GREAT WEST LIFE & ANNUITY INSURANCE CO – 10-Q – Management’s Discussion and Analysis of Financial Condition and Results of Operations

Edgar Online, Inc.

General

As used in this Form 10-Q, the "Company" refers to Great-West Life & Annuity Insurance Company, a stock life insurance company originally organized on March 28, 1907 and domiciled in the state of Colorado, and its subsidiaries.

This Form 10-Q contains forward-looking statements. Forward-looking statements are statements not based on historical information and that relate to future operations, strategies, financial results, or other developments. In particular, statements using words such as "may," "would," "could," "should," "estimates," "expected," "anticipate," "believe," or words of similar import generally involve forward-looking statements. Without limiting the foregoing, forward-looking statements include statements that represent the Company's beliefs concerning future or projected levels of sales of its products, investment spreads or yields, or the earnings or profitability of the Company's activities.

Forward-looking statements are necessarily based upon estimates and assumptions that are inherently subject to significant business, economic and competitive uncertainties and contingencies, many of which are beyond the Company's control and many of which, with respect to future business decisions, are subject to change. Some of these risks are described in "Risk Factors" in Item 1A of this report. These uncertainties and contingencies can affect actual results and could cause actual results to differ materially from those expressed in any forward-looking statements made by, or on behalf of, the Company. Whether or not actual results differ materially from forward-looking statements may depend on numerous foreseeable and unforeseeable events or developments, some of which may be global or national in scope, such as general economic conditions and interest rates, some of which may be related to the insurance industry generally, such as pricing competition, regulatory developments and industry consolidation and others of which may relate to the Company specifically, such as credit, volatility and other risks associated with its investment portfolio and other factors. Readers should also consider other matters, including any risks and uncertainties, discussed in documents filed by the Company and certain of its subsidiaries with the Securities and Exchange Commission.

The following discussion addresses the Company's results of operations for the three and six months ended June 30, 2013 compared with the same period in 2012. The discussion should be read in conjunction with the Company's Annual Report on Form 10-K for the year ended December 31, 2012, under Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations," to which the reader is directed for additional information.

On January 1, 2013, the Company terminated its reinsurance agreement with an affiliate, The Canada Life Assurance Company ("CLAC"), pursuant to which it had ceded certain participating life business on a coinsurance basis. Participating policyholders share in the financial results of the participating business in the form of policyholder dividends. The policyholder dividends can be distributed directly to the policyholders in the form of cash or through an increase in benefits such as paid-up additions. The participating policyholder earnings that cannot be distributed to the shareholder are not included in the Company's condensed consolidated net income and are reflected in liabilities in undistributed earnings on participating business in the Company's condensed consolidated balance sheets.

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The Company recorded the following on January 1, 2013 in its condensed consolidated statement of income in connection with the termination of the reinsurance agreement (In thousands):

   Premium income                                                              $   42,297 Other revenue                                                                    7,355 Total                                                                           49,652  Increase (decrease) in future policy benefits                                   41,297 Dividends to policyholders                                                       1,000 Total                                                                           42,297  Participating policyholders' net income before income taxes                      7,355 Income tax expense                                                               2,574 Participating policyholders' income                                              4,781  

Provision for policyholders' share of earnings on participating business 4,781 Net income available to shareholder

                                         $        -     Company Results of Operations   

Three months ended June 30, 2013 compared with the three months ended June 30, 2012

The following is a summary of certain financial data of the Company for the three months ended June 30, 2013 and 2012:

                                               Three months ended June 30, Income statement data (In millions)          2013               2012 Premium income                           $          66      $          75 Fee income                                         163                135 Net investment income                              299                300 Net realized investment gains (losses)              (1 )               25 Total revenues                                     527                535 Policyholder benefits                              265                265 Operating expenses                                 199                177 Total benefits and expenses                        464                442 Income before income taxes                          63                 93 Income tax expense                                  20                 32 Net income                               $          43      $          61    

The Company's consolidated net income decreased by $18 million, or 30%, to $43 million for the three months ended June 30, 2013 when compared to 2012. The decrease in earnings is primarily due to lower realized and unrealized investment gains (losses) driven by the sale of certain perpetual debt investments and higher mortality losses. These decreases in earnings are partially offset by an increase in investment margins.

Premium income decreased by $9 million, or 12%, to $66 million for the three months ended June 30, 2013 when compared to 2012. This decrease is primarily related to the $13 million decrease in the Company's Individual Markets segment which is driven by lower sales in the executive benefits market.

