Net income per diluted share was $3.73, $3.76 and $3.45 for the years 2006, 2005 and 2004, respectively. Net income for these same periods was $203.8 million, $211.1 million and $199.4 million, respectively. Net income for 2006 was affected by premium growth, offset by comparatively higher claims expense. Premium growth in the Insurance Services segment was 6.1% for 2006 compared to 2005, and 10.1% for 2005 when compared to 2004. For the Insurance Services segment, claims experience for the group insurance products, as indicated by the benefit ratio (benefits to policyholders and interest credited measured as a percentage of premiums), was 78.3% for 2006, compared to a favorable benefit ratio of 75.8% for 2005 and a benefit ratio of 77.4% for 2004.
Estimated annual growth in assets under administration of 10% to 15%, which follows 2006 growth of more than 190% primarily as a result of the acquisition of Invesmart in 2006,
An estimated reduction to 2007 pre-tax earnings of $3 million to $5 million related to the adoption of American Institute of Certified Public Accountants Statement of Position (“SOP”) 05-1, Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection With Modifications or Exchanges of Insurance Contracts.
Revenues consist primarily of premiums, administrative fees and net investment income. Total revenues increased 6.7% to $2.49 billion for 2006 compared to 2005, and increased 9.0% to $2.34 billion for 2005 compared to 2004.
The three primary factors that influence premium growth for our Insurance Services segment are sales, employment and wage growth (“organic growth”), and customer retention. Sales for our group insurance businesses, reported as annualized new premiums, were $317.8 million for 2006, compared to $324.9 million for 2005. Persistency, measured as a percentage of premiums, was 88.1% and 88.2% for 2006 and 2005, respectively. Despite a very price competitive sales environment, slower industry growth, and termination of a
few large contracts early in 2006 we continued to have premium growth that exceeded the industry average based on available market data through mid-year 2006.
Strong sales in 2005, growth in our in force block of business from organic growth, and comparatively favorable persistency in our group insurance businesses resulted in stronger premium growth for 2005 compared to 2004. Sales for the group insurance businesses, reported as annualized new premiums, were nearly equal to the record sales of $330.3 million for 2004. Persistency, measured as a percentage of premiums, increased to 88.2% for 2005, compared to 85.6% for 2004.
Net investment income increased 2.9% to $478.9 million for 2006 compared to 2005, and increased 4.5% to $465.2 million for 2005 compared to 2004. Net investment income is primarily affected by changes in levels of invested assets, interest rates and commercial mortgage loan prepayment fees. The increases in net investment income for 2006 compared to 2005, and 2005 compared to 2004 were due to an increase in average invested assets, offset by a combination of lower yields on our fixed maturity securities and commercial mortgage loan portfolios, and a decrease in commercial mortgage loan prepayment fees. Average invested assets increased 4.9% for 2006 compared to 2005, and 7.0% for 2005 compared to 2004. The portfolio yield for fixed maturity securities decreased to 5.57% at the end of 2006, from 5.61% at the end of 2005 and 5.81% at the end of 2004. Similarly, the portfolio yield for commercial mortgage loans decreased to 6.40% at the end of 2006, from 6.46% at the end of 2005 and 6.71% at the end of 2004.
Commercial mortgage loan prepayment fees were $9.8 million, $13.4 million and $14.9 million for 2006, 2005 and 2004, respectively. The level of commercial mortgage loan prepayment fees will vary depending primarily on the overall interest rate environment. As interest rates rise, we expect prepayment fees to continue to be lower than prior levels. Over 79% of our commercial mortgage loans have a provision that requires the borrower to pay a prepayment fee that assures that the Company’s expected cash flow from commercial mortgage loan investments will be protected in the event of prepayment. Since 2001, all new commercial mortgage loans originated by the Company contain this prepayment provision. The remainder of our commercial mortgage loans contains fixed prepayment fees that mitigate prepayments, but may not fully protect the Company’s expected cash flow in the event of prepayment.
The growth in benefits to policyholders, including interest credited, is driven by different factors for each of our product segments. For the Insurance Services segment, three primary factors drive benefits to policyholders: premium growth (reserves are established in part based on premium levels), claims experience, and the assumptions used to establish related reserves. The predominant factors affecting claims experience are incidence (number of claims) and severity (length of time a disability claim is paid and the size of the claim). The assumptions used to establish the related reserves reflect expected incidence and severity, as well as new investment interest rates and overall portfolio yield, both of which affect the discount rate used to establish reserves. See “Critical Accounting Policies and Estimates-Reserves.”
For our Asset Management segment, the primary factors that drive benefits to policyholders are related to interest credited to customers. The primary factors that affect interest credited are growth in general account assets under management and individual fixed-rate annuity deposits, new investment interest rates and overall portfolio yield (which influence our interest crediting rate for our customers), and customer retention.
The increase in policyholder benefits, including interest credited, for the Asset Management segment for all comparative periods resulted from an increase in assets under administration due to favorable customer retention, growth in general account assets in our retirement plans business and growth in individual fixed annuity deposits, offset by reduced interest crediting rates due to lower new investment interest rates and overall portfolio yield. Growth in general account assets for our retirement plans business and individual fixed-rate annuity deposits was 10.2% for 2006 when compared to 2005, and 11.5% for 2005 when compared
to 2004. In addition, a significant increase in the sales of life contingent annuities for our individual fixed annuities business in 2005 increased benefits to policyholders for that period. See “Business Segments.”
The majority of the operating expense growth increases for 2005 compared to 2004 occurred in our Insurance Services segment and related to our effort to leverage technology in our expense structure and support our continued focus on our customer service and product delivery platforms. See “Business Segments.”
Commissions and bonuses primarily represent sales-based compensation, which can vary depending on the product, the structure of the commission program, and factors such as persistency (customer retention), sales, growth in assets under administration, and profitability of the business in each of our segments. Commissions and bonuses increased 9.0% to $183.6 million for 2006 compared to 2005, and 9.1% to $168.5 million for 2005 compared to 2004. The increases for the comparative periods were due to premium growth, persistency and growth in assets under administration in each of our segments. In addition, commissions and bonuses increased due to the Invesmart operations. Excluding Invesmart, growth in commissions and bonuses was 8.2% for 2006 when compared to 2005.
