STATE OF NEBRASKA. Department of Insurance EXAMINATION REPORT USAA DIRECT LIFE INSURANCE COMPANY. as of. December 31, 2011

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2 STATE OF NEBRASKA Department of Insurance EXAMINATION REPORT OF USAA DIRECT LIFE INSURANCE COMPANY as of December 31, 2011

3 TABLE OF CONTENTS Item Page Salutation...1 Introduction...2 Scope of Examination...2 Description of Company: History...4 Management and Control: Holding Company...6 Shareholder...7 Board of Directors...7 Officers...8 Committees...9 Transactions with Affiliates...9 Amended and Restated Services Agreement...9 USAA Group Federal Income Tax Liability and Allocation Agreement...10 USAA Group State Income/Franchise Tax Liability Allocation Agreement...10 Territory and Plan of Operation...10 Reinsurance: Ceded...11 General...12 Body of Report: Growth...13 Financial Statements...13 Examination Changes in Financial Statements...16 Compliance with Previous Recommendations...16 Commentary on Current Examination Findings: Reinsurance Contract Not Executed...16 Offset Clause in Reinsurance Contract...16 Summary of Comments and Recommendations...17 Acknowledgment...18

4 Lincoln, Nebraska May 19, 2013 Honorable Joseph Torti, III Chairman, Financial Condition (E) Committee, NAIC Deputy Director and Superintendent of Insurance Rhode Island Division of Insurance 1511 Pontiac Avenue, Bldg #69-2 Cranston, Rhode Island Honorable John M. Huff Chair, Midwestern Zone, NAIC Director of Insurance Missouri Department of Insurance 301 West High Street, Room 530 Jefferson City, Missouri Honorable Bruce R. Ramge Director of Insurance Nebraska Department of Insurance 941 O Street, Suite 400 Lincoln, Nebraska Dear Sirs: Pursuant to your instruction and authorizations, and in accordance with statutory requirements, an examination has been conducted of the financial condition and business affairs of: USAA DIRECT LIFE INSURANCE COMPANY which has its Statutory Home Office located at with its Principal Executive Office located at 1650 Farnam Street Omaha, NE Fredericksburg Rd. San Antonio, TX (hereinafter also referred to as the Company ) and the report of such examination is respectfully presented herein.

5 INTRODUCTION The Company was last examined as of December 31, 2009 by the State of Nebraska. The current financial condition examination covers the intervening period to, and including, the close of business on December 31, 2011, and includes such subsequent events and transactions as were considered pertinent to this report. The State of Nebraska participated in this examination and assisted in the preparation of this report. The Texas Department of Insurance also conducted an examination of USAA Life Insurance Company, who has ultimate control of the Company, as of December 31, SCOPE OF EXAMINATION This examination was conducted pursuant to and in accordance with both the NAIC Financial Condition Examiners Handbook (Handbook) and Section (1) of the Nebraska Insurance Statues. The Handbook requires that examiners plan and perform the examination to evaluate the financial condition and identify prospective risks of the Company by obtaining information about the Company including, but not limited to: corporate governance, identifying and assessing inherent risks within the Company, and evaluating system controls and procedures used to mitigate those risks. The examination also includes assessing the principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation and management s compliance with Statutory Accounting Principles and Annual Statement Instructions, when applicable to domestic state regulations. The examination was completed under coordination of the holding company group approach with the Texas Department of Insurance as the coordinating state. The companies examined under this approach benefit to a large degree from common management, systems and 2

6 processes, and internal control and risk management functions that are administered at the consolidated or business unit level. The coordinated examination applies procedures sufficient to comprise a full scope financial examination of each of the companies in accordance with the examination procedures and standards promulgated by the NAIC and by the respective state insurance departments where the companies are domiciled. The objective is to enable each domestic state to report on their respective companies financial condition and to summarize key results of examination procedures. A general review was made of the Company s operations and the manner in which its business has been conducted in order to determine compliance with statutory and charter provisions. The Company s history was traced and has been set out in this report under the caption Description of Company. All items pertaining to management and control were reviewed, including provisions for disclosure of conflicts of interest to the Board of Directors and the departmental organization of the Company. The Articles of Incorporation and By-Laws were reviewed, including appropriate filings of any changes or amendments thereto. The minutes of the meetings of the shareholder, Board of Directors and committees, held during the examination period, were read and noted. Attendance at meetings, proxy information, election of Directors and Officers, approval of investment transactions and authorizations of salaries were also noted. The fidelity bond and other insurance coverages protecting the Company s property and interests were reviewed, as were plans for employee welfare and pension. Certificates of Authority to conduct the business of insurance in the various states were inspected and a survey was made of the Company s general plan of operation. 3

