) addressing those requirements. Some of the regulatory participants in the AG38 revision process appeared to believe that one of the purposes of the revisions was to calculate reserves for ULSG similarly to reserves for guaranteed level term life insurance contracts with the same guarantee period. The effect of the revisions was to increase the level of reserves that must be held by insurers on ULSG with certain product designs that are issued on and after January 1, 2013, and to cause insurers to test the adequacy of reserves, and possibly increase the reserves, on ULSG with certain product designs that were issued before January 1, 2013. The Company has developed and introduced a new ULSG product for sales in 2013. The Company cannot predict future regulatory actions that could negatively impact the Company’s ability to market its new product. Such regulatory reactions could include, for example, withdrawal of state approvals of the new product, or adoption of further changes to AG38 or other adverse action including retroactive regulatory action that could negatively impact the Company’s new product. A disruption of the Company’s ability to sell financially viable life insurance products or an increase in reserves on ULSG policies issued either before or after January 1, 2013, could have a material adverse impact on the Company’s financial condition or results of operations.

 

The Company currently uses affiliated captive reinsurance companies in various structures relating to term life insurance and universal life insurance with secondary guarantees, and certain guaranteed benefits relating to variable annuities, to finance statutory requirements for so-called XXX and AXXX reserves and reserves for variable annuity contracts with guaranteed minimum withdrawal and death benefits. The NAIC, through various committees, subgroups and dedicated task forces, has undertaken a review of the use of captives and special purpose vehicles used to transfer insurance risk in relation to existing state laws and regulations, and several committees have adopted or exposed for comment white papers and reports that, if or when implemented, could place significant limitations on the use of captives and other reinsurers (including traditional reinsurers) (the “Affected Business”). The NAIC’s Financial Condition (E) Committee adopted an “interim solution for captives” in the form of a new charge requiring the Financial Analysis Working Group (or “FAWG”) to review captive transactions submitted by the states in a peer review and comment process. The Principles Based Reserving Implementation (EX) Task Force of the NAIC, charged with analysis of the adoption of a principles-based reserving methodology, recently adopted the “conceptual framework” contained in a report issued by Rector & Associates, Inc., dated June 4, 2014 (as modified or supplemented, the “Rector Report”), that contains numerous recommendations pertaining to the regulation and use of captive reinsurers. Certain high-level recommendations have been adopted and assigned to various NAIC working groups, which working groups are in various stages of discussions regarding recommendations. However, the recommendations in the Rector Report are subject to ongoing comment and revision. It is unclear at this time to what extent the recommendations in the Rector

 

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Report, or additional or revised recommendations relating to captive transactions or reinsurance transactions in general, will be adopted by the NAIC. If the recommendations proposed in the Rector Report are implemented, it will likely be difficult for the Company to establish new captive financing arrangements on a basis consistent with past practices and in some circumstances could impact the Company’s ability to engage in certain reinsurance transactions with non-affiliates.

 

The NAIC’s Financial Regulation Standards and Accreditation (F) Committee is considering a proposal to include insurer-owned captives and special purpose vehicles that are single-state licensed but assume reinsurance from cedants operating in multiple states within the definition of “multi-state insurer” found in the preambles to Parts A and B of the NAIC Financial Regulation Standards and Accreditation Program. If adopted, the revised definition would subject captives (on a prospective basis, as proposed) to all of the Accreditation Standards applicable to other traditional multi-state insurers, including standards related to capital and surplus requirements, risk-based capital requirements, investment laws and credit for reinsurance laws. Such application would likely have a significant and adverse impact on the Company’s ability to engage in captive finance transactions on the same or a similar basis as in past periods.

 

Any regulatory action or changes in interpretation that materially adversely affects the Company’s use or materially increases the Company’s cost of using captives or reinsurers for the Affected Business, either retroactively or prospectively, could have a material adverse impact on the Company’s financial condition or results of operations. If the Company were required to discontinue its use of captives for intercompany reinsurance transactions on a retroactive basis, adverse impacts would include early termination fees payable with respect to certain structures, diminished capital position and higher cost of capital. Additionally, finding alternative means to support policy liabilities efficiently is an unknown factor that would be dependent, in part, on future market conditions and the Company’s ability to obtain required regulatory approvals. On a prospective basis, discontinuation of the use of captives could impact the types, amounts and pricing of products offered by the Company’s insurance subsidiaries.

