The current low level of interest rates and the potential impact on the Company’s reserve discount rate on new claims; and
The Company restructured its individual income protection - closed block of business during 2004, as discussed more fully herein. The Company believes that this restructuring strengthened its balance sheet and minimized the Company’s exposure to potential future adverse morbidity from this block of business.
Responding to the industry-wide focus on broker compensation and related matters, changes in the interest rate environment, and possible fluctuations in the dollar relative to foreign currencies and its impact on reported results for the Company’s foreign operations;
In April 2003, the Company completed an analysis of its assumptions related to its group long-term income protection claim reserves. Included in the analysis was a review of active claim reserves, incurred but not reported (IBNR) reserves, and claim reopen reserves. An active claim reserve is established for future benefit payments when a claim is incurred and reported to the Company. IBNR reserves are established on claims which are estimated to have been incurred but not yet reported to the Company. Claim reopen reserves are established for those claimants who have previously recovered but who are anticipated to return to disabled status under the same disability and within a specified period of time, as contractually allowed by the disability policy. The analysis was initiated based on lower claim resolution rates observed during the first quarter of 2003. The claim resolution rate is the rate of probability that a disability claimant will recover, die, or reach maximum benefit limits and no longer receive benefit payments from the Company. Generally, claim resolution rates vary by the age of the claimant at the time of disability, duration or length of time since the disability initially occurred, and claim diagnosis. The claim resolution rates for group long-term income protection during the first quarter of 2003 were below levels anticipated for reserves and were lower than those experienced in the full years 2002, 2001, and 2000. The analysis indicated not only a decrease in overall claim resolution rates, but also a change in claim resolution rates by claim duration. The analysis of emerging claim resolution rates and the reasons driving the changes resulted in a reduction in the Company’s long-term expectations with respect to claim resolution rates. The Company’s long-term expectations applied to all claims incurred regardless of the date of incurral. In addition, the Company reviewed the reserve discount rate, which is the interest rate at which future cash flows for benefits and expenses to be paid are discounted to determine the current value of those cash flows. The Company concluded at that time that a change in its discount rate assumptions was not warranted. Based on the April 2003 analysis, in the first quarter of 2003 the Company increased its group long-term income protection claim reserves by $454.0 million before tax, or $295.1 million after tax, to reflect its current estimate of future benefit obligations. The active claim reserve for claims already reported to the Company and still in open claim status was increased by $516.0 million, the IBNR reserve was decreased by $23.0 million, and the reopen reserve was decreased by $39.0 million before tax. The first quarter 2003 change represented a 6.5 percent increase in total net group long-term income protection reserves as of March 31, 2003, which for continuing operations equaled $7.017 billion prior to this increase and equaled $6.618 billion as of December 31, 2002.
Proceeds from the offerings were used primarily to increase the capitalization of the Company’s insurance subsidiaries and to repay amounts loaned to the Company from its insurance subsidiaries.
The Company has various stock-based employee compensation plans. Prior to 2003, the Company accounted for those plans under the recognition and measurement principles of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations. Effective January 1, 2003, the Company adopted the fair value recognition provisions of Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation, and selected the prospective method of adoption allowed under the provisions of Statement of Financial Accounting Standards No. 148, Accounting for Stock-Based Compensation - Transition and Disclosure. The adoption increased before tax operating expenses for 2003 approximately $0.9 million.
Since policies may receive claim payments for a number of years, it is unlikely that the chosen discount rate assumption will prove to be accurate for any one policy; rather, the discount rate is chosen to apply to many claims with various characteristics of length and severity. The Company uses its experience and analysis of its existing claims and investment performance to determine the appropriate discount rate assumption. Actual claim reserves incurred in the calendar quarter are sensitive to the choice of discount rate. For example, a 25 basis point increase or decrease in the group long-term income protection claim discount rate would have changed a quarter’s incurred claim cost in 2004 by approximately $5.0 million.
Sales in the Company’s U.S. operations declined in 2003 compared to the prior year, partially offset by an increase in sales in the United Kingdom operations. The decline in U.S. group life sales during 2003 was primarily attributable to lower sales in the large-employer market and the continuing impact of the Company’s strategic decision, which was fully implemented during 2002, to focus on integrated sales of life and income protection and less on stand-alone life sales. The increase in the United Kingdom sales was partially due to the inclusion of additional sales generated as a result of the 2003 Sun Life acquisition.
Past sales results have not grown at the rate the Company believes it can competitively and profitably achieve. In 2005, the emphasis will be on achieving consistent, profitable sales growth by focusing on the recruitment and productivity of agents, improved business tools, and enhanced marketing research and development.
