10-Q 1 a11-9428_110q.htm 10-Q

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 March 31, 2011

 

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)

 

(205) 268-1000

(Registrant’s telephone number, including area code)

 


 

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 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 April 25, 2011:   85,705,659

 

 

 



Table of Contents

 

PROTECTIVE LIFE CORPORATION

QUARTERLY REPORT ON FORM 10-Q

FOR QUARTERLY PERIOD ENDED MARCH 31, 2011

 

TABLE OF CONTENTS

 

 

 

Page

 

 

 

PART I

 

Item 1.

Financial Statements (unaudited):

 

 

Consolidated Condensed Statements of Income For The Three Months Ended March 31, 2011 and 2010

3

 

Consolidated Condensed Balance Sheets as of March 31, 2011 and December 31, 2010

4

 

Consolidated Condensed Statement of Shareowners’ Equity For The Three Months Ended March 31, 2011

5

 

Consolidated Condensed Statements of Cash Flows For The Three Months Ended March 31, 2011 and 2010

6

 

Notes to Consolidated Condensed Financial Statements

7

Item 2.

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

35

Item 3.

Quantitative and Qualitative Disclosures About Market Risk

87

Item 4.

Controls and Procedures

87

 

 

 

PART II

 

 

 

Item 1A.

Risk Factors and Cautionary Factors that may Affect Future Results

87

Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

89

Item 6.

Exhibits

90

 

Signature

91

 

2



Table of Contents

 

PROTECTIVE LIFE CORPORATION

CONSOLIDATED CONDENSED STATEMENTS OF INCOME

(Unaudited)

 

 

 

For The Three Months Ended March 31,

 

 

 

2011

 

2010

 

 

 

(Dollars In Thousands, Except Per Share Amounts)

 

Revenues

 

 

 

 

 

Premiums and policy fees

 

$

666,343

 

$

628,772

 

Reinsurance ceded

 

(331,808

)

(305,829

)

Net of reinsurance ceded

 

334,535

 

322,943

 

Net investment income

 

444,213

 

411,997

 

Realized investment gains (losses):

 

 

 

 

 

Derivative financial instruments

 

(12,686

)

(23,072

)

All other investments

 

4,472

 

47,899

 

Other-than-temporary impairment losses

 

(16,021

)

(21,856

)

Portion of loss recognized in other comprehensive income (before taxes)

 

10,358

 

9,987

 

Net impairment losses recognized in earnings

 

(5,663

)

(11,869

)

Other income

 

72,209

 

43,872

 

Total revenues

 

837,080

 

791,770

 

Benefits and expenses

 

 

 

 

 

Benefits and settlement expenses, net of reinsurance ceded: (three months: 2011 - $313,106; 2010 - $302,701)

 

536,369

 

507,295

 

Amortization of deferred policy acquisition costs and value of business acquired

 

74,363

 

81,289

 

Other operating expenses, net of reinsurance ceded: (three months: 2011 - $45,260; 2010 - $43,424)

 

122,253

 

101,910

 

Total benefits and expenses

 

732,985

 

690,494

 

Income before income tax

 

104,095

 

101,276

 

Income tax expense

 

36,629

 

31,570

 

Net income

 

67,466

 

69,706

 

Less: Net income (loss) attributable to noncontrolling interests

 

(51

)

(73

)

Net income available to PLC’s common shareowners(1)

 

$

67,517

 

$

69,779

 

 

 

 

 

 

 

Net income available to PLC’s common shareowners - basic

 

$

0.78

 

$

0.81

 

Net income available to PLC’s common shareowners - diluted

 

$

0.77

 

$

0.80

 

Cash dividends paid per share

 

$

0.14

 

$

0.12

 

 

 

 

 

 

 

Average shares outstanding - basic

 

86,603,228

 

86,500,199

 

Average shares outstanding - diluted

 

87,820,085

 

87,551,386

 

 


(1) Protective Life Corporation (“PLC”)

 

See Notes to Consolidated Condensed Financial Statements

 

3



Table of Contents

 

PROTECTIVE LIFE CORPORATION

CONSOLIDATED CONDENSED BALANCE SHEETS

(Unaudited)

 

 

 

As of

 

 

 

March 31, 2011

 

December 31, 2010

 

 

 

(Dollars In Thousands)

 

Assets

 

 

 

 

 

Fixed maturities, at fair value (amortized cost: 2011 - $23,958,988; 2010 - $24,002,893)

 

$

24,676,049

 

$

24,676,939

 

Equity securities, at fair value (cost: 2011 - $343,760; 2010 - $349,605)

 

352,927

 

359,412

 

Mortgage loans (2011 and 2010 includes: $903,122 and $934,655 related to securitizations)

 

4,873,678

 

4,892,829

 

Investment real estate, net of accumulated depreciation (2011 - $1,281; 2010 - $1,200)

 

21,884

 

25,340

 

Policy loans

 

784,320

 

793,448

 

Other long-term investments

 

276,291

 

276,337

 

Short-term investments

 

406,676

 

352,824

 

Total investments

 

31,391,825

 

31,377,129

 

Cash

 

230,938

 

264,425

 

Accrued investment income

 

343,181

 

329,078

 

Accounts and premiums receivable, net of allowance for uncollectible amounts (2011 - $4,023; 2010 - $4,330)

 

63,547

 

58,580

 

Reinsurance receivables

 

5,659,191

 

5,608,029

 

Deferred policy acquisition costs and value of business acquired

 

3,885,016

 

3,851,743

 

Goodwill

 

113,983

 

114,758

 

Property and equipment, net of accumulated depreciation (2011 - $132,224; 2010 - $130,576)

 

42,585

 

39,386

 

Other assets

 

176,778

 

169,664

 

Income tax receivable

 

29,422

 

45,582

 

Assets related to separate accounts

 

 

 

 

 

Variable annuity

 

5,797,956

 

5,170,193

 

Variable universal life

 

561,044

 

534,219

 

Total assets

 

$

48,295,466

 

$

47,562,786

 

Liabilities

 

 

 

 

 

Policy liabilities and accruals

 

$

19,928,641

 

$

19,713,392

 

Stable value product account balances

 

2,664,139

 

3,076,233

 

Annuity account balances

 

10,781,341

 

10,591,605

 

Other policyholders’ funds

 

557,378

 

578,037

 

Other liabilities

 

975,974

 

926,201

 

Mortgage loan backed certificates

 

51,540

 

61,678

 

Deferred income taxes

 

1,054,984

 

1,022,130

 

Non-recourse funding obligations

 

496,700

 

532,400

 

Debt

 

1,484,852

 

1,501,852

 

Subordinated debt securities

 

524,743

 

524,743

 

Liabilities related to separate accounts

 

 

 

 

 

Variable annuity

 

5,797,956

 

5,170,193

 

Variable universal life

 

561,044

 

534,219

 

Total liabilities

 

44,879,292

 

44,232,683

 

Commitments and contingencies - Note 7

 

 

 

 

 

Shareowners’ equity

 

 

 

 

 

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

 

 

 

 

 