Net Increase in Deferred Acquisition Costs (“DAC”), Value of Business Acquired (“VOBA”) and Intangibles
Total income taxes may differ from the amount computed by applying the federal corporate tax rate of 35% because of the net result of permanent differences and the inclusion of state and local income taxes, net of the federal benefit. The combined federal and state effective tax rates were 34.2%, 35.2% and 31.7% for 2006, 2005 and 2004, respectively. Income taxes for 2006 included a reduction for the release of a valuation allowance of $0.9 million. Income taxes for 2004 included a reduction of approximately $7 million from the resolution of prior years’ tax examinations and certain state income tax matters. We do not expect similar reductions in income taxes to recur.
Effective January 1, 2006, we realigned our businesses into two operating segments. Our individual disability business,
As the Insurance Services segment is our largest segment, it substantially influences our consolidated financial results. Income before income taxes for the Insurance Services segment was $282.4 million, $300.1 million and $264.6 million for 2006, 2005 and 2004, respectively. Income before income taxes for 2006 for this segment was affected by premium growth, comparatively less favorable claims experience in our group insurance products and operating expense growth below premium growth. The increase in income before income taxes for 2005 compared to 2004 resulted from increased premium growth and comparatively favorable claims experience. Premium growth in the Insurance Services segment was 6.1% for 2006 compared to 2005, and 10.1% for 2005 compared to 2004.
Revenues for the Insurance Services segment increased 5.7% to $2.25 billion for 2006 compared to 2005. The growth in revenues for 2006 was primarily due to increased premiums and net investment income, though at lower rates of growth than 2005. Revenues for the Insurance Services segment increased 8.6% to $2.13 billion for 2005 compared to 2004, primarily due to a 10.1% growth in premiums for the comparative periods.
Premiums for the Insurance Services segment increased 6.1% for 2006 compared to 2005, and 10.1% for 2005 compared to 2004. The slower rate of premium growth for 2006 compared to 2005 for the Insurance Services segment corresponded to a slower rate of premium growth for the group insurance industry. Premium growth in our Insurance Services segment has been consistently above the industry premium growth rate.
The primary factors that contribute to premium growth for the Insurance Services segment are sales and persistency for all of our insurance products and organic growth in our group insurance product lines due to employment and wage rate growth from existing group policyholders.
Sales. Sales of our group insurance products decreased 2.2% for 2006 compared to 2005, and decreased 1.6% for 2005 compared to 2004. The decline in sales for 2006
Benefits to policyholders, including interest credited, for the Insurance Services segment increased 9.4% to $1.51 billion for 2006 compared to 2005, and 7.6% to $1.38 billion for 2005 compared to 2004. The increase in benefits to policyholders resulted in part from business growth as evidenced by premium growth. Premiums for the Insurance Services segment increased 6.1% for 2006 compared to 2005, and 10.1% for 2005 compared to 2004.
Because premium growth is one of the primary factors that drive benefits to policyholders, the benefit ratio (benefits to policyholders and interest credited measured as a percentage
In addition, we experienced favorable and sustained claims recovery patterns for our group long term disability insurance in 2005 and 2004, and as a result of our assessment of those recovery patterns, we released $9 million and $12 million in reserves in 2005 and 2004, respectively. There were no similar reserve releases for 2006. In addition, benefits to policyholders for 2004 included a $9 million premium deficiency reserve established during the first quarter of 2004 as a result of a pricing miscalculation on long term disability contracts with one large group insurance customer. Given the inherent periodic fluctuations in claims experience for the insurance businesses, the benefit ratios can fluctuate widely, particularly from quarter to quarter.
For 2006, we increased our discount rate for newly established disability claim reserves by 75 basis points to
5.50% from 4.75% at December 31, 2005. Given that we discount new reserves established in each quarter using our average new money investment rate less a margin, changes in our average new money investment rate may result in a change in the discount rate used to establish new reserves, and therefore may increase or decrease the expense of benefits to policyholders. Based on our current size, a 25 basis point increase in the discount rate would result in a short-term decrease of approximately $2 million per quarter of benefits to policyholders, and a corresponding increase to pre-tax earnings. Offsetting adjustments to group insurance premium rates can take from one to three years given that most new contracts have rate guarantees in place.
Our new money rate at December 31, 2006 was 5.87%. Should reinvestment rates ultimately prove to be lower than provided for in the margin between the new money investment rate and the reserve discount rate, we could be required to increase reserves, which could cause benefits to policyholders expense to increase. Our investments are generally not callable or they have prepayment penalties. The margin at December 31, 2006 in our overall block of business for group insurance between invested asset yield and weighted-average reserve discount rate was 38 basis points. See “Liquidity and Capital Resources.”
The Asset Management segment offers full-service 401(k) plans, 457 plans, defined benefit plans, money purchase pension plans, profit sharing plans, 403(b) plans and non-qualified deferred compensation products and services through an affiliated broker-dealer. This segment also offers investment management services, commercial mortgage loan origination and servicing, and individual fixed annuities. Beginning in the third quarter of 2006, this segment includes the operations of Invesmart. The business acquired services over 3,800 retirement plans with assets under administration of $11.05 billion at December 31, 2006. Invesmart provides
administration. Premiums and benefits to policyholders reflect the conversion of retirement plan assets into life contingent annuities, which can be selected by plan participants at the time of retirement. Most of the sales for this segment are recorded as deposits and are therefore not reflected as premiums. Individual fixed annuity deposits earn investment income, a portion of which is credited to policyholders.
