The Phoenix Companies, Inc. Q2 2009 Earnings Call Transcript

Aug. 4.09 | About: The Phoenix (PNX)

The Phoenix Companies, Inc. (NYSE:PNX)

Q2 2009 Earnings Call

August 4, 2009 11:00 am ET

Executives

Naomi Kleinman - IR

Jim Wehr - Chief Executive Officer

Peter Hofmann - Chief Financial Officer

Chris Wilkos - Chief Investment Officer

Analysts

Bob Glasspiegel - Langen McAlenney

Steven Schwartz - Raymond James & Associates

Donna Halverstadt - Goldman Sachs

Eric Berg - Barclays Capital

Richard Spashing - Hovde Capital

Jason Nelson - Rumel Asset Management

Craig Carlozzi - Mast Capital Management

Bob Glasspiegel - Langen McAlenney

Steven Schwartz - Raymond James

Operator

Welcome to the Phoenix second quarter 2009 Earnings Call. (Operator Instructions).

I will now turn the call over to the Head of Phoenix Investor Relations, Naomi Kleinman. You may begin.

Naomi Kleinman

Good morning and thank you for joining us. I am going to start with the required disclosures and then turn it over to Jim Wehr, our President and CEO, for an overview of the quarter.

With us today are Peter Hofmann, Chief Financial Officer. Phil Polkinghorn, Senior Executive Vice President for Life and Annuity, Chris Wilkos, Chief Investment Officer, and Dave Pellerin, Chief Accounting Officer.

Our second quarter earnings release, our quarterly financial supplement and the second quarter earnings review presentation are available on our website at phoenixwm.com.

Slide 2 of the presentation contains the important disclosures. We may make forward-looking statements on this call that are subject to certain risks and uncertainties. These risks and uncertainties are discussed in detail in our second quarter earnings release and our latest SEC filings. Our actual results may differ materially from such forward-looking statements. In addition to Generally Accepted Accounting Principles, we use non-GAAP financial measures to evaluate our financial results; reconciliations of these non-GAAP financial measures to the applicable GAAP measures are included in our press release and financial supplement.

Now, I will turn the call over to Jim.

Jim Wehr

Good morning and thank you for joining us for our report on the second quarter. As we have done before, I will give my high level perspective on the results, Peter will provide the financial details and then Chris will take you through the investment portfolio, which continues to be an important part of our story.

Let me say upfront that we feel more confident about many aspects of our business in this quarter compared to how we felt at the beginning of the year but clearly repositioning Phoenix, particularly in this economic environment, is not an easy thing to do. We have many activities underway that will benefit the company financially and therefore shareholders but it will take more time. We don't want to make promises, we want to deliver and we expect to deliver more fully in the third and fourth quarters.

Let me take you through the highlights from the second quarter. In short it was a mixed quarter. There were some favorable developments that started to materialize but also a number of challenges. This is reflected in our reported net loss of $111.2 million, as well as an operating income of $14.4 million, excluding unusual items that affected income. As I go through the quarter, I will note where we made progress and where the challenges remain, and I will do that within the context of the four pillars of our strategy, the four are: a healthy balance sheet; policyholder security; expense reductions, and a sustainable growth strategy that maximizes our core strengths and capabilities.

First, what is favorable? There were several positives in the quarter starting with the progress on our first pillar, maintaining a healthy balance sheet, to that end, our investment portfolio showed clear signs of improvement. Unrealized losses were $500 million lower than in the first quarter, Chris will update you on another $220 million of appreciation in the month of July. Impairments improved and our structured securities portfolio held up well relative to the industry. We maintained adequate liquidity at the Life Company and substantially increased the level of cash and securities at the holding company. At the end of the quarter we had 12% of the fixed income portfolio invested in the most highly liquid instruments. Clearly we are moving toward a 10% liquidity target, which means we will be investing money into investment grade bonds and private placements during the third quarter.

We also settled an inter-company tax receivable between the holding company and the downstream subsidiary of Phoenix Life, which was triggered by the Virtus spin-off. As of June 30, the holding company has approximately $89 million in cash and securities. To give you a sense of our cash needs at the holding company, we expect an annual run rate for interest and operating expenses of roughly $26 million. Our debt-to-capital ratio remains relatively low at 23.6% and we do not have any debt maturing until 2032.

We also have a good story to tell in the quarter relating to our second pillar, policyholder security. Our active outreach to policyholders and producers has been effective as evidenced by Life surrenders trending down during the quarter from a spike in March and Annuity surrender levels improving overall from the first quarter. Both Life and Annuity surrenders remain within manageable levels.

During the quarter, we held two webinars for producers and sent more than 50,000 letters to policyholders detailing our financial strength and commitment to a strong balance sheet. We believe giving people facts can help counter motion and allow them to make informed decisions. We have also restructured an agreement with State Farm to service 90,000 Phoenix policies and contracts sold through State Farm's distribution system. This block of business has a better persistency rate than the company average and this restructured agreement ensures that State Farm's clients and agents will continue to receive the support they need to maintain their Phoenix policies. The restructured agreement does not include any new sales of Phoenix products through the State Farm distribution system.