Common Stock, $.50 par value, shares authorized: 2011 and 2010 - 160,000,000; shares issued: 2011 and 2010 - 88,776,960

 

44,388

 

44,388

 

Additional paid-in-capital

 

590,783

 

586,592

 

Treasury stock, at cost (2011 - 3,071,301 shares; 2010 - 3,108,983 shares)

 

(25,763

)

(26,072

)

Retained earnings

 

2,488,447

 

2,432,925

 

Accumulated other comprehensive income (loss):

 

 

 

 

 

Net unrealized gains (losses) on investments, net of income tax: (2011 -$209,949; 2010 - $195,096)

 

389,906

 

362,321

 

Net unrealized (losses) gains relating to other-than-temporary impaired investments for which a portion has been recognized in earnings, net of income tax: (2011 - $(8,831); 2010 - $(5,223))

 

(16,400

)

(9,700

)

Accumulated loss - derivatives, net of income tax: (2011 - $(3,096); 2010 - $(6,355))

 

(5,749

)

(11,802

)

Postretirement benefits liability adjustment, net of income tax: (2011 -$(26,063); 2010 - $(25,612))

 

(48,403

)

(47,565

)

Total Protective Life Corporation’s shareowners’ equity

 

3,417,209

 

3,331,087

 

Noncontrolling interest

 

(1,035

)

(984

)

Total equity

 

3,416,174

 

3,330,103

 

Total liabilities and shareowners’ equity

 

$

48,295,466

 

$

47,562,786

 

 

See Notes to Consolidated Condensed Financial Statements

 

4



Table of Contents

 

PROTECTIVE LIFE CORPORATION

CONSOLIDATED CONDENSED STATEMENTS OF SHAREOWNERS’ EQUITY

(Unaudited)

 

 

 

 

 

 

 

 

 

 

 

Accumulated Other

 

Total

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Comprehensive Income (Loss)

 

Protective

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Minimum

 

Life

 

 

 

 

 

 

 

 

 

Additional

 

 

 

 

 

Net Unrealized

 

Accumulated

 

Pension

 

Corporation’s

 

Non

 

 

 

 

 

Common

 

Paid-In-

 

Treasury

 

Retained

 

Gains / (Losses)

 

Gain / (Loss)

 

Liability

 

shareowners’

 

controlling

 

Total

 

 

 

Stock

 

Capital

 

Stock

 

Earnings

 

on Investments

 

Derivatives

 

Adjustments

 

equity

 

Interest

 

Equity

 

 

 

(Dollars In Thousands)

 

Balance, December 31, 2010

 

$

44,388

 

$

586,592

 

$

(26,072

)

$

2,432,925

 

$

352,621

 

$

(11,802

)

$

(47,565

)

$

3,331,087

 

$

(984

)

$

3,330,103

 

Net income for the three months ended March 31, 2011

 

 

 

 

 

 

 

67,517

 

 

 

 

 

 

 

67,517

 

(51

)

67,466

 

Change in net unrealized gains/losses on investments (net of income tax - $17,907)

 

 

 

 

 

 

 

 

 

33,263

 

 

 

 

 

33,263

 

 

33,263

 

Reclassification adjustment for investment amounts included in net income (net of income tax - $(3,054))

 

 

 

 

 

 

 

 

 

(5,678

)

 

 

 

 

(5,678

)

 

(5,678

)

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 $(3,608))

 

 

 

 

 

 

 

 

 

(6,700

)

 

 

 

 

(6,700

)

 

(6,700

)

Change in accumulated gain (loss) derivatives (net of income tax - $3,621)

 

 

 

 

 

 

 

 

 

 

 

6,724

 

 

 

6,724

 

 

6,724

 

Reclassification adjustment for derivative amounts included in net income (net of income tax - $(361))

 

 

 

 

 

 

 

 

 

 

 

(671

)

 

 

(671

)

 

(671

)

Change in minimum pension liability adjustment (net of income tax - $(451))

 

 

 

 

 

 

 

 

 

 

 

 

 

(838

)

(838

)

 

(838

)

Comprehensive income for the three months ended March 31, 2011

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

93,617

 

(51

)

93,566

 

Cash dividends ($0.14 per share)

 

 

 

 

 

 

 

(11,995

)

 

 

 

 

 

 

(11,995

)

 

(11,995

)

Stock-based compensation

 

 

 

4,191

 

309

 

 

 

 

 

 

 

 

 

4,500

 

 

4,500

 

Balance, March 31, 2011

 

$

44,388

 

$

590,783

 

$

(25,763

)

$

2,488,447

 

$

373,506

 

$

(5,749

)

$

(48,403

)

$

3,417,209

 

$

(1,035

)

$

3,416,174

 

 

See Notes to Consolidated Condensed Financial Statements

 

5



Table of Contents

 

PROTECTIVE LIFE CORPORATION

CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS

(Unaudited)

 

 

 

For The

 

 

 

Three Months Ended

 

 

 

March 31,

 

 

 

2011

 

2010

 

 

 

(Dollars In Thousands)

 

Cash flows from operating activities

 

 

 

 

 

Net income 

 

$

67,466

 

$

69,706

 

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

 

 

 

 

 

Realized investment losses (gains)

 

13,877

 

(12,958

)

Amortization of deferred policy acquisition costs and value of business acquired

 

74,363

 

81,289

 

Capitalization of deferred policy acquisition costs

 

(118,078

)

(121,980

)

Depreciation expense

 

1,650

 

1,949

 

Deferred income tax

 

23,314

 

(1,340

)

Accrued income tax

 

16,160

 

101,222

 

Interest credited to universal life and investment products

 

237,391

 

246,524

 

Policy fees assessed on universal life and investment products

 

(165,564

)

(150,168

)

Change in reinsurance receivables

 

(51,162

)

(111,708

)

Change in accrued investment income and other receivables

 

(15,220

)

(20,192

)

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

 

(14,041

)

61,857

 

Trading securities:

 

 

 

 

 

Maturities and principal reductions of investments

 

105,170

 

89,700

 

Sale of investments

 

300,010

 

244,133

 

Cost of investments acquired

 

(275,880

)

(272,249

)

Other net change in trading securities

 

(36,908

)

(26,432

)

Change in other liabilities

 

(26,873

)

20,464

 

Other income - surplus note repurchase

 

(10,095

)

 

Other, net

 

(15,288

)

26,904

 

Net cash provided by operating activities

 

110,292

 

226,721

 

Cash flows from investing activities

 

 

 

 

 

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

 

653,265

 

593,314

 

Sale of investments, available-for-sale

 

284,567

 

1,035,081

 

Cost of investments acquired, available-for sale

 

(998,309

)

(2,408,262

)

Mortgage loans:

 

 

 

 

 

New borrowings

 

(128,640

)

(30,531

)

Repayments

 

136,969

 

70,515

 

Change in investment real estate, net

 

2,508

 

120

 

Change in policy loans, net

 

9,128

 

10,696

 

Change in other long-term investments, net

 

(35,051

)

(17,531

)

Change in short-term investments, net

 

