- -------- (1) An adjustment of $93.6 million for the anticipated increase in claims duration considering the inpact of the merger with UNUM and an $8.0 million reserve strengthening for single premium annuities decreased operating results for 1998 by $101.6 million before taxes and $66.0 million ($0.48 per common share assuming dilution) after taxes. (2) The Company acquired GENEX Services, Inc. and The Paul Revere Corporation on February 28, 1997, and March 27, 1997, respectively. These financial results include the accounts and operating results from their respective dates of acquisition. The difference in comparability of the years is frequently attributed to this fact. See "Note 13 of the Notes to Consolidated Financial Statements."
(1) Revenue earned on corporate assets, general corporate expenses, interest expense on corporate debt, amortization of goodwill, and assets maintained for general corporate purposes are included in the Corporate segment. Assets have been allocated to the segments based upon identifiable liabilities and allocated stockholders' equity.
Amounts for 1997 and 1996 have been reclassified to conform to current year presentation.
Results for Affinity Groups, previously reported as a separate line of business in the Employee Benefits segment, have been allocated by product type to various other lines of business in the Employee Benefits and Other segments. Results for Voluntary Benefits, previously included in the Employee Benefits segment, are now reported as a separate segment. Results for Corporate, previously included in the Other segment, are now reported as a separate segment.
Management believes that the trends in new annualized sales in the Individual and Employee Benefits segments are important for investors to assess in their analysis of the Company's results of operations. The trends in new sales are indicators of the level of market acceptance of new products, particularly in the individual disability income line of business, and the Company's potential for growth in its respective markets. The Company has closely linked its various incentive compensation plans for management and employees to the achievement of its goals for new sales.
Revenue excluding net realized investment gains and losses ("revenue") increased $365.9 million, or 10.3 percent to $3,904.0 million in 1998 from $3,538.1 million in 1997. Revenue includes premium income, net investment income, and other income. This increase resulted from increased revenue in the Individual segment ($351.3 million), Employee Benefits segment ($201.3 million), Voluntary Benefits segment ($7.9 million), and Corporate segment ($4.8 million). This increase was partly offset by lower revenue in the Other segment ($199.4 million).
In 1997, revenue increased $1,237.6 million, or 53.8 percent, to $3,538.1 million from $2,300.5 million in 1996. This increase resulted from increased revenue in the Individual segment ($877.3 million), Employee Benefits segment ($335.0 million), Voluntary Benefits segment ($11.1 million), and Other segment ($15.4 million). This increase was partly offset by lower revenue in the Corporate segment ($1.2 million).
Revenue is not expected to be significantly impacted by the transition in products due to continued favorable persistency. The magnitude and duration of the decline in sales from previous years, such as that experienced during 1997 and 1998, are dependent on the response of customers and competitors in the industry.
Income in the Individual segment increased $2.7 million, or 1.2 percent, to $235.0 million in 1998 from $232.3 million in 1997. The increase in this segment was primarily the result of increased income in the individual life line of business to $36.0 million in 1998 from $28.7 million in 1997 due to the acquisition of Paul Revere and higher net investment income. Income in the individual disability income line of business declined $4.6 million, or 2.3 percent, to $199.0 million in 1998 from $203.6 million in 1997. This decline is primarily due to an $81.0 million increase in the individual disability reserves for existing claims related to the expected increase in claims duration due to management's expectation that productivity in the claims organization will be impacted as a result of planning, consolidation, and integration efforts related to the Company's merger with UNUM Corporation ("UNUM"). The impact on productivity is expected to lengthen the average claims duration for a relatively short period of time until the new claims organization completes its transition process following the merger.
- -------- (1) Results for 1997 and 1996 have been reclassified to conform to current year presentation.
Revenue in the Employee Benefits segment increased $201.3 million, or 27.6 percent, to $931.8 million in 1998 from $730.5 million in 1997. Premium income in this segment increased $158.3 million, or 28.7 percent, to $710.6 million in 1998 from $552.3 million in 1997. The increase is the result of the acquisition of Paul Revere and increased premium income in the group disability, group life, and accidental death and dismemberment lines of business. Revenue from GENEX totaled $92.3 million in 1998 compared to $72.3 million in 1997 subsequent to its acquisition.
this segment of $226.5 million, or 69.5 percent, to $552.3 million in 1997 from $325.8 million in 1996. The increase was primarily the result of the acquisition of Paul Revere, which added to premium income in the group life and group disability lines of business. In 1997, Paul Revere added $211.4 million to premium income and $241.3 million to revenue. GENEX contributed $72.3 million of revenue in 1997 subsequent to its acquisition.