Our third pillar, reducing expenses, also falls into the favorable category even though the significant actions we took do not show up in this quarter's earnings, and let me add, they certainly were not easy or pleasant to do. Specifically we have essentially completed a workforce reduction of more than 35% and as a result we have increased our annualized expense reduction target to $110 million. We will not realize the full benefit of these reductions until the fourth quarter.

Also keep in mind that these are cash expenses and under GAAP accounting the impact is muted due to deferrals and amortization. As I just said, these reductions were painful but necessary. Everyone, at Phoenix has an increased sense of urgency around what we must accomplish this year. We know that this is the year we have to hunker down, retain our financial health and stability and also pursue our business strategy with precision and focus.

Now, some of the more challenging aspects of the quarter; mortality was poor in the UL line with a larger than usual number of claims greater than $2 million. The nature of our business creates spikes like these every once in a while as was the case in the first quarters of 2008 and 2006. In other words we do not believe the mortality this quarter signals any underlying issue with the quality of our UL business. I should remind you that in the four previous quarters we had favorable mortality experience.

The Closed Block claims were moderately higher but mortality in our other lines of business was broadly within our expectations. Sales also fell into the challenging category as they continued to decline this quarter although the average face amount for Life sales remains high at $850,000, this lower level of business was a major driver in our efforts to adjust expenses downward. I should point out that taxes were challenging to our GAAP results this quarter as well, operating income includes a significant tax adjustment that Peter will cover in a few minutes.

Finally, turning to statutory results, statutory earnings were affected by lower earnings at Universal Life, losses in Alternative Investments and additional reserves we had to put up due to adverse developments related to our Group, Accident and Health reinsurance business. This decline, alongwith modest impairments and losses on derivatives associated with our Annuity block, contributed to our surplus declining by approximately $90 million. In turn this affected our RBC, which as of June 30, is estimated at 260%, down from an estimated 275% at the end of the first quarter and 338% at the end of 2008. Our RBC target remains 300%. We have several capital initiatives underway, largely focused on reinsurance and reduced risk, so we expect to meet our target by year end.

I also want to note a few things outside of our control that had a significant impact on our results during the quarter. I am speaking of two things; the general economic conditions that remain unstable, and the wholesale ratings downgrades of entire sectors of fixed income securities, Chris will give you more detail on how these downgrades affected our portfolio. Overall this one-two punch makes our other challenges more difficult, particularly as it relates to RBC. We remain focused on controlling what we can and managing through this period of instability.

I want to end by putting a little more detail around where we are in executing our new business strategy but let me repeat what I said at the start of these remarks, and that is, we do not make promises about performance or progress on anything before we have something concrete to say. We are being thoughtful and disciplined and are not compromising our commitment to capital preservation and expenses, those remain our top priorities. Having said that, our growth strategy is focused on leveraging our core strengths and capabilities; for example, we continue to see that the marketplace values are distribution capabilities and all that that entails, including our knowledge of the market, proven ability to sell and quality of service.

While I am not ready to share details but we are encouraged by the discussions we have had with a number of potential distribution partners. We are also continuing to look for opportunities to leverage our product manufacturing and administrative expertise, including private label relationships and we are pursing distribution sources that are less sensitive to rating for alternative retirement solutions products. At the same time we are adjusting our product portfolio through the planned withdrawal of our capital-intensive term and secondary guarantee UL products, as well as, introducing an innovative joint first-to-die UL product and our distribution team remains focused on expanding relationships with independent marketing organizations and other new distribution sources for our products.

In the third quarter I hope to be able to say more about each of these. In the meantime I want to convey how pivotal 2009 is for us. It has challenges but also opportunities. We are confident that we are taking the right actions to retain our financial health and stability and that we will turn this company around. Now, here is Peter.

Peter Hofmann

Thanks Jim and good morning to everyone. If you would turn to slide 4 of the presentation it shows a summary of the second quarter results. Again, we had an operating loss of $16 million or $0.14 per share, excluding the impact of the tax valuation allowance increase, as well as, severance and non-deferred sales-related costs, operating income was $14.4 million or $0.12 per share. The key business drivers of the second quarter were as follows; first, a favorable impact from the 15% appreciation in the equity markets particularly flowing through the Annuity line. Adverse mortality in UL was a negative and still weak though improved net investment income driven by continued pressure [on] alternative asset returns also is a negative. Margin compression as we are taking expense reductions are not yet fully reflected in the results.

On the flipside we have had improvements in our investment portfolio reflected in lower realized and unrealized losses and we had the addition to the reserve for our discontinued Group, Accident and Health reinsurance business.

Slide 5 shows the trend in operating earnings over the last several quarters. You can see that, aside from the tax valuation allowance increase and the costs associated with reducing expenses, our operating trends improved modestly from the first quarter. Book value per share increased 6.6% from March 31, driven primarily by appreciation in the investment portfolio.