(19,961

)

412,723

 

Net unsettled security transactions

 

152,168

 

158,661

 

Purchase of property and equipment

 

(4,847

)

(1,711

)

Payments for business acquisitions

 

(20,418

)

 

Net cash provided by (used in) investing activities

 

31,379

 

(176,925

)

Cash flows from financing activities

 

 

 

 

 

Borrowings under line of credit arrangements and debt

 

 

15,000

 

Principal payments on line of credit arrangement and debt

 

(17,000

)

(40,000

)

Issuance (repayment) of non-recourse funding obligations

 

(35,700

)

 

Dividends to shareowners

 

(11,994

)

(10,270

)

Issuance of common stock

 

 

 

Investments product deposits and change in universal life deposits

 

996,367

 

785,155

 

Investment product withdrawals

 

(1,081,920

)

(797,767

)

Other financing activities, net

 

(24,911

)

(4,305

)

Net cash used in financing activities

 

(175,158

)

(52,187

)

Change in cash

 

(33,487

)

(2,391

)

Cash at beginning of period

 

264,425

 

205,325

 

Cash at end of period

 

$

230,938

 

$

202,934

 

 

See Notes to Consolidated Condensed Financial Statements

 

6



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 month period ended March 31, 2011, are not necessarily indicative of the results that may be expected for the year ending December 31, 2011. The year-end consolidated condensed balance sheet 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, 2010.

 

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

 

Accounting Pronouncements Recently Adopted

 

Accounting Standard Update (“ASU” or “Update”) No. 2010-06 — Fair Value Measurements and Disclosures — Improving Disclosures about Fair Value Measurements. In January of 2010, the Financial Accounting Standards Board (“FASB”) issued ASU No. 2010-06 — Fair Value Measurements and Disclosures — Improving Disclosures about Fair Value Measurements. This Update provides amendments to Subtopic 820-10 that require the following new disclosures. 1) A reporting entity should disclose separately the amounts of significant transfers in and out of Level 1 and Level 2 fair value measurements and describe the reasons for the transfers. 2) In the reconciliation for fair value measurements using significant unobservable inputs (Level 3), a reporting entity should present separately information about purchases, sales, issuances, and settlements (that is, on a gross basis rather than as one net number).

 

This Update provides amendments to Subtopic 820-10 that clarify existing disclosures. 1) A reporting entity should provide fair value measurement disclosures for each class of assets and liabilities. 2) A reporting entity should provide disclosures about the valuation techniques and inputs used to measure fair value for both recurring and nonrecurring fair value measurements. Those disclosures are required for fair value measurements that fall in either Level 2 or Level 3. This Update also includes conforming amendments to the guidance on employers’ disclosures about postretirement benefit plan assets (Subtopic 715-20). The conforming amendments to Subtopic 715-20 change the terminology from major categories of assets to classes of assets and provide a cross reference to the guidance in Subtopic 820-10 on how to determine appropriate classes to present fair value disclosures. This Update is effective for interim and annual reporting periods beginning after December 15, 2009, which the Company adopted for the period ending March 31, 2010, except for the disclosures about purchases, sales,

 

7



Table of Contents

 

issuances, and settlements in the roll forward of activity in Level 3 fair value measurements. Those disclosures were adopted by the Company as of January 1, 2011. This Update did not have a material impact on the Company’s consolidated condensed results of operations or financial position.

 

ASU No. 2010-15 — Financial Services—Insurance — How Investments Held through Separate Accounts Affect an Insurer’s Consolidation Analysis of Those Investments. The amendments in this Update clarify that an insurance entity should not consider any separate account interests held for the benefit of policy holders in an investment to be the insurer’s interests. The entity should not combine general account and separate account interests in the same investment when assessing the investment for consolidation. Additionally, the amendments do not require an insurer to consolidate an investment in which a separate account holds a controlling financial interest if the investment is not or would not be consolidated in the standalone financial statements of the separate account. The amendments in this Update also provide guidance on how an insurer should consolidate an investment fund in situations in which the insurer concludes that consolidation is required. This Update is effective for fiscal years beginning after December 15, 2010. For the Company this Update became effective January 1, 2011. This Update did not have an impact on the Company’s consolidated condensed results of operations or financial position.

 

ASU No. 2010-28 — Intangibles — Goodwill and Other — When to Perform Step 2 of the Goodwill Impairment Test for Reporting Units with Zero or Negative Carrying Amounts. The amendments in this Update modify Step 1 of the goodwill impairment test for reporting units with zero or negative carrying amounts. For those reporting units, an entity is required to perform Step 2 of the goodwill impairment test if it is more likely than not that a goodwill impairment exists. In determining whether it is more likely than not that a goodwill impairment exists, an entity should consider whether there are any adverse qualitative factors indicating that an impairment may exist. This Update is effective for fiscal years, and interim periods within those years, beginning after December 15, 2010. This Update was effective for the Company as of January 1, 2011. This Update did not have an impact on the Company’s results of operations or financial position.

 

Accounting Pronouncements Not Yet Adopted

 

ASU No. 2010-26 — Financial Services — Insurance - Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts. The objective of this Update is to address diversity in practice regarding the interpretation of which costs relating to the acquisition of new or renewal insurance contracts qualify for deferral. This Update prescribes that certain incremental direct costs of successful initial or renewal contract acquisitions may be deferred. It defines incremental direct costs as those costs that result directly from and are essential to the contract transaction and would not have been incurred by the insurance entity had the contract transaction not occurred. This Update also clarifies the definition of the types of incurred costs that may be capitalized and the accounting and recognition treatment of advertising, research, and other administrative costs related to the acquisition of insurance contracts. This Update is effective for periods beginning after December 15, 2011 and is to be applied prospectively. Early adoption and retrospective application are optional. The Company is currently evaluating the impact this Update will have on its results of operations or financial position.

 

ASU No. 2011-02 — Receivables — A Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring. The objective of this Update is to evaluate whether a restructuring constitutes a troubled debt restructuring. In evaluating whether a restructuring constitutes a troubled debt restructuring, a creditor must separately conclude that both of the following exist: 1) the restructuring constitutes a concession and 2) the debtor is experiencing financial difficulties. This Update also clarifies the guidance on a creditor’s evaluation of whether it has granted a concession. The amendments in this Update are effective for the first interim or annual period beginning on or after June 15, 2011, and should be applied retrospectively to the beginning of the annual period of adoption. For the Company, this Update will become effective on July 1, 2011. The Company is currently evaluating the impact this Update will have on its results of operations or financial position.

 

ASU. No. 2011-03 — Transfers and Servicing - Reconsideration of Effective Control for Repurchase Agreements. This Update amends the assessment of effective control for repurchase agreements to remove 1) the criterion requiring the transferor to have the ability to repurchase or redeem the financial assets on substantially the agreed terms, even in the event of default by the transferee, and 2) the collateral maintenance implementation guidance related to the criterion. The Boards determined that these criterion should not be a determining factor of effective control. This Update is effective for the first interim or annual period beginning on or after December 15, 2011, for the Company, the Update will be applied to all repurchase agreements beginning January 1, 2012. The Company is currently evaluating the possible impact of this Update.

