Our principal, domestic office locations, including various support operations, along with Group Disability and Life Insurance, Health Services, Core Medical and Service Operations and the domestic office of our Global Supplemental Benefits business are the Wilde Building located at 900 Cottage Grove Road in Bloomfield, Connecticut (our corporate headquarters) and Two Liberty Place located at 1601 Chestnut Street in Philadelphia, Pennsylvania. The Wilde Building measures approximately 833,000 square feet and is owned, while Two Liberty Place measures approximately 462,000 square feet and is leased office space.
Unless otherwise indicated, financial information in the MD&A is presented in accordance with accounting principles generally accepted in the United States of America ("GAAP"). See Note 2 to the Consolidated Financial Statements for additional information regarding the Company's significant accounting policies. We measure the financial results of our segments using "segment earnings (loss)", defined as shareholders' net income (loss) before after-tax realized investment results. In this MD&A, we also present information using adjusted income from operations. Adjusted income (loss) from operations is another measure of profitability used by our management because it presents the underlying results of operations of our businesses and permits analysis of trends in underlying revenue, expenses and shareholders' net income. Adjusted income (loss) from operations is defined as segment earnings (loss) excluding special items (described in the table on page 35 of this Form 10-K) and results of the GMIB business. This measure is not determined in accordance with GAAP and should not be viewed as a substitute for the most directly comparable GAAP measure that is shareholders' net income. We exclude special items because management does not believe they are representative of our underlying results of operations. We also exclude the results of the GMIB business because, prior to February 4, 2013, the changes in the fair value of GMIB assets and liabilities were volatile and unpredictable.
To execute on our mission, we have focused our efforts over the past several years on serving the emerging needs of our customers around the world through our "Go Deep, Go Global, Go Individual" strategy, as follows:
GO DEEP: We seek to increase our presence and brand strength in key "go deep" geographic areas, grow in targeted segments or capabilities, and deepen our relationships with current customers through cross-selling.
GO INDIVIDUAL: We strive to establish a deep understanding of our customers' unique needs and to be a highly customer-centric organization. To do this, we are seeking to further simplify the buying process by providing choice, transparency of information, and a personalized customer experience. Our goal is to build
We report the financial results of our businesses in five segments, the following three of which are the most significant:
We also report in two other segments: Run-off Reinsurance and Other Operations, including Corporate-owned Life Insurance.
Pharmacy Benefit Management ("PBM") Services Agreement. In June 2013, we entered into a ten-year pharmacy benefit management services agreement with Catamaran Corporation ("Catamaran"). Under this agreement, we will utilize their technology and service platforms, prescription drug procurement and inventory management capabilities, and order fulfillment services to lower costs and enhance our home-delivery pharmacy, retail network contracting and claims processing services. In the second quarter of 2013, we recorded one-time transaction costs of $37 million pre-tax, primarily for advisory fees associated with this
agreement, resulting in an after-tax charge of $24 million that is reported as a special item. This agreement had an immaterial impact to adjusted income from operations in 2013, and is expected to produce a positive contribution to earnings beginning in 2014 through improved clinical management, purchasing and administrative efficiencies.
Finans-Emeklilik. We entered into a joint venture with Finansbank to expand our global footprint in Turkey.
Shareholders' net income declined 9% in 2013 compared with 2012 due primarily to the $507 million after-tax charge associated with the February 4, 2013 reinsurance agreement with Berkshire. However, shareholders' net income in 2013 increased 17% over 2011 including the 2013 charge. The reinsurance transaction in 2013 aligned with our strategy of increasing financial flexibility by accomplishing an effective exit from the run-off GMDB and GMIB businesses.
Cash flows from operating activities in 2013 declined by $1.6 billion compared with 2012 primarily due to payments totaling $2.2 billion made in 2013 to Berkshire in connection with the reinsurance transaction. See the Liquidity and Capital Resources section of this MD&A for additional information.
During 2013, our unfunded pension liability decreased by approximately $1.0 billion to $611 million, largely due to an increase of 100 basis points in the assumed discount rate, strong asset performance and Company contributions of $195 million. See Note 9 to the Consolidated Financial Statements for additional information.
On February 21, 2014, CMS issued its Advance Notice for Calendar Year 2015 (the "Notice"). The final terms are expected to be published on April 7, 2014. While the terms contained within the Notice are within the range of our expectations, there remain numerous open issues and substantial uncertainties regarding the final terms of the Notice. We expect that CMS will receive a significant number of comments from interested parties (including Cigna) prior to issuance of the final terms; however, there can be no assurance that CMS will amend its current positions. Given the uncertainty regarding the final terms of the Notice, we cannot reliably estimate the impact on our business, revenues or results of operations in 2015 and beyond; under certain circumstances, it is possible that the impact could be materially adverse. In addition, we expect to adjust our programs and services in response to the proposed 2015 terms.
For additional information regarding the specific provisions of Health Care Reform affecting us, see the "Regulation" section of this Form 10-K. Outlined below are the reported and expected future financial effects of various provisions of Health Care Reform.
During the second quarter of 2013, we finalized an agreement with the Departments of Insurance for Maine, Massachusetts, Pennsylvania, Connecticut and California (together, the "monitoring states") related to our long-term disability claims handling practices. In connection with the terms of the agreement, the Company recorded a charge of $77 million before-tax ($51 million after-tax) in the first quarter of 2013. The charge is comprised of two elements: (1) $48 million of benefit costs and reserves from reassessed claims expected to be reopened, including $925,000 in fines, $750,000 in regulatory surcharges and $9.5 million in claims handling expenses; and (2) $29 million in additional costs for open claims as a result of the claims handling changes being implemented. This charge is reported in the Group Disability and Life segment. We will be subject to re-examination 24 months after the execution date of the agreement. If the monitoring states find material non-compliance with the terms of the agreement upon re-examination, we may be subject to additional fines or penalties. In addition to the monitoring states, most other jurisdictions have joined the agreement as participating, non-monitoring states.
Revenues: The components of the revenue increases are discussed further below:
Premiums and Fees. The increase in 2013 compared with 2012 reflected continued customer growth in targeted markets of all of the ongoing segments, and, to a lesser extent, acquisitions in late 2012 in the Global Supplemental Benefits segment. In 2012, the increase over 2011 was largely due to contributions from the 2012 HealthSpring acquisition. Continued customer growth in the targeted market segments also contributed to the strong premium growth in 2012.
Net Investment Income. The increase in 2013, compared with 2012, primarily reflected higher yields driven in part by higher partnership income, partially offset by lower average investment assets primarily due to sales of assets to fund the reinsurance transaction with Berkshire. In 2012, net investment income remained flat compared with 2011, primarily reflecting higher average investment assets and improved results from partnership investments offset by lower reinvestment yields.
Global medical customers increased in 2013 compared with 2012 and in 2012 compared with 2011 primarily driven by continued growth in the regional, select, individual, and government market segments. In 2012, the HealthSpring acquisition contributed to the increase.
Cash provided by operating activities declined by $1.6 billion in 2013 compared with 2012 primarily due to payments totaling $2.2 billion made in 2013 to Berkshire in connection with the reinsurance transaction. Cash provided by operating activities in 2012 increased by $0.9 billion compared with 2011, primarily as a result of strong earnings growth in our ongoing business segments and the absence of claim run-out from the Medicare IPFFS business exited in 2011.
Cash flows from investing activities increased by $3.9 billion in 2013 compared with 2012 primarily driven by the absence of the 2012 payment to acquire HealthSpring. Excluding that acquisition, cash flows from investing activities in 2012 increased by $0.6 billion compared with 2011 primarily due to lower net purchases of fixed maturity investments.
We maintain a share repurchase program that was authorized by our Board of Directors. The decision to repurchase shares depends on market conditions and alternate uses of capital. We have, and may continue from time to time, to repurchase shares on the open market through a Rule 10b5-1 plan that permits a company to repurchase its shares at times when it otherwise might be precluded from doing so under insider trading laws or because of self-imposed trading blackout periods. We suspend activity under this program from time to time and also remove such suspensions, generally without public announcement.
At December 31, 2013, there was approximately $760 million in cash and short-term investments available at the parent company level. In 2014, the parent company's combined cash obligations are expected to be approximately $480 million for commercial paper maturities, interest and pension contributions.
However, our cash projections may not be realized and the demand for funds could exceed available cash if our ongoing businesses experience unexpected shortfalls in earnings, or we experience material adverse effects from one or more risks or uncertainties described more fully in the Risk Factors section of this Form 10-K. In those cases, we expect 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 $1.2 billion from its insurance subsidiaries without prior state approval. As of December 31, 2013, the parent company had no net intercompany loan balance with its insurance subsidiaries. Alternatively, to satisfy parent company liquidity requirements we may use short-term borrowings, such as the commercial paper program, the committed revolving credit and letter of credit agreement of up to $1.5 billion subject to the maximum debt leverage covenant in its line of credit agreement. As of December 31, 2013, we had $1.5 billion of borrowing capacity under the credit agreement. Within the maximum debt leverage covenant in the line of credit agreement, we have an additional $6.0 billion of borrowing capacity in addition to the $5.2 billion of debt outstanding.
