The following consolidated statement of operations and balance sheet data have been derived from the consolidated financial statements of the Company, which have been prepared in accordance with GAAP. The selected financial data should be read in conjunction with Management's Discussion and Analysis of Financial Condition and Results of Operations in Part II -
Measures within this MD&A that are not based on accounting principles generally accepted in the U.S. (non-GAAP) are marked with an asterisk (*) the first time they are presented within Part II - Item 7 of this report. An explanation of these measures is contained in the Glossary of Selected Terms included as Exhibit 99.1 to this Annual Report on Form 10-K and are reconciled to the most directly comparable measures prepared in accordance with accounting principles generally accepted in the U.S. (GAAP) in the Appendix to the Company's Fourth Quarter 2019 Investor Supplement.
The purpose of this MD&A is to provide an understanding of the Company’s consolidated results of operations and financial condition. This MD&A should be read in conjunction with the Consolidated Financial Statements and Notes thereto contained in Part II - Item 8 of this report.
HMEC is an insurance holding company and through its subsidiaries, the Company markets and underwrites personal lines of property and casualty insurance, supplemental health insurance and limited short-term supplemental disability coverages, retirement products, including annuities, and life insurance in the U.S. The Company markets its products primarily to K-12 teachers, administrators and other employees of public schools and their families.
In the second quarter of 2019, the Company reinsured a $2.9 billion block of in force fixed and variable annuity business with a minimum crediting rate of 4.5%. This represented approximately 50% of the Company’s in force fixed annuity account balances. The arrangement contains investment guidelines and a trust to help meet the Company’s risk management objectives. The annuity reinsurance transaction was effective April 1, 2019.
On July 1, 2019, the Company acquired all of the equity interests in NTA. NTA’s insurance subsidiaries predominantly sell a variety of guaranteed renewable supplemental health insurance products (primarily heart, cancer and limited short-term supplemental disability coverages). The insurance subsidiaries also market life insurance products. NTA’s insurance subsidiaries are licensed in 50 states, the U.S. Virgin Islands and the District of Columbia and their marketplace is primarily within the public sector for which approximately 80% are individuals employed by educational institutions, with the remainder employed in state and local governments and emergency services facilities. NTA’s results are reported in a newly created Supplemental segment.
For 2019, insurance premiums and contract charges earned increased $80.7 million compared to 2018, primarily due to the addition of earned premiums from Supplemental as well as increases in average premium per policy for both automobile and property. For 2018, insurance premiums and contract charges earned increased $22.6 million compared to 2017, primarily due to increases in average premium per policy for both automobile and property.
For 2019, net investment gains increased primarily due to recognition of a realized investment gain of $135.3 million in the second quarter of 2019 in connection with the transfer of investments related to the aforementioned annuity reinsurance transaction.
Effective January 1, 2018, with the adoption of new accounting guidance for recognition and measurement of financial instruments, equity securities are reported at fair value with changes in fair value recognized in net investment gains (losses). The changes in fair value of equity securities accounted for the 2018 increase in net investment losses over 2017. The break down of net investment gains (losses) by transaction type is shown in the following table:
For 2019, benefits, claims and settlement expenses were lower due to reduced catastrophe losses and improved automobile experience, partially offset by the inclusion of losses from the new Supplemental segment. For 2018, benefits, claims and settlement expenses increased compared to 2017, driven primarily by elevated catastrophe costs in Property and Casualty.
For 2019, 2018 and 2017, interest credited steadily increased, primarily due to higher interest costs on FHLB funding agreements.
DAC unlocking and amortization expense was comparable to 2018. The 2018 increase in DAC amortization expense was primarily attributable to DAC unlocking in Retirement accompanied by growth in premiums and related commissions for Property and Casualty. For Life, DAC unlocking resulted in immaterial changes to amortization for the three years ended 2019, 2018 and 2017.
For 2019, the increase in intangible asset amortization expense was due to the acquisitions of NTA and BCG.
For 2019, other expense represents an annuity goodwill impairment charge in Retirement resulting from the annuity reinsurance transaction. See Part II - Item 8, Note 7 of the Consolidated Financial Statements in this report for further information.
At the time of issuance of this Annual Report on Form 10-K, management estimates that 2020 full year net income will be within a range of $2.55 to $2.75 per diluted share and that the Company anticipates generating a core return on equity* of over 8%. Management expects the Company's overall pretax net investment income to be flat with 2019, with increases from a full year of Supplemental net investment income offsetting declines in Retirement net investment income. This projection also reflects an overall effective tax rate of between 17% and 19%.
Retirement net investment income is expected to reflect further spread compression with rates on new investments below the average portfolio earned rate as well as the impact of lower invested assets as a result of the annuity reinsurance transaction. This should be offset by a reduced level of operating expenses. As a result, net income for Retirement is anticipated to be in the range of $27 million to $29 million.
The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the U.S. (GAAP) requires the Company's management to make estimates and assumptions based on information available at the time the consolidated financial statements are prepared. These estimates and assumptions affect the reported amounts of the Company's consolidated assets, liabilities, shareholders' equity and net income. Certain accounting estimates are particularly sensitive because of their significance to the Company's consolidated financial statements and because of the possibility that subsequent events and available information may differ markedly from management's judgments at the time the consolidated financial statements were prepared. Management has discussed with the Audit Committee the quality, not just the acceptability, of the Company's accounting principles as applied in its financial reporting. The discussions generally included such matters as the consistency of the Company's accounting policies and their application, and the clarity and completeness of the Company's consolidated financial statements, which include related disclosures. Information regarding the Company's accounting policies pertaining to these topics is located in the Notes to Consolidated Financial Statements as listed in Part II - Item 8 of this report.
The Company gains assurance that its portfolio of fixed maturity securities and hard-to-value fixed maturity securities is appropriately valued through the execution of various processes and controls designed to ensure the overall reasonableness and consistent application of valuation methodologies, including inputs and assumptions, and compliance with accounting standards. The Company’s processes and controls are designed to ensure (1) the valuation methodologies are appropriate and consistently applied, (2) the inputs and assumptions are reasonable and consistent with the objective of determining fair value, and (3) the fair values are accurately recorded. For example, on a continuing basis, the Company assesses the reasonableness of individual fair values that have stale security prices or that exceed certain thresholds as compared to previous fair values received from valuation service providers. The Company performs procedures to understand and assess the methodologies, processes and controls of valuation service providers. In addition, the Company may validate the reasonableness of fair values by comparing information obtained from valuation service providers or broker-dealers to other third-party valuation sources for selected securities.
At December 31, 2019, Level 3 invested assets comprised 4.8% of the Company's total investment portfolio fair value. Invested assets are classified as Level 3 when fair value is determined based on unobservable inputs that are supported by little or no market activity and those inputs are significant to the determination of fair value.
The Company's methodology of assessing OTTI for fixed maturity securities is based on security-specific facts and circumstances as of the reporting date. The Company has a policy and process to evaluate fixed maturity securities (at the cusip/issuer level) on a quarterly basis to assess whether there has been OTTI. These reviews, in conjunction with the Company's investment managers' monthly credit reports and relevant factors such as (1) the financial condition and near-term prospects of the issuer, (2) the length of time and extent to which the fair value has been less than the amortized cost basis, (3) the Company's intent to sell a security or whether it is more likely than not the Company will be required to sell the security before the anticipated recovery of the amortized cost basis, (4) the market leadership position of the issuer, (5) the debt ratings of the issuer, and (6) the cash flows and liquidity of the issuer or the underlying cash flows for asset-backed securities, are all considered in the impairment assessment.
Goodwill represents the excess of the amounts paid to acquire a business over the fair value of its net assets at the date of acquisition. Goodwill is not amortized, but is tested for impairment at the reporting unit level at least annually or more frequently if events occur or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying value. Goodwill impairment is the amount by which a reporting unit’s carrying value exceeds its fair value, not to exceed the carrying amount of goodwill. A goodwill impairment charge could have a material adverse effect on the Company's results of operations. The Company's reporting units, for which goodwill has been allocated, are equivalent to the Company's operating segments. As of December 31, 2019, the Company's allocation of goodwill by reporting unit was as follows: $9.5 million, Property and Casualty; $19.6 million, Supplemental; $10.1 million, Retirement; and $9.9 million, Life. Also see Part II - Item 8, Notes 1 and 7 of the Consolidated Financial Statements in this report.
