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ING USA ANNUITY & LIFE INSURANCE CO – 10-Q – Management’s Narrative Analysis of the Results of Operations and Financial Condition (Dollar amounts in millions, unless otherwise stated)
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Overview
The following narrative analysis presents a review of the results of operations ofING USA Annuity and Life Insurance Company ("ING USA ," the "Company," "we" or "us," as appropriate) for each of the three and six months endedJune 30, 2013 and 2012 and financial condition as ofJune 30, 2013 andDecember 31, 2012 . This item should be read in its entirety and in conjunction with the Condensed Financial Statements and related notes and other supplemental data, which can be found under Part I, Item 1., contained herein, as well as the "Management's Narrative Analysis of the Results of Operations and Financial Condition" section contained in our 2012 Annual Report on Form 10-K. Investors are also directed to consider the risks and uncertainties discussed in this Item 2. and in Item 1A. of Part II contained herein, as well as in other documents we filed with theSEC . Except as may be required by the federal securities laws, we disclaim any obligation to update forward-looking information.
Basis of Presentation
ING USA is a stock life insurance company domiciled in theState of Iowa and provides financial products and services inthe United States .ING USA is authorized to conduct its insurance business in all states, exceptNew York , and in theDistrict of Columbia . In 2009, ING Groep N.V. ("ING Group " or "ING") announced the anticipated separation of its global banking and insurance businesses, including the divestiture of ING U.S., Inc., which together with its subsidiaries, including the Company, constitutesING's U.S.-based retirement, investment management and insurance operations. OnApril 11, 2013 , ING U.S., Inc. announced plans to rebrand in the future as Voya Financial. OnMay 2, 2013 , the common stock of ING U.S., Inc. began trading on theNew York Stock Exchange under the symbol "VOYA." OnMay 7, 2013 , ING U.S., Inc. completed the offering of 65,192,307 shares of its common stock, including the issuance and sale by ING U.S., Inc. of 30,769,230 shares of common stock and the sale byING Insurance International B.V . ("ING International "), an indirect wholly owned subsidiary of ING Group and previously the sole stockholder of ING U.S., Inc., of 34,423,077 shares of outstanding common stock of ING U.S., Inc. (collectively, the "IPO"). Immediately following the closing of the IPO onMay 7, 2013 ,ING International owned 75% of the outstanding common stock of ING U.S., Inc. OnMay 31, 2013 , in connection with the option granted to the underwriters in the IPO to acquire up to an additional 9,778,846 shares of ING U.S., Inc. common stock fromING International , the underwriters exercised such option (ultimately acquiring an additional 9,778,696 shares) andING International's ownership of ING U.S., Inc.'s common stock was reduced to 71%.ING USA is a direct, wholly owned subsidiary ofLion Connecticut Holdings Inc. ("Lion" or "Parent"), which is a direct, wholly owned subsidiary of ING U.S., Inc.ING International owns approximately 71% of the common stock of ING U.S., Inc.ING International is a wholly owned subsidiary ofING Verzekeringen N.V. ("ING V"), which is a wholly owned subsidiary ofING Insurance Topholding N.V. ("ING Topholding"), which is a wholly owned subsidiary of ING Group, the ultimate parent company.ING is a global financial services holding company based inThe Netherlands , with American Depository Shares listed on theNew York Stock Exchange under the symbol "ING ." InAugust 2013 , ING Group announced thatING International , ING V andING Topholding will distribute shares of common stock of ING U.S., Inc. that are held directly byING International as a dividend in kind to ING Group (effectively removingING International , ING V and ING Topholding from the chain of intermediate ownership, and resulting in such shares being held directly by ING Group). Subject to receipt of regulatory approvals and/or notices of non-objection, as the case may be, this transaction is expected to be completed onSeptember 30, 2013 .
We have one operating segment.
Critical Accounting Policies, Judgments and Estimates
The preparation of financial statements in conformity with accounting principles generally accepted inthe United States ("U.S. GAAP") requires the application of accounting policies that often involve a significant degree of judgment. Management, on an ongoing basis, reviews estimates and assumptions used in the preparation of the financial statements. There can be no assurance
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that actual results will conform to estimates and assumptions and that reported results of operations will not be materially affected by the need to make future accounting adjustments to reflect changes in these estimates and assumptions from time to time. We have identified the following accounting policies, judgments and estimates as critical in that they involve a higher degree of judgment and are subject to a significant degree of variability: Reserves for future policy benefits, valuation and amortization of deferred policy acquisition costs ("DAC"), value of business acquired ("VOBA") and sales inducements, valuation of investments and derivatives, impairments, income taxes and contingencies. In developing these accounting estimates and policies, we make subjective and complex judgments that are inherently uncertain and subject to material changes as facts and circumstances develop. Although variability is inherent in these estimates, we believe the amounts provided are appropriate based upon the facts available upon preparation of the Condensed Financial Statements. In assessing loss recognition related to DAC, VOBA, and sales inducements, we must select an approach for aggregating different blocks of business in the loss recognition calculation. In the first quarter of 2013, we updated the aggregation approach used in the assessment of such loss recognition. This change in estimate was due to certain organizational changes that commenced in the first quarter of 2013, which resulted in changes to how we manage the variable annuity business that is no longer actively marketed. As a result of this estimate change, we recognized loss recognition of $350.8 before taxes during the first quarter of 2013. This amount was recorded in the Condensed Statements of Operations of $306.0 to Net amortization of deferred policy acquisition costs and value of business acquired and $44.8 to Interest credited and other benefits to contract owners/policyholders, with a corresponding decrease in the Condensed Balance Sheets to Deferred policy acquisition costs, Value of business acquired, and Sales inducements to contract owners. This update impacted the loss recognition calculation for us but did not have an impact on the consolidated financial statements of ING U.S., Inc.
The above critical accounting estimates are described in the Business, Basis of Presentation and Significant Accounting Policies Note to the Financial Statements in the 2012 Annual Report on Form 10-K.
Results of Operations
Overview
Products currently offered by us include immediate and deferred fixed annuities, designed to address individual customer needs for tax-advantaged savings, retirement needs and wealth-protection concerns and guaranteed investment contracts and funding agreements sold primarily to institutional investors and corporate benefit plans.
We derive our revenue mainly from (a) fee income generated on variable assets under management ("AUM"), (b) investment income earned on investments, (c) premiums, (d) realized capital gains (losses) on investments and product guarantees and (e) certain other management fees. Fee income is primarily generated from separate account assets supporting variable options under variable annuity contract investments, as designated by contract owners.
Investment income earned on invested assets is mainly generated from annuity products with fixed investment options, guaranteed investment contract ("GIC") deposits and funding agreements. Our expenses primarily consist of (a) Interest credited and other benefits to contract owners/policyholders, (b) amortization of DAC, VOBA and sales inducements, (c) expenses related to the selling and servicing of the various products offered by us and (d) other general business expenses. 59
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Three Months Ended
Our results of operations for the three months endedJune 30, 2013 and 2012 and changes therein, primarily reflect a decrease in Interest credited and other benefits to contract owners/policyholders partially offset by unfavorable changes in Net realized capital gains (losses) and Net amortization of DAC/VOBA. Three Months Ended June 30, $ Increase % Increase 2013 2012 (Decrease) (Decrease) Revenues: Net investment income$ 305.4 $ 315.2 $ (9.8 ) (3.1 )% Fee income 208.3 205.1 3.2 1.6 % Premiums 121.7 117.4 4.3 3.7 % Net realized capital gains (losses): Total other-than-temporary impairments (3.1 ) (4.7 ) 1.6 34.0 % Less: Portion of other-than-temporary impairments recognized in Other comprehensive income (loss) (0.7 ) (2.6 ) 1.9 73.1 % Net other-than-temporary impairments recognized in earnings (2.4 ) (2.1 ) (0.3 ) (14.3 )% Other net realized capital gains (losses) (377.4 ) 457.8 (835.2 ) NM Total net realized capital gains (losses) (379.8 ) 455.7 (835.5 ) NM Other revenue 9.0 12.2 (3.2 ) (26.2 )% Total revenues 264.6 1,105.6 (841.0 ) (76.1 )% Benefits and expenses: Interest credited and other benefits to contract owners/policyholders (451.7 ) 1,282.9 (1,734.6 ) NM Operating expenses 116.2 114.3 1.9 1.7 % Net amortization of deferred policy acquisition costs and value of business acquired 226.8 (81.2 ) 308.0 NM Interest expense 7.0 7.8 (0.8 ) (10.3 )% Other expense 5.6 5.3 0.3 5.7 % Total benefits and expenses (96.1 ) 1,329.1 (1,425.2 ) NM Income (loss) before income taxes 360.7 (223.5 ) 584.2 NM Income tax expense (benefit) 134.9 (40.2 ) 175.1 NM Net income (loss)$ 225.8 $ (183.3 ) $ 409.1 NM NM - Not Meaningful Revenues Total revenues decreased$841.0 from$1,105.6 to$264.6 for the three months endedJune 30, 2013 , primarily due to unfavorable changes in Total net realized capital gains (losses). Net investment income decreased$9.8 from$315.2 to$305.4 primarily due to lower general account assets. General account assets decreased mainly due to lapses in multi-year guaranteed annuities ("MYGAs"). Certain MYGAs, mostly sold in 2002, reached the end of their current guarantee period in 2012. Most of these MYGAs had high crediting rates and the supporting assets generated returns below the targets set when the contracts were issued. The high lapse rate was expected as renewal crediting rates offered were lower than the crediting rates during the initial term. Partially offsetting this variance was the effect of a loss on sale of certain alternative investments in the second quarter of 2012. Total net realized capital gains (losses) changed$(835.5) from a gain of$455.7 to a loss of$379.8 primarily due to unfavorable net changes in variable annuity hedging derivatives and losses on fixed maturities, partially offset by gains in the fair value of embedded derivatives. Under the variable annuity and fixed indexed annuity hedge programs, changes in equity and interest markets during the three months endedJune 30, 2013 resulted in net losses of$691.1 on interest, equity and foreign exchange
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derivatives compared to net gains of$998.0 during the prior period, an unfavorable net change of$1,689.1 . Derivative losses of$680.0 in the second quarter 2013 and derivative gains of$983.3 in the second quarter 2012 were ceded to Security Life ofDenver International Limited ("SLDI") under the combined coinsurance and coinsurance funds withheld agreement and an offset is recorded in Interest credited and other benefits to contract owners/policyholders. Unfavorable net changes of$32.0 of realized gains/(losses) on fixed maturities and$35.1 in the fair value of fixed maturities using fair value option also contributed to the variance. Partially offsetting these variances were favorable net changes of$917.1 in the fair value of embedded derivatives on variable annuity and fixed indexed annuity product guarantees (from a loss of$562.5 in the second quarter 2012 to a gain of$354.6 in the second quarter 2013).
