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Executives

Naomi Kleinman – Head, IR

Jim Wehr – President and CEO

Peter Hofmann – Senior EVP and CFO

Chris Wilkos – EVP and Chief Investment Officer

Analysts

Bob Glasspiegel – Langen McAlenney

Steven Schwartz – Raymond James & Associates

The Phoenix Companies, Inc. (PNX) Q2 2010 Earnings Call Transcript August 5, 2010 12:00 PM ET

Operator

Welcome to the Phoenix second quarter 2010 earnings conference call. All participants will be in a listen-only mode until the question-and-answer session. (Operator Instructions) Today's call is being recorded. If you have any objections, you may disconnect at this time. I will now turn the call over to the Head of Phoenix Investor Relations, Naomi Kleinman. You may begin.

Naomi Kleinman

Thank you. Good afternoon 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; Chris Wilkos, Chief Investment Officer; Phil Polkinghorn, Senior Executive VP for Business Development; and Mike Hanrahan, Chief Accounting Officer.

Our second quarter earnings release, our quarterly financial supplements and the second quarter earnings review presentation are available on our website at PhoenixWM.com. Slide two of the presentation contains 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 the financial supplement. Now, I will turn the call over to Jim.

Jim Wehr

Thanks, Naomi and good afternoon to everyone. We appreciate you taking the time to join our second quarter call. We'll conduct today's call as in the past. I will provide an overview and my perspective on the quarter. Peter will take everyone through the numbers in detail. Chris will talk about our investment results and then we'll take questions.

For several quarters now, we have been saying there are a lot of moving parts and how they come together will provide solid signals for Phoenix's future and that current quarter results put us in a position to make more progress in the coming quarters and that is what's happening.

We continue to make headway against the strategic goals of balance sheet strength, policy holder security, expense management and growth. In short, we have demonstrated we can deliver results in areas that are critical to our long-term success. Statutory surplus, risk-based capital, investment performance and expense management are key measures where Phoenix has steadily improved.

Further, persistency is significantly better relative to last year. And as we continue to benefit from our stable revenue base, our growth initiatives are gaining traction, particularly in annuity sales. However, the quarter was not all good news. Although we had net income of about $10 million, we had an operating loss of almost $20 million.

The loss was a product of the negative equity markets as well as some Phoenix specific events, including a renegotiated life reinsurance contract and adverse results in our Phoenix Accumulator Universal Life or PAUL product. This experience largely related to lapses. That being said, the actions we have taken have produced a base of strength that gets us past the inevitable bumps in the road, whether they come from the market environment or elsewhere.

Let me provide a few concrete examples of our progress and expand on them. We have positive results relating to the balance sheet and overall financial strength as evidenced by growth in statutory surplus and RBC for the second straight quarter. RBC is now estimated at 290%, up 67 points from year end 2009.

Statutory surplus increased 24% to $715 million from $574 million at year end. Another element of balance sheet strength is the overall health of our investment portfolio. We moved into an unrealized gain position this quarter and had higher net investment income and lower credit impairments. In sum, we feel good about our financial strength and our balance sheet.

Conservation is another area where we put a lot of effort and improving persistency has been the result. Both life and annuity surrenders remain significantly lower than the levels in 2009 and life persistency improved again this quarter.

We also continue our focus on expenses as demonstrated by an almost 8% reduction in core GAAP expenses compared to last quarter and an 18% reduction year-over-year. Our progress in reducing expenses has contributed to improved profitability.

We returned the company to positive GAAP and statutory net income this year. At the same time, we recognize the need to build consistency in our operating results.

Let me give you a little more detail what happened this quarter and what we're doing to address these issues. The impact of the negative equity markets our annuity line was certainly a key factor in our operating loss. While we can't control the equity markets, our continuing efforts to strengthen the company will allow us to better withstand the effects of ongoing market volatility.

Operating income was also impacted in a couple of ways by the PAUL series of policies in our universal life block. As I mentioned, overall life persistency continued to improve, but we did see an increase in lapses in the PAUL block this quarter.

We believe it is tied to a number of factors, including impaired market liquidity, lack of premium financing in the market and a cost of insurance rate increase we announced for a subset of policies in this product line. We are analyzing the block carefully but don't see a trend yet.

On the first three of our four strategic priorities, balance sheet strength, business persistency and expense management, there was visible improvement in the quarter. As it continues, it will help offset the types of negative factors that hurt us this quarter, such as the equity market.

