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Genworth Life Insurance Company 2017 Annual MD&A

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Genworth Life Insurance Company 2017 Annual MD&A

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Genworth Life Insurance Company 2017 Annual MD&A

  1. 1. MANAGEMENT’S DISCUSSION AND ANALYSIS *70025201735000100* GENWORTH LIFE INSURANCE COMPANY December 31, 2017 This Management’s Discussion and Analysis is management’s assessment of the statutory financial position, results of operations, cash flows and liquidity for Genworth Life Insurance Company (the “Company”) and is presented to supplement the statutory information provided in the financial statements, footnotes, interrogatories, exhibits and schedules of the Company’s 2017 Annual Statement. This Management’s Discussion and Analysis contains certain “forward-looking statements.” Forward-looking statements may be identified by words such as “expects,” “intends,” “anticipates,” “plans,” “believes,” “seeks,” “estimates,” “will,” or words of similar meaning and include, but are not limited to, statements regarding the outlook for the Company’s future business and financial performance. Forward-looking statements are based on management’s current expectations and assumptions, which are subject to inherent uncertainties, risks and changes in circumstances thatare difficulttopredict. Actualoutcomesandresultsmaydiffer materiallyduetoglobalpolitical,economic,business, competitive, market, regulatory and other factors and risks. CORPORATE OVERVIEW The Company is a stock life insurance company incorporated under the laws of Delaware on September 28, 1956. The Company is licensed to do business in the District of Columbia and all states except NewYork.The Companyis wholly- owned by Genworth North America Corporation (“GNA”), which is indirectly wholly-owned by Genworth Financial, Inc. (“Genworth”), its ultimate parent. The Company offers long-term care insurance products. On March 7, 2016, Genworth suspended sales of its traditional life insurance and fixed annuity products. While the Company no longer sells these products, the Company continues to service its existing retained and reinsured blocks of business. The Company also has other non-strategic products which primarily include institutional and corporate-owned life insurance products. Institutional products consist of funding agreements. On October 21, 2016, Genworth entered into an agreement and plan of merger (the “Merger Agreement”) with Asia Pacific Global Capital Co., Ltd. (the “Parent”), a limited liability company incorporated in the People’s Republic of China, and Asia Pacific Global Capital USA Corporation (“Merger Sub”), a Delaware corporation and an indirect, wholly-owned subsidiary of the Parent. Subject to the terms and conditions of the Merger Agreement, including the satisfaction or waiver of certain conditions, Merger Sub would merge with and into Genworth with Genworth surviving the merger as an indirect, wholly-owned subsidiary of the Parent. The Parent is a newly formed subsidiary of China Oceanwide Holdings Group Co., Ltd. (together with its affiliates, “China Oceanwide”). China Oceanwide has agreed to acquire all of Genworth’s outstanding common stock for a total transaction value of approximately $2.7 billion,or $5.43 per share in cash. At a special meeting held on March 7, 2017, Genworth’s stockholders voted on and approved a proposal to adopt the Merger Agreement. GenworthandChina Oceanwidecontinueto worktowardssatisfyingthe closingconditionsoftheirproposedtransaction as soon as possible. To date, Genworth has announced approvals from the Virginia State Corporation Commission Bureau of Insurance, the North Carolina Department of Insurance, the South Carolina Department of Insurance and the Vermont Insurance Division. In February 2018, Genworth and China Oceanwide re-filed their joint voluntary notice with the Committee on Foreign Investment in the United States (“CFIUS”). In Genworth’s most recent joint filing, Genworth provided an additional mitigation approach to further protect the personal data of Genworth policyholders and customers in the United States, the structure of which includes the participation of a leading U.S. third-party data administrator. Genworth and China Oceanwide are fully committed to developing an acceptable solution with CFIUS; however, there can be no assurance that CFIUS will ultimately agree to clear the transaction between Genworth and China Oceanwide on terms acceptable to the parties or at all. In addition to approval and clearance by CFIUS, the closing of the proposed transaction remains subject to the receipt of required regulatory approvals in the U.S., China, and other international jurisdictions and other closing conditions. Genworth and China Oceanwide also continue to be actively engaged with the other relevant regulators regarding the pending applications. On November 29, 2017, Genworth, the Parent and Merger Sub entered into a Waiver and Agreement pursuant to which Genworth and the Parent each agreed to waive until April 1, 2018 its right to terminate the Merger Agreement and abandon the merger in accordance with the terms of the Merger Agreement. This was the second waiver and agreement extension, which extended the previous deadline of November 30, 2017, and allows additional time for regulatory reviews of the transaction. If Genworth is unable to reach an agreement as to a further extension of the deadline or are unabletosatisfytheclosingconditionsbytheapplicabledeadline,theneitherpartymayterminatetheMergerAgreement. On March 27, 2018, Genworth, the Parent and Merger Sub entered into another Waiver and Agreement pursuant to which Genworth and the Parent each agreed to waive until July 1, 2018 its right to terminate the Merger Agreement andabandonthemergerinaccordancewiththetermsoftheMergerAgreement.Thiswasthefourthwaiverandagreement extension, which extended the previous deadline of April 1, 2018. In addition, Genworth and the Parent acknowledged that the Merger Agreement may be terminated, and the merger abandoned, at any time prior to July 1, 2018 by the board of directions of either Genworth or the Parent, if CFIUS notifies Genworth, the Parent and Merger Sub that it has completed its review of the Merger and the mitigation proposals presented by the parties, and intends to recommend that the President of the United States of America act to suspend or prohibit the merger or any of the other transactions 1
  2. 2. MA AGEME T’S DISCUSSIO A D A ALYSIS 2 contemplated by the Merger Agreement. Genworth and China Oceanwide remain committed to satisfying the closing conditions under the Merger Agreement as soon as possible. SIG IFICA T REI SURA CE TRA SACTIO S Effective December 1, 2017, River Lake Insurance Company X (“RLIC X’’) recaptured the monthly renewable term reinsurance agreement with the Company, resulting in a $9.4 million terminal payment from the Company to RLIC X. Effective December 1, 2017, River Lake Insurance Company VI (“RLIC VI”) recaptured the monthly renewable term reinsurance agreement with the Company, resulting in a $6.8 million terminal payment from the Company to RLIC VI. Effective July 1, 2017, the Company recaptured from Genworth Life and Annuity Insurance Company (“GLAIC”) the reinsuranceagreementwherebytheCompanyhadcededsinglepremiumdeferredannuity(“SPDA”)businesstoGLAIC on a modified coinsurance (“Modco”) basis (the “GLAIC SPDAModco Treaty Recapture”). The Company recaptured $263.4 million of modified coinsurance reserves and paid a recapture payment of $4.3 million to GLAIC. Effective April 1, 2017, the Company ceded certain term life insurance business to GLAIC with an initial premium of $68.9 million and received a ceding commission of $48.6 million from GLAIC. For the net settlement, the Company transferred bonds of $7.7 million, mortgage loans of $8.2 million and cash of $4.4 million to GLAIC. Reserves ceded as of December 31, 2017 were $69.7 million. EffectiveApril 1, 2017, the Company ceded certain universal life insurance business to GLAIC with an initial premium of $101.0 million and received a ceding commission of $4.9 million from GLAIC. For the net settlement, the Company transferred bonds of $79.8 million, mortgage loans of $14.4 million and cash of $0.2 million to GLAIC resulting in a deferred gain of $1.7 million. Reserves ceded as of December 31, 2017 were $106.7 million. Effective April 1, 2017, the Company ceded certain single premium whole life insurance business to GLAIC with an initialpremiumof$134.5millionandreceivedacedingcommissionof$2.8millionfromGLAIC. Forthenetsettlement, the Company transferred bonds of $89.8 million, mortgage loans of $26.1 million, policy loans of $14.9 million and cash of $0.3 million to GLAIC resulting in a deferred gain of $0.7 million. Reserves ceded as of December 31, 2017 were $128.1 million. These April 1, 2017 reinsurance agreements to cede life business to GLAIC are collectively referred to as the “GLAIC Life April 1, 2017 Treaties.” On;ovember 1, 2016,Genworth Life Insurance Company of ;ewYork (“GLIC;Y”) recaptured 100% of the liabilities of its SPDAand single premium immediate annuity(“SPIA”) businesspreviously ceded to the Company (the “GLIC;Y SPDA And SPIA Treaty Recapture”) and terminated the trust with the trustee, the Bank of ;ew York Mellon. The Company paid GLIC;Y recapture consideration of $27.5 million and released the related reserves of $25.8 million. On ;ovember 1, 2016, the Company transferred to GLIC;Y six securities with a lower of cost or market value of $27.2 million and accrued interest of $0.3 million. ;o cash was exchanged. Effective January 1, 2000, the Company assumed new universal life and term life insurance business from GLAIC. These agreements were terminated with respect to new business in 2001. Effective September 1, 2016, most of the universal life insurance business was recaptured by GLAIC resulting in a $100.0 million assumed reserve decrease. Effective April 1, 2011, the Company amended and restated an existing universal life insurance treaty with GLAIC to cede certain additional universal life insurance policies, including Total Living Coverage (“TLC”) policies. Effective September 1, 2016, the Company recaptured most of the TLC policies, resulting