Though we believe we have adequate sources of liquidity, continued significant disruption or volatility in the capital and credit markets could affect our ability to access those markets for additional borrowings or increase costs associated with borrowing funds.
We maintain a capital management strategy to indefinitely reinvest the earnings of certain of our foreign operations overseas. Indefinitely reinvested earnings are generally deployed in these countries, and other foreign jurisdictions in support of the liquidity and capital needs of our foreign operations, where possible. As of December 31, 2013 indefinitely reinvested earnings were approximately $1.1 billion. Approximately $176 million of cash and cash equivalents held in these countries would, if repatriated, be subject to a charge representing the difference between the U.S. and foreign tax rates. This strategy does not materially limit our ability to meet our liquidity and capital needs in the United States. Cash and cash equivalents in foreign operations are held primarily to meet local liquidity and surplus needs with excess funds generally invested in longer duration high quality securities.
Solvency II. Our businesses in the European Union will be subject to the directive on insurance regulation, solvency and governance requirements known as Solvency II. This directive will impose economic risk-based solvency and governance requirements and supervisory rules and becomes effective in 2016, although certain EU country regulators are requiring companies to demonstrate technical capability and comply with increased capital levels in advance of their effective date. Our European insurance companies are capitalized at levels consistent with projected Solvency II requirements and in compliance with anticipated governance and technical capability requirements.
We are contingently liable for various contractual obligations entered into in the ordinary course of business. The maturities of our primary contractual cash obligations, as of December 31, 2013, are estimated to be as follows:
The expected future cash flows for GMDB and GMIB contracts included in the table above (within future policy benefits and other long-term liabilities) do not consider any of the related reinsurance arrangements.
Short-term debt represents commercial paper, current maturities of long-term debt, and current obligations under capital leases.
Long-term debt includes scheduled interest payments. Capital leases are included in long-term debt and represent obligations for IT network storage, servers and equipment.
Other long-term liabilities. These items are presented in accounts payable, accrued expenses and other liabilities in our Consolidated Balance Sheets. This table includes estimated payments for GMIB contracts, pension and other postretirement and postemployment benefit obligations, supplemental and deferred compensation plans, interest rate and foreign currency swap contracts, and certain tax and reinsurance liabilities.
The above table also does not contain $17 million of liabilities for uncertain tax positions because we cannot reasonably estimate the timing of their resolution with the respective taxing authorities. See Note 19 to the Consolidated Financial Statements for the year ended December 31, 2013 for further information.
Purchase obligations. As of December 31, 2013, purchase obligations consisted of estimated payments required under contractual arrangements for future services and investment commitments as follows:
We had commitments to invest in limited liability entities that hold real estate, loans to real estate entities or securities. See Note 11(D) to the Consolidated Financial Statements for additional information.
Management has discussed the development and selection of its critical accounting estimates with the Audit Committee of our Board of Directors and the Audit Committee has reviewed the disclosures presented below.
See Note 2 to the Consolidated Financial Statements for further information on significant accounting policies.
We completed our annual evaluations of goodwill for impairment during the third quarter of 2013. These evaluations were performed at the reporting unit level, based on discounted cash flow analyses. The evaluations indicated that no impairment was required.
If we do not achieve our earnings objectives or the cost of capital rises significantly, the assumptions and estimates underlying these impairment evaluations could be adversely affected and result in future impairment charges that would negatively impact our operating results. The fair value estimate of our Government reporting unit could decrease by approximately 30% before an indication of impairment of goodwill occurs. Future changes in the funding for our Medicare programs by the federal government could substantially reduce Cigna-HealthSpring's revenues and profitability and have a significant impact on the fair value of the Government operating segment.
Using past experience, we expect that it is reasonably possible that a favorable or unfavorable change in assumptions for the discount rate or expected return on plan assets of 50 basis points could occur. An unfavorable change is a decrease in these key assumptions with resulting impacts as discussed below. If discount rates for the qualified and nonqualified pension plans decreased by 50 basis points:
If the expected long-term return on domestic qualified pension plan assets decreased by 50 basis points, annual pension costs for 2014 would increase by approximately $10 million after-tax.
If we used the market value of assets to measure pension costs as opposed to the market-related value, annual pension cost for 2013 would decrease by approximately $20 million after-tax.
In 2013, actual experience differed from our key assumptions as of December 31, 2012, resulting in $182 million of favorable incurred claims related to prior years' medical claims payable or 1.3% of the current year incurred claims as reported in 2012. In 2012, actual experience differed from our key assumptions as of December 31, 2011, resulting in $200 million of favorable incurred claims related to prior years' medical claims, or 2.2% of the current year incurred claims reported in 2011. Specifically, the favorable impact is due to faster than expected completion factors and lower than expected medical cost trends, both of which included an assumption for moderately adverse experience.
Determining fair value for a financial instrument requires management judgment. The degree of judgment involved generally correlates to the level of pricing readily observable in the markets. Financial instruments with quoted prices in active markets or with market observable inputs to determine fair value, such as public securities, generally require less judgment. Conversely, private placements including more complex securities that are traded infrequently are typically measured using pricing models that require more judgment as to the inputs and assumptions used to estimate fair value. There may be a number of alternative inputs to select, based on an understanding of the issuer, the structure of the security and overall market conditions. In addition, these factors are inherently variable in nature as they change frequently in response to market conditions. Approximately two-thirds of our fixed maturities are public securities, and one-third are private placement securities.
Typically, the most significant input in the measurement of fair value is the market interest rate used to discount the estimated future cash flows from the instrument. 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. If the spreads used to calculate fair value increased by 100 basis points, the fair value of the total fixed maturity portfolio of $16.5 billion would decrease by approximately $900 million.
Assessment of "other-than-temporary" impairments of fixed maturities To determine whether a fixed maturity's decline in fair value below its amortized cost is other than temporary, we must evaluate the expected recovery in value and its intent to sell or the likelihood of a required sale of the fixed maturity prior to an expected recovery. To make this determination, we consider a number of general and specific factors including the regulatory, economic and market environments, length of time and severity of the decline, and the financial health and specific near term prospects of the issuer.
For all fixed maturities with cost in excess of their fair value, if this excess was determined to be other-than-temporary, shareholders' net income for the year ended December 31, 2013 would have decreased by approximately $65 million after-tax.
We measure the operating effectiveness of the Global Health Care segment using the following key factors:
operating expense as a percentage of segment revenues (operating expense ratio); and
medical expense as a percentage of premiums (medical care ratio or "MCR") in the guaranteed cost and Medicare businesses.
The increase in Global Health Care's segment earnings and adjusted income from operations in 2013, as compared with 2012, reflected revenue growth from a higher customer base and rate increases consistent with underlying medical cost trends. In 2013, both measures also benefited from increased specialty contributions and higher net investment income.
Premiums and fees increased in 2013, compared with 2012, in U.S. Commercial due to customer growth and rate increases consistent with underlying medical cost trends. In addition, Medicare Advantage premiums were higher due to timing of the HealthSpring acquisition and customer growth.
Premiums and fees increased in 2012 compared with 2011, primarily reflecting the HealthSpring acquisition. U.S. Commercial growth was driven by rate increases consistent with underlying medical cost trends, and ASO customer growth. International health care premiums increased primarily due to the conversion of Vanbreda business from service to risk.
Mail order pharmacy revenues increased in each of 2013 and 2012, compared with each prior year, primarily reflecting higher prescription volume for specialty medications (injectibles).
Operating expenses increased 5% in 2013 compared with 2012, primarily reflecting customer growth, increased investments, including costs associated with our new PBM arrangement, and the timing of the HealthSpring acquisition, partially offset by operating cost efficiencies. Operating expenses increased in 2012 compared with 2011 driven by the acquisition of HealthSpring.
The operating expense ratio decreased in both 2013 and in 2012, compared with the prior year. These decreases were primarily driven by revenue growth and operating cost efficiencies partially offset by higher investments, including 2013 costs associated with our new PBM arrangement. The 2012 operating expense ratio, compared with 2011, benefited from additional HealthSpring business. Because the HealthSpring business is fully insured, it has a substantially lower operating expense ratio compared to our commercial business as approximately 80% of our commercial medical customers are in ASO arrangements.
Effective tax rate. The slight decline in the effective tax rate in 2013 compared with 2012 primarily reflected the recognition of tax benefits in certain of the segment's foreign operations. In 2012, the segment's effective tax rate was essentially flat compared with 2011.
Throughout this discussion, prior period currency adjusted income from operations, revenues, and benefits and expenses are being calculated by applying the current period's exchange rates to reported results in the prior period. A strengthening U.S. Dollar against foreign currencies will decrease segment earnings, while a weakening U.S. Dollar produces the opposite effect.
