CIGNA’s headquarters, including staff support operations, along with CIGNA Disability and Life Insurance, the domestic office of CIGNA International, and portions of CIGNA HealthCare, are located in approximately 450,000 square feet of leased office space at Two Liberty Place, 1601 Chestnut Street, Philadelphia. CIGNA HealthCare is located in approximately 825,000 square feet of owned office space in the Wilde Building, located at 900 Cottage Grove Road, Bloomfield, Connecticut. In addition, CIGNA owns or leases office buildings, or parts thereof, throughout the United States and in other countries. CIGNA believes its properties are adequate and suitable for its business as presently conducted. For additional information concerning leases and property, see Notes 2 and 20 to CIGNA’s Consolidated Financial Statements beginning on pages 86 and 130 of this Form 10-K. This paragraph does not include information on investment properties.
In 2008, the Company recorded significant charges related to the guaranteed minimum income benefits and guaranteed minimum death benefits businesses. For additional information, see the Run-off Reinsurance section of the Management’s Discussion and Analysis beginning on page 62.
Effective January 1, 2007, CIGNA changed its presentation to report the results of the Run-off Retirement business within Other Operations. Prior period results have been restated to conform to this presentation.
In this filing and in other marketplace communications, CIGNA Corporation and its subsidiaries (the Company) make certain forward-looking statements relating to the Company’s financial condition and results of operations, as well as to trends and assumptions that may affect the Company. Generally, forward-looking statements can be identified through the use of predictive words (e.g., “Outlook for 2009”). Actual results may differ from the Company’s predictions. Some factors that could cause results to differ are discussed throughout Management’s Discussion and Analysis (MD&A), including in the Cautionary Statement beginning on page 78. The forward-looking statements contained in this filing represent management’s current estimate as of the date of this filing. Management does not assume any obligation to update these estimates.
The Company constitutes one of the largest investor-owned health service organizations in the United States. Its subsidiaries are major providers of health care and related benefits, the majority of which are offered through the workplace. In addition, the Company has an international operation that offers life, accident and supplemental health insurance products as well as international health care products and services to businesses and individuals in selected markets. The Company also has certain inactive businesses, including a Run-off Reinsurance segment.
the ability to profitably price products and services at competitive levels;
The Company is continuing to improve the performance of and profitably grow its ongoing businesses and manage the risks associated with the run-off reinsurance operations.
The Company has undertaken several initiatives to realign its organization and consolidate support functions in an effort to increase efficiency and responsiveness to customers and to reduce costs.
In 2008, the Company conducted a comprehensive review of its ongoing businesses with an emphasis on reducing operating expenses in the Health Care segment. As a result of the review, during the fourth quarter of 2008, the Company committed to a plan to reduce operating costs in order to meet the challenges and opportunities presented by the current economic environment. The Company anticipates the plan will be substantially complete by the end of 2009. As a result, the Company recognized in other operating expenses a total charge of $55 million pre-tax ($35 million after-tax), which included $44 million pre-tax ($28 million after-tax) for severance and other related costs resulting from reductions of approximately 1,100 positions in its workforce and $11 million pre-tax ($7 million after-tax) resulting from consolidation of facilities. The Company expects to pay $53 million in cash related to this charge, most of which will occur in 2009. The Health Care segment reported $44 million pre-tax ($27 million after-tax) of the total charge. The remainder was reported as follows: Disability and Life: $3 million pre-tax ($2 million after-tax), and International: $8 million pre-tax ($6 million after-tax). As a result of these actions, the Company expects annualized after-tax savings of approximately $70 million, a portion of which is expected to be realized in 2009.
In order to facilitate an understanding and comparison of results of operations and permit analysis of trends in underlying revenue, expenses and income from continuing operations, presented below are special items, which management believes are not representative of the underlying results of operations.
The special item for 2007 consisted of previously unrecognized tax benefits resulting from the completion of the IRS examination for the 2003 and 2004 tax years.
a charge associated with the settlement of the shareholder class action lawsuit brought against the Company. This charge included certain costs to defend and was net of expected insurance recoveries; and
a charge for severance costs resulting from a review of staffing levels in the Health Care operations and in supporting areas.
Income from continuing operations for the year ended December 31, 2008 declined significantly compared with 2007, as a result of the following:
The Company’s results in 2008 were also negatively affected by the special charges for litigation and cost reduction matters discussed beginning on page 46.
These factors were partially offset by higher earnings in the Health Care (see page 54), Disability and Life (see page 59), International (see page 60) and Run-off Reinsurance (see page 62) segments.
The Company expects 2009 income from continuing operations, excluding realized investments results, the results of the GMIB business, and special items, to be higher than 2008 due to overall earnings growth in the ongoing operating segments, as well as lower losses in the Run-off Reinsurance segment. This outlook includes an assumption that results of the GMDB business will be approximately break-even for full-year 2009. This assumption reflects management’s view that the long-term reserve assumptions are appropriate and that equity market conditions and volatility will return to more normal levels in 2009. The Company’s outlook is subject to the factors cited in the Cautionary Statement and the sensitivities discussed in the Critical Accounting Estimates section of the MD&A on pages 49 through 53. If the unfavorable equity market and interest rate movements continue, the Company could experience additional losses related to the GMDB business.
Total revenue increased by 8% in 2008, compared with 2007; and 7% in 2007 compared with 2006. Changes in the components of total revenue are described more fully below.
Premiums and fees increased by 8% in 2008, compared with 2007 reflecting the impact of the acquired business, growth in the Disability and Life segment, as well as growth and rate increases in the International segment. See segment reporting discussions for additional detail and drivers.
Net investment income decreased 5% in 2008, compared with 2007 primarily due to lower yields driven by declines in short-term interest rates, commercial mortgage pre-payment fees, and income from security partnerships.
Net investment income decreased 7% in 2007. This decrease was primarily attributable to lower average assets due to share repurchase activity and a decline in the Health Care segment average invested assets resulting from:
Mail order pharmacy revenues increased 8% in 2008, compared with 2007 due to increased script volume and rate increases.
Realized investment results in 2008 were lower than 2007, primarily due to higher losses associated with asset write-downs and increases in valuation allowances primarily due to higher interest rates and credit losses resulting from current economic conditions. In addition, the Company had higher losses on sales of fixed maturities and equity securities. These losses were partially offset by higher gains on sales of real estate investments held in joint ventures. See Note 13 to the Consolidated Financial Statements for additional information.
Partial surrender refers to the fact that most contractholders have the ability to withdraw substantially all of their mutual fund investments while retaining any available death benefit coverage in effect at the time of the withdrawal. Once a partial surrender is made, the liability increases reflecting lower future assumed premiums, a lower likelihood of lapsation, and a lower likelihood of account values recovering sufficiently to reduce the death benefit exposure in future periods. These effects are not covered by the Company’s GMDB equity hedge program. Market declines could expose the Company to higher amounts of death benefit exposure that can be retained by contractholders subsequent to a significant partial surrender and to higher election rates of future partial surrenders. Thus, if equity markets decline, the Company’s liability for partial surrenders increases and there is no corresponding offset from the hedge program. The election rate for expected future partial surrenders is updated quarterly based on emerging experience.
Current assumptions used to estimate these liabilities are detailed in Note 7 to the Consolidated Financial Statements. If an unfavorable change were to occur to those assumptions, the approximate after-tax decrease in net income would be as follows:
As of December 31, 2008, if contractholder account values invested in underlying equity mutual funds declined by 10% due to equity market performance, the after-tax decrease in net income resulting from an increase in the provision for partial surrenders would be approximately $25 million.
These liabilities are presented above both gross and net of reinsurance and other recoverables.
See Note 5 to the Consolidated Financial Statements for additional information.
The Company’s estimate of the liability for medical claims incurred but not yet reported is primarily calculated using historical claim payment patterns and expected medical cost trends. The Company analyzes the historical claim payment patterns by comparing the dates claims were incurred, generally the dates services were provided, to the dates claims were paid to determine “completion factors”, which are a measure of the time to process claims. A completion factor is calculated for each month of incurred claims. The Company uses historical completion factors combined with an analysis of current trends and operational factors to develop current estimates of completion factors. The Company estimates the ultimate liability for claims incurred in each month by applying the current estimates of completion factors to the current paid claims data. The difference between this estimate of the ultimate liability and the current paid claims data is the estimate of the remaining claims to be paid for each incurral month. These monthly estimates are aggregated and included in the Company’s Health Care medical claims payable at the end of each reporting period. Completion factors are used to estimate the health care medical claims payable for all months where claims have not been completely resolved and paid, except for the most recent month as described below.
Completion factors are impacted by several key items including changes in the level of claims processed electronically versus manually (auto-adjudication), changes in provider claims submission rates, membership changes and the mix of products. As noted, the Company uses historical completion factors combined with an analysis of current trends and operational factors to develop current estimates of completion factors. This approach implicitly assumes that historical completion rates will be a useful indicator for the current period. It is possible that the actual completion rates for the current period will develop differently from historical patterns, which could have a material impact on the Company’s medical claims payable and net income.
Claims incurred in the most recent month have limited paid claims data, since a large portion of health care claims are not submitted to the Company for payment in the month services have been provided. This makes the completion factor approach less reliable for claims incurred in the most recent month. As a result, in any reporting period, for the estimates of the ultimate claims incurred in the most recent month, the Company primarily relies on medical cost trend analysis, which reflects expected claim payment patterns and other relevant operational considerations. Medical cost trend is impacted by several key factors including medical service utilization and unit costs and the Company’s ability to
The corresponding impact of favorable prior year development on net income was $7 million for the year ended December 31, 2008. The change in the amount of the incurred claims related to prior years in the medical claims payable liability does not directly correspond to an increase or decrease in the Company’s net income.
Because historical trend factors are often not representative of current claim trends, the trend experienced for the most recent history along with an analysis of emerging trends, have been taken into consideration in establishing the liability for medical claims payable at December 31, 2008 and 2007. It is possible that the actual medical trend for the current period will develop differently from the expected, which could have a material impact on the Company’s medical claims payable and net income.
For each reporting period, the Company evaluates key assumptions by comparing the assumptions used in establishing the medical claims payable to actual experience. When actual experience differs from the assumptions used in establishing the liability, medical claims payable are increased or decreased through current period net income. Additionally, the Company evaluates expected future developments and emerging trends which may impact key assumptions. The estimation process involves considerable judgment, reflecting the variability inherent in forecasting future claim payments. The adequacy of these estimates is highly sensitive to changes in the Company’s key assumptions, specifically completion factors, which are impacted by actual or expected changes in the submission and payment of medical claims, and medical cost trends, which are impacted by actual or expected changes in the utilization of medical services and unit costs.
