AMERICAN NATIONAL INSURANCE CO /TX/ – 10-K – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
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Set forth on the following pages is management's discussion and analysis ("MD&A") of our financial condition and results of operations. This narrative analysis should be read in conjunction with the forward-looking statement information in this document; see Part I, Item 1A, Risk Factors; Part II, Item 7A, Quantitative and Qualitative Disclosures About Market Risk; and Part II, Item 8, Financial Statements and Supplementary Data. INDEX Segments 31 Outlook 31 Critical Accounting Estimates 35 Consolidated Results of Operations 46 Life 47 Annuity 51 Health 55 Property and Casualty 59 Corporate and Other 69 Investments 70 Liquidity 73 Capital Resources 74 Contractual Obligations 75 Off-Balance Sheet Arrangements 76 Related Party Transactions 77 30
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Overview
We are a diversified insurance and financial services company, offering a broad spectrum of life, annuity, health, and property and casualty insurance products. Chartered in 1905, we are headquartered inGalveston, Texas . We operate in all 50 states, theDistrict of Columbia ,Guam ,American Samoa andPuerto Rico . Segments We manage our business through five business segments, which are comprised of four insurance segments: Life, Annuity, Health and Property and Casualty, and our Corporate and Other business segment. The life, annuity, and health insurance segments are operated primarily through six domestic life insurance companies. The property and casualty insurance segment is operated through eight domestic property and casualty insurance companies. The insurance segments have revenues consisting primarily of net premium earned on insurance contracts, net investment income, policy and investment contract fees, and other income. The insurance segments' expenses are comprised of benefits and claims incurred, interest credited to policyholder account balances, acquisition costs and amortization of deferred policy acquisition costs, operating expenses, and income tax expense. The insurance segments have liabilities plus an amount of surplus allocated sufficient to support each segment's business activities. The insurance segments do not directly own assets. Rather, assets are allocated to the segments to support the liabilities and surplus of each segment. The mix of assets allocated to each of the insurance segments is modified as necessary to provide for a match of cash flows and earnings to properly support the characteristics of the insurance liabilities. We have utilized this methodology consistently over all periods presented. The Corporate and Other business segment acts as the owner of all of the invested assets of the Company. As noted previously, assets and surplus from the Corporate and Other business segment are allocated to the insurance segments to match the liabilities of those segments. The investment income from the invested assets is also allocated to the insurance segments from the Corporate and Other business segment in accordance with the amount of assets allocated to each segment. Earnings of the Corporate and Other business segment are derived from our non-insurance businesses as well as earnings from those invested assets that are not allocated to the insurance segments. All realized investment gains and losses are recorded in this segment. Outlook The "Outlook" section contains many forward-looking statements, particularly relating to our future financial performance. These forward-looking statements are based on information currently available to us, are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995, and are subject to the precautionary statements set forth in the introduction to this Annual Report on Form 10-K. Actual results are likely to differ materially from those forecasts, depending on the outcome of various factors. In recent years, our business has been and likely will continue to be, influenced by a number of industry-wide and segment or product-specific trends and conditions. In our discussion below, we first outline the broad macro-economic or industry trends (General Trends) that we expect will have an impact on our overall business. Second, we discuss certain segment-specific trends that we believe may impact either individual segments of our business or specific products within these segments. General Trends Challenging Financial and Economic Environment: We believe that as expectations for global economic growth remain uncertain, factors such as consumer spending, business investment, the volatility and condition of the capital markets and inflation will affect the business and economic environment and, in turn, impact the demand for the type of financial and insurance products we offer. Adverse changes in the economy could affect earnings negatively and have a material 31
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adverse effect on our business, financial condition and results of operations. However, we believe those risks are somewhat mitigated by our financial strength, active risk management and disciplined underwriting for our products. Our diverse product mix across multiple lines of business (life, annuity, health and property and casualty) is a strength that will help us adapt to current economic times and give us the ability to serve the changing needs of our customers. For example, fluctuations in the stock market during recent years have led investors to search for financial products that are insulated from the volatility of the markets. We are well positioned to serve the demand in this marketplace given our success with fixed annuity products. Additionally, through our conservative business approach, we believe we remain financially strong, and we are committed to providing a steady and reliable source of financial protection for policyholders and investors alike. Low Interest Rates: Low interest rate environments are typically challenging for life and annuity companies as the spreads on deposit-type funds and contracts narrow and policies approach their minimum crediting rates. Low market interest rates may reduce the spreads between the amounts we credit to fixed annuity and individual life policyholders and the amounts we earn on the investments that support these obligations. We have an ALM Committee that actively manages the profitability of our in-force insurance and annuity contracts. In response to the unusually low interest rates in recent years, we have reduced the guaranteed minimum crediting rates on newly issued fixed annuity contracts and reduced crediting rates on in-force contracts, where permitted to do so. These actions have helped mitigate the adverse impact of low interest rates on our spreads and on the profitability of these products, although sales volume and persistency could diminish as a result. Additionally, we maintain assets with various maturities to support product liabilities and ensure liquidity. A gradual increase in longer-term interest rates relative to short-term rates generally will have a favorable effect on the profitability of these products. Although rapidly rising interest rates could result in reduced persistency of our spread-based products, as contract holders shift assets into higher yielding investments, we believe that our ability to react quickly to the changing marketplace will help us to manage this risk. Low interest rates are also challenging for property and casualty companies. Investment income is generally a substantial element in earning an acceptable profit margin. Lower interest rates resulting in lower investment income require the company to achieve better underwriting results. We have taken pricing actions to help mitigate the adverse impact of low interest rates on our property and casualty business. As a result, we have seen sales volume and persistency diminish. Focus on Operating Efficiencies: The challenging economic environment and the recent investment-related losses across the industry have created a renewed focus on operating cost reductions and efficiencies. We aggressively manage our cost base while maintaining our commitment to provide superior customer service to agents and policyholders. Investments in technology are aligned with activities and are coordinated through a disciplined project management process. We anticipate continually improving our use of technology to enhance our policyholders' and agents' experience. Changing Regulatory Environment: The insurance industry is regulated primarily at the state level. In addition, some life and annuity products and services are subject to U.S. federal regulation. The debate over the U.S. federal regulatory role in the insurance industry continues to be a divisive issue within the industry. We proactively monitor this debate to determine its impact on our business. Life and Annuity Life insurance continues to be our mainstay segment, as it has been during our long history. We believe that the combination of predictable and decreasing mortality rates, positive cash flow generation for many years after policy issue and favorable persistency characteristics suggest a viable and profitable future for this line of business. We continue to use a wide variety of marketing channels and plan to expand our traditional distribution models with additional agents. We are committed to maintaining our annuity product lines. We have a conservation program that is intended to retain policyholders through proactive communication and education when a policyholder is considering surrendering his or her policy. We believe this program has resulted in retaining approximately 8.5% of our policyholders who have submitted surrender requests. 32
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Effective management of invested assets and associated liabilities involving credited rates and, where applicable, financial hedging instruments (which are utilized as economic hedges of equity-indexed annuity products), is crucial to the success of our annuity segment. Asset "disintermediation", the risk of large outflows of cash at times when it is disadvantageous to us to dispose of invested assets, is a risk associated with this segment. This risk is monitored and managed by the ALM Committee, using statistical measures such as duration and projected future cash flows based on large numbers of possible future interest scenerios and the use of modeling to identify potential risk areas. These techniques are designed to manage asset-liability cash flow and minimize potential losses. Demographics: We believe a key driver shaping the actions of the life insurance industry is the rising income protection, wealth accumulation, and insurance needs of retiring Baby Boomers (those born between 1946 and 1964). According to U.S. Census information published in 2008, about 19.3 percent of the total population will be over 65 by 2030, compared to about 13.0 percent now. Also, the most rapidly growing age group is expected to be the 85 and older population. As a result of increasing longevity and uncertainty regarding theSocial Security system, retirees will need to accumulate sufficient savings to support retirement income requirements. We are well positioned to address the Baby Boomers' increasing need for savings tools and income protection. We believe our overall financial strength and broad distribution channels position us to respond with a variety of products to individuals approaching retirement age who seek information to plan for and manage their retirement needs. We believe our products that offer guaranteed income flows for life, including single premium immediate annuities, are well positioned to serve this market. Competitive Pressures: The life insurance industry remains highly competitive. Product development and life cycles have shortened in many products, leading to more intense competition with respect to product features. In addition, several of the industry's products can be quite homogeneous and subject to intense price competition. We believe we possess sufficient scale, financial strength and flexibility to effectively compete in this market. The annuity market is also highly competitive. In addition to aggressive annuity rates and new product features such as guaranteed living benefit riders within the industry, there is also a growing competition from other financial service firms. Insurers continue to evaluate their distribution channels and the way they deliver products to consumers. At this time, we have elected not to provide guaranteed living benefits as a part of our variable annuity products. We believe these products were not adequately priced relative to the risk profile of the product. While this may have impeded our ability to sell variable annuities in the short term, we believe this strategy has given us an advantage in terms of profitability over the long term. We believe we will continue to be competitive in the life and annuity markets through our broad line of products, our diverse distribution channels, and our consistent high level of customer service. We modify our products to meet customer needs and to expand our reach where we believe we can obtain profitable growth. Some highlights of recent activities include:
• In 2010, we established a
which offers a variety of annuity products. In 2011, the subsidiary
started selling life insurance. Sales are made through independent and multiple-line agents and direct to the consumer.
• Sales of traditional life insurance products through our Career Sales and
Service Division increased in 2011. This, coupled with our focus on policy
persistency and expense management, allowed us to continue to maintain a
stable and profitable block of in-force business.
• Sales of Universal Life insurance products increased for our Multiple-line
and Career Sales and Service Divisions in 2011.
• We believe there will be a continuing shift in sales emphasis to utilizing
the Internet, endorsed direct mail and innovative product/distribution
combinations. Our direct sales of life insurance products rebounded in
2010 and continued into 2011. Selling traditional life insurance products
through our Internet and third-party marketing distribution channels will remain a focus. 33
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Table of Contents Health We experienced a decline in our Medicare Supplement policies in-force in 2011 and 2010. Price pressure from traditional Medicare Supplement carriers seeking the lowest market rates and, to a lesser extent, competition fromMedicare Advantage plans continues to impact our production. We remain committed to the traditional Medicare Supplement plans, which we consider viable for the long term. DuringMarch 2010 , the Patient Protection and Affordable Care Act, and a reconciliation measure, the Health Care and Education Reconciliation Act of 2010 (collectively, "the Health Acts"), were signed into law. The Health Acts mandate broad changes in the delivery of health care benefits that impact our current business model, including its relationship with current and future customers, producers and health care providers, products, services, processes and technology. As a result of the Health Acts, management decided to discontinue the sale of individual medical expense insurance plans effectiveJune 30, 2010 . Such insurance plans included our major medical and hospital surgical products. The Health Acts have generated new opportunities in the limited benefit and supplemental product markets. During 2011, we began building a portfolio of products to be sold in the worksite market as well as to individuals. Our marketing research indicates that there are areas in these markets that are underserved. In 2012, we intend to establish new distribution channels and sales strategies through which we expect to see results. We expect our Managing General Underwriter line ("MGU"), which provides a large contribution to Health profits, to continue to grow during 2012. It is important to note that most of the income associated with this line is in the form of a fee income included in "Other income" of the Health segment's operating results; we retain only 10% of the MGU premium. Property and Casualty Our operating results continue to be significantly impacted by a high level of catastrophe losses in the Midwest and Northeast. We are not currently planning to change our geographic concentrations as we factor the higher level of losses into our pricing models. "U.S. Property/Casualty - Review and Preview" published byA.M. Best onFebruary 6, 2012 noted that the U.S. property and casualty insurance industry has continued to experience sharply deteriorated operating performance as a result of significant catastrophe related losses, persistent competition, underpricing of many commercial lines, low investment yields and lingering weakness in the macroeconomic environment. The industry's underwriting performance deteriorated in 2011, as unusually high catastrophe related losses, driven by increased frequency of low-severity perils, and weaker results in the commercial market took a heavy toll on overall underwriting results resulting in the largest underwriting loss since 2002. The U.S. property and casualty industry experienced large catastrophe related losses in 2011, driven by a sharp upswing in the frequency of catastrophic events, including an unprecedented tornado season, one of the most active ever recorded, as well as the first hurricane to hit the U.S since 2008, severe thunderstorms, winter storms, wildfires and floods. While the severity of many of these events was not significant, two events affectingJoplin, Missouri andTuscaloosa, Alabama resulted in large losses for the industry. To illustrate the increased frequency of events in the U.S. during 2011, theFederal Emergency Management Agency declared a record number of major disasters of 99 during the year, up from 81 declared in 2010. The historical average of major disasters is 34 per year. Demand for P&C credit-related insurance products continues to increase. Credit markets have improved from the previous recessionary years, which resulted in increasing sales in the auto dealer market and, in turn, demand for our GAP products. We continue to update credit insurance product offerings and pricing to meet changing market needs, as well as adding new agents to expand market share in the credit-related insurance market. We are reviewing and implementing procedures to enhance customer service and, at the same time, looking for efficiencies to reduce administrative costs. 34
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Competition: Property and casualty insurers are facing a continued competitive pricing environment. The condition of the economy in 2011 prevented the rate hardening most industry leaders were expecting following the declines in previous years. The competitive environment is expected to continue into 2012 as excess industry capital, industry loss reserve releases, and an anticipated sluggish economic recovery all undermine any significant improvement in the market. Despite the challenging pricing environment, we expect to identify profitable opportunities through our strong distribution channels, expanding geographic coverage, target marketing efforts and new product development. Through our multiple-line exclusive agents, we will continue to focus on increasing our market share in the home, auto and targeted commercial insurance markets. Critical Accounting Estimates The preparation of the consolidated financial statements in accordance with GAAP requires us to make estimates and assumptions that often involve a significant degree of judgment, in particular, expectations of current and future mortality, morbidity, persistency, claims and claim adjustment expenses, recoverability of receivables, investment returns and interest rates. In developing these estimates, we make subjective and complex judgments that are inherently uncertain and subject to material changes as facts and circumstances develop. Although variability is inherent in these estimates, we believe that the amounts as reported are appropriate, based upon the facts available upon compilation of the consolidated financial statements. Management reviews the estimates and assumptions used in the preparation of the consolidated financial statements on an ongoing basis. If management determines that modifications in estimates and assumptions are appropriate given current facts and circumstances, our financial position and results of operations as reported in the consolidated financial statements could change significantly. A discussion of these critical accounting estimates is presented below. Reserves Life and Annuity Reserves: Liability for Future Policy Benefits and Policy Account Balances - For traditional life products, liabilities for future policy benefits have been calculated based on a net level premium method using estimated investment yields, withdrawals, mortality and other assumptions that were appropriate at the time of policy issuance. The estimates used are based on our experience, adjusted with a provision for adverse deviation. Investment yields used for non-participating traditional life products range from 3.0% to 8.0% and vary by issue year. Future policy benefits for universal life and investment-type deferred annuity contracts reflect the current account value before applicable surrender charges. Future policy benefits for group life policies have been calculated using a level interest rate ranging from 3.0% to 5.5%. Mortality and withdrawal assumptions are based on our experience. Fixed payout annuities included in future policy benefits are calculated using a level interest rate ranging from 3.0% to 5.6%. Mortality assumptions are based on standard industry mortality tables. Liabilities for payout annuities classified as investment contracts (payout annuities without life contingencies) are determined as the present value of future benefits at the "breakeven" interest rate determined at inception. At least annually, we test the net benefit reserves (policy benefit reserves less DAC) established for life insurance products, including consideration of future expected premium payments, to determine whether they are adequate to provide for future policyholder benefit obligations. This testing process is referred to as "Loss Recognition" for traditional products or "Unlocking" for non-traditional products. The assumptions used to perform the tests are our current best estimate assumptions as to policyholder mortality, persistency, company maintenance expenses and invested asset returns. 35