During 2003, the Company recognized in the Corporate segment an impairment loss of $1.2 million before tax on its Japanese operation.
$3.9 million loss during the first quarter of 2004 on securities issued by a Brazilian electric generation company. This company experienced short-term liquidity problems, significant issues at affiliated companies, concerns regarding local utility regulation, and the weak Brazilian economy. Certain changes to the terms of these notes relative to the timing of principal and interest repayments were agreed upon by the note holders subsequent to negotiations finalized in the first quarter of 2004 and in conjunction with a comprehensive restructuring of the borrower’s parent company operations in Brazil. The securities were investment-grade at the time of purchase but were downgraded to below-investment-grade in the fourth quarter of 2002. At the time of the impairment loss, these securities had been in an unrealized loss position
$23.2 million loss during the first quarter of 2002 on securities issued by the holding company of a large national wholesale communications company. In the third quarter of 2001, the company reported sales of $298 million, a 42 percent increase over the comparable prior year period, and liquidity of $1.4 billion in cash equivalents. It was expected that the company would use the proceeds from the sale of non-core assets to further supplement liquidity. In January 2002, the company’s banks agreed to extend the negotiating period for an amendment to the credit agreement until the end of February 2002. During the first quarter of 2002, the company reported fourth quarter 2001 results, including an 11 percent increase in revenue to $330.3 million. The company had cash equivalents in excess of $1.0 billion, an indication that the company had sufficient liquidity to fund its business plan through 2003. However, late in the first quarter of 2002, the company’s banks unexpectedly refused to allow the company to draw on its credit lines. The company
For the year ended December 31, 2003, the Company realized a loss of $143.6 million on the sale of fixed maturity securities in its continuing operations. The securities sold during the year had a book value of $821.0 million and a fair value of $677.4 million at the time of sale and represented 94 different issuers, of which approximately 59 percent were a part of the Company’s previously discussed program to reduce its below-investment-grade fixed maturity securities holdings. Realized investment losses representing five percent or more of the total loss recognized during 2003 are as follows:
The Company had no impaired mortgage loans at December 31, 2004 or 2003, and no restructured mortgage loans at December 31, 2004. Restructured mortgage loans totaled $7.5 million at December 31, 2003, and represented loans that had been refinanced with terms more favorable to the borrower. Interest lost on restructured loans was immaterial for 2003.
The Company’s policyholder liability maturities, which are presented net of reinsurance ceded, represent the projected payout of the current inforce policyholder liabilities and therefore incorporate uncertainties as to the timing and amount of claim payments. The Company utilizes extensive liability modeling to project future cash flows from the inforce business. The primary assumptions used to project future cash flows are claim incidence rates for mortality and morbidity, claim resolution rates, persistency rates, and interest rates. These cash flows are discounted to determine the current value of the projected claim payments. The timing and amount of payments on policyholder liabilities may vary significantly from the projections above.
Statement of Financial Accounting Standards No. 123 (revised 2004) (SFAS 123(R)) requires all stock-based employee compensation, including grants of employee stock options, to be recognized in the financial statements using the fair value based method. SFAS 123(R) is a revision of SFAS 123 and supersedes Opinion 25. The Company will adopt the provisions of SFAS 123(R) effective July 1, 2005, as required. Because the Company adopted the fair value recognition provision of SFAS 123 effective January 1, 2003, the adoption of this pronouncement will have an immaterial impact on the Company’s financial position and results of operations.
Equity Securities: Fair values are based on quoted market prices, or, in the case of private placements, are based on the Company’s share of the investee’s ownership equity.
In January 2004, the Company completed its annual review of claim reserves to ensure that its claim reserves make adequate and reasonable provision for future benefits and expenses. Based upon this review, the Company increased its group income protection claim reserves as of December 31, 2003 by $440.0 million before tax, or $286.0 million after tax. Approximately $300.0 million of the reserve strengthening reflected implementation of a lower discount rate for the Company’s group income protection claim reserves. The discount rate was lowered to reflect the Company’s actual change in investment portfolio yield rates during 2003, the expectation of future investment portfolio yield rates, and the Company’s new discount rate management approach of maintaining a wider spread between its group income protection portfolio investment yield rate and its average discount rate. The Company’s new discount rate management approach is intended to better reflect the current investment environment and position the Company to be more responsive with discount rates on new incurred claims as changes to the investment environment emerge. Approximately $140.0 million of the reserve increase related to a strengthening of the morbidity assumptions to reflect the impact of the Company’s view of a continuing jobless economic recovery on claim incidence and severity. Of this amount, approximately $64.0 million was established to reflect higher claim incidence expectations. Claim incidence in the second half of 2003 was 8.4 percent higher than the first half of the year and 5.8 percent above the second half of 2002. Claim incidence was expected to continue at an elevated level for several quarters as the Company believed that early indications of a recovering economy were not yet reflected in improved consumer confidence or job creation. Also included in the $140.0 million strengthening was approximately $76.0 million to reflect higher severity expectations driven primarily by a lengthening of claim duration expectations in those claims that had been open 36 months or longer. The $440.0 million reserve increase represented a 5.4 percent increase in total net group income protection reserves as of December 31, 2003, which totaled $8.186 billion prior to this increase.