As discussed in Note 2(B) to the Consolidated Financial Statements, the Company implemented SFAS No. 157, “Fair Value Measurements,” on January 1, 2008. At adoption, the Company was required to change certain assumptions. As a result, the Company recorded a charge of $131 million after-tax, net of reinsurance ($202 million pre-tax).
The Company considers the various assumptions used to estimate the fair values of assets and liabilities associated with those contracts in two categories. The first group of assumptions used to estimate these fair values consist of capital market inputs including market returns and discount rates, claim interest rates and market volatility.
• 50 basis point decrease in interest rates (which are aligned with LIBOR) used for projecting market returns and discounting - $25 million
• 50 basis point decrease in interest rates used for projecting claim exposure (7-year Treasury rates) - $20 million
The second group of assumptions consists of future annuitant behavior including annuity election rates, lapse, and mortality, retrocessionaire credit risk, and a risk and profit charge.
Risk and profit charge refers to the amount that a hypothetical market participant would include in the valuation to cover the uncertainty of outcomes and the desired return on capital.
See Note 8 to the Consolidated Financial Statements for additional information.
The Company estimates these liabilities with actuarial models using various assumptions including discount rates and an expected long-term return on plan assets.
If the December 31, 2008 fair values of domestic qualified plan assets decreased by 10%, the accrued pension benefit liability would increase by approximately $225 million as of December 31, 2008 resulting in an after-tax decrease to shareholders’ equity of approximately $145 million.
Changes in fair value are reflected as an increase or decrease in shareholders’ equity. A decrease in fair value is recognized in net income when the decrease is determined to be “other than temporary.”
See Note 12(A) to the Consolidated Financial Statements for a discussion of the Company’s review of declines in fair value.
The Health Care segment’s earnings in 2008, as compared with 2007, were favorably impacted by lower management incentive compensation expense of $21 million after-tax. In addition, the segment’s earnings include the after-tax impact of favorable prior year claim development of $7 million in 2008, $8 million in 2007 and $54 million in 2006. The amount of prior year claim development recorded in 2008 and 2007, compared with 2006, is lower because actual medical cost trends and completion factors were more in line with initial assumptions.
improved Medicare Part D results due in part to increased membership.
lower membership and higher medical cost ratio in the guaranteed cost business;
Excluding prior year claim development and the special items for cost reduction, segment earnings in 2007 increased over 2006 due to:
aggregate medical membership growth of approximately 800,000 members, including growth in the voluntary/limited benefits business.
These factors were partially offset by lower margins in the experience-rated business as well as lower net investment income due to lower average assets and lower yields.
(3) Includes minimum premium members, who have a risk profile similar to experience-rated funding arrangements. The risk portion of minimum premium revenue is reported in experience-rated medical premium whereas the self funding portion of minimum premium revenue is recorded in fees. Also, includes certain non-participating cases for which special customer level reporting of experience is required.
(4) Other medical premiums include risk revenue for stop-loss and specialty products.
Premiums and fees increased 9% in 2007, compared with 2006, primarily reflecting:
Net investment income decreased by 1% in 2008 compared with 2007 reflecting lower yields partially offset by higher average assets. Net investment income decreased by 23% in 2007 compared with 2006 reflecting primarily lower average assets and to a lesser extent lower yields.
Other revenues increased 27% in 2008 and 11% in 2007. In 2008, the increase primarily reflected the impact of the acquired business, while the increase in 2007 was primarily due to business growth.
Medical claims expense included favorable prior year claim development of approximately $11 million in 2008, $12 million in 2007 and $83 million in 2006. Medical claims expense increased 7% in 2008 compared with 2007 largely due to the impact of the acquired business. In addition, medical trend was largely offset by lower risk membership. Excluding the prior year claim development, medical claims expense increased 10% in 2007 compared with 2006 primarily due to medical trend, increased Medicare Part D membership and the impact of the Star HRG operations.
Excluding the items noted above, other operating expenses increased in 2008, compared with 2007, primarily reflecting higher spending on operational improvement initiatives, including segment expansion and investments in information technology. This
increase was partially offset by lower management incentive compensation expenses in 2008, as well as productivity savings which were reflected in lower operating expenses per member due to the success of various expense reduction initiatives. Other operating expenses increased in 2007, compared with 2006, reflecting membership growth and higher spending on information technology, including market facing capabilities.
The Company’s medical membership includes any individual for whom the Company retains medical underwriting risk, who uses the Company’s network for services covered under their medical coverage or for whom the Company administers medical claims. As of December 31, estimated medical membership was as follows:
(2) Includes minimum premium members, who have a risk profile similar to experience-rated funding arrangements. The risk portion of minimum premium revenue is reported in experience-rated medical premium whereas the self funding portion of minimum premium revenue is recorded in fees. Also, includes certain non-participating cases for which special customer level reporting of experience is required.
Reducing other operating expenses. The Company operates in an intensely competitive marketplace and its ability to establish a fully competitive cost advantage is key to achieving its initiatives. Accordingly, the Company is focused on reducing operating expenses in three key areas primarily to facilitate operating efficiency and responsiveness to customers. These three areas include: customer acquisition, which encompasses spending on sales, the account management process, underwriting and marketing; fulfillment, mainly claims processing and billing; and reducing overhead in various administrative and staffing functions. In connection with these efforts, in the fourth quarter of 2008, the Company completed a review of staffing levels and organization and announced a plan to reorganize its business model and supporting areas to more tightly align the ongoing operating segments. See the Introduction section to this MD&A for further discussion beginning on page 43. The Company expects to take additional actions during 2009 to further reduce operating expenses and improve its competitive cost position in the marketplace.
Maintaining and upgrading information technology systems. The Company’s current business model and long-term strategy require effective and reliable information technology systems. The Company’s current systems architecture will require continuing investment to meet the challenges of increasing customer demands from both our existing and emerging customer base to support its business growth and strategies, improve its competitive position and provide appropriate levels of service to customers. The Company is focused on providing these enhanced strategic capabilities in response to increasing customer expectations, while continuing to provide a consistent, high quality customer service experience with respect to the Company’s current programs. Accordingly, in 2009, the Company’s efforts will be focused primarily on optimizing the technology underlying our claims processing and call servicing capabilities with specific emphasis on reducing handling time and improving customer service. Continued integration of the Company’s multiple administrative and customer facing platforms is also required to support the Company’s growth strategies, and to ensure reliable, efficient and effective customer service both in today’s employer focused model as well as in a customer directed model. The Company’s ability to effectively deploy capital to make these investments will influence the timing and the impact these initiatives will have on its operations.
Profitably growing medical membership. The Company continues to focus on growing its medical membership by:
maintaining a strong clinical quality in medical, specialty health care and disability management; and
The Company is also focused on segment and product expansion. In segments, our focus is predominantly in the “Select” (employers with 51-250), small business (employers with 2-50) and individual segments. We also expect to expand our voluntary capabilities and to focus on health as well as pharmacy and dental. As part of its effort to achieve these objectives, the Company completed the acquisition of Great-West Healthcare of Denver, Colorado on April 1, 2008. Also, our Star HRG acquisition serves as our platform to further develop our voluntary portfolio. These acquisitions will enable the Company to broaden its distribution reach and provider network, particularly in the western regions of the United States, and expand the range of health benefits and product offerings. Additionally, the Company has recently developed new product offerings for both our guaranteed cost and experienced rated portfolios. Driving additional cross selling is also key to our value proposition. We are expanding network access for our dental product and improving network flexibility to ensure better alignment with our customers’ needs. Also, with the acquisition of Great-West Healthcare, we will be working in 2009 to transition this book to CIGNA pharmacy and increase penetration across the entire book.
Underwriting and pricing products effectively. One of the Company’s key priorities is to achieve strong profitability in a competitive health care market. The Company is focused on effectively managing pricing and underwriting decisions at both the case and overall book of business level, particularly for the guaranteed cost and experience-rated businesses.
higher net investment income due to higher average assets and yields;
a lower expense ratio driven by effective operating expense management; and
Premiums and fees increased 8% in 2008 and 13% in 2007 reflecting new sales growth in the disability, life and accident lines of business and strong customer retention.
Excluding the pre-tax impact of the reserve studies, reinsurance settlement and cost reduction charge noted above, benefits and expenses increased 5% in 2008 compared with 2007, reflecting overall business growth, partially offset by favorable claims experience in the disability and specialty businesses tempered by less favorable claims experience in the life and accident businesses. In addition, lower expenses were driven by continued focus on operating expense management, lower disability and workers’ compensation case management expenses and lower management incentive compensation expenses.
The International segment includes life, accident and supplemental health insurance products and international health care products and services, including those offered to expatriate employees of multinational corporations.
Excluding the special items noted in the table above, International segment earnings increased 8% in 2008, compared with 2007, and 26% in 2007 compared with 2006, primarily due to continued growth in the life, accident and supplemental health insurance business and the expatriate employee benefits business, as well as continued competitively strong margins. Earnings growth in 2008 was partially offset by unfavorable currency movements, primarily in South Korea. International segment earnings, excluding the impact of foreign currency movements and the special items noted in the table above, increased 16% in 2008, compared with 2007, and 23% in 2007 compared with 2006. The impact of foreign currency movements is calculated by comparing the reported results to what the results would have been had the monthly average exchange rates remained constant with the prior year’s comparable period exchange rates.
Premiums and fees. The increase in premiums and fees of 4% in 2008, compared with 2007, and 18% in 2007 compared with 2006, was primarily attributable to new sales growth in the life, accident and supplemental health insurance operations, particularly in Taiwan and South Korea, and membership growth in the expatriate employee benefits business. These increases also continue to reflect rate adjustments on the renewal of existing business. Premium growth in 2008 was partially offset by unfavorable foreign currency movements in South Korea.
Loss ratios decreased in 2008 and 2007 in the life, accident and supplemental health business due to favorable claims experience and a shift away from traditional life products toward accident and health products. In the expatriate business, loss ratios decreased slightly in 2008 and increased slightly in 2007 due to claims volatility.
foreign currency movements affecting the South Korean currency, which could have a significant impact on the segment’s results and the Company’s consolidated financial results.
Segment losses for the year included losses from the GMIB business of $437 million, and losses from the GMDB business of $267 million. Excluding the charge on adoption of SFAS No. 157 for the GMIB business, (see Note 2(B) to the Consolidated Financial Statements) these losses were primarily related to declines in equity markets and interest rates and increased market volatility. Excluding the results of the GMIB and GMDB businesses, segment earnings for Run-off Reinsurance were lower in 2008 than 2007, reflecting reduced favorable settlement activity related to personal accident and workers’ compensation.