in a $398.0 million ceded reserve decrease. As part of these September 1, 2016 recaptures of the universal life insurance and TLC policies between the Company and GLAIC, (collectively, the “GLAIC UL And TLC Recaptures”), GLAIC transferred to the Company 83 securities with a lower of cost or market value of $273.1 million and accrued interest of $3.0 million and paid $0.1 million in cash in September 2016. On October 1, 2016, Brookfield Life and Annuity Insurance Company Limited (“BLAIC”), merged with and into the Company and the Company was the surviving entity. Prior to the merger, BLAIC was a party to a reinsurance agreement to assume certain term life insurance between 1996 and 1999 from GLAIC on a coinsurance basis and was subject to the reserving requirements of Regulation XXX. Effective July 1, 2016, all of the liabilities of the term life insurance policies were recaptured from GLAIC (the “GLAIC Term Life Treaty Recapture”), resulting in a decrease in assumed reserves of $215.4 million. Prior to the merger, BLAIC was also a party to a reinsurance agreement to assume certain universal life insurance policies on a Modco 60% first dollar quota share basis from GLAIC. EffectiveApril 1, 2016, the universal life insurance blockofpolicieswasrecapturedbyGLAIC(the“GLAICULModcoTreatyRecapture”)resultinginarecapturepayment of $16.2 million received from GLAIC, a decrease in assumed premiums of $318.1 million and a decrease in change in reserve/Modco reinsurance expense of $318.1 million. SUMMARY OF CRITICALACCOU TI G ESTIMATES A D POLICIES Management prepares the statutory financial statements of the Company in conformity with accounting practices prescribedor permittedbytheDelawareDepartment ofInsurance (“DelawareDepartment”). These prescribedstatutory accounting practices (“SAP”) include a variety of publications of the ;ationalAssociation of Insurance Commissioners (“;AIC”), including Statements of Statutory Accounting Principles (“SSAP”), as well as state laws, regulations, and general administrative rules. ;AIC SAP requires management to adopt accounting policies and make estimates and assumptions that affect amounts reported in the statutory financial statements. The most critical estimates and
  3. 3. MA AGEME T’S DISCUSSIO A D A ALYSIS 3 assumptions include those used in determining: (i) investment impairments; (ii) the estimated fair value of investments; (iii) accounting for derivatives; and (iv) policy reserves. In applying these policies, management makes informed judgments and estimates that are inherently uncertain. Many of these policies, estimates and related judgments are common in the insurance industry and others are specific to the Company’s businesses and operations. Actual results could differ from those estimates. Investments The Company’s principal investments are bonds, preferred and common stocks, mortgage and contract loans, cash, short-term investments, derivatives and securities lending reinvested collateral. Impairments The Company regularly evaluates securities, excluding loan-backed and structured securities, in an unrealized loss position for other-than-temporary impairments (“OTTI”). For these securities, the Company considers all available information relevant to the collectability of the securities, including information about past events, current conditions, and reasonable and supportable forecasts, when developing the estimate of cash flows expected to be collected. When it is determined that an impairment is other than temporary because the Company has made a decision to sell the security at an amount below its carrying value, or it is probable that the Company will not collect all amounts due based on the contractual terms of the security, the Company will recognize that an OTTI has occurred and record a realized loss equal to the difference between the security’s carrying value and its fair value. For loan-backed and structured securities, the Company also utilizes performance indicators of the underlying assets including defaults or delinquency rates, loan to collateral value ratios, third-party credit enhancements, current levels of subordination, collateral vintage and other relevant characteristics of the underlying assets or the security to develop its estimate of cash flows. Estimating the expected cash flows is a quantitative and qualitative process that incorporates information received from third-party sources along with certain internal assumptions and judgments regarding the future performance of the underlying collateral. Where possible, this data is benchmarked against third-party sources. When it is determined that an impairment is other-than-temporary because it is probable that the Company will not collect all amounts due based on the contractual terms of the security, even if the Company has no intent to sell and has the intent and ability to hold to recovery, the Company will recognize a realized loss equal to the difference between the carrying value of the security and the present value of the expected cash flows. Under circumstances whereby the Company has the intent to sell or does not have the ability and intent to hold to recovery, the security is impaired to its fair value. In addition, for certain asset-backed securities in an unrealized loss position, management also evaluates whether it has the intent and ability to retain the investment for a period of time sufficient to recover the amortized cost basis. Impaired loans are defined by SSAP ;o. 37, Mortgage Loans, as loans for which it is probable that the Company will be unable to collect all amounts due according to original contractual terms of the loan agreement. In determining whether it is probable that the Company will be unable to collect all amounts due, the Company considers current payment status, debt service coverage ratios, occupancy levels and current loan-to-value. For individually impaired loans, the Company records an impairment charge when it is probable that a loss has occurred. Impaired loans are carried on a non-accrual status. Loans are placed on non-accrual status when, in management’s opinion, the collection of principal or interest is unlikely, or when the collection of principal or interest is 90 days or more past due. Income on impaired loans is not recognized until the loan is sold or the cash received exceeds the carrying amount recorded. Fair value The Company holds certain long-term bonds, common stocks, derivatives, securities held as collateral and separate account assets which are carried at fair value. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Fair value measurements are based upon observable and unobservable inputs. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect a view of market assumptions in the absence of observable market information. The Company utilizes valuation techniques that maximize the use of observable inputs and minimize the use of unobservable inputs. All assets carried or disclosed at fair value are classified and disclosed in one of the following three categories: • Level 1—Quoted prices for identical instruments in active markets. • Level 2—Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations whose inputs are observable or whose significant value drivers are observable. • Level 3—Instruments whose significant value drivers are unobservable. Level 1 primarily consists of separate account assets and exchange traded derivatives whose value is based on quoted market prices of the underlying mutual fund investments. Level 2 includes those financial instruments that are valued using industry-standard pricing methodologies, models or other valuation methodologies. These models are primarily industry-standard models that consider various inputs, such as interest rate, credit spread and foreign exchange rates for the underlying financial instruments. All significant inputs are observable, or derived from observable information, in the marketplace or are supported by observable levels at
  4. 4. MA AGEME T’S DISCUSSIO A D A ALYSIS 4 which transactions are executed in the marketplace. Financial instruments in this category primarily include: certain public and private corporate bonds; government or agency securities; certain mortgage-backed and asset-backed securities;securitiesheldascollateral;andcertainnon-exchange-tradedderivativessuchasinterestrateorcrosscurrency swaps. Level 3 is comprised of financial instruments whose fair value is estimated based on industry-standard pricing methodologies and internally developed models utilizing significant inputs not based on, nor corroborated by, readily available market information. In limited instances, this category may also utilize non-binding broker quotes. This category primarily consists of certain less liquid bonds and preferred stocks, and certain derivative instruments where the Company cannot corroborate the significant valuation inputs with market observable data. As of each reporting period, all assets and liabilities recorded or disclosed at fair value are classified in their entirety based on the lowest level of input that is significant to the fair value measurement. The assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment, and considers factors specific to the asset or liability, such as the relative impact on the fair value from including a particular input. The Company reviews the fair value hierarchy classifications each reporting period. Changes in the observability of the valuation attributes may result in a reclassification of certain financial assets or liabilities. Such reclassifications are reported as transfers in and out of Level 3 at the beginning fair value for the reporting period in which the changes occur. Derivatives Derivative instruments used in hedging transactions that meet the criteria of a highly effective hedge are valued and reported consistently with the hedged items. Derivative instruments used in hedging transactions that do not meet or no longer meet the criteria of an effective hedge shall be valued at fair value with the changes in fair value recorded as unrealized gains and losses in statutory surplus. The Company uses interest rate swaps, credit default swaps, cross currency swaps, inflation indexed swaps and bond purchase commitments. Interest rate swaps are used to reduce market risks from changes in