The Company occupies two connected buildings totaling approximately 901,000 square feet in Chattanooga, Tennessee. The office buildings and substantially all of the surrounding 23 acres of land used for employee parking are owned by the Company, including an employee parking garage and a 27-unit apartment building for corporate use. In addition, approximately 171,000 square feet of office space is leased and occupied in a nearby office building.
The Company owns and occupies five facilities in Portland, Maine, with approximately 838,000 square feet of office space and 250 acres of land, a portion of which has been developed for employee parking. In addition, approximately 169,000 square feet of office space is leased and occupied in two additional buildings.
The Company also owns office buildings in the United Kingdom which serve as the home offices of Unum Limited. The property in the United Kingdom is located in Dorking, with approximately 67,000 square feet of office space located on approximately 60 acres with a portion developed for employee parking. In addition, approximately 49,000 square feet of office space is leased and occupied in two office buildings located in Bristol and Basingstoke and another 11,000 square feet of leased office space serves five major city locations in England and Scotland.
(3) The Company adopted the provisions of Statement of Financial Accounting Standards No. 142 (SFAS 142), Goodwill and Other Intangible Assets effective January 1, 2002. Prior to January 1, 2002, goodwill was amortized on a straight-line basis over a period not to exceed 40 years. Had amortization of goodwill been excluded from expenses for the years ended December 31, 2001 and 2000, net income would have been $561.5 million and $560.3 million, respectively, and net income per common share assuming dilution would have been $2.30 and $2.31, respectively.
The Company also reported strong statutory results in 2004. The Company’s U.S. insurance subsidiaries’ statutory combined net gain from operations was $662.1 million in 2004 compared to $214.8 million in 2003 and $220.7 million in 2002, and statutory combined net income, which includes realized net investment gains and losses, was $607.6 million in 2004, compared to $22.7 million for 2003 and a loss of $209.7 million for 2002.
Described below are the significant challenges which the Company faced during 2004.
Stabilizing or improving the Company’s existing debt and financial strength ratings and improving external perception surrounding the strength of the Company’s balance sheet and the adequacy of the capitalization of the Company;
In its U.S. group income protection business, the Company implemented targeted rate increases to specific cases and market segments which were not meeting profit expectations, adjusted its business plan to improve the balance in its sales mix by case size, and increased the focus on the profitability of new sales.
Regarding sales, the Company believes that while lower than desired for the long-term, the results for 2004 were appropriate in the short-term given the Company’s disciplined approach to pricing in the current competitive environment and due to the Company’s continued shift to focus on the small and mid-employer market to restore a more balanced mix of business. Also, the Company believes that while negatively impacting the Colonial segment’s sales during 2004, the changes it implemented during 2004 will strengthen future sales for that segment.
The Company proactively met with customers, brokers, and the rating agencies during 2004 to discuss rating agency actions and the Company’s improved financial position and performance. Additionally, during 2004 and 2003 the Company improved its consolidated risk-based capital position for its U.S. insurance subsidiaries and believes it has met or exceeded financial measures provided by its primary rating agency for maintenance of the Company’s ratings. See “Ratings” contained herein in Item 7 for discussion of ratings and financial measures used by the rating agencies. During 2004, the Company improved its overall balance sheet strength through the combined 2004 and 2003 equity and equity-related securities offerings of $1.450 billion, the strengthening of existing claim reserves for its group income protection business, the reduction in the Company’s holdings in below-investment-grade securities, and the sale or reinsurance of several non-core businesses and product lines. The Company also completed comprehensive scenario testing of its deferred policy acquisition costs during 2004 and believes the asset to be fully recoverable.
Rebuilding U.S. Brokerage profitable sales momentum in the marketplace and effectively managing persistency of the existing block of business;
Focusing on operational excellence, continuous improvement, and process innovation while aggressively managing expenses;
a reassessment process for claimants of certain previously denied or closed claims who elect to participate;
additional corporate and board governance to support the oversight of the reassessment process and general claims handling practices; and
In the fourth quarter of 2004, the Company recorded a charge of $127.0 million, before tax, or $87.8 million, after tax, comprised of four elements: $27.5 million of incremental direct operating expenses to conduct the two-year reassessment process; $44.0 million for benefit costs and reserves from claims reopened from the reassessment; $40.5 million for additional benefit costs and reserves for claims already incurred and currently in inventory that are anticipated as a result of the claim process changes being implemented; and the $15.0 million fine. The charge decreased before-tax operating results for group income protection, individual income protection - recently issued, and individual income protection - closed block $116.7 million, $1.7 million, and $8.6 million, respectively. The ongoing costs of changes in the claims handling process and governance improvements will be included in the Company’s operating expenses as incurred going forward. These ongoing costs are not anticipated to materially affect the Company’s results of operations.
The insurance commissioners of Maine, Massachusetts, and Tennessee, the states in which the Company’s three principal insurance subsidiaries are domiciled, began the multistate targeted market conduct examination in September 2003 and, as the lead state regulators, directed the course of the exam. The Company also has an insurance subsidiary domiciled in New York, but New York had been proceeding separately with its market conduct examination prior to commencement of the multistate examination. It became a participating state and also entered into a substantially identical settlement agreement covering the subsidiary domiciled in New York. The purpose of the examination was to determine whether the long-term disability claims handling practices of the Company’s insurance subsidiaries reflected unfair claim settlement practices. Examiners working under the direction of the three lead state regulators reviewed policy forms, manuals, and administration and organization charts, but primarily focused on reviewing individual or group long-term claim files closed, appealed, or open during two time periods from 2002 to early 2004. The claim file review led to discussions with the Company that resulted in the settlement agreements.
A principal feature of the settlement agreements is a reassessment process. Under the agreements, the Company is offering to reassess any individual or group long-term disability claim that was denied or closed since January 1, 2000, except for specific categories of closures such as settlement, death, or payment of maximum benefits. The potential pool of claims decided over the nearly five year period that are eligible for reassessment if the claimant elects to participate is approximately 215,000 claims. However, almost half of these claims are subject to a preliminary determination as to whether the claimant seeking reassessment “returned to work” under the policy, in which case the claim is not eligible for further reassessment. The Company will also accept requests for
The agreements will remain in place until the later of January 1, 2007, or the completion of an examination of claims handling practices and an examination of the reassessment process, both of which will be conducted by the lead state regulators. In addition to the fine of $15.0 million, the insurance subsidiaries that are parties to the settlement agreements are subject as a group to potential fines for non-compliance with the settlement agreements, including contingent fines of $100,000 per day if certain implementation deadlines are not met and a contingent fine of $145.0 million for failure to satisfactorily meet the performance standards in the settlement agreements relating to the examinations referred to above, which will be conducted in approximately two years. This latter contingent fine relating to examination of the claims handling practices or the reassessment process is limited to a maximum of $145.0 million for both examinations should the performance standards not be met. The performance standard is based on compliance with a maximum tolerance standard for claims procedures based on review of a statistically credible random sample of individual or group claims. The Company believes that the changes it has made and will be making to its claims operations and to enhance its oversight functions will substantially reduce the likelihood that the Company would fail to meet the performance standards in the agreements when these examinations are concluded.
Arizona, California, Minnesota, and New Mexico participated in the multistate examination; however, while the multistate examination was in progress those states chose to continue pursuing their own market conduct examinations and investigations, each of which had begun prior to the beginning of the multistate examination. The Company reached agreement with the Minnesota Department of Commerce covering three exam periods dating from 1995 and involving three of the Company’s insurance subsidiaries, which have agreed to pay a penalty totaling $250,000 relating to various matters outside the general scope of the multistate examination. Minnesota joined the multistate settlement agreements. California has conducted an examination with two phases and an investigation relating to claims handling. California chose not to join the multistate settlement agreements, and discussions with the California Department of Insurance have been ongoing relating to various issues, some of which are within the general scope of the multistate examination and others that are outside its scope and relate to California specific issues. Arizona and New Mexico consented to join the multistate settlement agreements. The Company understands that Arizona is in the process of concluding its examination that will focus on non-claim related matters, and New Mexico may, or may not, continue to pursue its own examination which was begun prior to the multistate examination.
In the first quarter of 2004, the Company restructured its individual income protection - closed block business wherein three of its insurance subsidiaries entered into reinsurance agreements to reinsure approximately 66.7 percent of potential future losses that occur above a specified retention limit. The individual income protection - closed block reserves in these three subsidiaries comprise approximately 90 percent of the Company’s overall retained risk in the closed block of individual income protection. The reinsurance agreements effectively provide approximately 60 percent reinsurance coverage for the Company’s overall consolidated risk above the retention limit, which equals approximately $8.0 billion in existing statutory reserves. The maximum risk limit for the reinsurer is approximately $783.0 million initially and grows to approximately $2.6 billion over time, after which any further losses will revert to the Company. These reinsurance transactions were effective as of April 1, 2004. The Company transferred cash equal to $521.6 million of reserves ceded in the Individual Income Protection - Closed Block segment plus an additional $185.8 million in cash for a before-tax prepaid cost of insurance which was deferred and will be amortized into earnings over the expected claim payment period covered under the Company’s retention limit. The Company retained the higher yielding investments historically associated with these reserves and redeployed these investments to other lines of business.
In conjunction with the restructuring of the individual income protection - closed block business, effective January 1, 2004, the Company modified its reporting segments to include a separate segment for this business. The reporting, monitoring, and management of the closed block of individual income protection business as a discrete segment is consistent with the Company’s financial restructuring and separation of this business from the lines of business which actively market new products. In the past, this business had been reported in the Income Protection segment. Prior to 2004, detailed separate financial metrics and models were unavailable to appropriately manage this block of business separately from the recently issued individual income protection block of business.
The change in the Company’s reporting segments required the Company to perform, separately for the individual income protection - closed block business and individual income protection - recently issued business, impairment testing for goodwill and loss recognition testing for the recoverability of deferred policy acquisition costs and value of business acquired. As required under GAAP, prior to the change in reporting segments, these tests were performed for the individual income protection line of business on a combined basis. The testing indicated impairment of the individual income protection - closed block deferred policy acquisition costs, value of business acquired, and goodwill balances of $282.2 million, $367.1 million, and $207.1 million, respectively. These impairment charges, $856.4 million before tax and $629.1 million after tax, are included in the results reported for 2004.
Also as part of the restructuring, the Company analyzed the reserve assumptions related to its individual income protection - closed block reserves as a stand-alone segment. Previously these reserves were analyzed for the individual income protection line of business on a combined basis. Included in the analysis was a review of morbidity assumptions, primarily claim resolution rates, and claim reserve discount rate assumptions. Based upon this analysis, the Company lowered the claim reserve discount rate to reflect the segmentation of assets between the individual income protection - recently issued business and the individual income protection - closed block business, the change in the Company’s investment portfolio yield rates during the first quarter of 2004, the Company’s expectation of future investment portfolio yield rates, and the Company’s desire to maintain the relationship between the claim reserve discount rate and the investment portfolio yield rate for the individual income protection - closed block at the Company’s long-term objective. The segmentation of the investment portfolio was necessary to ensure appropriate matching of the duration of the assets and the related policy liabilities. Based on this analysis, in the first quarter of 2004 the Company increased its individual income protection - closed block claim reserves by $110.6 million before tax, or $71.9 million after tax, to reflect its current estimate of future benefit obligations. The first quarter 2004 change represented a 1.2 percent increase in total net individual income protection - closed block reserves as of March 31, 2004, which for continuing operations equaled $9.530 billion prior to this increase.
In May 2004, the Company issued 12.0 million 8.25% adjustable conversion-rate equity security units (units) in a private offering for $300.0 million. The Company subsequently registered the privately placed securities for resale by the private investors. Each unit has a stated amount of $25 and will initially consist of (a) a contract pursuant to which the holder agrees to purchase, for $25, shares of the Company’s common stock on May 15, 2007 and which
Proceeds from the offering were used to restore the Company’s insurance subsidiaries’ risk-based capital to the approximate overall level that existed prior to the individual income protection - closed block reinsurance transaction and to provide additional liquidity at the holding company level.
With the goal of focusing on its core operations, in the first quarter of 2004, the Company sold its Japanese operation, Unum Japan Accident Insurance Co., Ltd. The Company also entered into an agreement with the buyer to reinsure certain existing income protection business and intends to have a continuing presence in these operations for at least one year. The Company wrote down the book value of the Japan operations to the estimated fair value less cost to sell during the fourth quarter of 2003 and at that time recognized an impairment loss of $1.2 million before tax and $0.8 million after tax. The Company also recognized a tax benefit of $6.8 million, for a net after-tax gain of $6.0 million in 2003.
During the second quarter of 2004, the Company completed the sale of its Canadian branch and reported a loss of $70.9 million after tax on the sale. On a statutory basis of reporting, Provident Life and Accident Insurance Company, the Company’s insurance subsidiary which included the Canadian branch business, reported a 2004 gain of $250.6 million after tax on the sale of the branch. Additionally, the transaction resulted in an approximate 158 point improvement in the statutory risk-based capital (RBC) ratio of Provident Life and Accident Insurance Company and an approximate 29 point improvement in the Company’s RBC ratio for its U.S. insurance subsidiaries, calculated on a weighted average basis.
Under the Life Insurance Company Tax Act of 1959, stock life insurance companies were required to maintain a policyholders’ surplus account containing the accumulated portion of income which had not been subjected to income tax in the year earned. The Deficit Reduction Act of 1984 required that no future amounts be added after 1983 to the policyholders’ surplus account and that any future distributions to shareholders from the account would become subject to federal income tax at the general corporate federal income tax rate then in effect. During 2004, the American Jobs Creation Act of 2004 (AJCA) was enacted. The AJCA provides, in part, that distributions from policyholders’ surplus accounts during 2005 and 2006 will not be taxed.
The amount of the policyholders’ surplus accounts of the Company’s life insurance subsidiaries at December 31, 2004, was approximately $228.8 million. Under the AJCA, distributions made during 2005 and 2006 by these life insurance subsidiaries, including dividend distributions, are deemed to occur first from the policyholders’ surplus accounts. As a result, the Company’s life insurance subsidiaries expect to distribute the entire balance of their policyholders’ surplus accounts to the holding company during 2005 and 2006. This will result in the elimination of a future potential tax of approximately $80.1 million. This will also allow the Company to engage in transactions in the future without concern of triggering a tax liability related to distributions from the policyholders’ surplus accounts. No current or deferred federal income taxes have currently been provided on the amounts in the policyholders’ surplus accounts because management considers the conditions under which such taxes would be paid to be remote. Therefore, this provision of the AJCA does not affect the consolidated financial position or results of operations of the Company.