Net investment income increased in 2013 compared with 2012, primarily due to the acquisitions in the second half of 2012. In 2012, net investment income increased compared with 2011, primarily due to asset growth in South Korea.
Benefits and expenses increased in each of 2013 and 2012, compared with the comparable prior year. Excluding the organizational efficiency plan charges from 2013 and 2012 and applying actual 2013 currency exchange rates to 2012 results, benefits and expenses increased by 25%. These increases were primarily due to the acquisitions and business growth. Excluding the special items in the table above and applying actual 2013 currency exchange rates to results, benefits and expenses increased 30% in 2012, compared with 2011, primarily due to the acquisitions and business growth.
Loss ratios increased in 2013 and 2012 compared with each prior year, reflecting the inherently higher loss ratios of the acquisitions.
Policy acquisition expenses increased in 2013 and 2012, compared with the prior year, reflecting the acquisitions and business growth, partially offset by lower acquisition costs in Europe reflecting a decision to cease selling activities in certain markets during 2012.
Excluding the realignment and efficiency charges from 2013 and 2012, expense ratios decreased in 2013 compared with 2012. The decrease was primarily driven by the impact of the lower expense ratios associated with the Great American Supplemental Benefits business, partially offset by strategically planned investment spending to support future business growth. Excluding special items, expense ratios increased in 2012 compared with 2011 primarily driven by the impact of higher expense ratios associated with FirstAssist.
For our Global Supplemental Benefits segment, South Korea is the single largest geographic market, generating 51% of segment revenues and 87% of the segment earnings in 2013. Due to the concentration of business in South Korea, the Global Supplemental Benefits segment is exposed to potential losses resulting from economic, regulatory and geopolitical developments in that country, as well as foreign currency movements affecting the South Korean currency, that could have a significant impact on the segment's results and our consolidated financial results. In 2013, our operations in South Korea represented 4% of Cigna's total consolidated revenues and 10% of shareholders' net income.
other operating expense as a percentage of earned premiums and fees (expense ratio).
The decrease in segment earnings was primarily due to a charge associated with a disability claims regulatory matter discussed further in the Overview section of this MD&A. Adjusted income from operations increased in 2013, reflecting a lower disability loss ratio, higher net investment income and a lower expense ratio, partially offset by a higher life loss ratio. Results in 2013 include the favorable after-tax effect of reserve reviews of $60 million. Results in 2013 also include the $29 million favorable after-tax effect of a higher discount rate on claims incurred during 2013 as a result of reallocating higher yielding assets to the disability and life portfolio. Results in 2012 include the $43 million after-tax favorable impact of reserve reviews. The favorable impact of the reserve reviews continues to reflect strong operational performance by the disability claims management operation as well as reserve assumptions consistent with current business and economic conditions.
Net investment income. The increases in both 2013 and in 2012 are primarily due to higher assets and higher partnership investment income.
The increase in 2013, compared with 2012, resulted from the $77 million before-tax impact of the disability claims regulatory matter, premium growth in the disability and life business and a higher loss ratio in the life business, partially offset by a lower disability loss ratio and lower operating expense ratio. The higher life loss ratio reflected higher new claim sizes. The lower disability loss ratio is driven by reserve reviews and discount rate changes. The lower expense ratio was driven by lower overhead. Benefits and expenses in 2013 included the before-tax favorable impact of reserve reviews of $84 million compared with $60 million in 2012. Benefits and expenses in 2013 also included the before-tax favorable effect of $40 million related to an increase in the discount rate for 2013 incurred claims as a result of the reallocation of higher yielding assets to the disability and life portfolio.
The 2012 increase, compared with 2011, resulted from premium growth in the disability and life business, a higher loss ratio in the disability business and a higher operating expense ratio, partially offset by a lower loss ratio in the life business. The higher disability loss ratio reflected less favorable claim experience primarily as a result of higher new claims. The higher operating expense ratio was driven by higher commissions and strategic information technology and claim office investments. The lower life loss ratio primarily reflected lower new claims. Benefits and expenses included the favorable impact of reserve studies of $60 million in 2012 as compared with the $59 million favorable impact of reserve studies offset by a $10 million litigation accrual in 2011.
In this segment, the effective tax rate is generally lower than the federal tax rate of 35%, primarily due to tax-exempt interest income on bonds. The decline in the effective tax rate in 2013 compared with 2012 is due to the tax benefit reported in 2013 related to the completion of the 2009-2010 tax audits. The increase in the effective tax rate in 2012 compared with 2011 reflects the absence of the tax benefit reported in 2011 related to the completion of the 2007-2008 tax audits.
We exclude the results of the GMIB business from adjusted income (loss) from operations because the fair value of GMIB assets and liabilities is recalculated each quarter using updated capital market assumptions. Prior to the reinsurance transaction with Berkshire, the resulting changes in fair value that were reported in shareholders' net income were volatile and unpredictable. Beginning on February 4, 2013, changes in GMIB fair value due to non-performance risk are reflected in realized investment gains or losses. Other net changes in GMIB fair values are expected to be minimal.
Segment results improved in 2012 compared to 2011 due to significantly more favorable results for the GMIB business and lower reserve strengthening for GMDB.
See the Benefits and Expenses section for further discussion of the results of the GMIB and GMDB business, including the impact of the February 4, 2013 reinsurance transaction.
These hedging programs generally produced losses when equity markets and interest rates were rising and gains when equity markets and interest rates were falling. Amounts reflecting related changes in liabilities for GMDB contracts were included in benefits and expenses consistent with GAAP for a premium deficient book of business, resulting in no effect on shareholders' net income (see below "Other Benefits and Expenses"). Changes in liabilities for GMIB contracts, including the portion covered by the hedges, were recorded in GMIB fair value (gain) loss.
GMIB fair value gains of $41 million for 2012 were primarily due to the effect of increases in underlying account values, updates in the claim exposure calculation, and a reduction in annuitization rates, partially offset by a reduction in lapse rates and general declines in interest rates.
As explained in Other revenues above, these changes did not affect shareholders' net income because they were offset by gains or losses on futures contracts used to hedge equity market and interest rate performance.
The 2013 reserve strengthening was driven by the reinsurance transaction of February 4, 2013.
COLI contributes the majority of earnings in Other Operations. The COLI regulatory environment continues to evolve, with various federal budget related proposals recommending changes in policyholder tax treatment. Although regulatory and legislative activity could adversely impact our business and policyholders, management does not expect the impact to materially affect our results of operations, financial condition or liquidity.
Segment earnings decreased in 2012 compared with 2011, primarily reflecting lower COLI interest margins and mortality gains and the continued decline in deferred gain amortization associated with the sold businesses. The effective tax rate in 2011 reflected the favorable effect of completing the 2007-2008 IRS examinations in 2011.
Net investment income was essentially flat in 2013 compared with 2012. In 2012, net investment income decreased compared with 2011, primarily reflecting lower average yields.
Other revenues decreased in 2013, compared with 2012 primarily due to lower deferred gain amortization related to the sold retirement benefits and individual life insurance and annuity businesses. Other revenues were flat in 2012 compared with 2011.
intersegment eliminations, compensation cost for stock options, expense associated with our frozen pension plans and certain overhead and project costs.
The decrease in Corporate's segment loss in 2013, compared with 2012, is primarily attributable to the absence of special item costs associated with both litigation matters and the HealthSpring acquisition in 2012.
Additional information regarding our investment assets and related accounting policies is included in Notes 2, 10, 11, 12, 13, 14 and 17 to the Consolidated Financial Statements.
The following table reflects our fixed maturity portfolio by type of issuer as of December 31, 2013 and 2012.
The fixed maturity portfolio decreased approximately $1.2 billion during 2013 driven by lower valuations due to an increase in market yields and sales activity supporting the funding of the Berkshire reinsurance agreement. Although overall asset values are well in excess of amortized cost, there are specific securities with amortized cost in excess of fair value by $99 million in aggregate as of December 31, 2013. See Note 11 to the Consolidated Financial Statements for further information.
We invest in high quality foreign government obligations, with an average quality rating of Aa as of December 31, 2013. These investments are primarily concentrated in Asia consistent with the geographic distribution of the international business operations. Foreign government obligations also include $178 million of investments in European sovereign debt, none of which are in countries with significant political or economic concerns.
Our investment in state and local government securities is diversified by issuer and geography with no single exposure greater than $32 million. We assess each issuer's credit quality based on a fundamental analysis of underlying financial information and do not rely solely on statistical rating organizations or monoline insurer guarantees. As of December 31, 2013, 97% of our investments in these securities were rated A3 or better excluding guarantees by monoline bond insurers, consistent with the prior year. As of December 31, 2013, approximately 63% or $1,340 million of our total investments in state and local government securities were guaranteed by monoline bond insurers, providing additional credit quality support. The quality ratings of these investments with and without this guaranteed support as of December 31, 2013 were as follows:
As of December 31, 2013, our investments in other asset and mortgage-backed securities totaling $1,037 million included $463 million of private placement securities with an average quality rating of Baa3 that are guaranteed by monoline bond insurers. Quality ratings without considering the guarantees for these other asset-backed securities were not available.