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For traditional business, a "lock-in" principle applies, whereby the assumptions used to calculate the benefit reserves and DAC are set when a policy is issued and do not change with changes in actual experience. These assumptions include margins for adverse deviation in the event that actual experience differs from the original assumptions. For non-traditional business, best-estimate assumptions are updated to reflect observed changes based on experience studies and current economic conditions. We reflect the effect of such assumption changes in DAC and reserve balances accordingly. Due to the long-term nature of many of the liabilities, small changes in certain assumptions may cause large changes in the degree of reserve adequacy or DAC recoverability. In particular, changes in estimates of the future invested asset return assumption have a large effect on the degree of reserve adequacy. Life Reserving Methodology - We establish liabilities for amounts payable under life insurance policies, including participating and non-participating traditional life insurance and interest-sensitive and variable universal life insurance. In general, amounts are payable over an extended period of time and related liabilities are calculated as the present value of future expected benefits to be paid, reduced by the present value of future expected premiums (for traditional life insurance), or as the account value established for the policyholder (for universal and variable universal life insurance). Such liabilities are established based on methods and underlying assumptions in accordance with GAAP and applicable actuarial standards. Principal assumptions used in the establishment of liabilities for future policy benefits are mortality, policy lapse rates, investment return, inflation, expenses and other contingent events as appropriate to the respective product type. Future policy benefits for non-participating traditional life insurance policies are equal to the aggregate of the present value of expected benefit payments and related expenses less the present value of expected future net premiums. Assumptions as to mortality and persistency are based upon our experience, with provisions for adverse deviation, when the basis of the liability is established. Interest rates for the aggregate future policy benefit liabilities range from 3.0% to 8.0% and vary by issue year. Future policy benefit liabilities for participating traditional life insurance policies are equal to the aggregate of (i) net level premium reserves for death and endowment policy benefits (calculated based upon the non-forfeiture interest rate, ranging from 2.5% to 5.5%, and mortality rates assumed in calculating the cash surrender values described in such contracts); and (ii) the liability for terminal dividends. Future policy benefits for interest-sensitive and variable universal life insurance policies are equal to the current account value established for the policyholder. Some of our universal life policies contain secondary guarantees, for which an additional liability is established.Liabilities for universal life secondary guarantees and paid-up guarantees are determined by estimating the expected value of death benefits payable when the account balance is projected to be zero and recognizing those benefits over the accumulation period based on total expected assessments. Incurred but not reported ("IBNR") claims for life policies are estimated using historical claims information. We analyze our claims data annually and develop an average IBNR factor, which is applied to paid claims in the current period to reflect estimated claims for which the deaths are not reported until a subsequent period. In addition, we make an estimate for additional reserves whenever new information becomes available. Adjustments in IBNR reserves, if any, are reflected in the results of operations during the period when such adjustments are made. We regularly evaluate estimates used and adjust the liability balances, with a related charge or credit to benefit expense, if actual experience or other evidence suggests that assumptions should be revised. The assumptions used in estimating the secondary and paid-up guarantee liabilities are consistent with those used for amortizing DAC and are thus subject to the same variability and risk. The assumptions used in calculating our liabilities are based on the average benefits payable over a range of scenarios. 36
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Annuity Reserving Methodology - We establish liabilities for amounts payable under annuity contracts, including fixed payout and deferred annuities. An immediate or payout annuity is an annuity contract in the benefit "payout" phase. In a fixed payout annuity contract, the insurance company agrees, for a cash consideration, to make specified benefit payments for a fixed period, or for the duration of a designated life or lives. The cash consideration can be funded with a single payment, as is the case with single premium immediate annuities, or with a schedule of payments, as is the case with "limited-pay" products. Payout annuities with more than an insignificant amount of mortality risk are calculated in accordance with the applicable accounting guidance for limited pay insurance contracts. Benefit and maintenance expense reserves are established by using assumptions reflecting our expectations, including an appropriate margin for adverse deviation. Payout annuity reserves are calculated using standard industry mortality tables specified for statutory reporting and an interest rate range of 3.0% to 5.6% for life annuities and 3.0% for shorter duration contracts, such as term certain payouts. If the resulting reserve would otherwise cause profits to be recognized at the issue date, additional reserves are established. The resulting recognition of profits would be gradual over the expected life of the contract. Liabilities for deferred annuities are established based on methods and underlying assumptions in accordance with the applicable accounting guidance for investment contracts. Policyholder account balances are established as the account value held on behalf of the policyholder. The possible need for additional reserves for guaranteed minimum death benefits is determined in accordance with the applicable accounting guidance. The profit recognition on deferred annuity contracts is gradual over the expected life of the contract. No immediate profit is recognized on the sale of the contract. Health Reserves: Overview - We establish future policy benefit reserves in order to match income and benefit expenses by accounting period. Policy and contract claim reserves are established in order to associate future benefit payments, both known and unknown, with the period in which they were incurred. As of year-end 2011, the total Health net reserves were$164.3 million versus$181.2 million at year-end 2010. The following methods are employed to establish the Health reserves: Completion Factor Approach: The claim reserves for most health care coverage can be suitably calculated using a completion factor method. This method assumes that the historical lag pattern will be an accurate representation of unpaid claim payments. An estimate of the unpaid claims is calculated by subtracting period-to-date paid claims from an estimate of the ultimate 'complete' payment for all incurred claims in the period. Completion factors are calculated which "complete" the current period-to-date payment totals for each incurred month to estimate the ultimate expected payout. This method is best used when the incurred date and subsequent paid date is known for each claim and if fairly consistent patterns can be determined from the progression of the incurred date until the date paid in full. For the individual and association medical block (includingMedicare Supplement), we use a completion factor approach to establish claim reserves. MGU and group claim reserves are also calculated using these methods. Outstanding claim inventories are monitored monthly to determine if any adjustment to the completion factor calculation is needed. For some larger MGUs we engage external actuarial firms to provide an estimate of the claim reserves for their respective blocks. We independently evaluate the external claim reserve estimates for reasonableness as well as for consistency with other completion-factor based reserves. These estimates are incorporated into our reserve analysis to determine the booked reserves for the Health segment. Tabular Claims Reserves: Disability income and long-term care blocks of business utilize a tabular calculation to generate the present value of expected future payments. These reserves are called tabular because they rely on the published valuation continuance tables. These tables were created using industry experience regarding assumptions of continued morbidity and subsequent recovery. The tabular reserves are calculated by applying these continuance tables, along with appropriate company experience adjustments, to the stream of contractual benefit payments. The present value of these expected benefit payments discounted at the required interest rate establishes the tabular reserve. 37
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Credit health claim reserves are also based on a tabular calculation using actuarial tables published by theSociety of Actuaries and accepted by the NAIC. The reserve for this business is calculated as a function of open claims using the same actuarial tables discussed above. Periodically, we test the total claim reserve using a completion factor calculation. Future Policy Benefits - Reserves for future policy benefits have been calculated based on a net level premium method. Future policy benefits are equal to the aggregate of the present value of expected future benefit payments, less the present value of expected future premiums. Morbidity and termination assumptions are based on our experience or published valuation tables when available and appropriate. Interest rates for the aggregate future policy benefit liabilities range from 3.0% to 8.0% and vary by issue year. Premium Deficiency Reserves - Deficiency reserves are established when the expected claims payments for a classification of policies having homogenous characteristics are in excess of the expected premiums for these policies. The determination of a deficiency reserve takes into consideration the likelihood of premium rate increases, the timing of these increases, and the expected benefit utilization patterns. We have established premium deficiency reserves for segments of the major medical business and the long-term care business. These lines of business are in run-off and continue to under-perform relative to the original pricing. The assumptions and methods used to determine the deficiency reserves are reviewed periodically for reasonableness, and the reserve amount is monitored against emerging losses. Property and Casualty Reserves: Reserves for Claims and Claim Adjustment Expense ("CAE") - Property and casualty reserves are established to provide for the estimated costs of paying claims under insurance policies written. These reserves include estimates for both:
• Case reserves - claims that were reported to us but not yet paid, and
• IBNR - anticipated cost of claims incurred but not reported. IBNR reserves
include a provision for potential development on case reserves, losses on
claims currently closed which may reopen in the future, and claims that have been incurred but not yet reported. These reserves include an estimate of the expense associated with settling claims, including legal and other fees, and the general expenses of administering the claims adjustment process. The two major categories of CAE are defense and cost containment expense and adjusting and other expense. The details of property and casualty reserves are shown in the following table (in thousands): December 31, 2011 December 31, 2010 Gross Ceded Net Gross Ceded Net Case $ 470,519 $ 37,673 $ 432,846 $ 469,051 $ 23,015 $ 446,036 IBNR 440,473 15,479 424,994 458,509 17,537 440,972 Total $ 910,992 $ 53,152 $ 857,840 $ 927,560 $ 40,552 $ 887,008 Case Reserves: Reserves for reported losses are established on either a judgment or a formula basis, depending on the timing and type of the loss. They are based on historical paid loss data for similar claims with provisions for trend changes, such as those caused by inflation. The formula reserve is a fixed amount for each claim of a given type. Judgment reserve amounts generally replace initial formula based reserves and are set on a per case basis based on facts and circumstances of each case, the type of claim and the expectation of damages. We regularly monitor the adequacy of judgment reserves and formula reserves on a case-by-case basis and change the amount of such reserves as necessary. 38
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IBNR: IBNR reserves are estimated based on many variables, including historical statistical information, inflation, legal developments, economic conditions, and general trends in claim severity, frequency and other factors that could affect the adequacy of claims reserves. Loss and premium data is aggregated by exposure class and by accident year. IBNR reserves are calculated by projecting ultimate losses on each class of business and subtracting paid losses and case reserves. Unlike case reserves, IBNR is generally calculated at an aggregate level and cannot usually be directly identified as reserves for a particular loss or contract. Our overall reserve practice provides for ongoing claims evaluation and adjustment based on the development of related data and other relevant information pertaining to such claims. Adjustments in aggregate reserves, if any, are reflected in the results of operations of the period during which such adjustments are made. We believe our actuaries conservatively reflect the potential uncertainty generated by volatility in our loss development profiles when selecting loss development factor patterns for each line of business. See Results of Operations and Related Information by Segment - Property and Casualty, PriorPeriod Reserve Development section of the MD&A for additional information. The evaluation process to establish the claims and CAE reserves involves the collaboration of underwriting, claims and internal actuarial departments. The process also includes consultation with independent actuarial firms on a regular basis. Work performed by independent actuarial firms is an important part of our process of gaining reassurance that the claims and CAE reserves determined by our internal actuarial department sufficiently meet all present and future obligations arising from all claims incurred as of year-end. Additionally, the independent actuarial firms complete the Statements of Actuarial Opinion at each year-end, certifying that the recorded claims and CAE reserves appear reasonable. Premium Deficiency Reserve: Deficiency reserves are established when the expected claims payments and a maintenance component for a product line is in excess of the expected premiums for that product line. The determination of a deficiency reserve takes into consideration the current profitability of a product line using anticipated claims, claims expense, and policy maintenance costs. The assumptions and methods used to determine the deficiency reserves are reviewed periodically for reasonableness and the reserve amount is monitored against emerging losses. There were no reserves of this type atDecember 31, 2011 . P & C Reserving Methodology - The following actuarial methods are utilized in our reserving process during both annual and interim reporting periods: • Initial Expected Loss Ratio: This method calculates an estimate of ultimate losses by applying an estimated loss ratio to an estimate of
ultimate earned premium for each accident year. This method is appropriate
for classes of business where the actual paid or reported loss experience
is not yet mature enough to override initial expectations of the ultimate
loss ratios.
• Bornhuetter Ferguson: This method uses as a starting point an assumed
initial expected loss ratio method and blends in the loss ratio implied by
the claims experience to date by using loss development patterns based on
our own historical experience. This method is generally appropriate where
there are few reported claims and a relatively less stable pattern of reported losses.
• Loss or
or defense and cost containment expense data and the historical development profiles on older accident periods to project more recent, less developed periods to their ultimate position. This method is appropriate when there is a relatively stable pattern of loss and expense emergence and a relatively large number of reported claims. 39
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Table of Contents • Ratio of Paid Defense and Cost Containment Expense to Paid Loss Development: This method uses the ratio of paid defense and cost
containment expense to paid loss data and the historical development
profiles on older accident periods to project more recent, less developed
periods to their ultimate position. In this method, an ultimate ratio of
paid defense and cost containment expense to paid loss is selected for
each accident period. The selected paid defense and cost containment
expense to paid loss ratio is then applied to the selected ultimate loss
for each accident period to estimate the ultimate defense and cost containment expense. Paid defense and cost containment expense is then subtracted from the ultimate defense and cost containment expense to calculate the unpaid defense and cost containment expense for that accident period.
• Calendar Year Paid Adjusting and Other Expense to Paid Loss: This method
uses the ratio of prior calendar years' paid expense to paid loss to
project ultimate loss adjustment expenses for adjusting and other expense.
The key to this method is the selection of the paid expense to paid loss
ratio based on prior calendar years' activity. A percentage of the selected ratio is applied to the case reserves (depending on the line of insurance) and 100% to the indicated IBNR reserves. These ratios assume
that a percentage of the expense is incurred when a claim is opened and
the remaining percentage is paid throughout the claim's life.
The basis of our selected single point best estimate on a particular line of business is often a blended result from two or more methods (e.g. weighted averages). Our estimate is highly dependent on actuarial and management judgment as to which method(s) is most appropriate for a particular accident year and class of business. Our methodology changes over time, as new information emerges regarding underlying loss activity and other factors. Key Assumptions: Implicit in the actuarial methodologies previously discussed are the following critical reserving assumptions, which may impact our reserves:
• Future inflation rates will remain stable and consistent with historical
norms;
• The selected loss ratio used in the initial expected loss ratio method and
Bornhuetter Ferguson method for each accident year; • The expected loss development profiles; • A consistent claims handling process; • A consistent payout pattern; • No unusual growth patterns;
• No major shift in liability limits distribution on liability policies; and
• No significant prospective changes in laws that would significantly affect
future payouts.