Fee income increased by $28 million, or 21%, to $163 million for the three months ended June 30, 2013 when compared to 2012. The increase is primarily related to improved variable fee income resulting from increased average-asset levels driven by higher average equity market levels and positive cash flows. The equity market performance is evidenced by the 19% increase in the average S&P 500 index during the three months ended June 30, 2013 as compared to the three months ended June 30, 2012. Additionally, there was an increase in fee income related to the single premium universal life ("SPUL") product.

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Net investment income remained relatively consistent, decreasing $1 million, or less than 1%, during the three months ended June 30, 2013 when compared to 2012.

Net realized investment gains (losses) decreased by $26 million from a gain of $25 million in 2012 to a loss of $1 million in 2013. The fluctuation is driven primarily by the sale of certain perpetual debt investments which consisted of junior subordinated debt instruments sold at a loss of $20 million during the three months ended June 30, 2013. The remainder of the fluctuation is a combination of lower realized gains on other bonds and investments partially offset by a $5 million increase in realized gains on mortgages due to prepayments.

Total benefits and expenses increased by $22 million, or 5%, to $464 million for the three months ended June 30, 2013 when compared to 2012 due to higher operating expenses. The increase in operating expenses is due to higher asset based commissions and incentive compensation, as well as a guaranteed fund assessment incurred by the Company in the Retirement Services segment. The Individual Markets segment had an increase in operating expenses as a result of an increase in the amortization of deferred acquisition costs resulting from an increase in realized investment gains within the segment in 2013 as compared to 2012. Additionally, the Company had higher general and administrative expense due to overall growth in 2013.

Income tax expense decreased by $12 million, or 38%, to $20 million for the three months ended June 30, 2013 when compared to 2012 primarily due to a decrease in net income before tax.

Six months ended June 30, 2013 compared with the six months ended June 30, 2012

The following is a summary of certain financial data of the Company for the six months ended June 30, 2013 and 2012:

                                                Six months ended June 30, Income statement data (In millions)          2013              2012 Premium income                           $         245     $         204 Fee income                                         319               262 Other revenue                                        7                 - Net investment income                              590               603 Net realized investment gains (losses)              21                37 Total revenues                                   1,182             1,106 Policyholder benefits                              610               595 Operating expenses                                 392               342 Total benefits and expenses                      1,002               937 Income before income taxes                         180               169 Income tax expense                                  62                57 Net income                               $         118     $         112    

The Company's consolidated net income increased by $6 million, or 5%, to $118 million for the six months ended June 30, 2013 when compared to 2012. The increase in earnings is primarily due to higher fee income due to increased average-asset levels driven by higher average equity market levels and positive cash flows, improved mortality and an increase in investment margins. These increases in earnings are partially offset by lower realized and unrealized investment gains (losses) driven by the sale of certain perpetual debt investments.

Premium income increased by $41 million, or 20%, to $245 million for the six months ended June 30, 2013 when compared to 2012. This increase is primarily related to the $37 million increase in the Company's Individual Markets segment which is driven by the $42 million received in conjunction with the termination of the reinsurance agreement with CLAC. The increase in premium from the CLAC agreement was partially offset by a $9 million decrease in premium income primarily related to sales of the single premium whole life ("SPWL") product marketed through banks. In 2011, the Company began replacing the SPWL product with a SPUL product. The SPWL product is considered an insurance contract, and SPWL sales are recognized as premium income. Conversely, the SPUL product is considered an investment contract, and SPUL sales are recognized as deposits rather than as premium income.

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Fee income increased by $57 million, or 22%, to $319 million for the six months ended June 30, 2013 when compared to 2012. The increase is primarily related to improved variable fee income primarily due to increased average asset levels, driven by higher average equity market levels and positive cash flows. The equity market performance is evidenced by the 16% increase in the average S&P 500 index during the six months ended June 30, 2013 as compared to the six months ended June 30, 2012. Additionally, there was an increase in fee income related to the SPUL product.

Other revenue increased by $7 million for the six months ended June 30, 2013 when compared to 2012 as a result of the termination of the reinsurance agreement with CLAC.

Net investment income decreased by $13 million, or 2%, to $590 million for the six months ended June 30, 2013 when compared to 2012. The primary drivers of the change are a $14 million decrease in unrealized gains primarily generated by derivative and hedging activities.