On slide 6 is a more detailed earnings summary. I will just go through some of the items. Revenues in the Open Block were stable versus the first quarter and reflect lower premiums, still weak but improving net investment income and higher fees. Benefits and reserves increased due to the poor mortality in our Universal Life block. DAC amortization was primarily due to the good performance in Annuities. The regulatory Closed Block contribution remains table and consistent with the glide path for the block but recall that this line does not include any operating expenses.

The effective tax rate reflects the impact of a number of significant GAAP tax adjustments and I will go through those in a moment. In addition to impairments, realized losses included transaction losses and results from our living benefit hedges. The hedges performed well, the losses were entirely due to the FAS 157 non-performance risk factor, which basically requires us to reflect Phoenix's credit risk in the calculation of the liability.

The net loss in discontinued operations includes the $25 million in incremental reserves; this has largely resulted from adverse arbitration developments in the quarter. While it is unfortunate to have this issue arise after we successfully mitigated these exposures over the past 10 years we believe that our current net reserves, which stand at $32 million, are adequate for future claims. That said, this is a long-tail business and we cannot categorically rule out charges in future periods.

Now, since the fourth quarter we have been dealing with a number of complex GAAP accounting issues related to tax accounting under FAS 109, which even though they are entirely non-cash in nature have made it difficult to interpret our financials. The underlying reason for this is that since year-end we have had very limited ability to rely on long-term projections or tax planning strategies to support our deferred tax assets. We think it is important for you to understand what is going on, so I will spend a few minutes on slide 7.

You can see in the top table that at June 30th, we had a net deferred tax asset on the balance sheet of $678.7 million against which we had an aggregate valuation allowance of $433.7 million. The second quarter includes an incremental valuation allowance of $42 million, which is a net number reflecting pluses and minuses flowing through operating earnings, realized losses, discontinued operations and OCI, the $19 million that we mentioned earlier is part of this $42.5 million.

The GAAP tax valuation allowances have no bearing on whether deferred tax assets will ultimately will be available to be utilized. We believe that our tax attributes still have substantial value. The bottom panel breaks out the details of those attributes. It shows that, at this time our NOL tax credit and capital loss carry-forwards are fully offset by the valuation allowances. It also underscores that substantial time remains for us to ultimately recognize these benefits.

There are three implications of all of this for our tax expense; first, to the extent that we have positive earnings we will, in essence, report a zero-effective tax rate, any emerging tax expense will be offset by the release of a valuation allowance. Second, to the extent that we have losses we will not have the ability to recognize tax benefits against those losses because we will have to put up immediate valuation allowances for any tax benefit. Third, it is quite possible that FAS 109 will create further income statement noise as elements of the valuation allowance have the potential to get reclassified among different categories.

Moving on now to slide 8 which details expenses for the past five quarters, there are a few key points on this slide. First of all, we have significantly reduced the level of deferrals in 2009 to reflect our lower sales volumes and you can see that emerging in the orange bar. The actions taken to-date are not yet fully reflected in our reported results. It will not fully emerge until the fourth quarter and beyond. We expect fourth quarter total expenses before deferrals to be more than $20 million below last year's fourth quarter, however, a significant portion of the reductions will be in expenses that would otherwise have been deferred. So, reported GAAP expenses will decline more modestly. While we have substantially completed our planned staff reductions, we continue to pursue a variety of non-staff related expense reductions, which will benefit us in 2010 and factor into the target that Jim mentioned earlier.

Turning to the mortality results on slide 9. Margins in our VUL block were in line with expectations, however, as already discussed, UL mortality was poor. This was again, largely driven by a small number of large claims. The estimated impact of this excess was $18 million before taxes. With new business volumes declining we do expect mortality margins to begin decreasing. Our expected margins for the remainder of the year are approximately 45% in Universal Life and 55% in Variable Universal Life.

As Jim mentioned earlier, we continue to very closely watch persistency and slide 10 shows annualized aggregate surrender rates based on fund value surrendered. Again, experience can differ significantly by block of business. Life surrenders have increased over the past three quarters modestly and remain at manageable levels. Annuity surrenders have been more volatile, partially because we include our discontinued products and private placement contracts at Philadelphia Financial Group in this measure.

It is important to recognize that from a general account liquidity perspective these numbers do not represent cash out the door because in many cases there are loans outstanding against the policies, as well as, surrender charges due upon surrender. In addition, the measures include separate account surrenders, which don't affect our general account liquidity.

Let's move to realized losses on slide 11, this is another complex picture. Chris will cover the impairments and transaction losses in the portfolio and let me just comment on one other area, specifically, you can see that our hedging program had a $11 million gain in the quarter, which was offset by the FAS 157 non-performance risk factor. So, when you net those two lines we recorded a realized loss on the hedging program of $34.4 million for GAAP purposes.

The statutory results are summarized on slide 12. Surplus for Phoenix Life decreased $90 million primarily as a result of unrealized derivative losses, negative alternative asset returns, adverse mortality in UL, and the discontinued reinsurance reserve. RBC for Phoenix Life decreased to an estimated 260%. The year-to-date statutory gain from operations for Phoenix Life was $9 million, which does reflect the impact of discontinued reinsurance reserve.