Benefits and Expenses
Total benefits and expenses decreased$1,425.2 from$1,329.1 to$(96.1) for the three months endedJune 30, 2013 primarily due to a decrease in Interest credited and other benefits to contract owners/policyholders, partially offset by an increase in Net amortization of DAC/VOBA. Interest credited and other benefits to contract owners/policyholders decreased$1,734.6 from$1,282.9 to$(451.7) primarily due to the change in the amount of equity and interest rate derivative gains/losses transferred under the combined coinsurance and coinsurance funds withheld agreement with SLDI (the corresponding offsetting amount is reported in Total net realized capital gains/(losses)) and the change in the embedded derivative on the two coinsurance funds withheld arrangements.
Net amortization of DAC and VOBA increased
Income Taxes
Income tax expense (benefit) changed$175.1 from$(40.2) to$134.9 primarily due to an increase in income before taxes, partially offset by a decrease in the valuation allowance and an increase in the dividends received deduction.
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Six Months Ended
Our results of operations for the six months endedJune 30, 2013 and 2012 and changes therein, primarily reflect a decrease in Interest credited and other benefits to contract owners/policyholders partially offset by increases in Net amortization of DAC/VOBA and Net realized capital losses and a decrease in Net investment income. Six Months Ended June 30, $ Increase % Increase 2013 2012 (Decrease) (Decrease) Revenues: Net investment income$ 608.1 $ 661.2 $ (53.1 ) (8.0 )% Fee income 409.1 413.0 (3.9 ) (0.9 )% Premiums 237.5 229.9 7.6 3.3 % Net realized capital gains (losses): Total other-than-temporary impairments (4.3 ) (8.6 ) 4.3 50.0 % Less: Portion of other-than-temporary impairments recognized in Other comprehensive income (loss) (0.7 ) (2.7 ) 2.0 74.1 % Net other-than-temporary impairments recognized in earnings (3.6 ) (5.9 ) 2.3 39.0 % Other net realized capital gains (losses) (1,153.4 ) (852.1 ) (301.3 ) (35.4 )% Total net realized capital gains (losses) (1,157.0 ) (858.0 ) (299.0 ) (34.8 )% Other revenue 15.9 20.3 (4.4 ) (21.7 )% Total revenues 113.6 466.4 (352.8 ) (75.6 )% Benefits and expenses: Interest credited and other benefits to contract owners/policyholders (1,060.1 ) 478.3 (1,538.4 ) NM Operating expenses 225.7 225.7 - - % Net amortization of deferred policy acquisition costs and value of business acquired 945.2 46.1 899.1 NM Interest expense 14.0 15.6 (1.6 ) (10.3 )% Other expense 11.3 16.5 (5.2 ) (31.5 )% Total benefits and expenses 136.1 782.2 (646.1 ) (82.6 )% Income (loss) before income taxes (22.5 ) (315.8 ) 293.3 92.9 % Income tax expense (benefit) 88.3 (73.0 ) 161.3 NM Net income (loss)$ (110.8 ) $ (242.8 ) $ 132.0 54.4 % NM - Not Meaningful Revenues
Total revenues decreased
Net investment income decreased$53.1 from$661.2 to$608.1 primarily due to lower general account assets. General account assets decreased mainly due to lapses in multi-year guaranteed annuities ("MYGAs"). Certain MYGAs, mostly sold in 2002, reached the end of their current guarantee period in 2012. Most of these MYGAs had high crediting rates and the supporting assets generated returns below the targets set when the contracts were issued. The high lapse rate was expected as renewal crediting rates offered were lower than the crediting rates during the initial term. Partially offsetting this variance was the effect of a loss on sale of certain alternative investments in the second quarter of 2012. Total net realized capital losses increased$299.0 from a loss of$858.0 to a loss of$1,157.0 primarily due to unfavorable net changes in variable annuity hedging derivatives and losses on fixed maturities, partially offset by gains in the fair value of embedded derivatives. Under the variable annuity and fixed indexed annuity hedge programs, changes in equity and interest markets during the six months endedJune 30, 2013 resulted in net losses of$1,765.2 on interest, equity and foreign exchange derivatives compared
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to net losses of$616.0 during the first half of 2012, a net change of$(1,149.2) . Derivative losses of$1,709.6 in the first half of 2013 and derivative losses of$311.7 in the first half of 2012 were ceded to Security Life ofDenver International Limited ("SLDI") under the combined coinsurance and coinsurance funds withheld agreement and an offset is recorded in Interest credited and other benefits to contract owners/policyholders. Unfavorable net changes of$89.6 of realized gains/(losses) on fixed maturities and$33.5 in the fair value of fixed maturities using fair value option also contributed to the variance. Partially offsetting these variances were favorable net changes of$957.0 in the fair value of embedded derivatives on variable annuity and fixed indexed annuity product guarantees (from a loss of$290.2 in the first half of 2012 to a gain of$666.8 in the first half of 2013).
Benefits and Expenses
Total benefits and expenses decreased$646.1 from$782.2 to$136.1 for the six months endedJune 30, 2013 primarily due to a decrease in Interest credited and other benefits to contract owners/policyholders, partially offset by an increase in Net amortization of DAC/VOBA. Interest credited and other benefits to contract owners/policyholders decreased$1,538.4 from$478.3 to$(1,060.1) primarily due to the change in the amount of equity and interest rate derivative gains/losses transferred under the combined coinsurance and coinsurance funds withheld agreement with SLDI (the corresponding offsetting amount is reported in Total net realized capital gains/(losses)) and the change in the embedded derivative on the two coinsurance funds withheld arrangements. Net amortization of DAC and VOBA increased$899.1 from$46.1 to$945.2 primarily due to higher amortization due to higher actual gross profits in the current period compared to the prior year period. An increase in amortization of$306.0 resulting from loss recognition on DAC and VOBA in the first quarter 2013 also contributed to the change (see Critical Accounting Policies, Judgments and Estimates).
Income Taxes
Income tax expense (benefit) changed$161.3 from$(73.0) to$88.3 primarily due to a decrease in loss before taxes and an increase in the dividends received deduction. Also contributing to the change is an increase in the valuation allowance which mainly results from a decrease in tax planning. Financial Condition Investments Investment Strategy Our investment strategy seeks to achieve sustainable risk-adjusted returns by focusing on principal preservation, disciplined matching of asset characteristics with liability requirements and the diversification of risks. Investment activities are undertaken according to investment policy statements that contain internally established guidelines and risk tolerances and in all cases are required to comply with applicable laws and insurance regulations. Risk tolerances are established for credit risk, credit spread risk, market risk, liquidity risk and concentration risk across issuers, sectors and asset types that seek to mitigate the impact of cash flow variability arising from these risks. Segmented portfolios are established for groups of products with similar liability characteristics. Our investment portfolio consists largely of high quality fixed maturities and short-term investments, investments in commercial mortgage loans, alternative investments and other instruments, including a small amount of equity holdings. Fixed maturities include publicly issued corporate bonds, government bonds, privately placed notes and bonds, Asset-backed securities ("ABS"), traditional Mortgage-backed securities ("MBS") and various Collateralized mortgage obligations ("CMO") tranches managed in combination with financial derivatives as part of a proprietary strategy. We use derivatives for hedging purposes to reduce our exposure to the cash flow variability of assets and liabilities, interest rate risk, credit risk and market risk. In addition, we use credit derivatives to replicate exposure to individual securities or pools of securities as a means of achieving credit exposure similar to bonds of the underlying issuer(s) more efficiently. Since the height of the financial crisis in 2008, we have pursued a substantial repositioning of the investment portfolio aimed at reducing risk, increasing the stability and predictability of returns and pursuing intentional investment risks that are reliant on our core strengths. The repositioning has resulted in a significant decrease in exposure to structured assets, an improvement in the 63
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Portfolio Composition
The following table presents the investment portfolio as of the dates indicated: June 30, 2013 December 31, 2012 Carrying % of Carrying % of Value Total Value Total Fixed maturities, available-for-sale, excluding securities pledged$ 21,930.8 78.4 %$ 20,586.6 71.1 % Fixed maturities, at fair value using the fair value option 304.3 1.1 % 326.7 1.1 % Equity securities, available-for-sale 14.7 0.1 % 29.8 0.1 % Short-term investments(1) 1,410.0 5.0 % 2,686.6 9.3 % Mortgage loans on real estate 2,798.0 10.0 % 2,835.0 9.8 % Policy loans 97.9 0.4 % 101.8 0.4 % Limited partnerships/corporations 163.7 0.6 % 166.9 0.6 % Derivatives 376.7 1.3 % 1,381.3 4.8 % Other investments 80.9 0.3 % 80.7 0.3 % Securities pledged(2) 775.6 2.8 % 714.0 2.5 % Total investments$ 27,952.6 100.0 %$ 28,909.4 100.0 % (1) Short-term investments include investments with remaining maturities of one year or less, but greater than 3 months, at the time of purchase. (2) See "Management's Discussion and Analysis of Results of Operations and Financial Condition-Liquidity and Capital Resources" for information regarding securities pledged. 64
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Fixed Maturities
Total fixed maturities by market sector, including securities pledged, were as follows as of the dates indicated:
June 30, 2013 Amortized % of Fair % of Cost Total Value Total Fixed Maturities: U.S. Treasuries$ 2,143.1 9.7 %$ 2,159.1 9.4 %U.S. Government agencies and authorities 65.9 0.3 % 66.5 0.3 % State, municipalities and political subdivisions 50.0 0.2 % 53.1 0.2 % U.S. corporate securities 10,305.7 46.9 % 10,745.8 46.7 % Foreign securities(1) 5,039.6 22.9 % 5,274.0 22.9 % Residential mortgage-backed securities 2,234.6 10.2 % 2,399.5 10.4 % Commercial mortgage-backed securities 1,490.3 6.8 % 1,647.2 7.2 % Other asset-backed securities 660.9 3.0 % 665.5 2.9 % Total fixed maturities, including securities pledged$ 21,990.1 100.0 %$ 23,010.7 100.0 % (1) Primarily U.S. dollar denominated. December 31, 2012 Amortized % of Fair % of Cost Total Value Total Fixed Maturities: U.S. Treasuries$ 1,218.9 6.2 %$ 1,311.5 6.1 %U.S. Government agencies and authorities 19.3 0.1 % 23.7 0.1 % State, municipalities and political subdivisions 80.1 0.4 % 90.0 0.4 % U.S. corporate securities 9,511.8 48.6 % 10,537.5 48.7 % Foreign securities(1) 4,877.8 24.9 % 5,366.6 24.8 % Residential mortgage-backed securities 1,617.1 8.3 % 1,853.7 8.6 % Commercial mortgage-backed securities 1,565.4 8.0 % 1,763.6 8.2 % Other asset-backed securities 681.6 3.5 % 680.7 3.1 % Total fixed maturities, including securities pledged$ 19,572.0 100.0 %$ 21,627.3 100.0 % (1) Primarily U.S. dollar denominated.