7 Data reflecting the Company's growth during the period under review, as developed from the Company's filed annual statements, is reflected in the financial section of this report under the caption "Body of Report". The Company's reinsurance facilities were ascertained and noted, and have been commented upon in this report under the caption "Reinsurance". Accounting records and procedures were tested to the extent deemed necessary through the risk-focused examination process. The Company s method of claims handling and procedures pertaining to the adjustment and payment of incurred losses were also noted. All accounts and activities of the Company were considered in accordance with the riskfocused examination process. This included a review of workpapers prepared by Ernst and Young, the Company s external auditors, during their audit of the Company s accounts for the years ended December 31, 2010 and Portions of the auditor s workpapers have been incorporated into the workpapers of the examiners and have been utilized in determining the scope and areas of emphasis in conducting the examination. This utilization was performed pursuant to Title 210 (Rules of the Nebraska Department of Insurance), Chapter 56, Section 013. Any failure of items to add to the totals shown in schedules and exhibits appearing throughout this report is due to rounding. DESCRIPTION OF COMPANY HISTORY The Company was organized and incorporated under the laws of the State of Arizona on July 2, 1969 as a stock insurance company under its original name, Arcadia National Insurance Company. 4

8 Subsequently, the Company s name was changed to Arcadia National Life Insurance Company and remained as such until Reliance Insurance Company (RIC) purchased the Company from Household Group on February 25, Simultaneously with the redomestication of the Company to the State of Delaware on August 15, 1999, the Company s name was changed to Reliance Life Insurance Company (RLIC). RLIC was a wholly owned subsidiary of RIC. RLIC began producing new business in the first quarter of During 2000 a management decision was made to stop production of all new business. RLIC ceased producing business during the third quarter of 2000 and any inforce business was placed into run-off. On October 3, 2001, the Insurance Commissioner of the Commonwealth of Pennsylvania, in her capacity as Rehabilitator of RIC, petitioned the Commonwealth Court of Pennsylvania for a liquidation order. RIC was declared insolvent and Commonwealth Court issued an order that placed RIC into liquidation. M. Diane Koken, Insurance Commissioner of Pennsylvania, and her successors in office were appointed as Liquidator of RIC, and were directed to immediately take possession of RIC s property, business and affairs, and liquidate RIC in accordance with Pennsylvania law. As part of the obligation to protect the interest of RIC s policyholders and other creditors and maximize the value of the Estate, it was the stated intent of the Liquidator of RIC to sell RLIC. On September 14, 2007, USAA Life Insurance Company (USAA Life), a wholly owned subsidiary of United Services Automobile Association (USAA), purchased RLIC from the Pennsylvania Department of Insurance, who was appointed liquidator of the Reliance Estate. 5

9 The Company then redomesticated from Delaware to Nebraska and changed its name to USAA Direct Life Insurance Company. MANAGEMENT AND CONTROL Holding Company The Company is a member of an insurance holding company system as defined by Nebraska Statute. An organizational listing flowing from the Ultimate Controlling Person, as reported in the 2011 Annual Statement, is represented by the following (subsidiaries are denoted through the use of indentations, and unless otherwise indicated, all subsidiaries are 100% owned): United Services Automobile Association USAA General Indemnity Company USAA Reciprocal Attorney-In-Fact, Inc. USAA Lloyd s Attorney-In-Fact, Inc. USAA Texas Lloyd s Company (management agreement) USAA Casualty Insurance Company Garrison Property and Casualty Insurance Company USAA County Mutual Insurance Company Catastrophe Reinsurance Company USAA Limited Enterprise Indemnity Captive Insurance Company, Inc. USAA Insurance Agency, Inc. UIPCO, LLC USAA Life Insurance Company USAA Life Insurance Company of New York USAA Life General Agency, Inc. USAA Direct Life Insurance Company USAA Annuity Services Corporation USAA Alliance Services LLC USAA Financial Planning Services Insurance Agency, Inc. USAA Financial Advisors, Inc. USAA Capital Corporation USAA Financial Services Corporation USAA Finance Company, LLC USAA Investment Corporation USAA Investment Management Company USAA Transfer Agency Company La Cantera Development Company 6