Our leverage remains modest even with declines in GAAP book value as we continue to repurchase our debt in the open market, through the second quarter, we cumulatively have repurchased and effectively retired $30.5 million par of our $300 million senior debt issued. In addition, our holding company liquidity was strengthened, as Jim already mentioned, through a $74 million inter-company tax settlement in the quarter.

Slide 13 shows the major components of the decline in our estimated RBC ratio. Note that approximately half the decline is due to rating downgrades in the Bond portfolio, which was more than offset by high-yield bond sales during the quarter. As Jim mentioned our RBC targets for year-end is 300%, our main focus to achieving this will be on pursuing reinsurance option, optimizing our internal capital management and reducing risk.

With that, let me turn it over to Chris.

Chris Wilkos

Thanks Peter. Investment markets improved markedly during the second quarter and the Phoenix portfolio benefited from that improvement. I plan to cover four topics on today's call that reflect improved performance in our portfolio. The first is an attribution of our investment income results for the quarter. The second is a review of our second quarter credit impairments and trends in the level of unrealized portfolio losses. The third is an analysis of our portfolio quality and liquidity and finally, a review of our RMBS and CMBS portfolio holdings.

Let's start with net investment income on slide 14. Net investment income increased by a total of $9.5 million from the first quarter to the second quarter and was higher in both the Open and Closed blocks. Open block investment income increased for the second straight quarter. The increase in investment income was attributable to a reduction in losses from our venture capital and other invested asset segments, which comprise 5% of our portfolio. The first quarter was particularly difficult for alternative asset classes and while the second quarter still showed losses we have seen an improvement in these markets that has paralleled the substantial improvement in equity and credit markets but because of the one-quarter lag in partnership accounting, improvements in alternative returns have not fully materialized through our income statement. Investments in private equity mezzanine funds and other partnership assets have been volatile over the last 18 months but have produced superior returns relative to bonds over long time periods and we expect that trend to continue.

Slide 15 shows second quarter credit impairments by sector compared to our fourth quarter '08 and first quarter '09 results. Credit impairments declined sequentially for the second straight quarter dropping to $20.9 million from $38.3 million in the first quarter. In addition to these impairments we also had another $7 million of losses from sales of distressed assets, both debt and partnership impairments decreased.

In the fixed income portfolio, corporate bonds accounted for 24% of impairments, while mortgage securities comprised of prime, Alt-A and subprime accounted for 39% of impairments, the balance came from collateralized loan obligations. Our private placement bond portfolio, which comprises almost 30% of our fixed income portfolio had no impairments during the quarter, reflecting the benefits of covenants and other protections inherent in those securities. We have almost no exposure to commercial mortgage whole loans and therefore do not have any impairments in that category.

Slide 16 shows that the Phoenix fixed income portfolio had a substantial decrease in unrealized losses during the second quarter consistent with the significant improvement in credit spreads in all risk sectors. Unrealized losses declined by over $500 million or about one-third. The extreme fear and pessimism that created depressed valuations and high-liquidity premiums earlier this year has clearly begun to subside. 60% of the unrealized losses in our portfolio are attributable to investment-grade rated securities, which have extremely low historical default rates. Only 15% of the unrealized losses are attributable to securities rated single-B or below, given the strong performance of the credit markets in July, we estimate that our unrealized loss position further improved by over $220 million since quarter end, dropping the net unrealized loss to about $850 million. This trend in lower unrealized losses has increased the liquidity of our portfolio as more securities can be sold at prices that are at or exceed their accounting values.

On slide 17, the impact of continued significant market downgrade activity has been to increase our portfolio's percentage of below investment grade bonds to 10.5% of total bonds up from 10.2% at the end of the first quarter. This result is slightly above the top of our allocation range for below investment grade holdings. The fact that almost 60% of our below investment grade allocation is rated NAIC 3 or BB should be viewed as a positive as historical BB default rates are a fraction of the overall high-yield default rate. Given the recent strength in the below investment grade market we actively worked to reduce our below investment grade holdings during the second quarter. On a GAAP basis we sold $160 million of high-yield bonds but we also experienced $129 million of downgrades to below investment grade. In total, our overall high-yield percentage increased slightly due to the significant and higher market appreciation in our remaining below investment grade holdings compared to the portfolio overall.

As you are aware, the NAIC rules require us to use the lower of two ratings when a security is split-rated. Given changes in rating agency methodologies for valuing many securities since year end and the requirement to use the lower rating, we ended up with 10.5% below investment grade securities. In contrast, using either a Standard & Poor's or Moody's rating, individually, would drop the percentage of below investment grade securities below 10% and using the higher of either of the ratings would produce a further decline in the below investment grade percentage. The percentage of below investment grade bonds is really a range, which depends on which rating is used. In today's environment of differing views among agencies that point is important in viewing portfolio quality.