Income in the Employee Benefits segment increased $45.6 million, or 114.0 percent, to $85.6 million in 1998 from $40.0 million in 1997. The increase is primarily the result of the acquisition of Paul Revere and improved results in the group disability, group life, accidental death and dismemberment, and GENEX lines of business. The group disability line of business produced income of $39.4 million in 1998 compared to $15.3 million in 1997, primarily due to the acquisition of Paul Revere and the impact of updated factors used in calculating Social Security offset amounts and probabilities and claim termination rates, resulting from year-end 1997 group disability reserve studies. Included in the results from this line for 1998 is a $12.6 million increase in group disability reserves for existing claims related to the expected increase in claims duration due to management's expectation that productivity in the claims organization will be impacted as a result of planning, consolidation, and integration efforts related to the Company's merger with UNUM. Also in this segment, income in the group life and accidental death and dismemberment lines increased to $41.0 million in 1998 from $22.7 million in 1997. Income for GENEX increased to $5.2 million in 1998 from $2.0 million in 1997.
Revenue in the Voluntary Benefits segment increased $7.9 million, or 7.3 percent, to $116.4 million in 1998 from $108.5 million in 1997. The increase is primarily the result of an increase in premium income in this segment of $4.9 million, or 6.2 percent, to $84.2 million in 1998 from $79.3 million in 1997. Also in this segment, net investment income increased $1.9 million, or 7.5 percent, to $27.1 million in 1998 from $25.2 million in 1997. New sales in this segment increased 4.2 percent to $29.9 million in 1998 from $28.7 million in 1997.
In 1997, revenue in the Voluntary Benefits segment increased $11.1 million, or 11.4 percent, to $108.5 million from $97.4 million in 1996. The increase is primarily the result of an increase in premium income of $8.7 million, or 12.3 percent, to $79.3 million in 1997 from $70.6 million in 1996. Also in this segment, net investment income increased $1.9 million, or 8.2 percent, to $25.2 million in 1997 from $23.3 million in 1996. New sales in this segment increased 24.8 percent in 1997 to $28.7 million from $23.0 million in 1996.
Income in the Voluntary Benefits segment increased $8.1 million, or 53.6 percent, to $23.2 million in 1998 from $15.1 million in 1997. The increase is primarily the result of an increase in revenue as well as improved mortality experience in 1998 relative to 1997.
In 1997, income in the Voluntary Benefits segment increased $0.4 million, or 2.7 percent, to $15.1 million from $14.7 million in 1996, primarily as a result of an increase in revenue and an improved mortality experience.
Revenue in the Other segment declined $199.4 million, or 25.8 percent, to $574.6 million in 1998 from $774.0 million in 1997. The decline in revenue in this segment is primarily due to lower net investment income, which declined $156.8 million, or 25.4 percent, to $460.8 million in 1998 from $617.6 million in 1997. This decline is primarily the result of a decrease in GIC funds under management from $1,603.6 million as of December 31, 1997, to $656.8 million as of December 31, 1998, resulting from the strategic decision to discontinue the sale of GICs. Also in this segment, premium income declined $57.3 million, or 42.3 percent, to $78.2 million in 1998 from $135.5 million in 1997. This decline is primarily due to the transfer of the dental block in 1997.
Revenue in the Corporate segment increased $4.8 million, or 21.1 percent, to $27.6 million in 1998 from $22.8 million in 1997. This increase is primarily the result of higher net investment income from unallocated capital and surplus.
In 1997, revenue in the Corporate segment declined $1.2 million, or 5.0 percent, to $22.8 million from $24.0 million in 1996. This decline is primarily the result of a lower level of net investment income from unallocated capital and surplus.
In April 1998, the Company entered into a $150.0 million five-year revolving credit facility and a $150.0 million 364-day revolving credit facility with various domestic and international banks. The purpose of the facilities is for general corporate purposes. There are no outstanding borrowings under either of the credit facilities.
The proceeds from these offerings funded the repayment of the short-term borrowing used for the February 1998 debt repayment and preferred stock redemption.
The Company believes the cash flow from its operations will be sufficient to meet its operating and financial cash flow requirements. Periodically, the Company may issue debt or equity securities to fund internal expansion, acquisitions, investment opportunities, and the retirement of the Company's debt and equity.
State insurance laws generally restrict the ability of insurance companies to pay cash dividends or make other payments to their affiliates in excess of certain prescribed limitations. In the Company's insurance subsidiaries' states of domicile, regulatory approval is required if an insurance company seeks to make loans to affiliates in amounts equal to or in excess of three percent of the insurer's admitted assets or to pay cash dividends in any twelve month period in excess of the greater of such company's net gain from operations of the preceding year or ten percent of its surplus as regards policyholders as of the preceding year end, each as determined in accordance with accounting practices prescribed or permitted by insurance regulatory authorities. The Company anticipates that $153.3 million will be available in 1999 for such purposes without regulatory approval.