Excluding the results of the GMIB business, segment earnings improved in 2007 compared with 2006. The improvement was predominantly due to an increase in earnings from several settlements and commutations that were favorable to the Company’s reserve position at the time, as well as higher earnings in the workers’ compensation and personal accident business, resulting from more favorable claim development.
The GMIB liabilities and related assets are calculated using a complex internal model and assumptions that in 2008 are from the viewpoint of a hypothetical market participant. This resulting liability (and related asset) is higher than the Company believes will ultimately be required to settle claims primarily because market-observable interest rates are used to project growth in account values of the underlying mutual funds to estimate fair value from the viewpoint of a hypothetical market participant. The Company’s payments for GMIB claims are expected to occur over the next 15 to 20 years and will be based on actual values of the underlying mutual funds and the 7-year Treasury rate at the dates benefits are elected. The Company does not believe that current market-observable interest rates reflect actual growth expected for the underlying mutual funds over that timeframe, and therefore believes that the recorded liability and related asset do not represent what management believes will ultimately be required as this business runs off.
adverse impacts of overall market declines of $210 million ($136 million after-tax). This includes (a) $185 million ($120 million after-tax) related to the provision for partial surrenders, including $40 million ($26 million after-tax) for an increase in the assumed election rates for future partial surrenders and (b) $25 million ($16 million after-tax) related to declines in the values of contractholders’ non-equity investments such as bond funds, neither of which is included in the GMDB equity hedge program;
adverse interest rate impacts. Interest rate risk is not covered by the GMDB equity hedge program, and the interest rate returns on the futures contracts were less than the Company’s long-term assumption for mean investment performance generating an additional $14 million ($9 million after-tax).
In addition to the reserve strengthening discussed above, other benefits and expenses were higher in 2008 than 2007 due to the impact of changes in the equity markets on GMDB contracts. Equity markets decreased significantly in 2008 while they increased in 2007 leading to higher benefits expense in 2008. Equity market declines result in decreases in underlying annuity account values, which increases the exposure under the contracts. These changes in benefits expense are partially offset by futures gains and losses, discussed in Other Revenues above. In addition, benefits expense related to personal accident and workers’ compensation was higher in 2008 than 2007, as a result of reduced favorable settlement activity in 2008.
The Company’s reserves for underlying reinsurance exposures assumed by the Company, as well as for amounts recoverable from retrocessionaires, are considered appropriate as of December 31, 2008, based on current information. However, it is possible that future developments, which could include but are not limited to worse than expected claim experience and higher than expected volatility, could have a material adverse effect on the Company’s consolidated results of operations and could have a material adverse effect on the Company’s financial condition. The Company bears the risk of loss if its payment obligations to cedents increase or if its retrocessionaires are unable to meet, or successfully challenge, their reinsurance obligations to the Company.
The COLI portion of this business has contributed the majority of the earnings in 2008, 2007 and 2006 for Other Operations. Federal legislation enacted in 1996 affected certain policies sold by the COLI business by eliminating on a prospective basis the tax deduction for policy loan interest for most leveraged COLI products. There have been no sales of this particular product since 1997. As a result of an Internal Revenue Service initiative to settle tax disputes regarding leveraged products, some customers have surrendered their policies and management expects earnings associated with these products to continue to decline. Management does not expect this to have a significant impact on the future operating results of the segment.
Excluding the special item noted above, segment earnings for Other Operations declined in 2008 compared with 2007, reflecting lower results from the COLI business driven by less favorable mortality and lower interest margins. Interest margins decreased due to the movement of assets from the general account to separate accounts, and lower interest rates. In addition, the continuing decline in deferred gain amortization associated with sold businesses contributed to lower earnings.
Net investment income. Net investment income decreased 5% in 2008 compared with 2007, primarily reflecting lower average invested assets due in part to the movement of assets from the general account to separate accounts in the COLI business as well as lower interest rates. Net investment income decreased 6% in 2007 compared with 2006 primarily due to a reduction in assets resulting from the conversion of the single premium annuity business to indemnity reinsurance and the resulting transfer of trust assets to the buyer of the retirement benefits business.
Excluding the special items noted above (see Consolidated Results of Operations section of the MD&A beginning on page 46 for more information on special items), Corporate results were lower in 2008, compared with 2007, primarily reflecting higher net interest expense attributable to lower average invested assets and increased debt to finance the acquired business. These factors were partially offset by lower directors’ expenses due to reduced deferred compensation obligations caused by a decline in the Company’s stock price.
realized gains on the disposition of certain directly-owned real estate investments in 2007 and 2006 as discussed in Note 13 to the Consolidated Financial Statements.
The disability industry is under continuing review by regulators and legislators with respect to its offset practices regarding Social Security Disability Insurance (“SSDI”). There has been specific inquiry as to the industry’s role in assisting individuals with their applications for SSDI. The Company has received one Congressional inquiry and has responded to the information request. Also, legislation prohibiting the offset of SSDI payments against private disability insurance payments for prospectively issued policies has been introduced in the Connecticut state legislature. The Company is also involved in related pending litigation. If the industry is forced to change its offset SSDI procedures, the practices and products for the Company’s Disability & Life segment could be significantly impacted.
There are certain other matters that present significant uncertainty, which could result in a material adverse impact on the Company’s consolidated results of operations. See Note 22 to the Consolidated Financial Statements for further information.
matching investment maturities to the estimated duration of the related insurance and contractholder liabilities; and
Cash flow from operating activities consists of cash receipts and disbursements for premiums and fees, gains (losses) recognized in connection with the Company’s GMDB equity hedge program, investment income, taxes, and benefits and expenses.
For the year ended December 31, 2008, cash flows from operating activities were greater than adjusted income from operations by $406 million, including cash inflows of $333 million associated with the GMDB equity hedge program which did not affect net income. Excluding those inflows, cash flows from operating activities were higher than adjusted income from operations by $73 million, primarily reflecting favorable receivable collections and increases in GMDB reserves due to the 2008 charges. These factors were partially offset by payments for certain prepaid expenses and litigation matters.
Cash provided from financing activities primarily consisted of proceeds from the net issuance of short-term debt of $298 million and long-term debt of $297 million. These borrowing arrangements were entered into for general corporate purposes, including the
For the year ended December 31, 2007, cash flows from operating activities were lower than adjusted income from operations by $21 million, including cash outflows of $32 million associated with the GMDB equity hedge program which did not affect net income. Excluding those outflows, cash flows from operating activities were higher than adjusted income from operations by $11 million.
Cash provided by investing activities primarily consisted of net sales of investments of $495 million and net purchases of property and equipment of $180 million.
Cash used in financing activities primarily consisted of dividends on and repurchases of common stock of $1.2 billion and repayment of debt of $378 million, partially offset by proceeds from the issuance of debt of $498 million and proceeds from the issuance of common stock under the Company’s stock plans of $248 million.
The increase in interest expense in 2008 was primarily due to the issuance of debt in connection with the Great-West Healthcare acquisition. At December 31, 2008, the Company has recognized cumulative losses of $40 million pre-tax ($26 million after-tax) related to its treasury rate lock derivative in accumulated other comprehensive income. The loss on this derivative will continue to fluctuate until it closes in 2009. If the Company issues debt in the first half of 2009 as expected, the loss at the time the derivative closes would increase the effective interest rate recognized over the life of the debt. If the Company is unable to issue debt in the first half of 2009, this loss would be recognized as a reduction to results of operations in the first half of 2009.
is authorized to sell from time to time short-term unsecured commercial paper notes up to a maximum of $500 million. The proceeds are used for general corporate purposes, including working capital, capital expenditures, acquisitions and share repurchases. The Company uses the credit facility described below as back-up liquidity to support the outstanding commercial paper. If at any time funds are not available on favorable terms under the Program, the Company may use the Credit Agreement (see below) for funding. In October 2008, the Company added an additional dealer to its Program. As of December 31, 2008, the Company had $299 million in commercial paper outstanding, at a weighted average interest rate of 6.31%, used to finance the Great-West Healthcare acquisition and for other corporate purposes.
On March 4, 2008, the Company issued $300 million of 6.35% Notes (with an effective interest rate of 6.68% per year). Interest is payable on March 15 and September 15 of each year beginning September 15, 2008. The proceeds of this debt were used for general corporate purposes, including financing the acquisition of Great-West Healthcare. These Notes will mature on March 15, 2018. The Company may redeem these Notes, at any time, in whole or in part, at a redemption price equal to the greater of:
At December 31, 2008, there was approximately $90 million in cash available at the parent company level. In 2009, the parent company’s debt service consists of scheduled interest payments of approximately $140 million on outstanding long term debt of $2.1 billion at December 31, 2008 and approximately $300 million of commercial paper that will mature over the next three months. There are no scheduled long-term debt repayments in 2009. The company expects to refinance the commercial paper either by issuing long-term debt or re-issuing commercial paper.
continued significant disruption or volatility in the capital and credit markets reduces the Company’s ability to raise capital or
a substantial increase in funding is required for the Company’s GMDB equity hedge program.
In those cases, the Company expects to have the flexibility to satisfy liquidity needs through a variety of measures, including intercompany borrowings and sales of liquid investments. The parent company may borrow up to $400 million from Connecticut General Life Insurance Company without prior state approval. In addition, the Company may use short-term borrowings, such as the commercial paper program and the committed line of credit agreement of up to $1.75 billion subject to the maximum debt leverage covenant in its line of credit agreement. As of December 31, 2008, the Company had an additional $750 million of borrowing capacity within the maximum debt leverage covenant in the line of credit agreement in addition to the $2.4 billion of debt outstanding as of December 31, 2008.
Though the Company believes it has adequate sources of liquidity, continued significant disruption or volatility in the capital and credit markets could affect the Company’s ability to access those markets for additional borrowings or increase costs associated with borrowing funds.
The Company, through its subsidiaries, is contingently liable for various contractual obligations entered into in the ordinary course of business. The maturities of the Company’s primary contractual cash obligations, as of December 31, 2008, are estimated to be as follows:
Insurance liabilities. Contractual cash obligations for insurance liabilities, excluding unearned premiums and fees, represent estimated net benefit payments for health, life and disability insurance policies and annuity contracts. Recorded contractholder deposit funds reflect current fund balances primarily from universal life customers. Contractual cash obligations for these universal life contracts are estimated by projecting future payments using assumptions for lapse, withdrawal and mortality. These projected future payments include estimated future interest crediting on current fund balances based on current investment yields less estimated cost of insurance charges and mortality and administrative fees. Actual obligations in any single year will vary based on actual morbidity, mortality, lapse, withdrawal, investment and premium experience. The sum of the obligations presented above exceeds the corresponding insurance and contractholder liabilities of $15.7 billion recorded on the balance sheet because the recorded insurance liabilities reflect discounting for interest and the recorded contractholder liabilities exclude future interest crediting, charges and fees. The Company manages its investment portfolios to generate cash flows needed to satisfy contractual obligations. Any shortfall from expected investment yields could result in increases to recorded reserves and adversely impact results of operations. The amounts associated with the sold retirement benefits and individual life insurance and annuity businesses are excluded from the table above as net cash flows associated with them are not expected to impact the Company. The total amount of these reinsured reserves excluded is approximately $6.5 billion.