The assessment of goodwill recoverability requires significant judgment and is subject to inherent uncertainty. The use of different assumptions, within a reasonable range, could cause the fair value of a reporting unit to be below carrying value. Subsequent goodwill assessments could result in impairment, particularly for each reporting unit with at-risk goodwill, due to the impact of a volatile financial markets on earnings, discount rate assumptions, liquidity and market capitalization. The annuity reinsurance transaction triggered an assessment resulting in the write-down of a certain amount of goodwill for impairment during the second quarter of 2019 (see Part II - Item 8, Note 7 of the Consolidated Financial Statements in this report for more information). There were no other events or material changes in circumstances during 2019 that indicated that an adverse material change in the fair value of the Company's reporting units had occurred.
The value of business acquired (VOBA) represents the difference between the fair value of insurance contracts and insurance policy reserves measured in accordance with the Company's accounting policies for insurance contracts acquired. VOBA was based on an actuarial estimate of the present value of future distributable earnings for insurance in force on the acquisition date. VOBA was $90.7 million as of December 31, 2019 and is being amortized by product based on the present value of future premiums to be received. The Company estimates that it will recognize VOBA amortization of $7.1 million in 2020, $6.7 million in 2021, $6.2 million in 2022, $5.8 million in 2023 and $5.4 million in 2024.
The Company accounts for the value of agency relationships based on the present value of commission overrides retained by NTA. Agency relationships was $15.5 million as of December 31, 2019 and is being amortized based on the present value of future premiums to be received. The Company estimates that it will recognize agency relationships amortization of $2.6 million in 2020, $2.2 million in 2021, $1.9 million in 2022, $1.6 million in 2023 and $1.4 million in 2024.
VOBA is reviewed for recoverability from future income, including net investment income, and costs which are deemed unrecoverable are expensed in the period in which the determination is made. No such costs were deemed unrecoverable during the year ended December 31, 2019.
DAC, consisting of commissions, policy issuance and other costs which are incremental and directly related to the successful acquisition of new or renewal business, are deferred and amortized on a basis consistent with the type of insurance coverage. For supplemental policies, DAC is amortized in proportion to anticipated premiums over the terms of the insurance policies (approximately 6 years, based on an estimated average duration across all supplemental products). For all investment (annuity) contracts, DAC is amortized over 20 years in proportion to estimated gross profits. DAC is amortized in proportion to estimated gross profits over 20 years for certain life insurance products with account values and over 30 years for IUL. For further information, see Part II - Item 8, Note 1 of the Consolidated Financial Statements in this report.
The most significant assumptions that are involved in the estimation of annuity gross profits include interest rate spreads, future financial market performance, business surrender/lapse rates, expenses and the impact of net investment gains (losses). For the variable deposit portion of Retirement, the Company amortizes DAC utilizing a future financial market performance assumption of an 8.0% reversion to the mean approach with a 200 basis point corridor around the mean during the reversion period, representing a cap and a floor on the Company's long-term assumption. The Company's practice with regard to future financial market performance assumes that long-term appreciation in the financial markets is not changed by short-term market fluctuations, but is only changed when sustained annual deviations are experienced. The Company monitors these fluctuations and only changes the assumption when the long-term expectation changes. The potential effect of an increase/(decrease) by 100 basis points in the assumed future rate of return is reasonably likely to result in an estimated decrease/(increase) in DAC amortization expense of approximately $3.0 million. Although this evaluation reflects likely outcomes, it is possible an actual outcome may fall below or above these estimates. At December 31, 2019, the ratio of DAC to the total annuity accumulated cash value was 2.5%.
period in which the adjustment is made. As noted above, there are key assumptions involved in the evaluation of DAC. In terms of the sensitivity of this amortization to three of the more significant assumptions, based on DAC as of December 31, 2019 and assuming all other assumptions are met, (1) a 10 basis point deviation in the annual targeted interest rate spread assumption would impact amortization between $0.3 million and $0.4 million, (2) a 1.0% deviation from the targeted financial market performance for the underlying mutual funds of the Company's variable annuities would impact amortization between $0.3 million and $0.4 million and (3) a $1.0 million net investment gain (loss) would impact amortization by approximately $0.1 million. These results may change depending on the magnitude and direction of any actual deviations but represent a range of reasonably likely experience for the noted assumptions. Detailed discussion of the impact of adjustments to DAC amortization expense is included in Results of Operations by Segment for the Three Years Ended December 31, 2019.
Underwriting results of Property and Casualty are significantly influenced by estimates of the Company's ultimate liability for insured events. There is a high degree of uncertainty inherent in the estimates of ultimate losses underlying the liabilities for unpaid claims and claim settlement expenses. This inherent uncertainty is particularly significant for liability-related exposures due to the extended period, often many years that transpire between a loss event, receipt of related claims data from policyholders and ultimate settlement of the claim. Reserves for Property and Casualty claims include provisions for payments to be made on reported claims (case reserves), IBNR claims and associated settlement expenses (together, loss reserves).
There are a number of assumptions involved in the determination of the Company's Property and Casualty loss reserves. Among the key factors affecting recorded loss reserves for both long-tail and short-tail related coverages, claim severity and claim frequency are of particular significance. Management estimates that a 2.0% change in claim severity or claim frequency for the most recent 36 month period is a reasonably likely scenario based on recent experience and would result in a change in the estimated net reserves of between $6.0 million and $10.0 million for long-tail liability related exposures (automobile liability coverages) and between $2.0 million and $4.0 million for short-tail liability related exposures (property and automobile physical damage coverages). Actual results may differ, depending on the magnitude and direction of the deviation.
Favorable prior years' reserve re-estimates increased net income in 2019 by approximately $7.5 million pretax, primarily the result of favorable severity trends in auto for accident year 2018. The lower than expected claims emergence and resultant lower expected loss ratios caused the Company to lower its reserve estimate at December 31, 2019.
Liabilities for future policy benefits on life insurance policies, excluding indexed universal life (IUL) products, are computed using the net level premium method and are based on assumptions as to future investment yield, mortality and lapses. Mortality and lapse assumptions for all policies have been based on actuarial tables which are consistent with the Company's own experience. In the event actual experience is worse than the assumptions, additional reserves may be required. This would result in recognition of a loss for the period in which the increase in reserves occurred. Also, see Part II - Item 8, Note 1 of the Consolidated Financial Statements in this report. Liabilities for IUL products are bifurcated into an embedded derivative and a host contract. The embedded derivative is recognized at fair value and is set equal to the fair value of the current call options purchased to hedge the liability. The host contract is measured using the retrospective deposit method which is equal to the account balance.
The valuation of insurance contracts, consisting of VOBA and insurance policy reserves, and VODA, required management to use judgment to estimate the fair value. Assumptions included discount rate, future policy and contract charges, premiums, morbidity and mortality, and persistency by product, as well as expenses, investment returns, growth rates, agent termination rates and other factors. Two of the most significant inputs in these calculations are the discount rate assumption used to arrive at the present value of the net cash flows and the morbidity assumption used to estimate the fair value of insurance contracts and insurance policy reserves
and future business to be produced by the existing distribution channel. Actual experience on the purchased business may vary from these projections and the recovery of the net assets recorded is dependent upon the future profitability of the related business.
Results of Operations by Segment for the Three Years Ended December 31, 2019
On a reported basis, the improvement in the automobile combined ratio in 2019 was mainly attributed to 4.0 points of improvement in the underlying loss ratio* due to rate actions combined with continued stabilization in auto loss trends. The property combined ratio improved 28.9 points in 2019 primarily due to lower catastrophe losses. On an underlying basis, the property loss ratio* increased 1.0 point compared to the prior year.
The Property and Casualty expense ratio was 26.9%, 27.0% and 26.7% for 2019, 2018 and 2017, respectively.
The Company continues to evaluate and implement actions to further mitigate its risk exposure. Such actions could include, but are not limited to, non-renewal of property policies, restricted agent geographic placement, limitations on agent new business sales, further tightening of underwriting standards and increased utilization of third-party vendor products.
The Company acquired NTA on July 1, 2019. As a result, the Company’s reporting segments have changed effective in the third quarter of 2019. A new reporting segment titled "Supplemental" was added to report on the personal lines of supplemental insurance products (primarily heart, cancer, accident and limited short-term supplemental disability coverages) that are marketed and underwritten by NTA.
The following table provides certain information for the Supplemental segment for the periods indicated.
(2) Expense ratio and pretax profit margin measured to total revenues.
2018 net income declined due to a favorable impact from TCJA enacted in 2017. 2018 core earnings decreased $7.2 million compared to 2017, reflecting tightening annualized net interest spreads on fixed annuities, higher DAC unlocking, and higher operating expenses to support long-term retirement infrastructure.
Amount reported as of December 31, 2019 excludes $707.8 million of assets under management held under modified coinsurance reinsurance.