Net investment income for the Asset Management segment increased 4.8% to $140.3 million for 2005 compared to 2004. The increase for the comparative periods was primarily due to a 16.8% increase in average retirement plan general account assets under administration, partially offset by lower yields on fixed maturity securities and commercial mortgage loans, a $1.2 million decrease in commercial mortgage loan prepayments and a $1.2 million decrease in commercial mortgage loan commitment fees.
Interest credited represents interest paid to policyholders on retirement plan general account assets and individual fixed annuity deposits. Interest credited for the Asset Management segment increased 11.2% to $84.4 million for 2006 compared to 2005, and increased 5.4% to $75.9 million for 2005 compared to 2004. The increases in interest credited were due to growth in average assets under administration for both retirement plans general account and individual fixed annuities of 14.9% and 6.7%, respectively, for 2006 compared to 2005, and 16.8% and 11.4%, respectively, for 2005 compared to 2004. The increase in average assets under administration was partially offset by decreases in the interest crediting rate to customers, which declined with the yield of associated invested assets.
The Other category reported a loss before income taxes of $11.1 million for 2006, compared to a loss before income
Asset/Liability management is a part of the Company’s risk management structure. The Asset/Liability mismatch risks assumed by the Company vary with economic conditions. The primary source of economic risk originates from changes in interest rates. It is management’s objective generally to align the characteristics of assets and liabilities so that the Company’s financial obligations can be met under a wide variety of economic conditions. From time to time, management may choose to liquidate certain investments and reinvest in alternate investments so that the certainty of meeting the Company’s financial obligations is increased. See “-Investing Cash Flows.”
As a percentage of our fixed maturity investments, callable bonds were 2.1% at December 31, 2006. Since 2001, all commercial mortgage loans originated by the Company contain a provision requiring the borrower to pay a prepayment fee to assure that the Company’s expected cash flow from commercial mortgage loan investments would be protected in the event of prepayment. Approximately 79% of our commercial mortgage loan portfolio contains this prepayment provision. The remainder of our commercial mortgage loans contains fixed prepayment fees that mitigate prepayments, but may not fully protect the Company’s expected cash flow in the event of prepayment.
for Standard and to the board of directors for The Standard Life Insurance Company of New York.
Our fixed maturity securities totaled $4.79 billion at December 31, 2006. We believe that we maintain prudent diversification across industries, issuers and maturities. Our corporate bond industry diversification targets are based on the Lehman Investment Grade Credit Index, which is reasonably reflective of the mix of issuers broadly available in the market. We also target a specified level of government, agency and municipal securities in our portfolio for credit quality and additional liquidity. The overall credit quality of our fixed maturity securities investment portfolio was A+ (Standard & Poor’s) at December 31, 2006. The percentage of fixed maturity securities below investment-grade was 3.6% and 3.8% at December 31, 2006 and 2005, respectively. Should the credit quality of our fixed maturity securities decline, there could be a material adverse effect on the Company’s business, financial position, results of operations or cash flows.
At December 31, 2006, there were two loans in our portfolio that were more than sixty days delinquent totaling $2.9 million, of which one commercial mortgage loan with a balance of $1.2 million was in the process of foreclosure. We had a net balance of restructured loans of $6.8 million at December 31, 2006, and a commercial mortgage loan loss reserve of $2.4 million. The performance of our commercial mortgage loan portfolio may fluctuate in the future. Should the delinquency rate or loss performance of our commercial mortgage loan portfolio increase, the increase could have a material adverse effect on the Company’s business, financial position, results of operations or cash flows.
At December 31, 2006, our commercial mortgage loan portfolio was collateralized by properties with the following characteristics:
At December 31, 2006, our commercial mortgage loan portfolio was diversified regionally as follows:
Commercial mortgage loans in California accounted for 31% of our commercial mortgage loan portfolio at December 31, 2006. Through this concentration, we are
exposed to potential losses resulting from the risk of an economic downturn in California as well as to certain catastrophes, such as earthquakes, that may affect the state. Although we diversify our commercial mortgage loan portfolio within California by both location and type of property in an effort to reduce certain catastrophe and economic exposure, such diversification may not eliminate the risk of such losses. Historically, the delinquency rate of our California-based commercial mortgage loans has been consistent with our experience in other states. In addition, we do not require earthquake insurance for properties on which we make commercial mortgage loans, but do consider the potential for earthquake loss based upon seismic surveys and structural information specific to each property when new loans are underwritten. We do not expect the exposure to catastrophe or earthquake damage to the properties in our commercial mortgage loan portfolio located in California to have a material adverse effect on our business, financial position, results of operations or cash flows. However, if economic conditions in California decline, we could experience a higher delinquency rate on the portion of our commercial mortgage loan portfolio located in California, which could have a material adverse effect on the Company’s business, financial position, results of operations or cash flows.
Under the laws of certain states, environmental contamination of a property may result in a lien on the property to secure recovery of the costs of cleanup. In some states, such a lien has priority over the lien of an existing mortgage against such property. As a commercial mortgage lender, we customarily conduct environmental assessments prior to making commercial mortgage loans secured by real estate and before taking title through foreclosure on real estate collateralizing delinquent commercial mortgage loans held by us. Based on our environmental assessments, we believe that any compliance costs associated with environmental laws and regulations or any remediation of affected properties would not have a material adverse effect on the Company’s business, financial position, results of operations or cash flows. However, we cannot provide assurance that material compliance costs will not be incurred by us.
Financing cash flows consist primarily of policyholder fund deposits and withdrawals, borrowings and repayments on the line of credit, borrowings and repayments on long-term debt, a third party interest in a limited liability company, repurchases of common stock and dividends paid on common stock. Net cash provided by financing activities was $362.0 million, $265.7 million and $200.7 million for 2006, 2005 and 2004, respectively. The increase for 2005 primarily resulted from a third party interest in a limited liability company created for the purpose of holding commercial mortgage loans originated by StanCorp Mortgage Investors. The minority third party investment totaled $143.2 million for 2005. The limited liability company was dissolved in December 2006. Standard retained its ownership share of the commercial mortgage loans upon the dissolution of the limited liability company. The non-cash transaction in the Consolidated Statements of Cash Flows for 2006 represented the transfer of commercial mortgage loans to the minority shareholders at dissolution. The Company repurchased common stock at a total cost of $70.1 million, $106.4 million and $74.7 million for 2006, 2005 and 2004, respectively.