As of
Fixed Maturities Credit Quality - Ratings
Information about certain of our fixed maturity securities holdings by NAIC designation is set forth in the following tables. Corresponding rating agency designation does not directly translate into NAIC designation, but represents our best estimate of comparable ratings from rating agencies, includingFitch Ratings, Inc. ("Fitch"),Moody's Investors Service, Inc. ("Moody's") andStandard & Poor's Ratings Services ("S&P"). If no rating is available from a rating agency, then an internally developed rating is used. The fixed maturities in our portfolio are generally rated by external rating agencies and, if not externally rated, are rated by us on a basis similar to that used by the rating agencies. As ofJune 30, 2013 andDecember 31, 2012 , the average quality rating of our fixed maturities portfolio was A. Ratings are derived from three ARO ratings and are applied as follows based on the number of agency ratings received:
• when three ratings are received, the middle rating is applied;
• when two ratings are received, the lower rating is applied;
• when a single rating is received, the ARO rating is applied; and
• when ratings are unavailable, an internal rating is applied.
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Total fixed maturities by NAIC designation category, including securities pledged, were as follows as of the dates indicated:
June 30, 2013 NAIC Amortized % of Fair % of Designation Cost Total Value Total 1$ 12,791.5 58.2 %$ 13,365.1 58.1 % 2 8,171.5 37.2 % 8,569.1 37.2 % 3 755.2 3.4 % 778.8 3.4 % 4 159.0 0.7 % 156.0 0.7 % 5 72.3 0.3 % 79.3 0.3 % 6 40.6 0.2 % 62.4 0.3 % Total$ 21,990.1 100.0 %$ 23,010.7 100.0 % December 31, 2012 NAIC Amortized % of Fair % of Designation Cost Total Value Total 1$ 10,615.6 54.1 %$ 11,753.1 54.3 % 2 7,899.0 40.4 % 8,752.2 40.5 % 3 719.6 3.7 % 755.0 3.5 % 4 205.9 1.1 % 196.6 0.9 % 5 91.9 0.5 % 103.1 0.5 % 6 40.0 0.2 % 67.3 0.3 % Total$ 19,572.0 100.0 %$ 21,627.3 100.0 %
Total fixed maturities by ARO quality rating category, including securities pledged, were as follows as of the dates indicated:
June 30, 2013 Amortized % of Fair % of ARO Ratings Cost Total Value Total AAA$ 5,413.3 24.6 %$ 5,628.0 24.4 % AA 1,497.1 6.8 % 1,558.8 6.8 % A 5,563.7 25.3 % 5,808.1 25.2 % BBB 8,193.9 37.3 % 8,596.5 37.4 % BB 777.6 3.5 % 823.0 3.6 % B and below 544.5 2.5 % 596.3 2.6 % Total$ 21,990.1 100.0 %$ 23,010.7 100.0 % December 31, 2012 Amortized % of Fair % of ARO Ratings Cost Total Value Total AAA$ 3,810.7 19.5 %$ 4,213.3 19.5 % AA 1,355.4 6.9 % 1,488.1 6.9 % A 5,202.2 26.6 % 5,767.0 26.7 % BBB 7,867.9 40.2 % 8,718.8 40.3 % BB 675.8 3.5 % 733.4 3.4 % B and below 660.0 3.3 % 706.7 3.2 % Total$ 19,572.0 100.0 %$ 21,627.3 100.0 % 66
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Fixed maturities rated BB and below may have speculative characteristics and changes in economic conditions or other circumstances that are more likely to lead to a weakened capacity of the issuer to make principal and interest payments than is the case with higher rated fixed maturities. The amortized cost and fair value of fixed maturities, including securities pledged, as ofJune 30, 2013 andDecember 31, 2012 , are shown below by contractual maturity. Actual maturities may differ from contractual maturities as securities may be restructured, called, or prepaid. MBS and Other ABS are shown separately because they are not due at a single maturity date. June 30, 2013 December 31, 2012 Amortized Fair Amortized Fair Cost Value Cost Value Due to mature: One year or less$ 804.9 $ 823.0 $ 1,122.5 $ 1,145.2 After one year through five years 5,798.6 6,022.7 4,967.1 5,274.6 After five years through ten years 7,151.4 7,315.8 5,836.5 6,440.6 After ten years 3,849.4 4,137.0 3,781.8 4,468.9 Mortgage-backed securities 3,724.9 4,046.7 3,182.5 3,617.3 Other asset-backed securities 660.9 665.5 681.6 680.7 Fixed maturities, including securities pledged$ 21,990.1 $ 23,010.7 $ 19,572.0 $ 21,627.3
As of
Unrealized Capital Losses
Unrealized capital losses (including noncredit impairments), along with the fair value of fixed maturities, including securities pledged, by market sector and duration were as follows as ofJune 30, 2013 : More Than
Six
Six Months or Less Below Amortized Months and Twelve Months or Less More Than Twelve Months Below Cost Below Amortized Cost Amortized Cost Total Unrealized Unrealized Unrealized Unrealized Fair Value Capital Losses Fair Value
Capital Losses Fair Value Capital Losses Fair Value Capital Losses U.S. Treasuries$ 1,498.1 $ 33.7 $ - $ - $ - $ -$ 1,498.1 $ 33.7U.S. Government agencies and authorities 49.6 0.4 - - - - 49.6 0.4 U.S. corporate, state and municipalities 2,888.7 116.5 167.1 12.2 75.3 9.2 3,131.1 137.9 Foreign 974.1 43.3 2.3 0.3 93.4 10.9 1,069.8 54.5 Residential mortgage-backed 910.3 17.5 59.3 1.3 151.9 16.6 1,121.5 35.4 Commercial mortgage-backed - - 0.4 - 14.6 1.9 15.0 1.9 Other asset-backed 64.9 0.5 - - 127.0 15.8 191.9 16.3 Total$ 6,385.7 $ 211.9$ 229.1 $ 13.8$ 462.2 $ 54.4$ 7,077.0 $ 280.1 67
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Unrealized capital losses (including noncredit impairments), along with the fair value of fixed maturities, including securities pledged, by market sector and duration were as follows as ofDecember 31, 2012 : More Than
Six
Six Months or Less Below Amortized Months and Twelve
Months or Less More Than Twelve Months Below
Cost Below Amortized Cost Amortized Cost Total Unrealized Unrealized Unrealized Unrealized Fair Value Capital Losses Fair Value
Capital Losses Fair Value Capital Losses Fair Value Capital Losses U.S. Treasuries $ - $ - $ - $ - $ - $ - $ - $ -U.S. Government agencies and authorities - - - - - - - - U.S. corporate, state and municipalities 237.3 2.9 40.1 0.6 94.0 10.4 371.4 13.9 Foreign 33.3 3.1 23.9 1.8 158.1 17.6 215.3 22.5 Residential mortgage-backed 116.3 2.2 10.9 0.1 181.6 29.1 308.8 31.4 Commercial mortgage-backed 4.8 - 11.2 1.2 15.8 1.8 31.8 3.0 Other asset-backed 0.1 - - - 152.8 23.5 152.9 23.5 Total$ 391.8 $ 8.2$ 86.1 $ 3.7$ 602.3 $ 82.4$ 1,080.2 $ 94.3
Of the unrealized capital losses aged more than twelve months, the average market value of the related fixed maturities was 89.5% and 87.9% of the average book value as of
Gross unrealized losses on fixed maturities, including securities pledged, increased$185.8 as ofJune 30, 2013 . The increase is primarily due to increasing interest rates and widening spreads. Gross unrealized capital losses on fixed maturities, including securities pledged, decreased$204.7 as ofDecember 31, 2012 . The decrease was primarily due to improving market conditions with Other ABS and CMBS in addition to declining yield and tightening credit spreads. As ofJune 30, 2013 we had one fixed maturity with an unrealized capital loss in excess of$10.0 . The unrealized capital loss on this fixed maturity equaled$13.8 , or 4.9% of the total unrealized losses. As ofDecember 31, 2012 , we did not have any fixed maturities with an unrealized capital loss in excess of$10.0</money>.