 

Recently, new laws and regulations have been adopted in certain states that require life insurers to search for unreported deaths. The National Conference of Insurance Legislators (“NCOIL”) has adopted the Model Unclaimed Life Insurance Benefits Act (the “Unclaimed Benefits Act”) and legislation has been enacted in various states that is similar to the Unclaimed Benefits Act, although each state’s version differs in some respects. The Unclaimed Benefits Act would impose new requirements on insurers to periodically compare their in-force life insurance and annuity contracts and retained asset accounts against a Death Database, investigate any potential matches to confirm the death and determine whether benefits are due, and to attempt to locate the beneficiaries of any benefits that are due or, if no beneficiary can be located, escheat the benefit to the state as unclaimed property. Other states in which the Company does business may also consider adopting legislation similar to the Unclaimed Benefits Act. The Company cannot predict whether such legislation will be proposed or enacted in additional states. Additionally, the NAIC Unclaimed Life Insurance Benefits (A) Working Group recently recommended to its parent committee the development of an NAIC model unclaimed property law that, if developed, would overlap with the NCOIL based laws already adopted in several states. Other life insurance industry associations and regulatory associations are also considering these matters.

 

A number of state treasury departments and administrators of unclaimed property have audited life insurance companies for compliance with unclaimed property laws. The focus of the audits has been to determine whether there have been maturities of policies or contracts, or policies that have exceeded limiting age with respect to which death benefits or other payments under the policies should be treated as unclaimed property that should be escheated to the state. In addition, the audits have sought to identify unreported deaths of insureds. There is no clear basis in previously existing law for treating an unreported death as giving rise to a policy benefit that would be subject to unclaimed property procedures. A number of life insurers, however, have entered into resolution agreements with state treasury departments under which the life insurers agreed to procedures for comparing their previously issued life insurance and annuity contracts and retained asset accounts against a Death Database, treating confirmed deaths as giving rise to a death benefit under their policies, locating beneficiaries and paying them the benefits and interest, and escheating the benefits and interest to the state if the beneficiary could not be found. The amounts publicly reported to have been paid to beneficiaries and/or escheated to the states have been substantial.

 

The NAIC has established an Investigations of Life/Annuity Claims Settlement Practices (D) Task Force to coordinate targeted multi-state examinations of life insurance companies on claims settlement practices. The state insurance regulators on the Task Force have initiated targeted multi-state examinations of life insurance companies with respect to the companies’ claims paying practices and use of a Death Database to identify unreported deaths in their life

 

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insurance policies, annuity contracts and retained asset accounts. There is no clear basis in previously existing law for requiring a life insurer to search for unreported deaths in order to determine whether a benefit is owed. A number of life insurers, however, have entered into settlement or consent agreements with state insurance regulators under which the life insurers agreed to implement systems and procedures for periodically comparing their life insurance and annuity contracts and retained asset accounts against a Death Database, treating confirmed deaths as giving rise to a death benefit under their policies, locating beneficiaries and paying them the benefits and interest, and escheating the benefits and interest to the state if the beneficiary could not be found. It has been publicly reported that the life insurers have paid substantial administrative and/or examination fees to the insurance regulators in connection with the settlement or consent agreements.

 

Certain of the Company’s subsidiaries as well as certain other insurance companies from whom the Company has coinsured blocks of life insurance and annuity policies are subject to unclaimed property audits and/or targeted multistate examinations by insurance regulators similar to those described above. It is possible that the audits, examinations and/or the enactment of state laws similar to the Unclaimed Benefits Act could result in additional payments to beneficiaries, additional escheatment of funds deemed abandoned under state laws, payment of administrative penalties and/or examination fees to state authorities, and changes to the Company’s procedures for identifying unreported deaths and escheatment of abandoned property. It is possible any such additional payments and any costs related to changes in Company procedures could materially impact the Company’s financial results from operations. It is also possible that life insurers, including the Company, may be subject to claims, regulatory actions, law enforcement actions, and civil litigation arising from their prior business practices. Any resulting liabilities, payments or costs, including initial and ongoing costs of changes to the Company’s procedures or systems, could be significant and could have a material adverse effect on the Company’s financial condition or results of operations.