Net realized investment gains (losses) decreased by $16 million, or 43%, to $21 million during the six months ended June 30, 2013 when compared to 2012. The fluctuation is driven primarily by the sale of certain perpetual debt investments which consisted of junior subordinated debt instruments sold at a loss of $20 million during the three months ended June 30, 2013. The remainder of the fluctuation is a combination of lower realized gains on other bonds and investments partially offset by a $5 million increase in realized gains on mortgages due to prepayments.

Total benefits and expenses increased by $65 million, or 7%, to $1,002 million for the six months ended June 30, 2013 when compared to 2012. The increase in benefits expense is attributable to the $25 million increase in the Company's Individual Markets segment primarily driven by benefits expense incurred in conjunction with the termination of the reinsurance agreement with CLAC partially offset by a decrease in policyholder benefits due to the change in the mix of sales mentioned in premiums and improved mortality in 2013 as compared to 2012. The Retirement Services segment had an increase of $33 million primarily driven by higher asset based commissions and incentive compensation, as well as higher general and administrative expense due to segment growth in 2013. The increase in Retirement Services segment operating expenses was partially offset by a decrease in policyholder benefits due to a decrease in interest paid to policyholders. The Other segment had an increase of $6 million primarily due to higher policyholder benefits as a result of higher premiums due to the renewal of 10-year term policies whose original term ended in 2013.

Income tax expense increased by $5 million, or 9%, to $62 million for the six months ended June 30, 2013 when compared to 2012 primarily due to an increase in net income before tax. The Company also incurred approximately $3 million of additional income tax expense related to the policyholders' share of earnings on participating business as a result of the termination of the reinsurance agreement with CLAC.

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Individual Markets Segment Results of Operations

Three months ended June 30, 2013 compared with the three months ended June 30, 2012

The following is a summary of certain financial data of the Individual Markets segment for the three months ended June 30, 2013 and 2012:

                                               Three months ended June 30, Income statement data (In millions)          2013               2012 Premium income                           $          29      $          42 Fee income                                          24                 19 Net investment income                              184                183 Net realized investment gains (losses)              14                 11 Total revenues                                     251                255 Policyholder benefits                              176                184 Operating expenses                                  37                 31 Total benefits and expenses                        213                215 Income before income taxes                          38                 40 Income tax expense                                  12                 14 Net income                               $          26      $          26    

Net income for the Individual Markets segment remained constant during the three months ended June 30, 2013 when compared to 2012.

Premium income decreased by $13 million, or 31%, to $29 million for the three months ended June 30, 2013 when compared to 2012. The decrease is primarily related to lower sales in the executive benefits market.

Fee income increased by $5 million, or 26%, to $24 million for the three months ended June 30, 2013 when compared to 2012. The increase is primarily related fees earned on the SPUL product. Additionally, the increase is driven by fees on the executive benefits and IRA products reflecting higher variable policy balances and an overall increase in the size of the block of business.

Net investment income remained relatively consistent, increasing only $1 million, or less than 1%, during the three months ended June 30, 2013 when compared to 2012.

Net realized investment gains (losses) increased by $3 million, or 27%, to $14 million during the three months ended June 30, 2013 when compared to 2012. Of the increase, $5 million resulted from mortgage gains due to prepayments.

Total benefits and expenses remained relatively consistent, decreasing $2 million during the three months ended June 30, 2013 when compared to 2012. The change in benefits and expenses is primarily attributable to an $8 million, or 4%, decrease in policyholder benefits due to lower premiums partially offset by lower mortality gains. Operating expenses increased by $6 million, or 19%, as a result of an increase in the amortization of deferred acquisition costs resulting from an increase in realized investment gains in 2013 as compared to 2012. Additionally, there was higher general and administrative expense due to overall segment growth in 2013.

Income tax expense remained relatively consistent, decreasing $2 million during the three months ended June 30, 2013 when compared to 2012.

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Six months ended June 30, 2013 compared with the six months ended June 30, 2012

The following is a summary of certain financial data of the Individual Markets segment for the six months ended June 30, 2013 and 2012:

                                                Six months ended June 30, Income statement data (In millions)          2013              2012 Premium income                           $         183     $         146 Fee income                                          47                37 Other revenue                                        7                 - Net investment income                              363               365 Net realized investment gains (losses)              25                16 Total revenues                                     625               564 Policyholder benefits                              454               435 Operating expenses                                  73                67 Total benefits and expenses                        527               502 Income before income taxes                          98                62 Income tax expense                                  35                21 Net income                               $          63     $          41    

Net income for the Individual Markets segment increased by $22 million to $63 million for the six months ended June 30, 2013 when compared to 2012. The increase in earnings is primarily due to improved mortality, higher fee income from the SPUL product, an increase in realized investment gains, and improved investment margins.