Slide 18 provides an update on liquidity in our portfolio at quarter end. For the past 15 months, we have believed that having ample liquidity was an essential priority given the severe recession and the credit market freeze, as well as, preparing for potentially elevated surrender activity. During the past year we increased the percentage of our investments in two extremely liquid market segments; we increased our short-term cash and treasury position, and doubled our allocation to agency mortgage-backed securities, which are also very high quality and extremely liquid. The net effect of our actions has been to more than double liquidity from a normal 5% allocation to 12.4% at quarter end. Given the improved liquidity in the fixed income market and the appreciation in our portfolio values combined with the recent declines in our surrender activity, we have begun reducing our overall liquidity position during the third quarter. We are currently moving toward a 10% liquidity target, that percentage would be about where our liquidity metric was at the end of the first quarter of 2009. We are also redeploying a portion of our cash and short term treasury position into agency mortgage-backed securities, a move that will result in a yield pickup of about 450 basis points.

Slide 19 summarizes our non-agency residential mortgage holdings by borrower type, credit quality, vintage and collateral type, the factors that drive the ultimate performance of residential mortgage securities. Not much has changed in our mortgage-backed securities portfolio in the last several quarters. The Phoenix portfolio remains very high quality, seasoned, and has a substantially higher amount of fixed rate mortgages compared to the market overall. We believe those factors drive relative performance and the percentage of delinquent loans in our RMBS portfolio is about half of the market delinquency rate for each of the categories in the table above.

Slide 20 provides performance data on our commercial mortgage-backed securities portfolio. We have compared our CMBS holdings to a peer group analysis of nine publicly traded insurers that was recently completed by Eric Berg of Barclays. Our CMBS portfolio is characterized by its seasoning with an average loan age of over seven years. We avoided much of the aggressive underwriting of the 2006 through 2008 period, the portfolio is also highly rated with 91.5% AAA and AA rated securities and less than 2% of holdings in BBB or lower rated bonds.

This analysis compares the percentage of select watchlist loans in each insurer's underlying CMBS holdings with the weighted average credit enhancement of those holdings. In terms of exposure to select watchlist codes, Phoenix's portfolio is near the top of the peer group. Our overall weighted average credit enhancement is first among this peer group at 31%. Dividing the credit enhancement by the percentage of watchlist loans produces a coverage ratio of 3.57 times for the Phoenix portfolio, indicating that we have over 3.5 times coverage if the watchlist loans turn into problems. This high level of coverage is indicative of the seasoning and quality of our portfolio and ranks best among those peers. We believe this type of analysis illustrates the strength of the Phoenix CMBS portfolio.

Question-And-Answer Session

Operator

(Operator Instructions). Our first question comes from Bob Glasspiegel, Langen McAlenney.

Bob Glasspiegel - Langen McAlenney

I was wondering if you guys can give me some more color on the discontinued reinsurance, specifically what happened on the arbitration, how many more arbitrations are outstanding? Any help on how we should think about this going forward would be appreciated.

Jim Wehr

Bob, I am going to ask Dave Pellerin to respond to that.

Dave Pellerin

In terms of the discontinued reinsurance situation we had a settlement in the quarter relating to a dispute that had been subject to arbitration proceedings and that was certainly a contributing factor to the decision to increase reserves in the quarter. In terms of remaining disputes, you will recall perhaps that this is legacy business and over the past 10 years we have successfully, in most cases, mitigated our exposure through a combination of arbitration proceedings and commercial settlements. We have a handful of disputes that I would characterize as active at this stage. We are clearly at the tail-end of the exposure, at this point our reserves reflect our current best estimates and terms of active arbitrations, there are two in particular that are likely to occur out in 2010, but we are at a quite preliminary stage in terms of discovery.

Bob Glasspiegel - Langen McAlenney

Have you done an external review for the reserves on this [book]?

Dave Pellerin

The significant exposure in the book of business related to a pool, referred to as (inaudible) and that particular exposure has been regularly reviewed on an annual basis since 1999 and indeed that exposure has been quite benign in recent years. The remaining disputes tend to be outliers in the sense that they relate to a similar type of business that was written in the same timeframe, however, did not throw out the level of volume and scrutiny, shall we say, as [bad as] like Unicover, and it is really cleaning up those outlier exposures that we are talking about here.

Bob Glasspiegel - Langen McAlenney

Thank you very much. Jim, good luck on the four pillars up from, I guess the three prongs before. Good luck.

Jim Wehr

Thanks Bob.

Operator

Our next question comes from Steven Schwartz, Raymond James & Associates.

Steven Schwartz - Raymond James & Associates

Quick follow-up, so Unicover is a name I haven't heard in a while. So, everything outstanding here is some type of [spiral] business in the London market?

Dave Pellerin

This is Dave Pellerin again. As I indicated, we are not speaking of Unicover here and for (inaudible) of the exposure, technically we are not talking purely about London market [spiral] either, we are talking about workers' compensation carve-out business that was contributing to Unicover and for that matter to the London market [spiral] business we were in the mid to late 1990s. So this particular dispute resolved in the quarter had aspects of those characteristics but I wouldn't characterize it purely as London market [spiral].