Substantially all of the Company’s employees are eligible to participate in an ESPP. Under the plan, up to 3,460,000 shares of the Company’s common stock are authorized for issuance. Stock may be purchased at the end of each financial quarter at a purchase price of 85 percent of the lower of its beginning or end of quarter market prices. The Company sold 205,172, 318,499, and 191,383 shares to employees with a weighted average exercise price of $12.88, $9.73, and $18.67 during the years 2004, 2003, and 2002, respectively.
The change in the Company’s reporting segments required the Company to perform, separately for the individual income protection - closed block business and individual income protection - recently issued business, impairment testing for goodwill and loss recognition testing for the recoverability of deferred policy acquisition costs and value of business acquired. As required under GAAP, prior to the change in reporting segments, these tests were performed for the individual income protection line of business on a combined basis. The testing indicated impairment of the individual income protection - closed block deferred policy acquisition costs, value of business acquired, and goodwill balances of $282.2 million, $367.1 million, and $207.1 million, respectively. Also as part of the restructuring, the Company increased its claim reserves for the closed block of individual income protection
On November 22, 2002, the first of five purported shareholder derivative actions, Ferrari, Derivatively on Behalf of Nominal Defendant UnumProvident Corporation v. Armstrong, et al., was filed in the State of Tennessee Chancery Court of Hamilton County. Between December 27, 2002 and March 11, 2003, four additional purported derivative actions were filed in Tennessee state court or the United District Court for the Eastern District of Tennessee, styled Lerner v. Armstrong, et al., Friedman v. Chandler, et al., Levy v. Chandler, et al., and Patterson v. Chandler, et al. The defendants removed each of the actions that were filed in Tennessee state court to the United States District Court for the Eastern District of Tennessee. On October 23, 2003, the district court denied motions filed by the plaintiffs to remand those actions back to Tennessee state court.
On October 17, 2003, the district court consolidated these actions under the caption In re UnumProvident Corporation Derivative Actions. On April 19, 2004, the plaintiffs filed a single consolidated amended complaint. On September 10, 2004, the defendants answered the consolidated amended complaint by denying generally the salient factual allegations in the complaint and by asserting various affirmative defenses. The defendants strongly deny the allegations in the complaints and will vigorously defend both the substantive and procedural aspects of the litigation.
On January 23, 2003, a jury in California State Court in Marin County, in the case of Chapman v. UnumProvident Corporation, et al., returned a verdict of $31.6 million against UnumProvident and two of its subsidiaries, The Paul Revere Life Insurance Company and Provident Life and Accident Insurance Company. The largest portion of the verdict was $30.0 million in punitive damages. The Company strongly disagreed with the verdict because the evidence did not support it. The Company filed post-trial motions which challenged, among other things, the excessiveness of the punitive damage award. On March 25, 2003, the court entered an order reducing the punitive damage award to $5.0 million, thereby reducing the total award to $6.1 million. On April 8, 2003, the plaintiff in the Chapman case accepted the reduced award. The Company has now appealed the final verdict to the California Court of Appeals.
On October 26, 2004, the Company received a subpoena from the Office of the Attorney General of the State of Connecticut. This subpoena also requested information regarding the quoting process and information regarding compensation agreements with brokers. The Company is producing information and will fully cooperate with this investigation.
On February 4, 2005, David Boros on behalf of himself and all others similarly situated v. Marsh and McLennan Companies, Inc., et al., was filed in the United States District Court of the Northern District of California. The complaint is a putative class action and alleges violations of the Sherman Act, RICO, federal and state common law, state antitrust laws, and unfair or deceptive trade practices laws. The allegations are brought against numerous broker organizations and insurers and assert claims based on bid-rigging, price fixing, and undisclosed and improper compensation practices. The complaint seeks restitution, disgorgement of profits, establishment of a constructive trust, injunctive relief, punitive damages, and damages as provided by federal and state antitrust laws and by RICO. The Company denies the allegations of the complaint and will vigorously defend the case.