interest rates and to alter interest rate exposures arising from mismatches between assets and liabilities. Under interest rate swaps, the Company agrees with other parties to exchange at specified intervals, the difference between fixed-rate and floating-rate interest amounts calculated by reference to an agreed notional principal amount. The Company enters into credit default swaps to manage the credit risk of bond investments by entering into agreements whereby the Company buys protection against potential reductions in credit quality. The Company sells protection under single name credit default swaps and default swap index tranches in combination with purchasing other investments to reproduce investment characteristics of similar investments based on the credit quality and term of the credit default swap. Cross currency swaps are used to reduce exposure to changes in foreign exchange rates and changes in interest rates. Inflation indexed swaps are used to hedge the variable cash flows from U.S. Treasury Inflation Protected Securities (“TIPS”). The Company uses bond purchase commitments to lock in prices of future bond purchases. Interest rate, cross currency and inflation indexed swaps that qualify for hedge accounting and certain credit default swaps used in replication transactions are carried at amortized cost while non-qualifying interest rate swaps and credit default swaps are carried at fair value with changes in fair value recorded in statutory surplus. Realized investment gains and losses from derivatives that qualify for hedge accounting are reduced by amounts transferred to interest maintenance reserve (“IMR”) and are reflected as an element of investment income, net of investment and interest expenses. Any fees associated with swaps are held in surplus and the full fee amount will be recognized in income at the time of termination. Policy reserves The Company calculates and maintains policy reserves for the estimated future payment of claims to its policyholders andcontractholders basedonactuarial assumptions and inaccordance with applicablestatutory andactuarial guidelines. Management monitors actual experience, and where circumstances warrant, will revise its assumptions. The methods of determining such estimates and establishing the liability are reviewed continuously and any adjustments are reflected in operations in the period in which they become known. Future developments may result in losses greater or less than the liabilities provided. GE ERAL TRE DS A D CO DITIO S AFFECTI G THE COMPA Y’S BUSI ESS The Company’s business is, and is expected to continue to be, influenced by a number of industry-wide and product- specific trends and conditions. General trends and conditions Financial and economic environment The stability of both the financial markets and global economies in which Genworth and its subsidiaries operate impacts the sales, revenue growth and profitability trends of its businesses as well as value of assets and liabilities. The U.S. and international financial markets have been impacted by concerns regarding global economies and the rate and strength of recovery. Slower growth and higher debt levels in China have created uncertainty for global economies, heightened by Standard & Poor’s Financial Services, LLC’s (“S&P”) and Moody’s Investors Service, Inc. (“Moody’s”) downgrade of the financial strength rating of China in September 2017 and May 2017, respectively. The Company continues to operate in a challenging economic environment characterized by low interest rates, slow global growth,
  5. 5. MA AGEME T’S DISCUSSIO A D A ALYSIS 5 in spite of a moderate increase in the second half of 2017, and fluctuating oil and commodity prices. Long-term interest rates remain at historically low levels despite the fact the U.S. Federal Reserve raised its benchmark lending rate three timesin 2017.Additionally, during2017,the U.S.FederalReserve announced that itwould beginto normalize monetary policy and scale back quantitative easing. As a result of the U.S. Federal Reserve’s actions, the U.S. Treasury yield curve flattened as short-term U.S. Treasury yields rose significantly while long-term U.S. Treasury yields decreased compared to 2016. Low interest rates continue to adversely impact the Company’s results and the portfolio yield continues to decline as cash flows are reinvested in lower yielding assets. The U.S. equity markets increased and credit spreads tightened during 2017 despite periods of volatility associated with geopolitical issues and natural disasters. In the fourth quarter of 2017, credit markets and investment valuations also increased due to recently enacted U.S. tax legislation under the Tax Cuts and Jobs Act (“TCJA”). The macroeconomic environment remains generally positive given global growth, mostly in the second half of 2017, and positive corporate profits. U.S. fixed income market issuances exceeded expectations and demand from foreign and domestic investors continued to support valuations. Global equity markets were higher and the economies of the Eurozone countries continued to improve. Varied levels of economic growth, coupled with uncertain economic outlooks, changes in government policy, regulatory and tax reforms, and other changes in market conditions, influenced, and the Company believes will continue to influence, investment and spending decisions by consumers and businesses as they adjust their consumption, debt, capital and risk profiles in response to these conditions. These trends change as investor confidence in the markets and the outlook for some consumers and businesses shift.As a result, the Company’s sales, revenues and profitability trends of certain products as well as the value of assets and liabilities have been and could be further impacted going forward. In particular, factors such as government spending, monetary policies, the volatility and strength of the capital markets, further changes in tax policy and/or in U.S. tax legislation under the TCJA, and the impact of global financial regulation reform will continue to affect economic and business outlooks, level of interest rates and consumer behaviors moving forward. The U.S. government, the Federal Reserve, and other legislative and regulatory bodies have taken certain actions in recent years to support the economy and capital markets, influence interest rates, influence housing markets and mortgage servicing and provide liquidity to promote economic growth. These include various mortgage restructuring programs implemented or under consideration by the government-sponsored enterprises, lenders, servicers and the U.S. government. A U.S. or global recession or regional or global financial crisis could materially and adversely affect the Company’s business, financial condition and results of operations. Derivatives Following downgrades of the Company in 2016 and 2017, the Company actively responded to the risk to the Company’s derivatives portfolio arising from the right of the Company’s counterparties to terminate their bilateral over-the-counter derivatives transactions with the Company as a result of the downgrades. The Company notified its counterparties of the downgrades to determine whether they will exercise their rights to terminate the transactions, agree to maintain the transactions with the Company under revised terms or permit the Company to move the transactions to clearing. Although some counterparties have indicated that they reserve their rights to take action against the Company, none have done so and the Company continues to discuss downgrades with its counterparties. Tax Reform On December 22, 2017, President Trump signed the TCJA into law. The enactment of the new law signified the first major overhaul of the U.S. Federal income tax system in more than 30 years. In addition to the law’s corporate income tax rate reduction, several other provisions are pertinent to the Company’s financial statements and related disclosures for the year ended December 31, 2017, and will have an impact on deferred taxes in future years. The TCJA impacted the Company’s capital through a reduction in the statutory admitted deferred tax asset and impacted certain cash flow scenario testing included in the risk-based capital calculation. Prior to the TCJA, the top U.S. corporate income tax rate was 35% for corporations with taxable income greater than $10.0 million. The TCJAreduced the U.S. corporate income tax rate to 21% effective for taxable years beginning after December 31, 2017. Included in the Company’s 2017 results was a tax expense of $343.0 million, recorded as a component of statutory surplus, as a result of the reduction in tax rate on its net deferred tax asset. DuringFebruary2018, the StatutoryAccounting PrinciplesWorkingGroup (“SAPWG”) issued guidanceon accounting for the TCJA regarding a limited scope exception to SSAP ;o. 9, Subsequent Events. In this guidance, the SAPWG adopted many of the provisions issued by the U.S. Securities Exchange Commission in Staff Accounting Bulletin 118 (“SAB 118”) with regard to estimates under the TCJA. For items under the TCJA that are complete, the Company has reflected the income tax effects in its 2017 statutory financial statements. For items under the TCJAthat are incomplete, but a reasonable estimate has been determined, the Company has recorded a reasonable estimate. For items for which a reasonable estimate cannot be determined at this time, the Company has applied existing guidance based on the provisions of the tax laws that were in effect prior to the TCJA being enacted. Reasonable estimates updated and/or established after the issuance of the 2017 statutory financial statements but before the issuance of the year end 2017 audited financial statements, shall not be recognized as Type I subsequent events. Instead, these changes, as well as future changes in estimates shall be recognized as a change in accounting estimate, pursuant to SSAP;o. 3, Accounting Changes and Corrections of Errors, when the information necessary to update the estimate becomes available. Consistent with SAPWG guidance and SAB 118, the Company will be working in good faithto complete the accounting for the changes adopted under the TCJA, and all accounting impacts will be completed within the measurement period, not to exceed one year.
