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PHL VARIABLE INSURANCE CO /CT/ - 10-K - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) Management's narrative analysis of the results of operations is presented in lieu of Management's Discussion and Analysis of Financial Condition and Results of Operations, pursuant to General Instruction (I)(2)(a) of Form 10-K. FORWARD-LOOKING STATEMENTS The discussion in this Form 10-K may contain "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. We intend for these forward-looking statements to be covered by the safe harbor provisions of the federal securities laws relating to forward-looking statements. These forward-looking statements include statements relating to trends in, or representing management's beliefs about our future transactions, strategies, operations and financial results and often contain words such as "will," "anticipate," "believe," "plan," "estimate," "expect," "intend," "is targeting," "may," "should" and other similar words or expressions. Forward-looking statements are made based upon management's current expectations and beliefs concerning trends and future developments and their potential effects on us. They are not guarantees of future performance. Our actual business, financial condition or results of operations may differ materially from those suggested by forward-looking statements as a result of risks and uncertainties which include, among others: (A) risks related to the Restatement, failure to file timely periodic reports with the SEC and our internal control over financial reporting, which include (i) the potential failure to remediate material weaknesses in our internal control over financial reporting and other material weaknesses may be identified in the future, which would adversely affect the accuracy and timing of our financial reporting; (ii) the extraordinary processes undertaken to effect the Restatement may not have been adequate to identify and correct all errors in our historical financial statements and, as a result, we may discover additional errors and our financial statements remain subject to the risk of future restatement; (iii) our failure to have current financial information available; (iv) the risk of failure to comply with the filing deadlines included in the SEC's Cease-and-Desist Order, dated March 21, 2014, as amended by the Amended Cease-and-Desist Order, dated August 1, 2014, including that the SEC may seek sanctions against or deregister PNX and the Company; (v) the risk of PNX's failure to file its delayed SEC filings and its 2014 Quarterly Reports on Form 10-Q by March 16, 2015, the extended deadline for providing these SEC filings to the bond trustee, as well as the risk associated with seeking additional consents from bondholders of its outstanding 7.45% Quarterly Interest Bonds Due 2032 regarding these SEC filings; (vi) the outcome of litigation and claims as well as regulatory examinations, investigations, proceedings and orders arising out of the Restatement and the failure by the Company and PNX to file SEC reports on a timely basis; (vii) further downgrades or withdrawals of our financial strength credit ratings, which could increase policy surrenders and withdrawals, adversely affect our relationships with distributors, reduce new sales, limit our ability to trade in derivatives and increase our costs of, or reduce our access to, future borrowings; (viii) our inability to hedge our positions due to our inability to replace hedges as a result of our credit rating; (ix) the incurrence of significant expenses related to the Restatement, the U.S. GAAP restatement undertaken by PNX, the remediation of weaknesses in our internal control over financial reporting and disclosure controls and procedures, and the preparation of this Form 10-K and our delayed SEC reports; (x) diversion of management and other human resources attention from the operation of our business; (xi) the risk that the Company's and Phoenix Life's restatements, the delay in our filing of periodic reports with the SEC and errors corrected in subsequent Statutory financial statement filings with state insurance regulators could result in regulatory investigations, examinations and/or inquiries, which may increase compliance costs and the potential for additional regulatory investigations, proceedings or other claims; and (xii) risks associated with our failure to file certain reports with state regulatory authorities; (B) risks related to our business, which include (i) unfavorable general economic developments including, but not limited to, specific related factors such as the performance of the debt and equity markets; (ii) the potential adverse effect of interest rate fluctuations on our business and results of operations; (iii) the potential adverse effect of legal actions and proceedings inherent in our business on our results of operations, financial position, business or reputation; (iv) the impact on our results of operations and financial condition of any required increase in our reserves for future policyholder benefits and claims if such reserves prove to be inadequate; (v) the possibility that mortality rates, persistency rates, funding levels or other factors may differ significantly from our assumptions used in pricing products; (vi) limited access to external sources of liquidity and financing; (vii) the effect of guaranteed benefits within our products; (viii) potential exposure to unidentified or unanticipated risk that could adversely affect our businesses or result in losses; (ix) the consequences related to variations in the amount of our statutory capital could adversely affect our business; (x) the possibility that we may not be successful in our efforts to implement a business plan focused on new market segments; (xi) changes in our investment valuations based on changes in our valuation methodologies, estimations and assumptions; (xii) the availability, pricing and terms of reinsurance coverage generally and the inability or unwillingness of our reinsurers to meet their obligations to us specifically; (xiii) our ability to attract and retain key personnel in a competitive environment and while delayed in our SEC reporting obligations; (xiv) our dependence on third parties to maintain critical business and administrative functions; (xv) the strong competition we face in our business from banks, insurance companies and other financial services firms; (xvi) changes in tax law and policy may affect us directly or indirectly through the cost of, the demand for or profitability of our products or services; (xvii) the possibility that federal and state regulation may increase our cost of doing business, impose additional reserve or capital requirements, levy financial assessments or constrain our operating and financial flexibility; (xvii) regulatory actions or examinations may harm our business; and (xviii) changes in accounting standards; and (C) other risks and uncertainties described herein or in any of our filings with the SEC. Certain other factors which may impact our business, financial condition or results of operations or which may cause actual results to differ from such forward-looking statements are discussed or included in our periodic reports filed with the SEC and are available on our website at www.phoenixwm.com under "Investor Relations." You are urged to carefully consider all such factors. We do not undertake or plan to update or revise forward-looking statements to reflect actual results, changes in plans, assumptions, estimates or projections, or other circumstances occurring after the date of this Form 10-K, even if such results changes or circumstances make it clear that any forward-looking information will not be realized. If we make any future public statements or disclosures which modify or impact any of the forward-looking statements contained in or accompanying this Form 10-K, such statements or disclosures will be deemed to modify or supersede such statements in this Form 10-K. 28 -------------------------------------------------------------------------------- MANAGEMENT'S DISCUSSION AND ANALYSIS Management's discussion and analysis reviews our financial condition at December 31, 2013 and 2012; our results of operations for the years 2013, 2012 and 2011; and, where appropriate, factors that may affect our future financial performance. This discussion should be read in conjunction with our financial statements in this Form 10-K. Executive Overview Business We provide life insurance and annuity products through independent agents and financial advisors. Our policyholder base includes both affluent and middle market consumers, with our more recent business concentrated in the middle market. Most of our life insurance in force is permanent life insurance (universal life and variable universal life) insuring one or more lives. Our annuity products include fixed and variable annuities with a variety of death benefit and guaranteed living benefit options. In 2013, 99% of PHL Variable product sales, as defined by total annuity deposits and total life premium, were annuities, and 89% of those sales were fixed indexed annuities. Saybrus Partners, Inc. ("Saybrus"), an affiliate, provides dedicated life insurance and other consulting services to financial advisors in partner companies, as well as support for sales of Phoenix's product line through independent distribution organizations. Earnings Drivers Our profitability is driven by interaction of the following elements: • Fees on life and annuity products consist primarily of: (i) cost of insurance ("COI") charges, which are based on the difference between policy face amounts and the account values (referred to as the NAR); (ii) asset-based fees (including mortality and expense charges for variable annuities) which are calculated as a percentage of assets under management within our separate accounts; (iii) premium-based fees to cover premium taxes and renewal commissions; and (iv) surrender charges. • Policy benefits include death claims net of reinsurance cash flows, including ceded premiums and recoverables, interest credited to policyholders and changes in policy liabilities and accruals. Certain universal life reserves are based on management's assumptions about future COI fees and interest margins which, in turn, are affected by future premium payments, surrenders, lapses and mortality rates. Actual experience can vary significantly from these assumptions, resulting in greater or lesser changes in reserves. In addition, we regularly review and reset our assumptions in light of actual experience, which can result in material changes to these reserves. For fixed indexed annuities, policy benefits include the change in the liability associated with guaranteed minimum withdrawal benefits. The assumptions used to calculate the guaranteed minimum withdrawal liability are consistent with those used for amortizing deferred policy acquisition costs. Certain of our variable annuity contracts include guaranteed minimum death and income benefits. The change in the liability associated with these guarantees is included in policy benefits. The value of these liabilities is sensitive to changes in equity markets, equity market volatility and interest rates, as well as subject to management assumptions regarding future surrenders, rider utilization rates and mortality. In addition, the universal life block of business has experience which produces profits in earlier periods followed by losses in later periods for which an additional liability is required to be held above the account value liability. These reserves for future losses are determined by accruing ratably over historical and anticipated positive income. The assumptions used in estimating these liabilities are consistent with those used for amortizing deferred policy acquisition costs and are subject to the same variability and risk, and these factors can vary significantly from period to period. • Interest margins consist of net investment income earned on universal life, fixed indexed annuities and other policyholder funds, gains on options purchased to fund index credits less the interest or index credits applied to policyholders on those funds. Interest margins also include investment income on assets supporting the Company's surplus. 29-------------------------------------------------------------------------------- • Non-deferred operating expenses are expenses related to servicing policies, premium taxes, reinsurance allowances, non-deferrable acquisition expenses and commissions and general overhead. They also include pension and other benefit costs which involve significant estimates and assumptions. • Deferred policy acquisition cost amortization is based on the amount of expenses deferred, actual results in each quarter and management's assumptions about the future performance of the business. The amount of future profit or margin is dependent principally on investment returns in our separate accounts, interest and default rates, reinsurance costs and recoveries, mortality, surrender rates, premium persistency and expenses. These factors enter into management's estimates of gross profits or margins, which generally are used to amortize deferred policy acquisition costs. Actual equity market movements, net investment income in excess of amounts credited to policyholders, claims payments and other key factors can vary significantly from our assumptions, resulting in a misestimate of gross profits or margins, and a change in amortization, with a resulting impact to income. In addition, we regularly review and reset our assumptions in light of actual experience, which can result in material changes in amortization. • Net realized investment gains or losses related to investments and hedging programs include transaction gains and losses, OTTIs and changes in the value of certain derivatives and embedded derivatives. Certain of our variable and fixed annuity contracts include guaranteed minimum withdrawal and accumulation benefits which are classified as embedded derivatives. The fair value of the embedded derivative liability is calculated using significant management estimates, including: (i) the expected value of index credits on the next policy anniversary dates; (ii) the interest rate used to project the future growth in the contract liability; (iii) the discount rate used to discount future benefit payments, which includes an adjustment for our credit worthiness; and (iv) the