The loss ratio selections and loss development profiles are developed primarily using our own historical claims and loss experience. These assumptions have not been modified from the preceding periods and are consistent with historical loss reserve development patterns. Management believes our loss reserves atDecember 31, 2011 are adequate. New information, legislation, events or circumstances, unknown at the original valuation date, however, may result in future development to our ultimate losses significantly greater or less than the recorded reserves atDecember 31, 2011 . 40
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For non-credit lines of business, future inflation rates could vary from our assumption of relatively stable rates. Unexpected changes in future inflation rates could impact our financial position and liquidity, and thus we chose to measure the sensitivity of our reserve levels to unexpected changes in inflation. The table below presents estimates of the impact of likely scenarios related to changes in future inflation. A future 1.5% decrease and 2.5% increase over the implied inflation rate in our reserves is presented. The impacts on our estimate of gross loss reserves at year-end (amounts in thousands) is displayed. Year ended December 31, 2011 Cumulative Increase (Decrease) in Reserves Future Inflation 1.5% Decrease 2.5% Increase Personal: Personal Auto $ (5,104 ) $ 14,856 Homeowner (703 ) 3,572 Commercial: Agribusiness (6,018 ) 22,243 Commercial auto (2,141 ) 6,811 The analysis of our credit insurance line of business quantifies the estimated impact on gross loss reserves of a reasonably likely scenario of varying the ratio applied to the unearned premium to determine the IBNR reserves atDecember 31, 2011 . IBNR reserving methodology for this line of business focuses primarily on the use of a ratio applied to the unearned premium for each credit insurance product. The selected ratios are based on historical loss and claim data. In our analysis, we varied this ratio by +/- 5% across all credit insurance products combined. The results of our analysis show an increase or decrease in gross reserves across all accident years combined of approximately$8.3 million . It is not appropriate to aggregate the impacts shown in our sensitivity analysis, as our lines of business are not directly correlated. The variations set forth are not meant to be a "best-case" or "worst-case" scenario, and therefore, it is possible that future variations will be more or less than the amounts in our sensitivity analysis. While we believe these are possible scenarios based on the information available to us at this time, we do not believe the reader should consider our sensitivity analysis an actual reserve range. Reserving by Class of Business: The weight given to a particular actuarial method depends on the characteristics specific to each class of business, including the types of coverage and the expected claim-tail. Short-tail business - Lines of business for which loss data emerge more quickly are referred to as short-tail lines of business. For these lines, emergence of paid losses and case reserves is credible and likely indicative of ultimate losses; therefore, more reliance is placed on the Loss orExpense Development methods. Large catastrophe and weather-related events are analyzed separately using information available to our claims staff, loss development profiles from similar events and our own historical experience. Long-tail business - For long-tail lines of business, emergence of paid losses and case reserves is less credible in early periods and, accordingly, may not be indicative of ultimate losses. For these lines of business, more reliance is placed on the Bornhuetter Ferguson and Initial Expected Loss Ratio methods. Credit business - For credit lines of business, the IBNR is estimated either by applying a selected ratio to the unearned premium reserve or by using the loss development methods previously discussed. Claim adjustment expenses - We estimate adjusting and other expenses separately from loss reserves using the Calendar Year Paid-to-Paid method. Reserves for defense and cost containment expense are estimated separately from loss reserves, using either the Loss orExpense Development method or Ratio of Paid Defense and Cost Containment Expense to Paid Loss method. 41
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Deferred Policy Acquisition Costs We incur significant costs in connection with acquiring insurance business, including commissions and certain underwriting and direct marketing expenses. Some of these costs are deferred and recorded as DAC in the assets section of the consolidated statements of financial position. The deferred costs are subsequently amortized over the lives of the underlying contracts in relation to the anticipated emergence of premiums, profit margins, or gross profits, depending on the type of product. DAC on traditional life and health products are amortized with interest over the anticipated premium-paying period of the related policies, in proportion to the ratio of annual premium revenue to be received over the life of the policies. Expected premium revenue is estimated by using the same mortality, morbidity and withdrawal assumptions used in computing liabilities for future policy benefits. The amount of DAC is reduced by a provision for anticipated inflation of maintenance and settlement expenses in the determination of such amounts by means of grading interest rates. Costs deferred on universal life, limited pay and investment-type contracts are amortized as a level percentage of the present value of anticipated gross profits from investment yields, mortality, and surrender charges. The effect on DAC that would result from realization of unrealized gains (losses) is recognized with an offset to "Accumulated Other Comprehensive Income" in consolidated statements of financial position as of the reporting date. It is possible that a change in interest rates could have a significant impact on DAC calculated for these contracts. DAC associated with property and casualty insurance business consists principally of commissions, underwriting and issue costs. These deferred costs are amortized over the coverage period of the related policies, in relation to premium revenue recognized. We had a total DAC asset of approximately$1.35 billion and$1.32 billion atDecember 31, 2011 and 2010, respectively. In 2010, a new accounting guidance was issued which specifies that only costs directly related and incremental to the successful acquisition of insurance contracts can be capitalized as DAC. The new guidance also specifies that advertising costs should be deferred only if the capitalization criteria for direct-response advertising are met. EffectiveJanuary 1, 2012 , we retrospectively adopted this new accounting guidance and implemented a new DAC capitalization policy. Upon adoption, our DAC asset was reduced with a corresponding reduction in retained earnings. See Note 3, Recently Issued Accounting Pronouncements, of the Notes to the Consolidated Financial Statements for a detailed discussion regarding the impact of this pronouncement on the Company. We believe that the estimates used in our DAC calculations provide a representative example of how variations in assumptions and estimates would affect our business. The following table displays the sensitivity of reasonably likely changes in assumptions included in the amortization of the DAC balance of our long-tail business for the year endedDecember 31, 2011 (in thousands):
Increase/(decrease)
in DAC Increase in future investment margins of 25 basis points $
33,015
Decrease in future investment margins of 25 basis points
(38,077 )
Decrease in future life mortality by 1%
2,886
Increase in future life mortality by 1% (2,915 ) 42
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Reinsurance
Reinsurance recoverable balances include amounts owed to us in respect of paid and unpaid ceded losses and loss expenses and are presented net of a reserve for non-recoverability. AtDecember 31, 2011 and 2010, reinsurance recoverable balances were$405.0 million and$355.2 million , respectively. Recoveries on our gross ultimate losses are determined using distributions of gross ultimate loss by layer of loss retention to estimate ceded IBNR as well as through the review of individual large claims. The most significant assumption we use is the average size of the individual losses for claims that have occurred but have not yet been recorded by us. The reinsurance recoverable is based on what we believe are reasonable estimates and is disclosed separately in the consolidated financial statements. However, the ultimate amount of the reinsurance recoverable is not known until all claims are settled. We manage counterparty risk by entering into agreements with reinsurers we generally consider to be highly rated. However, we do not require a specified minimum rating. We monitor the concentrations of the reinsurers and reduce the participation percentage of lower-rated companies when appropriate. We believe we currently have no significant reinsurance amounts with any significant risk of becoming unrecoverable due to reinsurer insolvency. Some of our reinsurance contracts contain clauses that allow us to terminate the participation with reinsurers whose ratings are downgraded. Information used in our risk assessment is comprised of industry ratings, recent news and reports, and a limited review of financial statements. We also may require letters of credit, trust agreements, or cash advances from unauthorized reinsurers (reinsurers not licensed in our state of domicile) to fund their share of outstanding claims and CAE. Final assessment is based on the judgment of senior management. Other-Than-Temporary Impairment Our accounting policy requires that a decline in the fair value of investment securities below their cost basis be evaluated on an ongoing basis to determine if the decline is other-than-temporary. A number of assumptions and estimates inherent in evaluating impairments are used to determine if they are other-than-temporary which include 1) our ability and intent to hold the investment securities for a period of time sufficient to allow for an anticipated recovery in value; 2) the expected recoverability of principal and interest; 3) the length of time and extent to which the fair value has been less than cost basis; 4) the financial condition, near-term and long-term prospects of the issue or issuer, including relevant industry conditions and trends and implications of rating agency actions and offering prices; and 5) the specific reasons that a security is in a significant unrealized loss position, including market conditions, which could affect liquidity. Valuation of Financial Instruments The fair value of available-for-sale securities (equity and fixed maturity securities) is determined by management using one of the three primary sources of information, including the quoted prices in active markets, third-party pricing services and independent broker quotations. Estimated fair value of securities based on quoted prices in active markets are readily and regularly available; therefore, valuation of these securities generally does not involve management judgment. For securities priced using third-party pricing services, fair value measurements of securities are determined using the third-party pricing services' proprietary pricing applications. The typical inputs used by the third-party pricing services are relevant market information, benchmark curves, benchmark pricing of like securities, sector groupings and matrix pricing. Any securities remaining unpriced after utilizing the first two pricing methods are submitted to the independent brokers for prices. We have analyzed the third-party pricing services and independent brokers' valuation methodologies and related inputs, and have evaluated the various types of securities in our investment portfolio to determine an appropriate fair value hierarchy level based upon trading activity and the observability of market inputs. 43
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We utilize equity options as a means to hedge equity-indexed deferred annuity benefits. Equity-indexed deferred annuities include a fixed host annuity contract and an embedded equity derivative. The embedded derivative portion of the contract represents benefits in excess of fixed guarantees, and the host is associated with fixed guarantees. At issue, the value of the host contract equals the premium paid less the fair value of the embedded derivative. The initial host contract value is accreted to the fixed guaranteed value at end of the contract indexing term. The fair value of the embedded derivative is recalculated at each reporting period using the current contract values and option pricing assumptions. Interest credited is generally comprised of interest accruals to fixed deferred annuity account balances. In addition to the accrual of interest on the host contract, the gain or loss on the embedded equity derivative is also recognized as interest credited for equity-indexed deferred annuities. Embedded derivative gains and losses can introduce material fluctuations in interest credited from one period to the next. Pension and Postretirement Benefit Plans Our pension and postretirement benefit obligations and related costs are calculated using actuarial concepts in accordance with the relevant accounting guidance. The discount rate and the expected return on plan assets are important elements of expense and/or liability measurements. Each year, these key assumptions are reevaluated to determine whether they reflect the best estimates for the current period. Changes in the methodology used to determine the best estimates are made when facts or circumstances change, for example, a general decline or rise in interest rates that have not yet been reflected in the rates implicit in the current prices of annuity contracts. Other assumptions involve demographic factors such as retirement age, mortality, turnover and rate of compensation increases. We use a discount rate to determine the present value of future benefits on the measurement date. We are currently using a high-quality long-term corporate bond rate as our guideline for setting this rate. To determine the expected long-term rate of return on plan assets, a building-block method is used. The expected rate of return on each asset is broken down into three components: (1) inflation, (2) the real risk-free rate of return (i.e., the long-term estimate of future returns on default-free U.S. government securities), and (3) the risk premium for each asset class (i.e., the expected return in excess of the risk-free rate). Using this approach, the expected return derived will fluctuate somewhat from year to year; however, it is our policy to hold this long-term assumption relatively constant. The assumptions used in the measurement of our pension benefit obligations for 2011 and 2010 are as follows: Used for Net Used for Net Benefit Cost Used for Benefit Benefit Cost Used for Benefit for year ended Obligations as of for year ended Obligations as of December 31, 2011 December 31, 2011 December 31, 2010 December 31, 2010 Discount rate 5.34 % 4.19 % 6.17 % 5.34 % Rate of compensation increase 3.78 3.74 4.20 3.78 Long-term rate of return 7.65 7.67 7.65 7.65 Litigation Contingencies We review existing litigation and potential litigation with counsel quarterly to determine if an accrual of a liability for possible losses is necessary. Liabilities for contingent losses are established whenever they are probable and estimable based on our best estimate of the probable loss. If no one number within the range of possible losses is more probable than any other, we record a liability at the low end of the estimated range. Based on information currently available, we believe that amounts ultimately paid, if any, arising from existing and currently potential litigation would not have a material effect on our results of operations and financial condition. However, it should be noted that the frequency of large damage awards, which bear little or no relation to the economic damages incurred by plaintiffs, continue to create the potential for an unpredictable judgment in any given lawsuit. It is possible that, if the defenses in these lawsuits are not successful, and the judgments are greater than we anticipate, the resulting liability could have a material impact on the consolidated financial statements. See Note 20, Commitments and Contingencies, of the Notes to the Consolidated Financial Statements for additional details. 44
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Federal Income Taxes Our effective tax rate is based on income, non-taxable and non-deductible items, statutory tax rates and tax planning opportunities available. Inherent in determining our annual tax rate are judgments regarding business plans, planning opportunities and expectations about future outcomes. Deferred tax assets generally represent items that can be used as a tax deduction or credit in future years for which we have already recorded the tax benefit in our income statement. Deferred tax liabilities generally represent tax expenses recognized in our consolidated financial statements for which tax payment has been deferred, or expenditures for which we have already taken a deduction in our tax return but have not yet recognized in our consolidated financial statements. GAAP requires us to evaluate the recoverability of our deferred tax assets and establish a valuation allowance, if necessary, to reduce our deferred tax asset to an amount that is more-likely-than-not to be realized. Considerable judgment is required in determining whether a valuation allowance is necessary, and if so, the amount of such valuation allowance. Although realization is not assured, management believes it is more-likely-than-not that the deferred tax assets, net of valuation allowances, will be realized. Our accounting represents management's best estimate of future events that can be appropriately reflected in the accounting estimates. Certain changes or future events, such as changes in tax legislation, geographic mix of earnings and completion of tax audits could have an impact on our estimates and effective tax rate. For example, the dividends received deduction ("DRD") reduces the amount of dividend income subject to tax and is a significant component of the difference between our actual tax expense and the expected amount determined using the U.S. federal statutory tax rate of 35%.The U.S. Department of the Treasury and theIRS intend to address through regulations the methodology to be followed in determining the DRD related to variable life insurance and annuity contracts. A change in the DRD, including the possible retroactive or prospective elimination of this deduction through regulations or legislation, could increase our actual tax expense and reduce our consolidated net income. Our liability for income taxes includes the liability for unrecognized tax benefits, interest and penalties, that relate to tax years still subject to review by theIRS or other taxing authorities. Audit periods remain open for review until the statute of limitations has passed. The statute of limitations for the examination of federal income tax returns by theIRS for years 2006 to 2010 either has been extended or has not expired. In the opinion of management, all prior year taxes have been paid or adequate provisions have been made for any uncertain tax positions taken in prior year returns. 45
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Consolidated Results of Operations The following is a discussion of our consolidated results of operations. For discussions of our segment results, see the "Results of Operations and Related Information by Segment" section. The following table sets forth the consolidated results of operations (in thousands): Years ended December 31, Change over prior year 2011 2010 2009 2011 2010 Premiums and other revenues: Premiums $ 1,748,612 $ 1,877,908 $ 1,974,024 $ (129,296 ) $ (96,116 ) Other policy revenues 189,494 185,805 179,504 3,689 6,301 Net investment income 968,165 911,915 839,777 56,250 72,138 Realized investments gains (losses), net 90,866 74,062 (73,855 ) 16,804 147,917 Other income 25,890 23,491 21,291 2,399 2,200 Total premiums and other revenues 3,023,027 3,073,181 2,940,741
(50,154 ) 132,440
Benefits, losses and expenses: Policyholder benefits 480,063 500,125 547,428 (20,062 ) (47,303 ) Claims incurred 1,032,497 1,108,290 1,162,471 (75,793 ) (54,181 ) Interest credited to policyholder's account balances 405,083 393,119 370,563 11,964 22,556 Commissions for acquiring and servicing policies 430,310 446,463 457,989 (16,153 ) (11,526 ) Other operating expenses 462,470 462,656 476,165 (186 ) (13,509 ) Change in deferred policy acquisition costs (1) (41,107 ) (40,095 ) (63,611 ) (1,012 ) 23,516 Total benefits and expenses 2,769,316 2,870,558 2,951,005 (101,242 ) (80,447 ) Income (loss) before other items and federal income taxes $ 253,711 $ 202,623 $ (10,264 ) $ 51,088 $ 212,887 (1) A negative amount of net change indicates more expense was deferred than
amortized and represents a decrease to expenses in the periods indicated.
Consolidated earnings increased during 2011 compared to 2010 primarily as a result of:
• improved Property and Casualty segment results, and
• an increase in net investment income primarily due to an increase in
invested assets, • partially offset by a decrease in Life segment results.
Consolidated earnings increased during 2010 compared to 2009. The increase was primarily driven by the following:
• an increase in our Corporate and Other business segment's realized
investment gains and net investment income as a result of improved market
conditions, • a decrease in policy benefits across all segments, and
• a decrease in other operating costs and expenses in our Life and Health
segments,
• partially offset by a decrease in Life and Health segment premiums and an
increase in Annuity segment interest credited to policyholder account
balances ("interest credited").