  6. 6. MA AGEME T’S DISCUSSIO A D A ALYSIS 6 Trends and conditions affecting the Company’s businesses Results of the Company’s businesses depend significantly upon the extent to which its actual future experience is consistent with assumptions and methodologies used in calculating its reserves. Many factors can affect the reserves in the Company. Because these factors are not known in advance, change over time, are difficult to accurately predict and are inherently uncertain, the Company cannot determine with precision the ultimate amounts it will pay for actual claims or the timing of those payments. The Company will continue to monitor experience and assumptions closely and make changes to its assumptions and methodologies, as appropriate. Even small changes in assumptions or small deviationsof actualexperience from assumptions can have, and in the past have had, material impacts on the Company’s reserve levels, results of operations and financial condition. The Company will continue to migrate to a new valuation and projection platform for certain lines of business, while it upgrades platforms for other lines of business. The migration and upgrades are part of Genworth’s ongoing efforts to improve the infrastructure and capabilities of its information systems and routine assessment and refinement of financial, actuarial, investment and risk management capabilities and processes enterprise wide. These efforts will also provide the Company’s businesses with improved platforms to support emerging accounting guidance and ongoing changes in capital regulations. Concurrently, actuarial processes and methodologies will be reviewed, and may result in additional refinements to models and/or assumptions. Any material changes in balances, margins or income trends thatmayresult fromtheseactivitieswillbedisclosedaccordingly.Genworthintendstocontinuedevelopingitsmodeling capabilitiesofitsvariousbusinesses,includingforitslong-termcareinsuranceprojectionswheretheCompanymigrated substantially all of the retained long-term care insurance business to this new modeling system in 2016 and 2017. The new modeling system values and forecasts associated liability cash flows and policyholder behavior at a more granular level than the previous system. Results of the Company’s businesses are also impacted by interest rates. The continued low interest rate environment puts pressure on the profitability and returns of these businesses as higher yielding investments have matured and been replaced with lower-yielding investments.The Company seeks to manage the impact of low interest rates through asset- liability management as well as interest rate hedging strategies for a portion of its long-term care insurance product cash flows. Additionally, certain products have implicit and explicit rate guarantees or optionality that are significantly impacted by changes in interest rates. In February 2016, Genworth announced that one of its strategic objectives was to separate, then isolate, through a series of transactions, its long-term care insurance business from its other U.S. life insurance businesses. Genworth’s goal under the plan was to align substantially all of its in-force life insurance and annuity business under GLAIC and all long-term care insurance business under the Company. As part of this strategic objective, a holding company would purchase GLAIC from the Company at fair value and GLAIC would no longer be a subsidiary of the Company, referred to as “unstacking.” Completion of these transactions and approval of the unstacking were included as conditions to the closing of Genworth’s proposed acquisition by China Oceanwide. In preparation for the unstacking, the Company completed several reinsurance agreements, including the GLAIC Life April 1, 2017 Treaties, as discussed above. In addition, effective July 1, 2017, the Company ceded certain fixed deferred annuity business, including the business recaptured from GLAIC by the GLAIC SPDA Modco Treaty Recapture as discussed above, and certain fixed payout annuity business to GLAIC on a modified coinsurance basis as well as ceded certain corporate-owned life insurance business to GLAIC on a modified coinsurance basis. These reinsurance treaties had an adverse impact on the risk-based capital ratio of the Company and GLAIC. The Company and GLAIC had anticipated that the unstacking would be completed by December 31, 2017 and that certain capital benefits relating to the unstacking would offset the adverse impact to its risk-based capital ratio as of year end. With the unstacking not being completed by year end and without a target date for such completion, the Company and GLAIC mutually agreed to terminate the July 1, 2017 reinsurance treaties. As of December 31, 2017, the Company had a net payable of $29.8 million to GLAIC related to the termination of these treaties. The intercompany amounts were settled in cash on January 10, 2018. As discussed above, these internal transactions are required to be completed under the Merger Agreement with China Oceanwide. Long-term care insurance Results of the Company’s long-term care insurance business are influenced primarily by the Company’s ability to achievein-forcerateactions,morbidity,mortality,persistency,investmentyields,expenses,sales,changesinregulations and reinsurance. Sales of the Company’s products are impacted by the relative competitiveness of its ratings, product features, pricing and commission levels and the impact of in-force rate actions on distribution and consumer demand. Changesinregulationsorgovernmentprograms,includinglong-termcareinsurancerateactionlegislation,couldimpact the Company’s long-term care insurance business either positively or negatively. Claim reserves are reviewed quarterly and the Company conducts a detailed review of claim reserve assumptions for the long-term care insurance business annually typically during the third quarter of each year. During the third quarter of 2017, the Company reviewed assumptions and methodologies relating to claim reserves of the long-term care insurance business but did not make any significant changes to the assumptions or methodologies, other than routine updates to benefit utilization rates as the Company typically does each quarter. The updates in the third quarter of 2017 did not have a significant impact on claim reserve levels. During the fourth quarter of 2017, the Company updated its claimsadministrationexpense assumptions, whichresulted in a claim expensereserve decreaseof $30.2 million.During the third quarter of 2016, the Company completed its annual review of assumptions and methodologies related to long- term care insurance claim reserves, which resulted in recording higher claim reserves of $431.9 million. In the third quarter of 2016, the Company updated several assumptions and methodologies primarily impacting claim termination rates, benefit utilization rates and incurred but not reported reserves.
  7. 7. MA AGEME T’S DISCUSSIO A D A ALYSIS 7 In the fourth quarter of 2017, the Company performed assumption reviews and cash flow testing. As part of the annual testing, the Company reviewed assumptions for incidence and interest rates, among other assumptions, and considered incremental benefits from expected future in-force rate actions. As of December 31, 2017, the Company’s cash flow testing margins were positive but were reduced from the 2016 levels as higher costs relating primarily to changes to expected future incidence of claims were partially offset by the higher modeled benefit of planned future in-force rate actions. As a result, the Company determined that its reserves were adequate and no additional reserves were recorded. Future premium rate action assumptions are based on expected future claims costs and are generally assumed to be filed in the next 10 years (including certain currently pending filings) and implemented over the next 15 years as regulatory approvals are received. The Company will continue to regularly review methodologies and assumptions in light of emerging experience and may be required to make adjustments to long-term care insurance claim reserves in the future, which could also impact cash flow testing results. In connection with the updated assumptions and methodologies that increased claim reserves on existing claims in the 2016 review, the Company now establishes higher claim reserves on new claims, which have decreased earnings in 2017andtheCompanyexpectsearningstodecreasegoingforwardashigherreservesarerecorded.Additionally,average claim reserves for new claims are higher as the mix of claims continues to evolve, with an increasing number of policies withhigherdailybenefitamounts,unlimitedbenefitpoolsandhigherinflationfactorsgoingonclaim.Also,theCompany expects growth in new claims as the blocks of business continue to age. In addition, premiums will decline as policies terminate from mortality and lapses. The Company experiences volatility in loss ratios caused by variances in policy terminations, claim terminations, claim severity and claim counts. Approved in-force rate actions may also cause fluctuations in loss ratios during the period when reserves are adjusted to reflect policyholders taking reduced benefits or non-forfeiture options within their policy coverage.Inaddition,theCompanyperiodicallyreviewsreserveassumptionsandmethodologiesbasedupondeveloping experience, which may result in changes to claim reserves and cash flow testing results, causing volatility in operating results and loss ratios. The Company also manages risk and capital allocated to the long-term care insurance business through utilization of external reinsurance in the form of coinsurance. The Company executed external reinsurance agreements to reinsure 20% of all sales of its individual long-term care insurance products that have been introduced since early 2013. External new business reinsurance is dependent on a number of factors, including price, availability, risk tolerance and capital levels. Over time, there can be no assurance that affordable, or any, reinsurance will continue to be available. The Company also has external reinsurance on some older blocks of business which includes a treaty on a yearly renewable term basis on business that was written between 1998 and 2003. This yearly renewable term reinsurance provides coverage for claims on those policies for 15 years after the policy was written. After 15 years, reinsurance coverage ends for policies not on claim, while reinsurance coverage continues for policies on claim until the claim ends. Since 2013, the Company has seen, and may continue to see, an increase in benefit costs as policies with reinsurance coverage exhaust their benefits or terminate and policies which are not covered by reinsurance go on claim. As a result of ongoing challenges in the long-term care insurance business, the Company continues pursuing initiatives to improve the risk and profitability profile of this business including: premium rate increases and associated benefit reductions on in-force policies; product refinements; changes to current product offerings; new distribution strategies; refining underwriting requirements; managing expense levels; actively exploring additional reinsurance strategies; executing investment strategies targeting higher returns; enhancing financial and actuarial analytical capabilities; and considering other actions to improve the performance of the overall business. As part of the Company’s strategy for its long-term care insurance business, the Company has been implementing, and expects to continue to pursue, significant premium rate increases and associated benefit reductions on the older generation blocks of business in order to bring those blocks closer to a break-even point over time and reduce the strain on capital. The Company is also requesting premium rate increases on newer blocks of business, as needed, some of which may be significant, to help bring its loss ratio back towards its original pricing. The Company received 114 filing approvals from 36 states in 2017, representing a weighted-average increase of 28% on approximately $714 million in annualized in-force premiums. The Company submitted 226 new filings in 45 statesin 2017 on approximately $1.3 billion in annualized in-force premiums. As of December 31, 2017, the Company had suspended sales in Hawaii, Massachusetts, ;ew Hampshire and Vermont, and will consider taking similar actions in the future, in other states where it is unable to obtain satisfactoryrate increases on in-force policies and/or unable to obtain approval for new products. The Company will also consider litigation against states that decline actuarially justified rate increases. As of December 31, 2017, the Company was in litigation with one state that has refused to approve actuarially justified in-force rate actions. The approval process for in-force premium rate increases and the amount and timing of the rate increases approved vary by state. In certain states, the decision to approve or disapprove a rate increase can take a significant amount of time. After approval, insureds are provided with written notice of the increase and increases are generally applied on the insured’s next policy anniversary date. As a result, the benefits of any rate increase are not fully realized until the implementation cycle is complete and are, therefore, expected to be realized over time. The Company’s long-term care insurance sales decreased 23% in 2017 compared to 2016. Sales decreased primarily due to the Company’s lower ratings. The Company expects that its sales will continue to be adversely impacted by its current ratings. Future adverse ratings announcements or actions could negatively impact sales levels further. Additionally, effective April 1, 2018, the Company plans to suspend sales of its long-term care insurance products in Florida, which could reduce sales levels further.