 

Significant Accounting Policies

 

For a full description of significant accounting policies, see Note 2 of Notes to Consolidated Financial Statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010. There were no significant changes to the Company’s accounting policies during the three months ended March 31, 2011, except as noted above.

 

8



Table of Contents

 

3.                                      INVESTMENT OPERATIONS

 

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

 

 

 

For The

 

 

 

Three Months Ended

 

 

 

March 31, 2011

 

 

 

(Dollars In Thousands)

 

Fixed maturities

 

$

5,295

 

Equity securities

 

9,100

 

Impairments on fixed maturity securities

 

(5,663

)

Impairments on equity securities

 

 

Modco trading portfolio

 

(5,649

)

Other investments

 

(4,274

)

Total realized gains (losses) - investments

 

$

(1,191

)

 

For the three months ended March 31, 2011, gross realized gains on investments available-for-sale (fixed maturities, equity securities, and short-term investments) were $14.6 million and gross realized losses were $5.8 million, including $5.6 million of impairment losses. The $5.6 million excludes $0.1 million of impairment losses in the trading portfolio for the three months ended March 31, 2011.

 

The $9.1 million of gains included in equity securities primarily relates to gains of $6.9 million on securities that have recovered in value as the issuer exited bankruptcy and $1.2 million that relates to gains recognized on the sale of Federal National Mortgage Association preferreds.

 

For the three months ended March 31, 2011, the Company sold securities in an unrealized gain position with a fair value (proceeds) of $236.0 million. The gain realized on the sale of these securities was $14.6 million.

 

For the three months ended March 31, 2011, the Company sold securities in an unrealized loss position with a fair value (proceeds) of $20.0 million. The loss realized on the sale of these securities was $0.2 million.

 

The amortized cost and fair value of the Company’s investments classified as available-for-sale as of March 31, 2011, are as follows:

 

 

 

 

 

Gross

 

Gross

 

 

 

 

 

Amortized

 

Unrealized

 

Unrealized

 

Fair

 

 

 

Cost

 

Gains

 

Losses

 

Value

 

 

 

(Dollars In Thousands)

 

Fixed maturities:

 

 

 

 

 

 

 

 

 

Bonds

 

 

 

 

 

 

 

 

 

Residential mortgage-backed securities

 

$

2,350,063

 

$

49,118

 

$

(101,952

)

$

2,297,229

 

Commercial mortgage-backed securities

 

178,296

 

5,420

 

(1,106

)

182,610

 

Other asset-backed securities

 

889,737

 

1,236

 

(30,505

)

860,468

 

U.S. government-related securities

 

1,205,592

 

27,064

 

(5,548

)

1,227,108

 

Other government-related securities

 

164,395

 

5,231

 

(46

)

169,580

 

States, municipals, and political subdivisions

 

979,587

 

11,812

 

(21,069

)

970,330

 

Corporate bonds

 

15,341,954

 

932,526

 

(155,120

)

16,119,360

 

 

 

21,109,624

 

1,032,407

 

(315,346

)

21,826,685

 

Equity securities

 

332,397

 

13,447

 

(4,280

)

341,564

 

Short-term investments

 

251,233

 

 

 

251,233

 

 

 

$

21,693,254

 

$

1,045,854

 

$

(319,626

)

$

22,419,482

 

 

As of March 31, 2011, the Company had an additional $2.9 billion of fixed maturities, $11.4 million of equity securities, and $155.4 million of short-term investments classified as trading securities.

 

9



Table of Contents

 

The amortized cost and fair value of available-for-sale fixed maturities as of March 31, 2011, 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.

 

 

 

Amortized

 

Fair

 

 

 

Cost

 

Value

 

 

 

(Dollars In Thousands)

 

Due in one year or less

 

$

397,337

 

$

408,901

 

Due after one year through five years

 

4,731,422

 

4,891,990

 

Due after five years through ten years

 

5,357,058

 

5,607,355

 

Due after ten years

 

10,623,807

 

10,918,439

 

 

 

$

21,109,624

 

$

21,826,685

 

 

Each quarter the Company reviews investments with unrealized losses and tests for other-than-temporary impairments. The Company analyzes various factors to determine if any specific other-than-temporary asset impairments exist. 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 the Company’s intent to sell the security (including a more likely than not assessment of whether the Company will be required to sell the security) before recovering the security’s amortized cost, 5) the time period during which the decline has occurred, 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, and in some cases, an analysis regarding the Company’s expectations for recovery of the security’s entire amortized cost basis through the receipt of future cash flows is performed. Once a determination has been made that a specific other-than-temporary impairment exists, the security’s basis is adjusted and an other-than-temporary impairment is recognized. Equity securities that are other-than-temporarily impaired are written down to fair value with a realized loss recognized in earnings. Other-than-temporary impairments to debt securities that the Company does not intend to sell and does not expect to be required to sell before recovering the security’s amortized cost are written down to discounted expected future cash flows (“post impairment cost”) and credit losses are recorded in earnings. The difference between the securities’ discounted expected future cash flows and the fair value of the securities is recognized in other comprehensive income (loss) as a non-credit portion of the recognized other-than-temporary impairment. When calculating the post impairment cost for residential mortgage-backed securities (“RMBS”), commercial mortgage-backed securities (“CMBS”), and other asset-backed securities, the Company considers all known market data related to cash flows to estimate future cash flows. When calculating the post impairment cost for corporate debt securities, the Company considers all contractual cash flows to estimate expected future cash flows. To calculate the post impairment cost, the expected future cash flows are discounted at the original purchase yield. Debt securities that the Company intends to sell or expects to be required to sell before recovery are written down to fair value with the change recognized in earnings.

 

During the three months ended March 31, 2011, the Company recorded other-than-temporary impairments on investments of $16.0 million related to debt securities. Of the $16.0 million of impairments for the three months ended March 31, 2011, $5.7 million was recorded in earnings and $10.3 million was recorded in other comprehensive income (loss). For the three months ended March 31, 2011, there were no other-than-temporary impairments related to equity securities. During this period, there were no other-than-temporary impairments related to debt securities or equity securities that the Company intends to sell or expects to be required to sell, except with respect to certain debt securities that were part of the Company’s collateral in its securities lending program.

 

At the end of the period, the Company decided to discontinue this program. The Company believed that certain debt securities that were part of this program’s collateral, and were in an unrealized loss position, will be sold prior to their respective maturities. Therefore, the Company recorded a $1.3 million other-than-temporary impairment loss on these securities during the period.