expected costs of annual call options that will be purchased in the future to fund index credits beyond the next policy anniversary. These factors can vary significantly from period to period. • Income tax expense/benefit consists of both current and deferred tax provisions. The computation of these amounts is a function of pre-tax income or loss and the application of relevant tax law and U.S. GAAP accounting guidance. In assessing the realizability of our deferred tax assets, we make significant judgments with respect to projections of future taxable income, the identification of prudent and feasible tax planning strategies and the reversal pattern of the Company's book-to-tax differences that are temporary in nature. We also consider the expiration dates and amounts of carryforwards related to net operating losses, capital losses, foreign tax credits and general business tax credits. Based on our assessment, we have recorded a valuation allowance against a significant portion of our deferred tax assets based upon our conclusion that there is insufficient objective positive evidence to overcome the significant negative evidence from our cumulative losses in recent years. This assessment could change in the future, resulting in a release of the valuation allowance and a benefit to income. Under U.S. GAAP, premiums and deposits for variable life, universal life and annuity products are not immediately recorded as revenues. For certain investment options of variable products, deposits are reflected on our balance sheets as an increase in separate account liabilities. Premiums and deposits for universal life, fixed annuities and certain investment options of variable annuities are reflected on our balance sheets as an increase in policyholder liabilities. Premiums and deposits for other products are reflected on our balance sheets as an increase in policy liabilities and accruals. Recent Trends in Earnings Drivers • Net realized investment gains (losses). Net realized investment gains, excluding OTTI, of $5.4 million were recognized for the twelve months ended December 31, 2013 compared to net realized investment losses, excluding OTTI, of $19.5 million for the twelve months ended December 31, 2012. The change in the net realized investment gains is primarily attributable to a decrease in realized losses on derivatives that are used to hedge the risks associated with variable annuity guarantees and the fixed indexed annuity liabilities. For the twelve months ended December 31, 2013 there were losses on derivative investments of $23.1 million, while there were losses of $49.0 million for the twelve months ended December 31, 2012. The continued improvement in the equity markets results in losses on the derivatives that are used to hedge the risk associated with the variable annuity guarantees, that are offset by gains on the derivatives that are used to hedge the risks associated with the fixed indexed annuities. The fixed indexed annuity hedging gains were more significant in 2013 due to more significant increases in the equity market in 2013 than in 2012, as well as additional derivatives purchased due to continued sales of fixed indexed annuities. 30--------------------------------------------------------------------------------• Policy benefits. Policy benefits decreased $110.3 million for the twelve months ended December 31, 2013 compared with the twelve months ended December 31, 2012. The decrease in policy benefit expenses is primarily due to gains on guaranteed insurance benefit liabilities and reserves for profits followed by losses of $84.1 million as a result of assumption changes made during the annual comprehensive review of assumptions in the fourth quarter of 2013. The most significant driver of the positive 2013 unlock results was the incorporation of a mortality improvement assumption in the overall mortality table, which resulted in improved expected mortality on universal life and variable universal life products. • Operating expenses. Operating expenses increased by $13.2 million for the twelve months ended December 31, 2013 compared with the twelve months ended December 31, 2012. The increase in operating expenses was a result of higher professional fees and outside consulting services primarily as a result of the restatement. • Income taxes. The effective tax rate for 2013 and 2012 was (63.8%) and (13.3%) respectively. The principal cause of the difference between the effective rate and the U.S. statutory rate of 35% in 2013 was the dividend deduction and a decrease in the valuation allowance on the pre-tax income. The principal cause of the difference between the effective rate and the U.S. statutory rate of 35% in 2012 was the dividend received deduction and an increase in the valuation allowance on the pre-tax loss. Strategy and Outlook We are focused on the following key strategic pillars, which have defined our strategy since 2009: • Balance sheet strength; • Policyholder service; • Operational efficiency; and • Profitable growth. We believe this strategy has produced a firm foundation and positioned us for continued growth, even as our business remains sensitive to general economic conditions and capital market trends including equity markets and interest rates. We believe there is significant demand for our products among middle market households seeking to accumulate assets and secure lifetime income during retirement. The current low interest rate environment provides limited opportunities for consumers to protect principal and generate predictable income. Our indexed annuity products are positioned favorably vis-à-vis traditional investments such as bank certificates of deposits. Recent trends in the life insurance industry may affect our mortality, policy persistency and premium persistency. The evolution of the financial needs of policyholders, the emergence of a secondary market for life insurance, and increased availability and subsequent contraction of premium financing suggest that the reasons for purchasing our products have changed. Deviations in experience from our assumptions have had, and could continue to have, an adverse effect on the profitability of certain universal life products. Most of our current products permit us to increase charges and adjust crediting rates during the life of the policy or contract (subject to guarantees in the policies and contracts). We have made, and may in the future make, such adjustments. Impact of New Accounting Standards For a discussion of accounting standards and changes in accounting, see Note 2 to our financial statements under "Item 8: Financial Statements and Supplementary Data" in this Form 10-K. 31 --------------------------------------------------------------------------------Critical Accounting Estimates The discussion and analysis of our financial condition and results of operations are based upon our financial statements, which have been prepared in accordance with U.S. GAAP. U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Critical accounting estimates are reflective of significant judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. Certain of our critical accounting estimates are as follows: Deferred Policy Acquisition Costs We amortize deferred policy acquisition costs ("DAC") based on the related policy's classification. For universal life, variable universal life and deferred annuities, deferred policy acquisition costs are amortized in proportion to estimated gross profits ("EGPs") discussed more fully below. EGPs are also used to amortize other assets and liabilities in the Company's balance sheets, such as sales inducement assets ("SIA") and unearned revenue reserves ("URR"). Components of EGPs are used to determine reserves for universal life and fixed indexed and variable annuity contracts with death and other insurance benefits such as guaranteed minimum death and guaranteed minimum income benefits. EGPs are based on historical and anticipated future experience which is updated periodically. Deferred policy acquisition costs are adjusted through other comprehensive income ("OCI") each period as a result of unrealized gains or losses on securities classified as available-for-sale in a process commonly referred to as shadow accounting. This adjustment is required in order to reflect the impact of these unrealized amounts as if these unrealized amounts had been realized. The projection of EGPs requires the extensive use of actuarial assumptions, estimates and judgments about the future. Future EGPs are generally projected for the estimated lives of the contracts. Assumptions are set separately for each product and are reviewed at least annually based on our current best estimates of future events. The following table summarizes the most significant assumptions used in the categories set forth below: Significant Assumption Product Explanation and Derivation Separate account Variable Annuities Separate account return investment return (8.0% long-term return assumptions are derived from assumption) the long-term returns observed Variable Universal Life in the asset classes in which (8.0% long-term return the separate accounts are assumption) invested. Short-term deviations from the long-term expectations are expected to revert to the long-term assumption over five years. Interest rates and Fixed and Indexed Investment returns are based default rates Annuities on the current yields and Universal Life maturities of our fixed income portfolio combined with expected reinvestment rates given current market interest rates. Reinvestment rates are assumed to revert to long-term rates implied by the forward yield curve and long-term default rates. Contractually permitted future changes in credited rates are assumed to help support investment margins. 32-------------------------------------------------------------------------------- Significant Assumption Product Explanation and Derivation Mortality / longevity Universal Life Mortality assumptions are Variable Universal Life based on Company experience Fixed and Indexed Annuities over a rolling five-year period plus supplemental data from industry sources and trends. A mortality improvement assumption is also incorporated into the overall mortality table. These assumptions can vary by issue age, gender, underwriting class and policy duration. Policyholder behavior - Universal Life Policy persistency assumptions policy persistency Variable Universal Life vary by product and policy Variable Annuities year and are updated based on Fixed and Indexed Annuities recently observed experience. Policyholders are generally assumed to behave rationally; hence rates are typically lower when surrender penalties are in effect or when policy benefits are more valuable. Policyholder behavior - Universal Life Future premiums and related premium persistency Variable Universal Life fees are projected based on contractual terms, product illustrations at the time of sale and expected policy lapses without value. Assumptions are updated based on recently observed experience and include anticipated changes in behavior based on changes in policy charges if the Company has a high degree of confidence that such changes will be implemented (e.g., change in COI charges). Expenses All products Projected maintenance expenses to administer policies in force are based on annually updated studies of expenses incurred. Reinsurance costs / Universal Life Projected reinsurance costs recoveries Variable Universal Life are based on treaty terms Variable Annuities currently in force. Recoveries are based on the Company's assumed mortality and treaty terms. Treaty recaptures are based on contract provisions and management's intentions. Annually, we complete a comprehensive assumption review where management makes a determination of best estimate assumptions based on a comprehensive review of recent experience and industry trends. Assumption changes resulting from this review may change our estimates of EGPs in the DAC, SIA, and URR models, as well as projections within the death benefit and other insurance benefit reserving models, the profits followed by losses reserve models, and cost of reinsurance models. Throughout the year, we may also update the assumptions and adjust these balances if emerging data indicates a change is warranted. All assumption changes, whether resulting from the annual comprehensive review or from other periodic assessments, are considered an unlock in the period of revision and adjust the DAC, SIA, URR, death and other insurance benefit reserves, profits followed by losses reserve, and cost of reinsurance balances in the balance sheets with an offsetting benefit or charge to income to reflect such changes in the period of the revision. An unlock that results in an after-tax benefit generally occurs as a result of actual experience or future expectations of product profitability being more favorable than previous estimates. An unlock that results in an after-tax charge generally occurs as a result of actual experience or future expectations of product profitability being less favorable than previous estimates. Our process to assess the reasonableness of the EGPs uses internally developed models together with consideration of applicable recent experience and analysis of market and industry trends and other events. Actual gross profits that vary from management's estimates in a given reporting period may also result in increases or decreases in the rate of amortization recorded in the period. An analysis is performed annually to assess if there are sufficient gross profits to recover the deferred policy acquisition costs associated with business written during the year. If the estimates of gross profits cannot support the recovery of deferred policy acquisition costs, the amount deferred is reduced to the recoverable amount. 