At December 31, 2019, assets under management were $2.3 billion below a year ago, driven primarily by the annuity reinsurance transaction. Variable assets under management, excluding amounts held under the modified coinsurance agreement, decreased by $218.4 million primarily due to the annuity reinsurance transaction partially offset by favorable market performance. The 194 basis point net interest spread for full-year 2019 includes the 142 basis point net annualized net interest spread for the first quarter, which was prior to the annuity reinsurance transaction.
For 2019, insurance premiums and contract deposits* decreased $1.2 million in 2019 compared to 2018, primarily due to a decline in single premiums. The ordinary life insurance in force lapse ratio was 4.6%, 4.6% and 4.9% for 2019, 2018 and 2017, respectively.
Excluding accreted investment income on the deposit asset on reinsurance, 2019 net investment income decreased $82.2 million compared to 2018, primarily due to a $2.1 billion reduction of invested assets from investments transferred under the annuity reinsurance transaction in the second quarter of 2019 as well as low rates on new investments and prepayments that were partially offset by stronger returns on alternative investments. For 2018, net investment income was comparable to 2017 as increased prepayment activity and returns on alternative investments offset by a reduction in yields from a strategic decision to improve the quality of the portfolio.
At December 31, 2019, the fair value amount included $9.3 million which were non-investment grade.
The All Other Corporates category contains 18 additional industry classifications. Broadcasting and media, aerospace and defense, consumer products, metal and mining and retail represented $158.4 million of fair value at December 31, 2019, with the remaining 13 classifications each representing less than $18.0 million.
Holdings are geographically diversified, 51.4% are tax-exempt and 77.5% are revenue bonds tied to essential services, such as mass transit, water and sewer. The overall credit quality of the municipal bond portfolio was AA- at December 31, 2019.
Based on fair value, 95.2% of the collateralized loan obligation securities were rated investment grade by Standard & Poor's Global Inc. (S&P), Moody's Investors Service, Inc. (Moody's) and/or Fitch Ratings, Inc. (Fitch) at December 31, 2019.
At December 31, 2019, the Company's diversified fixed maturity securities portfolio consisted of 3,133 investment positions, issued by 1,988 entities, and totaled approximately $5.8 billion in fair value. This portfolio was 96.4% investment grade, based on fair value, with an average quality rating of A+. The Company's investment guidelines generally limit single corporate issuer concentrations to 0.5% of invested assets for AA or AAA rated securities, 0.35% of invested assets for A or BBB rated securities, and 0.2% of invested assets for non-investment grade securities.
The following table presents the composition and fair value of the Company's fixed maturity and equity securities portfolios by rating category. At December 31, 2019, 95.7% of these combined portfolios were investment grade, based on fair value, with an overall average quality rating of A+. The Company has classified the entire fixed maturity securities portfolio as available for sale, which is carried at fair value.
At December 31, 2019, the AA rated fair value amount included $458.9 million of U.S. Government and federally sponsored agency securities and $708.4 million of mortgage-backed and asset-backed securities issued by U.S. Government and federally sponsored agencies.
At December 31, 2019, the fixed maturity securities portfolio had $13.6 million of pretax gross unrealized investment losses on $951.6 million of fair value related to 467 positions. Of the investment positions with gross unrealized investment losses, there were six securities trading below 80.0% of the carrying value at December 31, 2019.
The Company views the unrealized investment losses of all of the securities at December 31, 2019 as temporary. Future changes in circumstances related to these and other securities could require subsequent recognition of OTTI.
Information regarding the Company's investment portfolio, which is comprised primarily of investment grade, fixed maturity securities, is presented in Part II - Item 7, Results of Operations by Segment for the Three Years Ended December 31, 2019, Part I - Item 1, Investments and in Part II - Item 8, Note 3 of the Consolidated Financial Statements in this report.
As a holding company, HMEC conducts its principal operations in the personal lines portion of the property and casualty and life insurance industries through its subsidiaries. HMEC's insurance subsidiaries generate cash flow from premium and investment income, generally well in excess of their immediate needs for policy obligations, operating expenses and other cash requirements. Cash provided by operating activities primarily reflects net cash generated by the insurance subsidiaries.
On July 1, 2019, the Company utilized $135.0 million of its $225.0 million senior revolving credit facility to partially fund the acquisition of NTA.
The Company has entered into various operating lease agreements, primarily for real estate offices.
Estimated Future Policy Benefit and Claim Payments - Retirement and Life
For the majority of the Company's Retirement and Life insurance operations, the estimated contractual obligations for future policyholder benefits as presented in the table above were derived from the annual cash flow testing analysis used to develop actuarial opinions of statutory reserve adequacy for state regulatory purposes. These cash flows are materially representative of the cash flows under GAAP. Actual amounts may vary, potentially in a significant manner, from the amounts indicated due to deviations between assumptions and actual results and the addition of new business in future periods.
For the majority of the Company's Supplemental insurance operations, the estimated contractual obligations for future policyholder benefits as presented in the table above were derived from future projections of the business developed as part of the purchase accounting associated with the acquisition of NTA.
See Part II - Item 8, Note 1 of the Consolidated Financial Statements in this report for a description of the Company's method for establishing life and annuity reserves in accordance with GAAP.
The Company has determined the amount of capital which is needed to adequately fund and support business growth, primarily based on risk-based capital formulas including those developed by the NAIC. Historically, the Company's insurance subsidiaries have generated capital in excess of such needed capital. These excess amounts have been paid to HMEC through dividends. HMEC has then utilized these dividends and its access to the capital markets to service and retire long-term debt, pay dividends to its shareholders, fund growth initiatives, repurchase shares of its common stock and for other corporate purposes. If necessary, HMEC also has other potential sources of liquidity that could provide for additional funding to meet corporate obligations or pay shareholder dividends, which include a revolving line of credit, as well as issuances of various securities. The insurance subsidiaries are subject to various regulatory restrictions which limit the amount of annual dividends or other distributions, including loans or cash advances, available to HMEC without prior approval of the insurance regulatory authorities. The maximum amount of dividends that may be paid in 2020 from all of HMEC's insurance subsidiaries without prior regulatory approval is $105.3 million, excluding the impact and timing of prior year dividends. Management anticipates that the Company's sources of capital will continue to generate sufficient capital to meet the needs for business growth, debt interest payments, shareholder dividends and its share repurchase program. Additional information is contained in Part II - Item 8, Note 14 of the Consolidated Financial Statements in this report.
The total capital of the Company was $2,000.3 million at December 31, 2019, including $298.0 million of long-term debt and $135.0 million of short-term debt outstanding. Total debt represented 21.6% of total capital including net unrealized investment gains on securities (24.5% of total capital excluding net unrealized investment gains on securities*) at December 31, 2019, which was below the Company's long-term target of 25.0%.
Shareholders' equity was $1,567.3 million at December 31, 2019, including net unrealized investment gains on securities in the Company's investment portfolio of $230.4 million after taxes and the related impact of DAC associated with investment contracts and life insurance products with account values. The market value of the Company's common stock and the market value per share were $1,800.5 million and $43.66, respectively, at December 31, 2019. Book value per share was $38.01 at December 31, 2019 ($32.42 excluding net unrealized investment gains on securities*).
Total shareholder dividends were $47.3 million for the year ended December 31, 2019. In March, May, September and December 2019, the Board announced regular quarterly dividends of $0.2875 per share. Compared to the full year per share dividends paid in 2018 of $1.14, the total 2019 dividends paid per share of $1.15 represented an increase of 0.9%.
As of December 31, 2019, the Company had $135.0 million outstanding under its Bank Credit Facility. On June 21, 2019, the Company, as borrower, replaced its current line of credit with a new five-year Credit Agreement (Bank Credit Facility). The new Bank Credit Facility increased the amount available on this senior revolving credit facility to $225.0 million from $150.0 million. PNC Capital Markets, LLC and JPMorgan Chase Bank, N.A. served as joint leads on the new agreement, with The Northern Trust Company, U.S. Bank National Association, KeyBank National Association, Comerica Bank and Illinois National Bank participating in the syndicate. Terms and conditions of the new Bank Credit Facility are substantially consistent with the prior agreement, with an interest rate based on LIBOR plus 115 basis points.
To provide additional capital management flexibility, the Company filed a "universal shelf" registration on Form S-3 with the SEC on March 13, 2018. The registration statement, which registered the offer and sale by the Company from time to time of an indeterminate amount of various securities, which may include debt securities, common stock, preferred stock, depositary shares, warrants, delayed delivery contracts and/or units that include any of these securities, was automatically effective on March 13, 2018. Unless withdrawn by the Company earlier, this registration statement will remain effective through March 13, 2021. No securities associated with the registration statement have been issued at the time of issuance of this Annual Report on Form 10-K.
