8. Separate Accounts, Death Benefits and Other Insurance Benefit Features and Embedded Product Derivatives

9 Months Ended

Sep. 30, 2012

Notes to Financial Statements

Separate Accounts, Death Benefits and Other Insurance Benefit Features and Embedded Product Derivatives

Separate account products are those for which a separate investment and liability account is maintained on behalf of the policyholder. Investment objectives for these separate accounts vary by fund account type, as outlined in the applicable fund prospectus or separate account plan of operations. Our separate account products include variable annuities and variable life insurance contracts. The assets supporting these contracts are carried at fair value and are reported as separate account assets with an equivalent amount reported as separate account liabilities. Amounts assessed against the policyholder for mortality, administration and other services are included within revenue in insurance and investment product fees. For the three and nine months ended September 30, 2012 and 2011, there were no gains or losses on transfers of assets from the general account to a separate account.

Assets with fair value and carrying value of $1.7 billion supporting fixed indexed annuities are maintained in accounts that are legally segregated from the other assets of the company, but policyholders do not direct the investment of those assets and the investment performance does not pass through to the policyholders. These assets supporting fixed indexed annuity contracts are reported within the respective investment line items on the balance sheets.

On May 21, 2012, the employee pension plan surrendered its variable annuity contract with PHL Variable. All assets held within the employee pension plan separate account were subsequently transferred to the direct control of the plan’s trustee. This resulted in a decrease in separate account assets and liabilities of $464.2 million during the quarter ended September 30, 2012.

Separate Account Investments of Account Balances of Variable Annuity Contracts with Guarantees:	Sept 30,		Dec 31,
($ in millions)	2012		2011
			As restated and amended
Debt securities	$	377.6		$	395.5
Equity funds		1,553.9			1,537.7
Other		52.5			58.3
Total	$	1,984.0		$	1,991.5

Death benefits and other insurance benefit features

Variable annuity guaranteed benefits

We establish policy benefit liabilities for minimum death and income benefit guarantees relating to certain annuity policies as follows:

● Liabilities associated with the guaranteed minimum death benefit (“GMDB”) are determined by estimating the expected value of death benefits in excess of the projected account balance and recognizing the excess ratably over the expected life of the contract based on total expected assessments. The assumptions used for calculating the liabilities are consistent with those used for amortizing deferred policy acquisition costs.

● Liabilities associated with the guaranteed minimum income benefit (“GMIB”) are determined by estimating the expected value of the income benefits in excess of the projected account balance at the date of annuitization and recognizing the excess ratably over the accumulation period based on total expected assessments. The assumptions used for calculating such guaranteed income benefit liabilities are generally consistent with those used for amortizing deferred policy acquisition costs.

For variable annuities with GMDB and GMIB, reserves for these guarantees are calculated and recorded in policy liabilities and accruals on our balance sheets. Changes in the liability are recorded in policy benefits on our statements of comprehensive income. We regularly evaluate estimates used and adjust the additional liability balances, with a related charge or credit to benefit expense if actual experience or other evidence suggests that earlier assumptions should be revised.

Changes in Guaranteed Insurance Benefit Liability Balances:	As of
($ in millions)	September 30, 2012
	Annuity GMDB			Annuity GMIB
Liability balance as of January 1, 2012	$	10.8		$	17.2
Incurred		—			3.6
Paid		(0.9	)		—
Assumption unlocking		—			(0.2	)
Liability balance as of September 30, 2012	$	9.9		$	20.6

Changes in Guaranteed Insurance Benefit Liability Balances:	Year Ended
($ in millions)	December 31, 2011
	As restated and amended
	Annuity GMDB				Annuity GMIB
Liability balance as of January 1, 2011		$	11.2			$	17.5
Incurred			1.5				(0.7	)
Paid			(1.9	)			—
Assumption unlocking			—				0.4
Liability balance as of December 31, 2011		$	10.8			$	17.2