Subprime and Alt-A Mortgage Exposure
The performance of underlying subprime and Alt-A mortgage collateral, originated prior to 2008, has continued to reflect the problems associated with a housing market that has since seen substantial price declines and an employment market that has declined significantly and remains under stress. Credit spreads have widened meaningfully from issuance and rating agency downgrades have been widespread and severe within the sector. During 2012, market prices and sector liquidity demonstrated more sustained improvements, driven by an improved technical picture and positive sentiment regarding the potential for fundamental improvement within the sector. This positive momentum continued into 2013, with the first quarter characterized by improving housing market indicators and strong liquidity. In managing our risk exposure to subprime and Alt-A mortgages, we take into account collateral performance and structural characteristics associated with our various positions. We do not originate or purchase subprime or Alt-A whole-loan mortgages. Subprime lending is the origination of loans to customers with weaker credit profiles. We define Alt-A mortgages to include the following: residential mortgage loans to customers who have strong credit profiles but lack some element(s), such as documentation to substantiate income; residential mortgage loans to borrowers that would otherwise be classified as prime but whose loan structure provides repayment options to the borrower that increase the risk of default; and any securities backed by residential mortgage collateral not clearly identifiable as prime or subprime. We have exposure to Residential mortgage-backed securities ("RMBS"), Commercial mortgage-backed securities ("CMBS") and ABS. Our exposure to subprime mortgage-backed securities is primarily in the form of ABS structures collateralized by subprime residential mortgages and the majority of these holdings were included in Other ABS under "Fixed Maturities" above. As of June 30, 2013 , the fair value, amortized cost and gross unrealized losses related to our exposure to subprime mortgage-backed securities was $187.6 , $193.6 and $16.2 , respectively, representing 0.8% of total fixed maturities, including securities pledged, based on fair value. As of December 31, 2012 , the fair value, amortized cost and gross unrealized losses related to our exposure 68
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to subprime mortgage-backed securities were
The NAIC designations for structured securities, including subprime and Alt-A RMBS, are based upon a comparison of the bond's amortized cost to the NAIC's loss expectation for each security. Securities where modeling results in no expected loss in all scenarios are considered to have the highest designation of NAIC 1. A large percentage of our RMBS securities carry a NAIC 1 designation while the ARO rating indicates below investment grade. This is primarily due to the credit and intent impairments recorded by us which reduced the amortized cost on these securities to a level resulting in no expected loss in all scenarios, which corresponds to a NAIC 1 designation. The revised methodology reduces regulatory reliance on rating agencies and allows for greater regulatory input into the assumptions used to estimate expected losses from such structured securities. The following tables present our exposure to subprime mortgage-backed securities by credit quality using NAIC designations, ARO ratings and vintage year as of the dates indicated: % of Total Subprime Mortgage-backed Securities NAIC Designation ARO Ratings VintageJune 30, 2013 1 65.4 % AAA - % 2007 11.7 % 2 3.2 % AA 0.3 % 2006 6.3 % 3 14.7 % A 12.2 % 2005 and prior 82.0 % 4 13.5 % BBB 8.2 % 100.0 % 5 2.5 % BB and below 79.3 % 6 0.7 % 100.0 % 100.0 % December 31, 2012 1 67.1 % AAA - % 2007 13.2 % 2 3.1 % AA 4.0 % 2006 6.2 % 3 14.2 % A 9.1 % 2005 and prior 80.6 % 4 13.5 % BBB 8.5 % 100.0 % 5 1.0 % BB and below 78.4 % 6 1.1 % 100.0 % 100.0 % Our exposure to Alt-A mortgages is included in the "RMBS" line item in the "Fixed Maturities" table under "Fixed Maturities" section above. As ofJune 30, 2013 , the fair value, amortized cost and gross unrealized losses related to our exposure to Alt-A RMBS aggregated to$125.4 ,$125.2 and$11.0 , respectively, representing 0.5% of total fixed maturities including securities pledged, based on fair value. As ofDecember 31, 2012 , the fair value, amortized cost and gross unrealized losses related to our exposure to Alt-A RMBS aggregated to$133.6 ,$139.9 and$21.7 , respectively, representing 0.6% of total fixed maturities, including securities pledged, based on fair value.
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The following tables summarize our exposure to Alt-A residential mortgage-backed securities by credit quality using NAIC designations, ARO ratings and vintage year as of the dates indicated: % of Total Alt-A Mortgage-backed Securities NAIC Designation ARO Ratings VintageJune 30, 2013 1 44.2 % AAA - % 2007 32.8 % 2 15.7 % AA 0.3 % 2006 19.3 % 3 25.3 % A 0.8 % 2005 and prior 47.9 % 4 11.3 % BBB 3.1 % 100.0 % 5 2.6 % BB and below 95.8 % 6 0.9 % 100.0 % 100.0 % December 31, 2012 1 36.3 % AAA 0.2 % 2007 31.4 % 2 10.9 % AA 0.8 % 2006 19.4 % 3 15.7 % A 0.6 % 2005 and prior 49.2 % 4 30.4 % BBB 2.6 % 100.0 % 5 5.7 % BB and below 95.8 % 6 1.0 % 100.0 % 100.0 %
CMBS investments represent pools of commercial mortgages that are broadly diversified across property types and geographical areas. Delinquency rates on commercial mortgages increased over the course of 2009 through mid-2012. Since then, the steep pace of increases observed in the early years following the credit crisis has slowed and some recent months have posted month over month declines in delinquencies. In addition, other performance metrics like vacancies, property values and rent levels have shown improvements, although these metrics can differ widely by dimensions such as geographic location and property type. The primary market for CMBS has continued its recovery from the credit crisis with higher total new issuances in 2012, the fourth straight year of higher new issuances. This positive momentum continued into 2013, with total new issuance volume in first quarter the highest quarterly total since 2007. Higher primary issuance resulted in increased credit availability within the commercial real estate market.
For consumer Other ABS, delinquency and loss rates have exhibited general stability after the credit crisis and done so at levels considered historically low. Relative strength in various credit metrics across multiple types of asset-backed loans have been observed on a sustained basis.
As ofJune 30, 2013 , the fair value, amortized cost and gross unrealized losses related to our exposure to CMBS aggregated to$1.6 billion ,$1.5 billion and$1.9 , respectively. As ofDecember 31, 2012 , the fair value, amortized cost and gross unrealized losses related to our exposure to CMBS aggregated to$1.8 billion ,$1.6 billion and$3.0 , respectively. 70
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The following tables summarize our exposure to CMBS holdings by credit quality using NAIC designations, ARO ratings and vintage year as of the dates indicated: % of Total CMBS NAIC Designation ARO Ratings VintageJune 30, 2013 1 99.3 % AAA 47.1 % 2008 0.7 % 2 - % AA 24.8 % 2007 27.8 % 3 0.4 % A 9.9 % 2006 36.4 % 4 0.3 % BBB 7.0 % 2005 and prior 35.1 % 5 - % BB and below 11.2 % 100.0 % 6 - % 100.0 % 100.0 % December 31, 2012 1 97.5 % AAA 47.6 % 2008 0.6 % 2 1.8 % AA 25.4 % 2007 28.8 % 3 0.4 % A 10.1 % 2006 35.3 % 4 0.3 % BBB 7.3 % 2005 and prior 35.3 % 5 - % BB and below 9.6 % 100.0 % 6 - % 100.0 % 100.0 % As ofJune 30, 2013 , the fair value and amortized cost related to our exposure to Other ABS, excluding subprime exposure, aggregated to$482.9 and$470.3 , respectively. As ofJune 30, 2013 there were$0.1 of gross unrealized losses related to Other ABS, excluding subprime exposure. As ofDecember 31, 2012 , we did not have any gross unrealized losses related to Other ABS, excluding subprime exposure. As ofDecember 31, 2012 , the fair value and amortized cost related to our exposure to Other ABS, excluding subprime exposure, aggregated to$491.9 and$476.1 , respectively. As ofJune 30, 2013 , the Other ABS was also broadly diversified both by type and issuer with credit card receivables, nonconsolidated Collateralized loan obligations ("CLO") and automobile receivables, comprising 25.2%, 11.0% and 41.9%, respectively, of total Other ABS, excluding subprime exposure. As ofDecember 31, 2012 , Other ABS was also broadly diversified both by type and issuer with credit card receivables, nonconsolidated CLO and automobile receivables, comprising 29.2%, 11.2% and 36.6%, respectively, of total Other ABS, excluding subprime exposure.
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The following tables summarize our exposure to Other ABS holdings, excluding subprime exposure, by credit quality using NAIC designations, ARO ratings and vintage year as of the dates indicated: % of Total Other ABS NAIC Designation ARO Ratings VintageJune 30, 2013 1 98.5 % AAA 93.8 % 2013 0.6 % 2 0.6 % AA 2.0 % 2012 21.8 % 3 - % A 2.7 % 2011 17.3 % 4 - % BBB 0.6 % 2010 4.1 % 5 - % BB and below 0.9 % 2009 6.0 % 6 0.9 % 100.0 % 2008 1.0 % 100.0 % 2007 and prior 49.2 % 100.0 % December 31, 2012 1 97.0 % AAA 92.5 % 2012 18.0 % 2 2.2 % AA 1.0 % 2011 17.1 % 3 - % A 3.5 % 2010 4.6 % 4 - % BBB 2.2 % 2009 6.0 % 5 - % BB and below 0.8 % 2008 3.1 % 6 0.8 % 100.0 % 2007 14.7 % 100.0 % 2006 and prior 36.5 % 100.0 % Troubled Debt Restructuring We seek to invest in high quality, well performing portfolios of commercial mortgage loans and private placements. Under certain circumstances, modifications are granted to these contracts. Each modification is evaluated as to whether a troubled debt restructuring has occurred. A modification is a troubled debt restructuring when the borrower is in financial difficulty and the creditor makes concessions. Generally, the types of concessions may include reducing the face amount or maturity amount of the debt as originally stated, reducing the contractual interest rate, extending the maturity date at an interest rate lower than current market interest rates and/or reducing accrued interest. We consider the amount, timing and extent of the concession granted in determining any impairment or changes in the specific valuation allowance recorded in connection with the troubled debt restructuring. A valuation allowance may have been recorded prior to the quarter when the loan is modified in a troubled debt restructuring. Accordingly, the carrying value (net of the specific valuation allowance) before and after modification through a troubled debt restructuring may not change significantly, or may increase if the expected recovery is higher than the pre-modification recovery assessment. As ofJune 30, 2013 andDecember 31, 2012 , we did not have any new troubled debt restructurings. During the three and six months endedJune 30, 2013 and 2012, we did not have any commercial mortgage loans or private placements modified in a troubled debt restructuring with a subsequent payment default.
Mortgage Loans on Real Estate
Our mortgage loans on real estate are all commercial mortgage loans held for investment, which totaled
We diversify our commercial mortgage loan portfolio by geographic region and property type to manage concentration risk. We manage risk when originating commercial mortgage loans by generally lending only up to 75% of the estimated fair value of the underlying real estate. Subsequently, we continuously evaluate all mortgage loans based on relevant current information including a review of loan-specific credit, property characteristics and market trends. Loan performance is continuously monitored on a loan-specific basis throughout the year. Our review includes submitted appraisals, operating statements, rent revenues and annual 72
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inspection reports, among other items. This review evaluates whether the properties are performing at a consistent and acceptable level to secure the debt.
We rate all commercial mortgages to quantify the level of risk. We place those loans with higher risk on a watch list and closely monitor these loans for collateral deficiency or other credit events that may lead to a potential loss of principal and/or interest. If we determine the value of any mortgage loan to be other-than-temporary impairments ("OTTI") (i.e., when it is probable that we will be unable to collect on all amounts due according to the contractual terms of the loan agreement), the carrying value of the mortgage loan is reduced to either the present value of expected cash flows from the loan, discounted at the loan's effective interest rate, or fair value of the collateral. For those mortgages that are determined to require foreclosure, the carrying value is reduced to the fair value of the underlying collateral, net of estimated costs to obtain and sell at the point of foreclosure. The carrying value of the impaired loans is reduced by establishing an other-than-temporary write-down recorded in Net realized capital gains (losses) in the Condensed Statements of Operations.