On March 13, 2018, the Company filed a "shelf" registration statement on Form S-4 with the SEC which became effective on May 2, 2018. Under this registration statement, the Company may from time to time offer and issue up to 5,000,000 shares of its common stock in connection with future acquisitions of other businesses, assets or securities. Unless withdrawn by the Company, this registration statement will remain effective indefinitely. No securities associated with the registration statement have been issued at the time of issuance of this Annual Report on Form 10-K.
HMEC's principal insurance subsidiaries are rated by S&P, Moody's, A.M. Best and Fitch. These rating agencies have also assigned ratings to the Company's long-term debt securities. The ratings that are assigned by these agencies, which are subject to change, can impact, among other things, the Company's access to sources of capital, cost of capital, and competitive position. These ratings are not a recommendation to buy or hold any of the Company's securities.
Assigned ratings for HMEC and its Property and Casualty and Life insurance subsidiaries were reviewed by all of the rating agencies in June and July 2019 in conjunction with the announcement of the Company's financing plans to purchase NTA. A.M. Best and S&P affirmed the ratings that were in place at December 31, 2018. Moody's and Fitch affirmed their ratings with a stable outlook, removing negative watches from their respective debt and insurance financial strength ratings placed after the announcement of NTA acquisition in December 2018.
Information regarding the reinsurance programs for the Company's Property and Casualty, Supplemental, Retirement and Life segments are located in Part I - Item 1, Reporting Segments of this report.
There are several pending accounting standards that the Company has not implemented because the implementation date has not yet occurred. For a discussion of these pending standards, see Part II - Item 8, Note 1 of the Consolidated Financial Statements in this report. The effect of implementing certain accounting standards on the Company's financial results and financial condition is often based in part on market conditions at the time of implementation of the standard and other factors that the Company is unable to determine prior to implementation. For this reason, the Company is sometimes unable to estimate the effect of certain pending accounting standards until the relevant authoritative body finalizes these standards or until the Company implements them.
The Company's operating results are affected significantly in at least three ways by changes in interest rates and inflation. First, inflation directly affects Property and Casualty claims costs. Second, the investment income earned on the Company's investment portfolio and the fair value of the investment portfolio are related to the yields available in the fixed income markets. An increase in interest rates will decrease the fair value of the investment portfolio, but will increase investment income as investments mature and proceeds are reinvested at higher rates. Third, as interest rates increase, competitors will typically increase crediting rates on investment contracts and life insurance products with account values, and may lower premium rates on Property and Casualty lines to reflect the higher yields available in the market. The risk of interest rate fluctuation is managed through asset/liability management techniques, including cash flow analysis. In addition, an annuity reinsurance agreement entered into in the second quarter of 2019, which reinsured a $2.2 billion block of in force fixed annuities with a minimum crediting rate of 4.5%, helps mitigate the risk of not being able to generate appropriate spreads on the annuity business.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the Company’s internal control over financial reporting as of December 31, 2019, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission, and our report dated February 28, 2020 expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.
As discussed in Notes 1 and 4 to the consolidated financial statements, as of December 31, 2019, the Company has recorded an estimated fair value for fixed maturity securities, of which a portion represent securities that are
We identified the assessment of the Company’s estimate of the fair value of hard-to-value fixed maturity securities as a critical audit matter. Due to the significant measurement uncertainty associated with the fair value of such securities, there was a high degree of subjectivity and judgment in evaluating the fair value and certain related assumptions. Our assessment included evaluating the specific inputs and assumptions to which the estimate is most sensitive.
The primary procedures we performed to address this critical audit matter included the following. We tested certain internal controls over the Company’s process to measure the fair value of hard-to-value securities. In addition, we tested internal controls over the Company’s pricing assumptions and methodologies for hard-to-value fixed maturity securities. We involved valuation professionals with specialized skills and knowledge, who assisted in:
As discussed in Notes 1 and 8 of the consolidated financial statements, the Company employs actuarial techniques to estimate the liability for property and casualty unpaid claims and claims expenses (reserves). The Company develops reserves based on the application of appropriate methods and assumptions to historical claim experience. The reserves are continually updated by the Company as experience develops and new information becomes known. The Company recorded an estimated liability of $266.5 million for property and casualty unpaid claims and claim expenses as of December 31, 2019.
We identified the assessment of the estimate of reserves as a critical audit matter because it involved measurement uncertainty requiring complex auditor judgment. Complex auditor judgment and specialized skills and knowledge were required in evaluating the Company’s methods and key assumptions, including the selection of loss development factors and changes in claim frequency and severity trends. The assumptions included a range of potential inputs and changes to these assumptions could affect the reserves recorded by the Company.
Evaluating the Company’s reserving methods, procedures, key assumptions and judgments by comparing to generally accepted actuarial standards;
Examining the Company’s internal actuarial analyses for certain remaining lines of business;
Assessing any movement of the Company’s recorded reserves within the range of reserves.
As discussed in Notes 1, 2, and 7 to the consolidated financial statements, on July 1, 2019, the Company acquired NTA Life Enterprises, LLC (NTA) in a business combination. As a result of the transaction, the Company acquired the assets and assumed the liabilities of NTA. The Company uses judgment to determine the appropriate assumptions used to estimate the fair value of the insurance contracts, consisting of the value of business acquired (VOBA) and insurance policy reserves, and the future business to be written by the existing distribution channel (VODA). The acquisition-date balance was $94.4 million, $366.8 million and $49.0 million for VOBA, insurance policy reserves, and VODA, respectively.
We identified the assessment of the fair value of the insurance contracts acquired, consisting of VOBA and insurance policy reserves, and VODA, as a critical audit matter. There was a high degree of subjective auditor judgment in evaluating the valuation methods and certain assumptions used to estimate the fair value of the insurance contracts, consisting of VOBA and insurance policy reserves, and VODA. Changes in certain assumptions, specifically morbidity and discount rate, could affect the fair value of the balances recorded by the Company. Specialized skills and knowledge were required to assess the valuation methods, models, and assumptions used to estimate fair value.
We involved actuarial professionals with specialized skills and knowledge, who assisted in:
Performing independent estimates of insurance policy reserves using the Company’s policy data and assumptions for a selection of policies; and
Assessing the morbidity and discount rate assumptions in light of NTA’s historical experience as well as industry trends.
We involved valuation professionals with specialized skills and knowledge, who assisted in:
Comparing the estimated fair value of VODA to an independent estimate derived using a multi-period excess earnings method under the income approach based on NTA’s forecasted business production.
The accompanying audited consolidated financial statements of Horace Mann Educators Corporation and its wholly-owned subsidiaries (HMEC; and together with its subsidiaries, the Company or Horace Mann) have been prepared in accordance with accounting principles generally accepted in the U.S. (GAAP) and with the rules and regulations of the Securities and Exchange Commission (SEC). The preparation of consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect (1) the reported amounts of assets and liabilities, (2) disclosure of contingent assets and liabilities at the date of the consolidated financial statements, and (3) the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
The consolidated financial statements include the accounts of HMEC and its wholly-owned subsidiaries. HMEC and its subsidiaries have common management, share office facilities and are parties to intercompany service agreements for management, administrative, utilization of personnel, financial, investment advisory, underwriting, claims adjusting, agency and data processing services. Under these agreements, costs have been allocated among the companies in conformity with GAAP. In addition, certain of the subsidiaries have entered into intercompany reinsurance agreements. HMEC and its subsidiaries (with exception of National Teachers Associates Life Insurance Company and NTA Life Insurance Company of New York) file a consolidated federal income tax return, and there are related tax sharing agreements. All significant intercompany balances and transactions have been eliminated in consolidation.
As described more fully in Note 2, the Company acquired NTA Life Enterprises, LLC (NTA) on July 1, 2019. As a result, the Company’s reporting segments have changed effective in the third quarter of 2019. A new reporting segment titled "Supplemental" was added to report on the personal lines of supplemental insurance products (primarily heart, cancer, accident and limited short-term supplemental disability coverages) that are marketed and underwritten by NTA.
The Company has evaluated subsequent events through the date these consolidated financial statements were issued. There were no subsequent events requiring adjustment to the consolidated financial statements or disclosure.