10 USAA Real Estate Company United Lender Services Corporation Florida ULS, Inc. USAA Federal Savings Bank USAA Mortgage Solutions, LLC USAA Acceptance, II, LLC USAA Relocation Services, Inc. USAA Acceptance, LLC USAA Savings Bank USAA Acceptance, III, LLC Shareholder The Company s Amended and Restated Articles of Incorporation state, the total number of shares of stock which the Corporation shall have authority to issue is 5,000,000. All such shares are to be common stock, par value of one dollar ($1.00) per share. As of December 31, 2011, 2,500,000 shares are currently outstanding. No dividends were declared or paid during 2010 or The Amended and Restated By-Laws of the Company provide that, the Annual Meeting of the Stockholders for the election of Directors, the receiving of reports and the transaction of such other business as may properly be brought before the meeting shall be held before May 1 of the year. The meetings, shall be held at such time and place, either within or outside the State of Nebraska, as shall be stated in the Notice of the meeting or in a duly executed Waiver of Notice thereof. Board of Directors The Amended and Restated By-Laws provide that, the Board shall consist of not fewer than five Directors, one of whom shall be a Nebraska resident. The Directors shall be elected at the Annual Meeting of the Stockholders and each Director elected shall hold office until his successor is elected and qualified, or until his earlier death, resignation, or removal. The following persons were serving as Directors at December 31, 2011: 7

11 Name and Residence Jeffrey G. Nordstrom San Antonio, TX William A. Smith San Antonio, TX Timothy S. Alvarez Gretna, NE Shawn T. Loftus San Antonio, TX William H. McCartney San Antonio, TX Principal Occupation President and Chief Actuary, USAA Life Insurance Company Vice President, Senior Financial Officer (Life) United Services Automobile Assn. Property Field Staff Adjuster, United Services Automobile Assn. Vice President and Actuary, USAA Life Insurance Company Senior Vice President, P&C Insurance Counsel United Services Automobile Assn. Officers The Amended and Restated By-Laws of the Company provide that, the Officers of the Corporation shall be chosen by the Board and shall be as necessary to enable the Corporation to sign instruments and stock certificates in compliance with the Nebraska Code. One of the Officers shall have the duty to record the proceedings of the Stockholders and Directors in a book to be kept for that purpose. The Board may also appoint such other Officers as the Board may deem necessary, desirable or appropriate. The following is a partial listing of Senior Officers elected and serving the Company at December 31, 2011: Name and Residence Jeffrey G. Nordstrom Christopher P. Laia William H. McCartney Kirsten M. Register William A. Smith Office President and Chief Actuary Secretary and Vice President Senior Vice President and Assistant Secretary Vice President and Controller Vice President and Senior Financial Officer and Treasurer 8

12 Committees The Amended and Restated By-Laws provide that, the Board may designate one or more committees, each committee to consist of one or more Directors of the Company. The Board may designate one or more Directors as alternate members of any committee, who may replace any absent or disqualified member at any meeting of the committee. An Executive Committee was established on April 21, 2010 but has not had any meetings to date. Per the By-Laws, upon establishment of an Executive Committee of the Board, the executive committee shall, to the extent permitted by law, exercise all the authority of the Board in the management of the Company in the intervals between meetings of the Board. The following persons were serving on the Executive Committee at December 31, 2011: Jeffrey G. Nordstrom William A. Smith Shawn T. Loftus TRANSACTIONS WITH AFFILIATES Amended and Restated Services Agreement This agreement, between USAA and its affiliates, including the Company, addresses the services and facilities provided by USAA to its U.S. affiliates. Costs are allocated to the affiliates based on the charge for the services and facilities provided using USAA s internal cost allocation process. Services to be performed under this Agreement include administrative services, professional services, insurance services, investment services, information technology services, marketing and call center services, and banking services. The Agreement also provides for USAA and affiliates to share employees. The effective date of the amended agreement is November 15, The Company will reimburse USAA monthly or annually depending on the materiality of the charges for the services performed. USAA Group Federal Income Tax Liability and Allocation Agreement 9

13 This agreement is between USAA and any subsidiary or affiliate of USAA. The agreement provides for the filing of a consolidated federal income tax return. The tax liability will be allocated among the parties based upon the ratio of the separate taxable income of each party to the sum of all taxable income. USAA Group State Income/Franchise Tax Liability Allocation Agreement This agreement is between USAA and the subsidiaries, affiliates or successors of USAA. It is agreed that the Tax Compliance Officer of USAA is delegated authority to determine the procedure and method for filing state or local franchise and income tax returns. The combined tax liabilities will be allocated and paid between the parent or subsidiaries at least annually, but not more often than quarterly. The combined taxes will be generally allocated among parties to the contract using a Separate Company method which is consistent with the method used to allocate federal income tax. TERRITORY AND PLAN OF OPERATION As evidenced by current or continuous Certificates of Authority, the Company is licensed to transact business in all states, with the exception of Connecticut, New Hampshire and New York. Prior to its acquisition by USAA Life Insurance Company in 2007, the Company briefly wrote business during Production ceased in the third quarter of 2000, and the minimal amount of business remaining was placed into run-off. The Company started writing business again in The initial product offerings are two simplified issue life insurance products. The two products are Starter Term, which is a low cost entry level term life insurance product, and Simple Life for Home, which is designed with a simplified underwriting experience that allows qualified members to purchase simplified issue term life insurance in connection with the purchase of a home. 10