 

10



Table of Contents

 

The following chart is a rollforward of credit losses on debt securities held by the Company for which a portion of an other-than-temporary impairment was recognized in other comprehensive income (loss):

 

 

 

For The

 

 

 

Three Months Ended

 

 

 

March 31,

 

 

 

2011

 

2010

 

 

 

(Dollars In Thousands)

 

Beginning balance

 

$

39,427

 

$

25,076

 

Additions for newly impaired securities

 

3,609

 

6,556

 

Additions for previously impaired securities

 

668

 

1,734

 

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

 

 

 

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

 

(3,089

)

 

Other

 

 

 

Ending balance

 

$

40,615

 

$

33,366

 

 

The following table includes investments’ 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 March 31, 2011:

 

 

 

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

 

$

274,481

 

$

(21,813

)

$

785,977

 

$

(80,139

)

$

1,060,458

 

$

(101,952

)

Commercial mortgage-backed securities

 

33,146

 

(1,106

)

 

 

33,146

 

(1,106

)

Other asset-backed securities

 

89,806

 

(2,269

)

579,475

 

(28,236

)

669,281

 

(30,505

)

U.S. government-related securities

 

272,367

 

(5,548

)

 

 

272,367

 

(5,548

)

Other government-related securities

 

28,855

 

(40

)

14,994

 

(6

)

43,849

 

(46

)

States, municipals, and political subdivisions

 

560,651

 

(21,069

)

 

 

560,651

 

(21,069

)

Corporate bonds

 

2,631,263

 

(82,462

)

744,750

 

(72,658

)

3,376,013

 

(155,120

)

Equities

 

15,596

 

(2,296

)

13,545

 

(1,984

)

29,141

 

(4,280

)

 

 

$

3,906,165

 

$

(136,603

)

$

2,138,741

 

$

(183,023

)

$

6,044,906

 

$

(319,626

)

 

The RMBS have a gross unrealized loss greater than twelve months of $80.1 million as of March 31, 2011. These losses relate to a widening in spreads and defaults as a result of continued weakness in the residential housing market which have reduced the fair value of the RMBS holdings. 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 the investments.

 

The other asset-backed securities have a gross unrealized loss greater than twelve months of $28.2 million as of March 31, 2011. This category predominately includes student-loan backed auction rate securities whose underlying collateral is at least 97% guaranteed by the Federal Family Education Loan Program (“FFELP”). These losses relate to the auction rate securities (“ARS”) 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. In addition, the Company has the ability and intent to hold these securities until their values recover or until maturity.

 

The corporate bonds category has gross unrealized losses greater than twelve months of $72.7 million as of March 31, 2011. These losses relate primarily to fluctuations in credit spreads. 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 including the Company’s ability and intent to hold these securities to recovery.

 

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 basis.

 

11



Table of Contents

 

As of March 31, 2011, the Company had securities in its available-for-sale portfolio which were rated below investment grade of $2.7 billion and had an amortized cost of $2.8 billion. In addition, included in the Company’s trading portfolio, the Company held $290.5 million of securities which were rated below investment grade. Approximately $568.2 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

 

 

 

Three Months Ended

 

 

 

March 31, 2011

 

 

 

(Dollars In Thousands)

 

Fixed maturities

 

$

27,960

 

Equity securities

 

(416

)

 

4.                                      MORTGAGE LOANS

 

Mortgage Loans

 

The Company invests a portion of its investment portfolio in commercial mortgage loans. As of March 31, 2011, the Company’s mortgage loan holdings were approximately $4.9 billion.

 

As of March 31, 2011 and December 31, 2010, the Company had an allowance for mortgage loan credit losses of $4.3 million and $11.7 million, respectively. Over the past ten years, the Company’s commercial mortgage loan portfolio has experienced an average credit loss factor of approximately 0.2%. Due to such low historical losses, 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 Subtopic 310. Since the Company uses the specific identification method for calculating reserves, 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 monitor borrower conditions such as payment practices, borrower credit, operating performance, 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 borrower. 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 borrower. 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 March 31, 2011, delinquent mortgage loans, foreclosed properties, and restructured loans pursuant to a pooling and servicing agreement totaled $30.2 million, and were less than 0.1% of invested assets. The Company does not expect these investments to adversely affect its liquidity or ability to maintain proper matching of assets and liabilities. 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 previously a part of variable interest entity securitizations and thus subject to a contractual pooling and servicing agreement. The loans subject to a pooling and servicing agreement have been included on our consolidated condensed balance sheet (“balance sheet”) beginning in the first quarter of 2010 in accordance with ASU 2009-17. For loans not subject to a pooling and servicing agreement, as of March 31, 2011, $13.6 million, or 0.3%, of the mortgage loan portfolio was nonperforming. In addition, as of March 31, 2011, $16.6 million, 0.3%, of the mortgage loan portfolio that is subject to a pooling and servicing agreement was either nonperforming or has been restructured under the terms and conditions of the pooling and service agreement.

 

12



Table of Contents

 

An analysis of the change in the allowance for mortgage loan credit losses is provided in the following chart:

 

 

 

As of

 

 

 

March 31, 2011

 

December 31, 2010

 

 

 

(Dollars In Thousands)

 

Beginning balance

 

$

11,650

 

$

1,725

 

Charge offs

 

(8,008

)

(1,146

)

Recoveries

 

(2,000

)

 

Provision

 

2,643

 

11,071

 

Ending balance

 

$

4,285

 

$

11,650

 

 

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 March 31, 2011:

 

 

 

 

 

 

 

Greater

 

 

 

 

 

30-59 Days

 

60-89 Days

 

than 90 Days

 

Total

 

 

 

Delinquent

 

Delinquent

 

Delinquent

 

Delinquent

 

 

 

(Dollars In Thousands)

 

Commercial mortgage loans

 

$

61,699

 

$

 

$

12,455

 

$

74,154

 

Number of delinquent commercial mortgage loans

 

8

 

 

3

 

11

 

 

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 ninety 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 March 31, 2011:

 

 

 

 

 

Unpaid

 

 

 

Average

 

Interest

 

Cash Basis

 

 

 

Recorded

 

Principal

 

Related

 

Recorded

 

Income

 

Interest

 

 

 

Investment

 

Balance

 

Allowance

 

Investment

 

Recognized

 

Income

 

 

 

(Dollars In Thousands)

 

Commercial mortgage loans:

 

 

 

 

 

 

 

 

 

 

 

 

 

With no related allowance recorded

 

$

3,740

 

$

3,740

 

$

 

$

1,870

 

$

35

 

$

35

 

With an allowance recorded

 

22,066

 

22,066

 

4,285

 

4,413

 

119

 

119

 

 

5.                                      GOODWILL

 

During the three months ended March 31, 2011, the Company decreased its goodwill balance by approximately $0.8 million. The decrease was due to adjustments in the Acquisitions segment related to tax benefits realized during 2011 on the portion of tax goodwill in excess of GAAP basis goodwill. As of March 31, 2011, the Company had an aggregate goodwill balance of $114.0 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 compared 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

 

13



Table of Contents

 

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 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, 2010, the Company performed its annual evaluation of goodwill and determined that no adjustment to impair goodwill was necessary.