The AJCA also provides for a deduction of 85 percent of certain foreign earnings that are repatriated during 2005, up to $500.0 million. The Company is currently reviewing its ability to take advantage of this provision and has not yet completed its evaluation. The Company expects to complete this evaluation during the first half of 2005. If the Company determines it is feasible to repatriate any amount of foreign earnings under this provision, the repatriation would be expected to positively impact the financial results of the Company in 2005 through reduced tax expense.
During 2004, the Company recognized tax benefits as a result of settlements with the Internal Revenue Service (IRS) of certain tax issues (primarily related to insurance tax reserves and investment losses) affecting the Company’s federal income tax liability related to its 1996 through 1998 tax years. During the fourth quarter of 2004, the Company obtained a judgment in refund litigation for federal income tax paid for tax year 1984, plus interest, and as a result will be entitled to a refund of tax plus interest for all tax years subsequent to tax year 1984 in which the IRS took inconsistent positions on the deductibility of insurance tax reserves that were the subject of the litigation and for which the Company paid tax based on the IRS’ inconsistent positions. Included in 2004 operating results is income of $14.0 million before tax and approximately $59.3 million after tax attributable to these prior year tax items.
Disregarding any potential unusual adjustments with regard to legislative changes or IRS exams, the Company expects the effective tax rate in 2005 to approximate 35 percent. The increase in the effective tax rate is due primarily to the increased earnings in the Company’s U.K. operations.
The Company’s net periodic benefit cost for its U.S. and foreign pension plans, which is calculated in accordance with Statement of Financial Accounting Standards No. 87, Employers’ Accounting for Pensions (SFAS 87), was $56.3 million in 2004. Based on projections as of December 31, 2004, the Company estimates its net periodic benefit cost for 2005 will be in the range of $67.0 million to $70.0 million.
In December 2004, as a result of lowering the discount rate used for projecting the benefit obligation, the Company increased the non-cash minimum pension liability adjustment in accumulated other comprehensive income in stockholders’ equity by $36.6 million, net of tax. See “Pension and Postretirement Benefits Plans” contained herein for further discussion.
In January 2004, the Company completed its annual review of claim reserves to ensure that its claim reserves make adequate and reasonable provision for future benefits and expenses. Based upon this review, as of December 31, 2003, the Company increased its group long-term income protection claim reserves by $421.0 million and its group short-term income protection claim reserves by $19.0 million, for a total increase of $440.0 million before tax and $286.0 million after tax. Approximately $300.0 million of the reserve strengthening reflected implementation of a lower discount rate for the Company’s group income protection claim reserves. The discount rate was lowered to reflect the Company’s actual change in investment portfolio yield rates during 2003, the expectation of future investment portfolio yield rates, and the Company’s new discount rate management approach of maintaining a wider spread between its group income protection portfolio investment yield rate and its average discount rate. The Company’s new discount rate management approach is intended to better reflect the current investment environment and position the Company to be more responsive with discount rates on new incurred claims as changes to the investment environment emerge. Approximately $140.0 million of the reserve increase related to a strengthening of the morbidity assumptions to reflect the impact of the Company’s view of a continuing jobless economic recovery
In order to strengthen its capital position, during 2003, the Company issued 52.9 million shares of common stock, par value $0.10 per share, in a public offering and received approximately $547.7 million in proceeds from the sale of the shares after deducting underwriting discounts. Also in 2003, the Company issued 23.0 million 8.25% adjustable conversion-rate equity security units (units) in a $575.0 million public offering. Each unit has a stated amount of $25 and will initially consist of (a) a contract pursuant to which the holder agrees to purchase, for $25, shares of the Company’s common stock on May 15, 2006 and which entitles the holder to contract adjustment payments at the annual rate of 2.25 percent, payable quarterly, and (b) a 1/40, or 2.5 percent, ownership interest in a senior note issued by the Company due May 15, 2008 with a principal amount of $1,000, on which the Company will pay interest at the initial annual rate of 6.00 percent, payable quarterly. Upon settlement of the common stock purchase contract and successful remarketing of the senior note element of the units, the Company will receive proceeds of approximately $575.0 million and will issue between 43.3 million and 52.9 million shares of common stock. Prior to settlement of the common stock purchase contract in May 2006, the purchase contract element of these units will have a dilutive effect on the Company’s net income per common share, assuming dilution, when the average market price of the Company’s common stock during the period exceeds the threshold appreciation price of $13.27 per share. After settlement of the common stock purchase contract in 2006, the weighted average common shares outstanding for computing net income per common share, both basic and assuming dilution, will increase by the actual number of shares issued.
Effective December 31, 2003, the Company adopted the provisions of the Financial Accounting Standards Board Interpretation No. 46 (FIN 46), Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin (ARB) No. 51 and subsequently adopted FIN 46(R) (revised December 2003) effective March 15, 2004. FIN 46 and FIN 46(R), which supersedes FIN 46, expand upon ARB No. 51, Consolidated Financial Statements, to address financial accounting and reporting for certain entities in which a controlling financial interest cannot be identified based on an evaluation of voting interests.
Transition to the provisions of SFAS 142 required the Company to complete, within the year of adoption, transitional impairment tests of goodwill existing at January 1, 2002, measured as of that date using a fair value approach. The Company had previously, prior to the adoption of SFAS 142, used undiscounted cash flows to determine if goodwill was recoverable. The Company completed the required tests during 2002 and determined the carrying value of its goodwill should be reduced $11.0 million. The charge, net of a $3.9 million tax benefit, was $7.1 million and is reported as a 2002 cumulative effect of accounting principle change in the consolidated statements of operations.
Claim reserves, net of ceded reinsurance, were $19.4 billion at December 31, 2004. Claim reserves, in general, are an estimate of the current value of future, otherwise unfunded, benefit commitments or liabilities. The calculation of claim reserves involves numerous assumptions. In setting these assumptions, the Company depends upon industry information and experience, Company experience and analysis, and reasoned judgment. There can be no guarantee that these assumptions individually, or collectively, will be duplicated by actual experience over time. The primary assumptions related to claim reserves are the discount rate, the claim resolution rate, and the incidence rate for IBNR claims.
The discount rate is the interest rate at which future benefit cash flows are discounted to determine the current value of those cash flows. It is important since higher discount rates produce lower reserves. If the discount rate is higher than future investment returns, the Company’s reserves will not earn sufficient investment income to support future liabilities. In this case, the reserves will eventually be insufficient. Alternatively, if a discount rate is chosen that is too low relative to future investment results, the reserve, and thus the claim cost in the current period, will be overstated and profits will be accumulated in the reserves rather than released to current shareholders through earnings. The Company sets its discount rate assumptions in conjunction with the current and expected future investment income rate of the assets supporting the reserves. If the investment yield at which new investments are
The claim resolution rate is the rate of probability that a disability claim will close or change due to maximum benefits being paid under the policy, the recovery or death of the insured, or a change in status in any given period. It is important because it is used to estimate how long benefits will be paid for a claim. Estimated resolution rates that are set too high will result in reserves that are lower than they need to be to pay the claim benefits over time. A claim closes due to maximum benefits being paid if all of the contractual benefits under the policy have been paid. A claim also closes if the policyholder recovers from his or her disability and is no longer receiving disability benefit payments or if the policyholder dies in the period. A claim may change status during the period. For example, a policyholder receiving disability benefits may return to part time work, and the claim benefit may be reduced to reflect the change to partial disability. Establishing claim resolution assumptions is complex and involves many factors, including the cause of disability, the policyholder’s age, the type of contractual benefits provided, etc. Claim resolution assumptions also vary by duration of disability and time since initially becoming disabled. The Company uses its extensive claim experience and analysis to develop its claim resolution assumptions. Claim resolution experience is studied over a number of years with more weight placed on the more recent experience. Claim resolution assumptions are established to represent the Company’s future resolution rate expectations. Due to the individual nature of each claim, it is unlikely that the claim resolution rate will be accurate for any particular claim. The Company establishes its claim resolution assumptions to apply as an average to its large base of active claims. In this manner, the assumed rates are much more accurate over the broad base of claims. Actual claim reserves incurred in the calendar quarter are sensitive to the choice of resolution rate. For example, a one percent increase or decrease in the group long-term income protection claim resolution rate would have changed a quarter’s incurred claim cost in 2004 by approximately $3.0 million.
Presented as follows are reserves by each major line of business within each segment with discussion regarding material changes.
(1) IBNR for income protection includes “reopen reserves”. These two categories of reserves are developed and maintained in aggregate based on historical monitoring that has only been on a combined basis.
The increase in IBNR within the Income Protection and Life and Accident segments is directly related to the underlying growth in the business. The rapid premium growth within the Company’s operations in the United Kingdom contributed to this IBNR growth along with premium growth within the long-term care and individual income protection - recently issued lines of business. Additionally, IBNR reserves for group income protection, individual income protection - recently issued, and individual income protection - closed block increased $39.7 million, $0.6 million, and $3.7 million, respectively, in the fourth quarter of 2004 for the reserve charge related to settlement of the multistate market conduct examination.
A portion of the reported growth in the reserves for the U.K. operations also resulted from the favorable foreign currency exchange rate in 2004 relative to 2003, which increased IBNR reserves approximately $12.2 million and all other reserves approximately $117.6 million.
The Company defers certain costs incurred in acquiring new business and amortizes (expenses) these costs over the life of the related policies. Deferred costs include certain commissions, other agency compensation, selection and policy issue expenses, and field expenses. Acquisition costs that do not vary with the production of new business, such as commissions on group products which are generally level throughout the life of the policy, are excluded from deferral. The Company uses its own historical experience and expectation of the future performance of its business in determining the expected life of the policies. Approximately 92 percent of the Company’s deferred policy acquisition costs relate to traditional non interest-sensitive products, for which the costs are amortized in proportion to the estimated premium income to be received over the life of the policies in accordance with the provisions of Statement of Financial
Deferred costs for group life and accidental and death and dismemberment products are amortized over a fifteen-year period, with approximately 85 percent of the cost expected to be amortized by year ten. Deferred costs for brokerage voluntary life and other products are amortized over a fifteen-year period, with approximately 90 percent of the cost expected to be amortized by year ten. Deferred costs for products issued by the Colonial segment are amortized over a seventeen-year period, on average, with approximately 80 percent and 90 percent of the original deferred costs expected to be amortized by years ten and fifteen, respectively.
Based on this review of the entire investment portfolio, individual investments may be added to or removed from the Company’s “watch list”, which is a list of securities subject to enhanced monitoring and a more intensive review. The Company also determines if its investment portfolio is overexposed to an issuer that is showing warning signs of deterioration and, if so, the Company makes no further purchases of that issuer’s securities and may seek opportunities
to sell securities it holds from that issuer to reduce the Company’s exposure. The Company monitors below-investment-grade securities as to individual exposures and in comparison to the entire portfolio as an additional credit risk management strategy, looking specifically at the Company’s exposure to individual securities currently classified as below-investment-grade. In determining current and future business prospects and cash availability, the Company considers the parental support of an issuer in its analysis but does not rely heavily on this support.
If the Company determines that the decline in value of an investment is other than temporary, the investment is written down to fair value, and an impairment loss is recognized in the current period to the extent of the decline in value. If the decline is considered temporary, the security continues to be carefully monitored. These controls have been established to identify the Company’s exposure to possible credit losses and are intended to give the Company the ability to respond rapidly.
The Company has no held-to-maturity fixed maturity securities. All fixed maturity securities are classified as available-for-sale and are reported at fair value. Fair values are based on quoted market prices, where available.
As of December 31, 2004, the key assumptions used to estimate the fair value of private placement fixed maturity securities included the following:
Current Baa corporate bond spreads ranging from 0.62 percent to 1.35 percent plus an additional 30 basis points were added to the risk free rate to reflect the lack of liquidity.
Increasing the 30 basis points added to the risk free rate for lack of liquidity by 1.5 basis points, increasing the five basis points added to the risk free rates for foreign investments by one basis point, and increasing the additional basis points added to each industry considered to be of greater risk by one basis point would have decreased the December 31, 2004 net unrealized gain in the fixed maturity securities portfolio by approximately $2.3 million. Historically, the Company’s realized gains or losses on dispositions of its private placement fixed maturity securities have not varied significantly from amounts estimated under the valuation methodology described above.
Goodwill is the excess of the cost of an acquired entity over the net of the amounts assigned to assets acquired and liabilities assumed. Goodwill is not amortized, but the Company reviews on an annual basis the carrying amount of goodwill for indications of impairment, with consideration given to financial performance and other relevant factors. In accordance with accounting guidance, the Company tests for impairment at either the operating segment level or one level below. In addition, certain events including, but not limited to, a significant adverse change in legal factors or the business environment, an adverse action by a regulator or rating agency, or unanticipated competition would cause the Company to review goodwill for impairment more frequently than annually.
Group long-term income protection sales on a fully insured basis decreased during 2004 compared to 2003 due to declines in the Company’s U.S. brokerage business. The Company’s U.S. brokerage sales of fully insured group long-term income protection products declined 38.7 percent in 2004 relative to 2003 due to a decline in sales as a result of the Company’s disciplined approach to pricing and also due to the Company’s continued shift to focus on the small and mid-employer market to restore a more balanced mix of business between small, medium, and large-employer customers. The decrease in the U.S. sales was partially offset by growth of 26.9 percent in the Company’s United Kingdom operations in 2004 compared to the prior year. A portion of that reported growth also resulted from the favorable foreign currency exchange rate in 2004 relative to 2003. When measured in its local currency, the sales growth rate in the United Kingdom’s group long-term income protection line was approximately 13.2 percent year over year. Group short-term income protection sales on a fully insured basis also decreased in 2004 compared to the prior year due to the Company’s shift in its business strategy.
Sales for individual income protection - recently issued declined primarily due to a decrease in sales in both the U.S. operations and the Company’s United Kingdom operations. The portion of the individual income protection sales attributable to multi-life business in the Company’s U.S. operations was approximately 81 percent for 2004 sales
and 77 percent for 2003 sales, although both multi-life and non multi-life sales declined in 2004 relative to the prior year.