Premium income increased by $37 million, or 25%, to $183 million for the six months ended June 30, 2013 when compared to 2012. The increase is primarily related to the $42 million received in conjunction with the termination of the reinsurance agreement with CLAC. The increase in premium from the CLAC agreement was partially offset by a $9 million decrease in premium income primarily related to sales of the SPWL product marketed through banks. In 2011, the Company began replacing the SPWL product with a SPUL product. The SPWL product is considered an insurance contract, and SPWL sales are recognized as premium income. Conversely, the SPUL product is considered an investment contract, and SPUL sales are recognized as deposits rather than as premium income.

Fee income increased by $10 million, or 27%, to $47 million for the six months ended June 30, 2013 when compared to 2012. The increase is primarily related fees earned on the SPUL product. Additionally, the increase is driven by fees on the executive benefits and IRA products reflecting higher variable policy balances and an overall increase in the size of the block of business.

Other revenue increased by $7 million for the six months ended June 30, 2013 when compared to 2012 as a result of the termination of the reinsurance agreement with CLAC.

Net investment income remained consistent, decreasing by $2 million, or less than 1%, to $363 million for the six months ended June 30, 2013 when compared to 2012.

Net realized investment gains (losses) increased by $9 million, or 56%, to $25 million during the six months ended June 30, 2013 when compared to 2012. Of the increase, $5 million resulted from mortgages gains due to prepayments and $4 million resulted from increased realized gains on sales of bonds.

Total benefits and expenses increased by $25 million, or 5%, to $527 million for the six months ended June 30, 2013 when compared to 2012. The change in benefits and expenses is primarily attributable to a $19 million, or 4%, increase in policyholder benefits of which $47 million was incurred in conjunction with the termination of the reinsurance agreement with CLAC. This was partially offset by a decrease in policyholder benefits of $28 million due to the change in the mix of sales mentioned in premiums and improved mortality in 2013 as compared to 2012. Operating expenses increased by $6 million, or 9%, as a result of an increase in the amortization of deferred acquisition costs resulting from an increase in realized investment gains in 2013 as compared to 2012. Additionally, there was higher general and administrative expense due to overall segment growth in 2013.

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Income tax expense increased by $14 million, or 67%, to $35 million during the six months ended June 30, 2013 when compared to 2012, primarily due to the increase in net income before taxes. The Company also incurred approximately $3 million of additional income tax expense related to the policyholders' share of earnings on participating business as a result of the termination of the reinsurance agreement with CLAC.

Retirement Services Segment Results of Operations

Three months ended June 30, 2013 compared with the three months ended June 30, 2012

The following is a summary of certain financial data of the Retirement Services segment for the three months ended June 30, 2013 and 2012:

                                               Three months ended June 30, Income statement data (In millions)          2013               2012 Premium income                           $           1      $           1 Fee income                                         138                115 Net investment income                              103                105 Net realized investment gains (losses)             (15 )               14 Total revenues                                     227                235 Policyholder benefits                               48                 53 Operating expenses                                 140                128 Total benefits and expenses                        188                181 Income before income taxes                          39                 54 Income tax expense                                  13                 18 Net income                               $          26      $          36    

Net income for the Retirement Services segment decreased by $10 million, or 28%, to $26 million for the three months ended June 30, 2013 when compared to 2012. The decrease in earnings is primarily due to lower realized and unrealized investment gains (losses) driven by the sale of certain perpetual debt investments. These decreases in earnings are partially offset by higher fee income due to increased average-asset levels driven by higher average equity market levels and positive cash flows and an increase in investment margins.

Fee income increased by $23 million, or 20%, to $138 million for the three months ended June 30, 2013 when compared to 2012. The increase is primarily related to improved variable fee income due to increased average-asset levels driven by higher average equity market levels and positive cash flows. The equity market performance is evidenced by a 19% increase in the average S&P 500 index during the three months ended June 30, 2013 as compared to the three months ended June 30, 2012.

Net investment income remained consistent, decreasing by $2 million, or 2%, to $103 million for the three months ended June 30, 2013 when compared to 2012.