Our commercial mortgage loans are fixed rate loans, diversified by property type, location and borrower. Loans are secured by high quality commercial properties and are generally made at less than 75% of the property's value at origination of the loan. Property value, debt service coverage, quality, building tenancy and stability of cash flows are all important financial underwriting considerations. We hold no direct residential mortgage loans and do not securitize or service mortgage loans.
We completed an annual in depth review of our commercial mortgage loan portfolio during the second quarter of 2013. This review included an analysis of each property's year-end 2012 financial statements, rent rolls, operating plans and budgets for 2013, a physical inspection of the property and other pertinent factors. Based on this review and subsequent fundings and repayments, the portfolio's average loan-to-value improved to 64% at December 31, 2013, decreasing from 65% as of December 31, 2012. The portfolio's average debt service coverage ratio was estimated to be 1.62 at December 31, 2013, an improvement from 1.56 as of December 31, 2012.
The following table reflects the commercial mortgage loan portfolio as of December 31, 2013, summarized by loan-to-value ratios.
Although the total fair values of investments exceeded their carrying values as of December 31, 2013, the fair value of our ownership interest in certain funds that are carried at cost was less than carrying value by $30 million. We expect to recover our carrying value over the average remaining life of these investments of approximately 4 years. Given the current economic environment, future impairments are possible; however, management does not expect those losses to have a material effect on our results of operations, financial condition or liquidity.
At December 31, 2013, included $7 million and at December 31, 2012, included $29 million of restructured loans classified in Other long-term investments that were previously reported in commercial mortgage loans.
There were no credit losses on fixed maturities for which a portion of the impairment was recognized in other comprehensive income.
Interest-rate risk on fixed-rate, medium-term instruments. Changes in market interest rates affect the value of instruments that promise a fixed return and our employee pension liabilities.
Foreign currency exchange rate risk of the U.S. dollar primarily to the South Korean won, Euro, British pound, Taiwan dollar, Chinese yuan renminbi and Turkish lira. An unfavorable change in exchange rates reduces the carrying value of net assets denominated in foreign currencies.
Use of derivatives. We generally use derivative financial instruments to minimize certain market risks.
a hypothetical strengthening of the U.S. dollar to foreign currencies, primarily for the net assets of foreign subsidiaries denominated in a foreign currency.
The effects of hypothetical changes in market rates or prices on the fair values of certain of our financial instruments, subject to the exclusions noted above (particularly insurance liabilities), would have been as follows as of December 31 (the effects of the GMIB business are presented as though our 2013 reinsurance agreement was effective as of December 31, 2012):
The effect of a hypothetical increase in interest rates was determined by estimating the present value of future cash flows using various models, primarily duration modeling. The impact of a hypothetical increase to interest rates at December 31, 2013 was less than that at December 31, 2012 reflecting asset sales (primarily to fund the reinsurance transaction with Berkshire) and an increase in market yields, resulting in a decrease in fair values for certain of our financial instruments, primarily fixed maturities, commercial mortgage loans, and long-term debt.
The effect of a hypothetical strengthening of the U.S. dollar relative to the foreign currencies held by us was estimated to be 10% of the U.S. dollar equivalent fair value. Our foreign operations hold investment assets, such as fixed maturities, cash, and cash equivalents, that are generally invested in the currency of the related liabilities. Due to the increase in the amount of these investments in 2013 that are primarily denominated in the South Korean won, the effect of a hypothetical 10% strengthening in U.S. dollar to foreign currencies at December 31, 2013 was greater than that effect at December 31, 2012.
Cigna Corporation and its subsidiaries (either individually or collectively referred to as "Cigna", "the Company", "we", or "our") is a global health services organization with a mission to help its customers improve their health, well-being and sense of security. Its insurance subsidiaries are major providers of medical, dental, disability, life and accident insurance and related products and services, the majority of which are offered through employers and
other groups (e.g. governmental and non-governmental organizations, unions and associations). Cigna also offers Medicare and Medicaid products and health, life and accident insurance coverages primarily to individuals in the U.S. and selected international markets. In addition to its ongoing operations described above, Cigna also has certain run-off operations, including a Run-off Reinsurance segment.
The Consolidated Financial Statements include the accounts of Cigna Corporation and its subsidiaries. Intercompany transactions and accounts have been eliminated in consolidation.
In preparing these Consolidated Financial Statements, the Company has evaluated events that occurred between the balance sheet date and February 27, 2014.
Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income ("AOCI") (Accounting Standards Update ("ASU") 2013-02). Effective January 1, 2013, the Company adopted updated guidance from the Financial Accounting Standards Board ("FASB") on reporting items of AOCI reclassified to net income. The updated guidance requires disclosures of the effect of items reclassified out of AOCI into net income on each individual line item in the statement of income. See Note 17 for the Company's updated disclosures.
Disclosures about Offsetting Assets and Liabilities (ASU 2011-11). The FASB's requirements to disclose information on both a gross and net basis for certain derivatives, repurchase and reverse repurchase agreements, and securities borrowing and lending transactions that are either offset in accordance with specific criteria or subject to a master netting or similar arrangement became effective January 1, 2013. There were no effects to the Company's financial statements because no transactions or arrangements were subject to these new disclosure requirements.
Amendments to Fair Value Measurement and Disclosure. Effective January 1, 2012, the Company adopted the FASB's amended guidance on fair value measurement and disclosure (ASU 2011-04) on a prospective basis. A key objective was to achieve common fair value measurement and disclosure requirements between GAAP and IFRS. The amended guidance changes certain fair value measurement principles and expands required disclosures to include quantitative and qualitative information about unobservable inputs in Level 3 measurements and leveling for financial instruments not carried at fair value in the financial statements. Upon adoption, there were no effects on the Company's fair value measurements. See Note 10 for expanded fair value disclosures.
Policy loans. Policy loans are carried at unpaid principal balances plus accumulated interest, the total of which approximates fair value. The loans are collateralized by life insurance policy cash values and therefore have no exposure to credit loss. Interest rates are reset annually based on an index.
Derivative financial instruments. The Company applies hedge accounting when derivatives are designated, qualify and are highly effective as hedges. Effectiveness is formally assessed and documented at inception and each period throughout the life of a hedge using various quantitative methods appropriate for each hedge, including regression analysis and dollar offset. Under hedge accounting, the changes in fair value of the derivative and the hedged risk are generally recognized together and offset each other when reported in shareholders' net income.
Changes in the fair value of derivatives that hedge market risk related to future cash flows and that qualify for hedge accounting are reported in accumulated other comprehensive income ("cash flow hedges").
Investment gains and losses. Realized investment gains and losses are based on specifically identified assets and result from sales, investment asset write-downs, changes in the fair values of certain derivatives and changes in valuation reserves on fixed maturities and commercial mortgage loans.
Premiums, accounts and notes receivable are reported net of an allowance for doubtful accounts of $43 million as of December 31, 2013 and $51 million as of December 31, 2012. Reinsurance recoverables are estimates of amounts that the Company will receive from reinsurers and are recorded net of an allowance for unrecoverable reinsurance of $4 million as of December 31, 2013 and 2012. The Company estimates these allowances for doubtful accounts and unrecoverable reinsurance using management's best estimates of collectability, taking into consideration the age of the outstanding amounts, historical collection patterns and other economic factors.
Liabilities for contractholder deposit funds primarily 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. In addition, this caption includes: 1) premium stabilization reserves representing experience refunds under group insurance contracts left with the Company to pay future premiums; 2) deposit administration funds used to fund non-pension retiree insurance programs; 3) retained asset accounts; and 4) annuities or supplementary contracts without significant life contingencies. Interest credited on these funds is accrued ratably over the contract period.
Liabilities for GMDB contracts represent the excess of the guaranteed death benefit over the contractholder's account values. See also Note 7 for additional information.
The Company consistently estimates incurred but not yet reported losses using actuarial principles and assumptions based on historical and projected claim incidence patterns, claim size, subrogation recoveries and the expected payment period. The Company recognizes the actuarial best estimate of the ultimate liability within a level of confidence, consistent with actuarial standards of practice that the liabilities be adequate under moderately adverse conditions.
Medical claims payable for the Global Health Care segment include reported claims, estimates for losses incurred but not yet reported and liabilities for services rendered by providers as well as liabilities under risk-sharing and quality management arrangements with providers. The Company uses actuarial principles and assumptions consistently applied each reporting period and recognizes the actuarial best estimate of the ultimate liability within a level of confidence. This approach is consistent with actuarial standards of practice that the liabilities be adequate under moderately adverse conditions.