Short-term debt represents commercial paper and current obligations under capital leases.
Nonrecourse obligations represent principal and interest payments due which may be limited to the value of specified assets, such as real estate properties held in joint ventures.
Future service commitments include an agreement with IBM for various information technology (IT) infrastructure services. The Company’s remaining commitment under this contract is approximately $504 million over a 5-year period. The Company has the ability to terminate this agreement with 90 days notice, subject to termination fees.
The Company’s remaining estimated future service commitments primarily represent contracts for certain outsourced business processes and IT maintenance and support. The Company generally has the ability to terminate these agreements, but does not anticipate doing so at this time. Purchase obligations exclude contracts that are cancelable without penalty or those that do not specify minimum levels of goods or services to be purchased.
The Company, through its subsidiaries, is contingently liable for various financial guarantees provided in the ordinary course of business. See Note 22 to the Consolidated Financial Statements for additional information on guarantees.
The Company’s investment assets do not include separate account assets. Additional information regarding the Company’s investment assets and related accounting policies is included in Notes 2, 11, 12, 13 and 16 to the Consolidated Financial Statements.
The Company performs ongoing analyses on prices to conclude that they represent reasonable estimates of fair value. This process involves quantitative and qualitative analysis and is overseen by the Company’s investment professionals. This process also includes review of pricing methodologies, pricing statistics and trends and backtesting recent trades.
The Company’s fixed maturity portfolio continues to be diversified by issuer and industry type, with no single industry constituting more than 10% of total invested assets as of December 31, 2008.
Other mortgage-backed assets consist principally of commercial mortgage-backed securities and collateralized mortgage obligations of which $41 million were residential mortgages and home equity lines of credit, all of which were originated utilizing standard underwriting practices and are not considered sub-prime loans.
Private placement investments are generally less marketable than public bonds, but yields on these investments tend to be higher than yields on publicly offered debt with comparable credit risk. The fair value of private placement investments was $4.4 billion as of December 31, 2008 and 2007. The Company maintains controls on its participation in private placement investments. In particular, the Company performs a credit analysis of each issuer, diversifies investments by industry and issuer and requires financial and other covenants that allow the Company to monitor issuers for deteriorating financial strength so the Company can take remedial actions, if warranted. See the “Critical Accounting Estimates” section of the MD&A beginning on page 49 for additional information.
principal or interest payments past due by more than 30 but fewer than 60 days;
The Company recognizes interest income on “problem” bonds and commercial mortgage loans only when payment is actually received because of the risk profile of the underlying investment. The amount that would have been reflected in net income if interest on non-accrual investments had been recognized in accordance with the original terms was not significant in 2008, 2007 or 2006.
(1) Other primarily represents the impact of rising interest rates on investments where the Company cannot demonstrate the intent and ability to hold until recovery.
In addition to these asset write-downs, in 2008, the Company recognized after-tax losses of $9 million on hybrid securities (classified as equity securities) of certain quasi-federal government agencies where the Company believes that the decline in fair value is “other-than-temporary”.
The U.S. and global financial markets experienced significant challenges throughout 2008. The unprecedented downgrading of billions of dollars of previously highly rated, liquid public securities led to a significant crisis of confidence and a dramatic tightening of credit conditions leading to historically wide credit spreads and substantially higher market yields in spite of near record low treasury rates. Both debt and equity markets are expected to remain volatile until confidence is restored. As a result of this economic environment, the credit risks in the Company’s investment portfolio are elevated.
The value of the Company’s fixed maturity portfolio declined substantially throughout 2008 resulting in after-tax unrealized depreciation of $147 million. The Company’s commercial mortgage portfolio also declined substantially in 2008, resulting in after-tax unrealized depreciation of $140 million (a decline in fair value versus carrying value). The possibility of increased market investment yields for an extended period could cause the Company to recognize impairment losses if it cannot demonstrate the intent and ability to hold certain
investments until recovery. Future realized and unrealized investment results will be impacted largely by market conditions that exist when a transaction occurs or at the reporting date. These future conditions are not reasonably predictable.
Management believes that a significant portion of the Company’s fixed maturity and commercial mortgage investments will continue to perform under their contractual terms, and that the recent declines in their fair values are temporary. Based on the Company’s strategy to match the duration of invested assets to the duration of insurance and contractholder liabilities, it has both the intent and ability to hold these assets to recovery. Therefore, future credit related losses are not expected to have a material adverse effect on the Company’s liquidity or financial condition.
Use of local currencies for foreign operations. The Company generally conducts its international business through foreign operating entities that maintain assets and liabilities in local currencies. While this technique does not reduce the Company’s foreign currency exposure of its net assets, it substantially limits exchange rate risk to net assets.
Use of derivatives. The Company generally uses derivative financial instruments to minimize certain market risks and enhance investment returns.
See Notes 2(C) and 12(F) to the Consolidated Financial Statements for additional information about financial instruments, including derivative financial instruments.
hypothetical changes in market interest rates primarily for fixed maturities and commercial mortgage loans, partially offset by liabilities for long-term debt and GMIB contracts;
hypothetical changes in market prices for equity exposures primarily for equity securities and GMIB contracts.
The effect of a hypothetical increase in interest rates on the fair value of certain of the Company’s financial instruments decreased in 2008 as a result of increased net liabilities for GMIB contracts, along with declining fair values of fixed maturities, partially offset by a decrease in the duration of long-term debt. Net liabilities for GMIB contracts increased in 2008 primarily due to the adoption of SFAS No. 157 and declines in the equity markets and interest rates. During 2008, the underlying equity account values from GMIB contracts decreased by 50% primarily due to equity market declines. Therefore, the current effect of a hypothetical 10% decrease in market prices for equity exposures at December 31, 2008 is expected to be less than at December 31, 2007. See the “Critical Accounting Estimates” section of the MD&A beginning on page 49 for further discussion of guaranteed minimum income benefits.
The Company uses futures contracts as part of a GMDB equity hedge program to substantially reduce the effect of equity market changes on certain reinsurance contracts that guarantee minimum death benefits based on unfavorable changes in underlying variable annuity account values. The hypothetical effect of a 10% increase in the S&P 500, S&P 400, Russell 2000, NASDAQ, TOPIX (Japanese), EUROSTOXX and FTSE (British) equity indices and a 10% weakening in the U.S. dollar to the Japanese yen, British pound and euro would have been a decrease of approximately $140 million in the fair value of the futures contracts outstanding under this program as of December 31, 2008. A corresponding decrease in liabilities for GMDB contracts would result from the hypothetical 10% increase in these equity indices and 10% weakening in the U.S. dollar. See Note 7 to the Consolidated Financial Statements for further discussion of this program and related GMDB contracts.
risks associated with pending and potential state and federal class action lawsuits, disputes regarding reinsurance arrangements, other litigation and regulatory actions challenging the Company’s businesses, government investigations and proceedings, and tax audits;
significant changes in interest rates for a sustained period of time;
adjustments to the reserve assumptions (including lapse, partial surrender, mortality, interest rates and volatility) used in estimating the Company’s liabilities for reinsurance contracts covering guaranteed minimum death benefits under certain variable annuities;
significant deterioration in economic conditions and significant market volatility, which could have an adverse effect on the
businesses of our customers (including the amount and type of healthcare services provided to their workforce and our customers’ ability to pay receivables) and our vendors (including their ability to provide services);
changes in public policy and in the political environment, which could affect state and federal law, including legislative and regulatory proposals related to health care issues, which could increase cost and affect the market for the Company’s health care products and services; and amendments to income tax laws, which could affect the taxation of employer provided benefits, and pension legislation, which could increase pension cost;
challenges and risks associated with the successful management of the Company’s outsourcing projects or key vendors, including the agreement with IBM for provision of technology infrastructure and related services;
The Company’s independent registered public accounting firm, PricewaterhouseCoopers, has audited the effectiveness of the Company’s internal control over financial reporting, as stated in their report located on page 137 in this Form 10-K.
Discontinued operations. Summarized financial data for discontinued operations in 2008 primarily represents a gain of $3 million after-tax from the settlement of certain issues related to a past divestiture.
Fair value measurements. Effective January 1, 2008, the Company adopted Statement of Financial Accounting Standards No. (SFAS No.) 157, “Fair Value Measurements.” This standard expands disclosures about fair value measurements and clarifies how to measure fair value by focusing on the price that would be received when selling an asset or paid to transfer a liability (exit price). In addition, the Financial Accounting Standards Board (FASB) amended SFAS No. 157 to provide additional guidance for determining the fair value of a financial asset when the market for that instrument is not active. See Note 11 for information on the Company’s fair value measurements including new required disclosures.
The Company carries certain financial instruments at fair value in the financial statements including approximately $12.1 billion in invested assets at December 31, 2008. The Company also carries derivative instruments at fair value, including assets and liabilities for reinsurance contracts covering guaranteed minimum income benefits (GMIB assets and liabilities) under certain variable annuity contracts issued by other insurance companies and related retrocessional contracts. The Company also reports separate account assets at fair value; however, changes in the fair values of these assets accrue directly to policyholders and are not included in the Company’s revenues and expenses. At the adoption of SFAS No. 157, there were no effects to the Company’s measurements of fair values for financial instruments other than for GMIB assets and liabilities discussed below. In addition, there were no effects to the Company’s measurements of financial assets of adopting the recent amendment to SFAS No. 157.
At adoption, the Company was required to change certain assumptions used to estimate the fair values of GMIB assets and liabilities. As a result, the Company recorded a charge of $131 million after-tax, net of reinsurance ($202 million pre-tax), in Run-off Reinsurance. Because there is no market for these contracts, the assumptions used to estimate their fair values at adoption were determined using a hypothetical market participant’s view of an exit price. The Company considered the following in determining the view of a hypothetical market participant:
At adoption, the assumptions used to estimate the fair value of these contracts were determined using a hypothetical market participant’s view of an exit price rather than using historical market data and actual experience to establish the Company’s future expectations. For many of these assumptions, there is limited or no observable market data so determining an exit price requires the Company to exercise significant judgment and make critical accounting estimates.