Let me move on to our growth initiatives, the fourth strategic priority. We have established relationships with about two dozen distributors who work within the middle market, mostly independent marketing organizations with an initial focus on our repositioned annuity line. Annuity sales continue to grow this quarter, with total deposits up to about $27 million from about $19 million in the first quarter.

The numbers are still small, but we're building sales momentum. We introduced the first of our life products targeted to the middle market in the second quarter and it is going to take time to build life sales. We're confident we can.

Turning to Saybrus Partners, our progress here continues. As you know, Saybrus signed a deal with the second partner in June. And we anticipate we will add at least one more partner by year end. Saybrus is not yet profitable, with net costs a little under $5 million this quarter. However, Saybrus revenue is increasing and we expect Saybrus to be break even in the first quarter of 2011. And finally, our alternative retirement solutions business.

We reached the milestone a few weeks ago when the regulators completed their review of our standalone living benefit product. Implementation and product rollout have begun. So we're gaining ground on a number of growth fronts and beginning to see revenues from these new initiatives.

Stepping back, where are we? How are we doing? I made four key points last quarter. First, that we expected the effects of our expressive reduction efforts to kick in. Second, capital would grow organically. Third, investment performance was improving on all fronts and would continue to improve.

And fourth, our growth initiatives would begin to gain more traction. It is pretty clear we can put checkmarks against these important objectives. However, challenges remain, particularly in the area of growth. We worked hard to build a stable financial foundation to support that growth because our customers demand it, partners require it and you our investors deserve it.

Thanks again for joining the call. As always, we look forward to keeping you updated on our company. Let me now turn it over to Peter. Peter.

Peter Hofmann

Thank you, Jim. Please turn to slide three of the presentation. I will start there. From a financial perspective, we have two very different pictures this quarter – one statutory, the other GAAP – and many of the benefits of our strategy are clearly emerging in the statutory results. GAAP operating earnings remain challenging.

Most important for the long-term is the continued generation of statutory capital as reflected in the positive net income and gain from operations at Phoenix Life and in the 8% surplus growth this quarter. With the RBC ratio estimated at 290%, we have made significant progress from the lows just two quarters ago.

Improvements in the investment portfolio played a major role in this recovery. We increased capital through higher portfolio returns and meaningfully reduced the percentage of risky assets in the portfolio.

Our aggressive expense reductions also continue to flow through the results, especially on the statutory side. Surrenders continue to be below last year's elevated levels, though not at the levels we saw before being downgraded. Mortality was moderately adverse in the quarter, driven by the closed block.

On the GAAP side, the picture is much more clouded. The operating loss was driven by four things – a charge related to a 2008 life reinsurance transaction, the impact of the equity market decline in the quarter, ongoing net start up costs for Saybrus Partners and adverse results in the policy area's UL block. I will get into each of these in a bit more detail. While still modest, new business trends showed progress both for Phoenix products and at Saybrus.

Moving to slide four, this highlights the trends in GAAP operating earnings and book value. Book value per share improved by $0.87 to $11.27. The increase was driven by positive net income and a decrease in net unrealized losses. We try to highlight for you on this chart the discrete items that affect operating income comparisons.

There are two this quarter – the reinsurance transaction charge and $0.5 million of tax benefits which we back out. As we indicated in prior calls, for operating earnings comparisons, we have a zero effective tax rate for this year. Deviation from this rate have been largely due to the GAAP interperiod tax allocation. Even backing out these items, we had a loss of $0.08 per share, so let me explain that result.

Slide five shows income statement detail excluding the closed block. Revenues remained flat compared with last year and are modestly down from the first quarter, reflecting lower premiums and fee income partially offset by higher net investment income. Benefits are higher versus last quarter, but lower than a year ago.

Operating expenses included the reinsurance charge. Excluding this charge, expenses were $63.4 million, meaningfully below the prior year. The regulatory closed block contribution of $14.4 million is in line with the first quarter, is consistent with the glide path of the block and represents the expected quarterly level in 2010.

We had realized gains of $15.1 million in the quarter, largely driven by a GAAP gain in our variable annuity hedging program. Additionally, discontinued operations income of $15 million in the quarter included a correction of the loss calculated on the sale of PFG and that sale closed this quarter.

I mentioned several business drivers for the results earlier – variable annuities, universal life and Saybrus. The impacts are spread across different line items on this page. Let me summarize each.

In variable annuities, we saw three effects, largely due to the 12% decline in the S&P in the quarter. A reduction in fees due to lower average asset balances, an increase in back amortization and an increase in reserves for GMDBs and GMIBs, the two benefits that are not included in our hedge program.