14 REINSURANCE Ceded As of December 31, 2011, the Company ceded a total of $690,363 of life premiums and $405 of accident and health premiums for all reinsurance arrangements in 2011 and took total reserve credits of $383,194 on life and $9,874 on accident and health business. The Company ceded reinsurance using coinsurance agreements on an automatic basis. The coinsurance arrangements were used primarily with level term products and were first dollar quota share with a high percentage of the business reinsured. The Company s general policy was to use several ceded reinsurance arrangements to provide coverage on risks in excess of $200,000 per life. For Term insurance, the Company enters into certain reinsurance treaties that are based on a first dollar quota-share pool. These agreements have quota share coinsurance varying from 75% to 80% of the risk, up to the normal retention limit. Once the $200,000 retention limit has been reached, the quota-share pool also reinsures the remaining risk above the Company s retention. The credit life insurance and credit accident and health business is 100% coinsured by Household Life Insurance Company. The direct premiums, losses, expenses, and reserves for these blocks of business are 100% ceded and are therefore presented as zero on a net basis in the accompanying financial statements. The Company is named on a quota share coinsurance agreement with RGA Reinsurance Company (RGA), Swiss Re Life & Health America, Inc. (Swiss Re), and Transamerica Life Insurance Company (Transamerica) which became effective June 1, The Company s Five Year Renewable Convertible Term is the plan that is reinsured and they retain 25% of the business while ceding 30% of the face amount to RGA up to a maximum of $30,000, 20% of the 11

15 face amount to Transamerica up to a maximum of $20,000, and 25% of the face amount to Swiss Re up to $25,000. It was noted that the contract with Swiss Re stated a ceding percentage of 18.75% but when looked into further, the billing statements showed that 25% was ceded in order for the total ceding percentage to equal 75%. The Company is named on another quota share coinsurance agreement with Transamerica, RGA, Hannover Life Reassurance Company of America (Hannover), Generali USA Life Reassurance Company (Generali), and General Re Life Corporation (General Re) which became effective February 1, The Company s Simple Life for Home is the plan that is reinsured and they retain 20% of the business while ceding the remaining 80% to a pool of reinsurers; ceding 25% of the pool face amount to Transamerica up to a maximum of $110,000, 15% of the pool face amount to RGA up to a maximum of $82,500, 25% of the pool face amount to Hannover up to a maximum of $110,000, 20% of the pool face amount to Generali up to a maximum of $88,000, and 15% of the pool face amount to General Re up to a maximum of $66,000. It was noted that the contract with Hannover stated a ceding percentage of 80% but when looked into further, the billing statements showed that 25% was ceded which is the correct percentage. The General Re agreement was also noted as not being executed and instead it was just a letter from General Re stating the terms of an agreement to be executed in the future. General All contracts reviewed contained standard insolvency, arbitration, errors and omissions, and termination clauses where applicable. All contracts contained the clauses necessary to assure reinsurance credits could be taken. It was noted in the reinsurance review, however, that the offset clause uses language that appears to make the clause apply to other reinsurance contracts and not solely the contract being read and therefore it is not in compliance with SSAP No

16 BODY OF REPORT GROWTH The following comparative data reflects the growth of the Company during the period covered by this examination: Bonds 8,027,558 7,147,815 Admitted assets 9,240,141 7,413,612 Aggregate reserves for life contracts (8,788) 21,677 Total liabilities 144, ,260 Capital and surplus 9,095,297 6,425,352 Premium income (57,722) (139,063) Net investment income 115, ,805 Death benefits 50,000 Net income (151,444) (2,676,604) Life insurance in-force (in thousands) 68, ,105 FINANCIAL STATEMENTS The following statement of admitted assets and liabilities, together with the accompanying summary of operations, reflects the financial condition of the Company at December 31, 2011 and its transactions during the year 2011 as determined through this examination. A reconciliation of the capital and surplus account for the period under review is also included. FINANCIAL STATEMENT December 31, 2011 Assets Net Assets Not Admitted Assets Admitted Assets 13