The following table presents our investment in commercial mortgage loans as of the dates indicated:
June 30, 2013 December 31, 2012 Commercial mortgage loans$ 2,799.3 $ 2,836.2 Collective valuation allowance (1.3 ) (1.2 )
Total net commercial mortgage loans
There were no impairments taken on the mortgage loan portfolio for the three and six months ended
The following table presents the activity in the allowance for losses for all commercial mortgage loans for the periods indicated:
June 30, 2013 December 31, 2012 Collective valuation allowance for losses, balance at January 1 $ 1.2 $ 1.5 Addition to / (reduction of) allowance for losses 0.1 (0.3 ) Collective valuation allowance for losses, end of period $ 1.3 $ 1.2
Our policy is to recognize interest income until a loan becomes 90 days delinquent or foreclosure proceedings are commenced, at which point interest accrual is discontinued. Interest accrual is not resumed until the loan is brought current.
Loan-to-value ("LTV") and debt service coverage ("DSC") ratios are measures commonly used to assess the risk and quality of commercial mortgage loans. The LTV ratio, calculated at time of origination, is expressed as a percentage of the amount of the loan relative to the value of the underlying property. An LTV ratio in excess of 100% indicates the unpaid loan amount exceeds the value of the underlying collateral. The DSC ratio, based upon the most recently received financial statements, is expressed as a percentage of the amount of a property's net income (loss) to its debt service payments. A DSC ratio of less than 1.0 indicates that a property's operations do not generate sufficient income to cover debt payments. These ratios are utilized as part of the review process described above. The LTV and DSC ratios as of the dates indicated are as presented below: June 30, 2013(1) December 31, 2012(1) Loan-to-Value Ratio: 0% - 50% $ 507.2 $ 658.9 50% - 60% 823.8 848.0 60% - 70% 1,337.1 1,169.4 70% - 80% 121.7 149.4 80% and above 9.5 10.5 Total Commercial mortgage loans $ 2,799.3 $ 2,836.2
(1) Balances do not include allowance for mortgage loan credit losses.
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June 30, 2013(1) December 31, 2012(1) Debt Service Coverage Ratio: Greater than 1.5x $ 1,924.6 $ 1,970.9 1.25x - 1.5x 480.7 464.8 1.0x - 1.25x 272.5 259.2 Less than 1.0x 121.5 141.3 Total Commercial mortgage loans $ 2,799.3 $ 2,836.2
(1) Balances do not include allowance for mortgage loan credit losses.
Other-Than-Temporary Impairments
We evaluate available-for-sale fixed maturities and equity securities for impairment on a regular basis. The assessment of whether impairments have occurred is based on a case-by-case evaluation of the underlying reasons for the decline in estimated fair value. See the Business, Basis of Presentation and Significant Accounting Policies Note of the Financial Statements in our Annual Report on Form 10-K for a policy used to evaluate whether the investments are other-than-temporarily impaired. The following tables present our credit-related and intent-related impairments included in the Condensed Statements of Operations, excluding impairments included in Accumulated other comprehensive income (loss), by type for the periods indicated: Three Months Ended June 30, 2013 2012 No. of No. of Impairment Securities Impairment Securities U.S. corporate $ - - $ 0.5 1 Foreign(1) - - 0.3 1 Residential mortgage-backed 2.3 29 1.2 30 Commercial mortgage-backed - - - - Other asset-backed 0.1 2 0.1 1 Total $ 2.4 31 $ 2.1 33
(1) Primarily U.S. dollar denominated.
Six Months Ended June 30, 2013 2012 No. of No. of Impairment Securities Impairment Securities U.S. corporate $ - - $ 0.5 1 Foreign(1) - - 0.7 3 Residential mortgage-backed 3.5 42 2.7 41 Commercial mortgage-backed - * 1 1.7 1 Other asset-backed 0.1 2 0.3 3 Total $ 3.6 45 $ 5.9 49 (1) Primarily U.S. dollar denominated. * Less than$0.1 . The above tables include$2.4 and$3.6 of write-downs related to credit impairments for the three and six months endedJune 30, 2013 , respectively, in Other-than-temporary impairments, which are recognized in the Condensed Statements of Operations. There were no remaining write-downs for the three and six months endedJune 30, 2013 related to intent impairments. The above tables include$1.4 and$3.0 of write-downs related to credit impairments for the three and six months endedJune 30, 2012 , respectively, in Other-than-temporary impairments which are recognized in the Condensed Statements of Operations. The remaining$0.7 and$2.9 in write-downs for the three and six months endedJune 30, 2012 are related to intent impairments.
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The following tables summarize these intent impairments, which are also recognized in earnings, by type for the periods indicated:
Three Months Ended June 30, 2013 2012 No. of No. of Impairment Securities Impairment Securities U.S. corporate $ - - $ 0.4 1 Foreign(1) - - 0.3 1 Commercial mortgage-backed - - - - Other asset-backed - - - - Total $ - - $ 0.7 2
(1) Primarily U.S. dollar denominated.
Six Months Ended June 30, 2013 2012 No. of No. of Impairment Securities Impairment Securities U.S. corporate $ - - $ 0.4 1 Foreign(1) - - 0.7 3 Commercial mortgage-backed - * 1 1.7 1 Other asset-backed - - 0.1 1 Total $ - * 1 $ 2.9 6 (1) Primarily U.S. dollar denominated. * Less than$0.1 . As part of our investment strategy, we may sell securities during the period in which fair value has declined below amortized cost for fixed maturities or cost for equity securities. In certain situations, new factors, including changes in the business environment, can change our previous intent to continue holding a security. Accordingly, these factors may lead us to record additional intent related capital losses.
The fair value of fixed maturities with OTTI as of
During the three and six months ended
Net Investment Income
Net investment income was as presented below for the periods indicated:
Three Months Ended June 30, Six Months Ended June 30, 2013 2012 2013 2012 Fixed maturities$ 264.1 $ 285.9 $ 527.7 $ 585.2 Equity securities, available-for-sale 0.6 1.0 1.3 1.8 Mortgage loans on real estate 40.0 44.6 79.2 86.7 Policy loans 1.5 1.5 3.1 2.9 Short-term investments and cash equivalents 0.1 0.1 0.1 0.3 Other 11.7 (4.8 ) 21.8 10.7 Gross investment income 318.0 328.3 633.2 687.6 Less: Investment expenses 12.6 13.1 25.1 26.4 Net investment income$ 305.4 $ 315.2 $ 608.1 $ 661.2 75
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Net Realized Capital Gains (Losses)
Net realized capital gains (losses) are comprised of the difference between the amortized cost of investments and proceeds from sale and redemption, as well as losses incurred due to the credit-related and intent-related other-than-temporary impairment of investments. Realized investment gains and losses are also primarily generated from changes in fair value of embedded derivatives within product guarantees and fixed maturities, changes in fair value of fixed maturity securities recorded at FVO and changes in fair value including accruals on derivative instruments, except for effective cash flow hedges. The cost of the investments on disposal is generally determined based on first-in-first-out ("FIFO") methodology. Net realized capital gains (losses) were as presented below for the periods indicated: Three Months Ended June 30, Six Months Ended June 30, 2013 2012 2013 2012 Fixed maturities, available-for-sale, including securities pledged $ (14.2 ) $ 17.8 $ (8.3 ) $ 81.3 Fixed maturities, at fair value option (38.2 ) (3.1 ) (59.9 ) (26.4 ) Equity securities, available-for-sale (0.1 ) (0.1 ) 0.1 (0.1 ) Derivatives (670.6 ) 999.0 (1,739.0 ) (622.4 ) Embedded derivatives - fixed maturities (11.3 ) 2.5 (16.6 ) (0.9 ) Embedded derivatives - product guarantees 354.6 (562.5 ) 666.8 (290.2 ) Other investments - 2.1 (0.1 ) 0.7
Net realized capital gains (losses)
Sale of Certain Alternative Investments
OnJune 4, 2012 , we entered into an agreement to sell certain general account private equity limited partnership investment interest holdings with a carrying value of$146.1 as ofMarch 31, 2012 to a group of private equity funds that are managed byPomona Management LLC , our affiliate. The transaction resulted in a net pretax loss of$16.9 in the second quarter of 2012 reported in Net investment income on the Statements of Operations. The transaction closed in two tranches with the first tranche closed onJune 29, 2012 and the second tranche closed onOctober 29, 2012 . Consideration received included$8.2 of promissory notes due in two equal installments atDecember 13, 2013 and 2014. In connection with these promissory notes, ING U.S., Inc. unconditionally guarantees payment of the notes in the event of any default of payments due. No additional loss was incurred on the second tranche since the fair value of the alternative investments was reduced to the agreed-upon sale price as ofJune 30, 2012 . We sold these assets in order to reduce our exposure to alternative investments as part of our ordinary course portfolio management. The transaction reduced certain rating agency required capital levels, in light of the high capital charge associated with the asset class and improved liquidity.
European Exposures
We closely monitor our exposures to European sovereign debt in general, with a primary focus on our exposure to the sovereign debt ofGreece ,Ireland ,Italy ,Portugal and Spain (which we refer to as "peripheralEurope "), as these countries have applied for support from theEuropean Financial Stability Facility or received support from theEuropean Central Bank via government bond purchases in the secondary market. The financial turmoil inEurope continues to be a threat to global capital markets and remains a challenge to global financial stability. Additionally, the possibility of capital market volatility spreading through a highly integrated and interdependent banking system remains elevated. Furthermore, it is our view that the risk among European sovereigns and financial institutions warrants specific scrutiny, in addition to our customary surveillance and risk monitoring, given how highly correlated these sectors of the region have become. We quantify and allocate our exposure to the region, as described in the table below, by attempting to identify all aspects of the region or country risk to which we are exposed. Among the factors we consider are the nationality of the issuer, the nationality of the issuer's ultimate parent, the corporate and economic relationship between the issuer and its parent, as well as the political, legal and economic environment in which each functions. By undertaking this assessment, we believe that we develop a more accurate assessment of the actual geographic risk, with a more integrated understanding of all contributing factors to the full risk profile of the issuer.