In the Consolidated Results of Operations above and in the segment discussions that follow, certain amounts in the prior year have been reclassified to conform to the current year presentation. See Note 18, Segment Information, of the Notes to the Consolidated Financial Statements for additional details. 46
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Results of Operations and Related Information by Segment Life The Life segment markets traditional life insurance products such as whole life and term life, and interest-sensitive life insurance products such as universal life, variable universal life and indexed universal life. These products are marketed on a nationwide basis through career and multiple-line agents, as well as through direct marketing channels. Life segment financial results for the periods indicated were as follows (in thousands): Years ended December 31, Change over prior year 2011 2010 2009 2011 2010 Premiums and other revenues: Premiums $ 277,724 $ 282,160 $ 284,530 $ (4,436 ) $ (2,370 ) Other policy revenues 174,406 170,729 164,748 3,677 5,981
Net investment income 238,275 234,905 233,505
3,370 1,400 Other income 3,301 3,547 2,720 (246 ) 827 Total premiums and other revenues 693,706 691,341 685,503 2,365 5,838 Benefits, losses and expenses: Policyholder benefits 344,328 294,177 297,719 50,151 (3,542 ) Interest credited to policyholder's account balances 60,494 59,149 58,983 1,345 166 Commissions for acquiring and servicing policies 88,300 91,165 91,968 (2,865 ) (803 ) Other operating expenses 173,619 178,619 185,048 (5,000 ) (6,429 ) Change in deferred policy acquisition costs (1) (3,777 ) (1,963 ) 1,536
(1,814 ) (3,499 )
Total benefits and expenses 662,964 621,147 635,254
41,817 (14,107 )
Income before other items and federal income taxes $ 30,742 $ 70,194 $ 50,249 $ (39,452 ) $ 19,945 (1) A negative amount of net change indicates more expense was deferred than
amortized and represents a decrease to expenses in the periods indicated.
For the year endedDecember 31, 2011 , earnings decreased compared to 2010 as a result of an increase in policyholder benefits. This increase includes$26.6 million increase in claims not yet reported and$4.9 million increase in claims incurred or paid all due to a modification of our claim settlement procedures. Earnings for the year endedDecember 31, 2010 increased significantly compared to 2009 primarily due to an increase in other policy revenues, decreases in policy benefits and operating expenses and an increase in deferred policy acquisition costs. Operating expenses in 2010 were lower due to the absence of nonrecurring costs associated with the Company'sSEC registration and lower direct marketing expenses. The increase in other policy revenues was due to higher policy service fees on a growing block of interest-sensitive life policies. Premiums and other revenues Changes in premiums are primarily driven by new sales during the period, the persistency of in-force policies, and reinsurance activity. Premiums have decreased slightly each of the past two years. The decrease in 2011 compared to 2010 was primarily driven by higher reinsurance premiums due to increasing policy face values, and a decrease in the credit-related life products as a result of lower sales. The decrease during 2010 compared to 2009 was attributable to increasing Yearly-Renewable-Term renewal ceded reinsurance premiums on the higher face amounts issued in previous years. Other policy revenues include mortality charges, earned policy service fees, and surrender charges on interest-sensitive life insurance policies. These charges increased for the year endedDecember 31, 2011 and 2010 compared to each preceding year primarily due to higher policy service fees on a growing block of life policies. This increase reflects the continued growth in interest-sensitive life business. 47
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Benefits, losses and expenses Policyholder benefits increased for the year endedDecember 31, 2011 compared to 2010, primarily as the result of an increase in the estimate of claims incurred but not reported and an increase driven by higher mortality costs net of reinsurance, due to an increase in claims on larger face-value policies. During the year endedDecember 31, 2010 , policy holder benefits were relatively flat compared to 2009. During 2011, there was an emerging shift of view regarding claim processes from the long-standing practice that a claim must be filed by a beneficiary to a view that an insurer should actively seek possible beneficiaries by monitoring information of a policyholder's death. This type of information might be ascertainable using the U.S. Social Security Death Master File ("SSA Master File"). We modified our claims settlement procedures in the fourth quarter of 2011 to apply this perspective on a nationwide basis. This led to an increase in our IBNR life claims reserve of$26.6 million . We also paid or accrued additional benefits of$4.9 million during the fourth quarter of 2011 as a result of these new procedures. For additional information, see "Item 1A, Risk Factors." Other operating costs and expenses decreased for the year endedDecember 31, 2011 compared to 2010, and for the year endedDecember 31, 2010 compared to 2009. The decrease during 2011 was primarily the result of the release of a litigation liability. The decrease during 2010 was primarily due to reductions in consulting fees attributed to Sarbanes-Oxley andSEC registration, as well as marketing and legal expenses. The following table presents the components of the change in DAC (in thousands): Years ended December 31, Change over prior year 2011 2010 2009 2011 2010 Acquisition cost capitalized $ 79,653 $ 80,789 $ 77,161 $ (1,136 ) $ 3,628 Amortization of DAC (75,876 ) (78,826 ) (78,697 ) 2,950 (129 ) Change in deferred policy acquisition costs(1) $ 3,777 $ 1,963 $ (1,536 ) $ 1,814 $ 3,499 (1) A positive amount of net change indicates more expense was deferred than
amortized and represents a decrease to expenses in the periods indicated.
Acquisition costs capitalized decreased for the year endedDecember 31, 2011 compared to 2010 primarily as a result of the decrease in premiums. The increase during 2010 compared to 2009 was a result of non-commission related compensation. The decrease in the amortization of DAC during 2011 compared to 2010 was the result of a decrease in terminations and surrenders. The amortization of DAC was relatively flat during 2010 compared to 2009. Reinsurance The table below summarizes reinsurance reserves and premium amounts assumed and ceded (in thousands): Reserves Premiums December 31, Years ended December 31, 2011 2010 2009 2011 2010 2009
Reinsurance assumed
2,974 $ 5,716 $ 9,038 Reinsurance ceded (188,812 ) (173,097 ) (160,934 ) (92,208 ) (90,459 ) (81,122 ) Total $ (184,494 ) $ (163,270 ) $ (141,420 ) $ (89,234 ) $ (84,743 ) $ (72,084 ) 48
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We use reinsurance to mitigate excessive risk to the Life segment. As ofDecember 31, 2011 , our retention limits were$2,350,000 for issue ages 65 and under, and$1,550,000 for issue ages 66 and older, for traditional and universal life, as compared to a single limit of$1,550,000 as ofDecember 31, 2010 . Accidental death benefits and premium waiver benefits are mostly retained on new business issued beginning in 2008. Increases in reserves and premium amounts ceded primarily reflect increased use of reinsurance in conjunction with treaties related to universal life products. Decreases in assumed reserves and premium were primarily due to the cancellation of our reinsurance agreement with two credit life reinsurers. Those blocks of business are now in run-off, and the new business retained is currently written by us on a direct basis. We periodically adjust our reinsurance program and retention limits as market conditions warrant, consistent with our corporate risk management strategy. While, in the past, we have reinsured up to 90% of new business, we are currently reinsuring newly developed permanent products on a modified excess retention basis, in which we reinsure mortality risk on a yearly renewable term basis, ceding a 75% quota share of policies with a face value of at least$500,000 up to our retention and then a 100% quota share in excess of retention. Term products are coinsured between 60% and 100% on a first-dollar quota share basis. Current traditionally marketed term products are coinsured on a 90% quota share basis, while current direct-marketed products are coinsured on a 60% basis, up to our retention, and then a 100% quota share in excess of retention. Reinsurance is used in the credit life business primarily to provide producers of credit-related insurance products the opportunity to participate in the underwriting risk through offshore producer-owned captive reinsurance companies. A majority of the treaties entered into by our Credit Insurance Division are written on a 100% coinsurance basis with benefit limits of$100,000 on credit life. We have entered into funds withheld reinsurance treaties, which are ceded to the reinsurer on a written basis. Our individual life reinsurance is primarily placed with highly rated companies, and we monitor the financial condition of those companies. For 2011, the companies where we have placed material amounts of reinsurance for the Life segment are shown in the table below (in thousands, except percentages): A.M. Best Ceded Percentage of Reinsurer Rating(1) Premium Gross Premium Swiss Re Life and Health America Inc. A+ $ 23,759 6.4 % Munich American Reassurance Company A+ 12,637 3.4 Transamerica Life Insurance Company A+ 9,362 2.5 Reinsurance Group of America (RGA Reinsurance Company) A+ 8,351 2.3 Canada Life Reinsurance A+ 6,338 1.7 SCOR Global Life Re Insurance Company of Texas A 5,543 1.5 Other Reinsurers with no single company greater than 5% of the total ceded premium 26,218 7.1 Total life reinsurance ceded $ 92,208 24.9 %
(1)
Policy in-force information The following table summarizes changes in the Life segment's in-force amounts (in thousands): December 31, Change over prior year 2011 2010 2009 2011 2010 Life insurance in-force: Traditional life $ 46,484,826 $ 45,919,219 $ 45,229,407 $ 565,607 $ 689,812 Interest-sensitive life 23,671,800 23,879,283
24,218,843 (207,483 ) (339,560 )
Total life insurance in-force
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The following table summarizes changes in the Life segment's number of policies in-force:
December 31, Change Over Prior Year 2011 2010 2009 2011 2010 Number of policies in-force: Traditional life 2,204,187 2,274,144 2,347,423 (69,957 ) (73,279 ) Interest-sensitive life 178,595 176,160 174,738 2,435 1,422
Total number of policies 2,382,782 2,450,304 2,522,161
(67,522 ) (71,857 ) There was an increase in total life insurance in-force in 2011 compared to 2010. The increase in our traditional life products is believed to be the result of consumers seeking contract guarantees due to the economic environment in recent years. This increase was partially offset by a decrease in our interest-sensitive life policies as the result of lower prevailing interest rates. The decrease in our policy count is attributable to surrenders and lapses, as well as new business activity generally being comprised of fewer but larger face-value policies. There was a slight increase in total life insurance in-force in 2010 compared to 2009, as new policies issued exceeded the aggregate face amount of older policies terminated by death, lapse, or surrender. The decreasing policy count, from 2009 through 2010, is attributable primarily to the natural attrition of a larger number of older policies, partially offset by newer policies that are fewer in number but larger in face amount. 50
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Annuity
We offer a variety of immediate and deferred annuities. We sell these products through independent agents, brokers, and financial institutions, along with multiple-line and career agents. Annuity segment financial results for the periods indicated were as follows (in thousands):
Years ended December 31, Change over prior year 2011 2010 2009 2011 2010 Premiums and other revenues: Premiums $ 94,753 $ 174,193 $ 220,284 $ (79,440 ) $ (46,091 ) Other policy revenues 15,088 15,076 14,756 12 320
Net investment income 577,707 535,581 471,192
42,126 64,389 Other income 250 607 373 (357 ) 234 Total premiums and other revenues 687,798 725,457 706,605
(37,659 ) 18,852
Benefits, losses and expenses: Policyholder benefits 135,735 205,948 249,709 (70,213 ) (43,761 ) Interest credited to policyholder's account balances 344,589 333,970 311,580 10,619 22,390 Commissions for acquiring and servicing policies 94,851 95,701 107,053 (850 ) (11,352 ) Other operating expenses 72,325 71,298 63,497 1,027 7,801 Change in deferred policy acquisition costs (1) (29,554 ) (44,569 ) (62,013 )
15,015 17,444
Total benefits and expenses 617,946 662,348 669,826
(44,402 ) (7,478 )
Income before other items and federal income taxes $ 69,852 $ 63,109 $ 36,779 $ 6,743 $ 26,330 (1) A negative amount of net change indicates more expense was deferred than
amortized and represents a decrease to expenses in the periods indicated.