 

During December 2012, the West Virginia Treasurer filed actions against the Company’s subsidiaries Protective Life Insurance Company and West Coast Life Insurance Company in West Virginia state court (State of West Virginia ex rel. John D. Perdue v. Protective Life Insurance Company, State of West Virginia ex rel. John D. Perdue v. West Coast Life Insurance Company; Defendants’ Motions to Dismiss granted on December 27, 2013; Notice of Appeal filed on January 27, 2014). The actions, which also name numerous other life insurance companies, allege that the companies violated the West Virginia Uniform Unclaimed Property Act, seek to compel compliance with the Act, and seek payment of unclaimed property, interest, and penalties. While the legal theory or theories that may give rise to liability in the West Virginia Treasurer litigation are uncertain, it is possible that other jurisdictions may pursue similar actions. The Company does not currently believe that losses, if any, arising from the West Virginia Treasurer litigation will be material. The Company cannot, however, predict whether other jurisdictions will pursue similar actions or, if they do, whether such actions will have a material impact on the Company’s financial results from operations. Additionally, the California Controller has recently sued several insurance carriers for alleged failure to comply with audit requests from an appointed third party auditor. The Company cannot predict whether California might pursue a similar action against the Company and further cannot predict whether other jurisdictions might pursue similar actions. The Company does not believe however that any such action would have a material impact on the Company’s financial condition or results of operations.

 

Under insurance guaranty fund laws in most states, insurance companies doing business therein can be assessed up to prescribed limits for policyholder losses incurred by insolvent companies. From time to time, companies may be asked to contribute amounts beyond prescribed limits. The Company cannot predict the amount or timing of any future assessments.

 

The purchase of life insurance products is limited by state insurable interest laws, which in most jurisdictions require that the purchaser of life insurance name a beneficiary that has some interest in the sustained life of the insured. To some extent, the insurable interest laws present a barrier to the life settlement, or “stranger-owned” industry, in which a financial entity acquires an interest in life insurance proceeds, and efforts have been made in some states to liberalize the insurable interest laws. To the extent these laws are relaxed, the Company’s lapse assumptions may prove to be incorrect.

 

At the federal level, bills are routinely introduced in both chambers of the United States Congress (“Congress”) that could affect life insurers. In the past, Congress has considered legislation that would impact insurance companies in numerous ways, such as providing for an optional federal charter or a federal presence for insurance, preempting state law in certain respects regarding the regulation of reinsurance, increasing federal oversight in areas

 

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such as consumer protection and other matters. The Company cannot predict whether or in what form legislation will be enacted and, if so, whether the enacted legislation will positively or negatively affect the Company or whether any effects will be material.

 

The Company is subject to various conditions and requirements of the Healthcare Act. The Healthcare Act makes significant changes to the regulation of health insurance and may affect the Company in various ways. The Healthcare Act may affect the small blocks of business the Company has offered or acquired over the years that are, or are deemed to constitute, health insurance. The Healthcare Act may also affect the benefit plans the Company sponsors for employees or retirees and their dependents, the Company’s expense to provide such benefits, the tax liabilities of the Company in connection with the provision of such benefits, and the Company’s ability to attract or retain employees. In addition, the Company may be subject to regulations, guidance or determinations emanating from the various regulatory authorities authorized under the Healthcare Act. The Company cannot predict the effect that the Healthcare Act, or any regulatory pronouncement made thereunder, will have on its results of operations or financial condition.

 

The Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) enacted in July 2010 made sweeping changes to the regulation of financial services entities, products and markets. Certain provisions of Dodd-Frank are or may become applicable to the Company, its competitors or those entities with which the Company does business. Such provisions include, but are not limited to the following: the establishment of the Federal Insurance Office, changes to the regulation and standards applicable to broker-dealers and investment advisors, changes to the regulation of reinsurance, changes to regulations affecting the rights of shareowners, and the imposition of additional regulation over credit rating agencies.