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In the normal course of our ongoing risk and portfolio management process, we closely monitor compliance with a credit limit hierarchy designed to minimize overly concentrated risk exposures by geography, sector and issuer. This framework takes into account various factors such as internal and external ratings, capital efficiency and liquidity and is overseen by a combination of Investment and Corporate Risk Management, as well as insurance portfolio managers focused specifically on managing the investment risk embedded in our portfolio. As ofJune 30, 2013 , we had$300.0 of exposure to peripheralEurope , which consists of a broadly diversified portfolio of credit-related investments solely in the industrial and utility sectors. We had no fixed maturity and equity securities exposure to peripheral European sovereigns or financial institutions based in peripheralEurope . Peripheral European exposure included non-sovereign exposure inItaly of$78.1 ,Ireland of$119.7 and Spain of$102.2 . We had no exposure toGreece orPortugal . As ofJune 30, 2013 , there was$0.7 derivative assets exposure to financial institutions in peripheralEurope . For purposes of calculating the derivative assets exposure, we had aggregated exposure to single name and portfolio product CDS, as well as all non-CDS derivative exposure for which we either had counterparty or direct credit exposure to a company whose country of risk is in scope. Among the remaining$2.4 billion of total non-peripheral European exposure, we had a portfolio of credit-related assets similarly diversified by country and sector across developed and developingEurope . As ofJune 30, 2013 , our sovereign exposure was$103.3 , which consists of fixed maturities. We also had$273.8 in net exposure to non-peripheral financial institutions with a concentration in theUnited Kingdom of$84.2 ,France of$60.3 andSwitzerland of$28.9 . The balance of$2.0 billion was invested across non-peripheral, non-financial institutions. In addition to aggregate concentration to theUnited Kingdom of$851.3 andthe Netherlands of$391.8 , we had significant non-peripheral European total country exposures toSwitzerland of$169.0 ,Germany of$224.7 andFrance of$250.1 . We place additional scrutiny on our financial exposure in theUnited Kingdom ,France andSwitzerland given our concern for the potential for volatility to spread through the European banking system. We believe the primary risk results from market value fluctuations resulting from spread volatility and the secondary risk is default risk, should the European crisis worsen or fail to be resolved. 77
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The following table represents our European exposures at fair value and amortized cost as of
Fixed Maturity and Equity Securities Derivative Assets Total Total, Net Non-U.S. Financial Non-Financial (Fair Total Financial Non-Financial Less: Margin & (Fair Funded at Sovereign Institutions Institutions Value) (Amortized Cost) Sovereign Institutions Institutions Collateral Value)June 30, 2013 (1)Ireland $ - $ - $ 119.0$ 119.0 $ 112.1 $ - $ 0.7 $ - $ -$ 0.7 $ 119.7Italy - - 78.1 78.1 74.4 - - - - - 78.1 Spain - - 102.2 102.2 97.6 - - - - - 102.2 Total PeripheralEurope - - 299.3 299.3 284.1 - 0.7 - - 0.7 300.0France - 43.3 189.8 233.1 219.4 - 25.4 - 8.4 17.0 250.1Germany - 7.6 208.9 216.5 206.1 - 8.2 - - 8.2 224.7Norway - 0.6 121.2 121.8 116.3 - - - - - 121.8Netherlands - 78.3 313.5 391.8 364.3 - - - - - 391.8Switzerland - 21.1 140.1 161.2 149.6 - 7.1 - (0.7 ) 7.8 169.0United Kingdom - 74.3 767.1 841.4 806.8 - 2.8 - (7.1 ) 9.9 851.3 Other non-peripheral(2) 103.3 5.7 272.5 381.5 360.3 - - - - - 381.5 Total Non-PeripheralEurope 103.3 230.9 2,013.1 2,347.3 2,222.8 - 43.5 - 0.6 42.9 2,390.2 Total$ 103.3 $ 230.9 $ 2,312.4$ 2,646.6 $ 2,506.9 $ - $ 44.2 $ -$ 0.6 $ 43.6 $ 2,690.2 (1) Represents: (i) Fixed maturity and equity securities at fair value; and (ii) Derivative assets at fair value. (2) Other non-peripheral countries include:Austria ,Belgium ,Bulgaria ,Croatia ,Denmark ,Finland ,Hungary ,Iceland ,Kazakhstan ,Latvia ,Lithuania , Luxembourg,Russian Federation , Slovakia,Sweden andTurkey .
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Liquidity and Capital Resources
Liquidity is our ability to generate sufficient cash flows to meet the cash requirements of operating, investing and financing activities.
Liquidity Management
Our principal available sources of liquidity are annuity product charges, GIC, funding agreements and fixed annuity deposits, investment income, proceeds from the maturity and sale of investments, proceeds from debt issuance and borrowing facilities, repurchase agreements, securities lending, reinsurance and capital contributions. Primary uses of these funds are payments of commissions and operating expenses, interest and premium credits, payments under guaranteed death and living benefits, investment purchases, repayment of debt and contract maturities, withdrawals and surrenders and payment of dividends. Our liquidity position is managed by maintaining adequate levels of liquid assets, such as cash, cash equivalents and short-term investments. As part of the liquidity management process, different scenarios are modeled to determine whether existing assets are adequate to meet projected cash flows. Key variables in the modeling process include interest rates, equity market movements, quantity and type of interest and equity market hedges, anticipated contract owner behavior, market value of the general account assets, variable separate account performance and implications of rating agency actions. The fixed account liabilities are supported by a general account portfolio, principally composed of fixed rate investments with matching duration characteristics that can generate predictable, steady rates of return. The portfolio management strategy for the fixed account considers the assets available-for-sale. This strategy enables us to respond to changes in market interest rates, prepayment risk, relative values of asset sectors and individual securities and loans, credit quality outlook and other relevant factors. The objective of portfolio management is to maximize returns, taking into account interest rate and credit risk, as well as other risks. Our asset/liability management discipline includes strategies to minimize exposure to loss as interest rates and economic and market conditions change. In executing this strategy, we use derivative instruments to manage these risks. Our derivative counterparties are of high credit quality.
Liquidity and Capital Resources
Additional sources of liquidity include borrowing facilities to meet short-term cash requirements that arise in the ordinary course of business. We maintain the following agreements:
• A reciprocal loan agreement with ING U.S., Inc. an affiliate, whereby
either party can borrow from the other up to 3.0% of our statutory net
admitted assets, excluding Separate Accounts, as of the prior
As of
receivable/payable from/to ING U.S., Inc. under the reciprocal loan agreement.We and ING U.S., Inc. continue to maintain the reciprocal loan agreement and future borrowings by either party will be subject to the reciprocal loan terms summarized above.
• We hold approximately 52.4% of our assets in marketable securities. These
assets include cash, U.S. Treasuries, Agencies, Corporate Bonds, ABS, CMBS
and CMO and Equity securities. In the event of a temporary liquidity need, cash may be raised by entering into reverse repurchase, dollar rolls and/or security lending agreements by temporarily lending securities and receiving cash collateral. Under our Liquidity Plan, up to 12% of our
general account statutory admitted assets may be allocated to reverse
repurchase, dollar roll programs and securities lending. At the time a
temporary cash need arises, the actual percentage of admitted assets
available for reverse repurchase transactions will depend upon outstanding
allocations to the three programs. As of
lending collateral assets of
our general account statutory admitted assets.
Management believes that our sources of liquidity are adequate to meet our short-term cash obligations.
Capital Contributions and Dividends
During the six months ended
During the six months endedJune 30, 2013 , following receipt of required approval from our domiciliary state insurance regulator and consummation of the IPO of ING U.S., Inc., we paid a return of capital distribution of$230.0 to our Parent. During the six months endedJune 30, 2012 , following receipt of required approval from our domiciliary state insurance regulator, we paid a return of capital distribution of$250.0 to our Parent.
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OnMay 8, 2013 , we reset, on a one-time basis, our negative unassigned funds account as ofDecember 31, 2012 (as reported in our 2012 statutory annual statement) to zero (with an offsetting reduction in gross paid-in capital and contributed surplus). The reset was made pursuant to a permitted practice in accordance with statutory accounting practices granted by theIowa Insurance Division. This permitted practice has no impact on our total capital and surplus and has been reflected in our second quarter statutory financial statements. Reinsurance Agreements Reinsurance Ceded
Guaranteed Living Benefit - Coinsurance and Coinsurance Funds Withheld
EffectiveJune 30, 2008 , we entered into an automatic reinsurance agreement with an affiliate, SLDI, covering 100% of the benefits guaranteed under specific variable annuity guaranteed living benefit riders attached to certain variable annuity contracts issued by us on or afterJanuary 1, 2000 . Also effectiveJune 30, 2008 , we entered into a services agreement with SLDI, under which we provide certain actuarial risk modeling consulting services to SLDI with respect to hedge positions undertaken by SLDI in connection with the reinsurance agreement. For the three and six months endedJune 30, 2013 , revenue related to the agreement was$3.0 and$6.1 , respectively. For the three and six months endedJune 30, 2012 , revenue related to the agreement was$2.9 and$6.0 , respectively. EffectiveJuly 1, 2009 , the reinsurance agreement was amended and restated to change the reinsurance basis from coinsurance to a combined coinsurance and coinsurance funds withheld basis. OnJuly 31, 2009 , SLDI transferred assets with a market value of$3.2 billion to us and we deposited these assets into a funds withheld trust account. As ofJune 30, 2013 , the assets on deposit in the trust account were$4.6 billion . We also established a corresponding funds withheld liability to SLDI, which is included in Funds held under reinsurance treaties with affiliates on the Condensed Balance Sheets. Funds held under reinsurance treaties with affiliates had a balance of$4.6 billion and$3.6 billion , as ofJune 30, 2013 andDecember 31, 2012 , respectively. In addition, as ofJune 30, 2013 andDecember 31, 2012 , we had an embedded derivative with a value of$27.1 and$293.6 , respectively, which is recorded in Funds held under reinsurance treaties with affiliates on the Condensed Balance Sheets.
Also effective
EffectiveOctober 1, 2011 , we and SLDI entered into an amended and restated automatic reinsurance agreement in order to provide more flexibility to us and SLDI with respect to the collateralization of the reserves related to the variable annuity guaranteed living benefits reinsured under the agreement. As ofJune 30, 2013 andDecember 31, 2012 , reserves ceded by us under this agreement were$2.2 billion and$2.1 billion , respectively. In addition, a deferred loss in the amount of$334.6 and$343.9 as ofJune 30, 2013 andDecember 31, 2012 , respectively, is included in Other assets on the Condensed Balance Sheets and is amortized over the period of benefit. OnMay 8, 2013 , following the ING U.S., Inc. IPO, ING U.S., Inc. made a capital contribution in the amount of$1.8 billion into SLDI, which SLDI deposited into the funds withheld trust account established to provide collateral for the variable annuity guaranteed living benefit riders ceded to SLDI under the amended and restated automatic reinsurance agreement. Upon deposit of such contributed capital into the funds withheld trust, we submitted toING Bank N.V. ("ING Bank ")$1.5 billion of contingent capital letters of credit ("LOC") issued by ING Bank under the$1.5 billion contingent capital LOC facility between ING Bank and SLDI, and the contingent capital LOCs were canceled and the facility was terminated. Ratings Our access to funding and our related cost of borrowing, requirements for derivatives collateral posting and the attractiveness of certain of our products to customers are affected by our credit ratings and insurance financial strength ratings, which are periodically reviewed by the rating agencies. Financial strength ratings and credit ratings are important factors affecting public confidence in an insurer and its competitive position in marketing products. The credit ratings are also important for the ability to raise capital through the issuance of debt and for the cost of such financing.