In November 1998, the Company announced its plans to merge with UNUM, a leading provider of disability products and other employee benefits, in a transaction that will create UNUMProvident Corporation. See "Note 17 of the Notes to Consolidated Financial Statements" for further discussion.
The Company is subject to various market risk exposures including interest rate risk and foreign exchange rate risk. The following discussion regarding the Company's risk management activities includes forward-looking statements that involve risk and uncertainties. Estimates of future performance and economic conditions are reflected assuming certain changes in market rates and prices were to occur (sensitivity analysis). Caution should be used in evaluating the Company's overall market risk from the information presented below, as actual results may differ. The Company employs various derivative programs to manage these material market risks. See "Notes 3 and 4 of the Notes to Consolidated Financial Statements" for further discussions of the qualitative aspects of market risk, including derivative financial instrument activity.
The operations of the Company are subject to risk resulting from interest rate fluctuations, primarily long-term U.S. interest rates. Changes in interest rates and individuals' behavior affect the amount and timing of asset and liability cash flows. Management continually models and tests asset and liability portfolios to improve
Assuming an immediate increase of 100 basis points in interest rates from the December 31, 1998 levels, the net hypothetical decrease in stockholders' equity related to financial and derivative instruments is estimated to be $455.2 million at December 31, 1998. Additionally, the fair value of those assets currently reported in the Consolidated Statements of Financial Condition at their amortized cost or unpaid balances, namely held-to-maturity securities and policy loans, would decrease by $36.0 million and $179.9 million, respectively. Assuming a 100 basis point decrease in long-term interest rates from the December 31, 1998 level, the fair value of the Company's long-term debt and company-obligated mandatorily redeemable preferred securities would increase approximately $63.4 million and $46.2 million, respectively. The effect of a change in interest rates on asset prices is determined using a matrix pricing system whereby all securities are priced with the resulting market rates and spreads assuming a change of 100 basis points. These hypothetical prices are compared to the actual prices for the period to compute the overall change in market value. The changes in fair value of long-term debt and company-obligated mandatorily redeemable preferred securities are determined using discounted cash flows analyses. Because the Company actively manages its investments and liabilities, actual changes could be less than those estimated above.
Investment activities are an integral part of the Company's business, and profitability is significantly affected by investment results. Invested assets are segmented into portfolios, which support the various product lines. Generally, the investment strategy for the portfolios is to match the effective asset durations with related expected liability durations and to maximize investment returns, subject to constraints of quality, liquidity, diversification, and regulatory considerations. The following table provides the distribution of invested assets for the years indicated.
For the past three years, the Company's exposure to non-current investments has improved significantly from prior years. These non-current investments are primarily foreclosed real estate and mortgage loans which became more than thirty days past due in their principal and interest payments. Non-current investments totaled $20.5 million at December 31, 1998, or 0.12 percent of invested assets.
Changes in interest rates and individuals' behavior affect the amount and timing of asset and liability cash flows. Management regularly models and tests all asset and liability portfolios to improve interest rate risk management and net yields. Testing the asset and liability portfolios under various interest rate and economic scenarios allows management to choose the most appropriate investment strategy as well as to prepare for the most disadvantageous outcomes.
The Company utilizes forward interest rate swaps, forward treasury purchases, and options on forward interest rate swaps to manage and increase yield on cash flows expected from current holdings. All transactions are hedging in nature and not speculative. Almost all transactions are associated with the individual disability product portfolio. See "Note 4 of the Notes to Consolidated Financial Statements" for further discussion.
In addition, there are different areas of remediation requiring different solutions. These include the following: (i) business applications (systems supporting core business processes; this area constitutes more than 75 percent of the overall project effort), (ii) user developed systems (non-mission critical systems developed by business areas in the Company for specific tasks), (iii) hardware and software (computers, central operating systems, software development, and non-information technology systems; this area requires contacting vendors as to year 2000 compliance), (iv) enterprise computing (compliance of the computing infrastructure and year 2000 test facilities), and (v) business partners (other external business relationships that have year 2000 compliance issues; this area requires contacting third parties as to the status of year 2000 compliance). Operational control of the project is the responsibility of the project office.
The following table provides information as to the timeline of phases of completion of the year 2000 project for different areas of the Company's business:
- -------- (1) With regard to GENEX, a separate operating subsidiary acquired in February 1997, the primary approach to attaining year 2000 compliance will be replacing non-compliant systems with compliant systems. This process is expected to be complete in the third quarter of 1999.
With the exception of GENEX, as of December 31, 1998, the Company has completed the compliance testing of its material business systems. Compliance testing was conducted in an isolated, date-forward environment using the Company's standard of compliance (see above). In March 1999, the Company will begin periodically testing its systems in this date-forward environment to ensure continued compliance into the next century, as well as scheduling testing of external electronic interfaces with its business partners.