 

Dodd-Frank also created the Financial Stability Oversight Council (the “FSOC”), which has issued a final rule and interpretive guidance setting forth the methodology by which it will determine whether a non-bank financial company is a systemically important financial institution (“SIFI”). A non-bank financial company, such as the Company, that is designated as a SIFI by the FSOC will become subject to supervision by the Board of Governors of the Federal Reserve System (the “Federal Reserve”). The Company is not currently supervised by the Federal Reserve. Such supervision could impact the Company’s requirements relating to capital, liquidity, stress testing, limits on counterparty credit exposure, compliance and governance, early remediation in the event of financial weakness and other prudential matters, and in other ways the Company currently cannot anticipate. FSOC-designated non-bank financial companies will also be required to prepare resolution plans, so-called “living wills,” that set out how they could most efficiently be liquidated if they endangered the U.S. financial system or the broader economy. The FSOC has made its initial SIFI designations, and the Company was not designated as such. However, the Company could be considered and designated at any time. Because the process is in its initial stages, the Company is at this time unable to predict the impact on an entity that is supervised as a SIFI by the Federal Reserve Board. The Company is not able to predict whether the capital requirements or other requirements imposed on SIFIs may impact the requirements applicable to the Company even if it is not designated as a SIFI. The uncertainty about regulatory requirements could influence the Company’s product line or other business decisions with respect to some product lines. There is a similarly uncertain international designation process. The Financial Stability Board, appointed by the G-20 Summit, recently designated nine insurers as “G-SII’s,” or global systemically-important insurers. As with the designation of SIFI’s, it is unclear at this time how additional capital and other requirements affect the insurance and financial industries. The insurers designated as G-SIIs to date represent organizations larger than the Company, but the possibility remains that the Company could be so designated.

 

Additionally, Dodd-Frank created the Consumer Financial Protection Bureau (“CFPB”), an independent division of the Department of Treasury with jurisdiction over credit, savings, payment, and other consumer financial products and services, other than investment products already regulated by the United States Securities and Exchange Commission (the “SEC”) or the U.S. Commodity Futures Trading Commission. CFPB has issued a rule to bring under its supervisory authority certain non-banks whose activities or products it determines pose risks to consumers. It is unclear at this time which activities or products will be covered by this rule. Certain of the Company’s subsidiaries sell products that may be regulated by the CFPB. CFPB continues to bring enforcement actions involving a growing number of issues, including actions using state Attorney’s General, which could directly or indirectly affect the Company or use any of its subsidiaries. Additionally, the CFPB is exploring the possibility of helping Americans manage their retirement savings and is considering the extent of its authority in that area. The Company is unable at this time to predict the impact of these activities on the Company.

 

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Dodd-Frank includes a new framework of regulation of over-the-counter (“OTC”) derivatives markets which requires clearing of certain types of transactions which have been or are currently traded OTC by the Company. The types of transactions to be cleared are expected to increase in the future. The new framework could potentially impose additional costs, including increased margin requirements and additional regulation on the Company. Increased margin requirements on the Company’s part, combined with restrictions on securities that will qualify as eligible collateral, could continue to reduce its liquidity and require an increase in its holdings of cash and government securities with lower yields causing a reduction in income. The Company uses derivative financial instruments to mitigate a wide range of risks in connection with its businesses, including those arising from its variable annuity products with guaranteed benefit features. The derivative clearing requirements of Dodd-Frank could continue to increase the cost of the Company’s risk mitigation and expose it to the risk of a default by a clearinghouse with respect to the Company’s cleared derivative transactions.

 

Numerous provisions of Dodd-Frank require the adoption of implementing rules and/or regulations. The process of adopting such implementing rules and/or regulations have in some instances been delayed beyond the timeframes imposed by Dodd-Frank. Until the various final regulations are promulgated pursuant to Dodd-Frank, the full impact of the regulations on the Company will remain unclear. In addition, Dodd-Frank mandates multiple studies, which could result in additional legislation or regulation applicable to the insurance industry, the Company, its competitors or the entities with which the Company does business. Legislative or regulatory requirements imposed by or promulgated in connection with Dodd-Frank may impact the Company in many ways, including but not limited to the following: placing the Company at a competitive disadvantage relative to its competition or other financial services entities, changing the competitive landscape of the financial services sector and/or the insurance industry, making it more expensive for the Company to conduct its business, requiring the reallocation of significant company resources to government affairs, legal and compliance-related activities, causing historical market behavior or statistics utilized by the Company in connection with its efforts to manage risk and exposure to no longer be predictive of future risk and exposure or otherwise have a material adverse effect on the overall business climate as well as the Company’s financial condition and results of operations.