 

The Company also considers its market capitalization in assessing the reasonableness of the fair values estimated for its reporting units in connection with its goodwill impairment testing. In considering the Company’s March 31, 2011 common equity price, which was lower than its book value per share, the Company noted there are several factors that would result in its market capitalization being lower than the fair value of its reporting units that are tested for goodwill impairment. Such factors that would not be reflected in the valuation of the Company’s reporting units with goodwill include, but are not limited to: a potential concern about future earnings growth, negative market sentiment, different valuation methodologies that resulted in low valuation, and increased risk premium for holding investments in mortgage-backed securities and commercial mortgage loans. Deterioration of or adverse market conditions for certain businesses may have a significant impact on the fair value of the Company’s reporting units. In the Company’s view, market capitalization being below book value does not invalidate the Company’s fair value assessment related to the recoverability of goodwill in its reporting units, and did not result in a triggering or impairment event.

 

6.                                      DEBT AND OTHER OBLIGATIONS

 

Non-recourse funding obligations outstanding as of March 31, 2011, on a consolidated basis, are shown in the following table:

 

 

 

 

 

 

 

Year-to-Date

 

 

 

 

 

 

 

Weighted-Avg

 

Issuer

 

Balance

 

Maturity Year

 

Interest Rate

 

 

 

(Dollars In Thousands)

 

 

 

 

 

Golden Gate II Captive Insurance Company

 

$

496,700

 

2052

 

1.42

%

 

Golden Gate II Captive Insurance Company (“Golden Gate II”), a special purpose financial captive insurance company wholly owned by Protective Life Insurance Company (“PLICO”), had $575 million of outstanding non-recourse funding obligations as of March 31, 2011. These outstanding non-recourse funding obligations were issued to special purpose trusts, which in turn issued securities to third parties. Certain of the Company’s affiliates purchased a portion of these securities during 2010 and 2011. As a result of these purchases, as of March 31, 2011, securities related to $496.7 million of the outstanding balance of the non-recourse funding obligations were held by external parties and securities related to $78.3 million of the non-recourse funding obligations were held by affiliates.

 

Under a revolving line of credit arrangement, the Company has the ability to borrow on an unsecured basis up to an aggregate principal amount of $500 million (the “Credit Facility”). 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 $600 million. Balances outstanding under the Credit Facility accrue interest at a rate equal to (i) either the prime rate or the London Interbank Offered Rate (“LIBOR”), plus (ii) a spread based on the ratings of our senior unsecured long-term debt. The Credit Agreement provides that the Company is liable for the full amount of any obligations for borrowings or letters of credit, including those of PLICO, under the Credit Facility. The maturity date on the Credit Facility is April 16, 2013. There was an outstanding balance of $125.0 million at an interest rate of LIBOR plus 0.40% under the Credit Facility as of March 31, 2011.

 

14



Table of Contents

 

7.                                      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. The Company does not believe such assessments will be materially different from amounts already provided for in the financial statements. Most of these laws do provide, however, that an assessment may be excused or deferred if it would threaten an insurer’s own financial strength.

 

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. The Company, in the ordinary course of business, is involved in such litigation and arbitration. The occurrence of such litigation and arbitration may become more frequent and/or severe when general economic conditions have deteriorated. Although the Company cannot predict the outcome of any such litigation or arbitration, the Company does not believe that any such outcome will have a material impact on its financial condition or results of the operations.

 

8.                                      COMPREHENSIVE INCOME (LOSS)

 

The following table sets forth the Company’s comprehensive income (loss) for the periods presented below:

 

 

 

For The

 

 

 

Three Months Ended

 

 

 

March 31,

 

 

 

2011

 

2010

 

 

 

(Dollars In Thousands)

 

Net income

 

$

67,466

 

$

69,706

 

Change in net unrealized gains (losses) on investments, net of income tax: (three months: 2011 - $17,907; 2010 - $142,481)

 

33,263

 

263,959

 

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: 2011 - $(3,608); 2010 - $(3,495))

 

(6,700

)

(6,492

)

Change in accumulated (loss) gain - derivatives, net of income tax: (three months: 2011 - $3,621; 2010 - $3,423)

 

6,724

 

5,718

 

Minimum pension liability adjustment, net of income tax: (three months: 2011 - $(451); 2010 - $324)

 

(838

)

602

 

Reclassification adjustment for investment amounts included in net income, net of income tax: (three months: 2011 - $(3,054); 2010 - $1,725)

 

(5,678

)

3,418

 

Reclassification adjustment for derivative amounts included in net income, net of income tax: (three months: 2011 - $(361); 2010 - $(974))

 

(671

)

(1,752

)

Comprehensive income

 

93,566

 

335,159

 

Comprehensive income attributable to noncontrolling interests

 

 51

 

 73

 

Comprehensive income attributable to Protective Life Corporation

 

$

93,617

 

$

335,232

 

 

15



Table of Contents

 

9.                                      STOCK-BASED COMPENSATION

 

During the three months ended March 31, 2011, 191,000 performance shares with an estimated fair value of $5.4 million were issued. The criteria for payment of the 2011 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 9.0%, no award is earned. If the Company’s ROE is at or above 10.0%, the award maximum is earned. Awards are paid in shares of the Company’s common stock. No performance share awards were issued during the three months ended March 31, 2010.

 

Additionally, the Company issued 172,000 restricted stock units for the three months ended March 31, 2011. These awards had a total fair value at grant date of $4.9 million. Approximately half of these restricted stock units vest in 2014, and the remainder vest in 2015.

 

Stock appreciation right (“SARs”) have 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 grants 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 as of December 31, 2010

 

$

21.97

 

2,324,837

 

SARs granted

 

 

 

SARs exercised / forfeited / expired

 

5.05

 

29,141

 

Balance as of March 31, 2011

 

$

22.18

 

2,295,696

 

 

There were no SARs issued for the three months ended March 31, 2011. 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.

 

10.                               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

 

 

 

Three Months Ended

 

 

 

March 31,

 

 

 

2011

 

2010

 

 

 

(Dollars In Thousands)

 

Service cost — benefits earned during the period

 

$

2,194

 

$

2,068

 

Interest cost on projected benefit obligation

 

2,508

 

2,357

 

Expected return on plan assets

 

(2,512

)

(2,312

)

Amortization of prior service cost

 

(98

)

(98

)

Amortization of actuarial losses

 

1,388

 

1,026

 

Total benefit cost

 

$

3,480

 

$

3,041

 

 

During the three months ended March 31, 2011, the Company contributed $2.1 million to its defined benefit pension plan for the 2010 plan year. In addition, during April of 2011, the Company contributed $2.3 million to the defined benefit pension plan for the 2011 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%.

 

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 three months ended March 31, 2011, was immaterial to the Company’s financial statements.