We expect a number of these factors to reverse if the market recovery since the end of June holds for the quarter. In universal life, we're seeing an impact related to the PAUL series block, particularly in policies written since 2004.

The impact in the quarter was largely reflected in lower COI fee revenue and higher back amortization for policies that are no longer on the books. We experienced higher than expected lapses this quarter – that is, policies that expired without value because owners did not pay premium to keep them in force. We will continue to monitor this block closely and manage it proactively.

Finally, we continue to incur start up expenses for Saybrus partners. Second quarter net start-up costs of $4.9 million are improved from the first quarter. We expect Saybrus to break even in the first quarter of 2011.

Moving onto mortality results, slide six shows mortality cost ratios for the open and closed blocks. Overall open block experience this quarter, although higher than last quarter and a year ago, was close to expectations. The closed block had unfavorable experience this quarter.

This was largely driven by a handful of second debts on large survivorship policies. As a reminder, because of the policy holder dividend obligation, closed block mortality experience has not directly affected GAAP earnings.

Slide seven shows annualized aggregate surrender rates based on contract values surrendered. Annualized life surrenders once again improved in the second quarter, dropping to 7.9% from 8.4% in the first quarter.

Notably, in the closed block annualized surrenders were at 7.5%, the lowest level in six quarters. Annuity surrenders were at annualized rate of 13.5%, higher than the first quarter but still lower than a year ago and the 2009 full-year results. As you have already heard, one of our critical initiatives continues to be controlling expenses.

Slide eight shows consolidated statutory expenses and GAAP expenses adjusted for non-core items. The expense reductions we have taken over the last 18 months are clearly emerging, driven primarily by lower employee related expenses. Statutory expenses are down 27% year-over-year and before deferrals, core GAAP expenses are down 18%.

Slide nine shows an update of our tax attributes. As I mentioned earlier, the effective tax rate remains close to zero as taxable income has been offset by prior period net losses. For capital related accounts, because of the appreciation in the portfolio, we are now in a position of having net deferred tax liabilities.

As a result, we now carry DTA for ordinary income equal to the DTL. We continue to carry DTA related to unrealized assets. As a reminder, GAAP tax valuation allowances do not have any bearing on whether deferred tax assets will ultimately be available to reduce taxes.

Let's move to realized gains on slide 10. Chris is going to cover the impairments and transactions. I will just comment briefly on our variable annuity hedging program. The program generated a $7.3 million economic loss in the quarter.

This was primarily driven by assumption changes made to the liability model. It was significantly offset by a $27 million change in nonperformance risk factor that represents the change in the gross profit liability due to Phoenix's own credit. Cumulatively for the year, the program is at break even before any adjustments for Phoenix credit.

The summary of our balance sheet metrics is shown on slide 11. Leverage remains low at 24.4%. Holding company liquidity was $48.6 million in cash and securities as of June 30 and total assets and liabilities on the balance sheet declined by $3.5 billion in the quarter because of the sale of PFG.

Slide 12 shows details on our second quarter statutory results. As mentioned earlier, statutory surplus for Phoenix Life increased by 24% versus year end 2009. The increase was driven by core earnings at Phoenix Life, gains in the alternative asset portfolio and increased admitted deferred tax assets.

The increases in estimated RBC from year end 2009 was due to this increase in surplus, but also due to reduced balance sheet risk driven by a reduction in the percentage of below investment grade bonds and lower variable annuity capital charges. With that, I will turn it over to Chris for a discussion of the investment portfolio.

Chris Wilkos

Thanks Peter. For my team and me, managing the investment portfolio continues to be about the Company's first pillar, a healthy balance sheet. The story this quarter is a very, very good one. Even with the volatility investment markets in the second quarter, the Phoenix portfolio produced solid results in all key areas, including higher net investment income, a sharp appreciation in portfolio values, reduced bond and stronger credit quality.

Let's start with net investment income on slide 13. Sequential net investment income increased by $12.3 million or 6%, driven by a strong increase in alternative investment returns.

Income from long-term debt securities decreased as the effect of the low interest rate environment continues to impact new fixed income investments. The increase in alternative asset returns was broad based, with all categories of alternatives showing quarterly increases.

In particular, venture capital income more than doubled, mezzanine fund income continued to grow, and a loss in joint venture real estate reversed to a positive contribution. On an ongoing basis, we expect the level of alternative asset returns to be closer to Q1 results than Q2 numbers. The bulk of these earnings are in the closed block and have a modest impact on GAAP income.

Consistent with the ongoing improvement in credit markets and declining default rates, our portfolio impairments shown on slide 14 declined to $12.4 million in the second quarter. These impairments were concentrated in structured investments, including prime and Alt-A mortgage backed securities and CLOs.