The fair value of a fixed maturity security is the estimated amount at which the security could be exchanged in an orderly transaction between knowledgeable, unrelated and willing parties. The Company utilizes its investment managers and its custodian bank to obtain fair value prices from independent third-party valuation service providers, broker-dealer quotes, and model prices. Each month, the Company obtains fair value prices from its investment managers and custodian bank, each of which use a variety of independent, nationally recognized pricing sources to determine market valuations for fixed maturity securities. Differences in prices between the sources that the Company considers significant are researched and the Company utilizes the price that it considers most representative of an exit price. Typical inputs used by these pricing sources include, but are not limited to, reported trades, bids, offers, benchmark yield curves, benchmarking of like securities, rating designations, sector groupings, issuer spreads, and/or estimated cash flows, prepayment and default speeds, among others. The Company's fixed maturity securities portfolio is primarily publicly traded, which allows for a high percentage of the portfolio to be priced through pricing services. Approximately 94.1% of the portfolio, based on fair value, was priced through pricing services or index priced using observable inputs as of December 31, 2019.
The valuation of hard-to-value fixed maturity securities (generally 100 -150 securities) is more subjective because the markets are less liquid and there is a lack of observable market-based inputs. This may increase the potential that the estimated fair value of an investment is not reflective of the price at which an actual transaction would occur. When the pricing sources cannot provide fair value determinations, the investment managers and custodian bank obtain non-binding price quotes from broker-dealers. For those securities where the investment manager cannot obtain broker-dealer quotes, they will model the security, generally using anticipated cash flows of the underlying collateral. Broker-dealers' valuation methodologies as well as investment managers’ modeling methodologies are sometimes matrix-based, using indicative evaluation measures and adjustments for specific security characteristics and market sentiment. The selection of the market inputs and assumptions used to estimate the fair value of hard-to-value fixed maturity securities require judgment and include: benchmark yield, liquidity premium, estimated cash flows, prepayment and default speeds, spreads, weighted average life, and credit rating. The extent of the use of each market input depends on the market sector and market conditions. Depending on the security, the priority of the use of inputs may change or some market inputs may not be relevant. For some securities, additional inputs may be necessary.
The Company invests in fixed maturity securities and alternative investment funds that could qualify as interests in variable interest entities (VIEs), including corporate securities, mortgage-backed securities and asset-backed securities. Such interests in VIEs have been reviewed and the Company determined that those VIEs are not subject to consolidation as the Company is not the primary beneficiary because it does not have the power to direct the activities that most significantly impact those VIEs' economic performance.
With respect to fixed maturity securities involving securitized financial assets - primarily asset-backed and commercial mortgage-backed securities in the Company's portfolio - the underlying collateral cash flows are stress tested to determine if there has been any adverse change in the expected future cash flows.
Judgments regarding whether a corporate fixed maturity security is other-than-temporarily impaired include analyzing the issuer's financial condition and whether there has been a decline in the issuer's ability to service the specific security. The analysis of the security issuer is based on asset coverage, cash flow multiples or other industry standards. Several factors assessed include, but are not limited to, credit quality ratings, cash flow sustainability, liquidity, financial strength, industry and market position. Sources of information include, but are not limited to, management projections, independent consultants, external analysts' research, peer analysis and the Company's internal analysis.
If the Company has concerns regarding the viability of the issuer or its ability to service the specific security after this assessment, a cash flow analysis is prepared to determine if the present value of future cash flows has declined below the amortized cost basis of the fixed maturity security. This analysis to determine an estimate of ultimate recovery value is combined with the estimated timing to recovery and any other applicable cash flows that are expected to be collected. If a cash flow analysis estimate is not feasible, then the market's view of cash
The Company estimates the amount of the credit loss component of a fixed maturity security impairment as the difference between amortized cost basis and the present value of the expected future cash flows of the security. The present value is determined using the best estimate of cash flows discounted at the effective interest rate implicit to the security at the date of purchase or the current yield to accrete an asset-backed or floating rate security. The methodology and assumptions for establishing the best estimate of cash flows vary depending on the type of security. Corporate fixed maturity security and municipal bond cash flow estimates are derived from scenario-based outcomes of expected restructurings or the disposition of assets using specific facts and other circumstances, including timing, security interests and loss severity and when not reasonably estimable, such securities are impaired to fair value as management's best estimate of the present value of future cash flows.
The cash flow estimates for mortgage-backed and other structured securities are based on security specific facts and circumstances that may include collateral characteristics, expectations of delinquency and default rates, loss severity and prepayment speeds, and structural support, including subordination and guarantees.
DAC consists of commissions, policy issuance and other costs which are incremental and directly related to the successful acquisition of new or renewal business, which are deferred and amortized on a basis consistent with the type of insurance coverage. For property and casualty policies, DAC is amortized over the terms of the insurance policies (6 or 12 months). For supplemental policies, DAC is amortized in proportion to anticipated premiums over the terms of the insurance policies (approximately 6 years, based on an estimated average duration across all supplemental products). For all investment (annuity) contracts, DAC is amortized over 20 years in proportion to estimated gross profits. DAC is amortized in proportion to estimated gross profits over 20 years for certain life insurance products with account values and over 30 years for indexed universal life (IUL) products. For other individual life contracts, DAC is amortized in proportion to anticipated premiums over the terms of the insurance policies (10, 15, 20, 30 years).
The most significant assumptions that are involved in the estimation of supplemental gross profits include morbidity, persistency, expenses and interest rates expected to be received on investments. When a supplemental policy lapses, there is an immediate write down of the associated DAC. The impact on amortization due to assumption changes has an immaterial impact on the results of operations.
Annually, the Company performs a gross premium valuation on life insurance and supplemental policies to assess whether a loss recognition event has occurred. This involves discounting expected future benefits and expenses less expected future premiums. To the extent that this amount is greater than the liability for future benefits less the DAC asset, in aggregate for the life insurance or the supplemental block, a loss would be recognized by first writing off the DAC and then increasing the liability.
The Company accounts for the value of distribution acquired (VODA) associated with the acquisition of NTA based on an actuarial estimate of the present value of future business to be written by the existing distribution channel. VODA was $47.5 million as of December 31, 2019 and is being amortized on a straight-line basis. The Company estimates that it will recognize VODA amortization of $2.9 million in each of the years 2020 through 2024, respectively.
The Company accounts for VODA associated with the acquisition of Benefit Consultants Group, Inc. (BCG) based on management's estimate of the present value of future business to be written by the existing distribution channel. VODA was $4.6 million as of December 31, 2019 and is being amortized based on the present value of future profits to be received. The Company estimates that it will recognize VODA amortization of $0.4 million in each of the years 2020 through 2024, respectively.
Intangible assets that are not subject to amortization (i.e., trade names and state licenses) are tested for impairment annually or more frequently if events or changes in circumstances indicate that the asset might be impaired. The impairment test consists of a comparison of the fair value of an intangible asset with its carrying value. If the carrying value of an intangible asset that is not subject to amortization exceeds its fair value, an impairment loss is to be recognized in an amount equal to that excess.
As of October 1, 2019, the Company performed a qualitative assessment to determine whether it was necessary to perform a quantitative goodwill impairment test. Based on the assessment of qualitative factors, there were no events or circumstances that lead to a determination that it is more likely than not that the fair value of a reporting unit is less than its carrying value.
A guaranteed minimum death benefit (GMDB) generally provides an additional benefit if the contractholder dies and the variable annuity contract value is less than a contractually defined amount. The Company has estimated and recorded a GMDB reserve on variable annuity contracts in accordance with GAAP. Contractually defined amounts vary from contract to contract based on the date the contract was entered into as well as the GMDB feature elected by the contractholder. The Company regularly monitors the GMDB reserve considering fluctuations in financial markets. The Company has a relatively low exposure to GMDB risk as shown below.
The Company elected to not use hedge accounting for derivative transactions related to the FIA products. As a result, the Company accounts for the purchased call options and the embedded derivative related to the provision of a contingent return at fair value, with changes in fair value recognized as Net investment gains (losses) in the Consolidated Statements of Operations. The embedded derivative is bifurcated from the host contract and included in Other policyholder funds in the Consolidated Balance Sheets. The host contract is accounted for as a debt instrument in accordance with GAAP and is included in Investment contract and life policy reserves in the Consolidated Balance Sheets with any discount to the minimum account value being accreted using the effective yield method. In the Consolidated Statements of Operations, accreted interest for FIA products and benefit claims on these products incurred during the reporting period are included in Benefits, claims and settlement expenses.