During 2003, the Company introduced a new distribution model for the sale of individual income protection and individual long-term care insurance products which will enable the Company to maintain its focus on workplace customers and increased integration between individual multi-life and group offerings. The Company also introduced changes in the individual long-term care product offering during 2003. These actions have slowed the growth in sales of non multi-life individual income protection and individual long-term care insurance relative to historical trends.
Group long-term income protection sales on a fully insured basis decreased during 2003 compared to 2002. The slight net decline occurred in the Company’s U.S. market, with a decline in the large-employer market more than offsetting growth in the small and mid-employer markets. Sales increased in the mid-employer market during 2003 as the Company began to shift its focus to this market, which is comprised of groups of 500 to 1,999 lives. The decrease in the U.S. sales was partially offset by growth of 42.9 percent in the Company’s United Kingdom operations. The comparative decline for 2003 versus 2002 in short-term income protection ASO sales was primarily due to a large case sold in 2002.
Sales for individual income protection decreased in 2003 relative to the prior year, with declines in the Company’s United Kingdom operations and in the Company’s U.S. operations. The sales decline occurred primarily in the U.S. individual sales market rather than in the multi-life market. The portion of the individual income protection sales attributable to multi-life business in the Company’s U.S. operations was approximately 77 percent of 2003 sales and 73 percent of 2002 sales.
Persistency during 2004 for the overall block of group long-term income protection on average declined from that experienced in 2003. Terminations were more heavily concentrated in the large-employer market, while persistency in the small and mid-employer market improved slightly in 2004 compared to 2003. Persistency for fully insured short-term income protection also declined during 2004, on average, over the prior year. These declines in persistency were expected due to the Company’s more disciplined approach to pricing, renewals, and risk selection. Approximately 35 percent of the Company’s group business has an effective renewal date of January 1. The Company experienced a decline in persistency for group income protection business to be renewed effective January 1, 2005. The Company believes this is attributable to the competitive pricing environment and the Company’s continued pricing discipline and, to a lesser extent, the adverse publicity surrounding the Company. The Company expects that persistency for its overall
For the years 2002 and subsequent, the Company lowered its premium persistency assumptions for group income protection policy acquisition costs deferred in those years to reflect its current estimate of persistency. This accelerated the amortization of group long-term and short-term income protection acquisition costs deferred in those years into the early life of the policy by using lower premium persistency assumptions to determine the “scheduled” or expected amortization. Although persistency in the future may be lower than historical levels, particularly in certain issue years due to the Company’s increased emphasis on retaining profitable business, the acceleration of “scheduled” amortization may eliminate the need for additional amortization related to the decline in actual persistency relative to “scheduled” or expected persistency. The persistency of individual income protection and long-term care continues to be within expected levels.
During the third quarter of 2004, the Company completed comprehensive scenario testing with respect to the amortization and recoverability of its group income protection and group life deferred policy acquisition costs under severe prolonged adverse persistency levels. The deferred policy acquisition costs were fully recoverable, even when tested at persistency rates deteriorating to below 70 percent and continuing at that level throughout the remainder of the life of the inforce block. The assessment was performed primarily to test the limits of recoverability. Sustained adverse persistency at the levels tested, while not resulting in a loss recognition charge, would result in lower emerging future profits due to lower overall premium levels and additional acceleration, on a prospective basis, of the amortization of deferred policy acquisition costs relative to the “scheduled” or expected amortization, but the Company does not anticipate prolonged persistency rates at the stress levels tested. The study was the result of normal experience testing.
Persistency during 2003 for the overall block of group long-term income protection on average was higher than that experienced in 2002. Persistency for fully insured short-term income protection also improved, on average, over the prior year. During 2002, persistency for group long-term and short-term income protection was lower for certain issue years when compared to the persistency expected at the time the business was written. This resulted in additional amortization of deferred policy acquisition costs of $12.9 million in 2002 for group income protection. There was no additional amortization of deferred policy acquisition costs in 2003. As previously discussed, since the Company’s actual persistency experienced in recent years was lower than that expected when policies were issued, the Company lowered its premium persistency assumptions for costs deferred in 2002 and subsequent to reflect its current estimate of persistency.
A critical part of the Company’s strategy for group income protection involves executing its 2005 renewal program and managing persistency in its existing block of business. Although the 2005 renewal program is smaller than that of 2004, the Company believes this strategy will have a positive effect on future profitability. The Company has shifted emphasis from revenue growth to profit margin expansion, raising prices and remaining more disciplined in risk selection, and restoring a more balanced mix of business between small, medium, and large-employer customers, since large-employer customers are often more price sensitive and vulnerable to weak economic conditions. The Company’s previous renewal programs have generally been successful in retaining group income protection business that is relatively more profitable than business that terminated. While it is expected that the additional premium and related profits associated with renewal activity will continue to emerge, the Company intends to balance the renewal program with the need to maximize persistency and retain producer relationships.
(1) Included in these ratios is the 2004 before-tax reserve charge of $80.2 million related to the settlement of the multistate market conduct examination and the 2003 before-tax reserve strengthening of $894.0 million. Excluding these charges, the benefit ratios for 2004 and 2003 would have been 88.7% and 92.0%, respectively.
(2) Included in the ratio for 2004 is the before-tax charge of $36.5 million related to the settlement of the multistate market conduct examination. Excluding this charge, the operating expense ratio for 2004 would have been 21.6%.
As previously discussed, in 2003 the Company strengthened its group income protection claim reserves $894.0 million. Excluding this charge, group income protection would have reported operating income of $126.8 million for 2003.
The growth in premium income resulted from new sales and stable persistency of the existing block of business. The decline in net investment income in 2004 relative to the prior year resulted from a decline in the yield on the portfolio as well as internal redistributions of invested assets in conjunction with the Company’s management of asset and liability cash flows.
The slight increase in the benefit ratio for 2004 relative to the prior year was primarily due to a decline in the net claim resolution rate, partially offset by a decrease in submitted claim incidence. The impact on benefits and change in reserves for the lower claim resolutions was an increase of approximately $45.0 million compared to 2003, offset by a decrease of approximately $35.0 million for the lower submitted claim incidence. Multi-life business, which
constitutes approximately 59 percent of the individual income protection - recently issued block of business, has consistently had lower claim incidence rates than the non multi-life business.
Shown below are financial results and key performance indicators for long-term care.
Acquisition costs capitalized during 2004 were lower than in the prior year due to the reduction in sales. Commissions and operating expenses in 2004 also declined relative to the prior year due to lower selling expenses.
Premium income increased primarily due to new sales growth in previous periods. Net investment income continued to increase due to the growth in invested assets supporting this line of business.
Operating revenue from disability management services, which includes the Company’s wholly-owned subsidiaries GENEX Services, Inc. and Options and Choices, Inc., totaled $177.1 million in 2004, compared to $173.0 million in 2003 and $174.8 million in 2002. Operating income totaled $16.2 million in 2004, compared to $17.2 million in 2003 and $18.9 million in 2002.
The Company intends to continue its disciplined approach to pricing, renewals, and risk selection, with a more conscious effort to balance growth and profitability. Although this strategy may cause a somewhat lower persistency or market share, historically the profitability of business that terminates has generally been less than the profitability of retained business. As previously discussed, the Company expects that persistency rates in 2005 for its U.S. group long-term income protection business will be approximately 80 to 82 percent.
The Company believes that its income protection product results will benefit if there is an improvement in overall economic conditions and a higher interest rate environment, although the improvement in results may lag behind the improvements in the economy and interest rate environment. Continuation of the current low interest rate environment may result in a lowering of the Company’s reserve discount rate on new income protection claims during 2005.
Sales for group life decreased in 2004 relative to the prior year due to a 31.1 percent decrease in sales in the Company’s U.S. operations, partially offset by an increase in sales in the United Kingdom operations. The decline in U.S. group life sales in 2004 was primarily attributable to a more competitive market, which resulted in sales declines in all market sizes, and also due to a decrease in large-employer market sales resulting from the previously discussed business mix shift. Brokerage voluntary life and other sales improved in 2004 relative to last year and were generally in line with the Company’s expectations.
The benefit ratio increased slightly in 2004 relative to 2003. For the U.S. group life business, submitted and paid claim incidence for group life were both marginally higher in 2004 relative to 2003. The average paid claim size for group life also increased during 2004 relative to 2003.
Acquisition costs capitalized during 2004 for the life and accident segment were lower than in the prior year due primarily to an updated analysis of costs associated with the acquisition of new business and due to the decrease in sales.
Premium growth in 2003 relative to 2002 was attributable to favorable renewal results, strong sales results in the United Kingdom operations, and stable persistency.
Submitted and paid claim incidence for U.S. group life were both lower in 2003 relative to 2002. The average paid claim size for group life increased from 2002.
The amortization of deferred policy acquisition costs for 2002 includes $9.2 million of additional amortization due to the higher level of terminations for group life products experienced during 2002 than expected at the time the policies were written. There was no additional amortization of deferred policy acquisition costs in 2003. As previously discussed in the operating results for group income protection and as also applicable to group life and accidental death and dismemberment, the Company has accelerated the amortization of costs pertaining to certain of its lines of business into the early life of the policy by using lower premium persistency assumptions in determining its “scheduled” or expected amortization. Although persistency in the future may be lower than historical levels, particularly in certain issue years due to the Company’s increased emphasis on retaining profitable business, the acceleration of “scheduled” amortization may eliminate the need for additional amortization related to the deterioration of actual persistency relative to “scheduled” or expected persistency.
Since the group life and accidental death and dismemberment products are primarily sold in conjunction with group income protection, the more focused renewal effort in group income protection may reduce persistency somewhat in the group life line as well. Persistency may also be negatively impacted by a more focused renewal effort on the stand-alone large-employer market group life business sold during 2000 through 2002 as well as the highly competitive group life marketplace. The Company expects that persistency rates in 2005 for its U.S. group life business will be approximately 74 to 76 percent.
The 2.3 percent sales decrease in 2004 relative to 2003 was attributable to a decline in sales of income protection products, partially offset by an increase in sales for the cancer and life products. The decline in sales for income protection results from the discontinuance by the Company of new sales of group long-term income protection as well as from lower sales of individual short-term income protection to employee groups of 2000 or more lives. The Company expects positive sales growth in the Colonial segment during 2005.
Growth in premium income was attributable primarily to favorable persistency. The 2004 benefit ratio for this segment was lower than in 2003 due primarily to a lower benefit ratio for the income protection product line. This resulted in an improvement in benefits and change in reserves of approximately $20.1 million in 2004 relative to what would have been reported had the benefit ratio equaled that of 2003. Individual short-term income protection claim incidence decreased for 2004 compared with the prior year while the average claim duration for closed claims was higher in 2004 relative to 2003. The average indemnity for individual short-term income protection was higher in 2004 relative to 2003. For accident and sickness products, which are included in the income protection line of business, the claim incidence rate decreased in 2004 relative to the prior year, but the average claim payment increased over that reported from 2003. The life line of business reported an increase in the number of paid claims relative to 2003 and an increase in the average claim payment.
The premium income increase in 2003 relative to 2002 was attributable to new sales and overall favorable persistency.
The Company expects growth in revenue and profitability to be driven by increasing premium income through sales growth and stable persistency while maintaining a focus on high-quality business and the management of expenses. High quality service is viewed as a differentiator for the Colonial segment in the marketplace. The two key drivers for quality service delivery are trained service professionals and effective use of technology. These key drivers will be emphasized by seeking to increase innovation, productivity, and performance through leadership development and technological advances.
The Individual Income Protection - Closed Block segment generally consists of those individual income protection policies in force prior to the Company’s substantial changes in product offerings, pricing, distribution, and underwriting. These changes generally occurred during the period 1994 through 1998. A minimal amount of new business continued to be sold subsequent to these changes, but the Company ceased selling new policies in this segment at the beginning of 2004 other than update features contractually allowable on existing policies. Shown below are financial results and key performance indicators for the Individual Income Protection - Closed Block segment.
(2) Included in this ratio is the 2004 before-tax reserve strengthening of $110.6 million and the $856.4 million before-tax impairment of intangible assets. Excluding these charges, the before-tax operating income (loss) ratio for 2004 would have been 14.6%.
The Company believes that the restructuring of this closed block of business has strengthened the balance sheet for this segment and minimized the Company’s exposure to potential future adverse morbidity. The Company expects no change in the level of service provided to policyholders of this business as a result of the restructuring. Total revenue is expected to decline very slowly over time as the Company believes that persistency will remain in the mid-90 percent range. The Company believes that the interest adjusted loss ratio will be relatively flat over the long-term, but the segment may experience quarterly volatility. The expense ratio is expected to remain fairly consistent throughout 2005 with that reported for 2004. As discussed previously, future operating earnings relative to 2003 and prior will be positively impacted due to the lack of amortization of deferred policy acquisition costs and value of business acquired. Continuation of the current low interest rate environment may result in a lowering of the Company’s reserve discount rate on new individual income protection - closed block claims in 2005.
The Corporate segment includes investment income on corporate assets not specifically allocated to a line of business, corporate interest expense, and certain corporate income and expense not allocated to a line of business.
The Corporate segment reported operating losses of $153.7 million in 2004, $193.5 million in 2003, and $155.0 million in 2002. Interest and debt expense increased from $162.4 million in 2002 to $187.2 million in 2003 and $207.1 million in 2004 due to the impact of the debt offerings, as discussed under “Liquidity and Capital Resources” included herein. Included in operating expenses for 2003 is approximately $15.0 million in severance and pension benefit payouts related to the change of the Company’s president and chief executive officer.
Income (loss) from discontinued operations was $(60.8) million, $(161.7) million, and $11.4 million, net of tax, in 2004, 2003, and 2002, respectively. Excluding the 2004 and 2003 losses on the sale and the write-downs, income from discontinued operations was $10.5 million and $35.2 million in 2004 and 2003, respectively.
Investment activities are an integral part of the Company’s business, and profitability is significantly affected by investment results. Invested assets are segmented into portfolios that support the various product lines. Generally, the investment strategy for the portfolios is to match the effective asset cash flows and durations with related expected liability cash flows and durations to consistently meet the liability funding requirements of the Company’s business. The Company seeks to maximize investment income and total return and to assume credit risk in a prudent and selective manner, subject to constraints of quality, liquidity, diversification, and regulatory considerations. The Company’s overall investment philosophy is to invest in a portfolio of high quality assets that provide investment returns consistent with that assumed in the pricing of its insurance products. Assets are invested predominately in fixed maturity securities, and the portfolio is matched with liabilities so as to eliminate as much as possible the Company’s exposure to changes in the overall level of interest rates.