  8. 8. MA AGEME T’S DISCUSSIO A D A ALYSIS 8 Life insurance Results of the Company’s life insurance business are impacted primarily by mortality, persistency, investment yields, expenses, reinsurance and statutory reserve requirements, among other factors. As previously disclosed, the Company suspended sales of its traditional life insurance products on March 7, 2016. The Company experienced lower mortality results in 2017 compared to 2016 resulting from changes to the Company’s reinsurance agreements. Between 1999 and 2009, the Company had a significant increase in term life insurance sales, as compared to 1998 and prior years. As 15-year term life insurance policies written in 1999 and 2000 transition to their postguaranteed levelpremium rate period, the Companyhas experienced lower persistencycomparedto its pricing and valuation assumptions. The blocks of business issued since 2000 vary in size as compared to the 1999 and 2000 blocks of business. Accordingly, in the future as additional 10-, 15-, and 20-year level premium period blocks enter their post guaranteed level premium rate period, the Company may experience volatility in premiums and mortality experience, which may reduce profitability or create losses in term life insurance products, in amounts that could be material, if persistency is lower than original assumptions and if overall block mortality worsens as healthier lives lapse. In 2017, the Company experienced higher lapses associated with its large 15-year and 20-year term life insurance blocks entering their post guaranteed level premium rate periods. The Company anticipates this trend will continue as larger blocks reach the end of their level premium periods through 2020, especially for the 2000 block, and will continue as the Company’s other blocks reach their post guaranteed level premium rate period. The Company has also taken actions to mitigate potentially unfavorable impacts through the use of reinsurance. Fixed annuities Resultsof the Company’sfixed annuitiesbusinessare affectedprimarilyby investmentperformance,interest rate levels, the slope of the interest rate yield curve, net interest spreads, mortality, persistency, and expense and commission levels. As previously disclosed, the Company suspended sales of its traditional fixed annuity products on March 7, 2016. TheCompany monitors and changes creditingrates onfixed annuitieson a regular basisto maintainspreads and targeted returns. However, if interest rates remain at current levels or decrease further, the Company could see declines in spreads. Dividend Activity During 2017 The Company did not pay any shareholder dividends during 2017. Capital Contributions and Returns of Capital During 2017 On August 28, 2017, the Company made a capital contribution to GLIC Real Estate Holdings, LLC (“GLIC RE”), of a certain loan made by Eastgate Professional Office Park, Ltd., an Ohio limited liability company, in the original principal amount of $8.5 million, with a market value of $6.4 million. On June 30, 2017, the Company received a return of capital from GLIC RE in the amount of $19.6 million in cash.
  9. 9. MA AGEME T’S DISCUSSIO A D A ALYSIS 9 Financial Position The highlights of the Company’s financial position as of December 31, 2017 and 2016 was as follows (in millions): 2017 2016 $ Change % Change ADMITTED ASSETS Cash and invested assets $ 38,936.7 $ 39,113.2 $ (176.5) (0.5)% Amounts recoverable from reinsurers and funds held 124.1 121.0 3.1 2.6 % Deferred tax asset 274.0 336.0 (62.0) (18.5)% Premium tax receivable 35.2 14.4 20.8 144.4 % Premiums and accounts receivable 190.8 193.7 (2.9) (1.5)% Investment income due and accrued 406.7 401.9 4.8 1.2 % Other assets 29.3 30.7 (1.4) (4.6)% Separate account assets 15.2 14.9 0.3 2.0 % TOTALADMITTED ASSETS $ 40,012.0 $ 40,225.8 $ (213.8) (0.5)% LIABILITIES A D CAPITALA D SURPLUS LIABILITIES Aggregate reserves-life $ 2,219.5 $ 2,469.6 $ (250.1) (10.1)% Aggregate reserves-annuity contracts 7,896.6 8,666.5 (769.9) (8.9)% Aggregate reserves-accident and health policies 24,156.8 22,588.3 1,568.5 6.9 % Liability for deposit-type contracts 679.5 762.8 (83.3) (10.9)% Liability for policy and contract claims 179.7 181.2 (1.5) (0.8)% Premiums and annuity considerations received in advance 85.1 92.9 (7.8) (8.4)% Interest maintenance reserve 939.5 973.0 (33.5) (3.4)% General expenses due or accrued 195.7 226.3 (30.6) (13.5)% Asset valuation reserve 237.6 201.2 36.4 18.1 % Other amounts payable on reinsurance 77.5 76.1 1.4 1.8 % Payable for securities lending 193.3 345.1 (151.8) (44.0)% Payable for collateral received from derivatives counterparties 151.7 223.8 (72.1) (32.2)% Derivative liabilities 112.9 145.9 (33.0) (22.6)% Other liabilities 143.7 105.3 38.4 36.5 % Separate account liabilities 15.2 14.9 0.3 2.0 % TOTAL LIABILITIES 37,284.3 37,072.9 211.4 0.6 % TOTAL CAPITALA D SURPLUS 2,727.7 3,152.9 (425.2) (13.5)% TOTAL LIABILITIES, CAPITALA D SURPLUS $ 40,012.0 $ 40,225.8 $ (213.8) (0.5)% Admitted Assets Cash and invested assets Cash and invested assets decreased $176.5 million mainly attributable to a decline in assets under management for the fixed annuity block of business, a $324.9 million decrease in affiliate common stock and a $151.8 million decrease in securitieslendingreinvestedcollateral assets mainly driven bya decline in market demandfor corporate bond securities, partially offset by growth of the long-term care insurance in-force block of business. The decrease in common stock was driven by decreases in the investments in GLAIC and GLIC;Y, both of which were mostly driven by decreases in the deferred tax asset as a result of the impact of the TCJA and the net loss on each company primarily driven by reserve increases. Deferred tax asset Deferred tax asset decreased $62.0 million mainly attributable to the impact of the TCJA.