At December 31, 2006, our estimated total capital in excess of targeted RBC and holding company requirements was approximately $100 million. We will continue to maintain our three priorities, in the following order, for the remaining excess capital:
In addition, we seek to maintain amounts sufficient to fund holding company operating expenses, interest on our debt and our annual dividend to shareholders. Maintaining additional capital provides timing flexibility should we wish to access capital markets to finance growth or acquisitions. StanCorp has a $1.0 billion shelf registration statement with the SEC. See “Liquidity and Capital Resources-Financing Cash Flows.”
StanCorp’s ability to pay dividends to its shareholders, repurchase its shares and meet its obligations substantially depends upon the receipt of distributions from its subsidiaries, including Standard. Standard’s ability to pay dividends to StanCorp is affected by factors deemed relevant by Standard’s board of directors, including the ability to maintain adequate RBC according to Oregon statute. Under Oregon law, Standard may pay dividends only from the earned surplus arising from its business. It also must receive the prior approval of the Director of the Oregon Department of Consumer and Business Services-Insurance Division (“Oregon Insurance Division”) to pay a dividend if such dividend exceeds certain statutory limitations. The current statutory limitations are the greater of (a) 10% of Standard’s combined capital and surplus as of December 31 of the preceding year, or (b) the net gain from operations after dividends to policyholders and federal income taxes before realized capital gains or losses for the 12-month period ended on the December 31 preceding. In each case, the limitation must be determined under statutory accounting practices. Oregon law gives the Oregon Insurance Division broad discretion to disapprove requests for dividends in excess of these limits.
During 2005 and 2006, Standard made distributions to StanCorp totaling $150.8 million and $147.0 million, respectively. In February 2007, Standard’s board of directors approved a dividend to StanCorp of $95 million, subject to the approval of the Oregon Insurance Division.
On November 6, 2006, the board of directors of StanCorp declared an annual cash dividend of $0.65 per share, calculated and payable on a per share basis. The ex-dividend date was November 17, 2006. The annual cash dividend for 2006 represented a 4% increase over the dividend for 2005. The declaration and payment of dividends in the future is subject to the discretion of StanCorp’s board of directors. It is anticipated that annual dividends will be paid in December of
each year depending on StanCorp’s financial condition, results of operations, cash requirements, future prospects, regulatory restrictions on distributions from the insurance subsidiaries, the ability of the insurance subsidiaries to maintain adequate capital and other factors deemed relevant by the board of directors.
During 2006, we repurchased approximately 1.5 million shares of common stock at a total cost of $70.1 million for a volume weighted-average price of $46.16 per common share. At December 31, 2006, there were 1,448,800 shares remaining under the Company’s current share repurchase program. Also during 2006, the Company acquired 3,076 shares of common stock from an executive officer to cover tax liabilities of this officer resulting from the release of performance-based shares and retention-based shares at a total cost of $0.2 million for a volume weighted-average price of $52.38 per common share, which reflects the market price on the transaction dates.
Financial strength ratings, which rate claims paying ability, are an important factor in establishing the competitive position of insurance companies. Ratings are important in maintaining public confidence in our company and in our ability to market our products. Rating organizations continually review the financial performance and condition of insurance companies, including ours. In addition, credit ratings on our senior notes are tied to our financial strength ratings. A ratings downgrade could increase surrender levels for our annuity products, could adversely affect our ability to market our products and also could increase costs of future debt issuances. Standard & Poor’s, Moody’s Investors Service, Inc., A.M. Best Company and Fitch, Inc. provide financial strength and credit ratings. In August 2006, Standard & Poor’s raised the financial strength rating of Standard to AA- from A+.
Standard & Poor’s, Moody’s Investors Service, Inc., Fitch, Inc. and A.M. Best Company provide credit ratings on StanCorp’s senior notes. As of February 2007, ratings from these agencies were A-, Baa1, A- and bbb+, respectively. In August 2006, Standard & Poor’s raised the credit rating of StanCorp to A- from BBB+. In July 2006, A.M. Best Company assigned an issuer credit rating of a+ to Standard.
The Company had no off-balance sheet arrangements at December 31, 2006 and 2005.
Insolvency regulations exist in many of the jurisdictions in which subsidiaries of the Company do business. Such regulations may require insurance companies operating within the jurisdiction to participate in guaranty associations. The associations levy assessments against their members for the purpose of paying benefits due to policyholders of impaired or insolvent insurance companies. Association assessments levied against the Company from January 1, 2004 through December 31, 2006, aggregated $0.3 million. At December 31, 2006, the Company maintained a reserve of $0.7 million for future assessments with respect to currently impaired, insolvent or failed insurers.
Standard and The Standard Life Insurance Company of New York prepare their statutory financial statements in accordance with accounting practices prescribed or permitted by their states of domicile. Prescribed statutory accounting practices include state laws, regulations, and general administrative rules, as well as the Statements of Statutory Accounting Practices set forth in publications of the NAIC.
Statutory accounting practices differ in some respects from GAAP. The principal statutory practices which differ from GAAP are: a) bonds and commercial mortgage loans are reported principally at amortized cost; b) asset valuation and the interest maintenance reserves are provided as prescribed by the NAIC; c) certain assets designated as non-admitted, principally deferred tax assets, furniture, equipment, and unsecured receivables, are not recognized as assets, resulting in a charge to statutory surplus; d) annuity considerations with life contingencies, or purchase rate guarantees, are recognized as revenue when received; e) reserves for life and disability policies and contracts are reported net of ceded reinsurance and calculated based on statutory requirements, including required discount rates; f) commissions, including initial commissions and expense allowance paid for reinsurance assumed, and other policy acquisition expenses are expensed as incurred; g) initial commissions and expense allowance received for a block of reinsurance ceded net of taxes are reported as deferred gains in surplus and recognized as income in subsequent periods; h) federal income tax expense includes current income taxes defined as current year estimates of federal income taxes and tax contingencies for current and all prior years and amounts incurred or received during the year relating to prior periods, to the extent not previously provided; i) deferred tax assets, net of deferred tax liabilities, are included in the regulatory financial statements but are limited to those deferred tax assets that will be realized within one year; j) surplus notes are included in capital and surplus; and k) interest on surplus notes is not recorded as a liability nor an expense until approval for payment of such interest has been granted by the commissioner of the state of domicile.