The Company considers the various assumptions used to estimate fair values of these contracts in two categories: capital markets and future annuitant and retrocessionaire behavior assumptions. Estimated components of the charge by category (net of reinsurance) are described below, including how these updated assumptions differ from those used historically to estimate fair values for these contracts.
Assumptions Related to Capital Markets - $183 million of the $202 million pre-tax charge, net of estimated receivables for reinsurance, reflected the impact of changes in capital markets assumptions including market return, discount rate, the projected interest rate used to calculate the reinsured income benefits at the time of annuitization (claim interest rate), and volatility. These assumptions were updated to reflect market-observable interest rates (LIBOR swap curve) and volatility consistent with that implied by derivative instruments in a consistently active market, under the assumption that a hypothetical market participant would hedge all or a portion of the net liability. The capital markets pre-tax charge is comprised of:
$131 million related to using market-observable interest rates to project the growth in the contractholders’ underlying investment accounts rather than using an estimate of the actual returns for the underlying equity and bond mutual funds over time. Market-observable growth rates were lower than the market return assumptions at December 31, 2007 which ranged from 5-11% varying by fund type. The Company believes market-observable rates would be used by a hypothetical market participant who is expected to hedge the risk associated with these contracts because they would earn market interest returns from hedging instruments. However, the Company’s actual payments will be based on, among other variables, the actual returns that the contractholders earn on their underlying investment accounts.
5.75% used at December 31, 2007 prior to the adoption of SFAS No. 157.
The Company’s results of operations related to this business are expected to continue to be volatile in future periods both because underlying assumptions will be based on current market-observable inputs which will likely change each period and because the recorded liabilities, net of receivables from reinsurers, are higher after adoption of SFAS No. 157. See Note 11 for additional information.
The FASB deferred the effective date of SFAS No. 157 until the first quarter of 2009 for non-financial assets and liabilities (such as intangible assets, property and equipment and goodwill) that are required to be measured at fair value on a periodic basis (such as at impairment). On adoption in the first quarter of 2009, the Company does not expect material changes to their periodic fair value measurements for non-financial assets and liabilities.
Uncertain tax positions. Effective January 1, 2007, the Company implemented FASB Interpretation No. (FIN No.) 48, “Accounting for Uncertainty in Income Taxes.” This interpretation provides guidance for recognizing and measuring uncertain tax positions that are “more likely than not” to result in a benefit if challenged by the Internal Revenue Service (IRS). The guidance clarifies that the amount of tax benefit recognized should be measured using management’s best estimate based on the most favorable expected benefit with greater than fifty percent likelihood of being realized. The interpretation also requires that interest expense and penalties be recognized for any reserved portion of an uncertain tax position beginning when the effect of that position is reported to tax authorities. The cumulative effect of implementing the interpretation for unrecognized tax benefits decreased opening retained earnings by $29 million. See Note 18 for additional information.
Certain financial instruments. Effective January 1, 2007, the Company implemented SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments,” an amendment of FASB Statements No. 133 and 140. This standard clarifies when certain financial instruments and features of financial instruments must be treated as derivatives and reported on the balance sheet at fair value with changes in fair value reported in net income. At adoption, the Company elected to fair value certain existing investments in preferred stock and debt securities with call or conversion features (hybrid securities) and future changes in the fair value of these investments will be reported in net income. As a result, the Company reclassified $12 million after-tax of unrealized appreciation from the opening balance of accumulated other comprehensive loss to retained earnings with no net change to total shareholders’ equity. In addition, this standard may affect future income recognition for certain future financial instruments if the fair value election is used or if additional derivatives are identified because any changes in their fair values will be recognized in net income each period. See Note 12(A) for a review of instruments that the Company has elected to fair value.
Pension and other postretirement benefit plans. Effective December 31, 2006, the Company implemented SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Benefits Plans.” This standard requires that the overfunded or underfunded status of all defined benefit postretirement plans be measured as the difference between the fair value of plan assets and the benefit obligation and recognized in the balance sheet. Changes in actuarial gains and losses and prior service costs are required to be recognized in accumulated other comprehensive income, net of tax, each period. The effects on the consolidated financial statements were as follows:
The implementation of SFAS No. 158 did not impact the Company’s pension expense, funding requirements or financial covenants. See Note 10 for further information on pension and other postretirement benefit plans.
Most financial instruments that are subject to fair value disclosure requirements are carried in the consolidated financial statements at amounts that approximate fair value. The following table shows the fair values and carrying values of the Company’s financial instruments not carried at fair value that are subject to fair value disclosure requirements, at the end of 2008 and 2007:
Fair values of financial instruments are based on quoted market prices when available. When market prices are not available, management generally estimates fair value based on discounted cash flow analyses, which use current interest rates for similar financial instruments with comparable terms and credit quality. Management estimates the fair value of the liabilities for contractholder deposit funds using the amount payable on demand.
cost plus the Company’s ownership percentage of reported income or loss in cases where the Company has significant influence, otherwise the investment is carried at cost. Also included in other long-term investments are loans to unconsolidated real estate entities secured by the equity interests of these real estate entities, which are carried at unpaid principal balances (mezzanine loans). Additionally, other long-term investments include interest rate and foreign currency swaps carried at fair value. See Note 12(F) for information on the Company’s accounting policies for these derivative financial instruments.
Other assets consist of various insurance-related assets and the gain position of certain derivatives, primarily GMIB assets. The Company’s other intangible assets include purchased customer and producer relationships, provider networks, and trademarks. The Company amortizes other intangibles on an accelerated or straight-line basis over periods from 1 to 30 years. Management revises amortization periods if it believes there has been a change in the length of time that an intangible asset will continue to have value. See Note 9 for additional information.
Liabilities for contractholder deposit funds include deposits received from customers for investment-related and universal life products and investment earnings on their fund balances. These liabilities are adjusted to reflect administrative charges and, for universal life fund balances, mortality charges.
Because benefit payments may be made over an extended time period, the Company discounts certain claim liabilities related to group long-term disability and workers’ compensation. Discount rate assumptions are based on projected investment returns for the asset portfolios that support these liabilities and range from 2.1% to 6.5%. When estimates change, the Company records the adjustment in benefits and expenses in the period in which the change in estimate is identified. Discounted liabilities associated with the long-term disability and certain workers’ compensation businesses were $3.2 billion at December 31, 2008 and $3.1 billion at December 31, 2007.
actuarial best estimate of the ultimate liability within a level of confidence, as required by actuarial standards of practice, which require that the liabilities be adequate under moderately adverse conditions.
Because historical trend factors are often not representative of current claim trends, the trend experienced for the most recent history along with an analysis of emerging trends, have been taken into consideration in establishing the liability for Health Care medical claims payable at December 31, 2008 and 2007. It is possible that the actual medical trend for the current period will develop differently from that expected, which could have a material impact on the Company’s medical claims payable and net income.
Accounts payable, accrued expenses and other liabilities consist principally of pension, other postretirement and postemployment benefits and various insurance-related liabilities, including amounts related to reinsurance contracts and insurance-related assessments that management can reasonably estimate. Accounts payable, accrued expenses and other liabilities also include certain overdraft positions and the loss position of certain derivatives, primarily for GMIB contracts (see Note 12(F)). Legal costs to defend the
Company’s litigation and arbitration matters are expensed when incurred in larger cases for which the Company cannot reasonably estimate the ultimate cost to defend. In smaller cases for which the Company can reasonably estimate the cost to defend, these costs are recognized when the claim is reported.
Premiums for life, accident and health insurance and managed care coverages are recognized as revenue on a pro rata basis over the contract period. Benefits and expenses are recognized when incurred.
Fees for mortality are recognized as assessed, which is as earned.
The Company’s participating life insurance policies entitle policyholders to earn dividends that represent a portion of the earnings of the Company’s life insurance subsidiaries. Participating insurance accounted for approximately 2% of the Company’s total life insurance in force at the end of 2008, 2007 and 2006.
The Company recognizes deferred income taxes when the financial statement and tax based carrying values of assets and liabilities are different and recognizes deferred income tax liabilities on the unremitted earnings of foreign subsidiaries. The Company establishes valuation allowances against deferred tax assets if it is more likely than not that the deferred tax asset will not be realized. The need for a valuation allowance is determined based on the evaluation of various factors, including expectations of future earnings and management’s judgment. Note 18 contains detailed information about the Company’s income taxes.
In accordance with SFAS No. 141, “Business Combinations”, the Company has substantially completed its allocation of the total purchase price to the tangible and intangible net assets acquired based on management’s estimates of their fair values and expects only minor adjustments in the first quarter of 2009, the remaining allocation period. Accordingly, approximately $290 million was allocated to intangible assets, primarily customer relationships and internal-use software. The weighted average amortization period is 9 years for customer relationships and 6 years for internal-use software. The remainder, net of tangible net assets acquired, is goodwill which approximated $1.1 billion and was allocated entirely to the Health Care segment. Substantially all of the goodwill is tax deductible and will be amortized over the next 15 years for federal income tax purposes.
December 31, 2006, the assets and liabilities of the Chilean insurance operations, which were held for sale, were reported in other assets and accounts payable, accrued expenses and other liabilities.
In 2004, the Company sold its retirement benefits business, excluding the corporate life insurance business, for cash proceeds of $2.1 billion. The sale resulted in an initial after-tax gain of $809 million, of which $267 million after-tax was recognized immediately and the remaining amount was deferred. The Company recognized deferred gains of $3 million after-tax in 2008, $5 million after-tax in 2007 and $14 million after-tax in 2006. As of December 31, 2008, the remaining deferred gain of $33 million after-tax will be recognized in the Company’s results of operations through 2032.
In 1998, the Company sold its individual life insurance and annuity business for cash proceeds of $1.4 billion. The sale generated an after-tax gain of approximately $800 million, the majority of which was deferred and is recognized at the rate that earnings from the sold business would have been expected to emerge (primarily over 15 years on a declining basis). The Company recognized deferred gains of $22 million after-tax in 2008, $25 million after-tax in 2007 and $28 million after-tax in 2006. The remaining deferred gain as of December 31, 2008, was $108 million after-tax.