The Company is able to hold to this investment philosophy throughout credit and interest rate cycles because of its capital position, the fixed nature of its liabilities, and the matching of those liabilities with assets and also because of the experience gained through many years of a consistent investment philosophy. It is the Company’s intent, and has been its practice, to hold investments to maturity to meet liability payments.
The Company adopted the provisions of Statement of Financial Accounting Standards No. 133 Implementation Issue B36 (DIG Issue B36), Embedded Derivatives: Modified Coinsurance Arrangements and Debt Instruments That Incorporate Credit Risk Exposure That Are Unrelated or Only Partially Related to the Creditworthiness of the Obligor Under Those Instruments, effective October 1, 2003. The 2004 and 2003 realized investment gains and losses include changes in fair values of the embedded derivatives, as shown in the following chart.
The following discussion of other than temporary impairment losses includes those representing five percent or greater of the total other than temporary impairment losses for the respective periods presented, the circumstances that contributed to the impairment loss, the length of time the security had been in a continual loss position, whether it was investment-grade or below-investment-grade at the time of initial purchase and at the time of the impairment loss, and how the circumstances of the impairment loss might cause impairments in other material investments held by the Company. Approximately 58 percent of the 2004 impairments in continuing operations occurred in the financial institutions and airlines industries, and approximately 46 percent of the 2003 impairments in continuing operations occurred in the energy and utilities industries. In 2002, approximately 48 percent of the impairments in continuing operations occurred in the communications sector.
$8.9 million aggregate loss during 2004 on private equity securities issued by a U.S. based insurance services company. The Company initially recognized an impairment loss on these securities in the first quarter of 2002 due to the negative revenue impact resulting from the company’s loss of a single large client. The Company closely monitored the financial performance of the company during 2002 and 2003. In the first quarter of 2004, following a review of the company’s capital condition, its revenue and earnings performance, and discussions with company management, it was determined that the investment was further impaired. In the third quarter of 2004, the company was recapitalized at a market price that indicated an additional impairment loss had occurred. The investment was originally purchased as part of the Company’s private equity investment program. There has been no unrealized gain or loss subsequent to the initial impairment loss in 2002. The circumstances of this impaired investment have no impact on other investments.
$5.2 million loss during the second quarter of 2004 on securities issued by a U.S. based heavy construction company. The company has been struggling with a number of problem projects and is below plan in attaining new business. This continued financial stress culminated in the company’s failure to make its monthly interest payment for June 2004. These bonds are secured by a number of real estate properties. These securities were investment-grade at the time of purchase, but were downgraded to below-investment-grade in the third quarter of 2002. At the time of the impairment loss, these securities had been continuously in an unrealized loss position for a period of greater than two years but less than three years. The circumstances of this impaired investment have no impact on other investments.
$4.9 million aggregate loss during 2004 on structured securities issued by a trust and collateralized by a pool of high yield bonds. The Company performs a periodic review of the estimated cash flows associated with all of its securitized high yield securities. During each of the 2004 quarterly reviews, it was determined that an adverse change in estimated cash flows had occurred for these securities. The investment was originally purchased as part of the Company’s below-investment-grade strategy. At the time of the initial impairment loss, these securities had been in an unrealized loss position for a period of greater than two years but less than three years. The circumstances of this impaired investment have no impact on other investments.
$14.4 million loss during the first quarter of 2003 on securities issued by a United Kingdom electrical generation subsidiary of a U.S. based company. Although this industry’s operating environment in the U.K. weakened over the past few years due to competitive pricing pressures, the company had benefited from a favorable, long-term power sales agreement with a large, investment-grade U.K. power customer. Depressed electricity prices in the merchant power market and operating problems at the company, as well as financial difficulties experienced by the company’s U.K. power customer, contributed to a weakened financial profile. In October 2002, the financial problems associated with the major U.K. customer resulted in the termination of the favorable power contract. The company made its December 2002 interest payments as scheduled. However, due to discussions that were initiated between the issuer and senior lenders in the first quarter of 2003 and the continued weakness in the U.K. power market, it was determined that this investment was other than temporarily impaired. The securities were investment-grade at the time of purchase but were downgraded to below-investment-grade in the fourth quarter of 2001. Prior to its impairment loss, the investment had been in an unrealized loss position for a period of greater than one year but less than two years. The Company also owns securities in the previously mentioned U.K. power customer of this issuer and previously recorded an impairment loss on those securities in the fourth quarter of 2002.
$11.3 million loss during the second quarter of 2003 on securities issued by a regulated natural gas pipeline company located in Argentina. The impairment loss was taken following continued delays by the Argentine government in implementing tariff reform and the company’s default on its interest payment due during the second quarter. These securities were investment-grade at the time of purchase but were downgraded to below-investment-grade in the second quarter of 2001. At the time of the impairment loss, these securities had been continuously in an unrealized loss position for a period of greater than two years but less than three years. The circumstances of this impaired investment have no impact on other investments.
$11.1 million loss during the fourth quarter of 2003 on securities issued by a leading producer of performance products for the automotive industry and nylon fibers for the carpet industry. The securities were investment-grade at the time of purchase but were downgraded to below-investment-grade in the first quarter of 2002. The issuer was current on its interest payments as of September 30, 2003, but filed for bankruptcy in December 2003, despite having implemented several successful measures which improved liquidity and
$27.8 million loss during the second quarter of 2002 on securities issued by a U.S. based global telecommunications company providing global voice and data services. It was discovered in June 2002 that the company had misclassified certain expenses, materially changing the reported financial condition and profitability of the business. The company had an investment-grade rating prior to its downgrade to below-investment-grade in the second quarter of 2002. Prior to its impairment loss, the investment had been in an unrealized loss position for a period of greater than one year but less than two years. The circumstances of this impaired investment have no impact on other investments.
For the year ended December 31, 2004, the Company realized a loss of $53.0 million on the sale of fixed maturity securities in its continuing operations. The securities sold during the year had a book value of $604.6 million and a fair value of $551.6 million at the time of sale and represented 67 different issuers. Realized investment losses representing five percent or more of the total loss recognized during 2004 are as follows:
$5.8 million aggregate loss during the first three quarters of 2004 on the sale of securities issued by a leading builder of power plants and a provider of electricity generation in the U.S., Canada, and the United Kingdom. The company had suffered from an over supply of power generation in most of the markets in which it operates. In addition, the company had experienced weak cash flow and high debt ratios as a result of weak industry and economic fundamentals. These securities were originally purchased as part of the Company’s below-investment-grade strategy. At the time of the initial sale in 2004, these securities had been continuously in an unrealized loss position for a period of greater than two years but less than three years. The circumstances of this investment have no impact on other investments.
$5.3 million loss during the third quarter of 2004 on the sale of securities issued by an international reinsurance provider. The company was negatively impacted after it was determined it had failed to adequately reserve for projected claims. The company’s financial strength ratings were subsequently downgraded by Standard & Poor’s Corporation and A.M. Best Company. These securities were investment-grade at the time of purchase but were downgraded to below-investment-grade in the third quarter of 2004. At the time of the sale, these securities had been continuously in an unrealized loss position for a period of less than ninety days. The circumstances of this investment have no impact on other investments.
$4.0 million aggregate loss during the first and second quarters of 2004 on the sale of securities issued by a large domestic based airline. The company has been suffering from the aftermath of September 11th, a higher cost structure, and industry overcapacity. The Company sold the securities to reduce its exposure to the airline. These securities had an investment-grade rating until being downgraded to below-investment-grade in the third quarter of 2001. At the time of the initial sale in 2004, these securities had been continuously in an unrealized loss position for a period of greater than two years but less than three years. The circumstances of this investment have no impact on other investments.
$15.2 million aggregate loss during the first three quarters of 2003 on the sale of debt issued by a major domestic airline. The Company has systematically sold the securities during the first nine months of 2003 to substantially reduce its exposure to the airline. These securities had an investment-grade rating until the various issues were downgraded to below-investment-grade in the third quarter of 2001 and the first quarter of 2002. At the time of the initial sale, the investment had been in an unrealized loss position for a period of greater than one year but less than two years. The Company also took an other than temporary impairment charge of $0.3 million on the value of certain private, secured debt obligations of this issuer as part of a consensual restructuring proposal.
For the year ended December 31, 2002, the Company realized a loss of $62.1 million on the sale of fixed maturity securities in its continuing operations. These securities had a book value of $236.4 million and a fair value of $174.3 million at the time of sale and represented 42 different issuers. Realized investment losses representing five percent or more of the total loss recognized during 2002 are as follows:
The Company realized $34.0 million in losses on the sale of securities issued by a U.S. based global telecommunications company providing global voice and data services. This company had misclassified certain expenses, materially changing the reported financial condition and profitability of the business. The price of this issuer’s securities dropped significantly in the second quarter of 2002 as the information became public. This company is under multiple investigations, and several senior officers of the issuer have been accused of committing major accounting fraud. These circumstances were significant enough for the Company to change its intent to hold these securities to maturity or recovery. The investment was
The following table provides the distribution of invested assets for the periods indicated. Ceded policy loans of $2.9 billion and $2.7 billion as of December 31, 2004 and 2003, respectively, which are reported on a gross basis in the consolidated statements of financial condition contained herein in Item 8, are excluded from the table below. The investment income on these ceded policy loans is not included in income.
As of December 31, 2004, $259.3 million or 75.5 percent of the unrealized losses in the fixed maturity bond portfolio were concentrated in derivative instruments, financial institutions, transportation, and U.S. government agencies and municipalities. The Company’s current view of risk factors relative to these industries is as follows:
Derivative Instruments: The unrealized losses on derivative instruments are associated with the Company’s foreign currency interest rate swaps whereby the Company receives a fixed rate of interest denominated in U.S. dollars (functional currency) and pays a fixed rate of interest denominated in a foreign currency. These derivatives eliminate the variability of functional currency cash flows associated with the foreign currency denominated securities owned by the Company. Subsequent to the time these foreign currency swaps were entered into, the U.S. dollar has weakened in relation to the foreign currencies being hedged, resulting in the unrealized losses. Although the functional currency value of these foreign currency swaps has decreased, these unrealized losses are mitigated by an increase in the functional currency value of the hedged securities. The Company has the ability and intent to hold these securities and related derivatives to maturity.
Transportation: This sector consists of airlines, airports, railroads, and shipping. The sector has encountered significant difficulties during the past three years, primarily in commercial aviation. Despite an improving economy, extremely competitive conditions exist, and fare wars have contributed to weak revenues in the sector. Margins continue to be pressured by high labor costs and expenses related to rising fuel prices. The credit quality of issuers in the sector remains weak. The outlook for the airline segment depends heavily on economic improvement, negotiations with labor unions, and continued expense reductions. The outlook for airports has improved in the past two years as overall passenger traffic has risen, despite the problems endured by the mainline carriers. Demand for railroad and shipping services is also highly correlated to the economy, although the industry fundamentals are currently strong.
U.S. Government Agencies and Municipalities: This sector includes the U.S. Government Treasury Department, government agencies, and government-sponsored enterprises. The sector has minimal credit risk and excellent liquidity, which enables the Company to maintain a higher limitation on investments in these subsectors.
Of the $343.5 million in gross unrealized losses at December 31, 2004, $286.6 million, or 83.4 percent, are related to investment-grade fixed maturity bonds. The following table shows the length of time the Company’s investment-grade fixed maturity bonds had been in a gross unrealized loss position as of December 31, 2004.
As of December 31, 2004, the Company held two securities with a gross unrealized loss of $10.0 million or greater, as shown in the chart below.
For those fixed maturity securities with an unrealized loss and on which the Company has not recorded an impairment loss, the Company believes that the decline in fair value below amortized cost is temporary. The Company has the ability to hold its securities to the earlier of recovery or maturity and intends to hold all of its fixed maturity investments until maturity to meet its liability obligations. If information becomes available that changes the Company’s assessment as to whether the Company will receive contractual payments related to a fixed maturity security and the security is also not projected to recover in value, the related security is generally sold. The Company may also in certain circumstances sell a security in an unrealized loss position because of changes in tax laws, when a merger or the disposition of a segment or product line results in positions outside of the Company’s investment guidelines, due to changes in regulatory or capital requirements, due to unexpected changes in liquidity needs, or to take advantage of tender offers that recover up to or beyond the cost of the investment.
For those securities with a gross unrealized loss of $10.0 million or greater, further discussed as follows are (a) the factors which the Company believes resulted in the impairment and (b) the information the Company considered, both positive and negative, in reaching the conclusion that the impairments were not other than temporary.
The fixed maturity bond of the U.S. government sponsored mortgage funding company was issued by the Federal Home Loan Mortgage Corporation. The bond was rated AAA by Standard & Poor’s Corporation (S&P) as of December 31, 2004, with no negative outlook by rating agencies or in analysts’ reports. The changes in the market value of this security relates to changes in interest rates subsequent to the purchase of the bond. The Company believes that the decline in fair value of this security is temporary. The Company has the ability to hold this security to the earlier of recovery or maturity and intends to hold its fixed maturity investments until maturity to meet its liability obligations.
The principal protected equity linked note is a zero coupon bond, issued by a large, well capitalized Fortune 500 financial services company, the return of which is linked to a Vanguard S&P 500 index mutual fund. This bond matures on August 24, 2020 and carries the AAA rating of the issuer, as determined by S&P as of December 31, 2004. This note has an embedded derivative contract and substitutes highly rated bonds in place of the underlying S&P 500 index mutual fund to provide principal protection in the event of a significant decline in the equities market. The note derives its value from the underlying S&P 500 index mutual fund. The reduction in the market value of this note was the result of the decline in the S&P 500 index subsequent to the purchase date of the note. The S&P 500 index had an 8.99 percent return for the twelve months ending December 31, 2004. Based on historical long-term returns of the S&P 500 index, the Company believes that the value of the underlying S&P 500 index mutual fund will equate to or exceed the par value of the security at maturity. The Company therefore believes that the decline in fair value of the note is temporary. The Company has the ability to hold this security to the earlier of recovery or maturity and intends to hold its fixed maturity investments until maturity to meet its liability obligations.