Peter Hofmann

Can I just add one comment and I may be saying something a bit non-technical here and Dave will correct me but one of the features of this arbitration and one of the upshots of these arbitration proceedings was that claims that had been in essence held up over the course of the arbitration, for multiple years, in essence got unclogged, if you will, and started being presented to the reinsurers in retrocessionaires. So, there is a bit of a, I characterize it as sort of an elephant through the snake aspect to this, that is a lot of it, but it is not all of it but I think that is important to understand as these disputes get resolved, there is a bit of a sort of a clog running through the [grime] type of analogy.

Steven Schwartz - Raymond James & Associates

Okay, if I may go on to my two, a couple here, first Peter, you made a statement that, because new business is coming down, the margins on UL and VUL are expected to come down, if you could explain that to us, I would appreciate it, that is slide 9, I guess. Then on slide 14, I am just trying to get a handle here, the alternative investment income, is that the other invested assets plus the venture capital?

Peter Hofmann

That's right.

Steven Schwartz - Raymond James & Associates

Okay. Just to keep on that for a second here, Peter, I don't really care about the Closed block, right, because that comes out of the dividends?

Peter Hofmann

The Closed block net investment income currently to the degree that there are losses, and we're talking on a GAAP basis now, those get absorbed by the policyholder dividend obligation. Once that policyholder dividend obligation reaches zero and it has been declining, then any additional losses would flow through the GAAP earnings that you see. So for now, you are right, it doesn't factor into the bottom line but we cannot indefinitely continue to see losses in the Closed block.

Steven Schwartz - Raymond James & Associates

How much is the policyholder dividend obligation now?

Peter Hofmann

I don't have the number at my fingertips but I want to say it is less than $30 million.

Steven Schwartz - Raymond James & Associates

Okay. All right...

Peter Hofmann

…[potential] exposure, and secondly, on a statutory basis, so from a statutory capital perspective, you are right as well. The policyholder dividends absorb the experience in the Closed block overtime. So, as long as there is flexibility to reduce policyholder dividends overtime you will not see statutory capital affected by losses in the Closed block and there is substantial cushion there, that is a very remote scenario where we would actually run out of capacity to adjust the dividend, the statutory dividend, policyholder…

Steven Schwartz - Raymond James & Associates

Then on the margins, what is the technical reason for those coming down?

Peter Hofmann

I will let Phil address that, it relates to the nature of the pricing.

Phil Polkinghorn

Steve the way the products are priced, remember, the mortality margin represents that portion of the cost of insurance charge in the product that is not utilized by benefits in the current period. So, with the heavy acquisition costs associated with the sale of Life policies we set those margins between cost of insurance charges and expected mortality at very high levels in the early part of a policy's life so that we recover acquisition costs as quickly as possible but then to remain competitive, those margins, cost of insurance charges over expected mortality are not nearly as large in the very later durations of a policy's life. So, if you have constant heavy new business coming on, you have got policies in their early durations with margins very high, policies in the later durations where they are lower, with the drop off in new sales, you should expect to see that sort of taper a little bit and follow the pattern for a newly issued policy.

Steven Schwartz - Raymond James & Associates

Okay, I got that.

Phil Polkinghorn

(inaudible) it is not a fall-off because of changing of experience. If you just took one policy and mapped it based upon expected experience over its life, we would anticipate high mortality margins early, tapering off and lower in the later policy durations, and when you lay on years and years of issues, the pattern can stay stable but when you have a drop-off in new issues, the expected pattern will go down.

Steven Schwartz - Raymond James & Associates

Okay, I understand that.

Operator

(Operator Instructions). Our next question comes from Amanda Lyman, Goldman Sachs.

Donna Halverstadt - Goldman Sachs

Hi, it's actually Donna Halverstadt. Thanks for taking my question. I was wondering if you would talk about any discussions you had with the regulator on making your surplus note interest payments and if you don't get back to a 300% RBC ratio by year-end how problematic does it become for getting approval to make those payments? Thank you.

Peter Hofmann

It's Peter Hofmann. Every quarter we submit to the regulator the request to make the interest payment; they may or may not ask us for some information. There is no particular RBC hurdle or any other specific hurdle that they articulate and we have made the payments regularly since the notes were issued. So, don't anticipate any issues there.

Operator

Our next question comes from Eric Berg, Barclays Capital.

Eric Berg - Barclays Capital

A couple of questions one for Jim and maybe one for Peter. Why are you hopeful that switching to a more independent oriented distribution will have an effect on sales? Behind my question, wouldn't it be the case that lower ratings and competitors would have the same effect on all distributors? Why will it be different dealing with -- why will the sales process be easier selling through independents than through say a Merrill? Are they for sure less rating sensitive than the larger broker-dealers?

Jim Wehr

Eric, I will start on this and then maybe I'll turn it over to Phil who has got a little bit more experience in this area. Our observations, our experience has been that that segment of the market, because it is less concentrated in the high net worth segment of potential buyers, is and has been less rating-sensitive. So, that is not to suggest that it is not rating-sensitive but historically, and our experience recently has been that it is less rating-sensitive. So, we don't want to imply that ratings don't matter in that space but it tends to be more middle market focused and as a result somewhat less rating-sensitive, and maybe I'll turn it to Phil to follow up a little bit.