Our consolidated financial statements and certain disclosures made in this Form 10-K have been prepared in accordance with GAAP and require us to make estimates and assumptions that affect reported amounts of assets and liabilities and contingent assets and contingent liabilities at the dates of the financial statements and the reported amounts of revenues and expenses during the reporting periods. The estimates most susceptible to material changes due to significant judgment (identified as the “critical accounting policies”) are those used in determining impairments, the reserves for future policy benefits and claims, DAC, VOBA, other intangibles, goodwill and the provision for income taxes. The results of these estimates are critical because they affect our profitability and may affect key indicators used to measure the Company’s performance. These estimates have a material effect on our results of operations and financial condition.
Reserves represent amounts set aside today to pay future benefits and claims. Developing the estimates for reserves (and therefore the resulting impact on earnings) requires varying degrees of subjectivity and judgment, depending upon the nature of the reserve. For most of our reserves, the calculation methodology is prescribed by various accounting and actuarial standards, although judgment is required in the determination of assumptions to use in the calculation. At December 31, 2006, these reserves represented approx
DAC for group disability and group life insurance products is amortized in proportion to future premiums generally over five years. DAC for individual disability insurance products is amortized in proportion to future premiums over the life of
the contract, averaging 20 to 25 years with approximately 50% and 75% expected to be amortized by years 10 and 15, respectively. DAC for individual deferred annuities is amortized in proportion to expected gross profits generally over 30 years with approximately 50% and 90% expected to be amortized by years 5 and 15, respectively. DAC for group annuity products is amortized in proportion to expected gross profits over 10 years with approximately 30% expected to be amortized by year five. Beginning with the adoption of SOP 05-1 on January 1, 2007, we will amortize DAC for group insurance products over the initial premium rate guarantee period, which averages 2.5 years. The Company estimates 2007 pre-tax earnings will be reduced by between $3 million and $5 million related to the adoption of SOP 05-1. See Item 8, “Financial Statements and Supplementary Data-Notes to Consolidated Financial Statements-Note 1-Summary of Significant Accounting Policies-Accounting Pronouncements.”
taxes for 2004 were reduced approximately $7 million related to the favorable resolution of uncertainties related to the Internal Revenue Service examination of the Company’s tax years through 2001, and favorable outcomes on state tax return matters. Currently, years open for audit by the Internal Revenue Service are 2003 through 2006.
Our actual results and financial condition may differ, perhaps materially, from the anticipated results and financial condition in any such forward-looking statements and, given these uncertainties or circumstances, readers are cautioned not to place undue reliance on such statements. We undertake no obligation to update or revise any forward- looking statements, whether as a result of new information, future events or otherwise.
growth in assets under administration including performance of equity investments in the separate account;
the impact of rising benefit costs on employer budgets for employee benefits;
competition from other insurers and financial services companies, including the ability to competitively price our products;
changes in the regulatory environment at the state or federal level;
We have audited the accompanying consolidated balance sheets of StanCorp Financial Group, Inc. and subsidiaries (the “Company”) as of December 31, 2006 and 2005, and the related consolidated statements of income and comprehensive income, changes in shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2006. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
As discussed in Notes 1, 11 and 12 to the consolidated financial statements, in 2006 the Company changed its method of accounting for defined benefit and other postretirement plans upon the adoption of Statement of Financial Accounting Standards No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans.
StanCorp is a leading provider of group insurance products and services serving the life and disability insurance needs of employer groups and the disability insurance needs of individuals. Through our subsidiaries, we have the authority to underwrite insurance products in all 50 states. We also provide accidental death and dismemberment (“AD&D”) insurance, dental insurance, annuity products, retirement plan products and services and investment advisory services. Our mortgage business originates and services fixed-rate commercial mortgage loans for the investment portfolios of our insurance subsidiaries and for participation to institutional investors. Effective January 1, 2006, we realigned our businesses into two operating segments: Insurance Services and Asset Management, each of which is described below. See “Note 3-Segments.”
StanCorp was incorporated under the laws of Oregon in 1998. We conduct business through our subsidiaries: Standard Insurance Company (“Standard”); The Standard Life Insurance Company of New York; StanCorp Mortgage Investors, LLC (“StanCorp Mortgage Investors”); StanCorp Investment Advisers, Inc. (“StanCorp Investment Advisers”); StanCorp Equities, Inc. (“StanCorp Equities”); StanCorp Trust Company; and Invesmart, Inc. (“Invesmart”), now renamed Standard Retirement Services, Inc. (“Standard Retirement Services”). We are headquartered in Portland, Oregon.
The Standard Life Insurance Company of New York was organized in 2000 and provides group long term and short term disability, life, AD&D and dental insurance in New York.
StanCorp Equities is a licensed broker-dealer. For the sale of registered contracts, a broker-dealer must serve as principal underwriter and distributor, providing supervision and oversight that is required by the National Association of Securities Dealers. Standard developed a registered group annuity contract to expand its market to 403(b) plans, 457 tax-exempt plans and non-qualified deferred compensation plans of private employers. StanCorp Equities is the principal underwriter and distributor of registered contracts for Standard.
In January 2006, StanCorp established StanCorp Trust Company, which offers limited directed trust services to clients.