The Company offers indexed universal life (IUL) products as part of its product portfolio with interest crediting strategies linked to the S&P 500 Index and the DJIA as well as a fixed option. The Company purchases call options monthly to economically hedge the potential liabilities arising in IUL accounts. The Company elected to not use hedge accounting for derivative transactions related to the IUL products. As a result, the Company records the purchased call options and the embedded derivative related to the provision of a contingent return at fair value, with changes in fair value reported in Net investment gains (losses) in the Consolidated Statements of Operations. IUL policies with a balance in one or more indexed accounts are considered to have an embedded derivative. The benefit reserve for the host contract is measured using the retrospective deposit method, which for Horace Mann's IUL product is equal to the account balance. The embedded derivative is bifurcated from the host contract, carried at fair value, and included in Investment contract and life policy reserves in the Consolidated Balance Sheets.
Liabilities for Property and Casualty unpaid claims and claim expenses include provisions for payments to be made on reported claims, claims incurred but not yet reported (IBNR) and associated settlement expenses. All of the Company's reserves for Property and Casualty unpaid claims and claim expenses are carried at the full value of estimated liabilities and are not discounted for interest expected to be earned on reserves. Estimated amounts
Other policyholder funds includes payout annuity contracts without life contingencies and dividend accumulations, as well as balances outstanding under funding agreements with FHLB and embedded derivatives related to FIA products. Except for embedded derivatives, each of these components is carried at cost. Embedded derivatives are carried at fair value. Amounts received and repaid under FHLB funding agreements are classified as financing activities in the Company's Consolidated Statements of Cash Flows combined with annuity contract deposits and disbursements, respectively.
If the Company determines that a reinsurance agreement exposes the reinsurer to a reasonable possibility of a significant loss from insurance risk, the ceded unearned premiums and reinsurance balances recoverable on paid and unpaid losses and settlement expenses are reported separately as assets, instead of being netted with the related liabilities, since reinsurance does not relieve the Company of its legal liability to its policyholders. See Note 9 for further details.
period. Contract deposits to investment contracts and life insurance contracts with account values represent funds deposited by policyholders and are not included in the Company's premiums or contract charges earned.
In 2019, 2018 and 2017, the Company granted stock options as quantified in the table below, which also provides the weighted average grant date fair value for stock options granted in each year. The fair value of stock options granted was estimated on the respective dates of grant using the Black-Scholes option pricing model with the weighted average assumptions shown in the following table.
The Company uses the asset and liability method for calculating deferred federal income taxes. Income tax provisions are generally based on income reported for financial statement purposes. The provisions for federal income taxes for the years ended December 31, 2019, 2018 and 2017 included amounts currently payable and deferred income taxes resulting from the cumulative differences in the Company's assets and liabilities, determined on a tax return versus financial statement basis.
Basic earnings per share is computed based on the weighted average number of common shares outstanding plus the weighted average number of fully vested RSUs and common stock units (CSUs) payable as shares of HMEC common stock. Diluted earnings per share is computed based on the weighted average number of common shares and common stock equivalents outstanding, to the extent dilutive. The Company's common stock equivalents relate to outstanding common stock options, deferred compensation CSUs and incentive compensation RSUs, which are described in Note 13.
Options to purchase 622,500 shares of common stock at $38.05 to $44.75 per share were granted in 2017, 2018 and 2019 but were not included in the computation of 2019 diluted earnings per share because of their anti-dilutive effect. These options, which expire in 2027, 2028 and 2029, were still outstanding at December 31, 2019.
Comprehensive income (loss) represents the change in shareholders' equity during a reporting period from transactions and other events and circumstances from non-shareholder sources. For the Company, comprehensive income (loss) is equal to net income plus or minus the after tax change in net unrealized investment gains (losses) on securities and the after tax change in net funded status of benefit plans for the periods as shown in the Consolidated Statements of Changes in Shareholders' Equity. AOCI represents the accumulated change in shareholders' equity from these transactions and other events and circumstances from non-shareholder sources as shown in the Consolidated Balance Sheets.
The pretax amounts reclassified from AOCI, $157.4 million, $(16.4) million and $(4.9) million, are included in net investment gains (losses) and the related tax expenses, $33.1 million, $(3.4) million and $(1.7) million, are included in income tax expense in the Consolidated Statements of Operations for the years ended December 31, 2019, 2018 and 2017, respectively.
For purposes of the Consolidated Statements of Cash Flows, cash constitutes cash on deposit at banks as well as restricted cash. See Note 17 for further information.
In June 2016 , the FASB issued guidance which revises the credit loss recognition criteria for certain financial assets measured at amortized cost, including reinsurance recoverables. The new guidance replaces the existing incurred loss recognition model with an expected loss recognition model. The objective of the expected credit loss model is for a reporting entity to recognize its estimate of expected credit losses for affected financial assets in a valuation allowance that when deducted from the amortized cost basis of the related financial assets results in a net carrying value at the amount expected to be collected. A reporting entity must consider all relevant information available when estimating expected credit losses, including details about past events, current conditions, and reasonable and supportable forecasts over the life of an asset. Financial assets may be evaluated individually or on a pooled basis when they share similar risk characteristics. The measurement of credit losses for available-for-sale debt securities measured at fair value is not affected except that credit losses recognized are limited to the amount by which fair value is below amortized cost and the carrying value adjustment is recognized through a valuation allowance which may change over time but once recorded cannot subsequently be reduced to an amount below zero. The guidance is effective for reporting periods beginning after December 15, 2019, and for most affected instruments must be adopted using a modified retrospective approach, with a cumulative effect adjustment recorded to beginning retained earnings.
The Company’s implementation activities are substantially complete and the impacts relate primarily to the Company’s commercial mortgage portfolio, property and casualty reinsurance recoverables and off-balance-sheet credit exposures for unfunded commercial mortgage loan commitments. The Company adopted the new guidance on January 1, 2020 and recognized a cumulative effect adjustment that decreased retained earnings by an insignificant amount.
In August 2018, the FASB issued accounting and disclosure guidance that contains targeted improvements to the accounting for long-duration insurance contracts. Under the new guidance, the cash flow assumptions used to measure the liability for future policy benefits for traditional insurance contracts will be required to be updated at least annually with changes recognized as a benefit expense (i.e., assumptions will no longer be locked-in). Insurance entities will be required to use a standard discount rate to measure the liabilities that will be equivalent to the yield from a high-quality bond. The new guidance also changes the amortization of DAC to be on a constant-level basis over the expected term of the related contracts with no interest accruing on the DAC balance. The new guidance also introduces a new category of contract features associated with deposit type contracts referred to as market risk benefits (MRBs). Contract features meeting the definition of a MRB will be measured at fair value. New disclosures will be required for long-duration insurance contracts in order to provide better transparency into the exposure of insurance entities and the drivers of their results. For public business
On January 2, 2019, the Company acquired all of the equity interests in BCG for a total purchase consideration of $25.0 million. BCG provides advisory and benefit plan record keeping services. BCG's results are reported in Retirement. The acquisition of BCG resulted in the recognition of intangible assets of $16.2 million and goodwill of $10.1 million as a result of the purchase accounting. The intangible assets that are amortizable have lives of 10 to 16 years. See Note 7 for further information. The amount of goodwill that is expected to be deductible for federal income tax purposes is $10.1 million.
On July 1, 2019, the Company acquired all the equity interests in NTA pursuant to a Purchase Agreement (Agreement) dated as of December 10, 2018. The purchase price of the transaction was $425.9 million which includes $20.9 million representing NTA's share of "adjusted earnings" (as determined in accordance with the terms of the Agreement) from July 1, 2018 to July 1, 2019. As a result of the acquisition, NTA became a wholly owned subsidiary of the Company. NTA provides supplemental insurance products (primarily heart, cancer, accident and limited short-term supplemental disability coverages) primarily within the public sector for which approximately 80% are individuals employed by educational institutions, with the remainder employed in state and local governments and emergency services facilities. NTA's results are being reported in a newly created reporting segment titled "Supplemental".
The unaudited pro forma basic and diluted net income per share calculations are based on the Company's historical basic and diluted weighted average number of shares outstanding for the years ended December 31, 2019 and 2018, respectively.
The following table reconciles net investment gains (losses) by transaction type:
Effective January 1, 2018, with the adoption of new accounting guidance for recognition and measurement of financial instruments, equity securities are reported at fair value with changes in fair value recognized in Net investment gains (losses) and are no longer included in impairment write-downs or change in intent write-downs.
Fair value includes securities issued by Federal National Mortgage Association (FNMA) of $405.1 million and $441.3 million; Federal Home Loan Mortgage Corporation (FHLMC) of $283.1 million and $417.3 million; and Government National Mortgage Association (GNMA) of $147.4 million and $96.5 million as of December 31, 2019 and 2018, respectively.
Fixed maturity securities with an investment grade rating represented 93.9% of the gross unrealized losses as of December 31, 2019. With respect to fixed maturity securities involving securitized financial assets, the underlying collateral cash flows were stress tested to determine there was no adverse change in the present value of cash flows below the amortized cost basis.