For those guarantees of benefits that are payable in the event of death, the net amount at risk (“NAR”) is generally defined as the benefit payable in excess of the current account balance at the balance sheet date. We have entered into reinsurance agreements to reduce the net amount of risk on certain death benefits. Following are the major types of death benefits currently in-force:

GMDB and GMIB Benefits by Type:			NAR		Average
($ in millions)	Account		after		Attained Age
	Value		Reinsurance		of Annuitant
September 30, 2012
GMDB return of premium	$	776.0	$	7.1		62
GMDB step up		1,444.5		26.0		62
GMDB earnings enhancement benefit (“EEB”)		38.9		0.1		63
GMDB greater of annual step up and roll up		27.5		7.5		66
Total GMDB at September 30, 2012		2,286.9	$	40.7
Less: General account value with GMDB		318.2
Subtotal separate account liabilities with GMDB		1,968.7
Separate account liabilities without GMDB		142.0
Total separate account liabilities	$	2,110.7
GMIB (1) at September 30, 2012	$	413.4				63
December 31, 2011 as restated and amended
GMDB return of premium	$	795.6	$	20.7		61
GMDB step up		1,450.6		91.2		62
GMDB earnings enhancement benefit (“EEB”)		39.7		0.4		62
GMDB greater of annual step up and roll up		27.1		8.8		66
Total GMDB at December 31, 2011		2,313.0	$	121.1
Less: General account value with GMDB		336.9
Subtotal separate account liabilities with GMDB		1,976.1
Separate account liabilities without GMDB		570.7
Total separate account liabilities	$	2,546.8
GMIB (1) at December 31, 2011	$	428.1				63

———————

(1) Policies with a GMIB also have a GMDB. The NAR for each benefit is shown in the table above, however these benefits are not additive. When a policy terminates due to death, any NAR related or GMIB is released. Similarly, when a policy goes into benefit status on a GMIB, its GMDB NAR is released.

Fixed indexed annuity guaranteed benefits

Many of our fixed indexed annuities contain guaranteed minimum withdrawal and death benefits.

Liabilities associated with the GMWB for the fixed indexed annuities differ from those contained on variable annuities in that the GMWB feature and the underlying contract, exclusive of the equity indexed crediting option, are fixed income instruments. These liabilities are determined by estimating the expected value of the withdrawal benefits in excess of the projected account balance at the date of election and recognizing the excess ratably over the accumulation period based on total expected assessments. The assumptions used for calculating such guaranteed withdrawal benefit liabilities are consistent with those used for amortizing deferred policy acquisition costs. Some of these riders also contain a GMDB or chronic care benefit in addition to the withdrawal benefits.

The GMWB, GMDB and chronic care guarantees are recorded in policy liabilities and accruals on our balance sheets. Changes in the liability are recorded in policy benefits on our statements of comprehensive income. We regularly evaluate estimates used and adjust the additional liability balances, with a related charge or credit to benefit expense if actual experience or other evidence suggests that earlier assumptions should be revised.

Changes in Guaranteed Liability Balances:	Fixed Indexed Annuity
($ in millions)	GMWB & GMDB
	Sept 30,			Dec 31,
	2012			2011
				As restated and amended
Liability balance, beginning of period		$	5.6		$	0.5
Incurred			32.3			5.1
Paid			—			—
Liability balance, end of period		$	37.9		$	5.6

Universal life

Liabilities for universal life contracts, some of which contain secondary guarantees, are generally determined by estimating the expected value of benefits and expenses when claims are triggered and recognizing those benefits and expenses over the accumulation period based on total expected assessments. The assumptions used in estimating these liabilities are consistent with those used for amortizing deferred policy acquisition costs.