For each reporting period, the Company compares key assumptions used to establish the medical claims payable to actual experience. When actual experience differs from these assumptions, medical claims payable are adjusted through current period shareholders' net income. Additionally, the Company evaluates expected future developments and emerging trends that may impact key assumptions. The estimation process involves considerable judgment, reflecting the variability inherent in forecasting future claim payments. These estimates are highly sensitive to changes in the Company's key assumptions, specifically completion factors and medical cost trends.
The redeemable noncontrolling interest primarily comprises the preferred and common stock interests not purchased by the Company in its acquisition of Finans Emeklilik in 2012 (see Note 3A for further information). The holder may require the Company to purchase the 49% redeemable noncontrolling interest at a redemption value equal to its net assets in Finans Emeklilik and the value of its in-force business in 15 years. Cigna also has the right to require the holder to sell its 49% interest to Cigna for the same value in 15 years. The redeemable noncontrolling interest was recorded at fair value on the date of purchase. Subsequently, if the estimated redemption value exceeds the recorded value for the redeemable noncontrolling interest,
Premiums for group 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. For experience-rated contracts, premium revenue includes an adjustment for experience-rated refunds which is calculated according to contract terms and using the customer's experience (including estimates of incurred but not reported claims). Premium revenue also includes an adjustment to reflect the estimated effect of rebates due to customers under the commercial minimum medical loss ratio provisions of Health Care Reform.
Net investment income on assets supporting investment-related products is recognized as earned.
Net investment income on assets supporting universal life products is recognized as earned.
Contract fees and expenses for administrative services only ("ASO") programs and pharmacy programs and services are recognized as services are provided net of estimated refunds under performance guarantees. In some cases, the Company provides performance guarantees associated with meeting certain service standards, clinical outcomes or financial metrics. If these service standards, clinical outcomes or financial metrics are not met, the Company may be financially at risk up to a stated percentage of the contracted fee or a stated dollar amount. The Company establishes deferred revenues for estimated payouts associated with these performance guarantees. Approximately 14% of ASO fees reported for the year ended December 31, 2013 were at risk, with reimbursements estimated to be approximately 1%.
Mail order pharmacy revenues and cost of goods sold are recognized as each prescription is shipped.
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 1% of the Company's total life insurance in force at the end of 2013, 2012 and 2011.
In accordance with GAAP, the total purchase price has been allocated to the tangible and intangible net assets acquired based on management's estimates of their fair value. Approximately $168 million was allocated to intangible assets, primarily the VOBA asset that will be amortized in proportion to premium recognized over the life of the contracts, primarily over 15 years. Amortization is expected to be higher in early years and decline as policies lapse. Goodwill has been allocated to the Global Supplemental Benefits segment. Substantially all of the goodwill is tax deductible and will be amortized over 15 years for federal income tax purposes.
The Company valued the share-based compensation awards as of the acquisition date using Cigna's stock price for restricted stock and a Black-Scholes pricing model for stock options. The assumptions used were generally consistent with those disclosed in Note 20 to the Company's 2012 Consolidated Financial Statements, except the expected life assumption of these options ranged from 1.8 to 4.8 years and the exercise price did not equal the market value at the grant date. Fair value of the new stock options approximated intrinsic value because the exercise price at the acquisition date for substantially all of the options was significantly below Cigna's stock price.
The fair value of these options and restricted stock awards was included in the purchase price to the extent that services had been provided prior to the acquisition based on the grant date of the original HealthSpring awards and vesting periods. The remaining fair value not included in the purchase price was recorded as compensation expense subsequent to the acquisition date over the remaining vesting periods. Most of the expense was recognized in 2012 and 2013.
The estimated fair values and useful lives for intangible assets are as follows:
The fair value of the customer relationship and the amortization method were determined using an income approach that relies on projected future net cash flows including key assumptions for the customer attrition rate and discount rate. The estimated weighted average useful life reflects the time period and front-loaded pattern of expected future cash flows. Amortization is recorded on a basis consistent with that pattern, and as a result amortization expense declined in 2013 from 2012, and will continue to decline in subsequent years. The Company expects more than 50% of the intangible asset value to be amortized by the end of 2014.
Medical claims payable for the Global Health Care segment reflects estimates of the ultimate cost of claims that have been incurred but not yet reported, those that have been reported but not yet paid (reported claims in process) and other medical expense payable, that comprises accruals primarily for provider incentives and other amounts payable to providers.
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 ASO business where the right of offset does not exist. See Note 7 for additional information on reinsurance. For the year ended December 31, 2013, actual experience differed from the Company's key assumptions resulting in favorable incurred claims related to prior years' medical claims payable of $182 million, or 1.3% of the current year incurred claims as reported for the year ended December 31, 2012. Actual completion factors accounted for $74 million, or 0.5%, while actual medical cost trend resulted in the remaining $108 million, or 0.8%.
For the year ended December 31, 2012, actual experience differed from the Company's key assumptions, resulting in favorable incurred claims related to prior years' medical claims payable of $200 million, or 2.2% of the current year incurred claims as reported for the year ended December 31, 2011. Actual completion factors resulted in $91 million, or 1.0%, while actual medical cost trend resulted in the remaining $109 million, or 1.2%.
The corresponding impact of prior year development on shareholders' net income was $77 million for the year ended December 31, 2013 compared with $66 million for the year ended December 31, 2012. The favorable effects of prior year development on net income in 2013 and 2012 primarily reflect low medical services utilization trend. 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 shareholders' net income recognized for the following reasons:
First, the Company consistently recognizes the actuarial best estimate of the ultimate liability within a level of confidence, consistent with actuarial standards of practice that the liabilities be adequate under moderately adverse conditions. As the Company establishes the liability for each incurral year, the Company ensures that its
Third, changes in reserves for the Company's retrospectively experience-rated business for accounts in surplus do not usually impact shareholders' net income because such amounts are generally offset by a change in the liability to the policyholder. An account is in surplus when the accumulated premium received exceeds the accumulated medical costs and administrative charges, including profit charges.
The determination of liabilities for Global Health Care medical claims payable requires the Company to make critical accounting estimates. See Note 2(N) for further information around the assumptions and estimates used to establish this liability.
The Company is constantly evaluating ways to deliver its products and services more efficiently and at a lower cost. During 2013 and 2012, the Company adopted specific plans to increase its organizational efficiency as follows.
2013 Plan. During the fourth quarter of 2013, the Company committed to a plan to increase its organizational efficiency and reduce costs through a series of actions that includes employee headcount reductions. As a result, the Company recognized charges in other operating expenses of $60 million pre-tax ($40 million after-tax) in the fourth quarter of 2013, consisting mostly of severance costs. The Global Health Care segment reported $47 million pre-tax ($31 million after-tax). The remainder was reported as follows: $11 million pre-tax ($8 million after-tax) in the Global Supplemental Benefits segment and $2 million pre-tax ($1 million after-tax) in Group Disability and Life. We expect most of the severance to be paid by the end of 2015.
On February 4, 2013, the Company entered into an agreement with Berkshire Hathaway Life Insurance Company of Nebraska ("Berkshire") to effectively exit the GMDB and GMIB businesses via a reinsurance transaction. Berkshire reinsured 100% of the Company's future claim payments in these businesses, net of retrocessional arrangements existing at that time. The reinsurance agreement is subject to an overall limit of approximately $3.8 billion plus future premiums collected under the contracts being reinsured that will be paid to Berkshire. The Company estimates that these future premium amounts will be from $0.1 to $0.3 billion and,
accordingly, expects future claims of approximately $4 billion to be covered by the agreement.
The Company had reinsurance recoverables related to the GMDB business of $1.3 billion and GMIB assets of $751 million as of December 31, 2013. Approximately 90% of the combined GMDB recoverables and GMIB assets of $2.1 billion are secured by assets in trust, letters of credit, or are not subject to collection risk. Approximately $1.6 billion of the combined GMDB recoverables and GMIB assets relate to the February 4, 2013 reinsurance arrangement with Berkshire, including approximately $0.7 billion for the cost of reinsurance (excess of payment over recorded reserves).
The Company estimates this liability with an internal model using many scenarios and assumptions based on the Company's experience and future expectations over an extended period, consistent with the long-term nature of this product. Because this product is premium deficient, the Company records increases to the reserve if it is inadequate based on the model. Prior to the February 4, 2014 reinsurance transaction with Berkshire, any such reserve increases were recorded as a charge to shareholders' net income. Reserve increases after February 4, 2013 are expected to have a corresponding increase in the recorded reinsurance recoverable, provided that the increased recoverable remains within the overall Berkshire limit (including the GMIB asset).