The following table presents the distribution of the Company's fixed maturity securities portfolio by estimated expected maturity. Estimated expected maturities differ from contractual maturities, reflecting assumptions regarding borrowers' utilization of the right to call or prepay obligations with or without call or prepayment penalties. For structured securities, including mortgage-backed securities and other asset-backed securities, estimated expected maturities consider broker-dealer survey prepayment assumptions and are verified for consistency with the interest rate and economic environments.
Proceeds received from sales of fixed maturity and equity securities, each determined using the specific identification method, and gross gains and gross losses realized as a result of those sales for each year were:
Gross gains realized presented above include a $135.3 million realized investment gain associated with a transfer of investments to a reinsurer as consideration paid during the second quarter of 2019 in connection with the reinsurance of a $2.9 billion block of in force fixed and variable annuity business. See Notes 6 and 17 for further information.
As of December 31, 2019 and 2018, the carrying value of equity method limited partnerships totaled $383.7 million and $328.5 million, respectively. Principal factors influencing carrying value appreciation or decline include operating performance, comparable public company earnings multiples, capitalization rates and the economic environment. The Company recognizes an impairment loss for equity method limited partnerships when evidence demonstrates that the loss is other than temporary. Evidence of a loss in value that is other than temporary may include the absence of an ability to recover the carrying amount of the investment or the inability of the investee to sustain a level of earnings that would justify the carrying amount of the investment.
At December 31, 2019 and 2018, there were no investments which exceeded 10% of total shareholders' equity in entities other than obligations of the U.S. Government and federally sponsored government agencies and authorities.
The Company's derivatives (call options) are subject to enforceable master netting arrangements. Collateral support agreements associated with each master netting arrangement provide that the Company will receive or pledge cash collateral in the event minimum thresholds have been reached.
Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. Level 3 assets and liabilities include financial instruments whose value is determined using pricing models, certain discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation and for which the significant inputs are unobservable. This category generally includes certain private debt and equity investments, as well as embedded derivatives.
When the inputs used to measure fair value fall within different levels of the hierarchy, the level within which the fair value measurement is categorized is based on the lowest level input that is significant to the fair value measurement in its entirety. As a result, a Level 3 fair value measurement may include inputs that are observable (Level 1 or Level 2) and unobservable (Level 3). Net transfers into or out of each of the three levels are reported as having occurred at the end of the reporting period in which the transfers were determined.
FHLB membership and activity stocks - Fair value is based on redemption value, which is equal to par value.
The following table presents the Company's fair value hierarchy for those assets and liabilities measured and carried at fair value on a recurring basis. At December 31, 2019, Level 3 investments comprised approximately 4.8% of the Company's total investment portfolio at fair value.
Separate Account (variable annuity) assets represent contractholder funds invested in various actively traded mutual funds that have daily quoted net asset values that are readily determinable for identical assets that the Company can access. Separate Account (variable annuity) liabilities are equal to the estimated fair value of Separate Account (variable annuity) assets.
Other investments includes policy loans and mortgage loans. For policy loans, fair value is based on estimates using discounted cash flow analysis and current interest rates being offered for new loans. For mortgage loans, fair value is estimated by discounting the future cash flows using current rates at which similar loans would be made to borrowers with similar credit ratings and similar remaining maturities.
The fair value of the embedded derivatives related to FIA products is estimated at each reporting date by (1) projecting policy contract values and minimum guaranteed contract values over the expected lives of the contracts and (2) discounting the excess of the projected contract value amounts at the applicable risk free interest rates adjusted for the Company's nonperformance risk related to those liabilities. The projections of policy contract values are based on the Company's best estimate assumptions for future contract growth and decrements. The assumptions for future contract growth include the expected index credits which are derived from the fair values of the underlying call options purchased to fund such index credits and the expected costs of annual call options that will be purchased in the future to fund index credits beyond the next contract anniversary. Projections of minimum guaranteed contract values include the same best estimate assumptions for contract decrements used to project policy contract values.
The Company offers FIA products, which are deferred fixed annuities that guarantee the return of principal to the contractholder and credit interest based on a percentage of the gain in a specified market index. The Company also offers IUL products which credit interest based on a percentage of the gain in a specified market index. When deposits are received for FIA and IUL contracts, a portion is used to purchase derivatives consisting of call options on the applicable market indices to fund the index credits due to FIA and IUL policyholders. For the Company, substantially all such call options are one-year options purchased to match the funding requirements of the underlying contracts. The call options are carried at fair value with changes in fair value included in Net investment gains (losses), a component of revenues, in the Consolidated Statements of Operations.
The Company carries all derivatives at fair value in the Consolidated Balance Sheets. The Company elected to not use hedge accounting for derivative transactions related to the FIA and IUL products. As a result, the Company recognizes the purchased call options and the embedded derivatives related to the provision of a contingent return at fair value, with changes in the fair value of the derivatives recognized immediately as Net investment gains (losses) in the Consolidated Statements of Operations. The fair values of derivatives, including derivatives embedded in FIA and IUL contracts, are presented in the Consolidated Balance Sheets as follows:
The Company's strategy attempts to mitigate potential risk of loss under these agreements through a regular monitoring process, which evaluates the program's effectiveness. The Company is exposed to risk of loss in the event of nonperformance by the counterparties and, accordingly, option contracts are purchased from multiple counterparties, which are evaluated for creditworthiness prior to purchase of the contracts. All of these options have been purchased from nationally recognized financial institutions with a S&P/Moody's Investors Service, Inc. (Moody's) long-term credit rating of "BBB+/A3" or higher at the time of purchase and the maximum credit exposure to any single counterparty is subject to concentration limits. The Company also obtains credit support agreements that allow it to request the counterparty to provide cash collateral when the fair value of the exposure to the counterparty exceeds specified amounts.
As of December 31, 2019 and 2018, the Company held $14.3 million and $1.9 million, respectively, of cash and securities received from counterparties for derivative collateral, which is included in Other liabilities on the Consolidated Balance Sheets. This derivative collateral limits the Company's maximum amount of economic loss due to credit risk that would be incurred if parties to the call options failed completely to perform according to the terms of the contracts to $0.3 million per counterparty.
The changes in the carrying amount of goodwill by reportable segment for the year ended December 31, 2019 were as follows:
In regard to the definite-lived intangible assets in the table above, the VOBA intangible asset represents the difference between the fair value of insurance contracts and insurance policy reserves measured in accordance with the Company's accounting policies for insurance contracts acquired. VOBA was based on an actuarial estimate of the present value of future distributable earnings for insurance in force as of the acquisition date. The VODA intangible asset represents the present value of future business to be written by the existing distribution channel. The value of agency relationships intangible asset represents the present value of the commission overrides retained by NTA. The value of customer relationships intangible asset represents the present value of the expected profits from existing BCG customers in force at the date of acquisition. All of the aforementioned definite-lived intangible assets were valued using the income approach.
The trade names intangible asset represents the present value of future savings accruing NTA and BCG by virtue of not having to pay royalties for the use of the trade names, valued using the relief from royalty method. The state licenses intangible asset represents the regulatory licenses held by NTA that were valued using the cost approach.
Unpaid claims and claim expenses as reported in the Consolidated Balance Sheets also include reserves for Supplemental, Retirement and Life of $55.9 million, $29.5 million and $28.6 million as of December 31, 2019, 2018 and 2017, respectively, in addition to Property and Casualty reserves.
The Company continually updates loss estimates using both quantitative and qualitative information from its reserving actuaries and information derived from other sources. Adjustments may be required as information develops which varies from experience, or, in some cases, augments data which previously were not considered sufficient for use in determining liabilities. The effects of these adjustments may be significant and are charged or credited to income in the period in which the adjustments are made.
a product line. Individual risk factors are also subject to interactions with other risk factors within product line coverages.
Based on the Company's products and coverages, historical experience, and various actuarial methodologies used to develop reserve estimates, the Company estimates that the potential variability of the Property and Casualty loss reserves within a reasonable probability of other possible outcomes may be approximately plus or minus 6.0% of reserves, which equates to plus or minus approximately $13.0 million of net income as of December 31, 2019. Although this evaluation reflects the most likely outcomes, it is possible the final outcome may fall below or above these estimates.
At the time each of the reserve analyses was performed, the Company believed that each estimate was based upon sound methodology and such methodologies were appropriately applied and that there were no trends which indicated the likelihood of future loss reserve development. The financial impact of the net reserve development was therefore accounted for in the period that the development was determined.