Net realized investment gains (losses) changed by $29 million from a gain of $14 million to a loss of $15 million during the three months ended June 30, 2013 when compared to 2012. The fluctuation is driven primarily by the sale of certain perpetual debt investments which consisted of junior subordinated debt instruments sold at a loss of $20 million during the three months ended June 30, 2013. The remainder of the fluctuation is lower realized gains on other bonds.

Total benefits and expenses increased by $7 million, or 4%, to $188 million for the three months ended June 30, 2013 when compared to 2012. The increase in benefits and expenses is primarily attributable to a $12 million, or 9%, increase in operating expenses due to higher asset based commissions and incentive compensation, as well as higher general and administrative expense due to a guaranteed fund assessment incurred by the Company and overall segment growth in 2013. Offsetting the increase in operating expenses is a $5 million, or 9%, decrease in policyholder benefits primarily driven by a decrease in interest paid to policyholders due to reduced crediting rates.

Income tax expense decreased by $5 million, or 28%, to $13 million during the three months ended June 30, 2013 when compared to 2012. The increase is primarily due to the decrease in income before income taxes.

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Six months ended June 30, 2013 compared with the six months ended June 30, 2012

The following is a summary of certain financial data of the Retirement Services segment for the six months ended June 30, 2013 and 2012:

                                                Six months ended June 30, Income statement data (In millions)          2013               2012 Premium income                           $           1      $           2 Fee income                                         270                223 Net investment income                              203                214 Net realized investment gains (losses)              (4 )               21 Total revenues                                     470                460 Policyholder benefits                               93                102 Operating expenses                                 282                240 Total benefits and expenses                        375                342 Income before income taxes                          95                118 Income tax expense                                  32                 39 Net income                               $          63      $          79    

Net income for the Retirement Services segment decreased by $16 million, or 20%, to $63 million for the six months ended June 30, 2013 when compared to 2012. The decrease in earnings is primarily due to lower realized and unrealized investment gains (losses) driven by the sale of certain perpetual debt investments. These decreases in earnings are partially offset by an increase in investment margins.

Fee income increased by $47 million, or 21%, to $270 million for the six months ended June 30, 2013 when compared to 2012. The increase is primarily related to improved variable fee income due to increased average-asset levels driven by higher average equity market levels and positive cash flows. The equity market performance is evidenced by a 16% increase in the average S&P 500 index during the six months ended June 30, 2013 as compared to the six months ended June 30, 2012.

Net investment income decreased by $11 million, or 5%, to $203 million for the six months ended June 30, 2013 when compared to 2012. The primary drivers of the change are a $10 million decrease in unrealized gains primarily generated by derivative and hedging activities.

Net realized investment gains (losses) changed by $25 million from a gain of $21 million to a loss of $4 million during the six months ended June 30, 2013 when compared to 2012. The fluctuation is driven primarily by the sale of certain perpetual debt investments which consisted of junior subordinated debt instruments sold at a loss of $20 million during the three months ended June 30, 2013.

Total benefits and expenses increased by $33 million, or 10%, to $375 million for the six months ended June 30, 2013 when compared to 2012. The increase in benefits and expenses is primarily attributable to a $42 million, or 18%, increase in operating expenses due to higher asset based commissions and incentive compensation, as well as higher general and administrative expense due to a guaranteed fund assessment incurred by the Company and overall segment growth in 2013. Offsetting the increase in operating expenses is a $9 million, or 9%, decrease in policyholder benefits primarily driven by a decrease in interest paid to policyholders due to reduced crediting rates in 2013 as compared to 2012.

Income tax expense decreased by $7 million, or 18%, to $32 million during the six months ended June 30, 2013 when compared to 2012. The increase is primarily due to the decrease in income before income taxes.

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Other Segment Results of Operations

Three months ended June 30, 2013 compared with the three months ended June 30, 2012

The following is a summary of certain financial data of the Company's Other segment for the three months ended June 30, 2013 and 2012:

                                            Three months ended June 30, Income statement data (In millions)       2013               2012 Premium income                        $          36      $          32 Fee income                                        1                  1 Net investment income                            12                 12 Total revenues                                   49                 45 Policyholder benefits                            41                 28 Operating expenses                               21                 18 Total benefits and expenses                      62                 46 Loss before income taxes                        (13 )               (1 ) Income tax benefit                               (5 )                - Net loss                              $          (8 )    $          (1 )    

Net loss for the Company's Other segment changed by $7 million from $1 million to $8 million during the three months ended June 30, 2013 when compared to 2012. The decrease in income is primarily due to a $13 million increase in benefits expense as a result of poor mortality and higher surrenders in 2013 as compared to 2012. The increase in benefits expense was partially offset by an increase in income tax benefit of $5 million as a result of higher loss before income taxes.