We had only minor impairments in our corporate bond portfolio. We have previously described the high quality and careful construction of our CMBS holdings and this portion of the portfolio has held up very well. We have suffered minimal impairments in this category of bonds.

We believe this reflects our disciplined approach and in depth knowledge of these securities. Since we have no commercial mortgage whole loans, we have no impairments in that asset class.

Slide 15 illustrates the continued significant improvement in the market value of the Phoenix fixed income portfolio. With a sharp drop in Treasury rates during the second quarter, the portfolio's value has appreciated to an unrealized gain position of $115 million, an improvement of over $440 million since year end and the first net gain position since 2007.

As spreads have normalized over the last 18 months and interest rates have fallen, our portfolio value has appreciated and unrealized losses have been eliminated. This improvement, along with reduced credit impairments, reflects the strength and resiliency of the investment portfolio. The improvement in portfolio valuations has been a significant factor in strengthening our balance sheet and enhancing surplus.

On slide 16, the portfolio's percentage of below investment grade bonds declined from 10.1% at the end of Q1 to 9.1% on June 30. Our upper limit for below investment grade bonds is 10% of the total portfolio.

The significant appreciation in below investment grade markets since the depths of the credit crisis in early 2009 has meant that we can sell positions at levels close to book value. We have been patient and used the strength in the below investment grade market over the last several quarters to sell smart at price levels that we believe are attractive and reflective of a normalized market.

We have been able to achieve the reduction in our high yield position over the last several quarters with virtually no net losses on sales and dispositions. Going forward, we will continue to look for opportunities to reduce below investment grade holdings, but will balance that against the need for the yield that these assets produce.

Slide 17 provides an update on liquidity in our portfolio at quarter end. The improved bond market from both valuation and liquidity perspectives has allowed Phoenix to decrease highly liquid assets and ship the composition of our liquidity pool from very low yielding Treasury bills and notes to higher yielding agency mortgage backed securities.

Based on the improvement in portfolio evaluations and reduced surrender activity, we are working toward an 8% liquidity target. The decrease in liquid assets is being redeployed into investment grade public and private debt securities to enhance investment income. At the end of Q2, we had a liquidity position of 8.5% of the portfolio net of unsettled purchases.

We didn't include snapshots of our RMBS or CMBS portfolios for this presentation, but they are available in the Investor supplement. The composition of both of these portions of the portfolio remains high quality, well seasoned and stronger than the market for each of those asset classes. Now, I will turn the call back over to Jim.

Jim Wehr

Thanks, Chris. Before opening it up for questions, I want to conclude the presentation by saying that despite the operating loss this quarter, I am still very positive and energized about our prospects. We are much stronger now than we were just a year ago. We know we will encounter bumps in the road from time to time, but there is positive momentum here at Phoenix. Thanks again. Shirly, please open the line for questions.

Question-and-Answer Session

Operator

(Operator Instructions). Our first question is from Bob Glasspiegel from Langen McAlenney. Please ask your question.

Bob Glasspiegel – Langen McAlenney

Good morning. I was wondering if you can give us more information behind what's going on with the reinsurance transaction, what were you trying to do and what drove the charge?

Jim Wehr

Bob, I am going to ask Peter to take that one. Peter.

Peter Hofmann

Sure. Bob, it was the unique one-time situation. The charge basically reflected a payment that we will refund to reinsurance counterparty. The specifics of the negotiation are subject to confidentiality agreements. But basically this emerged out of some ambiguity in the original agreement that was signed back in 2008, so while unfortunate, it is a one-off item and has really no ongoing impact.

Bob Glasspiegel – Langen McAlenney

It is a catch-up on an old transaction where there was a dispute on coverage or I am just trying to get the general – not the specific.

Peter Hofmann

It was an inconsistency in the agreement in terms of how the parties looked at it.

Bob Glasspiegel – Langen McAlenney

This is an important relationship reinsurance company that you …?

Peter Hofmann

Yes, yes.

Bob Glasspiegel – Langen McAlenney

Have an ongoing business relationship with?

Peter Hofmann

That's absolutely correct.

Jim Wehr

That's a big part of it, Bob.

Bob Glasspiegel – Langen McAlenney

Okay. Second question is lower yields are a double-edged sword. They are great for book value and good for surplus, I guess. Some companies are struggling, though, to keep up with sort of prior commitments, particularly if you're keeping some liquidity in your insurance companies. You may not have been matched properly.