33 -------------------------------------------------------------------------------- Over the last several years, the Company has revised a number of assumptions that have resulted in changes to expected future gross profits. The most significant assumption updates resulting in a change to future gross profits and the amortization of DAC, SIA and URR in 2013 are related to changes in expected premium persistency, and the incorporation of a mortality improvement assumption. Other of the more significant drivers of changes to expected gross profits over the last several years include changes in expected separate account investment returns due to changes in equity markets; changes in expected future interest rates and default rates based on continued experience and expected interest rate changes; changes in mortality, lapses and other policyholder behavior assumptions that are updated to reflect more recent policyholder and industry experience; and changes in expected policy administration expenses. Policy Liabilities and Accruals Generally, future policy benefits are payable over an extended period of time and related liabilities are calculated recognizing future expected benefits, expenses and premiums. Such liabilities are established based on methods and underlying assumptions in accordance with U.S. GAAP and applicable actuarial standards. Principal assumptions used in the establishment of liabilities for future policy benefits are mortality, morbidity, policyholder behavior, investment returns, inflation, expenses and other contingent events as appropriate. These assumptions are intended to estimate the experience for the period the policy benefits are payable. Utilizing these assumptions, liabilities are established on a cohort basis, as appropriate. If experience is less favorable than assumed, additional liabilities may be established, resulting in a charge to policyholder benefits and claims. Additional policyholder liabilities for guaranteed benefits on variable annuity and on fixed index annuity contracts are based on estimates of the expected value of benefits in excess of the projected account balance, recognizing the excess over the accumulation period based on total expected assessments. Because these estimates are sensitive to capital market movements, amounts are calculated using multiple future economic scenarios. Additional policyholder liabilities are established for certain contract features that could generate significant reductions to future gross profits (e.g., death benefits when a contract has zero account value and a no-lapse guarantee). The liabilities are accrued over the lifetime of the block based on assessments. The assumptions used in estimating these liabilities are consistent with those used for amortizing deferred policy acquisition costs, and are, thus, subject to the same variability and risk. The assumptions of investment performance and volatility for variable and equity index products are consistent with historical experience of the appropriate underlying equity indices. We expect that our universal life block of business will generate profits followed by losses and, therefore, we establish an additional liability to accrue for the expected losses over the period of expected profits. The assumptions used in estimating these liabilities are consistent with those used for amortizing deferred policy acquisition costs and are subject to the same variability and risk. The Company periodically reviews its estimates of actuarial liabilities for policyholder benefits and compares them with its actual experience. Differences between actual experience and the assumptions used in pricing these policies and guarantees, as well as in the establishment of the related liabilities, result in variances in profit and could result in losses. See Note 2 to our financial statements under "Item 8: Financial Statements and Supplementary Data" and the "Enterprise Risk Management" section of "Item 7: Management's Discussion and Analysis of Financial Condition and Results of Operations" in this Form 10-K for more information. 34 --------------------------------------------------------------------------------Embedded Derivative Liabilities We make guarantees on certain variable annuity contracts, including GMAB, GMWB and COMBO as well as provide credits based on the performance of certain indices ("index credits") on our fixed indexed annuity contracts that meet the definition of an embedded derivative. The GMAB, GMWB and COMBO embedded derivative liabilities associated with our variable annuity contracts are accounted for at fair value, using a risk neutral stochastic valuation methodology with changes in fair value recorded in realized investment gains. The inputs to our fair value methodology include estimates derived from the asset derivatives market, including the equity volatility and the swap curve. Several additional inputs are not obtained from independent sources, but instead reflect our internally developed assumptions related to mortality rates, lapse rates and policyholder behavior. The fair value of the embedded derivative liabilities associated with the index credits on our fixed indexed annuity contracts is calculated using the budget method with changes in fair value recorded in realized investment gains. The initial value under the budget method is established based on the fair value of the options used to hedge the liabilities. The value of the index credits in future years is estimated to be the budgeted amount. The budget amount is based on the impact of projected interest rates on the discounted liabilities. Several additional inputs reflect our internally developed assumptions related to lapse rates and policyholder behavior. As there are significant unobservable inputs included in our fair value methodology for these embedded derivative liabilities, we consider the above-described methodology as a whole to be Level 3 within the fair value hierarchy. Our fair value calculation of embedded derivative liabilities includes a credit standing adjustment (the "CSA"). The CSA represents the adjustment that market participants would make to reflect the risk that guaranteed benefit obligations may not be fulfilled ("non-performance risk"). We estimate our CSA using the credit spread (based on publicly available credit spread indices) for financial services companies similar to the Company and its insurance company affiliates. The CSA is updated every quarter and, therefore, the fair value will change with the passage of time even in the absence of any other changes that would affect the valuation. For example, the December 31, 2013 fair value of $74.8 million would increase to $79.7 million if the spread were decreased by 50 basis points. If the spread were increased by 50 basis points, the fair value would decrease to $70.2 million. Valuation of Debt Securities We classify our debt securities as available-for-sale and report them in our balance sheets at fair value. Fair value is based on quoted market price or external third party information, where available. When quoted market prices are not available, we estimate fair value by discounting debt security cash flows to reflect interest rates currently being offered on similar terms to borrowers of similar credit quality, by quoted market prices of comparable instruments and by independent pricing sources or internally developed pricing models. Fair Value of Securities As of by Pricing Source: [1] December 31, 2013 ($ in millions) Fixed % of Maturities Total at Fair Value Fair ValuePriced via independent market quotations $ 2,367.8 67.5 % Priced via matrices 988.8 28.2 % Priced via broker quotations 50.9 1.5 % Priced via other methods 18.8 0.5 % Short-term investments [2] 81.0 2.3 % Total $ 3,507.3 100.0 % ------- [1] Inclusive of short-term investments. [2] Short-term investments are valued at amortized cost, which approximates fair value. See Note 9 to our financial statements under Item 8 "Financial Statements and Supplementary Data" in this Form 10-K for additional disclosures of our fair value methodologies. 35--------------------------------------------------------------------------------Other-than-Temporary Impairments on Available-for-Sale Securities We recognize realized investment losses when declines in fair value of debt securities are considered to be an OTTI. For debt securities, the other-than-temporarily impaired amount is separated into the amount related to a credit loss and is reported as net realized investment losses included in earnings and any amounts related to other factors are recognized in OCI. The credit loss component represents the difference between the amortized cost of the security and the net present value of its projected future cash flows discounted at the effective interest rate implicit in the debt security prior to impairment. Any remaining difference between the fair value and amortized cost is recognized in accumulated other comprehensive income ("AOCI"). Subsequent to the recognition of an OTTI, the impaired security is accounted for as if it had been purchased on the date of impairment at an amortized cost basis equal to the previous amortized cost basis less the OTTI recognized in earnings. We will continue to estimate the present value of future expected cash flows and, if significantly greater than the new cost basis, we will accrete the difference as investment income on a prospective basis once the Company has determined that the interest income is likely to be collected. In evaluating whether a decline in value is other-than-temporary, we consider several factors including, but not limited to, the following: • the extent and the duration of the decline; • the reasons for the decline in value (credit event, interest related or market fluctuations); • our intent to sell the security, or whether it is more likely than not that we will be required to sell it before recovery; and • the financial condition and near term prospects of the issuer. A debt security impairment is deemed other-than-temporary if: • we either intend to sell the security, or it is more likely than not that we will be required to sell the security before recovery; or • it is probable we will be unable to collect cash flows sufficient to recover the amortized cost basis of the security. Impairments due to deterioration in credit that result in a conclusion that the present value of cash flows expected to be collected will not be sufficient to recover the amortized cost basis of the security are considered other-than-temporary. Other declines in fair value (for example, due to interest rate changes, sector credit rating changes or company-specific rating changes) that result in a conclusion that the present value of cash flows expected to be collected will not be sufficient to recover the amortized cost basis of the security may also result in a conclusion that an OTTI has occurred. On a quarterly basis, we evaluate securities in an unrealized loss position for potential recognition of an OTTI. In addition, we maintain a watch list of securities in default, near default or otherwise considered by our investment professionals as being distressed, potentially distressed or requiring a heightened level of scrutiny. We also identify securities whose fair value has been below amortized cost on a continuous basis for zero to six months, six months to 12 months and greater than 12 months. We employ a comprehensive process to determine whether or not a security in an unrealized loss position is other-than-temporarily impaired. This assessment is done on a security-by-security basis and involves significant management judgment. The assessment of whether impairments have occurred is based on management's evaluation of the underlying reasons for the decline in estimated fair value. The Company's review of its debt securities for impairments includes an analysis of the total gross unrealized losses by severity and/or age of the gross unrealized loss, as summarized in the, "Duration of Gross Unrealized Losses on Securities" section. An extended and severe unrealized loss position on a debt security may not have any impact on the ability of the issuer to service all scheduled interest and principal payments and the Company's evaluation of recoverability of all contractual cash flows or the ability to recover an amount at least equal to its amortized cost based on the present value of the expected future cash flows to be collected. In contrast, for certain equity securities, greater weight and consideration are given by the Company to an extended decline in market value and the likelihood such market value decline will recover. Specifically for structured securities, to determine whether a collateralized security is impaired, we obtain underlying data from the security's trustee and analyze it for performance trends. A security-specific stress analysis is performed using the most recent trustee information. This analysis forms the basis for our determination of the future expected cash flows to be collected for the security. 