The foregoing discussion of the year 2000 issue contains forward-looking statements relating to such matters as financial performance and the business of the Company. The Private Securities Litigation Reform Act of 1995 provides a safe harbor for forward-looking statements. In order for the Company to comply with the
See "Note 1 of the Notes to Consolidated Financial Statements" for information concerning accounting pronouncements outstanding.
We have audited the accompanying consolidated statements of financial condition of Provident Companies, Inc. and Subsidiaries as of December 31, 1998 and 1997, and the related consolidated statements of income, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 1998. Our audits also included the financial statement schedules listed in the Index at Item 14(a). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
Basis of Presentation: The accompanying financial statements have been prepared on the basis of generally accepted accounting principles. Such accounting principles differ from statutory accounting practices prescribed or permitted by state regulatory authorities (see Note 16). The consolidated financial statements include the accounts of Provident Companies, Inc. and its wholly-owned subsidiaries (the Company). Material intercompany transactions have been eliminated. Certain prior year amounts in the consolidated financial statements have been reclassified to conform to the 1998 presentation.
hold to maturity are classified as available-for-sale. Fixed maturity securities that the Company has the positive intent and ability to hold to maturity are classified as held-to-maturity. The Company determines the appropriate classification of fixed maturity securities at the time of purchase.
Realized investment gains and losses, which are reported as a component of revenue in the consolidated statements of income, are based upon specific identification of the investments sold and do not include amounts allocable to separate accounts. At the time a decline in the value of an investment is determined to be other than temporary, a loss is recorded which is included in realized investment gains and losses.
The fair values of interest rate swap agreements which hedge available-for- sale securities are reported in the consolidated statements of financial condition as a component of fixed maturity securities. The fair values of interest rate swap agreements which hedge liabilities are not reported in the consolidated statements of financial condition. Amounts to be paid or received pursuant to interest rate swap agreements are accrued and recognized in the consolidated statements of income as an adjustment to net investment income for asset hedges or as an adjustment to policy and contract benefits for liability hedges.
The Company accounts for all of its interest rate swap agreements as hedges. Accordingly, any gains or losses realized on closed or terminated interest rate swap agreements are deferred and amortized to net investment income for asset hedges or policy and contract benefits for liability hedges over the expected remaining life of the hedged item. If the hedged item matures or terminates earlier than anticipated, the remaining unamortized gain or loss is amortized to net investment income or policy and contract benefits in the current period. If the hedged asset is disposed, the remaining unamortized gain or loss is recognized as an adjustment to net realized investment gains and losses. Gains or losses realized on interest rate swap agreements which are terminated when the hedged assets are sold or which are terminated because the hedged anticipated transaction is no longer likely to occur are reported in the consolidated statements of income as a component of net realized investment gains and losses. The Company regularly monitors the effectiveness of its hedging programs. In the event a hedge becomes ineffective, it is marked-to-market, resulting in a charge or credit to net investment income or policy and contract benefits.
Option Contracts give the owner the right, but not the obligation, to buy or sell a financial instrument at an agreed-upon price on or before a specific date. The purchasing counterparty pays a premium to the selling counterparty for this right. The notional amounts of contracts represent the Company's involvement but not the future cash requirements, as the Company intends to close out contracts prior to the expiration date when the market price of the underlying financial instrument exceeds the option price or allow contracts to expire if the option price exceeds the market price. All of the Company's option contracts are accounted for as hedges. The book and fair values of option contracts are reported in the statements of financial condition in a manner similar to the underlying hedged item. Gains or losses on the termination of option contracts are accounted for in the same manner as interest rate swap agreements.
Goodwill: Goodwill is the excess of the amount paid to acquire a business over the fair value of the net assets acquired. Goodwill is amortized on a straight-line basis over a period not to exceed 40 years. The accumulated amortization for goodwill was $33.6 million and $12.6 million as of December 31, 1998 and 1997, respectively. The carrying amount of goodwill is regularly reviewed for indicators of impairment in value.
Policy and Contract Benefits: Policy and contract benefits, principally related to accident and health insurance policies, are based on reported losses and estimates of incurred but not reported losses for traditional life and accident and health products. For interest-sensitive products, benefits are the amounts paid and expected to be paid on insured claims in excess of the policyholders' policy fund balances.
Reserves for Future Policy and Contract Benefits: Active life reserves for future policy and contract benefits on traditional life and accident and health products have been provided on the net level premium method. The reserves are calculated based upon assumptions as to interest, withdrawal, morbidity, and mortality that were appropriate at the date of issue. Withdrawal assumptions are based on actual Company experience. Morbidity and mortality assumptions are based upon industry standards adjusted as appropriate to reflect actual Company experience. The assumptions vary by plan, year of issue, and policy duration and include a provision for adverse deviation.