Medical claims payable for the Health Care segment reflects estimates of the ultimate cost of claims that have been incurred but not yet reported, those which have been reported but not yet paid (reported claims in process) and other medical expense payable, which primarily comprises accruals for provider incentives and other amounts payable to providers. Incurred but not yet reported comprises the majority of the reserve balance as follows:
Reinsurance and other amounts recoverable reflect amounts due from reinsurers and policyholders to cover incurred but not reported and pending claims for minimum premium products and certain administrative services only business where the right of offset does not exist. See Note 8 for additional information on reinsurance. For the year ended December 31, 2008, actual experience differed from the Company’s key assumptions resulting in favorable incurred claims related to prior years’ medical claims payable of $60 million, or 0.9% of the current year incurred claims as reported for the year ended December 31, 2007. Actual completion factors resulted in a reduction in medical claims payable of $29 million, or 0.4% of the current year incurred claims as reported for the year ended December 31, 2007 for the insured book of business. Actual medical cost trend resulted in a reduction in medical claims payable of $31 million, or 0.5% of the current year incurred claims as reported for the year ended December 31, 2007 for the insured book of business.
For the year ended December 31, 2007, actual experience differed from the Company’s key assumptions, resulting in favorable incurred claims related to prior years’ medical claims payable of $80 million, or 1.3% of the current year incurred claims as reported for the year ended December 31, 2006. Actual completion factors resulted in a reduction of the medical claims payable of $46 million, or 0.7% of the current year incurred claims as reported for the year ended December 31, 2006 for the insured book of business. Actual medical cost trend resulted in a reduction of the medical claims payable of $34 million, or 0.6% of the current year incurred claims as reported for the year ended December 31, 2006 for the insured book of business.
The favorable impact in 2008 and 2007 relating to completion factor and medical cost trend variances is primarily due to the release of the provision for moderately adverse conditions, which is a component of the assumptions for both completion factors and medical cost trend, established for claims incurred related to prior years. This release was substantially offset by the establishment of the provision for moderately adverse conditions established for claims incurred related to the current year.
The corresponding impact of prior year development on net income was $7 million in 2008 and $8 million in 2007. The change in the
amount of the incurred claims related to prior years in the medical claims payable liability does not directly correspond to an increase or decrease in the Company’s net income recognized for the following reasons:
In 2008, the Company conducted a comprehensive review of its ongoing businesses with an emphasis on reducing operating expenses in the Health Care segment. As a result of the review, during the fourth quarter of 2008, the Company committed to a plan to reduce operating costs in order to meet the challenges and opportunities presented by the current market environment. The Company anticipates the plan will be substantially complete by the end of 2009. As a result, the Company recognized in other operating expenses a total charge of $55 million pre-tax ($35 million after-tax), which included $44 million pre-tax ($28 million after-tax) for severance and other related costs resulting from reductions of approximately 1,100 positions in its workforce and $11 million pre-tax ($7 million after-tax) resulting from consolidation of facilities. The Company expects to pay $53 million in cash related to this charge, most of which will occur in 2009. The Health Care segment reported $44 million pre-tax ($27 million after-tax) of the total charge. The remainder was reported as follows: Disability and Life: $3 million pre-tax ($2 million after-tax), and International: $8 million pre-tax ($6 million after-tax).
In order to substantially reduce the equity market exposures relating to guaranteed minimum death benefit contracts, the Company operates a dynamic hedge program (GMDB equity hedge program), using exchange-traded futures contracts. The hedge program is designed to offset both positive and negative impacts of changes in equity markets on the GMDB liability. The hedge program involves detailed, daily monitoring of equity market movements and rebalancing the futures contracts within established parameters. While the hedge program is actively managed, it may not exactly offset changes in the GMDB liability due to, among other things, divergence between the performance of the underlying mutual funds and the hedge instruments, high levels of volatility in the equity markets, and differences between actual contractholder behavior and what is assumed. The performance of the underlying mutual funds compared to the hedge instruments is further impacted by a time lag, since the data is not reported and incorporated into the
adverse impacts of overall market declines of $210 million pre-tax ($136 million after-tax). This is comprised of (a) $185 million ($120 million after-tax) related to the provision for partial surrenders, including $40 million ($26 million after-tax) for an increase in the assumed election rates for future partial surrenders and (b) $25 million ($16 million after-tax) related to declines in the values of contractholders’ non-equity investments such as bond funds, neither of which is included in the GMDB equity hedge program;
The mean investment performance assumption is 5% considering the Company’s GMDB equity hedge program using futures contracts. This is reduced by fund fees ranging from 1-3% across all funds. The results of futures contracts are reflected in the liability calculation as a component of investment returns.
the contractholders account value as of the last anniversary date (anniversary reset); or
The table below presents the account value, net amount at risk and average attained age of underlying contractholders for guarantees in the event of death, by type of benefit as of December 31. The net amount at risk is the death benefit coverage in force or the amount that the Company would have to pay if all contractholders died as of the specified date, and represents the excess of the guaranteed benefit amount over the fair value of the underlying mutual fund investments.
Retirement benefits business. The Company had a reinsurance recoverable of $1.9 billion as of December 31, 2008, and $2.1 billion as of December 31, 2007 from Prudential Retirement Insurance and Annuity Company resulting from the sale of the retirement benefits business, which was primarily in the form of a reinsurance arrangement. The reinsurance recoverable, which is reduced as the Company’s reinsured liabilities are paid or directly assumed by the reinsurer, is secured primarily by fixed maturities and mortgage loans equal to or greater than 100% of the reinsured liabilities held in a trust established for the benefit of the Company. As of December 31, 2008, the trust was adequately funded and S&P had assigned this reinsurer a rating of AA.
Individual life and annuity reinsurance. The Company had reinsurance recoverables totaling $4.6 billion as of December 31, 2008 and $4.7 billion as of December 31, 2007 from The Lincoln National Life Insurance Company and Lincoln Life & Annuity of New York resulting from the 1998 sale of the Company’s individual life insurance and annuity business through indemnity reinsurance arrangements. Effective December 31, 2007, a substantial portion of the reinsurance recoverables are secured by investments held in a trust established for the benefit of the Company. At December 31, 2008, the trust assets secured approximately 90% of the reinsurance recoverables and S&P had assigned both of these reinsurers a rating of AA.
Approximately 40% of recoverables are due from reinsurers that have been assigned ratings of AA- or better from S&P. An additional 30% of recoverables are due from reinsurers that have been assigned an S&P rating of A- or better and the remaining 30% primarily represent recoverables associated with unrated reinsurers. Approximately 50% of the recoverables from unrated reinsurers are supported by collateral arrangements with none of the remaining reinsurers holding more than 2% of the total recoverable balance.
The Company reviews its reinsurance arrangements and establishes reserves against the recoverables in the event that we believe that recovery is not probable. As of December 31, 2008, the Company’s recoverables related to these segments were net of a reserve of $12 million.
Assumed and Ceded reinsurance: Run-off Reinsurance segment. The Company’s Run-off Reinsurance operations assumed risks related to GMDB contracts, GMIB contracts, workers’ compensation, and personal accident business. The Company’s Run-off Reinsurance operations also purchased retrocessional coverage to reduce the risk of loss on these contracts.
Liabilities related to GMDB, workers’ compensation and personal accident are included in future policy benefits and unpaid claims. Because the GMIB contracts are treated as derivatives under GAAP, the asset related to GMIB is recorded in the Other assets, including other intangibles caption and the liability related to GMIB is recorded in the Accounts payable, accrued expenses, and other liabilities caption on the Company’s Consolidated Balance Sheets (see Notes 11 and 22 for additional discussion of the GMIB assets and liabilities).
The reinsurance recoverables for GMDB, workers’ compensation and personal accident of $169 million are diversified over more than 100 retrocessionaires. Approximately 20% of the recoverables are due from reinsurers that have been assigned ratings of AA- or better from S&P. An additional 60% of the recoverables from reinsurers have been assigned an S&P rating of A- or better and the remaining 20% primarily represent recoverables associated with unrated reinsurers. Approximately 18% of the recoverables from unrated reinsurers are supported by collateral arrangements with none of the remaining reinsurers holding more than 5% of the total recoverable balance. The Company reviews its reinsurance arrangements and establishes reserves against the recoverables in the event that we believe that recovery is not probable. As of December 31, 2008, the Company’s recoverables related to this segment were net of a reserve of $11 million.
The Company’s payment obligations for underlying reinsurance exposures assumed by the Company under these contracts are based on ceding companies’ claim payments. For GMDB, claim payments vary because of changes in equity markets and interest rates, as well as mortality and policyholder behavior. For workers’ compensation and personal accident, the payments relate to accidents and injuries. Any of these claim payments can extend many years into the future, and the amount of the ceding companies’ ultimate claims, and therefore the amount of the Company’s ultimate payment obligations and corresponding ultimate collection from retrocessionaires, may not be known with certainty for some time.
In the Company’s consolidated income statements, premiums and fees were net of ceded premiums, and benefits and expenses were net of reinsurance recoveries, in the following amounts:
Amortization expense for internal-use software was $143 million in 2008, $111 million in 2007 and $97 million in 2006. Amortization expense for other intangibles, excluding internal-use software, was $25 million in 2008, $9 million in 2007 and $21 million in 2006.
The Company and certain of its subsidiaries provide pension, health care and life insurance defined benefits to eligible retired employees, spouses and other eligible dependents through various plans. Effective December 31, 2008, the Company split its domestic qualified pension plan, with no change in benefits for any plan participant. Former employees of the Company who are only entitled to an annuity benefit but not yet receiving benefits were placed into a new plan. All other plan participants remain in the original plan. Both plans are reflected in the information below.
The Company funds its qualified pension plans at least at the minimum amount required by the Employee Retirement Income Security Act of 1974 (ERISA) and the Pension Protection Act of 2006.
The Company did not make domestic pension plan contributions in 2008 or 2007 to its primary qualified domestic pension plan. The Company expects contributions to the qualified pension plan to be approximately $410 million during 2009. This amount could change based on final valuation amounts and the level at which the Company decides to fund the plan. These estimates do not include funding requirements related to the litigation matter discussed in Note 22 to the Consolidated Financial Statements, as management does not expect this to be resolved in 2009. Future years’ contributions will ultimately be based on a wide range of
factors including but not limited to asset returns, discount rates, and funding targets.
Components of net pension cost, for the years ended December 31 were as follows:
The Company expects to recognize in 2009 $54 million of pre-tax loss from amortization of past experience and $11 million of pre-tax gain from amortization of prior service cost.
The Company expects to recognize in 2009 $19 million of pre-tax gain related to amortization of prior service cost and $8 million of pre-tax gain from amortization of past experience.