  10. 10. MA AGEME T’S DISCUSSIO A D A ALYSIS 10 Investments As of December 31, 2017, the Company had a $30,619.1 million bond (long and short-term) portfolio representing 78.6% of its total invested assets. Publicly traded bonds accounted for 74.2% of the bond portfolio. Of the total bond portfolio, 3.2% mature in less than one year, 21.3% mature between one and five years, and the balance of 75.5% mature in more than five years. As of December 31, 2017 and 2016, the Company’s bond portfolio was invested as follows: Category 2017 2016 ;AIC Class 1 59.6% 62.2% ;AIC Class 2 34.9 32.9 ;AIC Class 3 4.2 4.5 ;AIC Class 4 1.3 0.4 TOTAL 100.0% 100.0% Bond quality remained relatively stable as of December 31, 2017, when compared with December 31, 2016. Bonds with ratings categories ranging from AAA/Aaa to BBB/Baa, as assigned by a rating service such as S&P or Moody’s, are generally regarded as investment grade securities. Some agencies and treasuries (that is, those securities issuedbytheU.S.governmentoranagencythereof) arenotrated,butallareconsideredtobeinvestmentgradesecurities. The ;AIC regards agencies and treasuries and all A ratings as Class 1 (highest quality), BBB/Baa ratings as Class 2 (high quality), BB/Ba ratings as Class 3 (medium quality), B ratings as Class 4 (low quality), CCC/Caa ratings as Class 5 (lower quality), and CC/Ca or below ratings as Class 6 (in or near default). The Company had impairments of $9.6 million and $24.1 million during the years ended December 31, 2017 and 2016, respectively. Common stock represented 3.9% of total invested assets as of December 31, 2017, most of which related to investments in the Company’s insurance company subsidiaries of $1,477.7 million. In evaluating the credit quality of mortgage loans, the Company assesses the performance of the underlying loans using both quantitative and qualitative criteria. Certain risks associated with mortgage loans can be evaluated by reviewing both the loan-to-value and debt service coverage ratios to understand both the probability of the borrower not being able to make the necessary loan payments as well as the ability to sell the underlying property for an amount that would enable the Company to recover its unpaid principal balance in the event of default by the borrower.Ahigher debt service coverage ratio indicates the borrower is less likely to default on the loan. The debt service coverage ratio should not be used without considering other factors associated with the borrower, such as the borrower’s liquidity or access to otherresourcesthatmayresultintheCompany’sexpectationthattheborrowerwillcontinuetomakethefuturescheduled payments. A lower loan-to-value indicates that its loan value is more likely to be recovered in the event of default by the borrower if the property was sold. The following table sets forth the average loan-to-value of mortgage loans by property type as of December 31, 2017 (amounts in millions): 2017 Average loan-to-value(1) Property type 0% -50% 51% - 60% 61% - 75% 76% -100% Greater than 100% Total Retail $ 513.3 $ 332.4 $ 547.7 $ — $ — $ 1,393.4 Office 294.2 273.9 357.5 6.9 1.9 934.4 Industrial 381.6 212.5 326.3 — — 920.4 Apartments 119.4 62.3 123.1 — — 304.8 Mixed use 71.7 23.1 57.9 — — 152.7 Other 31.8 10.7 174.2 — — 216.7 Total $ 1,412.0 $ 914.9 $ 1,586.7 $ 6.9 $ 1.9 $ 3,922.4 Percent of total 36.0 % 23.3 % 40.5 % % 0.0 % 100.0 % Weighted-average debt service coverage ratio(2) 2.3 1.9 1.6 (0.2) 1.0 1.9 (1) Average loan-to-value is based on the Company’s most recent estimate of the fair value for the underlying property as of the date indicated above. Values are evaluated at least annually and updated more frequently if necessary to better indicate risk associated with the loan. (2) Debt service coverage ratio is based on “normalized” annual net operating income of the property compared to the payments required under the terms of the loan. ;ormalization allows for the removal of annual one-time events such as capital expenditures, prepaid or late real estate tax payments or non-recurring third-party fees (such as legal, consulting or contract fees). This ratio is evaluated at least annually and updated more frequently if necessary to better indicate risk associated with the loan. As of December 31, 2017, the Company had future commitments related to its investments in commercial mortgage loans of $12.9 million, limited partnerships of $310.9 million, bank loans of $17.8 million, and private placement securities of $80.5 million.
  11. 11. MA AGEME T’S DISCUSSIO A D A ALYSIS 11 Liabilities Aggregate reserves for accident and health policies Aggregate reserves for accident and health policies increased $1,568.5 million related to long-term care insurance products primarily due to growth and aging of the in-force blocks and higher severity on new claims. Aggregate reserves for annuity contracts Aggregate reserves for annuity contracts decreased $769.9 million due to fixed annuity products contractual liabilities maturing and a relatively large block exiting the surrender charge period in 2017. Aggregate reserves for life contracts Aggregate reserves for life contracts decreased $250.1 million due to a $324.0 million decrease related to life insurance productsmainlydriven bythe $304.5millioninreserves cededonthe GLAIC LifeApril1, 2017Treatiesasof December 31, 2017, partially offset by a $73.9 million increase in corporate-owned life insurance products due to growth in account value, partially offset by death benefits. Capital and Surplus The following table sets forth the changes in capital and surplus as of and for the year ended December 31, 2017 (in millions): Capital and surplus as of December 31, 2016 $ 3,152.9 ;et loss (39.1) Change in net unrealized capital gains and losses (332.3) Change in net unrealized foreign exchange capital gains and losses 2.3 Change in net deferred tax assets (296.2) Change in nonadmitted assets 275.5 Change in liability for reinsurance in unauthorized companies 0.1 Change in asset valuation reserve (36.4) Change in surplus as a result of reinsurance 32.4 Prior period correction - long-term care insurance reserves related to initial claim dates, net of taxes 21.6 Prior period correction - long-term care insurance due premium, net of taxes (34.4) Prior period correction - long-term care insurance reserves related to benefit inflation coding, net of taxes (18.7) Capital and surplus as of December 31, 2017 $ 2,727.7 The change in net unrealized capital gains and losses of $332.3 million was driven by unrealized losses on common stocks of affiliates. The change in net deferred tax assets and nonadmitted assets primarily resulted from the impact of the TCJA. Included in the Company’s 2017 results was a tax expense of $343.0 million, recorded as a component of statutory surplus, as a result of the reduction in tax rate on its net deferred tax asset. The net loss of $39.1 million is discussedbelowunder“ResultofOperations.”Thechangeinsurplusasofresultofreinsurancewasprimarilyattributable to deferring the initial ceding commission received, net of tax, related to the GLAIC LifeApril 1, 2017Treaties, partially offset by current year amortization. During 2017,the Company recordeda prior period correctionto its long-term care insurance reservesrelatedto recorded initial claim dates. To record the correction, the Company decreased aggregate reserves for accident and health policies by $27.3 million, liability for policy and contract claims by $4.8 million, general expenses due or accrued by $1.1 million (for a total decrease to claim and claim expense reserves of $33.2 million) and deferred tax assets by $11.6 million, with an offsetting increase of $21.6 million to unassigned surplus, in accordance with SSAP ;o. 3. During 2017, the Company also recorded a prior period correction related to premium accruals on the Company’s long- term care insurance business. To record the correction, the Company decreased premiums and accounts receivable by $58.8 million and commissions payable by $5.9 million and increased deferred tax assets by $18.5 with an offsetting decrease to unassigned surplus of $34.4 million, in accordance with SSAP;o. 3.Additionally, the Company decreased thenonadmittedportionof premiumsandaccountsreceivable by$55.6million,withan offsettingincreasetounassigned surplus. During 2017, the Company recorded a prior period correction to its long-term care insurance reserves related to benefit inflation coding. To record the correction, the Company increased aggregate reserves for accident and health contracts by $28.7 million and net deferred tax assets by $10.0 million, with an offsetting decrease of $18.7 million to unassigned surplus, in accordance with SSAP ;o. 3.