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A downgrade in our credit ratings or the credit or financial strength ratings of our parent or rated affiliates could potentially, among other things, limit our ability to market products, reduce our competitiveness, increase the number or value of policy surrenders and withdrawals, increase our borrowing costs and potentially make it more difficult to borrow funds, adversely affect the availability of financial guarantees or LOCs, cause additional collateral requirements or other required payments under certain agreements, allow counterparties to terminate derivative agreements and/or hurt our relationships with creditors, distributors or trading counterparties thereby potentially negatively affecting our profitability, liquidity and/or capital. In addition, we consider nonperformance risk in determining the fair value of our liabilities. Therefore, changes in our credit or financial strength ratings or the credit or financial strength ratings of our Parent or rated affiliates may affect the fair value of our liabilities. The following table presents our financial strength and credit ratings. In parentheses is an indication of that rating's relative rank within the agency's rating categories. That ranking refers only to the generic or major rating category and not to the modifiers appended to the rating by the rating agencies to denote relative position within such generic or major category. For each rating, the relative position of the rating within the relevant rating agency's ratings scale is presented, with "1" representing the best rating in the scale. Company A.M. Best Fitch Moody's S&P INGUSA Annuity & Life Insurance Financial Strength Rating A A- A3 A- (3 of 16) (3 of 9) (3 of 9) (3 of
9)
Short-term Issuer Credit Rating P-2 A-2 NR NR (2 of 4) (2 of 8) Rating Agency Financial Strength Rating Scale A.M. Best(1) "A++" to "S" Fitch(2) "AAA" to "C" Moody's(3) "Aaa" to "C" S&P(4) "AAA" to "R" (1)A.M. Best's financial strength rating is an independent opinion of an insurer's financial strength and ability to meet its ongoing insurance policy and contract obligations. It is based on a comprehensive quantitative and qualitative evaluation of a company's balance sheet strength, operating performance and business profile. Ratings from "aa" to "ccc" may be enhanced with a "+" (plus) or "-" (minus) to indicate whether credit quality is near the top or bottom of a category.A.M. Best's short-term credit rating is an opinion to the ability of the rated entity to meet its senior financial commitments on obligations maturing in generally less than one year. (2) Fitch's financial strength ratings provide an assessment of the financial strength of an insurance organization. The IFS Rating is assigned to the insurance company's policyholder obligations, including assumed reinsurance obligations and contract holder obligations, such as guaranteed investment contracts. Within short-term ratings, a "+" or a "-" may be appended to a rating to denote relative status within major rating categories. (3) Moody's financial strength ratings are opinions of the ability of insurance companies to repay punctually senior policyholder claims and obligations. Moody's appends numerical modifiers 1, 2 and 3 to each generic rating classification from Aa through Caa. The modifier 1 indicates that the obligation ranks in the higher end of its generic rating category; the modifier 2 indicates a mid-range ranking; and the modifier 3 indicates a ranking in the lower end of that generic rating category. Moody's short-term credit ratings are opinions of the ability of issuers to honor short-term financial obligations. (4) S&P's insurer financial strength rating is a forward-looking opinion about the financial security characteristics of an insurance organization with respect to its ability to pay under its insurance policies and contracts in accordance with their terms. A "+" or "-" indicates relative strength within a category. An S&P credit rating is an assessment of default risk, but may incorporate an assessment of relative seniority or ultimate recovery in the event of default. Short-term credit ratings reflect the obligor's creditworthiness over a short-term time horizon. Our ratings byA.M. Best Company, Inc. ("A.M. Best"), Fitch, Moody's and S&P reflect a broader view of how the financial services industry is being challenged by the current economic environment, but also are based on the rating agencies' specific views of our financial strength. In making their ratings decisions, the agencies consider past and expected future capital and earnings, asset quality and risk, profitability and risk of existing liabilities and current products, market share and product distribution capabilities and direct or implied support from parent companies. Rating agencies use an "outlook" statement for both industry sectors and individual companies. For an industry sector, a stable outlook generally implies that over the next 12 to 18 months the rating agency expects ratings to remain unchanged among companies in the sector. For a particular company, an outlook generally indicates a medium- or long-term trend in credit fundamentals, which if continued, may lead to a rating change.
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Ratings actions affirmation and outlook changes by
• On
of ING U.S., Inc.'s operating subsidiaries, including us.
• On
ING U.S., Inc.'s operating subsidiaries, including us. • OnMay 14, 2013 , S&P affirmed the A- financial strength ratings of ING U.S., Inc.'s operating subsidiaries, including us under its revised insurance criteria.
• On
ratings of ING U.S., Inc.'s operating subsidiaries, including us. • OnMay 6, 2013 , following the announcement by ING U.S., Inc. that it
completed the recent IPO, Moody's commented that the completion of the IPO
is credit positive for ING U.S., Inc.
• On
its IPO will not affect the ratings or outlook on ING U.S., Inc. or any of
its rated insurance subsidiaries, including us.
• On
ratings of ING U.S., Inc.'s operating subsidiaries, including us. Furthermore, Fitch removed all ratings from Ratings Watch Evolving and assigned a stable outlook to the ratings.
Minimum Guarantees
Variable annuity contracts containing minimum guaranteed death and living benefits expose us to equity risk. A decrease in the equity markets may cause a decrease in the account values, thereby increasing the possibility that we may be required to pay amounts to contract owners due to guaranteed death and living benefits. An increase in the value of the equity markets may increase account values for these contracts, thereby decreasing our risk associated with guaranteed death and living benefits.
We ceased new sales of retail variable annuity products in
Guaranteed Minimum Death Benefits ("GMDBs"):
• Standard - Guarantees that, upon death, the death benefit will be no less
than the premiums paid by the contract owner, adjusted for any contract
withdrawals.
• Ratchet - Guarantees that, upon death, the death benefit will be no less
than the greater of (1) Standard or (2) the maximum contract anniversary
(or quarterly) value of the variable annuity, adjusted for contract withdrawals.
• Combo (Max 7) - Guarantees that, upon death, the death benefit will be no
less than the greater of (1) Ratchet or (2) Rollup (Rollup guarantees
that, upon death, the death benefit will be no less than the aggregate
premiums paid by the contract owner accruing interest at the contractual
rate per annum, adjusted for contract withdrawals, which may be subject to
a maximum cap on the rolled up amount.)
A number of other versions of death benefits were offered previously but sales were discontinued. For contracts issued prior toJanuary 1, 2000 , most contracts with enhanced death benefit guarantees were reinsured to third party reinsurers to mitigate the risk produced by such guaranteed death benefits. For contracts issued afterDecember 31, 1999 , we instituted a variable annuity guarantee hedging program in lieu of reinsurance. The variable annuity guarantee hedging program is based on us entering into derivative positions to offset exposures to guaranteed minimum death benefits due to adverse changes in the equity markets.
The guaranteed value of these death benefits in excess of account values, as of the dates indicated, was estimated to be as follows:
June 30, 2013 Net amount at risk, before reinsurance $ 6,960.4 Net amount at risk, net of reinsurance 6,350.8December 31, 2012 Net amount at risk, before reinsurance $ 7,623.2 Net amount at risk, net of reinsurance 6,920.6
The decrease in the guaranteed value of these death benefits was primarily driven by favorable equity market performance during 2013.
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The additional liabilities recognized related to GMDB's, as of the dates indicated, were as follows:
June 30, 2013 Separate account liability $ 39,865.9 Additional liability balance 461.9 December 31, 2012 Separate account liability $ 39,799.1 Additional liability balance 488.0 The above additional liability recorded by us, net of reinsurance, represented the estimated net present value of our future obligation for guaranteed minimum death benefits in excess of account values. The liability decreased mainly due to a decrease in expected future claims attributable to favorable equity market performance during the year. Guaranteed Living Benefits:
• Guaranteed Minimum Income Benefit ("GMIB") - Guarantees a minimum income
payout, exercisable each contract anniversary on or after a specified
date, in most cases the 10th rider anniversary.
• Guaranteed Minimum Withdrawal Benefit ("GMWB") and Guaranteed Minimum
Withdrawal Benefit for Life ("GMWBL") - Guarantees an annual withdrawal
amount for a specified period of time (GMWB) or life (GMWBL) that is
calculated as a percentage of the benefit base that equals premium at the
time of contract issue and may increase over time, based on a number of factors, including a rollup percentage (7%, 6% or 0%, depending on versions of the benefit) and ratchet frequency (primarily annual or quarterly, depending on versions). The percentage used to determine the
guaranteed annual withdrawal amount may vary by age at first withdrawal
and depends on versions of the benefit. A joint life-time withdrawal
benefit option was available to include coverage for spouses. Most
versions of the withdrawal benefit included reset and/or step-up features
that may increase the guaranteed withdrawal amount in certain conditions. Earlier versions of the withdrawal benefit guarantee that annual withdrawals of up to 7.0% of eligible premiums may be made until
eligible premiums previously paid by the contract owner are returned,
regardless of account value performance. Asset allocation requirements
apply at all times where withdrawals are guaranteed for life. • Guaranteed Minimum Accumulation Benefit ("GMAB") - Guarantees that the account value will be at least 100% of the eligible premiums paid by the contract owner after 10 years, net of any contract withdrawals (GMAB 10).
In the past, we offered an alternative design that guaranteed the account
value to be at least 200% of the eligible premiums paid by contract owners
after 20 years (GMAB 20).