Phil Polkinghorn

Yeah, Eric, I think the other thing that is important is that we are moving in terms of the size of the organization so your comment on Merrill versus some other perhaps smaller independent marketing organization is right on. We are moving to places where at least at the gatekeeper level, where we are on the shelf where there is not one person making a decision for 16,000 agents all at once and that is not to say that within that segment there won't be individual agents who aren't rating-sensitive, it is just that we get the opportunity to work with those who are satisfied with our ratings.

Eric Berg - Barclays Capital

My question for Peter relates to liquidity, sort of, a two-part question, one, where do [relapse] rates stand as we speak? In other words, what happened in the month of July in your Life business, is it the same as, better than, or worse than what you are reporting for the June quarter? Relatedly, you have mentioned that there are two reasons why when a person cancels his policy, her policy the cash outflow is not as great as it might first seem, as it might seem on first blush, on of the reasons relates to the presence of a policy loan, I didn't hear the other reason that dampens the effect. Thank you, Peter.

Peter Hofmann

The other reason was the surrender charges that we collect if the policy is within the surrender period. In terms of liquidity in the Life business, the surrenders in July continued the more moderated trend that we saw towards the latter part of the second quarter in terms of what you were getting at…

Eric Berg - Barclays Capital

Yes, you are saying, if I heard your answer correctly, just to repeat it to you to check my understanding, you are saying that the general tendency in July was similar to what we saw -- similar to the improving trend that we saw in the second half of the June quarter?

Peter Hofmann

Yes, consistent with that.

Operator

Our next question comes from Richard Spashing, Hovde Capital.

Richard Spashing - Hovde Capital

Just in terms of the statutory capital on slide 13, what was the impact of the equity market improvement with regard to the variable annuity and VUL book and its impact on that capital?

Peter Hofmann

The headline impact was from the Annuity guarantees and basically what we had is a net negative impact, call it, $25 million or so, which was a combination of the hedged assets, the derivative, which is mark-to-market declining substantially because of the equity market rally and swap rate increase and the statutory reserves under AG34 and AG39 declining not as much because it is a more static calculation, if you will. So, again, economically our hedge performed well but on the statutory accounting basis, the asset decreased a lot more than the liability.

Richard Spashing - Hovde Capital

Also just quickly, now that the below investment grade is above the 10%, I am just wondering what is your statutory limit there and I wonder was there any RBC impact just because you are hitting that limit?

Peter Hofmann

The limits on high-yield exposure in the bulk of our portfolio are the New York limits, which are at 20% of admitted assets, we are not anywhere near that. At the Connecticut company, where the limit is 10% of admitted assets, we are constrained by not in terms of what we can buy but in terms of, fallen angels, and what you have on the books, you are not made to un-admit any of those assets. So, it basically keeps us from buying high-yield but we have other reasons for not buying high-yield.

Jim Wehr

I think also from a strategy standpoint it is important to point out that even though our allocation has been going up over the last 18 months we have actually been a net seller of high-yield. So, it has really been the fallen angel effect more than offsetting the net sales that we have executed.

Operator

Our next question comes from Jason Nelson, Rumel Asset Management.

Jason Nelson - Rumel Asset Management

Jim in your opening remarks, I believe you stated that you believe that the company will show better operating performance in the second half of this year. Can you provide some color behind that, what provides you this type of optimistic outlook? Is it just simply having expenses reduced and the business structured to more in line with current business or just any color you can provide there would be helpful because given you guys are embarking on trying to restructure the business in a way, I don't think there is an example you can point to where this has happened in the insurance industry. I just want to get a feel for why you're so optimistic given the challenges you face.

Jim Wehr

First of all, I guess, I would characterize our perspective as cautiously optimistic and realistic given the challenges we are up against. First I would expand the perspective to beyond just our operating performance to include our balance sheet and really when we are looking at what we have accomplished over the last few months with some help from the markets we have enhanced our liquidity at both the holding company, operating company, we are seeing those benefits already. The portfolio, as Chris mentioned, has improved and we are seeing ongoing improvement in the third quarter. Expenses, as Peter pointed out, we have lowered, but we are not going to see those translate into operating results until the fourth quarter but that is a known in terms of the actions that have been completed and it is really just a matter of waiting for the results to materialize. So, that is not really, I would consider optimism, but really just patience.

On conservation, we are seeing ongoing improvement in terms of the slowdown in surrenders and so our expectation there is that we will continue to see that, that clearly has an impact on our operations. Finally, some of the growth initiatives that we are working on, and in particular the distribution company, which we would characterize as the most fully developed of our growth initiatives, should begin to translate into revenues in the latter part of the year and earnings as we move into 2010. So, when you look at all that combination of both, what has been accomplished already and what is in process and you put it all together, those are kind of the facts that support our outlook.

Jason Nelson - Rumel Asset Management

So are you saying you have actually signed on with a partner of some type to distribute your product? I am looking at your strategic pillars, I know it sounds like one, two, three you guys have covered fairly well, just this number four that is the bugaboo where I try to think about an example where this has successfully taken place and I have a hard time finding one.