Six months ended June 30, 2013 compared with the six months ended June 30, 2012

The following is a summary of certain financial data of the Company's Other segment for the six months ended June 30, 2013 and 2012:

                                             Six months ended June 30, Income statement data (In millions)       2013               2012 Premium income                        $          61      $          56 Fee income                                        2                  2 Net investment income                            24                 24 Total revenues                                   87                 82 Policyholder benefits                            63                 58 Operating expenses                               36                 35 Total benefits and expenses                      99                 93 Loss before income taxes                        (12 )              (11 ) Income tax benefit                               (4 )               (3 ) Net loss                              $          (8 )    $          (8 )    

Net loss for the Company's Other segment remained relatively consistent during the six months ended June 30, 2013 when compared to 2012. Premium income increased $5 million, or 9%, as a result of renewal premiums received on a block of 10-year term policies whose original term ended in 2013. This increase in premium was offset by a $5 million, or 9%, increase in policyholder benefits as a result of the renewed policies.

   Investment Operations   

The Company's primary investment objective is to acquire assets with duration and cash flow characteristics reflective of its liabilities, while meeting industry, size, issuer and geographic diversification standards. Formal liquidity and credit quality parameters have also been established.

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The Company follows rigorous procedures to control interest rate risk and observes strict asset and liability matching guidelines. These guidelines ensure that even under changing market conditions, the Company's assets should meet the cash flow and income requirements of its liabilities. Using dynamic modeling to analyze the effects of a range of possible market changes upon investments and policyholder benefits, the Company works to ensure that its investment portfolio is appropriately structured to fulfill financial obligations to its policyholders.

    A summary of the Company's general account investment assets and the assets as a percentage of total general account investments at June 30, 2013 and December 31, 2012 follows:    (In millions)                           June 30, 2013            December 31, 2012 Fixed maturities, available-for-sale                  $   18,210        65.6 %  $    18,188         69.7 % Fixed maturities, held for trading                                    199         0.7 %          368          1.4 % Mortgage loans on real estate            3,058        11.0 %        2,882         11.0 % Policy loans                             4,181        15.0 %        4,260         16.3 % Short-term investments, available-for-sale                       1,998         7.2 %          266          1.0 % Limited partnership and other corporation interests                      102         0.4 %          125          0.5 % Other investments                           19         0.1 %           21          0.1 % Total investments                   $   27,767       100.0 %  $    26,110        100.0 %     Fixed Maturity Investments   

Fixed maturity investments include public and privately placed corporate bonds, government bonds and mortgage-backed and asset-backed securities. Included in available-for-sale fixed maturities are perpetual debt investments which primarily consist of junior subordinated debt instruments that have no stated maturity date but pay fixed or floating interest in perpetuity. The Company's strategy related to mortgage-backed and asset-backed securities is to focus on those investments with low prepayment risk and minimal credit risk.

Private placement investments are generally less marketable than publicly traded assets, yet they typically offer enhanced covenant protection that allows the Company, if necessary, to take appropriate action to protect its investment. The Company believes that the cost of the additional monitoring and analysis required by private placement investments is more than offset by their enhanced yield.

One of the Company's primary objectives is to ensure that its fixed maturity portfolio is maintained at a high average credit quality to limit credit risk. All securities are internally rated by the Company on a basis intended to be similar to that of the rating agencies. The Company's internal rating methodology generally takes into account ratings from Standard & Poor's Ratings Services, Fitch Ratings and Moody's Investor Services, Inc. In addition, the National Association of Insurance Commissioners ("NAIC") implemented a ratings methodology for RMBS, CMBS and other structured securities. The Company may also utilize inputs from this ratings process to develop its internal rating.