The Company’s investment in mortgage-backed and asset-backed securities was approximately $3.8 billion and $4.0 billion on an amortized cost basis at December 31, 2004 and 2003, respectively. At December 31, 2004, the mortgage-backed securities had an average life of 5.2 years and effective duration of 3.9 years. The mortgage-backed and asset-backed securities are valued on a monthly basis using valuations supplied by the brokerage firms that are dealers in these securities. The primary risk involved in investing in mortgage-backed securities is the uncertainty of the timing of cash flows from the underlying loans due to prepayment of principal with the possibility of reinvesting the funds in a lower interest rate environment. The Company uses models which incorporate economic variables and possible future interest rate scenarios to predict future prepayment rates. The Company has not invested in mortgage-backed derivatives, such as interest-only, principal-only or residuals, where market values can be highly volatile relative to changes in interest rates.
The Company’s exposure to below-investment-grade fixed maturity securities at December 31, 2004, was $2,169.6 million, representing 6.4 percent of the fair value of invested assets excluding ceded policy loans. Below-investment-grade bonds are inherently more risky than investment-grade bonds since the risk of default by the issuer, by definition and as exhibited by bond rating, is higher. Also, the secondary market for certain below-investment-grade issues can be highly illiquid. The Company expects that additional downgrades may occur during 2005, but the Company does not anticipate any liquidity problem caused by its investments in below-investment-grade securities, nor does it expect these investments to adversely affect its ability to hold its other investments to maturity.
The Company’s mortgage loan portfolio was $498.2 million and $474.7 million at December 31, 2004 and 2003, respectively. The Company believes its mortgage loan portfolio is well diversified geographically and among property types. The incidence of problem mortgage loans and foreclosure activity remains low, and management expects the level of delinquencies and problem loans to remain low in the future.
Real estate was $27.4 million and $25.9 million at December 31, 2004 and 2003, respectively. Investment real estate is carried at cost less accumulated depreciation. Real estate acquired through foreclosure is valued at fair value at the date of foreclosure and may be classified as investment real estate if it meets the Company’s investment criteria. If investment real estate is determined to be permanently impaired, the carrying amount of the asset is reduced to fair value. Occasionally, investment real estate is reclassified to real estate held for sale when it no longer meets the Company’s investment criteria. Real estate held for sale, which is valued net of a valuation allowance that reduces the carrying value to the lower of cost or fair value less estimated cost to sell, amounted to $6.2 million at December 31, 2004 and $4.9 million at December 31, 2003.
The Company uses derivative financial instruments to manage duration, increase yield on cash flows expected from current holdings and future premium income, and manage currency risk. Historically, the Company has utilized interest rate futures contracts, current and forward interest rate swaps and options on forward interest rate swaps, current and forward currency swaps, interest rate forward contracts, forward treasury locks, currency forward contracts, and forward contracts on specific fixed income securities. All of these freestanding derivatives transactions are hedging in nature and not speculative. Positions under the Company’s hedging programs for derivative activity that were open during 2004 involved current and forward interest rate swaps, current and forward currency swaps, forward contracts on credit spreads on specific fixed income securities, currency forward contracts, and options on forward interest rate swaps.
The Company’s current credit exposure on derivatives, which is limited to the value of those contracts in a net gain position, was $103.0 million at December 31, 2004. Additions and terminations, in notional amounts, to the Company’s hedging programs during 2004 were $1,706.6 million and $911.9 million, respectively. Additions and
terminations in 2003 were $3,945.0 million and $1,326.6 million, respectively. Additions and terminations include roll activity, which is the closing out of an old contract and initiation of a new one when a contract is about to mature but the need for it still exists. The notional amount of derivatives outstanding under the hedge programs was $4,795.9 million at December 31, 2004 and $4,001.2 million at December 31, 2003.
As of December 31, 2004 the Company had $707.3 million notional amount of open current and forward foreign currency swaps to hedge fixed income Canadian dollar denominated securities the Company retained after the sale of the Canadian branch.
The Company’s exposure to non-current investments totaled $91.5 million at December 31, 2004, or 0.3 percent of invested assets excluding ceded policy loans, compared to $235.9 million at December 31, 2003. Non-current investments are those investments for which principal and/or interest payments are more than thirty days past due. At December 31, 2004 these investments, which are subject to the same review and monitoring procedures in place for other investments in determining when a decline in fair value is other than temporary, consisted of fixed maturity securities for which before-tax impairment losses of approximately $184.1 million had been recorded life-to-date. The amortized cost of these securities was $74.4 million. Approximately $85.0 million of these securities, on a fair value basis, had principal and/or interest payments past due for a period greater than one year.
The Company’s liquidity requirements are met primarily by cash flows provided from operations, principally in its insurance subsidiaries. Premium and investment income, as well as maturities and sales of invested assets, provide the primary sources of cash. Debt and/or other securities offerings provide an additional source of liquidity. Cash is applied to the payment of policy benefits, costs of acquiring new business (principally commissions), operating expenses, and taxes, as well as purchases of new investments. The Company has established an investment strategy that management believes will provide for adequate cash flows from operations.
The Company’s policy benefits are primarily in the form of claim payments, and the Company therefore has minimal exposure to the policy withdrawal risk associated with deposit products such as individual life policies or annuities. The Company’s cash flows from operations could be negatively impacted by a decrease in demand for the Company’s insurance products or an increase in the incidence of new claims or the duration of existing claims. Cash flow could also be negatively impacted by a deterioration in the credit market whereby the Company’s ability to liquidate its positions in certain of its fixed maturity securities would be impacted such that the Company might not be able to dispose of these investments in a timely manner. The Company believes its cash resources are sufficient to meet its liquidity requirements for the next twelve months.
Operating cash flows are primarily attributable to the receipt of premium and investment income, offset by payments of claims, commissions, expenses, and income taxes. Premium income growth is attributable not only to new sales, but to renewals of existing business, renewal price increases, and stable persistency. Investment income growth is dependent on the growth in the underlying assets supporting the Company’s insurance reserves and on the investment portfolio yield rates. Cash flows for commissions and operating expenses are affected by new sales growth and first year acquisition expenses associated with new business, as well as the control of administrative expenses. Cash flows for paid claims are affected by the continued growth and aging of the block of business and also by the general economy and its influence on the level of claim incidence and the duration of claims, as previously discussed in the operating results by segment.
During 2003, the Company had $152.5 million of cash outflows related to the disposition, through reinsurance ceded, of a block of policies previously sold through trade associations.
The increase in net cash used in investing activities in 2003 over 2002 is partly attributable to the Company’s $1,151.7 million increase in investments acquired as a result of the deployment of the cash generated from the Company’s combined offering during 2003. The Company generated higher proceeds from maturities of available-for-sale securities in 2003 than in 2002, primarily due to an increase in bond calls and mortgage-backed security prepayments that resulted from the lower interest rate environment. The Company received less in proceeds from sales of available-for-sale securities during 2003 compared to 2002. During 2002, the Company essentially
completed its portfolio repositioning initiated subsequent to the merger in June 1999. In 2003, the Company was more focused on investing, and its sales were primarily related to the reduction and restructuring of its below-investment-grade portfolio.
In 2002, the Company had cash outflows of $2.8 million to acquire whereiwork.
During 2003, the Company reduced short-term debt $235.0 million by repayment of reverse repurchase agreements and $20.0 million by repayment of the current portion of the medium-term notes. During 2002, the Company used $45.0 million in cash to repurchase its common stock.
Restrictions under applicable state insurance laws limit the amount of ordinary dividends that can be paid to the Company from its insurance subsidiaries in any 12-month period without prior approval by regulatory authorities. For life insurance companies domiciled in the United States, that limitation equals, depending on the state of domicile, either ten percent of an insurer’s statutory surplus with respect to policyholders as of the preceding year end or the statutory net gain from operations, excluding realized investment gains and losses, of the preceding year.
The payment of ordinary dividends to the Company from its insurance subsidiaries is further limited to the amount of statutory surplus as it relates to policyholders. Based on the restrictions under current law, during 2005, $663.3 million is available for the payment of ordinary dividends to the Company from its domestic insurance subsidiaries.
The Company also has the ability to draw a dividend from its United Kingdom-based affiliate, Unum Limited. Such dividends are limited in amount, based on insurance company law in the United Kingdom, which requires a minimum solvency margin. Approximately $152.5 million will be available for the payment of dividends from Unum Limited during 2005.
The amount available during 2004 for the payment of ordinary dividends from the Company’s domestic insurance subsidiaries was $384.8 million. Of the total available, $160.1 million was utilized. The amount available during 2004 from Unum Limited was $135.0 million, none of which was utilized.
The ability of the Company to continue to receive dividends from its insurance subsidiaries without regulatory approval will be dependent upon the level of earnings of its insurance subsidiaries as calculated under law. In addition to regulatory restrictions, the amount of dividends that will be paid by insurance subsidiaries will depend on additional factors, such as risk-based capital ratios, funding growth objectives at an affiliate level, and maintaining appropriate capital adequacy ratios to support the ratings desired by the Company. Insurance regulatory restrictions do not limit the amount of dividends available for distribution to the Company from its non-insurance subsidiaries except where the non-insurance subsidiaries are held directly or indirectly by an insurance subsidiary and only indirectly by the Company. The Company’s risk-based capital (RBC) ratio for its U.S. insurance subsidiaries, calculated on a weighted average basis using the NAIC Company Action Level formula, was 298 percent and 247 percent at the end of 2004 and 2003, respectively. The increase in the ratio during 2004 resulted primarily from strong statutory net income in 2004, the statutory gain on the sale of the Canadian branch, and capital contributions of $80.0 million. The individual RBC ratios for the Company’s principal operating subsidiaries ranged from 227 percent to 443 percent at December 31, 2004. The individual RBC ratio for each insurance subsidiary is above the range that would require state regulatory action.
During the fourth quarter of 2004, the Company filed with the Securities and Exchange Commission a shelf registration to allow the Company to issue various types of securities, including common stock, preferred stock, debt securities, depository shares, stock purchase contracts, units and warrants, or preferred securities of wholly-owned finance trusts up to an aggregate of $1.0 billion. The shelf registration, which was declared effective February 7, 2005, will enable the Company to raise funds from the offering of any individual security covered by the shelf registration as well as any combination thereof, subject to market conditions and the Company’s capital needs.
In 1998, the Company completed public offerings of $200.0 million of 7.25% senior notes due March 15, 2028, $200.0 million of 6.375% senior notes due July 15, 2005, $200.0 million of 7.0% senior notes due July 15, 2018, and $250.0 million of 6.75% senior notes due December 15, 2028.
The Company actively manages its asset and liability cash flow match as well as its asset and liability duration match in order to minimize interest rate risk. Changes in interest rates affect the amount and timing of cash flows. Asset and liability portfolio modeling is updated on a quarterly basis and is used as part of the overall interest rate risk management strategy. Cash flows from the inforce asset and liability portfolios are projected at current interest rate levels and also at levels reflecting an increase and a decrease in interest rates to obtain a range of projected cash flows under the different interest rate scenarios. These results enable the Company to assess the impact of projected changes in cash flows and duration resulting from potential changes in interest rates. The Company may redistribute its investments within its different lines of business, when necessary, to adjust the cash flow and/or duration of the asset portfolios to better match the cash flow and duration of the liability portfolios. Testing the asset and liability portfolios under various interest rate scenarios enables the Company to choose the most appropriate investment strategy as well as to minimize the risk of disadvantageous outcomes. This analysis is a precursor to the Company’s activities in derivative financial instruments, which are used to hedge interest rate risk and to match duration. At December 31, 2004, the weighted average duration of the Company’s policyholder liability portfolio was approximately 8.00 years, and the weighted average duration of the Company’s investment portfolio supporting those policyholder liabilities was approximately 7.55 years.
The Company has an agreement with an outside party wherein the Company is provided computer data processing services and related functions. Under the terms of the contract, the contract will expire in 2013, but the Company may cancel the agreement effective January 2006 or later upon payment of applicable cancellation charges. The aggregate noncancelable contractual obligation remaining under this agreement was $61.8 million at December 31, 2004, with no annual payment expected to exceed $52.1 million.
In May 2004 and again in November 2004, AM Best reaffirmed the Company’s ratings. While reaffirming the ratings in November 2004, AM Best commented that it will be closely monitoring the Company’s operations as to the impact of the multistate market conduct regulatory settlement. In this regard it noted that California conducted a separate examination and that there could be fines or remediation costs in addition to the charge announced by the Company in connection with the multistate settlement. AM Best also noted that it will be monitoring the operating results of the Company’s core group long-term income protection business. AM Best stated that the maintenance of the Company’s current ratings reflected the agency’s expectation that several key financial and operational measures would be maintained. These measures are as follows:
The Company believes that its results for December 31, 2004 are in compliance with each of these measures.
In the first quarter of 2004, the ratings from Fitch were placed under review for a possible downgrade due to concerns expressed about the Company’s fourth quarter of 2003 reserve strengthening for group income protection and the profitability for this line of business. In May 2004 and again in November 2004, Fitch reaffirmed all of the Company’s ratings but kept the ratings under review pending Fitch’s completion of an analysis of the Company’s reserves. In February 2005, Fitch completed its analysis, reaffirmed all of the Company’s ratings, and revised the outlook to stable.
In May 2004, Moody’s downgraded the Company’s senior debt credit ratings to Ba1 from Baa3 and the financial strength ratings on the Company’s insurance company subsidiaries to Baa1 from A3. The ratings outlook is “negative”. This action concluded the ratings review Moody’s initiated in February 2004. Moody’s indicated that the primary driver in the rating action was concern about the execution risk associated with the Company’s strategic plans to restore profitability to its core U.S. group long-term income protection business. Moody’s also noted that the Company had made considerable progress in improving its capital position throughout 2003. The change in the senior debt rating to Ba1 represents a below-investment-grade rating. In November 2004, Moody’s placed the Company’s senior debt credit ratings and the financial strength ratings of the Company’s insurance company subsidiaries on review for possible downgrade due to the heightened event risk associated with the issues concerning broker compensation in the employee benefit market.
The Company maintains an ongoing dialogue with these rating agencies to inform them of progress it is making regarding its strategic objectives and financial plans, as well as other issues which could impact the Company. There can be no assurance that further downgrades by these or other ratings agencies will not occur.