Earnings increased for the year endedDecember 31, 2011 compared to 2010 primarily as the result of the growth in net investment income outpacing the growth in interest credited. Additionally, a previously disclosed litigation matter impacted other operating expenses during 2011, and without this accrual, earnings would have increased$18.7 million compared to 2010. See Note 20, Commitments and Contingencies, of the Notes to the Consolidated Financial Statements for additional details. Earnings for the year endedDecember 31, 2010 improved significantly when compared to 2009 primarily due to an increase in our net investment income offset by an increase in interest credited to policy account balances. Premiums and other revenues Annuity premium and deposit amounts received are shown in the table below (in thousands): Years ended December 31, Change over prior year 2011 2010 2009 2011 2010
Fixed deferred annuity
$ 424,730 $ (670,442 ) Single premium immediate annuity 159,824 177,688 227,937 (17,864 ) (50,249 ) Equity-indexed deferred annuity 142,526 340,920 239,664 (198,394 ) 101,256 Variable deferred annuity 99,224 90,188 99,429 9,036 (9,241 ) Total 1,871,733 1,654,225 2,282,901 217,508 (628,676 ) Less: policy deposits 1,776,980 1,480,032 2,062,617
296,948 (582,585 )
Total earned premiums
$ (79,440 ) $ (46,091 ) 51
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We monitor account values and changes in those values as a key indicator of the performance of our Annuity segment. Changes in account values are mainly the result of net inflows, surrenders, policy fees, interest credited and market value changes (in thousands): Years endedDecember 31, 2011 2010
2009
Fixed deferred annuity:
Account value, beginning of period $ 9,006,692 $ 8,151,365 $ 6,918,365 Net inflows 1,349,874 1,180,826 1,751,397 Surrenders (863,590 ) (652,519 ) (820,980 ) Fees (10,146 ) (10,080 ) (10,592 ) Interest credited 341,586 337,100 313,175
Account value, end of period
Single premium immediate annuity: Reserve, beginning of period $ 903,126 $ 820,295 $ 701,141 Net inflows 32,167 42,502 84,785 Interest and mortality 43,429 40,329 34,369 Reserve, end of period $ 978,722 $ 903,126 $ 820,295 Variable deferred annuity: Account value, beginning of period $ 415,757 $ 400,624 $ 309,011 Net inflows 88,044 86,528 98,312 Surrenders (112,221 ) (114,320 ) (77,860 ) Fees (4,786 ) (4,795 ) (4,096 ) Change in market value and other (6,665 ) 47,720 75,257 Account value, end of period $ 380,129 $ 415,757 $ 400,624 Fixed deferred annuity deposits increased significantly for 2011 compared to 2010. The increase was primarily a result of our marketing efforts to expand distribution through new accounts. Fixed deferred annuity receipts decreased for the year endedDecember 31, 2010 compared to 2009, which had abnormally high sales in the first quarter of 2009 due to a "flight to safety" related to the credit crisis of late 2008. Equity-indexed fixed annuities, which are included as fixed deferred annuities in the account values table, allow policyholders to participate in equity returns while also having certain downside protection resulting from guaranteed minimum crediting rates. Deposits for this product decreased during 2011 compared to the same period in 2010. We believe this decrease was primarily due to lower fixed investment yields resulting in lower declared indexed crediting terms. Deposits increased for the year endedDecember 31, 2010 compared to 2009 as certain annuitants accepted some exposure to volatility in the pursuit of potentially higher returns. Single premium immediate annuities ("SPIA") decreased for 2011 and 2010 compared to their preceding years. Premiums for this product have decreased primarily as a result of lower investment yields, restraining demand for this product in anticipation of increased income payments in the future. We believe that the current low interest rate environment has led some prospective SPIA buyers to defer their purchase of a payout annuity and temporarily invest in cash and cash equivalents, in the hope that rates will be higher at a later date, affording a higher annuity payment per premium dollar. Variable deferred annuity products are a relatively small portion of our annuity portfolio. 52
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Benefits, losses and expenses Benefits consist of annuity payments and reserve increases on SPIA sales classified as insurance contracts. Benefits decreased for the years endedDecember 31, 2011 and 2010, compared to the previous years. The changes in benefits are consistent with the changes in total earned premium in the current and comparable periods. Commissions remained flat in 2011 and decreased for the year endedDecember 31, 2010 compared to 2009, primarily due to fluctuations in sales and the shifting of the product mix each year. The change in DAC represents acquisition costs capitalized, net of amortization of existing DAC. The amortization of DAC is calculated in proportion to gross profits. The following table presents the components of the change in DAC (in thousands): Years ended December 31, Change over prior year 2011 2010 2009 2011 2010 Acquisition cost capitalized $ 118,011 $ 117,090 $ 126,769 $ 921 $ (9,679 ) Amortization of DAC (88,457 ) (72,521 ) (64,756 )
(15,936 ) (7,765 )
Change in deferred policy acquisition costs(1) $ 29,554 $ 44,569 $ 62,013 $ (15,015 ) $ (17,444 ) (1) A positive amount of net change indicates more expense was deferred than amortized and is a decrease to expense in the periods indicated. An important measure of the Annuity segment is amortization of DAC as a percentage of gross profits. The amortization of DAC as a percentage of gross profits for the years endedDecember 31, 2011 , 2010, and 2009 was 42.6%, 39.1%, and 44.6%, respectively. The increase in the ratio during 2011 compared to 2010, was the result of a decline in persistency during the year due to an increase in terminations and surrenders. Conversely, the decrease during 2010 compared to 2009 was the result of improved persistency from fewer terminations and surrenders. Options and Derivatives Shown below is the analysis of the impact to net investment income of the option return, along with the impact to interest credited of the equity-indexed annuity embedded derivative (in thousands): Years ended December 31, Change over prior year 2011 2010 2009 2011 2010 Net investment income Without option return $ 581,373 $ 523,373 $ 466,546 $ 58,000 $ 56,827 Option return (3,666 ) 12,208 4,646
(15,874 ) 7,562
Interest credited to policy account balances Without embedded derivative 352,410 327,366 303,442 25,044 23,924 Equity-indexed annuity embedded derivative (7,821 ) 6,604 8,138 (14,425 ) (1,534 ) 53
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Net investment income without option return, as well as the related interest credited without equity-indexed return, increased during the year endedDecember 31, 2011 compared to 2010, as well as in 2010 compared to 2009. The increases were due to increases in aggregate annuity account values from each year's sales. The overall increase in the investment asset base attributed to annuities was 9.2% and 13.9% during the years endingDecember 31, 2011 and 2010, respectively. Option return, as well as the related equity-indexed-annuity embedded derivative return, decreased during 2011 compared to 2010 due to the lack of a return in the S&P 500 Index during 2011, compared to the 12.8% gains during 2010. Option return increased during 2010 compared to 2009 due to the aforementioned increase to the S&P500 index during 2010. The related equity-indexed annuity embedded derivative return, however, decreased as a result of surrenders during 2009 participating in the return, whereas in recent years surrenders did not participate in this return. Reinsurance We employ reinsurance for guaranteed minimum death benefit risks on certain variable annuity contracts. Our maximum guaranteed minimum death benefit exposure, before reinsurance, which represents the total exposure in the event that all annuity policyholders die, was$3.9 million and$3.0 million as ofDecember 31, 2011 and 2010, respectively. After reinsurance, the net amounts at risk were$1.3 million and$1.1 million , as ofDecember 31, 2011 and 2010, respectively. All such guaranteed minimum death benefit reinsurance is with reinsurers rated "A" or higher byA.M. Best . 54
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Health
The Health segment primarily focuses on supplemental and limited benefit coverage products including Medicare Supplement insurance for the senior market as well as hospital surgical and cancer policies for the general population. For the year endedDecember 31, 2011 , premium volume was concentrated in our Medicare Supplement (43.5%) and medical expense (20.4%) lines. Our other health products include credit accident and health policies and other limited benefit coverages. Health products are distributed through a network of independent agents and MGUs. Health segment results for the periods indicated were as follows (in thousands): Years endedDecember 31 ,
Change over prior year
2011 2010 2009 2011 2010 Premiums and other revenues: Premiums $ 231,793 $ 263,294 $ 309,701 $ (31,501 ) $ (46,407 ) Net investment income 13,413 15,492 16,564 (2,079 ) (1,072 ) Other income 13,356 10,384 10,382 2,972 2 Total premiums and other revenues 258,562 289,170 336,647
(30,608 ) (47,477 )
Benefits, losses and expenses: Claims incurred 159,289 184,554 239,407 (25,265 ) (54,853 ) Commissions for acquiring and servicing policies 25,808 35,263 51,717 (9,455 ) (16,454 ) Other operating expenses 47,169 49,634 62,134 (2,465 ) (12,500 ) Change in deferred policy acquisition costs (1) 9,144 4,886 5,017 4,258 (131 ) Total benefits and expenses 241,410 274,337 358,275
(32,927 ) (83,938 )
Income before other items and federal income taxes $ 17,152 $ 14,833 $ (21,628 ) $ 2,319 $ 36,461 (1) A negative amount of net change indicates more expense was deferred than
amortized and represents a decrease to expenses in the periods indicated.
Earnings increased for the year endedDecember 31, 2011 as compared to 2010 driven primarily by an increase in other income comprised of fee income associated with high sales by a new MGU. Also, a decrease in the benefit ratio for the health segment contributed to the increase in earnings. The increase in earnings was partially offset by the discontinuation of sales of our medical expense insurance plans effectiveJune 30, 2010 . Additionally, sales of our Medicare Supplement product decreased due to stringent competition. Earnings increased for the year endedDecember 31, 2010 as compared to 2009 primarily due to a decline in the benefit ratio. A lower expense ratio, associated with lower personnel costs, also contributed to the improvement in earnings. A decrease in premiums resulting from a reduction of in-force policies partially offset the improvement in earnings. Both year over year comparisons were impacted by the continued diminishment in the size of the health block due to the discontinuation of medical expense insurance sales and slow Medicare Supplement sales attributable to the current extremely competitive Medicare Supplement market. 55
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Premiums and other revenues Health premiums for the periods indicated are as follows (in thousands, except percentages): Years ended December 31, 2011 2010 2009 dollars percentage dollars percentage dollars percentage Medicare Supplement $ 100,924 43.6 % $ 117,132 44.5 % $ 123,102 39.7 % Medical expense 47,323 20.4 67,050 25.5 80,716 26.1 Group 33,906 14.6 29,343 11.1 33,484 10.8 Credit accident and health 19,897 8.6 21,553 8.2 19,627 6.3 MGU 13,681 5.9 11,173 4.2 34,015 11.0 All other 16,062 6.9 17,043 6.5 18,757 6.1 Total $ 231,793 100.0 % $ 263,294 100.0 % $ 309,701 100.0 % The Health segment's earned premiums decreased during the year endedDecember 31, 2011 as compared to 2010 primarily due to the discontinuation of sales of our medical expense insurance plans effectiveJune 30, 2010 . In-force policies continue to lapse and this produced the reduction in premiums. Due to the competitive nature of the market, sales of our Medicare Supplement product also decreased. Additionally, our credit accident and health premiums decreased primarily due to a decrease in new business related to short-term financing. Premiums decreased during the year endedDecember 31, 2010 as compared to 2009, which was mainly attributable to the discontinuation of sales of our medical expense insurance plans effectiveJune 30, 2010 . Additionally, the decrease was driven by the non-renewal of two MGU's, decreased sales of ourMedicare Supplement product, and the recording in 2009 of a one-time premium associated with the unwinding of an MGU. Our in-force certificates or policies as of the dates indicated are as follows: December 31, 2011 2010 2009 number percentage number percentage number percentage Medicare Supplement 42,760 6.8 % 48,584 7.7 % 58,627 8.6 % Medical expense 7,962 1.3 11,057 1.8 18,368 2.7 Group 20,122 3.2 20,893 3.3 23,890 3.5 Credit accident and health 271,700 43.3 294,702 46.6 309,695 45.5 MGU 147,251 23.5 103,666 16.4 106,617 15.6 All other 137,596 21.9 152,917 24.2 164,118 24.1 Total 627,391 100.0 % 631,819 100.0 % 681,315 100.0 % In-force policies increased in 2011 compared to 2010 due to an increase in MGU production. The MGU line increased due to the addition of a new MGU, which produced a significant policy count increase. The "all other" line is composed of closed blocks of business, and has no new sales.The MGU and Group counts include 100% reinsured certificates, which is a rapidly growing block of business. The increases in these 100% reinsured certificates will not translate into corresponding increases in premiums. Our total in-force policies had a net decrease during the year endedDecember 31, 2010 as compared to 2009. The decrease was mainly attributed to a decrease in the credit accident and health line due to a decrease in our short-term furniture and finance company credit products. Also contributing to the decrease in the in-force policies were the decrease in ourMedicare Supplement line production resulting from current market conditions and a decrease in our medical expense line as a result of discontinuance of sales. 56
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Benefits, losses and expenses Claims incurred decreased during the year endedDecember 31, 2011 compared to the same period in 2010. The decrease was primarily the result of a decline in sales of our two largest health lines, our medical expense insurance plans and Medicare Supplement products. The decline in claims incurred was consistent with lower premiums and lower commissions. Additionally, the medical expense benefit ratio, measured as the ratio of claims and other benefits to premiums, decreased to 68.7% for the year endedDecember 31, 2011 , from 70.1% for the same period in 2010. This was driven primarily by a significant decrease in claims in 2011 as compared to 2010. In 2010, a reduction in the medical expense benefit ratio, the loss of two MGUs, and the discontinuance of medical expense sales produced a decrease in benefits. The medical expense benefit ratio, measured as the ratio of claims and other benefits to premiums, decreased to 70.1% for the year endedDecember 31, 2010 , from 77.3% for the same period in 2009. Unexpected high claim payments on medical expense products in 2009, with a subsequent return to lower levels during 2010, contributed to the decrease in the benefit ratio. Commissions decreased for the year endedDecember 31, 2011 compared to the same period in 2010, as a result of lower sales, consistent with lower premiums. Commissions decreased during the year endedDecember 31, 2010 compared to 2009 as a result of lower sales and a large ceded commission in the MGU line in 2009 that did not occur in 2010. Other operating costs and expenses for the year endedDecember 31, 2011 as compared to 2010 were substantially unchanged. Other operating costs and expenses decreased for the year endedDecember 31, 2010 compared to 2009, which was mainly attributable to lower payroll costs and a one-time write-off of agent balances in 2009. Change in Deferred Policy Acquisition Costs The following table presents the components of the change in DAC (in thousands): Years ended December 31, Change over prior year 2011 2010 2009 2011 2010 Acquisition cost capitalized $ 11,893 $ 18,087 $ 16,729 $ (6,194 ) $ 1,358 Amortization of DAC (21,037 ) (22,973 ) (21,746 )
1,936 (1,227 )
Change in deferred policy acquisition costs(1) $ (9,144 ) $ (4,886 ) $ (5,017 ) $ (4,258 ) $ 131 (1) A negative amount of net change indicates less expense was deferred than
amortized and represents an increase to expenses in the periods indicated.
Acquisition cost capitalized decreased for the year endedDecember 31, 2011 compared to 2010. The decrease in DAC was caused by the overall decrease in sales and resulting decrease in commissions. For the year endedDecember 31, 2010 compared to 2009, the change in deferred policy acquisition costs was insignificant. Reinsurance For the major medical business, we use reinsurance on an excess of loss basis. Our retention limit is$500,000 per claim on these types of policies. Certain amounts of stop-loss and other types of catastrophe health reinsurance programs are also reinsured. We manage these risks by reinsuring a majority of the risk to highly rated reinsurance companies. We maintain reinsurance on a quota share basis for our long-term care and disability income business. 57
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Reinsurance is used in the credit accident and health business. In certain cases, particularly in the auto retail market, we may also reinsure the policy written through offshore producer-owned captive reinsurers to allow the dealer to participate in the performance of these credit accident and health contracts. A majority of the treaties entered into by our Credit Insurance Division are written on a 100% coinsurance basis with benefit limits of$1,000 per month. The companies where we have placed material amounts of reinsurance for the Health segment are shown in the table below (in thousands, except percentages): A.M. Best Ceded Percentage of Reinsurer Rating(1) Premium Gross Premium United States Fire Insurance Company A $ 39,845 10.1 % American Healthcare Indemnity Company B++ 28,263 7.2 Topanga Reinsurance NR 14,127 3.6 WFI Reinsurance Company, Ltd. NR 12,274 3.1 Transatlantic Reinsurance A 11,399 2.9 Other reinsurers with no single company greater than 5.0% of the total ceded premium 56,075 14.2 Total health reinsurance ceded $ 161,983 41.1 %
(1) A.M.Best rating as of the most current information available
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Property and Casualty Property and Casualty business is written primarily by our exclusive Multiple-Line agents and through our Credit Insurance Division agents. Property and Casualty segment results for the periods indicated were as follows (in thousands, except percentages): Years ended December 31, Change over prior year 2011 2010 2009 2011 2010 Premiums and other revenues: Net premiums written $ 1,137,445 $ 1,154,415 $ 1,152,840
$ (16,970 )
Net premiums earned
$ (13,919 ) $ (1,248 ) Net investment income 72,071 72,620 71,368 (549 ) 1,252 Other income 6,003 5,778 5,112 225 666 Total premiums and other revenues 1,222,416 1,236,659 1,235,989 (14,243 ) 670 Benefits, losses and expenses: Claims incurred 873,208 923,736 923,064 (50,528 ) 672 Commissions for acquiring and servicing policies 221,351 224,334 207,251 (2,983 ) 17,083 Other operating expenses 124,336 124,410 124,266 (74 ) 144 Change in deferred policy acquisition costs (1) (16,920 ) 1,551 (8,151 ) (18,471 ) 9,702 Total benefits and expenses 1,201,975 1,274,031 1,246,430 (72,056 ) 27,601 Income (loss) before other items and federal income taxes $ 20,441 $ (37,372 ) $ (10,441 ) $ 57,813 $ (26,931 ) Loss ratio 76.3 % 79.8 % 79.6 % (3.5 ) 0.2 Underwriting expense ratio 28.7 30.2 27.9 (1.5 ) 2.3 Combined ratio 105.0 % 110.0 % 107.5 % (5.0 ) 2.5 Impact of catastrophe events on combined ratio 11.4 10.8 7.8 0.6 3.0 Combined ratio without impact of catastrophe events 93.6 % 99.2 % 99.7 % (5.6 ) (0.5 ) Gross catastrophe losses $ 217,851 $ 141,685 $ 80,866 $ 76,166 $ 60,819 Net catastrophe losses 120,628 123,239 90,253 (2,611 ) 32,986 (1) A negative amount of net change indicates more expense was deferred than
amortized and represents a decrease to expenses in the periods indicated.