36-------------------------------------------------------------------------------- See Note 6 to our financial statements under "Item 8: Financial Statements and Supplementary Data" and the "Debt Securities" and "Enterprise Risk Management" sections of "Item 7: Management's Discussion and Analysis of Financial Condition and Results of Operations" in this Form 10-K for more information. Income Taxes We account for income taxes in accordance with ASC 740, Accounting for Income Taxes. We are included in the consolidated federal income tax return filed by PNX and are party to a tax sharing agreement by and among PNX and its subsidiaries. In accordance with this agreement, federal income taxes are allocated as if they had been calculated on a separate company basis, except that benefits for any net operating losses or other tax credits generated by the Company will be provided at the earlier of when such loss or credit is utilized in the consolidated federal tax return and when the tax attribute would have otherwise expired. Deferred tax assets and/or liabilities are determined by multiplying the differences between the financial reporting and tax reporting bases for assets and liabilities by the enacted tax rates expected to be in effect when such differences are recovered or settled. U.S. GAAP requires an assessment of the realizability of deferred tax assets in order to determine whether a valuation allowance should be recorded. The total deferred tax asset, net of any valuation allowance, represents the deferred tax asset that management estimates to be realizable. The assessment of the realizability of deferred tax assets involves management making assumptions and judgments about all available positive and negative evidence including the reversal of gross deferred tax liabilities, projected future taxable income, prudent and feasible tax planning strategies and recent operating results, including the existence of cumulative income (loss) incurred over the three-year period ended December 31, 2013. As of December 31, 2013, we concluded that our estimates of future taxable income, certain tax planning strategies and other sources of income did not constitute sufficient positive evidence to assert that it is more likely than not that certain deferred tax assets would be realizable. Accordingly, a valuation allowance of $74.2 million has been recorded on net deferred tax assets of $102.2 million. The valuation allowance recorded constitutes a full valuation allowance on the net deferred tax assets that require future taxable income in order to be realized. The remaining deferred tax asset of $28.0 million attributable to available-for-sale debt securities with gross unrealized losses do not require a valuation allowance due to our ability and intent to hold these securities until recovery of fair or principal value through sale or contractual maturity, thereby avoiding the realization of taxable losses. This conclusion is consistent with prior periods. The impact of the valuation allowance on the allocation of tax to the components of the financial statements included a decrease of $31.7 million in net loss and an increase of $0.5 million in OCI-related deferred tax balances. The calculation of tax liabilities involves uncertainties in applying certain tax laws. ASC 740 provides that a tax benefit that arises from an uncertain tax position that is more likely than not to be upheld upon IRS examination shall be recognized in the financial statements. The more likely than not threshold requires judgments made by management and the related tax liability is adjusted accordingly as new information becomes available. Due to the complexities of such uncertainties, tax payments made upon IRS examination may be materially different from the current estimate of tax liabilities. The impact of payments that differ from the recognized liability are reflected in the period in which the examinations are completed. The Company has minimal uncertain tax positions and accordingly, the liability for uncertain tax positions is not material to the financial statements. See Note 10 to our financial statements under "Item 8: Financial Statements and Supplementary Data" in this Form 10-K for more information related to income taxes. Litigation Contingencies The Company is a party to legal actions and is involved in regulatory investigations. Given the inherent unpredictability of these matters, it is difficult to estimate the impact on our financial position. Liabilities are established when it is probable that a loss has been incurred and the amount of the loss can be reasonably estimated. On a quarterly and annual basis, the Company reviews relevant information with respect to liabilities for litigation, regulatory investigations, and litigation-related contingencies to be reflected in the Company's financial statements. It is possible that an adverse outcome in certain of the Company's litigation or the use of different assumptions in the determination of amounts recorded could have a material effect upon the Company's net income or cash flows in particular quarterly or annual periods. 37 -------------------------------------------------------------------------------- Results of Operations Summary Financial Data: Years Ended Increase (decrease) and ($ in millions) December 31, percentage change 2013 2012 2013 vs. 2012 REVENUES: Premiums $ 13.9 $ 8.5 $ 5.4 64 %Insurance and investment product fees 367.6 365.3 2.3 1 % Net investment income 140.8 130.9 9.9 8 % Net realized investment gains (losses): Total other-than-temporary impairment ("OTTI") losses (1.1 ) (5.0 ) 3.9 (78 %) Portion of OTTI losses recognized in other comprehensive income ("OCI") (0.9 ) 2.2 (3.1 ) NM Net OTTI losses recognized in earnings (2.0 ) (2.8 ) 0.8 (29 %) Net realized investment gains (losses), excluding OTTI losses 5.4 (19.5 ) 24.9 NM Net realized investment gains (losses) 3.4 (22.3 ) 25.7 NM Total revenues 525.7 482.4 43.3 9 % BENEFITS AND EXPENSES: Policy benefits 286.5 396.8 (110.3 ) (28 %) Policy acquisition cost amortization 88.4 103.5 (15.1 ) (15 %) Other operating expenses 116.8 103.6 13.2 13 % Total benefits and expenses 491.7 603.9 (112.2 ) (19 %) Income (loss) before income taxes 34.0 (121.5 ) 155.5 NM Income tax expense (benefit) (21.7 ) 16.2 (37.9 ) NM Net income (loss) $ 55.7 $ (137.7 ) $ 193.4 NM ------- Not meaningful (NM) Analysis of Results of Operations Year ended December 31, 2013 compared to year ended December 31, 2012 The Company recorded net income of $55.7 million for the twelve months ended December 31, 2013 as compared with a net loss of $137.7 million for the twelve months ended December 31, 2012. The increase in net income is primarily due to the following items: • Net realized investment gains, excluding OTTI, of $5.4 million were recognized for the twelve months ended December 31, 2013 compared to net realized investment losses, excluding OTTI, of $19.5 million for the twelve months ended December 31, 2012. The change in the net realized investment gains is primarily attributable to a decrease in realized losses on derivatives that are used to hedge the risks associated with variable annuity guarantees and the fixed indexed annuity liabilities. For the twelve months ended December 31, 2013 there were losses on derivative investments of $23.1 million, while there were losses of $49.0 million for the twelve months ended December 31, 2012. The continued improvement in the equity markets results in losses on the derivatives that are used to hedge the risk associated with the variable annuity guarantees, that are offset by gains on the derivatives that are used to hedge the risks associated with the fixed indexed annuities. The fixed indexed annuity hedging gains were more significant in 2013 due to more significant increases in the equity market in 2013 than in 2012, as well as additional derivatives purchased due to continued sales of fixed indexed annuities. • Policy benefits decreased $110.3 million for the twelve months ended December 31, 2013 compared with the twelve months ended December 31, 2012. The decrease in policy benefit expenses is primarily due to gains on guaranteed insurance benefit liabilities and reserves for profits followed by losses of $84.1 million as a result of assumption changes made during the annual comprehensive review of assumptions in the fourth quarter of 2013. The most significant driver of the positive 2013 unlock results was the incorporation of a mortality improvement assumption in the overall mortality table, which resulted in improved expected mortality on universal life and variable universal life products. 38--------------------------------------------------------------------------------• Income taxes provided a benefit of $21.7 million for the twelve months ended December 31, 2013 compared with an expense of $16.2 million for the twelve months ended December 31, 2012. The primary driver of the income tax benefit is a decrease in the valuation allowance of $31.7. Partially offsetting the increase in net income were the following items: • Operating expenses increased by $13.2 million for the twelve months ended December 31, 2013 compared with the twelve months ended December 31, 2012. The increase in operating expenses was a result of higher professional fees and outside consulting services primarily as a result of the restatement. Effects of Inflation For the years 2013, 2012 and 2011, inflation did not have a material effect on our results of operations. Enterprise Risk Management Our ultimate parent company, PNX, has an enterprise-wide risk management program under which PHL Variable operations are covered. Our Chief Risk Officer reports to the Chief Executive Officer and monitors our risk management activities. The Chief Risk Officer provides regular reports to the Board without the presence of other members of management. Our risk management governance consists of several management committees to oversee and address issues pertaining to all our major risks-operational, market and product-as well as capital management. In all cases, these committees include one or more of our Chief Executive Officer, Chief Financial Officer, Chief Investment Officer and Chief Risk Officer. Operational Risk Operational risk is the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. As reported in "Item 9A: Controls and Procedures" of this Form 10-K, the Company has concluded that there are material weaknesses in its internal control over financial reporting, which have materially adversely affected its ability to timely and accurately report its results of operations and financial condition, and that its disclosure controls and procedures are ineffective as of December 31, 2013. These material weaknesses have not been fully remediated as of the filing date of this report and the Company cannot assure that other material weaknesses will not be identified in the future. It is necessary for the Company to maintain effective internal control over financial reporting to prevent fraud and errors, and to maintain effective disclosure controls and procedures so that it can provide timely and reliable financial and other information. If the Company fails to maintain an effective system of internal controls, the accuracy and timing of its financial reporting may be adversely affected. Further, the absence of timely and reliable financial and other information about the Company's business operations may inhibit the Company's ability to identify operational risk. A failure to correct material weaknesses in our internal controls could result in further restatements of financial statements and correction of other information filed with the SEC. See "Item 1A: Risk Factors" in Part I of this Form 10-K for a description of these and other risks that may impact the Company's operations. Also see "Item 9A: Controls and Procedures" in Part II of this Form 10-K for more information regarding these weaknesses, an evaluation of the effectiveness of the Company's disclosure controls and procedures, and the Company's remediation plans. PNX has established an Operational Risk Committee, chaired by the Chief Risk Officer, to develop an enterprise-wide framework for managing operational risks. This committee meets periodically and includes membership that represents all significant operating, financial and staff departments of PNX. Among the risks the committee reviews and manages and for which it provides general oversight are business continuity risk, disaster recovery risk and risks related to the Company's information technology systems. Market Risk Market risk is the risk that we will incur losses due to adverse changes in market rates and prices. We have exposure to market risk through both our investment activities and our insurance operations. Our investment objective is to maximize after-tax investment return within defined risk parameters. Our primary sources of market risk are: • interest rate risk, which relates to the market price and cash flow variability associated with changes in market interest rates; • credit risk, which relates to the uncertainty associated with the ongoing ability of an obligor to make timely payments of principal and interest; and • equity risk, which relates to the volatility of prices for equity and equity-like investments, such as limited partnerships. 39-------------------------------------------------------------------------------- We measure, manage and monitor market risk associated with our insurance and annuity business, as part of our ongoing commitment to fund insurance liabilities. We have developed an integrated process for managing the interaction between product features and market risk. This process involves our Corporate Finance, Corporate Portfolio Management and Life and Annuity Product Development departments. These areas coordinate with each other and report results and make recommendations to our Asset-Liability Management Committee ("ALCO") chaired by the Chief Risk Officer. We also measure, manage and monitor market risk associated with our investments, both those backing insurance liabilities and those supporting surplus. This process primarily involves Corporate Portfolio Management. This organization makes recommendations and reports results to our Investment Policy Committee, chaired by the Chief Investment Officer. Please refer to the sections that follow, including "Debt Securities," following this discussion of Enterprise Risk Management, for more information on our investment risk exposures. Within the parameters specified in our investment policy, we regularly refine our allocations based on factors including ratings, duration and type of fixed income security to appropriately balance market risk exposure and expected return. Interest Rate Risk Management Interest rate risk is the risk that we will incur economic losses due to adverse changes in interest rates. Our debt security investments include U.S. and foreign government bonds, securities issued by government agencies, corporate bonds, asset-backed securities and mortgage-backed securities, most of which are exposed to changes in medium-term and long-term U.S. Treasury rates. Our exposure to interest rate changes results primarily from our significant holdings of fixed rate investments and our interest-sensitive insurance liabilities. Our insurance liabilities largely comprise dividend-paying universal life policies and annuity contracts. We manage interest rate risk as part of our asset-liability management and product development processes. Asset-liability management strategies include the segmentation of investments by product line and the construction of investment portfolios designed to satisfy the projected cash needs of the underlying product liabilities. All asset-liability strategies are approved by the ALCO. We manage the interest rate risk in portfolio segments by modeling and analyzing asset and product liability durations and projected cash flows under a number of interest rate scenarios. We also manage interest rate risk by purchasing securities that feature prepayment restrictions and call protection. Our product design and pricing strategies include the use of surrender charges or restrictions on withdrawals in some products. We regularly undertake a sensitivity analysis that calculates liability durations under various cash flow scenarios. In addition, we monitor the short- and medium-term asset and liability cash flows profiles by portfolio to manage our liquidity needs. One of the key measures we use to quantify our interest rate exposure is duration, a measure of the sensitivity of the fair value of assets and liabilities to changes in interest rates. For example, if interest rates increase by 100 basis points, or 1%, the fair value of an asset or liability with a duration of five is expected to decrease by 5%. We believe that as of December 31, 2013, our asset and liability portfolio durations were reasonably matched. The Company uses an industry recognized analytic model to calculate the fair value of its fixed income portfolio. The Company's interest rate sensitivity analysis reflects the change in market value assuming a +/-100 basis point parallel shift in the yield curve. The down 100 basis point shift is floored at zero to prevent rates from going negative. The table below shows the estimated interest rate sensitivity of our fixed income financial instruments measured in terms of fair value. Interest Rate Sensitivity of As of Fixed Income Financial Instruments: December 31, 2013 ($ in millions) -100 Basis +100 Basis Point Point Change Fair Value Change Cash and short-term investments $ 262.1 $ 262.0 $ 261.7 Available-for-sale debt securities 3,628.4 3,426.3 3,231.1 Fair value investments [1] 50.2 48.6 46.9 Totals $ 3,940.7 $ 3,736.9 $ 3,539.7 -------[1] Includes debt securities where the fair value option has been elected. 