    The distribution of the Company's fixed maturity portfolio by the Company's internal credit rating at June 30, 2013 and December 31, 2012 is summarized as follows:    Credit Rating                         June 30, 2013   December 31, 2012 AAA                                            27.9 %              30.0 % AA                                             15.3 %              14.4 % A                                              26.4 %              23.9 % BBB                                            29.0 %              30.1 % BB and below (Non-investment grade)             1.4 %               1.6 % Total                                         100.0 %             100.0 %                                            50 

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The following table contains the sector distribution of the Company's corporate fixed maturity investment portfolio, calculated as a percentage of fixed maturities, at June 30, 2013 and December 31, 2012:

   Sector              June 30, 2013   December 31, 2012 Utility                      18.4 %              17.9 % Finance                       9.6 %              10.4 % Consumer                     10.1 %              10.1 % Natural resources             5.5 %               5.1 % Transportation                2.7 %               2.7 % Other                        11.3 %              10.1 %    

Fair Value Measurement of Fixed Maturity Investments Classified as Available-for-Sale

Each fixed maturity investment is categorized in a hierarchy based on the observability of inputs into the valuation methodology with Level 3 being the least observable. Management uses some judgment in determining the observability of valuation inputs. Total assets measured using significant unobservable inputs (Level 3) decreased by $4 million at June 30, 2013 from December 31, 2012. Level 3 assets at June 30, 2013 were $263 million or 1% of total net assets and liabilities carried at fair value compared to Level 3 assets of $267 million or 1% at December 31, 2012. The decrease in Level 3 assets is primarily due to principal reductions.

Securities Lending, Repurchase Agreements and Cash Collateral Reinvestment Practices

Cash collateral related to the securities lending program, reverse repurchase agreements and dollar repurchase agreement practices is invested in U.S. Government, U.S. Government Agency, or investment grade corporate debt securities that mature within one year. Some cash collateral may be invested in short-term reverse repurchase agreements which are collateralized by U.S. Government or U.S. Government Agency securities. In addition, the securities lending agent indemnifies the Company against borrower risk, meaning that the lending agent agrees contractually to replace securities not returned due to a borrower default. As of June 30, 2013 and December 31, 2012, the Company had $62 million and $138 million, respectively, of securities out on loan, $750 million and $4 million, respectively, in short-term reverse repurchase agreements and $1,894 million and zero, respectively, in dollar repurchase agreements, all of which are fully collateralized as described above. The increase in dollar repurchase agreements during the period ended June 30, 2013 was due to the Company's review and management of capital resources. The Company does not enter into these types of transactions for liquidity purposes, but rather for yield enhancement on its investment portfolio.

   Mortgage Loans on Real Estate   

The Company's mortgage loans on real estate are comprised exclusively of domestic commercial collateralized real estate loans. The mortgage loan portfolio is diversified with regard to geographical markets and commercial real estate property types within the United States. The Company originates, directly or through correspondents, real estate mortgages with the intent to hold to maturity. The Company's portfolio includes loans which are fully amortizing, amortizing with a balloon balance at maturity, interest only to maturity and interest only for a number of years followed by an amortizing period. During the six months ended June 30, 2013 and the year ended December 31, 2012, the Company originated 18 and 36 new loans with aggregate principal balances of $259 million and $525 million, respectively.

   Derivatives   

The Company uses certain derivatives, such as futures, swaps and interest rate swaptions, for purposes of managing the interest rate, foreign currency exchange rate and equity market risks impacting the Company's business. These derivatives, when taken alone, may subject the Company to varying degrees of market and credit risk; however, since used for hedging purposes, these instruments are intended to reduce risk. The Company controls the credit risk of its over-the-counter derivative contracts through credit approvals, limits, monitoring procedures and in most cases, requiring collateral. Risk of loss is generally limited to the portion of the fair value of derivative instruments that exceeds the value of the collateral held and not to the notional or contractual amounts of the derivatives.

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Summary of Critical Accounting Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America ("GAAP") requires the Company's management to adopt accounting policies to enable them to make a significant variety of accounting and actuarial estimates and assumptions. These estimates and assumptions affect, among other things, the reported amounts of assets and liabilities, the disclosure of contingent liabilities and the reported amounts of revenues and expenses. Actual results can differ from the amounts previously estimated, which were based on information available at the time the estimates were made.

Critical accounting estimates are those that management believes are important to the portrayal of the Company's results of operations and financial condition and which require them to make difficult, subjective and/or complex judgments. Critical accounting estimates cover accounting and actuarial matters that are inherently uncertain because the future resolution of such matters is unknown. Many of these policies, estimates and related judgments are common in the insurance and financial services industries. The Company believes that its most critical accounting estimates include the following:

† Valuation of investments and derivatives in the absence of quoted market values;

 †       Impairment of investments;  †       Valuation of policy benefit liabilities; and  †       Valuation of DAC.   

A discussion of each of these critical accounting policies may be found in the Company's Annual Report on Form 10-K for the year ended December 31, 2012, under Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations."