17 Bonds $7,147,815 $7,147,815 Cash and short-term investments 132, ,222 Subtotal, cash and invested assets $7,280,037 $7,280,037 Investment income due and accrued 27,342 27,342 Amounts recoverable from reinsurers 75,000 75,000 Other amounts receivable under reinsurance contracts 25,112 25,112 Guaranty funds receivable 3,121 3,121 State tax recoverable 3,000 3,000 Totals $7,413,612 $7,413,612 Liabilities, Surplus, and Other Funds Aggregate reserve for life contracts $ 21,677 Life contract claims 25,000 Premiums received in advance 690 Other amounts payable on reinsurance 39,980 Interest maintenance reserve 7,788 Current federal income taxes 534,823 Remittances and items not allocated 145 Payable to parent, subsidiaries and affiliates 358,039 Accrued interest payable on policy funds 118 Total liabilities $ 988,260 Common capital stock $2,500,000 Gross paid in and contributed surplus 5,555,362 Unassigned funds (surplus) (1,630,010) Surplus $3,925,352 Total capital and surplus $6,425,352 Totals $7,413,612 SUMMARY OF OPERATIONS 2011 Premiums for life contracts $ (139,063) Net investment income 178,805 Amortization of interest maintenance reserve 1,763 14

18 Commissions and expense allowances on reinsurance ceded 521,012 Miscellaneous income (109) Totals $ 562,408 Death benefits $ 50,000 Interest and adjustments on contract funds 784 Increase in aggregate reserves for life contracts 30,465 Totals $ 81,248 General insurance expenses $ 2,971,926 Insurance taxes, licenses and fees 192,078 Totals $ 3,245,252 Net gain from operations before federal income taxes $(2,682,844) Federal income taxes incurred (6,240) Net income $(2,676,604) CAPITAL AND SURPLUS ACCOUNT Capital and surplus, beginning $9,247,086 $ 9,095,297 Net income $ (151,444) $(2,676,604) Change in net deferred income tax 265 (265) Change in nonadmitted assets 1, Change in asset valuation reserve (2,247) 6,659 Net change for the year $ (151,789) $(2,669,945) Capital and surplus, ending $9,095,297 $ 6,425,352 EXAMINATION CHANGES IN FINANCIAL STATEMENTS 15

19 Unassigned funds (surplus) in the amount of $(1,630,010), as reported in the Company's 2011 Annual Statement, has been accepted for examination purposes. Examination findings, in the aggregate, were considered to have no material effect on the Company s financial condition. COMPLIANCE WITH PREVIOUS RECOMMENDATIONS No recommendations were made as a result of the previous examination. COMMENTARY ON CURRENT EXAMINATION FINDINGS Reinsurance Contract Not Executed The Company has a reinsurance agreement with General Re Life Corporation that has been in effect since February 1, At this time the reinsurance contact still has not been executed. Therefore, it appears that the Company is not in compliance with Title 210, Chapter 57, which states, in the case of a letter of intent, a reinsurance agreement or an amendment to a reinsurance agreement must be executed within a reasonable period of time, not exceeding ninety (90) days from the execution date of the letter of intent, in order for credit to be granted for the reinsurance ceded. It is recommended that the Company executes all reinsurance contracts in accordance with Nebraska Title 210, Chapter 57. Offset Clause in Reinsurance Contracts Review of the reinsurance contracts noted that the Company has a right to offset clause within the agreement, however, it does not appear to comply with SSAP No. 64 which in part states, a right of setoff is a reporting entity s legal right, by contract or otherwise, to discharge all or a portion of the debt owed to another party by applying an amount that the other party owes to the reporting entity against the debt. The Nebraska Department of Insurance has determined that the right to offset applies to the reinsurance contract only and not to other 16

20 contracts. It is recommended that the Company ensures that their reinsurance agreements are in compliance with SSAP No. 64. SUMMARY OF COMMENTS AND RECOMMENDATIONS examination: The following comments and recommendations have been made as a result of this Reinsurance Contract Not Executed It is recommended that the Company executes all reinsurance contracts in accordance with Nebraska Title 210, Chapter 57. Offset Clause in Reinsurance Contracts It is recommended that the Company ensures that their reinsurance agreements are in compliance with SSAP No

21 ACKNOWLEDGEMENT The courteous cooperation extended by the Officers and employees of the Company during this examination is hereby acknowledged. In addition to the undersigned, Linda Scholl, CFE, Information Systems Specialist with the Nebraska Department of Insurance, participated in this examination and assisted in the preparation of this report. Respectfully submitted, Andrea Szwanek, CFE Examiner-in-Charge Department of Insurance State of Nebraska 18

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