Minority interest related to consolidated entities included in other liabilities was $0.6 million at December 31, 2006, and $143.7 million at December 31, 2005. The decrease was due to the dissolution of a limited liability company established in 2005, which invested in commercial mortgage loans originated by StanCorp Mortgage Investors. Standard retained its ownership share of those commercial mortgage loans upon the dissolution of the limited liability company.
The consolidated financial statements include StanCorp and its subsidiaries. Intercompany balances and transactions have been eliminated.
For all investments, capital gains and losses are recognized using the specific identification method. Net investment income and capital gains and losses related to separate account assets and liabilities are included in the separate account assets and liabilities. For all investments, we record impairments when it is determined that the decline in fair value of an investment below its amortized cost basis is other than temporary. We reflect impairment charges in net capital gains or losses and permanently adjust the cost basis of the investment to reflect the impairment. In our quarterly impairment analysis, we evaluate whether a decline in value of fixed maturity securities is other than temporary. Factors considered in this analysis include the length of time and the extent to which the fair value has been below amortized cost, the financial condition and near-term prospects of the issuer, our intent and ability to retain the investment for a period of time sufficient to allow for any anticipated recovery in market value, and the value of any security interest we may have collateralized in the investment. See “Note 5-Investment Securities.” For securities expected to be sold, an other than temporary impairment charge is recorded if we do not expect the realizable market value of a security to recover to amortized cost prior to the expected date of sale. Once an impairment charge has been recorded, we continue to review
Real estate held for investment is stated at cost less accumulated depreciation. Depreciation generally is provided on the straight-line method, with property lives varying from 30 to 40 years. Accumulated depreciation for real estate totaled $27.0 million and $31.9 million at December 31, 2006 and 2005, respectively. Real estate acquired in satisfaction of debt is recorded at the lower of cost or fair value less estimated costs to sell and is depreciated consistently with real estate held for investment.
DAC, VOBA, other intangible assets and goodwill are considered intangible assets. These intangible assets are generally originated or acquired through the issuance of new business or the purchase of existing business, either by purchasing blocks of insurance policies from other insurers or by the outright purchase of other companies.
against related future premiums or gross profits, as appropriate. We normally defer certain acquisition-related commissions and incentive payments, certain costs of policy issuance and underwriting and certain printing costs. Assumptions used in developing DAC and amortization amounts each period include the amount of business in force, expected future persistency, withdrawals, interest rates and profitability. These assumptions are modified to reflect actual experience when appropriate. Additional amortization of DAC is charged to current earnings to the extent it is determined that future premiums or gross profits are not adequate to cover the remaining amounts deferred.
DAC, VOBA, other intangible assets and goodwill are subject to impairment tests on an annual basis, or more frequently if circumstances indicate that carrying values may not be recoverable.
The accumulated amortization of VOBA at December 31, 2006 and 2005 was $50.5 million and $44.5 million, respectively. The accumulated amortization of other intangibles at December 31, 2006 and 2005 was $3.5 million and $1.9 million, respectively.
Property and equipment are stated at cost less accumulated depreciation. The Company provides for depreciation of property and equipment using the half-year, straight-line method over the estimated useful lives, which are generally 40 years for properties, and from three to ten years for equipment. Leasehold improvements are amortized over the estimated useful life of the asset, not to exceed the life of the lease. Depreciation expense for 2006, 2005 and 2004 was $15.1 million, $12.7 million and $12.5 million, respectively. The Company reviews property and equipment for impairment when circumstances or events indicate the carrying amount of the asset may not be recoverable and recognizes a charge to earnings if an asset is impaired.
Non-affiliated tenants leased approximately 40.0%, 40.6% and 41.6% of the home office properties at December 31, 2006, 2005 and 2004, respectively. Income from the leases is included in net investment income.
instead estimates based on assumptions and considerations concerning a number of factors, including:
Other policyholder funds are liabilities for investment-type contracts and are based on the policy account balances including accumulated interest.
Other comprehensive loss includes changes in unrealized capital gains and losses on investment securities available-for-sale, net of the related tax effects, and the changes in the unfunded liability of the non-qualified supplemental retirement plan. The following table sets forth unrealized capital gains and losses and adjustments for realized capital gains and losses for the years ended December 31:
In February 2006, the FASB issued SFAS No. 155, Accounting for Certain Hybrid Financial Instruments, an amendment of FASB Statement Nos. 133 and 140, which applies to all financial instruments acquired or issued in fiscal years beginning after September 15, 2006. The statement permits fair value re-measurement of any hybrid financial instrument that contains an embedded derivative that would otherwise require bifurcation, such as our equity-indexed annuity product. The Company currently separates the embedded derivative within an equity-indexed annuity and values the embedded derivative at fair value, while the host contract continues to be valued at amortized cost. SFAS No. 155 allows the irrevocable option to measure the entire equity-indexed annuity at fair value, which can be made on a contract by contract basis. Currently, the Company does not intend to elect the option allowed under this guidance.
tax benefit for an uncertain tax position that meets the “more likely than not” threshold is based on a cumulative probability model under which the largest amount of tax benefit recognized is the amount with a greater than 50 percent likelihood of being realized upon ultimate settlement with a taxing authority. FIN 48 also requires significant new annual disclosures. FIN 48 will be applied beginning January 1, 2007. The cumulative effect will be reported as an adjustment to the opening balance of retained earnings as of the date of adoption. The Company has performed an analysis of the impact the adoption of FIN 48 will have on our financial statements and does not expect it to have a material effect.