40 --------------------------------------------------------------------------------See Note 9 to our financial statements under "Item 8: Financial Statements and Supplementary Data" in this Form 10-K for more information on fair value instruments. We also use derivative financial instruments, primarily interest rate swaps, to manage our residual exposure to fluctuations in interest rates. We enter into derivative contracts with a number of highly rated financial institutions, to both diversify and reduce overall counterparty credit risk exposure. We enter into interest rate swap agreements to reduce market risks from changes in interest rates. We do not enter into interest rate swap agreements for trading purposes. Under interest rate swap agreements, we exchange cash flows with another party at specified intervals for a set length of time based on a specified notional principal amount. Typically, one of the cash flow streams is based on a fixed interest rate set at the inception of the contract and the other is based on a variable rate that periodically resets. No premium is paid to enter into the contract and neither party makes payment of principal. The amounts to be received or paid on these swap agreements are accrued and recognized in net investment income. The table below shows the interest rate sensitivity of our derivatives measured in terms of fair value, excluding derivative liabilities embedded in products. These exposures will change as our insurance liabilities are created and discharged and as a result of portfolio and risk management activities. Interest Rate Sensitivity of As of Derivatives: December 31, 2013 ($ in millions) Weighted- -100 +100 Basis Average Basis Basis Notional Term Point Point Amount (Years) Change Fair Value Change Equity Futures [1] $ 159.7 0.3 $ 12.5 $ 12.5 $ 12.1 Interest Rate Swap 139.0 7.9 1.0 (2.9 ) (6.2 ) Variance Swap 0.9 3.0 (8.0 ) (7.9 ) (7.8 ) Call Option [2] 155.3 0.1 21.9 22.0 22.0 Put Option 391.0 5.1 35.1 29.5 24.6 Swaption 3,902.0 1.1 7.0 30.7 99.0 Total $ 4,747.9 $ 69.5 $ 83.9 $ 143.7 -------[1] Equity futures fair value includes margin account cash balance of $12.5 million. [2] Excludes call options, hedging fixed indexed annuity products. See Note 8 to our financial statements under "Item 8: Financial Statements and Supplementary Data" in this Form 10-K for more information on derivative instruments. To calculate duration for liabilities, we project liability cash flows under a number of stochastically generated interest rate scenarios and discount them to a net present value using a risk-free market rate increased for CSA. For interest-sensitive liabilities the projected cash flows reflect the impact of the specific scenarios on policyholder behavior as well as the effect of minimum guarantees. Duration is calculated by revaluing these cash flows at an alternative level of interest rates and by determining the percentage change in fair value from the base case. Liabilities in excess of the policyholder account balance for universal life contracts, some of which contain secondary guarantees, are generally determined by estimating the expected value of benefits and expenses when claims are triggered and recognizing those benefits and expenses over the accumulation period based on total expected assessments. The assumptions used in estimating these liabilities are consistent with those used for amortizing deferred policy acquisition costs. The universal life block of business has experience which produces profits in earlier periods followed by losses in later periods for which a liability is required to be held in addition to the policy liabilities recorded. See the "Critical Accounting Estimates" section above for more information on deferred policy acquisition costs and policy liabilities and accruals. 41 -------------------------------------------------------------------------------- To estimate the impact of a 100 basis point increase or decrease in interest rates, the Company revised estimated future new money yields thereby modifying future expected portfolio returns. These shocks resulted in higher or lower investment margins and discount rates for products subject to loss recognition and profits followed by losses. All material, interest sensitive blocks of business were considered; the most significant of which is universal life. We measured the impact upon deferred policy acquisition costs and policy liabilities. Management believes that the Company's exposure to interest rate volatility related to its fixed index annuity product is limited and has been omitted from the analysis below. This exposure is limited due to the short duration of the indexed credit feature and the lack of guaranteed minimum benefit exposure that varies with interest rates associated on the product. The table below shows the interest rate sensitivity of our deferred policy acquisition costs and policy liabilities. Interest Rate Sensitivity of As of Deferred Policy Acquisition Costs and December 31, 2013 Policy Liabilities: Deferred Policy ($ in millions) -100 Basis Acquisition Costs +100 Basis -100 Basis Policy +100 Basis Point Change [1] Point Change Point Change Liabilities [1] Point Change Universal and variable universal life $ 186.4 $ 192.6 $ 194.6 $ 433.9 $ 368.8 $ 359.4 Other life and annuity products [2] - - - 46.9 44.4 42.3 -------[1] The values below represent changes to balances before adjustment for unrealized gains/losses. [2] Includes term life and payout annuity products subject to loss recognition. The selection of a 100 basis point immediate increase or decrease in interest rates at all points on the yield curve is a hypothetical rate scenario used to demonstrate potential risk. While a 100 basis point immediate increase or decrease of this type does not represent our view of future market changes, it is a hypothetical near-term change that illustrates the potential effect of such events. Although these measurements provide a representation of interest rate sensitivity, they are based on our exposures at a point in time and may not be representative of future market results. These exposures will change as a result of new business, management's assessment of changing market conditions and available investment opportunities. Credit Risk Management We manage credit risk through the fundamental analysis of the underlying obligors, issuers and transaction structures. Through internal staff and an outsource relationship, we employ experienced credit analysts who review obligors' management, competitive position, cash flow, coverage ratios, liquidity and other key financial and non-financial information. These analysts recommend the investments needed to fund our liabilities while adhering to diversification and credit rating guidelines. In addition, when investing in private debt securities, we rely upon broad access to management information, negotiated protective covenants, call protection features and collateral protection. We review our debt security portfolio regularly to monitor the performance of obligors and assess the stability of their current credit ratings. We also manage credit risk through industry and issuer diversification and asset allocation. Maximum exposure to an issuer or derivatives counterparty is defined by quality ratings, with higher quality issuers having larger exposure limits. We have an overall limit on below-investment-grade rated issuer exposure. In addition to monitoring counterparty exposures under current market conditions, exposures are monitored on the basis of a hypothetical "stressed" market environment involving a specific combination of declines in stock market prices and interest rates and a spike in implied option activity. Equity Risk Management Equity risk is the risk that we will incur economic losses due to adverse changes in equity prices. At December 31, 2013, we held certain financial instruments that are sensitive to equity market movements, primarily related to our holdings of common stock and mutual funds, private equity partnership interests and other equities, as well as fair value equity instruments, equity options and other investments. We manage equity price risk through industry and issuer diversification and asset allocation techniques. 42 --------------------------------------------------------------------------------The table below shows the sensitivity of our investments that are sensitive to public equity market movements measured in terms of their fair value. Sensitivity to As of Public Equity Market Movements: December 31, 2013 ($ in millions) Balance after Balance after -10% Equity Fair +10% Equity Price Change Value Price Change Limited partnerships and other investments [1] $ 7.1 $ 7.9 $ 8.7 Derivative instruments [2] 90.3 83.9 78.7 -------[1] Includes private equity funds. The value of private equity investments are not highly correlated to public equity markets, because of their liquidity and valuation methodologies. Direct private equity investments have been included in the sensitivity because they have equity exposure for the Company. [2] Primarily includes swaptions, put options, call options and equity futures, excluding those associated with the fixed indexed annuity products. Certain liabilities are sensitive to equity market movements. Our exposure to changes in equity prices primarily results from our variable annuity and variable life products. We manage our insurance liability risks on an integrated basis with other risks through our liability and risk management and capital and other asset allocation strategies. Certain variable annuity products sold by us contain GMDBs. The GMDB feature provides annuity contract owners with a guarantee that the benefit received at death will be no less than a prescribed amount. This minimum amount is based on the net deposits paid into the contract, the net deposits accumulated at a specified rate, the highest historical account value on a contract anniversary or, if a contract has more than one of these features, the greatest of these values. To the extent that the GMDB is higher than the current account value at the time of death, the Company incurs a cost. This typically results in an increase in annuity policy benefits in periods of declining financial markets and in periods of stable financial markets following a decline. As of December 31, 2013, the difference between the GMDB and the current account value (NAR) for all existing contracts was $13.7 million. This was our exposure to loss had all contract owners died on December 31, 2013. See Note 7 to our financial statements under "Item 8: Financial Statements and Supplementary Data" in this Form 10-K for more information. Certain variable annuity products sold by us contain guaranteed minimum living benefits. These include guaranteed minimum accumulation, withdrawal, income and payout annuity floor benefits. The GMAB guarantees a return of deposit to a policyholder after 10 years regardless of market performance. The GMWB guarantees that a policyholder can withdraw a certain percentage for life regardless of market performance. The GMIB guarantees that a policyholder can convert his or her account value into a guaranteed payout annuity at a guaranteed minimum interest rate and a guaranteed mortality basis, while also assuming a certain level of growth in the initial deposit. We also offer a combination rider that offers both GMAB and GMDB benefits. We have established a hedging program for managing the risk associated with our guaranteed minimum accumulation and withdrawal benefit features. We continue to analyze and refine our strategies for managing risk exposures associated with all our separate account guarantees. Management believes that the Company's exposure to equity market volatility related to its fixed index annuity product is limited and has been omitted from the analysis below. This exposure is limited to the indexed credit feature of the product, which is reasonably managed through the Company's ongoing hedging program. See Note 4 to our financial statements under "Item 8: Financial Statements and Supplementary Data" in this Form 10-K for more information regarding deferred policy acquisition costs. 