The Property and Casualty segment earnings improved during the year endedDecember 31, 2011 compared to 2010 primarily due to improvements in pricing adequacy, improvements to our reinsurance programs which provided an increase in recoveries on catastrophe losses in excess of additional reinsurance premium paid, and to a lesser extent strong management of our expenses resulting in a net improvement to earnings. The Property and Casualty segment earnings deteriorated significantly during the year endedDecember 31, 2010 compared to 2009. The decline was primarily driven by a$33.0 million increase in net catastrophe losses which was offset by a$32.3 million improvement in non-catastrophe loss results, an increase in commissions, and an increase in deferred policy acquisition expense. Premiums and other revenues Both net premiums written and earned decreased during the year endedDecember 31, 2011 compared to 2010. The decrease is primarily due to an increase in catastrophe reinsurance reinstatement premiums and decreased premiums across personal lines of business due to a decline in policies in-force, partially offset by increased premium per exposure. Our catastrophe reinsurance reinstatement premium increased by$9.0 million over the same period in 2010 as the result of higher catastrophe reinsurance recoveries in 2011 compared to 2010. Net premiums written increased for the year endedDecember 31, 2010 compared to 2009, primarily due to increases in our personal auto products partially offset by decreases in our commercial lines. Net premiums written and earned remained relatively flat during 2010 compared to 2009 primarily due to increases in our personal lines, partially offset by decreases in our commercial lines. 59
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Benefits, losses and expenses Claims incurred decreased for the year endedDecember 31, 2011 compared to 2010. The decrease was attributable to a decline in losses in all lines except agribusiness and other personal lines. Claims incurred remained flat during the year endedDecember 31, 2010 compared to 2009 as a result of the net catastrophe experience increase over the prior year, offset by the decreases in our credit-related property products and non-catastrophe loss experience. Gross catastrophes for the year endedDecember 31, 2011 were$217.9 million , compared to$141.7 million for the same period in 2010. Although we experienced a significant increase in our gross catastrophe losses, our improved reinsurance program mitigated the impact, providing a significant increase in catastrophe reinsurance recoveries in 2011 compared to 2010. The additional catastrophe reinsurance recovery was attributable to lower catastrophe loss retentions and an aggregate property catastrophe excess reinsurance contract placed during 2011. While the frequency of catastrophe events in 2011 was two fewer than 2010, gross catastrophe losses increased primarily from the severity of the catastrophe events over 2011. The 2011 catastrophe activity includes a record number of tornados, including two events which impacted primarilyAlabama in late April, andJoplin, Missouri in May. These two events alone accounted for$102.6 million in gross catastrophe losses and$30.5 million in net catastrophe losses during 2011. For the year endedDecember 31, 2010 , gross catastrophe losses increased to$141.7 million compared to$80.9 million in 2009 as a result of 33 catastrophes experienced in 2010 compared to 27 in 2009. The combined ratio, excluding the impact of catastrophe events, improved to 93.6% for the year endedDecember 31, 2011 compared with 99.2% and 99.7% for 2010 and 2009, respectively. This was primarily driven by an improvement in rate adequacy. Inherent to our fundamental risk management practices, we continue to evaluate and manage our aggregate catastrophe risk exposure with risk selection and reinsurance coverage. Commissions remained flat for the year endedDecember 31, 2011 but increased significantly during the year endedDecember 31, 2010 compared to the same period in 2009. This was primarily the result of a one time expense of$10.0 million related to a revision in our post termination compensation for certain agents, as well as increases in our credit-related property products due to a change in our product mix. Excluding this one time expense, commissions throughDecember 31, 2011 increased from 2010 due to an increase in commissions on our credit-related property products. The decrease in expense as a result of the change in DAC for the year endedDecember 31, 2011 compared to 2010 is attributable to a shift in our credit-related property products from shorter duration products to longer duration products. The increase in expense as a result of the change in DAC for the year endedDecember 31, 2010 , was primarily driven by the change in our deferral estimates during 2009 to improve our consistency among subsidiaries. An increase in commissions on our credit-related property insurance products added to this increase. We regularly review the recoverability of DAC, and if the actual emergence of future profitability were to be substantially lower than estimated, we would accelerate DAC amortization to account for any recoverability issues or premium deficiency. We have not historically experienced these issues with our DAC balances. 60
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Products
Our Property and Casualty segment consists of three product lines: (i) Personal Lines, which we market primarily to individuals, represent 61.0% of net premiums written, (ii) Commercial Lines, which focus primarily on agricultural and other targeted commercial markets, represent 26.9% of net premiums written, and (iii) Credit-related property insurance products, which are marketed to and through financial institutions and retailers, and represent 12.1% of net premiums written. Personal Products Property and Casualty segment results for Personal Products for the periods indicated were as follows (in thousands, except percentages): Years ended December 31, Change over prior year 2011 2010 2009 2011 2010 Net premiums written Auto $ 444,454 $ 468,100 $ 456,960 $ (23,646 ) $ 11,140 Homeowner 213,513 217,785 217,963 (4,272 ) (178 ) Other Personal 35,691 38,875 38,815 (3,184 ) 60
Total net premiums written 693,658 724,760 713,738
(31,102 ) 11,022 Net premiums earned Auto 463,171 470,535 452,754 (7,364 ) 17,781 Homeowner 217,619 216,849 208,558 770 8,291 Other Personal 36,173 39,298 37,283 (3,125 ) 2,015
Total net premiums earned
$ (9,719 ) $ 28,087 Loss ratio Auto 75.7 % 78.0 % 83.9 % (2.3 ) (5.9 ) Homeowner 102.1 104.1 100.6 (2.0 ) 3.5 Other Personal 67.8 61.6 44.9 6.2 16.7 Personal line loss ratio 83.3 % 84.9 % 86.8 % (1.6 ) (1.9 ) Combined Ratio Auto 96.6 % 102.3 % 104.9 % (5.7 ) (2.6 ) Homeowner 125.7 129.6 122.8 (3.9 ) 6.8 Other Personal 89.6 68.7 51.3 20.9 17.4
Personal line combined ratio 105.0 % 108.6 % 107.4 %
(3.6 ) 1.2 Personal Automobile: Net premiums written and earned decreased in our personal automobile line during 2011 compared to 2010, due to a decline in policies in-force resulting from a competitive marketplace and lower new business sales. Net premiums written and earned increased in our personal automobile line during 2010 as a result of premium rate increases implemented during the second half of 2009. The increase in premium per policy is slightly offset by a decline in the policies in-force. Average premium per policy increased during the periods 2009 through 2011, driven by improving rate adequacy, resulting in an improvement in the loss and combined ratios. The combined ratio improved for the year ended 2011 compared to 2010 due to the previously mentioned increase in commissions in 2010 that was not incurred in 2011 and improvement in the loss ratio. The 2010 combined ratio improved over the 2009 combined ratio from the improved loss ratio offset by the increase in commissions. The combined industry ratios for 2011 (estimated), 2010, and 2009 of 100.8%, 101.0%, and 101.3%, respectively, perA.M. Best's "U.S. Property/Casualty-Review and Preview" showed an improvement of 0.5 points over the three year period, while our combined ratio showed an improvement of 8.3 points over the same three year period. Homeowners: Net premiums written decreased through the year endedDecember 31, 2011 compared to 2010 attributable to increased catastrophe reinsurance reinstatement premiums as a result of higher catastrophe reinsurance losses ceded and a decline in policies in-force, partly offset by an increase in our average premium per policy due to rate activity. Net premiums written remained relatively flat during 2010 compared to 2009. 61
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Net premiums earned remained relatively flat during 2011 compared to 2010, and increased during the year endedDecember 31, 2010 compared to 2009. The increase in 2010 was due to an increase in net written premiums in the previous year as a result of rate increases across this product line, and were partially offset by a decline in the number of policies from our risk management initiatives and the impact of the rate increases. The loss and combined ratios improved slightly during the year endedDecember 31, 2011 compared to 2010 primarily due to improved rate adequacy. The loss and combined ratios deteriorated during the year endedDecember 31, 2010 compared to the same period in 2009 due to increases in the frequencies of both catastrophe and non-catastrophe claims, as well as increases in the average loss severity, resulting in a total increase of$15.9 million in policy benefits. The additional increase in the 2010 combined ratio was a result of the lower amount of expenses being deferred as previously mentioned. The combined ratios for the industry perA.M. Best for 2011 (estimated), 2010 and 2009 were 123.7%, 106.7% and 105.8%, respectively. Our 2011 combined ratio is comparable to the industry average, whereas 2010 and 2009 were 22.9 points and 17.0 points above the industry averages, respectively. Our combined ratio for the prior years was negatively impacted due to the concentration of catastrophe events occurring in the Midwest, and was also negatively impacted in 2010 from an unusual$20.0 million catastrophe event inArizona . Other Personal: This product line is comprised primarily of watercraft, rental-owner and umbrella coverages for individuals seeking to protect their personal property not covered within their homeowner and auto policies. Net premiums written and earned decreased during the year endedDecember 31, 2011 compared to 2010 due to a decline in policies in-force. Premiums generally trend with the homeowners and personal automobile lines as policies are typically sold in conjunction with one another. The loss ratio increased throughDecember 31, 2011 compared to 2010 primarily due to a decrease in premiums while claims remained consistent with the prior year. The combined ratio for this same period increased as a result of a change in our expense allocation, which resulted in higher expense being allocated to this line of business. The loss and combined ratios deteriorated during 2010 compared to 2009 due to an increase in the severity of claims. As this is currently our smallest line of business in our Personal Products line, minor fluctuations in results can more easily cause volatility in these ratios than with larger lines. 62
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Commercial Products Property and Casualty segment results for Commercial Products for the periods indicated were as follows (in thousands, except percentages): Years ended December 31, Change over prior year 2011 2010 2009 2011 2010 Net premiums written Other Commercial $ 126,013 $ 123,605 $ 127,292 $ 2,408 $ (3,687 ) Agribusiness 98,152 103,937 101,074 (5,785 ) 2,863 Auto 82,266 80,109 88,642 2,157 (8,533 ) Total net premiums written 306,431 307,651 317,008 (1,220 ) (9,357 ) Net premiums earned Other Commercial 121,420 120,365 125,855 1,055 (5,490 ) Agribusiness 102,946 106,678 105,921 (3,732 ) 757 Auto 84,201 80,948 91,074 3,253 (10,126 ) Total net premiums earned $ 308,567 $ 307,991 $ 322,850 $ 576 $ (14,859 ) Loss ratio Other Commercial 66.2 % 82.9 % 76.9 % (16.7 ) 6.0 Agribusiness 118.2 108.3 90.1 9.9 18.2 Auto 60.8 72.9 74.3 (12.1 ) (1.4 ) Commercial line loss ratio 82.1 % 89.1 % 80.5 % (7.0 ) 8.6 Combined ratio Other Commercial 94.4 % 112.1 % 106.4 % (17.7 ) 5.7 Agribusiness 155.0 145.2 126.8 9.8 18.4 Auto 83.0 97.2 96.9 (14.2 ) 0.3 Commercial line combined ratio 111.5 % 119.6 % 110.4 % (8.1 ) 9.2 Other Commercial: Net written and earned premiums increased through 2011 compared to 2010 primarily as a result of rate increases in the workers' compensation product, whereas 2010 decreased from 2009 as a result of the decline in premiums from our workers' compensation and small business owner products. The premiums for our workers' compensation product decreased because of a reduction in exposures and overall rate levels, as well as a decrease in the premium assumed from involuntary pools. Our small business premiums declined primarily as a result of lower receipts for some of our client's businesses, as well as a lowering premium per policy as businesses reduced coverages and increased deductibles in an effort to reduce their costs. The loss and combined ratios improved during 2011 compared to 2010. This improvement is the result of lower claim severity in the workers' compensation products, resulting in a$15.3 million decrease to benefits during 2011. The loss and combined ratios deteriorated during 2010 compared to 2009 due to the decreases in premiums in addition to increases in the severity of workers' compensation claims as payrolls contracted. Agribusiness Product: Our agribusiness product allows policyholders to customize and combine their coverage for residential and household contents, buildings and building contents, farm personal property and liability. Net premiums written and earned decreased for the year endedDecember 31, 2011 compared to the same period in 2010. The decrease was due to a decrease in policies in-force as the result of non-renewing certain policies in unprofitable segments and catastrophe reinsurance reinstatement premiums that were not incurred in 2010. The loss and combined ratios have increased over the years primarily as the result of increases in catastrophe losses and the frequency and severity of non-catastrophe losses. The frequency and severity of storms and weather related events continue to cause variability in this line of business. Commercial Automobile: Net premiums written and earned increased during 2011 compared to 2010. The increase was primarily the result of a vehicle reclassification revision adjustment that resulted in refunds to policyholders in 2010 that did not occur in 2011. The increase was offset by a reduction in polices in-force from our primary lines and improved selective underwriting. Net premium written and earned decreased in 2010 as compared to 2009 primarily from the result of the previously mentioned vehicle classification revisions. 63
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This product line experienced a decrease in losses incurred during 2011 compared to 2010 due to a decrease in the frequency and severity of claims, which resulted in an improvement in the loss and combined ratios during the period. The loss and combined ratios remained relatively flat during 2010 compared to 2009. The combined industry ratios perA.M. Best for 2011 (estimated), 2010, and 2009 were 102.6%, 98.0% and 99.4%, respectively. The 2011 combined ratio was below the estimated industry average by 19.6 points and was comparable to 2010 and 2009 results. Credit Products Credit-related property products for the periods indicated were as follows (in thousands, except percentages): Years ended December 31, Change over prior year 2011 2010 2009 2011 2010 Net premiums written $ 137,356 $ 122,004 $ 122,094 $ 15,352 $ (90 ) Net premiums earned $ 118,812 $ 123,588 $ 138,064 $ (4,776 ) $ (14,476 ) Loss ratio 19.1 % 26.2 % 41.1 % (7.1 ) (14.9 ) Combined ratio 88.5 % 96.1 % 105.8 % (7.6 ) (9.7 ) Credit-related property insurance products are offered on automobiles, furniture and appliances in connection with the financing of those items. These policies pay an amount if the insured property is lost or damaged and is not directly related to an event affecting the consumer's ability to pay the debt. The primary distribution channel for credit-related property insurance is general agents who market to auto dealers, furniture stores and financial institutions. Net premiums written increased during 2011 compared to 2010. This increase is primarily driven by the reduction of reinsurance placed with producer-owned reinsurance companies. Net premiums written during 2010 remained relatively flat as compared to 2009. Net premiums earned decreased through 2011 and 2010 compared to 2009 due to our credit business continuing to shift from the shorter duration CPI products, to the longer duration GAP products. Shorter duration products generally earn the entire premium within 12 months of the effective date, while longer duration products may take up to 84 months before they are fully earned. The improvements in the loss ratios for the year endedDecember 31, 2011 compared to 2010 and 2009 were attributable to an overall decline in claims incurred as a result of lower frequency and severity of claims. Specifically, the GAP line of business experienced a positive trend in claims incurred as the result of used automobile market values rebounding from the recent financial crisis. The combined ratios improved during 2011 and 2010 compared to each previous year. The decrease in the loss ratio drove the decrease in the combined ratio, which was partially offset by higher underwriting expenses from rising commission expenses as a result of the change in our product mix. Property and Casualty Reinsurance We reinsure a portion of the risks that we underwrite to manage our loss exposure and protect capital resources. In return for a premium, reinsurers assume a portion of the claims incurred. Amounts not reinsured are known as retention. We primarily use the following types of reinsurance to manage our loss exposures:
• Treaty reinsurance, primarily excess of loss, where the reinsurer
indemnifies us against all, or a specified portion, of claims incurred in
excess of a specified retention or attachment point, and up to the
contract limit; and;
• Facultative reinsurance, in which an individual insurance policy or a
specific risk is reinsured with the prior approval of the reinsurer.