  12. 12. MA AGEME T’S DISCUSSIO A D A ALYSIS 12 Off-Balance Sheet Arrangements The table below summarizes the face amount of the Company’s financial instruments with off-balance sheet risk (in millions): Assets Liabilities 2017 2016 2017 2016 a. Swaps $ 3,163.4 $ 2,305.0 $ 10,493.7 $ 11,658.2 b. Cross currency 21.8 21.8 — — c. Credit default swaps 29.0 24.0 — 5.0 Total $ 3,214.2 $ 2,350.8 $ 10,493.7 $ 11,663.2 The following table sets forth credit default swaps where the Company sells protection on single name reference entities and the fair values as of December 31, 2017 (in millions): Reference entity credit rating and maturity otional value Assets Liabilities A Matures in less than one year $ 10.0 $ 0.1 $ — BBB Matures in less than one year 19.0 0.1 — Total single name credit default swaps $ 29.0 $ 0.2 $ — The Company is exposed to credit-related losses in the event of nonperformance by counterparties to financial instruments, but it does not expect any counterparties to fail to meet their obligations given their high credit ratings. The current credit exposure of the Company’s derivative contracts is limited to net positive fair value owed by the counterparties, less collateral posted by the counterparties to the Company. Credit risk is managed by entering into transactions with creditworthy counterparties and requiring the posting of collateral. In many instances, new over-the- counter derivatives contracts will require both parties to post initial margin, thereby resulting in overcollateralization. TheCompanyalsoattemptstominimizeitsexposuretocreditriskthroughtheuseofvariouscreditmonitoringtechniques and monitoring overall collateral held.All of the net credit exposure for the Company from derivative contracts is with investment-grade counterparties. Participation in High Yield Financings, Highly Leveraged Transactions or on-Investment Grade Loans and Investments The Company has not materially participated in any high yield financings, highly leveraged transactions or non- investment grade loans and investments relating to corporate restructurings or otherwise. Risk-Based Capital The Company maintains a risk-based capital ratio at a level in excess of the authorized control level that the Company deems appropriate for its product mix and risk profile. The Company had a total adjusted capital of $3,106.5 million and an authorized control level risk-based capital of $549.9 million as of December 31, 2017. Dividend Restrictions Themaximumamountof shareholder dividendsthat canbepaidby theCompany withoutprior approval ofthe Delaware Department is subject to restrictions. The maximum unrestricted dividend payout that may be made in 2018 is the greater of 10% of the Company’s statutory capital and surplus as of December 31, 2017 or its net gain from operations for 2017, with such dividend payout not to exceed the Company’s earned surplus. The Company has no capacity to make a dividend payment without prior approval in 2018. Ratings Ratings with respect to financial strength are an important factor in establishing the Company’s competitive position. Rating agencies review the financial performance and condition of the Company and provide opinions regarding financial strength, operating performance and ability to meet obligations to policyholders. As of December 31, 2017, the ratings for the Company were as follows: A.M. Best Company, Inc. (“A.M.Best”) B (Fair) S&P B+ (Weak) Moody’s B2 (Poor)
  13. 13. MA AGEME T’S DISCUSSIO A D A ALYSIS 13 On February 12, 2018, Moody’s downgraded its ratings of the Company to B3 (Poor) and A.M. Best downgraded its ratings of the Company to B- (Fair). A.M. Best states that the “B” and “B-” (Fair) ratings are assigned to those companies that have, in its opinion, a fair ability to meet their ongoing insurance obligations. The “B” and “B-” (Fair) ratings are the seventh- and eighth-highest of 15 ratings assigned by A.M. Best, which range from “A++” to “F.” S&P states that insurers rated “B” (Weak) have weak financial security characteristics. The “B” range is the sixth- highest of nine financial strength rating ranges assigned by S&P, which range from “AAA” to “R.” A plus (+) or minus (-) shows relative standing within a major rating category.These suffixes are not added to ratings in the “AAA” category or to ratings below the “CCC” category. Accordingly, the “B+” rating is the fourteenth-highest of S&P’s 21 ratings categories. Moody’s states that insurance companies rated “B” (Poor) offer questionable financial security. The “B” (Poor) range is the sixth-highest of nine financial strength rating ranges assigned by Moody’s, which range from “Aaa” to “C.” ;umeric modifiers are used to refer to the ranking within the group, with 1 being the highest and 3 being the lowest. These modifiers are not added to ratings in the “Aaa” category or to ratings below the “Caa” category. Accordingly, the “B2” and “B3” ratings are the fifteenth- and sixteenth-highest of Moody’s 21 ratings categories. A.M. Best, S&P and Moody’s review their ratings periodically and the Company cannot guarantee that it will maintain its current ratings in the future.
  14. 14. MA AGEME T’S DISCUSSIO A D A ALYSIS 14 RESULTS OF OPERATIO S The Company’s operating results for years ended December 31, 2017 and 2016 were as follows (in millions): 2017 2016 $ Change % Change REVE UES Premiums and annuity considerations $ 2,308.7 $ 2,084.8 $ 223.9 10.7 % Considerations for supplementary contracts with life contingencies 25.5 25.9 (0.4) (1.5)% ;et investment income 1,810.9 1,814.9 (4.0) (0.2)% Amortization of interest maintenance reserve 70.0 64.3 5.7 8.9 % Commission and expense allowances on reinsurance ceded 151.9 534.1 (382.2) (71.6)% Reserve adjustments on reinsurance ceded (287.7) (51.6) (236.1) ;M (1) Other income 1.3 4.1 (2.8) (68.3)% TOTAL REVE UES 4,080.6 4,476.5 (395.9) (8.8)% BE EFITS Death benefits 140.8 164.0 (23.2) (14.1)% Annuity benefits 503.1 485.9 17.2 3.5 % Disability benefits and benefits under accident and health policies 1,771.9 1,634.0 137.9 8.4 % Surrender benefits and other fund withdrawals 569.4 473.9 95.5 20.2 % Payments on supplementary contracts with life contingencies 27.9 30.4 (2.5) (8.2)% Interest and adjustments on contracts or deposit-type contract funds 24.1 27.0 (2.9) (10.7)% Increase in aggregate reserves – life, annuity, and accident and health 547.1 1,567.0 (1,019.9) (65.1)% TOTAL BE EFITS 3,584.3 4,382.2 (797.9) (18.2)% EXPE SES Commissions 220.8 354.2 (133.4) (37.7)% General insurance expenses 270.1 340.3 (70.2) (20.6)% Insurance taxes, licenses, and fees, excluding Federal income taxes 66.3 62.4 3.9 6.3 % ;et transfer from separate accounts (1.9) (0.7) (1.2) (171.4)% Change in reserve/Modco adjustment reinsurance — (329.7) 329.7 100.0 % Gains released from interest maintenance reserve related to reinsurance — (282.4) 282.4 100.0 % Increase in loading 0.9 14.3 (13.4) (93.7)% TOTAL EXPE SES 556.2 158.4 397.8 ;M (1) TOTAL BE EFITS A D EXPE SES 4,140.5 4,540.6 (400.1) (8.8)% Loss before Federal income taxes and realized capital losses, net (59.9) (64.1) 4.2 6.6 % Federal and foreign income tax (benefit) (32.9) (69.4) 36.5 52.6 % (Loss) income before realized capital losses, net (27.0) 5.3 (32.3) ;M (1) Realized capital losses, net (12.1) (44.4) 32.3 72.7 % ET LOSS $ (39.1) $ (39.1) $ — 0.0 % (1)“;M” is defined as not meaningful for increases or decreases greater than 200%. Total Company Overview Revenues Premiums and annuity considerations Premiums and annuity considerations increased $223.9 million primarily driven by increases of $318.1 million from the impact of the GLAIC ULModco Treaty Recapture in 2016 and $263.4 million from the impact of the GLAIC SPDA Modco Treaty Recapture in 2017, partially offset by a decrease of $304.4 million from the initial premium paid on the GLAIC Life April 1, 2017 Treaties. Commissions and expense allowance on reinsurance ceded Commissionsandexpense allowanceonreinsurance cededdecreased$382.2millionprimarilyattributabletothe $376.2 million impact from the recapture of the majority of the TLC product ceded to GLAIC in the third quarter of 2016.