43--------------------------------------------------------------------------------The table below shows the estimated equity risk sensitivity of our liability products that are sensitive to equity market movements measured in terms of their fair value. Equity Risk Sensitivity of As of Our Liability Products: December 31, 2013 ($ in millions) Balance after Balance after -10% Equity Fair +10% Equity Price Change Value Price Change GMAB [1] $ 3.7 $ 1.5 $ (0.7 ) GMWB [1] (2.3 ) (5.1 ) (7.8 ) COMBO [1] (0.3 ) (0.4 ) (0.4 ) -------[1] The values above represent changes to balances before adjustment for unrealized gains/losses. The selection of a 10% increase or decrease in equity prices is a hypothetical rate scenario used to demonstrate potential risk. While a 10% increase or decrease does not represent our view of future market changes, it is a hypothetical near-term change that illustrates the potential effect of such events. Although these fair value measurements provide a representation of equity market sensitivity, they are based on our exposures at a point in time and may not be representative of future market results. These exposures will change as a result of new business, management's assessment of changing market conditions and available investment opportunities. Estimated Fair Value Measurement Fair value is based upon quoted market prices, where available. If listed prices or quotes are not available, or are based on disorderly transactions or inactive markets, fair value is based upon internally developed models that use primarily market-based or independently sourced market parameters, including interest rate yield curves, option volatilities and currency rates. Valuation adjustments may be made to ensure that financial instruments are recorded at fair value. These adjustments include amounts to reflect counterparty credit quality, our own creditworthiness, liquidity and unobservable parameters that are applied consistently over time. Using professional judgment and experience, we evaluate and weigh the relevance and significance of all readily available market information to determine the best estimate of fair value. The fair values investments with unobservable inputs are determined by management after considering prices from our pricing vendors. Fair values for debt securities are primarily based on yield curve analysis along with ratings and spread data. Other inputs may be considered for fair value calculations including published indexed data, sector specific performance, comparable price sources and similar traded securities. See Note 9 to our financial statements under "Item 8: Financial Statements and Supplementary Data" in this Form 10-K for additional information regarding the estimated fair value of investments. Debt Securities We invest in a variety of debt securities. We classify these investments into various sectors using industry conventions; however, our classifications may differ from similarly titled classifications of other companies. We classify debt securities into investment grade and below-investment-grade securities based on ratings prescribed by the National Association of Insurance Commissioners ("NAIC"). In a majority of cases, these classifications will coincide with ratings assigned by one or more Nationally Recognized Statistical Rating Organizations ("NRSROs"); however, for certain structured securities, the NAIC designations may differ from NRSRO designations based on the amortized cost of the securities in our portfolio. Our available-for-sale debt securities portfolio consists primarily of investment grade publicly traded and privately placed corporate bonds, residential mortgage-backed securities ("RMBS"), commercial mortgage-backed securities ("CMBS") and other asset-backed securities. As of December 31, 2013, our available-for-sale debt securities, with a fair value of $3,426.3 million, represented 88.5% of total investments. 44 -------------------------------------------------------------------------------- Available-for-Sale Debt Securities Ratings by Percentage: As of ($ in millions) December 31, 2013 % of % of NAIC S&P Equivalent Fair Fair Amortized Amortized Rating Designation Value Value Cost Cost 1 AAA/AA/A $ 1,936.3 56.5 % $ 1,924.4 56.6 % 2 BBB 1,352.3 39.4 % 1,343.6 39.4 % Total investment grade 3,288.6 95.9 % 3,268.0 96.0 % 3 BB 108.8 3.2 % 105.9 3.1 % 4 B 19.5 0.6 % 20.0 0.6 % 5 CCC and lower 2.8 0.1 % 3.8 0.1 % 6 In or near default 6.6 0.2 % 4.9 0.2 % Total available-for-sale debt securities $ 3,426.3 100.0 % $ 3,402.6 100.0 % Available-for-Sale Debt Securities by Type: As of ($ in millions) December 31, 2013 Unrealized Gains (Losses) Fair Amortized Gross Gross Value Cost Gains Losses Net U.S. government and agency $ 68.6 $ 66.1 $ 3.3 $ (0.8 ) $ 2.5 State and political subdivision 154.6 156.2 3.8 (5.4 ) (1.6 ) Foreign government 65.5 63.1 2.7 (0.3 ) 2.4 Corporate 2,207.3 2,194.9 69.5 (57.1 ) 12.4 CMBS 253.7 241.9 13.0 (1.2 ) 11.8 RMBS 509.8 513.7 7.9 (11.8 ) (3.9 ) CDO/CLO 70.9 70.6 1.7 (1.4 ) 0.3 Other asset-backed 95.9 96.1 3.7 (3.9 ) (0.2 ) Total available-for-sale debt securities $ 3,426.3 $ 3,402.6 $ 105.6 $ (81.9 ) $ 23.7 Available-for-Sale Debt Securities by Type and Credit Quality: As of ($ in millions) December 31, 2013 Investment Grade Below Investment Grade Fair Value Amortized Cost Fair Value Amortized Cost U.S. government and agency $ 68.6 $ 66.1 $ - $ - State and political subdivision 154.6 156.2 - - Foreign government 62.2 60.0 3.3 3.1 Corporate 2,096.5 2,085.0 110.8 109.9 CMBS 249.6 237.8 4.1 4.1 RMBS 500.2 504.6 9.6 9.1 CDO/CLO 64.3 65.4 6.6 5.2 Other asset-backed 92.6 92.9 3.3 3.2 Total available-for-sale debt securities $ 3,288.6 $ 3,268.0 $ 137.7 $ 134.6 Percentage of total available-for-sale debt securities 96.0% 95.9% 4.0% 4.1% We manage credit risk through industry and issuer diversification. Maximum exposure to an issuer is defined by quality ratings, with higher quality issuers having larger exposure limits. Our investment approach emphasizes a high level of industry diversification. The top five industry holdings as of December 31, 2013 in our available-for-sale debt and short-term investment portfolio were banking (6.5%), electrical utilities (5.8%), diversified financial services (5.1%), oil (4.1%), and real estate investment trusts (3.2%). 45 --------------------------------------------------------------------------------Eurozone Exposure The following table presents exposure to European debt. We have focused on the countries experiencing significant economic, fiscal or political strain that could increase the likelihood of default. Fair Value of Eurozone Exposure by Country As of ($ in millions) December 31, 2013 Sovereign Financial All % of Debt Debt Institutions Other Total Securities [2] Spain $ - $ 1.0 $ 7.9 $ 8.9 0.2 % Ireland - - 6.9 6.9 0.2 % Italy - - 2.2 2.2 0.1 % Total - 1.0 17.0 18.0 0.5 % All other Eurozone [1] - 13.0 92.1 105.1 3.0 % Total $ - $ 14.0 $ 109.1 $ 123.1 3.5 % -------[1] Includes Finland, France, Germany, Luxembourg and Netherlands. [2] Inclusive of available-for-sale debt securities and short-term investments. Residential Mortgage-Backed Securities We invest directly in RMBS. To the extent these assets deteriorate in credit quality and decline in value for an extended period, we may realize impairment losses. When making investment decisions, we have been focused on identifying those securities that could withstand significant increases in delinquencies and foreclosures in the underlying mortgage pools before incurring a loss of principal. Most of our RMBS portfolio is highly rated. At December 31, 2013, 97.9% of the total residential portfolio was rated investment grade. We hold $58.2 million of RMBS investments backed by prime rated mortgages, $73.9 million backed by Alt-A mortgages and $45.8 million backed by sub-prime mortgages, which combined amount to 4.3% of our total investments. The majority of our prime, Alt-A, and sub-prime exposure is investment grade, with 94% being rated NAIC-1 and another 4% rated NAIC-2. We have employed a disciplined approach in the analysis and monitoring of our mortgage-backed securities. Our approach involves a monthly review of each security. Underlying mortgage data is obtained from the security's trustee and analyzed for performance trends. A security-specific stress analysis is performed using the most recent trustee information. This analysis forms the basis for our determination of whether the security will pay in accordance with the contractual cash flows. RMBS impairments during the year ended December 31, 2013 totaled $1.5 million. These impairments consist of $0.1 million from prime, $1.0 million from Alt-A and $0.4 million from sub-prime. Residential Mortgage-Backed Securities: ($ in millions) As of December 31, 2013 NAIC Rating 1 2 3 4 5 6 AAA/ CCC In or Amortized Market % General AA/ And Near Cost [1] Value [1] Account [2] A BBB BB B Below Default Collateral Agency $ 357.8 $ 350.9 8.7 % 100.0 % 0.0 % 0.0 % 0.0 % 0.0 % 0.0 % Prime 57.3 58.2 1.4 % 79.3 % 16.1 % 4.6 % 0.0 % 0.0 % 0.0 % Alt-A 73.2 73.9 1.8 % 78.9 % 12.1 % 9.0 % 0.0 % 0.0 % 0.0 % Sub-prime 44.7 45.8 1.1 % 93.5 % 3.1 % 1.2 % 2.2 % 0.0 % 0.0 % Total $ 533.0 $ 528.8 13.0 % 94.2 % 3.7 % 1.9 % 0.2 % 0.0 % 0.0 % -------[1] Individual categories may not agree with the Debt Securities by Type table on previous page due to nature of underlying collateral. In addition, RMBS holdings in this exhibit include $19.0 million classified as fair value investments on the balance sheets. For these fair value investments, there is no impact to OCI as carrying value is equal to market value. [2] Percentages based on market value of total investments and cash and cash equivalents. 46-------------------------------------------------------------------------------- Prime Mortgage-Backed Securities: ($ in millions) As of December 31, 2013 Year of Issue S&P Equivalent Amortized Market % Investment Post- 2003 andRating Designation Cost Value Assets [1] 2007 2007 2006 2005 2004 Prior NAIC-1 AAA/AAA/A $ 45.4 $ 46.2 1.1 % 0.0 % 0.0 % 4.3 % 27.0 % 48.9 % 19.8 % NAIC-2 BBB 9.3 9.4 0.2 % 0.0 % 6.6 % 18.3 % 49.7 % 18.5 % 6.9 % NAIC-3 BB 2.6 2.6 0.1 % 0.0 % 0.0 % 0.0 % 21.0 % 79.0 % 0.0 % NAIC-4 B - - - % 0.0 % 0.0 % 0.0 % 0.0 % 0.0 % 0.0 % CCC and NAIC-5 below - - - % 0.0 % 0.0 % 0.0 % 0.0 % 0.0 % 0.0 % In or near NAIC-6 default - - - % 0.0 % 0.0 % 0.0 % 0.0 % 100.0 % 0.0 % Total $ 57.3 $ 58.2 1.4 % 0.0 % 1.1 % 6.4 % 30.4 % 45.3 % 16.8 % -------[1] Percentages based on market value of total investments and cash and cash equivalents. Alt-A Mortgage-Backed Securities: ($ in millions) As of December 31, 2013 Year of Issue S&P Equivalent Amortized Market % Investment Post- 2003 andRating Designation Cost Value Assets [1] 2007 2007 2006 2005 2004 Prior NAIC-1 AAA/AAA/A $ 57.9 $ 58.3 1.4 % 2.0 % 5.2 % 8.8 % 12.9 % 44.3 % 26.8 % NAIC-2 BBB 8.9 9.0 0.2 % 0.0 % 0.0 % 0.0 % 0.0 % 83.3 % 16.7 % NAIC-3 BB 6.4 6.6 0.2 % 0.0 % 0.0 % 0.0 % 43.6 % 27.6 % 28.8 % NAIC-4 B - - - % 0.0 % 0.0 % 0.0 % 0.0 % 0.0 % 0.0 % CCC and NAIC-5 below - - - % 0.0 % 0.0 % 0.0 % 0.0 % 0.0 % 0.0 % In or near NAIC-6 default - - - % 0.0 % 0.0 % 0.0 % 0.0 % 0.0 % 0.0 % Total $ 73.2 $ 73.9 1.8 % 1.6 % 4.1 % 6.9 % 14.1 % 47.6 % 25.7 % -------[1] Percentages based on market value of total investments and cash and cash equivalents. Sub-Prime Mortgage-Backed Securities: ($ in millions) As of December 31, 2013 Year of Issue S&P Equivalent Amortized Market % Investment Post- 2003 andRating Designation Cost Value Assets [1] 2007 2007 2006 2005 2004 Prior NAIC-1 AAA/AAA/A $ 41.7 $ 42.8 1.1 % 0.0 % 26.4 % 9.4 % 27.4 % 4.3 % 32.5 % NAIC-2 BBB 1.4 1.4 - % 0.0 % 0.0 % 0.0 % 100.0 % 0.0 % 0.0 % NAIC-3 BB 0.5 0.6 - % 0.0 % 0.0 % 100.0 % 0.0 % 0.0 % 0.0 % NAIC-4 B 1.1 1.0 - % 0.0 % 0.0 % 0.0 % 100.0 % 0.0 % 0.0 % CCC and NAIC-5 below - - - % 0.0 % 0.0 % 0.0 % 0.0 % 0.0 % 0.0 % In or near NAIC-6 default - - - % 0.0 % 0.0 % 0.0 % 0.0 % 0.0 % 100.0 % Total $ 44.7 $ 45.8 1.1 % 0.0 % 24.7 % 10.0 % 30.9 % 4.0 % 30.4 % ------- [1] Percentages based on market value of total investments and cash and cash equivalents. 47--------------------------------------------------------------------------------Commercial Mortgage-Backed Securities We invest directly in CMBS. To the extent these assets deteriorate in credit quality and decline in value for an extended period, we may realize impairment losses. When making investment decisions, we have been focused on identifying those securities that could withstand significant increases in delinquencies and foreclosures in the underlying mortgage pools before incurring a loss of principal. Commercial Mortgage-Backed Securities: ($ in millions) As of December 31, 2013 Year of Issue S&P Equivalent Amortized Market % Investment Post- 2004 and Rating Designation Cost Value [1] Assets[2] 2007 2007 2006 2005 Prior NAIC-1 AAA/AAA/A $ 239.9 $ 251.9 6.2 % 66.9 % 5.0 % 13.8 % 11.1 % 3.2 % NAIC-2 BBB 2.8 2.8 0.1 % 0.0 % 0.0 % 85.1 % 14.9 % 0.0 % NAIC-3 BB 3.5 3.4 0.1 % 0.0 % 51.7 % 48.3 % 0.0 % 0.0 % NAIC-4 B - - 0.0 % 0.0 % 0.0 % 0.0 % 0.0 % 0.0 % CCC and NAIC-5 below - - 0.0 % 0.0 % 0.0 % 0.0 % 0.0 % 0.0 % In or near NAIC-6 default 2.2 2.5 0.0 % 0.0 % 0.0 % 0.0 % 0.0 % 100.0 % Total $ 248.4 $ 260.6 6.4 % 64.6 % 5.5 % 14.9 % 10.9 % 4.1 % -------[1] Includes commercial mortgage-backed CDOs with amortized cost and market values of $2.0 million and $2.3 million, respectively. CMBS holdings in this exhibit include $4.5 million classified as fair value investments on the balance sheets. For these fair value investments, there is no impact to OCI as carrying value is equal to market value. [2] Percentages based on market value of total investments and cash and cash equivalents. Realized Gains and Losses The following table presents certain information with respect to realized investment gains and losses including those on debt securities pledged as collateral, with losses from OTTI charges reported separately in the table. These impairment charges were determined based on our assessment of factors enumerated below, as they pertain to the individual securities determined to be other-than-temporarily impaired. 