Changes in Guaranteed Liability Balances:	Universal Life
($ in millions)	Secondary Guarantees
	Sept 30,				Dec 31,
	2012				2011
					As restated and amended
Liability balance, beginning of period		$	98.2			$	88.5
Incurred			12.4				16.0
Paid			(7.2	)			(6.3	)
Assumption unlocking			—				—
Liability balance, end of period		$	103.4			$	98.2

Embedded derivatives

Variable annuity embedded derivatives

Certain separate account variable products contain a GMWB, GMAB and/or COMBO rider as defined in the 2012 Form 10-K. These features are accounted for as embedded derivatives as described below.

Non-Insurance Guaranteed Product Features:			Average
($ in millions)	Account		Attained Age
	Value		of Annuitant
September 30, 2012
GMWB	$	559.7		63
GMAB		386.1		58
COMBO		9.8		61
Total at September 30, 2012	$	955.6
December 31, 2011 as restated and amended
GMWB	$	541.9		62
GMAB		374.4		57
COMBO		9.8		60
Total at December 31, 2011	$	926.1

On July 1, 2012 the Company recaptured the business associated with a reinsurance contract with Phoenix Life, whereby we ceded to Phoenix Life certain of the liabilities related to guarantees on our annuity products. This contract qualified as a freestanding derivative and the derivative asset previously reported within receivable from related parties was reversed at the time of recapture. The derivative asset was $3.5 million at December 31, 2011.

The GMWB, GMAB and COMBO represent embedded derivative liabilities in the variable annuity contracts that are required to be reported separately from the host variable annuity contract. These liabilities are recorded at fair value within policyholder deposit funds on the balance sheets with changes in fair value recorded in realized investment gains on the statements of comprehensive income. The fair value of the GMWB, GMAB and COMBO obligation is calculated based on actuarial and capital market assumptions related to the projected cash flows, including benefits and related contract charges, over the lives of the contracts, incorporating expectations concerning policyholder behavior. As markets change, contracts mature and actual policyholder behavior emerges, these assumptions are continually evaluated and may from time to time be adjusted. Embedded derivative liabilities for GMWB, GMAB and COMBO are shown in the table below.

Variable Annuity Embedded Derivative Liabilities:	Sept 30,			Dec 31,
($ in millions)	2012			2011
				As restated and amended
GMWB	$	18.0			$	22.0
GMAB		16.8				24.7
COMBO		(0.4	)			(0.3	)
Total variable annuity embedded derivative liabilities	$	34.4			$	46.4

There were no benefit payments made related to the GMWB and GMAB riders during the nine months ended September 30, 2012 or during the nine months ended September 30, 2011. We have established a risk management strategy under which we hedge our GMAB, GMWB and COMBO exposure using equity index options, equity index futures, equity index variance swaps, interest rate swaps and swaptions.

Fixed indexed annuity embedded derivatives

Fixed indexed annuities may also contain a variety of index-crediting options: policy credits that are calculated based on the performance of an outside equity market or other index over a specified term. The index options represent embedded derivative liabilities that are required to be reported separately from the host contract. These index options are accounted for at fair value within policyholder deposits within the balance sheets with changes in fair value recorded in realized investment gains, in the statements of comprehensive income. The fair value of these index options is calculated using the budget method. Several additional inputs reflect our internally developed assumptions related to lapse rates and policyholder behavior. The fair value of these embedded derivatives was $48.7 million and $35.9 million as September 30, 2012 and December 31, 2011, respectively. In order to manage the risk associated with these equity indexed-crediting features, we hedge using equity index options as described in Note 7 to these financial statements.

Embedded derivatives realized gains and losses

Changes in the fair value of embedded derivatives associated with variable annuity and fixed indexed annuity contracts are recorded as realized investment gains and losses within the statements of comprehensive income. Embedded derivatives gains and (losses) recognized in earnings for the three and nine months ended September 30, 2012 are $6.6 million and $6.1 million respectively. Embedded derivatives gains and (losses) recognized in earnings for the three and nine months ended September 30, 2011 are $(48.3) million and $(41.0) million respectively.