Translation of Foreign Currency: Revenues and expenses of the Company's Canadian operations are translated at average exchange rates. Assets and liabilities are translated at the rate of exchange on the balance sheet date. The translation gain or loss is generally reported in accumulated other comprehensive income, net of deferred tax.
Statement of Financial Accounting Standards No. 132 (SFAS 132), Employers' Disclosures about Pensions and Other Postretirement Benefits. In 1998, the Company adopted the provisions of SFAS 132 which revise employers' disclosures about pension and other postretirement benefit plans. It standardizes the disclosure requirements for pensions and other postretirement benefits to the extent practicable, requires additional information on changes in the benefit obligations and fair values of plan assets that will facilitate financial analysis, and eliminates certain disclosures required by Statements of Financial Accounting Standards No. 87, Employers' Accounting for Pensions, No. 88, Employers' Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits, and No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions. Disclosures for prior periods have been restated for comparative
Statement of Financial Accounting Standards No. 123 (SFAS 123), Accounting for Stock-Based Compensation. SFAS 123 defines a fair value based method of accounting for stock-based employee compensation plans. Under this method, compensation cost is measured at the grant date based on the value of the award and is recognized over the service period, which is usually the vesting period. SFAS 123 also allows an entity to continue to measure compensation cost using the intrinsic value based method of accounting prescribed by Accounting Principles Board Opinion No. 25 (Opinion 25), Accounting for Stock Issued to Employees. Under this method, compensation cost is the excess, if any, of the quoted market price of the stock at grant date or other measurement date over the amount an employee must pay to acquire the stock. The Company adopted the provisions of SFAS 123 in 1996 (see Note 11), but elected to continue to measure compensation cost for stock-based compensation under the expense recognition provisions of Opinion 25. The adoption of SFAS 123, therefore, did not have an effect on the Company's financial position or results of operations.
Cash flow hedge. To the extent it is effective, changes in the fair value of the derivative are recognized as a component of accumulated other comprehensive income in stockholders' equity until the hedged item affects earnings. Any ineffective portion must be recognized in income at the same time the change in fair value is recognized on the statement of financial condition.
Foreign currency exposures hedge. In a hedge of foreign currency exposures in a net investment in a foreign operation, to the extent the hedge is effective, the change in the fair value of the derivative is treated as a translation gain or loss and recognized in accumulated other comprehensive income offsetting other translation gains and losses arising in consolidation. Any ineffective portion must be recognized in income at the same time the change in fair value of the derivative is recognized on the statement of financial condition.
Statement of Position 98-1 (SOP 98-1), Accounting for the Costs of Computer Software Developed for or Obtained for Internal Use. In 1998, the American Institute of Certified Public Accountants (AICPA) issued SOP 98-1 which requires the capitalization of certain costs incurred in connection with developing or obtaining software for internal use. SOP 98-1 is to be applied prospectively from the date of adoption. At this time, the effects that the adoption of SOP 98-1 will have on the Company's financial statements have not been determined. The Company will adopt the provisions of SOP 98-1 effective January 1, 1999.
Mortgage Loans: Fair values for mortgage loans are based on estimated sales prices at the balance sheet date.
Short-term Investments and Cash and Bank Deposits: Carrying amounts for short-term investments and cash and bank deposits approximate fair value.
Policyholders' Funds: Fair values for GICs are estimated using discounted cash flow calculations, based on current market interest rates available for similar contracts with maturities consistent with those remaining for the contracts being valued. At December 31, 1998, the carrying amounts for deferred annuity products
approximate fair value due to the assumption of business in 1998 as discussed in Note 14. At December 31, 1997, fair values for deferred annuity products are estimated using the cash surrender values of the annuity contracts. The carrying amounts for supplementary contracts without life contingencies approximate fair value.
Long-term Debt and Company-Obligated Mandatorily Redeemable Preferred Securities: Fair values for long-term debt and company-obligated mandatorily redeemable preferred securities were obtained from independent pricing services.
The basic types of risks associated with derivatives are market risk (that the value of the derivative will be adversely impacted by changes in the market, primarily the change in interest rates) and credit risk (that the counterparty will not perform according to the terms of the contract). The market risk of the derivatives should generally offset the market risk associated with the hedged financial instrument or liability.
acceptable collateral with the other counterparty in the event the net loss position meets or exceeds an agreed upon amount. The Company's current credit exposure on derivatives, which is limited to the value of those contracts in a net gain position, was $51.3 million at December 31, 1998.
The Company has executed a series of cash flow hedges in the individual disability income portfolio and the group single premium annuities portfolio. The purpose of these hedges is to lock in the reinvestment rates on future cash flows and protect the Company from the potential adverse impact of declining interest rates on the associated policy reserves. The Company uses futures contracts to partially offset hedges on fixed maturity securities purchased prior to the termination date of interest rate swaps and forwards. The Company also uses futures contracts to replace terminated forwards and interest rate swaps in order to maintain hedges until the fixed maturity securities are purchased.