Basic net income per common share was calculated based on the weighted-average number of common shares outstanding. Net income per diluted common share reflects the potential effects of restricted stock grants and exercises of outstanding options. The weighted-average common share and share equivalents outstanding used to compute the dilutive effect of common stock options outstanding were computed using the treasury stock method. The computation of dilutive weighted-average earnings per share does not include options with an option exercise price greater than the average market price because they are anti-dilutive (i.e., would increase earnings per share). Net income per diluted common share was calculated as follows, for the years ended December 31:
Effective January 1, 2006, we realigned our businesses into two operating segments. Our individual disability business, which had been included in the Individual Insurance segment, was added to our Employee Benefits segment to combine our traditional insurance lines of business into the Insurance Services segment. The Insurance Services segment markets group and individual disability insurance, group life and AD&D insurance, and group dental insurance. We also combined our asset management and accumulation
businesses, which had been reported in the Individual Insurance and Retirement Plans segments and Other, into the Asset Management segment. The Asset Management segment offers full-service 401(k) plans, 457 plans, defined benefit plans, money purchase pension plans, profit sharing plans, 403(b) plans and non-qualified deferred compensation products and services through an affiliated broker-dealer. This segment also offers investment management services, commercial mortgage loan origination and servicing, and individual fixed annuities. Beginning in the third quarter of 2006, this segment included Invesmart, a national retirement financial services company. Resources are allocated and performance is evaluated at the segment level. Prior period amounts have been reclassified to reflect our current segment alignment.
Net capital gains and losses on investments, return on capital not allocated to the product segments, holding company expenses, interest on senior notes and adjustments made in consolidation will continue to be reflected in “Other.”
The following table sets forth carrying amounts and estimated fair values for financial instruments at December 31:
Actual maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations. Callable bonds represented 2.1%, or $99.1 million, of our investment securities at December 31, 2006.
Historically, our experience in California has been consistent with our experience in other states. However, if economic conditions in California decline, we could
experience a higher delinquency rate on the portion of our commercial mortgage loan portfolio located in California, which could have a material adverse effect on the Company’s business, financial position, results of operations or cash flows.
The commercial mortgage loan valuation allowance is estimated based on evaluating known and inherent risks in the loan portfolio. The allowance is based on management’s analysis of factors including changes in the size and composition of the loan portfolio, actual loan loss experience, economic conditions, and individual loan analysis. A loan is considered impaired when it is probable that the Company will be unable to collect all amounts due, including principal and interest. Loan impairment is measured using discounted cash flows except when the current fair value, reduced by costs to sell, is determinable. Loans that are deemed uncollectible are generally written off against the allowance, and recoveries, if any, are credited to the allowance.
SFAS No. 158 also requires the Company to recognize as a component of accumulated other comprehensive income (loss), net of tax, the actuarial gains or losses and prior services costs or credits that are excluded from the net periodic benefit cost. The following table sets forth the amounts recognized in accumulated other comprehensive loss at December 31, 2006:
The following table provides a reconciliation of the changes in the pension plans’ projected benefit obligations, fair value of assets and the funded status at December 31:
diversified across a number of equity asset categories and stable value assets. The investment goal of the agent pension plan is to invest in stable value assets in order to maintain its funded status.
The long run rate of return for the employee pension plan portfolio is derived by calculating the average return for the portfolio monthly, from 1971 to the present, using the average mutual fund manager returns in each asset category, weighted by the target allocation to each category. Because the average equity market value returns over the last 30 years generally have been higher than the long run expected rate of return, the historical average return used to determine the expected return on plan assets was reduced by 20% to better reflect the expected long run rate of return.
In 2006, the Company contributed $25.0 million to the employee pension plan. The Company is not obligated to make any contributions to its pension plans for 2007.
In addition, eligible executive officers are covered by a non-qualified supplemental retirement plan. The unfunded status was $17.2 million and $15.8 million at December 31, 2006 and 2005, respectively. Expenses were $1.8 million, $1.6 million and $1.4 million for 2006, 2005 and 2004, respectively. At December 31, 2006, a loss of $2.2 million, net of tax, was reported in accumulated other comprehensive income (loss), and $17.2 million was reflected in other liabilities.
Eligible executive officers, directors, agents and group producers may participate in non-qualified deferred compensation plans under which a portion of the deferred compensation may be matched. The liability for the plans was $8.1 million and $7.8 million at December 31, 2006 and 2005, respectively.
Standard sponsors and administers a postretirement benefit plan that includes medical, prescription drug benefits and group term life insurance. Eligible retirees are required to contribute specified amounts for medical and prescription drug benefits that are determined periodically, and are based on retirees’ length of service and age at retirement. Effective January 1, 2006, participation in the postretirement benefit plan is limited to employees who either have reached the age of 40 as of January 1, 2006, or whose combined age and length of service are equal to or greater than 45 years as of January 1, 2006. The reduction in participant eligibility requirements did not have a material impact on our financial statements.
The gains and losses, and prior servicing costs or credits that are excluded from the projected benefit obligation are recognized as a component of accumulated other comprehensive income (loss), net of tax. The following table
At December 31, 2006, the Company had contributed approximately $0.3 million to fund the postretirement benefit plan. The Company expects to make contributions of $0.7 million to its postretirement benefit plan in 2007.
The expected benefit payments for the Company’s postretirement benefit plan for the years indicated are as follows:
The Company has three share-based compensation plans: the 1999 Omnibus Stock Incentive Plan, the 2002 Stock Incentive Plan and the 1999 Employee Share Purchase Plan (“ESPP”).
Compensation costs related to all share-based compensation arrangements were $8.7 million, $6.4 million and $6.5 million for 2006, 2005 and 2004, respectively. The related tax benefits were $3.0 million, $2.2 million and $2.3 million for the same periods, respectively.
change of control agreement. Options generally expire 10 years from the grant date.
Performance-based awards are made to certain senior officers each year. Participants vest with respect to all or a portion of the awards based on the Company’s financial performance for that year. Each award consists of restricted stock (60%), and cash performance units, representing a right to receive cash equal to the value of one share of stock subject to the same employment and performance criteria (40%). Both restricted stock and cash performance units are subject to forfeiture if continued employment and financial performance criteria are not met.
The compensation cost of these awards is measured using an estimate of the number of shares that will vest at the end
Awards of retention-based restricted stock are made less frequently and at irregular intervals by the Compensation
On November 6, 2006, the board of directors of StanCorp approved a new director compensation schedule that will become effective May 7, 2007. Under the new schedule, each director who is not an employee of StanCorp or Standard will receive cash retainer fees to be paid quarterly. Additionally, each director will receive 1,000 shares of common stock beginning on the day preceding the annual shareholders’ meeting in May 2008.