NOTE 8 - Property and Casualty Unpaid Claims and Claim Expenses (continued)
The total amounts of reinsurance recoverable on unpaid insurance reserves classified as assets and reported in Other assets in the Consolidated Balance Sheets were as follows:
The Company maintains catastrophe excess of loss reinsurance coverage. For 2019, the Company's catastrophe excess of loss coverage consisted of one contract in addition to a minimal amount of coverage by the Florida Hurricane Catastrophe Fund (FHCF). The catastrophe excess of loss contract provided 95% coverage for catastrophe losses above a retention of $25.0 million per occurrence up to $175.0 million per occurrence. This contract consisted of three layers, each of which provided for one mandatory reinstatement. The layers were $25.0 million excess of $25.0 million, $40.0 million excess of $50.0 million and $85.0 million excess of $90.0 million.
The maximum individual life insurance risk retained by the Company is $0.5 million on any individual life, while either $0.1 million or $0.125 million is retained on each group life policy depending on the type of coverage. Excess amounts are reinsured. The Company also maintains a life catastrophe reinsurance program. For 2019, the Company reinsured 100% of the catastrophe risk in excess of $1.0 million up to $35.0 million per occurrence, with one reinstatement. The Company's life catastrophe risk reinsurance program covers acts of terrorism and includes nuclear, biological and chemical explosions but excludes other acts of war.
The Company designates debt obligations as "long-term" based on maturity date at issuance.
In 2017, Horace Mann Insurance Company (HMIC) became a member of the FHLB, which provides HMIC with access to collateralized borrowings and other FHLB products. As membership requires the ownership of membership stock, in June 2017, HMIC purchased common stock to meet the membership requirement. Any borrowing from the FHLB requires the purchase of FHLB activity-based common stock in an amount equal to 4.5% of the borrowing, or a lower percentage - such as 2.0% based on the Reduced Capitalization Advance Program. In the fourth quarter of 2017, HMIC purchased common stock to meet the activity-based requirement. In 2019, the Board authorized a maximum amount equal to 15% of net aggregate admitted assets less separate account assets of the insurance subsidiaries for FHLB borrowings. During the fourth quarter of 2017, the Company received $50.0 million in executed borrowings for HMIC. Of the total $50.0 million received, $25.0 million matures on October 5, 2022 and $25.0 million matures on December 2, 2022. Interest on the borrowings accrues at an annual weighted average rate of 1.99% as of December 31, 2019. HMIC's FHLB borrowings of $50.0 million are included in Long-term debt in the Consolidated Balance Sheets.
Income tax expense for the following periods differed from the expected tax computed by applying the federal corporate tax rate of 21% for 2019 and 2018 and 35% for 2017 to income before income taxes as follows:
A reconciliation of the beginning and ending amounts of unrecognized tax benefits, excluding interest and penalties, is as follows:
Interest and penalties were both immaterial in each of the years ended December 31, 2019, 2018 and 2017.
Future minimum lease payments under non-cancellable operating leases as of December 31, 2019 are as follows:
As of December 31, 2019, the Company has no additional operating leases that have not yet commenced.
In 1996, the shareholders of HMEC approved authorization of 1,000,000 shares of $0.001 par value preferred stock. The Board is authorized to (1) direct the issuance of the preferred stock in one or more series, (2) fix the dividend rate, conversion or exchange rights, redemption price and liquidation preference, of any series of the preferred stock, (3) fix the number of shares for any series and (4) increase or decrease the number of shares of any series. No shares of preferred stock were issued or outstanding at December 31, 2019 and 2018.
Comprehensive Plan which included an increase of 3,250,000 in the number of shares of common stock reserved for issuance under the Comprehensive Plan. As of December 31, 2019, approximately 1,187,200 shares were available for grant under the Comprehensive Plan. Shares of common stock issued under the Comprehensive Plan may be either authorized and unissued shares of HMEC or shares that have been reacquired by HMEC; however, new shares have been issued historically.
As further described in the paragraphs below, CSUs, stock options and RSUs under the Comprehensive Plan were as follows:
Options to purchase shares of HMEC common stock may be granted to executive officers, other employees and Directors. The options become exercisable in installments based on service generally beginning in the first year from the date of grant and generally become fully vested 4 years from the date of grant. The options generally expire 7 to 10 years from the date of grant. The exercise price of the option is equal to the market price of HMEC's common stock on the date of grant resulting in a grant date intrinsic value of $0.
The insurance departments of various states in which the insurance subsidiaries of HMEC are domiciled recognize as net income and surplus those amounts determined in conformity with statutory accounting principles prescribed or permitted by the insurance departments, which differ in certain respects from GAAP.
The NAIC has risk-based capital guidelines to evaluate the adequacy of statutory capital and surplus in relation to risks assumed in investments, reserving policies, and volume and types of insurance business written. At December 31, 2019 and 2018, the minimum statutory-basis capital and surplus required to be maintained by HMEC's insurance subsidiaries was $108.1 million and $108.5 million, respectively. At December 31, 2019 and 2018, statutory capital and surplus of each of the Company's insurance subsidiaries was above required levels. The restricted net assets of HMEC's insurance subsidiaries were $26.0 million and $17.7 million as of December 31, 2019 and 2018, respectively. The minimum statutory basis capital and surplus amount at each date is the total estimated authorized control level risk-based capital for all of HMEC's insurance subsidiaries combined. Authorized control level risk-based capital represents the minimum level of statutory basis capital and surplus necessary before the insurance commissioner in the respective state of domicile is authorized to take whatever regulatory actions considered necessary to protect the best interests of the policyholders and creditors of the insurer. The amount of restricted net assets represents the combined fair value of securities on deposit with governmental agencies for the insurance subsidiaries as required by law in various states in which the insurance subsidiaries of HMEC conduct business.
As disclosed in the reconciliation of the statutory capital and surplus of insurance subsidiaries to the consolidated GAAP shareholders' equity, the insurance subsidiaries have statutory capital and surplus of $868.8 million as of December 31, 2019, which is subject to regulatory restrictions.
All employees participate in the 401(k) plan and receive a 100% vested 3% "safe harbor" company contribution based on employees' eligible earnings. The Company matches each dollar of employee contributions up to a 5% maximum - in addition to maintaining the automatic 3% "safe harbor" contribution. The matching company contribution vests after 5 years of service. The 401(k) plan is fully funded.
Total expense recorded for the non-qualified defined contribution, 401(k), defined benefit and supplemental retirement plans was $9.3 million, $8.9 million and $9.1 million for the years ended December 31, 2019, 2018 and 2017, respectively.
The following tables summarize the funded status of the defined benefit and supplemental retirement pension plans as of December 31, 2019, 2018 and 2017 (the measurement dates) and identify (1) the assumptions used to determine the projected benefit obligation and (2) the components of net pension cost for the defined benefit plan and supplemental retirement plans for the following periods:
The Company has an investment policy for the defined benefit pension plan that aligns the assets within the plan's trust to an approximate allocation of 50% equity and 50% fixed income funds. Management believes this allocation will produce the targeted long-term rate of return on assets necessary for payment of future benefit obligations, while providing adequate liquidity for payments to current beneficiaries. Assets are reviewed against the defined benefit pension plan's investment policy and the trustee has been directed to adjust invested assets at least quarterly to maintain the target allocation percentages.
There were no Level 3 assets held during the years ended December 31, 2019 and 2018.
In 2020, the Company expects amortization of net losses of $0.3 million and $0.3 million for the defined benefit plan and the supplemental retirement plans, respectively, and expects no amortization of prior service cost for the supplemental retirement plans to be included in net periodic pension expense.
In 2020, there is no minimum funding requirement for the Company's defined benefit plan. The following table discloses that minimum funding requirement and the expected full year contributions for the Company's plans.
(1) HMEC's Annual Report on Form 10-K for the year ended December 31, 2019.
The Company's defined benefit plan may be subject to settlement accounting. Assumptions for both the number of individuals retiring in a calendar year and their elections regarding lump sum distributions are significant factors impacting the payout patterns for each of the plans below. Therefore, actual results could vary from the estimates shown. Estimated future benefit payments as of December 31, 2019 were as follows:
From time to time, the Company has outstanding commitments to fund investments in limited partnership interests, commercial mortgage loans and bank loans. Such unfunded commitments were $306.2 million and $145.4 million for the years ended December 31, 2019 and 2018, respectively.
See Note 2 for more information regarding the acquisition of NTA on July 1, 2019.
For the three months ended December 31, 2017, net income per basic share of $3.03 and net income per diluted share of $3.00 benefited $2.39 and $2.37, respectively, from TCJA.