The long-term rate of return assumption is the best estimate of the average annual assumed return that will be produced from the pension trust assets until current benefits are paid. For the U.S. pension plans, the actual asset allocation at December 31, 2004 was 70 percent equities and 30 percent fixed income securities. The investment portfolio contains a diversified blend of large cap, mid cap, small cap, and convertible equity securities, as well as both investment-grade and below-investment-grade fixed income securities. The Company uses a compound interest method in computing the rate of return on pension plan assets. The expected long-term rate of return assumption used for the U.S. pension plan was 8.50 percent as of December 31, 2004 and 2003. Lowering the expected long-term rate of return on the plan assets by 50 basis points would have increased the 2004 pension expense by approximately $2.1 million. For 2005, lowering the assumption by 50 basis points would increase pension expense by approximately $2.4 million.
The Company holds an unrecognized net loss representing cumulative liability and asset gains and losses that have not been recognized in pension expense. As of December 31, 2004, there was an estimated unrecognized loss of approximately $318.2 million in the U.S. pension plans, compared to $268.3 million at December 31, 2003. The unrecognized loss has increased due to the decline in the year end discount rate to 6.05 percent at 2004, from 6.25 percent at 2003, and due to a change in the assumed retirement age made as of December 31, 2004. The unrecognized net loss is amortized as a component of pension expense. Only amounts outside of a corridor (equal to 10 percent of the greater of the projected benefit obligation or market related value of assets) are amortized. The 2005 pension expense is expected to include a loss amortization of approximately $19.2 million. This loss amortization was $16.0 million, $18.0 million, and $1.0 million in 2004, 2003, and 2002, respectively.
The Company reported U.S. pension plan expense of $43.6 million and $41.8 million in 2004 and 2003, respectively, compared to a negative pension expense of $2.6 million in 2002.
The fair value of plan assets in the funded U.S. pension plan was $478.1 million at December 31, 2004, compared to $423.8 million at year end 2003. In recent years, the moderate increase in assets, coupled with the liability increase due to declining discount rates, has reduced the year end funding level in the plan such that it has a deficit of $176.5 million as of December 31, 2004, compared to $113.2 million as of December 31, 2003.
The Company elected to set the discount rate assumption at the measurement date for the Scheme to reflect the yield of a portfolio of high quality fixed income debt instruments matched against the timing and amounts of projected future benefits. The discount rate assumptions were 5.30 percent and 5.50 percent as of December 31, 2004 and 2003, respectively.
The Company previously maintained a separate defined benefit plan for the employees of its Canadian branch. As a result of the sale of the Canadian branch, the Company terminated the Canadian defined benefit pension plan during 2004 and recorded a curtailment loss of $0.7 million.
REPORT OF ERNST & YOUNG LLP, INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM, ON
We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control over Financial Reporting, that UnumProvident Corporation and subsidiaries maintained effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). UnumProvident Corporation and subsidiaries’ management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the company’s internal control over financial reporting based on our audit.
We have audited the accompanying consolidated statements of financial condition of UnumProvident Corporation and subsidiaries as of December 31, 2004 and 2003, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2004. Our audits also included the financial statement schedules listed in the index at Item 15(a). These financial statements and schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of UnumProvident Corporation and subsidiaries’ internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission, and our report dated March 7, 2005 expressed an unqualified opinion thereon.
Basis of Presentation: The accompanying consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (GAAP). Such accounting principles differ from statutory accounting principles (see Note 16). The consolidated financial statements include the accounts of UnumProvident Corporation and its subsidiaries (the Company). Material intercompany transactions have been eliminated. Certain prior year amounts have been reclassified to conform to current year presentation.
in other comprehensive income and reclassified into earnings in the same period or periods during which the hedged item affects earnings.
Value of Business Acquired: Value of business acquired represents the present value of future profits recorded in connection with the acquisition of a block of insurance policies. The asset is amortized based upon expected future premium income for traditional insurance policies and estimated future gross profits for interest-sensitive insurance policies, with the accrual of interest added to the unamortized balance at interest rates principally ranging from 5.35 percent to 6.38 percent. The accumulated amortization for value of business acquired was $301.3 million and $281.5 million as of December 31, 2004 and 2003, respectively. The Company periodically reviews the carrying amount of value of business acquired using the same methods used to evaluate deferred policy acquisition costs.
Revenue Recognition: Traditional life and accident and health products are long duration contracts, and premium income is recognized as revenue when due from policyholders. If the contracts are experience rated, the estimated ultimate premium is recognized as revenue over the period of the contract. The estimated ultimate premium, which is revised to reflect current experience, is based on estimated claim costs, expenses, and profit margins. For interest- sensitive products, the amounts collected from policyholders are considered deposits, and only the deductions during the period for cost of insurance, policy administration, and surrenders are included in revenue. Policyholders’ funds represent funds deposited by contract holders and are not included in revenue.
Disabled lives reserves for future policy and contract benefits on disability policies are calculated based upon assumptions as to interest and claim resolution rates that are currently appropriate. Claim resolution rate assumptions are based on Company experience. The assumptions vary by year of claim incurral and may include a provision for adverse deviation. The interest rate assumptions used for discounting claim reserves are based on projected portfolio yield rates, after consideration for defaults and investment expenses, for the assets supporting the liabilities for the various product lines. The assets for each product line are selected according to the specific investment strategy for that product line to produce asset cash flows that follow similar timing and amount patterns to those of the anticipated liability payments.
Accounting for Stock-Based Compensation: The Company has various stock-based employee compensation plans. Prior to 2003, the Company accounted for those plans under the recognition and measurement principles of Accounting Principles Board Opinion No. 25 (Opinion 25), Accounting for Stock Issued to Employees, and related Interpretations. All options granted prior to 2003 under the stock-based employee compensation plans had an exercise price equal to the market value of the underlying common stock on the date of grant.
The expense recognized in 2004 and 2003 for stock-based employee compensation is less than that which would have been recognized if the fair value method had been applied to all option awards granted after the original effective date of SFAS 123. Had the Company applied the fair value recognition provisions of SFAS 123 as of its original effective date, pro forma net income (loss) and net income (loss) per share would be as follows:
Effective January 1, 2003, the Company adopted the fair value recognition provisions of SFAS 123 and selected the prospective method of adoption allowed under the provisions of SFAS 148. SFAS 123 establishes financial accounting and reporting standards for stock-based employee compensation plans. SFAS 148 amended SFAS 123 to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. SFAS 148 also amended the disclosure requirements of SFAS 123. The adoption decreased after tax results for 2003 approximately $0.6 million.
Effective December 31, 2003, the Company adopted the provisions of Interpretation No. 46 (FIN 46), Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin (ARB) No. 51 and subsequently adopted FIN 46(R) (revised December 2003) effective March 15, 2004. FIN 46 and FIN 46(R), which supersedes FIN 46, expand upon ARB No. 51, Consolidated Financial Statements, to address financial accounting and reporting for certain entities in which a controlling financial interest cannot be identified based on an evaluation of voting interests. Transition to the provisions of FIN 46 at December 31, 2003 required the Company to consolidate four special purpose entities whose purposes are to support the Company’s investment objectives. Prior to December 31, 2003, these entities were accounted for as fixed maturity securities in the available-for-sale portfolio and carried at fair value which was derived from the fair value of the underlying assets. These entities are securitized asset trusts and contain specific financial instruments that do not include the Company’s common stock or debt. Three of these entities are trusts holding forward contracts to purchase unrelated equity securities. Each of these trusts also holds a defeasance swap contract for highly rated bonds to provide principal protection for the investments. The fair value of the underlying forward and swap contracts was $133.9 million at December 31, 2003, which was equivalent to the fair value at which they would have been reported as fixed maturity securities prior to the adoption of FIN 46. The fourth entity is a trust containing a highly rated bond for principal protection, unrelated equity securities, and several partnership equity investments. The Company contributed the bond and partnership investments into the trust at the time it was established. The purpose of this trust was to allow the Company to maintain its investment in the partnerships while at the same time protecting the principal of the investment. The fair values of the bond, equity securities, and partnerships were $61.8 million, $7.0 million, and $51.7 million, respectively, at December 31, 2003, which were equivalent to the fair values at which they would have been reported as fixed maturity securities. The adoption of FIN 46 and FIN 46(R) had no impact on the fair value of total invested assets reported in the Company’s consolidated statements of financial condition.
Adoption of FIN 46 and FIN 46(R) also resulted in the de-consolidation of a trust that currently holds $300.0 million of junior subordinated debt securities of the Company and has issued a similar amount of mandatorily redeemable preferred securities. The impact of the de-consolidation was the elimination of the company-obligated mandatorily redeemable preferred securities of subsidiary trust holding solely junior subordinated debt securities of the company included in the consolidated statements of financial condition and an increase of $300.0 million in long-term debt.
Effective January 1, 2002, the Company adopted the provisions of Statement of Financial Accounting Standards No. 142 (SFAS 142), Goodwill and Other Intangible Assets. SFAS 142 addresses financial accounting and reporting for acquired goodwill and other intangible assets. In accordance with SFAS 142, goodwill is no longer amortized but is subject to annual impairment tests. Prior to January 1, 2002, goodwill was amortized on a straight-line basis over a period not to exceed 40 years. Other intangible assets continue to be amortized over their useful lives. Transition to the provisions of SFAS 142 required the Company to complete, within the year of adoption, impairment tests of goodwill existing at January 1, 2002, measured as of that date using a fair value approach. The Company had previously, prior to the adoption of SFAS 142, used undiscounted cash flows to determine if goodwill was recoverable. Goodwill impairment is deemed to occur if the net book value of a reporting unit exceeds its estimated fair value. The Company’s reporting units are generally operating segments, as defined in Note 14, or one level below the operating segment if that reporting unit constitutes a business. The Company completed the required transitional impairment tests and determined that the carrying value of its goodwill should be reduced $11.0 million. The charge, net of a $3.9 million tax benefit, was $7.1 million ($0.03 per common share, basic and assuming dilution) and is reported as a cumulative effect of accounting principle change in the consolidated statements of operations for the year ended December 31, 2002.
During 2003, the Company entered into an agreement to sell its Canadian branch. In conjunction with the classification of the Canadian branch as an asset held for sale, the Company tested the goodwill related to the Canadian branch for impairment and determined that the balance of $190.9 million was impaired. The Company also recognized a loss of $9.3 million before tax and $6.0 million after tax to write down the value of bonds in the Canadian branch investment portfolio to market value. These two charges, which total $196.9 million after tax, were included in the 2003 loss from discontinued operations. The Company recognized an additional loss of $0.6 million before tax and $0.4 million after tax in the first quarter of 2004 to further write down the value of bonds in the Canadian branch investment portfolio to market value.
The transaction closed April 30, 2004, and in the second quarter of 2004, the Company reported a loss of $113.0 million before tax and $70.9 million after tax on the sale of the branch. Assets transferred to the buyer included available-for-sale fixed maturity securities with a fair value of $1,099.4 million (book value of $957.7 million) and cash of $31.7 million. Liabilities transferred included reserves of $1,254.8 million.
The Company retained a portion of the Canadian branch fixed maturity bond portfolio according to the terms of the transaction. At the close of the transaction, the bonds retained had a fair value of $732.9 million and a yield of 7.14 percent. These investments were subsequently redeployed to other lines of business.
Assets and liabilities for discontinued operations as of December 31, 2003, as reported in the accompanying consolidated statements of financial condition, are comprised of the following (in millions of dollars):
As previously discussed, the Company sold its Canadian branch effective April 30, 2004. Historical information pertaining to the Canadian branch is reported as discontinued operations in the consolidated financial statements and as such, the historical assets and liabilities are reported separately in the Company’s consolidated statements of financial condition. The Company retained a portion of the Canadian branch fixed maturity bond portfolio according to the terms of the transaction. Because the specific investments to be transferred to the buyer had not been identified for reporting periods ended prior to the closing of the transaction, the disclosures in Note 4 will in some instances necessarily include the total Canadian branch investment portfolio, including those transferred to the buyer at the close of the transaction, with an appropriate disclosure noting that the information includes fixed maturity securities reported separately as discontinued operations in the consolidated statements of financial condition.
The amortized cost and fair values of securities by security type are shown as follows. The fixed maturity securities reported as discontinued operations in the consolidated statements of financial condition are included in the 2003 presentation.
The gross unrealized losses on the redeemable preferred stocks and equity securities are attributable to holdings from 2 issuers and 10 issuers, respectively as of December 31, 2004 and 2 issuers and 16 issuers, respectively, as of December 31, 2003.
The following chart indicates the length of time the Company’s investment-grade and below-investment-grade fixed maturity bonds had been in a gross unrealized loss position as of December 31, 2004. The fair value and gross unrealized losses are categorized by the relationship of the current fair value to amortized cost for those securities on December 31, 2004. The fair value to amortized cost relationships are not necessarily indicative of the fair value to amortized cost relationships for the securities throughout the entire time that the securities have been in an unrealized loss position nor are they necessarily indicative of the relationships subsequent to December 31, 2004.
The Company has a significant investment in, but is not the primary beneficiary of, a special purpose entity which is a collateralized bond obligation asset trust (CBO) in which the Company holds interests in several of the tranches and for which the Company acts as investment manager of the underlying securities. This special purpose entity does not meet the consolidation requirements of FIN 46(R). The Company issued the CBO in 1998, and its purpose is to securitize high yield bonds and earn a spread over the cost of the funds from the different tranches issued. The outstanding balance of all tranches was $214.0 million at December 31, 2004, of which third parties hold $162.1 million. These third parties have no recourse against the Company. The total value of the CBO assets is $167.2 million at December 31, 2004. The Company’s maximum exposure to loss is $28.7 million, which is comprised of $25.6 million related to fixed maturity securities and $3.1 million related to a receivable for management fees at December 31, 2004.
The Company uses swaps, forwards, futures, and options to hedge interest rate and currency risks and to match assets with its insurance liabilities.
To help limit the credit exposure of the derivatives, the Company has entered into master netting agreements with its counterparties whereby contracts in a gain position can be offset against contracts in a loss position. The Company also typically enters into bilateral, cross-collateralization agreements with its counterparties to help limit the credit exposure of the derivatives. These agreements require the counterparty in a loss position to submit acceptable collateral with the other counterparty in the event the net loss position meets or exceeds an agreed upon amount. The Company’s current credit exposure on derivatives, which is limited to the value of those contracts in a net gain position, was $103.0 million at December 31, 2004.