The Company's dynamic hedge programs to reduce equity and interest rate exposures were discontinued during the first quarter of 2013 due to the Berkshire reinsurance transaction. These hedge programs generated losses (included in Other Revenues) of $32 million in 2013, $105 million in 2012 and $14 million in 2011. Offsetting amounts were recorded in benefits and expenses. As a result of discontinuing the hedge programs, the growth rate assumption for the underlying equity funds was changed to use long-term historical averages, resulting in a decrease in the gross reserve liability and the offsetting reinsurance recoverable.
Benefits paid and incurred are net of ceded amounts. For 2013, incurred benefits reflect the February 4, 2013 reinsurance transaction. The ending net retained reserve as of December 31, 2013 covers ongoing administrative expenses, as well as claims retained by the Company. Incurred benefits reflect the favorable or unfavorable impact of a rising or falling equity market on the liability, and included reserve strengthening of $43 million ($27 million after-tax) in 2012 due primarily to reductions to the lapse rate assumptions and adverse interest rate impacts that reflected management's consideration of the anticipated impact of continued low short-term interest rates. Reserve strengthening of $70 million ($45 million after-tax) in 2011 was driven primarily by volatility-related impacts due to turbulent equity market conditions and adverse interest rate impacts.
The table below presents the account value, net amount at risk and average attained age of underlying contractholders for guarantees assumed by the Company in the event of death. The net amount at risk is the amount that the Company would have to pay if all contractholders died as of the specified date. Unless the Berkshire reinsurance limit is exceeded, the Company would be reimbursed in full for these payments.
Individual life and annuity reinsurance. The Company had reinsurance recoverables of $3.9 billion as of December 31, 2013 and $4.0 billion as of December 31, 2012 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. The Lincoln National Life Insurance Company and Lincoln Life & Annuity of New York must maintain a specified minimum credit or claims paying rating, or they will be required to fully secure the outstanding balance. As of December 31, 2013, both companies had ratings sufficient to avoid triggering this contractual obligation.
The Company reviews its reinsurance arrangements and establishes reserves against the recoverables in the event that recovery is not considered probable. As of December 31, 2013, the Company's recoverables related to these segments were net of a reserve of $3 million.
The following table presents direct, assumed and ceded premiums and fees for both short-duration and long-duration insurance contracts. It also presents reinsurance recoveries that have been netted against direct benefits and expenses in the Company's Consolidated Statements of Income.
As noted in the GMDB section above, 2013 recoveries are net of the impact of a decrease in reinsurance recoverables due to a change in the growth rate assumption, resulting from the discontinuance of the hedge programs following the reinsurance transaction with Berkshire. The increase in direct premiums in 2012 as compared to 2011 primarily reflects the Company's acquisitions of HealthSpring and Great American Supplemental Benefits as well as the conversion of Vanbreda business from service to insurance contracts in 2012. The increase in long-duration assumed premiums in 2013 largely results from the acquisition of Great American Supplemental Benefits in 2012. The increase in assumed premiums in 2012 largely results from the acquisition of FirstAssist in 2011.
Goodwill is primarily reported in the Global Health Care segment ($5.7 billion) and, to a lesser extent, the Global Supplemental Benefits segment ($340 million).
Other property and equipment includes depreciation on assets recorded under capital leases of $16 million in 2013.
The increase in amortization of other intangibles in 2012 relates primarily to the acquisitions of HealthSpring and, to a lesser extent, Great American Supplemental Benefits and Finans Emeklilik.
During the first quarter of 2013, the Company announced two changes to its postretirement medical plan:
Effective March 31, 2013, the Company froze active employees' future benefit accruals, resulting in a pre-tax curtailment gain of $19 million ($12 million after-tax recorded in shareholders' net income).
Pension benefits. The Company's pension plans were underfunded by $0.6 billion in 2013 and $1.6 billion in 2012 and had related
The Company expects to recognize pre-tax losses of $57 million in 2014 from amortization of past experience. This estimate is based on a weighted average amortization period for the frozen and inactive plans that is based on the average expected remaining life of plan participants of approximately 28 years.
The Company expects to recognize immaterial pre-tax gains related to amortization of prior service cost and no pre-tax gains from amortization of past experience in 2014. The amortization period is based on an average expected remaining life of plan participants of 28 years.
fixed income and international equity funds priced using their daily net asset value that is the exit price; and
The Company sponsors a 401(k) plan in which the Company matches a portion of employees' pre-tax contributions. Another 401(k) plan with an employer match was frozen in 1999. Participants in the active plan may invest in various funds that invest in the Company's common stock, several diversified stock funds, a bond fund or a fixed-income fund. In conjunction with the action to freeze the domestic defined benefit pension plans, effective January 1, 2010, the Company increased its matching contributions to 401(k) plan participants.
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's common stock. The Company's expense for these plans was $91 million for 2013, $78 million for 2012 and $72 million for 2011.
Fair value is defined as the price at which an asset could be exchanged in an orderly transaction between market participants at the balance sheet date. A liability's fair value is defined as the amount that would be paid to transfer the liability to a market participant, not the amount that would be paid to settle the liability with the creditor.
The following tables provide information as of December 31, 2013 and 2012 about the Company's financial assets and liabilities carried at fair value. Separate account assets that are also recorded at fair value on the Company's Consolidated Balance Sheets are reported separately under the heading "Separate account assets" as gains and losses related to these assets generally accrue directly to policyholders.
Other derivative assets included $5 million of interest rate and foreign currency swaps qualifying as cash flow hedges and $36 million of interest rate swaps not designated as accounting hedges. Other derivative liabilities reflected foreign currency and interest rate swaps qualifying as cash flow hedges. See Note 12 for additional information.
Fixed maturities and equity securities. Approximately 91% 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-backed securities and preferred stocks. Because many fixed maturities do not trade daily, third-party pricing services and internal methods often use 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. Typical inputs and assumptions to pricing models include, but are not limited to, a combination of benchmark yields, reported trades, issuer spreads, liquidity, benchmark securities, bids, offers, reference data, and industry and economic events. For mortgage-backed securities, inputs and assumptions may also include characteristics of the issuer, collateral attributes, prepayment speeds and credit rating.
The following tables summarize the fair value and significant unobservable inputs used in pricing Level 3 securities that were developed directly by the Company as of December 31, 2013 and 2012. The range and weighted average basis point amounts reflect the Company's best estimates of the unobservable adjustments a market participant would make to the market observable spreads (adjustment to discount rates) used to calculate the fair values in a discounted cash flow analysis.
Other asset and mortgage-backed securities. The significant unobservable inputs used to value the following other asset and mortgage-backed securities are liquidity and weighting of credit spreads. When there is limited trading activity for the security, an adjustment for liquidity is made as of the measurement date that considers current market conditions, issuer circumstances and complexity of the security structure. An adjustment to weight credit spreads is needed to value a more complex bond structure with multiple underlying collateral with no standard market valuation technique. The weighting of credit spreads is primarily based on the underlying collateral's characteristics and their proportional cash flows supporting the bond obligations. The resulting wide range of unobservable adjustments in the table below is due to the varying liquidity and quality of the underlying collateral, ranging from high credit quality to below investment grade.
The non-performance risk adjustment is incorporated by adding an additional spread to the discount rate in the calculation of both (a) the GMIB liability to reflect a market participant's view of the risk of the
Company not fulfilling its GMIB obligations, and (b) the GMIB asset to reflect a market participant's view of the credit risk of the reinsurers, after considering collateral. Non-performance risk adjustments had an immaterial effect on shareholders' net income in 2013 and 2012.
GMIB fair value (gain) loss for amounts related to GMIB assets and liabilities, except for the impact of changes in non-performance risk subsequent to February 4, 2013.
In the tables above, gains and losses included in other comprehensive income are reflected in net unrealized appreciation (depreciation) on securities in the Consolidated Statements of Comprehensive Income.
Transfers into or out of the Level 3 category occur when unobservable inputs, such as the Company's best estimate of what a market participant would use to determine a current transaction price, become more or less significant to the fair value measurement. For the years ended December 31, 2013 and 2012, transfers between Level 2 and Level 3 primarily reflect the change in significance of the unobservable inputs used to value certain public and private corporate bonds, principally related to liquidity of the securities and credit risk of the issuers.
(1)As of December 31, 2013, non-guaranteed separate accounts included $3.8 billion in assets supporting the Company's pension plans, including $983 million classified in Level 3.
Separate account assets in Level 1 primarily include exchange-listed equity securities. Level 2 assets primarily include:
The following table summarizes the change in separate account assets reported in Level 3 for the years ended December 31, 2013 and 2012.
The fair values presented in the table above have been estimated using market information when available. The following valuation methodologies and inputs are used by the Company to determine fair value.
Commercial mortgage loans. The Company estimates the fair value of commercial mortgage loans generally by discounting the contractual cash flows at estimated market interest rates that reflect the Company's assessment of the credit quality of the loans. Market
Fair values of off-balance-sheet financial instruments were not material as of December 31, 2013 and 2012.