The estimated rate of future increases in the per capita cost of health care benefits beginning in 2009 through 2012 is 7%, decreasing to 6% in 2013 and 5% thereafter. This estimate reflects the Company’s current claim experience and management’s estimate that rates of growth will decline in the future. A 1% increase or decrease in the estimated rate would change 2008 reported amounts as follows:
Assumptions for pension and other postretirement benefit plans. Management determined the present value of the projected pension benefit obligation and the accumulated other postretirement benefit obligation and related benefit costs based on the following weighted average assumptions as of and for the years ended December 31:
The average remaining service period of active employees associated with the Company’s original domestic pension plan is approximately 6 years. The average remaining service period of active employees associated with the other postretirement benefit plans is approximately 9 years. These periods are used to amortize net losses from past experience. Since the new domestic qualified pension plan contains no active employees, net losses from past experience allocated to this new plan will be amortized over the average expected remaining life of the plan participants, which is approximately 29 years. Expected 2009 pre-tax amortization of net losses from past experience for the pension plans of $54 million reflects this longer period for the new plan. Had the domestic qualified pension plan not been split, estimated 2009 pre-tax amortization would have been $23 million higher.
The Company may elect to increase its matching contributions if the Company’s annual performance meets certain targets. A substantial amount of the Company’s matching contributions are invested in the Company common stock. The Company’s expense for these plans was $34 million for 2008, $35 million for 2007 and $42 million for 2006.
The Company’s financial assets and liabilities carried at fair value have been classified based upon a hierarchy defined by SFAS No. 157. The hierarchy gives the highest ranking to fair values determined using unadjusted quoted prices in active markets for identical assets and liabilities (Level 1) and the lowest ranking to fair values determined using methodologies and models with unobservable inputs (Level 3). An asset’s or a liability’s classification is based on the lowest level input that is significant to its measurement. For example, a Level 3 fair value measurement may include inputs that are both observable (Levels 1 and 2) and unobservable (Level 3). The levels of the fair value hierarchy are as follows:
(1) As of December 31, 2008, fixed maturities includes $514 million of net appreciation required to adjust future policy benefits for run-off settlement annuity business including $111 million of appreciation for securities classified in Level 3.
(2) The Guaranteed Minimum Income Benefit (GMIB) assets represent retrocessional contracts in place from two external reinsurers which cover 55% of the exposures on these contracts. The assets are net of a liability of $17 million for the future cost of reinsurance.
Fixed maturities and equity securities. Approximately 92% of the Company’s investments in fixed maturities and equity securities are classified in Level 2 including most public and private corporate debt and equity securities, federal agency and municipal bonds, non-government mortgage and asset-backed securities and preferred stocks. Because many fixed maturities and preferred stocks do not trade daily, fair values are often derived using recent trades of securities with similar features and characteristics. When recent trades are not available, pricing models are used to determine these prices. These models calculate fair values by discounting future cash flows at estimated market interest rates. Such market rates are derived by calculating the appropriate spreads over comparable U.S. Treasury securities, based on the credit quality, industry and structure of the asset.
Short-term investments. Short-term investments are carried at fair value, which approximates cost. On a regular basis the Company compares market prices for these securities to recorded amounts to validate that current carrying amounts approximate exit prices. The short-term nature of the investments and corroboration of the reported amounts over the holding period support their classification in Level 2.
Level 3: Financial Assets - $1.8 billion and Financial Liabilities - $1.8 billion
Guaranteed minimum income benefit contracts. Because cash flows of the GMIB liabilities and assets are affected by equity markets and interest rates, and are settled in lump sum payments, the Company reports these liabilities and assets as derivatives at fair value. The Company estimates the fair value of the assets and liabilities for GMIB contracts using assumptions regarding capital markets (including market returns, interest rates and market volatilities of the underlying equity and bond mutual fund investments), future annuitant and retrocessionaire behavior (including mortality, lapse, annuity election rates and retrocessional credit), as well as risk and profit charges. At adoption of SFAS No. 157, the Company updated assumptions to reflect those that the Company believes a hypothetical market participant would use to determine a current exit price for these contracts and recorded a charge to net income as described in Note 2(B). As certain assumptions used to estimate fair values for these contracts are largely unobservable, the Company classifies assets and liabilities associated with guaranteed minimum income benefits in Level 3 (GMIB assets and liabilities).
The market volatility assumptions for annuitants’ underlying mutual fund investments that are modeled based on the S&P 500, Russell 2000 and NASDAQ Composite are based on the market-implied volatility for these indices for three to seven years grading to historical volatility levels thereafter. For the remaining 57% of underlying mutual fund investments modeled based on other indices (with insufficient market-observable data), volatility is based on the average historical level for each index over the past 10 years. Using this approach, volatility ranges from 16% to 46% for equity funds, 4% to 10% for bond funds and 1% to 2% for money market funds.
The lapse rate assumption varies by contract from 2% to 17% and depends on the time since contract issue, the relative value of
the guarantee and the differing experience by issuing company of the underlying variable annuity contracts.
The annuity election rate assumption varies by contract and depends on the annuitant’s age, the relative value of the guarantee, whether a contractholder has had a previous opportunity to elect the benefit and the differing experience by issuing company of the underlying variable annuity contracts. Immediately after the expiration of the waiting period, the assumed probability that an individual will annuitize their variable annuity contract is up to 80%. For the second and subsequent annual opportunities to elect the benefit, the assumed probability of election is up to 30%. With respect to the second and subsequent election opportunities, actual data is just beginning to emerge for the Company as well as the industry and the estimates are based on this limited data.
In addition, the Company has considered other assumptions related to model, expense and nonperformance risk in calculating the GMIB liability.
The approach for these assumptions, including market-observable reference points, is consistent with that used to estimate the fair values of these contracts at January 1, 2008. The Company regularly evaluates each of the assumptions used in establishing these assets and liabilities by considering how a hypothetical market participant would set assumptions at each valuation date. Capital markets assumptions are expected to change at each valuation date reflecting current observable market conditions. Other assumptions may also change based on a hypothetical market participant’s view of actual experience as it emerges over time or other factors that impact the net liability. If the emergence of future experience or future assumptions differs from the assumptions used in estimating these assets and liabilities, the resulting impact could be material to the Company’s consolidated results of operations, and in certain situations, could be material to the Company’s financial condition.
GMIB liabilities are reported in the Company’s Consolidated Balance Sheets in Accounts payable, accrued expenses and other liabilities. GMIB assets associated with these contracts represent net receivables in connection with reinsurance that the Company has purchased from two external reinsurers and are reported in the Company’s Consolidated Balance Sheets in Other assets, including other intangibles. As of December 31, 2008, Standard & Poor’s (S&P) has given a financial strength rating of AA+ to one reinsurer and a financial strength rating of A- to the parent company that guarantees the receivable from the other reinsurer.
The following table summarizes the changes in financial assets and financial liabilities classified in Level 3 for the year ended December 31, 2008. This table excludes separate account assets as changes in fair values of these assets accrue directly to policyholders. Gains and losses reported in this table may include changes in fair value that are attributable to both observable and unobservable inputs.
As noted in the table above, total gains and losses included in net income are reflected in the following captions in the Consolidated Statements of Income:
Guaranteed minimum income benefits expense for amounts related to GMIB assets and liabilities.
For the year ended December 31, 2008, the GMIB assets and liabilities include a charge of $202 million for the adoption of SFAS No. 157, which is discussed in Note 2(B). After the adoption of SFAS No. 157 in 2008, the Company’s GMIB assets and liabilities are expected to be more volatile in future periods both because the liabilities, net of receivables from reinsurers, are larger and because these assumptions will be based largely on market-observable inputs at the close of each reporting period including interest rates and market-implied volatilities.
Excluding the charge discussed above, the increase in the net GMIB liability of $488 million for the year ended December 31, 2008 was primarily driven by:
updates to other assumptions that are used in the fair value calculation: $25 million; and
(1) Non-guaranteed separate accounts include $1.5 billion in assets supporting the Company’s pension plan, including $435 million classified in Level 3.
The following table summarizes the change in separate account assets reported in Level 3 for the year ended December 31, 2008.
Actual maturities could differ from contractual maturities because issuers may have the right to call or prepay obligations, with or without penalties. Also, in some cases the Company may extend maturity dates.
The above table includes investments with a fair value of $2.5 billion supporting the Company’s run-off settlement annuity business, with gross unrealized appreciation of $624 million and gross unrealized depreciation of $110 million at December 31, 2008. Such unrealized amounts are required to support future policy benefit liabilities of this business and, accordingly, are not included in accumulated other comprehensive income. At December 31, 2007, investments supporting this business had a fair value of $2.6 billion, gross unrealized appreciation of $476 million and gross unrealized depreciation of $20 million.
As of December 31, 2008, the Company had no outstanding commitments to purchase fixed maturities.
As of December 31, 2008, fixed maturities (excluding trading and hybrid securities) which were primarily investment grade corporate bonds with a decline in fair value from cost were as follows, including the length of time of such decline:
The unrealized depreciation of investment grade fixed maturities is primarily due to increases in market yields since purchase. Approximately $325 million of the unrealized depreciation is due to securities with a decline in value of greater than 20%. Approximately 95% of these securities had been in that position for less than six months. The remaining $272 million of the unrealized depreciation is due to securities with declines in value of less than 20%. There were no equity securities with a material decline in fair value from cost as of December 31, 2008. See Note 13(B) for discussion of impairments included in realized investment gains and losses.
As of December 31, 2008, the Company had commitments to extend credit under commercial mortgage loan agreements of $65 million, all of which were at a fixed rate of interest. These loan commitments are diversified by property type and geographic region. As of December 31, 2008, the Company had commitments to contribute additional equity of $9 million to real estate investments. The Company expects to disburse most of the committed amounts in 2009.
As of December 31, other long-term investments consisted of the following:
Investments in real estate entities with a carrying value of $96 million at December 31, 2008 and $40 million at December 31, 2007 were non-income producing during the preceding twelve months.
Features of certain investments and obligations, called embedded derivatives, are accounted for as derivatives. As permitted under SFAS No. 133, derivative accounting has not been applied to these features of such investments or obligations existing before January 1, 1999.
See Note 7 for a discussion of derivatives associated with GMDB contracts and Note 11 for a discussion of derivatives arising from GMIB contracts. The other effects of derivatives were not material to the Company’s consolidated results of operations, liquidity or financial condition for 2008, 2007 or 2006.
The table below presents information about the nature and accounting treatment of the Company’s primary derivative financial instruments. Derivatives in the Company’s separate accounts are not included because associated gains and losses generally accrue directly to policyholders.
To reduce domestic and international equity market exposures for certain reinsurance contracts that guarantee death benefits resulting from changes in variable annuity account values based on underlying mutual funds. Currency futures are primarily euros, Japanese yen and British pounds.
Fair value changes are reported in other revenues and cash flows are included in operating activities.
The Company receives (pays) cash daily in the amount of the change in fair value of the futures contracts.
The Company periodically exchanges cash flows between variable and fixed interest rates or between two currencies for both principal and interest.