48 --------------------------------------------------------------------------------Net realized investment gains (losses) Sources and Types of Net Realized Investment Gains (Losses): Years Ended December 31, ($ in millions) 2013 2012 2011 Total other-than-temporary debt impairments $ (1.1 ) $ (5.0 ) $ (9.7 ) Portion of loss recognized in OCI (0.9 ) 2.2 6.9 Net debt impairments recognized in earnings $ (2.0 ) $ (2.8 ) $ (2.8 ) Debt security impairments: U.S. government and agency $ - $ - $ - State and political subdivision - (0.1 ) - Foreign government - - - Corporate - - (0.4 ) CMBS (0.3 ) (0.1 ) (0.4 ) RMBS (1.5 ) (1.9 ) (1.5 ) CDO/CLO (0.2 ) (0.4 ) (0.4 ) Other asset-backed - (0.3 ) (0.1 ) Net debt security impairments (2.0 ) (2.8 ) (2.8 ) Equity security impairments - - (0.4 ) Impairment losses (2.0 ) (2.8 ) (3.2 ) Debt security transaction gains 11.3 22.8 2.5 Debt security transaction losses (0.4 ) (0.7 ) (0.7 ) Limited partnerships and other investment gains - - 0.1 Limited partnerships and other investment losses - (0.3 ) (0.1 ) Net transaction gains (losses) 10.9 21.8 1.8 Derivative instruments (23.1 ) (49.0 ) 6.2 Embedded derivatives [1] 17.6 11.2 (33.2 ) Related party reinsurance derivatives - (3.5 ) 9.0 Assets valued at fair value - - - Net realized investment gains (losses), excluding impairment losses 5.4 (19.5 ) (16.2 ) Net realized investment gains (losses), including impairment losses $ 3.4 $ (22.3 ) $ (19.4 ) ------- [1] Includes the change in fair value of embedded derivatives associated with fixed index annuity indexed crediting feature and variable annuity GMWB, GMAB and COMBO riders. See Note 8 to our financial statements under "Item 8: Financial Statements and Supplementary Data" in this Form 10-K for additional disclosures. Other-than-Temporary Impairments Management assessed all securities in an unrealized loss position in determining whether impairments were temporary or other-than-temporary. In reaching its conclusions, management exercised significant judgment and used a number of issuer-specific quantitative indicators and qualitative judgments to assess the probability of receiving a given security's contractual cash flows. This included the issue's implied yield to maturity, cumulative default rate based on rating, comparisons of issue-specific spreads to industry or sector spreads, specific trading activity in the issue and other market data such as recent debt tenders and upcoming refinancing requirements. Management also reviewed fundamentals such as issuer credit and liquidity metrics, business outlook and industry conditions. Management maintains a watch list of securities that is reviewed for impairments. Each security on the watch list was evaluated, analyzed and discussed, with the positive and negative factors weighed in the ultimate determination of whether or not the security was other-than-temporarily impaired. For securities for which no OTTI was ultimately indicated at December 31, 2013, management does not have the intention to sell, nor does it expect to be required to sell, these securities prior to their recovery. 49 -------------------------------------------------------------------------------- OTTIs recorded on available-for-sale debt securities in 2013 were primarily concentrated in structured securities. These impairments were driven primarily by increased collateral default rates. In our judgment, these credit events or other adverse conditions of the collateral have caused, or will most likely lead to, a deficiency in the contractual cash flows related to the investment. Therefore, based upon these credit events, we have determined that OTTIs exist. Total debt impairments recognized through earnings were $2.0 million in 2013, $2.8 million in 2012 and $2.8 million in 2011. There were equity security OTTIs of $0 in 2013, $0 in 2012 and $0.4 million in 2011. There were no limited partnerships and other investment OTTIs in 2013, 2012 and 2011. In addition to these credit-related impairments recognized through earnings, we impaired securities to fair value through other comprehensive loss for any impairments related to non-credit related factors. These types of impairments were driven primarily by market or sector credit spread widening or by a lack of liquidity in the securities. The amount of impairments recognized as an adjustment to other comprehensive loss due to these factors was $(0.9) million in 2013, $2.2 million in 2012 and $6.9 million in 2011. The following table presents a roll-forward of pre-tax credit losses recognized in earnings related to available-for-sale debt securities for which a portion of the OTTI was recognized in OCI. Credit Losses Recognized in Earnings on Available-for-Sale Debt Securities for As of December 31, which a Portion of the OTTI Loss was Recognized in OCI: 2013 2012 2011 ($ in millions) Balance, beginning of period $ (17.8 ) $ (21.3 ) $ (19.9 ) Add: Credit losses on securities not previously impaired [1] (0.3 ) (1.4 ) (1.0 ) Add: Credit losses on securities previously impaired [1] (0.8 ) (1.2 ) (1.4 ) Less: Credit losses on securities impaired due to intent to sell - - - Less: Credit losses on securities sold 0.3 6.1 1.0 Less: Increases in cash flows expected on previously impaired securities - - - Balance, end of period $ (18.6 ) $ (17.8 ) $ (21.3 ) -------[1] Additional credit losses on securities for which a portion of the OTTI loss was recognized in AOCI are included within net OTTI losses recognized in earnings on the statements of income and comprehensive income. Unrealized Gains and Losses Net unrealized investment gains and losses on securities classified as available-for-sale and certain other assets are included in our balance sheets as a component of AOCI. The table below presents the special category of AOCI for debt securities that are other-than-temporarily impaired when the impairment loss has been split between the credit loss component (in earnings) and the non-credit component (separate category of AOCI). Available-for-Sale Debt Securities Non-Credit OTTI Losses in AOCI, by Security Type: [1] As of December 31, ($ in millions) 2013 [1] 2012 U.S. government and agency $ - $ - State and political subdivision (0.2 ) (0.2 ) Foreign government - - Corporate (1.5 ) (1.5 ) CMBS (0.4 ) (0.6 ) RMBS (8.6 ) (9.0 ) CDO/CLO (3.0 ) (3.3 ) Other asset-backed - - Total available-for-sale debt securities non-credit OTTI losses in AOCI $ (13.7 ) $ (14.6 ) -------[1] Represents the amount of non-credit OTTI losses recognized in AOCI excluding net unrealized gains or losses subsequent to the date of impairment. 50-------------------------------------------------------------------------------- Duration of Gross Unrealized Losses on Securities: As of ($ in millions) December 31, 2013 0 - 6 6 - 12 Over 12 Total Months Months Months Available-for-sale debt securities Total fair value $ 1,424.6 $ 447.0 $ 777.6 $ 200.0 Total amortized cost 1,506.5 454.8 823.6 228.1 Unrealized losses $ (81.9 ) $ (7.8 ) $ (46.0 ) $ (28.1 ) Number of securities 404 120 205 79 Investment grade: Unrealized losses $ (78.2 ) $ (7.7 ) $ (44.2 ) $ (26.3 ) Below investment grade: Unrealized losses $ (3.7 ) $ (0.1 ) $ (1.8 ) $ (1.8 ) For available-for-sale debt securities with gross unrealized losses, 95.6% of the unrealized losses after offsets pertain to investment grade securities and 4.4% of the unrealized losses after offsets pertain to below-investment-grade securities at December 31, 2013. The following table represents those securities whose fair value is less than 80% of amortized cost (significant unrealized loss) that have been at a significant unrealized loss position on a continuous basis. Duration of Gross Unrealized Losses on Securities: As of ($ in millions) December 31, 2013 0 - 6 6 - 12 Over 12 Total Months Months Months Available-for-sale debt securities Unrealized losses over 20% of cost $ (12.1 ) $ (0.7 ) $ - $ (11.4 ) Number of securities 10 2 - 8 Investment grade: Unrealized losses over 20% of cost $ (11.0 ) $ (0.5 ) $ - $ (10.5 ) Below investment grade: Unrealized losses over 20% of cost $ (1.1 ) $ (0.2 ) $ - $ (0.9 ) Liquidity and Capital Resources In the normal course of business, we enter into transactions involving various types of financial instruments such as debt securities. These instruments have credit risk and also may be subject to risk of loss due to interest rate and market fluctuations. Our liquidity requirements principally relate to the liabilities associated with various life insurance and annuity products and operating expenses. Liabilities arising from life insurance and annuity products include the payment of benefits, as well as cash payments in connection with policy surrenders, withdrawals, and loans. Historically, we have used cash flow from operations, investing activities and capital contributions from our shareholder to fund liquidity requirements. Our principal cash inflows from life insurance and annuities activities come from premiums, annuity deposits, and charges on insurance policies and annuity contracts. Principal cash inflows from investing activities result from repayments of principal, proceeds from maturities, sales of invested assets, and investment income. 51-------------------------------------------------------------------------------- Summary Cash Flows: Years Ended December 31, ($ in millions) 2013 2012 Cash used for operating activities $ (130.5 ) $ (165.4 ) Cash used for investing activities (487.3 ) (627.2 ) Cash provided by financing activities 715.7 826.2 Change in cash and cash equivalents $ 97.9 $ 33.6 2013 compared to 2012 Cash used for operating activities decreased by $34.9 million during the year ended December 31, 2013 compared to the year ended December 31, 2012. This decrease was driven by lower death benefits paid for universal life during 2013 in conjunction with reduced commissions paid related to lower sales of our fixed indexed annuity product. Partially offsetting this increase were increased audit and consulting fees related to the Restatement. Cash flows used for investing activities decreased $139.9 million during the year ended December 31, 2013 compared to the year ended December 31, 2012 as a result of an decrease in purchases of short term investments. This is primarily driven by less cash being provided by financing and operating activities, namely due to a reduction in deposits and an increase in withdrawals of fixed index annuities, combined with significantly increased holdings of cash and cash equivalents in lieu of reinvestment. Cash flows provided by financing activities decreased $110.5 million during the year ended December 31, 2013. This decline was primarily a result of a decrease in policyholder deposits of fixed indexed annuities when compared to 2012. Offsetting this decline was the issuance of $30.0 million of debt during 2013, which were purchased by PNX. See Note 11 to our financial statements under "Indebtedness due to affiliate" under "Item 8. Financial Statements and Supplementary Data" in this Form 10-K for additional information on this transaction. Annuity Actuarial Reserves and Deposit Fund Liability As of December 31, Withdrawal Characteristics: 2013 2012 ($ in millions) Amount [1] Percent Amount [1] Percent Not subject to discretionary withdrawal provision $ 177.1 4 % $ 187.7 5 % Subject to discretionary withdrawal without adjustment 312.1 7 % 311.5 7 % Subject to discretionary withdrawal with market value adjustment 2,078.9 46 % 1,727.8 41 % Subject to discretionary withdrawal at contract value less surrender charge 29.6 1 % 35.8 1 % Subject to discretionary withdrawal at market value 1,903.2 42 % 1,922.3 46 % Total annuity contract reserves and deposit fund liability $ 4,500.9 100 % $ 4,185.1 100 % -------[1] Annuity contract reserves and deposit fund liability amounts are reported on a statutory basis, which more accurately reflects the potential cash outflows and include variable product liabilities. Annuity contract reserves and deposit fund liabilities are monetary amounts that an insurer must have available to provide for future obligations with respect to its annuities and deposit funds. These are liabilities in our financial statements prepared in conformity with statutory accounting practices. These amounts are at least equal to the values available to be withdrawn by policyholders. Individual life insurance policies are less susceptible to withdrawals than annuity contracts because policyholders may incur surrender charges and be required to undergo a new underwriting process in order to obtain a new insurance policy. As indicated in the table above, most of our annuity contract reserves and deposit fund liabilities are subject to withdrawals at market value. The cash value of certain individual life insurance policies increase over the lives of the policies. Policyholders have the right to borrow an amount up to a certain percentage of the cash value on those policies. As of December 31, 2013, we had approximately $689.8 million in cash values with respect to which policyholders had rights to take policy loans. For eligible policies, the majority of policy loans are at variable interest rates that are reset annually on the policy anniversary. Policy loans at December 31, 2013 were $66.1 million. 52 -------------------------------------------------------------------------------- The primary liquidity risks regarding cash inflows from the investing activities are the risks of default by debtors, interest rate and other market volatility, and potential illiquidity of investments. We closely monitor and manage these risks. We believe that the existing and expected sources of liquidity are adequate to meet both current and anticipated needs. Ratings Rating agencies assign financial strength ratings to Phoenix Life and its subsidiaries based on their opinions of the companies' ability to meet their financial obligations. A downgrade or withdrawal of any of our credit ratings could negatively impact our liquidity. For additional information regarding certain risks associated with our credit ratings, please see the risk factors under "Risks Related to the Restatement, Failure to File Timely Periodic Reports with the SEC and our Internal Control Over Financial Reporting." contained in "Item 1A: Risk Factors" in Part I of this Form 10-K. On August 28, 2013, A.M. Best Company, Inc. downgraded our financial strength rating from B+ to B. The rating was also removed from under review with negative implications and assigned a stable outlook. On April 9, 2013, A.M. Best Company, Inc. maintained their under review with negative implications outlook on our financial strength rating of B+. On December 7, 2012, A.M. Best Company, Inc. placed our B+ financial strength rating under review with negative implications. On January 13, 2012, A.M. Best Company, Inc. affirmed our financial strength rating of B+. They changed their outlook from stable to positive. On February 8, 2011, A.M. Best Company, Inc. affirmed our financial strength rating of B+ and changed their outlook from negative to stable. On January 14, 2014, Moody's Investor Services withdrew all ratings of The Phoenix Companies, Inc. including the Ba2 financial strength rating of the Company's life insurance subsidiaries and the B1 debt rating of Phoenix Life's surplus notes. On September 25, 2013, Moody's Investor Services maintained the review for downgrade for our Ba2 financial strength rating. On June 21, 2013, Moody's Investor Services maintained the review for downgrade for our Ba2 financial strength rating. On March 20, 2013, Moody's Investor Services maintained the review for downgrade for our financial strength rating of Ba2. On December 12, 2012, Moody's Investor Services placed our financial strength rating of Ba2 under review for downgrade. On December 16, 2011, Moody's Investor Services affirmed our financial strength rating of Ba2 and changed their outlook from stable to positive. On August 12, 2014, Standard & Poor's lowered its financial strength ratings on Phoenix Life and PHL Variable to B+ from BB- and affirmed its B- long-term counterparty credit rating on The Phoenix Companies, Inc. They removed the ratings from CreditWatch and assigned a negative outlook. They also affirmed The Phoenix Companies, Inc.'s long-term counterparty credit rating. On May 20, 2014, Standard & Poor's placed our financial strength rating of BB- and senior debt rating of B- on CreditWatch with negative implications. On May 22, 2013, Standard & Poor's affirmed our financial strength rating of BB-. All ratings were removed from CreditWatch with Negative Implications and placed on negative outlook. On March 8, 2013, Standard & Poor's placed our financial strength rating of BB- on CreditWatch Negative. On January 16, 2013, Standard & Poor's affirmed our financial strength rating of BB-. They also removed the ratings from CreditWatch Negative and returned the outlook to stable. On December 7, 2012, Standard & Poor's affirmed our financial strength rating of BB- and placed it on CreditWatch Negative. On April 5, 2012, Standard & Poor's affirmed our financial strength rating of BB- and maintained their stable outlook on our ratings. The financial strength ratings as of August 21, 2014 were as follows: Financial Strength Ratings of Rating Agency Phoenix Life and PHL Variable Outlook A.M. Best Company, Inc. B Stable Standard & Poor's B+ Negative Reference in this report to any credit rating is intended for the limited purposes of discussing or referring to changes in our credit ratings or aspects of our liquidity or costs of funds. Such reference cannot be relied on for any other purposes, or used to make any inference concerning future performance, future liquidity or any future credit rating. 