 

The Company may be subject to regulation by the United States Department of Labor when providing a variety of products and services to employee benefit plans and individual investors that are governed by the Employee Retirement Income Security Act (“ERISA”). The Department of Labor is currently in the process of re-proposing a rule that would change the circumstances under which one who works with employee benefit plans and Individual Retirement Accounts would be considered a fiduciary under ERISA. Severe penalties are imposed for breach of duties under ERISA and the Company cannot predict the impact that the Department of Labor’s re-proposed rule may have on its operations.

 

Certain life insurance policies, contracts, and annuities offered by the Company’s subsidiaries are subject to regulation under the federal securities laws administered by the SEC. The federal securities laws contain regulatory restrictions and criminal, administrative, and private remedial provisions. From time to time, the SEC and the Financial Industry Regulatory Authority (“FINRA”) examine or investigate the activities of broker-dealers and investment advisors, including the Company’s affiliated broker-dealers and investment advisors. These examinations or investigations often focus on the activities of the registered representatives and registered investment advisors doing business through such entities and the entities’ supervision of those persons. It is possible that any examination or investigation could lead to enforcement action by the regulator and/or may result in payments of fines and penalties, payments to customers, or both, as well as changes in systems or procedures of such entities, any of which could have a material adverse effect on the Company’s financial condition or results of operations.

 

In addition, the SEC is reviewing the standard of conduct applicable to brokers, dealers, and investment advisers when those entities provide personalized investment advice about securities to retail customers. FINRA has also issued a report addressing how its member firms might identify and address conflicts of interest including conflicts related to the introduction of new products and services and the compensation of the member firms’ associated persons. These regulatory initiatives could have an impact on Company operations and the manner in which broker-dealers and investment advisers distribute the Company’s products.

 

The Company may also be subject to regulation by governments of the countries in which it currently does, or may in the future, do, business, as well as regulation by the U.S. Government with respect to its operations in foreign countries, such as the Foreign Corrupt Practices Act. Penalties for violating the various laws governing the Company’s

 

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business in other countries may include restrictions upon business operations, fines and imprisonment, both within the U.S. and abroad. U.S. enforcement of anti-corruption laws continues to increase in magnitude, and penalties may be substantial.

 

Other types of regulation that could affect the Company and its subsidiaries include insurance company investment laws and regulations, state statutory accounting and reserving practices, anti-trust laws, minimum solvency requirements, enterprise risk requirements, state securities laws, federal privacy laws, insurable interest laws, federal anti-money laundering and anti-terrorism laws, employment and immigration laws (including laws in Alabama where over half of the Company’s employees are located), and because the Company owns and operates real property, state, federal, and local environmental laws. Under some circumstances, severe penalties may be imposed for breach of these laws.

 

The Company cannot predict what form any future changes to laws and/or regulations affecting participants in the financial services sector and/or insurance industry, including the Company and its competitors or those entities with which it does business, may take, or what effect, if any, such changes may have.

 

Item 2.         Unregistered Sales of Equity Securities and Use of Proceeds

 

During the quarter ended September 30, 2014, the Company issued no securities in transactions which were not registered under the Securities Act of 1933, as amended (the “Act”).

 

Purchases of Equity Securities by the Issuer

 

During the nine months ended September 30, 2014, the Company did not repurchase any of its common stock.

 

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Item 6.                     Exhibits

 

Item

 

 

Number

 

Document

31(a)

 

Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 filed herewith.

31(b)

 

Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 filed herewith.

32(a)

 

Certification Pursuant to 18 U.S.C Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 filed herewith.

32(b)

 

Certification Pursuant to 18 U.S.C Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 filed herewith.

101

 

Financial statements from the quarterly report on Form 10-Q of Protective Life Corporation for the quarter ended September 30, 2014, filed on November 7, 2014, formatted in XBRL: (i) the Consolidated Condensed Statements of Income, (ii) the Consolidated Condensed Statements of Comprehensive Income (Loss), (iii) the Consolidated Condensed Balance Sheets, (iv) the Consolidated Condensed Statement of Shareowners’ Equity, (v) the Consolidated Condensed Statements of Cash Flows, and (iv) the Notes to Consolidated Condensed Financial Statements.

 

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SIGNATURE

 

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 

 

PROTECTIVE LIFE CORPORATION

 

 

 

 

 

Date: November 7, 2014

By:

/s/ Steven G. Walker

 

 

 

 

 

Steven G. Walker

 

 

Senior Vice President, Controller

 

 

and Chief Accounting Officer

 

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