The Company has written certain reinsurance contracts to guarantee minimum income benefits resulting from the level of variable annuity account values compared with a contractually guaranteed amount. The actual payment by the Company depends on the actual account value in the underlying mutual funds and the level of interest rates when account holders elect to receive minimum income payments. The Company purchased reinsurance contracts to hedge the market risks assumed. These contracts are accounted for as written and purchased options.
Fair values are reported in other liabilities and other assets. Changes in fair value are reported in guaranteed minimum income benefits expense. These cash flows are reported in operating activities.
The Company pays a fee and may receive or pay cash, based on the difference between the amortized cost and fair values of underlying invested assets at the time of policyholder surrender.
Using cash flow hedge accounting, fair values are reported in other assets or other liabilities, with changes in fair value reported in accumulated other comprehensive income and amortized to benefits expense over the life of the underlying invested assets. These cash flows will be reported in financing activities.
The components of net investment income, for the years ended December 31 were as follows:
Other primarily represents the impact of rising interest rates where the Company cannot demonstrate its intent or ability to hold until recovery.
the present value of the remaining principal and interest payments on the Notes being redeemed discounted at the applicable Treasury Rate plus 40 basis points.
As of December 31, the Company had issued the following shares:
The Company has authorized a total of 25 million shares of $1 par value preferred stock. No shares of preferred stock were outstanding at December 31, 2008 or 2007.
Accumulated other comprehensive income (loss) excludes amounts required to adjust future policy benefits for run-off settlement annuity business.
State insurance departments and foreign jurisdictions that regulate certain of the Company’s subsidiaries prescribe accounting practices (which differ in some respects from GAAP) to determine statutory net income and surplus. The Company’s life insurance and HMO company subsidiaries are regulated by such statutory requirements. The statutory net income for the years ended, and surplus as of, December 31 of the Company’s life insurance and HMO subsidiaries were as follows:
A reconciliation of the beginning to ending amount of unrecognized tax benefits is as follows:
Over the next 12 months, the Internal Revenue Service (IRS) is expected to complete its examination of the Company’s 2005 and 2006 consolidated federal income tax returns. The Company has determined, subject to the resolution of certain disputed matters, it is reasonably possible that the level of unrecognized tax benefits could decline significantly as a result of this IRS review. This decline is not expected to exceed $38 million, of which $28 million would impact net income.
The IRS completed its examination of the Company’s 2003 and 2004 consolidated federal income tax returns in 2007, for which there were two unresolved issues. These contested matters moved through the administrative appeals process during 2008. The first issue has been tentatively resolved subject to pending IRS Commissioner approval; the second issue remains in dispute and will likely be litigated. Due to the nature of the litigation process, the timing of the resolution of this matter is uncertain. In addition, the IRS is scheduled to complete its examination of the Company’s 2005 and 2006 consolidated federal income tax returns early in 2009, although it is anticipated there will be at least one unresolved issue that will proceed to the administrative appeals level and move through that process during 2009.
The Company’s deferred tax asset is net of a federal and state valuation allowance (see table above). The valuation allowance reflects management’s assessment that certain deferred tax assets may not be realizable. As was the case at December 31, 2007, the valuation allowance at December 31, 2008 relates primarily to operating losses, and other deferred tax benefits, of the run-off reinsurance operations. It is reasonably possible there could be a significant decline in the level of valuation allowance recorded against deferred tax benefits of the reinsurance operations within the next 12 months. The $24 million decrease in the valuation allowance during 2008 relates primarily to the run-off reinsurance operations, but also includes amounts related to the international operations and certain state tax benefits. The international and state related reductions in the valuation allowance had no impact on net income.
Weakness in debt and equity markets during 2008 has resulted in a deferred tax asset of $238 million on accumulated other comprehensive loss and other than temporary impairment losses as of December 31, 2008. Management has concluded that no valuation allowance is required because the Company has sufficient unrealized gains, including $514 million of adjustments to future policy benefits excluded from other comprehensive loss, and prior taxable gains sufficient to realize the tax benefit.
The People Resources Committee of the Board of Directors awards stock options, restricted stock and deferred stock to certain employees. To a very limited extent, the Committee has issued common stock instead of cash compensation and dividend equivalent rights as part of restricted and deferred stock units. Stock appreciation rights issued with stock options are authorized but have not been issued for several years. The Company issues shares from Treasury stock for option exercises, awards of restricted stock and payment of deferred and restricted stock units.
The Company had the following number of shares of common stock available for award at December 31: 28.5 million in 2008, 31.1 million in 2007 and 33.0 million in 2006.
Stock options. The Company awards options to purchase the Company’s common stock at the market price of the stock on the grant date. Options vest over periods ranging from one to five years and expire no later than 10 years after the grant date.
The weighted average fair value of options granted under employee incentive plans was $14.33 for 2008, $16.05 for 2007 and $14.57 for 2006, using the Black-Scholes option-pricing model and the following assumptions:
The expected volatility reflects the Company’s past daily stock price volatility. The Company does not consider volatility implied in the market prices of traded options to be a good indicator of future volatility because remaining maturities of traded options are less than one year. In 2008 and 2007, the expected option life reflects the Company’s historical experience excluding activity related to options granted under a replacement option feature. Prior to 2007, the Company developed the expected option life by considering certain factors, including assumptions used by other companies with comparable stock option plan features and the Company’s cancellation of a replacement option feature in June 2004.
The fair value of vested restricted stock was: $35 million in 2008, $36 million in 2007 and $49 million in 2006.
Health Care includes medical, dental, behavioral health, prescription drug and other products and services that may be integrated to support consumer-focused health care programs. This segment also includes group disability and life insurance products that were historically sold in connection with certain experience-rated medical products.
(3) Includes minimum premium members who have a risk profile similar to experience-rated funding arrangements. The risk portion of minimum premium revenue is reported in experience-rated medical premium whereas the self funding portion of minimum premium revenue is recorded in fees. Also includes certain non-participating cases for which special customer level reporting of experience is required.
(5) Represents administrative service fees for medical members and related specialty product fees for non-medical members as well as fees related to Medicare Part D of $96 million in 2008, $61 million in 2007 and $27 million in 2006.
The Company, through its subsidiaries, is contingently liable for various financial guarantees provided in the ordinary course of business.
The Company’s reinsurance operations, which were discontinued in 2000 and are now an inactive business in run-off mode, reinsured minimum income benefits under certain variable annuity contracts issued by other insurance companies. A contractholder can elect the guaranteed minimum income benefit (GMIB) within 30 days of any eligible policy anniversary after a specified contractual waiting period. The Company’s exposure arises when the guaranteed annuitization benefit exceeds the annuitization benefit based on the policy’s current account value. At the time of annuitization, the Company pays the excess (if any) of the guaranteed benefit over the benefit based on the current account value in a lump sum to the direct writing insurance company.
The maximum potential undiscounted payments that the Company would make under those assumptions would aggregate $1.8 billion before reinsurance recoveries. The Company expects the amount of actual payments to be significantly less than this hypothetical undiscounted aggregate amount. The Company has retrocessional coverage in place from two external reinsurers which covers 55% of the exposures on these contracts. The Company bears the risk of loss if its retrocessionaires do not meet or are unable to meet their reinsurance obligations to the Company.
The Company had indemnification obligations as of December 31, 2008 in connection with acquisition and disposition transactions. These indemnification obligations are triggered by the breach of representations or covenants provided by the Company, such as representations for the presentation of financial statements, the filing of tax returns, compliance with law or the identification of outstanding litigation. These obligations are typically subject to various time limitations, defined by the contract or by operation of law, such as statutes of limitation. In some cases, the maximum potential amount due is subject to contractual limitations based on a percentage of the transaction purchase price, while in other cases limitations are not specified or applicable. The Company does not believe that it is possible to determine the maximum potential amount due under these obligations, since not all amounts due under these indemnification obligations are subject to limitation. There were no liabilities required for these indemnification obligations as of December 31, 2008.
additional restrictions on the use of prescription drug formularies and rulings from pending purported class action litigation, which could result in adjustments to or the elimination of the average wholesale price or “AWP” of pharmaceutical products as a benchmark in establishing certain rates, charges, discounts, guarantees and fees for various prescription drugs;
The Company is routinely involved in numerous claims, lawsuits, regulatory and IRS audits, investigations and other legal matters arising, for the most part, in the ordinary course of the business of administering and insuring employee benefit programs. An increasing number of claims are being made for substantial non-economic, extra-contractual or punitive damages. The outcome of litigation and other legal matters is always uncertain, and outcomes that are not justified by the evidence can occur. The Company believes that it has valid defenses to the legal matters pending against it and is defending itself vigorously. Nevertheless, it is possible that resolution of one or more of the legal matters currently pending or threatened could result in losses material to the Company’s consolidated results of operations, liquidity or financial condition.
Managed care litigation. On April 7, 2000, several pending actions were consolidated in the United States District Court for the Southern District of Florida in a multi-district litigation proceeding captioned In re Managed Care Litigation challenging, in general terms, the mechanisms used by managed care companies in connection with the delivery of or payment for health care services. The consolidated cases include Shane v. Humana, Inc., et al., Mangieri v. CIGNA Corporation, Kaiser and Corrigan v. CIGNA Corporation, et al. and Amer. Dental Ass’n v. CIGNA Corp. et. al.
In 2004, the court approved a settlement agreement between the physician class and CIGNA. However, a dispute over disallowed claims under the settlement submitted by a representative of certain class member physicians is in arbitration. Separately, in 2005, the court approved a settlement between CIGNA and a class of non-physician health care providers. Only the Amer. Dental Ass’n case remains unresolved. On February 11, 2009, the Court dismissed five of the six counts of the complaint without prejudice. The Company will continue to vigorously defend itself in this case.
CIGNA has received insurance recoveries related to this litigation. In 2008, the Court ruled that the Company is not entitled to insurance recoveries from one of the two insurers from which the Company is pursuing further recoveries. CIGNA has appealed that decision.
Broker compensation. Beginning in 2004, the Company, other insurance companies and certain insurance brokers received subpoenas and inquiries from various regulators, including the New York and Connecticut Attorneys General, the Florida Office of Insurance Regulation, the U.S. Attorney’s Office for the Southern District of California and the U.S. Department of Labor relating to their investigations of insurance broker compensation. CIGNA is cooperating with the inquiries and investigations.
The second quarter of 2008 includes an after-tax benefit of $34 million for the GMIB business and an after-tax charge of $52 million associated with litigation matters.
The third quarter of 2008 includes an after-tax loss of $61 million for the GMIB business.
The fourth quarter of 2007 includes an after-tax loss of $17 million for the GMIB business.