  15. 15. MA AGEME T’S DISCUSSIO A D A ALYSIS 15 Reserve adjustments on reinsurance ceded Reserve adjustments on reinsurance ceded decreased $236.1 million primarily attributable to the $263.4 million impact of the GLAIC SPDA Modco Treaty Recapture in 2017. Benefits Increase in aggregate reserves - life, annuity, and accident and health The increase in aggregate reserves for life, annuity and accident health policies decreased $1,019.9 million. Long-term care insurance products decreased $506.6 million primarily driven by a $431.9 million unfavorable adjustment in 2016 resulting from the annual claim reserve review, an $80.5 million decrease in reserves as a result of policyholders electing reduced benefit options as a result of in-force rate actions approved and implemented, $65.8 million in unfavorable claim reserve refinements recorded in the second quarter of 2016 and higher claim terminations, partially offset by aging and growth of the in-force block and higher severity on new claims. Life insurance products decreased $380.1 million primarily due to the $304.5 million in reserves ceded on the GLAIC Life April 1, 2017 Treaties as of December 31, 2017 and the $298.0 million impact from the GLAIC UL And TLC Recaptures in 2016, partially offset by the $215.4 million impact from the GLAIC Term Life Treaty Recapture in 2016. Fixedannuityproductsdecreased$172.3millionprimarilyattributableanincreaseinsurrenderbenefitsfromarelatively large block exiting the surrender charge period in 2017 and a decrease in direct premiums as a result of the suspension of sales in 2016, partially offset by the $25.8 million impact of the GLIC;Y SPDAAnd SPIA Recapture in 2016. Corporate-owned life insurance products increased $39.0 million mainly due to the surrender benefits paid in 2016 and growth in account value. Disability benefits and benefits under accident and health policies Disability benefits and benefits under accident and health policies increased $137.9 million primarily driven by aging and growth of the in-force block and higher severity on new claims, partially offset by higher claim terminations. Surrender benefits and other fund withdrawals Surrender benefits and other fund withdrawals increased $95.5 million mainly from a $125.7 million increase in fixed annuity products as a result of a relatively large block exiting the surrender charge period in 2017, partially offset by a $28.1 million decrease in corporate-owned life insurance from a group policy lapsing in 2016. Expenses Change in reserve/Modco Adjustment reinsurance Change in reserve/Modco Adjustment reinsurance decreased $329.7 million primarily due the $318.1 million impact of the GLAIC UL Modco Treaty Recapture. Gains released from IMR related to reinsurance GainsreleasedfromIMRrelatedtoreinsurance decreased$282.4million.During2016,the Companyterminatedcertain forward starting swaps and sold certain TIPS included in the Company’s long-term care insurance investment portfolio, resulting in pre-tax net gains of $849.2 million, or $552.0 million after-tax, which were recorded to IMR. After-tax gains of $276.0 million were released from IMR related to reinsurance in 2016. Commissions Commissions decreased $133.4 million primarily attributable to the $100.0 million impact of the GLAIC ULAnd TLC Recaptures in 2016 and the $27.5 million impact of the GLIC;Y SPDAAnd SPIATreaty Recapture in 2016 and lower commissionsdrivenbythe decreaseinproductionforlong-termcareinsurance,lifeinsuranceandfixedannuityproducts in 2017, partially offset by the $16.2 million impact of the GLAIC UL Modco Treaty Recapture in 2016. Overview by product Long-term care insurance Loss before taxes for long-term care insurance decreased $215.1 million from a loss before taxes of $355.2 million for the year ended December 31, 2016 compared to $140.1 million for the year ended December 31, 2017. The decrease was primarily attributable to higher claim reserves of $431.9 million in 2016 resulting from the annual claim reserve review completed in the third quarter of 2016, a $94.6 million increase in premiums and an $80.5 million decrease in the change in reserves as a result of policyholders electing reduced benefit options, both as a result of in-force rate actions approved and implemented and $65.8 million in unfavorable claim reserve refinements recorded in the second quarter of 2016, partially offset by a $282.4 million decrease in after-tax gains released from IMR related to reinsurance in 2016 as described above and higher severity on new claims.
  16. 16. MA AGEME T’S DISCUSSIO A D A ALYSIS 16 Life insurance Income before taxes for life insurance decreased $215.6 million from income before taxes of $232.8 million for the year ended December 31, 2016 compared to $17.2 million for the year ended December 31, 2017. The decrease was primarily attributable to a $215.4 million impact of the GLAIC Term Life Treaty Recapture in 2016. Fixed annuities Income before taxes for fixed annuities decreased $3.1 million from income before taxes of $60.4 million for the year endedDecember 31,2016 compared to$57.3 millionfor the year ended December 31,2017.The decreasewas primarily driven by the $4.3 million impact of the GLAIC SPDA Modco Treaty Recapture in 2017. Institutional Institutional had a loss before taxes of $3.5 million for the year ended December 31, 2017 compared to income before taxes of $1.2 million for the year ended December 31, 2016. The $4.7 million change was primarily due to a decrease in net investment income. Corporate-owned life insurance Income before taxes for corporate-owned life insurance increased $6.3 million from income before taxes of $14.0 million for the year ended December 31, 2016 compared to $20.3 million for the year ended December 31, 2017. The increase was driven by lower death benefits paid and lower general insurance expenses. Corporate Loss before taxes for corporate decreased $6.6 million from a loss before taxes of $17.6 million for the year ended December 31, 2016 compared to $11.0 million for the year ended December 31, 2017. The decrease was due to a decrease in net investment losses and a decrease in insurance taxes, licenses and fees. Other accident and health insurance Other accident and health had a loss before taxes of $0.1 million for the year ended December 31, 2017 compared to income before taxes of $0.3 million for the year ended December 31, 2016. The $0.4 million change was primarily driven by a decrease in net investment income due to runoff of the in-force block. CASH FLOWS A D LIQUIDITY The Company’s cash flow for the years ended December 31, 2017 and 2016 are summarized below (in millions): 2017 2016 $ Change % Change ;et cash provided by operations $ 599.6 $ 626.5 $ (26.9) (4.3)% ;et cash applied to investment activities (215.4) (669.8) 454.4 67.8 % ;et cash applied to financing and miscellaneous sources (370.5) (109.0) (261.5) ;M (1) ;et change in cash, cash equivalents and short-term investments $ 13.7 $ (152.3) $ 192.9 109.0 % (1) “;M” is defined as not meaningful for increases or decreases greater than 200%. The Company’s cash flow needs are generally met by cash provided by operations. Premiums are invested in assets that generally have durations similar to the Company’s liabilities. Principal sources of funds include premiums and other consideration received, contract charges earned and net investment income received. Investment proceeds generated from securities called, redeemed, prepaid, matured and sold, in addition to principal and interest payments received are generally reinvested. The Company maintains a primarily liquid investment portfolio. The Company has no material liquidity or capital commitments coming due in the next 12 months. Furthermore, the Company has no material long-term commitments impacting liquidity or capital other than those related to normal business operations. The Company’s subsidiaries have no capacity to make a dividend payment without prior approval in 2018. The decrease of $26.9 million in net cash provided by operations was mainly due to a $282.2 million increase in commissions, expenses paid and aggregate write-ins for deductions, higher benefit and loss related payments of $259.9 million and a $12.7 million decrease in miscellaneous income. These were partially offset by a $242.6 million increase in premiums collected net of reinsurance, a $240.3 decrease in Federal taxes paid, and a $44.2 million increase in net investment income. The decrease of $454.4 million in net cash applied to investment activities was mainly from a $1,961.0 million decline in investments acquired and an $82.5 million lower net increase in contract loans, partially offset by a decrease in investment proceeds of $1,589.1 million. The increase of $261.5 million in net cash applied to financing and miscellaneous sources was primarily attributable to a $148.0 million increase in cash applied to net deposits on deposit-type contracts and a $142.7 million increase in other cash applied. Securities Lending The Company participates in a program managed by an unaffiliated financial institution in which it lends securities to brokers or other parties. The securities are re-registered but remain beneficially owned by the Company. As collateral for the loan, the borrower provides cash or government securities, on a daily basis, in amounts equal to or exceeding
  17. 17. MA AGEME T’S DISCUSSIO A D A ALYSIS 17 102% of the fair value of the applicable securities loaned. ;one of the collateral is restricted. Cash collateral received is recorded in securities lending reinvested collateral and the offsetting liabilities are recorded in payable for securities lending. There were no securities lending collateral for transactions that extend beyond one year from the reporting date and there were no securities loaned in the Company’s separate accounts. As of December 31, 2017 and 2016, the fair value of loaned securities was $186.4 million and $334.4 million, respectively, and the fair value of the collateral held was $193.3 million and $345.1 million, respectively. Federal Home Loan Bank (“FHLB”) Funding Agreements The Company is a member of the Federal Home Loan Bank of Pittsburgh (“FHLB Pittsburgh”). As of December 31, 2017, the Company had outstanding funding agreements with FHLB Pittsburgh of $254.0 million which related to total liabilities of $254.6 million. As of December 31, 2016, the amount of funding agreements issued to FHLB Pittsburgh was $254.0 million, which related to total liabilities of $254.4 million. The Company uses these funds in an investment spread strategy, consistent with its other investment spread programs. The Company records the funds under SSAP ;o. 52, Deposit Type Contracts, consistent with its accounting for other deposit type contracts. It is not part of the Company’s strategy to utilize these funds for operations, and any funds obtained from the FHLB Pittsburgh for use in general operations would be accounted for under SSAP ;o. 15, Debt and Holding Company Obligations, as borrowed money. The Company has determined the actual or estimated maximum borrowing capacity in accordance with FHLB Pittsburgh regulatory and or specific borrowing limits.

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