At December 31, 1998 and 1997, the Company had an unrealized gain of $194.0 million and $133.8 million, respectively, on the open interest rate swaps, forwards, and futures. These derivatives are scheduled to be terminated in the years 1999 through 2002 as assets are purchased with the future anticipated cash flows.
In 1998 and 1997, the Company sold indexed annuity products whereby a portion of the crediting rate on the annuity was based on the performance of the S&P 500 stock index. In order to hedge this fluctuating credit rate, the Company purchased options with the S&P 500 stock index as the underlying item. These options will be settled with a net cash payment to the Company at the expiration date if the S&P 500 index moves above the
In 1998 and 1997, the Company opened interest rate futures contracts and wrote options on interest rate futures in order to hedge the borrowing rate on the anticipated refinancing of long-term debt (see Note 8). The Company realized a $10.3 million before-tax investment loss when these contracts were terminated. The loss on these contracts was deferred and is being amortized as an adjustment to interest and debt expense.
The deferred gain from this program amortized into income in the consolidated statements of income was $1.3 million, $2.0 million, and $2.2 million for the years ended December 31, 1998, 1997, and 1996, respectively.
During 1996, the Company terminated $600.0 million of these forward swaps as scheduled, realizing a $36.1 million before-tax investment loss. In addition, the Company used offsetting futures contracts to partially remove the hedge as fixed maturities were sold prior to the termination date of the interest rate swaps. The Company realized a $5.3 million before-tax investment loss on the termination of these futures contracts. The Company sold $423.0 million of fixed maturity securities associated with this hedge, realizing a $19.6 million before-tax investment gain.
During 1997, the Company terminated the remaining $300.0 million of these forward swaps as scheduled, realizing a $4.1 million before-tax investment loss. In addition, the Company used offsetting futures contracts to partially remove the hedge as fixed maturity securities were sold prior to the termination date of the interest rate swaps. The Company realized a $0.1 million before-tax investment gain on the termination of these futures contracts. The Company sold $302.0 million of fixed maturity securities associated with this hedge, realizing a $4.3 million before-tax investment gain.
The carrying amount of value of business acquired in 1996 was immaterial.
reserves has been calculated on the opening reserve balance less one-half year's cash payments at the average reserve discount rate used by the Company during 1998, 1997, and 1996.
During the fourth quarter of 1998, the Company recorded an increase in the reserve for existing individual and group disability claims of $93.6 million. This reserve increase is related to the expected increase in claims duration due to management's expectation that productivity in the claims organization will be impacted as a result of planning, consolidation, and integration efforts related to the merger with UNUM Corporation (see Note 17).
Significant components of the Company's deferred federal income tax liability are as follows:
be added after 1983 to the policyholders' surplus account. Further, any future distributions from the account would become subject to federal income taxes at the general corporate federal income tax rate then in effect. The amount of the policyholders' surplus account at December 31, 1998, is approximately $202.0 million. Future distributions from the policyholders' surplus account are deemed to occur if a statutorily prescribed maximum for the account is less than the value of the account or if dividend distributions exceed the total amount accumulated as currently taxable income in the year earned. If the entire policyholders' surplus account were deemed distributed in 1999, this would result in a tax of approximately $70.7 million. No current or deferred federal income taxes have been provided on these amounts because management considers the conditions under which such taxes would be paid to be remote.
In 1998, the Company negotiated a tentative settlement with the Internal Revenue Service of its federal income tax liability for years 1986 through 1992. The Internal Revenue Service continued its examination of the Company's federal income tax returns for tax years 1993 through 1995. Management believes this settlement and examination will have no material adverse impact on the Company's financial statements.
In 1996, the Company received a refund that had been accrued in 1995 relating to the final settlement of litigation for tax years 1980 through 1983. The refund of taxes was $1.5 million, and interest on the refund was $4.2 million. The Company also received a refund that had been accrued in 1994 relating to a final settlement of the remaining issues in dispute for the 1984 and 1985 tax years. The refund of taxes was $3.1 million, and related interest was $5.9 million.
Short-term debt at December 31, 1998 and 1997, was $39.4 million and $150.7 million, respectively, and consisted of reverse repurchase agreements with a weighted average interest rate of 5.75% and 6.38%, respectively.
In March 1998, the Company completed a public offering of $200.0 million of 7.25% senior notes due March 15, 2028. In July 1998, the Company completed a public offering of $200.0 million of 6.375% senior notes due July 15, 2005, and $200.0 million of 7% senior notes due July 15, 2018. The 7.25% senior notes are redeemable at the option of the Company. The 6.375% and 7% senior notes may not be redeemed prior to maturity.