53 -------------------------------------------------------------------------------- Financial Condition Increase (decrease) and Balance Sheets: As of December 31, percentage change ($ in millions) 2013 2012 2013 vs. 2012 ASSETS Available-for-sale debt securities, at fair value $ 3,426.3 $ 2,972.3 $ 454.0 15 % Short-term investments 81.0 244.9 (163.9 ) (67 %) Limited partnerships and other investments 10.5 6.7 3.8 57 % Policy loans, at unpaid principal balances 66.1 61.0 5.1 8 % Derivative instruments 237.8 149.4 88.4 59 % Fair value investments 48.6 38.5 10.1 26 % Total investments 3,870.3 3,472.8 397.5 11 % Cash and cash equivalents 181.0 83.1 97.9 118 % Accrued investment income 27.3 23.2 4.1 18 % Receivables 8.6 16.2 (7.6 ) (47 %) Reinsurance recoverable 500.6 427.1 73.5 17 % Deferred policy acquisition costs 462.3 426.2 36.1 8 % Deferred income taxes, net 28.0 16.2 11.8 73 % Receivable from related parties 2.6 - 2.6 NM Other assets 174.8 135.5 39.3 29 % Separate account assets 2,052.7 2,061.8 (9.1 ) - % Total assets $ 7,308.2 $ 6,662.1 $ 646.1 10 % LIABILITIES Policy liabilities and accruals $ 1,899.0 $ 1,876.2 $ 22.8 1 % Policyholder deposit funds 2,762.8 2,349.8 413.0 18 % Indebtedness due to affiliate 30.0 - 30.0 100 % Payable to related parties 14.1 11.0 3.1 28 % Other liabilities 177.1 68.2 108.9 160 % Separate account liabilities 2,052.7 2,061.8 (9.1 ) - % Total liabilities 6,935.7 6,367.0 568.7 9 % STOCKHOLDER'S EQUITY Common stock 2.5 2.5 - - % Additional paid in capital 847.2 802.2 45.0 6 % Accumulated other comprehensive loss (11.9 ) 11.4 (23.3 ) NM Retained earnings (accumulated deficit) (465.3 ) (521.0 ) 55.7 (11 %) Total stockholder's equity 372.5 295.1 77.4 26 % Total liabilities and stockholder's equity $ 7,308.2 $ 6,662.1 $ 646.1 10 % ------- Not meaningful (NM) December 31, 2013 compared to December 31, 2012 Assets The increase in total investments was primarily the result of purchases of new securities due to new deposits in the annuity business. Partially offsetting this were declines in the market value of available-for-sale debt securities resulting from increases in interest rates during 2013 and decreases in cash and short-term investments. 54-------------------------------------------------------------------------------- The increase in derivative instruments is primarily due to gains on the call options that are used to hedge the fixed indexed annuity business. This increase in derivative assets is offset by increases in derivative liabilities, which are recorded within other liabilities. The net derivative position of $127.0 million as of December 31, 2013 has not fluctuated significantly from the net derivative position of $103.7 million as of December 31, 2012. The increase in reinsurance recoverables is primarily due to large claims at the end of 2013 that were not yet reimbursed by third-party reinsurers. The increases in deferred policy acquisition costs overall are primarily driven by increases in the shadow component that offsets unrealized losses on investments within AOCI. The deferrals of commissions on new sales of fixed indexed annuities were relatively stable and were more than offset by continued amortization of previously deferred costs. The increase in other assets is primarily due to an increase in the current tax asset recoverable from PNX, due to the existing tax sharing agreement. Liabilities and Stockholder's Equity Policyholder deposit funds increased during the twelve months ended December 31, 2013 primarily as a result of continued sales of fixed indexed annuities. The Company issued $30 million of surplus notes on December 30, 2013 which were purchased by PNX. The notes are due on December 30, 2043 and interest is paid annually at a rate of 10.5%. The increase in other liabilities is due to additional accrued expenses related to audit and consulting services, and an increase in the fair value of derivative liabilities. The increase in the fair value of the derivative liabilities is offset by increases in derivative assets, which are recorded within investments. The net derivative position of $127.0 million as of December 31, 2013 has not fluctuated significantly from the net derivative position of $103.7 million as of December 31, 2012. The increase in total stockholder's equity was primarily a result of the net income recognized for the twelve months ended December 31, 2013 and capital contributions of $45.0 million during 2013. Partially offsetting these increases were additional accumulated other comprehensive losses associated with unrealized losses on available-for-sale debt securities due to the rise in interest rates during 2013. Contractual Obligations and Commercial Commitments Contractual Obligations and Commercial Commitments: As of ($ in millions) December 31, 2013 Total 2014 2015-2016 2017-2018 Thereafter Contractual Obligations Due Purchase liabilities [1] $ 9.1 $ 1.9 $ 3.8 $ 3.0 $ 0.4 Policyholder contractual obligation [2] 12,658.0 731.5 1,495.9 1,344.3 9,086.3 Total contractual obligations [3] $ 12,667.1 $ 733.4 $ 1,499.7 $ 1,347.3 $ 9,086.7 Commercial Commitment Expirations Other long-term liabilities [4] $ 70.7 $ 70.3 $ 0.4 $ - $ - Total commercial commitments $ 70.7 $ 70.3 $ 0.4 $ - $ - -------[1] Purchase liabilities relate to open purchase orders and other contractual obligations. This does not include purchases made by our ultimate parent company for which the resulting expenses are allocated to us when incurred. [2] Policyholder contractual obligations represent estimated benefits from life insurance and annuity contracts issued by us. Policyholder contractual obligations also include separate account liabilities, which are contractual obligations of the separate account assets established under applicable state insurance laws and are legally insulated from our general account assets. Future obligations are based on our estimate of future investment earnings, mortality and surrenders. Actual obligations in any single year, or ultimate total obligations, may vary materially from these estimates as actual experience emerges. As described in Note 2 to our financial statements under "Item 8: Financial Statements and Supplementary Data" in this Form 10-K, policy liabilities and accruals are recorded on the balance sheets in amounts adequate to meet the estimated future obligations of the policies in force. The policyholder obligations reflected in the table above exceed the policy liabilities, policyholder deposit fund liabilities and separate account liabilities reported on our December 31, 2013 balance sheets because the above amounts do not reflect future investment earnings and future premiums and deposits on those policies. Separate account obligations will be funded by the cash flows from separate account assets, while the remaining obligations will be funded by cash flows from investment earnings on general account assets and premiums and deposits on contracts in force. 55 --------------------------------------------------------------------------------[3] We do not anticipate any increases to unrecognized tax benefits that would have a significant impact on the financial position of the Company. Therefore, no unrecognized tax benefits have been excluded from this table. See Note 10 to our financial statements under "Item 8: Financial Statements and Supplementary Data" in this Form 10-K for additional information on unrecognized tax benefits. [4] Other long-term liabilities relate to agreements to fund venture capital partnerships. The venture capital commitments can be drawn down by private equity funds as necessary to fund their portfolio investments through the end of the funding period as stated in each agreement. Obligations Related to Pension and Postretirement Employee Benefit Plans Our ultimate parent company provides employees with post-employment benefits that include retirement benefits, through pension and savings plans, and other benefits, including health care and life insurance. This includes three defined benefit pension plans. We incur applicable employee benefit expenses through the process of cost allocation by PNX. Employee benefit expense allocated to us for these benefits totaled $3.2 million, $4.6 million and $7.6 million for 2013, 2012 and 2011, respectively. Over the next 12 months, Phoenix Life expects to make contributions to the pension plan of which approximately $6.4 million will be allocated to us. On July 6, 2012, the Surface Transportation Extension Act of 2012, Part II, was enacted into law and was effective immediately. The law includes certain pension funding stabilization provisions, which the Company has taken advantage of in 2012. See Note 13 to our financial statements under "Item 8: Financial Statements and Supplementary Data" in this Form 10-K for more information. Off-Balance Sheet Arrangements As of December 31, 2013, we did not have any significant off-balance sheet arrangements as defined by Item 303(a)(4)(ii) of SEC Regulation S-K. Reinsurance We use reinsurance agreements to limit potential losses, reduce exposure to larger risks and provide capital relief with regard to certain reserves. We remain liable to the extent that reinsuring companies may not be able to meet their obligations under reinsurance agreements in effect. Failure of the reinsurers to honor their obligations could result in losses to the Company. Since we bear the risk of nonpayment, on a quarterly basis we evaluate the financial condition of our reinsurers and monitor concentrations of credit risk. Based on our review of their financial statements, reputation in the reinsurance marketplace and other relevant information, we believe that we have no material exposure to uncollectible life reinsurance. At December 31, 2013, five major reinsurance companies account for approximately 73% of the reinsurance recoverable. Statutory Capital and Surplus and Risk-Based Capital Our statutory basis capital and surplus including asset valuation reserve ("AVR") decreased from $321.0 million at December 31, 2012 to $235.2 million at December 31, 2013. The principal factor resulting in this decrease was $123.1 million of reserve strengthening, including consideration of results from asset adequacy analysis. This was partially offset by $45.0 million of capital contributions received from PM Holdings, Inc. and $30 million relating to the issuance of surplus notes issued by PHL Variable and purchased by PNX. Connecticut Insurance Law requires that Connecticut life insurers report their RBC. RBC is based on a formula calculated by applying factors to various asset, premium and statutory reserve items. The formula takes into account the risk characteristics of the insurer, including asset risk, insurance risk, interest rate risk and business risk. The Connecticut Insurance Department has regulatory authority to require various actions by, or take various actions against, insurers whose Total Adjusted Capital (capital and surplus plus AVR) does not exceed certain RBC levels. The levels of regulatory action, the trigger point and the corrective actions required are summarized below: Company Action Level - results when Total Adjusted Capital falls below 100% of Company Action Level at which point the Company must file a comprehensive plan to the state insurance regulators; Regulatory Action Level - results when Total Adjusted Capital falls below 75% of Company Action Level where in addition to the above, insurance regulators are required to perform an examination or analysis deemed necessary and issue a corrective order specifying corrective actions; 56 --------------------------------------------------------------------------------Authorized Control Level - results when Total Adjusted Capital falls below 50% of Company Action Level RBC as defined by the NAIC where in addition to the above, the insurance regulators are permitted but not required to place the Company under regulatory control; and Mandatory Control Level - results when Total Adjusted Capital falls below 35% of Company Action Level where insurance regulators are required to place the Company under regulatory control. The estimated RBC of PHL Variable as of December 31, 2013 was in excess of 250% of the Company Action Level. See Note 15 to our financial statements under "Item 8: Financial Statements and Supplementary Data" in this Form 10-K for more information. Item 7A. Quantitative and Qualitative Disclosures About Market Risk For information about our management of market risk, see "Item 7: Management's Discussion and Analysis of Financial Condition and Results of Operations" in this Form 10-K under the heading "Enterprise Risk Management." |