The following table summarizes the timing of anticipated settlements of interest rate swaps outstanding at December 31, 2004, whereby the Company receives a fixed rate and pays a variable rate. The weighted average interest rates assume current market conditions.
The settlement dates of the forward contracts correspond to the settlement dates of the previously mentioned forward interest rate swap agreements. This combination of derivative instruments allows the Company to lock in the interest rate component and the credit spread component of yields on future bond purchases. The Company did not have any of these derivative contracts outstanding at December 31, 2004.
The Company has invested in certain structured fixed maturity securities that contain embedded derivatives. These embedded derivatives represent forward contracts and are accounted for as cash flow hedges. The purpose of these forward contracts is to hedge the risk of changes in cash flows related to the anticipated purchase of certain equity securities in the years 2020 through 2022.
During 2004, the Company purchased options on forward interest rate swaps in order to hedge the interest rate risk on certain insurance liabilities with minimum interest rate guarantees. By purchasing options on the interest rate swaps, the Company is able to lock in the minimum investment yields needed to meet the required interest rate guarantee on these insurance liabilities. If interest rates rise above the option’s strike rate, the Company will not exercise the option, but will instead invest at the higher rates. If interest rates fall below the option’s strike rate, the Company will exercise the option to enter a receive fixed/pay floating forward interest rate swap. In the event the options are exercised, the Company intends to settle for cash the forward interest rate swap agreements prior to commencement of the exchange of interest payments. These cash flows are hedged through the year 2006.
During 2004, the Company became responsible for the ongoing administration and management of the United Kingdom portion of the group income protection claims portfolio of Swiss Life (UK) plc (Swiss Life), and Swiss Life reinsured this portfolio to the Company. The Company also became a multi-national pooling partner for Swiss Life Insurance & Pension Company with respect to business written in the United Kingdom. The amount attributable to value of business acquired in conjunction with this transaction was $15.4 million.
During 2004, the Company sold its wholly-owned subsidiary Unum Japan Accident Insurance Co., Ltd. for $23.5 million. The Company received $18.8 million and recorded a receivable of $4.7 million due in January 2006, net of indemnification claims, if any. The Company wrote down the book value of the Japanese operation to the estimated fair value less cost to sell during the fourth quarter of 2003 and at that time recognized an impairment loss of $1.2 million before tax and $0.8 million after tax. The Company also recognized a tax benefit of $6.8 million, for a net after-tax gain of $6.0 million in 2003. In conjunction with the sale, the Company entered into an agreement with the buyer to reinsure certain existing income protection business and had a continuing presence in the operation throughout 2004.
During 2004, the Company reduced its ownership position in its Argentinean operation to 40 percent and reported a before-tax loss of $4.7 million. The Company also recognized a tax benefit of $7.4 million from this transaction, for a net after-tax gain of $2.7 million. The Company wrote down the book value of the Argentinean operation to the estimated fair value less cost to sell during the fourth quarter of 2003 and at that time recognized an impairment loss of $13.5 million before tax and $11.3 million after tax.
In April 2004, the Company completed an analysis of the assumptions related to its individual income protection - closed block claim reserves. The analysis was initiated based on the restructuring effective January 1, 2004, which reflected the individual income protection - closed block as a stand-alone segment. Previously these reserves were analyzed for the individual income protection line of business on a combined basis. Included in the analysis was a review of morbidity assumptions, primarily claim resolution rates, and claim reserve discount rate assumptions. Based upon this analysis, the Company lowered the claim reserve discount rate to reflect the segmentation of the investment portfolio between the individual income protection - recently issued business and the individual income protection - closed block business, the duration of the assets and the related policy liabilities. Based on the April 2004 analysis, in the first quarter of 2004 the Company increased its individual income protection - closed block claim reserves by $110.6 million before tax, or $71.9 million after tax, to reflect its current estimate of future benefit obligations. The first quarter 2004 change represented a 1.2 percent increase in total net individual income protection - closed block reserves as of March 31, 2004, which for continuing operations equaled $9.530 billion prior to this increase. In conjunction with this restructuring of the individual income protection - closed block business and the subsequent reserve strengthening, reinsurance, and other related adjustments, the net increase in the reserve liability reported in the preceding table for 2004 for total incurred claims was $237.9 million, $0.5 million of which was related to current year incurred claims and $237.4 million to prior year incurred claims.
In April 2003, the Company completed an analysis of its assumptions related to its group long-term income protection claim reserves. Included in the analysis was a review of active claim reserves, incurred but not reported (IBNR) reserves, and claim reopen reserves. An active claim reserve is established for future benefit payments when a claim is incurred and reported to the Company. IBNR reserves are established on claims which are estimated to have been incurred but not yet reported to the Company. Claim reopen reserves are established for those claimants who have previously recovered but who are anticipated to return to disabled status under the same disability and within a specified period of time, as contractually allowed by the disability policy. The analysis was initiated based on lower claim resolution rates observed during the first quarter of 2003. The claim resolution rate is the rate of probability that a disability claimant will recover,
A reconciliation of policy and contract benefits and reserves for future policy and contract benefits as reported in the consolidated statements of financial condition to the liability for unpaid claims and claim adjustment expense is as follows:
The net deferred income tax liability consists of the following. Certain prior year amounts have been reclassified to conform to current year reporting.
During 2004, the Company obtained a judgment in refund litigation for tax year 1984, and as a result will be entitled to a refund of tax plus interest for 1984 and for tax years subsequent to 1984 in which the Internal Revenue Service (IRS) took inconsistent positions on the deductibility of the insurance tax reserves that were the subject of the litigation and for which the Company paid tax based on the IRS’ positions. As a result of the judgment, during 2004 revenue increased by $14.0 million and results from operations increased by $26.2 million, after taxes. Also during 2004, the Company recognized tax benefits from settlements of IRS examinations of tax years 1996 through 1998. Under the settlements, the Company resolved issues raised by the IRS pertaining to calculation of insurance tax reserves and the deductibility of losses on notional principal contracts. Tax benefits of $33.1 million are included in 2004 results from operations attributable to the effect of prior year tax settlements.
Tax years through 1998 are closed to further assessment by the IRS. During 2004, the IRS continued its examination of tax years subsequent to 1998. Management believes any future adjustments that may result from IRS examinations of tax returns will not have a material adverse impact on the financial position, liquidity, or results of operations of the Company.
As of December 31, 2004, the Company’s subsidiaries had net operating loss carryforwards in the United States of approximately $552.1 million, capital loss carryforwards of $32.5 million, a foreign tax credit carryforward of $9.3 million, and alternative minimum tax credit carryforwards of $8.5 million. The majority of the net operating loss carryforwards will expire in 2019. Capital loss carryforwards of $3.2 million, $19.6 million, and $9.7 million will expire in 2007, 2008, and 2009, respectively. The foreign tax credit carryforward will expire in 2014. The alternative minimum tax credits have no expiration date.
At December 31, 2004, short-term debt consisted of $200.0 million for the 6.375% notes due in 2005 and $27.0 million for the portion of the Company’s medium-term notes due in 2005. The weighted average interest rate for the current portion of the medium-term notes outstanding during 2004 was 7.2 percent. The Company had no short-term debt as of December 31, 2003.
During the fourth quarter of 2004, the Company filed with the Securities and Exchange Commission a shelf registration on Form S-3. The shelf was declared effective on February 7, 2005. The shelf registration will allow the Company to issue various types of securities, including common stock, preferred stock, debt securities, depository shares, stock purchase contracts, units and warrants, or preferred securities of wholly-owned finance trusts up to an aggregate of $1.0 billion. The shelf registration will enable the Company to raise funds from the offering of any individual security covered by the shelf registration as well as any combination thereof, subject to market conditions and the Company’s capital needs.
In May 2003, the Company issued 23.0 million 8.25% adjustable conversion-rate equity security units (units) in a public offering for $575.0 million. Each unit has a stated amount of $25 and will initially consist of (a) a contract pursuant to which the holder agrees to purchase, for $25, shares of the Company’s common stock on May 15, 2006 and which entitles the holder to contract adjustment payments at the annual rate of 2.25 percent, payable
In 1998, Provident Financing Trust I (the trust) issued $300.0 million of 7.405% capital securities in a public offering. These capital securities, which mature on March 15, 2038, are fully and unconditionally guaranteed by the Company, have a liquidation value of $1,000 per capital security, and have a mandatory redemption feature under certain circumstances. The Company issued $300.0 million of 7.405% junior subordinated deferrable interest debentures which mature on March 15, 2038, to the trust in connection with the capital securities offering. The sole assets of the trust are the junior subordinated debt securities.
Of the $2,862.0 million of long-term debt at December 31, 2004, $575.0 million will mature in 2008, $300.0 million will mature in 2009, and $1,987.0 million will mature in 2011 and thereafter.
Interest paid on short-term and long-term debt and related securities during 2004, 2003, and 2002 was $205.2 million, $182.2 million, and $161.0 million, respectively.
A one percent increase or decrease in the assumed health care cost trend rate at December 31, 2004 would have increased (decreased) the service cost and interest cost by $0.7 million and $(1.0) million, respectively, and the postretirement benefit obligation by $14.9 million and $(13.7) million, respectively.
The Company’s funded pension plans’ weighted average asset allocations, by asset category, are as follows:
In June 2004, the Company also amended its postretirement medical plan to eliminate the premium subsidy for employees who had not reached a minimum age of 45 with minimum years of service on December 31, 2003. As a result of this amendment, the Company recorded a curtailment gain of $9.4 million before tax in the second quarter of 2004. The corresponding reduction to the accumulated benefit obligation was $3.4 million. Excluding the curtailment gain, the effect of the subsidy reduced net periodic benefit cost by approximately $1.2 million per year, beginning in the third quarter of 2004.
In computing earnings per share assuming dilution, only potential common shares that are dilutive (those that reduce earnings per share) are included. Potential common shares are not used when computing earnings per share assuming dilution if the results would be antidilutive, such as when a net loss from continuing operations is reported. For the years ended December 31, 2004 and 2003, approximately 5.6 million and 2.0 million issuable shares, respectively, related to the purchase contract elements of the units issued in 2003 and approximately 1.4 million and 1.2 million issuable common shares, respectively, for the assumed exercises of stock options and other dilutive securities were not used in the calculation of earnings per share due to the antidilutive effect when a net loss from continuing operations is reported.
Options to purchase approximately 14.4 million, 16.4 million, and 15.3 million shares of common stock for the years ended December 31, 2004, 2003, and 2002, respectively, were outstanding but were not included in the computation of earnings per share, assuming dilution, because the exercise prices of the options were greater than the average market price of the Company’s common stock. The purchase contract elements of the units issued in 2004 were also excluded from the computation for the year ended December 31, 2004 because the threshold appreciation price was greater than the average market price of the Company’s common stock.
The Company has several annual incentive plans for certain employees and executive officers that are designed to encourage achievement of specific goals. Compensation cost recognized in the consolidated statements of operations for annual incentive plans is $31.4 million, $29.9 million, and $27.5 million for 2004, 2003, and 2002, respectively.
fixed maturity securities held in trust. Virtually all of the remaining nine percent of the reinsurance receivable relates to business reinsured either with companies rated A- or better by A.M. Best Company, with overseas entities with equivalent ratings or backed by letters of credit or trust agreements, or through reinsurance arrangements wherein the Company retains the assets in its general account. Less than one percent of the reinsurance receivable is held by companies either rated below A- by A.M. Best Company or not rated.
During 2004, the Company restructured its individual income protection - closed block business wherein three of its insurance subsidiaries entered into reinsurance agreements to reinsure approximately 66.7 percent of potential future losses that occur above a specified retention limit. The reinsurance agreements effectively provide approximately 60 percent reinsurance coverage for the Company’s overall consolidated risk above the retention limit, which equals approximately $8.0 billion in existing statutory reserves. The maximum risk limit for the reinsurer is approximately $783.0 million initially and grows to approximately $2.6 billion over time, after which any further losses will revert to the Company. These reinsurance transactions were effective as of April 1, 2004. The Company transferred cash equal to $521.6 million of ceded reserves plus an additional $185.8 million in cash for a before-tax prepaid cost of insurance which was deferred and will be amortized into earnings over the expected claim payment period covered under the Company’s retention limit.
experience above Centre Re’s defined risk limit reverts back to the Company. As of December 31, 2004, the attachment point had not been reached.
The following discloses the various layers in the agreement at December 31, 2004 (in millions of dollars):
In conjunction with the restructuring of the individual income protection - closed block business, as discussed in Note 13, effective January 1, 2004, the Company modified its reporting segments to include a separate segment for this business. The reporting, monitoring, and management of the closed block of individual income protection business as a discrete segment is consistent with the Company’s financial restructuring and separation of this business from the lines of business which still actively market new products. In the past, this business had been reported in the Income Protection segment. Prior to 2004, detailed separate financial metrics and models were unavailable to appropriately manage this block of business separately from the recently issued individual income protection block of business.
business $110.6 million before tax. The impairment charges and reserve strengthening, which total $967.0 million before tax, are reported in the Individual Income Protection - Closed Block segment. The after-tax charge of $701.0 million is included in the net loss reported for the year ended December 31, 2004. See Note 7 for further discussion regarding the claim reserve strengthening.
Due to the aforementioned restructuring, effective January 1, 2004, the Company’s reporting segments include the following six business segments: Income Protection, Life and Accident, Colonial, Individual Income Protection - Closed Block, Other, and Corporate. The segments remain unchanged from the prior year reporting other than the separation of the Individual Income Protection - Closed Block from the Income Protection segment.
Selected data by segment is presented as follows. Segment information as of December 31, 2003 and for the years ended December 31, 2003 and 2002 has been reclassified to conform to current year reporting.
One purported to represent independent brokers who sold certain individual disability income policies with benefit riders that were issued by subsidiaries of Paul Revere and who claimed that their compensation had been reduced in breach of their broker contract and in violation of the Massachusetts Consumer Protection Act (the Massachusetts Act). A class was certified in February 2000. In April 2001, the jury returned a complete defense verdict on the breach of contract claim. Notwithstanding the jury verdict, the judge was obligated to rule separately on the claim that UnumProvident and its affiliates violated the Massachusetts Act. In September 2002, the judge ruled that Paul Revere violated the Massachusetts Act and awarded double damages plus attorneys’ fees. Complicating the matter was the unexpected death of the trial judge. In March 2003, a new judge was assigned to the case so the parties could proceed to conclude matters before the trial court. Subsequently, in November of 2004, the parties executed a Memorandum of Understanding agreeing in principle to settle all issues in the case. The settlement of $4.99 million dollars which includes all damages, fees, expenses and interest was approved by the court on January 12, 2005 after a fairness hearing on January 7, 2005. The settlement has been completed, and the action dismissed with prejudice.