Facultative reinsurance is purchased for the small number of risks which fall outside the treaty reinsurance. 64
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In addition to treaty and facultative reinsurance, we are partially protected by the Terrorism Risk Insurance Act of 2002, which was modified and extended throughDecember 31, 2014 by the Terrorism Risk Insurance Program Reauthorization Act of 2007. We retain the first$1.0 million of loss per risk, which will remain the same for 2012. Our corporate catastrophe reinsurance retention has been$40.0 million in recent years and will remain the same in 2012. In order to manage our risk exposure, we purchase the following additional catastrophe reinsurance coverages:
• We have coverage which lowers our retention to
and
include additional coastal states as well as
covers remained in place for 2011. In 2012, two more coastal states will
be added to the state-specific covers which will result in coverage for
all coastal states fromTexas toVirginia as well as the states ofOklahoma andArkansas .
• Additional catastrophe coverage is purchased for the remainder of the
country. The retention for this cover was
lowered to$10.0 million for 2011 where it will remain in 2012.
• We also purchased
states except
$645.0 million in 2009. The earthquake cover for 2012 will be$30.0 million with a$10.0 million retention. The combination of this cover and the corporate catastrophe cover will provide protection for
earthquake losses between
earthquake losses are covered above
in 2011 and 2010, down from
earthquake coverage purchased has decreased in recent years as a result of
a reduction in our earthquake business writings.
• In 2011,
purchased. This cover applies after
catastrophe losses has been reached. The first
catastrophe loss contributes to the
The catastrophe aggregate reinsurance coverage for 2011 was placed at
63.6% and will remain in place with the same coverage for 2012 at 50.6%.
The property catastrophe reinsurance limit was
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Our reinsurance programs use multiple reinsurers with each reinsurer absorbing part of the overall risk ceded. The primary reinsurers who participate in the programs and the amount of coverage each provides are shown in the following table: Percent of Risk Covered AM Best Non- Catastrophe Reinsurer Rating(1) catastrophe Coverage Hannover Ruck, Germany A 39.5 % - % Lloyd's Syndicates A 26.9 52.8 Platinum Re A 12.1 - Swiss Reinsurance America Corporation A+ 7.3 2.5 Catlin Insurance Co A 5.3 4.8 Tokio Millenium Re Ltd A++ - 6.7 Other reinsurers with no single company 8.9 33.2 greater than 5% of the total Total reinsurance coverage 100.0 % 100.0 %
(1)
Our credit-related property insurance products do not employ reinsurance to manage catastrophe loss exposure, and their reinsurers for risks other than catastrophes are not deemed significant to our business. PriorPeriod Reserve Development The table below shows the development of our claims and CAE reserves. The table does not present individual accident or policy year development data. The top line shows our original reserves, net of reinsurance recoverable, for each of the indicated years. The table then shows the cumulative net paid claims and CAE as of successive years. The table also shows the re-estimated amount of previously recorded reserves based on experience as of the end of each succeeding year. The cumulative deficiency or redundancy represents the aggregate change in the estimates over all prior years. Conditions and trends that affected development of liabilities in the past may not necessarily occur in the future. Accordingly, it may be inappropriate to anticipate future redundancies or deficiencies based on historical experience. While we believe that our claims reserves atDecember 31, 2011 are adequate, new information, events or circumstances, unknown at the original valuation date, may lead to future developments in our ultimate losses in amounts significantly greater or less than the reserves currently provided. The actual final cost of settling both claims outstanding atDecember 31, 2011 and claims expected to arise from unexpired periods of risk is uncertain. There are many other factors that would cause our reserves to increase or decrease, which include but are not limited to: changes in claim severity; changes in the expected level of reported claims; judicial action changing the scope or liability of coverage; changes in the regulatory, social and economic environment; and unexpected changes in loss inflation. The deficiency/ (redundancy) for different reporting dates is cumulative and should not be added together. 66
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Table of Contents Loss Development Table Property and Casualty Claims and Claim Adjustment Expense Liability Development-Net of Reinsurance Years Ended December 31, 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Liability for unpaid claims and claim adjustment expenses, net of reinsurance (includes loss reserves, IBNR, allocated and unalloc expense) $ 425,129 $ 490,215
Cumulative paid claims and claim expenses One year later 228,699 233,074 256,386 274,810 366,007 296,620 318,944 345,346 308,113 331,196 Two years later 322,112 338,459 377,139 405,748 506,463 453,042 477,958 495,277 467,402 Three years later 370,179 399,651 445,702 479,410 590,643 544,100 569,031 593,384 Four years later 396,758 429,408 479,524 518,972 640,003 593,126 625,925 Five years later 407,212 443,161 498,349 541,627 664,588 623,884 Six years later 412,004 452,256 509,521 552,136 682,171 Seven years later 416,207 457,972 513,968 563,113 Eight years later 420,045 460,785 518,251 Nine years later 423,256 463,303 Ten years later 423,636 Liabilites re-estimated One year later 432,028 488,595 564,287 638,910 770,238 711,880 766,882 798,587 776,808 818,937 Two years later 435,574 488,455 564,485 617,374 737,341 713,339 733,361 770,900 753,152 Three years later 441,564 490,717 553,163 596,242 739,825 680,900 727,675 766,994 Four years later 441,309 482,799 538,459 596,754 714,995 682,460 727,733 Five years later 435,796 476,615 542,429 585,370 717,474 685,471 Six years later 432,953 478,201 534,287 585,914 720,931 Seven years later 433,990 472,502 534,477 589,384 Eight years later 430,722 473,754 535,429 Nine years later 431,869 474,451 Ten years later 432,468
Deficiency(redundancy), net of reinsurance
$ (54,936 ) $ (88,995 ) $ (75,336 ) $ (116,482 ) $ (81,767 ) $ (80,866 ) $ (103,506 ) $ (68,071 )
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Net reserve, as initially estimated $ 425,129 $ 490,215
Reinsurance and other recoverables as initially estimated 65,327 59,806
52,908 67,698 65,186 62,115 55,951
89,410 46,778 40,552 53,152
Gross reserve as initially estimated 490,456 550,021 643,273 746,077 861,453 864,068 865,451 937,270 903,436 927,560 910,992 Net re-estimated reserve 432,468 474,451 535,429 589,384 720,931 685,471 727,733 766,994 753,152 818,937 Re-estimated and other reinsurance recoverables 79,453 82,791 85,663 86,021 499,076 99,023 81,321 115,108 48,869 46,190 Gross re-estimated reserve 511,921 557,242 621,092 675,405 1,220,007 784,494 809,054 882,102 802,021 865,127
Deficiency(redundancy), gross of reinsurance
$ (22,181 ) $ (70,672 )
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For 2011, the net favorable prior year claims and CAE development was$68.1 million , compared to approximately$79.9 million of net favorable prior year development in 2010, as a result of better than expected paid and incurred loss emergence across several lines of business. The current year loss ratio is a blend of the current accident year loss ratio and the impact of favorable or adverse development on prior accident years during the current calendar year. Excluding the 6.0 point impact of favorable prior year loss development for accident years 2010 and prior, the 2011 loss ratio would have been 82.3%. Excluding the 6.8 point impact of favorable prior year loss development for accident years 2009 and prior, the 2010 loss ratio would have been 86.6%. Net favorable reserve development during 2011 and 2010 was primarily driven by personal and commercial auto and commercial liability lines. For 2011 and 2010, net and gross reserve calculations have shown favorable development as a result of loss emergence compared to what was implied by the loss development patterns used in the original estimation of losses. For additional information regarding claims and CAE, refer to Note 12, Liability for Unpaid Claims and Claim Adjustment Expenses, of the Notes to the Consolidated Financial Statements. For the year endedDecember 31, 2005 , the$358.6 million deficiency gross of reinsurance was primarily the result of our participation in the National Flood Insurance Program as administered by theFederal Emergency Management Agency . As these losses are 100% reimbursed by the Federal government, they do not impact our net reserve calculations or our net loss development patterns. The National Flood Insurance Program had paid losses of$390.0 million for the year endedDecember 31, 2005 because of the 2005 hurricanes, specifically HurricaneKatrina . Since reserves are not set up for the National Flood Insurance Program, any payments made subsequent to year-end will appear as adverse development on a gross basis. If the flood losses were removed from the gross data, the$358.6 million deficiency would have been a$31.4 million redundancy, gross of reinsurance. 68
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Corporate and Other Our Corporate and Other business segment primarily includes the capital not allocated to support our insurance business segments. Corporate and Other business segment results for the periods indicated were as follows (in thousands): Years ended December 31, Change over prior year 2011 2010 2009 2011 2010 Premiums and other revenues: Net investment income $ 66,699 $ 53,317 $ 47,148 $ 13,382 $ 6,169 Realized investments gains, net 90,866 74,062 (73,855 ) 16,804 147,917 Other Income 2,980 3,175 2,704 (195 ) 471 Total premiums and other revenues 160,545 130,554 (24,003 ) 29,991 154,557 Benefits, losses and expenses: Other operating expenses 45,021 38,695 41,220 6,326 (2,525 ) Total benefits, losses and expenses 45,021 38,695 41,220 6,326 (2,525 ) Income before other items and federal income taxes $ 115,524 $ 91,859 $ (65,223 ) $ 23,665 $ 157,082 Earnings for the years endedDecember 31, 2011 and 2010 increased compared to the previous years. In both periods, the increases were primarily due to the increase in realized gains from investments as a result of improved financial markets, which also led to a reduction in other-than-temporary impairments below those recorded during 2009. The 2011 increase was also driven by the increase in net investment income as a result of our growing portfolio of bonds and mortgage loans. We recorded other-than-temporary impairments of$9.5 million ,$5.7 million and$79.1 million in 2011, 2010 and 2009, respectively. These other-than-temporary impairments are allocated to the Corporate and Other business segment and are included in "Realized investments gains, net." In accordance with our segment allocation process, all realized gains and losses, except those on derivatives, are allocated to the Corporate and Other business segment. For 2010 and prior periods, the Corporate and Other business segment was compensated for the risk it assumed for realized losses through a monthly charge to the insurance segments that reduced the amount of investment income allocated to those segments. During 2010, we undertook an assessment of the allocation process for assets and investment income. Beginning in 2011, we discontinued the monthly charge to the insurance segments to improve the comparability for measuring business results between segments and between periods. Discontinued Operations OnDecember 31, 2010 , we sold our wholly-owned broker-dealer subsidiary,Securities Management & Research, Inc. ("SM&R"). The sale qualifies for discontinued operations accounting and accordingly, the results of operations for this subsidiary are presented as income (loss) from discontinued operations in our consolidated statements of operations for all periods presented. The sale resulted in a$1.0 million loss for the year-ended 2010. SM&R had previously been a component of the Corporate and Other business segment. We chose to sell this business based on the belief that similar services could be contracted with a third party at lower cost while improving the services to agents and policyholders. See Note 22, Discontinued Operations, of the Notes to the Consolidated Financial Statements for additional details. 69
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Investments
We manage our investment portfolio to optimize our rate of return commensurate with sound and prudent practices to maintain a well-diversified portfolio. Our investment operations are governed by various regulatory authorities including, but not limited to, the state insurance departments where our insurance companies are domiciled. Investment activities, including the setting of investment policies and defining acceptable risk levels, are subject to review and approval by our Board of Directors, which is assisted by ourFinance Committee , comprised of two board members, senior executives and investment professionals. Our insurance and annuity products are primarily supported by investment-grade bonds, collateralized mortgage obligations and commercial mortgage loans. We purchase fixed maturity securities and designate them as either held-to-maturity or available-for-sale as necessary to match our estimated future cash flow needs. We also monitor the composition of our fixed maturity securities between held-to-maturity and available-for-sale securities and adjust the concentrations within the portfolio as investments mature or with the purchase of new investments. We invest in commercial mortgage loans when the yield and quality compare favorably with other fixed maturity securities. Investments in individual residential mortgage loans have not been part of our investment portfolio and we do not anticipate investing in them in the future. Historically, our strong capitalization has enabled us to invest in equity securities and investment real estate where there are opportunities for enhanced returns. We invest in real estate and equity securities based on a risk and reward analysis. Composition of Invested Assets The following summarizes the carrying values of our invested assets by asset class (other than investments in unconsolidated affiliates), (in thousands, except percentages): Year ended December 31, 2011 Year ended December 31, 2010 Amount Percent Amount Percent Bonds held-to-maturity, at amortized cost $ 9,251,972 49.0 % $ 8,513,550 47.5 % Bonds available-for-sale, at fair value 4,381,607 23.2 4,123,613 23.0 Equity securities, at fair value 1,006,080 5.3 1,082,755 6.0 Mortgage loans on real estate, net of allowance 2,925,482 15.5 2,679,909 15.0 Policy loans 393,195 2.1 380,505 2.1 Investment real estate, net of accumulated depreciation 470,222 2.5 521,768 2.9 Short-term investments 345,330 1.8 486,206 2.8 Other invested assets 109,514 0.6 119,251 0.7 Total Investments $ 18,883,402 100.0 % $ 17,907,557 100.0 % The increase in our total investments fromDecember 31, 2011 as compared to 2010 was primarily a result of purchasing investments with the net proceeds of annuity and life premium and investment income. During 2011, we sold a portfolio of directly owned industrial real estate and our interests in partnerships of similar industrial real estate. These sales are the primary causes of the decrease in our investments in investment real estate and other invested assets. Each of the components of our invested assets are described further in the Notes to the Consolidated Financial Statements within Item 8, Financial Statements and Supplementary Data. For the year endedDecember 31, 2011 , we reviewed our invested assets and recognized other-than-temporary-impairment losses of$9.5 million compared to$5.7 million for the year endedDecember 31, 2010 . Each of the recognized impairments was attributable to equity securities trading below cost basis for a prolonged period of time and investment and operating management did not foresee a recovery to our cost basis within a reasonable period of time. 70
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Investments to Support Our Insurance Business Bonds- We allocate most of our fixed maturity securities to support our insurance business. AtDecember 31, 2011 , our fixed maturity securities had an estimated fair market value of$14.2 billion , which was$851.7 million , or 6.4%, above amortized cost. The increase in total fair value from 2010 to 2011 was the result of new purchases to support policyholders' account values attributable to annuity sales as well as market value increases. Fixed maturity securities' estimated fair value, due in one year or less, increased to$961.2 million as ofDecember 31, 2011 from$685.3 million as ofDecember 31, 2010 , primarily as a result of approaching maturity dates of long-term bonds. The following table identifies the total bonds by credit quality rating, using both S&P and Moody's ratings (in thousands, except percentages): December 31, 2011 December 31, 2010 Amortized Estimated % of Fair Amortized Estimated % of Fair Cost Fair Value Value Cost Fair Value Value AAA $ 1,074,744 $ 1,153,696 8.1 % $ 1,258,952 $ 1,311,152 10.0 % AA 1,391,092 1,490,600 10.5 1,289,870 1,343,653 10.2 A 5,058,242 5,448,851 38.3 4,551,294 4,848,986 37.0 BBB 5,204,214 5,499,958 38.6 4,613,315 4,871,583 37.2 BB and below 659,290 646,193 4.5 725,436 728,073 5.6 Total $ 13,387,582 $ 14,239,298 100.0 % $ 12,438,867 $ 13,103,447 100.0 % The slight shifts in the credit quality distribution of our investment grade bonds atDecember 31, 2011 compared toDecember 31, 2010 , was primarily the result of purchase transactions and maturities. At 4.5% of our total bond portfolio, the exposure to below investment grade securities is acceptable to management. The decrease in the amount and percentage of fixed maturity securities rated below investment grade is primarily attributable to maturities. Mortgage Loans- We invest in commercial mortgage loans that are diversified by borrower, property-type and geography. We do not make individual residential mortgage loans. Therefore, we have no direct exposure to sub-prime or Alt A mortgage loans in our portfolio. Generally, mortgage loans are secured by first liens on income-producing real estate with a loan-to-value ratio of up to 75%. Mortgage loans are used to support a portion of our insurance liabilities. Mortgage loans held-for-investment are carried at outstanding principal balances, adjusted for any unamortized discount, deferred fees or expenses, and net of allowances. The weighted average coupon yield on the principal funded for mortgage loans was 6.0% and 6.8% for the years endedDecember 31, 2011 and 2010, respectively.Equity Securities - As ofDecember 31, 2011 , 96.3% of our equity securities consisted of publicly traded (on a nationalU.S. stock exchange ) common stock. The remaining 3.7% of the equity securities consisted of publicly traded preferred stock. As ofDecember 31, 2010 , 96.6% of our equity securities were invested in publicly traded (on a nationalU.S. stock exchange ) common stock. The remaining 3.4% of the equity portfolio was invested in publicly traded preferred stock. 71