 

16



Table of Contents

 

11.                               EARNINGS PER SHARE

 

Basic earnings per share is computed by dividing net income available to PLC’s common shareowners 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 available to PLC’s common shareowners 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

 

 

 

Three Months Ended

 

 

 

March 31,

 

 

 

2011

 

2010

 

 

 

(Dollars In Thousands, Except Per Share Amounts)

 

Calculation of basic earnings per share:

 

 

 

 

 

Net income available to PLC’s common shareowners

 

$

67,517

 

$

69,779

 

 

 

 

 

 

 

Average shares issued and outstanding

 

85,679,753

 

85,587,188

 

Issuable under various deferred compensation plans

 

923,475

 

913,011

 

Weighted shares outstanding - basic

 

86,603,228

 

86,500,199

 

 

 

 

 

 

 

Per share:

 

 

 

 

 

Net income available to PLC’s common shareowners - basic

 

$

0.78

 

$

0.81

 

 

 

 

 

 

 

Calculation of diluted earnings per share:

 

 

 

 

 

Net income available to PLC’s common shareowners

 

$

67,517

 

$

69,779

 

 

 

 

 

 

 

Weighted shares outstanding - basic

 

86,603,228

 

86,500,199

 

Stock appreciation rights (“SARs”)(1)

 

499,453

 

459,037

 

Issuable under various other stock-based compensation plans

 

140,937

 

155,118

 

Restricted stock units

 

576,467

 

437,032

 

Weighted shares outstanding - diluted

 

87,820,085

 

87,551,386

 

 

 

 

 

 

 

Per share:

 

 

 

 

 

Net income available to PLC’s common shareowners - diluted

 

$

0.77

 

$

0.80

 

 


(1)            Excludes 1,452,030 and 1,475,645 as of March 31, 2011 and 2010, 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.

 

12.                               INCOME TAXES

 

There have been no material changes to the balance of unrecognized income tax benefits which impacted earnings for the three months ended March 31, 2011. Within the next twelve months, the Company does not expect to have any material adjustments to its unrecognized income tax benefits liability with regard to any of the tax jurisdictions in which it conducts its business operations.

 

The Company has computed its effective income tax rate for the three months ended March 31, 2011 and 2010, based upon its estimate of its annual 2011 and 2010 income. The effective tax rate for the three months ended March 31, 2011 and 2010 was 35.2% and 31.2%, respectively. In the quarter ending March 31, 2010, the effective tax rate was favorably impacted by a release of $2.8 million of unrecognized income tax benefits.

 

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 March 31, 2011.

 

17



Table of Contents

 

13.                               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 condensed 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.

 

18



Table of Contents

 

The following table presents the Company’s hierarchy for its assets and liabilities measured at fair value on a recurring basis as of March 31, 2011:

 

 

 

Level 1

 

Level 2

 

Level 3

 

Total

 

 

 

(Dollars In Thousands)

 

Assets:

 

 

 

 

 

 

 

 

 

Fixed maturity securities - available-for-sale

 

 

 

 

 

 

 

 

 

Residential mortgage-backed securities

 

$

 

$

2,297,210

 

$

19

 

$

2,297,229

 

Commercial mortgage-backed securities

 

 

182,610

 

 

182,610

 

Other asset-backed securities

 

 

221,061

 

639,407

 

860,468

 

U.S. government-related securities

 

1,102,449

 

109,575

 

15,084

 

1,227,108

 

States, municipals, and political subdivisions

 

 

970,252

 

78

 

970,330

 

Other government-related securities

 

14,994

 

154,586

 

 

169,580

 

Corporate bonds

 

98

 

16,054,355

 

64,907

 

16,119,360

 

Total fixed maturity securities - available-for-sale

 

1,117,541

 

19,989,649

 

719,495

 

21,826,685

 

 

 

 

 

 

 

 

 

 

 

Fixed maturity securities - trading

 

 

 

 

 

 

 

 

 

Residential mortgage-backed securities

 

 

400,459

 

 

400,459

 

Commercial mortgage-backed securities

 

 

133,781

 

 

133,781

 

Other asset-backed securities

 

 

50,382

 

41,713

 

92,095

 

U.S. government-related securities

 

383,554

 

8,280

 

3,384

 

395,218

 

States, municipals, and political subdivisions

 

 

170,356

 

 

170,356

 

Other government-related securities

 

 

107,624

 

 

107,624

 

Corporate bonds

 

 

1,549,831

 

 

1,549,831

 

Total fixed maturity securities - trading

 

383,554

 

2,420,713

 

45,097

 

2,849,364

 

Total fixed maturity securities

 

1,501,095

 

22,410,362

 

764,592

 

24,676,049

 

Equity securities

 

262,333

 

11,050

 

79,544

 

352,927

 

Other long-term investments (1)

 

14,457

 

4,216

 

26,072

 

44,745

 

Short-term investments

 

399,135

 

7,541

 

 

406,676

 

Total investments

 

2,177,020

 

22,433,169

 

870,208

 

25,480,397

 

Cash

 

230,938

 

 

 

230,938

 

Other assets

 

7,152

 

 

 

7,152

 

Assets related to separate accounts

 

 

 

 

 

 

 

 

 

Variable annuity

 

5,797,956

 

 

 

5,797,956

 

Variable universal life

 

561,044

 

 

 

561,044

 

Total assets measured at fair value on a recurring basis

 

$

8,774,110

 

$

22,433,169

 

$

870,208

 

$

32,077,487

 

 

 

 

 

 

 

 

 

 

 

Liabilities:

 

 

 

 

 

 

 

 

 

Annuity account balances (2)

 

$

 

$

 

$

143,020

 

$

143,020

 

Other liabilities (1)

 

2,078

 

17,086

 

178,386

 

197,550

 

Total liabilities measured at fair value on a recurring basis

 

$

2,078

 

$

17,086

 

$

321,406

 

$

340,570

 

 


(1)            Includes certain freestanding and embedded derivatives.

(2)            Represents liabilities related to equity indexed annuities.

 

19



Table of Contents

 

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, 2010:

 

 

 

Level 1

 

Level 2

 

Level 3

 

Total

 

 

 

(Dollars In Thousands)

 

Assets:

 

 

 

 

 

 

 

 

 

Fixed maturity securities - available-for-sale

 

 

 

 

 

 

 

 

 

Residential mortgage-backed securities

 

$

 

$

2,547,730

 

$

20

 

$

2,547,750

 

Commercial mortgage-backed securities

 

 

155,125

 

19,901

 

175,026

 

Other asset-backed securities

 

 

207,638

 

641,129

 

848,767

 

U.S. government-related securities

 

1,054,375

 

104,419

 

15,109

 

1,173,903

 

States, municipals, and political subdivisions

 

 

963,225

 

78

 

963,303

 

Other government-related securities

 

14,993

 

186,214

 

 

201,207

 

Corporate bonds

 

100

 

15,725,900

 

65,032

 

15,791,032

 

Total fixed maturity securities - available-for-sale

 

1,069,468

 

19,890,251

 

741,269

 

21,700,988

 

 

 

 

 

 

 

 

 

 

 

Fixed maturity securities - trading

 

 

 

 

 

 

 

 

 

Residential mortgage-backed securities

 

 

432,015

 

 

432,015

 

Commercial mortgage-backed securities

 

 

137,606

 

 

137,606

 

Other asset-backed securities

 

 

18,415

 

59,925

 

78,340

 

U.S. government-related securities

 

383,423

 

11,369

 

3,442

 

398,234

 

States, municipals, and political subdivisions

 

 

160,539

 

 

160,539

 

Other government-related securities

 

 