Number one, do you have a good matching situation right now that's not a concern? Number two, what are you doing to pick up yields, or is that not an issue?

Jim Wehr

I am going to ask Chris to talk to this one. This clearly is, as you positioned it, a double-edged sword. In my old job, it was one of the – in my current job I should say, something that kept me up at night. We certainly have been faced with this before, but I am going to let Chris speak to both aspects of what you brought up. Chris?

Chris Wilkos

Bob, we have an asset liability management committee that reviews the duration or intersensitivity of our product lines on a regular basis. So I would answer your first question by saying, yes, we have a pretty strong asset liability process that matches off our asset portfolios pretty carefully against the liability. So we're not mismatched in any way.

In terms of the impact of lower yields, you are correct, it does help in the valuation of the portfolio. But clearly any money that you are investing currently is going to be invested at lower rates. And I think there the important point for us is that our portfolio turnover, what we're investing, is about 10% of the overall fixed income portfolio each year. So the impact of lower rates is going to have some impact on us. But it is certainly going to take a long time to play out because again of that investment pace.

The second is that as you saw this quarter, we also have a pretty healthy contribution from alternative investments. So part of the normalization of that portfolio has boosted our returns. And clearly that's really contributed to net investment income away from the fixed income market.

So again those assets – sometimes when the market is down, you wonder why you're holding them, but then clearly when it rebounds, you get a disproportionate effect. In terms of liquidity, you are also correct, that there is some give up from liquidity. But we reduced our liquid asset position as I noted pretty substantially over the last year or 1.5 years. And that will eventually start to kick in, but won't have any immediate impact.

Bob Glasspiegel – Langen McAlenney

Thank you, guys.

Operator

Thank you. (Operator Instructions). Our next question is from Steven Schwartz with Raymond James & Associates. You may ask your question.

Steven Schwartz – Raymond James & Associates

Good morning, everybody.

Jim Wehr

Good morning.

Steven Schwartz – Raymond James & Associates

If I could, Peter, could you go over again – I guess I didn't understand it, what was going on with the hedging and why it was actually a loss ex the nonperformance risk factor? I would imagine it should have been a gain.

Peter Hofmann

What we shoot for, Steven, is neither loss nor gain on an economic basis on the hedging program. We manage to – specific fairly tight limits on each of the major Greeks – Delta, Rho, Omega. What we also do is we continually refine our modeling of – particularly on the liability side to get as good an estimate of the liability on an economic basis as we can.

When we do that, there will be an impact on the liability and the first quarter actually we had a gain excluding the nonperformance risk factor. That was largely driven by a modeling refinement patent to be a positive. This quarter we had a modeling refinement going the other way. Throughout, though, the matching of the Greeks has been quite consistent and held up quite well. We will have some breakage from time to time as we continue to refine the process.

Steven Schwartz – Raymond James & Associates

So the hedging gains that you talk about here, that represents breakage? Okay. If I may, I think you did yourself a little bit of a disservice at least on slide 5. I am interested here, I know you put out the numbers in your press release on both the variable annuity and PAUL in total, but I was wondering if you could break out maybe the various effects – for example, on the VA you had reduction in fees.

And I think most companies would probably not break that out. But you had an increase in the DAC amortization associated with the S&P going down 12%. I think most companies would have broken that out assist non-recurring if the market stabilized. And on the GMDB and the GMIB, the reduction associated with those, I was wondering if you maybe had those numbers available and maybe we could talk about the DAC on PAUL and how much that was separate from the COI?

Peter Hofmann

I don't have the details right here. What I would suggest is for modeling purposes, Naomi can certainly step you through that. You're right that the fees are the smallest piece. So the DAC here is going to be by far the largest piece on the variable annuity side. And off the top of my head I would say up to $12 million DAC probably represents 60% to 70% of that and probably another $30 million or so from the reserves, and then a little bit from the fees.

So we tried to aggregate the combined impact of the market on the variable annuity business. The PAUL piece similarly is – that is probably split 50/50, but I don't have the exact numbers. Naomi can give you that.

Steven Schwartz – Raymond James & Associates

Not a problem. I will give Naomi a ring.

Operator

(Operator Instructions). At this time I am showing no further questions. I will turn the call back over to Jim Wehr.

Jim Wehr

Thank you, Shirley. Once again, we thank everybody for their time and attention. I know this week and this season is very busy for everybody on the call. We appreciate as always you taking the time to dial into our call. And we'll look forward to keeping you posted on our progress as we move forward. Thanks again.

Operator

Thank you. This does conclude today's conference. We thank you for your participation. At this time you may disconnect your lines.

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