On February 12, 2003, the first of five virtually identical alleged securities class action suits styled Knisley v. UnumProvident Corporation, et al., was filed in the United States District Court for the Eastern District of Tennessee. On February 27, 2003, a sixth complaint entitled Martin v. UnumProvident Corporation, et al., was filed in the United States District Court for the Southern District of New York, and later was transferred to the Eastern District of Tennessee by agreement of the parties. In two orders dated May 21, 2003 and January 22, 2004, the district court consolidated these actions under the caption In re UnumProvident Corp. Securities Litigation.
On November 6, 2003, the district court entered an order appointing a Lead Plaintiff in the consolidated action. On January 9, 2004, the Lead Plaintiff filed its consolidated amended complaint. The Lead Plaintiff seeks to represent a putative class of purchasers of UnumProvident Corporation publicly traded securities between March 30, 2000 and April 24, 2003. The plaintiffs allege, among other things, that the Company issued misleading financial statements, improperly accounted for certain impaired investments, failed to properly estimate its disability claim reserves, and pursued certain improper claims handling practices. The complaint asserts claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder. On March 19, 2004, the defendants filed a motion to dismiss the consolidated amended complaint, which has not as of yet been ruled upon by the court.
Discovery is stayed in each of these actions pursuant to the Private Securities Litigation Reform Act of 1995. The court entered a schedule providing for the completion of all pretrial proceedings in these actions by December 2005. The Company denies the allegations and will vigorously defend against the allegations raised by the complaints.
On July 18, 2003, Contreras v. UnumProvident Corporation, et al., was filed in the Southern District of New York. Plaintiffs allege claims on behalf of a putative class of ERISA plan participants, beneficiaries, third-party beneficiaries, or assignees of group long-term disability insurance issued by the insuring subsidiaries of UnumProvident, who have had a disability claim denied, terminated, or suspended by UnumProvident on or after June 30, 1999. Plaintiffs assert bad faith claims practices by UnumProvident in violation of ERISA. Plaintiffs seek equitable and injunctive relief to require, among other things, that UnumProvident re-evaluate all previously denied, terminated, or suspended claims. The Company denies the allegations in the complaint and will vigorously defend the litigation and any attempt to certify the putative class. This action was transferred to the Eastern District of Tennessee as part of the multidistrict litigation transfer order.
On December 22, 2003, the Tennessee Federal District Court entered an order consolidating all of the above actions other than the Taylor action for all pretrial purposes under the caption In re UnumProvident Corp. ERISA Benefit Denial Actions. Among other things, the court in that order appointed a lead counsel in the actions and directed lead counsel to file a consolidated amended complaint in the ERISA Benefit Denial Actions, which was filed on February 20, 2004. On March 26, 2004, the defendants answered the complaints in these actions, and simultaneously filed a motion for judgment on the pleadings in the ERISA Benefit Denial Actions. The court has not yet ruled upon that motion.
The parties have engaged in certain limited discovery in connection with ongoing court-ordered mediation, as well as certain discovery on the merits of the claims asserted in the actions.
On April 9, 2004, the plaintiffs in Taylor and in the ERISA Benefit Denial Actions separately filed motions seeking certification of a plaintiff class. The defendants opposed each of those motions. The court has not yet ruled upon the motions.
On April 29, 2003, the case of Gee v. UnumProvident Corporation, et al., was filed in the U.S. District Court for the Eastern District of Tennessee on behalf of a putative class of participants and beneficiaries of UnumProvident’s 401(k) Retirement Plan (“Plan”). Similar allegations were raised in Scanlon v. UnumProvident Corp., et al., filed May 16, 2003, in the Eastern District of Tennessee.
On October 2, 2003, the court issued an order consolidating these cases for all purposes. On January 9, 2004, plaintiffs filed their consolidated amended complaint against UnumProvident, several of its Officers and Directors, and several Plan fiduciaries, purportedly on behalf of a putative class of Plan participants and beneficiaries during the period since November 17, 1999. Plaintiffs allege that the named defendants violated the fiduciary provisions of ERISA by making direct and indirect communications to Plan participants that included material misrepresentations and omissions regarding investment in UnumProvident stock. Further, the plaintiffs allege the defendants failed to take action to protect participants from losses sustained from investment in the Plan’s UnumProvident Stock Fund.
The court entered a schedule providing for the completion of all pretrial proceedings in these actions by December 2005. The defendants strongly deny the allegations in the complaints and will vigorously defend the litigation.
The Company and its insurance company subsidiaries, as part of their normal operations in managing disability claims, are engaged in claim litigation where disputes arise as a result of a denial or termination of benefits. Most typically those lawsuits are filed on behalf of a single claimant or policyholder, and in some of these individual actions punitive damages are sought, such as claims alleging bad faith in the handling of insurance claims. For its general claim litigation, the Company and its insurance company subsidiaries maintain reserves based on experience to satisfy judgments and settlements in the normal course. Management expects that the ultimate liability, if any,
with respect to general claim litigation, after consideration of the reserves maintained, will not be material to the consolidated financial condition of the Company. Nevertheless, given the inherent unpredictability of litigation, it is possible that an adverse outcome in certain claim litigation involving punitive damages could, from time to time, have a material adverse effect on the Company’s consolidated results of operations in a period, depending on the results of operations of the Company for the particular period. The Company is unable to estimate a range of reasonably possible punitive losses.
On April 2, 2003, a jury in Phoenix, Arizona Federal Court in the case of Ceimo v. General American Life Insurance Company, Provident Life and Accident Insurance Company, and The Paul Revere Life Insurance Company returned a verdict of $85.6 million against General American Life Insurance Company and two subsidiaries of UnumProvident, Provident Life and Accident Insurance Company and The Paul Revere Life Insurance Company. This verdict included an award of $79.0 million in punitive damages. The Company filed all of the required post-trial motions. On September 17, 2003, the trial court ordered a reduction of the punitive damage verdict from $79.0 million to $7.0 million in punitive damages. The court’s ruling as to the reduction in punitive damages was based on the United States Supreme Court’s decision in State Farm Mutual Automobile Insurance Company v. Campbell. The remainder of the verdict was upheld, and the court awarded the plaintiff $0.6 million in attorneys’ fees. The Company has appealed the case to the Ninth Circuit Court of Appeals. The plaintiff Joanne Ceimo filed a notice of cross-appeal on October 7, 2003 seeking to reinstate the full amount of punitive damages awarded by the jury. The Company is awaiting notice of oral argument.
From time to time class action allegations are pursued, as in Jewel, where the claimant or policyholder purports to represent a larger number of individuals who are similarly situated. Since each insurance claim is evaluated based on its own merits, there is rarely a single act or series of actions, which can properly be addressed by a class action. Nevertheless, the Company monitors these cases closely and defends itself appropriately where these allegations are made.
The Company has also provided information to the NYAG regarding compensation arrangements that exist in the business of its subsidiary, GENEX Services Inc. (GENEX), which provides services for those administering workers’ compensation claims. These services are generally paid for by the employer and arranged for and administered by a third party administrator (TPA). Questions have been raised about the practices used by TPA’s in setting the terms of the services paid by the employers. The Company has been cooperating with the NYAG’s requests for information in both areas of its investigation.
On October 25, 2004, the Company received a letter from the Massachusetts Division of Insurance announcing its intention to conduct a limited scope market conduct examination to determine whether the allegations raised in the NYAG’s complaint against Marsh & McLennan are prevalent in the Commonwealth of Massachusetts. The Company has produced information requested and will fully cooperate with the Division’s conduct of this examination.
On November 3 and November 4, 2004, the five principal insurance subsidiaries of UnumProvident doing business in North Carolina received Demands for Information from the North Carolina Department of Insurance. The Demands related to the issue of “bid rigging” in the state of North Carolina as it pertains to any resident of North Carolina or any business transacted in the state of North Carolina. Each of the subsidiaries responded on December 7, 2004.
On November 12, 2004, the South Carolina Department of Insurance issued a formal Letter of Inquiry to Colonial Life & Accident Insurance Company (Colonial) seeking information relating to a range of inappropriate solicitation activities, including bid-rigging and steering business, and information on producer compensation. Colonial produced information in response to the request and intends to fully cooperate with the Department’s inquiry.
On December 8, 2004, the Massachusetts Attorney General issued a Civil Investigative Demand to UnumProvident Corporation regarding broker compensation and quoting practices in the state of Massachusetts. The Demand also makes specific inquiry into quotes provided to ULR on risks located in Massachusetts. The Company intends to fully cooperate with the Attorney General with regard to this Demand.
The Company has experienced increased market conduct examinations by state insurance departments focused specifically on its disability claims handling policies and practices. On March 19, 2003, the Company consented to the entry of an order by the Georgia Insurance Commissioner that, among other things, ordered four of the Company’s insurance subsidiaries to each pay a monetary penalty of $250,000 and to adhere to certain claims handling practices. The order also placed these four companies on regulatory probation for two years, during which period certain Georgia claims and complaints will be reviewed on a quarterly basis by representatives of the Georgia Department of Insurance. The Georgia order did not cite any violations of Georgia law or regulations.
Because of the number of market conduct examinations initiated during 2002 and 2003, the insurance commissioners of Maine, Massachusetts, and Tennessee, the states of domicile of the Company’s principal insurance subsidiaries, initiated a multistate targeted market conduct examination in September 2003 that focused on the disability claims handling policies and practices of these subsidiaries and whether they reflected unfair claim settlement practices. This multistate examination resulted in a report and regulatory settlement agreements that became effective on December 21, 2004 when the required number of participating states consented to the agreements. The examination report made no findings of violations of law or regulations. The examination identified areas of concern which became the focus of certain changes and enhancements to the Company’s disability claims handling operations and were designed to assure that each claim decision is made in a consistently high quality manner. In addition to enhancements to the Company’s claims handling procedures, the primary components of the settlement agreements include a reassessment of certain previously denied or closed claims, additional corporate and board governance and payment of a fine in the amount of $15.0 million to be allocated among the states and jurisdictions that joined the agreements. Forty-eight states and the District of Columbia consented to the settlement agreements.
On October 20, 2004, a purported class action complaint for violations of RICO, Ronald Scott Shirley v. Universal Life Resources, et al., was filed in the United States District Court for the Southern District of California. The allegations are made against ULR and several major insurers, including UnumProvident, claiming there was a conspiracy to fraudulently market, sell and administer insurance products to employee benefit plans by extracting undisclosed compensation and fees from the employers sponsoring the plans and from the participants of those plans. In November 2004, the plaintiff in the action indicated his intention to file an Amended Complaint in the action. On January 10, 2005, an amended complaint was filed and the amendment included the insertion of a new plaintiff, Cynthia Brandes. The case is now entitled, Cynthia Brandes individually and on behalf of all those similarly situated v. Universal Life Resources, et al. At a hearing on March 2, 2005, counsel for plaintiff indicated that they will file a Second Amended Complaint. Thereafter, defendants intend to file a motion to dismiss. The Company denies the allegations of the complaint and will vigorously defend the litigation.
On or about January 10, 2005, an amended complaint was filed in the case of United Policyholders, on behalf of the general public, v. Universal Life Resources, et al., in the Superior Court of the State of California, County of San Diego. UnumProvident Corporation was named as a defendant in this amended complaint. The complaint alleges violations of California Business and Professions Code section 17200 in connection with ULR defendants’ insurance brokering services and the insurance defendants’ sale of insurance to ULR customers and their employees. The complaint seeks injunctive relief and equitable relief in the form of restitution. The Company believes that this matter is particularly susceptible to dismissal because of the passage of proposition 64 in the state of California on November 2, 2004. That law required that the plaintiff in a section 17200 action be able to establish direct injury caused by the defendant. In this matter, United Policyholders has never had any business relationship with any UnumProvident subsidiary. Since UnumProvident was named as a defendant after the passage of Proposition 64, it is expected that this matter will be dismissed. In any event, the Company denies the allegations in the complaint and will vigorously defend the case.
The Company’s insurance subsidiaries’ statutory combined net income (loss), as reported in conformity with statutory accounting principles as prescribed by the National Association of Insurance Commissioners (NAIC) and adopted by the applicable state laws, for the years ended December 31, 2004, 2003, and 2002, was $607.6 million, $22.7 million, and $(209.7) million, respectively. Statutory combined net gain from operations was $662.1 million, $214.8 million, and $220.7 million for the years ended December 31, 2004, 2003, and 2002, respectively. Statutory capital and surplus at December 31, 2004 and 2003, was $4,105.4 million and $3,706.3 million, respectively.
Restrictions under applicable state insurance laws limit the amount of ordinary dividends that can be paid to the Company from its insurance subsidiaries without prior approval by regulatory authorities. For life insurance companies domiciled in the United States, that limitation typically equals, depending on the state of domicile, either ten percent of an insurer’s statutory surplus with respect to policyholders as of the preceding year end or the statutory net gain from operations, excluding realized investment gains and losses, of the preceding year.
The payment of ordinary dividends to the Company from its insurance subsidiaries is further limited to the amount of statutory surplus as it relates to policyholders. Based on the restrictions under current law, $663.3 million is available for the payment of ordinary dividends to the Company from its domestic insurance subsidiaries during 2005.
The Company also has the ability to draw a dividend from its United Kingdom subsidiary, Unum Limited. Such dividends are limited based on insurance company legislation in the United Kingdom, which requires a minimum solvency margin. The amount available under current law for payment of dividends to the Company from Unum Limited during 2005 is approximately $152.5 million. Regulatory restrictions do not limit the amount of dividends available for distribution to the Company from its non-insurance subsidiaries.
During the fourth quarter of 2004, the Company recognized a loss of $127.0 million before tax and $87.8 million after tax related to the settlement of the multistate market conduct examination. During the second quarter of 2004, the Company recognized a loss on the sale of its Canadian branch discontinued operations of $113.0 million before tax and $70.9 million after tax. Additionally, during the first quarter of 2004, the Company recognized a loss of $967.0 million before tax and $701.0 million after tax related to the restructuring of its individual income protection - closed block business. See Notes 2, 14, and 15 for further discussion.