Securities in the following table are included in fixed maturities and equity securities on the Company's Consolidated Balance Sheets. These securities are carried at fair value with changes in fair value reported in other realized investment gains (losses) and interest and dividends reported in net investment income. Hybrid investments include certain preferred stock or debt securities with call or conversion features.
The following information about fixed maturities excludes trading and hybrid securities. The amortized cost and fair value by contractual maturity periods for fixed maturities were as follows at December 31, 2013:
Actual maturities could differ from contractual maturities because issuers may have the right to call or prepay obligations with or without penalties. In some cases, the Company may also extend maturity dates.
Gross unrealized appreciation (depreciation) on fixed maturities by type of issuer is shown below (excluding trading securities and hybrid securities with a fair value of $6 million at December 31, 2013 and $16 million at December 31, 2012).
As of December 31, 2013, the Company had commitments to purchase $56 million of fixed maturities, all of which bear interest at a fixed market rate.
The following tables summarize the credit risk profile of the Company's commercial mortgage loan portfolio based on loan-to-value and debt service coverage ratios, as of December 31, 2013 and 2012:
The Company's annual in-depth review of its commercial mortgage loan investments is the primary mechanism for identifying emerging risks in the portfolio. The most recent review was completed by the Company's investment professionals in the second quarter of 2013 and included an analysis of each underlying property's most recent annual financial statements, rent rolls, operating plans, budgets, a physical inspection of the property and other pertinent factors. Based on historical results, current leases, lease expirations and rental conditions in each market, the Company estimates the current year and future stabilized property income and fair value, and categorizes the investments as loans in good standing, potential problem loans or problem loans. Based on property valuations and cash flows estimated as part of this review, and considering updates for loans where material changes were subsequently identified, the portfolio's average loan-to-value ratio improved to 64% at December 31, 2013 from 65% at December 31, 2012. The portfolio's average debt service coverage ratio was estimated to be 1.62 at December 31, 2013, a modest improvement from 1.56 at December 31, 2012.
During 2012, the Company restructured a $119 million problem mortgage loan, net of a valuation reserve, into two notes carried at $100 million and $19 million. The $100 million note was reclassified to impaired commercial mortgage loans with no valuation reserves and the $19 million note was classified as an other long-term investment. This modification was considered a troubled debt restructuring because the borrower was experiencing financial difficulties and an interest rate concession was granted. No valuation reserve was required because the fair value of the underlying property equaled the carrying value of the outstanding loan. Following the restructuring, the $100 million note was reclassified to good standing based on the results of the 2012 annual loan review and has been subsequently paid in full. In addition, the $19 million note was paid in full in the fourth quarter of 2013.
Certain other loans were modified during 2013 and 2012. However, these were not considered troubled debt restructures and the impact of such modifications was not material to the Company's results of operations, financial condition or liquidity.
The average recorded investment in impaired loans was $127 million during 2013 and $167 million during 2012. The Company recognizes interest income on problem mortgage loans only when payment is actually received because of the risk profile of the underlying investment. Interest income that would have been reflected in net income if interest on non-accrual commercial mortgage loans had been received in accordance with the original terms was not significant for 2013 or 2012. Interest income on impaired commercial mortgage loans was not significant for 2013 or 2012. See Note 2 for further information on impaired commercial mortgage loans.
As of December 31, 2013 and 2012, real estate investments consisted primarily of office and industrial buildings in California. Investments with a carrying value of $63 million as of December 31, 2013 and $49 million as of December 31, 2012 were non-income producing during the preceding twelve months. As of December 31, 2013, the Company had commitments to contribute additional equity of $3 million to real estate investments.
Investments in real estate entities and securities partnerships with a carrying value of $154 million at December 31, 2013 and $199 million at December 31, 2012 were non-income producing during the preceding twelve months.
$338 million to entities that hold securities diversified by issuer and maturity date.
The Company expects to disburse approximately 63% of the committed amounts in 2014.
Short-term investments and cash equivalents included corporate securities of $2.2 billion, federal government securities of $323 million and money market funds of $35 million as of December 31, 2013. The Company's short-term investments and cash equivalents as of December 31, 2012 included corporate securities of $1.1 billion, federal government securities of $167 million and money market funds of $217 million.
Collateral and termination features. The Company routinely monitors exposure to credit risk associated with derivatives and diversifies the portfolio among approved dealers of high credit quality to minimize this risk. Certain of the Company's over-the-counter derivative instruments contain provisions requiring either the Company or the counterparty to post collateral or demand immediate payment depending on the amount of the net liability position and predefined financial strength or credit rating thresholds. Collateral posting requirements vary by counterparty. The net liability positions of these derivatives were not material as of December 31, 2013 or 2012.
Cash flows. Under the terms of these various contracts, the Company periodically exchanges cash flows between variable and fixed interest rates and/or between two currencies for both principal and interest. Foreign currency swaps are primarily Euros, Australian dollars, Canadian dollars, Japanese yen, and British pounds, and have terms for periods of up to eight years. Net interest cash flows are reported in operating activities.
For the years ended December 31, 2013 and 2012, the amount of gains (losses) reclassified from accumulated other comprehensive income into shareholders' net income was not material. No amounts were excluded from the assessment of hedge effectiveness and no gains (losses) were recognized due to hedge ineffectiveness.
As explained in Note 7, the Company entered into an agreement to effectively exit the GMIB and GMDB business on February 4, 2013. As a result, the following disclosures related to derivative instruments associated with the GMIB and GMDB business are provided for context, including a description of the derivative accounting for the GMIB contracts. Cash flows on derivative instruments associated with the GMIB and GMDB business are reported in operating activities.
As described further in Note 7, the Company effectively exited the GMIB business by purchasing additional reinsurance coverage for
Purpose. The Company has written reinsurance contracts with issuers of variable annuity contracts that provide annuitants with certain guarantees of minimum income benefits resulting from the level of variable annuity account values compared with a contractually guaranteed amount ("GMIB liabilities"). According to the contractual terms of the written reinsurance contracts, payment by the Company depends on the actual account value in the underlying mutual funds and the level of interest rates when the contractholders elect to receive minimum income payments.
When the Company becomes involved with a variable interest entity and when the nature of the Company's involvement with the entity changes, in order to determine if the Company is the primary beneficiary and must consolidate the entity, it evaluates:
the entity's participants' ability to direct its activities, receive its benefits and absorb its losses. Participants include the entity's sponsors, equity holders, guarantors, creditors and servicers.
To provide certain services to its Medicare Advantage customers, the Company contracts with independent physician associations (IPAs) that are variable interest entities. Physicians provide health care services to the Medicare Advantage customers and the Company provides medical management and administrative services to the IPAs.
The components of pre-tax net investment income for the years ended December 31 were as follows:
Net investment income for separate accounts that is excluded from the Company's revenues was $232 million for 2013, $181 million for 2012, and $207 million for 2011.
Realized investment gains in other investments, including derivatives, in 2013 and 2011, primarily represented gains on sale of real estate properties held in joint ventures.
In March 2011, the Company issued $300 million of 10-Year Notes due March 15, 2021 at a stated interest rate of 4.5% ($298 million, net of discount, with an effective interest rate of 4.683% per year) and $300 million of 30-Year Notes due March 15, 2041 at a stated interest rate of 5.875% ($298 million, net of discount, with an effective interest rate of 6.008% per year). Interest is payable semi-annually. The proceeds of this debt were used for general corporate purposes, including the repayment of debt maturing in 2011.
the present value of the remaining principal and interest payments on the Notes being redeemed, discounted at the applicable Treasury rate plus 20 basis points (10-Year 4.5% Notes due 2021) or 25 basis points (30-Year 5.875% Notes due 2041).
The Company continues to indefinitely reinvest overseas the undistributed earnings of certain foreign operations, including those of its Korea operations. As a result, income taxes are provided on the earnings of these operations using the respective foreign jurisdictions' tax rate, as compared to the higher U.S. statutory tax rate. The Company continues to evaluate this reinvestment of foreign earnings for additional jurisdictions.
The Company classifies net interest expense on uncertain tax positions and any applicable penalties as a component of income tax expense, but excludes these amounts from the liability for uncertain tax positions. The Company's liability for net interest and penalties was immaterial at December 31, 2013, 2012 and 2011.
The IRS has completed their examination of the Company's 2009 and 2010 tax years. Two issues could not be resolved at the examination level that related to the timing of income tax deductions. On October 22, 2013, the Company filed a formal protest challenging the IRS positions on the two disputed matters. The IRS has since agreed to withdraw its challenge relating to one of these matters and is expected to re-issue the revenue agents report. The Company continues efforts to resolve the second matter.
The Company conducts business in numerous state and foreign jurisdictions, and may be engaged in multiple audit proceedings at any given time. Generally, no further state audit activity is expected for tax years prior to 2009, and prior to 2003 for foreign audit activity.
The Company had the following number of common stock shares available for award at December 31: 13.2 million in 2013, 8.4 million in 2012 and 11.7 million in 2011.