Interest paid on short-term and long-term debt during 1998, 1997, and 1996 was $49.6 million, $41.4 million, and $17.1 million, respectively.
The Company sponsors defined benefit pension and postretirement plans for its employees. Plan assets of the pension plan are invested in two separate accounts of a subsidiary of the Company, one of which invests in listed equity securities and the other in corporate obligations and U.S. bonds, and in an unrelated trust consisting of bonds and equity securities. The postretirement life insurance plan is noncontributory and is partially funded through life insurance contracts issued by the Company. The postretirement health care plan is unfunded.
In 1998, the Company amended its other postretirement benefit plans, establishing uniform benefits among the Company's subsidiaries.
The following tables provide the changes in the benefit obligation and fair value of plan assets for the years ended December 31, 1998 and 1997, and statements of the funded status of the plans as of December 31, 1998 and 1997.
For measurement purposes, a 8.67% annual rate of increase in the per capita cost of covered health care benefits was assumed for 1999. The rate was assumed to decrease gradually to 5.00% for 2005 and remain at that level thereafter.
The assumed health care cost trend rate has a significant effect on the amounts reported. A 1% change in the assumed health care cost trend rate would have the following effects:
During February 1998, the Company redeemed its 8.10% cumulative preferred stock outstanding of $156.2 million at $150 per share equivalent to $25 per depositary share. At December 31, 1997, there were 6,249,202 shares issued and outstanding.
In July 1997, the Board of Directors authorized a two-for-one stock split effected in the form of a stock dividend distributed on September 30, 1997. As a result of this action, 67,547,586 shares were issued to stockholders of record on August 28, 1997. Par value remained at $1 per share as a result of transferring $67.5 million from additional paid-in capital to common stock, representing the aggregate par value of the shares issued under the stock split. Historical share and per share amounts in the consolidated financial statements and notes thereto have been restated to reflect the stock split.
The components of accumulated other comprehensive income, net of deferred tax, are as follows:
The Company has in effect a management incentive compensation plan, the first part of which contains both cash and equity components and is designed to encourage achievement of specific annual goals in which key employees participate. The compensation cost recognized in the consolidated statements of income for this part of the plan is $4.3 million, $6.4 million, and $3.6 million for 1998, 1997, and 1996, respectively. The second part of this plan is a stock option plan. The Company applies Opinion 25 and related interpretations in accounting for the stock option plan.
Under the 1994 stock plan, the Company could grant options of up to 10,000,000 shares of common stock over the five year term of the plan which ended effective December 31, 1998. The exercise price of each option equaled the market price of the Company's stock on the date of grant. The vesting period for these options is at least one year after the date of grant, and the options have a maximum term of ten years after the date of grant. Options granted prior to 1994 were under the 1989 stock option plan.
During 1998, the Company granted options of common stock to eligible employees who were not participants in the management incentive compensation plan. The exercise price of each option equaled the market price of the Company's stock on the date of grant. The vesting period for these options is three years, and the options have a maximum term of ten years after the grant date. Options of 311,900 shares of common stock were granted.
Had compensation cost for the two plans been determined in accordance with the provisions of SFAS 123, the Company's net income and earnings per common share would have been as follows:
The Company routinely assumes and cedes reinsurance with other insurance companies. The primary purpose of ceded reinsurance is to limit losses from large exposures; however, if the assuming reinsurer is unable to meet its obligations, the Company remains contingently liable. The Company evaluates the financial condition of reinsurers and monitors concentration of credit risk to minimize this exposure. The reinsurance receivable at December 31, 1998, relates to approximately 33 reinsurance relationships. Of the three major relationships which account for approximately 85 percent of the reinsurance receivable amount at December 31, 1998, two are with companies rated A+ (Superior) by the A.M. Best Company and the third is fully securitized by investment-grade fixed maturity securities held in trust.
In 1995, the Company entered into an indemnity and assumption reinsurance agreement with another insurance company in connection with the sale of the group medical business. Total premium income and policy and contract benefits ceded under this reinsurance agreement were $41.7 million and $33.3 million, respectively, for the year ended December 31, 1998, $182.9 million and $153.8 million, respectively, for the year ended December 31, 1997, and $224.6 million and $188.5 million, respectively, for the year ended December 31, 1996. Substantially all of the business reinsured under the indemnity reinsurance agreement was assumptively reinsured effective April 1, 1998.
The following pro forma results of operations for the years ended December 31, 1997 and 1996, give effect to the acquisitions and the related financing arrangements, including the acquisition of debt and issuance of common stock equity. The pro forma results of operations, prepared from historical financial results of operations of the Company, Paul Revere, and GENEX, with such adjustments as are necessary to present the results of operations as if the acquisitions had occurred as of the beginning of each year presented, are as follows:
In 1996, Paul Revere strengthened reserves in its individual disability segment by $380.0 million before income taxes, which resulted in a decrease in net income of $244.3 million ($1.82 per common share assuming dilution). The reserve strengthening results from a comprehensive study, completed in October 1996, of the adequacy of the individual disability reserves under generally accepted accounting principles.