Jim Wehr

We have been upfront in terms of our commitment that we will provide facts as we have them and we are not going to speculate about negotiations or conversations that are in process. I can tell you that we have factored those conversations and negotiations into our outlook. I hope I am being clear that, of the three prongs that we have discussed previously, the one that we are most constructive on at this point in terms of delivering results most rapidly is the distribution company and we are saying that based on where we are at in terms of conversations with prospective partners.

Operator

Our next question comes from Craig Carlozzi, Mast Capital Management.

Craig Carlozzi - Mast Capital Management

My question is regarding your CDO book, specifically the bank loan collateral CDO book. Could you give me a break-out on vintage, approximate is fine?

Peter Hofmann

I'm not sure I can give you a break-out by vintage on the call. Our investment supplement is posted on our website; I think that would have it, the vintage break-out.

Craig Carlozzi - Mast Capital Management

Okay, I am going through it now; perhaps I missed it, if I didn't, can I follow-up offline, is that something that you can provide?

Peter Hofmann

Sure. The total holdings on a market value basis are about $225 million at the end of the quarter and the vast majority, I think as you noted, is in bank loans, about $175 million, again, we will get you the vintage information on a follow-up basis.

Operator

Our next question comes from Bob Glasspiegel, Langen McAlenney.

Bob Glasspiegel - Langen McAlenney

I was wondering if you could expand on -- I think you said you are discontinuing term insurance sales and there was a second Life product, did I hear that correctly.

Phil Polkinghorn

Yes, Bob, this is Phil. We are suspending sales of term insurance and the guaranteed UL products. I think as you are aware from past calls, we have never been a big seller of guaranteed UL to begin with, it is a very capital-intensive product for both guaranteed UL and term insurance. The typical techniques available in the marketplace to manage the capital [string] with those have either dried up or gotten more expensive and since they weren't a critical part of our portfolio and with our focus on maintaining strong capital it seemed like not the best place to put our capital.

Bob Glasspiegel - Langen McAlenney

Maybe you can give us a little color on what the ideal distribution partner would look like today?

Phil Polkinghorn

The ideal distribution partner I think would be a smaller, independent marketing organization, probably with a stronger affiliation with agents, perhaps providing some lead generation (inaudible) an organization that would value strong access to company management and being an important part, more important to the manufacture, would probably be a good profile and one that would leverage, as much as, possible existing Phoenix strengths as opposed to -- I think we recognize that we may, as we leverage Phoenix strength, also embark upon some new product lines that might be important to different organizations.

Jim Wehr

I think we probably have time for one more question.

Operator

Our final question comes from Steven Schwartz, Raymond James.

Steven Schwartz - Raymond James

Peter, can we just revisit page 7, that is, the tax valuation allowance development...

Peter Hofmann

We thought we would get by without it.

Steven Schwartz - Raymond James

Can you walk me through this second part one more time? I have got enough problems with statutory and GAAP accounting, what is the capital-related account, is that realized gains and losses?

Peter Hofmann

Yes, basically that is capital gains, from a tax perspective, capital gains and losses that typically you have five-year carryforward. The biggest piece of that is related to the spin-off of Virtus, and the point here is that we've fully allowed for that asset. So, any capital gains that we realize going forward, in essence, we would not be paying tax on. Similarly, on the ordinary income…

Steven Schwartz - Raymond James

Wait a minute, Peter. Okay, so you wouldn't be paying any tax on any capital gain but in this environment what we have been looking at is capital losses. Would you have any protection there?

Peter Hofmann

In capital losses, it goes the other way. Ordinarily, we'd book a deferred tax asset but we are not in a position to carry a deferred tax asset without valuation allowance against it. So…

Steven Schwartz - Raymond James

Right, so if you had a $50 million loss, say in the next quarter, I am just making up a number here, that is going straight to the bottom line?

Peter Hofmann

That's right. It is all GAAP (inaudible)

Steven Schwartz - Raymond James

Then, that would be GAAP and stat?

Peter Hofmann

No, nothing to do with stat.

Steven Schwartz - Raymond James

Nothing to do with stat.

Peter Hofmann

That is a separate story, which we can go through.

Steven Schwartz - Raymond James

Then the ordinary income, that is just your basic underwriting income, and that is through as well?

Peter Hofmann

The net operating losses and any tax credits that we have, which have much longer expiry dates.

Steven Schwartz - Raymond James

I can see that. Again, if you have operating income, there is no taxes but if you have an operating loss, you have got no protection?

Peter Hofmann

That's right.

Steven Schwartz - Raymond James

Then the DTA related to unrealized losses?

Peter Hofmann

That one, in essence, when we have unrealized losses, we take a tax offset, so we put asset on the books because the assumption is that we hold these securities to recovery, that would naturally unwind, right, as the security recovers or matures and because that is sort of built into the assumption of holding it to recovery, there is no need to put a valuation allowance up against that.

Steven Schwartz - Raymond James

Okay, so this would be on the AOCL?

Peter Hofmann

That's right.

Jim Wehr

We would like to thank everyone for their time and interest this morning.

Operator

Thank you. This does conclude today's conference call. We thank you for your participation and you may now disconnect your lines.

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