Application of Recent Accounting Pronouncements

See Note 2 to the accompanying condensed consolidated financial statements for a discussion of the application of recent accounting pronouncements.

Liquidity and Capital Resources

Liquidity refers to a company's ability to generate sufficient cash flows to meet the needs of its operations. The Company manages its operations to create stable, reliable and cost-effective sources of cash flows to meet all of its obligations.

The principal sources of the Company's liquidity are premiums and contract deposits, fees, investment income and investment maturities and sales. Funds provided from these sources are reasonably predictable and normally exceed liquidity requirements for payment of policy benefits, payments to policy and contractholders in connection with surrenders and withdrawals and general expenses. However, since the timing of available funds cannot always be matched precisely to commitments, imbalances may arise when demands for funds exceed those on hand. A primary liquidity concern regarding cash flows from operations is the risk of early policyholder and contractholder withdrawals. A primary liquidity concern regarding investment activity is the risk of defaults and market volatility. In addition, a demand for funds may arise as a result of the Company taking advantage of current investment opportunities. The sources of the funds that may be required in such situations include the issuance of commercial paper or other debt instruments. Management believes that the liquidity profile of its assets is sufficient to satisfy the liquidity requirements of reasonably foreseeable scenarios.

Generally, the Company has met its operating requirements by utilizing cash flows from operations and maintaining appropriate levels of liquidity in its investment portfolio. Liquidity for the Company has remained strong, as evidenced by the amounts of short-term investments, excluding collateral on dollar repurchase agreements, and cash that totaled $241 million and $278 million as of June 30, 2013 and December 31, 2012, respectively. In addition, 99% and 98% of the fixed maturity portfolio carried an investment grade rating at June 30, 2013 and December 31, 2012, respectively, thereby providing significant liquidity to the Company's overall investment portfolio.

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The Company continues to be well capitalized, with sufficient borrowing capacity. Additionally, the Company anticipates that cash on hand and expected net cash generated by operating activities will exceed the forecasted needs of the business over the next 12 months. The Company's financial strength provides the capacity and flexibility to enable it to raise funds in the capital markets through the issuance of commercial paper. The Company had $94 million and $98 million of commercial paper outstanding at June 30, 2013 and December 31, 2012, respectively. The commercial paper has been given a rating of A-1+ by Standard & Poor's Ratings Services and a rating of P-1 by Moody's Investors Service, each being the highest rating available. Through the recent financial market volatility, the Company continued to have the ability to access the capital markets for funds. The loss of this access in the future would not have a significant impact to the Company's liquidity as commercial paper is not used to fund daily operations and is an insignificant amount in relation to total invested assets.

The Company also has available a revolving credit facility agreement, which expires on March 1, 2018, in the amount of $50 million for general corporate purposes. The Company had no borrowings under this credit facility as of or during the six months ended June 30, 2013. The Company does not anticipate the need for borrowings under this facility and the loss of its availability would not significantly impact its liquidity.

Capital resources provide protection for policyholders and financial strength to support the underwriting of insurance risks and allow for continued business growth. The amount of capital resources that may be needed is determined by the Company's senior management and Board of Directors, as well as by regulatory requirements. The allocation of resources to new long-term business commitments is designed to achieve an attractive return, tempered by considerations of risk and the need to support the Company's existing business.

Off-Balance Sheet Arrangements

The Company makes commitments to fund partnership interests, mortgage loans on real estate and other investments in the normal course of its business. The amounts of these unfunded commitments at June 30, 2013 and December 31, 2012 were $164 million and $127 million, respectively. The precise timing of the fulfillment of the commitment cannot be predicted; however, these amounts are due within one year of the dates indicated. There are no other obligations or liabilities arising from such arrangements that are reasonably likely to become material.

The Company participates in a short-term reverse repurchase program for the purpose of enhancing the total return on its investment portfolio. This type of transaction involves the purchase of securities with a simultaneous agreement to sell similar securities at a future date at an agreed-upon price. In exchange, non-cash collateral is put on deposit by the financial institutions on our behalf with a third-party custodian. The amount of securities purchased in connection with these transactions was $750 million and $4 million at June 30, 2013 and December 31, 2012, respectively. Non-cash collateral on deposit with the third-party custodian on our behalf was $765 million and $4 million at June 30, 2013 and December 31, 2012, respectively, which cannot be sold or re-pledged and which has not been recorded on the condensed consolidated balance sheets.

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