In consideration for the transfer of statutory reserves, American General paid the Company a ceding commission of $58.0 million. In connection with the sale, the Company wrote off $18.7 million of goodwill associated with the annuity business acquired from Paul Revere. Total liabilities of $2,518.9 million were assumed by American General, and total assets, excluding the resulting reinsurance receivable, decreased $2,506.7 million. The gain recognized at the time of the sale increased 1998 operating earnings by $12.2 million ($0.09 per common share assuming dilution) before tax and $1.4 million ($0.01 per common share assuming dilution) after tax. Total revenue and income before federal income taxes for the annuity business sold were $152.7 million and $23.7 million, respectively, in 1997, and $24.6 and $0.1 million, respectively, in 1996. Included in these amounts were net realized investment gains of $8.0 million in 1997 and $0.5 million in 1996.
Regulatory restrictions limit the amount of dividends available for distribution to the Company from its insurance subsidiaries, without prior approval by regulatory authorities, to the greater of ten percent of an insurer's statutory surplus as regards policyholders as of the preceding year end or the statutory net gain from operations, excluding realized investment gains and losses, of the preceding year. The payment of dividends is further limited to the amount of statutory unassigned surplus. Based on these restrictions, $153.3 million will be available for the payment of dividends to the Company from its top-tier insurance subsidiaries during 1999.
In 1998, the NAIC approved a codification of statutory accounting practices effective January 1, 2001, which will serve as a comprehensive and standardized guide to statutory accounting principles. Following implementation, statutory accounting principles will continue to be governed by individual state laws and permitted practices until adoption by the various states. Accordingly, before codification becomes effective for the Company's insurance subsidiaries, their states of domicile must adopt codification as the prescribed basis of accounting. The adoption of the codification will change, to some extent, the accounting practices that the Company's insurance subsidiaries use to prepare their statutory financial statements.
The following pro forma combined condensed financial statements are presented to show the impact on the historical financial positions and results of operations of the Company and UNUM of the merger under the pooling of interests method of accounting. The pro forma combined condensed financial statements combine the historical financial information of the Company and UNUM as of December 31, 1998 and for each of the years ended December 31, 1998, 1997, and 1996. The pro forma combined condensed statements of income give effect to the merger as if it had been completed at the beginning of each year presented. The pro forma combined condensed balance sheet assumes the merger was completed on December 31, 1998.
(b) The pro forma adjustments to common stock, additional paid-in capital, and treasury stock reflect the retirement of shares of UNUM common stock held in treasury, the reclassification of the Company's
common stock on a 0.73 to 1 basis and the reduction in par value of the Company's common stock from $1.00 to $0.10 which results in 98.7 million shares issued to replace the 135.2 million shares of the Company's common stock held by stockholders on December 31, 1998, and the issuance to UNUM stockholders of 138.7 million shares of UNUMProvident common stock pursuant to the merger (calculated by multiplying the 138.7 million shares of UNUM common stock outstanding at December 31, 1998 by the exchange ratio of 1.0 to 1.0 representing the number of shares UNUM stockholders will receive for each share of UNUM common stock they own immediately prior to consummation of the merger). The number of shares of UNUMProvident common stock that will be issued after completion of the merger will be based on the actual number of shares of UNUM common stock and the Company's common stock (after the effectiveness of the Provident Reclassification Amendment) outstanding at the effective time of the merger.
The above unaudited combined condensed pro forma consolidated statements of income reflect the results of operations of the Company and UNUM combined for the years presented. No pro forma adjustments have been made to arrive at the UNUMProvident combined statements of income. Combined pro forma net income available to common shareholders of $615.5 million, $604.9 million, and $370.9 million for 1998, 1997, and 1996, respectively, was net of preferred stock dividends of $1.9 million in 1998 and $12.7 million in both 1997 and 1996. The pro forma combined basic and assuming dilution earnings per share for the years presented are based on the combined weighted average number of common and dilutive potential common shares and adjusted weighted shares of the Company and UNUM. The number of weighted average common shares and adjusted weighted average shares, including all dilutive potential common shares, reflects the reclassification of the Company's common stock on a 0.73 to 1 basis and the conversion of each outstanding share of UNUM common stock into one share of UNUMProvident common stock in the merger.
An adjustment of $93.6 million for the anticipated increase in claims duration considering the impact of the merger with UNUM and an $8.0 million reserve strengthening for single premium annuities decreased operating results for the fourth quarter of 1998 by $101.6 million before taxes and $66.0 million ($0.48 per common share assuming dilution) after taxes.