We reinsured most of our living benefit guarantee riders to SLDI to mitigate the risk produced by such benefits. This reinsurance agreement covers all of the GMIBs, as well as the GMWBs with lifetime guarantees (the "Reinsured living benefits"). The GMABs and the GMWBs without lifetime guarantees (the "Non-reinsured living benefits") are not covered by this reinsurance. The Non-reinsured living benefits are still covered by our variable annuity guarantee hedging program. The following guaranteed living benefits information is as of the dates indicated: Non-reinsured Reinsured Living Living Benefits Benefits (GMAB/GMWB) (GMIB/GMWBL) June 30, 2013 Net amount at risk, before reinsurance $ 29.4 $
3,698.5
Net amount at risk, net of reinsurance 29.4 - December 31,
2012
Net amount at risk, before reinsurance $ 38.4 $
5,219.1
Net amount at risk, net of reinsurance 38.4 - The net amount at risk for the reinsured living benefits is equal to the excess of the present value of the minimum guaranteed annuity payments available to the contract holder over the current account value. The methodology used to calculate the net amount at risk partially reflects the current interest rate environment and also includes a provision for the expected mortality of
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the clients covered by these living benefits. The decrease in the net amount at risk of these living benefits from
The net amount at risk for the non-reinsured living benefits is equal to the guaranteed value of these benefits in excess of the account values, which is reflected in the table above. The separate account liabilities subject to the requirements for additional reserve liabilities under ASC Topic 944 for minimum guaranteed benefits and the additional liabilities recognized related to minimum guarantees, by type, as of the dates indicated were as follows: Reinsured Living Non-reinsured Living Benefits Benefits (GMAB/GMWB) (GMIB/GMWBL) June 30, 2013 Separate account liability $ 899.0 $ 29,912.4 Additional liability balance, net of reinsurance 49.4 834.4 December 31, 2012 Separate account liability $ 954.1 $ 29,753.4 Additional liability balance, net of reinsurance 76.0 1,511.8 As ofJune 30, 2013 andDecember 31, 2012 , the above additional liabilities for non-reinsured living benefits recorded by us, net of reinsurance, represent the estimated net present value of our future obligations for these benefits. The above additional liabilities for reinsured living benefits recorded by us, net of reinsurance, represent the present value of future claims less the present value of future attributed fees (GMWBLs) or the benefits ratio approach (GMIBs), less the reinsurance ceded reserve calculated under Accounting Standards Codification Topic 944. The additional liability for GMIBs was zero. The entire decrease in the additional liability balance for reinsured living benefits corresponds to the GMWBL liability which decreased mainly due to favorable market performance and increasing interest rates during the year.
Hedging of Variable Annuity Guaranteed Benefits
We primarily mitigate variable annuity market risk exposures through hedging, including hedging for the risks retained by us as well as hedging on behalf of SLDI under the combined coinsurance and coinsurance funds withheld agreement. Market risk arises primarily from the minimum guarantees within the variable annuity products, whose economic costs are primarily dependent on future equity market returns, interest rate levels, equity volatility levels and policyholder behavior. The variable annuity guarantee hedge program is used to mitigate our exposure to equity market and interest rate changes and seeks to ensure that the required assets are available to satisfy future death benefit and living benefit obligations. While the variable annuity guarantee hedge program does not explicitly hedge statutory or U.S. GAAP reserves, as markets move up or down, in aggregate the returns generated by the variable annuity hedge program will significantly offset the statutory and U.S. GAAP reserve changes due to market movements. The objective of the guarantee hedge program is to offset changes in equity market returns for most minimum guaranteed death benefits and all guaranteed living benefits, while also providing interest rate protection for certain minimum guaranteed living benefits. We hedge the equity market exposure using a hedge target set using market consistent valuation techniques for all guaranteed living benefits and most death benefits. We also hedge a portion of the interest rate risk in our GMWB/GMAB/GMWBL blocks using a market consistent valuation hedge target. We do not hedge interest rate risks for our GMIB or GMDB primarily because doing so would result in volatility in our regulatory capital that exceeds our tolerances and, secondarily, because doing so would produce additional volatility in U.S. GAAP financial statements. These hedge targets may change over time with market movements, changes in regulatory and rating agency capital, available collateral and our risk tolerance. For example, in June, 2013, we reduced the amount of interest rate hedging for the GMWB/GMAB/GMWBL blocks so as to reduce the impact of interest rate movements on regulatory and rating agency capital. Equity index futures on various equity indices are used to mitigate the risk of the change in value of the policyholder-directed separate account funds underlying the variable annuity contracts with minimum guarantees. A dynamic trading program is utilized to seek replication of the performance of targeted fund groups (i.e., the fund groups that can be covered by indices where liquid futures markets exist). 84
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Total return swaps are also used to mitigate the risk of the change in value of certain policyholder-directed separate account funds. These include fund classes such as emerging markets and real estate. They may also be used instead of futures of more liquid indices where it may be deemed advantageous. This hedging strategy is employed at our discretion based on current risk exposures and related transaction costs.
Interest rate swaps are used to mitigate a portion of the impact of interest rates changes on the economic liabilities associated with certain minimum guaranteed living benefits.
Variance swaps and equity options are used to mitigate the impact of changes in equity volatility on the economic liabilities associated with certain minimum guaranteed living benefits. This program began in the second quarter of 2012.
Foreign exchange forwards are used to mitigate the impact of policyholder-directed investments in international funds with exposure to fluctuations in exchange rates of certain foreign currencies. Rebalancing is performed based on pre-determined notional exposures to the specific currencies.
Variable Annuity Capital Hedge Overlay Program
Variable annuity guaranteed benefits are hedged based on their economic or fair value; however, the statutory reserves and rating agency required assets are not based on a market value. When equity markets decrease, the statutory reserve and rating agency required assets for the variable annuity guaranteed benefits can increase more quickly than the value of the derivatives held under the guarantee hedging program. This causes regulatory reserves to increase and rating agency capital to decrease. The Capital Hedge Overlay strategy is intended to mitigate equity risk to the regulatory and rating agency capital of ING U.S., Inc. The hedge is executed through the purchase and sale of equity index futures and is designed to limit the uncovered reserve and rating agency capital increase in an immediate down equity market scenario to an amount we believe prudent for ING U.S., Inc. This amount will change over time with market movements, changes in regulatory and rating agency capital and our risk tolerance.
Derivatives
Our use of derivatives is limited mainly to economic hedging to reduce our exposure to cash flow variability of assets and liabilities, interest rate risk, credit risk, exchange rate risk and market risk. It is our policy not to offset amounts recognized for derivative instruments and amounts recognized for the right to reclaim cash collateral or the obligation to return cash collateral arising from derivative instruments executed with the same counterparty under a master netting arrangement. We enter into interest rate, equity market, credit default and currency contracts, including swaps, futures, forwards, caps, floors and options, to reduce and manage risks associated with changes in value, yield, price, cash flow, or exchange rates of assets or liabilities held or intended to be held, or to assume or reduce credit exposure associated with a referenced asset, index, or pool. We also utilize options and futures on equity indices to reduce and manage risks associated with our annuity products. Open derivative contracts are reported as Derivatives assets or liabilities on the Condensed Balance Sheets at fair value. Changes in the fair value of derivatives are recorded in Net realized capital gains (losses) in the Condensed Statements of Operations. If our current debt and claims paying ratings were downgraded in the future, certain terms in our derivative agreements may be triggered, which could negatively impact overall liquidity. For the majority of our counterparties, there is a termination event should our long-term debt ratings drop below BBB+/Baal. We also have investments in certain fixed maturities and have issued certain annuity products, that contain embedded derivatives whose fair value is at least partially determined by levels of or changes in domestic and/or foreign interest rates (short-term or long-term), exchange rates, prepayment rates, equity markets, or credit ratings/spreads. Embedded derivatives within fixed maturities are included with the host contract on the Condensed Balance Sheets and changes in fair value of the embedded derivatives are recorded in Other net realized capital gains (losses) in the Condensed Statements of Operations. Embedded derivatives within certain annuity products are included in Future policy benefits and contract owner account balances on the Condensed Balance Sheets and changes in the fair value of the embedded derivatives are recorded in Other net realized capital gains (losses) in the Condensed Statements of Operations. In addition, we have entered into two coinsurance with funds withheld arrangements that each contain an embedded derivative, the fair value which is based on the change in the fair value of the underlying assets held in trust. The embedded derivative within the coinsurance funds withheld arrangement is included in Funds held under reinsurance treaties with affiliates on the Condensed Balance Sheets and changes in the fair value are recorded in Interest credited and other benefits to contract owners/policyholders in the Condensed Statements of Operations. 85
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Deposits and Reinsurance Recoverable
We utilize reinsurance agreements to reduce our exposure to large losses in most aspects of our insurance business. Such reinsurance permits recovery of a portion of losses from reinsurers, although it does not discharge our primary liability as direct insurer of the risks reinsured. We evaluate the financial strength of potential reinsurers and continually monitor the financial condition of reinsurers. Only those reinsurance recoverable balances deemed probable of recovery are reflected as assets on our Condensed Balance Sheets.
Income Taxes
Income tax obligations include the allowance on unrecognized tax benefits related to
The
timing of the payment of the unrecognized tax benefit of
Impact of New Accounting Pronouncements
For information regarding the impact of new accounting pronouncements, see the Business, Basis of Presentation and Significant Accounting Policies Note to the Condensed Consolidated Financial Statements, in Part I, Item 1. of this Form 10-Q. Contingencies For information regarding other contingencies related to legal proceedings, regulatory matters and other contingencies involving us, see the Commitments and Contingencies Note to the Condensed Financial Statements included in Part I, Item1.
Legislative and Regulatory Developments
BeforeJune 26, 2013 , pursuant to Section 3 of the Defense of Marriage Act ("DOMA"), same-sex marriages were not recognized for purposes of federal law. On that date, theUnited States Supreme Court held inUnited States v. Windsor that Section 3 of DOMA is unconstitutional. TheWindsor decision affects over 1,000 federal laws and regulations, many of which touch upon our services and procedures. The appropriate legal and regulatory authorities need to provide further guidance regarding the open questions created by theWindsor decision. Although we recognize that certain changes will be required, we cannot predict with certainty how new regulations will impact our business, results of operations, cash flows or financial condition. TheWindsor decision also creates potential inconsistencies in the application of federal and state tax laws, including how tax withholding is computed. Future guidance from theInternal Revenue Service and state tax authorities may resolve these inconsistencies, and it is possible that significant changes will be required to our tax reporting and withholding systems as a result.
Regulatory Proposals
In the fourth quarter of 2011, theDepartment of Labor ("DOL") withdrew proposed regulations that would more broadly define the circumstances under which a person is considered to be a "fiduciary" by reason of giving investment advice to an employee benefit plan or a plan's participants. In earlyJuly 2013 , the DOL announced that it would re-propose these regulations, under the revised general topic of conflicts of interest under the Employee Retirement Income Security Act of 1974 ("ERISA") pertaining to investment advice. The new proposed regulation is estimated for release inNovember 2013 . We cannot predict with any certainty what will be contained in the re-proposed regulations, but they could alter the way our products and services are marketed and sold to ERISA plans and their plan participants and to purchasers of individual retirement accounts and individual retirement annuities.The Securities and Exchange Commission ("SEC") has also indicated it may propose rules creating a uniform fiduciary standard of conduct applicable to broker-dealers and registered investment advisers which, if adopted, may affect the distribution of our products. Should theSEC rules, if adopted, not align with any reissued and finalized DOL regulations related to conflicts of interest in the provision of investment advice, the distribution of our products could be further complicated.
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