The weighted-average per-share fair value for the Company’s ESPP offerings was $10.68, $7.66 and $7.30 during 2006, 2005 and 2004, respectively. The Company’s compensation cost resulting from the ESPP was $1.2 million, $0.9 million and $0.9 million for 2006, 2005 and 2004, respectively. The related tax benefit was $0.4 million, $0.3 million and $0.3 million for the same periods, respectively.
We manage risk through sound product design and underwriting, effective claims management, disciplined pricing, distribution expertise, broad diversification of risk by customer geography, industry, size and occupation, maintenance of a strong financial position, maintenance of reinsurance and risk pool arrangements, and sufficient alignment of assets and liabilities to meet financial obligations.
In order to limit our losses from large exposures, we enter into reinsurance agreements with other insurance companies. During 2004, we reviewed our retention limits and, based on our then current size and recent experience,
Subsequent to the terrorist events of September 11, 2001, we entered into a catastrophe reinsurance pool with other insurance companies. This pool spreads catastrophe losses on group life and AD&D over approximately 31 participating members. The annual fees paid by the Company to participate in the pool and claims to date have been minor. As a member of the pool, we are exposed to maximum potential losses experienced by other participating members of up to $81 million for a single event for losses submitted by a single company, and a maximum of $201 million for a single event for losses submitted by multiple companies. If we had been a member of the pool on September 11, 2001, the estimated pre-tax charges related to the terrorist events would have been approximately $15 million, compared to pre-tax charges of $5 million incurred. The Company’s percentage share of losses experienced by pool members will change over time as it is a function of our group life and AD&D in force relative to the total group life and AD&D in force for all
pool participants. The reinsurance pool does not exclude war or nuclear, biological and chemical acts of terrorism.
The Terrorism Risk Insurance Act of 2002 (“TRIA”) provided for federal government assistance to property and casualty insurers in the event of material losses due to terrorist acts on behalf of a foreign person or foreign interest. In December 2005, Congress passed the Terrorism Risk Insurance Extension Act of 2005, extending TRIA through 2007. Group life insurance is not currently covered under TRIA. Group life insurance represents a significant portion of our revenues and income. Concentration of risk is inherent in the group life insurance products we offer and we have group life insurance exposure to certain customers in amounts significantly in excess of our catastrophe reinsurance coverage. Because of our concentration of risk, an occurrence of a significant catastrophe or a change in the on-going nature and availability of reinsurance and catastrophe reinsurance could have a material adverse effect on the Company’s business, financial position, results of operations or cash flows.
Effective October 1, 2002, Standard entered into a reinsurance agreement with TIAA to assume TIAA’s group disability and group life insurance business. This business included approximately 1,800 group insurance contracts, representing 650,000 insured individuals. Standard paid a ceding commission of approximately $75 million and received approximately $705 million in assets and corresponding statutory liabilities. If Standard were to become unable to meet its obligations, TIAA would retain the reinsured liabilities. Therefore, in accordance with the agreement with TIAA, Standard established a trust for the benefit of TIAA with the market value of assets in the trust equal to TIAA’s reinsurance receivable from Standard. The market value of assets required to be maintained in the trust is determined quarterly. The market value of assets required to be maintained in the trust at December 31, 2006, was approximately $505.1 million. Approximately $60 million in VOBA was capitalized related to the reinsurance agreement. Regarding the effect of the adoption of SOP 05-1, see “Note 1- Summary of Significant Accounting Policies-Accounting Pronouncements.”
Other operating expenses include operating expenses, commissions and bonuses, premium taxes, and the net increase in DAC.
The following table presents StanCorp’s condensed balance sheets at December 31:
The following table presents StanCorp’s condensed statements of cash flows for the years ended December 31:
In the normal course of business, the Company is involved in various legal actions and other state and federal proceedings. A number of actions or proceedings were pending as of December 31, 2006. In some instances, lawsuits include claims for punitive damages and similar types of relief in unspecified or substantial amounts, in addition to amounts for alleged contractual liability or other compensatory damages. In the opinion of management, the ultimate liability, if any, arising from the actions or proceedings is not expected to have a material adverse effect on the Company’s business, financial position, results of operations or cash flows.
On June 15, 2006, the Company established a five-year, $200 million senior unsecured revolving credit facility (“Facility”). The termination date of the Facility is June 15, 2011. At the option of StanCorp and with the consent of the lenders under the Facility, the termination date can be extended for two additional one-year periods. Additionally, upon the request of StanCorp and with consent of the lenders under the Facility, the Facility can be increased by up to $100 million to a total of up to $300 million. Borrowings under the Facility will be used to provide for working capital and general corporate purposes of the Company and its subsidiaries and the issuance of letters of credit.
At December 31, 2006, minimum future rental receivables on non-cancelable leases of retail and office space with initial terms of one year or more are 2007, $11.5 million; 2008, $10.2 million; 2009, $9.2 million; 2010, $7.8 million and thereafter, $20.3 million.
Policyholder fund obligations include payments based on currently scheduled withdrawals and annuity benefit payments stemming from liabilities shown on the balance sheet as policyholder funds. Not included in the table is approximately $2.55 billion in policyholder funds that may be withdrawn upon request. In addition, amounts presented also exclude separate account liabilities of $3.83 billion.
From time to time, the board of directors has authorized share repurchase programs. Share repurchases are to be effected in the open market or in negotiated transactions in compliance with the safe harbor provisions of Rule 10b-18 under regulations of the Securities Exchange Act of 1934. Execution of the share repurchase program is based upon management’s assessment of market conditions for its common stock and other potential growth opportunities. On November 14, 2005, the board of directors authorized a share repurchase program of up to 3.0 million shares of StanCorp common stock on a post-stock-split basis. The repurchase program will be affected in the open market or in negotiated