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We carry our equity portfolio at market value based on quoted market prices obtained from external pricing services. The cost and estimated market value of the equity portfolio are as follows (in thousands):
Year ended December 31, 2011 Unrealized Unrealized Cost Gains Losses Fair Value Common stock $ 679,724 $ 305,269 $ (16,086 ) $ 968,907 Preferred stock 30,955 7,688 (1,470 ) 37,173 Total $ 710,679 $ 312,957 $ (17,556 ) $ 1,006,080 Year ended December 31, 2010 Unrealized Unrealized Cost Gains Losses Fair Value Common stock $ 690,245 $ 361,048 $ (5,405 ) $ 1,045,888 Preferred stock 30,420 6,714 (267 ) 36,867 Total $ 720,665 $ 367,762 $ (5,672 ) $ 1,082,755 The decrease in net unrealized gains in 2011 compared to 2010 was primarily the result of sales of common stock during 2011 resulting in realizing gains, which were previously unrealized.Investment Real Estate - We invest in commercial real estate with positive cash flows or where appreciation in value is expected. Real estate may be owned directly by our insurance companies or through non-insurance affiliates or joint ventures. The carrying value of real estate is cost, less accumulated depreciation. Depreciation is provided over the estimated useful life of each property. Short-Term Investments- Short-term investments are composed primarily of commercial paper rated A2/P2 or better by Standard & Poor's and Moody's, respectively. The amount fluctuates depending on the available long-term investment opportunities and our liquidity needs, including investment-funding commitments. The decrease in the amount of short-term investments sinceDecember 31, 2010 is attributable to our purchasing longer maturity fixed income investments and investing in commercial mortgages to support our insurance businesses. We monitor on a daily basis the amount of short-term investments and long-term investment opportunities to select appropriate investments to support our insurance businesses. Policy Loans- For certain life insurance products, we allow policyholders to borrow funds using their policy's cash value as collateral. The maximum amount of the policy loan depends upon the policy's surrender value and the number of years since policy origination. As ofDecember 31, 2011 , we had$393.2 million in policy loans with a loan to surrender value of 59.2%, and atDecember 31, 2010 , we had$380.5 million in policy loans with a loan to surrender value of 59.1%. Interest rates on policy loans range from 3.0% to 12.0% per annum. As ofDecember 31, 2011 and 2010, the average policy loan interest rate was 6.7%. Policy loans may be repaid at any time by the policyholder and have priority over any claims on the policy. If the policyholder fails to repay the policy loan, funds are withdrawn from the policy's death benefits. 72
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Net Investment Income and Realized Gains (Losses) Net investment income from bonds and mortgage loans used to support our insurance products increased over the period as assets increased with net annuity sales. Net investment income in other asset classes (equities, real estate and options) fluctuated in response to investment decisions based on valuations, financial markets movement and expectations of future returns. Mortgage loan interest income is accrued on the principal amount of the loan based on the loan's contractual interest rate. Accretion of discounts is recorded using the effective yield method. Interest income, accretion of discounts, and prepayment fees are reported in net investment income. Interest income earned on impaired loans is accrued on the principal amount of the loan based on the loan's contractual interest rate. However, interest ceases to be accrued for loans on which interest is more than 90 days past due or when the collection of interest is not considered probable. Loans in foreclosure are placed on non-accrual status. Interest received on non-accrual status mortgage loans is included in net investment income in the period received. Net Unrealized Gains and Losses The net change in unrealized gains (losses) on available-for-sale securities, as presented in the stockholders' equity section of the consolidated statements of financial position, was a decrease of$16.6 million atDecember 31, 2011 and an increase of$109.0 million in 2010. The decrease in 2011 was primarily the result of the previously mentioned sales of common stock and their related gains being realized. Liquidity Our liquidity requirements have been and are expected to continue to be met by funds from operations, resulting from premiums received from our customers. The primary use of cash has been and is expected to continue to be policy benefits and claims incurred during the regular course of business. No significant change in premiums was experienced during 2011 or is expected in the near-term. Current and expected patterns of claim frequency and severity may change from period to period but continue to be within historical norms. Management considers our current liquidity position to be sufficient to meet anticipated demands over the next twelve months. Our contractual obligations are not expected to have a significant impact to cash flow from operations. There are no known trends or uncertainties regarding product pricing, changes in product lines or rising costs, which would have a significant impact to cash flows from operations. Continued low-interest rate environments are expected to require higher than historical contributions to our defined benefit plans in the near future. Management does not expect these demands to have a significant impact to our cash flows from operations. Additionally, we have paid dividends to stockholders for over 100 consecutive years and expect to continue this trend. No significant capital expenditures are expected in the near future. A downgrade or a potential downgrade in our financial strength ratings could result in a loss of business and could adversely affect our cash flow from operations. See Item 1A, Risk Factors, for additional details. Further information regarding additional sources or uses of cash is described in Note 20, Commitments and Contingencies, of the Notes to the Consolidated Financial Statements. To ensure we will be able to continue to pay future commitments, the funds received as premium payments and deposits are invested in high quality investments, primarily fixed maturity securities and commercial mortgages. Funds are invested with the intent that income from the investments and proceeds from the maturities will meet our ongoing cash flow needs. We historically have not had to liquidate invested assets in order to cover cash flow needs; however, our portfolio of highly liquid available-for-sale fixed maturity and equity securities are available to meet future liquidity needs, if necessary. 73
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We have renewed our$100 million short-term variable rate borrowing facility containing a$55 million subfeature for the issuance of letters of credit. Borrowings under the facility are at the discretion of the lender and would be used only for funding our working capital requirements. The combination of borrowings and outstanding letters of credit cannot exceed$100 million at any time. As ofDecember 31, 2011 and 2010, the outstanding letters of credit were$31.7 million and$37.5 million , respectively, and there were no borrowings on this facility to meet liquidity requirements. This facility expires onSeptember 30, 2012 . We expect it will be renewed on substantially equivalent terms upon expiration. Our cash and cash equivalents and short-term investment position atDecember 31, 2011 was$447.4 million compared to$587.7 million atDecember 31, 2010 . The$140.3 million decrease in cash and cash equivalents and short-term investments relates primarily to our assessment of better long-term investment opportunities available throughout 2011, versus those available in 2010. We continue to look towards long-term investment opportunities, and in recent years we allocated more assets to shorter-term investment opportunities due to the limited availability of long-term investment opportunities with appropriate risk-return ratio. We were committed atto purchase, expand or improve real estate, to fund mortgage loans and to purchase other invested assets in the amount of $242.6 million , compared to$275.0 million for 2010. The expansion of mortgage loans in 2011 and 2010 is attributable to our ability to originate loans collateralized by quality real estate at appropriate yields. In the normal course of business, we have guaranteed bank loans for customers of a third-party marketing operation for the benefit of policyholders. The customers, through the use of a trust, use the bank loans to fund premium payments of life insurance policies. These bank loans enable individuals with substantial illiquid wealth to finance their life insurance premiums using the cash value of the policies as collateral for the loans. In the case of a default on the bank loan, we would be obligated to pay off the loans. As the cash values of the life insurance policies always equals or exceeds the balance of the loans, management does not foresee any loss on these guarantees. The total amounts of guarantees outstanding for 2011 and 2010 was approximately$206.5 million , while the total cash values of the related life insurance policies was$210.7 million for 2011 and 2010. Capital Resources Our capital resources consisted of American National stockholders' equity, summarized as follows (in thousands): December 31, 2011 2010 2009 American National stockholders' equity, excluding accumulated other comprehensive income (loss), net of tax ("AOCI") $ 3,498,566 $ 3,407,439 $ 3,342,805 AOCI 158,470
225,212 117,649
Total American National stockholders' equity
We have notes payable in our consolidated statements of financial position that are not part of our capital resources. These notes payable represent amounts borrowed by real estate joint ventures that we consolidate into our financial statements. The lenders for the notes payable have no recourse against us in the event of default by the joint ventures. Therefore, the only amount of liability we have for these notes payable is limited to our investment in the respective venture, which totaled$18.0 million and$21.2 million atDecember 31, 2011 and 2010, respectively. Total American National stockholders' equity in 2011 increased primarily due to the$192.2 million net income earned during the period, offset by$82.6 million in dividends paid to stockholders, a$50.0 million minimum pension liability adjustment and a decrease of$16.6 million in unrealized gains from available-for-sale securities due to security sales during the year. 74
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Total American National stockholders' equity in 2010 increased primarily due to the$144.0 million net income during the period and$109.0 million unrealized gains on marketable securities, offset by$82.6 million in dividends paid to stockholders. Statutory Surplus and Risk-based Capital Statutory surplus represents the capital of our insurance companies reported in accordance with accounting practices prescribed or permitted by the applicable state insurance departments. RBC is a minimum capital requirement calculated using formulas and instructions from the NAIC. State laws specify regulatory actions if an insurer's ratio of statutory surplus to RBC, a measure of an insurer's solvency, falls below certain levels. The RBC formula for life companies establishes minimum capital requirements for asset, interest rate, market, insurance and business risks. The RBC formula for property and casualty companies establishes minimum capital requirements for asset and underwriting risks including reserve risk. The achievement of long-term growth will require growth inAmerican National Insurance Company and our insurance subsidiaries' statutory capital. Our subsidiaries may obtain additional statutory capital through various sources, such as retained statutory earnings or equity contributions from us. As ofDecember 31, 2011 , the levels of our and our insurance subsidiaries' surplus and RBC exceeded the NAIC's minimum RBC requirements. Contractual Obligations The following table summarizes our contractual obligations as ofDecember 31, 2011 (in thousands): Payments Due by Period Less than More than Total 1 year 1-3 years 3-5 years 5 years Life insurance obligations(1) $ 5,523,113 $ 27,143 $ 169,170 $ 344,732 $ 4,982,068 Annuity obligations(1) 12,973,715 1,715,329 4,720,280 2,726,397 3,811,709 Property and casualty insurance obligations(2) 915,011 505,127 328,345 63,388 18,151 Accident and health insurance obligations(3) 126,187 70,237 17,081 9,454 29,415 Purchase obligations: Commitments to purchase and fund investments(4) 69,197 63,965 2,452 1,450 1,330 Mortgage loan commitments(4) 176,512 156,512 20,000 - - Operating leases(5) 3,880 483 1,390 1,851 156 Defined benefit pension plans(6) 132,969 9,230 22,199 17,905 83,635 Notes payable(7) 58,894 46,387 - 12,507 - Total $ 19,979,478 $ 2,594,413 $ 5,280,917
$ 3,177,684 $ 8,926,464
(1) Life and annuity obligations include estimated claim, benefit, surrender and
commission obligations offset by expected future premiums and deposits on
in-force insurance policies and annuity contracts. All amounts are gross of
reinsurance. Estimated claim, benefit and surrender obligations are based on
mortality and lapse assumptions that are comparable with historical experience. Estimated payments on interest-sensitive life and annuity obligations include interest credited to those products. The interest crediting rates are derived by deducting current product spreads from a
constant investment yield. The obligations shown in the table have not been
discounted. As a result, the estimated obligations for insurance liabilities
included in the table exceed the liabilities recorded in reserves for future
policy benefits and the liability for policy and contract claims. Due to the
significance of the assumptions used, the amounts presented could materially
differ from actual payments. Separate account obligations have not been
included in the table since those obligations are not part of the general
account obligations and will be funded by cash flows from separate account
assets. The general account obligations for insurance liabilities will be
funded by cash flows from general account assets and future premiums and
deposits. Participating policyholder dividends payable consists of
liabilities related to dividends payable in the following calendar year. As
such, the outstanding contractual obligation related to participating
policyholder dividends payable is presented in the table above in the less
than one-year category. All estimated cash payments in the table above are
undiscounted as to interest, net of estimated future premiums on policies
currently in-force and gross of any reinsurance recoverable. Estimated
future premiums on participating policies currently in-force are net of
future policyholder dividends payable. The participating policyholder share
obligation included in the other policyholder funds on the consolidated
statements of financial position, represents the accumulated net income from
participating policies and a pro-rata portion of net unrealized investment
gains (losses), net of tax, reserved for payment to such policyholders as
policyholder dividends. Due to the nature of the participating policyholder
obligation, the exact timing and amount of the ultimate participating
policyholder obligation is subject to significant uncertainty and the amount
of the participating policyholder obligation is based upon a long-term
projection of the performance of the participating policy block. 75
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(2) Expected future gross claims and claim adjustment expense payments from
property and casualty policies includes case reserves for reported claims
and reserves for IBNR. Timing of future payments is estimated based on our
historical payment patterns. The timing of these payments may vary
significantly from the pattern shown in the preceding table. The ultimate
losses may vary materially from the recorded amounts, which are our best
estimates.
(3) Accident and health insurance obligations reflect estimated future claim
payment amounts net of reinsurance for claims incurred prior to January 1,
2011. The estimate does not include claim payments for claims incurred after
and morbidity assumptions that are consistent with historical claims experience and are not discounted with interest so will exceed the liabilities recorded in reserves for future claim payments. Due to the
significance of the assumptions used the amounts presented could materially
differ from actual payments.
(4) Expected payments to fund investments based on mortgage loans and capital
commitments and other related contractual obligations.
(5) Represents estimated obligations due to contracts and agreements entered
into within the ordinary course of business for items classified as an operating lease. (6) Represents estimated payments for pension benefit obligations for the non-qualified defined benefit pension plan. These payments are funded
through continuing operations. A liability has been established for the full
amount of benefits accrued, including a provision for the effects on the accrued benefits of assumed future salary increases.
(7) Notes payable are comprised of obligations to third-party lenders, and are
collateralized by real-estate owned by the respective entity. The estimated
payments due by period for notes payable reflect the contractual maturities
of principal and estimated future interest payments. The payment of
principal and estimated future interest for the current portion of long-term
notes payable are reflected in estimated payments due in less than one year.
These are not corporate obligations and our liability is limited to its
investment in the respective joint venture. See Note 14, Notes Payable, of
the Notes to the Consolidated Financial Statements for additional details.
Off-Balance Sheet Arrangements We have off-balance sheet arrangements relating to third-party marketing operation bank loans. We could be exposed to a liability for these loans, which are supported by the cash value of the underlying insurance contracts. However, since the cash value of the life insurance policies is designed to always equal or exceed the balance of the loans, management does not foresee any losses related to these arrangements. See Note 20, Commitments and Contingencies, of the Notes to the Consolidated Financial Statements for additional details. 76
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Related-Party Transactions We have various agency, consulting and investment arrangements with individuals and corporations that are considered to be related parties. Each of these arrangements has been reviewed and approved by our Audit Committee. The total amount involved in these arrangements, both individually and in the aggregate, is not material to any segment or to our overall operations. See Note 21, Related Party Transactions, of the Notes to the Consolidated Financial Statements for additional details. 77
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