126,553

 

 

126,553

 

Corporate bonds

 

 

1,642,664

 

 

1,642,664

 

Total fixed maturity securities - trading

 

383,423

 

2,529,161

 

63,367

 

2,975,951

 

Total fixed maturity securities

 

1,452,891

 

22,419,412

 

804,636

 

24,676,939

 

Equity securities

 

271,483

 

10,831

 

77,098

 

359,412

 

Other long-term investments (1)

 

6,794

 

3,808

 

25,065

 

35,667

 

Short-term investments

 

344,796

 

8,028

 

 

352,824

 

Total investments

 

2,075,964

 

22,442,079

 

906,799

 

25,424,842

 

Cash

 

264,425

 

 

 

264,425

 

Other assets

 

6,222

 

 

 

6,222

 

Assets related to separate accounts

 

 

 

 

 

 

 

 

 

Variable annuity

 

5,170,193

 

 

 

5,170,193

 

Variable universal life

 

534,219

 

 

 

534,219

 

Total assets measured at fair value on a recurring basis

 

$

8,051,023

 

$

22,442,079

 

$

906,799

 

$

31,399,901

 

 

 

 

 

 

 

 

 

 

 

Liabilities:

 

 

 

 

 

 

 

 

 

Annuity account balances (2)

 

$

 

$

 

$

143,264

 

$

143,264

 

Other liabilities (1)

 

23,995

 

28,987

 

190,529

 

243,511

 

Total liabilities measured at fair value on a recurring basis

 

$

23,995

 

$

28,987

 

$

333,793

 

$

386,775

 

 


(1)            Includes certain freestanding and embedded derivatives.

(2)            Represents liabilities related to equity 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.

 

20



Table of Contents

 

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 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 over 90% of the Company’s fixed maturity securities. Based on the typical trading volumes and the lack of quoted market prices for 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 three months ended March 31, 2011.

 

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 “ABS”). As of March 31, 2011, the Company held $3.3 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

 

21



Table of Contents

 

the underlying assets, 2) average life of the security, 3) prepayment speeds, 4) credit spreads, 5) treasury and swap yield curves, and 6) discount margin.

 

As of March 31, 2011, the Company held $681.1 million of Level 3 ABS, which included $41.7 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, and 7) credit ratings of the securities.

 

The fair value calculation of available-for-sale ABSs classified as Level 3 had, but were not limited to, the following inputs:

 

Investment grade credit rating

 

100.0%

Weighted-average yield

 

1.6%

Amortized cost

 

$652.8 million

Weighted-average life

 

7.5 years

 

Corporate bonds, U.S. Government-related securities, and Other government related securities

 

As of March 31, 2011, the Company classified approximately $19.1 billion of corporate bonds, U.S. government-related securities, 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 brokers and third party pricing service utilizes a valuation model that consists of a hybrid income and market approach to valuation. The pricing model utilizes 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 March 31, 2011, the Company classified approximately $83.5 million of bonds and securities as Level 3 valuations. The fair value of the Level 3 bonds and securities are derived from an internal pricing model that utilizes a hybrid market/income approach to valuation. The Company reviews the following characteristics of the bonds and securities to determine the relevant inputs to use in the pricing model: 1) coupon rate, 2) years to maturity, 3) seniority, 4) embedded options, 5) trading volume, and 6) credit ratings.

 

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, 3) sector and issuer level spreads, 4) underlying collateral, 5) credit ratings, 6) maturity, 7) embedded options, 8) recent new issuance, 9) comparative bond analysis, and 10) an illiquidity premium.

 

The fair value calculation of bonds and securities classified as Level 3 had, but were not limited to, the following weighted-average inputs:

 

Investment grade credit rating

 

82.5%

Weighted-average yield

 

5.3%

Weighted-average coupon

 

7.3%

Amortized cost

 

$80.4 million

Weighted-average stated maturity

 

6.5 years

 

22



Table of Contents

 

Equities

 

As of March 31, 2011, the Company held approximately $90.6 million of equity securities classified as Level 2 and Level 3. Of this total, $62.7 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 made up of holdings we have obtained through bankruptcy proceedings or debt restructurings.

 

Other long-term investments and Other liabilities

 

Other long-term investments and other liabilities consist entirely of free standing and embedded derivative instruments. Refer to Note 14, Derivative Financial Instruments for additional information related to derivatives. Derivative instruments are valued using exchange prices, independent broker quotations, or pricing valuation models, which utilize market data inputs. Excluding embedded derivatives, as of March 31, 2011, 84.9% 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 and equity volatility, equity index levels, and treasury rates. The Company performs monthly analysis on derivative valuations that includes both quantitative and qualitative analysis.

 

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

 

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

 

Derivative instruments classified as Level 3 were total return swaps and embedded derivatives and include at least one non-observable significant 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 GMWB embedded derivative is carried at fair value in “other assets” 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 14, Derivative Financial Instruments for more information related to GMWB embedded derivative gains and losses. The fair value of the GMWB embedded derivative is derived through the income method of valuation using a valuation model that projects future cash flows using 1,000 risk neutral 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 mortality of 65% of the National Association of Insurance Commissioners 1994 Variable Annuity GMDB Mortality Table. The present value of the cash flows is found using the discount rate curve, which is London Interbank Offered Rate (“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 Company has ceded certain blocks of policies under modified coinsurance agreements in which the investment results of the underlying portfolios are passed directly to the reinsurers. As a result, these agreements are deemed to contain embedded derivatives that must be reported at fair value. Changes in fair value of the embedded derivatives are reported in earnings. The investments supporting these agreements are designated as “trading securities”; therefore changes in fair value of such investments are reported in earnings. The fair value of the embedded derivatives represents the unrealized gain or loss on the block of business in relation to the unrealized gain or loss of the trading securities. As a result, changes in fair value of the embedded derivatives reported in earnings are largely offset by the changes in fair value of the investments.

 

23



Table of Contents

 

Annuity account balances

 

The equity indexed annuity (“EIA”) 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 on a stochastic basis using 1,000 risk neutral 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 annually as a part of the formal unlocking process.

 

Included in the chart below, are current key assumptions which include risk margins for the Company. These assumptions are reviewed for reasonableness on a quarterly basis.

 

Asset Earned Rate

 

5.90%

Admin Expense per Policy

 

$91

Partial Withdrawal Rate (for ages less than 70)

 

2.20%

Partial Withdrawal Rate (for ages 70 and greater)

 

2.20%

Mortality

 

65% of 94 GMDB table

Lapse

 

2.2% to 55% depending on the surrender charge period

Return on Assets

 

1.5% to 1.85% depending on the guarantee period

 

The discount rate for the equity indexed annuities is based on an upward sloping rate curve which is updated each quarter. The discount rates for March 31, 2011, ranged from a one month rate of 0.32%, a 5 year rate of 3.58%, and a 30 year rate of 5.61%.

 

Separate Accounts

 

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

 

24


 


Table of Contents

 

The following table presents a reconciliation of the beginning and ending balances for fair value measurements for the three months ended March 31, 2011, 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