Excluding the HealthSpring rollover options issued in 2012, the weighted average fair value of options granted under employee incentive plans was $19.81 for 2013, $14.99 for 2012 and $13.96 for 2011, using the Black-Scholes option-pricing model and the assumptions presented in the following table. See Note 3 for additional information regarding the valuation of the HealthSpring rollover awards.
Strategic Performance Shares. The Company awards strategic performance shares to executives and certain other key employees generally with a performance period of three years. Strategic performance shares are divided into two broad groups: 50% are subject to a market condition (total shareholder return relative to industry peer companies) and 50% are subject to performance conditions (revenue growth and cumulative adjusted net income). These targets are set by the Committee. At the end of the performance period, holders of strategic performance shares will be awarded anywhere from 0 to 200% of the original grant of strategic performance shares in Cigna common stock.
The fair value of vested strategic performance shares was $42 million in 2013. No strategic performance shares vested in 2012 and 2011.
The Commercial operating segment encompasses both the U.S. commercial and certain international health care businesses serving employers and their employees, other groups, and individuals. Products and services include medical, dental, behavioral health, vision, and prescription drug benefit plans, health advocacy programs and other products and services to insured and self-insured customers.
Global Supplemental Benefits includes supplemental health, life and accident insurance products offered in selected international markets and in the U.S.
Corporate reflects amounts not allocated to other segments, such as net interest expense (defined as interest on corporate debt less net investment income on investments not supporting segment operations), interest on uncertain tax positions, certain litigation matters, intersegment eliminations, compensation cost for stock options, expense associated with its frozen pension plans, certain corporate project and overhead costs.
Revenue from external customers includes premiums and fees, mail order pharmacy revenues and other revenues. The following table presents these revenues by product type for the years ended December 31:
Revenues from external customers by geographic location were as follows for the years ended December 31:
Effective with the reinsurance agreement entered into on February 4, 2013, the Company has retrocessional coverage in place that covers the exposures on these contracts. See Notes 7, 10 and 12 for further information on GMIB contracts.
Under these guarantees, the future payment amounts are dependent on equity and bond fund market and interest rate levels prior to and at the date of annuitization election that must occur within 30 days of a policy anniversary after the appropriate waiting period. Therefore, the future payments are not fixed and determinable under the terms of these contracts. Accordingly, the Company's maximum potential undiscounted future payment of $760 million, without considering any retrocessional coverage, was determined using the following hypothetical assumptions:
all annuitants elected to receive their benefit on the next available date (2014 through 2019); and
all underlying mutual fund investment values remained at the December 31, 2013 value of $1.2 billion with no future returns.
The Company bears the risk of loss if its GMIB retrocessionaires do not meet or are unable to meet their reinsurance obligations to the Company.
The Company had indemnification obligations to lenders of up to $265 million as of December 31, 2013, related to borrowings by certain real estate joint ventures that the Company either records as an investment or consolidates. These borrowings, that are nonrecourse to the Company, are secured by the joint ventures' real estate properties with fair values in excess of the loan amounts and mature at various dates beginning in 2014 through 2042. The Company's indemnification obligations would require payment to lenders for any actual damages resulting from certain acts such as unauthorized ownership transfers, misappropriation of rental payments by others or environmental damages. Based on initial and ongoing reviews of property management and operations, the Company does not expect that payments will be required under these indemnification obligations. Any payments that might be required could be recovered through a refinancing or sale of the assets. In some cases, the Company also has recourse to partners for their proportionate share of amounts paid. There were no liabilities required for these indemnification obligations as of December 31, 2013.
As of December 31, 2013, the Company guaranteed that it would compensate the lessors for a shortfall of up to $41 million in the market value of certain leased equipment at the end of the lease. Guarantees of $16 million expire in 2016 and $25 million expire in 2025. The Company had liabilities for these guarantees of $5 million as of December 31, 2013.
The Company had indemnification obligations as of December 31, 2013 in connection with acquisition, disposition and reinsurance 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, actuarial models, 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, because not all amounts due under these indemnification obligations are subject to limitation. There were no liabilities for these indemnification obligations as of December 31, 2013.
Due to the uncertainties surrounding this matter, the Company is unable to estimate the amount of potential guaranty fund assessments. The Company will continue to monitor this situation.
When the Company (in the course of its regular review of pending litigation and legal or regulatory matters) has determined that a material loss is reasonably possible, the matter is disclosed. In accordance with GAAP, when litigation and regulatory matters present loss contingencies that are both probable and estimable, the Company accrues the estimated loss by a charge to income. The amount accrued represents the Company's best estimate of the probable loss at the time. If only a range of estimated losses can be determined, the Company accrues an amount within the range that, in the Company's judgment, reflects the most likely outcome; if none of the estimates within that range is a better estimate than any other amount, the Company accrues the minimum amount of the range. In cases when the Company has accrued an estimated loss, the accrued amount may differ materially from the ultimate amount of the loss. In many proceedings, it is inherently difficult to determine whether any loss is probable or even possible or to estimate the amount or range of any loss. The Company provides disclosure in the aggregate for material pending litigation and legal or regulatory matters, including accruals, range of loss, or a statement that such information cannot be estimated. As a litigation or regulatory matter develops, the Company monitors the matter for further developments that could affect the amount previously accrued, if any, and updates such amount accrued or disclosures previously provided as appropriate.
Amara cash balance pension plan litigation. On December 18, 2001, Janice Amara filed a class action lawsuit, captioned Janice C. Amara, Gisela R. Broderick, Annette S. Glanz, individually and on behalf of all others similarly situated v. Cigna Corporation and Cigna Pension Plan, in the United States District Court for the District of Connecticut against Cigna Corporation and the Cigna Pension Plan on behalf of herself and other similarly situated participants in the Cigna Pension Plan affected by the 1998 conversion to a cash balance formula. The plaintiffs allege various ERISA violations including, among other things, that the Plan's cash balance formula discriminates against older employees; that the conversion resulted in a wear-away period (when the pre-conversion accrued benefit exceeded the post-conversion benefit); and that these conditions are not adequately disclosed in the Plan.
Both parties appealed the court's decisions to the United States Court of Appeals for the Second Circuit that issued a decision on October 6, 2009 affirming the District Court's judgment and order on all issues. On January 4, 2010, both parties filed separate petitions for a writ of certiorari to the United States Supreme Court. Cigna's petition was granted, and on May 16, 2011, the Supreme Court issued its Opinion in which it reversed the lower courts' decisions and remanded the case to the trial judge for reconsideration of the remedy. The Court unanimously agreed with the Company's position that the lower courts erred in granting a remedy for an inaccurate plan description under an ERISA provision that allows only recovery of plan benefits. However, the decision identified possible avenues of "appropriate equitable relief" that plaintiffs may pursue as an alternative remedy. The case was returned to the trial court and hearings took place on December 9, 2011 and March 29-30, 2012.
The Company was named as a defendant in a number of putative nationwide class actions asserting that due to the use of data from Ingenix, Inc., the Company improperly underpaid claims, an industry-wide issue. All of the class actions were consolidated into Franco v. Connecticut General Life Insurance Company et al. that is pending in the United States District Court for the District of New Jersey. The consolidated amended complaint, filed on August 7, 2009, asserts claims under ERISA, the RICO statute, the Sherman Antitrust Act and New Jersey state law on behalf of subscribers, health care providers and various medical associations.
On September 23, 2011, the court granted in part and denied in part the Company's motion to dismiss the consolidated amended complaint. The court dismissed all claims by the health care provider and medical association plaintiffs for lack of standing to sue, and as a result the case proceeded only on behalf of subscribers. In addition, the court dismissed all of the antitrust claims, the ERISA claims based on disclosure and the New Jersey state law claims. The court did not dismiss the ERISA claims for benefits and claims under the RICO statute.
The agreement requires, among other things: (1) enhanced claims handling procedures related to documentation and disposition that are similar to those imposed on other companies through regulatory actions or settlements; (2) monitoring the Company's implementation of these procedures during a two-year period following the execution date of the agreement; and (3) a reassessment of claims denied or closed during a two-year prior period, except California for which the reassessment period is three years.
The following unaudited quarterly financial data is presented on a consolidated basis for each of the years ended December 31, 2013 and December 31, 2012. Quarterly financial results necessarily rely heavily on estimates. This and certain other factors, such as the seasonal nature of portions of the insurance business, suggest the need to exercise caution in drawing specific conclusions from quarterly consolidated results.
The fourth quarter of 2013 includes an after-tax charge of $40 million for an organizational efficiency plan.
The third quarter of 2012 includes an after-tax gain of $32 million for the GMIB business, an after-tax charge of $12 million for costs associated with acquisitions, and an after-tax charge of $50 million for costs associated with an organizational efficiency plan.
The fourth quarter of 2012 includes an after-tax gain of $7 million for the GMIB business and an after-tax charge of $68 million for litigation matters.